The five favorite structural valuation metrics of our European strategists – the CAPE, price to peak earnings, price to sales, market cap to GDP, and Tobin’s Q – all give the same reassuring message. European equities are at fair value, or even slightly cheap.
Based on this fair starting valuation, the FTSE100 and Eurostoxx should generate a 10-year nominal return of 10-12% a year, using the very close inverse relationship between the cyclically-adjusted price to earnings multiple (CAPE) and the subsequent 10-year nominal return.
True, since the 1980s, equity market earnings per share have benefited from a structural uptrend in profit margins. Such a tailwind may have added around 1.5% points a year to equity market returns. This boost will not last indefinitely, so a more prudent assumption would be that the 1.5% tailwind becomes a 1.5% headwind, lowering the prospective 10-year return to around 7% a year.
Compared to this conservative 7% prospective annual return from European equities, we know for certain that 10-year government bonds will return 2% in the U.K. and 1.7% in the euro area. Therefore, current valuations are discounting a prospective 10-year equity risk premium (ERP) of 5%.
Estimates vary for what a fair ERP should be, but in the U.K. the realized ERP over the past 40 years is around 3.5%. On this basis, Europe’s 5% equity risk premium appears attractive. It is also much greater than that available in either the U.S. or Japan.
Bottom Line: European equities are priced to generate very respectable 10-year nominal returns.
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