Since peaking last year, in the wake of Covid-19, stock markets around the world have been falling. A mix of persistently high inflation, rising interest rates and increased odds of a global recession have rattled markets and undone most of the stockpiles of gains accumulated after the March 2020 low.
The 2020-2021 rally has put stocks on stretched valuations, especially tech stocks. But, after a 23% drop since the start of the year, the S&P 500 offers some opportunities, particularly in certain sectors. However, the best opportunities are not in the United States, but in Europe. While macroeconomic conditions in Europe are not supportive, markets are mostly undervalued. Many trade at price-earnings (PE) ratios below 10x, providing long-term opportunities for investors. This is the case of Austria, Germany, Greece, Italy and Norway.
In March 2020, at the height of the pandemic, the PE ratios for the US, UK and European markets stood at 18.7x, 13.2x and 12.6x respectively. The rapid market recovery thereafter pushed these ratios to 31.3x, 22.4x and 21.4x in June 2021.
However, a mix of unfavorable conditions contributed to a further drop in prices and these ratios were reduced to 18.6x, 14.1x and 11.5x. The current numbers are similar to those seen during the peak of the pandemic. PE ratios currently stand at 9.5x, 8.4x, 7.3x, 6.2x and 3.4x for Germany, Norway, Italy, Austria and Greece, respectively, as measured using Thomson Reuters Datastream country indices.
These numbers represent good value opportunities for investors looking to accumulate stocks for long-term performance. The current crisis is certainly far from over, but it will not last forever and stock prices are already reflecting recession-induced discounts. In terms of US sectors, Communication Services, Materials and Energy are trading at the lowest price ratios.
Measure PE in relative terms
Not all indices and industries are equal. The PE ratio for tech stocks is typically much higher than for utilities. At the country level, their ratios are also very different. For example, over the past 40 years, the average PE ratios for the US, UK and Japan have been 18x, 15x and 34x respectively. However, it is difficult to compare these figures in absolute terms, as they reflect very different markets, each with its own characteristics.
One way to overcome the problem is to look at these numbers in relative terms. If we standardize the numbers, we get a better measure that gives an idea of where a market is. Standardizing the PE ratio involves subtracting the mean and dividing it by the standard deviation. PE ratios have zero mean and one standard deviation. It is then easy to interpret its meaning. A number around zero is neutral, a large positive number indicates overvaluation and a large negative number indicates undervaluation.
My data shows significant negative figures for Austria (-2.28), Italy (-1.98), Greece (-1.83) and Germany (-1.78). These markets are trading at a low PE in historical terms. Even though Austrian stocks are currently trading 23% above March 2020 levels, they look undervalued as earnings rise faster.
[insert four-countries]
In Italy, the political instability which resulted in the victory of a far-right party in the legislative elections contributed to the downward trend of the market. The last time it traded below the current PE of 7.3x was during the Global Financial Crisis (GFC). In Germany, the situation is similar. The current PE of 9.5x is higher than other markets but still very low in historical terms. In March 2020, the PE ratio was 11.7x and the lowest value observed over the last 40 years was 9.4x during the sovereign debt crisis in 2011 (and in 2003). In Greece, the current PE is 3.4x, the lowest PE in my data in absolute terms and close to the numbers seen in the country during its 2014 sovereign debt crisis. But the current turmoil is far from be close to what the country went through at the time.
While economic conditions are deteriorating in Europe, they are much better than those experienced during the GFC and the sovereign debt crisis. The job market is on much better footing and the European Central Bank now has more leeway to prevent a country from defaulting. From a value perspective, I think Austrian, Italian, Greek and German stocks are interesting. The prices reflect a deep crisis and long-term investors have an opportunity here.
Stocks from the aforementioned four countries are at the top of my list, but the undervaluation is present across the globe right now with a few exceptions. European countries and Japan are among the most undervalued countries. Australia and Hong Kong also offer value opportunities. However, Ireland looks overvalued and countries like the US, Portugal, New Zealand and the UK are neutral. PE ratios in the US and UK are currently at record highs of 18.6x and 14.1x, which are significantly higher than PE ratios in most European countries. In standardized terms, these ratios are converted to 0.02 and -0.27, which are neutral readings.
Looking at US sectors, the standardized PE measure picks Materials, Communication Services and Energy as the most undervalued sectors, currently showing negative values. On the overvalued side are utilities, industries and consumer staples. On this list, Materials and Utilities both show a number greater than one standard deviation (in absolute terms), but at opposite ends of the valuation.
put it all together
The current market correction is not over as inflation remains at very high levels around the world, forcing central banks to continue on the path of raising interest rates. These higher rates come at an unfavorable time due to the war in Ukraine and the unfolding energy crisis.
However, some markets are trading low in historical terms, especially in Europe. Austria, Italy, Greece and Germany offer investors very good long-term investment opportunities. Japanese and Australian stocks are also trading low. This opportunity is not reflected in the UK and US, where PE ratios look neutral.
Despite the price corrections seen in recent months, stocks in these countries have been pushed too high with stretched valuations and could fall further. To capture the value of US equities, investors should select market segments such as stocks in the materials, communications services and energy sectors that offer the best value. Utilities, a traditional defensive sector, has already been pushed too far and offers no value.
Investors looking for ways to invest in the above countries and sectors have several options in the world of ETFs. Some suggestions for investing in Austria, Germany, Italy and Greece include iShares MSCI Austria (NYSEARCA:EWO), Global X DAX Germany (NASDAQ:DAX), iShares MSCI Italy (NYSEARCA:EWI) And Global X MSCI Greece (NYSEARCA:GREK). For a US sector tilt, my suggestion is the ETFs Vanguard Materials (NYSEARCA:VAW), Energy (NYSEARCA:VDE) and Communication Services (NYSEARCA:VOX). There are many other options in the market, but these are good in terms of diversification and fees charged.
