Waiting for correction
Upwards, downwards or sideways – which way will the Euro-zone equities market move. Until now the view has been that, after moving upwards after the conclusion of the war in Iraq, equities have continued to move sideways.
Petr Kocourek, research analyst at Morgan Stanley Investment Management, says it is unclear which way the market will move next. “The main European indices all showed huge gains in the second quarter. Following the big run-up in equity values, the question now is whether the rally has further to go or whether the best is behind us.
“Earnings revisions do not appear to be improving very rapidly, except in the UK, which is seeing a pickup in revisions similar to the one witnessed in the US. On the other hand, valuations in Europe are still substantially lower than those in the US,” he says.
Rolf Elgeti and Lars Kreckel, pan European strategists at Commerzbank Securities in London, take the view that the market will continue to move sideways: “We so no clear trigger to significantly move equity markets in one direction or the other at this time.”
The lack of companies’ topline growth, a consequence of the weak economic environment and the adverse currency effects of a stronger euro was largely expected and has been offset by cost reduction, they say. “Companies have been successfully cutting costs and have thus managed to achieve respectable bottom line numbers.”
However, there is one cloud on the horizon – weak pricing. “The strong and improving figures from the various purchasing managers indices have one thing in common that worries us. The pricing component has ticked downward whereas the volume component have moved higher. This means that the margin of this recovery is lower than in previous cycles, whereas the market is pricing in a full scale recovery.
“So while we do not deny the chances of a recovery we are rather concerned about two things – how profitable is the recovery going to be and how much has the market priced in?”
A more sombre view is now gaining ground, that Euroland equities are due for a correction. Over-optimistic earnings forecasts, built on the back of the restructuring of corporate Europe, could lead to sharp downward revisions in the third quarter, dragging down the European indices with them
This is the view of Peter Schlagbauer, Euro-zone equities analyst at Raiffeisen Research in Vienna. Schlagbauer says that corporate earnings are being depressed by two factors – recessions in Germany and Italy and the impact of the stronger euro on exporting companies and financials.
“On the other hand we had a strong upward lag in the European indices in the second quarter, and the DAX was one of the strongest. In the second quarter alone it outperformed the Dow Jones Eurostoxx 50 by about 13 percentage points.” Some of this growth is because DAX is a performance index that includes dividends, he points out. “But even if you don’t count the dividends the performance gap between the DAX and the rest of Europe was still nine to 10 percentage points up to now.”
The reason for such exceptional growth, Schlagbauer says, was a fall in risk aversion in the market. This showed up on the VIX, the Chicago Board Options Exchange’s S&P 100 Implied Volatility Index. The VIX is calculated using the implied volatilities of options on the S&P100 index, and provides an indicator of overall market sentiment.
“You can see from the VIX that risk aversion was coming down. The broader market indices, the DJ Eurostoxx 50 and S & P 500, both reached their peak in June. They have not managed a further upward lag and have been consolidating since 1 August. On the other hand the Nasdaq and the DAX were still rising to further heights.
“This is an indication that the economic recovery has already been factored into prices for the third and the fourth quarters and was the driving force behind the rise in the indices up to June. But since then the fall in risk aversion has provided the driving force.
The effect of a predicted economic recovery and lower levels of risk aversion has been to inflate expectations of increased earnings forecasts, he says. “The expected earnings increases for this year are tremendously high. The expected increase for the Dow Jones Eurostoxx, for example, is 76%.”
Schlagbauer says the main reason for this high figure is the impact of the telecoms sector on the index. After writing off much of their investment in UMTS, European telecoms companies should be in much better shape than they were. Analysts expect that this year’s performance is bound to be better than the last.
“But if you don’t count on that and you look at the earnings growth expected for the Eurostoxx 50 without telecoms media and technology then there is still a net figure of 19.7% expected for this year.”
He attributes the high earnings expectations to the fact that analysts have made their forecasts from the high base. “Over the past three years we have found that bottom-up analysts tend to reduce current year earnings. This year the reduction in current earnings has not been very large so far because of the high base of last year.
“So our expectation is that within the third quarter, especially in September during the run-up to the third quarter of company results, the analysts’ expectations will come down very sharply. And this could trigger the correction that we expect, ” Schlagbauer says.
Raiffeisen Research expects the European indexes – in particular the DAX – to continue to decline until September. It is forecasting that the DAX will fall from its current level of 3,332 to 3,000, and that the Dow Jones Eurostoxx 50 will fall from its current 2,436 to 2,350. If this happens, the direction will become painfully clear – downwards.