“With valuations so high, should I take my money out of the stock market?“
I hear that question all the time.
The truth is, when stocks become as overextended as they are this year, the important questions are:
- When should I exit, and…
- Where should I go next?
Make no mistake, the leading sectors of the U.S. stock market are overextended.
This chart of the Nasdaq 100 shows that the scale and speed of this year’s break from the 10-year trendline is unmistakable. The bullish divergence in the moving average convergence indicator (MACD) is unprecedented. And it’s driven by trading volumes almost twice the long-term average:
People rationalize this in all sorts of ways.
Even in a pandemic, investors are willing to pay for future earnings. A crop of technology companies actually benefits from the COVID-19 crisis. Stimulus is coming (hopefully). So are vaccines (someday).
All of these things could be true, and it still wouldn’t be a good idea to stick with what’s worked so far this year.
The problem is that U.S. stocks don’t have much room to run. The cyclically adjusted price-to-earnings ratio of the U.S. market is the highest it’s been since the beginning of 2001.
And that’s just an average of all stocks. Stay at home darling Zoom (Nasdaq: ZM) is trading at 285 times annual earnings. And don’t even talk about Tesla (Nasdaq: TSLA) — 1,200 times earnings!
As I’ve been saying all year, U.S. stocks are in a speculative boom driven by extreme Federal Reserve liquidity and TINA (there is no alternative) thinking.
But what if alternatives emerge?
They will. And then savvy investors will start taking profits on this year’s winners and shifting money into beaten-down sectors to capture the upside from their rebound…
The good news is that you can position yourself for those rebound profits in a very familiar place.
The Sick Man of Global Stock Markets?
The European stock market hasn’t gotten much love over the last decade. That’s going to change next year.
Detractors point to the continent’s unstable common policy framework. The European Union has a single currency, but no common monetary policy. Debt-hating Germans dominate the European Central Bank (ECB). Regulation-happy bureaucrats run rampant in Brussels.
For its part, the European equity market has traditionally been dominated by staid industrial firms. Compared to the U.S. and China, the revolution in new technologies seems to have passed the continent by.
All of this has made equity investors shy of the European stock market (blue line) for a while now.
Look Ahead, Not Behind
In this context, investors should heed the lesson of the French generals the German Wehrmacht steamrolled in May 1940: Prepare for the next war, not the last one.
The truth is that Europe is much better placed than the United States to bounce back quickly from COVID-19. And that will give its beaten-down stocks a strong boost. Consider some of the tailwinds:
- The EU has achieved better coordination in response to the pandemic than the U.S. After an initial uptick in the fall, most European countries have been able to reduce daily infection rates. Meanwhile in the U.S., COVID-19 is out of control. European countries’ health care systems are better positioned to distribute vaccines quickly than the fragmented and costly U.S. system.
- The ECB has finally accepted its role in supporting the continental economy. The hawkish Germans have taken a step back. And while Mitch McConnell and Nancy Pelosi play footsie around the stimulus package, the EU agreed on a $2 trillion injection starting in 2021, including a $910 billion European Recovery Fund.
- From a longer-term perspective, the European equity market is becoming more like the U.S. Finance and energy companies have declined to 10% of market capitalization. Technology is now the largest single sector in the Euro Stoxx 50 Index. Global venture capitalists have begun to nurture a pipeline of strong software startups across the continent.
All of this adds up to the likelihood that Europe will recover sooner and faster than the United States. And that will have a positive impact on its equity markets … especially since they start from a lower valuation than the overvalued U.S. market.
Act Now Before It’s Too Late
Investors have already begun to notice Europe’s short- and long-term potential
The chart below shows a four-week comparison of the SPDR Portfolio Europe ETF (NYSE: SPEU) and iShares MSCI Europe Small-Cap ETF (NYSE: IEUS) versus the S&P 500:
Now, if you were to back out from a four-week time frame and look at the same data over a longer period, U.S. stocks would be on top.
But that’s the thing about stock markets … and history.
As any French general can tell you, it’s what’s coming next that matters, not where you’ve just come from.
Kind regards,
Editor, The Bauman Letter
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