Despite valuations in several sectors appearing stretched, stock markets continue to fly and defy any negative news that one would expect to rattle investor sentiment. As a follow-up to our previous blog on stretched valuations in international equity markets, we look into the valuations of European banks and the potential downside risk if the market corrects. While record high valuations could imply poor future performance, the earnings yield of European banks might justify further upside. For RIAs and other international equity investors, our goal is to better understand this risk-reward set-up and the potential implications for future returns.
To give you a quick snapshot, the chart below shows the MSCI ACWI Index is at all-time highs.
Meanwhile, the VIX, a measure of implied volatility and a proxy for perceived risk, is at all-time lows.
Now, let's look at the historic valuations of European universal banks (Barclays, BNP Paribas, Credit Agricole, Deutsche Bank, HSBC, ING, RBS, Société Générale, Standard Chartered).
The blue line shows that the average valuation (P/E, 1-year blended forward) of the universal banks is at a 12-year high (historical look-back period is limited due to the lack of reliable data). The orange bars show the average yearly returns of those banks. In the year of the financial crisis, the bank stocks saw an average loss of nearly -60%.
If the market corrects, what is the potential downside? Note that the banks' P/E valuations in the years up to the crisis were in the range of 6.5-8.0x (versus today's 11.6x). If stocks return to those prior valuation levels, multiples could come down -30-45%. If stocks correct to the crisis valuation level of 5.2x, that implies a multiple contraction of -55%. That doesn't mean stock returns will be down -55%; the banks saw -34% returns during the European debt crisis with similar multiple contraction as 2008. A simplistic view is that a market correction may be in the range of returns that were experienced in 2008 and 2011: between -34% and -60%. From this perspective, is there positive expected value in the European universal bank stocks next year? In the past 12 years, the only times the banks have seen positive returns between +34-60% was after severe market corrections, and when P/E valuations were near 5.0x.
Why do stocks continue to rise? This paper by the Federal Reserve Bank of Kansas City observes that high P/E ratios result in poor short-term performance, but this might only be relevant if the high P/E ratios result in lower earnings yields compared to other assets. As of December 12, 2017, we calculate the average earnings yield on these European bank stocks is 3.15%, which is still higher than the yields on almost every Western European 10-year government bond (between -0.21% and +1.69%). So perhaps, stocks still have a reason to run, but we would argue this represents little upside considering the potential downside.
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As international equity investors, the team at R Squared Capital Management (former team at Julius Baer / Artio Global) utilizes fundamental and macro analysis in our quest to correctly identify structural tailwinds and headwinds at the geographic, sector and company levels.
FROM THE DESK OF DAEIL CHA
Daeil Cha is a Partner and Analyst at R Squared Capital Management.
Prior to joining R Squared, Daeil was an Analyst at Suffolk Capital Management.
Daeil received an MBA from Columbia University and a Bachelor of Arts in Psychology, with a focus on Neuroscience, from Princeton University.
To view other RSQ team member bios, click here.