| Factors behind the recent decoupling of euro area stock prices from those in the US |
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| Over the past year, stock prices have posted large gains in the Euro area, while they have stagnated in the United States. The European Central Bank (ECB) have recently put forward some of the reasons why. |
Between end-December 2004 and end-December 2005, the Dow Jones EURO STOXX broad index surged by nearly 23 per cent, compared with an increase of just under 4 per cent in the Standard & Poor’s 500 index, which is surprising considering the weaker economic growth in the euro area.
In its March monthly bulletin, the ECB has suggested that a number of fundamental factors, including a more favourable development of corporate earnings, a weaker euro vis-?-vis the US dollar and more subdued interest rate increases in the euro area, may explain why the euro area stock market has outperformed that in the United States.
Starting with developments in relative profitability, according to earnings data on the Dow Jones EURO STOXX index and the Standard & Poor’s 500 index provided by Thomson Financial Datastream, earnings per share grew more strongly in the euro area than in the US in both 2004 and 2005. Earnings growth in 2005 was not only stronger in the euro area than in the US, it was also far stronger than anticipated a year earlier.
Another factor is the exchange rate. Marked exchange rate changes can affect both reported earnings and market perceptions of earnings prospects. Since the better performance of euro area equities appears to be closely related to the depreciation of the euro against the US dollar throughout 2005, the ECB suggests that it seems reasonable to assume that the latter contributed to the more favourable development of the earnings of euro area firms in comparison with those of US firms in 2005, possibly through corresponding general gains in export competitiveness.
For the purposes of gauging the impact of interest rates on stock prices, the ECB looked at long-term real yields in empirical terms. When these yields rise, stock prices – all other things being equal – typically tend to fall. The effects of discount factors on stock prices in the United States in 2005 must have been less favourable than those in the euro area. For instance, the long-term real yield on euro area inflation-linked bonds (with maturity in 2012) changed little between December 2004 and December 2005, while the real yield on comparable 2011-maturity index-linked bonds in the United States increased by about 80 basis points. Hence, it is likely that the strong increase in real bond yields roughly offset the impact of the generally positive development of earnings in the US stock market.
Moreover, euro area stock prices in 2005 may have benefited from the perception among investors that US equities entailed higher risks than euro area stocks. Throughout 2005, for example, in answer to the question as to the region in which they deemed equity markets to be most overvalued and most undervalued respectively (asked in the monthly Merrill Lynch Global Fund Manager Survey), an average net percentage of around 50 per cent of the fund managers surveyed perceived the US stock markets to be most overvalued.
For the euro area, this net percentage averaged about -16 per cent, indicating that fund managers tended to perceive the euro area stock market as undervalued. Such perceptions may have induced institutional investors, in particular, to overweight euro area equities and underweight US equities in their portfolios, thereby affecting relative stock price developments.
Overall, the better performance of euro area stock prices in comparison with those in the United States in 2005 has contributed to a levelling-off of some of the prevailing differences in stock market valuation metrics, says the ECB, such as the price-earnings ratios in the two economies, and could therefore be regarded as part of an equilibration process.
At the end of 2004, the ratio of equity prices to corporate earnings in the preceding 12 months was 20.5 for companies in the Standard & Poor’s 500 index, while – as measured for companies in the Dow Jones EURO STOXX index – it stood at 14.3 in the euro area. The relative movements of both the equity indices and the corporate earnings in 2005 brought the two price-earnings ratios still closer, to 18.5 and 15.9 respectively, at the end of the year. |
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| Article appeared in the April 2006 issue.
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