Bubble hunting has been a popular pastime since the real estate bubble popped in 2007-2008. Some would even say it has been in vogue since the dotcom bubble burst in 2000-2001. I prefer to date it back to tulip mania in the Netherlands in 1637, but then I am just an old traditionalist.
The fact is that overvaluing assets has always been with us. Rapid price increases are, in and of themselves, fine. Markets simply reflect the price at which a buyer and seller agree to do business. If that price is rooted in reality then how far it has moved in how short a time is irrelevant.
A problem occurs when price action and technicals get way ahead of good old fundamentals. That is what is happening now in terms of European stocks when taken as a whole. It wasn’t that long ago that all the talk was of a Euro crisis. In 2011 and 2012 the view that the Euro itself was doomed was common. As I wrote at the time, I didn’t believe that then. I still don’t think collapse of the currency is coming, but there is a major chance that the next big market disruption will emanate from across the pond.
On the surface, everything looks fine. The SPDR European STOXX 50 ETF (FEZ) is up by over one third from the low in June of last year.
It is even approaching the 5 year high of $44.42. It is as if nothing ever happened, or if it did, everything is okay now. Sovereign bond rates are sending the same message. Portugal just sold 10 year bonds at a yield of 3.725%. In January of 2012 their bonds were yielding 18.29%. Remember all of those riots in Greece? Well the Greek government sold 3 billion Euros of 5 year notes on April 10th at a yield of 4.95%. Great, you might think, problem over.
The only trouble is, it isn’t over. Greek unemployment stood at 26.2% at the end of 2012. The January reading this year was 27.5%; hardly a miraculous recovery. According to Eurostat, unemployment in Portugal, while falling, is still at 15.3% and youth unemployment in Spain is at a staggering 54.6%.
Okay, you say, so unemployment is still a problem, but that performance must mean the debt crisis is over, right? No, wrong. Again, using Eurostat's numbers, Greek government debt ended 2012 at 157.2% of GDP and by the end of last year was at 175.1%. Italy’s debt as a percentage of GDP also increased to 132.6 at the end of 2013.
The fact remains, though, that the European stock market is booming and the new debt issues of even previously struggling nations is in demand. The markets are rarely completely wrong and don’t act without reason, so what’s going on?
The stock market rise is caused by three things. Firstly, as in the US, corporate profits are increasing and are at record levels. Also as in the US, however, a large part of that is down to cost cutting rather than booming economic conditions. Secondly, the prospect of easier EU monetary policy is encouraging speculative buying. Thirdly, stock markets generally take their lead from bond markets and the signals there all say “panic over.”
I don’t believe, however, that a belief in economic recovery is what is prompting bond buyers to wade into peripheral European debt. Rather it is a belief that it is a risk free trade. The ECB and even the most fiscally conservative nation in the Union, Germany, sent a clear message in 2012. As I predicted in the article I wrote back then the collapse of the Euro is unthinkable and, however reluctantly, they are prepared to do whatever it takes to ensure its survival.
The ECB and the governments of the more financially and economically stable northern countries, however, face a problem. Bailing out the profligate peripherals is extremely unpopular. For this reason, if a bailout looks like being needed again there will be at least some tough talk. At that point the folly of a yield under 5% on the debt of a country with astronomically high debt and unemployment will be a little more evident to all.
Even if that doesn’t come about, the threat of deflation still hangs over the Eurozone. The ECB, by its very nature as a body attempting to set monetary policy for 18 disparate nations, is rarely quick to act. Decisive moves are unlikely until a problem takes hold. By that time it may be too late to stop a sharp correction in European stocks.
I am not a big one for bubble hunting, but, using the definition of an asset class that is overvalued against fundamentals, Europe, both in terms of stocks and sovereign debt, certainly fits the bill. The words “bubble” and “bursting” are probably too strong, but a correction large enough to send shock waves to other markets looks likely. I, for one, will be staying away from European assets for a while on that basis.