It's hard to be bullish about European equities. The economies look weak both inside and outside the euro zone and the single currency's crisis only seems to get worse. But the share prices may be discounting even more bad news.
The STOXX 50 index of leading euro zone shares has lost all the tentative gains made in the first part of this year and is standing at not much more than half the level of five years ago. The total return since then, including reinvested dividends, is a depressingly high loss of 35 per cent. In the United States, the total return of the S&P 500 over the same period is slightly positive.
Some underperformance is justified by Europe's weaker economic performance and by the euro zone's problems. The relative weakness on the eastern side of the Atlantic is reflected in earnings expectations for 2012. Thomson Reuters data indicate a 5 per cent gain in the euro zone and 10 per cent in the United States. The most recent economic news suggests the gap could widen.
But European share prices may reflect too much pessimism. European equities have usually been cheap by American standards; right now the discount of forward earnings multiple is above the post-1987 average. And not only is the 9.5 price-earnings ratio one-quarter less than the equivalent U.S. figure, it appears to discount no earnings growth at all in the next five years and no increase in valuation.
There could be big rewards for those brave enough to buy. If euro stocks' earnings rise at half the post-2005 annual rate of 10 per cent over the next five years and P/E ratios move only halfway back to the long term norm, then investors will earn inflation-adjusted annual returns of 11.6 per cent.
Euro stocks seem to discount the lion's share of the new misery. Those prepared to put their heads in the lion's mouth could come out smiling.