Idea of the Day: European stocks at risk ahead of the ECB

The ECB meeting this coming Thursday is focussing minds on what could come next for European stocks and the euro. We believe that whatever Draghi and co. at the ECB decide to do it may not be enough to save European stocks from a pullback for a few reasons...

The ECB meeting this coming Thursday is focussing minds on what could come next for European stocks and the euro. We believe that whatever Draghi and co. at the ECB decide to do it may not be enough to save European stocks from a pullback for a few reasons:

1, Volatility: The volatility index of the Eurostoixx 50 is close to its lowest ever level. While low volatility hasn’t been a barrier to further record highs in the main US indices, domestic problems in Europe including the Catalonia crisis, the Greek debt crisis and the potential for fallout from Brexit makes European stock market volatility inherently more risky at this junction. Thus, we believe that we could see a bounce in European stock market volatility before anywhere else.

Chart 1:

Source: City Index

2, The euro: When the euro is strong. The European stock market can fall, as we saw in June and July this year when the euro surged and European stocks stumbled. Although European stocks have played catch up since September, this has happened at the same time as the EUR/USD rate has backed away from $1.20 highs. If this week’s ECB meeting triggers another surge higher in the euro then European stocks could be at risk as they were earlier this year.

Chart 2:

Source: City Index

3, Valuations: European stocks are no longer looking cheap. As you can see in the chart below, the P/E ratio of the Eurostoxx 50 index is well above its 10-year average, which could be unattractive for investors. At this mature stage of the global stock market rally, investors are looking for value, high P/E ratios are thus off-putting. We may not see demand come back for European stocks until they sell off thereby becoming better value.

Chart 3:

Source: City Index

Conclusion: Overall, there are powerful reasons to believe that European stocks could be in a precarious position. A strong euro and high valuations could work against this index, which appears to have plateaued recently at a 5-month high around 3,600. If we do see a sell off then key initial support lies at 3,475 – the 200-day sma. 

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