Stocktake: Fund managers are gung-ho for Europe

Wall Street strategists have been unusually muted regarding prospects for US equities in 2016. Instead, they’re gung-ho for Europe, predicting gains of about 15 per cent for the Stoxx Europe 600 index.

The European investment case is a strong one. European equities have doubled since March 2009 but US stocks have tripled, creating a seemingly unsustainable valuation gap.

That gap closed in 2015 – Europe comfortably outperformed US indices – and momentum suggests it will narrow further in 2016. European earnings have just outperformed US earnings for the first time in five years. Additionally, US interest rates are on the rise but further stimulus is on the way in Europe.

One caveat, however: European sentiment may be too bullish. Merrill Lynch’s latest fund manager survey shows Europe is easily the most preferred region globally, with allocations way above historical norms.

Elevated sentiment can trigger steep sell-offs in the event of negative surprises, as happened last month when the ECB’s stimulus efforts disappointed investors.

In short, the case for European outperformance is a strong one, but the ride higher may be a bumpy one.

A bad year for Buffett

Last year was a bad one for

Warren Buffett

. Shares in

Berkshire Hathaway

fell 11 per cent – their worst underperformance relative to the S&P 500, which eked out small gains, since 2009.

Buffett was prematurely written off in 1999, when Berkshire shares plunged 20 per cent even as dotcom mania drove indices skyward.

In 1990, Berkshire also lost almost a quarter of its value. Both instances were soon forgotten; Buffett trounced indices in subsequent years.

Still, past periods of underperformance tended to be brief; this one has lasted seven years, Berkshire lagging the market since 2009.

Buffett would prefer to be judged over an entire market cycle, and Berkshire may well outperform when the current bull market finally ends.

However, the glory days are over. Last year, statistician and blogger Salil Mehta noted Berkshire shares rose by an annualised 30 per cent compared to 10 per cent for the S&P 500 between 1965 and 1989; over the next 25 years, annual returns fell to 14 per cent versus 10 per cent for the index.

Berkshire, now valued at $330 billion, is just too big to outperform in the manner of old. As Buffett himself admitted last year, Berkshire may well outperform the average company, “but our advantage, if any, won’t be great”.

Home bias and the Iseq

It was also a poor year for diversified investors, but you would have done very well if you had stuck to Irish stocks. The

Iseq

was one of 2015’s big winners, soaring 30 per cent and ranking ninth of 76 international indices tracked by

Bespoke Investment Group

.

That does not mean it was wise to bet the house on the Iseq. Home bias – investors’ tendency to overweight domestic stocks – is a common phenomenon. One study found that in 2008, domestic equities accounted for 54 per cent of UK investors’ portfolios, 76 per cent of Australian investors’ portfolios, 77 per cent of US investors portfolios and almost 99 per cent of Brazilian investors’ holdings.

This is dangerous behaviour. Individual stock markets can stagnate for years, even decades – Japan, Germany and France have all suffered 50-year periods where equities lagged inflation.

The Iseq might soar in 2016 and beyond, or it might chronically underperform – who knows? Whatever happens, investors should be wary about being overexposed to a tiny market dependent on a handful of stocks.

Analysts ‘optimistically wrong’

The US has suffered a profits recession – S&P 500 earnings are expected to register their third consecutive quarterly decline – but analysts expect a rebound in 2016, projecting that earnings will rise almost 8 per cent. Will they?

Unlikely. Analysts completely missed the profits recession, having predicted profits would surge 12 per cent in 2015.

This same optimism was evident in 2014 and 2013, with earnings growth barely half that forecasted by analysts.

These are not isolated examples. A 2010 McKinsey report found US analysts typically estimate annual earnings growth of 10-12 per cent, almost double the 6 per cent growth achieved over the last 25 years.

A recent study, Financial Analysts Were Only Wrong by 25%, found analyst optimism was a global phenomenon, with analysts being “optimistically wrong” by 25 per cent in their 2002-14 earnings forecasts.

Investors should assume 2016 will be no different, with analysts gradually cutting their elevated expectations as the year progresses.