Catch-up time for European markets

Pan-European indices have advanced just 3 per cent in 2014, compared with double- digit percentage gains in the United States. Might 2015 see a reversal of that trend?

US valuations relative to Europe have “turned outright expensive”, JPMorgan cautions, with the valuation differential now greater than at the peak of Europe’s debt crisis in 2012.

This is partly because European earnings have been terrible – the gap between the two regions has never been greater – but a rebound is overdue. The gap is already closing, says JPMorgan, with earnings revisions in the US no longer much better than those in Europe.

The same point is made by Credit Suisse. Awful European earnings allow huge room for improvement. It expects the Euro Stoxx 50 to gain 14 per cent next year, with the best- case scenario being a mighty 25 per cent advance.


Analysts have already endured a Godot-like wait for a European upturn. Still, the potential for European upside is obvious, while the US keeps getting more expensive. Betting on an eventual normalisation of relative valuations seems wise. Stocks to hit bubble levels US stocks will continue advancing next year, says veteran investor Jeremy Grantham (inset), with the Federal Reserve engineering a "fully fledged bubble" that will be followed by the third market crash in 15 years. Grantham, who manages $120 billion at GMO, notes in his latest client letter that the third year of a presidential cycle tends to be very strong for stocks. Overpricing, he adds, "has had no material effect" on third-year returns, so today's heady valuations are unlikely to derail the bulls.

Grantham has been on the money for some time, saying 12 months ago that stocks were “badly overpriced” but likely to gain another 20 to 30 per cent over the next two years. Equities have since gained 15 per cent.

Bubbles are followed by crashes, and Grantham expects GMO’s equity weighting to be below 20 per cent by the time prices peak. With no region especially cheap, he predicts a “purgatory of low returns” over the next seven years.

Grantham called the crashes of 2000 and 2007 and has been hugely successful over the last four decades. Investors nearing retirement age can only hope that this time his pessimism is unwarranted.

Volatility dormant, not dead Still awake? Traders could be forgiven for nodding off, given the S&P 500 recently rose or fell by less than 0.1 per cent on five consecutive days – the tightest five-day trading range in 50 years.

Additionally, it seems investors have decided market declines are a thing of the past, given the S&P 500 has gone more than four weeks without a one-day decline of more than 0.3 per cent. The index has been above its 5-day moving average for more than a month, the longest streak in history.

October was very volatile, with the Vix index briefly spiking to near-panic levels, making the recent action even more extraordinary.

It’s very rare to see a V-shaped recovery from volatility outbreaks. Markets usually calm down over a period of months. In this case, October’s fear has simply vanished.

Clearly, the 5½ -year bull market has further room to run.

However, even the strongest rallies are usually characterised by frequent pullbacks; volatility is surely dormant, not dead.

Fund managers' career risk Many active funds are little more than closet index funds, with managers often electing to hug the index in order to play it safe.

And little wonder. A new State Street report reveals 54 per cent of institutional investors fear they could lose their job if they underperformed over a period as short as 18 months.

Most money managers – 72 per cent – believe their bosses use a one-to-three-year time frame to measure their performance. Additionally, more than 60 per cent of investors would move to a more conservative portfolio if theirs fell 20 per cent in a year.

Everyone in the business talks about long-term goals but freaks out over short-term underperformance.

It’s hardly surprising, then, that herding is such a feature of financial markets, and that managers were buying tech stocks at the peak of the dotcom bubble and selling dirt-cheap stocks during the 2008-2009 global financial crisis.

Such decisions may seem dumb, but doing the right thing might just cost them their jobs. In numbers 675 Apple's market capitalisation hit an all-time high of more than $675 billion last week, making it more valuable than stock markets in Russia, Italy and Brazil.

914 S&P 500 companies will likely spend $914 billion of their $964 billion in profits on buybacks and dividends in 2014. 600 The number of billions of dollars in fees collected by active managers in 2014, according to State Street – equal to Switzerland’s gross domestic product. Just 18 per cent have beaten the market this year.