IEUR ETF Shows That Europe Is Nearing A Bottom

The iShares Core MSCI Europe ETF (NYSEARCA:IEUR) gives us solace, and we want to share how it does to SA readers that may be worried about current markets. US markets are a more complicated story, but we believe that we are not far from a bottom in Europe. Following simple required return logic, we think that an average 10% decline further in markets would arrive us at a pretty base case idea for fair value of European markets, which means we have a sane argument for why the market won’t completely detonate.

Thought Experiment

5.5% is typically the historical equity risk premium. Clearly, cost of equity has to rise now in order to stay ahead of risk free rates at more or less this spread. With reference rates possibly reaching 6%, that would mean that a 11% required return or so should be placed on equity markets.

Since we don’t expect earnings growth, how might we measure required returns implied by markets? Earnings yield! Without earnings growth, return and earnings yield can be equated.

Enter IEUR.

IEUR is a pretty decent representation of the European geographical region. Of course, it includes non-EU member Britain, but what matters is that all these geographies are at the locus of the energy crisis experienced as a consequence of Russia’s use of oil products for blackmail.

Key norther European economies and France feature highly, as well as the UK which still remains a major financial center in the European region, together with Switzerland. Financials feature heavily in the portfolio, and financials are actually a sector that are likely to produce some earnings growth, because both banking and insurance benefit in a higher rate environment. Therefore, the use of earnings yield might even be understating implied required returns.

Industrials is more of a mixed picture because of exposure to inflationary pressures. Healthcare and consumer staples are resilient and we like their pronounced presence in the ETF and in European economies broadly.

Remarks

Overall, the IEUR and the market valuations for its constituents well represent the distribution of industries across the European economy. For this portfolio, you get a P/E of 11x and therefore an earnings yield of almost 10%. Assuming no growth, a fairer earnings yield might be arrived at after a 10%-15% decline or so. Assuming earnings growth from financials, which represent a 16% allocation, it would be on the lower end of that range of declines, if not more.

Another way to look at it is that the IEUR has retraced back to 2016 levels. That would more or less imply that the value of these enterprises has regressed 6 years. That would seem punishment enough.

Regardless, based on basic required return logic, you can see that at least as far as Europe goes, we are beginning to get to a point where rather defensible earnings yields are nearing required returns for equity in a rate environment with 6% reference rates. More than 6% would be remarkable, and we aren’t really prepared for that, nor do we think such a thing would be necessary, although we don’t know. But with a limit of 6%, we think that the implied earnings yield is getting to price that reality in, and we do think that it’s going to be our reality. Therefore, IEUR and Europe in general is close to being a buy, and might be safe an average down now with a trickle of capital just to smooth out timing.