EURO STOXX 50: Here’s Why European Stocks Could Break Out

Euro_StoxxTerrible news for Europe has dominated headlines this year, dragging down indices like the EURO STOXX 50 Index and the Deutsche Boerse AG Index. The stare-down between Greece and its creditors drained nearly all the life out of European stocks, settling a cloud of pessimism around the continent.

The DAX Index is comprised of 30 blue chip German companies. The index is weighted by market capitalisation and has a base value of 1,000. The base year is 1987.

Interestingly, the DAX doesn’t simply track the stock prices of its constituent firms, but also the dividend income and reinvestment flows. This means that even in a year when capital gains were flat, the DAX could still grow. (Source: Reuters Glossary, last accessed September 17, 2015.)

On the other hand, the EURO STOXX 50 tracks more than four dozen large-cap companies across 12 eurozone countries, including Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain. (Source: EURO STOXX 50, September 17, 2015.)

Both indices had spectacular openings during the first quarter of 2015, but all the gains were lost in subsequent months. Many analysts see the pullback as a scary and off-putting event, but I see a perfect buying opportunity. Just as a reminder, here’s how well the DAX and STOXX performed between January and April:

Euro_Stoxx_Chart

Chart courtesy of www.StockCharts.com

Greece Worries Weigh on STOXX and DAX

The downturn in the EURO STOXX 50 and the DAX couldn’t be more transparent. It has everything to do with Greece. The little Mediterranean nation is a constant headache for investors, with sovereign debt issues creeping up on a yearly basis.

We’ve seen the Greek parliament crawl from crisis to crisis, but that’s not entirely their fault. Irresponsible borrowing and spending during the early 2000s built up a monstrous debt load which wasn’t actually boosting the country’s growth.

Fast forward several years and the yields on Greek government bonds were reaching unsustainable levels. Ultimately, Greece needed a bailout from the eurozone. Other members in the eurozone, namely Germany, demanded huge cuts in Greece’s domestic spending. The International Monetary Fund (IMF) joined the chorus of institutions arguing for austerity measures, and they won. Greece agreed to massive spending cuts. (Source: BBC, July 27, 2015.)

And here’s where I break with conventional wisdom. The popular story is that Greece’s attempts at fiscal responsibility failed; that they couldn’t muster the courage to gouge their budget.

But they did. At the start of 2015, Greece was making more money than it was spending, excluding interest payments. The enormous weight of Greece’s debt was the only thing pushing the country into the red.

Of course, many analysts suggest that this is necessary penance for excessive borrowing. But hold on, that doesn’t sound like analysis. It sounds like a morality lesson. Let’s not forget there are two sides to every loan, and it’s the lender’s job to access credit worthiness.

If Greece’s borrowing was so clearly irresponsible, then why did German banks continue to lend to them?

As Greek Moment Passes, SX5E and DAX Will Jump

Regardless of whose fault the crisis was, things came to a head this summer. Greece needed another bailout to pay for its debt, but without any spending cuts. The country’s creditors refused them point blank.

The resulting showdown ended in Greece defaulting on its debt and ultimately caving to creditors’ demands. As the uncertainty swept across Europe, capital fled the equity market for safer assets in the U.S.

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At their highest points in 2015, the DAX and the STOXX had gained 26.73% and 21.96%, respectively. The last several months whittled their profits to 4.76% and 3.71%.

As the fog of uncertainty lifts and investors return to their senses, we’ll see an influx of capital into European equities. If you subtract the Greek sovereign debt crisis from Europe’s growth equation, the original gains still stand.

So what does that mean? It means that both the DAX and the STOXX are at substantial discounts to their intrinsic value. Institutional investors panicked and fled because of the Greece crisis, creating a buying opportunity for the rest of us.