Irrational? Yes, but there's mileage yet in Europe's party

The past two years have seen a massive re-rating of European equities on the back of improved investor sentiment. But this has had nothing to do with improving results for the region’s companies. Expectations for earnings growth, the ultimate determinant of share prices, have pretty much halved since the beginning of the year.

In terms of what has driven the growth in markets, it has been valuations of low quality and peripheral country stocks, a sign that the gains are not the result of sustainable growth but of relief at Armageddon deferred and hopes for a wave of US-style money printing.

Last week’s historic move by the ECB to stave off a Japanese-style deflationary slump sees Europe’s belated arrival at the easy-money party that the US, Japan and Britain have been enjoying for many years now. This will undoubtedly be good for risky assets such as shares in the short term.

The combination of low growth, low interest rates and low inflation has been good news for the owners of assets. They have got significantly richer since the financial crisis, allowing them to reinvest their profits in other financial assets, pushing prices ever higher.

In the years after 2008, it was hard to argue against this virtuous circle. Higher asset prices were a necessary prop to the global economic recovery and valuations were so low rising markets were simply returning to normality.

It is much harder to argue that most financial assets are cheap today. In some areas they are quite highly priced and in parts of the market we are already seeing signs of excess. One that stands out is the market in new listings, where the quality of companies looking to float is worryingly poor. It is no coincidence that both Neil Woodford and Fidelity’s Alex Wright warned in the past few days that they are steering clear of most floats.

If you think that this is a counsel of despair, however, it is not. Or at least it is not yet. The reason is that, as Mr Greenspan discovered in the three years that followed his speech, markets can detach themselves from fundamentals for extended periods before they collapse under their own weight.

One of the consequences of a new era of eurozone monetary largesse will almost certainly be an upsurge in corporate activity. More takeovers will continue to fuel the increasing disconnect between share prices and earnings we have seen over the past two years in Europe.

This is an extremely uncomfortable time to be an investor. But as Keynes rightly observed, the market can stay irrational longer than you can remain solvent. This feels like a moment to go with the flow.

Tom Stevenson is an investment director at Fidelity Worldwide Investment. The views expressed are his own. He tweets at @tomstevenson63

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