The Vanguard Europe ETF, $VGK, and the European developed markets may be setup to outperform the U.S. equity market after a decade of underperformance. There are various ways to analyze this trade, and I will walk through a simple thought process to understand the risk and potential return of an overweight Europe versus U.S. equity position. First, I would like to look into the sector breakdown of each region. Below are the sector weightings of $VGK and $VTI:
The largest sector difference is in the technology sector. The U.S. has a much higher technology weighting than Europe, 20.4% versus 4.3%. On the other hand, Europe has higher weightings to materials, defensive, financials, telecom, industrials and energy.
Take a look at the super sectors to get in even higher level breakdown. Here are the super sector weightings:
Europe is overweight the cyclical and defensive super sectors while the U.S. is overweight the sensitive super sector.
Looking at the top holdings, this trade sells $AAPL, $GOOGL, $MSFT, $AMZN, and $FB to buy Nestle, HSBC, British American Tobacco, BASF, and Anheuser-Busch InBev. These American tech stocks have been some of the best performers over the past decade. This trade could be thought of simply as taking some gains on U.S. mega cap tech stocks to double down in Europe.
This trade sounds like a risk-off position, but the historical data clearly shows that Europe has been more volatile than the U.S. over the past 3 years. So Europe has had terrible returns and high volatility. This trade is a contrarian and mean reversion play against this horrible past performance.
The last graph is really the most surprising. The relative performance of the 2 regions is in stark contrast. Europe has been pretty flat for over a decade while the U.S. market has doubled. This return difference has been mainly driven by the earnings outperformance in the U.S. The U.S. valuation premium is between 7-26% which I don't view as excessive.
Which region is likely to have stronger earnings growth in the coming years? My sense of mean-reversion tells me that it will be difficult for the U.S. to continue to grow earnings faster than Europe given the magnitude of the current gap. I think Europe could easily close part of this gap over the next few years given the hurdles are set pretty low.
Europe stocks look to dethrone US counterparts as earnings beats hit 7-year high - CNBC
European Equity Barometer - Blackrock
Europe Earnings Outshine U.S. to Signal Long-Awaited Rebound - Bloomberg
Michael Grove, CFA