Why European Markets Could Double

Take the ten-year average profitability and apply it to European companies as a way to normalize earnings. And you get a market discounted below the long term moving average says Peter Oppenheimer of Goldman Sachs. The conclusion? European markets could double if valuations mean-revert.

Assuming, as we do, that ROE mean reverts to long run averages by then, we estimate the broader European market to double (420 on the DJ Stoxx 600).

This is based on the July 30th "Strategy Matters" piece, and I should highlight that there is a lot more in the piece, essentially he looks at valuations for the European markets from many different angles and couches the above call with substantial amounts of hedged statements, as he must. It's a good read for a wide audience, (thus great broker material!) since it provides a view for people of various valuation philosophies from adjusted earnings as above all the way to (ugh) the dividend discount model. (aka name your target price and work backwards from there) It's a buffet of valuation views. But overall is bullish from many angles. Also has some interesting overall historical earnings perspective in the piece, below.

The initial recoveries in profits after economic downturns tend to be very strong. As Exhibits 24 and 25 show, the first five years of profit recovery from the downturns were 127% in the early 1990s and 210% in the mid-2000s. For non-Financials it was 110% and 202%, respectively.

Looking at the chart above, here's the problem though. What if the forward earnings picture ends up looking more like the early 90's (ie many years of decline) rather than post internet bubble. If this ends up being the case, then the sharp recovery shown for 2010 could end up being overly aggressive. Put a gun to my head though, and I suspect a lot of European companies are cheap even if analyst earnings end up being a bit too optimistic. Worst case, you have mean reversion in your favor across many different valuation metrics, as shown in this latest research piece.