By Brian Swint

Germany, the biggest economy in Europe, is in a slump that it can't seem to shake. So it might seem surprising country's stocks are defying gravity.

After two years of strong gains among U.S.-listed companies, valuations may be getting stretched. Investors looking for opportunities should consider German and European stocks. The S&P 500 has gained 23% in 2024. The STOXX Europe 600 has gained just 9% since Jan. 1.

What's more, European companies are trading at a bigger discount than usual. They're trading at about 14 times earnings, compared with about 22 times earnings for the S&P 500 index. That 8-times difference is substantially larger than the traditional discount of about 3 times earnings for European stocks compared with their U.S. counterparts.

"If you look at valuations in Europe, they're still super depressed," said Maximilian Uleer, head of European equity and cross asset strategy at Deutsche Bank. "They're almost at an all-time high discount compared with the U.S."

Known as a powerhouse in industry and automobiles, Germany has been hit harder than others by the war between Russia and Ukraine, which shut off key sources of energy, and the slowdown in China, which crippled trade for manufacturers.

That's had a devastating impact on economic activity. Output shrank in 2023. This month, the government downgraded its forecast for this year to foresee another 0.2% contraction, compared with a previous prediction of 0.3% expansion. It hopes for a return to growth in 2025.

Impressive Index

Despite all that, Germany's benchmark stock index is doing just fine. The DAX hit a record last week. It has gained 17% this year and is more than 30% higher than 12 months ago.

The discrepancy is stark, but there's a reason for the disconnect. Unlike in the U.S., many foreign stock indexes don't depend much on their own local economies for growth. That's something U.S. investors may want to keep in mind when considering shopping abroad for shares.

"The German economy has been doing poorly," Uleer said. "But a lot of DAX companies make more money in the U.S. than in Germany, and that explains a big part of the success that the stock market is having."

One thing to keep in mind, though, is that the kinds of companies Germany is known for -- exporters of cars, machinery, and pharmaceuticals -- may not be doing that well and might still need to be avoided. Volkswagen, the biggest car maker, has slumped 22% this year, for example. Bayer, the pharma firm that invented aspirin, is down 20%.

Uleer points out that industrials, financials, and technology firms on the DAX have nevertheless been strong. SAP, the business software maker, is up 50% this year.

China Crisis

A big part of the German economy's problems are related to the slump in China, its fourth biggest trading partner after the U.S. and neighbors France and the Netherlands. While China's recent announcements of fresh government spending and lower interest rates may help German companies eventually, Uleer says it's too early to hope for the world's second-biggest economy to ride to the rescue.

"Germany has higher exposure to China than the rest of Europe," he said. "It's important to see if the stimulus has legs, but even if this is a turning point for the Chinese economy, it's going to take a while before anything materializes in German manufacturing."

One thing European stocks can offer U.S. investors is a pivot away from technology shares. To be fair, tech has been a major driver for the S&P and Nasdaq the past two years -- most noticeably through the performance of the large-cap Magnificent Seven companies. Because it relies more on other sectors, Europe could offer a hedge should tech start to falter.

"I'm not making the case that Europe is a better place to invest than the U.S. right now," Uleer said. But diversification is quite a big theme. Europe has more of the dynamics of the equal-weight index" of the S&P 5oo index.

Diversification and discounts are strong arguments that make European shares look more attractive right now, even if the economy across the pond isn't nearly as strong as in the U.S.

Write to Brian Swint at brian.swint@barrons.com

This content was created by Barron's, which is operated by Dow Jones & Co. Barron's is published independently from Dow Jones Newswires and The Wall Street Journal.

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October 21, 2024 01:01 ET (05:01 GMT)

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