Earlier this year we examined the contours of the recent stock market decline in the United States, by most typical measures the worst bear market since the Great Depression.¹ We found that much of the market's travails were concentrated among the information technology and telecommunications sectors, and among the largest companies in the Standard & Poor's 500 index—those megacapitalized companies whose market capitalization surpassed $50 billion. An update of this analysis in June confirmed our findings: combined, the S&P 500 index's 154 IT, telecom, and megacap stocks were responsible for the entire 33 percent decline from January 2000 to June 2003. The other 346 companies in the index actually contributed a positive 5 percent, preventing the overall average from sinking even further.

Such was the shape of the US bear market. To explore what took place in equity markets in the United Kingdom and continental Europe, we conducted the same analysis there.

Anatomy of a European bear market

Using the FTSE Euro 300 index as a proxy for top-line returns, we discovered that the European boom represented a more widespread inflation of stock price levels than in the United States. Similarly, the market's decline was harsher and affected more sectors than in the United States. In local currency terms, the European index increased even more aggressively² than the S&P 500 until the end of 1999, and then declined to an index somewhat below the US market by the end of June 2003. In both the United States and Europe, the market bubble and the subsequent decline were driven largely by changes in overall price-to-earnings ratios (P/E). The market, in short, responded more to expectations than actual business performance.

The contrast between how the US and EU markets declined can be seen even more clearly in the share price performance of the 500 largest European companies. Prior to January 2000, the median increase of European share prices stood at 21 percent per year, noticeably higher than for the United States, at 17 percent. In fact, on a sector-by-sector basis, the European equity markets significantly outperformed the US market for each sector during the bull market, even in the high-tech sectors (Exhibit 1). Unfortunately, European share prices since December 1999 have seen a massive 12 percent annualized median decline, compared to a positive 1 percent median return for the US market over the same three-and-one-half year period. This is largely because all European sectors did much worse than their US counterparts, thereby losing any ground they may have won during the bull market (Exhibit 2). And while the European high-tech sectors also performed worse than in the United States, their relative weight in the market was also much smaller and hence they contributed much less to the overall decline.

Is the European market fairly valued now?

Using the same valuation model that we used to review the US market, we found that actual P/E ratios in the United Kingdom behaved much the same way as those in the United States, deviating from a range predicted by market fundamentals only during the oil shocks of the 1970s and the new-economy euphoria of the 1990s.³ Wildly different interest rates and inflation levels across European countries would make it difficult to assemble a truly European long-term perspective on P/E valuation levels, but at least for the period that we could reasonably construct a European market environment—since 1997—it followed the same pattern as the UK and US markets. The conclusion we came to, when looking at the economic fundamentals of European countries, was that even during the bull market it was impossible to justify P/E ratios of 20 or more (Exhibit 3).⁴ Over the past few months, as with the US market, the P/Es of European markets have returned close to their fundamental range, indicating that after a period of extreme volatility, current valuations are broadly in line with economic fundamentals over the past six months.

We won't forecast near-term market direction, but given that long-term economic fundamentals have been surprisingly stable over time, we can estimate that European markets will generate around 6.5 to 7.0 percent real returns over the next ten years. In Europe, returning to peak market levels is likely to take a bit longer than in the United States largely because the bull market rise was stronger in Europe, and the decline steeper.

Why might Europe's markets have acted as they did? Among the many possible reasons for the differences in the European and US bull and bear markets, a few seem most likely. One could be a pervasive overoptimism among Europeans in the late '90s, looking forward to the potential benefits of the European monetary unification and the expected additional growth and productivity from further market integration. After the bubble burst, overoptimism may actually have swung in the other direction, resulting in an even deeper downturn when compared to the US market. One could also argue that investors expected European corporate incumbents to capture more new-economy benefits than US incumbents because venture capital for start-up companies in Europe was not as available as it was in the United States. Finally, European investors may have used the P/E levels of the tech driven US market as a reference for European valuations without fully realizing how much more modest the role of technology and telecom was in Europe's markets.

Europe's bull market was more bullish and its bear market more bearish, than those in the United States. But the value of Europe's stock markets now appears to have returned to long-term fundamental levels.