European stocks could be top performers in 2011

Fears are growing of a Lehman part two in the eurozone in the next 12 months. But if that happens, European stocks could be the major outperformers overseas.

In the credit crunched autumn of 2007, the worst of the major stock indices over two years was Japan. Despite strong exports, Japan had participated minimally in the boom during the middle of the decade following its own banking crisis in the late 1990s.

According to Financial Express, the Japanese Topix returned less than the MSCI Emerging Markets, DJ Euro Stoxx 50 and S&P 500 indices in either local currency or sterling terms to November 24. The latter ranked one to three over two years.

However, over the next 12 months, the order reversed. Japan came first, America second, Europe third and emerging markets fourth.

Owing to its previous woes, Japan was not overvalued. As the credit crisis started in America, American markets had done more to price it in. Europe had yet to suffer as much as America, but the markets by now realised the entire developed world was contaminated to an extent.

The only place the credit crunch was not priced in was emerging markets, which investors still said could decouple from the developed world’s problems.

As the sovereign debt crisis heats up in the autumn of 2010, the broad discrepancies look similar. (article continues below)

Over two years to November 23, emerging markets have outperformed massively, deemed to have enough firepower to decouple from the problems in the eurozone and America.

In second place is America’s S&P 500. Although America’s state and municipal debt and mortgage markets are suffering, the federal government bond boom has not ended – yet.

In third place is Japan, which has more public debt than America and an even more difficult economy.

In fourth comes the eurozone, which despite strong exports is pricing in a local debt crisis.

If the debt crisis spreads Lehman-like to other areas of the world, European stocks may soon look like the most realistically valued overseas market, just as Japan did in hindsight in November 2007.

Performance for the other markets could reverse in a similar manner: the more optimistic over two years, the harder the fall over one.

Not that any of them, in a Lehman scenario, would make positive returns.