Value investing has a rich history dating back nearly 100 years. Many of the billionaire legends we follow are value investors. And value investors tend to be contrarian.

Value investing is contrarian at heart because, most of the time, it means buying things that are cheap or out of favor. Rather than looking for the most popular investment or the hottest area of the market, great value investors tend to do the opposite. They look for investments that are unloved, or boring, or suffering from temporary problems.

This has proven to be a great strategy over the long-term. But it comes with a built-in flaw: Many value investors, even the great ones, tend to be too early when they decide to buy.

We see this over and over with certain members of the billionaires’ club. They will see a wonderful investment idea and add it to their portfolio.

And then whatever they bought will stay in the Stock State Indicator (SSI) red zone for six months, or twelve months — or sometimes even longer. And then, finally, the position starts to see gains. But only after a long wait.

This pattern, which happens time and time again, is a problem for investors who don’t like “dead money” tying up their portfolio capital as an investment goes sideways (or drips downward) for long periods of time. But the problem has a simple solution.

When a smart value investor that you follow buys something in the red zone, keep an eye on it. But then be patient and wait for the trend to change. Let it come back to the green zone, or at least the yellow zone, before making an investment.

In 2019, we may get the chance to make money this way — possibly a lot of money — in a currently beaten-down area of global markets: European equities.

European equities have been underperformers for a long time. They have lagged U.S. equities for seven out of the past nine years. And 2018 has mostly been more of the same.

There are logical reasons for this. The U.S. economy has been stronger than Europe’s. And U.S. markets have benefited from the huge outperformance of the FANG stocks, for which no counterpart exists in Europe.

Now, though, U.S. equities are seen as highly overvalued relative to European equities. And the FANGs are starting to cool off in a big way. Those factors could help reverse the trend.

At the same time, European equities have been bruised and battered by a run of high-profile problems in 2018. Events in Britain, France, and Italy have all made investors nervous or even nauseous. But those storm clouds could lighten, too.

And if the ugly headlines go from “bad” to “less bad,” European equities could rocket higher in 2019, largely because smart value investors and large institutional investors have been eyeballing the cheap valuations (especially relative to the U.S.) and wanting to buy.

Below, you will find a selection of European equity ETFs. As you can see, they are all in the red zone. That red zone status is telling us not to act prematurely here. We would want to see a return to green zone status to start building any positions. But it’s not too early to put this idea on the radar screen.

European ETFs in the SSI red zone
You will notice that the volatility quotient (VQ) is relatively low for all the ETFs listed above. That is another factor in European equities’ favor. When volatility levels rise from a low base — and the trend is rising at the same time — that is an extremely bullish combination. Again, this isn’t happening yet. But it’s something to watch for.

Investors are increasingly worried about U.S. equities right now. But there are good things happening in the world overall, and with the FANGs taking up less of the spotlight, investors could take notice.

For example: World profitability has been rising, as you can see from the below chart via JP Morgan Asset Management:

World profitability has been rising
The headlines out of Europe have been awful, and this is another factor making European equities cheap.

But the short-term bearish news is a potential source of bullishness, once the storm-clouds have passed: Ugly news can discount the value of assets, making them cheaper to buy, which enables more of a price rise later.

In the final weeks of 2018, there are three negative stories dominating investor sentiment in Europe. The first is the chaotic state of “Brexit”; the second is a flare-up of violent protests in France; and the third is worries over the Italian budget and the risk of a new EU fiscal crisis.

The Brexit negotiations are truly wild, so much so that nobody knows how things will turn out. The possibilities range from a disastrous “no-deal” Brexit, in which goods pile up at the borders and economic disaster follows to a last-minute negotiation of “soft” Brexit to a new referendum and the whole thing being called off (no Brexit at all).

Of those three outcomes, only a “no-deal” Brexit would be horrible for European equities. The others would likely produce a sigh of relief. There is a similar calculus with the populist protests in France and worries over the Italian budget. It’s possible that either of those events turns into a worst-case scenario and spins out of control.

But the greater likelihood is that the storm will pass — or in some way go from “bad” to “less bad” in the eyes of investors — at which point cheap European valuations could be seen as a great buy relative to expensive U.S. ones.

As we explained from the beginning, this isn’t a call to action right away. It’s more like the situation where one of the billionaires we follow makes a big investment in a stock that is still in the red zone. The thing to do is take notice, and then watch and wait. And finally, if the backdrop still looks good, take action as things move back to yellow and green.

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Richard Smith, PhD
CEO & Founder, TradeSmith