Recent market activity shows us that investors seem to be deeply divided on the answer to the above question. Over the past year the main U.S. stock index, the Standard & Poor’s, or S&P, 500, reached a new high $2,134.72 (€1,968.39), while CNN reported that American cash was flooding into European equities markets—$3.9 billion (€3.6 billion) in just one week in late March.
The conventional wisdom is that American stocks are less stable, which makes them more liquid, while European stocks are more stable, which makes them more secure. This thinking might explain the recent flow of money from America to Europe. Some investors are skeptical of the U.S. markets and are searching for something more secure. So who is correct here—those that concentrate their investments in Europe, those that buy U.S. equities, or the people that buy both?
The Case for American Stocks
The classic case for American stocks is a very simple one that a lot of people are familiar with: U.S. markets generate far more liquidity because of their vast size and concentration. The American stock market’s ability to generate liquidity is enormous.
The market capitalization of all the stocks traded on the two major U.S. bourses, the New York Stock Exchange and the NASDAQ, was $27.1 trillion (€24.41 trillion) at the end of May 2015, CNN Money reported. In contrast, the largest European market, the Euronext, had a market cap of $3.5 trillion (€3.16 trillion).
Those looking for liquidity would be well advised to send their money to New York. One U.S. company, Apple Inc. (NASDAQ: AAPL), reported a market capitalization of $700.07 billion (€630.52 billion) on June 30, 2015.
One reason why American stocks are so liquid is that the fund managers that control most of the trades usually reinvest all or most of their profits in stocks. Many American companies also go out of their way to boost shares’ liquidity. During the first quarter of 2015, Apple spent $4 billion (€3.6 billion) on stock buybacks and paid out $3.1 billion (€2.79 billion) in dividends. The American stock market, it seems, is geared towards the generation of liquidity at all costs.
The Case against American Stocks
The cost for such liquidity can be a high one however; on June 1, 2015, economist Nouriel Roubini, aka “Doctor Doom,” warned of a liquidity time bomb in a Guardian editorial. Roubini believes that highly liquid markets like the one for U.S. stocks are inherently unstable.
He pointed to the “Flash Crash” of May 2010, when U.S. indices lost 10% of their value in 30 minutes, as an example of such volatility. Roubini also believes that much of the liquidity in the American stock market is actually created by U.S. government policy, namely quantitative easing, in which the U.S. Federal Reserve deliberately keeps interest rates extremely low to stimulate the economy with cheap money. Like many observers, he thinks that any increase in U.S. interest rates would lead to “severe market illiquidity” and a massive drop in U.S. stock values.
Like a number of observers, Roubini is also worried about the influence of so-called high frequency traders—mostly pension and other fund traders that use computer algorithms to trade massive amounts of stock at once on the market. He even thinks markets could be illiquid without them.
“Indeed, trading in the US nowadays is concentrated at the beginning and the last hour of the trading day, when HFTs are most active; for the rest of the day, markets are illiquid, with few transactions,” Roubini wrote.
The Case for European Stocks
The classic case for European stocks usually goes something like this: European companies and markets are tightly regulated, which greatly reduces the amount of risk involved in stock trading.
One classic argument is that given European regulations, you would never see an Enron in Europe. Enron was a well-respected U.S. energy trading company that used a variety of accounting tricks to hide massive losses in the late 1990s before collapsing completely in December 2001. Many Americans blamed the deregulation of the U.S. energy markets and lax financial reporting standards for the collapse of the company. Enron attracted a great deal of attention because it was one of the most visible U.S. stocks of the late 20th century.
Tighter regulation and a smaller market do make for a higher level of stability on European bourses. One side effect of this is that companies are more responsive to individual investors because there is less institutional money at play. That can reduce liquidity because private investors are less likely to sink profits back into the market.
Lack of liquidity also makes for less of the risk that Mr. Roubini and others like to warn us about. Money is less likely to flow quickly out of markets like the German DAX during a sudden downturn.
The Case against European Stocks
The major case against European stocks is a simple one: They are too conservative. Tighter regulation and lower amounts of liquidity make companies less risk adverse, which can lead to stagnation as well as stability.
With less liquidity, companies and institutional investors are less likely to engage in activities that boost stock values, such as buybacks. Values are more likely to remain constant, which discourages the flow of money into the market, reducing liquidity even further.
The same circumstances that would discourage a European Enron would also discourage a European Google. Highly speculative ventures, which usually lead to the most liquidity in stocks, are actively discouraged in Europe, even as American markets often encourage such activity to sometimes ridiculous levels.
The Case for Diversification
Not surprisingly, investors will want to manage risks and increase liquidity by investing in both American and European stocks. Such an individual might buy a highly liquid U.S. stock like Amazon.com Inc. (NASDAQ: AMZN) and invest any gains from it in a traditionally stable European equity such as Volkswagen (OTC: VLKAF).
The obvious benefit here is that a person could enjoy increased liquidity but convert that liquidity into something more secure. Such an investor could theoretically reap the best of both worlds by holding a highly stable European offering and more liquid American shares.
A second and more conservative strategy would be to hold a few select American and European shares. A person might buy and hold American tech stocks, which historically generate lots of liquidity, and German auto stocks, which are inherently stable for example; the idea being that the stability of the German shares would offset the volatility of the American ones.
The Case against Diversification
The obvious argument against such transatlantic diversification is that there is no guarantee that European stocks would be stable enough to compensate for American volatility.
For example, Google Inc. (NASDAQ: GOOG), one of the most liquid of American stocks that had been fairly stable for the first half of 2015, saw dramatic gains and losses in July 2015. The search engine company was trading at $556.11 a share on July 10, 2015. That price rose to a dramatic $699.62 on July 17 then fell back to $658.68 on July 27, 2015. No amount of stability could compensate for such inherent volatility.
Which Stocks to Buy?
There is no easy answer to the question we asked at the beginning. American and European stocks both have their advantages and disadvantages.
An investor would be better served by asking the important question “What do I want the stock to do for me?” before buying on either side of the Atlantic. A person in search of liquidity and a higher long-term gain would be better served by American stocks. Someone looking to protect capital from losses would be better off in European markets.
Both investors would be advised to avoid diversification. The contradictions it creates can nullify the strengths of both European and American stocks.