European stocks offer a 3% yield hedge as US tech concentration hits 47%

US stocks trade at 41 times inflation-adjusted earnings, near their dot-com peak, as technology and communications stocks swell to 47% of the S&P 500. The S&P 500 slipped 0.14% to 7,543.64 on Tuesday while the Dow rose 0.89% to 52,132.01, reflecting a rotation out of megacap tech into cyclicals.

"Europe is cheap for legitimate reasons, but a lot of investors have just forgotten about it and left it for dead," said Tim Murray, a capital-market strategist in the multiasset division at T. Rowe Price Associates. "When expectations are low, there's more room for upside surprise."

The MSCI Europe index trades at less than 23 times long-term inflation-adjusted earnings — roughly half the US multiple — with technology representing just 10% of the benchmark, one-quarter its S&P 500 weight. European stocks yield nearly 3%, compared with 1.1% for the S&P 500, which has seen its dividend yield shrink from about 2% as recently as 2022. The biggest company in the European index, Dutch semiconductor supplier ASML, accounts for only 5%, versus Nvidia's nearly 8% weighting in the S&P 500 alone.

The divergence matters because US equity concentration has reached levels that historically preceded mean reversion. The S&P 500's information technology sector now accounts for 39.6% of the index, up from 6.7% in 1990, while the correlation between the S&P 500 and the Nasdaq-100 has climbed to 0.98 — meaning the two benchmarks move almost in lockstep, exposing investors to steeper losses when tech sells off.

Why Europe, Why Now

Financial stocks are the largest sector in the MSCI Europe index, followed by industrials and healthcare — a composition that offers exposure to value-oriented, cash-generating companies rather than high-multiple growth bets. European companies are improving operations with an urgency that many investors underappreciate, according to Sarah Ketterer, chief executive of Causeway Capital Management.

"The urgency with which they're improving operations and becoming more efficient is like nothing I've ever seen," Ketterer said.

The case for Europe is not without risks. The European Central Bank just raised interest rates. War continues in Ukraine. Energy prices rose an estimated 11% in May. US tariffs have hit European exporters. The US 10-year Treasury yield has climbed as the Federal Reserve begins its first meeting under Chair Kevin Warsh, with investors watching for clues on rate policy. And over the past decade, US stocks outperformed European ones by more than 150 percentage points, leaving many investors skeptical.

The Risks of Rotating

Investors have withdrawn nearly $500 million from European stock ETFs so far this year, according to FactSet, suggesting the rotation has yet to gain momentum. Moving into Europe reduces exposure to a potential collapse in AI-related stocks but raises the risk of missing out on bigger gains if the AI boom continues. A Russian attack on Eastern Europe, an oil price spike above $150 a barrel, or a sharp rise in the dollar against the euro would hit Old World stocks hard.

"The point of diversification is not to own a bunch of assets that all go up at the same time," Jason Zweig wrote in The Wall Street Journal. "If you do, they're also likely to go down at the same time."

For investors with all or nearly all of their stock money in the US, adding some exposure to Europe makes sense as a hedge — not a replacement. The S&P 500's dividend yield of 1.1% leaves little room for income, while Europe's 3% provides ballast if the AI story fails to meet expectations, said Jurrien Timmer, director of global macro at Fidelity Investments.

"If the S&P 500 goes down, they will probably go down less, because there's less price buildup that would get undone," Timmer said. "They can be a port in the storm."

This article is for informational purposes only and does not constitute investment advice.