Where to Next for the Record-Beating DAX rally?

• Dr. Jan-Carl Plagge, Head of Applied Research
  

German stocks have paced a rally in European equities this year. The benchmark DAX® Index climbed 12% in 2017 through June 19, touching a record high. Excluding dividends, the gains amounted to 9.7%.

Investors have turned more positive on European stocks, lured by the region’s relatively cheap valuations, falling support for populist parties, and an economy that’s showing signs of gathering pace, even if slowly, after years of stagnation. Germany lies at the centre of that economic recovery, helped by increased consumption at home and a strengthening outlook for key export markets.

Germany’s private sector output expanded in May at the sharpest rate in over six years. A measure of the country’s manufacturing and services activity rose last month to 57.4 from 56.7 in April.¹ A reading above 50 suggests expansion. Manufacturing new export orders grew at the fastest rate in seven years.

Rally may cool off, say strategists

Following the rally, strategy teams from Deutsche Bank to Commerzbank are warning that stock prices may struggle. Deutsche Bank predicts the DAX may fall 7.9% by year-end. Strategists at Germany’s largest bank say the global economy’s momentum may cool down, dragging sentiment down on German equities from their ‘elevated’ levels. Commerzbank sees the German blue-chip benchmark trading sideways between 11,500 and 13,000 in the next three months, from 12,889 on June 19.

To put the DAX’s performance into context, the average of 12 strategist forecasts on Bloomberg at the start of this year expected the index to reach 11,497 by the end of December 2017. That means the index is 12% above that prediction, six months ahead of time.

Valuations only slightly above averages

That said, valuations for the DAX have climbed only slightly above their recent history, suggesting there may still be room for further appreciation. The index is valued at 14 times estimated earnings, compared with an average ratio of 13.3 since 2013.

Moreover, a rally for the DAX between 2011 and 2015 only faltered once the benchmark reached a valuation of 16 times estimated earnings. The index surged an additional 27% in 2015 when it moved from a valuation of 14 times earnings – where it is now – to 16.

These ratios are supported by a resurgence in German profits. DAX companies are likely to boost earnings by 11% in 2017, according to Bloomberg data, after falling flat in 2016.

Derivatives interest on DAX

The rally in equities has underpinned demand in the derivatives market, instruments that allow investors to both bet on further gains and to protect existing holdings from drawdowns.

Open interest in DAX index futures climbed 21% in May from a year earlier, according to data from Eurex, Europe’s largest derivatives exchange. There are also Mini-DAX® futures that carry a smaller value and lower capital requirement. Options on the DAX have held around an average of 2 million contracts traded monthly.

‘Consolidation’ followed by rebound

One German brokerage suggests any retreat in the DAX would prove temporary. BayernLB expects the German index to fall to 12,300 by August, before rebounding to 13,200 – and possibly higher – by May next year, lifted by monetary stimulus from the European Central Bank, a lower euro and higher German corporate profits.

“We expect global monetary policy to remain supportive, and the global economic expansion to remain on track, underpinning the DAX and its very global companies,” said Manfred Bucher, equity strategist at BayernLB in Munich.

“We see accelerating growth in emerging markets, and stable growth in the US and in Europe,” said Bucher. “Unless that changes, market consolidations should prove to be temporary and not usher in a trend reversal on the downside.”

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¹ IHS Markit Flash Germany PMI®, May 2017.