The rising US dollar is hurting US stocks – another reason to buy Europe

US markets took a painful knock yesterday.

The Dow Jones dived by almost 400 points at one point, and ended down around 1.7%.

Small wonder.

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A wide range of multinationals, from Microsoft to DuPont, warned that weakening global growth and the surging dollar would hit profits this year.

But there's a bigger issue. US stocks are simply too expensive.

What the Cape ratio says about stock markets today

Cape for the uninitiated stands for cyclically-adjusted price/earnings ratio.

A normalprice/earnings (p/e) ratiois the share price divided by current or predictedearnings per share. Ittells you how much you're paying for a given level of earnings.

As a rule of thumb, the lower the p/e, the cheaper the share for example, a p/e of 7 basically means that for every £1 of annual earnings the company makes, you're paying £7. If earnings stay at that level, you'll have made your money back in seven years. So all else being equal, that looks more attractive than a p/e of 20.

Trouble is, earnings don't stay the same every year. They go up and down. And some companies and sectors offer more of a rollercoaster ride than others. In boom and bust sectors like housebuilding or mining, you can hit peak profitability one year, then be reporting a loss the next.

So a p/e that looks cheap on the basis of peak earnings is going to look a lot more expensive (or even meaningless) when the business cycle turns and earnings plunge.

How do you take account of that? That's where the Cape comes in. It doesn't just take earnings for one year it takes ten (or even 20 in some cases) and averages them out. The idea is that you smooth out' the company's earnings cycle. As a result, the Cape gives a much better idea of whether a company is actually cheap or not, rather than being at a specific point in the business cycle.

Incidentally, the Cape is better known for being applied to markets, but this idea of average earnings is something that Benjamin Graham (the father' of value investing) thought should be applied to individual stocks too.

Anyway - the Cape is by no means a perfect timing measure. All you can say about it is that when it's high, your future long-term returns (we're talking ten years here) are likely to disappoint. And when it's low, you're likely to do well.

So there isn't a single number that screams "buy NOW!" or "sell NOW!"

But then, such a number doesn't exist. The point is, if you're the sort of investor who prefers to buy markets when they're cheap rather than when they're expensive (and if you're buying for the long term, you should be), then the Cape is a useful tool.

The US is pricing in too much good news; Europe too much bad

That doesn't mean the gap is going to close tomorrow. But what it does sum up, as Shiller put it, is that the US is priced for a future in which earnings remain very high, whereas Europe is pricing in a much gloomier future.

A value investor might say that there's a margin of safety in European stocks that just isn't there in the US. A margin of safety matters. Because none of us can predict the future. So you don't want to be in a share or market where your returns depend on everything going your way.

Yesterday, we got some of the first signs that the US view of things might be a bit too rosy. The strong US dollar has dented earnings at everyone from machinery giant Caterpillar to the likes of computing group Microsoft and consumer-goods blue chip Procter & Gamble.

Apple, of course, reported record-setting earnings after the market closed which should buoy spirits today but even if you're not an Apple fan, I think you'd have to acknowledge that Apple is a very unusual company. And even Apple said its results would have been even better without "fierce foreign exchange volatility".

We can expect this to continue. And for a market that's priced for good news, any sort of bad news even relatively predictable stuff like this can hit confidence hard.

Sure, there's a good chance that the strong dollar might make the Federal Reserve reconsider its view on interest rates. We'll get a better idea of just how rattled the Fed is tonight.

But for now, with currency wars erupting across the world following the European Central Bank's quantitative easing (QE) decision, it's going to be hard to keep the US dollar down.

It's also worth remembering that no central bank has really acknowledged that currency weakness is a desirable side effect or even a target of QE. If the Fed re-enters the fray now in the absence of obvious economic weakness in the US it's going to have some tricky explaining to do.

In short, as I've been suggesting for a while now, I'd still be happier investing in cheaper markets like Europe (and Japan) than in the US, and I'd also stick with US dollar-earning stocks in the UK.

We've got more on the implications of eurozone QE in the latest issue of MoneyWeek magazine, out on Friday. If you're not already a subscriber, act right now you can currently get eightissues free, but that offer ends tomorrow, and we'll be back down to four. So don't put it off any longer!