I am convinced that 2014 will go down in history as the year the European economy rose from the ashes.
Many nations in the European Union are showing signs of recovery after a prolonged economic slowdown. These slowly improving economies create profitable opportunities for savvy investors.
The question is: What's the best way to position your portfolio to capture profits from the nascent recovery?
The answer lies in the United States' financial crisis and recovery. While it isn't likely that the European recovery will be as sharp and rapid as that of the U.S., powerful investing guidance can be gleaned by studying what happened in the U.S. stock market during its dark days and recovery.
First, let's take a brief look at the European economic picture. In this year's second quarter, the 17 countries comprised in the eurozone had collective economic growth of 0.3%. That doesn't sound like much -- until you look at it in context.
This is the first overall positive signal since 2011, and its importance is magnified by the fact that the Markit manufacturing purchasing managers' index has remained above the critical 50 level through October. (I discussed the significance of PMI as a leading indicator in my 2014 outlook piece last week.)
As you can see by the chart, both the GDP and the PMI are above their critical levels and trending higher. This makes it evident that the first bullish signs of a permanent recovery have arrived.
While these are all positive signals, the numbers that have me most convinced are the European Commission's economic forecast through 2015. Nearly every EU nation's GDP is forecasted to continue growing over the next several years.
Certainly, there are a handful of reasons why this recovery might fail to gain traction. However, smart investors are starting to increase their exposure to European equities, and the markets are reflecting this fact.
Using what happened in the U.S. markets as a guide, small-cap stocks are the optimal investment for the European rebound. As seen in the U.S., small-cap stocks underperform during market sell-offs but provide outstanding performance during the initial recovery.
While you could study the European small-cap market and stock picks, this method is riskier and more difficult than simply buying one or two European small-cap exchange-traded funds. ETFs provide professional management, diversification and local knowledge to their portfolios. The slight premium paid is more than compensated for by these three factors. This is particularly true when it comes to non-U.S.-based stocks for most investors.
My favorite European small-cap ETF is the Wisdom Tree Europe Small Cap Dividend ETF (NYSE: DFE). This ETF follows the Wisdom Tree Small Cap Dividend Index and has just over $500 million in assets. I like the dual nature of this investment, as it not only benefits from the small-cap advantage but provides a dividend yield of nearly 3% to boot. It's up an impressive 38% this year.
The industrial sector makes up the majority of its holdings at just over 23%, with technology and consumer cyclicals at about 16% and 14%, respectively. Logitech (Nasdaq: LOGI) is its top holding, at just over 3% of assets, followed closely by German telecom Drillisch (traded on the Deutsche Bourse under the ticker symbol DRI), with slightly less than 3%.
Taking a look at the technical picture, DFE has been in a steady uptrend since mid-July. The price is effectively using the 50-day simple moving average as support as it climbs higher.
Risks to Consider: Despite the improvement, many eurozone nations are still at high risk. Should there be a reversal of the bullish trend, small-cap stocks will be the first to feel the heat. Always diversify and use stop-loss orders when investing.
Action to Take --> I like DFE right now, as the price has pulled back to near support at the 50-period simple moving average. Buying between $53 and $54 with stops just below $51 and a 12-month target of $65 makes solid sense.