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Nicholas A. Vardy, CFA

Feb. 9, 2015, 11:03 a.m. EST

How to profit from Europe’s surprise bull market

By Nicholas A. Vardy, CFA

If you look at the headlines, the contrast between the U.S. and European economies could hardly be greater.

Last week's Bloomberg Business Week has a roaring American Bald Eagle riding a Harley Davidson motorcycle. The article celebrates the American economy's flexibility and the savvy of U.S, policymakers at the height of the financial crisis.

In contrast, Tuesday's Financial Times in London features an awkward picture of Greece's new radical leftist prime minister clad in a leather jacket alongside his buttoned up U.K. counterpart in front of Number 10 Downing Street. The British Chancellor was urging his Greek counterpart — a self-avowed Marxist — to "act responsibly" to avoid "the greatest risk to the global economy."

Neither of these images wants to make you open your checkbook and invest in Europe.

Yet, the performance of the U.S. and European stock markets in 2015 tells a different story.

So far this year, the Europe ETF MSCI Vanguard (PSE:VGK)  is up by 2.58%. That compares with a 0.72% loss for the SPDR S&P 500 ETF (PSE:SPY) .

The major European stock markets are performing even better. The iShares MSCI Germany ETF (PSE:EWG)  is up 4.85% and the i Shares MSCI France ETF (PSE:EWQ)  has gained 3.29%.

If it weren't for the collapsing euro, you'd already looking at close to double-digit gains in each of these markets less than five weeks into the New Year.

Why europeans stock markets will outperform the U.S. in 2015

I believe Europe's U.S. market-beating returns are just the beginning of a longer period of outperformance.

This prediction may leave you scratching your head

After all, the Old Continent is on the verge of entering recession. Sixteen eurozone economies reported falling prices in December alone. And many major European economies are burdened with serious structural challenges.

And, of course, as last week's headlines confirm, you never know the wrench Greece is ready to throw into the works.

But look below the surface, the outlook for European stocks isn't as negative as most investors think. Here's why...

First, there's the issue of valuation. European stocks are simply cheaper than those in the United States. According to Morgan Stanley, European stocks have not been this cheap relative to the U.S. since 1979 when Jimmy Carter occupied the White House.

Based on the cyclically adjusted price/earnings (P/E) ratios — Nobel Prize-winning economist Robert Shiller's favorite measure — European stocks currently trade at nearly a 40% discount to U.S. equities. That compares with an average historical discount of 10%.

Second, a 40% discount to U.S. stocks could be justified if European companies had lousy earnings. But that's not the case. Although their economies are stagnant, European corporate earnings are expected to grow by 10% in 2015. That compares to 6% to 8% earnings growth in the United States.

This marks the first time European companies have outpaced U.S. stocks since 2008.

European stock markets' ace in the hole

Of course, cheap stocks can remain cheap for a long time.

So the real upside for European stocks comes from the European Central Bank (ECB) recent introduction of quantitative easing (QE). Recall that QE boosted has both the U.S. and Japanese stock markets over the past few years.

After years of hemming and hawing, ECB announced in mid-January that it plans to spend over €1 trillion buying bonds. I'm betting that the current round of QE in Europe is just the start of long commitment to QE. After all, European banks still have €1 trillion in losses left on their books before the inflationary impact of QE kicks in. So the size of the current program will hardly make a dent in the problem.

All this is good news for European share prices.

QE has been always a big boon to financial assets. As the extra QE funds get recycled, prices of assets like European stocks and property will be bid up.

And with European stock markets both "under-owned and under-loved," there is a lot more upside in European assets compared to a fully valued U.S. market.

How to deal with a collapsing euro

The euro already has plummeted 16.05% against the U.S. dollar over the last year. And with the introduction of QE, the euro is likely to remain depressed for years.

On the one hand, this is a big boost to the stocks of export-oriented European companies. A weaker euro makes European exports more competitive, boosting top-line revenues in euro terms.

On the other, a weak Euro poses a challenge to a U.S. dollar investor. Over the past year, the fall in the value of the euro roughly canceled out gains in European stock markets when these were translated back into U.S. dollars.

So you need to hedge your bets on European stock against the impact of a weak Euro.

The WisdomTree Europe Hedged Equity Fund (PSE:HEDJ)  does exactly that. Focusing on European companies worth more than $1 billion that generate at least half of their revenue outside of Europe — revenue presumably boosted by a weak euro — HEDJ offers a solid fundamental bet on European stocks with a built-in hedge against the euro decline.

Leather-jacket-clad Greek Marxist Finance Ministers notwithstanding, HEDJ is already up an impressive 9.13% in 2015.

With the U.S. bull market showing signs of its age, and European stock undervalued, I believe the hedged bet on European stocks has plenty more to go.

Link to MarketWatch's Slice.