The stabilization of the European economy last year was encouraging for global markets, and in the second half of 2013 many investors quickly acted on these green shoots by allocating more than $20 billion to European-focused exchange-traded funds (ETFs) in their search for investment opportunities.1 With continued positive economic growth readings at the end of last year and leading indicators signaling further expansion during 2014, sentiment among investors continues to build positive momentum.

Positioning for Earnings Recovery

One reason to have a continued positive view of European equities is that the current stage of the economic cycle—being very early in the economic recovery—may imply that the earnings cycle is about to ramp up to a higher gear. For investors who share this view, it may be beneficial to increase their allocations to small caps, which had higher growth expectations than their large-caps peers2 and typically provide more exposure to the economically sensitive sectors.

Ned Davis Research (NDR) has created a model to help determine the relative attractiveness of European small caps compared to large caps. The model calculates a composite score by looking at a combination of fundamentals, economic indicators and technical indicators3 to determine the relative attractiveness of European small caps.

Europe Cap Model

Small Caps Displayed Strong Momentum – The top chart compares the performance of European small caps as represented by the MSCI Europe Small Cap Index against large caps and mid-caps as represented by the MSCI Europe Large Cap Index and MSCI Europe Mid Cap Index. The chart moving higher means small caps are exhibiting stronger relative performance. This relative strength of small caps, visible through the line’s upward trend, is typically a positive technical signal.