(Bloomberg) -- Investors are betting that Europe will drive the next leg of the global equity rally, broadening their playbooks as a more expensive US market evokes memories of the dot-com bubble.

Hedge funds are now the most exposed they have ever been to European stocks relative to a global benchmark, according to Goldman Sachs Group Inc. data. Mutual funds have also amped up allocations to the region’s equities by the most since June 2020, a recent survey by Bank of America Corp. showed.

The prospect of “Europe’s outperformance against US stocks certainly has legs,” Paul Brain, deputy chief investment officer of multi-asset at Newton Investment Management, said in an interview in London. “US big tech seems fully priced and may run into headwinds from competition and regulation after the recent rally.”

Euro area shares have risen by around 4% in March, outpacing their US peers, and investors expect them to keep climbing if a rebound in economic growth revitalizes corporate profits. That’s as the artificial intelligence fervor gripping the US market makes the fortunes of the S&P 500 Index increasingly reliant on a group of relatively expensive tech stocks.

Hedge funds’ allocation to Europe versus the MSCI All-Country World Index reached 5.8% overweight last week, the highest level on record, according to the Goldman Sachs data.

Despite Europe’s gains this month, its benchmark Stoxx 600 Index still looks cheap. Its forward 12-month price-to-earnings ratio of about 14 is only slightly higher than its long-term average, according to data compiled by Bloomberg. Even excluding richly valued tech stocks, the S&P 500 is in expensive territory.

Europe’s heavier weighting in more cyclical sectors could work in its favor as economies such as Germany and the UK look set to dodge a prolonged recession and global growth picks up. Any easing in interest rates could also help.

“As interest rates come down and we get this soft landing, the opportunity for broadening out into some more cyclical parts of the market is improving,” Goldman Sachs’ Peter Oppenheimer said on Bloomberg TV. Tech stocks will perform well, but the strategist sees “better relative valuation opportunities outside the US.”

A drastic reduction in short positioning also shows sentiment toward European stocks is improving, according to S&P Global. Estimated short positions on the region were cut to less than 0.2% of total market capitalization at the end of last year, the lowest level in at least a decade, and have remained near that level since.

BlackRock Inc.’s EMEA iShares team including Karim Chedid and Laura Cooper are seeing signs that funds from clients are making their way back to Europe.

“We’ve leaned into Europe from a tactical momentum perspective,” they said in an interview. “We’re seeing some flows coming back, including from US investors, so we’ve been warming up.”

The BlackRock team remains overweight US stocks on a longer-term outlook, betting on more gains related to artificial intelligence. Other market participants are convinced of a sustained rally in US stocks as they expect large-cap names to continue to deliver on earnings growth.

Going by track record, European equities have been underperforming their US peers relentlessly since the aftermath of the global financial crisis, with brief periods of relative recovery. The last significant episode of outperformance lasted about four months, between October 2022 and March 2023, and saw the Stoxx 600 beating the S&P 500 by more than 12 percentage points over that period.

The US is also expected to see strong earnings growth this year. Analysts see profits at S&P 500 firms rising 8.3% in 2024, while Stoxx 600 earnings are projected to grow 4%, according to data compiled by Bloomberg Intelligence.

Still, this offers room to catch up, said Nicolas Simar, a senior equity fund manager at Goldman Sachs Asset Management. “There could be some interesting opportunities in the European market,” he said.

--With assistance from Julien Ponthus and Thyagaraju Adinarayan.

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