Soon after taking office, U.S. Treasury Secretary Tim Geithner made U.S. banks undergo a stress test to see how they would fare in ever more dire economic scenarios. Almost all U.S. banks passed the test with flying colors. And as investors breathed a sigh of relief, they called their brokers to place “buy” orders. From there ensued one of the greatest bull market runs in history from the market bottom of March, 2009.

More than a year later, European regulators decided to copy that move, and sure enough, almost all European banks passed the test as well. Could a similar rally result in Europe? The answer is a qualified “yes.”

Nobody can predict or should expect stocks to post the +50%, +100% and even +200% gains we saw after March of 2009. But this is a major market hurdle, and these stress tests may be flashing a solid buy signal.

What it means (and what it doesn’t)
The key takeaway from these tests is that European banks aren’t likely to teeter and pull the whole continent into an economic maelstrom. And as long as investors can assume that the economic environment will remain generally stable, they’ll be emboldened to seek out bargain-priced stocks. But this doesn’t mean that European economic activity is about to take off. Here in the United States, even as banks got much healthier, they still kept lending activity to a minimum. Many U.S. businesses and consumers have had a tough time borrowing money, and the same will continue to be said of their peers in Europe.

Just as was the case with the stress tests, the U.S. economy has a chance of getting back on a solid growth path before Europe does. U.S. corporate profits have risen sharply in recent quarters and as corporate cash balances rise, we could see the long-awaited hiring spree we’ve all been waiting for. More jobs means more consumer spending — always a good thing. In Europe, however, job growth could remain anemic for some time.

Moving up off the lows
Using Barclays’ iShares S&P Europe 350 Index (NYSE: IEV) as a proxy, investors had already anticipated positive results from last week’s stress tests and started pushing stocks up from their lows of several weeks earlier. In early July, the index flirted with 25-week lows, hovering around $31, but is now moving toward the $36 mark. Yet the index remains more than -40% below the low $60s range seen in 2007 and P/E ratios of many European blue chips remain well below historical levels.

I remain a fan of blue chips like Diageo (NYSE: DEO), Arcelor (NYSE: MT) and ABB (NYSE: ABB), as I’ve noted earlier.

But I’m even more enamored with Europe’s small cap stocks, for one main reason. Coming out of a recession, stocks of smaller companies tend to outperform their larger peers, in large part because they were more heavily sold off going into the downturn. For example, Invesco’s European Small Company Fund (Nasdaq: ESMAX) plunged from $35 in early 2008 to $6 in early 2009. More than a year later, the fund still remains below $10.

In a recent interview with Reuters, JP Morgan’s mid-cap strategist Eduardo Lecubarri noted that the current environment is a “once in a lifetime opportunity” for investors to find real value among small/mid-cap equities, noting that more than 40% of pan-European small/mid-cap stocks, are still down more than -50% from their three-year highs and more than half of those stocks trade below book value.

Action to Take –> Risks still remain in Europe, especially if belt-tightening measures trigger a fresh recession. But it increasingly looks as if the deepest fears have been overblown.

You can play a potential rebound in one of four ways:
— Buy a U.S. multinational like Procter & Gamble (NYSE: PG) or Ford Motor (NYSE: F) that have a high degree of exposure to Europe.
— One of those European blue chips I noted earlier.
— A mutual fund like Invesco’s European Small Company Fund
— Or a low-cost index fund like the Vanguard European ETF (NYSE: VGK).