It seems like every day there's better news coming out of the United States. Unemployment looks to be finally moving in the right direction, manufacturing output continues to increase and consumers have begun opening their wallets. While there is still plenty of uncertainty, the picture is certainly improving.

As the economy begins to show signs of real improvement, the time could be right to consider overweighting stocks likely to benefit from economic expansion. While the trend has been towards focusing on the large dividend-paying firms, small cap growth stocks could be exactly what the doctor ordered in the expanding economic environment. (For related reading, see An Introduction To Small Cap Stocks.)

Investopedia Markets: Explore the best one-stop source for financial news, quotes and insights.

Still Room to Grow
So far this year, small cap stocks as represented by the iShares Russell 2000 Index ETF (NYSE:IWM) are up about 12% YTD and are the fifth best-performing domestic "fund category." However, as the macroeconomic picture continues to improve, analysts estimate that there could be more gains in the months ahead. A new report by Credit Suisse (NYSE:CS) predicts that small caps will rise at least 3% during this current cycle and could see an additional 9% gain by year's end.

The broad measure of small caps currently trades for a forward P/E of around 15, slightly below its historical average. The investment bank points out that small caps tend to underperform when their P/E's are closer to 18. This leaves room for gains. In addition, Credit Suisse points to historical statistics for some additional gains. In years in which the Russell 2000 opens with a positive first month, the index's average full-year gain is near 17%. That jumps to a huge 24% gain when January produces a 7% or better return.

There may be some underlying fundamentals for Credit Suisse's predictions. First, the Federal Reserve is giving smaller firms a present, by keeping interest rates low for an "extended period of time." Low interest rates allow smaller firms to buy more equipment, increase hiring and produce more goods cheaply. Due to their smaller size, all of these things will quickly manifest themselves in small-cap bottom lines and revenue.

Additionally, larger firms flushed with an abundance of cash, have gone on an M&A spree. Faced with the lack of organic growth, analysts predict that the trend of "large buying small" will continue throughout the year, boosting small-cap shares. (For more information, read Valuing Small-Cap Stocks.)

Get Small
With the economies improving fundamentals, it may be time to overweight small cap firms within a portfolio. With around $7.9 billion in assets and a rock bottom 0.12% expense ratio, the Vanguard Small Cap Growth ETF (ARCA:VBK) makes an ideal broad-based choice. The fund tracks 969 different small cap growth firms including miner Royal Gold (Nasdaq:RGLD) and baker Panera Bread (Nasdaq:PNRA). So far the ETF is up around 12% for the year, but could see greater gains as "growth" could win over "value" in the expanding economy. For those willing to add more firepower to their small cap investment, the leveraged Direxion Daily Small Cap Bull 3X Shares (ARCA:TNA) could be used.

Some of the best gains could be had in technology small-caps. The acquisition environment in tech is extremely robust and most recently Oracle (Nasdaq:ORCL) offered to purchase cloud computing HR-software firm Taleo (Nasdaq:TLEO) for $1.9 billion. Analysts point to IT infrastructure software firms like SolarWinds (NYSE:SWI) and TIBCO Software (Nasdaq:TIBX) as potential targets. Tracking all the tech firms in the S&P 600 Small cap index, the PowerShares S&P SmallCap Tech ETF (Nasdaq:PSCT) can be used as a broad play on the M&A activity in the space. The fund charges 0.29% in expenses.

The Bottom Line
Given the improving economic conditions in the United States, investors may want to add a healthy dose of small caps to a portfolio. Already, smaller caps have performed well since the start of the year, but these improving conditions could help boost share prices even further. The previous ideas, along with the iShares S&P SmallCap 600 Index (ARCA:IJR), make excellent choices to play the trend. (To learn more, read Small Cap Research Can Have Big Impact.)

Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!

At the time of writing, Aaron Levitt did not own shares in any of the companies mentioned in this article.

Related Articles
  1. Mutual Funds & ETFs

    Top 3 Japanese Bond ETFs

    Learn about the top three exchange-traded funds (ETFs) that invest in sovereign and corporate bonds issued by developed countries, including Japan.
  2. Mutual Funds & ETFs

    What Exactly Are Arbitrage Mutual Funds?

    Learn about arbitrage funds and how this type of investment generates profits by taking advantage of price differentials between the cash and futures markets.
  3. Savings

    Become Your Own Financial Advisor

    If you have some financial know-how, you don’t have to hire someone to advise you on investments. This tutorial will help you set goals – and get started.
  4. Investing News

    Ferrari’s IPO: Ready to Roll or Poor Timing?

    Will Ferrari's shares move fast off the line only to sputter later?
  5. Investing Basics

    6 Reasons Hedge Funds Underperform

    Understand the hedge fund industry and why it has grown exponentially since 1995. Learn about the top six reasons why the industry underperforms.
  6. Mutual Funds & ETFs

    Top Three Transportation ETFs

    These three transportation funds attract the majority of sector volume.
  7. Stock Analysis

    5 Cheap Dividend Stocks for a Bear Market

    Here are five stocks that pay safe dividends and should be at least somewhat resilient to a bear market.
  8. Investing Basics

    Tops Tips for Trading ETFs

    A look at two different trading strategies for ETFs - one for investors and the other for active traders.
  9. Investing

    How to Win More by Losing Less in Today’s Markets

    The further you fall, the harder it is to climb back up. It’s a universal truth that is painfully apparent in the investing world.
  10. Fundamental Analysis

    Use Options Data To Predict Stock Market Direction

    Options market trading data can provide important insights about the direction of stocks and the overall market. Here’s how to track it.
  1. How can insurance companies find out about DUIs and DWIs?

    An insurance company can find out about driving under the influence (DUI) or driving while intoxicated (DWI) charges against ... Read Full Answer >>
  2. Can mutual funds invest in IPOs?

    Mutual funds can invest in initial public offerings (IPOS). However, most mutual funds have bylaws that prevent them from ... Read Full Answer >>
  3. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  4. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  5. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  6. Does index trading increase market vulnerability?

    The rise of index trading may increase the overall vulnerability of the stock market due to increased correlations between ... Read Full Answer >>

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!