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Small caps are making big moves, especially after the Federal Reserve decided this week to leave short term interest rates unchanged.
If the Fed and many economists are correct, the economy has turned the corner and the stock market should start reflecting the pace of economic growth six to nine months down the road. That's why they call the stock market a "leading" indicator - theoretically, it predicts the economy's future. And small-cap companies are generally on the leading edge of that forecast, rising and falling more than larger stocks in bull and bear markets.
And we've been on one heck of a rally since the start of this year, as the stock market has managed to defy gravity. Large cap indices such as the Dow Jones Industrial Average and the S&P 500 have gained more than 11 percent and 12 percent respectively, but small-cap benchmarks are doing far more.
The Russell 2000 and S&P 600 Small Cap Index have posted year-to-date returns of 22 percent and 18 percent respectively, although both of those indices arguably have broader-than-usual ranges for their sectors. Small-cap companies under the traditional definition have market values of no more than $500 million, but the largest Russell 2000 component is worth more than $1 billion, and the S&P 600 has an upper limit of about $900 million.
Regardless of how high you set the limit for "small," there's no question that most small cap companies are less established and have little analyst coverage. They are usually more illiquid and volatile than blue chips, but they can also grow faster -- and therein lies their appeal. But investors must do their homework to uncover those diamonds in the rough.
Many small caps could be diamonds right now, especially after being beaten down during the recent three-year bear market. The survivors are efficient, having tightened their belts in an effort to control costs during the lean years. It follows that their earnings could grow, reflecting the revenue boost from a growing economy.
Because small caps are inherently volatile, most investors looking to play that sector should look for mutual funds that specialize in small caps, or buy a basket of individual stocks to hedge their bets. And as usual, diversify -- never put all your eggs in one small cap basket. Include them in a portfolio that has some large and mid-cap stocks as well.
Find out more about "small" investing on this week's Wall $treet Week with FORTUNE broadcast, when we'll talk to small-cap fund managers Jim Oberweis and Kevin Kennedy, and newsletter expert Mark Hulbert. The Oberweis Report has outperformed the Wilshire 5000 by more than 10 percentage points since Hulbert started tracking it; and Kennedy's Coolcat Explosive Small Cap Growth Stock Report has outpaced the Wilshire by almost 50 percent over the past four years.
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