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A strengthening U.S. economy, a stronger U.S. dollar and an increasingly tight U.S. labour market all point to continued small-cap outperformance.

ISSEI KATO/REUTERS

The wild market swings of the past month have caused understandable investor caution on high-flying, higher-risk market sectors like U.S. small caps. But it's also true that the most successful investment stories are often contrarian and unmarketable at the outset.

There are three big reasons to believe that the Russell 2000 index of smaller companies is one of these investment ideas: A strengthening U.S. economy, a stronger U.S. dollar and an increasingly tight U.S. labour market all point to continued small-cap outperformance.

Economists have been reducing estimates for 2015 global gross domestic product growth while raising expectations for the U.S. economy. As a result, U.S. GDP growth of 3 per cent next year is expected to exceed the global average for the first time in three years.

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The relative attractiveness of the U.S. economy supports investment in small-cap companies, which are largely sensitive to domestic, rather than global, growth.

The U.S. trade-weighted dollar index – which measures the greenback against the country's major trade partners' currencies – also supports strength in the small-cap sector. The dollar index has climbed 19 per cent from 73 to 87 since 2011. The possibility of higher interest rates explains much of the move, which suggests the Federal Reserve would need to be confident enough in the positive economic momentum to remove monetary training wheels.

Value of $10,000 invested: Russell 2000 vs S&P 500

SOURCE: Scott Barlow/Bloomberg

The rising U.S. dollar is a distinct advantage for small-cap stocks relative to their multinational corporate counterparts. Smaller companies generate the vast majority of their revenue in domestic currency. Global companies receive foreign revenue that, relative to the greenback, is declining in value. On its own, this currency translation effect can cut into corporate profits for larger companies, making small caps more attractive.

Steady improvement in the U.S. civilian unemployment rate and an ongoing decline in weekly initial jobless claims make rising wages increasingly likely in the coming quarters. Consumption is local, not global, so the benefits of climbing salaries are once again a bigger help to smaller U.S firms.

The outlook is promising, and small-cap stocks have already drastically outperformed the S&P 500 in the post-crisis period. But Canadian investors should keep their exposure to U.S. small caps diversified, through ETFs such as the mammoth iShares Russell 2000 Index Fund, and as a smaller portion of their portfolios. The sector is known as "high beta" – in other words, it goes up a lot more when things are good and down a lot further when things are bad. The odds are in investors' favour, at this point, but nothing in the market is guaranteed.

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