Those who follow small-cap stocks like to say that if the Dow sneezes, small companies catch the flu. This little adage is actually quite accurate. Since the Dow failed to hold onto its new highs in summer 2007, the panic that proceeded reverberated down to the tiniest stocks on the market.

Indeed, microcap securities caught a horrible bug. The Russell 2000, a closely followed small-cap benchmark, fell from a high of 855 in July 2007 to the low 690s in January 2008. It wasn’t until the index tested support in the 650s in March that it began to recover…

For the small-cap investor, the best returns across the board come during rapid periods of recovery out of a falling market. Traditionally, small caps lead market comebacks in a big way. And judging by the recent strong performance of the NASDAQ and the Russell 2000, we could be witnessing a return of the bulls -- at least in the short term.

According to one research firm, the stars have aligned to form the perfect conditions for microcaps to surge.

When analyzing the performance of his microcap index over the past 60 years, Alpha Plus Advisors President Marvin Bolt found three main factors that contributed to its performance: inflation, growth in U.S. gross domestic product and changes in the dollar exchange rate.

The Alpha Plus data shows that the strongest microcap returns have actually been during periods of higher inflation, which it quantifies at between 3-5%. This bit of data goes against Wall Street’s common knowledge, since large caps have suffered during similar periods of higher inflation.

Bolt’s data also show real GDP growth produces superior performance among smaller stocks. In contrast, the worst environment for the microcap stock index was when the U.S. dollar’s value was falling.

The conclusion one can draw from this information is compelling. It appears inflation is actually good for microcaps, while a rapidly falling dollar tends to benefit larger companies that are competitive in overseas markets.

Anecdotally, we can see how these factors have influenced smaller securities during the recent bear market. The value of the U.S. dollar fell precipitously and GDP growth had been weak.

More recently, we’re seeing a perfect storm brewing - one that could lead to significantly better returns for microcap investors. Just look at the indicators: Inflation is higher due to price pressures on food and fuel, first-quarter GDP growth numbers were higher than expected and the value of the dollar is beginning to stabilize.

All of this points to one thing: a small-cap rally. In fact, we’re already seeing the beginnings of the resurgence. The NASDAQ and the Russell 2000 started their respective turnarounds in March and haven’t looked back. It’s still early, but all signs point to a stronger performance for both of these indexes - and bigger gains for loyal microcap investors.