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It may seems obvious to some and it is definitely obvious once it is pointed out to investors, but where to invest in periods of economic expansion is definitely not in typical bond portfolios. Instead, value funds or mutual funds with a good blend of value and growth securities would be the most logical place to start. As an investment strategy, this is not an art or a learned skill; it simply makes sense once the description of an economic expansion is properly understood.

So what is an economic expansion?

According to Smart Money, which published a great article about the Yield Curve, and economic expansion typically occurs immediately after a recession. Now, we have to be careful about how we define a recession. Yes, it means for tough economic times and periods of cutting back and sacrifices. But economically, a recession is different than what people like you and I experience. Instead, a recession is categories by certain economic statistics, including among other things, several periods of consecutive negative growth. Once that trend is broken and other economic statistics line up, that recession is over. And strange things start to happen.

Like what?

For starters, yields on treasuries and bonds steepen. This means that the rate on a 3 month treasury bill more than 3% lower than the rate charged on a 30-year treasury bond. As of today (March 15, 2010, that spread is more like 4.47%), this certainly holds true according to data on bloomberg.com. And if the Yield Curve is at all accurate in everything it has suggested since the late 1970′s, then we are in a period where the economy is expected to start growing quickly in the near future.

What does that tell us about where to invest!

Before we get to that, consider what it tells us about where not to invest. Obviously, when rates are expected to increase (everything we hear today combined with the yield curve tell us as much), bonds are out of the question. This means lightening up on income-class securities and moving money into equity based securities.

But does that mean growth funds or value funds (or a blend of both).

At the Mutual Fund Site, we have suggested that some small cap funds are actually no brainers. We outline the reasons why in some detail, but let’s look at the most fundamental reasons why some small caps are a good starting point:

• Value. Yes, we said it. Small caps offer tremendous value right now. Why? Because they were beaten down the credit crisis of 2007 dragged through 2008 and into 2009. The fear was that small cap stocks would disappear off the face of the earth once they could not fund their operations through credit or they went broke trying to make payments on higher-rate capital. In many cases, this did not happen and the survivors stand to benefit. In our case, we like regional financial institutions because they have government stimulus and people’s returning to work (okay, in some cases where employment is over 20% like in some areas of California, this seems like a stretch, but things will improve even in these highly unemployed areas) on their side. Plus, many of these companies have been very profitable during the last few years… even with the world crumbling around them!
• Small caps are one of the first segments to record steeper profit growth. This could be a numbers game in some cases, but it could also be the result of smaller companies willing to take the risks that larger corporations are unable to take. Blame it on smaller boards, less restrictive financial covenants, etc., but smaller cap companies take risks where larger companies simply will not… and this often bodes well for them.
• Lastly, small cap securities are one of the first to experience a “pop” in security price when recessions are over. Look at Citigroup as an obvious example (although you cannot say they are small cap, their story is quite well known). When it became clear that they would survive after all, its share price popped on the news alone. All they had to say was they were going to survive! Imagine a company that had numbers to back this up! Small caps have those numbers.

Does that mean we recommend small cap stocks? If small cap stocks are where to invest, what does that say about less risky alternatives?

Well, we believe that value funds are where to invest. Because even larger cap securities (and many mutual funds hold them) offer tremendous value, even in today’s market. And this is where investors should be — in value funds or funds that invest in such securities. Is it too late? No, not if we believe what the yield curve is telling us. I mean, look at GE, one of the world’s largest and most-diversified conglomerates. In 2008, its stock price touched below $6.00. Talk about extreme value… now it trade at nearly $16 and it still has inherent value.

Of course, we advise clients to be careful when they look at value funds and make sure they are investing in something that meets their investment needs and risk tolerance.