Stay away from small-cap bank stocks.

It was nearly 18 months ago now that Tim first dished out that advice. Though they looked cheap at the time, writedowns were happening across the industry, making financial institutions nearly impossible to value. On top of that, the economy was showing signs of sputtering with no resolution in sight.

Not much has changed
It's hard to believe, but the current economic downturn is nearly two years old now -- and it's gone from bad to worse. Notwithstanding the recent rising tide in the market, stocks have gotten "cheaper," writedowns have gotten bigger, and the federal government is throwing Hail Mary passes in the hopes of averting further crisis.

And while big financials such as Lehman, AIG (NYSE: AIG), Fannie Mae , Freddie Mac , and Citigroup (NYSE: C) have dominated the headlines, small financials have been hit just as hard. In fact, it's gotten so bad that former mid-cap banks are now de facto small caps: KeyCorp (NYSE: KEY) and Comerica (NYSE: CMA) have lost 60% or more of their value since this crisis began in late 2007!

All of this is to say, it's still not time to start buying small-cap banks.

It may, however, be time to start looking hard at something a little off the beaten path: small-cap value.

What's the difference?
Small-cap value and small-cap banks often get conflated -- and for good reason. As Brian noted last year, the Vanguard Small-Cap Value ETF (VBR), like most small-cap value indexes, has substantial exposure to small banks. For the quarter ending March 31, small financial services companies accounted for 34% of VBR's holdings.

But although small-cap value stocks have been 2009's worst performers, Russell Investments recently released a report suggesting that "they could emerge as the frontrunners if the economy stages a recovery."

So while you don't want to buy small-cap banks, you do want to buy small-cap value net of banks because, as Mark Hulbert noted in a New York Times article at the end of 2008, these historical outperformers "produce their most explosive gains right at the start of a bull market."

But let us be clear
Neither we nor Hulbert are predicting that we're at the start of a bull market. Rather, we're noting that:

And thus: Now is a good time to start buying small-cap exposure for the long term.

After all, a little exposure to this market segment gives you the chance to take advantage of this historical trend and puts you in position for significant outperformance whenever this bear market turns for good.

What next?
But Hulbert's recommended small-cap value investment vehicle, while low-cost, is imperfect -- because he advised investors to "buy and hold an index fund benchmarked to the sector and to ride out the market's turbulence." Continued...