From employment trends to factory production levels to trade figures, all signs are pointing to an improving U.S. economy. And in the early stages of any economic rebound, investors always flock to stocks with small market capitalizations. Back in 1990, when the economy was about to break out of its shell, the Russell 2000 Index, which focuses on small cap stocks, rose 100% during the next 36 months.

These days, these small caps are back in vogue again. The Russell 2000 has risen for seven of the last eight months. The index is now within just a few points of all-time highs hit back in 2007.

Unlike blue chip stocks found in the S&P 500, smaller company stocks in the Russell 2000 tend to be much more volatile. Of course, that means even bigger gains in rising markets for some names. Right now, I’m taking a closer look at the hottest small caps, those Russell 2000 components that rose more than 50% in March. These sharp moves may be a harbinger of even better days ahead, or they may have become over-inflated in a euphoric market.

Let’s take a look…
 

Drugstore.com (Nasdaq: DSCM) moved higher on a merger with Walgreen (NYSE: WAG). Sauer-Danfoss (NYSE: SHS) posted remarkably good fourth-quarter results and could see even higher demand for its hydraulic and electronic equipment in 2011, but shares are no longer a bargain. And Vasco Data (Nasdaq: VDSI) may be up on rumors of a coming buyout or it may be perceived as a beneficiary of a recent security flaw found with rival EMC’s (NYSE: EMC) products. Let’s call these stocks fair-valued.

#-ad_banner-#A star in the making?
I have to admit that I was wary of Star Scientific (Nasdaq: CIGX), when I noted last summer that the company had a history of false promises.

It now looks as if management may finally deliver on years of hopes. The Food and Drug Administration has just issued a ruling that Star’s tobacco lozenges won’t be regulated like other tobacco products. That bolsters the company’s claims that its tobacco products aren’t nearly as carcinogenic as traditional tobacco products.

What does this mean for investors? Well, for starters, revenue may finally start to roll in after being stuck below $1 million for each of the past five years. How high can sales go? Expectations should be tempered. Major tobacco companies such as R.J. Reynolds (NYSE: RAI) and Phillip Morris (NYSE: MO) are testing their own dissolvable tobacco products. And with their marketing muscle, Star may be hard-pressed to compete.

I’m more intrigued by the company’s claim that one of the key ingredients in the tobacco product could also have therapeutic abilities, such as the ability to possibly cure Alzheimer’s Disease. Right about now, you should stop and realize that companies have been coming across “cures” for Alzheimer’s for a long time, yet not a single one has actually ever proven effective in large-scale testing. So these claims should be taken with a mighty large grain of salt. That said, this stock pounds out gains day after day, and some of its most bullish backers think shares have room to run much higher, so it’s certainly worth further research. But you should also know that this stock surged in 2000, 2005 and 2009 to $5 only to give back those gains every time. Will this time be different?

Travelzoo (Nasdaq; TZOO)
Here’s the recipe for a high-flying stock. Find a company that is being targeted by short-sellers, and then get that company’s CEO on TV with stock entertainer Jim Cramer and watch the shorts run for the hills as mom-and-pop investors follow instructions to “Buy, buy, buy.” The shorts were right in early March when the stock was at $40. Forced to cover those positions, they’ve pushed the stock right up to $68. Now this stock is really, really overvalued, at nine times trailing revenue, 24 times book value and 50 times trailing free cash flow.

Travelzoo toils in the crowded field of online travel, which is dominated by firms like Priceline.com (Nasdaq: PCLN), Expedia.com (Nasdaq: EXPE) and Orbitz (NYSE: OWW). With $113 million in 2010 sales, Travelzoo is the smallest of the group.

For quite a while, its business model held a lot of promise. The company quickly built a list of 22 million subscribers who received “travel deal” e-mail blasts. That approach is now showing signs of fatigue. The company boosted the subscriber base by just 1% sequentially in the fourth quarter.

Looking ahead, the company is trying to ride the coattails of the new group-buying frenzy pioneered by sites such as groupon.com and livingsocial.com. Truth is, those firms are securing far more traffic than Travelzoo. Travelzoo will capture some of the buzz and a bit of market share, but its main core business has so greatly slowed that the company may be hard-pressed to boost sales 20% this year, as analysts currently forecast. In short, this is a company that is a lot better at generating investor buzz than actually building sales. The shorts had to cover their positions back when the stock was at $40, but at $70, this is a screeching short.

The one to own
The only stock in this group that has my attention is VirnetX Holdings (NYSE: VHC), which I discussed last summer.

The stock has tripled since then and may have even more room to run.

VirnetX holds a number of key data-transmission patents and has started to pile up legal victories. Last August, the company’s IP strategy was still evolving and some expected major patent infringement lawsuits had yet to be filed. I concluded that “it’s impossible to predict if and when those suits will be resolved, but VirNetX’s $270 million market value appears to sharply discount the prospect of a few more major legal victories.”

That market value is now almost $1 billion, yet it appears that annual royalty payments could be even higher than I first thought — well into the hundreds of millions. In mid-March, the company updated its patent protection plans and now looks to be positioned to secure royalties on all smartphones that transmit at high speeds, known as “4G.” Over their lifetime, those royalty streams could total several billion dollars. So the company’s market value, even after a strong run, still discounts potential coming windfalls.

Action to Take –> Of this whole group, TravelZoo looks full of hot air, while VirnetX Holdings seems to have even more upside — perhaps 50% or more from current levels.

P.S. — Few investors realize that a 20-year energy agreement between the United States and Russia is about to expire. This deal supplies 10% of America’s electricity. As broke as our government is, the situation is so serious that President Obama is asking for $36 billion to avert this crisis. And Republicans support him. Here’s what’s going on…