A funny thing is happening to small-cap stocks. They're rising from the dead.

From March 23 through yesterday, the Russell 2000 index, the most popular benchmark for the stocks of small companies, has jumped 16 percent -- nearly four times the increase in the large-cap Standard & Poor's 500-stock index.

Since mid-May, all stocks have been dithering, caught in short-term uncertainties over inflation and higher interest rates (anxieties that smart investors should ignore). But the point is that small-caps are moving in the right direction.

In fact, they have been engaged in a kind of stealth bull market since last fall. The Russell peaked at 487 on April 17, 1998, then plummeted to 310 just six months later. Rising in fits and starts, the index closed yesterday at 443.76, returning 44 percent in eight months, while the large-cap S&P has returned 39 percent.

But, looking at the performance of small-cap funds and talking to small-cap money managers, you would think that small-caps are still in deep trouble. And, in a way, they are.

Six of the 10 worst-performing general equity funds since the start of 1999 specialize in small-cap stocks, according to the Value Line Mutual Fund Survey. PBHG Emerging Growth, for example, has dropped 8 percent; T. Rowe Price Small-Cap Value, run by an excellent manager, Preston Athey, has eked out a gain of 0.3 percent for 1999 but has fallen 16 percent over the past 12 months. It is not a pretty picture.

How can we explain the Russell's performance? In part, Internet stocks.

The Frank Russell Co. calculates the index first by determining the 3,000 largest U.S. stocks by market capitalization (that is, the number of shares outstanding for each company multiplied by its price). The stocks that rank 1,001st to 3,000th make up the Russell 2000 index.

The current market-cap ranking was done on June 30, 1998. Since then, while many of the Russell 2000 stocks have languished, some high-technology stocks have soared -- and those stocks have had a disproportionate effect on the index.

For example, the market cap of E-Trade Group Inc. (EGRP), the online brokerage firm, has risen from $1.4 billion to $9.5 billion in the past 12 months. By no stretch of the imagination is E-Trade a small-cap stock (the ceiling is usually considered $1 billion to $2 billion), yet it has powered the Russell higher.

On Friday, Russell will publish the preliminary additions and deletions for the 2000 index for the year ahead, and you can bet that companies such as E-Trade will be bounced from the list. (For details, see the Russell Web site at www.russell.com. The composition of the Russell 2000, as well as many other indexes, can be found at the Chicago Board Options Exchange site at www.cboe.com.

The truth is that conventional small-caps -- real small-caps -- are doing much better, but they still have a long way to go to catch up with the valuations of large-caps. "Over the past 10 weeks," notes Salomon Smith Barney Inc. in a letter to clients, "while small- and mid-cap stocks consistently beat the returns posted by the deified S&P 500, most investors remain skeptical and unconvinced that the rotation into smaller caps can be sustained."

That's actually good news. Investors continue to withhold cash from rising smaller stocks, and, as a result, their prices remain attractive despite "robust" profits (in Salomon's words). For example, the price-to-earnings ratio of the stocks of T. Rowe Price New Horizons, one of the oldest of the small-cap funds, stands at just 83 percent of the P/E of the market as a whole -- the biggest discount in history. Normally, the New Horizons P/E is considerably higher than that of the market.

"There still are plenty of bargains left from which to choose," writes Al Frank, editor of the Prudent Speculator, a newsletter that concentrates on small-cap value stocks.

But there is bad news as well. Jay Weinstein, a small-cap specialist who heads Oak Forest Investment Management in Bethesda, believes that, as mutual funds grow in size, their managers become less interested in small-cap stocks since an investment of even 2 percent of their portfolios is a huge chunk of a small company's total capitalization. That makes it harder to buy into the stock without increasing its price, and harder to get out without depressing its price.

But don't despair. Small-caps, Weinstein points out, beckon as takeover targets (if the funds want bigger stocks, then companies will become bigger through mergers). Think of it this way: A company with $100 million in sales and $5 in after-tax earnings may be spending $300,000 a year just to comply with Securities and Exchange Commission filing requirements and another $2 million to $3 million a year for the compensation of top managers who could be eliminated in a merger. By cutting out those costs, the acquiring company can increase the bottom line by 40 percent or so.

Meanwhile, smaller firms are putting their cash to its best use by buying up their own shares at low prices, thus enhancing the ownership position of the remaining stockholders.

One of Weinstein's favorite companies, for example, is Supreme Industries Inc. (STS), a Goshen, Ind., manufacturer of specialized truck bodies with a market cap of $113 million. Last month, Supreme bought back 1.7 million of its 11.5 million shares. The company, with an impressive history of rising earnings, trades at a P/E of 11. For the 12 months ending this July, its profit is expected to rise 16 percent from the same period a year ago.

As for Frank, his current list includes Barringer Technologies Inc. (BARR), which makes equipment used in detecting trace amounts of explosives and illegal drugs; Independence Holding Co. (INHO), life and health insurance, at a P/E of 7; and Old Dominion Freight Line Inc. (ODFL), a trucker with earnings growth of 15 percent and a P/E of 8.