Looking for cheap stocks? Consider investing in the depressed US Small Cap sector.

As contrarian investors we are always on the lookout for value. When we say value we mean those stocks that are beaten down and depressed. After all, value must be found amongst that which nobody else wants.

In order to find these diamonds in the rough, we use a number of screens / techniques. Amongst them are:

• The CBS Marketwatch industry scanner - used to find the worst performing industries.
• Back page of the Economist - ranks global markets by return in local currency and US Dollars (we look for the worst performer).
• Ranking the worst performing commodities or bonds and then looking for stocks that are exposed to them.
• Ranking returns by market cap i.e. large, mid, small or micro and finding the area of capitalization that has performed the worst.

Gazing into the wide expanse of the stock universe we find that in Dollar terms, the US market hase been amongst the worst performer globally (Dow +9% year-on-year). This is most likely due to chronic weakness in the US Dollar instead of the stock market itself.

Drilling down even further we find that the wost performing sector by market capitalization has been small caps. Logically, small caps are hardest hit by a weakening economy.

Chart 1: Russell small cap index bottoming against the Dow; Dow rebounding (below)

After today's spectacular bounce by the Dow (green circle), coming back from critical support, we reiterate our overall bullishness on the stock market. As we explained in The 100 Dollar Bill drop we believe stocks are about to embark on their next bullish leg fueled by more liquidity injections and rate cuts. Thus begging the question, where should we put our money?

Traditionally we favor the Gold and Oil sectors because we believe they are in massive bull markets. But as contrarians we note the US small caps offer tremendous value as they bottom against large caps (chart 1 - MACD and RSI divergences at price lows - green lines).

Drilling down even further, the CBS Marketwatch Industry screener shows the 10 Worst Performing Industries over the last 3 months as:

• DJ US Mortgage Finance Index -31.03%
• DJ US Home Construction Index -24.68%
• DJ US Consumer Electronics Index -20.85%
• DJ US Real Estate Holding & Develop... -16.06%
• DJ US Transportation Services Index -15.03%
• DJ US Business Training & Employment... -14.32%
• DJ US Clothing & Accessories Index -13.19%
• DJ US Specialty Finance Index -12.97%
• DJ US Home Improvement Retailers In... -12.84%
• DJ US Mobile Telecommunications Ind... -12.50%

2 sectors we are looking to for the next small cap winners are Business Training & Employment and Mobile Telecommunications. In comparison to other industries they are the least affected by ongoing credit problems.

The above approach forms a good basis from which to build a diversified portfolio and take advantage of the next round of monetary inflation.

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