What to Sell Short on the next Rally

As much as you may think I have just gone MAD, I believe it is time to start dipping your toe in on the short side in the stock market on the next major rally.

I want to elaborate on the finer points of the rationale for doing this trade.

Whatever last gasps of the tailwind provided by last year’s tax bill are rapidly being extinguished by an escalating trade war. Just ask anybody in the real estate and auto industries which are already well into recessions.

It has reminded them how high stocks have run and how much now withering unrealized profits are sitting on their books.

The Russell 2000 (IWM) is actually misnamed as it now has only 1,650 stocks.

The rest have disappeared over the years through mergers, privatizations, or bankruptcies, and have not been replaced, as happens quarterly with the S&P 500 (SPY).

For you and me, this means that the (IWM) is more illiquid than the (SPY). When stock markets fall, the (IWM) falls about 1.5 times faster than the (SPY).

In other words, it’s a great short to have in a falling market.

I think stock markets may be starting to either top out or roll over here. The Fed is taking away the punch bowl and the party is ending.

That is especially true of the Russell 2000.

An approaching yearend is a big risk for the markets, as are overstretched valuations and prices.

The warning signs of a selloff are absolutely everywhere but, until now, have been ignored. They show that the normal life of a medium-term topping process is two months.

When will that two months end?

About the end of December, before gigantic deferred tax selling hits the market in January.

Small cap stocks have other problems.

Since they lack the sources of internal finance that the big companies do, they are much more sensitive to the economic cycle.

That makes them much more dependent on a boost from tax cuts.

Large companies don’t pay taxes anyway, so there’s nothing in the tax package for them.

Small caps also are much more dependent on domestic sales than large ones.

They lack the financing and the sophistication to create elaborate offshore structure to minimize their tax bill.

So any developments that threaten to dilute or derail tax cuts will hit small companies much greater than big ones.

Another way to play this is to buy the ProShares Short Russell 2000 ETF (RWM), a bet that small cap stocks will fall.

If you are looking for other ways to hedge your portfolios, you might consider the Trade Alert I also sent yesterday to buy gold (GLD). The last stock meltdown finally delivered some serious moves up in the barbarous relic.

Look at the chart below for the barbarous relic and you see that we have a sideways triangle formation setting up over the past month that will be a nice springboard for a sudden move upward.

All we need is one more escalation of the trade war with China which, these days, seem to be coming out of the woodwork.

Sell short the Russell 2000.