Time to short a fatally flawed recovery

A wise investor would hardly be putting money into the stock market right now. Whenever you read headlines like ‘FTSE hits 31-month high’ it is not a time to buy. This is, however, a great time to short the market.

More fortunes are made shorting stock market corrections than in bidding up rallies. Timing is always a problem, otherwise you would just establish a short position and keep it open until the bonanza came. But you can be pretty sure that something is wrong when the market is at a high but the economic recovery is a fatally flawed proposition.

British boom?

It is easiest to spot this in the UK. The government has just embarked on three years of public spending cuts and austerity with higher taxation, and inflation has shot up to 3.7 per cent meaning that higher interest rates must be on the near horizon.

You might wonder why foreigners would hold capital in sterling with inflation so high. You might wonder at the realistic profit outlook for companies in this environment. You might ponder what is likely to happen to domestic demand, disposable income and consumer spending.

However, this squeeze is also happening across the pond at the state level. Where California goes so goes the rest of the union. And California’s new governor Jerry Brown is promising massive cuts, including 10 per cent off state salaries, and much higher taxes.

Then there is the expiring federal stimulus to worry about. Printing money like crazy brings growth forward but once the effect wears off you need more of the same drug, and more does not necessarily do the same job. It has been fairly evident from recent bond yield rises that the $600-800 billion QE2 program is not working as advertised with interest rates rising and not falling.

QE2 sinking?

More importantly the latest recalculations of QE2 suggests it will be more modest at $180 billion. Something is going to suffer disappointment from that lower liquidity injection and the GDP growth rate looks a prime candidate.

That does not mean that investors should necessarily dump all their stocks and go to cash. But it might well be prudent to hedge large positions with shorts. This can be easily and simply achieved by buying short exchange traded funds which carry the warning that they are for short-term trading only and not for the long-term as they slowly wind down.

Emerging markets like China and India seem to be feeling the headwinds earliest, and look a prime candidate for shorting. But the correction in the developed markets could come very suddenly and it might be advisable to go short now rather than wait. Black swan events are by their nature highly unpredictable.

The ArabianMoney February newsletter will discuss which short ETFs are the best buy but this maybe too late (click here to make sure you get your own copy on time). Better to make money out of a crisis than lose your shirt!