Warning: The Party May be Over in These Stocks

After all three of the major indices reached record highs, it looks like the Trump rally may be running out of steam. That means many of the pre-election worries that weighed on stocks could come back to bear on the seven-year bull market.  

The S&P 500 had risen less than 3% in the 12 months leading up to the election and just 5.3% in the two years preceding it. In other words, this bull looks tired, and even hopes of fiscal stimulus during Trump's reign may not be enough to break stocks out of their rut or avoid a major correction.

One segment of the market could suffer disproportionately if the economy or market tumbles. This group struggled in the month and a half leading up to the election, and there's a good chance it will struggle again as the rally dissipates. 

Market Weakness Could Return in a Big Way

Stocks surged following the election, due in part to hopes of fiscal stimulus and an economy that seems to be growing somewhat better than its post-recession rut. That euphoria faded this week, though.

With the enthusiasm for potential fiscal stimulus already priced in, the market could soon realize that we're still many months away from the implementation of any stimulus. This would return the market to trading on fundamentals... which don't look great.

Global trade has stagnated since 2012, growing at just 3% annually and less than half the rate of the previous 30 years. Against the slow growth in trade, protectionist measures have increased to bolster domestic producers. According to the World Trade Organization, in the five months through mid-October, members of the largest 20 economies implemented an average of 17 trade barriers a month.

Meanwhile, the hope of exchange rates boosting earnings has evaporated. After falling for much of the year, the U.S. dollar index began to climb in late September as investors anticipated the first rate hike by the Federal Reserve in a year. And those gains accelerated after the election, with the greenback hitting a 13-year high last week.

Dollar strength could hurt earnings, which finally broke their recession in the third quarter. Companies in the S&P 500 reported year-over-year earnings growth of 3.2% in Q3, the first positive growth since Q1 2015. 

All of this speaks to the point that stocks may have trouble holding on to recent gains. Analysts don't see much upside from here, with an average year-end target of 2,209 for the S&P 500 -- a mere 0.5% above the current level.

And when investors take off their rose-colored glasses, one group stands to suffer more than the rest.

Book 86% While Protecting Your Portfolio

The Russell 2000 index of small-cap companies fell more than 5% from its Sept. 22 high through Election Day, before surging nearly 13% to an all-time high on Friday. But as the post-election rally fades, smaller companies are likely to be the ones hit hardest by the dual pressures of higher debt and wage costs.

It's almost a foregone conclusion that the Fed will raise interest rates by at least 0.25% in December and may need to boost them further next year if inflation picks up. Higher borrowing costs will hurt smaller companies with fewer financing options more than it will their mega-cap peers. 

The Atlanta Fed Wage Growth Tracker, a measure of the nominal wage growth of individuals, jumped to 3.9% in October. That's a full percentage point higher than a year ago, and a tight labor market threatens to push wages up even higher. Without the brand recognition of bigger rivals, smaller companies may not be able to pass the increased costs onto consumers.

The Russell 2000 drastically outperformed the S&P 500 following the election, but the small-cap index fell on Monday for the first time in 15 days, ending its longest winning streak since 1996. 

Small-cap stocks are typically more volatile than the broader market, and any weakness in the recent rally is likely to be felt there first. 

Traders can use a simple put option strategy on iShares Russell 2000 (NYSE: IWM) to hedge losses in small caps while still benefiting from potential upside in other picks. (If you'd like more information on how put options work, watch this six-minute training video.)

A put option allows you to leverage a downside move in a stock into much higher returns while also limiting your risk to the amount you pay for the option contract (as opposed to theoretically unlimited losses when shorting a stock).

With IWM trading around $132 at the time of this writing, we can buy one IWM Jan 135 Put for about $5.37. That is a put option with a $135 strike price that expires on Jan. 20. Each contract controls 100 shares, costing you $537 per contract.

This trade breaks even at $129.63 ($135 strike price minus $5.37 options premium), which is about 2% below the current price.

IWM has run into trouble around $125 over the past two years, reaching the level several times only to fall back below it. If shares fall to this level again before expiration, the put will be worth at least $10 per share ($1,000 per contract) for a return of 86% in less than two months. 

As you can see, options are a powerful tool both for outsized gains and hedging market risk. A colleague of mine has been consistently using them to earn 5-10 times as much as regular investors. He put together a six-minute training video that could help you do the same. For a limited time, you can access it for free here.

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