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Stocks That May Fall Short

If the market reverses, here's a watch list of shares that could be leaders to the downside.

This column was originally published on RealMoney on Oct. 30 at 11:56 a.m. EST. It's being republished as a bonus for TheStreet.com readers.

Friday's selloff could be the start of something more ominous, or just the pause that refreshes before the market zooms higher.

In either case, finding a tradable edge on the long side is getting harder and harder these days. Let's put together a watch list of short-side opportunities, just in case.

What exactly is a tradable edge?

Simply stated, the most profitable positions come when the crowd is leaning the wrong way. You might have noticed it's become highly unfashionable to engage in any discussion of market downside these days. This lopsided sentiment could set up timely short sales to take advantage of the overheated tape.

The trading gods routinely punish the easy play, while positions causing the most sleepless nights usually pay off.

It doesn't take a stock genius to see the herd is running mindlessly on the long side, hoping to turn good profits by throwing money at bad stocks. It's possible the market will put a big target on this crowd in November.

Consider the real meaning behind the classic expression "bull-market genius." This backhanded compliment denotes individuals who play a game of "told you so" with peers, strangers and anyone else within earshot whenever uptrends take control of the tape. The good news is these smug individuals rarely profit in the long term.

Just ask anyone who lost a fortune riding the long side down after the bubble burst in 2000.

In reality, the markets don't give away freebies for long and will go to great lengths picking pockets near the end of strong bull runs.

And it's an easy job because the herd is most aggressive with margining right at major turning points.

This warns overheated bulls to stop thumping their chests and pay closer attention to profit protection. If the long side starts to peter out here, the downside might be substantial.

Again, this isn't a prediction, even though just raising the topic will trigger the usual hate mail from bull-market geniuses.

Let's build our short-sale list from three sectors that have performed poorly in this strong October market.

The theory is quite simple here: Stocks that don't move higher when the broad indices are in rally mode should lead the downside during a correction. It's a common-sense gravity principle that worked in full glory earlier this year.

Semiconductors

It's no shocker that semiconductor subgroups led the downside in October.

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These underachieving stocks have been dead weight on the

Nasdaq

since the index bottomed out last summer. The group might offer excellent short sales in the weeks ahead, but interested traders should wait for the right signals before taking on exposure.

The Philadelphia Semiconductor Index (SOX) has carved out a well-defined trading range between 444 and 475. A break of the lower end of this congestion pattern could send dozens of chip stocks into persistent declines. So pull up a chair and keep a close watch on index support, especially after Election Day.

Chip stocks with the most interesting short-sale potential include

Advanced Micro Devices

(AMD) - Get Advanced Micro Devices, Inc. Report

,

Intersil Holdings

(ISIL)

,

SanDisk

(SNDK)

and

Linear Technologies

(LLTC)

.

Education and Training

These stocks had a terrible month, with quarterly earnings pointing to major structural issues. Sector leader

Apollo Group

(APOL)

missed profit and revenue targets, while admitting its options backdating review is uncovering "various deficiencies." This isn't the formula for higher prices.

These stocks have fallen apart in 2006, but most look washed out and capable of unexpected turnarounds. For this reason, short selling should be avoided with most; a few education stocks, however, still look like they have potential to go lower in November.

Career Education

(CECO) - Get Career Education Corporation Report

is my top short-sale pick in the group. Note the major downtrend since the stock broke multiyear support in June. It tried to recover after hitting a four-year low at $17.60 but ran into stiff resistance at the Aug. 4 gap. Look for this one to test the big low and break it decisively before the year is over.

Specialized Health Care

Many specialized health care stocks are heavily dependent on insurance and government programs. In particular, most drug benefit companies in the sector get paid through penny-pinching managed-care schedules. This can pose a huge problem when it comes to long-term profitability.

Express Scripts

(ESRX)

was a top performer for many years, but it has run into a major brick wall. The stock stalled out at $95 in February after rising over 300% in just 16 months.

The orderly correction following its high-water mark is now turning into a full-scale rout that has triggered substantial downside before this year's holiday season is over.

The stock has carved out an ominous double-top pattern, with support at the October 2005 breakout near $64. Price action on the weekly chart is testing that key level and could break down sometime in November. That unfortunate event could set the stage for a sharp downtrend into round-number support near $50.

Other attractive short-sale possibilities in specialized health include

Caremark Rx

(CMX)

and

Psychiatric Solutions

(PSYS)

.

At the time of publication, Farley held none of the stocks mentioned, although holdings can change at any time.

Alan Farley is a professional trader and author of

The Master Swing Trader

. Farley also runs a Web site called HardRightEdge.com, an online resource for trading education, technical analysis and short-term investment strategies. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Farley appreciates your feedback;

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to send him an email.

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