Behind the Decline: Jim Cramer’s Sell-Off Strategies

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Skeptics have been insisting the stock market was frothy and on Monday it seemed like their predictions would prove accurate.

Stocks declined sharply with the Dow Jones dropping by triple digits; energy and materials were among the sectors hardest hit.

Perhaps the most frustrating aspect of Monday's decline was the reason behind the sell-off; there wasn't one.

"I listened and read all day and could not find a single reason why we got hit as hard as we did." said Cramer.

When uncertainty reaches this kind of crescendo, Cramer said smart investors isolate the most likely scenarios; and then extrapolate their next moves based on the probabilities.

In this case Cramer thinks 3 scenarios are most likely:

Scenario #1 – The Nightmare

Cramer thinks it's possible, though not probable, that something big is happening and it's rippling across the market.

By something big Cramer means the collapse of a big bank, a country unable to pay its bills, an imminent threat of war – or the equivalent.

"This is the kind of news that when it surfaces, it will take your breath away," Cramer added. "It is entirely possible that today only the most clued in people knew what was happening."

Jim Cramer believes a shrewd investor should always entertain these kinds of nightmare scenarios, even when the probability is quite low.

If you think the current sell-off is the start of something quite serious, Cramer says, "you must stay on the sidelines – at least in the early days of the sell-off."

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Scenario #2 – Global Weakness

Another possible explanation for the sell-off on Monday may be largely a growing belief that the global economy isn't nearly as robust as the market would otherwise suggest.

"It's possible the sudden weakness of almost every single country in the world, including the United States cumulatively spooked investors," Cramer said. "This theory says that with China clearly downshifting and with U.S. retail sales especially weak and with Europe on the ropes with no resolutions, the market is overbought."

This thesis suggests a cycle of slow growth or even deflation is coming and as a result companies will struggle to meet targets.

If you subscribe to this scenario, Cramer said figure out who benefits from this kind of weakness. "I think the answer is a company like General Mills," Cramer said – the decline should reduce all their input costs.

"They would benefit from declining grain prices, declining cardboard prices and declining plastic prices," said Cramer. "And if energy prices decline, their shipping costs drop too."

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Scenario #3 – Mechanical Trade

"Finally there is a third possibility," said Cramer, "this is a distinct possibility but may elude you at home: that is, some investors borrowed too much money and are basically being foreclosed on because they can't come up with the capital to pay off their margin loans," Cramer said

Cramer calls this scenario the mechanical trade because stocks and commodities are sold mechanically by margin clerks.

Here's how it works.

"The margin clerks call the managers of the funds who have borrowed too much and tell them 'look, here's the deal, you bought a lot of stocks and commodities and they have come down in value so you have to put up more for collateral. You have to send in some cash.'" Cramer said.

"Now as a former fund manager I have to tell you that most of the managers who get called don't have any more cash," Cramer said. "Instead what happens is the margin clerks simply sell out the positions. They sell them in the open market."

If you think that the mechanical trade is behind the sell-off Cramer said, "Then you would buy a higher yielding materials stock, a higher yielding industrial, an oil play or a master limited partnership." The underlying thesis here is that the current weakness has probably been exaggerated.

Call Cramer: 1-800-743-CNBC

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