Judging from the stock market rally of the past three weeks, it seems investors are warming to the idea that any resolution to the “fiscal cliff” will help the economy.
Maybe that’s right, maybe not. Either way, you’ll want to invest with protection in mind.
A little history can give us some perspective. Think back to the debt-ceiling battle in the summer of 2011. Stocks began to wobble as the debate got under way, but the sharpest drop took place after Congress cleared the debt-ceiling bill on Aug. 2, 2011.
Just seven trading days later, the S&P 500 Index had plunged 10.6%.
Why did the market tumble after the political crisis had passed? Your guess is as good as mine, but I suspect it might have been because investors looked at the final legislative package and weren’t particularly happy with the details. Indeed, the “solution” Congress came up with in August 2011 included the fiscal cliff that now has Wall Street so worried!
In short, the market’s reaction, when the fiscal cliff gets resolved, probably will depend largely on the details contained in the package. If the sausage, in its final form, includes at least some ingredients favorable to economic growth, stocks could soar.
On the other hand, if the wurst is stuffed with poisonous tax increases and little else, today’s plodding economy would likely skid into recession — with decidedly negative consequences for stock prices.
Since we don’t know, at this point, which track the legislation will take, I recommend that you hope for the best but protect yourself just in case. Buy some attractively priced stocks (there are still a few), but keep a slug of bonds as insurance.
Rather than bet on a dramatic near-term move in interest rates, I suggest spreading your bond holdings around to capture the unique dynamics of various market sectors. High-yield bonds will benefit if U.S. economic growth, however muted, continues.
Shorter Is Smarter
I’m spotting a pocket of value among junk bonds of short maturity — five years or less. History shows you can significantly reduce your risk of default with junk bonds if you focus on paper nearing maturity. (It stands to reason: The longer the remaining term to maturity, the greater the chances for the issuer’s business to sour.)
What’s more, the junk space is unusual in that you don’t have to accept much of a yield “haircut” for the added safety of short maturities. Most mutual funds and other institutional investors in lower-grade bonds are obsessed with locking in as high a yield as they can for as long as they can. Thanks to this institutional bias, short-term junk tends to be systematically underpriced (i.e., priced at a higher yield than you would normally expect).
Result: According to a recent study by Samuel Lee, a Morningstar analyst, the average short-term junk bond since 1986 has outperformed the average long-term junk IOU by about 80 basis points a year — with smaller month-to-month price swings.
Higher return, less risk: It isn’t supposed to work that way, but sometimes it does!
Profit From Inefficiency
Wells Fargo Advantage High Income Fund (MUTF:STHYX) is a no-load mutual fund — run by the same manager (Thomas Price) since 1998 — that yields 5.9% based on the past 12 months’ cash distributions. That’s mighty tempting for a fund with a weighted average maturity of just over five years — especially when you realize that a five-year Treasury note is paying only 0.63%.
You can buy STHYX without a transaction fee through Schwab, Fidelity, TD Ameritrade and other leading discount brokers.
Meanwhile, Treasuries furnish a hedge in case the European situation totally unravels or some other shock, unseen at the moment, drives the global economy into the ground.
Keep buying iShares Barclays 20+ Year Treasury Bond Fund (NYSE:TLT) on pullbacks.
Richard Band’s Profitable Investing advisory service helps retirement savers outperform the market without losing a minute of sleep along the way. His straightforward style and low-risk “value” approach has won seven “Best Financial Advisory” awards from the Newsletter and Electronic Publishers Foundation.