Investing Scenarios for the Fiscal Cliff

by Bryan Perry | October 17, 2012 9:30 am

Investors clearly have a lot riding on the election and how it will shape the White House and Congress in 2013. Here’s how most of the investing world has come to embrace the current backdrop:

There could be some gaps in my analysis, but I’m convinced about 80% of my contentions … and I’m pulling for Tebow in the other 20%.

Given the political stakes in play and the potential collateral damage to the leadership of both parties, it seems implausible that a deal to avert the fiscal cliff won’t be struck before the holidays. But if this situation does drag out to midnight on Dec. 23, then havoc in equity markets around the world will have already intensified.

Best-Case Scenario

If I had to speculate on a market-positive scenario, it would include a win for Mitt Romney, with Republicans taking control of the Senate and Democrats winning the House by a slim margin. In this scenario, the market would anticipate a more simplified tax code with lower taxes for all sizes of business, lower health care costs with an attempt to repeal the Affordable Care Act and a rally in the greenback with the expectation that further quantitative easing would be stifled and the $16 trillion deficit would get some heightened attention.

Lower taxes, a stronger dollar and reducing debt and the size of the federal government would be the mantra. This certainly doesn’t address whether it satisfies everyone’s moral code of ethics, but it does, in my view, stimulate the animal spirits that rule the stock market.

Best-Case Scenario Recommendation: Maintain all existing positions, including being long gold and short Russell 2000 hedges, for the time being. Trying to turn a slowing global economy around means staying the course, with rising expectations for improving business conditions.

Worst-Case Scenario

This situation is unlikely to materialize, but it should be presented nonetheless.

Obama gets reelected, and the polarized situation continues with a GOP House majority and a Democrat Senate majority. Gridlock rules, and fiscal cliff issues don’t get resolved by Jan. 1, so income and investment taxes spike and $1 trillion of federal spending is slashed, eliminating 500,000+ jobs overnight.

This would kick off a catastrophic market reaction. Major averages would correct 15% to 25% between Nov. 7 and Jan. 7, GDP could fall below 0.5% and the eurozone crisis would accelerate, causing the ECB to flood the banking system with liquidity. In the face of such inflation, gold would rally tremendously, perhaps 25% to 35%.

Worried? Don’t be. Here’s how to protect yourself if the worst happens:

Worst-Case Scenario Recommendation: Close out your high-yield positions that would fall prey to higher taxes, and go long gold in reaction to the sell-off in global currencies. Buy municipal bonds and master limited partnerships for the tax-free income.

I’d also recommend a few leveraged hedges such as the Direxion Small Cap 3X Shares (NYSE:TZA[1]) for triple leverage on the Russell 2000 decline and ProShares Ultrashort QQQ 2X Shares (NYSE:QID[2]) for double leverage on the Nasdaq 100 decline. Of course, if you just want to park your money with a 5.9% yield and wait out this mess[3], Dreyfus Strategic Municipals Fund (NYSE:LEO[4]) is your best bet.

Camping out in the above recommendations until the market corrects will allow you to sit on most of your cash with the ability to leg back into high-income assets at discounted prices.

Keep in mind that markets overshoot to the upside and to the downside, and that some of the greatest investments are made when broad panic selling sweeps across all sectors. We will want capital available to pounce on our favorite high-yielders when the time is right.

The opinions contained in this column are solely those of the writer.

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Endnotes:
  1. TZA: http://studio-5.financialcontent.com/investplace/quote?Symbol=TZA
  2. QID: http://studio-5.financialcontent.com/investplace/quote?Symbol=QID
  3. wait out this mess: http://investorplace.com/2012/10/3-dividend-payers-to-buy-for-the-fiscal-cliff/
  4. LEO: http://studio-5.financialcontent.com/investplace/quote?Symbol=LEO

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