Profiting From The Fiscal Cliff

Folks,

Unless you’ve been on the dark side of the moon, you’ll know that Congress is currently in negotiations with the President over the so called “fiscal cliff”.  The fiscal cliff is a package of spending cuts and tax increases, that if not prevented, will automatically kick in on New Years Day 2013.  How big are the tax increases and cuts?  Pretty big. 

The Tax Policy Center reports that middle-income families will pay an average of $2,000 more in taxes in 2013 (1).  A number of deductions will be subject to phase-out and tax breaks like the earned income credit, child tax credit, and American opportunity credit will be reduced.  Also, your taxes are going go up if the fiscal cliff isn’t mitigated.  In 2010 the tax brackets were 10%, 15%, 25%, 28%, 33% and 35%.  If Washington does not act those rates will increase respectively to 15%, 28%, 31%, 36% and 39.6%.

In addition, the short term economic consequences of the act could be very serious.  The Congressional Budget Office believes that up to 3.4 million jobs would be lost, post fiscal cliff, due to a slowing economy with layoffs stemming from cuts to sectors heavily dependent on federal contracts, including the defense industry.  This could result in  increasing the unemployment rate up to 9.1% and reducing quarterly economic growth by.5%.  In short, it could drive the country back into recession.

Is all this going to happen?  Well, probably not.  Even though the President and Congressional Republicans don’t necessarily see eye to eye, you have to have faith they both want the best for the country.  That said, there is plenty of uncertainty to go around.  First, the tone in Washington (I know, I live here) has deteriorated over the past couple of years.  There are fewer cross partisan friendships and gerrymandering of electoral districts has reduced moderate voices on both sides of the political spectrum.  It also seems that both the President and Congress view going off the fiscal cliff as part of a viable negotiation strategy.  So, its fair to say that while a political deal will likely be reached, it is still entirely possible DC could allow the collapse to happen.

But, in any crisis there is always opportunity.

So, what can you do to profit from DC’s foolishness?

There are three possible strategies.

1) Sell defense stocks short: The defense industry is disproportionately reliant on U.S. federal contracts.  Military spending is additionally a huge part of the federal budget and the wars in Iraq and Afghanistan have unfortunately been a major driver of the budget deficit.  So, its likely the defense budget is going to get cut as a part of any spending reduction agreement – its a fat target.  Since nobody buys more military hardware & services than Uncle Sam, its going to be hard for defense firms to make up the loss.  So, you might consider shorting the entire industry via an ETF or researching which companies (for example, Lockheed Martin) are going to take the hit.

2) Buy gold: Gold is moving up for a number of reasons.  While most of the demand for the yellow metal is due to increasing buyers in India and China, central banks are now purchasing it as hedge against a weakening dollar.  Some U.S. retail investors find it attractive as a store of value and as a safe harbor alternative when markets fluctuate.  If the worst case fiscal cliff scenario is realized, you might see gold pop by a couple of percentage points.  For this uyou might consider getting an electronic gold product, rather than physical bullion.  Its a lot easier to buy and sell.

3) Go all cash and buy low after the drop: A possibly likely scenario is the entire stock market will decline should the fiscal cliff happen.  If you have a big appetite for risk, you could dump your entire portfolio before the cliff then buy afterwords when stocks prices are lower.  In this case, look for fundamentals when you get back into the market.  The thinking here is if there is to be a recession, a cash rich-healthy business will be far better off than a marginally successful one.  In this case Warren Buffets adage is appropriate: only when the tide goes out do you discover who’s been swimming naked.

Just to wrap this up, there is some reason to believe that Congress and the President may not successfully negotiate the fiscal cliff crisis.  In the off chance that they cannot get it together, it could pay to consider a few speculative moves; selling defense stocks short, buying gold or going all cash.

Best,

James

James Hendrickson

James Hendrickson is an internet entrepreneur, blogging junky, hunter and personal finance geek. When he’s not lurking in coffee shops in Portland, Oregon, you’ll find him in the Pacific Northwest’s great outdoors. James has a masters degree in Sociology from the University of Maryland at College Park and a Bachelors degree on Sociology from Earlham College. He loves individual stocks, bonds and precious metals.