5 Key Strategies To Dodge The Looming “Fiscal Cliff”

A “fiscal cliff” lies just ahead but prepared investors can turn danger into opportunity.

In recent days, Federal Reserve President Ben Bernanke and others have sounded the alarm about the looming “fiscal cliff” they see coming in late 2012 that could have enormous economic impact for 2013 and beyond.  Dr. Bernanke has stated that the Fed would be unable to offset the negative effects of this drop off, and everyone seems to agree that Congress and the White House need to act to prevent a significant hit to the U.S. economy and avert a double dip recession.

The “fiscal cliff” revolves around $500 billion worth of tax cuts and spending boosts that will expire at the end of 2012.  This would be the worst-case scenario if Congress fails to act to address the ending tax cuts from the Bush Administration and the beginning of new tax hikes from ObamaCare.  Most politicians and analysts don’t believe Congress will let it get to that point, and most are hoping that they are correct.  Between here and there we have the Congressional summer recess and the Presidential Election year underway, meaning that Congress likely will have to negotiate this during the 7 weeks or so after the Presidential Election has been decided and during a lame-duck session of Congress.

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If Congress fails to act, the resulting absence of tax cuts and presence of tax hikes could lead to about $7 trillion being taken out of the economy and thrusting us into a recession almost instantly according to Maya MacGuineas, president of the Committee for a Responsible Federal Budget.  Additionally, economist Mark Zandi estimates that Congress’ failure to act to resolve the fiscal cliff by the end of 2012 could lead to a GDP drop of 3% for 2013 while other estimates range as high as 4-5%.  Since the economy is currently growing at less than 2%, the “fiscal cliff” represents the potential for significant contraction in U.S. GDP and another recession on the horizon. 

Conversely, if the tax cuts are extended and the spending cuts are canceled or delayed, the $7 trillion that is added to the economy would likely lead to growth continuing in 2013, but at the price of raising our national debt by $7 trillion, potentially hurting the U.S. economy by the end of this decade.  Hence, the dilemma known as the “fiscal cliff.”

The four main issues behind the fiscal cliff are the following:

  • Bush tax cuts expiring
  • Ending of the 2% payroll tax holiday
  • Ending of the extended unemployment compensation
  • Automatic spending and budget cuts being enacted by the Budget Control Act if Congress does not meet the Supercommittee’s deficit reduction goals

How did the economic landscape come to this looming financial cliff at the end of 2012?

The groundwork was first laid with the Bush tax cuts that were a series of tax measures enacted by Congress in 2001, 2003, and 2006.  These tax cuts lowered income and investment tax rates, cut back on the estate tax, and increased a number of tax breaks for low- and middle-income families. In addition, Congress also extended the temporary “patch” to the Alternative Minimum Tax AMT so that over 20 million families did not get hit with the AMT.

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If these policies are not extended, the average tax increase for households would be $3,000 according to the Tax Policy Center.  The lowest 20% of households would pay $512 more on average, while the highest-earning households would pay $12,819 more on average.  Of course, if these policies are extended, the federal budget will incur more debt without some corresponding policies enacted to pay for the extensions that would cost $5.35 trillion over 10 years according to the Congressional Budget Office.

Another factor contributing to the current economic landscape is the round of big spending cuts that will go into effect in 2013.  This was part of the debt ceiling deal that Congress struck just before the deadline in the summer of 2011.  These cuts would amount to $1 trillion over the next 9 years.  These cuts include reducing defense spending by 10% and non-defense discretionary programs by 8%.

A third factor is known as the “doc fix.”  This involves reimbursements to Medicare physicians; without an agreement, these reimbursements will be cut by 30%.  Due to the fact that the doc fix has been in place for years, it will likely be in place again before 2012 is over, costing another $30 billion for the 2013 budget.

A fourth factor is the tax extenders.  These temporary tax breaks for individuals and businesses involve individuals being able to deduct state sales taxes from their federal taxable income, while businesses are able to accelerate the depreciation on their equipment purchases.  It is debatable whether these will be kept in 2013; some think many of the breaks should be eliminated, while the breaks that remain should be made permanent.  Extending these tax breaks will cost another $25-$35 billion.

A fifth factor is the payroll tax cut (also known as the “payroll tax holiday”).  This involves the Social Security tax rate, which has been 4.2% for the previous 2 years (it used to be 6.2%).  Extending the payroll tax holiday to keep the lower rates will cost about $115 billion in 2013.

The sixth and final factor in the “fiscal cliff” calculations revolves around extended unemployment benefits set to expire at the end of 2012 and thereby reduce unemployment benefits.  Eliminating these unemployment benefits could be quite devastating to those out of work but extending these benefits will cost around $44 billion in 2013.

If Congress does not navigate around the fiscal cliff or takes too long to settle this dilemma, we can expect a significantly negative reaction from the U.S. stock market since another recession then becomes a more likely scenario.

Strategies to Dodge the Fiscal Cliff

Should Congress fail to avert this disaster and we go over the fiscal cliff, savvy investors with a well thought out plan will have plenty of ways to protect their assets and even to grow them through any downtrend that might occur.  Options to consider include:

1. One could move to the safety of cash.  Cash is the “ultimate hedge” and “cash is king” during times of severe market turmoil.

2. One could buy put options as “portfolio insurance” on long equity positions that you don’t want to sell.

3. One could increase allocation to U.S. Treasury Bonds.  (NYSEARCA:TLT) While bonds carry their own set of risks, bond prices tend to rise as stock prices fall during periods of great economic stress as would likely be caused by a fall off the fiscal cliff.

4. One could seek profits in any stock market decline through the use of inverse exchange traded funds.  Referring to the above major indexes, we find inverse ETFs that track opposite to the Dow Jones Industrial Average, Nasdaq 100 and Russell 2000.  These are ProShares Short Dow 30 (NYSEARCA:DOG), ProShares Short QQQ (NYSEARCA:PSQ) and ProShares Short Russell 2000 (NYSEARCA:RWM)

5. One could short the major indexes themselves by selling short ETFs that track the major indexes.  These include SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA) iShares Russell 2000 Index ETF (NYSEARCA:IWM) and PowerShares QQQ Trust (NYSEARCA:QQQ).

Bottom Line:  The U.S. economy is coming to a crossroads at the end of 2012, the “fiscal cliff” created by the confluence of expiring tax cuts, spending cuts and tax increases all set to occur at approximately the same time.

While most analysts expect a political resolution that will come in the “nick of time,” it is a high risk game of chicken that will likely be played out over the summer and going into autumn and the November election.

Should Congressional action be mistimed or inadequate, the looming fiscal cliff could wreak havoc on the markets and ETFs that track the major U.S. stock indexes.  In that event, investors could sidestep the fiscal cliff to protect their assets and even find significant profit opportunities on the “short” side of the market using inverse Exchange traded funds and other hedging strategies.

John Nyaradi is the author of The ETF Investing Premium Newsletter.

Disclosure: John Nyaradi’s service has positions in DOG, RWM, HDGE, TLT and positions can change at any time.