Markets can only crash when the masses aren't expecting it. And if history is any guide, Congress just might push us right off the "fiscal cliff."
The fiscal cliff is a combination of federal tax increases and spending cuts that are scheduled to go into effect at the end of 2012. In an already-fragile economic environment, an increase in taxes and a reduction in spending could pose a huge threat to growth. Economists estimate that it could shave as much as 4% off domestic growth in 2013 and cost the economy as many as 2 million jobs, which could send the country into another recession.
For the time being, the market remains uneasily confident that politicians will cut a deal before the deadline and avoid an economic crisis. But according to recent events, Wall Street has very good reason to be nervous right now.
The last time Congress was involved in a decision this big, it completely rocked the global markets. Remember August 2011? The S&P 500 plunged close to 20% after the Standard and Poor's downgraded the U.S. credit rating and Congress battled over the debt ceiling.
The politicians have played chicken with the market before. Take a look at the sharp pullback in the S&P 500 in the chart below.
Not only does Congress remain historically divided after the recent election, but it will have limited time to set up a team and pursue a deal.
When you put it all together, this is another very tough challenge for the market and politicians. Battle lines are being drawn. Getting deals done is very hard in a highly partisan Congress. The only reason the deal on the budget got done last year is because the market pressured politicians to find a solution. So expect this to be a tough battle that goes down to the wire.
And that means volatility.
But you don't need to be a Wall Street "guru" to take advantage of the situation. The fiscal cliff could be a short-term opportunity to make some long-term changes to your portfolio with sector and asset allocation rotations.
So if you want to get a little more defensive and avoid the uncertainty, here are three investments that can survive the adversities of the fiscal cliff:
1. iShares Barclays Credit Bond (NYSE: CFT)
I still think investment-grade corporate bonds are one of the most underrated investments in the market. With 10-year Treasuries carrying a negative real return, the iShares Barclays Credit Bond ETF's almost 4% dividend yield looks quite attractive.
This exchange-traded-fund (ETF) is linked to an index with more than 4,800 issues, providing plenty of diversity and protection against stock-specific risk. And with an expense ratio of just 0.20%, below the category average of 0.23%, this fund offers value, too.
2. SPDR Gold Shares (NYSE: GLD)
This might seem like an unusual pick for this article, but gold has seen some of its biggest inflows during times of panic. In August 2011, when the S&P 500 crashed, gold hit a new, non-inflation adjusted, all-time high above $1,900 an ounce. And longer term, even if Congress makes a deal to avoid the fiscal cliff, then keeping taxes low and spending high is a virtual cocktail for money-printing and inflation, which makes gold an attractive investment by contrast.
SPDR Gold Shares has high average daily volume for good liquidity and an expense ratio below its category average. With assets of more than $75 billion, it's one of the most popular exchange-traded funds in the market.
3. ProShares UltraPro Short Russell 2000 (Nasdaq: SRTY)
This would be a more aggressive way to play the fiscal cliff, an exchange-traded-fund that provides three times the inverse for the daily performance of the Russell 2000, an index of small-cap stocks.
It's important to understand that this isn't an investment. This instrument is designed as a hedge against volatility and for short-term use only. ProShares UltraPro enables investors to reduce equity exposure from their portfolio with a leveraged short position, bypassing individual stock trading, which would involve more transaction fees. With an expense ratio of 0.95%, this ETF is a little pricier, but still directly in line with its category average.
Risks to Consider: Market volatility can dissipate as quickly as it appears. If Congress is able to find a solution faster than expected, then it would have a positive impact on sentiment.
Action to Take --> The fiscal cliff is fast approaching, but the market isn't panicking -- yet. If another round of sustained volatility rears its head, then stocks will be under pressure. That makes this the perfect time for some sector and asset rotations to get your portfolio a little more defensive ahead of the big event. The three options I mention in this piece are a great place to start.