Wall Street just breathed a huge sigh of relief.
With a deal averting the fiscal cliff in hand, the bulls have been out in force, sending the S&P 500 to its biggest two-day rally since 1973. Although resolution of the fiscal cliff has given the market a very nice boost, the reality is that it's merely a warm up for the main event. A much bigger and more important battle looms just on the horizon.
I'm talking about the debt ceiling.
The United States hit its statutory debt limit on Dec. 31, requiring the federal government to take special measures announced last week in order to avoid a technical default, according to U.S. Treasury Secretary Tim Geithner. Those "extraordinary measures" will provide about $200 billion in short-term liquidity to keep funding government spending, while putting Congress back on the clock to find another round of solutions to the country's growing financial problems.
Uncertainty over the debt ceiling makes the fiscal cliff look like child's play. When Congress last battled issues with the debt ceiling in August 2011, it sent shockwaves through the market, with the S&P 500 falling 19%, just short of bear-market territory. Take a look below.
The debt ceiling is incredibly important because of its impact on the credit of the United States. In spite of the country's growing financial problems, the United States is still considered the safest borrower in the world. A credit downgrade for the safest borrower forces all other assets to be repriced as the "risk-free" rate is compromised. And that can have a devastating effect on stocks, as we saw in August 2011.
Despite this obstacle, I am still bullish on stocks in 2013. As I discussed here, any path higher is bound to be mired with the usual volatility and uncertainty that the market has gotten used to in the past few years.
Here are three investments to help protect your portfolio from short-term volatility with a big debt-ceiling battle on the horizon.
1. SPDR Barclays Capital Long-Term Treasury (NYSE: TLO)
This exchange-traded fund (ETF) is linked to an index that tracks U.S. Treasuries with an average maturity of 14 years. Although the yield of 2.66% isn't exactly eye-popping, shifting capital into fixed-income is a great way to diversify against equity exposure.
Ironically, even though the debt ceiling threatens the credit of the United States, Treasuries are still seen as a safe haven and have seen big capital inflows during times of uncertainty. That showed up last year when shares jumped from $55 to more than $70 in when the S&P 500 sold off on the debt ceiling battle. With assets under management more than $3 billion and an expense ratio of just 0.15%, this ETF is a popular and low-cost method to hedge against economic uncertainty.
2. Direxion Daily Small Cap Bear 3X Shares (NYSE: TZA)
This ETF (exchange-traded fund) enables investors to bet against stocks with leverage, providing three times the inverse daily movement of the Russell 2000, an index of small-cap stocks. Although shares have been trending lower the past few years, the Direxion Daily Small Cap Bear 3X saw big gains during 2011's debt ceiling battle, more than doubling in value to more than $60 a share. Those big inflows have pushed the fund's assets under management to $628 million just four years after debuting in November 2008. Average daily volume of more than 20 million shares provides plenty of liquidity and an expense ratio of 1.13% is only marginally higher than the category average of 0.95%.
3. SPDR Gold Shares (NYSE: GLD)
This ETF (exchange-traded fund) tracks the price of gold. Although 2012 was a relatively slow year for gold, gaining about 6% on the year, the precious metal remains a favorite among investors concerned about economic volatility, inflation and social unrest. And SPDR Gold is a great way to invest in gold. Assets under management of $72 billion make this one of the largest ETFs in the market, while a tight bid-ask spread reduces price slippage that investors are exposed to in the cash markets with bullion. Although an expense ratio of 0.40% is above some of the lowest-cost ETFs available, it is still less expensive than using futures and options to invest in gold.
Risks to Consider: A quick resolution to the debt ceiling could be good for sentient and send stocks jumping higher, similar to what just transpired with the fiscal cliff. Although a quick deal doesn't look likely based on the trend and recent events, it would weigh on defensive segments of the market.
Action to Take --> The market just got a big boost from the resolution of the fiscal cliff, but a much bigger battle looms with another debt ceiling battle taking shape. Using these three ETFs could be a good way to diversify against weakness in stocks and protect your portfolio from debt-ceiling volatility.