The markets still are largely digesting the big post-election sell-off, but it's not so much the reelection of President Barack Obama that's got everyone on Wall Street nervous. Rather, the biggest source of tensions fraying the nerves of traders is the potentially disastrous hit our economy could suffer if the administration and Congress fail to come to some type of meaningful agreement on the so-called "fiscal cliff."
As you likely know, if the powers that be in Washington, D.C., drive us off the fiscal cliff (which simply is a term for the poisonous cocktail of automatic spending cuts to crucial sectors such as defense, and automatic tax increases), the impact of that crash landing will be felt very hard on Wall Street. Last week, markets tanked due to the realization that a failure to resolve our budget issues could cut a $600-plus billion slice out of the nation's GDP pie.
In fact, the selling on Wednesday and Thursday of last week drove stocks down sharply, and for the first time in quite awhile, exchange-traded funds (ETFs) pegged to the inverse of the major U.S. averages were among the market's top performers.
Now, on the other side of the globe, there also is a looming change of leadership, but it isn't likely to come with any vigorous debate or disagreement over budget issues. Here I am referring to China, as a new cadre of Communist Party leaders will assume the reins of the second-largest economy in the world.
To be certain, the Chinese economy has had a tough time in the past 12-18 months, as there's been a slowdown in its rate of GDP growth from the double-digit percentage growth a few years ago. Most recent GDP data shows the Chinese economy growing at a rate of 7.4% in the third quarter, the lowest growth rate since early 2009.
However, other metrics of late have improved, including the purchasing managers index and trade data. Together, these numbers suggest an economy that's no longer sliding, and this stabilization has been reflected in the rising price of Chinese stocks since September.
I suspect that the fast money is ready to continue migrating to China for gains, while at the same time moving away from domestic equities, at least until the uncertainty over the fiscal cliff has been taken off the table.
Smart traders can take advantage of this with a pair trade that is long China and leveraged short the broad market S&P 500 index. Here are the particulars of the trade as I see it:
iShares FTSE China 25 Index (NYSE: FXI)
This is a fund pegged to the top 25 stocks on the Shanghai Exchange. I call FXI the "Dow industrials of China," as these are the behemoth companies that trade on that country's exchange.
Since the September low, FXI shares are up nearly 12%. I suspect this fund could see another big spike past the February highs of $40.49 on optimism over new leadership, as well as pessimism in the United States over the fiscal cliff, and the ever-present bailout and recession issues still plaguing Europe.
ProShares UltraShort S&P 500 (NYSE: SDS)
Buying this fund is a bet that the fiscal cliff issues will result in a flight of capital away from U.S. stocks. SDS is designed to deliver performance that's equal to twice the inverse of the S&P 500 index, so if the S&P 500 falls 2%, SDS should rise 4%.
Because of its leveraged nature, I don't recommend holding this fund for more than six weeks or so, but that's perfect given the fact that the fiscal cliff issue has a deadline of Dec. 31. I suspect that the fast money will continue pouring into this fund to gain some short-term alpha, and that's a wave you also can ride to higher gains.
Action to Take --> Buy SDS at the market price. Set stop-loss at $52.75. Set initial price target at $65 for a potential 10% gain by year's end.
This article originally appread on TradingAuthority.com:
The Trade Everyone Should Make Before the Fiscal Cliff Deadline