The Only Thing Worse than the Fiscal Cliff

Turn on the news anytime or read a newspaper online, and you’ll probably see at least one article talking about the pending fiscal cliff and the looming consequences on the U.S. economy. But there’s something that can have a far worse effect than the fiscal cliff itself: Credit downgrades.

Ratings agency Moody’s recently warned that it might downgrade its “Aaa” on the country’s credit rating if Congress fails to reach an agreement on budget cuts. The market fell by almost 17% last year when it looked like Standard & Poor’s would cut its rating of the country’s debt, so if history is any guide, then the market could fall by double-digits again. And while the market has recovered 30% since the S&P credit downgrade, it’s only because growth in China hit a wall and Europe faces a crisis so big, that it may break up. 

#-ad_banner-#The country owes $16 trillion in debt and an additional $60 trillion in future promises made for Social Security and Medicare. With a debt this big, who would want to buy U.S. Treasury bonds, which are known for their near-zero risks?

Bond guru Bill Gross recently compared the United States’ need for debt to that of a crystal meth addict. The co-founder of the world’s largest bond fund, Pimco, cited three separate studies by the International Monetary Fund, the World Bank and the Congressional Budget Office saying that, to put our fiscal house in order, the United States needs $1.6 trillion in increased taxes or reduced spending each of the next five to 10 years. For comparison, this is almost three times the $600 billion fiscal cliff everyone is worried about. “Bonds would be burned to a crisp and stocks would certainly be singed; only gold and real assets would thrive,” Gross said about the possible prospect.

In other words, a second downgrade could trigger an unprecedented market selloff and a permanent weakening of the U.S. economy. 

So how can investors protect their portfolio from this alarming economic scenario?

They can start by buying hard assets.

I wrote about mining firm Freeport McMoRan (NYSE: FCX) in mid-August as the stock that could beat the market in either scenario of continued market risk or global economic rebound. Since then, the stock is up 22% and has beaten the S&P500 by 18%, on a rebound in gold and copper prices. Currently, the company sees 12% of revenue from gold and 78% from copper. When risk jumps and investors pile into hard assets like gold, the company wins. When the global economy seems to be finding its footing and copper prices increase, the company also wins. While the stock’s price-to-earnings (P/E) ratio has increased in relation to the industry average, I still like the company because of management’s great execution and its 3% dividend yield

But while investment in the miners provides investors with regular dividend checks, I also think they need some exposure to the physical commodity itself — gold, silver and copper, to name a few. For example, the SPDR Gold Trust (NYSE: GLD) has beaten the Market Vectors Gold Miners ETF (NYSE: GDX) by an annualized 15% during the past five years. GLD is up 9% since the beginning of the year but still well off the all-time high set last year. The shares have returned an annualized 18% during the past eight years.

Aside from buying hard assets, investors can also buy stocks with strong revenue support. These are companies with significant revenue support from demographic issues such as the aging population. These are the kinds of stocks that will likely survive during a fiscal Armageddon.

In this case, CVS Caremark (NYSE: CVS) is the first to come to mind. The company is expected to see revenue jump almost 15% to $124 billion in 2012 on strength in its pharmacy benefit management program. Moreover, CVS is fully ready to take advantage of the coming demographic boom of the aging baby boomers as it has with more than 7,300 stores in 41 states and the District of Columbia. The company is also the largest operator of retail health care clinics in the United States, with 1,355 clinics in 25 states. Revenue is also benefitting from the surge in drug patent expirations, as the company keeps a greater share of the sales price for generic drugs. The stock trades for almost 17 times trailing earnings and pays a 1.4% dividend yield.

Health care real estate investment trusts (REITs) such HCP Inc. (NYSE: HCP) are also heading into a demographic and political sweet spot. More than 10,000 people are reaching the retirement age per day in the United States, so the coming demand for health care services and senior living communities is immense. With the Supreme Court passage of the Affordable Care Act, the number of insured people is about to jump by almost 50 million, and more insured individuals means more trips to the hospital for emergency and preventative care. The need for health care means the company’s revenue stream is relatively safe from the ups and downs of the economy. The shares have returned an annualized 14.8% during the past decade and pay a roughly 4.5% dividend yield.

Anyone can make money in a bull market, but the other half of the equation is not losing everything in a big market selloff. 

Risks to Consider: Our financial system is no stranger to debt and many have called for a debt-induced selloff in the past. Investors should position for one of two scenarios, either a further downgrade to our credit standing causes a widespread panic and financial assets plummet or it continues the trend to a weaker dollar and less competitiveness as a nation. 

Action to Take –> Politicians and the general public do not have the willingness to make the hard choices needed to return the country to solvency. So the smart choice in this scenario is to hedge your investments against a market selloff. Investors positioned for a continued trend in dollar weakness and hard assets like commodities will see higher returns, whether in a marketwide or over a longer period. The three stocks I mentioned here are good starting points.