How to manage volatility as the fiscal cliff looms8/3/12 12:46 PM ET (MarketWatch)
A flag flies in front of the U.S. Capitol. A year after the U.S. lost a triple-A rating, investors could be in for another period of volatility if lawmakers can't hammer out debt and tax deals.
SAN FRANCISCO (MarketWatch) -- As they say with foreboding in the popular television series Game of Thrones, "Winter is coming."
And for U.S. markets this year, "winter" could mean a storm of volatility in the form of November elections, a government debt ceiling hit soon after, and the so-called "fiscal cliff" in 2013, as the Bush-era tax cuts come due to expire and several billions of dollars in mandatory budget cuts kick in.
As investors mark the Aug. 5 anniversary of the United States losing its triple-A rating from Standard & Poor's, they do so in a market that looks deep in summer slumber -- a big change from a year-ago. Read Aug. 2011 article on downgrade.
In August and September 2011, market volatility spiked to levels reminiscent of the height of the U.S. financial crisis. By early October, the S&P 500 was flirting with a bear market. The debt downgrade, which came with the warning that more could be in store, followed weeks of watching congressional leaders play chicken with raising the country's debt ceiling and a feud over a deficit-cutting plan that few deemed deep enough. Read a recap of August 2011's wild ride.
Yet twelve months later, the Dow Jones Industrial Average (DJIA) , the S&P 500 Index (SPX) , and the Nasdaq Composite Index (COMP) have all risen about 10%. The U.S. dollar (DXY) has gained 11% against its rivals. U.S. Treasury yields are near record lows. Gold is about 4% lower, while oil prices are slightly lower though still in the $90-a-barrel area. Additionally, recent stock trading volume is off by about 30% compared with August's average daily volume a year ago.
But one of the biggest differences from last summer is the lack of volatility. The CBOE Market Volatility Index (VIX) , the so-called "fear index," is considerably lower from a year ago.
On Friday, the VIX was down 7% to 16.34 as favorable U.S. payroll and services data put investors into a risk-on mood that boosted stocks by about 2% across the board. The 50-day moving average is currently at 19.56, while the 200-day average is at 21.41.
In the past few months, the index has traded toward the low end of the 15 to 25 range, compared to the high end of last summer's 25 to 45 range.
Much of that volatility was triggered by last summer's congressional arm-twisting over raising the U.S. debt ceiling that threatened a government shutdown. To avoid a repeat of that, House and Senate leaders struck a deal Tuesday to fund the government for six months, but the deal doesn't do anything to resolve the debt-ceiling or the fiscal cliff. Read more on the stopgap measure.
This time around, in addition to a what promises to be a contentious national election, volatility will be fueled by uncertainty over the fate of the Bush-era tax cuts, the expiration of the 2% payroll tax cut, higher Medicare taxes as part of the health-care overhaul, slated budget cuts, and the expiration of extended unemployment insurance. Collectively, these tax increases and spending cuts have become known as the "fiscal cliff."
Winterizing the portfolio
Volatility levels are not likely to top those from last summer as we approach the end of the year, but investors need to be prepared for some renewed level of it, said Bill Stone, chief investment strategist at PNC Asset Management Group.
"The political process will be messy, but in the long run you have to make an educated decision on how it will play out," Stone said.
Stone believes after all the smoke clears on the political wrangling, most aspects of the fiscal cliff will be avoided. He estimates that if Congress does nothing, it will impede the economy by $606 billion, or 3.5% of gross domestic product.
While the Bush-era tax cuts may be preserved for those families making less than $250,000 a year and the middle class may dodge an expansion of exposure to the Alternative Minimum Tax, Stone sees the 2% payroll tax cut expiring and increased taxes to fund health-care reform laws that were backed by the U.S. Supreme Court in June.
He suggests one way to face the coming volatility is through dividend-focused stocks, or high-quality names with stable balance sheets and low debt that don't necessarily have the highest yields, but have the wherewithal to grow their dividend.
One such exchange-traded fund that follows consistent dividend growth stocks is the SPDR S&P Dividend Fund (SDY) , which is up about 9% from a year ago. Read Weekend Investor on dividend-growth stocks.
Brian Rehling, chief fixed income strategist at Wells Fargo Advisors, said a lot will depend on the election, such as whether control of the presidency and Congress will remain in the hands of one party or be split.
The combination of factors toward the end of the year, however, is unprecedented.
"Markets haven't dealt with this previously, and that has its own challenges," Rehling said. "Markets would like to see a medium-to-long term plan in place on the debt ceiling and the fiscal cliff."
The U.S. government is estimated to hit its $16.394 trillion debt ceiling sometime after the November elections.
While debate among politicians will spike volatility, Rehling said neither party wants the country to walk off the cliff completely and expects some sort of compromise to be hammered out. But if that compromise is a short-term fix from a stubborn, polarized Congress, that increases the likelihood of another downgrade to U.S. debt in 2013 or 2014 from S&P or one of the other ratings agencies, he said.
While the S&P downgrade from triple-A did not have negative consequences for U.S. debt costs -- and resulted in more money flowing to U.S. Treasurys as stocks sank -- another could have a negative affect on municipal and corporate debt. A further downgrade could make other countries' debt, like Japan's, more of a safe haven. Read Robert Powell on what to do if the U.S. is downgraded again.
Rehling also believes the payroll tax cut will not be extended but expects the issue of the Bush-era tax cuts and budget spending cuts to be kicked further down the road.
Expect volatility, then move on
Anticipating volatility this winter should mentally prepare investors to ride out the bumps and not fly out of stocks, according to Scott Wren, senior equity strategist at Wells Fargo Advisors. On other words, don't expect any sort of resolution and a lot of volatility until the new Congress is seated on Jan. 20, 2013.
"The lame-duck Congress won't get anything done, so on the first day of the new Congress they'll likely retroactively extend the Bush tax cuts," he said.
Wren acknowledges that while many retail investors are hesitant to go into stocks because of past burns from the tech and housing bubbles, the U.S. equities market is a relative safe haven compared with other international markets.
He still foresees an S&P 500 target of 1,400 to 1,450 for the end of the year, from 1,365 on Thursday, and has overweight positions in consumer discretionary, materials and tech stocks.
ETFs such as the
The volatility could start up well before U.S. elections if hopes for patching up Europe's fiscal mess begin to unravel. Mitch Schlesinger, chief investment officer at FBB Capital Partners, points out that Germany's Constitutional Court is expected to issue a verdict in mid-September on whether the European Stability Mechanism is constitutional under German law. Germany, which is set to contribute the most into the fund, still needs to ratify the treaty for the fund to take effect.
Leading into the winter, Schlesinger is taking a defensive posture, favoring dividend-paying stocks like utilities, telecoms and consumer staples.
On the fixed income side, he favors investment-grade corporate debt with yields in the 4% area, although, he admits, that yield is getting tougher to come by. Yields on 10-year Treasurys (10_YEAR) , which have fallen below 1.4% in the past month, are about 1.6% currently, compared with 2.6% a year ago. The
As for the fiscal cliff, he foresees a moderate increase on capital gains and dividend tax rates, and perhaps even a rewriting of regulations after the new Congress begins.
"No want wants to address this before the election," he said. "Congress put these rules in place and they can change them."