Ideology Vs. Common Sense In Washington: What Should Investors Do?

by: Steven Bavaria

The stock market's swoon since last week's election just shows again how much the markets fear the sort of political gridlock we have had in recent years, and expect it to continue. Whether ideology triumphs over common sense, or vice versa, as investors we should prepare for the worst (business as usual: i.e., gridlock, "fiscal cliff," etc.) but also be able to benefit if the hero (i.e., common sense, compromise, a "grand bargain," etc.) turns up in the final reel and saves the day.

That means continuing the "savvy senior" investing approach I have advocated previously of focusing on a broad portfolio of "all-weather" high current income producing funds and stocks that will continue to pump out an attractive stream of growing income, regardless of how the market values the assets producing that stream from one day to the next. See here.

Many of the high income producing investments I have recommended (and currently hold) are closed end funds that employ leverage, for example:

•Reaves Utility Income Fund (NYSEMKT:UTG)

•Cohen & Steers Infrastructure Fund (NYSE:UTF)

•Eaton Vance Limited Duration Fund (NYSEMKT:EVV)

•Nuveen Credit Strategies Income Fund (NYSE:JQC)

•Wells Fargo Advantage Multi-Sector Income Fund (NYSEMKT:ERC)

•Duff & Phelps Global Utility Income Fund (NYSE:DPG)

•Clearbridge Energy MLP Opportunity Fund (NYSE:EMO)

•Cohen & Steers Closed End Opportunity Fund (NYSE:FOF)

•MFS MultiMarket Income Trust (NYSE:MMT)

•ING Prime Rate Trust (NYSE:PPR)

•Black Rock Floating Rate Income Fund (NYSE:FRA)

Others are companies whose cash flows and dividend streams should endure an economic downturn:

•Royal Dutch Shell (NYSE:RDS.B)

•Kinder Morgan Inc. (NYSE:KMI)

•Kinder Morgan Management LLC (NYSE:KMR)

•Seadrill (NYSE:SDRL)

•Conoco Phillips (NYSE:COP)

•Consolidated Communications (NASDAQ:CNSL)

•Windstream (NASDAQ:WIN)

Leveraged closed end funds' ability to boost yields would particularly benefit from a "fiscal cliff" scenario that slows down the recovery or throws us back into recession, since it will virtually ensure the Fed has to continue its low interest rate program indefinitely. In that respect, Fed Chairman Bernanke's policies have been a boon to leveraged closed end fund investors. See here.

If you believe that scenario is likely to happen, and that we will end up in a second, double-dip recession, then I would focus more on the senior corporate loan funds (like FRA, JQC, and PPR, although there are many others as well). Senior loans, secured by collateral and covenants, have significantly higher recoveries and therefore, lower credit losses in the event of defaults, which go up during economic hard times. Meanwhile, I would ease up on high yield funds, like MMT and ERC, as well as the widely held high yield bond EFTs, like SPDR Barclays Capital High Yield Bond (NYSEARCA:JNK) and iShares iBoxx $ High Yield Corporate Bond (NYSEARCA:HYG). The choice to hold loan funds over high yield bond funds right now is an easy one. Because of the huge run up in high yield funds over the past year, yields on high yield bonds are about the same as the yields on the better secured senior corporate loans (both in the 6½% range on average, although with leverage in a closed end fund, you can bring that up by another 100-150 basis points). With loans, you are investing in the same basic cohort of borrowers (non-investment grade companies), but with pricing where it currently is right now, you can get the added safety of loans over bonds without paying any premium for it.

In the equity area, I would again focus on stocks and funds that have staying power and are likely to ride out another economic storm. I think the utility and infrastructure funds (UTG, UTF, DPG, EMO, KMI, KMR, WIN) and major resource firms (RDS.B and other oil majors, like Chevron CVX) should hold up well as income sources, although their market values may gyrate all over the place.

Personally I believe we will avoid the fiscal cliff scenario, but would not be surprised if we have to endure a wild ride before we see a reasonable compromise. Ironically, a "grand bargain" of the sort generally discussed -- serious long-term expenditure reductions accompanied by higher taxes (but not necessarily higher tax rates) on the wealthiest Americans -- would benefit everyone in the country, including the high-income taxpayers whose taxes would rise, once other beneficial results of the bargain -- like a new bull market -- were factored in.

That's because investors know that if the markets sensed that politicians in Washington were actually "back on the job" in a real sense, and working together to solve our nation's problems, there would be a rally like we haven't seen in years. Even slightly higher marginal tax rates for the wealthiest among us (if that were necessary to make the whole "grand bargain" palatable to ordinary Americans) would be forgotten in a hurry as real economic activity boomed and uncertainty about our financial and fiscal future receded. The capital gains -- both immediate and longer term -- in the portfolios of wealthy taxpayers would offset many times over the marginal increases in taxes they would pay as a result of a grand bargain.

Given the signals currently coming from both House Speaker Boehner and the White House, there may be areas for real compromise that still allow Boehner to stick to the GOP's "no new tax rates" pledge. For example, they can limit deductions to some maximum amount, or limit the amount of income subject to capital gains and dividend tax rates, while keeping the top income tax rates the same, etc.

The market has already signaled all this pretty clearly. The immediate drop in the Dow Jones Industrials by over 6% just after the election shows investors fear "business as usual" from an unchanged Washington power balance, with both sides perceived as dug in and unwilling to compromise. That paper loss alone is much more than the additional taxes the average wealthy person would have to pay if marginal tax rates were raised or deductions limited. Most investors know this, and would gladly see marginal tax rates raised to the level of the Clinton years (still less than half the rates during the Eisenhower/Kennedy era, and there were plenty of entrepreneurial job creators back then).

Disclosure: I am long RDS.B, KMI, KMR, SDRL, COP, CNSL, WIN, FRA, UTG, UTF, EVV, JQC, ERC, DPG, EMO, FOF, MMT, PPR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.