Seeking Alpha
Profile| Send Message| ()  

The Fiscal Cliff is a new invention and one that is important to view with caution as an investor; it is an event that hasn't occurred before and it will be difficult to gauge how the market will react as January 1st approaches.

While politicians debate in Washington over a grand bargain to avoid this change in fiscal policy, an opening bid from the president involves a $1.6 trillion increase in tax revenue, a $50 billion fiscal stimulus program, as well as a request for the authority to raise the debt limit. The opposition countered with a $800 billion tax increase and defined cuts over the next ten years. Both offers were turned down swiftly. As investors we must observe these demands without political bias, and not forget that "The Fiscal Cliff" is a creature of a past debate, one that the president touched upon in his initial offer.

I speak, of course, of the prior bargain that occurred July 31st, 2011 - the deal to raise the debt ceiling as an end to alleviate the debt crisis. This deal was to allow the US government to continue borrowing money to finance its operations to a limit. This deal, as many do, came with a rub: The Fiscal Cliff. The US debt ceiling is anticipated to be reached by February or March of 2013 at the latest. So, will The Fiscal Cliff grand bargain solve the debt ceiling problem in one fell swoop, or are we entering into a time of serious financial uncertainty leading up to January 1st, 2013, and throughout the first quarter of that year?

The only tool we have as investors is to take stock of the past. The gloom of the period coming up to the 2011 debt crisis is clear in the minds of investors, as is the doom directly thereafter. Even before Standard and Poor's downgraded the US debt from AAA to AA+ August 5th 2011, the Dow had shed 1,209.12 points or 9.60% in the period from July 24th to August 3rd. By the time S&P had downgraded the US debt, the Dow had plummeted 1,782.95 points, or 14.16% over the period from July 24th to August 7th.

Is this likely to repeat in the near future? S&P stated during the US credit downgrade, on August 5th, 2011, that it would lower the rating on US debt further to AA if the US doesn't get its fiscal house in order. If the fiscal cliff occurs, are the cuts and tax increases sufficient, and, more importantly, if the fiscal cliff is averted, will the necessary spending cuts and tax increases be sufficient to avoid a further credit downgrade?

Of course, this article is one which offers not only a perspective on past events, as well as how future events may unfold, but also insights on how to profit in the event of market panic leading up to, between, and after these events occur. This volatility may create gains in ETFs shorting the financial markets, such as FAZ or SKF. With regard to these last two, it would be well to view the performance of one of their 3x leveraged counterparts, FAS, or Direxion Daily Financial Bull 3x Shares, in the days leading up to and after July 31st of 2011.

From July 25th to August 2nd, in the days leading up to and after the bargain that settled the 2011 debt crisis, FAS had shed $17.75 or 14.27% from its position at $124.40/share. By August 7th, after the August 5th credit downgrade catalyst, FAS had dropped a further $62.19, or 49.92%, to $62.30/share. The reciprocal of FAS, FAZ, gained $34.83, or 77.87% over the period from July 25th to August 7th.

(click to enlarge)

This entire period was one of market instability brought about the talks before the resolution, and the aftermath of the resolution to the 2011 debt crisis: The Fiscal Cliff of January 1st, 2013. This leaves investors to wonder: will the Fiscal Cliff bargain, if there is one, include a deal on the debt ceiling, or will it create a new creature that is liable to provide markets with further uncertainty for Washington to deal with at a later date?

As has been shown above, it is clear that during the time leading up to the past debt ceiling crisis financials weren't an advisable asset to have in any portfolio. Looking to insiders for guidance, Goldman Sachs' Vice Chairman Evans J. Michael sold 150,408 shares recently for a total of $17,983,619. It would appear that the author of this article is not the only one with a short view of the financial market for the months ahead.

After political discourse ceases the markets will take stock of the situation at hand. If the debt ceiling is raised it will, perhaps, be bullish for precious metal ETFs such as GLD or SLV, where investors hedge their portfolios against the inflation which may come if The Federal Reserve acts to monetize the debt. If the debt ceiling is not raised, and significant cuts, or tax increases, are put into place, the effect on the US economy will be harsh and could trigger a recession, though it may also strengthen the global perception of the USD, especially against the ailing Euro, where positions in UUP or EUFX could prove to be profitable.

It is the opinion of the author of this article that there is no resolution to The Fiscal Cliff that the market will find palatable in the short, or long, term. Any tax increases to fund the US debt or any cuts to spending will reduce demand for goods and services across the board. If taxes aren't sufficiently increased, or spending is not sufficiently cut, the US faces the very serious risk of another credit downgrade, which is particularly true if the issue of the February/March debt ceiling is not sorted out promptly and precisely. If the US debt is downgraded further, it would be unlikely that the dollar would maintain is luster, and the cost of borrowing for the US could increase. If the price of money for the US is increased, it could send the US treasury in a downward spiral, and the US and other major economies down with it.

Source: Lest We Forget: The 2011 Debt Crisis And The U.S. Credit Rating