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Introduction

Following the United States Presidential election, equity markets were battered. Further, companies reporting third-quarter earnings delivered less than impressive results and many have been guiding lower for the fourth quarter and fiscal-year 2013. Add to this the proverbial "fiscal cliff" on every investor's mind, which has the potential to negatively impact everyone in the United States simultaneously, and there is major cause for concern. The fear of going over this devastating fiscal cliff has spooked many retail investors out of the markets until a resolution occurs. However, in this past two weeks of trading, the markets have rebounded quite a bit higher on some positive rhetoric out of Washington, that both Democrats and Republicans want to avert the cliff and investors hope that they will do so. It is all but guaranteed that the markets will continue to trade on news out of Washington for the remainder of the year, in addition to trading on major economic news. It is more than likely that markets will trade up on days where progress on a fiscal cliff resolution is seemingly made, and trade down when it seems negotiations are failing and move minimally or trade flat in between.

The markets will certainly not trade flat come the fiscal cliff deadline. If we go over the cliff, investors may want to consider taking some bearish action should market panic ensue. Bearish conditions could lead investors to consider selling stock, selling covered calls on their positions, shorting stocks, buying puts or investing in a bear fund. While each of these approaches in a bearish scenario has its respective benefits and risks, in this article, I want to highlight four ETFs for investors to consider if there is no resolution of the fiscal cliff situation by the end of year deadline.

If fiscal cliff negotiations fail, spending cuts and tax hikes go into effect

Massive spending cuts and across-the-board tax hikes will immediately pressure markets and each day that there is no resolution past the deadline there will be panic selling leading to a massive correction. The conservative investor will have little choice but to sell equities and sit in cash or risk holding and waiting weeks, months or possibly even years for the rebound. This is only wise with a diversified, high-yield portfolio and even then portfolio growth will be missed by sitting idle. Investors willing to take on more risk can buy puts, sell calls or straight out short stocks. For those who cannot or will not take this approach, there are bear funds that exist, both leveraged and unleveraged, which can protect capital in bear markets. In order of risk based on degree of leverage and underlying indices replicated, I highlight four bearish ETFs that will provide outsized returns should we plunge over the cliff.

ProShares Short S&P 500 (SH): This ETF seeks daily investment results that correspond to the inverse of the daily performance of the S&P 500 index. The S&P 500 index is a measure of large-cap United States stock performance. It is a capitalization weighted index of 500 United States operating companies and selected real estate investment trusts. SH attempts to invest at least 80% of its net assets, including any borrowings for investment purposes, to investments that, in combination, have economic characteristics that are inverse to those of the index. It intends to invest assets not invested in financial instruments, in debt instruments and/or money market instruments. The fund intends to concentrate its investments in a particular industry or group of industries to approximately the same extent the underlying index is concentrated. SH currently trades at $33.83 on approximately 3.3 million shares exchanging hands daily. SH is down 1.43% in the last week, while the S&P 500, as measured by the SPY is up by 0.5%. SH has a 52-week range of $33.33-$40.85.

ProShares UltraShort S&P 500 (SDS): This leveraged fund seeks daily investment results that correspond to twice the inverse of the daily performance of the S&P 500. SDS invests in common stock issued by public companies. SDS also invests in derivatives, which are financial instruments whose value is derived from the value of an underlying asset, interest rate or index. SDS recently underwent a one-for-four reverse split to bolster the share price as the nearly four-year bull market took its toll on this fund's value. However, in moments of panic and bearishness, it performs very well. It currently trades at $53.62 a share. SDS has average daily volume of 8.8 million shares exchanging hands. In the last week, SDS is down 1.4%, while the SPY is up 0.5%. SDS has a 52-week range of $52.12-$78.88.

Direxion Daily S&P 500 Bear 3x ETF (SPXS): SPXS, formerly the Direxion Daily Large Cap Bear 3X fund, seeks daily investment results before fees and expenses of 300% of the inverse of the price performance of the S&P 500 Index. As with other funds, there is no guarantee the fund will meet its stated investment objective. The fund has a 1.14% annual expense ratio. Under normal circumstances, SPXS management creates short positions by investing at least 80% of its net assets in: futures contracts; options on securities, indices and futures contracts; equity caps, collars and floors; swap agreements; forward contracts; short positions; reverse repurchase agreements; ETFs; and other financial instruments that, in combination, provide leveraged and unleveraged exposure to the S&P 500. SPXS currently trades at $16.65 a share. SPXS has average daily volume of 2.0 million shares exchanging hands. In the last week, SPXS is down 1.9%, while the SPDR S&P 500 Trust (NYSEARCA:SPY) is up 0.5%. SPXS has a 52-week trading range of $16.07-$30.53.

Direxion Daily Small Cap Bear 3X Shares (TZA): This is my favorite way to invest in a bear market short term. TZA seeks daily investment results of 300% of the inverse of the price performance of the Russell 2000 Index (also known as the small cap index). The Russell 2000 measures the performance of the small-cap segment of the United States equity universe and consists of the smallest 2,000 companies in the Russell 3000 Index, representing approximately 10% of the total market capitalization of the Russell 3000 Index. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership.

TZA actually does not invest in equity securities or stocks. What TZA does is creates short positions by investing at least 80% of its net assets in financial instruments to provide leveraged and unleveraged exposure to the small cap index and the remainder in money market instruments. TZA currently trades at $13.67 a share on average daily volume of 18.4 million shares. In the last week, TZA is down 6.8% compared with the Russell 2000 Index fund (NYSEARCA:IWM), which is up 1.3%. TZA has a 52-week range of $13.35-$27.13.

Conclusion

Many approaches exist to position accordingly for market panic. While central bank action had once bolstered markets, mediocre earnings reports, turmoil in Europe, the United States Presidential election outcome and now the looming fiscal cliff will continue to dictate the direction of equities markets. If fiscal cliff negotiations fail, the aforementioned bearish funds will perform very well in response to the market panic that will ensure. This is especially true if we head over the cliff without even a short-term fix in place. Should the politicians in Washington, pull together and get something done to resolve the fiscal cliff debacle, we will see a major risk-on event and thus these funds are to be avoided, or for the more advanced trader shorted either directly or through put options. It seems much of the idea of a resolution has been baked in to the markets, thus disappointment could lead to a quick drop across the board in equities.


Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Source: We've Gone Over The Fiscal Cliff - 4 Ways To Profit

Additional disclosure: I will be picking up TZA as we near the deadline. I often have a position in this name for a few days each month to profit from sell-offs.

Disclaimer: I am not recommending investors to be bullish, bearish or neutral. This article is for informational purposes only and highlights funds one can consider in response to a lack of a resolution to the fiscal cliff. It is not a recommendation to buy or sell any of the aforementioned assets or to position one way or the other ahead of the fiscal cliff deadline. Rather it is a recommendation to consider these funds in the immediate aftermath of a significant sell-off event, in addition to the myriad of other options to position a portfolio accordingly, as discussed above.