Great investors are not solely defined by their ability to choose opportune investments. What places an investor in a league of their own is their ability to monitor and adjust to the changing dynamics of the investment environment. Risk management is paramount within the strategies of savvy investors. Inclusive to this is the ability to adequately prepare for the worse.
The elections are over. We have the same administration, and bipartisanship is a must. Now the primary focus of attention is on the fiscal cliff. The fiscal cliff in simple terms is the expiration of the Bush tax cuts and automatic spending cuts by the U.S. government. At the present moment, falling off the fiscal cliff is the worse case scenario. In the wake of a more global environment, not only is this of utmost concern for the U.S. but the rest of world, especially Europe who is struggling to gain its footing.
One mistake that investors make is seeking unconventional strategies to them as a means of coping with extreme market realities. This is termed style drift. Style drift is not completely unacceptable, however, the timing of choosing a new strategy, especially a decision that is induced by emotion, is not the most effective means of risk management. Investors should seek to widen their investment base primarily to add to their current discipline, not as a means to cope with a material event. If you are a stock investor, invest in stocks. If you have a macro approach, employ it. If your niche is short selling, stick with it. Risk management is achieved when investors do what they know and are comfortable with. The same is true during the worst case scenario. In the wake of the possible fiscal cliff, research the possibilities, and derive at a model of best to worse case scenarios within your discipline (i.e. stocks, bonds, forex, etc.) Once you have a better understanding of the possibilities and a model of determining the probability of each outcome, your investment decisions will become more precise and thus more risk conscious.
Key changes relative to the fiscal cliff are the increase in payroll taxes, the end for certain business tax breaks, a potential increase in the alternative minimum tax, and taxes relating to the President's health care law. In addition to this, spending cuts relative to the debt ceiling would go into affect. Should these automatic spending cuts take place, a large part of which would be in the defense budget and Medicare.
David Wessel, an economist with the Wall Street journal, reported that the fiscal cliff can be broken down into five key issues:
- the size of government,
- defense spending,
- payroll taxes.
According to a recent study, 63% of government spending in 2011 was allocated to "pre-approved" issues, not requiring a vote of congress. This would mean that the constant tug-of-war between the two parties on government spending was related to the remaining 37%. The 63% was stated to have been allocated for Social Security, Medicare, Medicaid, Farm Subsidies, and Interest on the Federal Debt. The report also stated that 1/4 of spending is allocated to healthcare. In 1960, healthcare spending was less than 10%, prior to Medicare and Medicaid. Currently, healthcare spending accounts for 25% of total spending. Often, discussions arise illustrating the need to shrink the size of government. The study reported that if all of government workers were fired as a means of lowering the deficit, it would only generate $435 billion dollars. This is less than 1/3 of the deficit. Defense spending in 2011 was $700 billion. Our defense budget is larger than the next 17 countries defense spending combined. A fifth of spending currently is being allocated to the defense sector. The average person is averse to taxes. However, many are unaware that there has been a constant down trend in taxes over the past 30 years. In 1981 for instance, the middle class paid 19.2% in taxes relative to income. In 2007, the middle class paid 14.3% in taxes relative to income. The U.S. has among the lowest tax rates in the world. The fact that the U.S. borrows 36% of every dollar spent is a cause to seek domestic revenue.
Investing for the fiscal cliff can be approached from both a fundamental and technical standpoint. For the sake of this text, we will focus more on the fundamentals. The information presented above, albeit with other considerations, can begin to provide us with some areas of opportunity for our portfolio. An increase in payroll taxes will have an effect on consumer spending, thus, retail stocks may be one to avoid currently. However, if you believe that we will avoid the fiscal cliff, buying retailers at current levels will be profitable in the future. I suggest buying call options on the most strategically positioned retailers to limit your risk.
Healthcare has been a key subject for the tenure of the President. Hospitals are still the place to be in this industry headed toward the fiscal cliff. The heathcare law, by forcing the uninsured to be insured, greatly reduces the risk and liability of the hospitals. Another area that I see opportunity in is the education arena. President Obama has an emphasis on increasing the country's ranking in education, which is vital if we are to compete in a more global market. Currently, the U.S. is surpassed by 22 other nations in education. The rapid expansion in technology, creating non-traditional forms of education, will continue to grow. With a President investing in education. This is a key area to add to your portfolio. I also like technology stocks of companies that provide mobile and cloud computing. Cloud is the future and will continue to force traditional hardware and software companies to either adapt or suffer antiquity. I'm short companies that fail to create a mobile strategy and whose businesses are weighed down heavily by hardware and software operations. Regardless of the fiscal cliff, mobile and the cloud are here to stay.
For instance, Xerox (XRX), is trading below its 100 day moving average. The stock at its current price is down 21% from a year ago. If the stock falls below its current support line of $6.30, I see it going as low as the $5.00-$5.40 range.
Within the education space, Grand Canyon University (LOPE) and Apollo Group (APOL), are two major players. Of the two, I feel Grand Canyon is the better value. Grand Canyon offers both ground and online programs for those seeking undergraduate, and graduate degrees. As of the fourth quarter of last year, 88.6% of the students enrolled at the university were enrolled in its online program and 42.8% were pursuing masters or doctorate degrees. The company has experienced tremendous growth in revenue and earnings over the past five years. The company also has less leverage than that of the average in its industry.
Over the past few days, the market has shifted from stocks into bonds and other "safe" havens. This presents a great buying opportunity for stocks. I suggest slowly building into positions as we are likely to experience more volatility. Buying VIX options is another way to position your portfolio for the possible volatility.