A strategy for profiting from the U.S. fiscal cliff--just in case

10/30/2012 6:22 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Talk about sticking your head in the sand. (I’m talking about the U.S. fiscal cliff, not the way we’re going to ignore the implications of SuperStorm Sandy. More on that later this week.)

Everybody is worried about the potential of our squabbling, self-interested politicians in Washington pulling a Thelma and Louise and driving the U.S. economy straight off a fiscal cliff in 2013 and into new recession. Goodbye, 2% GDP growth. Hello, -0.6%. The U.S. economy in 2013 would look like the EuroZone does currently.

But Wall Street is dealing with that possibility by 1) pretending that it won’t happen (Yeah, and Congress didn’t sink the U.S. credit rating in an avoidable battle over the debt ceiling), or 2) hoping that some derivative purchased for portfolios will provide insurance against the disaster (Yeah, derivatives work really well when everybody wants to get on the same side of a trade.)

So instead, let’s take a novel approach today in this post and actually talk about something you can do—over the next few weeks and months to make the fiscal cliff, if it does happen, less painful and to make a nervous market, if the cliff begins to loom dangerously near, profitable to your portfolio.

I’m not going to pretend that this is a grand solution. I’d be quite happy if you called it a partial solution or even a baby step toward a solution. But this isn’t my last word on the subject and we do all have to start somewhere, right?

My solution? Dividends.

Today, I’m going to explain why creating a watch list of stocks with potential 5% (or better) dividend yields, putting cash away to buy those stocks if they hit my target (and I’ll explain what that is), and then buying in the confusion and chaos of any run up to the fiscal cliff is a smart long-term strategy.

Just in case you’ve been asleep and missed all the references to fiscal cliff, let’s review what it is and why it’s a big problem. Turns out that Congress and the President, probably without intending it, have turned the end of the year into an economic time bomb. Just on the tax side, on December 31, 2012 the temporary Social Security payroll tax cuts expire, the alternative minimum tax would begin to take a bigger share of income, the Bush Administration tax cuts come to an end, and new taxes required to pay for the Affordable Care Act/Obamacare go into effect. On the spending side, a deal put together as a way to get the U.S. debt ceiling increased would require automatic cuts to the military budget and the more than 1,000 other government programs.

In more specific terms, the lowest income tax rate would go to 15% from 10% and the highest rate would climb to 39.6% from 35%. (The 25%, 28% and 33% brackets would go to 28%, 31%, and 36%.) The tax rate on dividends would climb to the rates paid on ordinary income from 15%. Most capital gains would get taxed at 20% instead of 15% now. According to the Congressional Budget Office, taxes would go up by $347 billion in 2013.

On the budget outlay side, defense programs would take a 9% cut, most nondefense programs—besides Social Security, Medicare, and Medicaid—would get an 8% shave.  Medicare would take a 2% cut.

The total effect in 2013 would add up to $600 billion, according to the Congressional Budget office. Real economic growth (that’s growth above inflation) would fall at an annual rate of 2.9% in the first half of 2013 and the unemployment rate would climb to 9.1%, again according to the Congressional Budget Office. Stocks could fall, by 20% or more. (Any estimate of the dimensions of a stock market decline is pretty much guess work. But I think it’s safe to say, the results wouldn’t be pretty.)

The very extreme nature of these consequences is, of course, why many on Wall Street argue this scenario will never happen. Knowing that doing nothing or doing the wrong thing would have such dire consequences means that the politicians in Washington will never let this happen, the argument goes.

I think that ignores the very real possibility that the November elections will push one political party or another (or both) into a position of Damn the consequences; let’s just bring it all down and blame it on the other party.

And besides, we don’t have to actually go driving off the fiscal cliff to do real damage to the economy and the stock market. Even a whiff of the cliff could paralyze capital spending and consumption decisions. And it wouldn’t take more than a few day of panic at Congressional inaction from the talking heads on TV to send the market into a serious retreat.

I’ve got a suggestion for what to do with part of your portfolio in this fiscal cliff gets scary scenario. It’s based on my description of what I’ve called the “New Paranormal” market. (See my post from March 2 on what that means http://jubakpicks.com/2012/03/ .) In that market an investor will be faced with the worst of two worlds. As Pimco’s bondmeister Bill Gross has said of what he calls the “New Normal” investors will be lucky to see an average annual return of 5% during this coming period. And, what’s worse, that average return won’t be very smooth. Instead the average will be smooth over a period of extreme volatility (the “Paranormal” part) of my description. The challenge for investors will be to hold on through that volatility to reap that 5% average return and not to get whiplashed into buying high and selling low over and over again.

Which is where dividends in general and my 5% dividend rule in particular come in.

A better than decent dividend yield on a stock will, more times than not, keep an investor in a position. Holding onto a stock paying 4% in a scary market is relatively likely when the alternatives are 10-year Treasuries paying just 1.74% and money market accounts paying 0.17%. And since stocks that pay solid dividends are less volatile to begin with, a dividend strategy does stand a good chance of avoiding the buy high and sell low pattern that can decimate a portfolio.

Adding my 5% dividend rule to a general disposition to look for dividend stocks can turn that “good chance” of avoiding portfolio damage into a strategy for getting the best performance possible out of a New Normal or New Paranormal market.

The rule is pretty simple. If 5% is about the best annual average return you can reasonably expect, then when what you’d judge a good stock on the other usual standards, falls far enough to pay a 5% yield you should snap it up.

This rule winds up working a little bit like dollar cost averaging because you wind up buying fewer shares/fewer stocks when the market as a whole is expensive and more when the market is cheap.

Right now, for example, if you’re looking for 5% dividend stocks, the market looks expensive. That’s not surprising since at its October 26 close at 1412 the Standard & Poor’s 500 isn’t all that far below its 2012 closing high of 1466 set on September 14. When I scan any list of the stocks paying the highest dividends, I come away empty handed in any search for 5% yields. Even many of my favorite MLPs (master limited partnerships) that I’ve picked for my Dividend Income portfolio http://jubakpicks.com/ are showing yields below 5%. Look at Western Gas Partners (WES) at a 3.88% yield on October 26, or Magellan Midstream Partners (MMP) at 4.52% or ONEOK Partners (OKS) at 4.54%. To get anything much above that you have to go either for more risk, such as Buckeye Partners (BPL), which pays 8.6% but where pricy acquisitions have stretched the company’s balance sheet, or go overseas with a stock like Westpac Banking (WBK), where higher foreign withholding rates take a 6.43% yield down to a net 4.8%, or opt for both more risk and higher overseas withholding with a stock such as SeaDrill (SDRL), which pays a 8.38% gross yield with a high degree of balance-sheet leverage.

But, with an eye on the fiscal cliff I can see some interesting 5%--or better yields—perhaps—on the horizon. My most recent survey of the dividend geography turned up interesting potential future 5% yield buys among U.S. traded stocks at Statoil (STO), currently at a 4.48% yield; GlaxoSmithKline (GSK), currently at 4.66%; ConocoPhillips (COP), currently at 4.61%; Intel (INTC), currently at 4.1%; Diageo (DEO), currently at 3.03%; and Verizon (VZ), currently at 4.6%. Among MLPs these caught my eye: ONEOK, Magellan Midstream, and Plains All American Pipeline (PAA), currently at 4.8%. If you can trade in overseas markets, I’d look at Svenska Handelsbanken (SHBA.SS in Stockholm) at 4.2%; Konecranes (KCR1V.FH in Helsinki) currently at 4.11%, Starhub (STH.SP in Singapore), currently at 5.42%; and Natura Cosmeticos (NATU3.BZ in Sao Paulo) currently at 3.42%. Remember that those are gross yields and you have to correct those yields for higher overseas withholding rates. (The rules on how much of an overseas withholding tax you can recover on your U.S. income tax return aren’t simple but they’re not as complex as the IRS makes them seem either. You can find the IRS rules here http://www.irs.gov/publications/p514/index.html . For a simple list of what countries charge what see this list from Seeking Alpha http://seekingalpha.com/article/248039-withholding-tax-rates-by-country-for-foreign-stock-dividends. Note that Singapore and the United Kingdom have 0% withholding for U.S. citizens. )

The final bit of advice is that to take advantage of my 5% dividend rule, you’ll have to have some cash to use if the fiscal cliff roils stock prices. You certainly don’t want to be selling into a falling market in order to raise cash so you’ll need to raise some capital before that. I’d look to see about selling in mid-November to early December or so if the level of fear and yammer on the fiscal cliff seems to be rising. Fear of the fiscal cliff should still be subdued until then, and if the U.S. and Chinese economies continue to look like they’re staging even a minor recovery stock prices might be modestly higher by then. (For more on my read on possibility of that kind of rally in the relatively short-term —and for stocks to own beyond that time frame just in case the fiscal cliff doesn’t hit the stock market on this schedule-- see my post http://jubakpicks.com/2012/10/26/a-barbell-of-stock-picks-u-s-and-china-for-the-last-months-of-2012/ )

And, of course, any selling you might do means you’d go into any fiscal cliff-inspired downturn with more cash on the sideline and less in the market, which, in itself, wouldn’t be a bad thing.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did own shares of Natura Cosmeticos, SeaDrill, Singapore Engineering, Statoil, and Svenska Handelsbanken as of the end of June. For a full list of the stocks in the fund as of the end of June see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/

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