Preparing for More Volatility

 | Dec 28, 2012 | 1:00 PM EST
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"Cowardice ... is almost always simply a lack of ability to suspend the functioning of the imagination"

-- Ernest Hemingway

On Wednesday, the market treated investors to a roller-coaster ride driven by the ebb and flow of the fiscal-cliff talks. Stocks fell more than 1% after Senate Majority Leader Harry Reid took to the floor early in the session to say that any conclusion to the fiscal-cliff crisis is unlikely to be here by year-end. Stocks rallied to almost even late in the day when it became known that Congress will be pulled into session on Sunday.

Like most investors and voters, I am depressed by the tone and the lack of leadership from both sides out of Washington. However, I am amazed that the market looks like it was caught off guard by the latest flare-up in the acrimony in these discussions and by the realization that we are going to go over the cliff in some way by year-end.

This appears to have been destined for some time, as the two sides are far apart ideologically and have more to gain by going over the cliff than by crafting a "grand bargain." I have prepared for any equity selloff by keeping a higher percentage of my portfolio in cash (around 25% right now) than usual. I also bought some bull VIX call spreads in early December to profit from any increase in volatility that I figured would be forthcoming by the end of December. Those spreads are now up more than 100% and have offset some of the losses on the long side of my portfolio over the last week.

I am also planning to do two things as these discussions continue into 2013. First, I plan to add to my ProShares UltraShort 20-Year-Plus Treasury ETF (TBT) position (which is a bet on long-term government debt interest rates rising) on any pullbacks that trigger a "flight to safety" into government bonds. It is my "new gold" position to protect against accelerating inflation in 2013. This ETF has performed terribly in 2012 as the Federal Reserve choose to continue to expand its balance sheet and bought most of the new debt issued by Treasury throughout the year.

This can continue for only so long, and I believe interest rates will also rise in 2013 for two reasons. First and foremost, we are having the wrong conversation. Government revenue is within $100 billion of where it was in 2007 before the crisis. Government spending is up more than $1.1 trillion, yet we continue to spend most if not the entire focus of budget discussions on raising government revenue by $75 billion to $125 billion annually. I am deeply pessimistic that we will get any serious spending or entitlement cuts out of these discussions.

I also believe that the debt-limit conversations that should happen right after the fiscal cliff will be as acrimonious that the current discussions, or maybe more so. As a result, government debt ratings being downgraded by Standard & Poor's or Moody's cannot be discounted.

On a brighter note, if we do manage to get through the next two months without doing significant damage, 2013 is set up for better economic growth than in 2012, as Europe has stabilized and China looks like it has gotten past its recent economic rough patch in front its once-a-decade political transition. In this case, interest rates should also rise.

For prudent investors who have cash on hand, a good strategic exercise is to compile a shopping list of stocks that you would love to own or add to existing positions if they fell another 5% to 10% due to the silliness going on in D.C. My list includes EMC (EMC), Apple (AAPL) and JPMorgan (JPM), whose value propositions I have covered in previous articles. Happy hunting.

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