The presidential election is over, but another day of reckoning approaches. A "fiscal cliff" consisting of major tax increases and spending cuts is quickly approaching. And with it, a broad swath of investments ranging from stocks and bonds to commodities and currencies, may be affected in the months ahead.
If lawmakers don't reach an agreement by the end of the year, $532 billion in tax increases will kick in 2013 along with spending cuts totaling $136 billion in military and other domestic programs. The problem is that many economists are saying these huge spending cuts would send the U.S. economy into a recession next year. In addition, the elimination of Bush-era tax cuts would send tax rates of federal income, dividends and capital gains soaring. This means wealthy Americans could see dividend tax rates jump from a current 15% to as high as 39.5% by next year.
While I hope the fiscal cliff can be avoided, investors shouldn't just wait passively on the sidelines for events to unfold. Here are five specific actions you should take to help protect your portfolio against the negative consequences of the fiscal cliff...
|1. Adjust your portfolio to take advantage of lower capital gains tax rates
| The tax on capital gains could rise to 20% in the event of a fiscal cliff, so take the opportunity now to shed riskier stocks and replace them with high-quality blue chips that are better positioned to ride out a downturn. Household names such as Clorox (NYSE: CLX), Proctor & Gamble (NYSE: PG) and Kimberly Clark (NYSE: KMB) have dominant market shares, sizable cash flows and track records of at least 25 years of consecutive dividend growth. You can also look into what we here at StreetAuthority call Retirement Savings Stocks -- the ones that have a track record of safety and long-term gains.
|2. Trim exposure to defense and retail sectors
|More than half of fiscal cliff spending cuts will be to military programs, so defense stocks will be among the biggest losers. With a smaller budget, Lockheed Martin (NYSE: LM) would likely sell fewer F-35 fighter jets and Littoral Combat Ships to the military, for instance. BAE Systems (LSE: BA.L) would likely see demand drop for its nuclear submarines and Bradley-armored fighting vehicles as well.
Higher taxes will leave consumers with less discretionary income, which is bad news for high-end department stores and restaurant stocks. Luxury retailers such as Saks Inc. (NYSE: SKS), Nordstrom Inc. (NYSE: JWN) and Tiffany & Co. (NYSE: TIF) would probably feel the negative effects of lower consumer spending as would restaurant chains such as Yum Brands (NYSE: YUM) and Darden Restaurants (NYSE: DRI).
|3. Consider purchasing some municipal bonds
| Rising tax rates on dividends increases the appeal of tax-advantaged investments such as municipal bonds. The interest that municipal bonds pay is free from federal taxes and if you live in the state that issues the bond then interest is free from state and local taxes as well. However, you should do your due diligence before diving into the municipal bond pool since some states (California and Illinois, for example) and many municipalities have big budget shortfalls that exponentially increase credit risk.
A bond, like any loan, is only as good as the borrower\'s ability to pay, so focus on credit quality. You can also reduce your risk by holding a diversified portfolio. For this reason, I recommend purchasing a bond fund managed by Nuveen, Fidelity or other well-known managers, and leaving the selection of individual bonds to the pros.
|4. Also consider purchasing REITs
|Another asset class that becomes more enticing as dividend tax rates rise is real estate investment trusts (REITs), which enjoy a unique tax-advantaged status compared to other firms. REITs are allowed to deduct the dividends they pay from their taxable income. Instead of being taxed twice -- at the corporate and shareholder level like most corporate dividends -- REIT dividends are taxed just once. REIT dividends are taxed as ordinary income and never qualify for the 15% dividend rate. This means dividend tax increases won\'t hurt these investments.
Among the various property types, health care REITs are the best defensive investment because of their non-cyclical nature. Health care spending doesn\'t change during a recession. In addition, health care REITs are benefiting from industry consolidation and low borrowing costs. A pick to consider is Health Care REIT (NYSE: HCN), which is the nation\'s third-largest health care REIT and yields about 5%. Its pending purchase of Sunrise Senior Living (NYSE: SRZ) will greatly expand this REIT\'s portfolio of assisted living communities. Another safe pick is Health care Trust of America (NYSE: HTA). This REIT focuses almost exclusively on medical office space, which is considered the least risky type of health care property and boasts a nearly 6% dividend yield.
|5. Look for growth in Latin America
|If the United States falls off the fiscal cliff, then gross-domestic-product (GDP) growth will contract next year.
This means investors will need to look beyond the U.S. borders for growth. Europe\'s economy is in even worse shape and China has started to show signs of a slowdown. But Latin America is still hot. Most Latin American countries are projected to deliver 4% GDP growth in 2013, with Columbia and Chile probably registering 5% growth each.
Investing outside the United States is a bit riskier, so I prefer to invest in large-cap stocks with American depository receipts (ADRs) listed on a major U.S. exchanges. Petrobras (NYSE: PBR) is the world\'s fifth-largest oil company and a safe choice. In the past five years, this Brazilian energy giant has delivered 26% annual earnings growth and a nearly 4% yield. Telecom Argentina SA (NYSE: TEO) provides fixed-line and wireless telecommunication services in Argentina. This company generated 33% earnings growth last year and pays a rich 9% dividend yield.
Risks to Consider: Fiscal cliff or not, there are plenty of catalysts to spark investor fears and a return to extreme market volatility next year.
Action to Take --> Investors already have enough to worry about as a result of the European debt crisis, the United States' meager GDP growth and weakening corporate profits. Even if some grand deal happens and a fiscal cliff is avoided, these strategies are all great moves to reduce portfolio risk and help investors sleep better at night.