Managing Downside Risk With The Fiscal Cliff

Having been pushed into the background in recent weeks by the election, the Fiscal Cliff is now at the forefront of investors' concern. Basic game theory dictates that a resolution should not occur until late in December. Negotiators won’t know if they have extracted the maximum concessions from the other side if they agree too soon. In addition, since America returned approximately the same set of leaders to power that engineered the Debt Ceiling mess in the Summer of 2011, there’s little reason for high expectations. Ultimately, one would think the Democrats are more inclined to compromise to get a deal, since it is “their” economy. However, for Republicans so opposed to taxes, a failure to agree will result in automatic tax hikes and just what they don’t want.

The one caveat to all this is that, living in the North East U.S. and having just endured the disruption of Hurricane Sandy, the economy is a little more vulnerable than a month ago. Losing power for days on end can really mess with your productivity. On balance we expect a compromise that will avoid the more dire forecasts, but it won’t be an easy road to get there. In our Deep Value Equity Strategy we’ve raised from more cyclical names. Yesterday we invested a small amount in McDonalds (MCD), which remains under pressure because of disappointing sales, and today we added to Kraft Foods Group (KRFT), which reported earnings yesterday and now sports a dividend yield of 4.55%. Yesterday’s earnings report was good and although their payout ratio is high at 77% based on 2013 EPS guidance of $2.60 supporting the $2 dividend, we think it’s well covered and an attractive investment here.

Cash Reserves
But we continue to hold back some cash because of the increasing likelihood that the market will respond poorly to the undoubtedly messy negotiations.

The reflation theme remains compelling, with developed country central banks fully committed to keeping interest rates below inflation. Owning gold bullion through the Gold Miners ETF (GDX) remains one of our larger positions. Corrections Corp (CXW) also held their earnings call this morning and are still working towards restructuring themselves as a REIT which we think provides further compelling upside. The Fiscal Cliff represents a potential source of uncertainty for them since the Federal government is such an important client of theirs, but while that may cause some short-term uncertainty we don’t belive it materially alters the value of the company.