Got Protection?

The December fiscal cliff arguments were just a warm-up, February is when the real theatrics begin. So why would you not prepare yourself when you can get the VIX extremely cheap? By now you should know that Washington will hold the markets hostage as we near the March fiscal cliff. So what’s the trade?

VIXIt’s fairly simple, I’m looking to protect myself (and make money) by selling the March VIX puts. I’ve been looking at the March 18s (current price: $2.15), 19s (current price: $2.85), 20s (current price: $3.60) and the 21s (current price: $4.40) as perfect candidates. You may ask why I prefer selling puts over buying calls? It’s mainly because of time decay. If the VIX trades sideways until early February, you risk losing money on those calls. Obviously any other strategy that takes advantage of time decay is a good bet at these levels (if you don’t want to expose yourself to a lot of risk, selling the March 15 VIX puts is a better idea).
 
So What is the March Fiscal Cliff?

The spotlight will mainly shine on spending cuts and raising the debt ceiling, as Washington fights to reign in on its $16.4 trillion debt load. With Fitch and Moody’s repeatedly warning that the US could get downgraded, this is not the time for political chicken. But you should know by now that exactly the opposite is going to happen. Obama has already stated he’ll refuse to negotiate over the debt ceiling. And with disgruntled Republicans just getting over their December defeat, I highly doubt you’re going to find a lot of them giving in to Democrat plans.

To-Do List
 
So where does the US stand? Not to get too apocalyptic on you, in really bad shape, especially if Washington can’t get this done. With patience already running thin, this is not the time to kick the can down the road again.

Fiscal PictureRichard Johnson from the National Post constructed an organized fiscal graphic so you can visualize what Washington is dealing with. Notice the out of control spending and horrific revenue deficit numbers.

 

What Happens if the US Gets Downgraded Again?

Using history as a guide is quite difficult in this situation, since there is only one other time this has happened. After Standard and Poor’s downgraded the US on August 5, 2011, the U.S. 10 Year Treasury surprisingly rallied, falling from 2.58% to a historical low of 1.394% nearly one year later (when bonds rally, their yields react adversely or fall). This time around it may not be sunshine and rainbows. While the equity market would obviously plummet, bonds could follow suit. However, like the previous downgrade, it’s extremely hard to predict long term bond direction with the Federal Reserve in the picture until 2015. Even though yields should rise, they could stay artificially low because of the Fed. Conspiracy theories aside, the price of the 10 year Treasury is essentially whatever Bernanke says it is. Because the Fed holds nearly a third of some securities, it essentially could limit how far Treasury yields could rise by buying more. And with the Fed already pressuring interest rates (through bonds), any price it is not satisfied with will be corrected, with QE4.

Fed Balance SheetRising yields would not only hurt housing, but the entire country. The US is funding its spending using low interest rates. If they were to rise to 3%, that could dramatically alter the market environment, similar to what you see in many European countries.

 

Conclusion:

Many strategists have ignored imminent government spending cuts in their forecasts. If the US economy is growing around 1.5%-3% in this environment, how will it look when Washington decides to skim some of the fat off? Austerity and growth is an oxymoron, anyone who says otherwise is lying to themselves. Earnings will be impacted, growth will likely remain slow and the Fed will continue to support this market. Welcome to the lost decade, pull out a chair and get comfortable, things may get worse before they get better.

 
 

Questions? Comments? Leave me a reply.

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