Sit tight over U.S. fiscal cliff

Investors can be forgiven for feeling a little jittery these days. By now most have heard of the so-called U.S. fiscal cliff, a series of laws that will result in tax increases and spending cuts if left unchanged. If politicians in Washington can’t come to an agreement by the end of the year it could plunge the U.S. into another recession. So what should Canadian investors do to prepare? Not much.

While investors can expect more volatility over the next month, Michael Schaab, a portfolio manager with Vancouver-based Leith Wheeler Investment Counsel, says the worst thing someone can do is sell in anticipation of a market downturn. For one thing, it’s likely there will be some sort of deal, he says. “Neither party wants a 4% reduction in GDP, so it’s likely they’ll work to avoid that.”

He adds it’s also impossible to predict how markets will react. “I’d rather bet my money on who will win the Grey Cup than on how the market will respond,” says Schaab.

David Sherlock, a portfolio manager with Calgary-based McLean & Partners, thinks there’s a 70% chance that a crisis will be averted. And from what he can see, the market feels the same way. The VIX, an options-based index that investors use to determine future market volatility, is low, he says. That indicates that investors aren’t too concerned about the cliff. “One would think that the value of the VIX would have started to grind upwards and show the fear,” he says. “But it’s really been quite contained.”

If investors are wrong, though, and a deal isn’t struck, it’s better for people to lose some money than to sell now. That’s because markets always climb back up after every recession. For those keeping score, there have been 11 since the Second World War and we’ve had 10 recoveries, says Schaab, with the eleventh underway.

Of course talk of a fiscal cliff reminds many investors of what happened during the last round of fiscal squabbling. The high-stakes stand-off over the U.S. debt ceiling ultimately resulted in Standard & Poor’s cutting the country’s credit rating in August 2011. Markets responded by turning sharply negative. The S&P 500 dropped from a high of 1,370 to about 1,074 in just a few weeks. For almost all investors it was gut wrenching to watch, says Sherlock, but six months later the S&P was at 1,422.

If anything, all of this talk of a fiscal cliff proves how important it is to be a balanced, long-term investor owning stocks and bonds. “It’s really having a portfolio where you’re not trying to make short-term bets or guesses,” says Jon Palfrey, Leigth Wheeler’s senior vice-president.

Palfrey and Schaab both strongly recommend taking time to review your portfolio—it’s a good thing to do at the end of the year anyway—and making sure you don’t hold anything that could cause problems.

Investors should own companies that have a margin of safety, says Schaab. Buying for well-priced companies instead of ones that are fully valued will help protect you from market downturns, he says. “If something is worth $25 a share and it’s trading at $15 a share, then that’s a high margin of safety,” he says. “If it’s trading at $25 a share then there’s no margin of safety.”

Companies that offer a dividend and pay out a manageable amount of free cash flow are also important to own. Most experts say the payout ratio—the percentage of free cash flow paid out in dividends—should be around 40% to 70%, depending on the industry. If the ratio is too high the company could be forced to cut its dividend if it falls on hard times.

Both Schaab and Sherlock also suggest adding a few short-term bonds to a portfolio. It’s true that many people think low-paying fixed-income is risky now, but if the market does fall bonds will do well. It’s not a bad idea to purchase a few bond funds or ETFs, they say.

Sherlock also suggests holding some cash in an interest bearing account. If the market dives, there will be plenty of discounts to take advantage of, so it’s a good idea to have some liquid dollars at your disposal to take advantage of opportunities as they arise.

These are just portfolio tweaks, though. While the market will likely see some more ups and downs in the coming weeks, the last thing you should do is sell before, or during a fiscal cliff-created downturn. “There’s always a strong temptation to be that bi-polar investor,” says Palfrey. “But stay the course. It sounds boring and ineffective, but the data backs that strategy up.”