The financial media has been on fire with frightening stories about the pending fiscal cliff due to begin on Jan. 1, 2013. The fear in the market is strongly reflected by a drop of more than 900 points in the Dow Jones Industrial Average since mid September.
But markets are driven by perception, not reality.
The fiscal cliff refers to the automatic spending cuts and expiration of the Bush-era tax cuts that are set to take effect in the beginning of 2013, if Congress doesn't reverse these looming fiscal policies. On the one hand, these policies are designed to reduce the federal budget deficit and improve the economy in the long term. On the other, they could potentially drive the country into a recession next year, as spending cuts and tax increases would be an added drag to the already-weak economic expansion.
But the real question is: Are these spending cuts and tax increases really going to happen? I don't think so.
Congress will likely have a short-term solution by the Dec. 31, or at the very least, will be able to extend this deadline. Political experts are on both sides of the fence, and everyone else seems to have their own opinion of the situation.
But investors like you and me shouldn't fret. After all, there will be opportunities to profit, regardless of what happens. In fact, I came up with a handful of stocks we should be watching depending on which scenario pans out.
Scenario 1: Congress doesn't come up with a plan, and the fiscal cliff happens as expected
Clearly, the fiscal cliff will have a negative effect on the stock market. Stocks will likely have a difficult time gaining traction at the start of 2013. The new tax laws will take the current 15% dividend tax rate up to about 39%. Remember, for the past 12 years, taxpayers in the 10% or 15% tax bracket haven't had to pay any federal income tax on long-term capital gains, while individuals in higher tax brackets have paid a 15% tax on long-term capital gains. This means the dividend taxes will likely result in a migration away from dividend-paying stocks to more growth-oriented stocks in an effort to avoid the increased taxes.
In addition, strategies to avoid taxes will definitely come back into vogue. In this sense, life insurance will likely become popular as a tool to dodge taxes. Life insurance enables investors to transfer wealth while legally avoiding income taxes. In addition, money grows tax-deferred inside a life insurance policy. This means life insurance companies such as American International Group (NYSE: AIG) and Hartford Financial (NYSE: HIG) will likely benefit from this scenario. Financial service companies such as HR Block (NYSE: HRB) should also benefit as investors scramble for advice on how to rebalance their portfolios.
Scenario 2: Congress comes up with a short-term solution and the fiscal cliff doesn't happen or is delayed
I think this is a more likely scenario. Many stocks have been pushed lower simply because of fears of the fiscal cliff. But once Congress averts or delays the fiscal cliff, a relief rally in the stocks pressured lower will likely occur.
If you look back to August 2011 when Congress waited for the last minute to increase the debt ceiling, there was massive volatility in the equity markets. Investors who bought into stocks while they were at their lows made huge profits. The stock market jumped higher when Federal Reserve Chairman Ben Bernanke simply stated a deal may be pending to solve the crisis. Just imagine the bullish buying triggered when the solution is worked out. This is particularly true in fundamentally solid stocks that have been beat down for no other reason.
Under this scenario, two stocks in particular are poised to profit...
1. Verizon (NYSE: VZ)
This telecom company reported strong earnings during the third quarter of the year to 64 cents a share, almost in line with the same period last year. Fourth-quarter earnings are expected to grow 13.4% year over year to 59 cents a share. But because of fiscal cliff fears, the stock plunged in November to $40 prior to bouncing back to around $43 a share.
2. GNC Holdings (NYSE: GNC)
The health food chain recently posted better-than-expected earnings of 61 cents a share during the third quarter, a slight 5% improvement from the year-ago period. The stock is projected to earn 46 cents a share in the fourth quarter, a nice 32% increase year over year.
Yet fiscal cliff worries pressured shares 7.8% lower so far in November. Once these concerns are gone, this stock could easily go above $40 a share.
Risks to Consider: Regardless of what has happened in the past, the stock market often surprises everyone with its reaction to economic events. And sometimes, what we least expect happens.
Action to Take -- > No matter the possible outcomes, it's important to stay tuned for any financial news that could compromise your portfolio.
But if you agree with me that the fiscal cliff is an overblown hype and will be solved soon, then investing in beat-down but fundamentally strong stocks makes solid sense. If you believe the fiscal cliff may actually occur, then investing in stocks poised to profit from tax increase and spending cuts is the smart choice.