How to Build a Fiscal Cliff Portfolio (Part 2)

Submitted by Wall St. Daily as part of our contributors program.

A quick Google (Nasdaq: GOOG) news search for Fiscal Cliff turns up a staggering 82.4 million results. Meanwhile, a similar search for “presidential election” nets only 2.3 million results.

So I think it’s fair to say that the Fiscal Cliff dominates the news right now.

Such lopsided coverage naturally stirs up interest from Americans. And since this issue concerns the economy, investors are even more attentive and concerned.

A week ago, I did my best “simma down now” impression. I tried to convince you that the hoopla over the Fiscal Cliff is much ado about nothing, as Congress will most certainly reach a compromise before the spending cuts and tax increases kick-in on New Year’s Day.

You obviously weren’t buying it, though, since our inbox continues to be inundated with questions about the Fiscal Cliff.

Well, it turns out that other investors aren’t buying that a compromise is imminent, either.

Bank of America’s (NYSE: BAC) October client survey revealed that for 80% of respondents, the biggest concern right now is, indeed, the Fiscal Cliff.

So let’s pick up where we left off yesterday, and round out our Fiscal Cliff portfolio, just in case we need it.

Get Shorty

In the 1995 mob comedy, “Get Shorty,” Chili Palmer – played by John Travolta – boasts, “Now I’ve been shot at three times before. Twice on purpose and once by accident. And I’m still here. And I’m gonna be here for as long as I want to be.”

While the opportunities I shared yesterday promise to be similarly fortunate, others won’t. Accordingly, we’d be wise to sell the not-so-lucky ones short.

On such merits, here are the two most vulnerable areas of the market that make the best short candidates…

~ Defense Stocks

A key component of the Fiscal Cliff is the nearly $500 billion worth of across-the-board defense spending cuts. It won’t happen all at once. But it will be immediate enough that it could significantly hamper profits for defense companies.

Some smaller defense contractors might even be forced out of business.

Such prospects make selling short any of the defense-focused ETFs an attractive option. Like the SPDR S&P Aerospace & Defense Fund (NYSE: XAR), the iShares Dow Jones US Aerospace & Defense Fund (NYSE: ITA) and the PowerShares Aerospace & Defense Fund (NYSE: PPA).

If I had to pick one, I’d go with XAR because it has the most small- and mid-cap exposure (62 companies to be exact, or about 64% of the portfolio).

~ High-Yield Bonds

Default rates currently rest near an all-time low of around 3%. So it’s only a matter of time before they tick up, which I warned Dividends & Income Daily readers about here. And the Fiscal Cliff would certainly provide the catalyst.

If the economy tanks, less-than-credit-worthy issuers would be left without enough cash to cover the interest payments on their expensive debt.

That’s exactly what happened during the last recession, and default rates spiked above 10%.

Of course, if we simply sell short the most popular high-yield bond funds – the SPDR Barclays Capital High Yield Bond Fund (NYSE: JNK) and the iShares iBoxx $ High Yield Corporate Bond Fund (NYSE: HYG) – we have to cover the dividend payments.

That’s less than ideal, as it cuts into our potential profits. So I’d consider buying long-dated put options on either fund, instead.

“The Only Thing We Have to Fear is Fear Itself”

To complete our Fiscal Cliff portfolio, we need to incorporate a fear factor. Why? Because investors are going to scream and panic like little schoolgirls if we careen off the Cliff.

Instead of high-pitched shrieks, however, this panic promises to manifest itself in the market through the Volatility Index (or VIX).

And we can profit from a sudden spike in the VIX by buying cheap call options on the iPath S&P 500 VIX Short Term Futures ETN (NYSE: VXX).

Bottom Line: It never hurts to be prepared. So if you’re deathly afraid of the Fiscal Cliff, now you have a specific plan of attack.

As for me and my house, we’re sticking to our trailing stop discipline and putting our faith (gasp) in Congress’ ability to actually do its job and reach a bipartisan agreement.

How you proceed from this point forward, however, is entirely up to you.