Daily Gains Letter

Best Way to Hedge Against Political and Economic Uncertainty

By for Daily Gains Letter |

Hedge Against PoliticalWe’re less than a week away from the perfect economic storm in the U.S., and, based on what others are predicting, just a few short months away from a major 15% stock market correction.

At the beginning of October, almost a million federal employees were furloughed after the U.S. government shut down because it failed to ratify its annual budget. Should the government fail to raise the debt ceiling and therefore default on its loans, that issue will be exacerbated when the debt ceiling deadline arrives.

Failing to raise the debt ceiling will just add to America’s economic woes and put a major dent in the global economy while also undermining America’s credibility on the world stage. While some think a short-term default on the debt ceiling will not cause a major ripple, history is not on their side.

In 1979, the U.S. breached the debt ceiling on about $122 million in bills, but that was blamed on a technical issue related to a new-fangled word processing failure. The glitch caused yields to increase by half a percentage point, where they stayed elevated for months. A default on the debt ceiling this time around couldn’t be blamed on a technical difficulty due to new technology (having a disproportionate ego, however, could be a valid excuse).

Even after the U.S. government shutdown is resolved and the debt ceiling is raised, the U.S. will have suffered a major blow to its credibility. After that, it could go from bad to worse.

According to French banking giant Societe Generale, the S&P 500 will go through a tumultuous correction, even after the debt ceiling and shutdown have been remedied, falling 15% in the first quarter of 2014. The bank cites a tapering of quantitative easing and a dysfunctional environment in Washington as the causes. After the correction, it will take a number of years to just rebound to where we are today. (Source: Boesler, M., “SocGen: In a few months, the stock market will drop 15%, then go nowhere for years,” Financial Post web site, October 8, 2013.)

While I understand why a 15% correction might be a little unbelievable to those on Wall Street, I’m not so sure they should be shocked at the idea of a correction.

The fact of the matter is that there is a disconnect between what we are seeing on the stock market and what is going on in America. The S&P 500, Dow Jones Industrial Average, and NASDAQ are all doing exceptionally well, but the average American isn’t. The major indices are near record highs, but almost half of Americans are living paycheck-to-paycheck, unemployment remains above seven percent, and GDP growth has been revised downward.

You can’t deduce that because someone spent a record sum on an Andy Warhol painting that the whole U.S. economy is doing well.

With the U.S. government shutdown in full bloom and the debt ceiling just around the corner, it might be time for investors to start looking at hedging against political and economic uncertainty.

One of the easiest ways to hedge any of the major indices in the U.S. is with an inverse exchange-traded fund (ETF). Some of the more popular inverse ETFs include ProShares Short S&P500 (NYSEArca/SH), ProShares UltraPro Short QQQ (NYSEArca/SQQQ), and ProShares Short Dow30 (NYSEArca/DOG).

That doesn’t mean that to hedge your retirement portfolio against the debt ceiling fiasco you should concentrate on inverse ETFs; rather, it means investors need to revisit their retirement portfolios, find out where their strengths and weaknesses are, and rebalance their portfolio if they need to.

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