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Four Ways the Fiscal Cliff Could Play Out


Your investor guide to the financial opportunity presented.

No. 2: Tax reform in 2013 of some sort is likely.

The Republicans are willing to see taxes for the highest earners go up. At this point, that change is inevitable. However, they would like to trade that issue for a change to bad policy in the tax code – namely, misguided exemptions. The GOP would rather see the increase in taxes to the wealthy come through elimination of exemptions instead of an increase to the tax rate.

The GOP does not like the fact that the Congress has 'picked' certain industries to be winners by delivering them favorable tax incentives. They believe it has artificially propped up certain industries and is bad policy. A lower tax rate for everyone (even lower than the Bush levels in place now) but a reduction in exemptions would be better policy.

The GOP in particular thinks this would be good for small businesses. If a person grows his small business, he would get to keep more of profit because he would have a lower tax rate. It creates incentive for small businesses to invest in their businesses because of the predictable and lower taxes paid on the increased growth.

The Market Impact:
If this reform comes along, it should be good for small businesses and the public companies that service small businesses. Think about companies like VistaPrint (NASDAQ:VPRT), which is an online supplier of printed and promotional material as well as marketing services to micro businesses and consumers.

If reform occurs, I think it will be tempting for the Congress to address the mortgage interest deduction. I know this has been a 'holy' deduction that can't be touched. But I would not rule it out. As a consequence, avoid homebuilders for now. Home prices will be negatively affected by such a change in policy – if they have the guts to go after it.

No. 3: Defense cuts and entitlement spending cuts will occur, but on smaller scale.

The cuts that take effect in the fiscal cliff scenario are significant. In fact, Congress made them intentionally significant so that they would be forced to deal with them. They are split evenly between defense and non-defense cuts to the tune of $110 billion overall in 2013.

These cuts would significantly hurt a handful of industries based on the targets for these cuts. Some cuts are definitely going to occur, but probably something in the neighborhood of half of this total.

Also, Medicare payments to doctors are set to drop by 27%. This will likely be addressed by Congress. Expect the payments to doctors to decrease, but not by 27%. Overall, expect the negotiations to include some creative changes to Medicare in other areas as well.

Market Impact: So, these changes will affect some industries. The problem is the market has already reflected a decrease in the stocks that it expects to be affected. And the drops in the stocks are based on the magnitude of the cuts that are expected by the market. The cuts in the end will probably be something less than the $110 billion total, but still something in the neighborhood of half.

For now, I would avoid defense contractors and health-care companies. You don't want to be picking the winners and losers there while the negotiations are still ongoing. Just avoid them as they will likely trade in a more volatile nature than usual.
No positions in stocks mentioned.
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