How 3 Investing Pros Straddle the Fiscal Cliff

Richard Satran

The "Fiscal Cliff Ahead" warning sign was first flashed nearly 10 months ago and not much has changed since. Fund managers are preparing for the worst, but anticipating something not so horrible.

Already some say they have shifted assets to prepare for a prolonged period of stunted growth, large budget deficits, and potential inflation in anticipation of what comes after a Washington cliffhanger that has been previewed for so long there is not much drama left.

The market remains almost exactly where was at on February 17 when Federal Reserve Chairman Ben Bernanke popularized the term, saying the U.S. economy was headed for "a massive fiscal cliff of large spending cuts and tax increases."

Washington may indeed "kick the can" with moderate tax hikes and spending cuts, and it's not likely to impose Tea Party-proportioned government curtailments. Instead, slow growth and low interest rates are what many fund managers expect. And for stocks, that is not a bad scenario.

How are fund managers planning year-end moves with the cliffhanger approaching? Here are views of three of them:

[Read: The 10 Most Popular Mutual Funds of 2012.]

Rob Lutts, president and chief investment officer of Cabot Money Management, says any solution to the fiscal dilemma would likely weaken the dollar and lead to inflation at some point soon. The big winner would be gold, he says, which tends to rise if the dollar falls. Cabot is heavily invested in the pure play of bullion as opposed to mining stocks. His top investment is SPDR Gold Shares Trust (symbol: GLD), an exchange-traded fund (ETF) that tracks the price of physical gold.

But he sees a bigger problem looming in a government bond market pumped up by Fed policy in recent years by ultra-low rates. Lutts is preparing for an end to the "bubble phase" for U.S. bonds, which could collapse at the smallest whiff of inflation or sign that the Fed is moving to tighter credit.

"The assets we normally think of as having the lowest risk--high-quality U.S. bonds--have the highest risk right now," Lutts says.

He prefers financial assets in other currencies, among them two Wisdom Tree ETFs: Emerging Market Local Debt (ELD) and Asia Local Debt (ALD). He expects both funds, with a yield now between 4 percent and 5 percent, to rise to the 6 percent to 7 percent range for total returns in the year ahead.

He also likes Pimco's Income D (PONDX), a fund that can perform strongly even if the bond market falls because it is managed to adjust when the interest rate environment changes. Its yield is now just over 6 percent.

"We feel potentially good upside in equities when we get past this nervous period of concern," Lutts says. He prefers stocks of companies best positioned to maintain pricing power during times of inflation. His tech favorites are Qualcomm (QCOM), Sourcefire (FIRE), and electric car maker Tesla (TSLA). TJX Cos (TJX) is a retail stock he says could do well managing profit margins in a consumer rebound.

David Cassese, an associate fund manager at BlackRock who concentrates on consumer, healthcare, and technology sector funds, says that the market could get back to a fundamental earnings focus after two years of worry over fiscal brinkmanship in the United States and Europe. He says he will be "modestly optimistic" once there is a solution to the fiscal dilemma, which has "created a lot of noise" in markets.

"A slow-growth environment is not the worst thing in the world," he says. "Equities as a class are under-owned and valuations are attractive."

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Microsoft (MSFT) and Intel (INTC) are stocks his funds own. The launch of Windows 8, which promises "not fast growth but a long upward slope," he says, could lift earnings for the "Wintel" allies. In the mining sector, BHP (BHP) and Rio Tinto (RIO) are companies that can manage costs as demand grows for materials, he says. The retail sector also could hold up relatively well. His fund owns retailer VF Corp (VFC), a leisure apparel company.

Maury Fertig of Relative Value LLC says his strategy would be to buy closed-end funds at a discount if Washington fails to manage the fiscal cliff. A market fall between now and the end of the year could create opportunities.

"If you see another panic like a few weeks ago [when stocks dropped on fears over the fiscal cliff], look for bargains in closed end funds," he says.

Data show that the end of the year is nearly always the best time to buy closed-end funds, he says. They tend to recover in the New Year. The funds are publicly traded, like stocks, and unlike mutual funds, their trading value is not adjusted daily to reflect net asset value. That means they can fall to a discount to asset value.

[See the 10 Biggest Closed-End Mutual Funds.]

Royce Value Trust (RVT), a 25-year-old closed-end fund that invests in small- and mid-sized companies, recently traded at a 13 percent discount to its assets, even though it normally stays near its net asset value. It yields 7.3 percent. Alliance Bernstein Income (ACG), a multisector bond fund that holds mostly investment-grade assets, has dropped to a 9 percent discount to assets, pushing its yield to an above-normal 5.6 percent. The Eaton Vance Tax Managed Equity Fund (ETY) has also dropped to a double-digit discount. It uses a strategy of buying covered calls on relatively safe blue chips. Its price now reflects a missed dividend, but its payment record has been steady in the past and "they have said they have no plans to cut the dividend in the immediate future, " Fertig says.

None of the fund managers anticipate a breakthrough deal in the current talks. But the pressure could grow and stocks could fall if Congress goes any length of time into the New Year without some semblance of one.

"The fiscal cliff is the biggest thing for the market in the short term," says BlackRock's Cassese, "If we can't get a resolution, there is likely to be a recession in 2013."