The Opportunity in the Fiscal Cliff

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Created on Wednesday, 24 October 2012 20:06

Published on Wednesday, 24 October 2012 20:06

Written by Andrew Snyder, Editorial Director, Inside Investing Daily

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Day by day, we march closer to the dreaded fiscal cliff. Most folks say it's nothing to worry about... our elected leaders will hack out some sort of solution.

Maybe... maybe not.

In my research this week, I found corporate America has little faith in a solution. The blue chips of our economy have tucked their heads between their knees and are braced for impact. As they fight to avoid the pain ahead, records have been broken and market distortions are erupting in some unusual places.

It's created a phenomenal opportunity.

In a recent letter to a small group of readers who are working on a special project with me, I told them about the three common factors inherent in almost all of our successful trades. The first was volume anomalies. Nothing distorts a market better than a sudden twitch in trading activity. Next was a tie to the government -- the omnipotent force that kidnapped Father Economy. And finally... trends at their tipping points.

Whenever we uncover an opportunity with all three criteria... the odds are intensely in our favor.

That is certainly the case this week.

With the idea of the fiscal cliff starting to make headlines, most investors have focused on its effects on the equities market. Like one of Pavlov's hungry dogs, it's what we've been trained to do. We hear the opening bell, and our eyes automatically track the S&P 500.

But the real telltale is in the debt market.

Get this. For the first time in more than two years, Oracle went to the bond market last week. It borrowed a whopping $5 billion... and it got the cash at some of the lowest interest rates in bond market history.

What's interesting, though, is that the tech giant does not have specific plans for the cash. Sure, it will refinance some old debt, but it tells us most of the cash will go toward a share repurchase program.

In other words, it saw a good deal...and it took it.

It is the same story across the blue chips this month.

General Electric just issued $7 billion in fresh debt -- the first sale of its kind in nearly five years. What will it do with all that cash? Nothing, really. The company tells us it will roll over some debt that's due in February, but the rest will get stuffed into the coffers.

John Deere just announced it's ready to make a similar move. It plans to borrow at least $500 million.

Even more noteworthy, though, is the borrowing at the international level. European firms are borrowing dollars at the fastest pace in 18 months. Switzerland's Nestle upped its latest borrowing effort to $500 million -- nearly twice as much as initially expected. France's Total is in on the action. And so is London's Barclays.

In all, $49 billion worth of dollar bonds were issued last month. Again, it's the biggest monthly tally in 18 months.

Here's a chart of what the corporate bond trend looks like:

But why now? Why has demand surged in the last three weeks?

General Electric's chief financial officer Keith Sherin sums it up best. "We issued it in October, so we don't have to worry about what happens if the fiscal cliff is not resolved,"he said. "If it's choppy, we are prepared."

The world's largest companies are making their moves now... because they may never get the chance to do it again.

Once the great debate starts on Nov. 12, uncertainty will reign. We may see another credit downgrade. We may see a large spike in tax rates. Hundreds of billions of dollars' worth of federal spending could be slashed.

What's worse... we could watch as our leaders push us into another dirty recession.

In other words, in less than a month, lenders (bond buyers) may not be willing to loan their cash at such paltry interest rates. As business risk rises, so will the rates. That means bond prices will fall.

Now that the government is forced to act on the fiscal cliff, we've reached our tipping point. Something must change. That is our opportunity.

Now is the time to act.

Last Friday, the yield on the Barclays Capital U.S. Corporate Investment Grade Index reached a record low of 2.66%. That is why it makes sense that the iShares iBoxx Investment Grade Corporate Bond (LQD:NYSE)ETF currently sits just below its all-time high. Two weeks ago, it saw inflows of $562.4 million -- making it the third best-selling ETF on the market.

The trend has reached its peak.

As soon as the lame ducks waddle back to Washington, volatility will rise. The realm of corporate bonds will look nowhere close to as safe as it does today. Investors will be unwilling to accept such paltry returns as risk increases. Instead, they will turn to Treasuries or equities.

Here's a chart that shows the spread between corporate bonds and Treasuries. As the turnaround matures, that red line will spike higher.

So how do we take advantage of this opportunity? There are several ways, but only one is worthy of your dollars.

The way Wall Street wants you to take advantage of rising corporate bond rates is through an ETF that creates an artificial short position in corporate bonds. Through a scheme of swaps and other exotic derivatives, these funds move inversely to the daily movements of the index they're designed to track.

But because of the "daily"nature of these funds, they are strictly short-term trading instruments. Try to hold them for more than a few days and the deck is stacked against you. If we knew bond prices would collapse tomorrow morning and not sometime in the next two months, we'd buy an inverse ETF. But we don't... and we won't.

Instead, my focus is on the tried-and-true option market.

I am convinced LQD is ready to topple. We've seen the volume anomaly. We know Washington is behind all of this. And we know the pending fiscal cliff has created a concrete tipping point.

For option investors, it is only a matter of determining how far corporate bond prices will drop and when they will start their decline.

I can't give specifics in a free e-letter (I've already given you more than enough information to get your research off to a running start), but my money is on the short side of the trade. LQD is poised to fall.

If you make the trade, you are following the tracks of some of the nation's savviest investors. As companies like General Electric, John Deere, Oracle and all the international giants pile into the debt market ahead of the great debate that awaits us, the quick surge in volume and then the dearth of fresh activity late this year will disrupt the market. The volatility that ensues will hand us strong profits.

P.S. Your 401(k), your IRA, mutual funds -- even your savings account -- could all be wiped out if the US hurls itself off the fiscal cliff. That's why I've shown my Unconventional Wealth readers three key steps to protect their wealth right now. And these plays promise to profit alongside the coming chaos. Here's how you, too, can position yourself today.