The U.S. Treasury will run out of money sometime in mid-October, and Congress won't return from its August vacation until Sept. 9. In addition to the debt ceiling, lawmakers still haven't passed a budget, and a government shutdown could derail the economy.
If you've just had a touch of deja vu, it's not because you are trapped in a Hitchcock thriller. It's because we've been here before -- and the consequences of political theater are coming back to haunt the markets.
Going into the last quarter of 2012, the buildup to the debt ceiling and "fiscal cliff" expiration in January sent the markets reeling. Between Sept. 14 and Nov. 15 last year, the S&P 500 index plunged 7.7% on partisanship and panic.
This Time May Be Different
The drama over the last fiscal cliff eventually ended, and toward the end of the year, I argued for investors to get back in the market on signs that the economy would do just fine and that the so-called cliff was more a molehill. Stocks are now up 16.5% since late last year.
Before you jump back into the markets, you should be aware that the game may have changed this time around.
Now the markets are looking at slowing corporate earnings growth and a government that will probably do more harm than good in the coming months. Excluding financials, earnings actually declined 3.1% for companies in the S&P 500 in this year's second quarter. Financials did well in the quarter largely on lower loan loss reserves, artificially and unsustainably propping up their performance.
As for the government, the House of Representatives has tried 40 times to overturn the Affordable Care Act but has yet to work on a bipartisan budget proposal. Now parties are positioning their chips for political Armageddon over upcoming fiscal debates.
We've gone from investing despite the government to building a portfolio that can withstand the 535 Stooges in Congress.
At the height of the fiscal cliff scare, there were few places investors could hide. Every single sector saw losses. The Technology Select Sector SPDR (XLK) dropped more than 12.5%, and even the Health Care Select Sector SPDR (XLV) booked losses of 2.6% over the period.
But a small group of stocks was able to post gains because of strong business models and government-proof earnings. Two of those stocks may be your best bet this time around.
Between Sept. 14 and Nov. 15 last year, as investors rushed to companies with solid, government-proof revenue, Family Dollar (FDO) gained 2.6%, and Kellogg (NYSE: K) surged 7.4%.
Family Dollar's more than 7,400 stores in 45 states focus on core categories like home products and consumer staples at discount prices. Its revenue is not as cyclical as other retailers and may actually increase with people buying at the less-expensive chain during periods of economic uncertainty. Sales have increased every year over the past decade, even through the financial crisis, and have maintained a 7.8% average annual growth rate. The shares have a beta of just 0.4 which means they have been less than half as volatile as the general market.
Shares of FDO plummeted in January on a first-quarter report that missed earnings expectations by almost 8%, but the stock has rebounded as management missteps have been corrected. Even with the sell-off, the shares have matched the market's performance since mid-September and should do relatively well amid any government-inspired market weakness. The stock is approaching my $74 price target but is still a good buy as a defensive position.
Kellogg's May 2012 acquisition of Pringles has helped diversify revenue for Kellogg, which has always been dependent on its cereal business. The company now earns 23% of net sales from its snacks segment. The company still earns most (63%) of its total sales in the United States but has started to diversify to Latin America, Europe and Asia. With its ability to build brands, it wouldn't surprise me if these smaller markets were to make a strong contribution in the future.
The company recently announced a management restructuring that could help streamline decision-making. Kellogg has continued to outperform and has beaten the S&P 500 by 12% since last September. The shares have gotten a little pricey at 23.3 times trailing earnings as investors have bought into the high dividend yield and strong price performance. Any weakness in the shares could present an opportunity to add to a position as revenue growth is fairly stable and the company has extremely strong cash flow. The price still has a way to go before my $68 price target and will churn out a 2.9% dividend in the meantime.
Risks to Consider: Despite their resilience against a government-induced sell-off in stocks, these two picks still present company-specific risks that should be diversified with a portfolio of other names. Look for other names with non-cyclical and government-resistant revenues to weather the upcoming storm.
Action to Take --> You may not be able to completely avoid the losses associated with the market volatility around the coming debt ceiling or fiscal cliff negotiations, but these two stocks are a good start to a defensive position with some great potential upside.
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