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How to Protect Your Portfolio From the "Sequester"

David Goodboy

The "fiscal cliff" deadline came and went without even a bearish whimper from the stock market. Now, the so-called "budget sequester" -- a set of laws that limit federal spending -- was put into effect on March 1. Absolutely nothing negative has happened to the economy -- so far.

The bullish reactions to these events, which may result in long-term, negative overhang on the thriving stock market, have lulled many investors into a false sense of security. These satisfied investors point to the stock market roaring higher, steadily improving economic numbers and to bad news being dismissed as irrelevant as sure signs that the market's surge won't end any time soon.

But investors should be concerned...

What is the sequester?
On March 1, President Barack Obama signed an order mandating $110 billion in annual government spending cuts. This is part of a $1.2 trillion plan to slash federal spending and reduce the deficit. Spending cuts are planned for 1,200 programs, with defense cuts being 50% of the total. Fortunately, key government programs aren't going to be so affected. For example, Social Security is exempt, while Medicare will only experience a budget cut of 2%.

So far, the practical implications of the sequester have been that the U.S. Navy has decided against sending another aircraft carrier to the Middle East, the Army said it will start slowing down training for 80% of enlistees, and millions of government employees are preparing for possible once-a-week furloughs starting in April.

Why didn't the stock market drop?
One of the reasons we didn't see a severe negative reaction in the stock market is because the sequester cuts are slow-burning. It's a nine-year program ending in 2022, so it is hoped that the economy will have time to adjust to the spending slowdown.

March 27 is a critical date
There is another issue that runs hand in hand with the sequester. On March 27, the government is expected to run out of operating funds and be required to shut down. No one seems really worried about this, however, because many think Congress will likely draft new legislation to permit additional funding so that the federal government doesn't close. Along with this legislation, many say there may be an addition that rolls back or greatly eliminates the sequester.

Defense companies might suffer
If the sequester is postponed or reduced by a Congressional act arriving by March 27, expect very little market reaction. However, if it is not at least postponed, expect selling in defense-related stocks such as Raytheon (RTN) and Honeywell International (HON). Both of these companies have been in a solid uptrend, and investors may want to take profits prior to the March 27 date.

Bet on volatility increasing
In addition, volatility will likely start climbing if the sequester is not addressed by the March 27 deadline. Investors can profit from this increase by purchasing shares in the iPath 500 VIX Short Term Futures ETN (VXX), an exchange-traded note that replicates the S&P 500 VIX Short-Term Futures Total Return Index. The index offers exposure to a daily long position in the first- and second-month VIX futures contracts, reflecting the implied volatility of the S&P 500 Index. The ETN is trading on its multi-year lows and will be certain to increase should the market turn negative.

Risks to Consider: The primary risk in selling defense stocks now is that the sequester spending cuts will be modified in the near future. If this occurs, then there is a potential for a relief rally in defense stocks. As things can change on a daily basis, paying close attention to the news will help in making prudent decisions. In addition, even though the VIX is at multi-year lows, it can and will drop further, should the market continue to rall. Always position size properly, and use stops when investing.

Action to Take --> Taking profits in defense stocks and initiating a long position in the VIX index through the VXX ETN are the smart ways to hedge your portfolio from a possible drop in the stock prices. Remember, the sequester, as it stands now, is 50% focused on defense. Cost-cutting in this sector will likely result in defense stocks falling from the present rally. Even if the sequester cuts are reversed by the March 27 deadline, defense stocks will still probably suffer more than any other sector.

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