How to Trade the 'Fiscal Cliff' Drama If No Deal Is Reached

What has been nervous selling by investors would turn into a full blown recession trade if Congress takes the economy over the "fiscal cliff."

That means stocks and other risk assets would be sold, and investors would flock to safe haven Treasurys, municipal bonds and the dollar. Stocks aren't yet pricing in a "cliff" event, but they are reacting to the idea of higher capital gains and dividend taxes, and the possibility that some elements of the cliff could occur.

"It's a recession trade. Nothing ever really goes up in a recession," said Thomas Lee, JPMorgan chief equity strategist.

The cliff is the $500 billion combination of a series of expiring tax cuts, and the automatic spending cuts—or sequestration—that would occur if Congress does not find a resolution by Jan. 1. The Congressional Budget Office says the impact would cause a recession in the first two quarters of 2013, and then a recovery in the second half. It would result in a decline of a half percent in GDP, but some private economists expect even worse.

"If we have a cliff, the transmission is really pricing two things," said Lee. "One is sequestration and that's really broad. That's really going to hit the things that really receive a lot of government spending. It's defense, but it's also health care and education. It's a lot of those life science tool companies and the education stocks."

Trading the Fiscal Cliff - CNBC's Model ETF Portfolios

The stock market has lost about five percent since election day, when the re-election of President Barack Obama and a divided Congress led to concerns that an agreement would be hard to reach on taxes and on spending. The fear of that impact has chilled business investment already, even as consumers are showing a bit more optimism and housing is reviving.

"When you think about those cuts, those cuts would slow the economy so then cyclically sensitive groups would take a hit. So it would hurt industrial, basic materials and technology," Lee said. Some sectors that might perform better are big pharma, and consumer staples, he said.

"The other affect the cliff is going to have is through the expiration of a lot of the tax cuts, so therefore taxes would go up and that's going to crimp some consumer spending. There's going to be some hit to consumer discretionary stocks. I think it's going to hit a lot of groups that deal with the middle class."

(Read More: 'Fiscal Cliff'—America's Looming Economic Crisis)

Investors have already been positioning around the fiscal cliff drama, though many analysts do not believe Congress will let the economy fall off the cliff. Utilities, big dividend payers, have been declining. Investors have been flocking to the ProShares UltraShort S&P 500, up 9.8 percent since the election, while the cash S&P 500 is down five percent. (Read More: Could Housing Be the Antidote to the 'Fiscal Cliff'?)

The iShares Municipal Bond ETF is up nearly a percent since the election, and the rush by investors into municipal bond funds in the last several months has also driven rates in municipals to record lows. Investors are seeking the tax exempt status of muni investing, as they anticipate a jump in the dividend tax rate. That rate, now 15 percent, could rise to 43.4 percent for the richest tax payers if the Bush tax cuts are left to expire.

The iShares 20 year Treasury bond fund has risen 3.9 percent since the election, as Treasury yields have declined significantly in a flight to quality trade.

Investors who are betting on weak business spending have been bidding up the ProShares UltraShort Technology ETF. It is up 13.6 percent since the election. The ProShares UltraShort Consumer Services ETF is up 8 percent for the election. That ETF includes businesses dependent on consumer spending, such as Wal-Mart and Disney . The ProShares UltraShort Financials is also up 10.6 percent since the election, as financial stocks would flounder in a recession.

James Paulsen, chief investment strategist at Wells Capital Management, said hitting the cliff is probably the least likely outcome, but if it happens it would trigger a mad dash out of stocks and into Treasurys. "It's the least likely outcome, but more likely is we agree on a few things and extend most of it. That's how the stock market is acting too," he said. (Read More: 5 Dividend Winners Better Than Treasurys)

Some parts of the market are showing more pain than others. The Russell 2000 is down more than the broader market, and Apple, the darling of many portfolios, is down 9.5 percent since the election. Apple is 25 percent off its high, but is still up 30 percent for the year.

Lee said investors are clearly selling some stocks where they've made profits to capture the current capital gains rate, and one strategy is to buy them back now, or in the first quarter.

"That might be the biggest thing with this whole thing is how many portfolios are booking gains and then resettling positions," said Paulsen.

Lee said in 1986, investors sold stocks at the end of the year ahead of a bump up in the capital gains rate to 28 percent from 20 percent, but stocks rallied back 11 percent in January. Also that year, the highest income tax bracket was pared back to 38.5 from 50 percent.

If the cliff is averted, he expects a rally.

"Everyone I talk to says they'll chase the market up if we don't go off the cliff," Lee said. "It's basically a recovery trade so you'd be buying tech, industrials, materials. Consumer discretionary has held up pretty well, but they'd definitely be buying consumer discretionary." '

CNBC created two portfolios using ETFs to depict the type of trades investors might make should the cliff be avoided, and if it is hit.

Paulsen said investors need to keep an eye on negotiations and the trade needs to come before the actual decision. "Once that agreement is reached, whatever that agreement is, you might get some coming back in those stocks, because in the main areas, it's the defense stocks and dividend payers. If that happens, it's a buying opportunity. Even if they do raise the dividend tax I wonder if they overdo the malaise leading up to it," he said. The SPDR S&P Dividend is down 4 percent since the election.

Citigroup analyst Jason Gursky, in a note, said he thinks that the market is overly negative on the outlook for defense spending.

"When the dust settles, we expect a 10-year deal that flat-lines defense spending, making the same dollar-amount of cuts as the sequester, but spread more evenly over the 10-year period," he wrote. "In our view, this will be a positive outcome for defense stocks as it will add clarity to the trajectory of future budgets. Furthermore, this outcome would likely remove DoD's budget from the political agenda as the military will be able to claim $1 trillion in cuts to its 10-year budget outlook since mid-2011, a number that's in line with the most draconian DoD proposals we've heard to date, including Simpson Bowles."

SPDR S&P Aeropsace ETF is down about 6 percent since the election.

"Two things that are going to dominate ultimately are the broader-based economic recovery here and increasing evidence that China is turning up again," Paulsen said. "I think investors are struggling with how much do you put in the short term fiscal cliff trade."

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