HOW TO PLAY IT: Looking past the fiscal cliff rally

NEW YORK Thu Jan 3, 2013 7:59am EST

NEW YORK Jan 3 (Reuters) - The Standard and Poor's 500 index surged more than 2.5 percent Wednesday, but any rally could be short-lived with workers facing smaller paychecks and expected volatility ahead of a debate on the U.S. debt ceiling debate, fund managers and analysts said.

"It's a relief rally to some degree, and we'll see what happens when the euphoria goes away next week," said Peter Tuz, portfolio manager of the $125 million Chase Growth fund , adding that the deal could have been worse from an investor's point of view.

Investors should be wary of consumer companies, such as discount retailers, that cater to lower-end consumers who could be disproportionately impacted by higher payroll taxes on workers. They should look instead toward dividend-paying stocks for stability ahead of talks on raising the U.S. debt ceiling and at emerging markets with improving economies, analysts said. Here are some of their strategies for playing the impacts of the fiscal cliff deal.

PAYROLL TAX BITE

The expiration of the payroll tax cut that was agreed under the fiscal cliff deal will have a more significant impact on lower- and middle-income consumers and weigh down select consumer discretionary stocks, said David Kelly, global chief strategist at JPMorgan Funds.

A worker who earns $50,000 per year will pay approximately $1,000 more in federal taxes as Social Security payroll taxes revert to a 6.2 percent rate from the 4.2 percent rate that has been in effect for the last two years. All told, these higher taxes, which apply to income under $113,700, will take approximately $117 billion out of paychecks this calendar year, Kelly estimates. He believes that will significantly impact small-ticket consumer purchases like restaurants, movie theaters and retail sales.

"A lot of the things that people spend an extra $50 on will be hit by this," he said.

Tuz, the Chase fund manager, said he sold his positions in Target, TJ Maxx and Ross Stores in late December as it became clear that payroll taxes would rise and affect the lower-middle-income consumer base of these discount retailers.

But there are silver linings. Kelly said big-ticket items like cars and homes may not be affected because of pent-up demand. That's despite the fact that analysts expect 2012 was the best year for automakers since 2007, while new home sales are at their highest level since April 2010.

And, although payroll taxes are rising, because the fiscal cliff deal avoids raising income taxes for individuals earning less than $400,000, there should be a short-term benefit for consumer staples companies, said Diane Garnick, chief executive of Clear Alternatives LLC, an asset management firm specializing in Behavioral Finance.

With a better tax deal than many analysts predicted, consumer staples companies could "have their best January performance in years," she said.

Investors could opt for the $1.1 billion Vanguard Consumer Staples ETF, which has large stakes in Procter & Gamble , Coca-Cola and Wal-Mart Stores. The fund, which costs 14 cents per $100 invested, yields 2.9 percent and is trading near a 52-week high.

LOOKING AHEAD

With the fiscal cliff averted, both Washington and Wall Street will soon turn their attention to the debt ceiling, analysts said. The debt ceiling talks are expected to spur market volatility, something that will be a boon to the more stable world of dividend-paying stocks and to emerging market stocks.

Despite the popularity of dividend stocks in 2012, the highest-yielding stocks offered the worst returns of the year, according to Bespoke Investments. That could change in the new year, said Jeanie Wyatt, the chief investment officer at South Texas Money Management.

Dividend-paying stocks will also benefit from the fiscal cliff deal, which prevented a rise in the tax rate on dividends to as high as 39.6 percent from 15 percent. Instead, the top rate on dividends will rise only to 20 percent from 15 percent and only for individuals earning more than $400,000 a year, or married couples earnings more than $450,000.

Those tax rates continue to give dividend stocks a distinct tax advantage for most investors, Wyatt said. As a result, she is buying companies like Kraft Foods Group, in which a big percentage of returns come from dividend payout rates, she said. Kraft company yields 4.4 percent, roughly double the yield of the broad S&P 500 index.

Other investors are looking past the United States entirely. Michael Gayed, chief investment strategist at Pension Partners, said the debt ceiling issue will give investors another reason to look to emerging markets that have stronger fundamentals and more policy options available.

One option: the $8.5 billion iShares FTSE China 25 index fund, which is trading near a 52-week high as a result of improving manufacturing data that suggests that the Chinese economy is stabilizing. The fund, which costs 74 cents per $100 invested, yields 2.3 percent and has its largest position in China Mobile Ltd.