Saturday, January 1, 2011

2011 Outlook: Municipal Bonds

Similar to the European Union the United States is made up of many local state and governments which currently find themselves insolvent.

State and local governments receive a majority of their revenue from taxes on residential real estate. During the boom years of the real estate market (2000-2007) their revenues surged as rising property values created a rising tax basis.

Budget committees then used this trending growth as a guide for future spending. They provided huge pay boosts to current government workers and went on both a hiring and spending spree.

Then in December 2007 our country entered a depression, which it still finds itself in today 3 years later. Real estate prices have collapsed, unemployment has skyrocketed, and consumer spending and business activity have crumbled. All these factors have decimated the balance sheets of these local governments who continued to spend based on fantasy projections, but no longer have the income to pay for it.

This disaster would have surfaced far sooner, but Congress approved the $800 billion stimulus plan during the 1st quarter of 2009, and within that plan was $150 billion to boost the economy through state and local governments.

This money was not used to boost growth, but instead used to keep the states on life support as they began to hemorrhage money across the board.

In 2010, the Build America Bond program was introduced that backed a large portion of municipal (state and local government) debt payments by the federal government. This guarantee allowed the local governments to raise a tremendous amount of new debt in the market and bought them some more time.

As we enter 2011 the Build America Bond program is coming to an end, and the $150 billion in stimulus has been spent. We have reached the point of crisis.

The crisis comes in two forms. The first is payments to current government workers and current spending needs such as city construction projects.

The second is payments to retired government workers that collect pensions. This is known as “unfunded” pension liabilities.

It is estimated that there is close to $1 trillion in current budget deficits, and close to $3 trillion in unfunded pension liabilities.

Without some sort of new bail out, cities and towns will begin to declare bankruptcy in 2011. The process will start slow, and then begin to move rapidly as investors run from the municipal debt markets making it more difficult and more expensive for remaining governments to borrow money to stay alive. The process will be another form of contagion, as seen in the subprime crisis when investors shunned all forms of mortgage backed securities.

The outcome of the disaster, just as with the European debt crisis, will be based on the response by both our government and the Federal Reserve.

My personal view is that the Federal Reserve will step in and begin to purchase municipal debt through QE3, at some point during this year. Or Congress can push through another state “stimulus” package to try and put a backstop in the market.

The federal government will just add this cost to the federal deficit, and the Federal Reserve will purchase more federal debt through QE3. The end result will be the same.

In either case (Fed purchases or bankruptcies) you will see a massive reduction in government spending and government employment which will add to the current unemployment problems in the United States.

Continued unemployment will have an effect on US economic growth as well as the stock market in 2011.

2011 Outlook: Stocks

Entering 2011 the American stock market is coming off of an incredible 22 month run from the lows of 666 in March 2009 on the S&P 500 to end the year at 1257.



The consensus across the board is for this amazing growth to continue into 2011 and the euphoria in the market has reached a fever pitch.

This is known as sentiment, and it is an important indicator to track to determine major turning points in the market.

To understand why, imagine there are 5 investors in the market that each have $100 to invest. If they are only 20% bullish on the market, they probably have $20 dollars invested. This leaves each one of them with $80 in new capital to invest in the market, which would push the stock market higher.

If they are 100% bullish, they probably have $100 of their money in the market. They have no additional money to invest so if anyone begins to sell, the market will fall.

This is a very simple example to a very complicated market, but hopefully provides the understanding of why sentiment is important to consider, and why Warren Buffet says he likes to be brave when others are fearful, and fearful when others are brave.

The following shows the front page article of December 17th's USA Today titled, "5 Wall Street Heavyweights Say It's Time To Get Back Into Stocks."



In other articles within the Money section of the paper, experts offer 11 ways to make money in 2011.  They are all essentially telling investors to buy stocks.

Bloomberg conducted a poll of the chief market strategists for 13 of the largest banks in the world.  All 13 of them predicted stocks to be higher next year, and some are even calling for new all time record highs in the market.  The following chart shows each one of their predictions:



The AAII bullish/bearish sentiment indicator is a polling of retail investor's optimism on the current direction of the market.  Last week we topped out at a 63.8%, the most optimistic reading in over 6 years!

The put/call index, which is a measure of how many investors are buying puts (betting against the market) or calls (betting the market is going higher) last week hit its most optimistic level in over 4 years!

USA Today last week conducted an extensive interview on where market participants see stocks going in the year ahead.  40% said stocks would rise by more than 10%, 48% said stocks would rise by 10% or less, 7% felt stocks would be flat for the year.

Only 5% felt the market would fall, and less than 1% said stocks would fall by more than 10%. 

This type of bullish sentiment is astonishing.  All sentiment indicators across the board are at multi-year highs, even higher than they were at the stock market's peak back in October 2007.

In addition to sentiment, it is important to look at “value” or how expensive or cheap stocks are based on price to earnings. (P/E)





In December the Shiller P/E ratio shows stocks trading at 22.7. The higher the P/E, the more investors are willing to pay for a company’s earnings. In normal economic times the P/E ratio is between 14 and 16 times earnings. Coming out of a bursting credit bubble the P/E ratio is historically 12. At major secular bottoms the ratio is under 10. (Investors do not want stocks and refuse to pay a high premium for earnings)

P/E ratios are determined based on analysts estimates of current and future earnings.  Therefore, if an analyst uses a target of high earnings as a future projection, and earnings disappoint, then the P/E ratio will be even higher and stocks will be even more "expensive."

I believe analysts are painting too rosy a picture for 2011, and while stocks are already expensive using their high earnings projections, investors will realize they are extremely expensive when earnings disappoint.

Purchasing stocks means you are purchasing ownership in a company. As a reward for investing, companies pay investors a portion of the earnings through dividend payments.

Stocks are more attractive when they pay a higher dividend payment and are considered overvalued when paying a lower dividend payment. (Investors are willing to take a lower payment when they feel they will earn money on stock appreciation)

The following chart shows the historical dividend payment on the S&;P 500. As you can see we currently find ourselves at the lower range providing another indicator that stocks are “expensive.”



Based on current euphoric sentiment levels, a market that is overvalued in terms of price to earnings and dividend payments provide a dangerous outlook for stocks in the year ahead.

Let's now look at another major headwind that could impact the economy in 2011: Real Estate.

2011 Outlook: Housing

Entering the new year housing represents a troublesome story that gets very little attention.  I continuously make the argument against home ownership in the short term, and I will review the reasons here:

1.  Interest rates are at all time record lows.  The time to purchase a home, and make money is when interest rates are high and falling.  I discussed this topic last week in detail in Rising Rates: Simple Economics.

Long term interest rate chart shown below:



2.  The government is currently subsidising all mortgages through the use of FHA guarantees, and direct purchases by Fannie Mae and Freddie Mac.  If lenders know they can offload the new toxic mortgages to Fannie and Freddie they will continue to make reckless high risk loans.  (FHA loans ask as little as 3.5% down)

If Fannie and Freddie continue to be the dumping grounds for close to 100% of new mortgages, it will take years for the market to correct downward to free market levels.  If Congress should have to cut the Federal Budget, and they feel that paying for Fannie and Freddie losses are less important than food stamps, unemployment insurance, social security, or medicare (the four pillars keeping our society on the other side of the thin line representing mass social unrest) then housing prices will collapse.

Home prices falling is ultimately a very good thing for the country.  If people pay less every month on their mortgage and real estate taxes, they have more money to enjoy every month. (Or reinvest in the business community through stock purchases or private investment)

The following chart shows the current level of government loans provided. (100%)



3.  There is currently close to 40+ months of total inventory in the market, most of which is the now famous "shadow" inventory, which are homes that are bank owned but being held off the market to avoid losses.

As this inventory (which grows every month as prices fall and the unemployment numbers worsen) begins to make its way onto the market it will put tremendous pressure on prices to the downside.

4.  Home prices need to correct downward about another 35% to reach their long term growth chart line of 3.5% per year.  Usually markets over correct to the downside, which would have already happened had the government not interfered with the free market forces.



There will be an opportunity to buy real estate at very cheap prices.  But that time is not now entering 2011.

Thursday, December 30, 2010

Rising Rates: Simple Economics

The following chart shows the recent rise in mortgage rates.


This spells disaster for housing which was recently described by Robert Shiller as a market "where optimism is fading fast."

The time to purchase a home is when interest rates are high.  (If you are interested in making money on your home.)  The reason is because as interest rates fall it lowers monthly payments and allows new buyers into the market or current buyers to purchase at higher prices with their current income level.

Higher demand (more buyers) = higher prices if supply stayes equal.

The exact opposite is true for purchasing when interest rates are low.  (Unless you are interested in losing money on the home you purchase) 

Lower demand (less buyers) = lower prices if supply stayes equal.

The most recent rise in mortgage rates that can be viewed in the chart above pushed the monthly cost of a $300,000 mortgage from $1,462 to $1,585 per month.

This discussion does not look at the other side of the equation, supply, which as I've discussed previously is rising rapidly due to the shadow inventory of foreclosures beginning to enter the market.  Here is the full economic model for 2011 completed:

Lower demand (less buyers due to mortgage qualifications and unemployment) +

Supply growth (new inventory and months supply growing throughout 2011) =

Prices Falling

I only wanted to review this discussion because a realtor mentioned to my parents over Christmas break that they had buyers rushing into the market because interest rates were rising and they wanted to lock in at low rates.  This is the exact opposite way potential home buyers should be making a buying decision.

Wednesday, December 29, 2010

Jim Rickards On CNBC

Jim Rickards, who is fast becoming one of my favorite people in the financial world, spent some time with CNBC this morning to discuss the currency wars involving the US, China, and Europe.



If you want more Rickards, please visit the King World News link below where you can hear lengthy in depth interviews on the global economic and financial outlook:

King World News Interviews: Jim Rickards

Tuesday, December 28, 2010

Wealth Effect Meets Double Dip

While the developing economies around the world base their economic growth on savings and production, the American economy for decades has been based on borrowing and spending.

The key determinant to this ponzi scheme is the so called "wealth effect," which means that if Americans feel good they will be more likely to go out and spend.

After a massive rally in the stock market this year combined with an equally massive media campaign that the economic trouble is behind us, Americans went out this holiday season and spent a tremendous amount of money they should have been saving.

The wealth effect is improved in a more psychological fashion with a rising stock market, but is given larger substance with the increase in real estate prices because real estate makes up a far larger portion of the average Americans percentage of assets.  (The vast majority of stocks are held by the wealthy top 10 percent, and even more so by the top 1 percent)

For this reason, I find it fascinating that the current double dip in housing prices is receiving far less attention from market analysts in determining their 2011 forecast.

Case Shiller released their home price index this morning for the month of October. (An average of August, September, and October pricing)

The data showed the fourth consecutive month of falling prices, and a non-seasonally adjusted month over month drop of -1.32%. 



Many cities have now fallen to new lows from the peak in 2006 - 2007 (cities that saw an artificial bounce from the home buyer tax credit last spring) such as Atlanta, Charlotte, Miami, Portland, Seattle, and Tampa.  The rest of the cities will be joining them shortly.

These price declines come in the face of all time record low mortgage rates (which have just begun to rise) and a foreclosure moratorium which kept many additional homes off the market (which are now slowly being put back on.)

Rising mortgage rates, tighter lending restrictions, continued structurally high unemployment, and the onslaught of coming shadow inventory paint an ominous picture for the housing market entering 2011.

Let's hope everyone that believed the media that the housing market bottomed and spent an enormous amount of money this holiday shopping season, will brush off the coming loss in home equity as part of their "wealth effect" mindset.

Look for major trouble coming in 2011.