Market Musings Blog

Although default rates on municipal bonds have remained extremely low, the outcome of default and its effects on bondholders is evolving in the few cases that do exist. There are two facets to repayment of municipal debt: willingness to pay, and ability to pay. Analysts have believed that municipalities will always demonstrate willingness to pay in order to maintain access to the market at all; i.e., if a municipality ever wants to borrow again, it must pay its bondholders no matter what. Ordinarily, the fact that debt payments are usually a very small portion of a municipality’s budget makes payments a priority even if a municipality enters a fiscal crisis.

In Stockton, CA, which just filed Chapter 9 bankruptcy, this assumption will be challenged. Stockton is proposing a haircut to payments to bondholders in order to put its budget on the right path, espousing a philosophy that all stakeholders should “share the pain”. Through Ch 9, the municipality hopes to force its general obligation debt holders to take less in payments. Most of its GO debt is insured or backed by letters of credit, so most bondholders should not experience a hitch in payments. However, the precedent of seeking court approval for a reorganization plan that contains bond defaults – i.e., that does not place bondholders at the top of the creditor list – is ominous.

We think Stockton is being advised that market access will not be as much of an issue as previously assumed in the event of default. Evidence to the contrary is sketchy, which may support this theory. Corporations usually regain access post-bankrupcty; other troubled municipalities have regained market access fairly quickly, albeit sometimes with state help or with other factors at play. Greece has defaulted more than half the time on its government debt (including recently) but investors still loaned it substantial sums at mere basis points above what Germany paid, until about three years ago. The fact is, markets forget.

Time will tell how this case will turn out. But a decision embracing bond defaults will be particularly bad for California muni holders, and not wonderful news for the muni market generally.

Twitter recently sent a very informative message regarding their security protocol. I gleaned some interesting information from the note which sent me around the web to find other security tips.

We’ve already warned that passwords should be strong (see blog here). Charles Schwab & Co. recently told us that in the first quarter of 2012, they’ve experienced more wire fraud than in all of 2011, due to hackers obtaining client email addresses and intervening in the email flow between advisor and client. The hackers mimic the client once they have the flavor of the typical conversation, asking for a wire to be sent. If your email passwords are strong, this would be much tougher. So make sure to change passwords, and keep them strong.

Aside from passwords, there’s a little known opportunity to apply “do not track” to your browsing preferences. On your browser, you can specify private browsing. Visit here to find out more. Additionally, you can tell some advertisers NOT to track your browsing for the sake of pitching you “tailored” ads – those annoying sidebar ads that seem to relate to sites you’ve visited lately, or things you’ve purchased lately. Two organizations enforce “do not track” for advertisers: they are DAA standing for Digital Advertising Alliance (here) and the NAI, National Advertising Initiative (here). Go to those sites to remove and prevent “cookies” from advertisers who are in the business of capturing your private information.

Stay safe online!

In our last post we wrote about the potential long term effects of deleveraging the world. These include slow growth, lower living standards and defaults. Despite the negative potential for the economy, stocks won’t necessarily follow suit. Why would the stock outlook be rosier than the economic outlook? Here are a few reasons:

• First is price. We believe that the most important determinant of future return of an asset is its price today. “Cheap” today can translate to high rewards later. On the other hand, buy an asset at a high price, such as real estate in 2007, and it will either do nothing for years (best case), or crater (worst case) until its price comes in line with historical norms. The S&P 500 is up just 4.8% per year for the last fifteen years despite growing earnings and dividends, and reduced debt levels at companies. That is just about half the long term return since 1926. There’s a firestorm of controversy right now about whether this makes stocks cheap, but keep in mind that over this same time frame international and small cap stocks performed far better than the S&P 500. You don’t need to own the S&P to succeed with stocks.
• Second, companies have become more diversified in the last twenty years, largely by increasing their sales and manufacturing ranges to include most of the world. This diversification has helped mitigate earnings fluctuations normally caused by business cycle behavior. As a corollary, companies have learned to manage costs, inventories, and cash far better than in the past. This, too, has helped dampen volatility in earnings streams. Essentially, companies are managing themselves far better than many governments.
• The general popularity of stocks has plummeted. Global pension fund allocations to stocks dropped from 49% to 41% from 1995-2011. That might not sound dramatic, but given that the pension fund assets in question total $27.5 trillion, that’s a lot of bucks. Personal ownership of stocks in 401k accounts has fallen to the lowest level since Gallup began tracking the numbers, at 54%. See here for the data. When equities fall out of favor, that tends to be a good sign for future returns because the population of potential buyers increases.

Exactly when these factors will kick into gear to generate higher stock returns is a big unknown. But each of these factors is contributing to a scenario that will eventually cause a bull market, and in the meantime will at least support stock levels in the trading range that we’ve been experiencing for lo these many years.

Has anyone else noticed that world governments have been using debt to cure the indebtedness that bit us in the first place? While citizens everywhere have been defaulting or paying off their debts, governments have been accelerating their loans to worthless borrowers (Europe); sinking money into so-called stimulus projects (US, Japan); and subsidizing students (US), green energy (US, China and Europe), gas prices (Asia), social programs in aging demographies (Japan, US), property development (China) and so on. The result is that worldwide, debt is increasing despite the work that families have done to restructure their balance sheets. The 34 countries in the OECD (Organization of Economic Co-operation and Development) have seen their aggregate public debt top 100% of GDP in the last year, up from roughly 70% just a few years ago, swamping the debt reductions elsewhere in their economies.

How does this all end? There are various historical precedents for high levels of debt in specific economies (the US in the late ’20s and early ’30s for instance) but no instance in which most countries simultaneously have too much debt. We can hazard a guess however.

• First, expect declining living standards and slow growth. Paying back all this debt will take decades, and it will necessarily take money from other purposes. A great view on this comes from a new app for the iPhone, called Debt Bomb. You can get the app here. The point of the app is to show you that if you had to pay your share of the US deficit along with your taxes when you filed last Tuesday, your tax bill would have amounted to roughly 40% more than what you paid. Where would you cut spending to come up with those extra thousands? No vacations or new clothes maybe? Bingo: the economy slows.
• Declining living standards will lead to social and political instability. In the US, we are already swapping from party to party as elected officials seem unable to solve our problems or even make headway. In Athens, they prefer to bomb storefronts and go on strike.
• Expect a more volatile business cycle. During deleveraging, government regulations, spending, and cutbacks fall unevenly on the economy. Currently, housing and finance are in a funk, looking much worse than other sectors. That can shift, however. If Europe craters because of austerity, our manufacturers will feel it. Furthermore, very slow growth simply leaves less of a buffer for a mishap, like rising oil prices or a new war. Finally, investors will take more risk in a quest for better returns, leaving the economy vulnerable to new bubbles.
• Defaults. Yes, someone is going to lose money. There are hard defaults, like Greece, which won’t be paying back its debt under the same terms that it originally promised. Then there are soft defaults. These are the sneaky kind, like in the US where the Fed has driven interest rates below the rate of inflation for most bonds. If you’re a saver, you are losing money every day to inflation in the US, thanks to The Bernank. You are the victim of a soft default, and it’s contributing to your lower living standard.

Lest you think we can avoid all this because the deficit has never been a problem before, take a hard look at the average inflation adjusted wage in the US over the last several years, and you’ll see it declining as government debt has risen. Our living standards are already falling.

All in all, not a pretty picture. From an investor’s perspective, it’s hard to see the stock market performing very well under this scenario. In fact, you might just want to run out and buy bonds instead, along with everyone else who has reached the same conclusion. But that’s too easy and the markets are never easy. Stay tuned for The Endgame: Part Two for our take on why stocks can still do well despite a gloomy economic outlook.