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The Municipal Bond Debate & Financial Doomsday Predictions

Gary Karz, CFA (email)
Host of InvestorHome
Founder, Proficient Investment Management, LLC

One of the reasons I like to collect bullish and bearish predictions is to be able to show people that there are almost always people on both sides of the fence. People with a glass is half empty perspective will almost always be able to find pessimistic gurus making predictions that support their bearishness. Likewise, people with a glass is half full perspective will almost always be able to find optimistic gurus making predictions that support their bullishness. While consensus opinions among investors, advisors, and/or newsletter writers can swing to extremes (which some would argue is a contrary indicator) it happens relatively infrequently.

If markets are "efficient" and the information and arguments used by both the pessimists and optimists is publicly available and widely known, current price levels fully reflect the balance between the bullish and bearish views. Market timing tends to be counterproductive because investments historically rise over time and attempts to avoid drops are just as likely to be unsuccessful as they are to be successful. Yet stress, or fear of losing money can be a logical reason to be in cash and avoid investments that fluctuate over time.

J.P. Morgan was quoted over 100 years ago for stating that "Any man who is a bear on the future of this country will go broke." Yet in the recent financial crisis a large number of investors not only didn't go broke, they made huge returns betting against the mortgage and stock markets (at least in the short-term). There are also plenty of people that have made a lot of money selling newsletters, books, etc., that make bearish forecasts (see also bull and bear predictions from the 90s).

In the aftermath of the global financial crisis, there seem to be a larger than usual number of doomsday predictions. So I decided to start collecting extremely pessimistic predictions and take a closer look. My intention in including this information is not to scare anyone or support these arguments. Rather it is to take an open minded look and determine if any of their arguments hold water and therefore are deserving of attention by investors as they allocate their assets.

One of the financial doomsday scenarios that has gotten the most attention was discussed in this 60 Minutes segment that aired on 12/19/2010. It included comments by Meredith Whitney and others discussing problems with state and municipal budgets. More recently on CNBC Whitney defended her muni call (1/12/2011) and "she took the forecast a step further and said when the defaults begin in earnest, it will mark an exodus from the muni bond market."

Whitney was thrust into the limelight after her 10/31/2007 downgrade of Citigroup and her analysis that Citi would cut their dividend. She plays a prominent role in Michael Lewis' bestseller The Big Short and this Bloomberg article by Lewis titled The Rise and Rise of Analyst Meredith Whitney (4/9/2008). But this WSJ article (4/9/2009) titled When Meredith Whitney Calls, Should You Listen? states that other analysts downgraded Citi ahead of Whitney's call and while she gets credit for the Citigroup call, she didn't predict many of the other major dominoes during the crisis. See also The Analyst Who Rocked Citi (11/26/2007) and State Budget Crises: Weighing on Muni Bonds and Possibly Stocks from Eric Tyson (1/3/2011) to see why Tyson is not impressed with some of Whitney's more recent predictions.

As interest rates have risen many bond categories lost value in the 4th quarter of 2010 and the predictions of problems at municipalities have come at a time when bond markets are already under pressure. We now know investors have been pulling money from municipal bond funds at a record pace withdrawing over $23 billion in the prior eight weeks, reversing the previous eight months of inflows (see Mutual Fund Cash Exodus Continues (1/10/2011) in BankInvestmentConsultant). Since the 60 minutes segment ran there has been a steady stream of discussions on both sides of the argument with many well known investment personalities joining the debate (links now at top of the page).

Another perspective comes from Stocks for the Long Run author Jeremy Siegel, who discusses what he worries about in his February 2011 Kiplingers column, titled What Keeps Me Awake. Some excerpts include the following.

Siegel's argument that the federal government would rescue the states is debatable, especially in light of recent comments by Fed Chief Ben Benanke. According to Bernanke Rejects Bailouts (1/8/2011) in the WSJ, state and local governments shouldn't expect federal loans and Mr. Bernanke noted that muni markets have been functioning normally, with healthy trading volumes and lots of issuance. But he said that if municipal defaults did become a problem, it would be in Congress's hands, not his.

Another doomsday scenario comes from Stansberry Associates, which has a long presentation (pitching their products). The presentation suggests the next crisis will include a collapse of the dollar and that Americans should plan accordingly (which of course includes getting their reports which will tell you what to do). Some background on Porter Stansberry I found with a quick search is included here, here, and here. Also note that according to this article in the WSJ, Developing Countries Keep Buying Dollars (12/31/2010) and according to this Bloomberg article Pimco Says U.S. Will Keep Reserve-Currency Status (12/29/2010) which argues that rising powers such as China are not yet ready to absorb the $9 trillion in reserve assets and Europe, amid all of its financial woes, isn’t even close to ready to take the mantle.

The following is a small collection of financial doomsday style links.

Is the stock market over or undervalued? Are rising interest rates and the huge flows into bond funds in recent years leading us to a popping of a bond bubble? Is the dollar about to collapse or steadily lose value in coming years? Although markets aren't always completely efficient, I trust them to get it right most of the time and in the long run. No one wants to be in an asset class when part or all of the herd is rushing for the exit. But the herd (and individual investors) tends to have poor timing and crisis tends to create opportunities for investors. Investors that are uncomfortable with certain holdings may prefer to adjust their asset allocation to reach the sleeping point (rather than going all in or all out). Another alternative is to find a way to avoid coming in contact with financial predictions altogether.

We have two classes of forecasters: Those who don't know--and those who don't know they don't know.
John Kenneth Galbraith

As much as we’d like to believe otherwise, there’s only one person who can tell us where the economy and the market are going, and none of us gets to speak to him (or her), at least while we are alive.
Larry Swedroe in Lessons from 2010: Diversification Matters and Forecasters Don’t (1/11/2011)

Remember the First Law of Economics: For every economist, there is an equal and opposite economist--so for every bullish economist, there is a bearish one. The Second Law of Economics: They are both likely to be wrong.
William Sherden in The Fortune Sellers: The Big Business of Selling and Buying Predictions

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Last update 11/28/2011.
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