America’s Spain: California

by ETFguide | July 30, 2012 11:29 pm

How safe are municipal bonds? The correct answer is that it depends on who you ask.

Politicians say munibonds are still a good bet. Credit raters say that a AAA-rated bond is safer than a B- rated bond and actual credit risk is relative. Financial intermediaries (salespeople) promote muni bonds (NASDAQ: FHIGX[1]) for their tax free income.

Let’s take a quick look at California to see what’s really happening in the $3 trillion muni bond market.

Case Study: The Republic of Kalifornia

California is home to 37 million Americans and is a case study in fiscal insanity. On November 16, 2011, the Office of Legislative Analyst released a report forecasting a budget deficit of $3 billion at the end of 2011-12 and an operating shortfall of $9.8 billion by 2012-13.

Today, California’s actual budget deficit is now a $16 billion headache (up from $9 billion in January).

Instead of tackling debt, California lawmakers approved a $68 billion project to build a high-speed train connecting Los Angeles and San Francisco. (A flight from L.A. to S.F. takes about one hour and costs around $100 one way vs. a 10 hour drive.)

Interestingly, the approval allowed the state to collect $3.2 billion in federal funding that would’ve otherwise been rescinded. The federal government rewarded California for needless spending projects, leaving U.S. taxpayers on the hook!

Like many states, California is burdened by falling tax revenue, a $3.6 billion unfunded liability (per capita) for retirement benefits and rising Medicaid costs.

Lack of employment is something California and Spain both share in common. According to Department of Labor Department figures, California’s average unemployment rate from July 2011 through June 2012 was 11.2%. But its broader “under-employment” rate was an elevated 20.3%. Translation: Income tax revenue cannot increase with an employment market this weak.

To solve its financial problems, Gov. Jerry Brown (D) wants California voters to approve “temporary” tax increases on the highest income earners along with the sales and use tax rate by 0.5%. The vote is set for November 2012. Will other states copy California by trying to coax taxpayers into paying higher taxes?

California may be an extreme example of the fiscal challenges facing states, but it’s still a good representation of big problems elsewhere.

Broke Cities

The bankrupt city of San Bernardino offers muni bond investors another look – a more localized snapshot of financial incompetence.

Because of accounting mistakes, city officials believed they had more money than was actually on hand. In fiscal year 2010-11, they mis-reported a balance of $1.7 million, when it was actually just $410,293. And the following fiscal year, the reported balance was $2 million, when it was really minus $1.18 million.

Despite these serious flaws, politicians and credit analysts continue to laud muni bonds for their “historically low default rates.” And like sacrificial lambs, the dumb money is listening. Asset flows into muni bond mutual funds through the first six months of 2012 is on pace to match or surpass the record years of 2009-10.

Highly populated cities with large deficits like Cincinnati, Detroit, and Los Angeles look poised to follow San Bernardino’s lead to financial oblivion.

The Opportunity of Opportunities

For now, the municipal bond market (NYSE:MUB[2]) has been a calm place to invest. State specific funds linked to California (NYSE:CMF[3]), New York (NYSE:NYF[4]) and others have marched ahead. Money market munibond funds (NASDAQ:FTEXX[5]) have held steady. And unsuspecting investors continue to pile in.

But state tax revenues, based upon history, (see chart below) have been volatile and are entering a new phase of even higher volatility. Unlike the U.S. government, they can’t print their way out of debt. The stars are aligning.

For traders, a break below support for muni bond ETFs will signal a high probability setup for shorting. Being too late will mean a missed opportunity and being too early will mean disappointment.

The August ETF Profit Strategy Newsletter identifies mega-investment themes by using sentiment, cash flow, and other key indicators to locate trading opportunities ripe for the plucking.

  1. FHIGX:
  2. MUB:
  3. CMF:
  4. NYF:
  5. FTEXX:

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