Bull case for tax-free municipal bonds

Why I’m wary of the stock market:

The stock market has made enormous gains following the announcement of the $600 billion QE-2 by the fed, the extension of the Bush tax cuts, and the additional stimulus such as extended unemployment insurance, the payroll tax cut, and various tax credits before the new year.  While these programs have increased the short-term economic performance & consumer spending numbers, they will not work for the long term. 

Headwinds facing consumer spending include rising prices for food and gasoline, rising taxes on the local and state levels, continually high unemployment, falling real wages, and continuing weakness in the housing market.  The consumer typically represents 70% of US GDP, so I expect a pullback in expectations in the next few quarters.  Tightening of the state and local governments will also cut into GDP forecasts in the future, representing another 12% of GDP.  Also, with the Republicans in the house focusing on the US deficit, we can expect some form of US belt tightening along with possible federal tax hikes (or at least reduction of subsidies and tax credits).

From a technical perspective, the bull to bear ratio is high which indicates that the market sentiment and expectations are high, as you can see on the following chart:

Personally, I don’t see why the stock market should be so close to reaching the 2006-7 bubble highs when the economic fundamentals are so much worse and the risks higher from every aspect.

Interest rates likely to stay low for some time:

Inflation right now is confined to the commodities market, which may again implode like in 2008 (though I’m not betting on it).  However, with deflation in real estate and real wages, we won’t see big headline inflation in the US for some time.  I think we’ll see significant declines in the unemployment rate prior to any acceleration of inflation because the 1970’s-style inflation spiral typically goes through wages and reverberates through consumer prices.  With employment and rental space as pockets of deflation in businesses, combined with uncertain consumer demand, they won’t be passing on high price increases any time soon.

The Fed is unlikely to push through rate increases with low core inflation and high unemployment.  They are more likely to discuss a QE-3 than to raise rates by year’s end in my view, though I don’t expect them to do anything besides talking and pushing policy messages. 

With core inflation and the fed as the biggest drivers of yields, I am inclined to expect a moderate pullback in yields before year end, increasing the current value of fixed-income instruments.

Municipal bonds have 2 main advantages:

1. The media frenzy on pension funds and unsustainable debt has driven many away from this class of investments.  The time to buy is when everyone else has sold.  While some of these bonds may default, we must also realize that default rates have been historically low and that the ones with solid tax and income bases are unlikely to default.  Politicians rely too much on the debt markets to abandon them, and bailouts of trouble spots like Harrisburg are likely to be more common than complete defaults.  Remember also that when Orange County went bankrupt in the 90’s the bondholders were ultimately made whole. 

2. The landscape of rising taxes will further increase the value of tax-free municipals.  State and local governments have already been raising taxes, and I think that the federal government will at the very least let some of the tax cuts & credits expire as they focus more on the deficit. 

I realize that my bet on the VXZ so far went sour… my timing was lousy.  I still expect volatility to increase as the debt-ceiling issues come up, more debt turns over in Europe, inflation concerns are addressed in the emerging markets, and some trigger (perhaps further middle-east unease) pushes market sentiment on a path back down.  My advice is don’t necessarily bet on the VXZ unless you’re really confident about the timing, but don’t buy into cyclical (high-beta) stocks either.  Stick with non-cyclicals like utilities and health care, dividend payers, or something energy or commodities related and don’t be shy about putting into debt funds like the fixed income section on http://www.invescopowershares.com/products/

(I personally bought some PWZ, PZA, PZT, PGX & PHB)

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About johnonstocks

I've been trading stocks since 2003, active on Motley Fool's discussion boards and using first Hidden Gems, then Global Gains. I no longer have the newsletters, but I keep up on the WSJ and read David Rosenberg everyday at gluskinsheff.com. Education: CFA level 2 candidate MBA-focus in Finance, Marshall, University of Southern California - expected Dec 2010. BS Mechanical Engineering, UC San Diego, June 2002
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