Money Matters - Simplified

The Pessimist's Guide to 2011


I'm a long-term optimist. You should be, too. But even when you're an optimist, a healthy amount of skepticism -- maybe even pessimism -- can do you good. It makes you a more stable optimist.


"You can say, who wants to go through life anticipating trouble? Well I did. All my life I've gone through life anticipating trouble," said Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) Vice Chairman Charlie Munger in 2007. "It didn't make me unhappy to anticipate trouble all the time and be ready to perform adequately if trouble came. It didn't hurt me at all. In fact it helped me."

For those who anticipate trouble, here are five things to focus on in 2011. (For a different view, click here for five things to be optimistic about.) 

1. Municipal bonds
States are facing a $180 billion fiscal hole in 2011, and an additional $120 billion in 2012, according to the Center on Budget and Policy Priorities. States and localities face a long-term pension deficit of between $1.2 trillion and $3 trillion, depending on what discount rates you use. Property taxes -- a main source of revenue for local governments -- are falling and will continue to fall as property values are reassessed and real estate prices sag.

It's a mess.

Analyst Meredith Whitney, famous for calling Citigroup's (NYSE: C) blowup in 2007, now thinks muni bonds are the next shoe to drop. "There's not a doubt in my mind that you will see a spate of municipal bond defaults," she told 60 Minutes last week. "You could see 50 sizable defaults. Fifty to 100 sizable defaults. More. This will amount to hundreds of billions of dollars' worth of defaults."

Plenty have written off Whitney's latest prediction as uninformed babble. But they wrote her off in 2007, too. The main retort Whitney's analysis has faced is a version of the "It's never happened before, so it can't happen now" line. That, too, is what they said five years ago when some warned of a housing bust.

2. Rising interest rates
As grisly as the past three years have been on housing and employment, they've occurred against a backdrop of record-low interest rates -- a spectacular boon that's blunted the blow.

That could change. Long-term interest rates are already rising, with 30-year mortgage rates rising 70 basis points in the past month alone. The effect this has on real estate can be nasty. A $1,500 monthly mortgage at 5% can finance $285,000 worth of house. When rates jump to 6%, that same $1,500 per month will finance $250,000. At 7%, you're down to $225,000. Higher interest rates, lower home values.

3. Oil
Oil's explosion to $140 a barrel helped shove the economy into recession in 2007-2008. As a corollary to the old GM saying, what's good for ExxonMobil (NYSE: XOM) usually isn't good for America.

It was simple math: Gasoline prices rose from $2.29 to $4.05 between early 2007 and mid-2008. The U.S. consumed about 210 billion gallons of the stuff during that period. That's a $370 billion added tax on consumers.

With oil prices now breaching $90 a barrel -- almost 30% higher than a year ago -- a similar headwind is gaining momentum.

Should oil break above $100 a barrel, you get a two-for-one sting: Consumers are whacked by higher gas prices, and $100 breaks the psychological threshold of proving this country's energy policy is abysmal at best.

4. Mad man at the helm
Fed chairman Ben Bernanke has made it clear: He will keep interest rates ungodly low until the economy is out of the woods.

The problem is, time and time again, history shows the economy is well out of the woods long before anyone, including and especially the Fed, cares to admit it. That gives artificially low interest rates ample time to wreak havoc.

Even more troublesome is that the Fed is strictly concerned with price inflation, not assetinflation. Price inflation is when the price of goods like food goes up. Asset inflation is when there's a stock bubble. With the focus on the price of goods, assets can spin wildly out of control as the Fed looks the other way, insisting there's no inflation while bubbles form and inevitably burst. This is essentially what happened last decade with the housing bubble. Many think it's a story we're replaying line for line today.

5. Valuations
When the Fed prints money with abandon, there's a good chance the valuation of every financial asset will go nuts. Stocks. Bonds. Gold. Houses. Used cars. Everything gets distorted and becomes subject to bubblehood.

On one end, you have investors plowing into bonds, happy to buy the debt of governments, municipalities, and companies for returns that often round to zero. These investors won't be happy with the outcome. Just wait. At the other end, my colleague Alex Dumortier recently showed a few examples of irrational exuberance creeping back into the stock market, including what he found were high historical valuations, smart investors heading to the sidelines, and good ol' complacency.

The iron rule of investing is that there's a perfect negative correlation between returns and excitement. And there's a lot of excitement in almost every asset class these days.

© 2010 UCLICK L.L.C.