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Help wanted: $1 trillion stimulus

By Robert Lenzner,
December 18, 2008 08:55 IST
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The Obama stimulus package cannot come soon enough.

Even as infrastructure plays from US Steel to Fluor rallied in the stock market, another potential bubble was bursting--the vast market for municipal debt owned by wealthy individuals everywhere and absolutely required by hospitals, bridges, water systems and towns and cities across the nation.

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  • The municipal bond market is the lifeblood for the effective operation of cities from New York to Los Angeles, for social and welfare organizations, for the operation and maintenance of local and state government.

    Banks are issuing preferred stock with yields of 10% and higher. Nice yields, but don't get suckered into buying bad paper. Click here for Forbes-Lehmann Income Securities Investor.

    The smart money (solvent hedge funds and wily traders) are betting on state and local government defaults. The market is pricing the cost of buying insurance on muni debt at 330 basis points--more than it costs to protect your portfolio of investment grade corporate debt. This is a bad sign.

    The MCDX, a derivative contract on 40 different municipal bonds is being used to short munis, a bet that prices are going down because local governments will have trouble paying their tax-free interest coupons to investors. Protection on $10 million worth of munis will cost you $330,000 a year, which means you're paying a fee of 3.3% to protect principal on a bond that might be paying 4%. Net interest income on that deal is a measly 0.7%.

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  • With T-bills effectively at 0% and long Treasuries at 3%, investor psychology has reached a crucial inflection point. It is truly frightening to see New York Times bonds yielding 23%, an indication that the nation's leading newspaper company is headed for defaults or outright bankruptcy.

    So, what in the potential stimulus plan can turn this deterioration of the markets around? To put this in perspective, a $1 trillion stimulus would be equal to 50% of the entire prospective federal budget for fiscal 2009.

    A lower payroll tax for 95% of the population is unlikely to stimulate consumption, but it could be helpful in servicing mortgages and paying off credit card debt. Obama's original plan called for a cut of $780 billion over 10 years or about $80 billion a year. Clearly, with people worried about their jobs, they're more likely to save rather than spend. In fact, saving rates look to jump to 10% next year, according to Chris Wood, CLSA market analyst. The last time savings hit 10% was in 1985.

    Infrastructure spending is a given. There are projects worth $70 billion already approved but needing money to go ahead. Obama will probably push ahead on these projects and give money to state and local governments to refurbish transportation and other facilities.

    Problem is that new projects take years to gain approval to go forward. It means that the infrastructure payoff won't be in the first half of 2009. That is the predicament faced by Obama.

    There will be a "green energy" program that is still vague right now and seemingly doesn't have much chance of adding to economic activity in the short run.

    What hope is there for the stock market? Goldman Sachs is predicting earnings for the S&P 500 next year of $53. A multiple of 15 puts the index at 795 which is still lower than where we are today just below 900. It is hard to see how you could put a higher multiple on those earnings in the environment we are expecting. That suggests the recent rally will reverse its gains.

    Some observers of the scene think a special holiday for investors on capital gains taxes might spur investing. Or that a special tax credit for buying autos will help the economy. Hope springs eternal.

    A wiser view comes from Bill Gross, CIO of PIMCO, who believes stocks are not cheap in a time of "more regulation, lower leverage, higher taxes" when the government already owns roughly 20% of all bank capital and may soon own more. As Gross says in his December investor letter: "Better to own corporate bonds than corporate stocks."

    Indeed, the yield on many intermediate term corporate bonds is around 8.4%, which is roughly the expected annual rate of return on stocks. If you count on those interest payments being made, this kind of return looks like the most compelling in the marketplace.

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    Robert Lenzner,
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