How severe is the municipal budget deficit situation?

In some cases, it is getting to the point of no return. And it’s not just Californian cities that are in trouble; other municipalities in the U.S. economy are struggling to keep up as well.

For instance, San Diego could face a budget deficit of $84.0 million in 2013, compared to a $5.0-million surplus anticipated by the city’s mayor. (Source: U-T San Diego, November 22, 2012.) San Diego’s bigger-than-anticipated deficit is mainly due to investment losses in the city’s pension fund, infrastructure repairs, and the shutting down of its redevelopment agency.

Similarly, the Michigan state treasurer has warned Detroit about troubles ahead. In August of this year, it was estimated that Detroit would have a cash deficit of $62.0 million by June of 2013, and by this November, that number increased to $122 million. (Source: Reuters, December 15, 2012.)

The scrutiny for municipal bonds investors doesn’t end here; they have more reasons to be worried. The main reason municipalities in the U.S. economy are faced with such large deficits is because they promised generous salaries and pensions to their employees, but the tax revenues that would pay for those promises have deteriorated.

After the housing collapse, their property tax revenues fell short, but the obligations of municipalities remained the same. Municipalities issued bonds to fill their pension funds, thus, today’s municipal bond concerns.

Now Moody’s Investor Services is warning municipal bonds investors about cities involved in the practice of raising money simply to fill pension gaps. The rating agency believes that the cities are simply adding more to their liabilities and increasing their chances of default. (Source: Bloomberg, December 11, 2012.)

All of this is not good news for the municipal bonds investors. As I have been stressing in these pages for some time now, increasing budget deficits at the municipal and city levels are a big problem. Cities across the U.S. economy are in financial trouble, and they will continue to be in trouble for a long time.

At a certain point, cities with budget deficit issues will need to ask state governments to bail them out. State governments will then need to ask Washington for cash, since the states themselves don’t have it. There doesn’t seem to be an end in sight to the problems with localized budget deficits, and investors need to be wary about them in 2013. (I will do research this weekend on the Federal Reserve and its mandate. Could the Fed print more money, buy municipal bonds, and bail out cities and municipalities?)

Where the Market Stands; Where It’s Headed:

Third-quarter corporate earnings were dismal, as an 11-quarter streak of positive earnings by S&P 500 companies finally came to a halt. Corporate earnings of S&P 500 companies fell for the first time since 2009—something big that went almost unnoticed by investors. The overall corporate earnings of S&P 500 companies fell 0.9% in the third quarter of 2012. (Source: FactSet, November 29, 2012.)

But have no fear. The stock market keeps rising as the Federal Reserve creates trillions of new dollars.

And now, with the Fed’s promise to print more, another $85.0 billion per month to be exact, I believe investors are starting to realize that creating money out of thin air while stock prices rocket higher can only go on for so long.

What did the market do when the Fed announced another round of quantitative easing on December 12? The stock market actually went down, contrary to what it did when the Fed announced the first three rounds of quantitative easing. Look at the chart of the S&P 500 below.

Chart courtesy of www.StockCharts.com

Given what I have said above, does the stock market really have reason to go up anymore? The most important element of a real stock market rally is missing, dear reader—corporate earnings.

Looking ahead, 73% of all the S&P 500 companies that have thus far issued profit guidance for the fourth quarter of 2012 are expecting earnings to be soft. (Source: FactSet, December 3, 2012.)

Some examples:

Schlumberger Limited (NYSE/SLB), an S&P 500 company, expects its corporate earnings to be much lower in the fourth quarter. The company stated that its earnings will be lower by five to seven cents a share. (Source: Moneynews, December 14, 2012.)

Another S&P 500 company, insurance giant, MetLife, Inc. (NYSE/MET) warned investors of possible fourth-quarter fluctuation in the corporate earnings. According to the company, the low interest rates are making it challenging for it to hedge its risk (Source: Wall Street Journal, December 13, 2012.)

The stock market has lost its taste for quantitative easing. Right now, the S&P 500 and other key stock indices are going through a period of low volume because of the holiday season. Starting the beginning of next year, when the volume comes back, the direction of the stock market could be very different.

With Japan back in recession, with China’s economy growing at the slowest pace since 2009, American multinational companies will see continued profit pressure in 2013. And let’s not forget that the situation in the eurozone, from which 40% of the S&P 500 companies derive revenue, is getting worse, not better.

Case in point:

Italian national debt rose to $2.014 trillion euros in October—the highest level ever reported. In January of 2012, the country’s national debt stood at $1.940 trillion euros. Italian debt now stands at 126% of its gross domestic product (GDP), the second-highest debt-to-GDP multiple in the eurozone region after Greece. (Source: The Washington Post, December 14, 2012.)

To add further misery, home prices in Spain tumbled 15.2% in the third quarter compared to a year earlier, according to official statistics. (Source: The Financial Times, December 14, 2012.)

With all I have written above, how can 2013 not be a difficult year for the stock market?

Michael’s Personal Notes:

Usually, we do not publish controversial editorial. We try to base our opinions on economic and company data as it is released. But once in a while, something catches our attention that we believe our readers should at least be aware of. The following is such an example of journalism, based partly on fact, partly on very right-wing opinion. These are some closing words on gold bullion for 2012 from our gold guru, Robert Appel, BA, BBL, LLB:

In front of three witnesses, then Bank of England Governor Eddie George spoke to Nicholas J. Morrell (CEO of Lonmin Plc) after the gold price explosion in September/October 1999. George said, “We looked into the abyss if the gold price rose further. A further rise would have taken down one or several trading houses, which might have taken down all the rest in their wake. Therefore at any price, at any cost, the central banks had to quell the gold price, manage it. It was very difficult to get the gold price under control but we have now succeeded. The U.S. Fed was very active in getting the gold price down. So was the U.K.” (Source: Zero Hedge, last accessed December 20, 2012.)

To understand any puzzle, you need to look at all the pieces. For instance, we know that Reagan in 1989, by presidential order (which is rapidly becoming a replacement for the constitution), created a semi-secret group of financial interveners, empowered to use public money to assist in “emergencies,” and “stabilize” markets. “Stabilize” being, of course, a polite word for fix or manipulate.

We know that in 1991, leading Canadian publication The Financial Post published on its front page interviews with lifetime gold traders from all over the world. The gist of the story was that something “odd” was happening in the gold pits, something they had never seen. The events of this period compelled the owners of gold mines all over the world to band together and publicly accuse the Western governments of manipulation. Their organization, the Gold Anti-Trust Action Committee, is still very active today.

We know that in-your-face gold manipulation seemingly reached a zenith in 1999, when for the first time in 100 years, gold failed to maintain its usual ratio with the Dow Jones Industrial Average (prior to the 2000 crash); and we know that Gordon Brown not only sold tons of England’s gold for the lowest possible price in the last two decades, but did so in the public eye, and with gusto, possibly with the intent of showing the world that gold was, as he put it, a “useless asset…taking up space” in their vaults. And cost Britain billions in the process.

We suspected, at the time, that Brown was not alone, that all the Western nations were taking turns bad-mouthing gold, and selling gold wantonly, with the U.S. the lead choir singer.

Now, consider that the above quote, the “smoking gun” if you like, did not surface until about 2010, but retroactively confirms our worst suspicions. It is especially interesting that George gave the U.S. credit for the 1990s main gold whacking, but he was quick to add that the U.K. played its part, too. This is important when you recall how many times this year we have sent readers trading charts showing overnight whacks, either starting with the London bourse, or, more commonly, the N.Y. bourse. Sometimes, London is followed by the U.S., but—with the sole exception of the last three weeks, which we discuss below—never in Asia.

Now step back, and look at the big picture.

By the late 1990s, “da boyz” (whoever these gold whackers were) had done a great job.

By the end of the first decade of the new century, however, their performance was much less impressive. Gold had gone from $250.00 to $1,500 an ounce, and China was (unlike the west) buying up all the gold it could get, encouraging its own citizens to own gold. (In China, you can buy gold at most malls.)

So against this backdrop, and (we believe) seeing the $1,700–$1,800 level as a “line in the sand,” what do da boyz do in 2012?

And consider this too—over a decade has passed since the date referenced in that quote. There is incredible new technology now at the fingertips of the gold whackers. They also have a larger war chest from the many successful (but short-lived) “whacks” they have been attempting over the intervening years.

And, even better, for them, the public at large has become more de-sensitized to manipulation than anyone would have thought possible. In fact, we are now all living in an era (and historians of the future will write about this with shock and horror) where multiple sovereign governments intervene in markets on a regular basis and then boast about it on the six o’clock news!

(Make no mistake—we have now reached a point where one arm of the U.S. government borrows money in the bond market to meet cash obligations, and then another arm of that very same government steps in and purchases said debt—bonds—with newly printed cash or equivalent. Not only does John Q. Public see nothing amiss with this, but, astonishingly, the demand for these bonds—demand, please recall, which is covertly created by the same party who issued the bonds in the first place—appears to be so strong that, as is the nature of all debt markets since the beginning of time, rates are constantly dropping to reflect the “high demand for,” and “safety of,” these same instruments.)

So what is the bottom line?

We are ending one of the worst years for gold in a decade. A year where, mysteriously, technical analysis by the best of the best failed to predict that gold would weaken or go sideways. Mysteriously (again) gold keeps getting hit every time some news comes out that otherwise would be gold-positive.

OK, we take off our hats to these gold whacking guys. They “won” 2012. But China (the world’s strongest promoter of gold as a key factor in currency rebalancing) is rapidly approaching the point where its own middle class will soon be able to sustain its economy without being fully dependent on the West.

As we have said before, if this were easy, everyone would do it. We think da boyz will not be as successful in 2013 as they were in 2012. We note that the mining sector, in particular, is selling at bargain-value ratios only seen (on average) about five or six times every 100 years.

And every single time in the past that these specific ratios were hit, the market always turned bullish thereafter. We do not, however, want to be responsible for keeping anyone up at night. The world is too complex already. If the risk is too much, sell. But overall, nothing has changed. If anything, we expect the tide for gold to turn.