In Search of the Perfect Investment

Some days nothing pops. Your brain is elsewhere. It happens to all reporters. You see it more often now there are few reporters at the major publications. The Wall Street Journal is pressuring fewer reporters to produce financial sensationalism — a formula its new owner is renown for.

My weekend inbox is flooded with this story:

Jumping Into Munis Requires a Leap of Faith

By DAVID REILLY And LIAM DENNING

Who do you trust more, Steve Ballmer or Gary Herbert? Based on borrowing costs, the Microsoft CEO wins out over the Utah governor.

Despite a triple-A rating and taxation powers, Utah recently paid 0.75 percentage point over Treasurys to borrow about $100 million in taxable Build America bonds for 10 years. A day before, Microsoft paid a spread of 0.55 percentage point to borrow $1 billion.

Microsoft’s debt is more liquid. But Utah likely also paid a price for growing unease in the $2.8 trillion municipal-debt market. Besides well-publicized strains on local finances, there is growing recognition that investing in “munis” involves a leap of faith. Disclosure is often substandard and information isn’t vetted as intensively as in stock markets.

This needs to change. Until it does, muni investors need to think hard about the information they receive and how it is checked. This is doubly important when the standard pitch about ultralow historical default rates among munis bears an eerie similarity to precrisis assurances that home prices never fall.

Yet states—whose bonds account for 42% of the muni market, estimates Municipal Market Advisors—face a $350 billion shortfall for fiscal years 2010 and 2011, based on the Center on Budget and Policy Analysis. Pension deficits are possibly as high as $1 trillion.

Meanwhile, the collapse of muni-bond insurance means “we really have a virgin market,” says Matt Fabian of MMA. In the past, more than half of new muni bonds were insured. Now, barely a tenth of them are covered.

That means investors need to do more due diligence, especially after a lawsuit brought this summer by the Securities and Exchange Commission against New Jersey showed governments sometimes mislead muni investors.

As things stand, investors rely on credit ratings and muni issuers’ audited financial statements. Neither is foolproof. The financial crisis showed credit ratings can be flawed. Plus, the size of the muni market is a challenge. Moody’s, for example, has “120 professionals” focused on municipal finance, maintaining ratings on 29,000 issuers.

And financial statements in muni-land aren’t reviewed by the Securities and Exchange Commission, unlike those of public companies. In fact, the SEC is legally precluded from overseeing issuers’ statements. And disclosure isn’t timely: Investors often wait six months or more to get numbers.

What’s more, while the Public Company Accounting Oversight Board oversees public-company auditors, that isn’t so for auditors of muni financial statements. Instead, muni auditors engage in the kind of peer-review process scrapped for public-company auditors in the wake of Enron’s collapse.

State and local governments receiving more than $500,000 in federal assistance must file an annual, so-called single audit with the Federal Audit Clearinghouse. There is no formal review process, however. And in June 2007, the President’s Council on Integrity and Efficiency randomly surveyed 208 “single audits” with a focus on reporting relating to internal controls. Only 55% were deemed acceptable.

Accounting standards also differ from those used for public companies. For example, governments don’t include pension deficits on the balance sheet. “So all the numbers in terms of the liabilities are understated,” says Ed Ketz, an accounting professor at Penn State University.

Granted, chances of a systemic shock in the muni market are slim. But the market’s “trust-me” underpinnings could make matters worse should problems arise. Just as observed during the credit crisis, investors can pull back en masse if they don’t really know what they are holding.

What am I to make of it? Muni bonds are far bigger than stock. My muni bond portfolio is far bigger than my equity portfolio. Should I sell all my muni bonds because of this one sensationalist article? Clearly no, I’ve cherry picked the muni bonds that I think are safest. Just as I’ve picked stocks that I think are promising. The article is a call to CHECK. CHECK. CHECK. You can’t buy and hold anything, including muni bonds.

In short, I’m not concerned  about the article. But I can see the poor reporter. His wife is distracting him with social crap and the fact that half the kitchen appliances just crashed. And now as deadline approaches, he racks his brains for inspiration. Someone says “the next financial collapse” and here it is neatly packaged. If something happens he can say “I warned you.” If nothing happens, well that’s life…

Exhibit two. How to make zillions like John Paulson. The article is from Friday’s Wall Street Journal:

How to bet like John Paulson.

Hedge fund tycoon John Paulson is the man who made his name, and a fortune, betting against subprime mortgages when no one else even knew what they were.

And he’s just made three big financial calls that you need to know about.

Speaking to the University Club in New York, he said, first, that gold could go to $2,400 an ounce based on the fundamentals–and that momentum could carry it to $4,000 an ounce. Right now it’s around $1,300. Second, he said you should get out of bonds while you can: You’re much better off investing in blue chip stocks with good dividend yields than bonds.

And third, he said you should buy a home. Now.

“If you don’t own a home, buy one,” he reportedly said. “If you own one home, buy another one, and if you own two homes buy a third and lend your relatives the money to buy a home.”

(A spokesman for Mr. Paulson did not challenge the accounts of the meeting.)

Among the New York commentariat there’s been a lot of head-scratching about Mr. Paulson’s take–especially this contrarian stance on housing.

Is he right? If so, what does he know that everyone else doesn’t?

Ignore the critics. The odds have to be on his side. The reason is simple: Inflation.

There is a debate raging on Wall Street these days between those warning about deflation and those warning about inflation. We are at, or near, deflation at the moment. It may even get worse before it gets better. But Mr. Paulson sees inflation coming by 2012 or so. Last week, several contrarian money managers I was talking to made the same prediction.

The explanation isn’t hard to find.

Forget the usual technical issues economists like to talk about, such as output gaps, labor markets, money supply and the like.

Put simply: We will get inflation because we have to. It doesn’t get any more straightforward than that.

We are the most indebted nation in the history of the world.

Data out from the Federal Reserve last week revealed that in the second quarter the total sum of U.S. debts (excluding the financial sector) had risen to a record $35.5 trillion. That is 243% of gross domestic product–barely a smidgen from last year’s peak, and off the map by past history. Thirty years ago it was less than 150% of GDP.

The debt orgy has been everywhere. Government debt continues to skyrocket. Corporate debt–contrary to some reports–is rising too. And after two years of brutal retrenchment, defaults and pain, households have managed to slash their debts by a massive, er, 3% from the peak. Household debts are still twice what they were just a decade ago.

There is only one plausible route out of this appalling situation. The government needs inflation. The country needs inflation. That will shrink these debts in relation to the economy, asset prices and incomes.

Deflation would make debts even bigger in real terms. That would be a disaster. We’re skirting it at the moment, but it can’t be allowed to take hold. That’s why Fed chairman Ben Bernanke has just offered more quantitative easing–and if that won’t work he’ll try something else. Anything else.

That’s what Mr. Paulson knows–and what anybody could know if they just take a step back from the day to day details and look at the big picture.

If the government succeeds in stimulating inflation, bonds will be in big trouble. Fixed coupons become a lot less valuable when prices and interest rates rise. At 2.5%, the 10 year Treasury already offers a paltry yield: The risks surely outweigh the rewards. Take profits on your bond funds.

Housing? It isn’t just that home prices have fallen a long way. It’s also that, if you can get a mortgage, you are basically taking a reverse bet on the bond market. You could be a long-term borrower at fixed rates, instead of a long-term lender. Right now you can borrow for 30 years at around 4.3%. After the mortgage tax deduction, for some people the net effective interest rate is nearer to 3%. That’s going to prove an awesome deal if we see inflation again.

As for gold? Mr. Paulson’s prediction isn’t that extreme. I’ve seen guesses from perfectly sane people, based on the money supply and other measures, suggesting gold might go even higher.

No one knows, of course. But the bull market seems to be very much alive. And I think there’s a chance–a pretty good chance–that gold could be the next Nasdaq. (Is Gold the Next Bubble?)

Naturally, the future is unknown. And most normal people can’t afford to risk a lot of their money speculating–especially these days. But you don’t want to miss out on a boom.

How should you bet if you think Mr. Paulson’s right?

One idea: Instead of wagering a lot of your money on gold, try taking leveraged bets with small stakes. That way you can make plenty of profits if the boom continues, while minimizing your risks if it turns tail. Here are two suggestions.

First, try buying “out of the money call options” on the SPDR Gold Trust. These are simple, if misunderstood, products that can be bought through a regular broker. You can view them like long-odds bets on the GLD booming.

How do they work? Here’s an illustration: The GLD, worth one-tenth of an ounce of gold, costs around $127 a share right now. But for just $3.90 a share you can instead buy a call option, good until Jan. 2012, that will give you the unilateral right to buy into the GLD at $180 a share.

If it booms to, say, $300, equivalent to $3,000 an ounce, you can exercise the options and make $120. But if gold plummets, as it has in the past, all you can lose per share is your $3.90 stake.

A second alternative: Take a look at speculative gold mining stocks. They should give you plenty of bang for your buck in a mania. There are funds, such as U.S. Global Investors World Precious Minerals fund, that specialize in smaller mining companies. One intriguing stock is Alaska’s NovaGold Resources (For more see this MarketWatch story.) A number of rich, powerful investors are involved–including Marc Faber, George Soros, and… John Paulson.

In other words, the reporter doesn’t know what Paulson is buying (or selling).  But he’s guessing to fill space. I like housing. My son and his new wonderful wife are looking. My advice with housing (and with all real estate investments) is simple. The price you buy is the sole determinant of the success of your real estate investment. The worst thing yo can do is to fall in love with the property. Once you do, you’ll overpay. Bid ultra-low. Be prepared to walk. Look at 100. Bid on ten. If you get one, you’re home.

As for the certainty of inflation? Maybe, but not soon. Inflation is caused when the economy has run out of capacity — people and factory. Today, we’re many years from running out of capacity.

Something is often not worth what you paid for it. In fact, often it’s more complicated, more troublesome and more expensive to repair. Items: Mercedes versus Subaru. Wolf microwave oven ($500) versus a GE microwave oven ($149). Same specs. Same size. GE’s is better made. We bought the GE at our local Lowe’s on the weekend after the Wolf had crapped out. Identical specs — 2 cubic feet, 1200 watts.

Harry Newton who had a wonderful weekend playing tennis and fixing things around the house that crapped out. Oops, only some of the things. I bet that “cabin in the woods” leaks?