Saturday, December 25, 2010

Christmas Geese And Black Swans

Christmas has come but I'm not sure if the geese have gotten fat.  The old nursery rhyme at that link is a comforting reminder of simpler times and timeless values.  When the holiday ends, the real world returns.  What surprises could be in store for us?

State and local finance troubles can sink the municipal bond market.  This subject is getting beaten to death.  A "bond market collapse" does not mean funding will be permanently unavailable to governments that need it.  It does mean that interest rates will be much higher for solvent governments when bond investors freak out at municipal bankruptcies.

The PIIGS can still cause more trouble for Europe.  The EU's critical constitutional weakness is its reliance upon the sovereign authority of its constituent nations to raise taxes.  A truly continental budget would allow the EU to issue its own debt as raise taxes to fund things like debt bailouts.  Lack of that mechanism means the EU will need outside help if Portugal and Spain can't pay bondholders.  If the IMF can't help, China shows every willingness to step into the breach.  This is a convenient window for China to diversify away from the U.S. dollar. 

Real estate foreclosures could send the banking sector back into a tailspin.  Mortgage-relief programs aren't working out very well for many participants.  Healthy retail sales are helping commercial property owners collect rents right now, but it's hard to say how much of those sales are just future demand pulled forward.  Try sustaining this spending splurge with structural unemployment staying high for the forseeable future. 

The Sun could go supernova.  Hey, you never know.  Gotta cover all the bases. 

The events mentioned above may not come to pass.  Black swan disasters can have six-sigma probabilities, but they can still happen in an investor's lifetime.  Risk management techniques abound.  Muni bond risk can be hedged with credit default swaps (for large holdings from single issuers) or with options on a muni bond ETF.  Risk of a euro collapse can be mitigated by holding multiple currencies.  Real estate exposure is harder to hedge; REIT ETFs are optionable but the best tools are nonrecourse mortgages and free-and-clear ownership.  I know of no hedges against supernovas, so perhaps one of my super-intelligent readers can invent a working starship affordable for the average family.