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Despite the U.S. national debt, there is a silver lining for income
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international income investors could reap the rewards in the form of
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How California Could Ruin the
Recovery |
[http://www.streetauthority.com/includes/article-top-ao.htm]Published:
June 25, 2009
Lots of good things come from California.
Like sunshine. And wine, for instance.
But there's bad news on the West Coast, where the Golden
State is in serious financial trouble. Foreclosure rates are
off the charts. Unemployment is at 11.5% versus 9.1%
nationwide. And to make matters all the worse, the clock is
ticking on a $24 billion budget gap. Governor Arnold
Schwarzenegger may have an accent, but he was perfectly
clear when he summed up the situation thus: "Our wallet is
empty, our bank is closed and our credit is dried up."
Though the Democrats control the House and Senate and have
drafted any number of new proposals, the governor isn't
satisfied nor bent on compromise. Schwarzenegger, a
Republican, has said he'll veto any new taxes. As the
political brinkmanship continues, the number of headlines
grow and their tone becomes ever more shrill. Now, barring
a political miracle -- or mass political suicide -- the
crisis in Sacramento is poised to begin affecting markets in
New York.
The first ripples of panic are already being felt in the
debt market. Remember, there's tons more debt than equity in
the world, and a prudent equities investor should always
keep one eye on bonds. Moody's -- which failed to
distinguish itself in the last financial crisis -- has
already placed California's A2 credit rating, worst among
the 50 states, on a watch list. If a budget impasse forces
Sacramento to delay some of its interest payments, Moody's
says a downgrade of several notches could result.
|
State |
Unemployment Rate |
Credit Rating |
|
Michigan |
14.1% |
Aa3 |
|
Oregon |
12.4% |
Aa2 |
|
Rhode Island |
12.1% |
Aa3 |
|
California |
11.5% |
A2 |
|
Nevada |
11.3% |
Aa2 |
Now, on its face that doesn't sound all that bad, right? So
California's credit rating falls. No big deal. All that
means is it will be more expensive to borrow money, and
California shouldn't being doing that anyway.
But that's not all a downgrade could mean. Dropping
California three notches puts its bonds below investment
grade. That means that many institutions would no longer be
able to hold them. Should that rating slip and billions of
dollars of those bonds are dumped, their
value will crater.
I don't want to be the Boy Who Cried Wolf. The debt rating
could stay above junk levels. But any downgrade could prove
devastating. All investors are skittish these days, but
conservative income investors don't want any risk in their
fixed-income portfolios, and they'll play hot potato with
these bonds if they're downgraded.
So sometime right after a downgrade and just before
California's bonds bottom out, the stock market is going to
drop like a stone, and for exactly the same reason:
California-induced panic. Fear floods the market faster than
hope. Traders will be gripped with a mania that leads them
to think things are going to get as bad as they were.
Investors who were burned last year as the Dow fell from
13,000 to 6,500 won't wait before running for the exits this
time around and will bolt at the first sign of trouble.
California, I should mention, has never missed a debt
service payment. But that's a logical point, and logic has
nothing to do with investors running out of confidence and
growing more anxious and fearful about the state of the
economy. That's purely emotional. If anything can put an end
to the market's recent rally or even derail
an overall
recovery, it's the actions of a government. And we're not
talking about some third-world backwater. We're talking
about the largest state economy in the U.S. -- a $1.8 trillion behemoth.
In fact, California's economy is larger than Russia's or
Brazil's.
So the questions are these: How likely is a financial
stalemate in California, how far can the market fall -- and
how can investors take advantage?
I'll answer those, but first I feel obligated to tell you
how to protect yourself. You've got to get out of any
California general-obligation bonds you own. Let me be
clear: There's no downside to this move. If I'm wrong and
you keep the money in cash, you can always buy the bonds
back. If I'm right and they tank, you're protected from the
loss. You might even consider buying them back and locking
in a fat yield if you think California can come back.
I've heard calls to sell all tax-exempt bonds. That strikes
me as going a little too far. But please unload these bonds
before the impasse turns into a downgrade. It will be too
late then.
Now, let me answer those three questions...
The likelihood of a continued impasse is high. California
Democrats hold a compelling majority in the legislature, but
Gov. Schwarzenegger can't run for re-election and seems
willing to hold his ground. White House Press Secretary
Robert Gibbs says Mr. Obama will not be coming
to the rescue
and that California needs to put its own house in order.
The Dow
Jones Industrial Average could easily see a return to its early
March levels, especially if the situation in California
triggers a full-blown panic.
As for how investors can best take advantage, the answer is
to keep some cash on hand to go bargain hunting. The
Dow has gained +27% since its 6,500 ebb in early March, but
more than a few companies have racked up 10 times that. If
you haven't taken those profits, now is as good a time as
any. Should those stocks drop back to their previous low
levels, you want to be prepared to pounce on them and ride
the elevator up again. Bottom line here: The market has lost
some steam, but it could easily stand to lose more, and
California will be the catalyst.
Companies can't move the markets like this -- only
governments can. California's Legislature is facing a July 1
deadline -- that's five trading days from right now. That
could be bad news for some, but it will be a bright spot for
investors who play it right. We could be five days away from
another buying opportunity. In the meantime, sell those
bonds to protect yourself and hunker down to watch for
bargains. Don't let fear force bad decisions. Keep calm and
carry on.
[http://www.streetauthority.com/includes/editor-profiles-ao.htm]
Disclosure: None.
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