There has been much hand-wringing over Dubai and other countries and their sovereign debt problems since the end of November.  There is a fear that the exposure of this debt might be the tip of the iceberg.  It is feared that the government debt crisis will spread from the small and traditionally weak and underfunded economies of Portugal, Spain, Greece, Italy and Ireland (the PIIGS) to the more substantial and traditionally strong economies of France, Germany, Japan and the United States bringing with it the fear of a global sovereign debt melt-down.  This opinion is emotional and uninformed

All the “sovereign debt default” talk about Dubai, Greece and Spain is old news that is just now getting press because what was already in motion at the top of the debt bubble in 2007 is finally coming to fruition.  Now that the commercial bank crisis has been for the most part averted, the sovereign debt issues that are closely related come to the fore. The Dubai problems were obvious two years ago or more. And Abu Dhabi and other UAE brethren have little patience for the profligacy of Dubai. They will backstop Dubai only after those who overextended get taken out. Then they will ride to the rescue and take control of many of the assets.

Same thing in Spain or Greece. Spain dug itself a deep hole by committing significant debt to aggressive expansion of public works, most notably the 3GW solar power expansion.  The EU will backstop those countries, but only at a price. It is in no one’s interest to let the fire burn out of control. I compare this to hot spots after a forest fire. If they don’t threaten to flare up and ignite new fires, you let them die out on their own.  Other times you douse them (with financial liquidity in this case) to put them out before they spread. If the infection spreads to Japan, that would be a much more serious event than Dubai, only because of the size of the Japanese economy and the relative importance of the yen. But I think the global central bank leaders have an eye on this and will prevent a Japanese economic collapse. As long as all major economies pull together, there is no reason to think we will have a financial calamity. Economic collapses require the public to panic (and stop spending). Panic is totally a psychological phenomena and can only be brought about by careless or reckless political actions (or inactions).

It is very important to note that the countries that are in danger of defaulting, are not key world economies. The talk of a major economic power like Germany, Japan or the USA being forced into insolvency is from someone ignorant of what it takes to force a financial default. Defaults don’t just happen, they are initiated by a creditor. If the debtor is large enough as compared to the creditor, then it is non-sensical or impossible for the creditor to force the default. The punishment will fall as much or more on the creditor as compared to the debtor. To force a smaller debtor to default, though, makes sense. Assets can be seized and held or resold to recoup the investment. Just who would force the USA, Germany or Japan into default? Who could gain? Who could manage the assets that were forfeited for the debt? There is no private money (hedge funds, ala John Paulsen) with the size to force a large sovereign to default.  China is the only creditor nation with the size to force such a default. But China won’t do it because it would be suicidal. China, the creditor, needs the developed world as much as the debtors need China and other developing, export-driven creditor nations. It is totally symbiotic, or co-dependent if one wants to be cynical about the situation.

To make my point about the relative size of creditors and debtors as it relates to default: I just made a good return recently on General Growth Properties (GGWPQ.pk) because I understood this dynamic. GGP was in technical default because of the financial crisis and its inability to roll forward short term debt taken on during the two to three years prior to the financial collapse. It was / is still cash flow positive and can cover the costs of its interest obligations, much like sovereigns with their ongoing ability to raise revenue from tax.  But GGP wisely had filed for bankruptcy as a single entity and had pulled all its various mall properties under the single corporate parent umbrella. This made GGP in effect, too big to fail. No single creditor had the legal power to force all the properties into a firesale. The court (Judge Gropper) saw it the same way and made the decision to force the parties to work out the mortgagtes (to refinance). When the creditors found out they were not going to be able to drive a hard bargain and take away the mortgaged property for much less than market value, they had to deal. Now GGP is close to exiting bankruptcy with all its property intact.

Even though sovereigns are unlikely to default in a cascading way, the global economy still remains weak.  It will take consumers and businesses a long time to regain their confidence to buy and bankers to lend.  For the overall American market, from this point on, the economy must improve significantly to get the SP500 much above 1200. But I think that is the higher probability over the next year or two as compared to a melt-down. Politically, I think President Obama is finding out that it isn’t prudent to be too anti-business. He seems to have finally gotten the point that the top priority is jobs. Health care and environment are lower priority since there is no money to pay for them if we don’t have near full employment and full tax revenues. We aren’t hearing too much health care talk from the Admin or Congress the past 2-3 weeks. To demonstrate his new-found love for business, Obama just had T-Sec Geithner spell out the capital gains tax freeze and investment tax credits for 2010. This will help jump start business and improve consumer sentiment as people start getting jobs.

As Obama and other world government leaders turn their attention towards restarting business, the world economy will heal and the markets will respond. Asian stock markets might be a little overdone just because of being the crowded trade, so I have backed off on them, for now. I have moved almost everything back to domestic large cap stocks or energy / commodities. I think 2010 will be a “consolidation” year with only a little index movement, maybe from 1100 to 1250. 2011 might be a similar year, with gradual improvement from 1250 to 1400. That would get us back to May 2008 which was about where the final dive started (down to 666). Maybe we pull back 100 points (10-12%) somewhere in the next 2-3 years. But by 2014 we can pass 1550 and set new highs, if the government continues to be supportive of business and doesn’t get too radical (seems more likely right now than 6 months ago).

I am buying up some of the banks that look like they are turning the corner and will be survivors. I have a bunch of the leveraged financial index, UYG, which is weighted towards the survivors like GS, JPM or WFC. But I also am buying some BAC now (as of two weeks ago). Even Citi might be a buy at this point, now that they have a plan to exit TARP. But I am passing on them for now.

Otherwise, my theme is Tech, commodities, energy and materials. Tech is due for a positive replacement / upgrade cycle after 10 years of being down.  Microsoft’s (MSFT) Windows 7 should be the catalyst in 2010 once the IT budgets are approved. Just buy the XLK if you don’t have any favorites. SMH is the semicon index which has more beta than the XLK. My favorites in commodities tend to the miners and energy stocks, though I have recently picked up some Potash (POT).  I also have call options on (FCX) and (BHP).  This is a better way to play the weak dollar trade than gold, in my book, as operating leverage contributes to performance and generates cash flow which actually has value to an investor.  They have all outperformed Gold in 2009.  Commodities and Energy will benefit from the global economic expansion that is the natural reaction to the collapse. I find it interesting that Suncor (SU) was going up the last two days while oil futures are going down. I find that a very positive sign. I have really loaded up on Pennwest (PWE) and Provident Energy (PVX) .

Great Earnings this morning (Tuesday, October 20) from CAT, UTX, PFE and KO. CAT guidance was the economy is improving much faster than expected and the risk of a double dip recession is now ”very low” in 2010. CAT (a proxy for the export driven, industrial equipment market) beat earnings estimates by 85% and had higher revenues than forecast (which is supposedly what the market is begging for). So, what happened to its stock price? Sold off.

This earnings season has become the typical denial event by the Bears. The hardcore bear traders try and sell down every rally and discount any good news as either lies or misinterpretation. They first criticize the weakness of economic growth and unemployment levels, and then turn around and criticize the Fed for using accomodative policy to ramp back up the economy.  (Earth to Bears: you can’t have it both ways, unless Armageddon is your objective, in which case, tight policy will deliver the economic disaster you are awaiting)

This market is still climbing a huge “wall of worry” and so it will continue climbing higher (until all the Bears throw in the towel). When I stop seeing Michael Pento, David Rosenberg , Peter Schiff, Joe Battapaglia, etc on CNBC blasting the Fed and the market, that is when I will Sell.  There is no Euphoria.  There are no “rose-colored glasses.  There are only Bears (likely still short since SP500 of 666) begging for their wishes to be fulfilled.  Please keep ripping the market and economy.  It is making me wealthy.

Today, I was able to roll my October FLRs that were exercised on Friday to November sold puts, and picked up another 0.50 per contract in the process. I also flipped my BHP for a 2.47 gain the past 12 days (closed my Nov 70 puts at 1.75 and opened same number of Nov 75 puts at 4.50 a few minutes later) during the morning sell off. I am now waiting to get back into EWZ as Brazil sold off big today (down to 70 from 76). I will wait for $67 to get back in with some DITM calls on Mar 2010.

I also doubled down on my GE Mar 2010 Calls ($10s) at $5.80. They had been almost $7 a few days ago. Now I have 10 contracts (1000 shares) plus another 500 shares of GE.

Yesterday the SP500 hit 870 twice: at 12:00 and again at 2:00 Eastern. It held both times and ended the day at 879. 870 – 875 had been the SP500 target for weeks as the bottom of a trading range. So, the fact that it held, not once, but twice, is very encouraging. This forms a technical formation called a double bottom, which only means that an important level was tested  by traders more than once. The market trading bears didn’t have enough selling power to push the index through that level for now. Any good earnings news like the better-than-expected Alcoa results yesterday will give the bulls more encouragement and may force out the bears at some point.

I noticed that all the cyclical / materials stocks were moving exactly with the SP500 all day Wednesday. This is an indication that materials and energy are a proxy for economic recovery. When the market feels the prospects for the economy become better, deep cyclicals and materials move higher. So FCX made a bottom at around $43.50 at both times and SU made a bottom at around $25.75. For both high beta stocks, they are off by more than 20% in the past two weeks, which means they are in their own mini-bear markets. (FCX is off over 30% from its June high).

So, is this a good time to buy? The long term thesis is inflation to correct the Federal deficits and pay for growth in money supply / weakened dollar. Commodities / materials are the best way to play that move.  But is now the time? 

I am waiting as there is a lot of downside momentum in oil and basic metals (copper).  Many traders (probably too many for a contrarian like me), feel that oil is headed to $50.  But industry experts tell us that any price below $70 today will shut down supply, leading to higher prices at some point as demand exceeds supply.  I have small positions in energy (SU, PWE an UNG) but am out of basic materials (I normally use FCX and BHP).  If the SP500 gets back above 900 with some conviction as shown by volume, I will consider adding to the above positions. I hope I can put money back in by next week.

Swiss investor, Marc Faber, still hates America, but he has a good track record for market prediction. So, I paid attention when I read this in Barrons today, in the Investor Roundtable Part 3:

Faber: When volatility diminishes (in the next few months), you want to be in cyclical industries. Among the most cyclical stocks are resource producers. They were driven up by incremental demand from China, and then collapsed. In the next six months they could have significant upside. I like Rio Tinto, BHP Billiton and CVRD [Companhia Vale do Rio Doce].

The financial crisis and collapse in commodities will keep supplies out of the market. Nobody is exploring now. There is no money, and projects are being postponed. Whenever the recovery comes, in five or 10 years, resources stocks will go ballistic from today’s low levels. If you’re optimistic about the next six months, too, when the news may be slightly better than today, you should own them. Freeport McMoRan Copper & Gold fell from 127 to 15 and is now 26. Xstrata, in Switzerland, is another one. A lot of these stocks are more attractive than gold, because gold is at a 20-year high relative to industrial commodities.

Scott Black: Rio Tinto’s balance sheet isn’t in good shape. They have a refinancing issue.

Faber: Worst-case, the Chinese government could buy them out. China has taken a big stake in the company. Meryl recommended Kaiser Aluminum [KALU] earlier today. I would add Alcoa.

Felix Zulauf: You’re not saying this is the beginning of a big bull market, but of a base-building process from low levels.

Faber: Correct, but when stocks decline by the magnitude seen in resources shares, or the Nasdaq after 2000, a base-building period follows that can extend for several years. When you print money, you can get an artificial bull market (in cyclical and resource stocks) that exceeds everyone’s expectations.

And this is a quote from Scott Black, another on the Barrons Roundtable of great investors (and a disciple of Benjamin Graham and value investing). He makes the case for XTO. But the arguments and metrics can be applied just as well to the Canroys (though it appears XTO did a much better job of hedging than PWE or PGH):

BLACK : My next pick is an old favorite, XTO Energy, in Fort Worth. The stock is 37.58, there are 577 million fully diluted shares, and the market cap is $21.6 billion. The company did a smart thing by hedging approximately 77% of its natural-gas production in 2009. They have locked in 1.6 Bcf [billion cubic feet] of gas at $8.94 per Mcf [thousand cubic feet], and 62,500 barrels a day at $118.85 per barrel. Production has been growing dramatically, and should average about 2.67 Bcf per day in 2009, up 18% year over year. About half the increase is from drill-bit growth, the rest from acquisitions. XTO bought Hunt Petroleum last year for $4.2 billion, figuring it could triple reserves, which are now 80% gas, 20% oil. It has 12 Tcfe [trillion cubic feet-equivalent] of gas and 500 million barrels of oil.

BARRONS: What are you pricing reserves at?

Black: I value the gas reserves at $3 per Mcf and the oil at $8 per barrel. Breakup value is about $44 a share, so the stock is selling at 85% of breakup value. My 2009 revenue estimate is $9.86 billion — slightly higher than the Street’s — which converts to $4.50 a share in earnings. Return on equity is 15.5%, return on total capital 10.3%. Free cash flow is $2.28 billion. XTO has cut its capital-spending budget this year, to $3.8 billion from more than $5.3 billion. They are wed to the notion of knocking $1 billion to $2 billion of debt off the balance sheet.

Their finding and development costs were $1.45 to $1.50 per Mcfe in 2007, and $1.65 in 2008. This year they could fall to $1.50. XTO is one of the few energy companies with rising earnings, because of hedging. They will earn about $3.75 to $3.80 a share for 2008, and $4.50 for ‘09. The stock sells for 8.3 times earnings and 3.6 times discretionary cash flow. It is extremely cheap. You’ve got asset and earnings protection. And they are in every major field in the U.S. — the Barnett Shale, Fayetteville and so forth. Energy is a controversial investment today, but XTO is the cream of the crop.

Schafer: If they hedged this year, does that mean next year’s earnings will be down?

Black: No, because they hedged 2010, too.