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) .

Many people are very upset that the dollar has been declining the past few months.  The call is out for the Fed to raise interest rates (see Barrons headline, October 19, 2009). 

But there is a flip side to this argument.  Asset valuation (whether real estate, baseball cards or stock equities) is never about fact, but always a matter of opinion.  Facts, like the P/E ratio,  might support the opinion, but value is an attitude or belief, it is not an absolute truth.  Because valuation is an opinion, it is subject to psychology.  When people feel good about an object and can support that feeling with some fact, it has higher value.  When they feel poorly about the same object it has lower value.  But the object itself doesn’t physically change.  Value is psychic.

And what is the point of this observation? 

The same is true for currency of any kind, including the maligned dollar and revered Gold.  When people want it, the unit price is higher, when people don’t want it, the unit price is lower.  To turn what is obvious on its head, maybe it isn’t that house prices went down the past three years, but that the value of the dollars used to buy the house went up with demand from the world for a safe harbor. 

The American currency remains the safest form of wealth the world knows.  After all, contrary to its reputation, the price of gold declined during the worst of the panic.  It did so as the price of the dollar in the form of short term US Treasuries, increased to record levels (as interest rates went to zero). 

So, it was the currency ”safety trade” and a highly valued dollar that was a primary source of our real estate woes.  Put in this light, it makes much more sense that the Fed is working a policy to lower the value of the dollar back to where it was before the crash began.  By lowering the value of the dollar, all physical assets priced in dollars will increase in apparent value.  This will add to the wealth effect and eventually, business leaders will start hiring and consumers will start spending.  That is and always has been the sequence of economic events.

The easiest way to devalue the dollar and thereby reflate the economy is by creating a flood of currency liquidity.  The Fed has the power to do this and it is.  This action is right out of the anti-Great Depression playbook and was used in the 1930s to great effect until the Fed lost its nerve in 1937 and raised interest rates by shutting off liquidty (tightening money supply in other words); prematurely as history has proved. 

So what Andrew Bary in the Barrons piece is calling for, is really the recipe for a Double Dip Recession or perhaps even to tip the economy over into the Depression we just narrowly avoided.  To raise interest rates or reduce financial liquidity at this point would destroy the economic comeback, one which is unprecedented in its speed and amplitude. 

It is time to appreciate Ben Bernanke’s insight and command of monetary policy.  It is his (and the Treasury’s) knowledge and courage that have kept the global economy from capsizing.  We took on some water, but Bernanke and company kicked the bilge pumps into high gear and we are beginning to float high and unfurl the sails once again.  He should have no problem trimming those sails once the wind comes up.

There are many doomsayers on the economy and markets. They all say roughly the same thing: we have been profligate as a nation and as a world, and there is a big price to pay. This price will be paid in the form of a very long period of economic stagnation and declining markets. The doomsayers give many seemingly sound reasons for their outlook, that to some may seem irrefutable evidence of a coming economic armageddon.

Unfortunately, history does not support their thesis. If anything, what economic history proves is that there is a wired-in persistence of growth in the economy. When we look at our financial surroundings on a day to day basis, we get confused by the noise. Daily, monthly, even quarterly data might seem to indicate some watershed change in the economic future. But the facts show us that year after year, decade after decade, the economy continues to grow very evenly and consistently. The markets will mirror this growth in the long term, and once all the daily noise is removed.

Here is a chart I prepared showing this persistence. It dates from the earliest Gross National Product data available on the government economic data website. It shows that even the 1930s disaster looks relatively benign in an 80 year perspective.

The conclusion: invest for the future, not the next day. And you will be richly rewarded for your patience.

Today’s big news (at least in some corners of the investment world) is US Congressman Issa’s claim that Fed Chairman Ben Bernanke has “covered up” the facts regarding the Bank of America acquisition of Merrill Lynch and Mr. Bernanke’s supposed threats to BOA CEO Ken Lewis. Mr. Issa is an otherwise, insignificant Republican Congressman from Califronia, who, according to his webpage, has great admiration for President Ronald Reagan. But I promise you, President Reagan would want nothing to do with this idiot, and would quickly distance himself from his fellow state politician.

This whole Bank of America situation should be much ado about nothing. Whatever happened between the Federal Reserve, the US Treasury and the banking industry in the last few months of 2008 was done in desparation to keep the entire planet above water. Had the American banking industry collapsed at that time, there would have been a domino effect that would have collapsed the financial system worldwide. All large banks lend to each other on a global basis, and if a few of the “money center” banks like Citi and BOA had gone bankrupt in the middle of the crisis, all banks would have likely ended in the same situation. This would have magnified the recession several times over into a crisis that would have easily eclipsed the Great Depression.

For those new to this story: Fed Reserve Chairman Ben Bernanke and Hank Paulson, then-Secretary of the US Treasury, first convinced Ken Lewis to acquire Merrill Lynch, which was in very bad shape. Serial acquirer Mr. Lewis reportedly had coveted M-L for many years and was happy to oblige, with government assistance. But once the bean counters at BOA looked under the covers, M-L was in much worse shape than they had suspected. At this point, in early December 2008, Mr. Lewis wanted to pull out of the deal fearing for his reputation and the impact on BOA shareholders. Had Lewis done so at that point in time, the very fragile banking system may have collapsed, as it started to in September when the Treasury and bank regulators allowed Lehman to go bankrupt following the bankruptcies earlier of Bear Stearns, Fannie Mae, Freddie Mac and AIG.

And here is where the controversy begins. Mr. Lewis needed some amount of encouragement to keep his end of the bargain. Bernanke and Paulson helped him understand the danger to the entire global economic system if he abandoned the deal at that point in time. Mr. Lewis was not happy about the situation, but agreed to go through with the merger, because he came to understand the ramifications of pulling out, according to his own Congressional testimony a few weeks ago.

This should be “end of story”. We all know how dangerous the banking system was last Fall. The Fed and Treasury did what it took to stabilize the system at great risk to personal reputation, and reportedly 24/7 effort over more than a couple months. If some subtle arm twisting took place to help Mr. Lewis understand the significance of his decision, then so be it. What a small price to pay for saving the global economy. We aren’t talking water-boarding or horse heads here.

Then, along comes Rep. Issa and his over-reaching desire for political gain (apparently, that is the only motive that makes any sense). He is the Republican minority leader on the House Oversight Committee. Today, he decided to make hay of the misplaced concerns in Congress that Bernanke and Paulson overstepped their authority and coerced Mr. Lewis into making the acquisition, something Mr. Lewis has already denied under oath in his Congressional testimony.

Mr. Issa apparently thinks his personal political gain is more important than the stability of the world’s economy and the millions of unemployed. His accusations of “cover up” intentionally bring up comparsions to Watergate. Why else would he use such a volatile term? He obviously is trying hard to embarrass the President who has backed Bernanke. Some of the Republican “hard right” are not happy that Bernanke has saved the banking system preferring instead “to let the free market fix the problem”. Yeh, right.

So, I ask the question? Can a Congressman be impeached? And if so, how can I help impeach Mr. Issa? He is a disgrace to our country and to the Republican party and should be ashamed of himself for breaching protocol and making on his own as only the minority leader of this committee, his accusations regarding the Fed Chairman.