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Don’t Let the Nation Follow California’s Lead!

|Includes: iShares California AMT-Free Muni Bond ETF (CMF), CXA

California often leads the nation, for good and ill.  That’s why I titled my January 2006 Investor’s Edge® “Who Cares About California Real Estate?”  I answered, “We all should.  For my subscribers living between the Sierra Nevada and  the  Appalachians… I imagine you scratched your head when I advised in June that real estate prices would be coming down in over-heated areas.  After all, your real estate never got “un”stable. 


I continued in that same January 2006 article, “Nearly  20%  of  the  mortgages  entered  into  in 2004 were to ‘sub-prime’ borrowers.  [A term most people had never even heard of in January 2006…]  I predict these  homeowners  will  soon  become  renters and  those  holding  their  paper  will  soon become accidental landlords.  So, you ask, since you weren’t dumb enough to borrow $300,000 just because your house appreciated $325,000; and you bought the  Prius  and  a  case  of  Bud  instead  of  the Hummer  and  the  Veuve  Cliquot,  why  should you  care  that  housing  declines  on  the  Crazy Coasts?   Because when they raid The House, it doesn’t matter that you really were just the piano  player.    You’re  spending  the  night  in jail.    The  only  difference  is,  when The House gets raided, the company you keep is much nicer.”


Clearly, that trend of excess was in fact a harbinger for the whole country.  Within the year, citizens everywhere began to drink the Kool-Aid and by late the next year, 2007, the last greater fool had joined in.  I fear there is another trend that California has chosen to descend into that may afflict the entire nation.  It isn’t my intent to slam California -- it’s the state of my birth and still where my family, my wife’s family, and many of our dearest friends live.  To my way of thinking, it is still the most beautiful state in the union.  Carmel and the Big Sur Coast, the beaches of Southern California, San Diego’s beautiful bay, the wonders of Yosemite and the high Sierra, Lassen, the giant redwoods, San Francisco, the Wine Country, and the alpine jewel known as Lake Tahoe  are simply not duplicated anywhere else -- and that’s just a partial list.


But California is sliding down a slippery slope these days.  And there are huge investment implications here, not just for California but for all investors.  Because California’s undoing has been a very simple formula that is now being duplicated in many other states and, clearly, by the national government.  I fear the results will be predictable unless we reverse the trend.  That economy- and jobs-killing formula is: over-regulation, over-taxation, over-borrowing, minding other people’s business rather than your own, and under-investing in the people who create the most new jobs: entrepreneurs and small businesses.  Is the national government headed the same direction?  There are signs that it is.  Let’s look at these California hallmarks, one by one.


* Over-regulation.  How onerous it is to open and run a business is key to deciding where to open that business.  One of the hallmarks of Americans is our mobility.  The Dust Bowl brought hard-working people to California, people who had known travail and were determined not to let it take them down.  Back in the day, these were the people who made the state great.  But trying to get a job or open a business in California these days is an exercise in frustration.  The Small Business & Entrepreneurship Council publishes an annual ranking of the best and worst states in which to start and run a business.  My state, Nevada, which has seen an influx of new residents fleeing California, is ranked #2.  California is ranked #49. 


New regulations to finance the social engineering initiatives of politicians are added daily.  Businesses are being strangled by “hidden” taxes in the form of fees, licenses, and time away from productive work in order to gain permission and report progress to local commissars. 


The burden of small business red tape in California is estimated to be something like a half-trillion dollars every year.  For that kind of money, 4 million full-time California jobs could be created by private industry.  (P.S. California’s unemployment rate is 12.4%, fifth highest in the nation.)


* Over-taxation.  "Taxifornia’s" top tax rate for individuals is 10.3%, the highest in the nation -- higher than even DC, New York, New Jersey and other failed governments pursuing their social agenda at taxpayer expense.  A businessman organized as a sole proprietorship could increase his profits by 10.3% simply by moving his business to Texas, Nevada or one of the other 5 states that charge no personal income tax on top of the federal income tax.  At least California isn’t the very worst with its corporate income tax -- its 8.84% makes it only the 9th-worst behind bottom-of-the-barrel Pennsylvania, at 9.99%.  None of this has stopped California from giving the 6th-most liberal worker’s’ comp benefits, however.  After all, they can always soak the “rich” car wash owner, carpet-cleaner or landscapers who hires the workers.


Glad you don’t live in California?  That’s not the purpose of this article.  My purpose is to sound a clarion call to preserve the sanctity of a free economy where hard work is rewarded, not taxed to death.  Already, at the national level, 47% of Americans paid zero income taxes in 2009, up from 45% just two years prior.  At that rate in another three years 50.1%  of all voters would pay no taxes.  That is to say, those who do not contribute any of the money to be spent for the general welfare would be the ones telling the government how to spend it. Their interests may then be to “spread the wealth” even further and to vote only for those politicians who spread it in their direction. 


Alexis de Tocqueville is mis-attributed with the quote, “Democracy will last until the public realizes that it can vote itself largesse from the public trough."  And that is already happening in California and the nation.  How can a state go bankrupt when it has the best and the brightest in Silicon Valley, the most diverse farmland in America, great wineries, incredible offshore fishing banks, some of the world’s most perfect natural ports, and on and on? 


* Over-borrowing.  Bond buyers aren’t stupid.  If they see an issuer over-extending themselves, they will insist upon a higher rate of interest to compensate for their increase in risk.  California’s Single-A rating is now the lowest rating of any state. Yet it is the largest issuer of municipal bonds in the USA. California has gone back to the borrowing well so often that it has driven up the amount it pays above top-rated municipal debt 6 times since September 2008!   California has more than $83 billion in bond debt outstanding -- and faces a $20 billion revenue shortfall in the coming 18 months.  When asked how the state could keep its bonds from defaulting or the state from going bankrupt, Aaron McLear, spokesman for Governor Schwarzenegger, said,  “We’re going to stay at it to make sure we get our fair share from the feds.” That’s their solution? Get it from residents of Iowa, Texas, Alabama and Nevada?  Brilliant. 


* Minding other people’s business rather than your own.  The fact that they want us to bail them out doesn’t stop every state bureaucrat and elected official from pursuing their own social and environmental pet project they believe it is their God-given right to inflict on others.  For instance, all electricity imported from other states must be from green sources. Californian authorities don’t know the added cost this adds to small businesses, nor do they care.  As a result California, with abundant oil, gas and refineries, ranks 11th-worst in the nation in its cost of electricity.  And it has the highest state gasoline taxes of any state.


For an example of a politician elected to one jurisdiction using his bully pulpit to scold another, look at San Francisco mayor Gavin Newsom, who just banned city employee traveling to Arizona! Apparently, Mr. Newsom believes that this nation should have open borders, whether those dodging the law to enter illegally are looking for work, birthing a baby, or are Mexican drug cartels pushing drugs through street gangs or al Qaeda gun-runners and terrorists  -- as long as they are in Arizona, not San Francisco! 


I have good friends who are ranchers along the Mexican border. I never visit them unarmed, yet no matter what I bring to the party, the drug-runners that illegally enter this country every day have more firepower than I do -- or the Border Patrol does.  These same drug-lords just killed a rancher there because he touched one of their drug stashes on his property.  They just shot a deputy 140 miles north of the border.  Arizona had to defend itself since the US government has chosen not to.  It’s open season on Americans there.  If Gavin Newsom thinks this is a good thing, I suggest that everyone apprehended entering the US illegally, with or without criminal intent, be immediately flown to San Francisco.  He seems pretty quick to advise other people how to live their lives; let’s see how he handles the problem when it is his problem.


* Under-investing in the people who create the most new jobs: entrepreneurs and small businesses.  The sad truth is that Californians have thus far chosen to elect people who view job-creators as something evil -- exploiters of the masses and all that.  If the voters don’t change this approach this election, they will doom California to becoming a second-rate state.


Your investments, whether in California or in the United States of America, will never succeed unless they are given a fair chance at success.  If pursuing a personal social agenda becomes the primary role of elected leadership, all is lost.  If over-regulation, over-taxation and over-borrowing become the order of the day, no business can succeed.  California’s entitlements system and entitlements mentality are driving the state into bankruptcy.    How does California pay for its roads and highways, its courts, its mass transit, its water?  It issues bonds.  It borrows more money -- and spends more and more every year on interest for its ever-increasing debt.  We can all learn from this example -- and hope California voters do, as well -- and resolve not to re-create it in our own lives, or in our nation. 


Until then, may I suggest you avoid California municipal bonds (as well as the rest of the CO-MINNOW states I discussed here.)  It is often the case that suggesting what to avoid is even more valuable than suggesting buy ideas.  Conserve your capital.  Avoid California municipal bonds.  That goes for ETFs holding only California paper, as well.  Two I would specifically avoid are iShares S&P California Municipal ETF (NYSEARCA:CMF) andSPDR Barclays Capital California Municipal ETF (CXA.)


If your state is on the CO-MINNOW list, avoid those states’ munis, as well.  Life is too short to make 4% after taxes and lose 10% in principal at the next credit downgrade.  Yes, it’s true: if you hold them to maturity and if they’re still solvent enough to pay you off, you’ll receive par.  But there are just too many other fine investments out there to waste your time and money on those that have demonstrated their ability to squander their wealth and yours.





Author's Disclosure: We are long a number of special situations discussed in previous articles, and even a few specialized bond funds like those that float upward as rates rise – but we sold our California munis and muni funds a long time ago…

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