Published: June 26, 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.

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 be 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 three 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 a few 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.

Many happy returns --

Andy Obermueller
Chief Investment Strategist
Government-Driven Investing

P.S. Although California's fiscal future may be ominous, not everyone in the state has driven themselves into financial ruin. Andy Obermueller recently took a unique approach to analyzing the latest FDIC data and uncovered one small California bank with huge upside potential. Andy recently added shares of this bank to his Government-Driven Investing Portfolio.