I own California munis, and think it will soon be time to buy more. Let me lay out my four reasons:

Yet munis are one of the few markets left with real investors, and only modest speculative interest. An attempt to turn the staid muni market into a feast for rapacious financial innovation fell apart during the past two years. The muni buyer may have heartburn but is unlikely to roll out quickly. The Muni ETFs are more likely to suffer as investors take to the lifeboats.

Out here in the Left Coast of Cali-for-nia, the morning stories were about how the deficit is widening to over $25B, a number previously thought inconceivable. The exiting governator, Arnold Schwarzenegger, is trying to call a special session to deal with it, but the Democrat legislature would rather wait for the second coming of Jerry Brown. Maybe he can find a way to save their pensions and government salaries by cutting, well, what exactly? The Golden State has no defense budget to slash. Muni advisors look this way and see Greece .

A quick scan of the blogosphere will show boatloads of doom & gloom prognostication for the muni market. The collapse continued today and shows no sign of abating. Advisors are recommending an exit strategy , out of munis.

Muni bond investors felt that sinking feeling last week as their longer-term munis were swamped in the wake of QE2. " Munis in Trouble " headlined this jaw dropping chart of PIMCO's muni fund (courtesy The Big Picture ):

1) Seasonal factors have momentarily spiked rates: the muni market is about to absorb a lot of issues, about half coming from California. The Federal Buy America Bond program may expire soon, putting more pressure on the traditional muni market to issue more. While the muni market is relatively steady, it does swing down before big issues and up after. This is usually a good time to be a buyer.

These seasonal factors also include the impact of the election. The choice of Jerry Brown over Meg Whitman in California is hard to parse for bondholders: she would likely have been as stymied as Arnold Schwarzenegger in getting the State's finances under control; and maybe Jerry will "go to China" and whack the unions. One can dream. Outside of California, the election put more austerity governments into the States, which should be good for bonds.

The election has also thrown into doubt some props for munis from the Federal government. Citicorp did a good analysis of this, noting that regulatory uncertainty was causing weakness in munis. With clarity in the new Congress, munis should improve.

The election has also made the extension of the Bush tax cuts more likely. I am doubtful it would have much impact, but it may have helped cause the momentary bond weakness. While it makes the tax advantages of munis a little less valuable than they would have been otherwise, the size of the rate increase it the upper bracket is modest (3%). Oversold ...

2) Buying interest remains strong, still twice the selling interest:

Actual flows into munis have weakened recently, well off their heights over the summer. This is as expected: buying interest abates as rates rise. As the rate spikes flattens, buyers should return. Oversold ...

3) Munis trade much more on technicals than fundamentals, given their historic default rate. They respond the most to changes in Treasury rates, and this is why we have seen recent plunges.

Noteworthy to me is that the biggest drop are in longer-term munis, tracking the drop in the long bond. Mid-term munis have not moved that much, at least not quality issues.

In some respects you could argue that QE2 is working, at least to drive up inflationary expectations: the long bond yields have continued to rise. The Fed said it was not planning to buy long bonds. Ergo, rising on inflation fears.

What is most concerning is the wake of QE is also lifting the mid-term Treasuries, the 2-yr and 5-yr, bonds specifically target by the Fed for lower rates (chart from Doug Short):

My take on this is the markets are over-reacting. The bond vigilantes are out in force. Op-eds appear urging the Fed to back off QE. The rise of the ten-year may now be reflecting an expectation of QE being cancelled! Nuts. The Fed will not risk its own credibility (at least not that way - if QE2 is a bust, it will suffer).

Side note: the markets do not reflect the best price. Markets flow from one extreme to another. Does anyone believe in the efficient market hypotheses anymore? Markets are always overreacting, to one side or the other.

If it also turns out, as I expect, that inflation fears are overblown, the long bond should reverse as these fears are seen as overblown. Even if QE leads to later inflation, the typical lag from pump priming to inflation is as long as two years. Oversold ...

4) Fundamentals are looking tricky. Default risk is rising. Usually munis are not held to maturity, but traded, but if default risk rises too fast, all bets are off.

There are some disturbing signs. Cities in California are dropping services, such as police. Near where I live, San Carlos is disbanding a police force that it has had for 85 years. Over the coast range from San Carlos, Half Moon Bay is considering unincorporating (it gets a half its revenues from tourism, which is down). In both cases the problem falls into the lap of the county sheriff.

The event that almost sent shudders into the muni market happened in Harrisburg, Pennsylvania. Harrisburg dropped $3.3M in payments for its munis. At the last minute, the State came in and covered. It is now hard to see how Harrisburg escapes bankruptcy; they are exploring bankruptcy as an option. Payments may then be postponed, but the bonds usually have highest priority and should be safe, at least as to principal.

When the California city of Vallejo went bankrupt, the biggest fear was not muni default but some sort of deal between the city unions and the bondholders, politically improving the priority of union pay over bond payments. In California, we shall find which side of that divide Jerry Brown lives on. If he picks the wrong side, the California bond market will slap him hard. If he is unable to bridge that incredible budget gap with bonds, he will have to quickly run for President again. Jerry in 2012! Whichever, the wrong choice will not persist.

The risk to munis will be the highest over the next two years, as States finally deal with their budget shortfalls instead of kicking the can down the road. A pretty good summary of the situation is here, and is captured in this chart. Federal support is largely ending this year, and so the day of reckoning has finally come:

Muni defaults are said to be "soaring", but they are still at low levels, and look in 2010 to only get back to default levels of 1992, a far cry from the fear of wholesale collapse of muni payments.

My take is that the fears are grossly overblown. Weakness in munis separates the wheat from the chaff. A lot of munis are not well-backed by the State or city credit; they reflect industrial projects and special districts. Those sorts of projects are at risk, and most of the stories of muni default, such as this one about Jefferson County Alabama, are really about special projects (in this case sewers) plus plain old corruption. (The irony in that case is the bonds in question were to finance a federally-mandated improvement in sewers rather than local need.) The coming Calif budget cuts may wreak havoc on the junior claims in the muni stack, but the general obligation bonds are untouchable.

The past decade has been a Lost Decade for equities, but a good one for munis. This chart shows how a muni ETF has grown from 1400 to 3100 since 2000, for a 120% return. Contrary Investor, author of the accompanying article, said that looking back, the correct choice would have been to liquidate equities at the bubble peak and rollover into munis.

They take the classic contrarian position that the best time to go in is when everyone thinks you are nuts. We are not quite there with munis, as buying interest remains solid. They give several canaries in the muni goldmine, including any sharp break in the key funds, such as PIMCO - which is the chart at the top! So is the end of munis at hand?

My canary is the Dollar. If inflation is truly at hand, the Dollar will continue to drop well beyond the levels it has recently bounced off of. Instead, we now seem to have a recovery of the buck. It as bounced quite fast off the recent low, and has breached the recent downward channel to the upside. Dollar strength should call into question all the over-reaction about inflation and with it the continuation of rising bond rates. In the end the muni market is technical and responds to the larger trends in the bond market.