It’s quite a world we’re living in when a bunch of slightly mad developers in a corner of the world where theirs is the only sovereign state without an abundance of oil decide to compensate for this weakness by building an island bigger than Manhattan in the shape of a palm tree.

It was to be a hub for tourism in all its ostentatious glory. (I mean, who doesn’t want to stay on a fake island in the shape of a palm tree?)

It was to be a hub for finance, even though its cousin, Abu Dhabi, is light years ahead when it comes to that.

And it was to be a hub for trade, even though there is an enormous amount of competition in that part of the world at a time when every business is being hit by the Great Recession.

Dubai: From an Oasis to Early Warning Signal

Just as we were all about to forget about the markets and move on to more pleasant thoughts of turkey and football, the mad men of the state-owned conglomerate, Dubai World, announced that they are about to default on $26 billion in bonds.

The major European markets fell more than 3% on the news, while Asian markets plunged closer to 5%, and U.S. markets sold off about 1.5%.

Why?

Not because there is a lot of real financial risk from the billions of dollars at stake. And not because any large, systemically important banks are now at risk.

It is because their foolishness casts some light on the foolishness of other nations with sovereign debt that may not withstand a rise in interest rates or the unwillingness of market participants to roll over this debt.

Is Dubai a Harbinger of Things to Come?

While investors’ fears subsided Monday, when Dubai World broke its silence and announced the details of its proposed debt restructuring, almost all Eastern European countries are staring down the barrel of the same problems we’re seeing in Dubai.

Namely, these problems are too much government spending, too much deficit spending and too many bonds to roll over — and these problems cannot be solved overnight.

To make matters worse, in some of these countries, individuals and businesses borrowed in euros or U.S. dollars, and now have to pay these debts back with ever greater amounts of local currencies, which are depreciating in many cases. This will lead to further economic contraction, which would normally call for more government spending — but deficits are already too large and the bond markets too jittery.

The crown prince of fools in Europe is Greece. The country borrowed too much money for the Olympics they were barely able to host, and has continued to borrow, running the deficit up to 12% of GDP while the country is mired in a recession much deeper than the rest of the EU.

I’m sure glad that EU nations are only supposed to run deficits equal to 3% or less of GDP, according to the (unenforceable) rules that govern EU membership.

Then again, who are we to throw stones? We live in a country where the “fiscally responsible” party and president managed, in eight short years, to not only turn a surplus into a deficit, but pulled off the neat trick of doubling the national debt during a time of economic growth — and fought two wars without putting the cost in the budget. But I digress.

How do you find out what markets think of sovereign debt?

By checking out the cost of buying credit default swaps (CDS) — financial instruments used to insure buyers against the default of bonds. The cost of these is rising by the hour for many nations, reflecting increasing investor nervousness over the safety of sovereign debt from nations such as Dubai and Greece.

A Few Ways to Play More Bad News

What does this mean for investors?

Well, for the very aggressive among you, you can short the Eastern European markets by purchasing puts on the iShares MSCI Eastern Europe Fund (IEER), a London-listed ETF that provides exposure to companies in emerging markets such as the Czech Republic, Hungary, Poland and Russia. The comparable U.S.-listed ETF — the iShares MSCI Emerging Markets Eastern Europe Index Fund (ESR) — has little volume and no options are available, yet. But keep an eye on it.

For the vast majority of us, though, the thing to do is prepare for some sort of “Black Swan Event” in Greece, Lithuania and Latvia, which are among the eight countries listed by London-based credit-markets analysis as the most likely to default in the coming months.

When this happens, the market is likely to crash, albeit temporarily. Just look at what happened when Argentina reneged on its obligations earlier in the decade even though everyone new it was coming.

So you should be prepared to short the market by purchasing put options on the S&P 500 SPDR (SPY) in anticipation of such an event. Remember, this will likely be a temporary sell-off, but it could produce some spectacular short-term gains.

This is a story you have to watch closely, and then jump in with hard sell-stops and target prices. But something should blow — the question is when.

• 9 Ways to Profit From the Market’s Fall
• 10 Reasons the Economy Will NOT Recover in 2010
• 2 Recession Busters, 2 Busted Stocks

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