The Aftershock Investor: A Crash Course in Staying Afloat in a Sinking Economy (15 page)

This is where our kid gloves come off. As we have often said, the financial crisis and the Aftershock represent a fundamental failure of the economics profession. Their job is not to be cheerleaders. Their job is to create and support pathbreaking new methods of better understanding the economy.

But they don’t, and, honestly, they don’t even seem very interested. They aren’t using their protected, tenured positions as university faculty as a base from which to attack the status quo and advocate uncomfortable but sensible alternatives. Rather, they desperately try to support their privileged station in life by supporting the status quo. Their attacks on the status quo are always muted, and their alternatives are often far less than reasonable. Printing more money and borrowing more money are not reasonable alternative policies in the long term.

It is the job of academics to question the status quo and offer reasonable and sensible alternatives. They don’t always do that, but when academics are at their best, that is what they should do. In this task, academic economists have, for the most part, failed miserably. Of course, there are exceptions, but compared to financial analysts and money managers who have an obvious economic reason to support the status quo, there are far too few academics who are willing to seriously question and, most importantly, create good alternatives to the status quo economic policies.

This won’t be a fun environment in which to invest. Of course, it hasn’t been that much fun for 10 years now. Maybe it’s been fun for some investment bankers making big salaries, but for the rest of us, the past 10 years have been less than exciting.

Normally, in times of uncertainty or difficulty, Conventional Wisdom suggests that you add greater diversity to your portfolio. CW defines greater diversity as greater diversity across types of stocks, plus the addition of more bonds to create more safety. This was good advice in the past, when stocks and bonds were not in danger of significant long-term declines.

However, the correct view for investing in the future is to diversify by moving from endangered
asset classes
to safer asset classes. Stocks, bonds, and real estate are endangered asset classes and should be only short-term investments at this point. When to move out of those investments is tricky. Government intervention in the stock and bond markets through money printing and borrowing will work to maintain markets. Eventually, as we have said, these interventions will fail, especially as inflation grows beyond 5 percent. In the meantime, you can stay in if you really want to, but only with very careful and active management. Because of the massive amount of artificial stimulus keeping these markets going, there will be little underlying support for the markets once the stimulus fails. Hence, you need to be out before markets go down because when they do go down, they can go down very fast.

So the key to good timing will be to avoid trying to time it perfectly. Better to get out too early than too late. That means you need to begin diversifying early and continue to diversify as we get closer to the Aftershock. Of course, getting out early means you are guaranteed to leave some money on the table. But, again, better to be too early than too late. Don’t try to time it perfectly.

To survive in an evolving economy, you must continue to diversify away from endangered asset classes to safer asset classes over time. Your portfolio isn’t just diversified, it is diversifying—which means it is dynamic because it is actively changing over time. So the portfolio needs to be both dynamic and diversified, and hence the name Dynamic Diversified Aftershock Portfolio.

Again, you can hold stocks, bonds, and real estate for more time, but it is best to be reducing your exposure to those asset classes. In addition to outright sales of stocks and bonds, another way to reduce your exposure is to choose less vulnerable stocks and bonds. These are also known as defensive stocks and bonds. Defensive stocks tend to be in more boring companies that aren’t as affected by the economy and sometimes produce good dividends. Electric utilities would be a good example of a defensive stock. The downside is that they won’t go up as quickly as the market, like stock in Apple Computer, but they also don’t go down as quickly either.

Defensive bonds are shorter term and have less credit risk. Short-term U.S. Treasurys would be a good example. Another example is Treasury inflation-protected securities (TIPS). These are Treasury bonds that adjust for inflation. Junk bonds have a great deal of credit risk, so they are not defensive. High-grade corporate bonds and municipal bonds are in between. The key for those bonds would be to keep them shorter term.

As you move out of these endangered asset classes, the key question is: What are the safer asset classes to move into? Unfortunately, due to the nature of investments over the next 10 years, there aren’t a lot of long-term choices. This is further reason for active management. But even with active management, the number of options for many investors is more limited.

Very short-term debt or inflation-protected debt is clearly one of the options, especially as inflation goes higher. But, eventually, even government debt can get risky. Gold is an excellent option, but it will be highly volatile. Foreign currencies will also eventually do well but are hard for most investors to deal with. The same goes for agricultural commodities. Timing is hard, and they will be volatile. Shorting stock and bond markets will also work, but there is a great deal of risk in shorting and shouldn’t be undertaken by most investors.

We will discuss the elements of the Dynamic Diversified Aftershock Portfolio in the rest of the book, including chapters on each of the key components. The key take-away point here is that
over time
your portfolio must move away from endangered asset classes, such as stocks and bonds, to safer asset classes, such as short-term debt and gold.

That’s actually a good question. Investors do tend to get more pessimistic when markets have been doing poorly, as they have in the past 10 years. The same sentiment occurred at the end of the 1970s. Many investors thought that the market was entering a period of longer-term problems. None predicted an Aftershock-type situation, but few saw the enormous gains to be had in the 1980s and 1990s.

The difference is that we were just entering the stock, bond, and real estate bubbles at that point. There was also significant real growth in China and in Europe. Japan had troubles in the 1990s but was buoyed by the booming bubbles in the United States. All of these factors are not in existence going forward. Real growth in China will be hard to find once its massive construction bubble pops. Europe is already showing signs that its longer-term growth prospects are very limited. Japan is no longer growing off our bubbles since they are popping and will pop further. Real economic growth will be hard to find.

So maybe we could just find new bubbles to replace the old ones? Well, that is exactly what is happening. We are using the government debt and dollar bubbles to prop up the old bubbles. Will that last for another 20 years and keep the stock market moving up for another 20 years? The problem is that the government debt and dollar bubbles are best at maintaining old bubbles and not creating new ones. The reason is that if we powered up those bubbles to the point where they would create new bubbles, they would scare investors here and around the world. Tripling our money supply again and boosting our deficit to $3 trillion just to put the stock market into hyperdrive would quickly backfire because it would scare investors away.

So even if they won’t take us back to the good old days of the 1980s and 1990s, maybe the government debt and dollar bubbles can at least help us keep our gains for another 20 years? If we only had a government debt bubble, it’s possible we could keep it going for another 10 years or so. But, to help maintain the government debt bubble, we have had to create a dollar bubble. And that makes long-term viability an impossibility. If the government debt bubble could be maintained without money printing, then maybe we could make it another 10 years before it explodes in an Aftershock. Unfortunately, though, the money printing behind the dollar bubble has lit a fuse on the rest of the bubble economy, and that’s why we can’t keep maintaining the bubbles for another 20 years.

However, as we said before, it can maintain them for another two to four years. But that could be a very rocky road. Maintain doesn’t mean a Dow of 12,000. The stock market could easily fall 30 percent or more while being maintained by the government debt and dollar bubbles.

Again, if we were willing to borrow a whole lot more and print a whole lot more, we could keep such declines from happening and even get the market growing rapidly again, but we won’t. As we said, it could backfire pretty quickly. So even though government borrowing and printing will maintain the stock and bond bubbles, that doesn’t mean they will be maintained at a high level.

Maybe we’re not in a bubble at all? Maybe what we are seeing is real growth? If you still have your doubts about that, please go back and read Chapter 1.

Ideally, if you properly implement a good Aftershock investor strategy, your returns should look similar to the straight line in
Figure 3.9
. It should not look like the line that looks like a “W,” which shows the stock market moving violently up and down. Of course, no one can hit a straight line, but that should be the goal.

Figure 3.8
Ideal Aftershock Portfolio Performance in a Moderately Increasing, Volatile Stock Market

Shaded gray line is the performance of an Aftershock portfolio; the black line is stock market performance.

Some people don’t like that goal. They want to profit on every upswing and be protected from every drop. That is a lovely fantasy but not very achievable. You want to be the straight line, not the “W” line because you need to be prepared in case the downstroke on the W doesn’t rebound, which is what we think will eventually happen. So, right now, it’s not so much a matter of beating stock market returns, although you may still do that; the more important short-term goal is to maintain your returns in a way that doesn’t leave you exposed to the downstroke on the W.

Very high returns are probably not a smart goal right now because they carry too much risk and volatility. What you want is reasonable returns and limited exposure to what is potentially a big downside in the stock market and bond market. That’s your biggest threat over the next five years. Maybe not this year and maybe not next year, but within the next five years, which is far more important for most investors, that’s what you need to focus on.

It is almost impossible to perfectly time any market. But remember, even if you sell out early on stocks, you’re not really losing out on future stock gains unless you would have sold at a later time when stocks are higher than when you sold. If you don’t sell at the right time, you will have gained nothing because the stocks will come back down to levels where you sold earlier. So you have to sell at a higher level to lock in those gains, and almost nobody does that (otherwise, the market would fall dramatically). More importantly, if you get caught and don’t sell before the stock bubble pops, stocks will go below today’s level and you will take a significant loss over just selling today.

Again, the goal of the Aftershock investor is not perfect timing but reasonable returns with limited volatility and, most importantly, doing it without big exposure to a major downturn in stocks or bonds. It sounds simple, and it is. Implementing it is not so simple, but it is exactly what most investors need to do.

Even if there is no Aftershock, you still have to change your CW portfolio
. That’s because this is a new investment environment and the old ways will no longer protect you. Our advice about what to do instead of the usual CW investing is contained in the rest of this book, with separate chapters on stocks, bonds, real estate, insurance, and more. The bottom line is, regardless of whether you believe we will have a full Aftershock, given the coming rising inflation and coming rising interest rates, if you have a conventional wisdom investment portfolio (and most people do), you essentially have two options:

Change It or Lose It

Over the course of half a century, the American investor has fallen deeply in love with stocks. Stocks occupy the heart of most investment portfolios and are at the heart of what has made so many Americans so much money over so many decades, especially in the 1980s and 1990s. And what’s not to love? The stock market, as measured by the Dow Jones Industrial Average from 1980 to 2000, rose an astounding 1,000 percent. Not 100 percent, but
1,000 percent
. That’s pretty darn good. It’s especially good when you consider that the economy, as measured by gross domestic product (GDP), grew only 260 percent during that same time period. That’s a whole lot less than 1,000 percent.