Contents Acknowledgments Introduction Part I: Aftershock Chapter 1: Bubblequake and Aftershock A !

uick "e#iew of $ow %e &ot $ere and %hat's (e)t *ou Are (ot Asleep with the +heep Bubblequake, -irst a "ising Bubble .conom/0 (ow a -alling Bubble .conom/ -rom Boom to Bust: 1he 2irtuous 3pward +piral Becomes a 2icious 4ownward +piral %h/ 4on't 5ost Con#entional In#estors +ee 1his Coming6 %hat's a +a##/ Aftershock In#estor to 4o6 Chapter 7: +ince %e 8ast +poke 9 9 9 Ignoring the 5assi#e 5one/ Printing :the 4ollar Bubble; Is a <e/ &oal of the Cheerleaders Potential 1riggers 1hat Could Accelerate a 4owntrend in the 39+9 .conom/ A Closer 8ook at the Current 39+9 ="eco#er/> Bottom 8ine: ="eco#er/> Is +till 4ri#en b/ 5assi#e Borrowing and 5assi#e 5one/ Printing ?ur In#estment ?utlook 1he 7@17 Presidential .lection In Conclusion Chapter A: Con#entional %isdom %on't %ork 1his 1ime 1he <e/ to Con#entional %isdom: 1he -uture %ill Be Bust 8ike the Past 1he 5/th of a (atural &rowth "ate "eal Producti#it/ &rowth Is +lowing 4own0 $ere and Around the %orld %arren Buffett: 5aster of Con#entional %isdom 1he <e/ to Aftershock %isdom In#esting: 1he -uture Is (ot the Past, 1his 4ebate Is "eall/ (ot About Inflation or 4eflation0 It's About Protecting the +tatus !uo with 4enial $ow to In#est in a -alling Bubble .conom/ %hat's a +a##/ Aftershock In#estor to 4o6 Part II: Aftershock In#esting Chapter C: 1aking +tock of +tocks 8o#e +tor/: $ow +tocks Became the $eart of 5ost In#estment Portfolios $ow Are +tocks 2alued6 It's All about .arnings Con#entional %isdom on +tocks %h/ Con#entional %isdom Is %rong %hat's a +a##/ Aftershock In#estor to 4o6 ?ur Current "ecommendations Chapter D: B/eEB/e Bonds

%hat Are Bonds6 Con#entional %isdom on Bonds: 1he +afet/ of the "ecent Past 5eans %e Can Count on 5ore +afet/ Ahead %h/ Con#entional %isdom on Bonds Is %rong 1he -inal 1wo Bubbles in America's 5ultibubble .conom/ %ill Pop Bonds %ill -ail in 1hree +tages %hat's a +a##/ Aftershock In#estor to 4o6 Chapter F: &etting "eal about "eal .state %hat "eall/ 4ri#es "eal .state Prices6 1he "eal .state Bubble "ises Con#entional %isdom about "eal .state: Continued 8ow Interest "ates for as -ar as the ./e Can +ee %h/ Con#entional %isdom about "eal .state Is %rong %hat's a +a##/ Aftershock In#estor to 4o6 1iming *our .)its ?ut of "eal .state 1he $igh Cost of 4oing (othing Chapter G: 1hreats to the +afet/ (ets All Insurance and Annuities Are .ssentiall/ In#estments in Bonds0 +tocks0 .#en "eal .state Con#entional %isdom on %hole 8ife Insurance and Annuities: Perfectl/ +afe and %orth .#er/ Penn/, %h/ Con#entional %isdom Is %rong: -acing the "eal H@@EPound &orilla in the "oom %hat's a +a##/ Aftershock In#estor to 4o6 Chapter H: &old &old %as &olden for Centuries Current Con#entional %isdom on &old as an In#estment: %arren Buffett +a/s +ta/ Awa/, %h/ Con#entional %isdom on &old Is %rong %hat's a +a##/ Aftershock In#estor to 4o6 $ow to Bu/ &old ?wning &old as Part of a %ellE4i#ersified Acti#el/ 5anaged Aftershock Portfolio $ow $igh %ill &old &o6 Part III: *our Aftershock &ame Plan Chapter I: Aftershock Bobs and Businesses 1he "ising Bubble .conom/ Created $uge Bob &rowthJ (ow the -alling Bubble .conom/ 5eans -ewer Bobs Con#entional %isdom about -uture Bobs Is Based on -aith that the -uture %ill Be 8ike the Past %h/ Con#entional %isdom on Bobs Is %rong %hat's a +a##/ Aftershock In#estor to 4o6 1he -alling Bubbles %ill $a#e 2ar/ing Impacts on 1hree Broad .conomic +ectors ?pportunities after the Bubbles Pop: Cashing In on 4istressed Assets +hould I &o to College6 Chapter 1@: Aftershock "etirement and .state Planning 1/pes of "etirement Plans 1he Con#entional %isdom on "etirement Plans

%h/ the Con#entional %isdom on "etirement Is %rong %hat's a +a##/ Aftershock In#estor to 4o6 "etirement !KA .state Planning: 5aking the 5ost of *our Assets for *ourself and *our $eirs Chapter 11: *our Aftershock In#estment Portfolio Aftershock Portfolio +trateg/ <e/ Components 4o It *ourself or Bring in $elp6 1iming Better to 5o#e 1oo .arl/ than 1oo 8ate 1he 8ast "esort: 1he +tock 5arket $olida/ :the 3ltimate "eason %h/ *ou (eed to 5o#e .arl/ "ather than 8ater; 1he 5oral .pilogue Appendi): Additional Background on +tocks and Bonds Inde)

Cop/right L 7@17 b/ 4a#id %iedemer0 "obert A9 %iedemer0 and Cind/ +9 +pitMer9 All rights reser#ed9 Published b/ Bohn %ile/ K +ons0 Inc90 $oboken0 (ew Berse/9 Published simultaneousl/ in Canada9 (o part of this publication ma/ be reproduced0 stored in a retrie#al s/stem0 or transmitted in an/ form or b/ an/ means0 electronic0 mechanical0 photocop/ing0 recording0 scanning0 or otherwise0 e)cept as permitted under +ection 1@G or 1@H of the 1IGF 3nited +tates Cop/right Act0 without either the prior written permission of the Publisher0 or authoriMation through pa/ment of the appropriate perEcop/ fee to the Cop/right Clearance Center0 Inc90 777 "osewood 4ri#e0 4an#ers0 5A @1I7A0 :IGH; GD@EHC@@0 fa) :IGH; FCFEHF@@0 or on the %eb at www9cop/right9com 9 "equests to the Publisher for permission should be addressed to the Permissions 4epartment0 Bohn %ile/ K +ons0 Inc90 111 "i#er +treet0 $oboken0 (B @G@A@0 :7@1; GCHEF@110 fa) :7@1; GCHEF@@H0 or online at www9wile/9comNgoNpermissions 9 Important 4isclaimers: 1his book reflects the personal opinions0 #iewpoints0 and anal/ses of the authors9 (othing in this book constitutes specific in#estment ad#ice or an/ specific recommendation for an/ specific indi#idual with respect to a particular countr/0 sector0 industr/0 securit/0 or portfolio of securities9 All information is impersonal and not tailored to the circumstances or in#estment needs of an/ specific person9 8imit of 8iabilit/N4isclaimer of %arrant/: %hile the publisher and author ha#e used their best efforts in preparing this book0 the/ make no representations or warranties with respect to the accurac/ or completeness of the contents of this book and specificall/ disclaim an/ implied warranties of merchantabilit/ or fitness for a particular purpose9 (o warrant/ ma/ be created or e)tended b/ sales representati#es or written sales materials9 1he ad#ice and strategies contained herein ma/ not be suitable for /our situation9 *ou should consult with a professional where appropriate9 (either the publisher nor author shall be liable for an/ loss of profit or an/ other commercial damages0 including but not limited to special0 incidental0 consequential0 or other damages9 Cartoons used with permission of Cartoon +tock0 www9Cartoon+tock9com and Cartoon Bank9 -or general information on our other products and ser#ices or for technical support0 please contact our Customer Care 4epartment within the 3nited +tates at :H@@; GF7E7IGC0 outside the 3nited +tates at :A1G; DG7EAIIA or fa) :A1G; DG7EC@@79 %ile/ also publishes its books in a #ariet/ of electronic formats9 +ome content that appears in print ma/ not be a#ailable in electronic books9 -or more information about %ile/ products0 #isit our web site at www9wile/9com 9 IGHE1E11HE@GADCEC :cloth;J IGHE1E11HE777CHED :ebk;J IGHE1E11HE7F1@IED :ebk;J IGHE1E11HE7AAAHE7 :ebk;

Acknowledgments

1he authors thank Bohn +ilbersack of 1rident 5edia &roup and 4a#id Pugh0 8aura %alsh0 and Boan ?'(eil from Bohn %ile/ K +ons for their relentless support of this book9 %e would also like to thank +tephen 5ack and Beff &arigliano for their help in writing this book9 %e thank Bim -aMone0 Ba/ $arrison0 and (anc/ 5c+all/ for their work on the graphics0 5ichael 8ebowitM for his help on the data0 and Beth &ansner for her help in proofreading9 %e also want to acknowledge Christine Peglar's and Bennifer +choenefeldt's help in keeping us organiMed9

4a#id %iedemer

I thank m/ coEauthors0 Bob and Cind/0 for being indispensable in the writing of this book9 %ithout them this book would not ha#e been published and0 e#en if written0 would ha#e been inaccessible for most audiences9 I also thank 4r9 "od +te#enson for his longEterm support of the foundational work that is the basis for this book9 4r9 Beff %illiamson and 4r9 8ee $ansen also pro#ided me with important support in m/ academic career9 And I am especiall/ grateful to m/ wife0 Bets/0 and son0 Benson0 for their ongoing support in what has been an often arduous and tr/ing process9

"obert %iedemer

I0 along with m/ brother0 want to dedicate this book to our mother0 who died late last /ear9 +he inspired us to think creati#el/ and see the Po/ in learning and teaching9 %e also dedicate this to our father0 the original author in the famil/9 %e also want to thank our brother0 Bim0 for his lifelong support of the ideas behind this book9 Chris "udd/ and Aaron 4e $oog ha#e been enormous supporters of Aftershock9 It's been great to ha#e such support9 I also want to thank earl/ supporters +tan &oldstein0 1im +elb/0 +am +to#all0 and Phil &ross9 I also want to thank 4an Cohen and 5ichael Calkin for their support of this book9 I am most grateful to %eldon "ackle/0 who helped m/ father to become an author and who did the same for me9 A #er/ heartfelt thanks goes to Bohn "9 4ouglas for his #er/ special role in making our books a realit/9 ?f course0 m/ gratitude goes to 4a#e %iedemer and Cind/ +pitMer for being0 quite clearl/0 the best collaborators /ou could e#er ha#e9 It was trul/ a great team effort9 5ost of all0 I thank m/ wife0 +erap0 and children0 +eline and Bohn0 without whose lo#e and support this book0 and a reall/ great life0 would not be possible9

Cind/ +pitMer

1hank /ou0 4a#id and Bob %iedemer0 once again for the honor of collaborating with /ou on our fourth book9 It is alwa/s an e)citing e)perience0 and I look forward to man/ more9 -or their endless patience and support0 m/ deep appreciation and lo#e go to m/ husband0 Philip 1erbush0 our children Chelsea0 An/a0 and Qachar/0 and m/ dear friend Cindi Callanan9 I am also filled with a lifetime of gratitude for two wonderful teachers: Christine &ronkowski :+3(* Purchase College; and twoEtime PulitMer PriMe winner Bon -ranklin :35CP College of Bournalism;0 who each in their own wa/s mo#ed me along a path e)ceptional9 5/ appreciation also goes to Beth &oldstein and Christie Chroniger for their ongoing help with all things great and small9

Introduction

%e wrote our first book0 America's Bubble .conom/0 back in 7@@C and finished it in 7@@D0 long before the housing bubble was #isible to man/ people9 %e asked our publisher0 Bohn %ile/ K +ons0 to hold the book as long as the/ could because we were concerned that nobod/ would bu/ it9 -ew people belie#ed there was a housing bubble at that time0 much less a whole bubble econom/9 1he/ wouldn't hold it an/ longer than fall 7@@F0 and so it was published9 %ith that book and Aftershock0 we ha#e built up a good track record of predicting much of what has happened since then0 certainl/ better than most anal/sts9 Almost no economists or anal/sts wrote an entire book about such issues at the time0 although man/ ha#e written books since9 But man/ of those books are more historical than predicti#e9 It's still scar/ to predict the future9 It's much easier to re#iew the past9 %e ha#e been criticiMed b/ some as being oneEtrick ponies that we made one good prediction and that's it9 Certainl/0 there ha#e been cases of this in the past0 such as .laine &arMarelli0 the market anal/st who famousl/ predicted the 1IHG stock market crash9 But we're not tr/ing to predict a crash9 %hat we are tr/ing to do is predict a far larger change in the entire econom/9 *es0 an earlier real estate crash and stock market crash was part of that0 but there is much more to what's going on in the 39+9 econom/ and world econom/9 An/one who reads our books will see that9 +ome people ma/ sa/ we were right about one prediction0 but in fact0 it was a range of related predictions0 man/ of which we predicted will not occur for /ears more9 %e'll ha#e to wait to see if those come true9 But e#en if we got onl/ one prediction right0 that's better than man/ people who get far more attention for their predictions than we do0 such as Ben Bernanke9 $e predicted0 after the Bear +tearns collapse in Bune 7@@H and Pust four months before the biggest financial crisis in our histor/0 that all was fine with our financial s/stem9 %ell0 it's better to be right once than ne#er9 At least it should gi#e us more credibilit/9 But our forecasts are not meant to cheerlead or paint a ros/ picture0 and we know that leads man/ people to gi#ing us less credibilit/0 for ob#ious reasons9 1he/ would rather listen to a more bullish outlook0 such as 5r9 Bernanke's0 especiall/ on the stock market9 As one of our good friends on %all +treet said0 =(obod/ likes a bear0 especiall/ when the/'re right,> %e're not tr/ing to be a bear or a bull0 we're Pust tr/ing to help people better understand the econom/9 As another friend on %all +treet said0 =%hat /ou're reall/ doing is teaching people9> And that's e)actl/ what we want to do9 +ome people ha#e said we are arrogant0 but we tr/ not to be arrogant9 ?f course0 ma/be in the act of teaching something #er/ new that others aren't teaching0 there is a certain inherent arrogance9 1he best teachers ha#e a passion for what the/ teach9 And when /ou ha#e a passion0 /ou tr/ to make strong points of great substance that will stick with the people /ou are teaching9 If we ha#e o#erreached in some of our chapters and appeared arrogant0 we apologiMe9 %e tr/ to keep the book as nonarrogant and eas/ to read and enPo/able as possible0 while still getting our message across9 In fact0 we think that is critical to good writing and good teaching9 %e don't tr/ to attack an/one personall/9 If we do make a reference to someone personall/0 it is to make a larger point about the econom/ or the wa/ people look at the econom/0 not to personall/ put an/one down9 %e tr/ to be as fair as possible because we need to be as belie#able as possible9 1hat is absolutel/ critical to teaching an/thing new9 In this book we hope to e)pand on what we ha#e taught in the past0 and we hope more people will benefit9 1he greatest Po/ of writing a book is that someone benefits from it whether that's because the/ are entertained0 or li#e a more financiall/ secure life0 or simpl/ ha#e a better understanding of the wa/ our societ/ works9 It's all about feeling that /ou are somehow better off after reading the book than before9

%e wrote this latest book0 1he Aftershock In#estor0 in response to our readers' demands for more details about how to put the ideas in Aftershock into action9 1he old wa/s of in#esting based on Con#entional %isdom are becoming increasingl/ ineffecti#e and e#en dangerous9 -or those luck/ enough to see what is coming0 we need a new in#esting approach9 "ather than passi#el/ waiting for things to get better0 we need to acti#el/ manage our in#estment portfolios0 based on the correct macroeconomic #iew of the current and future econom/9 -or that0 we now offer /ou 1he Aftershock In#estor9

PA"1 I

A-1."+$?C<

C$AP1." 1

Bubblequake

and Aftershock A

!uick "e#iew of $ow %e &ot $ere and %hat's (e)t

%$* ".A4 1$I+ B??<6 B.CA3+. %. %.". "I&$10 (?% *?3 CA( B. "I&$10 1??

%e are not Ben Bernanke0 chairman of the -ederal "eser#e9 %e are not economic (obel PriMe winners0 like Paul <rugman9 %e don't run huge in#estment firms0 such as &oldman +achs or 5errill 8/nch9 But the/ were all wrong0 and we were right9 1hat is wh/ this book is worth reading9 %e don't ha#e a cr/stal ball no one does9 But we do ha#e something e#en more reliable o#er the long term: the correct macroeconomic #iew of what is occurring and what's coming ne)t9 ?nce /ou ha#e this correct Big Picture too0 /ou can be Pust as right as we ha#e been9 %ith this book0 /ou and /our famil/ and associates will likel/ ha#e a better chance than most to co#er /our assets0 protect /ourself0 and perhaps e#en find profits in the coming Aftershock9 1he purpose of this book is to mo#e /ou closer to that with e#er/ page9 Please note : If /ou ha#e not /et read an/ of our pre#ious books0 the rest of this chapter will ser#e as /our quick e)ecuti#e summar/9 If /ou ha#e alread/ read Aftershock 0 +econd .dition0 /ou could Pust skip ahead to Chapter 70 which offers a brief update since our 7@11 book9 $owe#er0 /ou ma/ want to sta/ with us here Pust for the quick re#iew9 If nothing else0 it will help /ou hold up /our end of the discussion with some people who ma/ still be in the dark about what is reall/ happening9

*ou Are (ot Asleep with the +heep

Back in 7@@F0 when the 39+9 econom/ was still looking prett/ good0 our first book0 America's Bubble .conom/0 accuratel/ predicted the future popping of the real estate bubble0 the fall of the stock market bubble0 the decline of the pri#ate debt and consumer spending bubbles0 and the widespread pain all this was about to inflict on our #ulnerable0 multibubble econom/9 ?f these bubbles0 we said the real estate bubble would be the first to go0 kicking off the fall of stocks and the decline of pri#ate debt and consumer spending e)actl/ what occurred in the financial crisis of 7@@H9 %e also predicted the e#entual bursting of the dollar bubble and the massi#e go#ernment debt bubble0 which are both still to come9 ?ther bearish anal/sts ha#e also predicted some of our current economic troubles0 but #er/ few did so as earl/ as 7@@F9 .#en those who did see parts of this mess coming are still failing to connect all of the dots9 1he/ don't full/ understand what's happened so far0 and the/ can't tell us what will happen ne)t9 America's Bubble .conom/ was the onl/ book to both warn about the current economic problems here and around the world0 and also to go wa/ out on a limb b/ predicting in substantial detail what would occur0 wh/ it would occur0 and when9 (ot too man/ authors ha#e been willing to go that far out on a limb0 mostl/ because the/ can't9 1he/ don't /et see the whole stor/0 and the/ don't dare take a chance on making inaccurate predictions that ma/ come back to haunt them later9 %e went out on a limb and it turned out to be rock solid9 ?f course0 back in 7@@F0 our prescient predictions were largel/ ignored9 1hen our ne)t two books0 Aftershock :7@@I; and Aftershock0 +econd .dition :7@11;0 further fineEtuned our forecasts0 e)plaining in more detail how massi#e stimulus spending b/ the federal go#ernment and massi#e mone/ printing b/ the -ederal "eser#e would temporaril/ boost the falling multibubble econom/0 particularl/ the stock market0 but would onl/ kick the can down the road and later make our bubble econom/ crash e#en harder9 1his time0 with the memor/ of the 7@@H financial crisis still painfull/ fresh0 more people began to take notice9 In 7@@I0 Aftershock was named one of +mart5one/'s Best Books9 And in 7@110 within weeks of publication in August0 Aftershock0 +econd .dition0 became a (ew *ork 1imes business bestseller0 a %all +treet Bournal business bestseller0 and the number one AmaMon personal finance book and number one AmaMon economics book9 +ince then0 the book has been translated into Bapanese0 Chinese0 Polish0 and <orean0 and recentl/ became a <orean bestseller9 1he book was made e#en more accessible in the form of an audio book0 beautifull/ read b/ Christopher <ipiniak0 which was nominated for an Audie Award9 B/ the end of 7@110 Aftershock0 +econd .dition0 was named b/ 1he .conomist magaMine as AmaMon's third bestselling personal finance book0 not Pust in the 3nited +tates but in the world9 %hat a difference a crash makes, +ome people are clearl/ starting to wake up9 But despite all the kudos and recognition our books ha#e gotten0 our basic macroeconomic message is still falling mostl/ on deaf ears or0 more accuratel/0 on den/ing minds9 5ost people simpl/ do not want to wake up and full/ face the truth of what is reall/ happening9 .#en the bearEoriented anal/sts are missing the bigger picture9 1his is not merel/ a bearish =down c/cle> that will e#entuall/ be followed b/ a bullish =up c/cle9> 1his econom/ is e#ol#ing9 %e are not going back to how it was before9 %e are going forward to something new9 -or a fuller e)planation of our macroeconomic #iews0 we encourage /ou to take a look at Aftershock0 +econd .dition9 -or /our con#enience0 we are also summariMing the ke/ ideas of that book in this first chapter0 before we tell /ou how /ou can potentiall/ protect and grow assets in this dangerous and e#ol#ing econom/9 But before we get to that0 we would like to take a moment to congratulate /ou the person who is reading these words right now not Pust for opening this book0 but more importantl/ for opening /our mind0 if not to our entire macroeconomic point of #iew0 at least to the possibilit/ that something is not quite right with this soEcalled =reco#er/9> Perhaps we are headed not back to the prosperit/ of the past but

forward0 toward something entirel/ new0 highl/ dangerous0 and potentiall/ profitable9 *ou are part of an elite0 earl/ group of people with their e/es open and their lights on9 *ou ma/ not know e#er/thing about what is occurring or e)actl/ what to do about it0 but /ou0 dear reader0 are not asleep with the sheep,

Bubblequake, -irst a "ising Bubble .conom/0 (ow a -alling Bubble .conom/

1he first thing /ou need to know about our current and future economic problems is that the/ didn't start /esterda/9 It all started decades ago with a combination of declining producti#it/ growth beginning in the 1IG@s0 coupled with a growing propensit/ to run big go#ernment deficits beginning in the 1IH@s9 Please understand that0 in and of itself0 running big deficits is not necessaril/ a bad thing9 In fact0 there are times when borrowing big mone/ is reall/ quite smart9 -or e)ample0 /ou might borrow a large sum of mone/ to start a profitable business or to go to medical school0 which among other benefits can increase /our real wealth in the future9 But this big go#ernment borrowing was not the equi#alent of starting a profitable business or going to medical school0 and it did not lead to increasing the nation's real wealth in the future9 Instead0 we Pust borrowed mone/ to bu/ things we wanted without ha#ing to raise ta)es the equi#alent of being able to go shopping with a credit card without ha#ing to get a betterEpa/ing Pob9 (ow0 to be fair0 the R1 trillion federal debt in 1IH7 reall/ wasn't that much compared to toda/'s nearl/ R1F trillion federal debt0 but the relati#el/ small annual federal budget deficits in the 1IH@s were significant because the/ were the earl/ beginnings of the big federal borrowing and big deficit spending that would come later9 ?f course0 at the time0 no one was too worried about the beginnings of big federal borrowing and deficit spending in the 1IH@s9 In fact0 the 39+9 econom/ grew nicel/ o#er the ne)t couple of decades0 with a 7F@ percent increase in 39+9 gross domestic product :&4P; from 1IH@ to 7@@@9 And asset #alues0 such as stocks0 bonds0 and real estate grew e#en faster9 $owe#er0 there was a hidden dri#er behind much of this rapidl/ rising abundance: bubbles,

%hat Is a Bubble6

1his should be a relati#el/ eas/ question to answer0 but0 belie#e it or not0 there is no academicall/ accepted definition of a financial or economic bubble9 -or our purposes0 we define a bubble as an asset #alue that temporaril/ rises and e#entuall/ falls0 primaril/ due to changing in#estor ps/cholog/ rather than due to underl/ing0 fundamental economic dri#ers that are sustainable o#er time9 Before it is a bubble0 an asset #alue ma/ first begin to rise because of real fundamental economic dri#ers0 such as when population growth pushes up the demand for housing and therefore the price9 But at some point0 the impact of the underl/ing fundamental dri#er has a diminishing effect and hopeful in#estor ps/cholog/ takes o#er0 pushing the asset #alue temporaril/ higher0 creating a bubble9 In the course of histor/0 asset bubbles ha#e #aried greatl/ in their causes0 duration0 height0 and crash impact0 but one thing has remained absolutel/ constant about all bubbles of e#er/ t/pe and siMe: the/ all e#entuall/ pop9 B/ definition0 if it is a bubble0 what goes up must come down9 1hat is the economic realit/ that no bubble can escape9 &ra#it/ happens9 It's onl/ a matter of time9 Because bubbles go up primaril/ due to in#estor ps/cholog/ rather than due to fundamental economic dri#ers0 all it takes for a bubble to fall is a significant enough change in in#estor ps/cholog/9 %hat makes in#estor ps/cholog/ change significantl/6 In#estor ps/cholog/ changes when enough people figure out that the/ ha#e bought into a bubble0 leading to a sellEoff and a bubble pop9 If it weren't reall/ a bubble0 the deep sellEoff wouldn't last9 (onbubble asset #alues can certainl/ drop0 but the underl/ing fundamental economic dri#ers would still be in place and e#entuall/ in#estors would soon return to bu/ back the asset0 stopping its fall9 ?nl/ bubbles popJ nonbubbles ma/ fall but e#entuall/ reco#er9 Is it possible to stop a bubble from falling or to reinflate it once it falls6 1he short answer is no9 *ou cannot indefinitel/ pre#ent a popping bubble from popping0 nor can /ou push it back up and keep it up once it full/ pops9 $owe#er0 the longer0 more nuanced answer is /es and no9 %hile we can't permanentl/ pre#ent a bubble from popping0 we can dela/ it from falling and e#en push it back up a bit with a lot of resources and artificial stimulus9 As we will see later in this chapter0 that is onl/ temporar/ and often leads to a much bigger bubble crash down the road9 %h/ doesn't artificial stimulus work to permanentl/ reinflate a bubble6 Because0 generall/ speaking0 /ou cannot fool the same people twice0 and e#en when /ou can fool the same people twice0 /ou cannot fool them for as long9 -or e)ample0 if /ou were among the in#estors who lost mone/ when the Internet bubble popped0 how willing ha#e /ou been since then to bu/ stock in technolog/ companies that show no profits6 In#estors do generall/ learn and mo#e on9 $owe#er0 with massi#e amounts of artificial stimulus :like massi#e mone/ printing b/ the -ederal "eser#e;0 it is possible for a falling bubble to def/ gra#it/ and temporaril/ rise again9 But because of the enormous costs0 massi#e stimulus cannot continue fore#er9 .#entuall/0 the stimulus has to stop and gra#it/ wins9 +o0 for #arious reasons0 including artificial stimulus0 a popping bubble ma/ not go down in a straight line9 Instead0 it ma/ pause in its descent or e#en lift up for a while0 but in the end down is its destin/9

$ow to +pot a Bubble

$ow can we know if an asset #alue is rising primaril/ due to positi#e in#estor ps/cholog/ :speculation leading to a bubble;0 rather than due to underl/ing0 fundamental economic dri#ers that are sustainable o#er time :real growth;6 %hile it is not alwa/s eas/0 it is possible to anal/Me and identif/ a notE/etEpopped bubble if /ou are willing to sta/ rational and obPecti#e0 and not get caught up in wishful thinking9 It is human nature to want to belie#e in a rising bubble0 especiall/ when it is a bubble that /ou profit from or depend on9 1he onl/ wa/ to see a bubble that has not /et full/ popped is to make a firm commitment to clearEe/ed logic9 *ou cannot sta/ asleep with the sheep9 As we pointed out in our earlier books0 there are two important truths about bubbles9 Bubbles Are a 8ot .asier to +ee After 1he/ Pop and

1he $ardest Bubble to +ee Is the ?ne *ou're In 1hroughout the ages0 asset bubbles ha#e alwa/s been largel/ in#isible right up until the end9 -or e)ample0 no one could see the 4utch tulip bubble before it popped in 1FAG9 2irtuall/ no one saw through the appealing +outh +eas stock bubble until it burst in 1G7@9 In#estors were not the least bit worried about the great -lorida land boom in the 1I7@s until the propert/ #alues crashed back to earth0 Pust as few people concerned themsel#es about the into)icating stock market boom of the 1I7@s until it e#aporated into the crash of 1I7I and the &reat 4epression9 And more recentl/0 precious few in#estors and anal/sts recogniMed the irrational e)uberance of the Internet stock bubble in time to get out before it popped in 7@@@9 8ooking back0 these e)amples of past bubble booms and busts seem so ob#ious now0 don't the/6 ?f course0 it makes no logical sense to o#erpa/ for tulips0 bu/ swamp land in -lorida0 or in#est in dotEcom companies with no profits0 but at the time0 all these seemed perfectl/ plausible0 e#en desirable to in#estors9 "egardless of the time0 place0 or t/pe of asset in question0 all bubbles share this common feature: positi#e in#estor ps/cholog/ pushes the bubble up0 and negati#e in#estor ps/cholog/ pushes the bubble down9 $ere is the t/pical bubbleEup0 then bubbleEdown pattern: An asset #alue begins to rise due to some underl/ing0 real economic dri#ers that begin to boost demand and therefore the price9 As the asset #alue begins to rise0 in#estor ps/cholog/ begins to rise as well0 leading to some in#estor speculation about the future #alue of the asset9 In#estors become e#en more interested in owning the rising asset0 pushing up the price9 5ore and more in#estors take notice and want to bu/ in before the asset price rises e#en further9 As the bubble approaches its peak0 some in#estors become an)ious about future growth and sustainabilit/0 which leads some in#estors to increase their profit taking :selling the asset;9 ?ther in#estors take notice and become an)ious or at least do not feel as positi#e about owning the asset0 also deciding to sell9 1he asset price no longer rises and begins to decline9 Positi#e in#estor ps/cholog/ is increasingl/ replaced with neutral or negati#e in#estor ps/cholog/0 sparking a larger sellEoff9 A critical le#el of negati#e in#estor ps/cholog/ is reached0 a mass e)it begins0 and the bubble pops9 5ost people cannot e)it quickl/ enough and most of their assets go to 5one/ $ea#en9

After the fact0 it all seems so terribl/ ob#ious0 doesn't it6 $owe#er0 this pattern is an/thing but eas/ to recogniMe before a bubble pops9 (otE/etEpopped bubbles are amaMingl/ difficult to see9 %h/6 Because we don't want to see them, %e want the big runEup in prices to be real and sustainable0 not a bubble9 It takes

a firm commitment to logic to see a bubble before it pops9 (ow let's take a clearEe/ed look at our current bubbles0 the ones that ha#e been working together to help push up the 39+9 econom/ o#er man/ /ears0 and more recentl/ ha#e started to deflate and lean hea#il/ on each other0 helping to push down the falling 39+9 econom/ as the/ pop9

America's Bubble .conom/

1he 39+9 econom/ has been such a strong and prosperous powerhouse for so long0 it's difficult to imagine an/thing else9 ?ur goal is not to con#ince /ou of an/thing /ou wouldn't conclude for /ourself0 if /ou had the right facts9 5ost people don't get the right facts because most financial anal/sis toda/ is based on preconcei#ed ideas about a hopedEfor positi#e outcome9 People want anal/sis that sa/s the econom/ will impro#e in the future0 not get worse9 +o the/ look for wa/s to create that anal/sis0 drawing on outdated and incorrect ideas0 such as repeating =market c/cles0> to support their case9 +uch is human nature9 %e all naturall/ prefer a future that is better than the past0 and luckil/ for man/ Americans0 that is what we ha#e enPo/ed for man/ /ears9 3p until a few decades ago0 we grew our rising economic prosperit/ the oldEfashioned wa/: b/ increasing real producti#it/9 %e laid railroad track from coast to coast that led to an e)plosion of trade9 %e in#ented cars and airplanes that changed how we li#ed and did business0 and that impacted economies around the world9 It wasn't all perfect0 but rising producti#it/ growth worked like 5iracleE&ro on the rising 39+9 econom/9 1hen something changed9 Instead of rising producti#it/ growth0 real producti#it/ growth began to slow down in the 1IG@s9 In addition to declining producti#it/ growth :and perhaps in some wa/s because of it;0 we also began to borrow massi#e amounts of mone/9 Please do not waste precious time assigning political blame9 ?#er the /ears0 presidents and congressional leaders from both parties participated in this org/ of borrowing and deficit spending9 8o#e or hate what we spent the mone/ on0 the fact is we ha#e been borrowing and spending a whole lot of ?P5 :other people's mone/; since the earl/ 1IH@s9 And please don't Pust blame the politicians9 All this public borrowing and spending b/ go#ernments was accompanied b/ plent/ of pri#ate borrowing and spending b/ businesses and consumers9 Plus0 there were plent/ of in#estments in what would e#entuall/ become asset bubbles0 all combining to gi#e us what we call America's Bubble .conom/ :spurring us to publish a book b/ that name in 7@@F;9 1o quickl/ re#iew0 we identified si) colinked0 econom/Eboosting bubbles that together helped boost the rising multibubble econom/ in the 1IH@s and 1II@s9 +ince 7@@F :with the popping of the real estate bubble;0 these bubbles ha#e been deflating and falling0 each putting increasing downward pressure on the others9 1hese are 9 9 9

1he "eal .state Bubble

(ow that it is partiall/ popped0 the real estate bubble is eas/ to see9 As shown in -igure 191 0 from 7@@@ to 7@@F0 home prices grew almost 1@@ percent9 -igure 191 Income &rowth #ersus $ousing Price &rowth 7@@1S7@@F Contrar/ to what some e)perts sa/0 the earlier rapid growth of housing prices was not dri#en b/ rising wage and salar/ income9 In fact0 from 7@@1 to 7@@F0 housing price growth far e)ceeded income growth9 +ource: Bureau of 8abor +tatistics and the +KPNCaseE+hiller $ome Price Inde)9

If nothing else0 looking at -igure 197 on inflationEadPusted housing prices since 1HI@0 created b/ *ale economist "obert +hiller0 should make an/one suspicious that there was a #er/ big real estate bubble in the making9 (ote that home prices barel/ rose on an inflationEadPusted basis until the 1IH@s and then Pust e)ploded in 7@@19 -igure 197

Price of $omes AdPusted for Inflation +ince 1HI@ Contrar/ to popular belief0 housing prices do not ordinaril/ rise rapidl/9 In fact0 until recentl/0 inflationE adPusted home prices ha#en't increased that significantl/0 but then the/ Pust e)ploded after 7@@1 :1HI@ inde) equals 1@@;9 +ource: Irrational .)uberance0 +econd .dition0 7@@F0 b/ "obert B9 +hiller9

According to the CaseE+hiller $ome Price Inde)0 while the inflationEadPusted wages and salaries of the people bu/ing the homes went up onl/ 7 percent for the same period :according to the Bureau of 8abor +tatistics;0 home prices shot up9 1he rise in home prices so profoundl/ outpaced the rise of incomes that e#en our most conser#ati#e anal/sis back in 7@@D led us to correctl/ predict that the #ulnerable real estate bubble would be the first to fall9 :%e ha#e a lot more to sa/ about what's ahead for the housing market in Chapter F0 and it's not what the economic cheerleaders want /ou to think9;

1he +tock 5arket Bubble

1he stock market bubble is one of the easiest0 most ob#ious bubbles to spot0 /et so #er/ difficult for most people to see9 +tocks can be anal/Med in so man/ different wa/s9 %e find the state of the stock market is easier to grasp b/ looking at -igure 19A 9 If this doesn't con#ince /ou that there was a stock bubble0 we don't know what will9 -rom 1IH@ to 7@@@0 &4P rose a #er/ decent 7F@ percent9 $owe#er0 the 39+9 stock market0 as measured b/ the 4ow Bones Industrial A#erage0 leaped up an astounding 101@@ percent, -igure 19A &4P up 7F@ Percent0 4ow up 5ore than 10@@@ Percent0 1IH@S7@@@ 1he stock market rose almost four times as much as the econom/ grew from 1IH@ to 7@@@9 1hat's a good indicator of a bubble9 +ource: 4ow Bones and -ederal "eser#e9

%e call that a stock market bubble, It looks e#en more out of line when /ou consider that the population of the 3nited +tates grew onl/ 7D percent from 1IH@ to 7@@@9 &i#en that population growth is one dri#er of &4P growth0 and gi#en that &4P growth is the fundamental dri#er of corporate earnings growth and therefore stock prices0 we would more or less e)pect to see the 4ow rise about as much as &4P0 which was about 7F@ percent9 A 101@@ percent rise in the 4ow is a giant flag0 spelling out the word BE3EBEBE8E.9 +hown in a different wa/ in -igure 19C 0 the #alue of financial assets as a percentage of &4P held relati#el/ stead/ at around CD@ percent from 1IF@ to 1IH@9 But starting in 1IH10 financial assets as a percentage of &4P rose to more than 10@@@ percent b/ 7@@G0 according to the -ederal "eser#e9 %e call that prima facie e#idence of both a stock market bubble and a real estate bubble9 -igure 19C

"ise of the -inancial Assets Bubble: -inancial Assets as a Percentage of &4P 1he e)ploding #alue of financial assets as a percentage of &4P is strong e#idence of a financial asset bubble9 +ources: 1homson 4atastream and the -ederal "eser#e9

1he Pri#ate 4ebt Bubble

%e can simplif/ the comple) pri#ate debt bubble b/ seeing it as essentiall/ a deri#ati#e bubble0 dri#en b/ two other bubbles: :1; the rapidl/ rising home price bubbleJ and :7; the rapidl/ rising stock market bubble0 which combined to make for a rapidl/ growing econom/9 In both cases0 lenders of all forms :not Pust banks; began to feel #er/ comfortable with the false belief that the risk of a falling econom/ had been essentiall/ eliminated0 and the risk of an/ t/pe of lending in that en#ironment was minimal9 1his fantas/ was supported for a time b/ the fact that #er/ few loans went into default9 Certainl/0 at the time we wrote our first book :one /ear before its publication in 7@@F; commercial and consumer loan default rates were at historic lows9 1he problem was not so much the amount of pri#ate debt that made it a bubble0 but taking on so much risk/ debt under the false assumption that nothing would go wrong with the econom/9 -or us0 it was eas/ to see e#en in 7@@F that if the #alue of housing or stocks were to fall dramaticall/ :as bubbles alwa/s e#entuall/ do;0 a tremendous number of loan defaults would occur9 %e felt the pri#ate debt bubble was an ob#ious deri#ati#e bubble that was bound to pop when the real estate and stock market bubbles popped9

1he Consumer 4iscretionar/

+pending Bubble

Consumer spending accounts for about G@ percent of the 39+9 econom/9 A large portion of consumer spending is discretionar/ spending0 meaning it's optional :how big a portion depends on e)actl/ how /ou define discretionar/;9 .as/ bubbleEgenerated mone/ and eas/ consumer credit made lots of eas/ discretionar/ spending possible at e#er/ income le#el9 %hen the real estate stock market0 and pri#ate debt bubbles began to pop and people started losing their Pobs or were increasingl/ concerned the/ might0 consumers began to reduce their spending0 especiall/ unnecessar/0 discretionar/ spending9 1his is t/pical in an/ recession0 but this time the effect has been much more profound for two ke/ reasons9 -irst0 the pri#ate debt bubble allowed consumers to spend like craM/ because of huge growth in housing prices and a growing stock market and econom/0 which ga#e them more access to credit than e#er before0 #ia credit cards and home equit/ loans9 As the bubbles popped0 that credit started dr/ing up0 and so did the huge consumer spending that was dri#en b/ it9 +econd0 much of our spending on necessities has a high discretionar/ component0 which is relati#el/ eas/ for us to cut back9 %e need food0 but we don't need %hole -oods9 %e need to eat0 but we don't need to eat at Bennigan's or +teak K Ale :both now bankrupt;9 %e need refrigerators and countertops0 but we don't need stainless steel refrigerators and granite countertops9 1he list of necessities that can ha#e a high

discretionar/ component0 complete with ele#ated prices0 goes on and on9 And0 of course0 there is a lot of other discretionar/ spending0 be/ond necessities0 such as entertainment and #acation tra#el9 1he combined fall of these first four bubbles housing0 stock market0 pri#ate debt0 and consumer spending bubbles make up what we call the Bubblequake of late 7@@H and 7@@I9 3nfortunatel/0 our troubles don't end there9 1wo more giant bubbles are about to burst in the coming Aftershock9

1he 4ollar Bubble :=Airbag> (umber 1;

Perhaps the hardest realit/ of all to face0 the once might/ greenback has become an unsustainable currenc/ bubble9 4ue to a rising bubble econom/0 in#estors from all o#er the world were getting huge returns on their dollarEdenominated assets9 1his made the dollar more #aluable but also more #ulnerable9 %h/6 Because we didn't reall/ ha#e a true booming econom/ based on real underl/ing0 fundamental economic dri#ers9 %e had a rising multibubble econom/9 1herefore0 the #alue of a currenc/ in a multibubble econom/ is linked not to real0 underl/ing0 fundamental dri#ers of economic growth :like true producti#it/ gains;0 but to the rising and falling bubbles9 -or man/ /ears our dollars rose in #alue because of rising demand for dollars to make in#estments in our bubbles9 5ore recentl/0 demand for 39+9 dollars has remained prett/ strong0 especiall/ in light of the current .uropean debt crisis9 But that strength will wane as the falling bubbles lead to falling demand for dollars0 despite all kinds of go#ernment efforts to stop it9 In our effort to stop the fall of our multibubble econom/0 the go#ernment has created two giant =airbags> to cushion the falling bubbles9 1he first airbag is the dollar bubble0 created b/ massi#e mone/ printing b/ the -ederal "eser#e9 1he -ed has been printing massi#e amounts of new mone/ through their program of quantitati#e easing :!.;9 1wo rounds of massi#e mone/ printing :!.1 and !.7; ha#e increased the 39+9 mone/ suppl/ from RH@@ billion in 5arch 7@@I to nearl/ RA trillion in 7@17 :see -igure 19D ;9 1his massi#e amount of mone/ printing :the dollar bubble; will e#entuall/ cause significant rising inflation9 -igure 19D &rowth of the 39+9 5onetar/ Base 5one/ printing basicall/ kept pace with economic growth until financial crisis0 when it e)ploded in 7@@I9 +ource: -ederal "eser#e9

-uture Inflation %ill Cause "ising Interest "ates In and of itself0 rising inflation would not be so bad if the onl/ consequence were rising prices and wages9 But rising inflation also e#entuall/ causes rising interest rates :see Aftershock0 +econd .dition0 for more

details;0 and rising interest rates will ha#e a #er/ negati#e impact on the rest of the bubbles and the econom/9 "ising interest rates will certainl/ be a big downer for the bond market :bond #alues drop as interest rates rise;0 as well as the real estate market :housing is not impro#ing much now0 e#en with mortgage rates at record lows;9 $igher interest rates also mean consumers will bu/ less on credit0 if the/ e#en qualif/ for credit cards and loans0 further depressing consumer spending0 on which G@ percent of the 39+9 econom/ depends9 And0 of course0 rising interest rates will also mean that businesses will borrow less mone/0 bu/ less in#entor/0 hire fewer workers0 and generall/ e)pand less9 1hat will negati#el/ impact emplo/ment0 which will negati#el/ impact consumer spending0 reduce compan/ earnings0 and lower stock #alues9 .#en without the alread/ falling bubbles0 rising interest rates would not be good for a nonbubble econom/ reco#ering from a recession9 -or a falling bubble econom/0 rising interest rates will be the beginning of the final multibubble pop9 %hile that is still off in the future0 when it finall/ occurs0 it will not take long for 39+9 stocks0 bonds0 real estate0 and other dollarEdenominated assets to drop9 5an/ in#estors0 including man/ foreign in#estors who now own an enormous amount of 39+9 assets :see -igure 19F ; will not want to hold on to these declining in#estments9 -oreign in#estors don't ha#e to all run awa/ at once to cause a big downward drop in dollarEdenominated assets9 .#en a significant decline would do the trick9 And0 of course0 domestic in#estors will not want to stick around either9 -igure 19F

&rowth of the -oreignE$eld 39+9 Assets Part of what fueled our bubble econom/ in the 1IH@s and 1II@s was massi#e inflows of capital from foreign in#estors0 which grew from less than a trillion dollars in 1IH@ to R779GH trillion in 7@1@9 %e remain highl/ #ulnerable to their continued support9 +ource: Bureau of .conomic Anal/sis9

%ith inflation and interest rates rising0 and e#en more mone/ printing likel/ in the future as the -ed tries to support the falling bubbles with more quantitati#e easing0 it is onl/ a matter of time before the big dollar bubble pops9

1he &o#ernment 4ebt Bubble :=Airbag> (umber 7;

In addition to massi#e mone/ printing :the dollar bubble;0 the go#ernment has pumped up another enormous airbag to temporaril/ cushion the falling bubble econom/9 %eighing in at more than RH9D trillion when our 7@@F book was published and now :7@17; nearing R1F trillion0 the whopping 39+9 go#ernment debt bubble0 as shown in -igure 19G 0 is currentl/ the biggest0 baddest bubble of all9 5uch of this debt has been funded b/ foreign in#estors0 primaril/ from Asia and .urope9 But as our multibubble econom/ continues to fall and the dollar starts to sink0 who in the world will be willing or e#en able to lend us more6 -igure 19G

&rowth of the 39+9 &o#ernment's 4ebt 1he 39+9 go#ernment's debt is massi#e and growing rapidl/9 %ith no plan and little abilit/ to pa/ it off0 the debt is quickl/ becoming the world's largest to)ic asset9 +ource: -ederal "eser#e9

-rom Boom to Bust: 1he 2irtuous 3pward +piral Becomes a 2icious 4ownward +piral

?n the wa/ up0 the si) conPoined bubbles described abo#e helped coEcreate America's booming multibubble econom/9 In a seemingl/ #irtuous upward spiral0 the inflating bubbles helped the 3nited +tates maintain its status as the biggest econom/ the world has e#er known0 e#en in the past few decades0 when declines in real producti#it/ growth could ha#e slowed our e)panding economic growth9 Instead0 these bubbles helped us ignore slowing producti#it/ growth0 boost our prosperit/0 disregard some fundamental problems0 and keep the part/ going9 (ot onl/ did the 39+9 econom/ continue to grow and remain strong0 but the rest of the world benefited as well9 5one/ we paid for rapidl/ increasing imports boosted the economies of de#eloping countries like China and India9 -irst %orld economies benefited from America's Bubble .conom/0 as well9 Because of our rising bubbles0 de#eloped economies0 such as Bapan and .urope0 were able to sell us lots of their cars and other highEend e)ports0 which helped their home economies prosper9 1he growing world econom/ created a rising demand for energ/0 pushing up oil prices0 which made some "ussian billionaires0 among others0 #er/ happ/9 &rowing demand for minerals0 like iron0 oil0 and copper0 pumped mone/ into e#er/ resourceE producing countr/9 -or e)ample0 China's and India's e)panding appetite for steel boosted iron ore e)ports from Australia0 lifting their econom/9 All combined0 America's rising bubble econom/ helped boom the world's rising bubble econom/9 (ow0 as our intermingled global part/ bubbles are beginning to deflate and fall0 the #irtuous upward spiral has become a #icious downward spiral9 8inked together and pushing hard against each other0 each time a bubble begins to sag and pop0 it puts tremendous downward pressure on the rest9

-irst the Bubblequake0 (e)t the Aftershock

As we said earlier0 the first four of the si) bubbles real estate stock0 pri#ate debt0 and discretionar/ spending ha#e begun to pop0 creating the beginning of what we call the Bubblequake9 In response0 the federal go#ernment and the -ederal "eser#e ha#e been pumping up the remaining two bubbles the dollar and go#ernment debt bubbles with massi#e mone/ printing and massi#e deficit spending since earl/ 7@@I in a dramatic attempt to stop the falling bubbles and to boost the o#erall econom/9 1his massi#e stimulus spending and especiall/ the massi#e mone/ printing ha#e been helping in the short term to temporaril/ boost the stock market and keep the o#erall bubble econom/ from sagging further9 But this massi#e stimulus cannot continue fore#er0 and in the longer term0 the bubbles will continue to fall9 (ot onl/ will the massi#e stimulus e#entuall/ ha#e to end0 it will actuall/ make our bubbles crash e#en harder when the/ finall/ do pop9 Continued use of massi#e stimulus is like using a powerful shortEterm drug that will later become a to)ic poison9 1he stimulus itself will later make the future crash all the worse9 It is important to understand that the Bubblequake problems we are now facing are due to much more than merel/ a popped real estate bubble9 If all we had was a burst real estate bubble0 it would not ha#e created so much financial pain here and around the globe9 In addition to the real estate bubble0 the pri#ate debt bubble and the stock market bubble also began to fall9 1hese Bubblequake problems are not going to be permanentl/ resol#ed an/time soon0 not e#en with the temporar/ boost from massi#e stimulus spending and massi#e mone/ printing9 "ather than a real economic reco#er/0 the combination of sagging bubbles and the future poisonous consequences of the massi#e stimulus will put increasing downward pressure on our entire bubbleEbased econom/9 ?nce our last two bubbles the dollar and go#ernment debt bubbles finall/ burst0 we will enter the ne)t phase0 what we ha#e dubbed the Aftershock0 in which all our asset bubbles will burst and the 39+9 econom/ will fall dramaticall/9

It's (ot Bust America's Bubble .conom/ 1he %orld $as a Bubble .conom/0 1oo
%hen America's bubble econom/ full/ pops0 so will the world's bubble econom/9 %h/6 Because all these bubbles are linked together9 ?n their wa/ up0 each supported and fueled the othersJ and on the wa/ down0 each falling bubble will put increasingl/ downward pressure on the rest9 -or e)ample0 the real estate boom in the 3nited +tates created a consumer spending org/ here that helped fuel China's rapid economic growth and boomed China's own real estate bubble9 1o keep up with growing demand for their e)ports0 China in turn has been bu/ing more natural resources from other regions0 such as +outh America9 But when our real estate bubble began to pop and 39+9 consumer spending dropped a bit0 China's growth also began to cool down o#er the past few /ears0 although it is still growing0 Pust at a slower rate9 In the coming Aftershock0 when 39+9 consumers will bu/ much less than the/ do toda/0 China's bubble econom/ will take a deep hit0 which will then spill o#er to +outh America0 Australia0 and other places that currentl/ suppl/ China's commodities demand9 5eanwhile0 back in the 3nited +tates0 stocks0 bonds0 real estate0 consumer spending0 and go#ernment spending will be down0 inflation and interest rates will be up0 and the bubble econom/ will be o#er9 In the coming Aftershock0 the global multibubble crash will kick off a deep0 longEterm downturn here and around the globe9 Please understand that we are not intrinsicall/ pessimistic or doomEandEgloom/ b/ nature9 %e are not dri#en b/ an/ particular political agenda0 left0 right0 or sidewa/s9 %e are not fanatical gold bugs :although we think gold will do quite well;9 And we are not paranoid sur#i#alists who think /ou should run out and build a fallout shelter filled with two /ears' worth of food9 %e are Pust calling it as we see it0 based on facts and rational anal/sis0 and we would like to help /ou see it0 too0 while there's still time to protect /our assets and prepare9

All 4ogs &o to $ea#en0 and +o %ill a %hole 8ot of 5one/ ,

People often ask where the massi#e amount of in#estment capital in stocks0 bonds0 and real estate will go in the future9 1he answer is 5one/ $ea#en9 5ost in#estment mone/ will go to 5one/ $ea#en in the future because most people won't pull their mone/ out of falling stocks0 real estate0 and bonds soon enough9 An/one who doesn't mo#e mone/ out earl/ won't be able to mo#e it out at all9 1hat's because other people will ha#e mo#ed their mone/ out of those in#estments earlier0 most importantl/0 and there will be little demand for those in#estments afterwards9 $ence0 the #alues of most people's in#estments will decline dramaticall/9 At that point most people will realiMe the/ should ha#e mo#ed their mone/ out0 but it will be too late9 1heir portfolios will ha#e been automaticall/ rebalanced for them0 hea#il/ weighted toward 5one/ $ea#en9 -or the mone/ managers and financial ad#isers who will preside o#er this reweighting of in#estors' portfolios into 5one/ $ea#en0 it's going to feel a lot less like 5one/ $ea#en and a lot more like 5one/ $ell9

%h/ 4on't %e $a#e the Aftershock "ight (ow6 1emporar/ =Airbags> Are +upporting the ?ther Partiall/ Popped Bubbles

!uestion : %e ha#e four falling bubbles but the/ are not /et full/ popped9 %hat is keeping these bubbles partiall/ inflated6 Answer : 1he pumping up of the final two bubbles, 1he easiest wa/ to understand the econom/ right now is to look at it as a set of deflating bubbles :stock0 real estate0 pri#ate credit0 and consumer spending; whose fall is being cushioned b/ the rapid inflation of the two final airbag bubbles: the dollar bubble and the go#ernment debt bubble9 B/ rapidl/ pumping up these two bubbles0 the go#ernment is temporaril/ postponing the fall of America's multibubble econom/9 Because the/ are cushioning and supporting the other bursting bubbles0 we like to think of these last two /etEtoEpop bubbles as America's airbags the/ are pre#enting a dangerous crash for a while0 but e#entuall/ the/0 too0 will fall9 %hen these final airbags o#erinflate and burst0 the rest of our bubble econom/ will burst0 bringing on the global Aftershock9 But0 these airbags aren't going to pop immediatel/ and that's wh/ we don't ha#e the Aftershock right now9

Airbag T1: 5assi#e &o#ernment Borrowing

5assi#e go#ernment borrowing :the go#ernment debt bubble; is boosting the econom/9 In fact0 most of the growth in the econom/ since the financial crisis has been directl/ related to the massi#e D@@ percent increase in federal go#ernment borrowing since 7@@G9 And let's not forget that the 39+9 deficit wasn't e)actl/ tin/ in 7@@G0 when it was alread/ weighing in at R1G@ billion9 (ow our deficit is nearing R197 trillionN/ear9 1hat is a big fat go#ernment debt bubble becoming a trul/ colossal go#ernment debt bubble9 (aturall/0 with the countr/ awash in so much deficit spending0 the notE/etEpopped go#ernment debt bubble is acting like a stillEinflated0 protecti#e airbag0 keeping the other bubbles from full/ falling9 +urel/0 had we not borrowed and spent all that e)tra mone/0 the 39+9 econom/ would be in far worse shape toda/9 1he problem is0 airbags e#entuall/ pop0 too9 B/ pumping up this protecti#e airbag so giganticall/0 it will onl/ make the future crash all the bigger9

Airbag T7: 5assi#e 5one/ Printing

5assi#e mone/ printing :the dollar bubble; b/ the -ederal "eser#e0 mostl/ in the form of quantitati#e easing or !.0 has also been acting as an airbag0 keeping the 39+9 and world economies protected from the popping bubbles9 5assi#e mone/ printing has worked like 2iagra to rein#igorate the stock market bubble whene#er it shows signs of deflating9 1his temporar/ lift to the stock market also indirectl/ boosts the rest of the consumerEbased econom/9 +tock in#estors spend more when their portfolios are up0 and studies show that e#en people who own no stocks spend more when the stock market is doing well9 +o massi#e mone/ printing has been doing its temporar/ airbag Pob0 first with !.1 and !.7 :7@@IS7@11;0 and ne)t with more mone/ printing ahead9

But the Airbags ?nl/ Postpone the Ine#itable

1he trouble with pumping up America's airbags :the dollar bubble and go#ernment debt bubble; is that it is Pust a shortEterm fi)9 And worse than being Pust a shortEterm fi)0 it is a shortEterm fi) that comes at an incredibl/ high longEterm price9 %e're not Pust kicking the can down the road we're Pust piling up sticks of d/namite in the can that will cause an e#en more massi#e e)plosion when we can kick the can down the road no further9

"ising -uture Inflation Is <e/

%hen the airbags fail0 all the bubbles will pop9 %hat will cause the airbags to fail6 "ising future inflation9 In a terribl/ ironic twist0 the #er/ things we are doing to support the econom/ :b/ printing mone/ and borrowing mone/; will lead to what e#entuall/ pops these airbags and causes the rest of the bubbles to fall e#en harder9 :-or more details0 please see Aftershock0 +econd .dition9; "ight now0 we can keep on borrowing :pumping up airbag T10 the go#ernment debt bubble; as long as we can keep on printing mone/ :pumping up airbag T70 the dollar bubble;9 5assi#e mone/ printing keeps interest rates low so we can keep borrowing9 %e will keep printing mone/ to fund our borrowing for as long as we can print mone/ without creating inflation9 As long as inflation remains low0 as it is toda/0 America's airbags can continue to keep America's Bubble .conom/ from full/ popping9 "ising future inflation :and the rising interest rates it will cause; can be a#oided for a while longer0 but rising inflation cannot be a#oided fore#er9 %e simpl/ cannot increase the mone/ suppl/ threefold0 with e#en more mone/ printing to come0 and not e#entuall/ get some #er/ significant inflation9 "ising inflation will force interest rates higher0 whether the -ed likes it or not9 1he -ed can't control interest rates once we ha#e significant inflation9 Printing mone/ can sol#e man/ of our ills short term0 but one ill it can ne#er sol#e is inflation9 1hat inflation will push up interest rates0 and rising interest rates will de#astate the stock0 bond0 and real estate markets0 and all the bubbles will fall9 Inflation is ke/9 %hen rising inflation and rising interest rates force the airbags to fail :i9e90 when we can do no more mone/ printing and borrowing;0 all the bubbles will fall9 3ntil then0 the airbags will hold off the coming Aftershock right up until the/ no longer work9

%h/ 4on't 5ost Con#entional In#estors +ee 1his Coming6

1he reasons for the current widespread bubble blindness b/ con#entional in#estors are man/9 1he/ include: A deep faith in =the m/th of the natural growth rate> that is supposed to guarantee us continued economic growth no matter what9 :1he m/th of the natural growth rate is described in detail in Chapter A9; 4enial: $uman ps/cholog/ makes it difficult to think rationall/ in the face of things we don't want to be true9 :In#estor ps/cholog/ is also addressed in Chapter A9; %hat we call =1he $amptons .ffect>: Con#entional in#estors and anal/sts desperatel/ need the current status quo :from which the/ greatl/ benefit; to continueJ otherwise0 the/ will lose e#er/thing: their Pobs0 wealth0 homes :in the $amptons0 for e)ample0 for wealth/ (ew *ork in#estors;0 social status0 and so on9 1hese people will fight to the end to keep what the/ ha#e0 e#en if that means complete bubble blindness9 If /ou are counting on blind people to guide /ou0 we suggest /ou keep /our e)pectations low9

%hat's a +a##/ Aftershock In#estor to 4o6

1he deadl/ combination of declining producti#it/ and the multibubble econom/ is gi#ing us massi#e debt0 massi#e mone/ printing0 future rising inflation and interest rates0 falling assets bubbles0 and an increasingl/ dangerous in#estment en#ironment9 Con#entional wisdom on in#esting0 such as the bu/EandEhold #alue in#esting practiced b/ %arren Buffett0 for e)ample0 will not hold up well under these worsening conditions9 Instead of con#entional wisdom0 we need a new kind of Aftershock wisdom :see Chapter A; for a new wa/ of in#esting :see Chapters C to 11; that will guide /ou to and through the coming Aftershock9 Ignore this new Aftershock wisdom at /our peril9 1he ke/ to Aftershock wisdom for successful in#esting is to ignore the economic cheerleaders and sta/ focused on what reall/ matters: inflation9 "ising future inflation and future rising interest rates pose the biggest threat to the future health of /our portfolio9 (ot too man/ people are worried about inflation and interest rates right now because both are remarkabl/ low and pose no immediate threat9 But rising inflation and rising interest rates will strike the final blow to the #ulnerable dollar and go#ernment debt bubbles0 and will send /our hardEearned assets to 5one/ $ea#en faster than /ou can log onto /our online brokerage account and hit =+ell,> 1he rest of this book is entirel/ focused on helping /ou protect /our wealth0 whether it is R7@@ or R7@@ million9 But there is onl/ so much we can tell /ou in a book9 1his is an e#ol#ing econom/ and in#estment en#ironment0 and therefore the actions /ou take must also e#ol#e o#er time9 Be/ond our books0 /ou can keep up with us through our newsletters0 or in#est with us0 and /ou will see each step we take as the Aftershock approaches9 %ith or without our help0 please understand that /ou must keep up with changing economic conditions in order to correctl/ manage and protect /our assets in this increasingl/ dangerous in#estment en#ironment9

C$AP1." 7

+ince %e 8ast +poke 9 9 9

A-1."+$?C<

3P4A1.: 1$.* ".A4 ?3" P8A*B??<0 1$. %?"84 I+ P"I(1I(& 5?(.*

+ince the most recent update of our outlook on the econom/ with the release of Aftershock0 +econd .dition0 in August 7@110 much has happened9 1he most striking change is that the stock market has reco#ered somewhat0 up about 1@ percent since its low in ?ctober 7@11 as of this writing in midEBune 7@179 In fact0 because of that reco#er/ a lot of people ha#e been asking us0 =4o /ou still think there will be an aftershock6> As if all we needed to wipe out the fundamental problems with the bubble econom/ was a 10@@@Epoint increase in the 4ow9 %e understand how tempting wishful thinking can be9 People naturall/ hope that the bad dream is o#er and all is on the upswing9 And it is good that people are optimistic9 But that outlook simpl/ is not realistic in the longer term9 .#en in the shorter term0 there are big questions looming9 Could this be like 7@110 which started #er/ optimisticall/ with hopes of =green shoots> :new growth; in the spring0 onl/ for those green shoots to wither and turn brown in the summer of 7@110 if the/ reall/ e#en e)isted in the first place6 Plus0 the stock market had e)ternal shocks from .urope0 8ib/a0 and the Bapanese tsunami9 1he same could happen in 7@17: dreams of green shoots at the start and a browning out as the /ear goes on0 although it is unlikel/ there will be an e)act repeat of the /ear before9 1here are certainl/ man/ potential e)ternal shocks that could further negati#el/ impact the 39+9 econom/0 such as from Iran or .urope or China0 which we discuss in more detail later in this chapter9 In addition0 that economic =reco#er/> that e#er/one was hoping for0 and e#en some declared that we alread/ were in0 simpl/ has not materialiMed to much of an e)tent0 if there is one at all9 In fact0 the .conomic C/cle "esearch Institute :.C"I;0 the most accurate forecaster of recessions :ha#ing correctl/ forecasted e#er/ recession since the/ were founded in 1IIF;0 still holds strongl/ to the prediction it made in +eptember 7@11 that the 3nited +tates is heading into a recession9 1he C.? of .C"I0 8akshman Achuthan0 further sa/s that he has enough data since +eptember to sa/ it is no longer Pust a prediction but almost a certaint/0 based on the #arious leading economic indicators he uses9 $owe#er0 Pob growth could continue past the beginning of a recession because Pob growth could continue past that point because Pob growth tends to lag behind economic growth9 .mplo/ment is considered a lagging indicator because emplo/ers don't tend to hire until growth in demand has been more pro#en and the/ don't fire until declining demand has been more pro#en9 5ost importantl/0 the fundamental issues we discussed in both America's Bubble .conom/ and Aftershock ha#e not changed far from it9 1he/ ha#e onl/ been further confirmed b/ recent e#ents9 In fact0 so much so that it almost seems like the -ed and other central banks around the world ha#e been reading our pla/book9 %e said that the final bubble to be pumped up will be the dollar bubble because it's the easiest wa/ for politicians in the 3nited +tates and around the world to sol#e the bubble problems temporaril/9 As we ha#e said before0 printing mone/ can sol#e almost an/ financial problem e)cept for one: inflation9 5one/ printing allows go#ernments to borrow more massi#el/0 it calms ner#ous stock and bond markets0 and it helps boost general economic acti#it/9 $ence0 almost e)actl/ as we had predicted0 go#ernments around the world ha#e opened the floodgates of printed mone/ :see -igure 791 ;9 According to B9P9 5organ Chase0 the -ederal "eser#e0 the .uropean Central Bank0 the Bank of .ngland and the Bank of Bapan combined ha#e printed more than RA9I trillion since 7@@I9 1o put that into perspecti#e0 the entire mone/ suppl/ of the 3nited +tates was about RH@@ billion in 7@@G9 4iscussion of an

=e)it strateg/> for the -ed's pulling back its printed mone/ out of the s/stem0 which was quite in #ogue onl/ a /ear ago0 has been completel/ forgotten9 -igure 791

Around the %orld0 Central Banks Are Printing 5one/ In response to the 7@@H financial crisis0 central banks around the world0 not Pust our -ederal "eser#e0 ha#e responded b/ printing mone/ as shown b/ central bankUs balance sheet growth9 1his is a world bubble econom/9 +ource: 2arious central banks9

1he .uropean Central Bank :.CB; has flooded the .uropean econom/ with more than 1 trillion euros of eas/ mone/ loans9 1hat has also taken pressure off the 39+9 financial markets as well and helped pa#e the wa/ for the stock market reco#er/ we had in the winter and earl/ spring of 7@179 (ot to be left out of the part/0 the Bank of .ngland keeps adding to its printed mone/ pile with more quantitati#e easing :!.;9 5eanwhile0 China's massi#e go#ernmentEcontrolled banking machine continues to stimulate its econom/ with mone/ printing0 although at a slower rate than when the financial crisis first hit China's econom/ with a baseball bat9 5ore on China0 too0 later in this chapter9 Bapan has also continued to increase its mone/ suppl/9 Bapan's e)ports are falling and the printed mone/ will help dri#e down the #alue of the /en0 making its e)ports cheaper9 5ore importantl/0 the Bapanese econom/0 which reco#ered smartl/ after the tsunami0 has slowed down again0 partl/ due to slowing .uropean demand for Bapanese e)ports0 as well as slowing demand from other Asian countries0 in particular China9 All of this mone/ printing has helped boost economies and especiall/ financial markets around the world9 (ow0 it ma/ not appear like a big boost because world economic growth is so slow9 But it is working0 especiall/ on the financial markets9 %ithout this massi#e mone/ printing0 financial markets could melt down9 In the case of .urope0 it is eas/ to see that bond /ields on +panish and Italian debt would ha#e quickl/ spiraled up out of control without massi#e .CB inter#ention to keep them lower9 ?utEofEcontrol interest rates in such large countries as +pain and Ital/ would rattle financial markets around the world0 taking the .uropean0 3nited +tates0 and Bapanese economies down with them9 +o the mone/ printing madness ma/ not look like it's helping because .uropean0 39+90 and Bapanese economic growth is so slow0 but it is most certainl/ helping keep the financial markets from deteriorating dramaticall/0 which would

ha#e a se#ere negati#e impact on all of those economies9 But0 of course0 massi#e mone/ printing0 while supporti#e in the short term0 is simpl/ another bubble0 not a solution9 Pumping up the huge dollar bubble with massi#e mone/ printing is onl/ going to make its crash e#en bigger and more uncontrollable later9 1hat's because massi#e mone/ printing e#entuall/ causes significant inflationJ rising inflation causes rising interest ratesJ and rising interest rates will pop what is left of the first four partiall/ popped bubbles :stocks0 real estate0 pri#ate debt0 and consumer spending; and will full/ burst the last two: the dollar and the go#ernment debt bubbles9 In the meantime0 no one wants /ou to think about that9

Ignoring the 5assi#e 5one/ Printing :the 4ollar Bubble; Is a <e/ &oal of the Cheerleaders

As with an/ bubble0 the ke/ to its shortEterm success is ignoring it9 If /ou don't ignore the bubble0 it is a lot harder to keep it going9 +o0 part of the ke/ to the shortEterm success of this mone/Eprinting madness will be for cheerleading financial anal/sts and economists to o#erlook the bubble it is creating9 -or help in o#erlooking bubbles it is alwa/s good to ha#e some academic support9 And0 sure enough0 as if on command0 there is growing support for a new economic theor/ called (ew 5onetarist 1heor/9 1he group of economists who support this theor/ think that deficits are good and cannot cause economic problems9 Actuall/0 deficits help go#ernments sol#e economic problems9 1he/ sa/ go#ernments can borrow massi#e amounts of mone/ and ne#er ha#e to default on their debt because their central banks can alwa/s bu/ their debt with more printed mone/9 But these economists don't Pust belie#e this will help in the short term0 the/ see it as an acceptable0 e#en desirable0 longEterm solution because the/ don't see an/ longEterm problems with it9 1he/ belie#e that this printed mone/ won't cause inflation because the new mone/ is simpl/ a =balance sheet adPustment> in the econom/9 8ike a magic trick0 it doesn't reall/ count and it won't hurt us in an/ wa/9 (ew 5onetarist 1heor/ is like <e/nesian economics on steroids9 And0 to a large degree0 at least in the short term0 it is true9 &o#ernment borrowing does help the econom/9 And0 /es0 the -ederal "eser#e0 with printed mone/0 can bu/ e#er/ single go#ernment bond Congress wants to sell if need be9 $ence0 there is no possibilit/ of a failed 1reasur/ auction and no possibilit/ of default e#en if go#ernment debt became incredibl/ massi#e9 ?f course0 as we ha#e been pointing out for /ears0 there is a giant flaw in this plan9 3sing printed mone/ to bu/ bonds will e#entuall/ cause inflation9 If it won't cause inflation0 then0 using the logic of the (ew 5onetarists0 the go#ernment could simpl/ eliminate all ta)es and borrow all the mone/ it needs b/ selling bonds to the -ed0 who will pa/ them in newl/ printed mone/ that didn't e)ist before9 (o ta)es and lots of go#ernment spending :funded b/ printed mone/; certainl/ would boost the econom/9 And if all that printed mone/ doesn't cause inflation0 /ou ha#e created the perfect solution to an/ econom/'s ills9 It would trul/ be =5one/ from $ea#en0> and it could basicall/ mo#e an/ econom/ in the world into h/perdri#e9 But0 of course0 5one/ from $ea#en does not reall/ e)ist9 As we ha#e said before0 5one/ from $ea#en is the path to $ell9 It is amaMing that such a line of economic thought is getting increasingl/ greater and more serious attention9 It is also a reflection of the sad state of the economics profession that this line of thinking represents cutting edge nonEmainstream economists9 1hat's a big problem because almost all real change in economic thought o#er the ne)t few decades will come outside of the mainstream9 1hat this represents current nonmainstream thinking shows how far the field of economics has /et to go9 1he fact that the economics profession has failed so miserabl/ is a ke/ part of the reason we are in this current economic mess and0 more importantl/0 it will be a ke/ part of the reason we will ha#e so much trouble getting out of this mess after the Aftershock hits9 5o#ing economics into a much more sensible direction is so important that we de#oted a whole chapter to this issue in Aftershock0 +econd .dition :Chapter I;9

1he -ool in the +hower

?ne issue that is not terribl/ important in the current econom/0 which was discussed in great detail in Aftershock0 +econd .dition0 is inflation9 $ence0 we are often asked wh/ past mone/ printing hasn't created inflation9 ?f course0 we point out that we do ha#e higher inflation0 but0 admittedl/0 it has not been high enough to increase interest rates0 which is the ke/ negati#e effect of inflation in a bubble econom/9 And it likel/ won't be high enough to increase interest rates for at least the rest of 7@179 +o0 wh/ isn't inflation higher6 It's due to what are called lag factors9 1here is alwa/s a lag between printing mone/ and inflation9 %e discussed lag factors in detail in Aftershock0 +econd .dition :Chapter A;9 1he easiest wa/ to understand lag factors is the =fool in the shower> analog/ used b/ (obel PriMeSwinning monetarist economist 5ilton -riedman9 1he fool walks into a shower and turns on the hot water9 At first0 all he gets is #er/ cold water9 +o he turns the knob higher to get hot water0 and still nothing0 so he keeps turning it up9 1hen0 all of a sudden0 the hot water hits and scalds him9 1hat's what happens with inflation and lag factors9 %e don't get inflation immediatel/0 so we see no harm in =turning up the hot water> b/ increasing the mone/ suppl/9 All we see are the shortEterm benefits0 and we keep printing more mone/ without getting burnt9 In fact0 as we ha#e said before0 the reason inflation could be #er/ high in the future is not because of the mone/ we ha#e alread/ printed0 but0 more importantl/0 because of the mone/ we will likel/ print in the future9 5ore mone/ printing will go from being somewhat discretionar/ to being more mandator/ due to the need for increasing support for financial markets here and abroad9 +ince we are simpl/ tr/ing to support falling bubbles in housing0 stocks0 pri#ate credit0 and consumer spending0 there will be a continuing need to print mone/9 (ot that the mone/ we ha#e alread/ printed won't create inflation it will9 But the greatest contributor to future inflation will be future mone/ printing9 $owe#er0 e#en with massi#e mone/ printing0 a lot can go wrong long before we get high inflation9 Printed mone/ helps to sol#e some of our economic problems short term0 but it doesn't work perfectl/ and it isn't a oneEstop cureEall9 &o#ernments can print mone/0 but that doesn't mean the/ ha#e an economic steering wheel0 accelerator0 and brake that allows them to dri#e the econom/ perfectl/9 5uch of the econom/ is entirel/ out of their control9 +o e#en if we don't ha#e high inflation0 we can still ha#e financial crises0 falling stock markets0 and #er/ sluggish real estate markets9 In all fairness0 it is true that if we were reall/ willing to open the mone/Eprinting spigot0 we probabl/ could sol#e all our problems short term :R1@ trillion would likel/ do the trick;9 But few people would support it9 And0 that tells /ou that the/ actuall/ know more than the/ are sa/ing the/ know that printing lots of mone/ will create inflation otherwise0 wh/ not print R1@ trillion right now6 1he/ know full well the dangersJ the/ are Pust hoping be/ond hope that somehow R7 trillion dollars won't be dangerous and won't cause future inflation9

Potential 1riggers 1hat Could Accelerate a 4owntrend in the 39+9 .conom/

1here are man/ possible situations that could accelerate a downturn in the econom/9 +ome are more likel/ than others and some are less probable but are still possible0 depending on unpredictable wildcard e#ents9 Potential triggers include: &reece China Iran 1he passage of time

&reece: Between a "ock and a $ard Place

Part of the bullish feeling in the stock market currentl/ is a result of the =resolution> of the &reek crisis9 8ike the economic =reco#er/0> the &reek =resolution> is likel/ not for the long term9 1he &reek econom/ is still in serious trouble9 ?nl/ an immediate default has been a#oided through the bailout and another round of loans9 5ore importantl/0 the spread of the &reek debt crisis to +pain and Ital/ has been temporaril/ stopped9 As we ha#e said all along0 the &reek crisis is reall/ a +panish and Italian crisis9 1he .uropean banking s/stem can withstand a &reek default0 but it can't weather a +panish andNor Italian default9 +o the .CB's mo#e to bu/ +panish and Italian bonds with printed mone/ and also to pro#ide o#er D@@ billion euros in loans to .uropean banks in late 7@11 :known as a longEterm refinancing operation V81"?W; and another D@@ billion euros in 5arch has helped keep the &reek problem from spreading to Ital/ and +pain in a catastrophic wa/9 But0 fundamentall/0 the problem remains se#ere9 &reece's econom/ has continued to spiral down0 with unemplo/ment now o#er 77 percent0 up from G percent in 7@@G9 1here is simpl/ no wa/ it can pa/ off or pa/ down its debt9 .#en optimistic proPections show &reece's debt to gross domestic product :&4P; ratio being at 17@ percent eight /ears from now9 (eedless to sa/0 those optimistic proPections are likel/ to be #er/ optimistic9 1he real numbers will probabl/ be far worse9 1his also shows a fundamental dilemma that man/ economies face0 including the 39+9 econom/9 &o#ernment austerit/ hurts growth9 8ots of go#ernment borrowing helps economic growth0 short term9 If that is cut0 the econom/ heads down9 (ow0 if we weren't in a bubble econom/0 the fundamental longEterm dri#ers of real growth would ultimatel/ help mo#e the econom/ toward reco#er/9 Argentina defaulted on its debt and0 due to strong growth in the world econom/0 especiall/ in the 3nited +tates and China0 its strong e)ports helped the Argentine econom/ to reco#er to a large degree9 But if there are no fundamental dri#ers of growth and past growth was based on a rising bubble econom/ that has popped0 then austerit/ simpl/ becomes part of a #icious downward spiral9 In the past decade0 the &reek econom/ has been propelled b/ a rising bubble of debt that financed its spending9 (ow that debt bubble has popped and there is nothing to replace it to propel their econom/9 Plus0 there is no strong growth in the .uropean econom/ or the rest of the world to lift it up9 1he situation in the 3nited +tates is similar9 5ost of the growth from 7@@@ to 7@1@ was due to bubbles0 not fundamental growth9 +o0 once those bubbles ha#e popped0 there aren't an/ growth dri#ers left9 1he lack of fundamental growth is e#idenced in the Pob creation numbers9 Between 7@@@ and 7@1@0 there were Mero net new Pobs created9 In fact0 we actuall/ lost about 7@@0@@@ Pobs9 $owe#er0 unlike &reece0 we ha#e the abilit/ to create two more bubbles to help pull us out of trouble temporaril/ the go#ernment debt and dollar bubbles9 1o the e)tent we tr/ to reduce the go#ernment debt or dollar bubbles0 our growth will fall9 $ence0 we are between a rock and a hard place0 Pust like &reece9 .ither we embrace austerit/ and let the bubbles fall0 or we tr/ to pump up more bubbles0 which will temporaril/ keep the other bubbles from popping but make the final pop much worse9 %e think this is an eas/ choice for politicians pump up the bubbles, 1his is also wh/ there will be more and more discussion about how go#ernment debt and mone/ printing isn't so bad0 but actuall/ #er/ good9 ?f course0 this is nuts0 but when times get tough0 people tend to go a bit nuts9 %hat's the solution6 1hat's eas/ don't blow up the bubbles in the first place9 ?nce /ou ha#e one0 there is no eas/ wa/ out of a bubble0 no soft landing9 After /ou ha#e a bubble0 the onl/ choices are pop it now or pop it later9 Both are painful9 ?ne is painful nowJ the other is e#en more painful later9 1hese bubbles were a mistake to begin with and0 unfortunatel/0 there is no eas/ wa/ to correct that mistake now9 3ltimatel/0 we will ha#e to focus on increasing producti#it/ to grow the econom/ rather than blowing bubbles9 Increasing producti#it/ is not Pust the best wa/ to grow an econom/J it is the onl/ wa/ to grow an econom/ in the long term9 +ince &reece doesn't ha#e the abilit/ to pump up two more bubbles0 it is facing a #icious downward spiral in its econom/9 Its unemplo/ment could Pump far higher than it is toda/ ma/be e#en A@ percent

within the ne)t 17 to 1H months9 -ueled b/ growing Poblessness0 businesses will lack confidence to in#est and consumers will lack confidence to spend9 It's a bad downward spiral that doesn't end quickl/9 A &reek default on its debt won't sol#e the problem either9 5uch more is hurting the &reek econom/ than ha#ing too much debt9 1he big problem is the inabilit/ to borrow as the/ did before to pump up the debtEfueled spending bubble that was so critical to their growth9 %ithout a bubble to dri#e growth0 the onl/ option is increasing producti#it/9 And0 for &reece0 that is likel/ to be a #er/ slow process9

China: A +hortE1erm 1hreat to the Part/

China's construction boom is unprecedented in human histor/9 B/ some estimates0 as much as D@ percent of their &4P is now dri#en b/ fi)ed in#estment0 a large part of which is construction9 -ar from encouraging a more consumerEdri#en econom/ rather than e)portEdri#en0 consumer spending as a percentage of the econom/ has actuall/ decreased while the construction part of the econom/ has become absolutel/ dominant9 .#en at the height of our housing bubble0 construction was onl/ 1G percent of our econom/9 At its height during +pain's housing bubble it was 7A percent0 and in 4ubai it approached A@ percent at the peak of its speculati#e construction boom9 +ome people feel this construction bubble is unsustainable0 although not surprisingl/ most people do not see it as unsustainable and think it can go on for man/ more /ears9 -or those who think it will slow down0 a lot of the discussion surrounding the fall of this construction boom re#ol#es around whether it will ha#e a soft landing or a hard landing9 5assi#e stateEcontrolled and Edirected bank lending0 which was fueled in part b/ printed mone/0 has been the dri#er for all these construction proPects9 $ence0 man/ belie#e that it is well within the go#ernment's abilit/ to control the slowdown9 $owe#er0 there is also the possibilit/ that the Chinese go#ernment can't so easil/ control economic growth0 especiall/ if the growth is based on an economicall/ unsustainable dri#er9 In fact0 using nonmarket methods0 such as forced bank lending0 to create construction proPects for which there is no market demand could easil/ make a downturn e#en harder for the go#ernment to control when it begins to go bad as it ine#itabl/ will9 China's growth o#er the past couple of decades has been dri#en b/ the go#ernment's opening up the Chinese econom/ increasingl/ to market competition and market forces9 $owe#er0 its growth in the past few /ears has come from Pust the opposite go#ernmentEcontrolled nonmarket inter#ention9 And0 we might add0 the onl/ reason the/ ha#e the financial power to do something so unwise as massi#e forced bank lending for construction is the enormous economic gains made from their mo#e toward a more freeE marketEdri#en econom/9 +o0 we think the possibilit/ arises for China to endure not Pust a hard landing0 but an economic meltdown due to a collapse in construction compounded b/ slowing e)ports9 At the #er/ least0 it seems highl/ unlikel/ that China's go#ernment can na#igate an e)it out of this construction bubble an/ more carefull/ than the 3nited +tates or +pain9 Bust maintaining their current growth rates means maintaining the unbelie#able amount of construction the/ are currentl/ doing and then doing e#en more e#er/ /ear0 plus not ha#ing an/ downturn in e)ports in fact0 the/ need continuous increases in e)ports9 It all sounds highl/ unlikel/ and #er/ much like the Bapanese e)portE and constructionEfueled econom/ of the 1IG@s and 1IH@s that finall/ popped in a most spectacular fashion9 *es0 some cheerleaders might be able to tell us wh/ China is so well managed that it can a#oid what happened to the 3nited +tates0 Bapan0 and +pain0 but it seems like pure cheerleading at its best9 (ot onl/ do we not belie#e China is better managed but that China's nonEmarket economic management the massi#e go#ernment inter#ention to circum#ent market forces is actuall/ going to result in a far bigger collapse than that faced b/ an/ of those countries when their construction bubbles popped9 1he best comparison is Bapan0 since0 like China0 it was fueled b/ massi#e e)port growth as well as massi#e internal constructionErelated growth9 1he Bapanese stor/ ended in great turmoil0 e#en though it was a much more ad#anced and capabl/ managed econom/ than China when its bubbles popped9 -or the world's bubble econom/0 a meltdown b/ China would ha#e unusuall/ harsh consequences9 1hat is part of the reason so man/ people are cheerleaders for China's construction bubble0 e#en though the/ wouldn't normall/ support such e)treme nonmarket inter#ention in the econom/ in their own countr/9 China is not onl/ the second biggest econom/ in the worldJ it is pro#iding almost all of the growth in the world since the financial crisis9 +o it is ha#ing an outsiMed impact on the 3nited +tates and world econom/9 It is also important ps/chologicall/ to the financial markets0 gi#ing them some real teeth behind the belief that high economic growth will continue0 Pust not dri#en b/ the 3nited +tates an/more9 If it pops0 it will be

a big disappointment0 especiall/ if the hard landing becomes a meltdown9 8ike so much about China and the econom/ in general0 it is hard to know e)actl/ when such a meltdown could occur because it is so dependent on go#ernment actions :Chinese go#ernment; and ps/cholog/9 But it is likel/ we will see a more pronounced slowdown than we are alread/ seeing in the second half of this /ear0 and 7@1A will be the first real chance for a meltdown to occur9 8ike our own go#ernment0 the Chinese go#ernment will fight this with mone/ printing0 but the/ ha#e been doing this for some time and0 at some point0 it simpl/ won't work9 China is alread/ a huge econom/0 and maintaining its high growth rates will become increasingl/ difficult under an/ circumstances9 And when that growth stops0 it won't go gentl/ into the night0 but rather will likel/ go from dream straight to nightmare9

Iran: ?ur (e)t Black +wan6

?n almost e#er/one's list of potential =black swan> e#ents this /ear is Iran9 %e think it is unlikel/ that the current administration would support bombing Iran's nuclear facilities in an election /ear9 $owe#er0 the possibilit/ of an Israeli strike on Iran looms as a real possibilit/9 1he reason is that man/ in the Israeli militar/ and go#ernment belie#e that there is onl/ a limited period of time left to attack those facilities before it is too late9 1he/ certainl/ ha#e said little to dampen discussion of an attack9 &i#en their past successes0 the/ ma/ feel the/ can pull off a repeat performance9 If such an attack is made0 it's not that rele#ant to in#estors whether it is successful or not9 An/ attack would upset Iran and the/ will attack back9 An/ such attacks will naturall/ dri#e up the price of oil9 .#en the threat of such attacks has alread/ dri#en up the price of oil9 $igher oil prices could be Pust the economic shock the world doesn't need gi#en the fragile state of man/ of the world's economies0 especiall/ .urope and Bapan9 Bim Chanos A "ealistic 2iew of China

1here are a few #oices out there sa/ing that China's problems are far greater than most economists and financial anal/sts realiMe0 most notabl/ hedge fund manager Bim Chanos of </nikos -und0 which is wh/ we gi#e him an AB. Award for Intellectual Courage :AB. stands for the name of our first book0 America's Bubble .conom/;9 Bim Chanos is the founder and president of </nikos Associates0 a hedge fund with a particular focus on short selling9 %hile the practice of short selling has been somewhat contro#ersial0 especiall/ in recent /ears0 one #alue of companies like </nikos is that the/ can point out critical flaws in the market long before most people see them9 -or e)ample0 back in 7@@@0 </nikos took short positions in a huge energ/ compan/0 one that -ortune had consistentl/ labeled America's most inno#ati#e compan/9 %ithin the ne)t 1C months0 the stock had lost II percent of its #alue and the compan/ ended up in bankruptc/9 *ou'#e probabl/ heard of .nron9 Chanos admits that he's not a =macro gu/9> $is focus is intensi#e fundamental research and anal/sis to find stocks that are o#er#alued9 But that hasn't stopped him from seeing some big picture problems0 too0 and in recent /ears he has pinpointed a maPor bubble in the world econom/: the Chinese construction bubble9 Chanos noticed se#eral /ears ago that propert/ de#elopment in China was reaching unsustainable proportions9 If the a#erage Chinese couple makes a combined RH0@@@ or so a /ear0 how can the/ afford condominiums that can easil/ cost up to R1D@0@@@6 It didn't add up9 5uch of this growth was dri#en b/ bad loans pushed b/ the go#ernment9 In fact0 Chanos found that man/ new apartment buildings sta/ empt/ and are flipped from speculator to speculator on the greater fool theor/9 As Chanos e)plains it0 China starts with0 X%e are going to grow I percent ne)t /ear9 (ow how do we get there6'> Because so much of China's &4P growth comes from construction0 the go#ernment needs to push new propert/ de#elopment in order to keep the growth going9 If construction slows0 the whole Chinese econom/ slows and that will hurt China's suppliers in Australia0 Canada0 &erman/0 and elsewhere :man/ of which are shorted b/ </nikos;9 Chanos insights aren't especiall/ popular in a financial communit/ that's counting on China to lead the global economic reco#er/9 $e has been publicl/ berated b/ some0 though the attacks against him tend to be #er/ short on data9 %hile he ma/ not be a macro gu/0 and doesn't agree with us on e#er/thing0 he deser#es big kudos for ignoring the cheerleaders and letting the facts speak for themsel#es9 ?ne question is Pust how long the oil price shock will last9 If the 3nited +tates is able to control an/ attacks on oil supplies militaril/0 the impact will be lessened9 But if it spirals out of control0 then all bets are off9 1he 8ib/an uprising had far less impact on oil supplies than an Iran war likel/ would0 and it still had significant longEterm impacts last /ear9 Iran could be bigger0 with much depending on e)actl/ what

happens9 (o doubt0 all financial markets will take a short term hit if there is an attack on Iran9 +tocks will be hit9 1here will likel/ be a flight to safet/ that will help bonds and the dollar9 &old will also likel/ benefit9 If there are no other problems in the world econom/0 there ma/ be a relati#el/ quick reco#er/9 But0 if combined with other problems in .urope or a slowdown in the 39+9 =reco#er/0> its effects will be multiplied and longer lasting9 It's certainl/ the Black +wan du Pour and one to keep an e/e on9

1he Passage of 1ime

%hile we tend to focus on possible future dangers that could kick off the coming Aftershock0 the most likel/ trigger will simpl/ be the passage of time9 It would be quite wonderful if we reall/ could print all the mone/ we want fore#er0 without e#er ha#ing to face a single bad consequence9 1hink of all the problems we could sol#e0 think of all the fun we could ha#e, But such nonsense is the stuff of childhood dreams9 ?f course0 we cannot print mone/ endlessl/ without a future cost9 And0 of course0 that cost is going to e#entuall/ come9 .#en if0 b/ some miracle or magic trick0 high future inflation is somehow a#oided0 what about all these bubbles6 In what uni#erse do rising bubbles ne#er fall6 +ooner or later0 bubbles alwa/s pop9 1hat is wh/0 regardless of what triggers ma/ or ma/ not occur0 regardless of what manipulations ma/ be deplo/ed0 e#en regardless of what marginal economic growth we ma/ be able to somehow produce0 time happens9 1he passage of time0 alone0 will be enough to make the colinked multibubble 39+9 and world economies e#entuall/ burst9

A Closer 8ook at the Current 39+9 ="eco#er/>

%e sometimes put the word =reco#er/> in quotation marks because it's not clear Pust how strong this economic reco#er/ reall/ is9 %e can easil/ see the reco#er/ in the stock market0 which is enormous9 But that's to be e)pected9 +ince the financial crisis0 the stock market has alwa/s Pumped on an/ signs of green shoots as an e)cuse to shoot up9 1he market is also #er/ careful in the numbers it looks at9 It closel/ watches good numbers and focuses less on bad numbers9 It also doesn't look too closel/ at those good numbers to see how real or accurate the/ reall/ are9

1he &ood 4octor

As we ha#e so often said0 this is not Pust America's Bubble .conom/J it is the %orld's Bubble .conom/9 China is an e)cellent e)ample of this0 which brings us to another issue9 +ome people sa/ that we are antiEAmerican because we talk about America's Bubble .conom/0 but we most certainl/ are not9 %e tr/ #er/ hard to be antiEnothing9 %e tr/ to be unbiased0 although we know that man/ people sa/ that and are not9 But we hope we are9 &i#en our #er/ pointed assertion in America's Bubble .conom/ and Aftershock that the 3nited +tates will absolutel/ perform the best after the Aftershock because of the inherent fle)ibilit/ of its econom/ and the structure of its econom/0 which encourages growth and inno#ation0 it seems that would indicate that we are not antiS3nited +tates9 In addition0 we also sa/ that China and its nonmarket0 hea#il/ go#ernmentEcontrolled econom/ will do the worst :with Bapan doing the ne)t worst and .urope doing the best outside of the 3nited +tates;9 %e further sa/ that it will be so bad that there will ultimatel/ be a popular re#olt against the go#ernment :a 1iananmen +quare that succeeds; that will mo#e the countr/ to a more democratic state9 1he point of this e)ample is that we tr/ not to ha#e an/ bias0 although after reading this0 some people would sa/ we are too proS3nited +tates9 It's hard to please e#er/one0 and we certainl/ do not tr/9 %e tr/ to call it as we see it0 Pust as an/ good doctor should in diagnosing and treating a patient9 %e stri#e to be the best and most unbiased economic doctor in the house9 +hort term0 that ma/ anger some people in#estors0 economists0 and financial media members and it ma/ please others9 8ong term0 we are absolutel/ sure it is the best0 and onl/0 approach to take if we are to trul/ understand and sol#e our economic problems9 A good e)ample of the bad numbers the/ are ignoring right now are corporate earnings9 -irst quarter earnings ha#e not been that good0 and companies are not gi#ing good signs that we should be e)pecting a big impro#ement ahead9 Another number the/ ignore is how much %all +treet insider selling there has been9 Insider selling in the first quarter of 7@17 was the hea#iest first quarter in a decade9 Insider selling is not alwa/s a good reason to doubt the market0 but it sure looks bad when it changes so fast and management decides to sell so much9 It seems like the/ aren't longEterm belie#ers in the market9 In addition0 stock market #olume has been #er/ weak9 In a bull market0 /ou would normall/ like to see big increases on increasing #olume0 not increases on decreasing #olume9 1hat doesn't indicate a lot of con#iction9 According to Bloomberg0 the a#erage monthl/ trading #olume for stocks was down A7 percent since ?ctober 7@11 :see -igure 797 ;9 And it's been down almost D@ percent since 7@@I9 -igure 797 +tock 5arket 2olume Is -alling 1he stock market has risen from the depths of the financial crisis on greatl/ falling #olume indicating a lack of widespread market support9 +ource: Bloomberg9

But0 despite all this0 the market has gone up0 which in the end is all that most in#estors care about9 Part of the reason it has gone up are the good numbers we ha#e seen0 most notabl/ in emplo/ment9 3p until April0 we had 11 months in a row where we created o#er 1@@0@@@ Pobs9 $owe#er0 the econom/ clearl/ began to slow down in late spring9 Bob growth fell well below 1@@0@@@0 and it had been declining e#er/ month in 7@179 ?ther indicators were indicating a fairl/ sharp slowdown9 1hat led to a lot of readPustments in economic outlooks for the /ear9 Because of these bad numbers0 in Bune0 &oldman +achs re#ised their estimate for &4P growth in 7@17 to 19F percent from A percent in the spring9 %e had a good increase in manufacturing since August 7@110 but that0 too0 slowed down in the spring9 -uture manufacturing growth will likel/ be crimped b/ declining .uropean and Chinese demand9 1here was a lot of cheerleading going on since August when things were looking bad9 (o surprise9 "emember the big cheers o#er holida/ sales on Black -rida/ in (o#ember 7@116 But when the holida/s were o#er0 the/ were actuall/ flat after adPusting for inflation9 4espite the cheerleading o#er the fake =good> numbers0 the/ carefull/ ignore one of the most important real numbers: how much we borrow each month9 (o one e#en talks about how go#ernment borrowing is increasing :see -igure 79A ;9 4o /ou e#er see it as one of the maPor numbers of the month6 *et it is the most important number of the month b/ far9 %ithout that mone/ we would not onl/ be in recession0 we'd be in an e)tremel/ deep recession because0 without it0 the stock0 housing0 pri#ate credit0 and consumer spending bubbles would pop9 8ack of borrowing would set off a #icious downward spiral9 *et do /ou see that often mentioned on the business 12 shows or the maPor financial print media6 (o one mentions how #itall/ important massi#e borrowing :made possible b/ massi#e mone/ printing; is to our continued =reco#er/9> -igure 79A Increase in &4P and &o#ernment Borrowing0 7@@HS7@11 1he =reco#er/> is being dri#en b/ go#ernment borrowing and mone/ printing9 Increased go#ernment borrowing greatl/ e)ceeded all increased growth in &4P9 +ource: 39+9 4epartment of 1reasur/9

1he -ed's (e)t +teps

+o what's a -ed to do6 1he stock market is up9 1he econom/ is doing oka/0 especiall/ to cheerleaders like the -ed9 .urope is no longer on the doorstep of a financial crisis9 1here's no real need to print mone/ right now9 *et the/ keep talking about it9 5a/be the/ want to keep assuring the stock market that the/ stand read/ with the mone/ hose should it be needed9 1he/ might be much more concerned about contagion from &reece0 +pain0 and Ital/ than the/ are sa/ing9 1he/ also ma/ see that this =reco#er/> is #er/ fragile9 %e don't know0 but we think another round of mone/ printing is likel/ this /ear or in the first half of 7@1A9 $owe#er0 it's definitel/ a waitEandEsee situation9 Another option is that the -ed has found other wa/s to stimulate the stock market without e)plicit !.0 at least temporaril/9 1he question of direct -ed inter#ention in the stock market is alwa/s a trick/ one9 %e brought it up in an appendi) to Aftershock0 +econd .dition9 It's still not something discussed in mainstream media0 e#en though it should be9 $owe#er0 the suspicion of it certainl/ goes be/ond our doors9 In fact0 coauthor Bob %iedemer attended a lunch of %all +treet anal/sts and in#estors in (ew *ork in August 7@11 and decided to ask the attendees how man/ thought it was possible that the -ed was directl/ inter#ening in the stock market9 (ot that the/ thought it was happening0 Pust that it was possible9 +urprisingl/0 almost two thirds of the attendees raised their hands9 Certainl/0 there are da/s recentl/ when the market has acted awfull/ funn/9 5ost notabl/ August I0 7@110 when the 4ow was down A@@ points in the afternoon and0 for no significant apparent reason0 re#ersed course0 climbing #er/ rapidl/0 and closed up A@@ points b/ the end of the da/9 -rom that point forward0 the market continued to climb in a bullish fashion with few retreats through the end of -ebruar/9

But whate#er the -ed is doing directl/ or indirectl/ to support the market0 one thing is clear: 1he/ are #er/ worried9 $ow do we know the/ are worried6 Because ne#er in the histor/ of the 3nited +tates ha#e the/ printed so much mone/ so fast9 And0 unlike before0 there is absolutel/ no talk about how to pull that mone/ out of the s/stem another sign of their #er/ serious concern about the econom/9 +o0 clearl/0 the/ are #er/ worried0 e#en though the/ tell us not to be9 And0 actuall/0 we should be #er/ worried0 too9

Bottom 8ine: ="eco#er/> Is +till 4ri#en b/ 5assi#e Borrowing and 5assi#e 5one/ Printing

1he =reco#er/> is still dri#en b/ go#ernment borrowing and printing9 1ake awa/ either one and we would be in a deep recession9 &o#ernment borrowing has soared since the financial crisis9 As an e)ample0 in -ebruar/ 7@110 the go#ernment borrowed more mone/ than in all of 7@@G9 As mentioned earlier0 we are borrowing about R1@@ billion per month9 It's worth mentioning again because it is so important9 1hat equates to borrowing about R197 trillion per /ear or about 1@ percent of our total &4P9 .liminate that borrowing and /ou effecti#el/ cut our &4P b/ 1@ percent9 And that doesn't include the negati#e effects such a deep recession would ha#e on consumer confidence0 in#estor confidence0 and the bubbles9 .#en the small reduction in borrowing discussed at the end of 7@11 :eliminating the Bush ta) cuts0 eliminating the unemplo/ment benefits e)tension0 and cutting 5edicare reimbursement le#els; would ha#e reduced &4P b/ 1 to 7 percent9 %ell0 &4P growth this /ear ma/ be onl/ about 19D percent9 +o we owe almost our entire growth this /ear to borrowing the mone/ to a#oid those reductions, 1hat's a fragile basis for an/ economic reco#er/9 5one/ printing is pla/ing an important role as well9 It has been critical to maintaining our stock market bubble9 %ithout it0 the stock market ma/ ha#e ne#er reco#ered much from the financial crisis or certainl/ fallen again e#en if it did reco#er somewhat9 And a falling stock market would ha#e big negati#e impacts on the econom/9 Combined0 go#ernment borrowing and mone/ printing are not onl/ ke/ to our current =reco#er/> the/ are the reco#er/9

?ur In#estment ?utlook

As of this writing in midEBune 7@170 here are our thoughts on: +tocks Bonds .urope International equities &old +il#er and commodities

+tocks

Belie#e it or not0 we actuall/ think 7@17 might end up being a decent /ear for stocks9 +tocks will likel/ be highl/ #olatile0 as the/ were in 7@119 $owe#er0 if stocks fall significantl/0 the -ed will likel/ inter#ene with /et another round of !.9 1his ma/ be done surreptitiousl/0 or it ma/ go b/ another name9 1his will work to boost the stock market in the short term0 at least9 A big round of mone/ printing could e#en send the 4ow toward its allEtime high of 1C01FC9 %hen this happens0 we will be much more bullish on stocks in the short term although there's still plent/ of longEterm risk9 +o when will this bubble pop6 In the past0 stocks ha#e fallen within weeks after the quantitati#e easing ended9 In the future0 it ma/ not be so clear cut9 1he ne)t round of !. ma/ be more openEended and that will pro#ide more ongoing support for the stock market in the short term9 In the longer term0 the stock market bubble will still pop0 but it's difficult to set a clear e)piration date right now9 +ta/ tuned and we will keep /ou updated as this de#elops9 In the meantime0 highEdi#idend stocks of stable0 conser#ati#e0 largeEcap companies such as electric utilities0 Bohnson K Bohnson0 and Procter K &amble are still worth looking at in a conser#ati#e portfolio9 1here is less potential for shortEterm growth0 but the/ also carr/ lower longEterm risk9

Bonds
Interest rates on bonds in the 3nited +tates are about as low as the/ can go meaning the potential for capital gains from bonds is prett/ slim9 $owe#er0 there could be some small gains to be had in 7@179 -inancial uncertaint/ in .urope will likel/ continue to make 1reasur/s a relati#el/ safe ha#en9 $owe#er0 if the -ed prints mone/ in another round of !.0 that traditionall/ has been a shortEterm negati#e for bonds since in#estors will be mo#ing out of bonds and into stocks9 And remember0 e#en a relati#el/ small increase in interest rates could send bonds downward #er/ quickl/9 +o we recommend keeping shorterEduration highEqualit/ bonds0 such as twoE0 threeE0 and fi#eE/ear 1reasur/s9 In addition0 there are special bonds0 such as mortgageEbacked bonds and 1IP+ :which stands for 1reasur/s InflationEprotected +ecurities;0 that are likel/ to outperform traditional bonds in a !.Et/pe en#ironment9 ?#erall0 the/ should be a good source for total return this /ear0 although not as good as 7@119 .)changeEtraded funds :.1-s;0 such as =1IP> :for 1IP+; and =5BB> :for mortgageEbacked bonds;0 are potentiall/ good wa/s to in#est in those bonds9

.urope

As we predicted0 the .uropean Central Bank has turned to printing mone/ in order to bu/ Italian and +panish bonds to pre#ent the &reek financial crisis from spreading throughout .urope and threatening the collapse of the -rench and &erman banking s/stems9 %hile the e)tent of the mone/ printing is nothing compared to the -ed's !.0 it has pre#ented the .uropean banking s/stem from melting down for the time being9 In 7@17 we can e)pect more of the same9 Countries with large debts and weak economies0 such as Ital/0 +pain0 and &reece0 will continue to run into liquidit/ problems and threaten to topple the banking s/stem9 1he .CB0 e#er reluctant to print mone/0 will nonetheless ha#e no choice but to continue to print mone/ to sa#e the da/9 ?f course0 this will lead to more inflation e#entuall/0 but in the meantime it will ha#e the intended effect of keeping the .uropean banking s/stem from collapsing9 3ltimatel/0 sa#ing the banking s/stem is the primar/ goal of the .CB9 In summar/0 we don't e)pect the .uroMone to collapse this /ear or the euro to be abandoned9 %hat we do e)pect is an increasingl/ reluctant .CB to print increasing amounts of mone/9 (o one will like it0 but it's the easiest =solution0> and politicians usuall/ choose the easiest solution9 ?ne ca#eat is that the &reekN+panishNItalian debt situation could deteriorate more rapidl/ than a reluctant .CB is willing to act9 1his could cause a lot of panic around world financial markets0 but we e)pect the .CB will be forced to act before it becomes a true 8ehman BrothersSt/pe meltdown :but no guarantee,;9

International .quities
Although international equit/ funds ha#e been touted b/ man/ brokerage firms o#er the past couple of /ears as a wa/ to di#ersif/ out of the 39+9 stock market0 the/ performed #er/ poorl/ last /ear9 Indian and Chinese markets were both down o#er 7@ percent9 5an/ .uropean markets were down from 1@ to 7@ percent9 *ou would ha#e been better off in 39+9 markets9 Could there be a rebound this /ear6 +ure0 especiall/ if the 39+9 market rebounds due to some -ed mone/ printing9 $owe#er0 Pust as we didn't like them before0 we still don't think international equities are worth the risk of a longerEterm hold9 1he issues we pre#iousl/ discussed regarding .urope and China will continue to weigh on the entire world econom/ and also on their stock markets this /ear9 Could there be shortEterm gains6 ?f course9 But0 o#erall0 we would continue to a#oid international equities as ha#ing too much risk and #olatilit/ for the potential gain9

&old

-irst0 let's be clear that we #iew gold as a longEterm in#estment9 %ith go#ernments around the world turning to mone/ printing in order to artificiall/ prop up struggling stock markets and banking s/stems0 the fundamentals in our econom/ are set up perfectl/ for a longEterm rise in gold9 %hen inflation goes up0 interest rates follow0 which will spell doom for stocks0 bonds0 and real estate9 At that point0 gold is the onl/ place to turn for man/ in#estors0 and it is likel/ to ha#e e)plosi#e growth9 According to some estimates0 gold comprises onl/ @91C percent of in#estable assets in the world9 8ess than a quarter percent is not much0 so an/ mo#ement out of stocks or bonds and into gold will ha#e a big effect on gold9 .#en in the past decade0 with #er/ low inflation0 gold has been an e)cellent in#estment0 quintupling in #alue o#er that span while the stock market performed poorl/ the +KP D@@ was flat0 and the (asdaq fell D@ percent9 But we like gold for its future ahead0 not for its past performance9 5an/ see gold's rise in the past decade as another bubble9 But as we see it0 the bubble has barel/ started9 %e won't sa/ how high we think it will go0 but it could easil/ increase se#eral times from where it is toda/ before this bubble pops9 +o wh/ has gold dropped so far since late 7@116 1here are plent/ of reasons wh/ gold can go down in the short term0 and we still e)pect some #olatilit/ between now and the dollar bubble burst9 %e'#e said before that there are signs of central bank manipulation0 and we'll likel/ see more of that in the /ears to come9 1he drop in gold price ma/ also ha#e a lot to do with the situation in .urope0 where liquidit/ problems increase demand for dollars and make it necessar/ for financial institutions to sell assets like gold9 1his is similar to what happened in 7@@H0 when the liquidit/ crisis sent the price of gold tumbling A@ percent in a matter of months9 1he important thing to remember is that gold has more than doubled since that low point of around RG@@Nounce9 .#en if /ou had bought gold at its peak before the 7@@H financial crisis0 /our in#estment would ha#e increased F@ percent b/ now9 B/ comparison0 the recent drop in the gold price0 percentageEwise0 was onl/ about half what it was in 7@@H0 and gold was still up about 1@ percent last /ear9 Among the factors dri#ing gold in 7@17 will be increased ph/sical demand in China0 continued bu/ing b/ peripheral central banks such as 1urke/0 <orea0 and others0 and continued financial uncertaint/9 %e see no reason wh/ the growth trend in 7@11 won't continue in 7@179 (ote on gold .1- P$*+: P$*+ doesn't alwa/s track the price of &840 the biggest gold .1-9 1he reason is that P$*+ t/picall/ trades at a premium to the price of gold :similar to gold bullion coins;9 In recent months0 the premium has ranged from 1 percent to F percent9 %hile the price of P$*+ is predicated on the price of gold0 it is also affected b/ the change in the premium9 As an e)ample0 if the price of gold was up 1 percent and the premium on P$*+ to gold was also up 1 percent from the prior da/0 P$*+ would be up 7 percent9 $ad the premium dropped 1 percent0 P$*+ would be unchanged9 +prott Asset 5anagement0 which manages P$*+0 does an e)cellent Pob putting this data on the following web site: www9sprottph/sicalgoldtrust9comN(etAsset2alue9asp) 9 $istorical data can also be found at the site9

+il#er and Commodities

In the long run0 we e)pect sil#er to track gold prett/ closel/0 meaning it will go up o#er time9 In the short run0 howe#er0 we e)pect sil#er to be more #olatile than gold9 1his is partl/ because sil#er is an industrial metal as well as a monetar/ metal9 ?#er half of sil#er's production each /ear is used for industrial purposes9 +il#er's longEterm rise will be tempered o#er the ne)t /ear b/ the declining demand for electronics0 particularl/ from China9 5ost commodities0 including sil#er0 are dependent on demand from China0 which in recent /ears has radicall/ increased its demand for food0 coal0 metals0 and other commodities9 1his doesn't bode well for the commodities market0 because there are signs the Chinese econom/ is slowing down dramaticall/9 It's difficult to be precise because the Chinese go#ernment has a tendenc/ to be less than truthful with its economic statistics9 +o don't e)pect economic readings from the Chinese go#ernment to indicate that9 5ost likel/0 Chinese go#ernment statistics will indicate perfect go#ernment management of a controlled slowing of economic growth from white hot to red hot9 %ould /ou e)pect an/thing less from a dictatorship and hea#il/ stateErun econom/6 ?f course0 man/ people on %all +treet will belie#e it because the/ want to belie#e it9 Also0 inaccurate inflation reporting0 as here in the 3nited +tates0 can make man/ economic numbers look better than the/ are9 But gi#en the dramatic slowdown of e)portEled economies like BraMil :whose growth has fallen to near 39+9 le#els;0 Canada0 Australia0 as well as Asian economies that are closel/ tied to China0 especiall/ $ong <ong :which is nearl/ in recession;0 it's #er/ unlikel/ that the Chinese econom/ is reall/ growing at nearl/ I percent as the go#ernment claims9 -alling Chinese demand will take a big toll on commodities o#er the ne)t few /ears0 so we would e)pect some downward pressure on commodities in 7@179 1he International .nerg/ Agenc/ Pust announced that it e)pects #er/ limited growth in oil demand this /ear due to the slowdown in the world econom/9 China is terribl/ important in commodities such as steel9 As an e)ample of that0 China now consumes more steel for its construction industr/ alone than the demand for steel for all uses in the 3nited +tates0 .urope0 and Bapan combined9 As further e#idence of its #oracious demand0 it uses almost half of the cement production in the world9 A big decline in Chinese construction demand would ha#e a big effect on commodities9 ?ffsetting this to some degree will be mone/ printing b/ the -ed0 which could cause a temporar/ upturn in commodities9 ?f course0 as inflation begins to get stronger0 commodities will push upward e#en with declining demand9 A (ote on ?il : 1he big #ariable with oil is Iran9 Political tensions ha#e been heating up between Iran and the %est latel/9 As this escalates0 it could lead Iran closer and closer to war9 If war with Iran does occur0 oil prices will sk/rocket9

1he 7@17 Presidential .lection

(o in#estment outlook written in midE7@17 would be complete without some mention of our upcoming presidential election9 ?f course0 b/ the time /ou read this book0 /ou will likel/ know much more than we do right now0 so we :once again; are going out on a prediction limb to tell /ou what we think will happen and wh/ in this case0 not about who will win in (o#ember0 but how whoe#er wins will likel/ impact the econom/ in the short term9 %hile man/ people will find this disappointing0 the truth is that the outcome of this election will likel/ ha#e #er/ little longEterm impact on the fate of the 39+9 econom/9 $owe#er0 there are a few shortEterm potential impacts worth mentioning9 Before we do0 we would like to remind /ou once again that we ha#e no political agenda in writing these booksJ we are simpl/ tr/ing to pro#ide /ou with the correct macroeconomic point of #iew so /ou can come to /our own logical conclusions about the direction of the econom/ and what /ou can do to protect /ourself9

If the "epublicans %in the %hite $ouse

If &o#ernor "omne/ becomes president0 he will likel/ tr/ to reduce the deficit b/ cutting spending9 $owe#er0 as he would soon disco#er0 that is a lot easier said than done9 %hat spending could "omne/ realisticall/ cut6 %ill he tr/ to cut +ocial +ecurit/6 (ot likel/9 %hat about cutting 5edicare6 (o one is going to like that too much9 $ow about trimming defense spending6 1hat's definitel/ out9 "omne/ will soon find that significantl/ cutting almost an/ go#ernment program will be politicall/ #er/ hard to do0 hard e#en for a "epublican Congress to go along with0 if the Congress also happens to become mostl/ "epublican9 Perhaps0 if Congress is mostl/ "epublican0 the/ will tr/ to cut some of the more 4emocratEfa#ored programs0 such as welfare9 But to get an/ real mileage out of Pust a few cuts0 the spending reductions would ha#e to be #er/ deep0 and the 4emocrats would surel/ fight that0 using the same filibuster rules that allowed the "epublicans to block so man/ 4emocratic initiati#es in the past four /ears9 ?f course0 if Congress remains mostl/ 4emocratic0 deep spending cuts will be e#en easier to block9 5eanwhile0 it is #er/ unlikel/ that an/ "epublican president will tr/ to increase re#enues to the go#ernment with an/ new ta)es9 Instead0 the mone/ printing and the borrowing will continue9 5one/ printing will continue because without it0 the stock market and o#erall econom/ will decline9 (obod/ wants that0 least of all in#estors and the business communit/0 who ma/ ha#e supported "omne/9 +o0 with continued mone/ printing0 continued borrowing0 few spending cuts0 and no new ta)es0 the longerEterm outcome of ha#ing a "epublican president0 e#en with a "epublican Congress0 won't be much different than the outcome of not ha#ing a "epublican win9 $owe#er0 in the shorter term0 man/ in#estors will likel/ feel more optimistic ha#ing a "epublican in the %hite $ouse0 and we could easil/ see the stock market doing well right after the election and continuing to do well for perhaps se#eral months0 assuming there is no bad news coming in from .urope0 Iran0 China0 or other negati#es that could end the "omne/ stock market hone/moon earl/9

If the 4emocrats %in the %hite $ouse

If President ?bama retains the %hite $ouse0 we can e)pect to see no big changes from toda/9 1he -ederal "eser#e will continue to print mone/0 the go#ernment will continue to roll o#er the debt with more borrowed mone/0 there will be no big spending cuts0 and probabl/ not much in the wa/ of new ta)es because0 the "epublicans will continue to block such attempts0 as the/ ha#e done before9 If ?bama keeps the presidenc/ but the "epublicans become the maPorit/ in Congress0 we can e)pect to see e#en less change0 and nothing much new will get done that either side would like9 1he budget deficit will remain about the same0 and our total debt will continue to grow9 If the 4emocrats keep the %hite $ouse0 in#estors will likel/ be less optimistic immediatel/ after the election than the/ would be if "omne/ gets in9 1he stock market could become more #olatile in the following months0 and that could lead to an earlier ne)t round of mone/ printing b/ the -ed than we might ha#e seen under "omne/0 but either wa/0 the -ed will print more it's onl/ a question of how soon9 As we said0 the 7@17 election will make little difference for the falling multibubble econom/ in the longer term9 (o matter what happens this (o#ember0 falling bubbles cannot be propped up fore#er9 2arious dela/ing tactics will be tried0 and some like massi#e mone/ printing will temporaril/0 marginall/ succeed in the short term9 But none will be able to ultimatel/ stop the coming multibubble pop and the Aftershock that will follow9

In Conclusion

?#erall0 7@17 should bring us short bouts of e)citement followed b/ long periods of relati#e boredom kind of like 7@119 .urope will likel/ pro#ide the biggest source of unwelcome financial e)citement9 China will pla/ an increasingl/ sinister background role0 slowing down the world econom/0 especiall/ toward the end of the /ear9 And American politics will likel/ pro#ide some more financial e)citement0 with Congress tr/ing to wrestle with the debt and our presidential election at the end of the /ear9 ?f course0 there is alwa/s the chance that the financial situation might get surprisingl/ bad this /ear9 %e don't think that will happen in 7@170 but we certainl/ can't entirel/ rule it out9 Also0 there is alwa/s the chance for a Black +wan e#ent0 Iran being an ob#ious e)ample9 %e'll be keeping our e/es wide open for an/ sign of a big surprise or for more incremental e#idence that we are mo#ing along toward the ine#itable Aftershock ahead9

+ta/ing Afloat in a +inking .conom/

It's one thing to read about the changing macro econom/J it's another to actuall/ do something about it9 5ost people will take no new actions until it's too late9 -or those who want to prepare for0 not Pust react to0 the coming Aftershock0 we offer the following ser#ices: *ou are welcome to #isit our website www9aftershockpublishing9com for more information as we approach the Aftershock9 %hile /ou are there0 /ou ma/ sign up for a twoE month free trial of our popular Aftershock In#estor's "esource Package :I"P;0 which includes our monthl/ newsletter0 li#e conference calls0 and more9 ?r /ou ma/ reach us at G@AEGHGE@1AI or infoYaftershockpublishing9com 9 %e also offer Pri#ate Consulting for indi#iduals0 businesses0 and groups9 Please contact coauthor Cind/ +pitMer at CCAEIH@EGAFG or tellmemoreYaftershockconsultants9com for more information9 1hrough our in#estment management firm0 Absolute In#estment 5anagement 0 we pro#ide handsEon0 AftershockEfocused asset management ser#ices on an indi#iduall/ managed account basis9 -or details0 please call G@AEGGCEAD7@ or eEmail absoluteYaftershockpublishing9com 9

C$AP1." A

Con#entional

%isdom %on't %ork 1his 1ime

I(1"?43CI(&

A-1."+$?C<

%I+4?5 I(2.+1I(&

-or /ears0 Con#entional %isdom :C%; mone/ gurus ha#e been telling us that bu/EandEhold in#esting is the wa/ to go9 All /ou ha#e to do to grow /ourself a nice nest egg is to get some highEqualit/ stocks and bonds in the right mi) to match /our age and goals0 and then like those infomercial o#ens on 120 /ou can =Pust set it and forget it9> 1he eas/ C% approach to in#esting naturall/ worked #er/ well in an o#erall rising multibubble econom/9 As long as /ou sta/ed well di#ersified with a collection of a#erage performing stocks and bonds0 /ou could count on earning a good profit in the stock market and a steadil/ rising total return in the bond market0 especiall/ from the 1IH@s to 7@@@9 %ith the 4ow rising 10@@@ percent in 7@ /ears and falling interest rates pushing bond prices e#er higher0 in#estors could practicall/ throw a dart at a stock page and end up with some good gains e#entuall/9 1hat's because C% in#esting in a rising bubble econom/ is nearl/ effortless9 1hen0 beginning in 7@@@0 all that started to change9 Bonds still did oka/0 but that 10@@@ percent growth in stocks got replaced b/ a big fat Mero percent growth for the 4ow and a D@ percent decline in (asdaq stocks o#er the ne)t decade9 (onetheless0 the C% gurus seemed unfaMed0 plowing ahead with their C% in#esting as if America's multibubble econom/ would alwa/s continue to rise9 1he/ didn't see the bubbles0 onl/ the growth9 And if that growth happened to occasionall/ e)perience a bit of a =down c/cle0> the/ could alwa/s Pust rela) and wait for an ine#itable =up c/cle0> 1hat's because the rising bubble econom/ had con#inced them that economic growth was #irtuall/ guaranteed if /ou Pust had patience and waited for a while9 C% has faith and C% doesn't quit9 +o when the real estate bubble started to pop in 7@@G and kicked off a global financial crisis in 7@@H0 along with a stock market drop of nearl/ C@ percent0 man/ C% in#estment e)perts were quite shocked and confused9 %ithout the correct macroeconomic #iew of what was occurring0 the/ held e#en more tightl/ to their faithful bu/EandEhold mantra9 C% in#esting had simpl/ not prepared them for moments like this9 1he/ used phrases like =Black +wan e#ent> and =highl/ unpredictable> to describe the 7@@H stock market crash and global economic downturn0 when in fact it was all #er/ predictable :and b/ the wa/0 was predicted in our book America's Bubble .conom/ in 7@@F;9 C%0 howe#er0 saw the entire global financial crisis as unpredictable and be/ond our control as if an une)pected asteroid suddenl/ hit us out of the blue in late 7@@H0 not something we s/stematicall/ created oursel#es o#er the course of decades9 1hen0 Pust when it looked like economic Armageddon0 the 39+9 -ederal "eser#e came to our rescue at least in the short term with massi#e mone/ printing beginning in earl/ 7@@I0 as well as massi#e federal go#ernment borrowing9 1he enormous e)pansion of the mone/ suppl/ directl/ boosted the stock market and helped support the o#erall econom/9 $owe#er0 it also left us with the specter of future rising inflation and rising interest rates dangling o#er C% in#esting like an unseen guillotine hanging b/ a thread9 +o now the question is what's ne)t6 +hould we stick with the C% folks0 like %arren Buffett and other pre#iousl/ highl/ successful in#estors0 or does this new and e#ol#ing econom/ call for a new and e#ol#ing approach6 $mmm0 can /ou tell which wa/ we are going with this6 Before we get to the details of our Aftershock wisdom on how to in#est in the new and changing econom/0 let's take a close look at C% in#esting and wh/ it's so #er/ hard for most people to gi#e it up9

1he <e/ to Con#entional %isdom: 1he -uture %ill Be Bust 8ike the Past

1he ke/ assumption behind all C% in#esting is prett/ simple: %hat worked well in the recent past will work well toda/9 It's eas/ to understand0 it's eas/ to follow0 and0 most of all0 it's #er/ comfortable9 And for a #er/ long time0 it was also #er/ true9 8et's look at some recent histor/ to see wh/ C% in#esting still has such powerful appeal9 ?#er the past centur/ or so0 the 39+9 stock market has e)perienced solid0 albeit slow :b/ the standards of the 1IH@s and 1II@s; growth9 .#en in the &reat 4epression a big economic collapse b/ an/ measure most maPor corporations sur#i#ed :man/ maPor corporations such as Caterpillar were e#en able to maintain profitabilit/;0 as did most maPor banking and in#estment banking firms9 1he go#ernment entered the 4epression with relati#el/ little debt and little inflation9 In fact0 the/ probabl/ printed too little mone/0 contributing to deflation during the &reat 4epression9 Also0 for the first half of the twentieth centur/0 the econom/ was much less capital dependent and0 hence0 much less #ulnerable to changes in interest rates9 8e#erage was less common for corporations and was certainl/ less common for consumers bu/ing homes or cars9 5ost of our grandparents would not ha#e e#en considered ha#ing more than a 1@E/ear mortgage on a home0 and the/ did not use credit to bu/ cars :e#en though that was becoming increasingl/ common;9 3se of debt had grown enormousl/ since the late 1H@@s0 but it was far less than toda/9 In addition0 there was much less consumer spending0 partl/ due to less credit for such acti#ities9 As an e)ample0 credit cards reall/ weren't in hea#/ use until the 1IG@s and especiall/ the 1IH@s9 1hus0 with less consumer spending0 the earlier econom/ was more resistant to downturns in consumer spending9 1he econom/ had also e)perienced onl/ a few maPor bubbles prior to the &reat 4epression9 1he 1I7@s stock bubble was the biggest0 but e#en that bubble was accompanied b/ huge real growth in the econom/9 "elati#el/ speaking0 it was a much smaller bubble than the combined stock0 housing0 pri#ate credit0 and consumer spending bubbles that rose up beginning in the 1IH@s9 1he inflation and flat stock market of the 1IG@s :due in large part to declining producti#it/ growth; was a harbinger of future problems0 but not enough to offset almost a centur/ of solid growth9 &ross domestic product :&4P; growth was still fairl/ good0 e#en in the 1IG@s9 .)cept for the period of the 4epression0 down c/cles were limited9 An/ down c/cles during the centur/ were relati#el/ modest and were far outweighed b/ the good to great up c/cles9 All of this enormous growth in the econom/ pro#ided a strong basis for solid0 but slow0 growth in the stock market0 which helped people like %arren Buffett and others do #er/ well :see -igure A91 ;9 -igure A91 +tocks #ersus +i) 5onth 1EBills and &old0 1IFD to 7@11 %hat R1@@ in#ested in 1IFD would be worth toda/9 +ource: Bloomberg9

1hen0 beginning in the 1IH@s0 all that slow and stead/ growth dri#en b/ real fundamental economic dri#ers was replaced b/ rapid growth dri#en b/ another kind of dri#er: rising bubbles9 As we re#iewed in Chapter 10 during this time we saw the rise of the 9 9 9 +tock market bubble "eal estate bubble Pri#ate debt bubble Consumer spending bubble &o#ernment debt bubble 4ollar bubble $owe#er0 since 7@@@0 these bubbles ha#e been stagnant and ha#e started to fall: 1he 4ow and the +tandard K Poor's :+KP; inde) ha#e been essentiall/ flat0 while the (asdaq fell D@ percent9 "eal estate has not reco#ered much since hitting bottom in 7@@H and 7@@I9 Pri#ate debt and consumer spending is still mostl/ down0 with onl/ marginal impro#ements9 5eanwhile0 gold :which0 later in the Aftershock0 will also become a bubble but is not there /et; is up more than D@@ percent since 7@@@9 $ow does C% account for the changes described abo#e6 1he/ sa/0 =4on't worr/0 be happ/9 Bust be patient and e#entuall/ e#er/thing will get better9> %hat in the world is gi#ing C% so much sustained confidence6 1he answer is 9 9 9

1he 5/th of a (atural &rowth "ate

Inherent in C% is the deep faith that the 39+9 econom/ possesses a reliable =natural> growth rate9 1his is somehow fundamental to our #er/ e)istence and will ne#er end9 $ence0 an/time we de#iate from that natural growth rate and go into a recession temporaril/0 we will also0 at some point0 usuall/ quickl/0 automaticall/ return to our natural growth rate9 1hat means that we can count on alwa/s ha#ing a rebound after e#er/ recession or0 more to the point0 after the recent financial crisis9 1his is also the fundamental basis for C%'s thinking about in#estments in stocks0 bonds0 and real estate9 C% sa/s the econom/ has a natural growth rate and0 hence0 stocks0 bonds0 and real estate all ha#e a natural growth rate0 too9 1hat is wh/ bu/EandEhold in#esting is at the heart of con#entional in#esting: Bust get in and hang on0 and e#entuall/ that natural growth rate will kick back in9 C% makes no acknowledgment that we could be in a bubble econom/ or that the world could be in a bubble econom/9 All bubbles e#entuall/ pop0 and the/ don't automaticall/ reinflate9 1here is no =natural> growth rate that we can alwa/s count on to pull us through9 +omething has to actuall/ cause a reco#er/J we don't Pust get one automaticall/ if we wait long enough0 like winter turning into spring9 1he 3nited +tates does not ha#e a natural growth rate that is in effect at all times and will alwa/s sa#e us9 In fact0 there ne#er has been a natural growth rate not for an/ countr/0 not in the past0 and not in the future9 1here is simpl/ no such thing as =natural> economic growth9 All economic growth has to be caused b/ somethingJ it doesn't Pust happen automaticall/9 1hat is wh/ not all countries e)perience economic growth all the time9 "eal :nonbubble; economic growth is dri#en b/ two forces: population growth and producti#it/ growth9 1hese two are related to some e)tent because higher agricultural producti#it/ will lead to a larger population9 $owe#er0 our focus should be on producti#it/ since we are primaril/ interested in becoming wealthier per person0 not Pust ha#ing a larger econom/ with lots and lots of poor people9 +o0 producti#it/ growth is the source of economic growth9 $ence0 economies will grow onl/ when producti#it/ grows9 An automatic increase in producti#it/ is not natural or automatic9 It has to come from changes in the wa/ we produce goods and ser#ices9 1his in#ol#es changes in the wa/ we do business0 and that often in#ol#es changes in go#ernment and changes in technolog/9 China is a great e)ample9 %hat was China's =natural> growth rate in the 1IF@s6 %hat was its =natural> growth rate in the 1II@s6 %e all know China's growth rate was much higher in the 1II@s than in the 1IF@s9 $ence0 there is no =natural> growth rate for China :or for an/ other countr/;9 It #aries quite a bit actuall/ depending on go#ernmental and business actions9 &rowth was higher in the 1II@s for China because the/ had made numerous important changes in the wa/ the/ conducted business and in the wa/ their go#ernment worked9 .ntrepreneurship was encouraged0 free markets were encouraged0 and more input from foreign in#estors and businesses was encouraged9 +o0 if China0 or an/ other countr/0 wants its econom/ to grow0 it will ha#e to continue to increase producti#it/9 *es0 some of that producti#it/ will continue to impro#e due to changes made in the past0 but e#entuall/ the impact of those past impro#ements will diminish and economic growth will plateau if people don't continue to make more impro#ements in producti#it/9 1his ma/ sound a lot like us telling /ou =there's no free lunch0> and that's true9 But it has enormous importance for how man/ economists are looking at the econom/9 5an/ economists are assuming that an/ downturn in our econom/ is simpl/ a di#ersion from our =natural> growth rate9 In fact0 /ou will e#en see that term used in man/ financial and economic articles9 (obod/ asks the most basic question: %here is that growth coming from6 Instead0 the/ simpl/ assume it is alwa/s there and that our econom/ will naturall/ bounce back into growth mode9 1he/ are assuming that producti#it/ is naturall/ growing all the time0 e#en when economic histor/ clearl/ shows it is not and that there is no =natural> or automatic growth rate9

"eal Producti#it/ &rowth Is +lowing 4own0 $ere and Around the %orld

"ather than sta/ing the same or accelerating0 producti#it/ growth in this countr/ and in the other maPor industrialiMed nations in .urope and in Bapan has been slowing dramaticall/9 Producti#it/ growth in the last quarter of the twentieth centur/ was much slower than in the first three quarters9 1hese are long periods of time9 1hat's how real producti#it/ impro#ement works9 It is a #er/ longEterm process9 B/ the wa/0 /ou should almost completel/ ignore the go#ernment =producti#it/> statistics or =output per manEhour9> (ot that the/ are biased or wrong0 but the/ don't gi#e /ou a true idea of real producti#it/ growth9 -or e)ample0 producti#it/ b/ that measure can be impro#ed enormousl/ b/ simpl/ stopping all research and de#elopment9 1hat is a dumb measure of producti#it/9 +o0 instead of looking at misleading go#ernment figures of output per manEhour :although not intentionall/ misleading as much as Pust bad information;0 let's look at real producti#it/ growth o#er a #er/ long period of time9 1hat's the onl/ wa/ to look at it0 since significant producti#it/ growth is a relati#el/ slow process9 -or e)ample0 when we look at the producti#it/ growth of food production in the 3nited +tates o#er the longer term0 we see that two centuries of ad#ancements ha#e made it possible for the number of people required to grow food to drop from I@ percent of the 39+9 population to Pust A percent9 (ow that's real producti#it/ growth, Across man/ sectors0 we had that kind of robust producti#it/ growth in the 3nited +tates for man/ decades9 $owe#er0 beginning in the 1IG@s :Pust before the bubbles started to inflate in the 1IH@s;0 o#erall producti#it/ growth began to slow significantl/ :see -igure A97 ;9 -igure A97 +lowing Producti#it/ &rowth :3sing 1otal -actor Producti#it/; Producti#it/ growth was #er/ rapid until the earl/ 1IG@s and then grew #er/ slowl/ afterward9 +ource: Bohn -ernald0 +an -rancisco -ederal "eser#e9

$ere is another wa/ to look at producti#it/9 3nder normal conditions0 income generall/ goes up when producti#it/ goes up9 As -igure A9A shows0 real income growth :=real> because it is adPusted for inflation; has slowed dramaticall/ since 1IG@9 1he lack of large increases in real income is another indicator that producti#it/ has not significantl/ grown since the 1IG@s9 -igure A9A "eal 5edian -amil/ Income 1ID@S7@@I +lowing growth in real famil/ income after 1IG@ is another indicator of slowing producti#it/ growth9 +ource: 39+9 Census Bureau9

B/ focusing on the big picture of producti#it/ which is the real fundamental dri#er of economic growth it is eas/ to see that the C% idea that we are merel/ in a market =down c/cle> that will soon be followed b/ an =up c/cle> is wrong9 1his is not a shortEterm down c/cleJ it is a longerEterm producti#it/ slump and the more bearish anal/sts ha#e it right when the/ sa/ we are not going to get out of this

economic downturn an/time soon9 But e#en the bears are wrong0 too9 1he/ are correct to see doom and gloom ahead0 but the/ don't see what is behind the doom and gloom0 onl/ that things are bad and will get worse9 $a#ing the correct macroeconomic #iew about stalled producti#it/ growth is what separates the brains from the bears0 and from C%0 as well9

%arren Buffett: 5aster of Con#entional %isdom

%ithout a doubt one of the best0 if not the best0 C% in#estors is %arren Buffett9 $e is trul/ a C% master and his incredible success attests to that9 If /ou in#ested R10@@@ in his in#estment firm0 Berkshire $athawa/0 in 1II@ it would be worth almost RA@0@@@ b/ the beginning of 7@@@9 1hat's prett/ impressi#e9 $owe#er0 after the beginning of 7@@@0 his growth slowed considerabl/9 Assuming /ou in#ested at the beginning of 7@@@0 before the Internet bubble burst0 a R10@@@ in#estment would grow to about R70A@@ at its peak in 7@@G Pust before the housing bubble burst9 1hat's still #er/ good growth but nothing like the earlier growth of the booming 1IH@s and 1II@s stock market9 And0 if /ou in#ested that R10@@@ at Berkshire's peak in 7@@G it would be worth about RI@@ toda/ :see -igure A9C ;9 -igure A9C

Berkshire $athawa/ Performance0 1IHG to Present 1he price of Berkshire's stock :%arren Buffett's firm; did e)tremel/ well in the 1IH@s and 1II@s0 and #er/ well until the financial crisis of 7@@H0 but has struggled since then9

+ome people would sa/ %arren has lost his touch9 %e don't think so9 %e think he Pust lost his bubbles9 %arren is still an e)cellent in#estor0 but he tends to do #er/ well during stock market bubbles and not so #er/ well when there is no bubble9 +o0 is it an/ wonder that %arren doesn't want to belie#e we are in a bubble econom/6 Is it an/ wonder that he so fer#entl/ pushes stocks as a good in#estment6 "emember -igure A91 at the beginning of this chapter that showed how well stocks had performed relati#e to gold and 1Ebills6 $e needs to push stocks because he desperatel/ needs a bubble econom/ and a bubble stock market in order to show good growth9 (ow0 of course0 he doesn't sa/ that0 but clearl/ that is true9 And if the stock bubble were to continue to rise0 /ou couldn't make a better choice than putting /our mone/ with %arren Buffett9 But if the stock bubble does not continue to rise or if it pops0 then /ou could be in real trouble betting on %arren9 *ou could e#en end up like those who in#ested in another master of con#entional wisdom in#esting0 Bill 5iller :see the sidebar that follows;9 Buffett's reliance on C% is alread/ showing problems because the stock market bubble is no longer rising9 As

-igure A9D shows0 stocks don't look nearl/ as good now0 while gold looks fantastic9 5r9 Buffett would sa/ this is simpl/ a di#ersion from the longerEterm pattern9 %e sa/ the pattern is changing for all the reasons we discussed earlier in this chapter and in our pre#ious books9 -igure A9D +tocks #ersus +i) 5onth 1EBills and &old0 7@@@ to 7@11 %hat R1@@ in#ested in 7@@@ would be worth toda/9 +ource: Bloomberg

Another C% 5aster: Bill 5iller

Bill 5iller wasn't as good as %arren at con#entional wisdom in#esting0 but he was still prett/ darn good9 $is mutual fund0 8egg 5ason Capital 5anagement 2alue -und0 beat the +KP D@@ inde) for 1F /ears in a row9 $owe#er0 with the fall in the stock market in 7@@G things began to change9 Bill saw housingErelated companies falling fast Companies like -annie 5ae and -reddie 5ac9 $e didn't see an/ fundamental problems9 $e Pust saw lots of bargains0 especiall/ in a longEterm growing 39+9 housing market9 $e was a longEterm #alue in#estor like %arren Buffett in some wa/s9 $e saw other stocks that had fallen and he snapped them up because it was Pust a down c/cle in a longEterm growth c/cle9 $e knew he was doing what an/ smart in#estor should do bu/ when e#er/one else runs awa/ because that's when the mone/ is made9 In C% in#esting0 that's e)actl/ how /ou make mone/9 1his kind of C% in#esting produced handsome returns for his mutual fund9 At its peak0 his fund had o#er R71 billion of assets under management9 3nfortunatel/0 housing wasn't in a short down c/cle but in a longerEterm bubble burst9 $is performance collapsed9 B/ 7@110 he had lost mone/ in four of the last fi#e /ears9 -ortunatel/0 he was sa#ed from e#en worse losses b/ the -ed's massi#e mone/ printing with quantitati#e easing :!.1 and !.7;9 +till0 it was all too much for 5r9 5iller9 $e left the fund in 7@119 As of Bune 7@170 total assets under management were down to R19H billion and R1@0@@@ in#ested in 1IIF was worth about RH0A@@9 1he fund had lost e#er/thing it had made in o#er 1D /ears9 %hen the bubbles start to pop0 C% in#esting is not the place to be9

Another .)ample of Con#entional %isdom Put to the 1est: $edge -unds

1he people managing hedge funds are some of the best in#estors in the business9 1hat's the Con#entional %isdom0 and this time we agree with con#entional wisdom9 +o0 if C% is working0 the/ would be some of the best practitioners of C% and would ha#e some of the best returns to show for their C% in#esting9 +o0 let's look at hedge fund returns9 -ortunatel/0 another Bohn %ile/ K +ons author0 +imon 8ack0 recentl/ published a book about hedge funds called 1he $edge -und 5irage :7@17; that re#iewed the actual performance of hedge funds9 Before we go on0 we should clarif/ that not all hedge funds use con#entional wisdom9 5an/ are trul/ hedge funds and use a #ariet/ of nonEC% strategies to get high returns9 $owe#er0 most hedge funds are surprisingl/ unhedged and #er/ con#entional9 1he/ are essentiall/ le#eraged stock funds9 *ou can see this clearl/ b/ looking at the correlation between stock market returns and hedge funds in -igure A9F 9 As the chart shows0 the/ reall/ do make a good case stud/ of the best in C% in#esting9 -igure A9F Increasing Correlation of $edge -und "eturns and the +tock 5arket +ince 7@@C0 hedge fund returns are becoming increasingl/ correlated with the stock market9 +ource: Bloomberg9

+o0 what did +imon 8ack find in his research on hedge funds6 Basicall/0 what he found is that hedge funds did #er/ well when the/ were first created in the earl/ 1II@s9 1he/ were smaller0 which made it easier to find a good niche from which to e)tract higher profits9 As the/ got bigger much bigger it became harder to find more or larger niches to properl/ in#est their funds9 And there was more opportunit/ when the stock bubble was Pust starting9 Also0 like an/ industr/0 the/ ma/ ha#e been a bit more creati#e when the/ were first starting the/ had to be to attract capital to a t/pe of in#esting that was not well accepted9 +o returns fell o#er time9 $owe#er0 fees did not9 1hat wasn't a big issue until the stock market collapsed in 7@@H9 At that point0 hedge funds lost an enormous amount of mone/9 1he/ weren't reall/ hedged at all9 ?r at least a large number of them weren't9 8et's keep in mind we're looking at an entire industr/9 1here alwa/s ha#e been outstanding performers and likel/ will be in the future9 But0 as an industr/0 it wasn't looking #er/ good in 7@@H9

5r9 8ack found that0 after deducting fees0 hedge funds had lost almost all of the profits that the industr/ had e#er made for in#estors in the stock market crash of 7@@HS7@@I9 1hat's right0 o#er 1D /ears of profits lost in less than F months0 as shown in 1able A9G 9 Please note that this table does not take into account =sur#i#al bias> :when companies go under; and other reasons wh/ these numbers are actuall/ more conser#ati#e than realit/9 In other words0 it was e#en worse than this9
1able A91 $edge -und "eturns after -ees

+o much for the best of C% in#esting9 1he/ had bet hea#il/ on a rising stock market and had lost e#er/thing the/ had e#er made in the few short months when the market took a big fall9 And these people are the best in the business9 1he bottom line is that it's increasingl/ tough to make mone/ with C% in#esting9 1his short summar/ of 5r9 8ack's groundbreaking work does it little Pustice9 It's a great book0 whether /ou ha#e an/ interest in hedge funds or not9 It's an honest and fascinating look at how the best American

in#estors operate9 Pick up a cop/ toda/ and hats off to another great Bohn %ile/ K +ons author9

1he <e/ to Aftershock %isdom In#esting: 1he -uture Is (ot the Past,

1he ke/ to correct in#esting in the future is to recogniMe that the future will be significantl/ different from the past9 Con#entional %isdom sa/s that nothing is fundamentall/ different about the econom/J we are Pust going through a rough spot9 If we can Pust be patient and don't do an/thing rash with our in#estments0 we can count on =natural growth> to e#entuall/ return and all will be oka/9 %hereas0 Aftershock wisdom sa/s that there is no =natural growth0> onl/ real growth created b/ real producti#it/ impro#ements9 %e ha#e not had an/ significant real producti#it/ impro#ements for man/ /ears9 Instead0 we had the rise and now the decline of multiple bubbles0 and therefore the future is not the past0 we are in a #er/ different econom/ than before9 In fact0 the entire world is in a #er/ different econom/ than before because we are in a worldwide bubble econom/ that is popping9 1his is different from the past9 %e ha#e seen bubbles before0 such as the Internet bubble0 and its demise reall/ wasn't such a big deal0 especiall/ on a global le#el9 But it is different this time9 1his time we ha#e not one smallish bubble0 but si)0 huge0 interdependent bubbles0 and when the/ fall full/0 it is not going to be an/thing we ha#e seen before in#ol#ing rising inflation0 rising interest rates0 and falling assets across the board9 %e ha#e also had inflation before0 such as in the late 1IG@s and earl/ 1IH@s0 but it is different this time9 1his time0 because we ha#e so man/ colinked bubbles0 high inflation and high interest rates are going to be the final blow to our multibubble econom/ and to the world's bubble econom/0 as well9

If the -uture Is (ot the Past0 $ow %ill It Be 4ifferent 1his 1ime6 -uture Inflation Is the <e/

?ur earlier books0 America's Bubble .conom/ :7@@F; and Aftershock :7@@I and 7@11;0 described in detail what created the multibubble econom/0 and how the final two bubbles the dollar and go#ernment debt bubbles will be the ne)t to pop0 bringing on the Aftershock9 $ere is a quick summar/: +ince the earl/ 1IH@s0 we ha#e been borrowing more and more mone/ :pumping up the go#ernment debt bubble;9 ?ne of the ke/ factors that made so much borrowing possible0 especiall/ in the past few /ears0 has been the abilit/ of the -ederal "eser#e to do massi#e mone/ printing :pumping up the dollar bubble;9 1his massi#e mone/ printing worked to keep interest rates low and has allowed the go#ernment to borrow astronomical amounts to fund its deficit spending9 In the /ears since the financial crisis of 7@@H0 both the dollar and go#ernment debt bubbles ha#e grown bigger than e#er0 in an effort to keep the rest of the multibubble econom/ afloat9 All that was0 and still is0 oka/ as long as the massi#e mone/ printing can continue9 But here is the problem: massi#e mone/ printing cannot continue fore#er9 %h/6 Because massi#e mone/ printing e#entuall/ causes rising inflation9 "ising inflation e#entuall/ causes rising interest rates0 and rising interest rates are not going to be good for maintaining this fake0 stimulusEcreated =reco#er/9> Instead0 rising inflation and rising interest rates are going to be the final blows that pop the bubbles9 1he dollar bubble will pop as a result of inflation spiking up0 reducing the bu/ing power of the dollar9 1here is no permanent wa/ around this coming inflation0 onl/ shortEterm dela/ing tactics9 If somehow massi#e mone/ printing would ne#er0 e#er cause rising future inflation0 that would be great in that case0 we could forget about pa/ing ta)es or e#en earning mone/ because we could all Pust print mone/ instead9 Clearl/0 that won't work9 $igh inflation and high interest rates will make dollarEdenominated assets not so appealing0 especiall/ to foreign in#estors0 who currentl/ own more than R7@ trillion in 39+9 assets9 %hen inflation comes0 foreign in#estment will fall0 and the dollar bubble will fall9 An/one who deludes himself into thinking foreign in#estors will sta/ in the 3nited +tates because the/ =ha#e nowhere else to go> is Pust being sill/9 ?f course the/ will ha#e other places to go9 1he/ will go back to their own countries' assets0 such as their own shortE term debt0 which will be falling as well0 but will not be falling as much as our dollarEdenominated assets9 .#en toda/ most mone/ sta/s in other countries9 It doesn't all come to the 3nited +tates9 1he decline in foreign in#estment in the 3nited +tates would not ha#e as much of an impact if there hadn't been so much inflow of foreign capital into our econom/ earlier9 ?n the wa/ in0 that e)tra mone/ helped pump up our bubbles0 and on the wa/ out0 the drop in foreign in#estment will help pop the bubbles as well9 1he combination of rising inflation and rising interest rates will pop the huge dollar and go#ernment debt bubbles0 and will pull down what is left of the alread/ falling real estate0 stock0 pri#ate debt0 and consumer spending bubbles9 %ith all our bubbles full/ popped0 the global Aftershock will begin9 .#en if that is not something /ou can currentl/ let /ourself belie#e is possible0 /ou must at least admit that rising inflation and rising interest rates will certainl/ not be good for an/ economic reco#er/9 And once /ou let /ourself see the bubbles0 /ou will realiMe that0 under these conditions0 these bubbles cannot last9 -rankl/0 e#en without rising future inflation and rising interest rates0 these bubbles cannot last9 %h/6 Because the/ are bubbles, Bubbles don't last fore#er9 %hat goes up must e#entuall/ come down because their rise was not dri#en b/ real producti#it/ growth and other fundamental economic dri#ers9 It was dri#en b/ speculation and a whole lot of borrowed and printed mone/9 4espite these facts0 C% will tr/ to den/0 ignore0 and happ/Etalk our wa/ through an increasingl/ ob#ious falling bubble econom/9 But ask /ourself this: $ow man/ C%Et/pe anal/sts and economists predicted or anticipated our current economic situation6 1his is how C% tries to ignore the change9 But0 of course0 that doesn't stop the realit/ of the current and future econom/9

1his enormous resistance b/ so man/ sophisticated economists and financial anal/sts to changing their C% economic outlook0 e#en in the face of o#erwhelming e#idence0 is highl/ unusual in 39+9 histor/9 Although there has certainl/ been cheerleading in the past and blatant ignoring of realit/ b/ economists and financial anal/sts0 this current period stands out as an e)treme le#el of resistance to facing facts9 C% has become blind as a bat0 while insisting its e/es are wide open9 <e/ to the C% position that nothing too bad will happen ne)t is their belief that inflation poses no threat9 +ome C% anal/sts :and e#en some bears; ha#e gone so far as to sa/ that future deflation0 not inflation0 is the real problem9

1he 5/th of 4eflation Is the 8ast "efuge of the 4eniers

2ital to the C% argument against our anal/sis is the wrong idea that instead of inflation0 we are about to enter into a period of deflation9 1he idea that deflation is the real threat0 not inflation0 is the last refuge of the deniers9 1he/ want to den/ that printing mone/ is a problem9 1he/ want to be able to print all the mone/ we need without an/ consequences0 without inflation9 +o0 instead0 the/ sa/ the/ are worried about deflation9 8et's start with a definition of inflation and then dissect the deflation arguments one at a time9 As (obel PriMeSwinning economist 5ilton -riedman famousl/ stated:

=Inflation is alwa/s and e#er/where a monetar/ phenomenon9> B/ using the word monetar/0 -riedman meant that inflation is a direct result of increasing the mone/ suppl/9 Increase the mone/ suppl/0 relati#e to the siMe of the econom/0 and /ou get inflationJ decrease the mone/ suppl/ and /ou get deflation9

%rong 4eflation Argument T1: Prices Are -alling

A lot of people think that falling prices equals deflation9 1hat is not true9 Prices can fall when there is a change in suppl/ and demand: falling demand andNor rising suppl/ naturall/ reduces prices9 1hat is not deflation9 4eflation is caused b/ a contracting mone/ suppl/ and inflation is caused b/ e)panding the mone/ suppl/ faster than the econom/ grows9 %e ha#e a massi#el/ e)panding mone/ suppl/0 and we are going to get significant future inflation0 not deflation9 5aking matters more confusing0 there is a difference between a change in the =nominal> price0 which is the price paid0 and a change in the =real> price0 which is the price adPusted for inflation9 1he nominal price can rise due to inflation0 while the real price can fall due to falling demand or rising suppl/9 1he fact that some asset #alues :in real dollars0 adPusted for inflation; will fall due to popping bubbles does not mean we ha#e deflation9 %hat we ha#e is falling bubbles9

%rong 4eflation Argument T7: 4emographics Are Changing

Another argument we'#e heard for deflation is based on demographics9 +ome ha#e said that as the Bab/ Boom generation reaches retirement0 more people will be sa#ing what mone/ the/ ha#e0 which will make dollars scarcer and therefore more #aluable9 1he problem with this is that0 in the twent/Efirst centur/0 when people sa#e their mone/0 the/ don't put it under their mattresses9 1he/ in#est it9 It circulates in the econom/ Pust like it alwa/s has9 .#en if there were some truth to this idea0 there's no wa/ that a little e)tra penn/ pinching b/ the Bab/ Boomers could offset the massi#e mone/ printing b/ the -ed that we'#e seen so far and will continue to see9 Also0 remember that we ha#e had no periods of deflation in the 3nited +tates since the end of the &reat 4epression when the go#ernment began to print more mone/9 Inflation helped pull us out of the 4epression9 %e simpl/ cannot ha#e significant deflation now or in the future when we are massi#el/ printing mone/9

%rong 4eflation Argument TA: 4ebt %riteE?ffs and Bankruptcies "educe the 5one/ +uppl/

Another common argument for deflation is that when debts cannot be repaid0 the resulting writeEoffs and bankruptcies will effecti#el/ decrease the mone/ suppl/9 1his argument seems to come from the fact that mone/ is created as debt9 But the argument goes one step too far in assuming that when debt is destro/ed0 that reduces the mone/ suppl/9 A simple thought e)periment will show wh/ this is untrue: If /ou lend me mone/ and I can't repa/ /ou0 the debt ma/ be wiped out0 but the mone/ went where#er I spent it9 It's still in circulation9 4estro/ing the debt does not destro/ the mone/9

%rong 4eflation Argument TC: A#ailable Credit Is 4eclining

A similar argument is that0 when we talk about the increase in the mone/ suppl/0 we're not considering that credit effecti#el/ functions as mone/9 +o if the amount of credit goes down in a struggling econom/0 the mone/ suppl/ is effecti#el/ decreased0 too9 But decreasing credit doesn't cancel out an/ mone/ alread/ in the s/stem it Pust slows the rate of new mone/ being introduced in the econom/0 which doesn't matter much if the econom/ has alread/ been flooded with mone/9 %hene#er a purchase is made using credit :sa/0 when /ou bu/ a 12 with /our credit card;0 sooner or later it ends up in a bank account somewhere9 ?nce it's in a deposit account0 it makes no difference where it came from9 It's in the econom/ for good9

%rong 4eflation Argument TD: 1he -ed Can &et "id of the .)tra Printed 5one/ before +erious Inflation <icks In

1here are two reasons wh/ this will not happen9 1he first problem with this solution is that the econom/ is showing no signs of growing under its own steam9 :"emember0 there is no =natural> growth rateJ the bubbles ha#e been the growth engine0 and without the bubbles0 not much growth happens;9 Pulling mone/ out of a noEgrowth econom/ would Pust make the recession far worse not better0 so that won't work9 1he second problem is that e#en if the econom/ did reco#er somehow0 not onl/ would a contraction of the mone/ suppl/ PeopardiMe those gains0 but the onl/ wa/ the -ed can pull that mone/ out of the econom/ is b/ selling R1 to R7 trillion worth of go#ernment bonds9 (ot e)actl/ a winning scenario in an alread/ precarious public debt situation9 If the/ tried to do this b/ selling the bonds0 interest rates would rise9 $igher interest rates would ha#e a negati#e impact on stocks0 bonds0 real estate0 and other assets0 which would hurt the econom/9 +o the -ed won't pull the mone/ out to spare us inflation later9

%h/ %e 8ook at the 5onetar/ Base Instead of 5 1 and 5 7

%hen we talk about how mone/ printing b/ the -ederal "eser#e is increasing the 39+9 mone/ suppl/0 we are talking about the 39+9 monetar/ base0 not 51 or 579 1hat is because 51 and 57 are both impacted b/ market beha#ior0 while the monetar/ base is not9 1he monetar/ base is the -ederal "eser#e's balance sheet9 It includes the go#ernment's mone/ holdings plus those of a few big banks9 51 is all currenc/ and demand deposits9 57 is currenc/0 demand deposits0 and sa#ings deposits9 Because it is possible to ha#e a rise in the monetar/ base while also ha#ing a decline in 51 or 57 due to other factors0 such as market beha#ior0 the siMe and growth of the monetar/ base is a more accurate predictor of potential future inflation9

(ot ?nl/ %ill 1here Be (o Contraction of the 5one/ +uppl/0 %e -oresee a 8ot 5ore 5one/ Printing Ahead

As the econom/ continues to struggle and markets fall0 the -ed will do e#en more mone/ printing0 and this will result in e#en more inflation than an/one would e)pect9 1he -ed will do e#en more mone/ printing in the future in order to co#er the costs of 9 9 9 5arket stabiliMation9 8ike the first rounds of quantitati#e easing that began in 7@@I0 the ne)t rounds will largel/ come from a need to prop up declining markets and a fragile banking s/stem9 +tabiliMing foreign currenc/ markets9 1he -ed can prop up the market and banking s/stem onl/ to a limited degree0 especiall/ as this goes on for a longer period of time9 -oreign in#estors will still get ner#ous9 $ence0 the -ed will also need to print mone/ to support the dollar in the foreign e)change markets9 &o#ernment spending deficit9 8ong term0 once the Aftershock hits0 the -ed will ha#e a #er/ hea#/ burden of financing the go#ernment9 %e alread/ fund about C@ percent of our spending with debt0 and it will be much higher when the Aftershock occurs9 1he mone/ to bu/ this debt will increasingl/ come from the -ed9

<eep in mind that this represents onl/ the base mone/ introduced b/ the -ed9 An/ loans created from these reser#es will ha#e a multiplier effect on that figure9 +o while we will not ha#e inflation on the le#el of Qimbabwe or the %eimar "epublic0 we will certainl/ ha#e #er/ high inflation0 and it will certainl/ ha#e a #er/ big impact on the future econom/9

1his 4ebate Is "eall/ (ot About Inflation or 4eflation0 It's About Protecting the +tatus !uo with 4enial

Because inflation will trul/ de#astate the stock0 bond0 and real estate markets0 people want to sa/ it won't happen9 If /ou own a stock0 such as Bank of America0 /ou desperatel/ want to belie#e the problem is deflation0 not inflationJ otherwise0 /our in#estment is about to be wiped off the planet9 -or that reason0 a lot of people want to belie#e we will ha#e deflation0 not inflation9 5a/be /ou belie#e it0 too9 If so0 ask /ourself this: If the -ed's bu/ing massi#e amounts of go#ernment bonds with printed mone/ doesn't create inflation0 wh/ don't we do more of it6 5ost economists agree that if we eliminated all ta)es tomorrow0 including corporate and +ocial +ecurit/ ta)es0 while maintaining all federal go#ernment spending0 that we would boost the econom/ right out of the current slump and into a period of enormous growth9 All we ha#e to do is borrow that mone/ instead of ta)ing it9 $ow do we borrow it6 B/ selling bonds to the -ederal "eser#e9 1hat's e)actl/ what we did in the past with !.1 and !.79 %ith the -ed bu/ing the bonds0 it won't stress the bond markets9 1he/ Pust bu/ whate#er it takes to fund the go#ernment each /ear9 (o more9 (o less9 +ince the deflationists strongl/ assert that massi#e -ederal "eser#e purchases of go#ernment bonds :as the/ ha#e done in the past few /ears with !.1 and !.7; won't create inflation0 then what's the downside6 %e can Pust print all the mone/ we want0 whene#er we want9 %e can quit pa/ing ta)es9 In fact0 wh/ should an/one work at all6 %e can all Pust print mone/ whene#er we need it0 Pust like the go#ernment9 (o ta)es and lots of shopping would be a great boost to the econom/0 right6 But we all know in our gut that this is a fraud9 %e instincti#el/ know that endless mone/ printing is impossible and would e#entuall/ create problems9 1here reall/ is no such thing as mone/ from hea#en0 and ha#ing the -ed bu/ our go#ernment bonds with printed mone/ is not mone/ from hea#en9 It is the fuel for inflation9 Inflation doesn't start immediatel/0 but that doesn't mean it doesn't happen9 Inflation doesn't start at a high le#el0 but that doesn't mean it won't get higher later9 1hat's where we are toda/ we are far enough along that inflation has started0 but it has not gotten to a high le#el /et9 Ask an/bod/ who's li#ed through an inflationar/ en#ironment0 and the/ will tell /ou that low inflation now is no protection from higher inflation later9 8ow inflation is simpl/ the beginning of high inflation when /ou are printing massi#e amounts of mone/9 8et's also be clear that we ha#e not had deflation in an/ wa/ since the financial crisis9 %e ha#e ne#er had a negati#e Consumer Price Inde) :CPI;0 which would be a good indicator of deflation9 %e ha#e alwa/s had a positi#e CPI9 And most honest obser#ers would sa/ that the CPI significantl/ underestimates the true rate of inflation most consumers are facing9 1he current denial of future inflation reminds us of the denial about the real estate bubble before it popped9 In 7@@A0 people belie#ed that housing prices would keep going up at 1@ percent per /ear for at least another decade0 ma/be longer9 1he/ were wrong0 terribl/ wrong0 but the/ admitted that onl/ after the bubble popped9 3ntil then0 it was all perfectl/ reasonable and risk free0 Pust like the/ sa/ all this mone/ printing is now9 ?ne of the proponents of belie#ing that real estate was not in a bubble was then -ederal "eser#e chairman Alan &reenspan :who famousl/ said we had =Pust a bit of froth on the coasts>;9 Come to think of it0 one of the proponents of the thinking that mone/ printing won't cause future inflation is the current -ederal "eser#e chairman0 Ben Bernanke9 It seems that den/ing economic realit/ is one of the ke/ Pob requirements for a -ederal "eser#e chairman9 But den/ing realit/ won't change realit/ as much as Alan or Ben or man/ others would like to think9 It helps people to Pustif/ bad in#estments0 but it doesn't turn those bad in#estments into good in#estments9 As much fun as it is in the short term0 denial is not realit/9

(e#er has been and ne#er will be9

%h/ 4on't 5ore People +ee 1his6

Because the/ ha#e so much to lose9 1he bubbles ha#e brought us the greatest flow of eas/ mone/ in our histor/9 1here is nothing better than eas/ mone/ it is much more fun than hard mone/J it's absolutel/ into)icating9 1he Internet bubble was a great e)ample of how people can den/ realit/ when there is so much eas/ mone/ to be had9 .#en the most sophisticated in#estors #enture capitalists and in#estment bankers fell #ictim to the siren song of eas/ mone/9 .#en toda/0 how good is it when /ou can sell a firm0 onl/ a few /ears after starting it0 and with no re#enues and no profits0 for R1 billion0 as was the case when Instagram was sold to -acebook in 5arch 7@179 1hat's prett/ good9 Bohn 49 "ockefeller ma/ ha#e made a lot of mone/0 but he ne#er made so much mone/ so fast as did Instagram9 "eal estate has had similar tales9 +easide cottages purchased for R1@0@@@ a few decades ago are now worth o#er R1 million9 +an -rancisco0 Boston0 and (ew *ork ha#e probabl/ benefited the most from the combined real estate and stock bubbles9 But there are lots of incredible tales of fast0 big wealth in 8os Angeles0 8as 2egas0 Phoeni)0 and -lorida9 1he bubbles ha#e been #er/0 #er/ good to us9 .#en if /ou weren't luck/ enough to get a huge windfall and become a millionaire or billionaire from stocks or real estate0 man/ people also benefited from businesses that prospered along with this enormous e)plosion of fast0 enormous wealth9 5an/ of those people worked hard for their mone/0 but the/ made a whole lot more mone/ because of the bubbles than the/ would ha#e otherwise9 1here was a lot of eas/Emone/ icing on top of the hardE mone/ cake9 And finall/0 man/0 man/ more participated in the general increase of eas/ mone/ in the form of a dartboard stock market that increased more than 10@@@ percent no matter where /ou threw the darts at the stock page0 or housing that doubled or tripled in #alue with little or no impro#ements9 It is good0 #er/ good9 Admit it eas/ mone/ is a lot of fun9 And0 we might add0 since it is a world bubble econom/0 there are lots of eas/Emone/ millionaires and billionaires around the world0 and that has a big impact on %all +treet's thinking as well9 1he/ don't want to lose an/ eas/ mone/0 whether it comes from the 3nited +tates or some other countr/9 -ast0 big mone/ from China0 "ussia0 or the 5iddle .ast will do Pust fine to keep them happ/9 "ight now in 8ondon0 the best homes are selling for o#er R1@@ million0 which is up from Pust a few million dollars se#eral decades ago9 And man/ are being bought b/ foreigners0 not the Brits0 with fast0 big mone/0 from "ussia0 the 5iddle .ast0 and elsewhere9

4on't .)pect %all +treet to +potlight 1his Problem

$ow man/ %all +treet anal/sts or economists predicted the recent financial collapse or e#en the Internet collapse6 1he/ can't and won't see the ne)t and much bigger one coming either9 "emember0 these are the same firms that0 in a period of low interest rates0 low unemplo/ment0 and low inflation0 basicall/ went bankrupt during the financial crisis9 In fact0 almost all of the best and biggest in#estment banking firms would ha#e failed without massi#e go#ernment assistance9 1his did not happen in the &reat 4epression0 despite record high unemplo/ment and a de#astated econom/9 5an/ firms sur#i#ed the 4epression without go#ernment bailouts9 1he reason for the incompetence toda/ is that the/ ha#e been blinded b/ eas/ mone/9 1he/ ha#e more ad#anced degrees from top schools than in the past and the same basic genetic intelligence0 but the/ are blinded b/ eas/ mone/9 +o don't look to them to shine a spotlight on the problem the/ are tr/ing desperatel/ to turn off the spotlight to sa#e that eas/ mone/9 -rankl/0 so are man/ of the rest of us who ha#e stock and real estate in#estments9 1his willingness to o#erlook realit/ doesn't affect Pust the financiall/ sophisticated0 but the financiall/ unsophisticated as well9 %e all want eas/ mone/9

People %ho %ant the .as/ 5one/ of the Past to Come Back Again Cannot Accept 1his Anal/sis

1hose who keep hoping the eas/ mone/ will return will sa/ stocks and bonds ha#e done well in the past A@ /ears and gold hasn't and that is true,, 8ook at those charts at the start of this chapter9 But0 as we ha#e said man/ times0 it is different this time9 %e are in a bubble econom/0 and it will e#entuall/ pop9 It's alread/ started to pop in stocks and real estate0 so the past 1@ /ears are more indicati#e of their future performance than were the 7@ /ears prior to that9 Although the past 1@ /ears ha#e been good for bonds0 that bubble is likel/ about to pop soon0 too9 1he bottom line is that the eas/ mone/ is coming to an end and the cheerleaders on %all +treet and those outside the +treet who cheer on the cheerleaders won't see this simpl/ because the/ don't want to9 "ather than face the decline and e#en demise of eas/ mone/0 C% in#estors want to still belie#e in the magical powers of the m/thical =natural growth rate> to bring us back to what we had before9 1he desire to hang on to C% in#esting0 despite all e#idence that it is no longer useful0 is rooted in the basic human desire to a#oid change and to belie#e in the past especiall/ when that past was so #er/0 #er/ good to us9 ?n some le#el0 man/ C% in#estment e)perts know that something feels =different> this time0 but the/ don't let themsel#es think about that too much and the/ don't radicall/ change course9 1he/ ma/ get #er/ worked up o#er political debates about how the go#ernment is handling the econom/0 depending on which side the/ support0 but the/ don't let themsel#es get too worked up about what will actuall/ make a big difference in their future: their own willingness to see the bubbles and prepare for the pop9 Interestingl/0 when the bubbles do begin to full/ burst0 C% in#estors will instantl/ change their minds about =natural growth> and all the rest0 and will completel/ understand that the/ need to get out of the popping bubbles as fast as the/ possibl/ can9 1here will be a stampede to sell0 not bu/0 when the bubbles fall9 If an/one reall/ belie#ed what the/ sa/ the/ belie#e0 wouldn't the/ want to sta/ in and bu/ up the soE called =bargains>6 +ome will do that0 but most will not9 At that point0 most in#estors will be sellers0 not bu/ers0 and C% in#esting will be no more9 3nfortunatel/0 a whole lot of their mone/ will ha#e gone to 5one/ $ea#en9 3ntil then0 most C% in#estors Pust cannot let themsel#es see the falling bubble econom/ and the dangerous Aftershock ahead9

In -airness to Current C% In#estors

%e ha#e come down hard on con#entional wisdom0 but we do not want to be so hard on C% in#estors9 1o be fair0 most C% in#estors simpl/ do not know what else to do9 1here are not a lot of sensible alternati#e #iews of the markets and econom/ a#ailable0 or wise ad#ice as to what to do about it9 If /ou ha#e been a C% in#estor up to now0 and most in#estors ha#e been0 then the first step is to allow /ourself to consider the possibilit/ that C% is not going to work for /ou fore#er9 5ost likel/0 /ou ha#e alread/ seen it fail /ou at least once0 in 7@@H9 1hat is Pust a small taste of what is to come9 If /ou are starting to think we ma/ be onto something and /ou want to e)plore /our options for changing /our in#estment approach0 please be prepared for /our current C% financial ad#isers and others to shoot /ou down or at least not show too much interest in hearing about our macro #iew9 5an/ C% ad#isers will go so far as to tell /ou to stop reading scar/ books because it's not good for /ou or /our portfolio9 Please remember that while these folks ma/ know more than /ou about man/ in#esting details0 onl/ /ou can decide what o#erall big picture of the in#estment en#ironment that /ou belie#e is correct9 *our point of #iew is not tri#ialJ it is essential to /our in#estment decisions9 4on't let others take the wheel9 1he/ are working for /ou0 not the other wa/ around9

In -airness to the Cheerleaders

%hile we don't like C% cheerleaders because the/ are working to keep people in denial0 we do understand wh/ the/ do it9 -or financial anal/sts0 the/'re Pust doing their Pob in being cheerleaders9 1hat's what the/ are paid to do0 whether the/ are stock and bond salespeople or the financial anal/sts who support them9 1here is a reason that financial anal/sts gi#e a bu/ or a hold recommendation o#er I@ percent of the time9 1he/ are paid b/ and are supported b/ stock and bond salespeople9 1he/ are paid based on selling people stocks and bonds0 not for pointing out the bubbles and telling /ou to go awa/9 If the/ did that0 the/ would be out of a Pob #er/ quickl/0 and nobod/ wants to be out of a Pob0 especiall/ in this market9 But it is important for the rest of us to understand that financial anal/sts ha#e that bias9 %e should not count on them to help us figure out what is reall/ occurring or help us prepare for future protection9 (e#er going to happen9

Cheerleading 5one/ 5anagers Are 5anaging ?ther People's 5one/

8ike financial anal/sts and stock and bond salesmen0 man/ cheerleading mone/ managers want to keep their Pobs9 And the/ don't keep their Pobs b/ in#esting their mone/ in mone/ market funds9 1he/ need to in#est their mone/ in stocks whether or not the risks are worth it9 (o one will hire a mone/ manager Pust to in#est in mone/ market funds9 Almost no one will hire a mone/ manager Pust to in#est in bonds9 1he/ ha#e to in#est in stocks to get the hope of a return to Pustif/ their high pa/9 .#en if the risks are far higher than the meager return from stocks Pustifies0 it's absolutel/ critical that the/ in#est in stocks to keep their Pobs9 1here are certainl/ e)ceptions to this rule0 but generall/ stocks are the stockEinEtrade of mone/ managers9 %hen stocks are in a longEterm bull market0 being so focused on stocks is fine9 But if the/ are in a bubble that is popping and turns into a longEterm bear market0 that's not so good9 <eep in mind that mone/ managers are in#esting other people's mone/9 .#en if the/ lose mone/0 as long as the/ are doing as well as other stockEoriented mone/ managers0 the/ will likel/ keep their Pobs9 ?f course0 there are a minorit/ of mone/ managers who are not primaril/ salespeople9 1he/ are willing to manage mone/ without a focus on stocks and it certainl/ isn't eas/9 +o0 not all mone/ managers are cheerleaders and salespeople9 But an awful lot of them are9 An indi#idual in#estor is #er/ different from a mone/ manager9 An indi#idual in#estor is in#esting his or her own mone/9 $is or her Pob is not dependent on in#esting in stocks9 1his is not =other people's mone/9> If indi#idual in#estors lose0 the/ lose big not Pust their bonuses at work but mone/ that their families depend on9 5an/ C% ad#isers call indi#idual in#estors =stupid mone/0> and the/ call mone/ managers =smart mone/9> At this point we couldn't disagree more9 1he wa/ we see it0 the/ Pust ha#e different goals9 1he people who pla/ with other people's mone/ are working to keep their PobsJ the people who in#est their own mone/ are working to protect their assets9 And the people who are in#esting their own mone/ are #oting with their feet9 .#en during the rebound of 7@11 and earl/ 7@170 in#estors were mo#ing their mone/ out of stock mutual funds9 1he outflows since the 7@@H crash ha#e been enormous0 despite the rebound0 as -igure A9H shows9 -igure A9G ?utflows from 4omestic +tock 5utual -unds +ince 7@@H Crash 4espite the big rebound in the stock market since the financial crisis of 7@@H0 indi#idual in#estors remain highl/ skeptical and ha#e been pulling their mone/ out of stock mutual funds e#er/ /ear since9 +ource: In#estment Compan/ Institute9

(ow /ou might sa/ that means these people are being too cautious and the mone/ managers are right9 If the stock market bubble is rising0 that is correct9 But0 if the stock market bubble is popping0 reducing /our stock market e)posure is absolutel/ the right thing to do9 People who manage other people's mone/ are biased to think the stock market bubble of the 1IH@s and 1II@s will return9 People who are risking their own mone/ are more willing to see the realit/ that this market has not produced good returns for o#er a decade and the risks far outweigh the benefits9 And the/ are reacting accordingl/9 It's not stupid mone/ at all9 It's people focused on protecting their own mone/ rather than people pla/ing with other people's mone/ who are simpl/0 and understandabl/0 tr/ing to keep their Pobs9

$owe#er0 %e &i#e (o .as/ Pass to the ?strich .conomists

1his is where our kid glo#es come off9 As we ha#e often said0 the financial crisis and the Aftershock represent a fundamental failure of the economics profession9 1heir Pob is not to be cheerleaders9 1heir Pob is to create and support pathbreaking new methods of better understanding the econom/9 But the/ don't0 and0 honestl/0 the/ don't e#en seem #er/ interested9 1he/ aren't using their protected0 tenured positions as uni#ersit/ facult/ as a base from which to attack the status quo and ad#ocate uncomfortable but sensible alternati#es9 "ather0 the/ desperatel/ tr/ to support their pri#ileged station in life b/ supporting the status quo9 1heir attacks on the status quo are alwa/s muted0 and their alternati#es are often far less than reasonable9 Printing more mone/ and borrowing more mone/ are not reasonable alternati#e policies in the long term9 It is the Pob of academics to question the status quo and offer reasonable and sensible alternati#es9 1he/ don't alwa/s do that0 but when academics are at their best0 that is what the/ should do9 In this task0 academic economists ha#e0 for the most part0 failed miserabl/9 ?f course0 there are e)ceptions0 but compared to financial anal/sts and mone/ managers who ha#e an ob#ious economic reason to support the status quo0 there are far too few academics who are willing to seriousl/ question and0 most importantl/0 create good alternati#es to the status quo economic policies9

$ow to In#est in a -alling Bubble .conom/

1his won't be a fun en#ironment in which to in#est9 ?f course0 it hasn't been that much fun for 1@ /ears now9 5a/be it's been fun for some in#estment bankers making big salaries0 but for the rest of us0 the past 1@ /ears ha#e been less than e)citing9 (ormall/0 in times of uncertaint/ or difficult/0 Con#entional %isdom suggests that /ou add greater di#ersit/ to /our portfolio9 C% defines greater di#ersit/ as greater di#ersit/ across t/pes of stocks0 plus the addition of more bonds to create more safet/9 1his was good ad#ice in the past0 when stocks and bonds were not in danger of significant longEterm declines9 $owe#er0 the correct #iew for in#esting in the future is to di#ersif/ b/ mo#ing from endangered asset classes to safer asset classes9 +tocks0 bonds0 and real estate are endangered asset classes and should be onl/ shortEterm in#estments at this point9 %hen to mo#e out of those in#estments is trick/9 &o#ernment inter#ention in the stock and bond markets through mone/ printing and borrowing will work to maintain markets9 .#entuall/0 as we ha#e said0 these inter#entions will fail0 especiall/ as inflation grows be/ond D percent9 In the meantime0 /ou can sta/ in if /ou reall/ want to0 but onl/ with #er/ careful and acti#e management9 Because of the massi#e amount of artificial stimulus keeping these markets going0 there will be little underl/ing support for the markets once the stimulus fails9 $ence0 /ou need to be out before markets go down because when the/ do go down0 the/ can go down #er/ fast9 +o the ke/ to good timing will be to a#oid tr/ing to time it perfectl/9 Better to get out too earl/ than too late9 1hat means /ou need to begin di#ersif/ing earl/ and continue to di#ersif/ as we get closer to the Aftershock9 ?f course0 getting out earl/ means /ou are guaranteed to lea#e some mone/ on the table9 But0 again0 better to be too earl/ than too late9 4on't tr/ to time it perfectl/9

$ow to Create a Proper =4/namic 4i#ersified Aftershock Portfolio>

1o sur#i#e in an e#ol#ing econom/0 /ou must continue to di#ersif/ awa/ from endangered asset classes to safer asset classes o#er time9 *our portfolio isn't Pust di#ersified0 it is di#ersif/ing which means it is d/namic because it is acti#el/ changing o#er time9 +o the portfolio needs to be both d/namic and di#ersified0 and hence the name 4/namic 4i#ersified Aftershock Portfolio9 Again0 /ou can hold stocks0 bonds0 and real estate for more time0 but it is best to be reducing /our e)posure to those asset classes9 In addition to outright sales of stocks and bonds0 another wa/ to reduce /our e)posure is to choose less #ulnerable stocks and bonds9 1hese are also known as defensi#e stocks and bonds9 4efensi#e stocks tend to be in more boring companies that aren't as affected b/ the econom/ and sometimes produce good di#idends9 .lectric utilities would be a good e)ample of a defensi#e stock9 1he downside is that the/ won't go up as quickl/ as the market0 like stock in Apple Computer0 but the/ also don't go down as quickl/ either9 4efensi#e bonds are shorter term and ha#e less credit risk9 +hortEterm 39+9 1reasur/s would be a good e)ample9 Another e)ample is 1reasur/ inflationEprotected securities :1IP+;9 1hese are 1reasur/ bonds that adPust for inflation9 Bunk bonds ha#e a great deal of credit risk0 so the/ are not defensi#e9 $ighEgrade corporate bonds and municipal bonds are in between9 1he ke/ for those bonds would be to keep them shorter term9 As /ou mo#e out of these endangered asset classes0 the ke/ question is: %hat are the safer asset classes to mo#e into6 3nfortunatel/0 due to the nature of in#estments o#er the ne)t 1@ /ears0 there aren't a lot of longEterm choices9 1his is further reason for acti#e management9 But e#en with acti#e management0 the number of options for man/ in#estors is more limited9 2er/ shortEterm debt or inflationEprotected debt is clearl/ one of the options0 especiall/ as inflation goes higher9 But0 e#entuall/0 e#en go#ernment debt can get risk/9 &old is an e)cellent option0 but it will be highl/ #olatile9 -oreign currencies will also e#entuall/ do well but are hard for most in#estors to deal with9 1he same goes for agricultural commodities9 1iming is hard0 and the/ will be #olatile9 +horting stock and bond markets will also work0 but there is a great deal of risk in shorting and shouldn't be undertaken b/ most in#estors9 %e will discuss the elements of the 4/namic 4i#ersified Aftershock Portfolio in the rest of the book0 including chapters on each of the ke/ components9 1he ke/ takeEawa/ point here is that o#er time /our portfolio must mo#e awa/ from endangered asset classes0 such as stocks and bonds0 to safer asset classes0 such as shortEterm debt and gold9

%hat if %e Are %rong and the Past 1@ *ears %ere 8ike the 1IG@s and 5a/be the (e)t +tock Boom Is Around the Corner6

1hat's actuall/ a good question9 In#estors do tend to get more pessimistic when markets ha#e been doing poorl/0 as the/ ha#e in the past 1@ /ears9 1he same sentiment occurred at the end of the 1IG@s9 5an/ in#estors thought that the market was entering a period of longerEterm problems9 (one predicted an AftershockEt/pe situation0 but few saw the enormous gains to be had in the 1IH@s and 1II@s9 1he difference is that we were Pust entering the stock0 bond0 and real estate bubbles at that point9 1here was also significant real growth in China and in .urope9 Bapan had troubles in the 1II@s but was buo/ed b/ the booming bubbles in the 3nited +tates9 All of these factors are not in e)istence going forward9 "eal growth in China will be hard to find once its massi#e construction bubble pops9 .urope is alread/ showing signs that its longerEterm growth prospects are #er/ limited9 Bapan is no longer growing off our bubbles since the/ are popping and will pop further9 "eal economic growth will be hard to find9 +o ma/be we could Pust find new bubbles to replace the old ones6 %ell0 that is e)actl/ what is happening9 %e are using the go#ernment debt and dollar bubbles to prop up the old bubbles9 %ill that last for another 7@ /ears and keep the stock market mo#ing up for another 7@ /ears6 1he problem is that the go#ernment debt and dollar bubbles are best at maintaining old bubbles and not creating new ones9 1he reason is that if we powered up those bubbles to the point where the/ would create new bubbles0 the/ would scare in#estors here and around the world9 1ripling our mone/ suppl/ again and boosting our deficit to RA trillion Pust to put the stock market into h/perdri#e would quickl/ backfire because it would scare in#estors awa/9 +o e#en if the/ won't take us back to the good old da/s of the 1IH@s and 1II@s0 ma/be the go#ernment debt and dollar bubbles can at least help us keep our gains for another 7@ /ears6 If we onl/ had a go#ernment debt bubble0 it's possible we could keep it going for another 1@ /ears or so9 But0 to help maintain the go#ernment debt bubble0 we ha#e had to create a dollar bubble9 And that makes longEterm #iabilit/ an impossibilit/9 If the go#ernment debt bubble could be maintained without mone/ printing0 then ma/be we could make it another 1@ /ears before it e)plodes in an Aftershock9 3nfortunatel/0 though0 the mone/ printing behind the dollar bubble has lit a fuse on the rest of the bubble econom/0 and that's wh/ we can't keep maintaining the bubbles for another 7@ /ears9 $owe#er0 as we said before0 it can maintain them for another two to four /ears9 But that could be a #er/ rock/ road9 5aintain doesn't mean a 4ow of 170@@@9 1he stock market could easil/ fall A@ percent or more while being maintained b/ the go#ernment debt and dollar bubbles9 Again0 if we were willing to borrow a whole lot more and print a whole lot more0 we could keep such declines from happening and e#en get the market growing rapidl/ again0 but we won't9 As we said0 it could backfire prett/ quickl/9 +o e#en though go#ernment borrowing and printing will maintain the stock and bond bubbles0 that doesn't mean the/ will be maintained at a high le#el9 5a/be we're not in a bubble at all6 5a/be what we are seeing is real growth6 If /ou still ha#e /our doubts about that0 please go back and read Chapter 19

%hat's a +a##/ Aftershock In#estor to 4o6

Ideall/0 if /ou properl/ implement a good Aftershock in#estor strateg/0 /our returns should look similar to the straight line in -igure A9I 9 It should not look like the line that looks like a =%0> which shows the stock market mo#ing #iolentl/ up and down9 ?f course0 no one can hit a straight line0 but that should be the goal9 -igure A9H Ideal Aftershock Portfolio Performance in a 5oderatel/ Increasing0 2olatile +tock 5arket +haded gra/ line is the performance of an Aftershock portfolioJ the black line is stock market performance9

+ome people don't like that goal9 1he/ want to profit on e#er/ upswing and be protected from e#er/ drop9 1hat is a lo#el/ fantas/ but not #er/ achie#able9 *ou want to be the straight line0 not the =%> line because /ou need to be prepared in case the downstroke on the % doesn't rebound0 which is what we think will e#entuall/ happen9 +o0 right now0 it's not so much a matter of beating stock market returns0 although /ou ma/ still do thatJ the more important shortEterm goal is to maintain /our returns in a wa/ that doesn't lea#e /ou e)posed to the downstroke on the %9 2er/ high returns are probabl/ not a smart goal right now because the/ carr/ too much risk and #olatilit/9 %hat /ou want is reasonable returns and limited e)posure to what is potentiall/ a big downside in the stock market and bond market9 1hat's /our biggest threat o#er the ne)t fi#e /ears9 5a/be not this /ear and ma/be not ne)t /ear0 but within the ne)t fi#e /ears0 which is far more important for most in#estors0 that's what /ou need to focus on9 It is almost impossible to perfectl/ time an/ market9 But remember0 e#en if /ou sell out earl/ on stocks0 /ou're not reall/ losing out on future stock gains unless /ou would ha#e sold at a later time when stocks are higher than when /ou sold9 If /ou don't sell at the right time0 /ou will ha#e gained nothing because the stocks will come back down to le#els where /ou sold earlier9 +o /ou ha#e to sell at a higher le#el to lock in those gains0 and almost nobod/ does that :otherwise0 the market would fall dramaticall/;9 5ore importantl/0 if /ou get caught and don't sell before the stock bubble pops0 stocks will go below toda/'s le#el and /ou will take a significant loss o#er Pust selling toda/9 Again0 the goal of the Aftershock in#estor is not perfect timing but reasonable returns with limited #olatilit/ and0 most importantl/0 doing it without big e)posure to a maPor downturn in stocks or bonds9 It sounds simple0 and it is9 Implementing it is not so simple0 but it is e)actl/ what most in#estors need to do9 .#en if there is no Aftershock0 /ou still ha#e to change /our C% portfolio 9 1hat's because this is a new in#estment en#ironment and the old wa/s will no longer protect /ou9 ?ur ad#ice about what

to do instead of the usual C% in#esting is contained in the rest of this book0 with separate chapters on stocks0 bonds0 real estate0 insurance0 and more9 1he bottom line is0 regardless of whether /ou belie#e we will ha#e a full Aftershock0 gi#en the coming rising inflation and coming rising interest rates0 if /ou ha#e a con#entional wisdom in#estment portfolio :and most people do;0 /ou essentiall/ ha#e two options: Change It or 8ose It

PA"1 II

A-1."+$?C<

I(2.+1I(&

C$AP1." C

1aking +tock of +tocks

-ACI(& 1$. -313". ?- +1?C<+0 5313A8 -3(4+0 A(4 I(4.Z -3(4+

?#er the course of half a centur/0 the American in#estor has fallen deepl/ in lo#e with stocks9 +tocks occup/ the heart of most in#estment portfolios and are at the heart of what has made so man/ Americans so much mone/ o#er so man/ decades0 especiall/ in the 1IH@s and 1II@s9 And what's not to lo#e6 1he stock market0 as measured b/ the 4ow Bones Industrial A#erage from 1IH@ to 7@@@0 rose an astounding 10@@@ percent9 (ot 1@@ percent0 but 10@@@ percent9 1hat's prett/ darn good9 It's especiall/ good when /ou consider that the econom/0 as measured b/ gross domestic product :&4P;0 grew onl/ 7F@ percent during that same time period9 1hat's a whole lot less than 10@@@ percent9 B/ contrast0 in the prior period from 1I7H to 1IH70 a time of huge growth of the 39+9 econom/0 the 4ow grew a more reasonable A@@ percent in DC /ears9 And /et0 in Pust 7@ /ears during the 1IH@s and 1II@s0 the 4ow shot up more than 10@@@ percent9 1hat is trul/ e)traordinar/, It is also the quintessential definition of a bubble9 8ike most bubbles0 the stock bubble originall/ started to rise for good reasons9 But as in#estors began to fall in lo#e with the profits from stocks0 those earl/ gains Pust made them fall e#en deeper in lo#e9 And not Pust American in#estors were smittenJ increasing numbers of foreign in#estors were Poining the lo#eEfest0 as well9 And not Pust indi#idual in#estors9 Big institutional in#estors who manage pensions0 endowments0 and life insurance funds fell in lo#e0 too9 But e#en lo#e is not enough to keep a bubble going fore#er9 &i#en enough time0 economic gra#it/ e#entuall/ kicks in and bubbles do pop9 <nowing this is a bubble does not mean we ha#e to e)it it immediatel/ because it is not going to pop toda/9 But /ou must be aware that it is going to pop e#entuall/0 and if /ou choose to sta/ in this bubble a while longer0 /ou will need to acti#el/ manage /our portfolio9 1here are big risks to sta/ing in stocks and it's not clear e)actl/ how much upside is left0 although there could be some9 +ince 7@@@ there has been little upside :o#erall0 the 4ow has barel/ risen in the last decade; and there has been a huge amount of #olatilit/9 -or (asdaq stocks0 the past decade has been e#en worse0 with almost a loss of up to D@ percent9 1he shortEterm future is hard to predict0 but if /ou time it right and get out before the stock bubble pops0 /ou could also lock in some larger gains9 .#en if /ou decide to mo#e entirel/ or hea#il/ out of the stock market0 or mo#e to a more defensi#e stock position0 /ou will still need to acti#el/ manage /our portfolio to protect /ourself and still make reasonable returns9 1o understand our #iew of stocks and how to acti#el/ manage an in#estment portfolio containing stocks0 /ou need to understand the Con#entional %isdom :C%; #iew of stocks9 1o understand the C% #iew of stocks0 it's essential to understand the recent histor/ of stocks9 *ou don't need to know how stock markets were formed and other ancient histor/0 but /ou do need to understand the more recent histor/ upon which current con#entional wisdom is based9

8o#e +tor/: $ow +tocks Became the $eart of 5ost In#estment Portfolios

+tocks were not alwa/s the popular in#estment the/ ha#e been for the past se#eral decades9 Before stocks became the darlings of the in#estment communit/0 bonds had a more fa#ored status9 And before bonds0 it was gold9 As each asset class pro#ed its reliabilit/ o#er time0 it became more popular9 ?nl/ when stocks began growing across the board for decades at a time did the/ become impossible to ignore for all but the most riskEa#erse in#estors9 ?riginall/0 stocks were primaril/ #alued for the di#idend pa/ments that came with them9 "ather than hoping to benefit from rising share prices0 in#estors looked at stocks essentiall/ as bonds with greater /ields pa/ments could be #ariable0 of course0 but in#estors paid close attention to earnings and gra#itated toward blue chip stocks with a consistent record of di#idend pa/ments9 It was onl/ in the 1I7@s that man/ in#estors began to see the #alue in bu/ing stocks with the intention of earning capital gains b/ selling them later at a higher price9 At that point0 the stock market became more speculati#e in nature and trading acti#it/ increased9 1his sent stock prices soaring9 In a si)E/ear span0 the 4ow Bones Industrial A#erage would quadruple in #alue0 but it would take onl/ a few da/s for e#er/thing to come crashing down in ?ctober 1I7I9 Although it's worth noting that e#en after the crash ended the great speculation of the 1I7@s0 it took se#eral /ears for the stock market to fall during the 4epression to its historic low point in 1IA79 After the market crash and the 4epression0 stocks were naturall/ #er/ unpopular9 (ew 4eal reforms0 in particular the establishment of the +ecurities and .)change Commission0 sought to curb the unethical and manipulati#e beha#ior that had been rampant among publicl/ traded companies0 and which had often left financiall/ ruined stockholders in its wake9 But it wasn't until the 1ID@s that stocks regained popularit/ among the general public9 B/ the 1IF@s0 the stock market was booming again0 though that boom turned into a miniEbust in the ne)t decade due to recession0 and particularl/ high inflation :the natural enem/ of the stock market;9

%hat Is a +tock6

A stock is a certificate indicating that /ou own some small portion of a compan/9 %hen /ou bu/ stock from a compan/0 /ou are pa/ing for part of e#er/thing owned b/ that compan/9 If the compan/ makes a profit in the future0 the #alue of /our stock goes up9 As partial owners of the compan/0 stockholders ha#e the power to #ote on decisions that ma/ impact the future of the compan/9 1he more shares /ou own in a compan/0 the more decisionEmaking power /ou ha#e9 2arious t/pes of stocks0 mutual funds0 and inde) funds are bought and sold on #arious stock markets around the world9 +ome readers ma/ need or want more background on stocks0 and some ma/ not9 +o0 in our attempt to keep the flow of the book mo#ing0 we ha#e put some background material on stocks in the Appendi)9 -inancial books can get a bit dull at times and we want to a#oid that9

Ir#ing -isher: +tock 5arket Cheerleader of the &reat 4epression

*es0 stock market cheerleading didn't Pust start recentl/J it's been around for a while9 It has simpl/ gained an enormous number of practitioners recentl/ with the massi#e boom in the stock market since the 1IH@s9 ?ne of the most memorable people to take up the cheerleading profession was Ir#ing -isher9 1he reason he's such an iconic figure is that he started with one of the earlier great stock market bubbles in the 1I7@s9 ?f course0 that was a mere pimple compared to our current bubble0 but there are similarities9 1he other characteristic that makes Ir#ing so iconic is that he was not part of %all +treet9 $e didn't earn his mone/ on the +treet0 and no one paid him to cheerlead9 $e was as pure a cheerleader as /ou can get9 $e actuall/ belie#ed it, And he had a lot of credibilit/9 Ir#ing was one of the most renowned economists from one of the most renowned uni#ersities in the nation: *ale9 $e not onl/ had good credentials9 $e actuall/ did good economic work9 $e was one of the most outstanding and most respected economists of the time9 $is two books0 1he "ate of Interest and 1he 1heor/ of Interest0 both were important contributions to our current understanding of interest and capital9 $owe#er0 Ir#ing was not so great at predicting the &reat 4epression9 In fact0 he infamousl/ said0 Pust three da/s before the 1I7I crash0 =+tock prices ha#e reached what looks like a permanentl/ high plateau9> ?f course0 no one at the time thought that statement would later become infamousJ the/ Pust thought -isher was a #er/ smart economist who made #er/ smart obser#ations that were right9 1hat quote was reflecti#e of a great deal of stock market cheerleading 5r9 -isher did in the late 1I7@s9 %e know now that his #er/ smart obser#ations turned out to be absolutel/ wrong0 and he himself lost quite a bit of mone/ because of it9 Bust getting popular support for /our economic predictions doesn't make them right it Pust makes them comfortable9 1he stock market collapsed and did not become full/ #ibrant again for decades and the econom/ sank into the &reat 4epression9 +o Ir#ing -isher was one of those reall/ smart economists with great credentials whom e#er/one wanted to belie#e was right0 who was not right9 And he won't be the last incredibl/ smart economist or financial anal/st with good credentials who is a market cheerleader9 Ir#ing -isher ser#es as a wonderful cautionar/ tale to toda/'s financial anal/sts and economists who keep cheerleading0 but it is a cautionar/ tale that goes largel/ ignored toda/ and will likel/ come back to haunt them later when the/ lose both their historical respect and their Pobs9 As we mentioned earlier0 for most of the past few decades0 an in#estor could make mone/ in the stock market Pust b/ throwing darts at a dartboard and watching his portfolio grow9 And in toda/'s era of 7CEhour stock market anal/sis on 12 and the Internet0 there's a temptation to di#orce stocks as a commodit/ from the companies whose ownership the/ represent9 %hen in#estors are willing to pa/ more for assets than their inherent #alue Pustifies particularl/ if that

in#estment is fueled b/ debt we ha#e an asset bubble9 But how do we assign an accurate0 nonbubble #alue to a stock6 It reall/ comes down to earnings9 But how to translate earnings into share price can be trick/9 %e'll look at some of the traditional wa/s and then at the wa/s we think are more reflecti#e of a compan/'s #alue9

$ow Are +tocks 2alued6 It's All about .arnings

.arnings0 fundamentall/0 are what /ou are bu/ing when /ou bu/ a stock9 *ou're usuall/ not bu/ing assetsJ /ou're bu/ing all of the compan/'s future earnings9 (ot Pust ne)t /ear's earnings but all its future earnings fore#er9 But how do /ou put a #alue on something so long term and something so unknowable6 %ell0 that's the trick9 It is a bet /ou are making9 *ou0 of course0 hope that bet is more than Pust a guess9 At the #er/ least0 /ou want it to be an educated guess9 Before we can tell /ou about how we look at stocks0 /ou ha#e to understand the con#entional wisdom approach to #aluing stocks9 Again0 /ou ha#e to know C% before /ou can understand an/ de#iation9

PriceEtoE.arnings

"atio

?ne of the most commonl/ used methods to #alue earnings is to determine a priceEtoEearnings ratio :PN. ratio or Pust PN.;9 1his is basicall/ a measure of how man/ /ears' worth of earnings /ou are willing to pa/ for the compan/'s stock9 -or e)ample0 a PN. of 1@ to 1 :often shortened to Pust 1@ b/ financial writers; means /ou are willing to pa/ 1@ times the compan/'s current annual earnings for the stock9 +o if the compan/'s annual earnings :not re#enues; are R1@ million0 the compan/ is worth R1@@ million at a PN. of 1@9 If /ou want to calculate the price of a share of stock0 /ou Pust use the earnings per share9 +o if the earnings per share is R1@ and the PN. is 1@0 a share of stock is worth R1@@9 1here is no magic rule as to how man/ /ears' worth of earnings in#estors should pa/ for a stock9 -or +KP D@@ stocks the PN. has #aried from H in 1IH@ to 77 in 7@@@9 &enerall/0 PN.s are higher for companies with higher growth9 Although the ratio is simple0 what goes into determining the correct ratio can be #er/ comple)9 ?ne of the ke/ issues that has to be considered is the cost of capital9 *ou're pa/ing now for earnings coming later9 1hose earnings in the future are not worth as much as the same amount of cash now :the time #alue of mone/;9 Also0 there is uncertaint/ regarding those earnings9 %hat if the compan/'s earnings decline quite a bit in the ne)t few /ears6 %hat if it goes out of business6 %hat if re#enues grow but earnings decline6 8ots of things can happen to a compan/'s earnings o#er a period of 1@ or 7@ /ears9 $ence0 the more /ears' worth of earnings /ou are willing to pa/0 the greater /our risk because the likelihood of bad things happening to a compan/'s earnings are much greater o#er a 7@E/ear period than a 1@E/ear period9 -inall/0 what if the stock market #alues those earnings less in the ne)t few /ears6 *our compan/ ma/ ha#e e)actl/ the earnings /ou hoped for0 but the market #alues them less and0 hence0 /our stock is worth less9 2aluing uncertain future earnings in an uncertain stock market is a #er/ trick/ game9 1hat's part of the reason wh/ #aluations can #ar/ so much o#er time9 1here's no certaint/ in the calculations9 5ost importantl/0 partl/ because of all this uncertaint/0 ps/cholog/ pla/s a huge role9 +ome people ma/ see fewer risks in a compan/'s future than others9 +ome people ma/ see fewer risks in the future econom/ than others9 %ho knows who's right and what the right PN. should be9 $owe#er0 if the econom/ slows0 e)pect PN.s to decline9 +ome of that decline ma/ ha#e been anticipated0 but latel/0 stock market anal/sts ha#e been none too good in predicting economic slowdowns9 $ence0 the PN.s fall onl/ when the econom/ has pro#en to be in a slowdown9 1hat also means that PN.s could fall a lot if the econom/ slows down a lot9 ?f course0 in a down econom/ not Pust PN.s are falling0 but the actual earnings are often falling as well9 1his will cause further damage to a stock's price9 In addition0 earnings can fall substantiall/ if interest rates rise substantiall/9 1hese are two ke/ #ulnerabilities that the stock market faces in the future as we near the Aftershock9 %e will talk more about these issues later in the chapter9 It's eas/ to see how ps/cholog/ can enter the stock #aluation game9 1here's a lot of uncertaint/ and Pudgment that are a ke/ part of #aluing stocks9 In addition0 if bubble ps/cholog/ enters the game0 it often doesn't matter what the =correct> PN. should be9 All that matters is that stocks ha#e been going up in price and in#estors want to get on board that rising boat9 .arnings #aluation and anal/sis is needed onl/ to make in#estors feel good about their decision to Pump on the bubble boat9 1o make matters e#en worse0 earnings themsel#es are not alwa/s eas/ to define and therefore the correct PN. is not a certaint/9 $ence0 different people look at the histor/ of PN.s differentl/9 "obert +hiller0 the person who helped create the CaseN+hiller $ome Price Inde) and did great work in tracking real historical home prices0 has also done a good Pob in tracking historical PN.s9 $is historical chart of PN.s is presented in -igure C91

9 -igure C91 $istorical PriceEtoE.arnings "atios (otice the high points were right before the crashes of 1I7I and 7@@H9 +ource: "obert +hiller0 *ale 3ni#ersit/9

5an/ people will ha#e different #iews of historical PN.s0 Pust as the/ ha#e different #iews of historical homes prices9 $owe#er0 we think 4r9 +hiller has done the best Pob at gi#ing us a good idea of what historical PN.s ha#e been9

4iscounted Cash -low 5odels

%hen /ou bu/ a stock0 /ou are bu/ing the compan/'s future earnings9 1he question anal/sts face is how to model that9 ?ne of the most commonl/ used methods to calculate the #alue of those earnings is a discounted cash flow :4C-; model :it actuall/ uses the free cash flow instead of profits0 but the concept is the same;9 Although this is a #er/ simple model and highEpowered financial anal/sts use more sophisticated models to calculate a compan/'s #alue0 it contains the ke/ elements of man/ #aluation models and ser#es to quickl/ illustrate what is in#ol#ed in such a model9 .ssentiall/0 a 4C- model attempts to capitaliMe all of a compan/'s future earnings and thus calculate the current #alue of the compan/ and its stock price9 ?f course0 that's not as simple as Pust adding up the future earnings of the compan/9 1hose earnings ha#e to be =discounted> to their current #alue9 1hat discount is determined based on a number of factors0 including the cost of capital0 the uncertaint/ of the earnings0 and the uncertaint/ of the stock market #aluation9 1hat discount rate is then applied to the compan/'s future earnings9 $owe#er0 since /ou can't add up the earnings of a compan/ fore#er :how long is fore#er6;0 a t/pical 4C- model onl/ adds up the earnings for0 sa/0 fi#e /ears in the future9 1o capture the =fore#er> part of the compan/'s #alue0 a =terminal #alue> is calculated9 5uch of the #alue of a compan/ in a 4C- model is in the terminal #alue9 (eedless to sa/0 this model isn't perfect9 %hat it does is tr/ to put numbers behind all the intangible issues of uncertaint/ in earnings and in #aluing the compan/'s earnings fore#er9 It also illustrates Pust how trick/ it can be to calculate the correct #alue of a stock and how much is alwa/s left to the Pudgment of the financial anal/st9

?ther %a/s to 2alue +tocks

Although PN.s are the most common method for #aluing stocks0 there are other methods for #aluing a compan/ that currentl/ doesn't ha#e earnings but could ha#e in the future0 or whose assets ha#e #alue be/ond their earnings :possibl/ due to mismanagement of the compan/'s assets;9 %e should also sa/ that there are a multitude of methods used to #alue companies0 some of which are proprietar/ and man/ of which are much more comple) than those discussed in this book9 %hat we are tr/ing to gi#e /ou is a basic o#er#iew of how stocks are #alued0 as a background to understand con#entional wisdom and wh/ it is wrong0 not a course in equit/ #aluation and anal/sis9 PriceEtoEre#enue ratio9 If a compan/ doesn't ha#e earnings due to mismanagement or an economic downturn0 or for a #ariet/ of reasons the compan/'s earnings are not a good measure of the compan/'s future or potential health0 a different measure of #alue could be used0 which is the priceEtoEre#enue ratio9 In this #aluation method the in#estor simpl/ looks at the price of the stock relati#e to its re#enues to determine its #alue9 1he clear risk in this anal/sis is that b/ ignoring earnings /ou could be getting /ourself into an in#estment that ultimatel/ doesn't pa/ off9 .#en #er/ large companies and in#estors ha#e made big mistakes rel/ing on such anal/sis to make in#estments9 It is also much easier to get a bubble #aluation when /ou ignore earnings9 Book #alue or liquidation #alue9 +ometimes a compan/ mismanages its assets9 5a/be it's an older retail chain that isn't #er/ good at retailing an/more but owns a lot of good retail real estate9 5a/be it's an oil compan/ that is not well managed and is Pust riding on the earnings from oil and gas wells drilled man/ /ears ago9 In this case0 #aluing the compan/ at its liquidation #alue makes sense9 A liquidation #alue is the #alue of the compan/'s assets0 not its earnings or re#enues9 1his ma/ help an in#estor see what ma/ be the hidden #alue in a mismanaged compan/9 A comparison of the compan/'s stock price to its liquidation or =book #alue> is also one wa/ to measure how the market #iews the qualit/ of a compan/'s management and its assets9 Currentl/0 man/ large banks are #alued below book #alue0 indicating that man/ in#estors think the bank is o#er#aluing its assets and is possibl/ managing what assets it has #er/ poorl/9 Pri#ateEcompan/ #aluation9 Pri#ate companies are usuall/ #alued at a significant discount to public companies9 1his is largel/ because the/ are less liquid :harder to sell; than public companies9 *ou can sell a share of public compan/ stock #er/ easil/9 (ot so with a pri#ate compan/9 1his is often referred to as the marketabilit/ or liquidit/ discount9 $owe#er0 toda/ a big part of the reason that pri#ate companies are #alued significantl/ less is that the/ are not participating in the public stock market bubble9 As a comparison to public companies0 pri#ateEcompan/ #aluations don't usuall/ #ar/ that much o#er time0 unless the/ happen to be in a hot industr/0 such as social media9 In fact0 the/ usuall/ trade for about C to F times earnings9 1hat means that pri#ate bu/ers are willing to pa/ about C to F /ears of profits to bu/ a compan/9 1hat actuall/ makes sense gi#en all the uncertainties in an/ compan/'s future earnings9 But notice how much lower that is than public compan/ stocks0 which often ha#e #aluations of 1D to 7@ times annual earnings9 A normal marketabilit/ discount might be 7@ to A@ percent9 But the actual discount for being pri#ate is much higher0 which is a partial indication of a bubble stock market9 In addition0 man/ pri#ate companies are bought with borrowed mone/ based on pa/ing back that loan from the compan/'s earnings9 $ence0 man/ people bu/ing a compan/ don't want to bu/ a compan/ that will take more than four to si) /ears to pa/ off its loans9 1he/ don't plan to flip the compan/9 1he/ plan to make mone/ from it0 and the/ want to make mone/ from it as soon as possible9 1his t/pe of #aluation makes a lot more fundamental sense than a bubble #aluation9 It is also similar to the le#eraged bu/out :8B?; #aluation model used in Aftershock wisdom0 which we will describe later in this chapter9

BenPamin &raham
(o discussion about stock #aluation would be complete without some mention of the bible of stock #aluation0 BenPamin &raham's classic book +ecurit/ Anal/sis9 Published in 1IAC0 this landmark book on

stock #aluation is what %arren Buffett most often refers to when speaking about his own #iews on compan/ #aluation9 &raham's book offers in#estors three guiding principles9 -irst0 alwa/s in#est with a margin of safet/ b/ bu/ing at a discount to a stock's =intrinsic #alue9> 1hat wa/0 if the market #alue falls a bit0 /ou are still ahead9 +econd0 e)pect market #olatilit/ and find wa/s to profit from it9 ?ptions for doing this include dollarEcost a#eraging and di#ersification9 And0 third0 know /our in#esting st/le: acti#el/ in#ol#ed and willing to research and learn on /our own o#er time or more passi#el/ in#ol#ed and in need of professional assistance and lower risk9

Con#entional %isdom on +tocks

1he o#erriding mantra of the recent stock market C% cheerleader is that stocks are alwa/s poised for growth0 while gold is at its peak and read/ for a fall9 (e#er mind that since 7@@@ e)actl/ the opposite has been true9 1he goal of the stock market cheerleader is to sell stocks0 not to do proper historical anal/sis9 ?f course0 as we alwa/s sa/0 C% faith in more growth ahead is grounded in histor/ at least the part of histor/ the/ like best :i9e90 the rising bubbles;9 C% sa/s the future will be like the good past9 *es0 the C% cheerleader would agree that the recent past has not been kind to stocks0 but if /ou look farther back in histor/0 the performance in stocks has been quite good9 ?n this0 the cheerleader is correct9 Bust like real estate0 stocks ha#e been a good bu/ o#er the long term0 especiall/ if we define the long term as since 1ID@9 If we ignore the &reat 4epression and the long0 slow reco#er/ of the market during %orld %ar II0 stocks look prett/ good historicall/9 If /ou look at the %arren Buffett chart on stocks since 1IFD that we presented in Chapter A0 it looks e#en better9 +o if the future is like the past0 especiall/ those golden /ears of 1IH@ to 7@@@0 when the stock market was up o#er 10@@@ percent0 the future is prett/ bright9 It's also easier to o#erlook the past 1@ /ears and assume that this is more like the 1IG@s Pust a prelude to another stock market e)plosion of 10@@@ percent or more9

C% +tock Cheerleading Is Based 5ore on +alesmanship than "igorous Anal/sis

$owe#er0 none of this anal/sis looks at the fundamentals9 In fact0 it reall/ isn't e#en anal/sis9 It's Pust sa/ing that the good part of the past will ine#itabl/ continue and the bad part will ine#itabl/ gi#e wa/ to the good part9 As we said in Chapter A0 there are fundamental economic reasons wh/ the future will be different from the past0 especiall/ the good parts of the past9 Actuall/0 if /ou go back o#er the past 7@@ /ears of financial and economic histor/0 it's eas/ to see that big change is the real pattern of financial histor/ not Pust endless and enormous growth in the stock market as far as the e/e can see9 1hat t/pe of anal/sis is not anal/sis0 it's Pust salesmanship9 And e#en hardEnosed stock market anal/sts are primaril/ emplo/ed b/ firms that all started as stock and bond sales firms and which to this da/ are hea#il/ dri#en b/ the sales of #arious stockE and bondErelated securities9 +o it's no surprise that when the financial anal/sts emplo/ed b/ these firms are asked to rate stocks0 the/ usuall/ rate them as a bu/ or a hold9 In fact0 research on anal/sts' opinions shows that the/ rate stocks as bu/ or holds o#er ID percent of the time0 as indicated in -igure C97 9 -igure C97 +tock Anal/sts' Bu/N+ell "ecommendations0 (o#ember 7@11 2er/ few anal/sts recommend selling stocks9 5ostl/ the/ suggest bu/ing or holding9 +ource: -act +et "esearch +/stems9

1his seems a whole lot less like anal/sis and a whole lot more like salesmanship9 And that salesmanship mentalit/ per#ades %all +treet and the financial press9 In one wa/ or another0 the li#elihoods of all these people often depend0 in one wa/ or another0 on good sales of stocks and bonds9 %e're not tr/ing to be critical it's Pust the truth9 .#er/bod/ has to make mone/9 But that means it's not the best en#ironment for hardEnosed and obPecti#e anal/sis9 Ask someone who knows and has tried to do obPecti#e anal/sis0 like 5ike 5a/o0 who recentl/ wrote .)ile on %all +treet :see sidebar; about his work anal/Ming the banking industr/9 1he financial press doesn't alwa/s like someone who challenges the pre#ailing C% on %all +treet and neither does %all +treet9

%hen Appl/ing 2aluation 5ethods Bust 4iscussed0 Anal/sts 5ake <e/ Assumptions

5an/ financial anal/sts would sa/ in protest that the/ are doing proper anal/sis and not cheerleading9 1he/ are appl/ing the #aluation methods Pust discussed in one form or another and those methods0 although impro#ed0 ha#en't fundamentall/ changed during the stock market bubble9 1hat's true0 but as we pointed out in that discussion0 assumptions of future economic conditions and compan/ earnings are absolutel/ fundamental to that anal/sis9 And the current anal/sis depends on two ke/ assumptions0 which we discussed in Chapter A: :1; the assumption of a natural growth rate and :7; the assumption that we are not in a multibubble econom/9

5ike 5a/o: 1he Courageous +tock Anal/st

5ike 5a/o is no stranger to contro#ers/9 A stock anal/st for 7D /ears0 5a/o has worked for some of the world's largest financial firms0 including 4eutsche Bank0 Credit +uisse0 and 8ehman Brothers9 $is frank anal/sis has led to some shak/ tenures and in some cases his departure9 =.#entuall/0 when I left V8ehman BrothersW0> 5a/o sa/s0 =I was literall/ escorted out of the office9> In late 7@110 he wrote a book detailing the fundamental problems with the financial industr/0 .)ile ?n %all +treet9 In 1III0 while working at Credit +uisse -irst Boston0 5a/o made wa#es b/ writing a report ad#ising the sale of all bank stocks0 citing lowered standards for loan procedures across the board9 1he response was less than welcoming9 $e was skewered b/ the financial communit/ and mocked on cable news programs9 $e recounts in his book: =?ne trader 9 9 9 printed out m/ photo and stuck it to her bulletin board with the word X%A(1.4' scribbled o#er it9> Clearl/0 5a/o had touched a ner#e0 but his anal/sis was prescient9 In 7@@G0 5a/o was one of the few anal/sts who saw the impending crisis in the financial sector0 predicting that the crisis could cost as much as RC@@ billion0 =a number that was much higher than an/one else's estimate to that point though one that still turned out to be too low9> 5a/o argues that the culture of the financial industr/ gi#es anal/sts0 ratings agencies0 and regulators little incenti#e to pro#ide in#estors with honest assessments9 =8ess than D percent of stock ratings on %all +treet are a negati#e rating0> sa/s 5a/o9 =An/ firstE/ear business school student can tell /ou that not ID percent of stocks are worth bu/ing9> 1oda/0 5a/o continues to send ripples through the financial communit/9 In 5a/ 7@170 now working at C8+A0 he downgraded his rating of BP 5organ Chase0 widel/ considered the industr/'s sturdiest firm0 to the industr/'s onl/ negati#e rating9 Bust before this mo#e0 he downgraded Bank of America0 and then later he issued a warning about 5organ +tanle/'s reputation after it mismanaged -acebook's IP?9 Clearl/0 5ike 5a/o has ne#er been afraid of calling it like it is0 e#en at great personal risk9 And for that we gi#e him an AB. Award for Intellectual Courage9 +tock anal/sts and cheerleaders naturall/ assume :almost unconsciousl/; that there is a natural economic growth rate9 1hat means an economic growth rate that alwa/s goes up no matter what0 and that means a stock market that alwa/s goes up9 %e discussed earlier wh/ there is no such thing as a natural economic growth rate there is simpl/ no theoretical or historical basis for a natural growth rate in an/ countr/ at an/ time9 All economic growth is basicall/ deri#ed from producti#it/ impro#ements0 and those happen onl/ when people make changes to impro#e their producti#it/9 .#en during periods of highE producti#it/ growth0 like the twentieth centur/0 the growth rates can change dramaticall/ because producti#it/ impro#ements are not being made all the time9 Bust look at China o#er the past centur/ or e#en the 3nited +tates o#er the past centur/9 It's hardl/ been one solid straight line of growth9 1he second assumption is harder to refute since we are still li#ing in a multibubble econom/ and it is #er/ hard for people to see bubbles until the/ pop especiall/ people who don't want to see it9 %e made the case for the multibubble econom/ quite a while ago in America's Bubble .conom/ in 7@@F0 but don't

e)pect the cheerleaders to see it9 It's simpl/ not in their stock and bond salesmen's interest9

%h/ Con#entional %isdom Is %rong

Aftershock wisdom is clearl/ different from con#entional wisdom on stocks9 It looks at some basics9 As discussed in Chapter A0 &4P grew 7F@ percent between 1IH@ and 7@@F0 /et the stock market grew o#er 10@@@ percent9 1hat Pust doesn't make economic sense9 Big growth that is not firml/ based on real fundamental economic dri#ers adds up to a bubble9 "esearch b/ the eminent economist 5ilton -riedman showed that o#er a longer period of time0 compan/ earnings don't outpace growth in &4P9 1hat's because an/ e)cess compan/ earnings abo#e economic growth are eliminated9 As we mentioned earlier0 if /ou look at a longerEterm historical perspecti#e0 the stock market grew A@@ percent from 1I7H to 1IH@ a period of more than D@ /ears of massi#e economic growth and population growth whereas in Pust 7@ short /ears0 from 1IH@ to 7@@@0 it grew more than 10@@@ percent9 %e think /ou will agree that -igure C9A e#en looks like a bubble9 %h/ else would there be so much growth in the stock market so quickl/0 compared to the past6 And0 economic growth was stronger in the past0 not weaker9 -igure C9A &rowth of the 4ow0 1I7HS1III 1he stock market had modest but reasonable growth until the 1IH@s and I@s when growth Pust e)ploded9 +ource: Bloomberg9

Also0 it's not Pust the rocket rise of stocks0 it's the whole rising multibubble 39+9 econom/ and the rising multibubble world econom/ that makes an e#en greater case for calling this a stock market bubble9 %e discussed this in Chapter 1 and in more detail in America's Bubble .conom/ and Aftershock0 +econd .dition0 so we won't go o#er it again here9 +uffice it to sa/ that Aftershock wisdom calls this a stock market bubble9 And as /ou alread/ know0 bubbles e#entuall/ pop9 But if this is a bubble0 how big is that bubble and how much of it is nonbubble6 In other words0 how much do stocks ha#e to fall to be more properl/ #alued6 Another wa/ to look at it is what is the correct wa/ to #alue stocks6 1he problem with the wa/ C% currentl/ #alues stocks :as described earlier in this chapter; is that all the C% #aluations rel/ hea#il/ on assumptions about the future econom/0 future earnings0 future interest rates0 and other #ariables that are highl/ subPect to optimistic and bubbleEinfused interpretation9 +o how can we get a #aluation method that isn't so easil/ influenced b/ bubbleEthink6

Introducing the 8e#eraged Bu/out 5odel of +tock 2aluation

Aftershock wisdom gi#es us an effecti#e and realistic method for #aluing public companies on a nonbubble basis9 %e call this method the le#eraged bu/out model of #aluation9 It's not a perfect name because it conPures up an image of the outrageousl/ o#erpriced 8B?s that dro#e up the pri#ateEequit/ bubble of 7@@G9 $owe#er0 we still use it because it is technicall/ correct9 3nlike the 8B?s that dro#e up the pri#ateEequit/ bubble of 7@@G0 which essentiall/ relied on pri#ateE equit/ firms pa/ing the highest possible price for a compan/ fueled b/ incredibl/ stupid bank loans and then hopefull/ flipping it for an e#en craMier public price down the road0 the 8B? #aluation model we are talking about is entirel/ different9 %hat we are talking about here is the le#erage that would be used for purchasing a normal pri#ate compan/ where a bank lends mone/ for the purchase and that loan is paid back to the bank out of the compan/'s earning o#er a period of se#eral /ears9 1he assumption is that the entire price of the compan/ is determined b/ what a bank is willing to lend to bu/ the compan/0 assuming the bank is paid back entirel/ out of the compan/'s earnings9 In this model0 there is no assumption that the bank loan will be paid off b/ the sale of the compan/9 1he loan can onl/ be paid back to the bank out of future compan/ earningsJ therefore0 the bank will lend onl/ the amount that can be paid back in this wa/9 1hat reall/ limits the potential for false bubble #aluation9 B/ definition0 a compan/'s 8B? #aluation will be a low #aluation b/ toda/'s standards9 $owe#er0 we belie#e this is correct now and later it will be the onl/ #aluation for an/ compan/ in the Aftershock9 1his is the =how low it can go> #aluation below which the stock market will not go9 If the stock market #alues it for less0 in#estors can then bu/ the compan/ for the 8B? #aluation amount and make mone/ b/ bu/ing the compan/ at a low price9 1he/ pa/ back the bank loans in a few /ears and keep an/ profits to be had after that time9 In the Aftershock0 the pa/back time banks will require will be #er/ short0 probabl/ no more than two to three /ears0 because the uncertaint/ of earnings is great enough that man/ banks won't want to take the risk of loaning more mone/ than can be paid back easil/ in a short period of time9 -or e)ample0 if the stock market #alues a compan/ at RC@ million dollars and its earnings are R7@ million dollars a /ear0 a bank :or other group of lenders; will likel/ be willing to make a loan of RC@ million to bu/ the compan/ under the assumption that it is quite likel/ it will recoup the RC@ million in a short period of time :two /ears;9 $ence0 the #alue of an/ public compan/ has a floor0 and that floor represents the nonbubble #aluation of the compan/0 which is the amount a lender will lend to purchase the compan/ o#er a short period of about two to three /ears9 An/ #alue abo#e that 8B? #aluation is a bubble #alue9 1his method of #aluation will produce #er/ low #aluations of companies0 but the/ will be nonbubble #aluations9 1his will be the model used once the Aftershock hits9 It's also where potentiall/ a lot of mone/ will be made b/ those few in#estors who are still acti#e enough to participate in the market9 (eedless to sa/0 banks will want heft/ equit/ on the part of the bu/er for an/ of their loans0 and when the Aftershock is at its worst0 there will be #er/ few loans of this t/pe9 1he point is that in order to correctl/ #alue companies on a nonbubble basis0 this method will be the onl/ reliable wa/ of accessing a compan/'s worth9 1here has to be enough future earnings to pa/ off a loan in a reasonable amount of time0 otherwise the loan is not Pustified and neither is the compan/ #aluation9

(ormal 2aluation 5ethods Are Irrele#ant0 ?nl/ Bubble 2aluation 5atters

As discussed earlier0 the normal #aluation methods are highl/ subPect to economic and financial assumptions that are changing and are about to change e#en more9 %hat matters now is bubbleEthink and the abilit/ of #arious economists and financial anal/sts to make people feel more comfortable belie#ing that bubble #aluations are real #aluations9 In#estor attitudes are ke/ to stock market #aluations toda/9 $owe#er0 in#estor attitudes can and will change9 Bubble blindness0 after all0 is onl/ a temporar/ condition9 All bubble blindness has a cure: time9 ?#er time0 it becomes increasingl/ ob#ious that we reall/ are in a multibubble worldwide econom/ and there is no =natural> economic growth rate to sa#e us9 ?#er time0 it will also become increasingl/ ob#ious that the go#ernment cannot borrow enormous amounts of mone/ that is enabled b/ enormous amounts of mone/ printing without creating inflation9 5ost importantl/0 bubble blindness is quickl/ cured b/ others who lose their blindness9 If onl/ 7@ percent of the in#esting public loses their blindness0 that is enough to pop the bubbles9 As with all bubbles0 onl/ a few in#estors will get out the door before this bubble pops9 5ost in#estors will sta/ blind until the bubbles pop and their mone/ suddenl/ goes to 5one/ $ea#en9 +o0 bubble blindness is alwa/s temporar/9 1he onl/ question is whether it is cured before the bubbles pop or it is cured when the bubbles pop9

+tocks %ill -ail in 1hree +tages

In#estors will not all run out and sta/ out of the stock market at the first signs of trouble9 1hat's wh/ the stock market will not fall all at once but will decline in stages0 leading up to the Aftershock0 before the biggest crash9 $ere is our best appro)imation of how that will happen9

+tage 1: 1he "ecent Past and (ow

4uring the global financial crisis of late 7@@H0 stock markets around the world fell C@ percent and more9 +ince then0 massi#e mone/ printing b/ the -ed and massi#e borrowing b/ the 39+9 go#ernment ha#e been helping to boost and support the stock market9 But the fact that stock in#estors are generall/ still trusting current stock #aluations doesn't mean those #aluations are worth/ of that trust9 8ots of things can temporaril/ sell at the =wrong> price for a while until in#estors figure it out9 But at that point0 in#estors' #iews of trustworthiness can change #er/ quickl/9

+tage 7: 1he +hortE1erm -uture

+tocks will likel/ not fall dramaticall/ in the immediate future0 although in#estors are getting more skittish and the 4ow could easil/ drop 1@@ to 7@@ points or more in a da/0 depending on the news9 $owe#er0 in the recent past0 it seems that e#en #er/ negati#e news does not alwa/s create as big a drop as one might e)pect9 %hen stocks do fall0 prices will not drop in a straight line9 In the short term0 each time stocks fall a bit0 there are some in#estors who see bargains rather than a falling bubble0 and the/ begin to bu/ those =bargains0> which pre#ents a deeper fall9 Also0 there is some reason to question whether this market is occasionall/ manipulated to some e)tent9 As long as the -ed is able to continue massi#e mone/ printing without significant inflation :/et; and as long as the go#ernment is able to continue its massi#e borrowing0 the 3nited +tates will continue to be #iewed as a relati#e safe ha#en0 especiall/ compared to .urope0 39+9 stocks still ha#e appeal for both foreign and domestic in#estors9 "emember0 these people are in lo#e with stocks0 and it will take some time to gi#e that up9

+tage A: 5ediumE1erm -uture

?#er time0 as inflation and interest rates rise0 the bloom of lo#e will begin to wilt9 Certainl/0 rising inflation and rising interest rates will not be good for companies or their stocks :or for an/ of the other bubbles;9 1hat's because massi#e stimulus is not the same thing as massi#e growth9 And0 increasingl/0 the stimulus will ha#e less of an impact0 o#er shorter and shorter periods9 =&reen shoots0> if an/0 will turn brown faster and faster9 %ithout a real reco#er/0 there will be lots of stock market oscillations9

+tocks Bust Before and 4uring the Aftershock

.#en if the -ed were to stop all mone/ printing toda/ :and the/ certainl/ will not;0 we ha#e alread/ increased the mone/ suppl/ threefold since 5arch 7@@I9 1hat is more than enough to gi#e us plent/ of future inflation and rising interest rates to damage the future econom/ and the stock market9 $igh inflation and high interest rates are not going to occur o#ernight9 It will happen o#er time9 +o the more time that goes b/0 the greater the risk to stocks9 $owe#er0 time is not the onl/ risk factor9 1here are a number of other potential triggers that could push things along sooner9 Among these possibilities are further problems with the .uropean debt crisis0 an economic downturn in China0 or a potential Israeli strike on Iran9 1hese were discussed in more detail in Chapter 79 Because so much of an/ bubble is dri#en b/ in#estor ps/cholog/ :both on the wa/ up and on the wa/ down;0 bubbles can pop #er/0 #er/ quickl/9 Please see Chapter 11 for details about how the stock market ma/ crash9 Before the Aftershock0 the federal go#ernment can0 and will0 ease the pain of this for as long as it can with more mone/ printing9 But as we'#e said0 e#entuall/ this medicine becomes a poison0 and there will be little the -ed or an/one else can do without Pust making things worse9 "ight now0 the -ed can put mone/ into the s/stem with #er/ few shortEterm consequences0 as an/ potential inflation will lag at least b/ a couple of /ears behind mone/ printing9 But once inflation gets going :in the D to 1@ percent range;0 the lag time behind an/ new mone/ printing will get shorter and shorter0 and in#estors will become increasingl/ concerned9 ?nce enough in#estors0 particularl/ foreign in#estors who now own so man/ dollarEdenominated assets0 begin to e)it0 the bubble will suddenl/ burst as more and more in#estors tr/ to flee9

%hat's a +a##/ Aftershock In#estor to 4o6

Clearl/0 being 1@@ percent out of all stocks before the Aftershock hits is essential9 $owe#er0 we are not there /et9 1hat means there is still time before inflation mo#es up high enough and interest rates rise high enough to kick off the coming multibubble pop and the Aftershock that will follow9 Before that occurs0 some stocks will hold up better than others9 +o in the shorter term0 it is still oka/ to own some stocks as long as the/ are part of a wellEdi#ersified0 AftershockEbased0 acti#el/ managed portfolio9 As we sa/ throughout this book0 con#entional wisdom will no longer protect /ou9 +o the first thing e#er/ stock in#estor must face is the fact that this is a bubble and it is going to pop9 ?nce /ou ha#e a firm grasp of that0 the ne)t logical questions are what to do about it and when6

1he Case for Acti#e 5anagement

In a rising bubble econom/ or in a growing nonbubble econom/0 successful in#esting means picking stocks that are going up or about to0 and then hanging on to those stocks until /ou are read/ for some profit taking9 $owe#er0 that kind of bu/EandEhold or setEitEandEforgetEit in#esting0 based on the old wa/s of #aluing stocks0 doesn't work too well in a falling bubble0 e#en if that bubble's fall has been temporaril/ slowed and boosted b/ massi#e go#ernment stimulus9 In a falling bubble or in a temporaril/ supported bubble that will fall again soon0 that is not going to fl/9 Instead0 if /ou are going to own an/ stocks between now and the Aftershock0 then /our portfolio requires acti#e management9 1he word management seems prett/ straightforward9 It means /ou ha#e to make some good decisions and e)ecute those decisions correctl/9 1hat is trick/ enough9 But it gets e#en more challenging because /ou also need =acti#e> management0 meaning /ou ha#e to keep making correct decisions and keep e)ecuting those decisions correctl/0 again and again0 as the econom/ and the in#estment en#ironment e#ol#e o#er time9

$ow to 1emporaril/ ?wn +tocks in an Acti#el/ 5anaged Aftershock Portfolio

-or the ne)t /ear0 stocks will be dri#en b/ more mone/ printing9 %hen the -ed prints more mone/0 such as a !.A0 stocks will go up9 It might onl/ require talk of more mone/ printing to push the market up0 but if there is no printing0 Pust talk0 it will go back down9 Also0 !.A will onl/ work for so long to keep up the market0 Pust like !.1 and !.79 It is a temporar/ fi)9 .#entuall/0 the !. mone/ tree will ha#e less impact on stock #alues because more people see it as Pust a temporar/ fi)9 1hat could easil/ happen as soon as a !.C it ma/ not work #er/ well to boost stock prices9 $ence0 !.Edri#en stock prices will onl/ last so long0 and pla/ing the !. trade b/ bu/ing when !. is announced won't work as well in the future9 1he decreasing impact of mone/ printing on the stock market will also ultimatel/ lead to a longEterm decline in stock prices9 +o what about e)iting stocks after !.A6 3nfortunatel/0 e)iting stocks is a bit different from e)iting bonds9 Ideall/0 we wanted to do a chart0 Pust like we did for bonds in Chapter D0 that broke stocks down into different categories and we would tell /ou what is a good time to e)it each categor/9 3nfortunatel/ for stocks0 there is an enormous le#el of correlation between all t/pes of stocks9 Because of this high degree of correlation0 it is likel/ that when stocks fall0 the/ will all fall at the same time9 +ome stocks ha#e a higher beta0 meaning the/ will both rise faster and fall faster than a#erage9 1hese include financial stocks0 highEtechnolog/ stocks0 and other stocks that are often placed in the =highE growth> categor/9 But that does not in an/ wa/ change the o#erall direction for all stocks Pust before and during the Aftershock9 1here will be no safe ha#ens in the stock market when the stock bubble pops9 1here will be no =timed e)its> where we can sa/ hold on to these stocks for a while longer but sell these other stocks now9 *es0 some will take less of a hit than others0 but all will decline9

?ur Current "ecommendations

Currentl/0 we recommend highEdi#idend stocks0 such as electric utilities0 as a temporar/ safe ha#en because the/ are defensi#e and pa/ good di#idends0 but when the market falls a lot0 the/ will fall0 too9 1he/ work best in a market that is mo#ing upward at a slow rate but with high #olatilit/0 as has been the case in the past couple of /ears9 Also0 highEdi#idend stocks are becoming high priced because man/ in#estors are looking for their di#idends and safet/9 $ence0 there ma/ not be a lot of upside left0 and the good returns from highEdi#idend stocks are likel/ to fall9 &i#en what we now know about stocks and what's going to happen to them0 it would be wise to keep up on economic conditions and especiall/ watching for rising inflation9 1he Consumer Price Inde) can be followed on the web site for the Bureau of 8abor +tatistics at www9bls9go# 9 :*ou can also keep up with us at www9aftershockpublishing9com 0 and e#en register for our Aftershock I"P newsletter9; As we mentioned0 we e)pect plent/ of stock manipulation from the -ed to prop the markets up0 and while this is bad news for the long term0 it will be good for stocks in the short term9 +o keeping a portion of /our portfolio in the stock market for the time being can be a good mo#e9 1here's nothing wrong with riding a bubble while it's inflating :or reinflating;0 as long as /ou get out before it pops9 But as we ha#e said repeatedl/0 it's far better to be out of stocks too earl/ rather than too late9 If /ou are particularl/ riskE a#erse0 don't worr/ too much about missing the last boost in the stock market before the crash9 In the long run0 /ou'll still be much better off than most9 A good wa/ to mo#e out of stocks is to mo#e out a little bit at a time0 selling off more and more each month and mo#ing into gold and other safe in#estments as we approach the Aftershock in the ne)t couple /ears9 1his wa/0 /ou can benefit from temporar/ rises in the stock market without e)posing /ourself to too much risk9 It's also a good strateg/ to sta/ di#ersified while the Aftershock is less imminent0 allowing /ou to protect /ourself more onl/ as /ou become more con#inced of the crash ahead9 In the meantime0 stocks in safer sectors like health care and electric utilities will generall/ be a safer bet than stocks in the #olatile financial or technolog/ sectors9 Also0 choosing stocks that pa/ high di#idends can mitigate potential drops0 and it will be easier to pull out of these stocks before suffering big losses9 %e mentioned before that selling short can be a risk/ practice9 1he big problem is timing9 %e know stock prices will fall0 but we don't alwa/s know e)actl/ when9 1his is one reason we like longEterm equit/ anticipation securities :8.AP+;0 which can be used to short stocks o#er a period of up to two /ears9 1iming is still sensiti#e here though9 If we're still two to four /ears awa/ from the Aftershock0 it might be a little earl/ right now to begin in#esting in 8.AP+9 1his is an ad#anced t/pe of in#estment and not for people with little knowledge of the market9 An easier option than shorting specific stocks or bu/ing put options and 8.AP+ is to in#est in in#erse inde) e)changeEtraded funds :.1-s;9 1here are .1-s that short #arious indices like the +KP D@@0 so when those indices fall0 these funds rise9 %hile timing is still sensiti#e here0 in#erse .1-s can be a good wa/ to hedge stock positions in the meantime before pulling out completel/9 $owe#er0 please be cautious with in#erse .1-s that are double le#eraged9 1hese funds will drop a whole lot whene#er the market temporaril/ mo#es up9 1he bottom line for stocks is that in the long run0 the/ will all drop sharpl/ in the Aftershock9 In the shorter term0 if /ou want to be in the market0 /ou must limit /our risks with acti#e portfolio management0 based on the correct macroeconomic #iew of what is occurring and what will happen ne)t9 :Please see Chapter 11 for more details about creating a di#ersified0 acti#el/ managed Aftershock portfolio9;

C$AP1." D

B/eEB/e Bonds

%$* B?(4+ A". &.11I(& "I+<* A(4 %$.( 1? &.1 ?31

%h/ do in#estors bu/ bonds6 1o radicall/ o#ersimplif/0 the main appeal of bonds is that the/ are not stocks9 In#estors bu/ bonds to preser#e capital :also known as a#oiding losing mone/ on stocks; and to earn some fi)ed income :because /ou can't count on stead/ profits from stocks;9 If the stock market were a Packrabbit0 full of e)citement and profit potential0 bonds would be /our steadfast turtle slow0 reliable0 and safe9 -inancial ad#isers tell us to ha#e a greater ratio of bonds to stocks as we get older9 %hile a /ounger person's portfolio might be A@ to C@ percent bonds0 older in#estors usuall/ go for F@ percent or more bonds0 especiall/ as the/ near retirement9 Because the profit potential for bonds is limited0 there is a broad assumption that their risk potential is limited as well9 3nder normal conditions0 this is usuall/ trueJ bonds are generall/ less risk/ than stocks9 But0 as /ou know b/ this stage of the book0 future conditions will be an/thing but normal9 As inflation and interest rates significantl/ rise in the lead up to and during the Aftershock0 our steadfast turtle will ine#itabl/ become in#estment road kill9 Con#entional wisdom :C%; sa/s stick with bondsJ the/ were good to us before and the/ will remain good to us in the future9 1he new Aftershock in#esting wisdom sa/s some bonds ma/ be oka/ for now0 but /ou better keep /our e/es open and get read/ to get out as the in#estment en#ironment continues to e#ol#e9 Bust as we e)plained in the pre#ious chapter about stocks0 it is not necessar/ to gi#e up on bonds immediatel/9 $owe#er0 please do not fool /ourself into thinking bonds will pro#ide /ou with lasting safet/9 Bust as with stocks0 owning bonds requires acti#e portfolio management based on a clear and correct macroeconomic #iew of what is occurring and will happen ne)t9 1he big problem that in#estors will face in the future0 as inflation and interest rates rise0 is that both the stock market and the bond market will become increasingl/ less attracti#e9 +o far0 that has not generall/ been the case0 and most con#entional in#estors who look to recent histor/ as their guide will not be prepared for what is ahead9 1hat's wh/ we keep telling /ou throughout this book that it's time to trade in /our old con#entional in#esting for a new AftershockEaware0 acti#el/ managed portfolio9 "emember: =Past performance does not predict future results9>

%hat Are Bonds6

Basicall/0 a bond is a loan9 Bonds are fi)edEincome securities issued b/ pri#ate or public entities in e)change for /our lending them mone/9 But unlike a t/pical loan /ou might make to a friend or a bank might make to /ou0 a bond can also be bought and sold for a profit or a loss on the bond market9 1his makes bonds more than a loanJ a bond is a securit/ that can be traded9 Based on the t/pe of borrower0 there are se#eral t/pes of bonds9 1he most common of these are: 3nited +tates 1reasur/s0 issued b/ the federal go#ernment9 1hese come in man/ #arieties0 based on maturit/ dates :short0 medium0 or long term; and other features0 such as inflation protection :1reasur/ inflationEprotected securities or 1IP+;9 5unicipal bonds0 issued b/ states and local go#ernment9 Corporate bonds0 issued b/ pri#ate companies9 5ortgageEbacked securities0 issued b/ go#ernmentEsponsored agencies0 such as -annie 5ae :-ederal (ational 5ortgage Association;0 as well as b/ pri#ate corporations9 +a#ings bonds0 issued b/ the federal go#ernment9 Certificates of deposit0 issued b/ pri#ate financial institutions9 5one/ market funds0 a collection of shortEterm securities pooled together0 issued b/ financial institutions9 -loatingErate notes0 change as an interest rate inde) changes9 %ith some corporate bonds0 the coupon changes0 while with 1IP+0 the principal changes9 As we mentioned in the pre#ious chapter on stocks0 some of our readers ma/ need or want more background on bonds and some ma/ not9 1o keep the book from becoming too boring0 we ha#e put some additional background material on bonds in the Appendi)9 1his chapter will focus on how bonds make mone/ and how to a#oid losing mone/ on bonds as we approach the Aftershock9

$ow 4o Bonds 5ake 5one/6 =1otal "eturn> Is the <e/

Bonds earn mone/ two wa/s: 19 ?#er time0 the issuer of the bond pa/s the bondholder a set percentage of interest on the loan0 called the coupon9 79 At an/ point0 the bondholder ma/ choose to sell the bond on the bond market for a potential profit0 called capital gain :or loss;9 1ogether0 the net of the coupon :the interest rate; plus the capital gain :gain or loss; equals a bond's total return9

1otal "eturn Component T1: 1he Coupon

%hen /ou bu/ a bond0 /ou agree to lend the issuer a certain amount of mone/ o#er a certain length of time9 In return0 the bond issuer agrees to make regular interest pa/ments to /ou o#er the life of the loan until its maturit/ date9 1his is called the coupon9 Interestingl/0 the interest pa/ment to bondholders is called the coupon because0 decades ago0 bonds were issued on actual paper and interest was paid when in#estors literall/ clipped coupons off their paper bonds and took them to the bank to recei#e each interest pa/ment9 1his incon#enient and risk/ procedure was e#entuall/ replaced b/ electronicall/ issued bonds and interest pa/ments0 but the old name remains9 1he amount of the coupon :fi)edEinterest rate; depends on a number of factors0 such as: 1he current market interest rate at the time the bond was issued9 1he creditworthiness of the borrower t/picall/0 higherEgrade bonds ha#e lower coupons than lowerEgrade bonds0 which are considered riskier9 1he length of time until maturit/ generall/0 the longer the maturit/ date0 the higher the coupon9

.)cept in the case of floatingErate bonds0 once the bond is issued0 its coupon usuall/ does not change o#er time0 which is wh/ bonds are called =fi)edEincome> in#estments9

1otal "eturn Component T7: Capital &ains

1urn on the news or read the business section of an/ newspaper or financial web site0 and /ou will hear a lot about stocks: %hat's up0 what's down0 and what might go up or down ne)t9 Bonds are hardl/ mentioned9 *et bonds make up a much larger market than stocks9 Bond prices change dail/ on the bond market depending on se#eral factors0 primaril/ changes in interest rates and an/ positi#e or negati#e news about the creditworthiness of the bond issuer9 1hat means if /ou bu/ an alread/ issued bond on the bond market0 its #alue ma/ be greater than it was at the time the bond was first issued9 4epending on the market #alue at an/ gi#en moment0 /ou ma/ ha#e a potential capital gain or a potential capital loss9 1his new #alue of the bond changes the total return /ou will make on the bond9 %h/6 Because total return is the sum of both the coupon and the capital gain :or loss;9

$ow to Calculate .)pected 1otal "eturn

-ollowing are three common measures that combine the coupon and the current market price to help calculate the e)pected capital gain :or loss; at maturit/9 Current /ield9 Because the latest price of the bond on the bond market also matters to in#estors0 the current /ield is the bond's interest rate as a percentage of the current price of the bond on the bond market9 *ield to maturit/9 1his is the total potential income return of both price and coupon of the bond if it is held to its maturit/ date9 1a)Eequi#alent /ield9 ?nl/ in the case of nonta)able municipal bonds0 the interest earned on /our bond is based on /our ta) bracket9

In addition to /our regular coupon pa/ments0 bonds ha#e another nice feature: 1he bond issuer agrees to repa/ the principal of the loan at its maturit/ date0 which ma/ range from Pust a few months to as much as A@ /ears or longer after the issue date9 If /ou hold a bond until maturit/0 /ou get the full coupon9 -or e)ample0 if /ou purchase a 1@E/ear bond for R10@@@ with a D percent coupon0 /ou would earn RD@ per /ear :with pa/ments of R7D made twice a /ear; for 1@ /ears9 ?n top of earning its fi)edEincome pa/ment0 a bond has another nice feature: 1he bond issuer guarantees to pa/ back /our principal in full9 (ot too man/ other in#estments offer such a reassuring promise9 +o0 going back to the e)ample of a 1@E/ear bond of R10@@@ with a D percent coupon0 /ou would recei#e a total of RD@@ in fi)edEincome coupon pa/ments :RD@N/ear for 1@ /ears;0 plus full repa/ment of /our original R10@@@ principal0 for a total of R10D@@, But the stor/ does not end there9 In addition to the potential /ield of the bond o#er time0 based on its fi)edEinterest rate0 there is also the option of earning a profit :or a loss; b/ selling /our bond on the bond market9 $ere is where bonds get a bit trickier9

*our Bond's 1otal "eturn Is Alwa/s Changing

As mentioned before0 a bond's total return is the sum of the capital gain and the coupon9 Because bonds are traded on the bond market and their prices continuousl/ change0 the bond's effecti#e or current /ield also changes0 regardless of its original coupon9 -or e)ample0 if /ou bu/ a 1@E/ear R10@@@ bond with a D percent coupon for R107@@0 /ou are no longer getting a D percent /ield from it9 *ou will still get the same fi)ed D percent coupon of R7D twice per /ear9 But because /ou paid R107@@ for the bond0 not R10@@@0 this coupon effecti#el/ represents a C97 percent annual /ield9 1herefore0 its effecti#e or current /ield is C97 percent9 But wait a second9 *ou also ha#e to consider that when the bond matures0 /ou will not get /our R107@@ back9 *ou will get R10@@@0 which was the original price of the bond9 1hat's a R7@@ capital loss to take into account0 which is wh/ it's a good idea to calculate a bond's /ield to maturit/ 9 *ield to maturit/ spreads the discount or premium paid for a bond across the length of time /ou own it9 -or e)ample0 if /ou bought this 1@E/ear R10@@@ bond 7 /ears after it was issued0 spreading that R7@@ loss o#er the time /ou own it gi#es /ou a /ield to maturit/ of onl/ 797D percent9 *ou ma/ be getting R7D e#er/ F months0 but when the bond matures0 /ou are effecti#el/ losing half of that /ield :getting 791 percent instead of D percent; because of that R7@@ loss on the premium price9 ?f course0 this is the case onl/ if /ou paid a premium for the bond9 If /ou paid a discount for the bond :meaning /ou paid less than R10@@@ for a R10@@@ bond;0 then the current /ield and /ield to maturit/ add to the #alue of /our bond9 *our total return :the coupon plus the capital gain; is the real #alue of /our bond at an/ gi#en time0 whether /ou sell it or not9 It ma/ be tempting to think that /our fi)edErate bond is Pust plodding along0 earning /ou a stead/ stream of income0 and it is9 But bonds are much more than their coupon #alue9 .#er/ minute that the bond market is open0 the total return #alue of /our bond is changing9 In addition0 /our options for putting /our mone/ into other in#estments are also changing9 All these factors must be considered when /ou decide if owning bonds is in /our best interest9 If /ou look onl/ at the bond's coupon interest rate0 /ou are missing the bigger picture of the total return9 And as we will see shortl/0 missing the bigger picture can lose /ou a lot of mone/ #er/0 #er/ quickl/9

%hat's a Better Bond Bet 6

%hich bond would /ou rather bu/: a 1@E/ear bond with a higher coupon selling at a premium or a lowerEcoupon bond that /ou can bu/ at a discount6 At first0 it ma/ seem as if the higherEcoupon bond is a better in#estment because of its better interest rate9 But that is not alwa/s the case9 +ometimes a lowerEcoupon bond0 bought at a discount0 is /our better choice9 %h/6 Because the onl/ thing that matters is the bond's total return0 which is the sum of the coupon plus the capital gain9 Pa/ing a premium for a bond :because it has a higher coupon; is an e)pense that must be considered when determining the capital gain9 +o if the higher coupon is not enough to offset the cost of the premium during the time /ou own the bond0 then the lowerEcoupon bond0 which can be purchased at a discount0 is actuall/ the better deal9

$igher "isk0 $igher *ields

Bonds ma/ be less risk/ than stocks because0 unlike stocks0 the/ pa/ interest and also guarantee the return of principal0 but the/ are not risk free9 1he le#el of percei#ed risk affects how much interest bond issuers are willing to pa/ when a bond is first issued9 After a bond is issued0 an/ changes in the le#el of risk will impact how much in#estors are willing to pa/ for that bond on the bond market9 1hese risk factors include changes in interest rates0 changes in creditworthiness0 and the passage of time9

Interest "ate "isk

1he bond market is ultraEsensiti#e to changes0 e#en #er/ small changes0 in interest rates9 4epending on current interest rates0 bonds ma/ trade at a premium or at a discount to their par or face #alue :i9e90 the principal for which it was originall/ purchased and will be paid at maturit/;9 If interest rates ha#e gone up since a bond has been issued0 the bond will trade at a discount to make up for the lower coupon pa/ments0 compared to the currentl/ higher rates one can get on newl/ issued bonds9 $owe#er0 if interest rates ha#e gone down since the bond was issued0 that bond will trade at a premium because of its higher coupon0 compared to current interest rates9 In general0 the longer the bond has to maturit/ or the lower the coupon0 the more price sensiti#it/ that bond has to /ield changes9 1he degree of this price sensiti#it/ is measured in terms of something called duration9 1he greater a bond's duration0 the more sensiti#e the price of the bond is to interest rate changes9 -or e)ample0 a bond with a duration of two will mo#e 7 percent in price for e#er/ 1 percent change in /ield9 A bond with a duration of four will mo#e C percent for e#er/ 1 percent in price change in /ield0 and so on9 Clearl/0 when interest rates rise0 the prices of bonds with the highest duration will fall the fastest9 As in all markets0 what in#estors belie#e ma/ happen in the future affects how the/ #alue or discount an/ asset9 In the case of bonds0 if in#estors foresee a decline in interest rates in the future0 the/ will want to bu/ bonds now in order to sell them at a profit later9 $owe#er0 if in#estors belie#e that interest rates ma/ rise in the future0 the/ will not be too eager to bu/ lower interest rate bonds now unless the/ can get them cheapl/9 %hen interest rates rise more and more0 demand for alread/ e)isting bonds will decline more and more0 and bond prices will fall more and more9 1his is wh/ in#estor beliefs about the future direction of interest rate changes make a difference in the current market #alue of bonds9 Bust as we discussed in the pre#ious chapter on stocks0 in#estor ps/cholog/ matters9

Credit "isk
In addition to being ultraEsensiti#e to interest rate changes0 bond #alues are also responsi#e to changes in percei#ed credit risk9 As with an/ loan0 higher percei#ed risk of the creditor comes with higher rewards to the lender :meaning higher interest rates;0 while lower percei#ed risk loans come with smaller rewards :lower interest rates;9 1hus0 the safest bonds tend to ha#e the lowest /ields0 and riskier bonds from the least creditworth/ companies0 or Punk bonds0 come with the highest /ields9 3nder normal conditions0 credit risk t/picall/ does not radicall/ change from the time a bond is issued until the time of its maturit/0 but that is not alwa/s the case9 A once creditworth/ bond issuer can become not so creditworth/ o#er time9 1hat is the credit risk9 .#en without a big change in creditworthiness0 this risk does change somewhat o#er time9 If in#estors feel that the creditworthiness of the bond issuer has gone down since the bond was first issued meaning the borrower has for some reason become less likel/ to pa/ the coupon or return the principal then bondholders are more likel/ to want to get rid of these bonds0 and their market prices will decline9 $owe#er0 when in#estors feel confident in the bond issuer0 the/ are willing to pa/ more for a bond that

appears to be a lower risk than for a bond that seems to be at higher risk9 ?f course0 the lower risk also means a lower coupon9 1he degree of credit risk is not a permanent feature of a bond9 Bust like interest rates0 creditworthiness changes o#er time and in#estor ps/cholog/ pla/s an important role9 Because the coupon is higher for the higherErisk bond0 in#estors ma/ want to take a bet on them0 hoping the bond issuer's poor public image ma/ impro#e down the road9 %hen in#estors feel less confident about the future0 the/ ma/ feel less eager to own e#en currentl/ highErated bonds if in#estors become concerned about future credit risk9

1ime "isk

All risk0 including interest rate risk and credit risk0 increases o#er time9 1he longer the maturit/ date0 the greater the odds of either interest rates going up or the bond issuer's creditworthiness going down9 +o the greater the amount of time to maturit/0 the greater the risk0 and therefore the higher the interest rate paid9 B/ t/ing up /our principal for a longer time0 /ou are making a bigger sacrifice b/ not ha#ing /our mone/ a#ailable for other purposes :the time #alue of mone/;0 and /ou are taking on greater interest rate and credit risk9 +o0 generall/ speaking0 longEterm bonds come with higher coupons than mediumEterm bonds0 which come with higher coupons than shortEterm bonds9 But it doesn't alwa/s work that wa/0 particularl/ if interest rates are e)pected to go down0 not up9 In that case0 longEterm bonds ma/ come with lower coupons than shortEterm bonds9 A longEterm bond that does not come with a higher /ield than a shortEterm bond can be a losing proposition for the bondholder unless /ou feel confident that interest rates will fall9 $owe#er0 if interest rates rise as we know the/ will when inflation increases then longEterm bonds are a #er/ bad bet because the future interest rates will likel/ be much higher than what these longEterm bonds currentl/ pa/0 making the market #alue of the longEterm bonds fall9

1he Bond 8adder

?ne traditional wa/ to protect /ourself from fluctuating interest rates is b/ creating a bond ladder9 1his is done b/ bu/ing a #ariet/ of bonds with staggered maturit/ dates0 so that /ou ha#e bonds maturing at least e#er/ /ear0 with the longest bonds maturing at later dates9 Bond ladders can be as short as A@ da/s to F months or as long as A@ da/s to A@ /ears9 As /ou get some of /our principal back each /ear0 /ou can reassess the current financial circumstances and rein#est accordingl/9 If interest rates rise0 /ou won't be hurt as badl/ as if /ou had all one kind of bond0 and if interest rates fall0 at least /ou will ha#e some portion of /our bond portfolio that will benefit9 1his is a great plan under normal conditions9 But0 as we keep sa/ing0 these are not normal conditions9 %e aren't sa/ing /ou should abandon the bond ladder strateg/ entirel/ now0 but please proceed with caution and take note of the ca#eats raised in this chapter0 especiall/ with longerEterm bonds9

In#estors $a#e 1hree &ood "easons to -eel Confident in Bonds

In general0 in#estors ha#e considered bonds to be among the safest of all in#estments9 1he reasons for this are rock solid: 19 Bonds issued b/ pri#ate entities are backed b/ the assets of the bond issuer0 so e#en if the/ become less creditworth/ or go into bankruptc/0 as a creditor0 /ou ha#e the right to collect on this debt9 Bonds are safer than stocks in this situation because bondholders get paid before shareholders9 79 1he bond issuer guarantees repa/ment of the principal9 (o stock issuer can make that claim9 A9 Bonds issued b/ public entities are backed b/ state and federal go#ernments9 1hese entities ha#e the abilit/ to raise ta)es to make good on their pa/ments9 &i#en these three #er/ nice safet/ features0 in#estors tend to think of man/ bonds as nearl/ risk free9 $owe#er0 nothing could be further from the truth in a falling bubble econom/ in which the go#ernment is massi#el/ printing mone/9 As we will e)plain in more detail shortl/0 as inflation goes up and interest rates rise0 bond #alues will quickl/ fall9 %hile there is a bit of concern that interest rates cannot sta/ this low fore#er0 in general0 in#estors are not too concerned about rising interest rates or a big downturn for bonds9 1his is the ke/ reason that so man/ indi#idual and institutional in#estors who follow con#entional wisdom on bonds will get hurt so badl/ in the coming Aftershock: 1he/ aren't e)pecting it9 An/ in#estor who is /ounger than D@ /ears old has been in a bull bond market their entire adult life9 1hat's a large percentage of our in#esting communit/0 and the/ will be #er/ much taken b/ surprise9 %hen inflation and interest rates rise significantl/0 longEterm bonds and all bonds are going to take a terrible beating9 5an/ large institutions are hea#il/ in#ested in bonds0 especiall/ longEterm bonds0 and a significant chunk of their assets will go to 5one/ $ea#en9

Con#entional %isdom on Bonds: 1he +afet/ of the "ecent Past 5eans %e Can Count on 5ore +afet/ Ahead

Almost all con#entional wisdomSt/pe thinking usuall/ has a good historical basis9 +o to understand C% we need to look at recent histor/9 ?nl/ b/ understanding C% can we understand the Aftershock #iew on bonds and wh/ C% is wrong9 8ike stocks0 we don't need to go back to the beginning of the bond marketJ we Pust need to take a brief look at the more recent histor/ of bonds because that's what C% focuses on9 +o0 if we look back at the beginning of the modern bond market in the late 1H@@s and earl/ 1I@@s0 we see that bonds dominated the in#estment landscape9 +tocks were not #er/ important9 As we discussed in the pre#ious chapter0 the/ were considered too risk/0 e#en for institutional pension funds9 .#entuall/0 as we mo#ed into the 1IF@s0 stocks became more acceptable0 but bonds maintained their position as a much less risk/ and more stable alternati#e to stocks9 Bonds were the wa/ to reduce risk in a stock portfolio9 $owe#er0 b/ the beginning of the 1IH@s0 bonds had entered a new era9 1hree maPor changes were about to occur: 19 Interest rates were #er/ high and about to start falling lower0 heating up the bond market9 79 8ooser go#ernment regulations made it possible for the banking sector to issue more bonds9 A9 1he go#ernment was starting to run large deficits and needed to issue enormous numbers of bonds9 1his was also part of an o#erall massi#e increase in consumer lending :often backed b/ bonds0 such as mortgage bonds; and corporate borrowing9 And it wasn't Pust a 39+9 phenomenon borrowing was rising all around the world9 1here was a worldwide massi#e increase in debt and e)posure to debt9 1he first factor0 declining interest rates0 made bonds a particularl/ good in#estment9 "emember what we said earlier about the importance of looking at the total return of the bond0 not Pust the interest rate9 As interest rates fell0 bonds were showing e)cellent capital gains9 As /ou can see from -igure D91 0 this bond bull due to falling interest rates has continued to this da/ and will likel/ continue for a while longer in the future9 -igure D91 -alling Interest "ates $a#e Pumped 3p Bond Prices +ince 1IH@ Bonds ha#e been a #er/ good in#estment since 1IH@9 +ource: Bloomberg and Bain Capital9

?f course0 that's where the second big change in the 1IH@s gets more important9 +ince the 1IH@s0 the amount of outstanding debt has e)ploded0 as -igure D97 indicates9 1his is not Pust go#ernment debt but all debt0 including corporate0 mortgage0 and consumer debt9 %hen the bubble econom/ pops0 this massi#e debt will be absolutel/ e)plosi#e9 %e saw a pre#iew on a small scale of what's to come with the mortgage debtSfueled financial meltdown in 7@@H9 -igure D97 Bond 5arket &rowth0 1II@S7@1@ 1he siMe of the bond market has e)ploded since 1IH@9

1he mortgage meltdown was onl/ a small pre#iew because mortgage debt is onl/ a small part of the world's o#erall debt9 Also0 the 39+9 go#ernment0 through its massi#e borrowing and mone/Eprinting powers0 was able to step in and essentiall/ take o#er much of the mortgage debt market9 In .urope the same thing is happening0 with a combination of increased borrowing and some mone/ printing being used to stabiliMe the go#ernment debt situation for &reece0 +pain0 and Ital/9 5an/ people think that because the go#ernment was able to take o#er the mortgage market0 and

go#ernments in .urope ha#e been able to keep the .uropean debt situation from melting down0 at least so far0 that there isn't a much larger debt problem9 But the massi#e debt problem is still thereJ it Pust can't be as easil/ seen9 And if it can't be easil/ seen0 /ou can bet that C% won't see it9 1he last thing C% wants to spot is problems9 %hat can be easil/ seen is that bonds ha#e performed #er/ well o#er the past few decades0 and e#en before then the/ were certainl/ quite safe9 *es0 there were some problems in 7@@H0 but the/ were sol#ed9 $ence0 bonds still seem safe and their in#estment performance has been amaMing9 +o0 needless to sa/0 C% is #er/ happ/ with bonds9 $istor/ pro#es the/ are right9 "ight6 But what if the underl/ing conditions of the past change in the future6 %hat if that massi#e increase in debt is actuall/ undermining the abilit/ of go#ernments and people to pa/ off these bonds6 5ost importantl/0 what if the world's bubble econom/ pops and inflation and interest rates rise substantiall/6 %ith those questions in mind0 let's look at the Aftershock #iew of what will happen to the bond market in the future9 (eedless to sa/0 it isn't what C% sees now or e#er wants to see9

%h/ Con#entional %isdom on Bonds Is %rong

Con#entional wisdom on in#esting in bonds is wrong because it relies on two ke/ assumptions that0 unfortunatel/0 are dead wrong: 19 1he recent past is a good reason to trust the near future9 79 If all else fails0 the federal go#ernment will somehow sa#e us :as it did for the mortgage bond market;9 8et's tackle each of these wrong assumptions one at a time9

%rong Assumption T1: 1he "ecent Past Is a &ood "eason to 1rust the (ear -uture

-irst of all0 and most importantl/0 the future is not the past, It ne#er was and it ne#er will be9 5arkets alwa/s e#ol#e9 1here is ne#er a question of if a market will e#ol#eJ it is alwa/s onl/ a question of when9 1he bond market has enPo/ed an amaMing run0 beginning in the 1IH@s9 As great as it has been0 what Pustification or e#idence do we ha#e right now to belie#e that somehow that great run will ne#er end6 "ight now0 interest rates are ridiculousl/ low9 Is it reasonable from here to e)pect interest rates to fall e#en lower6 8ogic tells us that interest rates are far more likel/ to e#entuall/ rise than to fall e#en further9 *ou don't ha#e to bu/ our macroeconomic point of #iew to see this e#entuall/ happening9 As a general rule0 interest rates tend to run about 7 to A percent abo#e the inflation rate9 1hat is certainl/ not the case toda/9 Interest rates are #er/ low0 relati#e to inflation0 and some interest rates ha#e actuall/ gone so low that the/ are now in negati#e territor/9 -or e)ample0 as of this writing in Bune 7@170 the +wiss twoE/ear bond had a coupon of [@9D percent9 1hat means in#estors who bu/ this bond are not onl/ willing to make no profit on the bond0 the/ are also willing to lose mone/0 Pust for the safet/ of =parking> capital in what the/ #iew as a safe ha#en9 %ith current interest rates so at/picall/ low and e#en negati#e0 the odds are that interest rates will e#entuall/ rise0 or not fall much further0 in the future9 "ight now0 massi#e mone/ printing is keeping interest rates low0 but massi#e mone/ printing cannot go on fore#er9 %h/ can't mone/ printing go on fore#er6 At the risk of dri#ing /ou craM/ from repeating oursel#es in e#er/ chapter0 it is because massi#e mone/ printing e#entuall/ causes massi#e inflation9 *ou simpl/ cannot print mone/ without end and a#oid de#aluing the dollar9 If we could escape that basic truth0 we could Pust keep printing without end and forget all our mone/ problems fore#er9 Can't do that9 .)panding the monetar/ base will cause rising inflation :for details0 please see Chapter A and also see Aftershock0 +econd .dition;0 and rising inflation will cause rising high interest rates9 "emember0 /ou don't need too much of an increase in interest rates to get a big drop in bonds9 .#en a small increase pushes bond #alues down :see sidebar and 1able D91 ;9 1herefore0 a big rise in future inflation and interest rates will create a massi#e downside for bonds9
1able D91 Interest "ates 3p0 Bond 2alues 4own

Interest rate D\ F\ G\ 1@\ 1D\

8ost bond #alue 1H\ lost 7D\ lost A1\ lost CF\ lost FA\ lost

%rong Assumption T7: If All .lse -ails0 the -ederal &o#ernment %ill +omehow +a#e 3s

1his will be true0 right up until the minute it is no longer true9 Certainl/0 the federal go#ernment will do all it can to protect bondholders0 if for no other reason than as soon as it stops protecting bondholders0 it can no longer issue an/ more bonds because no in#estors will be willing to bu/ those bonds9 But as we approach the coming Aftershock0 the go#ernment will not be able to sa#e the bond market9 %h/6 Because 9 9 9

5oderatel/ "ising Interest "ates .qual +harpl/ -alling Bond Prices

1hink 39+9 1reasur/ bonds are a safe in#estment6 +ure0 the 39+9 1reasur/ ma/ not default on bonds in the ne)t couple of /ears0 but bonds can still lose a lot of #alue when inflation goes up and forces interest rates to rise9 1o gi#e /ou some idea of how much a 1reasur/ bond can lose with relati#el/ small interest rate increases0 we offer /ou the following e)ample9 8et's assume /ou Pust bought a 1@E/ear 1reasur/ bond that is earning A percent9 If the interest rate rises from A percent to Pust C percent0 /our bond loses a whopping 17 percent of its #alue9 1able D91 shows what happens if interest rates go e#en higher9

1he -inal 1wo Bubbles in America's 5ultibubble .conom/ %ill Pop

1he dollar bubble and the go#ernment debt bubble will be the last of our si) conPoined bubbles to burst9 1he first four :stocks0 real estate0 pri#ate debt0 and discretionar/ spending; bubbles ha#e alread/ begun to fall0 and the/ will all full/ pop when the last two finall/ go9 1o support the falling econom/ since the real estate bubble popped and the stock market crashed in late 7@@H0 the go#ernment has been emplo/ing two powerful t/pes of temporar/ stimuli: huge deficit spending :borrowing mone/; and massi#e mone/ printing :which makes that huge borrowing possible b/ keeping interest rates low;9 1his has worked in the short term9 %ithout these t/pes of stimulus0 the stock market and econom/ would ha#e crashed b/ now9 $owe#er0 as we ha#e pointed out again and again0 the stimulus itself will soon add to0 not cure0 the problem9 1hat's because huge deficit spending0 while a temporar/ boost to the econom/0 adds to our alread/ huge go#ernment debt bubbleJ and massi#e mone/ printing0 while a temporar/ boost to the stock market0 will create rising future inflation :e#entuall/ popping the dollar bubble;9 And when inflation rises significantl/0 interest rates will rise9 Also0 the #alue of the dollar will fall and so will the #alue of most dollarEdenominated assets0 as in#estors make a mad dash to get out of them9 "ising inflation and rising interest rates would be bad for an/ econom/0 but the/ are especiall/ bad for a multibubble econom/ alread/ in decline9 $igh interest rates will be bad for stocks0 bonds0 real estate0 and businesses9 And high interest rates will be especiall/ bad for the go#ernment debt bubble9 1hat's because the go#ernment ne#er actuall/ pa/s back the principal of its debt0 onl/ the interest pa/ments0 and it makes these interestEonl/ pa/ments b/ borrowing more mone/9 1herefore0 each time interest rates rise0 the go#ernment has to borrow again and again at the new0 higher interest rate0 adding e)ponentiall/ to the debt9 As inflation and interest rates rise and the go#ernment debt spikes e#er upward0 in#estor ps/cholog/ will turn increasingl/ negati#e9 It is hard to belie#e now0 but e#entuall/ in#estors won't want to bu/ an/ of our debt9 At that point0 we will continue to make our interestEonl/ pa/ments with more printed mone/0 but soon that will not work either because more mone/ printing will push inflation higher and higher and interest rates higher and higher0 too9 At some point0 massi#e mone/ printing will ha#e to end and our interestEonl/ pa/ments will not be made0 and the 39+9 go#ernment will be in default on its debt9 As of this writing in Bune 7@170 +tandard K Poor's :+KP; rates the 3nited +tates at AA]0 while -itch and 5ood/'s still maintains its AAA credit rating for the 3nited +tates9 But that could change with the ne)t big federal budget showdown9 Also0 inflation and interest rates are low9 But later0 when inflation and interest rates rise enough to force an end to massi#e mone/ printing0 and when the go#ernment can no longer make its interest pa/ments on the debt0 39+9 go#ernment bonds will drop to ZZZ credit score #er/ quickl/0 Pust like the mortgage market crash0 because in#estor ps/cholog/ will change #er/ quickl/9

%h/ Aren't Bond In#estors %orried About 1his (ow6

In#estors ha#e some comforting reasons for not being too concerned about bonds :/et;9 -irst0 as e)plained earlier0 recent histor/ has been #er/ good for bonds9 1hat is hard to ignore0 especiall/ when /ou want that good recent histor/ to continue9 In addition0 in#estors draw comfort from the man/ nice safet/ features of bonds0 such as the guaranteed return of the original principal0 which other in#estments generall/ do not ha#e9 And0 of course0 bond in#estors draw deep comfort from their faith that the federal go#ernment can alwa/s print more mone/ and bu/ more bonds0 keeping the demand for bonds strong9 But e#en more than these reasons for their comfort with bonds0 in#estors' unwa#ering confidence in bonds comes from an e#en deeper and more powerful source: 1he ps/cholog/ of denial9 It is natural to want good things to last fore#erJ that's Pust human nature9 It is also human nature to not want to face certain facts that might threaten the current good status quo until those facts absolutel/ ha#e to be faced9 $owe#er0 we actuall/ often quietl/ know more than we want to openl/ face9 %e lie to oursel#es0 but to a certain e)tent we sort of alread/ know that it is a lie9 In the case of bonds0 most in#estors actuall/ alread/ know on some le#el the #er/ thing that the/ don't want to face9 5ost of them know that quantitati#e easing :!.; causes inflation0 that rising inflation causes rising interest rates0 and that rising interest rates cause bonds to fall9 Because the/ would rather not face these facts0 the/ are highl/ moti#ated to belie#e that whate#er the current le#el of mone/ printing we are now doing is Pust the right amount9 8ike &oldilocks with her fa#orite bowl of porridge0 the amount of !. is alwa/s =Pust right> not too hot0 not too cold0 not too little0 not too much9 .ach time more massi#e mone/ printing occurs0 C% in#estors and anal/sts declare it is Pust the right amount9 (o matter what is happening0 it is all =doable0> it is all Pust fine because the go#ernment will not let us fail9 4enial is what will keep the part/ going in the stock market and the bond market right up until the moment when the denial suddenl/ e#aporates and e#er/one wants out9 1hat is how /ou know it is denial9 If in#estors don't alread/ know on some le#el that things are not as wonderful as the/ seem0 wh/ is it so eas/ for them to change their minds on a moment's notice and head for the door6 Clearl/0 deep down0 in#estors are more skittish than the/ let on0 e#en perhaps to themsel#es9 But when the time comes0 the/ generall/ don't take #er/ long to figure out that the/ all want out9 :1his denial stage is the first of the si) ps/chological stages of dealing with the coming Aftershock0 described in more detail in our 7@11 book Aftershock0 +econd .dition;9

Bonds %ill -ail in 1hree +tages

In#estors will not all run out and sta/ out of the bond market at the first signs of trouble9 1hat's wh/ the bond market will not fall all at once0 but will decline in stages leading up to the Aftershock0 before the biggest crash9 $ere is our best appro)imation of how that will happen9

Bill &ross: <ing of Bonds

Bill &ross is the founder and coEchief in#estment officer of PI5C?0 an in#estment firm based in 8os Angeles :(ewport Beach;9 $e manages the largest bond fund in the world0 the PI5C? 1otal "eturn -und with o#er R19C trillion in assets9 1hat's also the largest mutual fund or e)changeEtraded fund in the world9 +o0 needless to sa/0 when Bill &ross speaks about bonds0 people listen9 $e can literall/ mo#e the markets9 ?f course0 since he has a #ested interest in what he is sa/ing0 /ou ha#e to keep in mind he ma/ want to mo#e the markets in whate#er direction benefits him9 But0 e#en with that ca#eat0 he is well worth listening to0 as he is one of the best of the big bond fund managers9 ?ne pronouncement he made in the spring of 7@11 was most interesting9 $e said he was mo#ing out of 39+9 1reasur/s9 1hat's a bold statement for a big bond manager9 $e said he thought the risks were increasing and it was time to mo#e9 As it turned out0 it was not time to mo#e9 $is fund suffered and missed out on the big bond rall/ caused in part b/ the downgrade of 39+9 bonds b/ +KP9 *es0 the logic of the bond market is prett/ screw/ right now0 but that's the wa/ it is when so man/ people are increasingl/ afraid of stocks9 $is fundamental instincts about problems with 1reasur/s were right0 but his timing was off9 It ser#es as a good lesson about Aftershock in#esting9 .#en if /ou can see a bubble as clear as da/0 that doesn't mean it is immediatel/ going to pop9 It will pop0 it Pust ma/ not pop tomorrow or e#en ne)t /ear9

+tage 1: 1he "ecent Past and (ow

As /ou ma/ ha#e noticed0 during the global financial crisis of late 7@@H0 while stock markets around the world were falling C@ percent and more0 the bond markets remained generall/ unfaMed9 If an/thing0 bonds benefited to a certain e)tent from the crisis because in#estors #iewed bonds as a safe ha#en as the/ fled from stocks9 1his Pust pro#ided more e#idence to the C% cheerleaders that bonds are #er/ low risk9 But the fact that the bond market is currentl/ trusting bonds0 which is keeping interest rates low0 doesn't mean bonds actuall/ are worth/ of that in#estor trust9 8ots of things can temporaril/ sell at the =wrong> price until in#estors figure it out9 At that point0 in#estors' #iews of trustworthiness can change #er/ quickl/9

+tage 7: 1he +hortE1erm -uture

As long as the 3nited +tates is still #iewed as a safe ha#en0 especiall/ compared to .urope0 and as long as massi#e mone/ printing b/ the -ederal "eser#e keeps working to keep interest rates low0 bonds will do oka/9 But bonds will become increasingl/ #ulnerable o#er time9 Clearl/0 an/ future rise in interest rates will hurt bonds0 so the big question is what will happen ne)t for interest rates6 $ow much lower can the/ go6 %ith 39+9 interest rates alread/ so low0 it is hard to see them going much lower0 although the/ could temporaril/9 Interest rates could e#en fall below Mero0 but that clearl/ would not be sustainable9 :An interest rate below Mero means that the bond holder is guaranteed to lose mone/ o#er time9 .#en if in#estors were willing to put up with that for a while0 the/ certainl/ don't want that o#er the longer term9; It is much more likel/ that interest rates will rise0 not fall0 o#er time9 In the short term :7@17 and 7@1A;0 interest rates will not likel/ rise too dramaticall/9 But remember0 an/ rise in interest rates will ha#e a negati#e impact on bond prices9 Please go back and take another look at 1able D91 if /ou need an/ further con#incing about how fast bond #alues drop as interest rates rise9 .#en a small rise in interest rates will hurt bonds9 1he sa#ing grace for bonds in the short term is that whene#er stocks take a significant dip0 in#estors t/picall/ like to mo#e temporaril/ into bonds in a flight to safet/9 1his will help keep up demand for bonds0 e#en if interest rates start to creep up a bit9

+tage A: 1he 5ediumE1erm -uture

As time goes on0 interest rates will creep up e#en further9 %hat will make interest rates rise further6 %ell0 b/ now /ou know all too well what we are about to sa/: 5assi#e mone/ printing will lead to rising inflation0 and rising inflation will e#entuall/ bring us rising interest rates9 1his is not something we can get out of b/ pretending it isn't there9 .#en if the -ed were to stop all mone/ printing toda/ :and the/ alread/ said clearl/ that the/ will not;0 we ha#e alread/ increased the mone/ suppl/ threefold since 5arch 7@@I9 1hat is more than enough to gi#e us plent/ of future inflation and rising interest rates9 $igh inflation and high interest rates are not going to occur o#ernight9 It will happen o#er time9 1he more time that goes b/0 the greater the risk to bonds9 "ising interest rates will clearl/ make bonds fall more and more9 As mone/ printing and other manipulations begin to backfire0 inflation and interest rates will rise0 and bond prices will decline much further9 But not e#er/ bond will crash in #alue o#ernight9 Bonds from weaker issuers the ones with higher interest rates that some in#estors thought would pa/ off big fail first0 as those companies can no longer secure cheap debt to prop up their earnings and are forced to default9

Bonds Bust Before and 4uring the Aftershock

8eading up to and during the Aftershock0 companies will be forced to liquidate0 but with so man/ going on the market at the same time0 the/ will ha#e little #alue0 and hordes of bondholders will line up for their man/ pieces of a #er/ small pie9 Bankruptcies0 decreased lending0 and a mass e)odus of foreign in#estment will lead to a collapse in the stock market0 and suddenl/ e#en the most rockEsolid companies will start to look like another 8ehman Brothers9 %hile a stock market holida/ ma/ be declared :see Chapter 11;0 there will be no need to declare a bond holida/9 1he bond market will effecti#el/ shut itself down9 1he federal go#ernment can0 and will0 ease the pain of this for as long as it can with more mone/ printing9 But as we'#e said0 e#entuall/ this medicine becomes the poison0 and there will be little the -ed or an/one else can do without Pust making things worse9 "ight now0 the -ed can put mone/ into the s/stem with #er/ few shortEterm consequences0 as an/ potential inflation will lag at least b/ a couple of /ears behind !.9 But once inflation gets going :in the D to 1@ percent range;0 the lag time behind an/ new mone/ printing will become shorter and shorter0 until e#entuall/ the econom/ responds almost instantl/ to an/ additional mone/ printing b/ the -ed b/ raising prices9 1his is trul/ being stuck between a rock and a hard place for the federal go#ernment9 %ith ta) re#enues dropping due to high unemplo/ment and e)penses sk/rocketing due not Pust to inflation but to bailouts and co#ering guarantees on pensions0 insurance0 and other debt obligations0 the go#ernment has no choice but to go deeper and deeper into debt9 But with inflation at e)orbitant le#els0 no one wants to put their mone/ into 1reasur/ debt without significantl/ higher interest rates9 1raditionall/0 here is where the 1reasur/ could turn to the -ed to print mone/ and finance its debt0 but with an/ increase in the mone/ suppl/ leading to nearEinstant inflation not to mention terrif/ing in#estors e#er/where that =solution> becomes selfEdefeating9 1reasur/ debt can't be paid9 &uarantees can't be co#ered9 .)penditures are out of control9 %hen the federal go#ernment can no longer borrow mone/0 there's no longer an/ need to worr/ about its credit rating9 1he/'ll probabl/ call it something like =repudiating pa/ment0> but make no mistake: 1his is where the most rockEsolid of debtors0 the 39+9 go#ernment0 goes into default9 (ot all go#ernment obligations will be repudiated0 but it's likel/ that most outstanding bonds will cease to be paid9 Cases of hardship will be gi#en priorit/0 but then that's not a position that most in#estors will want to be in9 In the Aftershock0 the go#ernment safet/ nets for bonds of all kinds will fail because the go#ernment will not ha#e the mone/ to co#er them9 %e will not be able to print mone/ fore#er due to the rising inflation9 ?nce we can no longer print mone/0 the go#ernment will no longer be able to make its interest pa/ments on the federal debt and the go#ernment debt bubble will pop9 (eedless to sa/0 at that point0 nearl/ all dollarEdenominated bonds and other assets will crash9

%hat's a +a##/ Aftershock In#estor to 4o6

Clearl/0 Pust as for stocks0 being 1@@ percent out of all bonds before the Aftershock hits is essential9 If 39+9 1reasur/s are in trouble0 no bond of an/ kind will be safe9 $owe#er0 remember that we are not there /et9 1hat means there is still time before inflation mo#es up high enough and interest rates rise high enough to kick off the coming multibubble pop and the Aftershock that will follow9 Before that occurs0 some bonds will hold up better than others9 +o in the shorter term0 it is still oka/ to own some bonds0 but onl/ if the/ are part of a wellEdi#ersified0 AftershockEbased0 acti#el/ managed portfolio that includes a #ariet/ of asset t/pes0 such as stocks0 bonds0 gold0 foreign currencies0 and more :see Chapter 11;9

%hat0 5e %orr/6 $ow 4angerous Are *our Bonds 6

5an/ in#estors make the mistake of thinking that if interest rates go up0 the/ can still get some benefit from holding on to their bonds because at least the/ are earning some interest on the bond0 and earning some interest is better than no interest at all0 e#en if the/ aren't getting the highest possible interest rate9 But there is much more to the stor/ than that9 1he problem is not merel/ that /ou will earn a lower interest rate9 1he problem is that the #alue of /our mone/ tied up in the bond will be falling due to rising inflation9 -or e)ample0 if /ou are holding on to a 7 percent bond because /ou think that earning 7 percent is better than earning Mero percent0 and if inflation is 17 percent0 then /ou are losing 1@ percent per /ear9 If inflation is 77 percent0 /ou are losing 7@ percent per /ear9 .#en if /ou don't belie#e inflation will go that high0 /ou are alread/ losing mone/ toda/ because inflation is alread/ more than the 7 percent /ou are getting on /our bond9 And if interest rates rise0 as the/ likel/ will e#en if we don't ha#e an Aftershock0 /our bond is onl/ going to drop in #alue9 +o a lowE percent bond is not better than no bond at all because if /ou ha#e no bond at all0 /ou ha#e that mone/ a#ailable to in#est in something that keeps up with inflation or0 e#en better0 earns /ou a profit9 "emember0 as we ha#e said in e#er/ chapter of this book0 bu/EandEhold in#esting is o#er9 Completel/ o#er, If /ou stick with a con#entional bu/EandEhold portfolio0 /ou will e#entuall/ e)perience bu/EandElose9

$ow to 1emporaril/ ?wn Bonds in an Acti#el/ 5anaged Aftershock Portfolio

8et's start with what not to own9 -irst0 we know that weaker bonds will be the first to crash9 1his includes less creditworth/ corporate bonds0 municipal bonds that are not go#ernment insured0 and highE/ield bonds9 4on't be lured in b/ their higher coupon rates9 1he #er/ real risks are not worth the potential rewards9 1he ne)t big red flag is all longEterm bonds0 which are more sensiti#e to interest rate changes than shortE term bonds9 Interest rates are probabl/ alread/ as low as the/ can realisticall/ go9 1his is due to the artificial demand for bonds created b/ the huge number of go#ernment bonds purchased b/ the -ed in recent /ears #ia !. :mone/ printing;9 An/ increase in interest rates is going to hurt longEterm bonds the most0 so sticking with shorterEterm bonds works to limit risk and can ease the pain when interest rates do rise9

4on't Be ?#erl/ Impressed b/ Credit "atings

%hile credit ratings can be a good measure of a bond issuer's creditworthiness at the moment0 these ratings are not necessaril/ good indicators of true future risk9 1hat is because the ratings agencies generall/ are assuming the continuation of a stable econom/ and do not foresee an/ maPor changes ahead9 1he/ are not predicting significant future inflation and rising interest rates0 let alone a worldwide0 multibubble burst9 ?nce that happens0 credit ratings in general are not going to mean #er/ much9 <eep in mind that credit ratings ha#e reall/ onl/ been tested during relati#el/ good and stable economic conditions9 And the few occasions when hard times ha#e hit0 these ratings s/stems ha#e not fared particularl/ well9 Case in point: +tandard K Poor's0 -itch0 and 5ood/'s all ga#e 8ehman Brothers an A rating right up until Pust before 8ehman collapsed9 +o much for the #alue of credit ratings, +o with these ca#eats0 what does that lea#e us6 &enerall/ speaking0 we want to stick with the lowestErisk0 go#ernmentEbacked0 shortEterm bonds for the sake of capital preser#ation9 1he point here is not to chase high interest rates0 but to maintain wealth in a wellEdi#ersified0 acti#el/ managed portfolio between now and the Aftershock9 In the short term0 before the Aftershock0 bonds to consider are: 19 5ortgageEbacked securities 79 +hortEterm 1Ebills and 1reasur/ notes A9 1IP+ :1reasur/ inflationEprotected securities;

5ortgageEBacked

+ecurities

%e said that real estate would be the first area hit and that man/ mortgages would go under9 But remember that &innie 5ae bonds in particular are federall/ guaranteed0 and while that guarantee won't mean much down the road in the Aftershock0 it will be helpful before the federal go#ernment comes close to default9 1here will be plent/ of warning signs in the meantime9 +o go#ernmentEsponsored mortgageE backed securities can actuall/ be a good option for capital preser#ation in the short term9

%hich Is Better0 Bu/ing Indi#idual Bonds or Bond -unds 6

%hether /ou're in the market for newl/ issued or secondEhand bonds0 the most common wa/ to purchase bonds is through a broker9 Bust like with stocks0 /ou can use a fullEser#ice broker or discount broker0 depending on how much help /ou need in choosing bonds9 If /ou use a fullEser#ice broker0 be sure that /ou understand how the commission is charged9 It is often included in the price of the bond0 meaning that /ou won't recei#e that part back when /our principal is returned9 *ou can also bu/ 39+9 sa#ings bonds from /our local bank9 $owe#er0 indi#idual bonds are harder to sell9 *ou will take a discount when /ou sell them9 -or some

t/pes of bonds0 like smallerEentit/ municipal bonds0 /ou ma/ ha#e to take a substantial discount of up to D percent or more to sell them9 $ence0 we recommend bu/ing bonds using e)changeEtraded funds :.1-s; or mutual funds9 .1-s and mutual funds are a con#enient wa/ to bu/ and sell bonds and are as liquid as bu/ing and selling a stock9 *ou will get the market #alue of the bonds whene#er /ou sell0 Pust like selling a bond0 but with less of a discount because the .1- or mutual fund is more liquid9 But0 unlike a bond .1- or mutual fund0 if /ou hold a bond to maturit/ and it doesn't default0 /ou will get /our entire principal back0 but /ou will be paid with less #aluable dollars depending on the le#el of inflation9 .#en if /ou hold to maturit/0 /ou're not getting paid more with a bond than with a bond fund0 it's Pust that the true market #alue is hidden9

+hortE1erm 1Ebills and 1reasur/ (otes

Again0 these won't ha#e the most attracti#e rates0 but the/ are much more reliable than corporate or municipal bonds9 %hile the -ed cannot print mone/ fore#er0 it can keep it up long enough to make these in#estments #er/ safe from credit risk in the shorter term9 1he/ ma/ still lose some #alue from inflation0 but because these mature faster0 than shorter term bonds0 that helps to limit the negati#e impact9 Also0 because the/ roll o#er so frequentl/0 /ou can repurchase them at the new higher interest rates9

1IP+
1IP+ be among the most resilient bonds9 +ince the principal is inde)ed to the CPI0 their #alue will go up as inflation rises0 both in principal and in market #alue9 .#en if the /ield is #er/ low0 these bonds can hold up #er/ well and for significantl/ longer than other t/pes of bonds9 But e#en 1IP+ will e#entuall/ be a bad idea9 5ost importantl/0 the CPI ma/ significantl/ understate the true rate of inflation0 so /ou will be losing some purchasing power9 Also0 when the go#ernment e#entuall/ does default on its debt0 adPustableErate loans0 such as 1IP+0 will be among the first to be repudiated9 +o it's important to keep an e/e on the situation and get out of 1IP+ before it is too late9 In other words0 e#en 1IP+ require acti#e in#estment management9

1iming *our .)its ?ut of Bonds before the Aftershock

1iming each stage of the demise of bonds is trick/ and depends on man/ mo#ing parts that are hard to predict in a book that will be published before man/ of these e#ents will take place9 %e know what will happen but we don't know the e)act moment that each new de#elopment will occur9 In the short term0 /ou can reasonabl/ assume that getting the timing perfectl/ right is unlikel/9 1hat means /ou are either going to be a bit too earl/ or a bit too late9 1oo earl/ seems like a much better choice9 1herefore0 e)iting all bonds sooner rather than later is not such a bad idea9 But if /ou are not read/ to get out of all bonds /et0 1able D97 summariMes our current thinking about bond risk0 with a ranking of A0 B0 and C at each stage prior to the rapid crash of bonds to ZZZ at the start of the Aftershock9
1able D97 %hen to .)it Bonds

Bonds in the Aftershock and Be/ond

5ost pre#iousl/ issued bonds will be essentiall/ worthless in the Aftershock9 Clearl/0 /ou will want to be out of all bonds before their A0 B0 or C score crashes to ZZZ9 Please don't let all /our bond in#estment capital go to 5one/ $ea#en before then9 "emember to keep /our e/es open and sta/ alert as these #ulnerable markets e#ol#e9 *ou can also follow our thinking in real time b/ #isiting our web site at www9aftershockpublishing9com 9

C$AP1." F

&etting "eal about "eal .state

%hen the 39+9 real estate bubble began to burst in 7@@G and 7@@H0 a lot of people were taken b/ surprise9 %e were not among them9 ?ur first book0 America's Bubble .conom/0 warned in 7@@F that home prices were rising too rapidl/ relati#e to incomes0 and that of our si) big fat0 colinked bubbles0 the real estate bubble would likel/ be the one to pop first9 At first0 the con#entional wisdom :C%; =e)perts> said it was nothing more than a subprime mortgage problem0 but soon the subprime mortgage problems spread to nonEsubprime mortgages and then to real estate in general0 as prices began to fall9 (o subprime mortgage problem could ha#e done that if we didn't alread/ ha#e a big fat real estate bubble0 #ulnerable to a pop9 And e#en when that happened0 the C% e)perts still told us not to worr/J reco#er/0 the/ promised0 was imminent9 +o far0 that has not happened9 Instead0 the falling real estate bubble has been #er/ painful9 4isappearing equit/ has put man/ mortgages underwater9 +hockingl/0 1D9G million mortgages in 5a/ 7@17 were underwater0 according to Qillow9 1hat is nearl/ one out of e#er/ three mortgages in the 3nited +tates, 1he falling real estate bubble has also pulled the plug on the housingEbubbleEdri#en consumer spending bubble0 and kicked off the domino multibubble fall that led to the global financial crisis of late 7@@H and is continuing to put downward pressure on the bubble econom/9 %hile all real estate is unique to /our particular location and situation0 in general0 home #alues ha#e not returned to pre#ious highs9 Prices ha#e recentl/ stabiliMed or picked up slightl/ in some areas0 while in other areas prices continue to fall9 It ma/ be tempting to think that falling real estate prices ha#e hit bottom0 but unfortunatel/ that isn't true9 1he primar/ reason that home prices ha#e not dropped much lower /et is that massi#e mone/ printing b/ the -ed and massi#e go#ernment borrowing are helping to keep the partiall/ popped bubbles temporaril/ afloat9 %hen this massi#e stimulus begins to cause serious inflation and rising interest rates0 the bubbles0 including the real estate bubble0 will fall9 1his is not a comforting thought for real estate owners0 but a#oiding realit/ will not help9 If /ou own propert/ of an/ kind0 /ou ha#e two choices: see the falling real estate bubble before it's too late to protect /our equit/J or see it later0 after the #alue of /our propert/ falls further and there are far fewer willing and able potential bu/ers9 %e are not sa/ing that /ou must sell nowJ we are sa/ing that /ou must face realit/ now0 so /ou can make /our own wise decisions about what to do9

%hat "eall/ 4ri#es "eal .state Prices6

It's eas/ to think that real estate prices should alwa/s go up o#er time9 But there are real fundamental economic dri#ers behind rising real estate prices0 and without those fundamental dri#ers0 the onl/ wa/ to push up prices is b/ inflating a bubble9 %hat fundamental economic dri#ers mo#ed real estate prices up in the past0 and what changed to create an o#erblown real estate bubble6 Centuries ago0 most people li#ed on farms0 with more or less e#er/thing the/ needed within close pro)imit/0 e#en if a great deal of labor was required to keep it going9 1his arrangement changed dramaticall/ in the nineteenth and twentieth centuries0 with three fundamental economic dri#ers gi#ing us a period of long0 sustained growth in real estate prices that continued nearl/ uninterrupted for generations: 19 Population growth9 As %ill "ogers once said0 =Bu/ land9 1he/ ain't making an/ more of the stuff9> 1he amount of land on this .arth does not increase9 +o when population grows rapidl/ as it did in the nineteenth and twentieth centuries0 it is a simple matter of suppl/ and demand for real estate9 4emand goes up0 suppl/ sta/s about the same0 and therefore prices rise9 79 3rban migration9 Increases in population and changes in the econom/ led to the growth of cities as people mo#ed awa/ from farms and competed for li#ing space in relati#el/ small areas9 Again0 the forces of suppl/ and demand made real estate prices rise9 A9 %age increases9 1echnolog/ and economic changes led to impro#ements in producti#it/0 and massi#e producti#it/ growth dro#e a corresponding growth in people's incomes0 gi#ing them more mone/ to spend on their homes9 1hat was more good news for real estate prices9 All three of these fundamental economic dri#ers contributed to each other and contributed tremendousl/ to the rise of real estate prices o#er more than a centur/9 Adding to this feedback loop was the increasing popularit/ of #acation homes9 As cities became more and more congested0 people sought refuge in quieter0 farEawa/ places9 2acation houses were cheap0 but o#er time more and more people with more and more mone/ were chasing the more desirable #acation spots0 which of course Pust dro#e real estate prices up e#en more9

1he "eal .state Bubble "ises

Beginning in the earl/ 1IG@s0 those three ke/ factors of population growth0 urban migration0 and wage increases all started to slow down substantiall/ after more than 1@@ /ears of high growth9 (onetheless0 real estate prices continued to climb9 1he late 1IG@s and earl/ 1IH@s were a time of relati#el/ high inflation0 so at first the price increases in real estate did not reflect much change in real #alue0 Pust higher prices due to a cheapening dollar :inflation;9 It is important to also note that income growth a strong fundamental dri#er of nonbubble real estate prices did not rise much during this time9 In fact0 since the 1IG@s0 real wage growth has been essentiall/ flat for more than a generation9 +o the primar/ dri#er of rising real estate prices in the 1IG@s was inflation0 certainl/ not income9 1hen0 in the earl/ 1IH@s0 things changed9 As inflation declined0 real estate prices began to take off due to something else: low interest rates and a booming econom/9 4uring the high inflation of the late 1IG@s and earl/ 1IH@s0 mortgage rates had been as high as 1H percent0 so when interest rates fell0 the cost of borrowing mone/ decreased a lot9 And not onl/ real estate got a big shot in the arm from this9 8ower interest rates and eas/ credit for consumers in the 1IH@s helped launch the beginnings of our rising multibubble econom/0 of which the real estate bubble was Pust one9 1he beaut/ of all this cheap0 eas/ credit was that lots of mone/ was a#ailable to make all kinds of purchases0 real estate included0 with a lo#el/ perk: Instead of spending one's own limited and hardEearned cash0 home bu/ers and consumers got to pla/ with the bank's mone/9 And0 m/ goodness0 is other people's mone/ a whole lot easier to spend, (aturall/0 as more and more people bought homes and other properties0 real estate prices went up and up9 1his created a bubbleEinflating feedback loop: %hen home prices went up0 people were then able to refinance their mortgages and pull out some of the increased equit/ in their homes making it possible to go shopping for e#en more stuff0 including more real estate0 not to mention all sorts of other bubble econom/ goodies0 from new cars to #acations to home impro#ement proPects and more9 Cheap loans0 eas/ credit0 and rising real estate #alues became a wonderful winEwin for the banks and consumers9 +oon the banks and other lenders were aggressi#el/ seeking more and more mortgage bu/ers0 especiall/ mortgage refinancing0 which began to grow rapidl/9 In fact0 b/ the earl/ 7@@@s0 homeowners were routinel/ using their rising home equit/ like personal A15s0 withdrawing essentiall/ =free> mone/ that helped pump up the rest of the rising bubble econom/9

%ithout the low interest rates0 the eas/ access to credit0 and the o#erall rising bubble econom/0 real estate prices would not ha#e risen much o#er the past three decades0 because during that time we had nearl/ no growth in real wages :adPusted for inflation;9 It has been almost all pure bubble growth9

Con#entional %isdom about "eal .state: Continued 8ow Interest "ates for as -ar as the ./e Can +ee

Con#entional wisdom sa/s that0 despite the recent downturn0 rising real estate prices are bound to return0 e#en if that takes a while9 And prior to its happening0 home #alues will certainl/ not fall too much lower9 1he worst is behind us9 It is Pust a matter of time before we get back on track to the assumed =natural growth> of real estate #alues Pust like we'#e had for more than 1@@ /ears9 Con#entional wisdom not onl/ belie#es we will =get back on track> soon0 the/ also belie#e that the main problem that caused the real estate drop and financial crisis in 7@@H was a lot of subprime mortgages going bad0 and that it was not due to an/ other problems9 (ow that we ha#e begun to sol#e those subprimeErelated problems0 C% e)pects to see real estate graduall/ reco#er9 1he/ acknowledge that the econom/ faces some temporar/ headwinds that are keeping the real estate rebound from happening sooner9 But0 in time0 demand will pick up and all will be well again0 as the o#erall 39+9 econom/ continues to reco#er9 ?ne reason C% feels so #er/ confident in this point of #iew is that the/ full/ belie#e that low interest rates will last fore#er9 8ow interest rates are what helped make home bu/ing so affordable0 and low interest rates will continue fore#er0 ensuring that real estate remains the fabulous in#estment that it has alread/ pro#ed itself to be for so man/0 man/ /ears9 C% sees no fatal future flaw in this logic primaril/ because the/ desperatel/ do not want to see it9 1he/ don't want to face the fact that future inflation is coming and interest rates will rise9 1he/ want to see low interest rates fore#er9 ?#er the long haul of time0 real estate has been a great in#estment0 not Pust for a few decades but for man/ generations9 5ore recentl/0 especiall/ between 7@@1 and 7@@F0 real estate profits had become enormous0 morphing into a supercharged in#estment9 (ot onl/ could /ou earn a cool 1@ to 1D percent or more :in some cases e#en 7D percent; per /ear in increasing equit/0 /ou could le#erage that in#estment with other people's mone/ at super low interest rates9 It used to be that onl/ the big pla/ers0 like hedge funds and big real estate de#elopers0 had eas/ access to le#erage0 and the/ used it well to create massi#e profits9 It was rare for a#erage American consumers to get access to so much le#erage0 and now the/0 too0 were using it to create huge returns9 And0 of course0 the bigger real estate in#estors were using le#erage0 too9 %h/ spend R1@@0@@@ to earn a 1@ percent return equaling R1@0@@@ when /ou can put down Pust R1@0@@@0 borrow the other RI@0@@@0 and earn 1@@ percent equaling R1@0@@@9 %ow0 what a bonanMa, 1he profits from le#eraged real estate in#estments were absolutel/ astronomical0 and C% absolutel/ does not want that to e#er end9

%h/ Con#entional %isdom about "eal .state Is %rong

Con#entional wisdom on real estate is wrong for the same reasons that C% is wrong about all the other falling bubbles it's a bubble, As e)plained earlier0 the growth of real estate prices since 1IH@ was no longer dri#en b/ fundamental economic dri#ers but instead b/ low interest rates0 eas/ access to credit0 and the rest of the rising bubble econom/9 Bubble prices don't last fore#er because bubbles e#entuall/ pop9 8et's go a little deeper now0 to dissect the C% m/th of =alwa/s rising> real estate #alues9 -irst0 the idea that real estate prices alwa/s grow is Pust plain historicall/ wrong9 In fact0 we ha#e had man/ periods of slow growth0 no growth0 and e#en negati#e growth in real estate prices9 -or e)ample0 from 1IA@ to 1ID@0 the growth of land prices was a dismal negati#e A97G percent9 1hen0 from 1IF@ to 1IG@0 we had a modest growth rate of 19GF percent9 .#en during the period from 1II@ to 7@@@0 land prices rose onl/ 19@H percent9 +o the whole idea of endless growth is Pust not borne out b/ the historical facts9

1he 5/th of 8imited 8and

Population growth ma/ be slowing down0 but the 39+9 population is still increasing9 And if the amount of land is constant0 some would argue that means land prices should alwa/s go up because demand for land :due to population growth; is rising while the suppl/ of land remains the same9 1his seems logical0 but actuall/ this logic is flawed9 1he issue is not the amount of land0 but the use of the land that matters most0 and land use is not a fi)ed quantit/9 1wo centuries ago0 1homas "obert 5althus predicted that population growth with a fi)ed suppl/ of land would ine#itabl/ lead to star#ation9 %e now know that he was wrong: After he said that0 farms in &reat Britain became much more producti#e0 and impro#ed sea tra#el made importing food much easier9 +ome might argue that technological de#elopments like that are in the past0 and we won't see an/thing like them again0 but we'd sa/ that's prett/ shortEsighted9 It's not that hard to imagine us making better use of our land in the near future than we do now0 and the result will mean lower land prices0 not higher9 %hat the go#ernment does to limit or e)pand use of land has a big impact9 -or e)ample0 propping up the #alue of farmland0 through farm subsidies and market protections0 makes owning farmland more profitable and thus more #aluable9 1he go#ernment can also place restrictions on land use to discourage new de#elopment0 creating scarcit/ and thus raising prices for other land9 1he go#ernment can limit access to roads and schools0 make permits difficult to acquire0 or e#en offer ta) ad#antages for unde#eloped land9 Bust as land can be limited in these wa/s0 it can be made less limited b/ curbing or re#ersing these actions9 An/ time de#elopment is encouraged highwa/s are built to pro#ide eas/ access0 for e)ample0 or Moning restrictions are eased the effect is to lower the price of real estate9 5uch like increasing producti#it/0 the end result might be better in the long run0 but go#ernment can stand in the wa/0 at least temporaril/9 +econd0 the idea that real estate #alues alwa/s rise because population is alwa/s growing and land is limited enough to alwa/s dri#e up prices is also not correct :see the sidebar on the m/th of limited land;9 -inall/0 the striking contrast between the lack of increase in incomes :in inflationEadPusted dollars;0 compared to the dramatic rise in home prices during this time0 confirms be/ond an/thing else that real estate has been a rising bubble0 not dri#en b/ real fundamentals9 %e would e)pect to see median home prices to rise with a corresponding rise in median incomes9 $owe#er0 if incomes are up 7 percent and real estate is up H@ percent0 b/ definition /ou ha#e a bubble9

-uture "ising Interest "ates %ill Pop %hat Is 8eft of the "eal .state Bubble

1he biggest flaw with con#entional wisdom on real estate is the idea that interest rates alwa/s will sta/ low0 as the/ ha#e for decades9 Instead0 we will ha#e rising interest rates9 "ising future inflation :due to massi#e mone/ printing to support the falling bubbles; will dri#e interest rates up significantl/0 and without an endless suppl/ of low interest rates0 the whole C% argument not to mention the bubble itself falls apart9 As interest rates rise and mortgages become more e)pensi#e0 we can kiss what is left of the falling real estate bubble goodb/e9 ?n the wa/ up0 this bubble was fueled b/ low interest rates and eas/ lending0 allowing people to bu/ houses the/ would not be able to afford under normal conditions9 But with higher mortgage rates0 more mone/ will go toward the bu/er's interest pa/ments0 lea#ing less mone/ a#ailable to pa/ for the propert/9 %hen people cannot afford something0 the/ bu/ less of it and prices go down9 "emember0 at the same time that mortgage rates rise0 emplo/ment will also fall further0 so there will be fewer potential bu/ers9 -ewer bu/ers means e#en more in#entor/ for sale9 Increasing suppl/ and falling demand means falling home prices and a big real estate bubble pop9

$ow Can People Be +o Blind6

%e certainl/ do not blame people for belie#ing that real estate prices should alwa/s generall/ go up9 1hat is what most of us ha#e seen0 and it is an awfull/ nice idea to belie#e in9 Aside from occasional dips due to recessions and one depression0 home prices ha#e generall/ risen0 not onl/ since most of us were born0 but since our parents and e#en our grandparents and great grandparents were born9 +o we don't blame homeowners for ha#ing faith that real estate will e#entuall/ rise again and will generall/ keep rising fore#er9 But we do blame the soEcalled =e)perts> :in#estment anal/sts0 economists0 go#ernment officials0 etc9; who should ha#e known better9 B/ looking at the facts rationall/0 it was not all that hard for us to describe the rising real estate bubble in our first book0 written in 7@@D and published in 7@@F9 (or was it so terribl/ hard for us to predict that the real estate bubble would be the first of our si) big colinked bubbles to blow0 putting downward pressure on the others9 1his took insight and anal/sis0 but mostl/ it took a willingness to see it9 %ithout a willingness to see it0 the correct macroeconomic #iew is a lot harder to see9 1he correct macroeconomic #iew is that real estate prices do not Pust go up automaticall/ and endlessl/ without cause9 1here are real economic forces that push real estate prices up0 and if those forces are absent and if real estate goes up an/wa/0 then we ha#e a rising bubble9 But bubbles do not rise fore#er9 .#entuall/0 bubbles pop9 It is as simple :and as painful; as that9 1he popping real estate bubble is an e)cellent e)ample of what all the other falling bubbles will look like when their time finall/ comes9 At first0 we maintain complete bubble blindness for as long as possible0 until the rising bubble begins to le#el off and fall a bit9 1hen begins the e)cuse making0 aimed at rationaliMing what is assumed to be Pust a temporar/ downturn9 (e)t0 when things don't dramaticall/ impro#e0 there is more minimiMing of the facts and more happ/ talk about the good old da/s soon returning9 1he denialEfest continues and the cheerleading carries on0 right up until the moment of the final pop9 At that point0 it all seems so ob#ious and the =e)perts> pretend the/ ha#e been e)pecting it all along9 It is onl/ a distant memor/ now0 but prior to 7@@G rarel/ did the media e#en mention the term real estate bubble9 (ow0 of course0 it is a household phrase9

%hat's a +a##/ Aftershock In#estor to 4o6

If /ou want to spare /ourself an/ further losses from the falling real estate bubble0 the first thing /ou must do is be willing to face facts0 without influence b/ the C% cheerleaders who want /ou to belie#e we are on the #erge of a lasting reco#er/9 %hile falling prices ma/ ha#e stabiliMed or e#en risen a bit in /our area0 there is no credible reason to belie#e that there will be a big rebound to pre#ious real estate #alues in the near future9 Instead0 prices will e#entuall/ fall e#en further9 1his bubble has not full/ popped9 Between now and then0 real estate owners ha#e a choice: +ee the falling bubble before it's too late to protect what is left of /our equit/0 or see it later0 after e#er/one else sees it0 too0 lea#ing #er/ few bu/ers to whom to sell /our propert/9 At that point0 /ou will either ha#e to sell at a significant loss or hold on to the propert/ for man/0 man/ /ears9 3nlike stocks or bonds0 real estate is more than Pust an in#estmentJ it is often an important part of our personal li#es9 %e ma/ li#e and raise our families in these properties0 or perhaps our parents did9 %e ma/ ha#e built businesses under some of these roofs9 +o there is often more to making real estate decisions than Pust a consideration of finances9 *ou ma/ also need to think about sentimental #alue0 school districts0 distance to work0 and a #ariet/ of other issues9 In a book0 we can't reall/ help /ou much with that9 $owe#er0 we can help /ou anal/Me the future prospects for real estate and /our current options9 ?ur ad#ice depends on the t/pe of real estate /ou own: *our primar/ home +econd homes and #acation properties IncomeEproducing rental properties Commercial real estate -armland

*our Primar/ $ome <eep It or +ell It6

.#er/one has to li#e someplace9 If /ou decide to keep /our current home0 be sure that /ou understand that /ou will not be able to sell it in the ne)t D to 1@ /ears without taking a big loss compared to what /ou could ha#e sold it for earlier or toda/9 Its price ma/ remain stable or e#en go up a little in the ne)t couple of /ears0 but after that0 the ne)t big drop is coming9 1herefore0 from this point forward0 think of /our mortgage pa/ment as if it were rent because0 Pust like rent0 /ou are not going to get it back later9 .#en though pa/ing a mortgage does ha#e some ad#antages o#er pa/ing rent0 the basic point here is that /ou are no longer building equit/J /ou are simpl/ pa/ing for a place to li#e9 1herefore0 ask /ourself0 =Is this someplace I would like to li#e for the ne)t se#eral /ears at m/ current mortgage pa/ment0 without building equit/ and without the abilit/ to lea#e unless I take a big equit/ loss6> If /our answer is /es0 /ou might as well sta/9 If the answer is no0 /ou will do better to sell now and find a rental so /ou will ha#e the fle)ibilit/ to mo#e later if /ou wish0 without a big equit/ loss9 But it's reall/ not that simple0 is it6 *ou ma/ ha#e children in a school district /ou like or a good Pob nearb/0 and a suitable rental in /our area ma/ be hard to find9 5a/be this house was /our parents' home0 or ma/be /ou Pust lo#e the place and want to spend the rest of /our life there9 %e understand there are man/ good nonfinancial reasons for keeping /our current home9 :All three coauthors of this book own their homes and don't plan to sell0 each for different reasons9; But whether /ou decide to sta/ or to sell0 here are some important points to keep in mind: All mortgages should be fi)edErate loans0 not adPustable rate9 As inflation rises0 /ou will pa/ back fi)edErate loans with cheaper and cheaper dollars as the #alue of the dollar falls0 while adPustableErate loans will become increasingl/ more e)pensi#e9 If /ou currentl/ ha#e an adPustableErate mortgage that /ou don't intend to pa/ off in the ne)t two /ears0 now would be a good time to refinance to a low fi)edErate loan9 4on't make more than /our minimum pa/ment9 Inflation will allow /ou to pa/ off /our loan later with cheaper dollars9 Accelerating /our pa/ments means /ou are pa/ing off /our loan with more e)pensi#e dollars9 (o point in doing that9 A#oid an adPustableErate home equit/ line of credit :$.8?C; for more than shortEterm loans9 If /our $.8?C loan is at an adPustable rate0 /our pa/ments will get increasingl/ larger as inflation and interest rates rise9 If /ou ha#e a fi)edErate $.8?C loan0 /our monthl/ pa/ments will remain the same9 +o if /ou ha#e an adPustableErate $.8?C loan0 either pa/ it off in the ne)t couple of /ears or refinance it as soon as /ou can to a low fi)edErate loan9 4on't e)aggerate the #alue of the mortgage interest ta) benefit9 +ince the amount of interest paid declines as /ou pa/ down /our loan0 the ta) benefit also decreases o#er time9 5ore important0 the gain of that ta) benefit will be entirel/ erased b/ the loss of /our home's #alue as real estate continues to fall0 before and during the Aftershock9 4on't assume that a re#erse mortgage is a good idea9 1he equit/ in /our house will decline as the real estate bubble falls further0 so borrowing against /our equit/ now and using it for li#ing e)penses o#er the ne)t few /ears could lea#e /ou with a lien against a greatl/ reducedE#alue house9 .#en worse than the lien0 /our pa/ments will likel/ stop because the compan/ won't be able to keep them up when things go bad in the Aftershock9 $owe#er0 if /ou borrow mone/ against /our current equit/ and in#est it well0 /ou could come out ahead9 1he ke/ is in#esting it well0 not li#ing on it9

*our Pool of Potential Bu/ers Is (ot Infinite

It is eas/ to assume that whene#er we want to sell something0 there will alwa/s be a bu/er9 If /ou are considering selling /our home or other real estate in the future0 here's a new wa/ to think about it9 *our pool of potential bu/ers for /our propert/ is not infinite9 At an/ gi#en moment0 there is onl/ a finite number of people who might want to bu/ /our propert/0 and as the bubbles continue to fall0 that pool of potential bu/ers will shrink9 %hile it is true that /ou onl/ need to find one bu/er to sell /our propert/0 the smaller /our pool of

potential bu/ers0 the less likel/ /ou are to find that person9 As time goes on0 /our pool will shrink each time someone figures out that this =reco#er/> is not real9 *our pool shrinks when the/ can't get credit or the/ don't ha#e the down pa/ment9 *our pool will shrink each time someone climbs out of the pool because the/ don't want to risk more price drops later9 And0 e#entuall/0 as inflation and interest rates go up0 /our pool will shrink each time someone gets kicked out of the pool b/ higher mortgage rates and stricter credit terms9 1he longer /ou wait to sell0 the smaller /our pool of potential bu/ers will become9 .#entuall/0 the onl/ wa/ to get someone to Pump back into the pool is to drasticall/ lower /our asking price0 which0 if /ou need to sell0 /ou will e#entuall/ do9 +o if /ou are thinking of selling0 /ou can either go fishing in /our pool now0 while it is still stocked with potential bu/ers0 luring them in with a reasonable selling price0 or /ou can wait too long to go fishing or not make the bait attracti#e enough0 and ne#er catch a bu/er9 If /ou decide to sell0 don't stubbornl/ hold out for /our top price9 8ower /our asking price sooner rather than later so /ou can find a willing and able bu/er while there are more of them still around :see sidebar;9 1here is no panic now0 and /ou can still hold off for a while if /ou wish0 but selling sooner is better than waiting too long9

%hat if I Am =3nderwater> in 5/ 5ortgage6

4epending on /our circumstances0 /ou ma/ qualif/ for one of the new programs now a#ailable to help homeowners refinance if their mortgages are greater than their homes are currentl/ worth0 especiall/ if /ou can't make /our pa/ments9 1he web site www9makinghomeaffordable9go# has information about go#ernment programs9 If /ou don't qualif/ for an/ go#ernment help and /ou are behind on /our pa/ments0 /ou ma/ be able to fight foreclosure and e#iction on technical grounds9 1his could in#ol#e spending some mone/ on legal ser#ices0 but it ma/ be worth doing because sometimes homeowners disco#er that their loan documents were not properl/ created or procedures were not properl/ followed b/ the lender0 which makes it #er/ difficult for a bank to foreclose9 .#en without a technicalit/ like that0 it takes a lot of time for foreclosures to finaliMe9 1he national a#erage is FGC da/s9 In (ew *ork0 the a#erage time is I@@ da/s0 and in -lorida0 the a#erage time period is now 10@@@ da/s9 Banks are not enthusiastic to foreclose because it forces them to tr/ to sell the real estate and take a loss9 +o /ou ma/ be able to negotiate with the bank to gi#e /ou a new and better arrangement0 perhaps making smaller0 fi)ed pa/ments o#er time9 -ailing that0 /ou ma/ ha#e to walk awa/ from the propert/0 but onl/ when e#iction is imminent9 If /ou do that0 the bank ma/ be able to get a deficienc/ Pudgment against /ou0 which #aries from state to state9 In a deficienc/ Pudgment0 the lender can come after /ou for an/ losses the/ sustained in the foreclosure proceedings9 ?f course0 this ma/ not matter much if /ou don't ha#e an/ assets to be seiMed9 (ot pa/ing /our mortgage will certainl/ damage /our credit score0 but during the Aftershock lots of pre#iousl/ creditworth/ people will ha#e poor credit scores0 and there won't be much credit a#ailable an/wa/9 If fighting foreclosure or walking awa/ is not for /ou0 another option is to tr/ to get the bank or lender to agree to a =short sale9> It's called a short sale because the propert/ is sold for less than the loan0 and the lender forgi#es the difference9 Banks won't alwa/s agree to this0 but if the/ think the onl/ other option is foreclosure0 the/ ma/ consider it the cheaper of the two losses9 If /ou do a short sale0 keep in mind that the amount of debt that has been forgi#en is t/picall/ counted as ta)able income when /ou file /our federal and state ta) returns9

+hould I <eep Pa/ing 5/ 3nderwater 5ortgage6

1here are two schools of thought on this9 +ome people decide to stop making pa/ments on an underwater mortgage and do one of the options described in the pre#ious section so the/ can get awa/ from their bad in#estment and stop throwing good mone/ after bad9 ?thers decide to sta/ in their homes and keep making their pa/ments9 If /ou can make /our pa/ments without hardship0 and if /ou ha#e a low0 fi)edErate loan :or can get one;0 /ou will find that rising inflation o#er the ne)t D to 1@ /ears will eat awa/ /our mortgage pa/ment9 1his assumes that /our income will go up more or less with inflation0 while /our mortgage pa/ment sta/s the same0 making it relati#el/ eas/ to pa/ off /our home0 despite its being underwater now9 But remember0 /ou ma/ not be able to count on uninterrupted income for the life of /our mortgage0 so ha#ing a cash cushion is important9 :Also0 ha#ing a di#ersified Aftershock portfolio of other in#estments that keep pace with or outpace rising inflation is important0 too9;

%on't Inflation Push 3p the Price of 5/ "eal .state6

*es0 inflation will make the nominal price in dollars rise9 But high interest rates and the crashing real estate bubble will make the real #alue of homes :in inflationEadPusted dollars; go down9 -or e)ample0 it won't reall/ matter if /our home is worth twice as man/ dollars as it used to be if it costs four times as man/ dollars to bu/ groceries or fill up /our car9 -urthermore0 when the real estate bubble full/ pops0 e)pect it to happen #er/ quickl/9 Inflation ma/ push up prices o#er time0 but the crash could easil/ de#astate the #alue of /our real estate nearl/ o#ernight9

1he "ealit/ of "eal .state

1he realit/ of real estate0 if the Aftershock happens0 is that /ou won't need to worr/ quite so much about the decision /ou make toda/9 5an/ people will simpl/ stop pa/ing their mortgages because foreclosures will be slow and difficult to enforce9 It alread/ takes a long time toda/0 and it will get much longer then9 1o the e)tent the bank mo#es to foreclose0 it will likel/ be quite willing to simpl/ work out a rental arrangement at a #er/ low rental rate9 1he/ can't sell the house since there are few bu/ers and almost no mortgage mone/ to be found with reasonable terms9 1he upside to all of this is that the cost of housing will be #er/ low and that will be an important plus in the Aftershock when mone/ is tight9 8ike all real estate0 there will be differences depending on where /ou li#e0 but the same large macroeconomic factors will affect all real estate and it will be surprising Pust how much effect it has0 e#en on highEend real estate9

Is (ow a &ood 1ime to Bu/6

In general0 we sa/ sta/ awa/ from bu/ing real estate now9 1his bubble is still popping and prices will onl/ fall lower later9 4on't let the cheerleaders talk /ou into seeing bargains where there reall/ aren't an/9 Premature real estate =bargains> are the false mirages of the bubble blind9 $owe#er0 there are two e)ceptions to our general 4on't Bu/ rule: If /ou want or need to bu/ a primar/ residence :not in#estment propert/;0 then this could be a good time to bu/0 while mortgage interest rates are still #er/ low9 But onl/ do this if /ou are prepared to own the propert/ for at least 1@ /earsJ otherwise0 /ou will take a big hit later when /ou ha#e to sell it at a loss or walk awa/9 And0 of course0 take out onl/ a fi)edErate loan0 no adPustableErate debt9 In the rare case when /ou can bu/ a propert/ at well below current market #alue and resell it quickl/ to a willing and able bu/er for a profit0 then this could be a good time to bu/9 1he danger is that /ou will get stuck holding the propert/ for too long0 prices will drop again0 and /our potential profit will e#aporate9 If /ou ne#er flipped a propert/ before0 now is not the time to start /our learning cur#e9 If /ou are a seasoned flipper0 it would be wise to tighten up /our criteria for what /ou identif/ as a =good deal9>

+econd $omes and 2acation Properties

As we ha#e alread/ seen in the first phase of the real estate bubble pop0 second homes and #acation properties lose #alue e#en faster than primar/ residences9 1he/ are a discretionar/ purchase that is not needed in the same wa/ that one's primar/ home is needed9 1he market #alue of these less needed homes will be de#astated in the Aftershock0 and before then the/ will drop in stages as the other bubbles fall9 +o unless /ou ha#e strong sentimental or other reasons for keeping it0 selling all second homes and #acation properties as soon as possible is a good idea9 4on't wait for more e#idence that the real estate market is not reco#ering9 B/ then0 the pool of potential bu/ers will be e#en smaller than it is now and /ou will likel/ ha#e to sell for a lot less than /ou could sell for toda/9 In the shorter term0 the #alue of some #acation properties in certain areas of the countr/ ma/ be somewhat protected0 especiall/ at the higher end of the market where some potential real estate bu/ers ma/ be temporaril/ buo/ed b/ the stock market bubble9 In the longer term0 howe#er0 all real estate will fall9 If /ou want to sell now but ha#e been unable to get a bu/er0 lower /our asking price if necessar/ to make the sale9 "emember0 if /ou don't lower /our price now0 /ou will onl/ ha#e to lower it e#en more later9 Please cheer up, 1here will be man/ wonderful second homes and #acation properties a#ailable for pennies on the dollar during the Aftershock but onl/ for those who were sa##/ enough to protect and grow their assets now so the/ ha#e mone/ a#ailable to bu/ those bargains later9

IncomeEProducing "ental Properties

"ight now0 it ma/ seem like owning rental propert/ is a good idea9 In some areas of the countr/0 demand for residential rentals has gone up as the real estate bubble has come down9 5ore people are renting because the/ ha#e lost their homes to foreclosure or ha#e put off bu/ing0 either because the/ are waiting to see if real estate falls further or the/ cannot get a loan9 In the short term0 this higher demand for rentals has led to higher rents in some areas0 and will likel/ continue for a while longer9 $owe#er0 in the longer term0 these higher rents will not last9 -uture rents will decline because 9 9 9 "ents alwa/s e#entuall/ track real estate #alues9 As real estate falls further0 rents will e#entuall/ fall0 too9 8ater0 as unemplo/ment climbs0 rents will fall because a growing number of renters will lose their Pobs and will stop pa/ing rent altogether9 "enters are usuall/ the first to get hit in a downturn9 In the Aftershock0 the courts will be too backed up for a quick e#iction and /our renters will simpl/ squat in /our propert/ without pa/ing an/thing0 perhaps for /ears9 %hen enough people are squatting without pa/ing rent0 those who do still pa/ rent will not be willing to pa/ too much9

If /ou are willing to own these properties after the/ no longer produce significant rental income0 then there is no reason to worr/ about an/ of this9 5a/be /ou will use it for other purposes b/ then :perhaps as future rentEfree homes for /our friends and relati#es who didn't read our books;9 But if /ou don't want to hold on to rental properties when the/ no longer bring /ou income0 then /ou will at some point want to sell these while /ou still can9 It is hard to let go of incomeEproducing real estate while the mone/ is still coming in0 especiall/ if /ou count on that income9 +o it's understandable that /ou would want to put off selling for as long as possible9 $owe#er0 the longer /ou wait to sell0 the harder it ma/ be to find a bu/er who is willing and able to pa/ /our asking price9 And if /ou wait too long to sell0 /ou ma/ not be able to find a bu/er at all9 ?ur ideas about timing /our e)it from incomeEproducing real estate are offered later in this chapter9

IncomeEProducing Commercial "eal .state

As the bubbles fall0 commercial real estate will decline for the same reasons that residential real estate will decline: rising suppl/ :because more properties will be up for sale; and falling demand :because there will be fewer willing and able bu/ers;9 "ight now and in the nearEterm future0 commercial real estate #alues are not dropping significantl/0 if at all9 +ome ha#e dropped a lot but ha#e more recentl/ rebounded9 +o now is the best time to sell0 while there are still potential bu/ers who think we are on the #erge of an economic reco#er/9 As we keep sa/ing0 if /ou wait until there is a lot of proof that there is no reco#er/0 there will be far fewer potential bu/ers9 In the long term0 commercial real estate #alues will decline substantiall/ in the Aftershock because unemplo/ment will rise0 consumer spending will drop0 and demand for rental space will fall dramaticall/9 "etail0 wholesale0 warehouse0 and office space will simpl/ not be needed at current le#els9 %e don't ha#e to be 1@@ percent right about this for /ou to be 1@@ percent out of luck9 .#en a 7@ percent drop in /our occupanc/ rate could kill /our profits9 %e agree with con#entional wisom that medical commercial real estate is different but not that different9 5edical commercial real estate will take longer to fall in #alue but will not be immune9 +ome medical practices will be more AftershockEproof0 but man/ will not0 particularl/ discretionar/ practices0 such as cosmetic surger/ and medicall/ super#ised weight loss centers0 as well as highEend boutique practices in general9 .#en basic medical and dental practices will sustain a big income loss and will seek lowerEcost leases in order to sta/ in business9 At first0 /ou ma/ see onl/ a slight decline in medical real estate #alues0 and then as the bubble econom/ falls further and pops0 a faster e)it of highEend medical practices and then other medical practices0 as the/ can no longer pa/ their leases9 %e also don't recommend that /ou count on go#ernment programs0 such as =+ection H> housing pa/ments0 to hold up fore#er9 .#en if the/ continue0 the/ will not keep pace with rising inflation0 and in time /our costs will outstrip /our income on these rentals9

-armland

1here are two #er/ separate t/pes of farmland: incomeEproducing farms and nonEincomeEproducing farms9 ?ur ad#ice depends greatl/ on which one of these /ou ha#e9 -or farmland that is nonEincomeEproducing0 the #alue of the land will fall with the rest of the real estate bubble9 5ost famil/ farms that are currentl/ being used for residential homes and perhaps famil/ recreation :hunting0 fishing0 etc9; should be considered as an/ residential propert/0 rather than a =farm9> If the farmland does not ha#e a house or other usable structures0 it is essentiall/ raw land that will rapidl/ fall in #alue as the bubbles pop9 $owe#er0 if /ou ha#e farmland that is producing an income0 either from crops or li#estock0 then /ou ha#e more than Pust a piece of real estateJ /ou ha#e a business9 In #aluing that business0 the general trend of falling land #alues is onl/ one consideration9 A larger consideration is the current and future business income0 plus the #alue of the equipment the business ma/ own9 As inflation rises0 the price of agricultural commodities in the 3nited +tates will increase as well0 so if /ou own farmland that produces food0 /our gross income should rise with inflation which is much better than most businesses will do as inflation rises9 5ore importantl/0 as the dollar falls e)ports of agricultural goods will increase and real prices :adPusted for inflation; will rise9 $owe#er0 /our e)penses will also go up0 at the same time that go#ernment agricultural financial support declines and credit becomes increasingl/ tight9 %ith real estate #alues down0 the selling of farmland will be mostl/ on a cash basis during the Aftershock0 based almost entirel/ on the #alue of the agricultural business9 -or owners of farmland and those looking into it0 the land #alue itself will be far less important than the #alue of the commodities produced on the land9

1iming *our .)its ?ut of "eal .state

"egardless of the t/pe of real estate /ou ma/ wish to sell0 our general ad#ice for e)iting is the same: +ooner Is Better than 8ater 3nlike stocks and bonds0 /ou cannot unload real estate at the click of a mouse9 It takes time to sell real estate0 so /ou ha#e to plan ahead9 "emember that e#aporating pool of potential bu/ers we described earlier9 1he longer /ou wait to sell0 the more potential bu/ers will figure out that real estate prices are not going back up and are continuing to go down9 Also0 the longer /ou wait to sell0 the higher mortgage rates will rise0 which will ha#e a #er/ negati#e impact on real estate prices :see -igure F91 ;9 As mortgage interest rates rise0 bu/ers with a set monthl/ pa/ment for real estate can onl/ afford cheaper and cheaper purchases9 -igure F91

$ome 2alues 4ecrease as 5ortgage Interest "ates "ise 1his chart assumes the current mortgage rate is C percent9 An increase to D percent would force home prices down 11 percent to maintain the same monthl/ pa/ment9 +ource: Aftershock Publishing9

(ow that /ou ha#e read this chapter0 /ou know that the combination of falling demand and rising mortgage rates will push real estate prices down dramaticall/ in the longer term9 $owe#er0 in the shorter term0 most people don't know this /et9 1herefore0 while the econom/ is still relati#el/ strong0 the sooner /ou begin the process of tr/ing to sell /our real estate0 the more likel/ it is that /ou will be able to find a willing and able bu/er9 If /ou alread/ know that /ou want to sell /our primar/ home or #acation home0 put it up for sale as soon as /ou can9 If /ou are still thinking about it0 don't think about it for too long9

$elp, 5/ Propert/ Isn't +elling,

%e often hear people complain that the/ can't sell their homes or other real estate9 $ere are some potential solutions for upping the odds of attracting a bu/er: .ngage a real estate agent who will do more than Pust take their commission9 &et recommendations from friends or from good customer re#iews on the Internet for an agent who is willing to work hard to help sell /our propert/9 1he right agent can make the difference between selling quickl/ or stalling out9 If /our home has been on the market for more than a few months0 consider taking it off the market for a while and tr/ing a new agent9 5ake /our propert/ stand out from the pack9 *ou can distinguish /our place from others for sale b/ offering something e)tra or unusual that gets /ou noticed9 -or e)ample0 throw in a flatEscreen 12 in the li#ing room9 ?r offer to include a paid #acation0 cruise0 or oneE/ear membership to the local pool or countr/ club for the bu/er and their famil/9 -or higherEend homes0 we'#e seen sellers include a brand new car in the dri#ewa/ or a si)Epack of tickets to the +uper Bowl9 4on't laugh sometimes this works9 1he number one fi) for a propert/ that isn't selling: 8ower /our price9 (obod/ likes to hear this but it works e)tremel/ well9 -ind out what similar places are selling for in /our area and cut it b/ D to 1@ percent9 As time goes on0 /ou will likel/ lower /our price an/wa/0 along with all the other sellers9 B/ doing it before the other sellers0 /ou increase /our odds of finding a bu/er before the other sellers9

.)iting ?ut of IncomeEProducing "eal .state Is 1rickier

In an ideal world0 /ou would naturall/ want to continue to collect /our income for as long as /ou could and then sell /our propert/ later when it is no longer producing a profit9 1he problem with this plan is that b/ the time the propert/ stops being profitable0 the #alue of the propert/ will ha#e fallen significantl/9 +o each month that /ou continue to earn income on /our real estate0 /ou are one month closer to the time when /ou cannot sell /our propert/ without taking a loss9 $ow do /ou time /our e)it out of something that brings ongoing income now but will fall in #alue later6 ?n one hand0 /ou want to wait as long as /ou can so /ou can keep getting that incomeJ on the other hand0 /ou want to sell before the price declines enough to wipe out the gain for that income9 If we knew e)actl/ how much the selling price would fall and we knew the rate of the fall o#er time0 we could create a formula to figure out the golden moment when it makes the most sense to sell0 in a wa/ that will ma)imiMe both /our income and /our selling price9 3nfortunatel/0 we don't ha#e that le#el of precision when predicting the rate of decline of #arious real estate prices in each local area9 +o the first thing /ou must do when deciding when to e)it /our incomeE producing real estate is to come to grips with the fact that it is nearl/ impossible to time this perfectl/9 1herefore0 /ou are either going to be a bit too earl/ or a bit too late9 (o one wants to be wa/ too earl/0 but a bit too earl/ is clearl/ better than a bit too late9 1he closer we get to the Aftershock0 the faster real estate prices will fall9 &i#en that we e)pect to see inflation and interest rates begin to rise significantl/ in the ne)t couple of /ears0 selling before that occurs would be ideal or Pust as it begins to occur is oka/ too9

%hat about In#esting in ".I1s 6

A real estate in#estment trust :".I1; is essentiall/ a holding compan/ that in#ests in real estate0 and in#estors can bu/ shares of a ".I1 Pust like a stock or mutual fund9 ?b#iousl/0 if we're ad#ising against owning real estate0 ".I1s would not be at the top of our list of safe in#estments9 $owe#er0 for sa##/ in#estors who want to put a small portion of their portfolio in ".I1s in the short term0 there still ma/ be some good opportunities for growth9 $owe#er0 the same ca#eat applies here as it does to an/ other real estate in#estment: It's better to get out too earl/ than too late9 ?nce /ou make the decision to sell0 don't make the mistake of holding out too long for a high price9 If /ou can't get a bu/er within a reasonable amount of time :a few months0 not /ears;0 lower /our asking price if necessar/ to make the sale9 As we mentioned earlier0 if /ou don't lower /our price now0 /ou will onl/ ha#e to lower it e#en more later9

1he $igh Cost of 4oing (othing

5an/ people find that owning real estate makes them feel comfortable and safe9 1his is understandable9 ?wning /our own home feels0 well0 like home9 Change0 especiall/ when it in#ol#es lea#ing home or losing income0 takes courage9 "emember that good decision making helped /ou acquire the real estate /ou ha#e toda/ and good decision making will also help /ou create /our future during this unusual time9 If /ou choose not to sell /our real estate now or soon0 while /ou can get the most for it0 that's perfectl/ fine as long as /ou are full/ aware of what /ou are doing and its consequences9 ?#er the ne)t se#eral /ears0 /our real estate equit/ is going to 5one/ $ea#en and it's not coming back9 Please also know that the biggest cost of hanging on to falling real estate is not Pust the loss of /our current equit/J it is the much bigger opportunit/ costs of losing wealth when /ou could ha#e been protecting and growing /our mone/ elsewhere9

+ta/ing Afloat in a +inking .conom/

It's one thing to read about the changing macro econom/J it's another to actuall/ do something about it9 5ost people will take no new actions until it's too late9 -or those who want to prepare for0 not Pust react to the coming Aftershock0 we offer the following ser#ices: *ou are welcome to #isit our website www9aftershockpublishing9com for more information as we approach the Aftershock9 %hile /ou are there0 /ou ma/ sign up for a twoE month free trial of our popular Aftershock In#estor's "esource Package :I"P;0 which includes our monthl/ newsletter0 li#e conference calls0 and more9 ?r /ou ma/ reach us at G@AEGHGE@1AI or infoYaftershockpublishing9com 9 %e also offer Pri#ate Consulting for indi#iduals0 businesses0 and groups9 Please contact coauthor Cind/ +pitMer at CCAEIH@EGAFG or tellmemoreYaftershockconsultants9com for more information9 1hrough our in#estment management firm0 Absolute In#estment 5anagement 0 we pro#ide handsEon0 AftershockEfocused asset management ser#ices on an indi#iduall/ managed account basis9 -or details0 please call G@AEGGCEAD7@ or eEmail absoluteYaftershockpublishing9com 9

C$AP1." G

1hreats to the +afet/ (ets

1$. -313". ?- %$?8. 8I-. I(+3"A(C. A(4 A((3I1I.+

%h/ do people bu/ whole life insurance and annuities6 ?ur faith in these products is so solid that the question seems almost sill/9 %e bu/ them for protection0 of course, If bonds are considered safer than stocks0 then insurance and annuities are supposed to be e#en safer than bonds9 1he uni#ersal assumption is that0 e#en in the rare e#ent that the compan/ goes under0 these policies alwa/s pa/ out9 1hese are the bedrock safet/ instruments that allow e#en the most an)ious in#estors to sleep soundl/ at night9 8ike the old Prudential ad that calml/ reassures us: /ou can alwa/s count on =1he "ock9> %here did this =rock solid> mentalit/ come from6 8ike most of our ideas about mone/ and in#esting0 it came from the past9 1oda/0 people don't worr/ too much about the safet/ of their mone/ in banks0 but before the -ederal 4eposit Insurance Corporation :-4IC; was established so that the go#ernment insured depositors' mone/0 banks were not alwa/s so safe9 If /ou li#ed in (ew *ork or Chicago0 /ou might ha#e access to some #er/ reputable financial institutions9 But if /ou li#ed in more remote parts of the countr/0 the pickings were slim9 If /ou had a nest egg to protect0 keeping it under /our mattress or bur/ing gold in /our back/ard ma/ ha#e seemed like a better option than risking it at the bank9 .nter whole life insurance and annuities9 1hese could be bought from a national compan/ with a solid reputation9 An annuit/ could pro#ide in#estors with the income the/ needed for the remainder of their li#es9 And with whole life insurance0 the polic/holder had reliable sa#ings that could be borrowed against when necessar/0 not to mention the protection for his or her heirs9 -or man/ people0 this made whole life insurance and annuities more attracti#e options than a sa#ings account at a potentiall/ less reliable local bank9 %h/ take a risk when /ou could own a piece of 1he "ock6 But this long histor/ of comfort that people ha#e deri#ed from owning whole life insurance and annuities has kept most of us from thinking about the deeper and riskier realities of these policies9 1hat is because 9 9 9

All Insurance and Annuities Are .ssentiall/ In#estments in Bonds0 +tocks0 .#en "eal .state

%hen /ou pa/ /our premiums to an insurance or annuit/ compan/0 the/ are not Pust stashing that cash under a mattressJ these companies are in#esting it9 1herefore0 whether /ou know it or not0 /ou are in#esting it9 %hen /ou bu/ an annuit/0 whole life insurance0 or longEterm care insurance0 /ou are bu/ing e)posure to the in#estments that these companies own9 %hat do these companies in#est in6 -or man/ /ears0 the/ in#ested primaril/ in longEterm corporate bonds9 ?ne of the main reasons that insurance and annuit/ companies ha#e the reputation for being so #er/ safe is that traditionall/ the/ in#ested almost e)clusi#el/ in safe0 highl/ rated bonds9 B/ pooling the policies of their clients into what is called a general account0 insurance companies t/picall/ in#est in a highl/ di#ersified portfolio of bonds0 pro#iding protection against default and related risks in the bond market9 In the past few decades0 insurance companies ha#e also begun in#esting in some stocks0 and more recentl/ the/ ha#e been pro#iding permanent financing to commercial real estate de#elopment0 and e#en to some largeEscale residential real estate proPects9 If /ou ha#e a whole life insurance polic/0 it is eas/ to think of it like car insurance something /ou can count on if an unfortunate e#ent occurs9 But0 reall/0 /our whole life insurance polic/ is an in#estment0 with bonds making up the biggest piece of /our compan/'s in#estment pie9 As a good e)ample of this0 we looked at the in#estment portfolio of (orthwestern 5utual :see -igure G91 ;9 %e chose (orthwestern because it is such a highl/ rated and wellEmanaged compan/9 Interestingl/0 the/ in#est in almost no go#ernment bonds due to their lower coupon rates9 1he/ prefer mostl/ longEterm corporate bonds0 which carr/ a higher risk and therefore offer higher /ields0 as can be seen in -igure G97 9 -igure G91 (orthwestern 5utual 5ostl/ In#ests in Bonds Bonds make up the lion's share of most insurance compan/ in#estments9 +ource: www9northwesternmutual9com 9

-igure G97 (orthwestern 5utual's Bond Portfolio &o#ernment bonds are onl/ a small proportion of (orthwestern 5utual's bond portfolio9 +ource: www9northwesternmutual9com 9

Con#entional %isdom on %hole 8ife Insurance and Annuities: Perfectl/ +afe and %orth .#er/ Penn/,

Based on past performance0 toda/'s con#entional wisdom tells us these policies are rock solid and safe9 1he top insurance companies in the 3nited +tates ha#e high ratings based on their historical reliabilit/ and creditworthiness9 5an/ of these companies ha#e been in business since before the &reat 4epression0 and the/ ha#e weathered e#er/ recession0 e#er/ market fall0 and e#er/ inflationar/ period along the wa/9 1his certainl/ inspires the full and longEterm confidence of in#estors who want to hold on to their policies for 7@ or A@ /ears or more9 1he insurance industr/'s primar/ rating agenc/0 A9 59 Best0 anal/Mes and grades insurance companies regarding their creditworthiness0 debt0 o#erall financial strength0 and other factors9 8ike a report card0 the/ rate each insurance compan/ from A]] for those considered the most superior0 to - for those in liquidation :see 1able G91 ;9
1able G91 A9 59 Best "ating +cale for ?#erall -inancial +trength

+ource: www9ambest9com
+ecure A]]0 A] :+uperior; A0 A[ :.)cellent; B]]0 B] :&ood; 2ulnerable B0 B[ :-air; C]]0 C] :5arginal; C0 C[ :%eak; 4 :Poor; . :3nder "egulator/ +uper#ision; - :In 8iquidation; + :+uspended;

As an additional wa/ of spreading out and limiting risk0 insurance companies ma/ also use reinsurance9 5an/ insurance companies also ha#e #er/ large reser#es and are well capitaliMed0 further adding to their strength9 1his t/pe of strength is part of what A9 59 Best is looking at when determining its insurance compan/ ratings9 Adding to the o#erall sense of securit/0 each state maintains a fund :funded primaril/ b/ an insurance polic/ premium ta); standing read/ to co#er insurance polic/holders in the e#ent that an indi#idual insurance compan/ happens to fail9 And if necessar/0 e#en the federal go#ernment could potentiall/ step in to bail out insurance companies0 as it did with AI&9

All 1his Pro#ides a 4eep +ense of +afet/0 but Comfort Comes at a Premium Price
%ith the support of seemingl/ rock solid credit ratings and the potential for go#ernment backup if necessar/0 it is understandable that insurance and annuities pro#ide a deep sense of safet/9 (ot surprisingl/0 that comes at a price9 $ere is a brief description of these policies and the relati#el/ higher premiums /ou must pa/ in order to feel safe9

%hole 8ife Insurance

1here are two general t/pes of life insurance: term and whole life9 1erm life insurance pro#ides /our beneficiar/ a set pa/out amount in the e#ent of /our death if it occurs within a limited =term> of time9 %hen that time period is up0 /our term polic/ ends9 If /ou want to bu/ another one at that point0 the new term polic/ will likel/ be at a higher premium because of /our greater age9 And if /ou ha#e also de#eloped a medical problem since /ou bought the first polic/0 /ou ma/ not be able to bu/ another polic/ or /ou ma/ ha#e to pa/ a much higher price9 In the case of whole life insurance0 /ou are bu/ing a combination of what /ou would get with a term life insurance polic/ e)cept that0 rather than terminating0 it lasts /our =whole> life9 In addition0 whole life insurance acts as a forced sa#ings account9 %hole life insurance gi#es some people the peace of mind that comes from feeling that the/ are guaranteed co#erage for life0 and it pro#ides a ta)Efree death benefit to the beneficiaries9 It also often pro#ides for the pa/ment of a certain amount of mone/ later0 under certain conditions or at specific times9 5ost policies also usuall/ allow loans to be made against the polic/9 A third t/pe of insurance0 called uni#ersal life0 is a h/brid of both term and whole life9 %hole life insurance policies :and to a lesser e)tent0 uni#ersal life; are significantl/ more e)pensi#e than term life insurance9 *ou are pa/ing for the feeling of safet/ of lifetime co#erage0 whether /ou need it or not0 and the feeling of safet/ that /ou ha#e a forced sa#ings account :e#en though /ou could earn more b/ in#esting it on /our own;9 %hole life insurance is much more of an in#estment than term life insurance and0 accordingl/0 it costs more9

Annuities

An annuit/ is a contract between /ou and an insurance compan/0 in which /ou gi#e them either a oneEtime or series of pa/ments in e)change for a guarantee of periodic pa/ments to /ou0 beginning now or in the future9 Annuities are popular in retirement plans because earnings are usuall/ ta) deferred9 %hen withdrawals are later taken0 the gains are ta)ed as ordinar/ income0 not capital gains9 1here are three t/pes of annuities: fi)ed0 inde)ed0 and #ariable9 In all three cases0 the annuit/ is basicall/ an in#estment in some t/pe of asset :t/picall/ bonds0 but also stocks;0 plus the addition of insurance that pro#ides some minimum pa/out in the e#ent that /our in#estment falls below a set amount9 A fi)ed annuit/ is essentiall/ the purchase of a fi)edEinterestErate bond with the addition of bond insurance0 plus perhaps some life insurance9 An inde)ed annuit/ pa/s based on changes in an inde)0 such as the +tandard K Poor's D@@0 and pro#ides insurance that earnings will not fall below some specified minimum0 regardless of inde) performance9 A #ariable annuit/ pa/s based on the performance of a #ariet/ of in#estment options0 each with different le#els of risk and return0 similar to a #ariet/ of mutual funds9 It also pro#ides insurance that earnings will not fall below some specified minimum9 Bu/ing an in#estment plus some insurance for that in#estment costs more than simpl/ bu/ing the in#estment directl/0 so whene#er /ou hear the word annuit/0 it reall/ means in#estment and insurance because that is the e)tra feature /ou are bu/ing9 Annuities can be complicated and come in man/ #arieties0 but the bottom line is that annuities are essentiall/ in#estments with some le#el of insurance protecting those in#estments9

5an/ annuities are hea#il/ in#ested in bonds9 In the case of a fi)ed annuit/0 this is especiall/ ironic because /ou are bu/ing a bond and /ou are insuring /our bond in#estment with some insurance that itself is an in#estment in bonds9 1he annuit/ uses the safet/ of one set of bonds :the bonds the insurance compan/ owns; to insure the safet/ of another set of bonds :the bonds /ou own in /our annuit/;9 8ike all forms of insurance0 /our bond insurance is limited9 It generall/ co#ers a relati#el/ narrow range of conditions0 such as onl/ a certain change in interest rates9 It does not co#er /ou under all conditions9 In the last few decades0 that has not been a problem9 Bonds ha#e done #er/ well as interest rates ha#e dropped since the earl/ 1IH@s9 And e#en if interest rates rise a bit in the future0 /our annuit/ is still safe because that narrow range of change would still be co#ered b/ /our bond insurance9 As long as conditions do not significantl/ change0 all is well for annuities9 Bust as with whole life insurance0 when /ou bu/ an annuit/0 /ou are bu/ing a le#el of comfort9 "ather than simpl/ bu/ing the in#estment directl/ at a lower price0 /ou are bu/ing an in#estment plus some in#estment insurance9 *ou are pa/ing a premium in order to feel safe9

8ongE1erm Care and 4isabilit/ Insurance

8ongEterm care :81C; insurance co#ers some of the costs of health care that is needed o#er an e)tended period0 such as in old age0 in particular0 nursing home care9 1he /ounger /ou are when /ou bu/ 81C insurance0 the cheaper the pa/ments will be0 but the longer /ou will probabl/ ha#e to make pa/ments before /ou need it9 1here are three basic t/pes of 81C insurance: indemnit/0 e)penseEincurred0 or cash policies9 Indemnit/ plans pa/ a fi)ed dail/ rate regardless of what /ou spend on care9 .)penseEincurred policies reimburse /ou for actual e)penses0 up to a fi)ed amount9 CashEbased policies pa/ /ou a fi)ed amount e#en if /ou incur no e)penses :for e)ample0 if a relati#e pro#ides /our care;9 -or an additional cost0 /our 81C insurance ma/ also pro#ide a limited inflation rider0 a returnEofEpa/ment rider in case /ou don't use it0 and simple or compound interest earned on /our pa/ments9 8ike whole life and annuities0 bu/ing longEterm care insurance is purchasing a feeling of safet/9

Are 1hese Policies a &ood 4eal6

Con#entional wisdom sa/s absolutel/ /es, 1heir track records in the past ha#e ranged from oka/ to great0 in large part because their main underl/ing in#estment bonds ha#e done so well0 especiall/ since the earl/ 1IH@s9 All that profit has helped insurance companies grow0 adding to their =rock solid> image9 In addition to their in#estments growing0 selling whole life and other insurance products has been quite profitable for these companies9 %ith the sale of a whole life insurance polic/0 the compan/ gets a customer for life9 .#en when that customer e#entuall/ dies and the/ pa/ the death benefit0 most of that pa/out will come from the polic/holder's own premium pa/ment9 And e#en if the pa/ments don't full/ co#er it0 whate#er difference the/ ha#e to make up will almost alwa/s be onl/ a fraction of the total income the compan/ made b/ in#esting their customer's mone/ o#er the life of the polic/9 In the case of annuities0 the companies also do well0 selling bonds plus bond insurance9 +o naturall/0 these companies push prett/ hard to sell whole life insurance and annuities9 But are the/ a good deal for /ou6 %hile not fantastic in#estments0 these policies ha#e been oka/ in#estments :and e#en good in#estments; in the past0 depending on /our age0 income0 famil/ situation0 and goals at the time9 And the/ are still oka/ in#estments now9 1hese policies are generall/ #er/ safe under the current conditions9 And e#en in a deeper recession0 there would be little reason for concern9 1he question is will these policies continue to be oka/ going forward0 as the econom/ continues to e#ol#e and we approach the coming Aftershock6

%h/ Con#entional %isdom Is %rong: -acing the "eal H@@EPound &orilla in the "oom

4o /ou remember the recent tele#ision commercial in which a #er/ large gorilla e)tols the #irtues of annuities6 A seemingl/ wellEinformed giant gorilla sits ne)t to an a#erageElooking American0 perhaps on an airplane or in an open con#ertible0 begging his bewildered human companion to consider the man/ mustE ha#e benefits of bu/ing an annuit/9 =*ou could ha#e guaranteed income for life,,> pleads the passionate primate0 as the person stares off an)iousl/ into the unknown9 =But0 he/0 what do I know9 I'm Pust the H@@Epound gorilla in the room9> Cle#er ad9 $owe#er0 the real H@@Epound gorilla in the room is actuall/ a multitrillionEdollar monke/ on our backs0 in the form of the ballooning 39+9 mone/ suppl/ :more than R79H trillion0 as of midE7@17; and massi#e federal debt :nearl/ R1F trillion and continuing to rise rapidl/;9 B/ this point in the book we probabl/ don't ha#e to remind /ou that we belie#e this massi#e mone/ printing b/ the -ed0 dri#en in part b/ our massi#e debt0 will e#entuall/ cause significant rising inflation9 "ising inflation will cause rising interest rates9 And rising interest rates will help pop what is left of our alread/ falling bubbles especiall/ the dollar and the go#ernment debt bubbles and bring on the Aftershock9 Con#entional %isdom :C%; on insurance is wrong because C% is making the usual mistake of assuming that inflation and interest rates will ne#er significantl/ rise9 As we said in the pre#ious chapter on real estate0 C% imagines low interest rates for as far as the e/e can see9

$ow %ill "ising Inflation and "ising Interest "ates Impact 5/ Insurance or Annuit/ Policies6

As we mentioned earlier0 one of the biggest misconceptions about whole life insurance0 annuities0 longE term care insurance0 and the like0 is that these are Pust insurance policies0 and therefore the/ are somehow separate and protected from the dangers of the markets9 But that is completel/ false9 1hese instruments are in#estments and the/ must be anal/Med and managed as such0 as these markets e#ol#e9 1he safet/ of whole life insurance0 annuities0 and the like is directl/ tied to the safet/ of bonds0 and to a lesser e)tent0 the safet/ of stocks and real estate9 1his is not Pust our point of #iew9 .#en the credit rating agencies know this is true9 %h/ else would the safet/ of these instruments be assessed and graded using similar indicators to ones used to assess the safet/ of bonds6 +o far0 the rating agenc/ we mentioned earlier0 A9 59 Best0 has had a good track record for rating the stabilit/ of insurance companies9 But Pust like the other rating agencies0 such as 5ood/'s and +KP0 the/ ha#e ne#er reall/ faced an AftershockEt/pe situation in the markets0 and their ratings do not reflect how a gi#en compan/ might hold up under the enormous pressures of multiple collapsing asset bubbles9 .#en under minimal stress0 ratings ha#e not alwa/s been so accurate9 As /ou ma/ recall from Chapter D0 bonds from the global financial ser#ices firm 8ehman Brothers had a #er/ high rating from both 5ood/'s and +KP until a few da/s before it went bankrupt in 7@@H9 +ince insurance companies are so hea#il/ dependent on bonds0 what happens to bonds when inflation and interest rates rise :see Chapter D; will happen to insurance and annuities0 as well9 "ising inflation will mean rising interest rates9 "ising interest rates will mean falling bond #alues and insurance and annuit/ companies0 which are so hea#il/ in#ested in bonds0 will be in trouble9 In a rising interest rate en#ironment0 whole life insurance has a bit of a buffer9 As their bond in#estments begin to fall0 whole life insurance companies can still pa/ out for a while0 dipping into their large reser#es9 But as inflation and interest rates continue to rise0 whole life policies will be worth less and less9 Annuities ha#e less of an initial buffer than whole life insurance9 1he/ are basicall/ Pust bond in#estments with some added bond insurance9 At first0 when interest rates start to go up and bond #alues falls0 the bond insurance will kick in9 But it will onl/ co#er a small rise in interest rates0 after which /our annuit/'s #alue falls9 As pointed out earlier0 that bond insurance is itself mostl/ Pust bonds9 +o don't count on it holding up when interest rates rise and bonds fall9 Also0 man/ annuities ha#e market adPustment clauses that adPust the cash #alue of an annuit/ if /ou take it out earl/9

*our Insurance Compan/ (eed (ot &o Bankrupt for *our Polic/ to Be %orth 5uch 8ess in the Aftershock

Please understand that the #alue of an insurance compan/'s assets dose not ha#e to fall to Mero in order for the compan/ to no longer be able to pa/ full #alue on /our insurance polic/ or annuit/9 1here is a fairl/ sensiti#e balance between inflow and outflow in these companies9 If their bond in#estments fall0 this balance will be undone and the/ won't ha#e the resource to pa/ /ou as promised9 "emember0 the/ don't ha#e a big pile of mone/ stashed awa/ somewhereJ the mone/ /ou ha#e been pa/ing them all these /ears is in#ested in bonds0 stocks0 and e#en real estate9 A significant drop in those assets will ha#e a big impact9 Please also don't make the mistake of thinking that /our insurance or annuit/ compan/ is =too big to fail> or has been around so long that it is =too safe to fail9> %hate#er is the fate of bonds is the fate of insurance and annuit/ companies9 Please see Chapter D for details about the fate of bonds in the Aftershock9 "ising interest rates will decimate bonds9 5ost insurance companies in#est mostl/ in bonds9 And e#en if /our compan/ can somehow escape all of this and is full/ functional and can continue to pa/ on /our polic/ in full0 /ou still ha#e another #er/ big problem: %ith rising inflation the #alue of that pa/out will be worth far less9 1he bottom line: 1here will simpl/ be no wa/ to come out ahead on /our whole life insurance or annuit/ policies when serious inflation and interest rates rise9

%hat About the +tate and -ederal &o#ernments %on't 1he/ Protect 3s6
-or a while0 /es the/ will9 In the earl/ stages0 when onl/ one or two insurance companies are in trouble0 the state ta) funds that we mentioned earlier will protect polic/holders within that state9 1he problem will come when more companies need help or e#en go under9 !uite quickl/0 state funds will get tapped out9 At that point0 the federal go#ernment will surel/ step in to bail out insurance companies9 But that will quickl/ become too large a task9 $ence0 as it becomes more difficult to bail out the entire insurance compan/0 the go#ernment will focus on helping polic/holders9 1he/ won't ha#e the mone/ to pa/ insurance plans in full0 but the/ will be able to make hardship pa/ments that are means tested9 If /ou ha#e few assets or little income0 /ou will likel/ qualif/ for some t/pe of hardship pa/ment from the go#ernment9 1he pa/ments are low because at the same time that the insurance industr/ will need big backup b/ the go#ernment0 man/ banks and other go#ernmentEinsured entities will clearl/ need backup0 too9 And0 e#en worse0 Pust at the time when the go#ernment will be so badl/ needed for backup in so man/ financial industries0 the go#ernment itself will be in financial trouble0 as well9 1he/ will continue to print mone/ for as long as the/ can :more borrowing at this point will be impossible;0 but e#entuall/ the mone/ printing will ha#e to end due to the rising inflation that it will cause9 At first the/ can ignore rising inflation and will9 But after a while people will adPust wages and prices for inflation more quickl/0 and the go#ernment will find less and less positi#e impact from printing more mone/ .#entuall/0 with borrowing and mone/ printing o#er and income ta) re#enue declining0 the federal go#ernment simpl/ will not ha#e the mone/ necessar/ to co#er /our insurance or annuit/ polic/9 1he/ will do all that the/ can0 for as long as the/ can9 But there will be a limit9 (ot e#er/ need will be fulfilled9

%hat's a +a##/ Aftershock In#estor to 4o6

1he first step0 as alwa/s0 is to face realit/9 (o matter how much /ou ma/ want to belie#e in the safet/ and comfort of these policies0 how can /ou belie#e in them if /ou also belie#e that massi#e mone/ printing will cause future inflation and that rising inflation will cause rising interest rates6 If /ou belie#e our macroeconomic point of #iew e#en if onl/ partiall/ then how can /ou continue to trust that bonds will do well o#er the ne)t se#eral /ears6 And if bonds don't do well0 how can /our policies be worth what /ou thought the/ would be worth6 All insurance is an in#estment in bonds because that is what these insurance companies primaril/ own9 1his isn't rocket science0 as the/ sa/9 It's Pust a matter of logic9 +o let's be logical and figure out what to do about /our whole life insurance and annuities9 "emember that the Aftershock is likel/ still a couple of /ears awa/0 so there is no need to panic and nothing has to be done immediatel/9

8ife Insurance
If /ou want to protect /our financial dependents during /our incomeEproducing /ears0 then term life insurance is preferable o#er whole life insurance9 %hole life costs more0 and when the Aftershock hits0 /our whole life polic/ will be worth a lot less than it's worth toda/9 If /ou ha#e whole life insurance0 now is a good time to e)plore /our options for cashing out of it9 8earning about e)it options is a #er/ important first step to protecting /ourself9 Another option is to borrow against the cash #alue of the polic/9 ?ften0 this mone/ ne#er has to be paid back and is simpl/ subtracted from the death benefit9 If /ou in#est wisel/0 this is not much of a penalt/9 Borrowing might be difficult with certain policies0 and it is #aluable onl/ if the proceeds are properl/ in#ested and not consumed9 If cashing out of or borrowing against /our whole life insurance polic/ now seems a bit rash0 there is no significant harm in waiting a while longer until /ou see more e#idence that we are right9 <eep an e/e on interest rates0 particularl/ mortgage rates9 %hen /ou see mortgage rates climbing to D or F percent0 that is a #er/ good indication that interest rates are heading up and bonds are heading down9 -or those looking to bu/ new life insurance policies0 term life insurance is the wa/ to go9 1erm life insurance makes sense for /oung and middleEaged people with dependents9 4isaster could strike at an/ time0 and it's important to make sure lo#ed ones will be pro#ided for9 1erm life insurance will help replace /our income should /ou happen to die while /ou are still a breadwinner0 so the timing of the polic/ is important9 If /ou get it for too short a term0 the risk is that /ou ma/ not be able to get it again because /ou ma/ ha#e de#eloped a medical problem that will push up the cost of term insurance be/ond /our reach9 8ongerEterm plans sol#e those problems9 1he/ are more affected b/ inflation0 but the premiums /ou pa/ don't go up with inflation either0 so /ou aren't losing mone/0 Pust losing the #alue of /our co#erage9 $ence0 /ou ma/ want to increase co#erage o#er time as inflation is rising9

Annuities
1o cash out of an annuit/0 there is usuall/ a sliding scale of penalties that decreases o#er time9 *ou should find out what these are9 Pulling out before /ou turn DI^ can also lead to penalties from the I"+9 %e hesitate to suggest taking penalties of an/ kind0 but at a certain point it ma/ be better to take a relati#el/ smaller penalt/ than to lose most of /our in#estment later9 If /ou ha#e reached the age when /ou can make withdrawals without a penalt/ now0 do so at the ma)imum amount9 "egardless of /our age0 as we get closer to the Aftershock and /ou feel increasingl/ confident that we are right0 /ou should mo#e faster out of all bondEbased insurances0 such as annuities9 1he inflation and interest rate protections the/ offer will #er/ quickl/ be o#erwhelmed b/ high inflation and high interest rates after the bubble econom/ full/ pops9 Again0 no need to panic now0 but e)iting before that happens is wise9

8ongE1erm Care Insurance and 4isabilit/ Insurance

8ongEterm care insurance will also not fare well as inflation and interest rates rise9 +ince longEterm care insurance is generall/ bought while the polic/holder is relati#el/ /oung0 these policies ha#e an in#estment component :although less so than whole life insurance; that will not be reliable when asset #alues are falling9 .#en now0 these policies can be challenging for some insurance companies9 5an/ companies ha#e alread/ pulled out of the longEterm care insurance business because the/ cannot make enough mone/ on their bonds to keep up with rising costs of nursing homes and other health care e)penses9 In the Aftershock0 this kind of insurance will all but disappear9 In man/ cases0 longEterm care insurance is not worth bu/ing or keeping9 $owe#er0 if /ou alread/ ha#e longEterm care insurance and /ou are in poor health now0 or in /our G@s or H@s and think /ou might need longEterm health care in the ne)t few /ears0 then it makes sense to hold on to /our polic/9 But if /ou are in /our F@s or /ounger0 and in good health0 the odds are that /ou will not need longEterm health care for at least another 7@ /ears0 if e#er9 5ost people will not need longEterm care0 e#en when the/ are older9 -or e)ample0 onl/ one out of four people will go to a nursing home0 and the a#erage age of admission is HA0 so it could be man/ decades before /ou would need this polic/9 And gi#en the coming Aftershock0 b/ that time /ou will not be able to count on it an/wa/9 4isabilit/ insurance is highl/ #ulnerable to inflation9 Although man/ policies do ha#e some inflation adPustments0 the/ often ha#e limits on the amount of adPustment9 If /ou are still in /our working /ears and hold an indi#idual disabilit/ polic/0 it makes sense to continue it for now9 But when the bubbles pop and the Aftershock begins0 these policies are going to become less reliable as the assets of insurance companies crash and state and federal go#ernments are stretched #er/ thin0 tr/ing to co#er so man/ needs9 +o continue pa/ing /our premiums on the polic/ while all is still relati#el/ well0 but discontinue /our pa/ments as we near the Aftershock9 ?ne important difference between longEterm care insurance and disabilit/ insurance is that disabilit/ insurance is often pro#ided as a benefit from an emplo/er and is not bought indi#iduall/0 so e#en though the benefit will be worth less in a period of high inflation0 at least /ou aren't pa/ing for it9

?ther 1/pes of Insurance that Are (ot In#estment 4ependent: $ealth0 Auto0 and $ome Insurance

(ot all t/pes of insurance are dependent on the performance of in#estments9 $ealth0 auto0 and home insurance0 for e)ample0 are much more dependent on premiums and not #er/ dependent on performance of the compan/'s assets9 If the #alues of bonds fall0 /our health0 home0 and auto insurance will be fine9 Premiums ma/ certainl/ continue to go up0 but it won't be because of poor performance in the bond markets9 Because of this0 we mostl/ agree with con#entional wisdom on these insurances that are not in#estment dependent9 1hese are good to ha#e0 and /ou should ha#e them9 But we do ha#e a few suggestions that we think are worth noting9 -irst0 when possible0 choose the higherEdeductible policies because the/ generall/ cost much less than the lowerEdeductible plans9 3nless /ou are a frequent claimant of insurance0 high deductibles usuall/ make more sense in the long term and can pa/ for themsel#es in Pust a few /ears9 +econd0 on /our homeowners insurance0 make sure /ou are not o#erpa/ing because the land #alue shot up during the rising real estate bubble9 *ou need to insure onl/ the dwelling0 not the land :it usuall/ sur#i#es a fire and is hard to steal;9 *ou should check /our insurance to make sure the dwelling #alue seems appropriate9 If not0 /ou should get the dwelling reE#aluated andNor get a second insurance compan/ bid to confirm /ou ha#e the right #alue9 -inall/0 if /our emplo/er pro#ides /our health insurance and /ou ha#e some choices0 take the best deal /ou can get9 But if /ou must bu/ /our own health insurance0 shop around9 1here are a lot of choices and a wide range of costs9 Choose a plan that best matches /our best guess of /our future health needs9 Again0 it usuall/ makes sense to get a higherEdeductible plan9

%hen to .)it *our In#estmentE4ependent Policies

Insurance

In keeping with the three stages we described in the chapters on stocks and bonds0 it is reasonable to e)pect insurance policies that are dependent on the performance of stocks and bonds to follow the same fate at each stage9

+tage 1: 1he "ecent Past and (ow

Bust as bonds did oka/ during the global financial crisis of late 7@@H0 so did most insurance companies9

+tage 7: 1he +hortE1erm -uture

As long as interest rates remain low0 all is well9 In the short term :7@17 and 7@1A;0 interest rates will not likel/ rise too dramaticall/9 But remember0 e#en Pust a small rise in interest rates will ha#e an earl/ negati#e impact on bonds9 B/ this time /ou should ha#e learned how to e)it /our bondEdependent insurance policies9 It ma/ be too earl/ to e)it0 but /ou should be increasingl/ read/ to pull the trigger9

+tage A: 5ediumE1erm -uture

%hen bond markets start taking a big hit0 /ou should ha#e e)ited or should quickl/ e)it bondEbased insurance and annuities9 $igh inflation and high interest rates are not going to occur o#ernight9 It will happen o#er time9 1he more time that goes b/0 the greater the risk to bonds9

BondE4ependent Insurance in the Aftershock

In the Aftershock0 the go#ernment safet/ nets for insurance policies of all kinds will fail because the go#ernment will not ha#e the mone/ to co#er all the demands on it9 +ome polic/holders ma/ continue to get some help0 based on need0 but that will be limited9 &etting out of /our in#estmentEdependent insurance policies before all this occurs is ob#iousl/ a good idea9 It is ne#er too earl/ to at least look into /our #arious options for e)iting0 including finding out the face #alue of /our policies0 the options for borrowing against it0 and the penalties :and ta) consequences; for earl/ withdrawal9

*our Best =Insurance> Is an Acti#el/ 5anaged Aftershock Portfolio

In deciding how to handle /our whole life insurance0 annuities0 and other insurance policies0 first0 be aware of the risksJ second0 be read/ to make a mo#eJ and third0 build an acti#el/ managed Aftershock portfolio9 5one/ that /ou can rescue from these bondEbased policies :that will be so badl/ impacted later b/ rising interest rates; can be better protected b/ in#esting in assets that can withstand and e#en profit from the economic changes ahead9 *ou ma/ choose to do this all at once and as soon as possibleJ or /ou can do it incrementall/0 perhaps making small regular purchases0 Pust as /ou would if /ou were pa/ing for an insurance polic/9 1he ke/ to correct in#esting before and during the Aftershock is to di#ersif/ across a range of asset classes0 not Pust within an asset class0 and most importantl/ to acti#el/ manage those in#estments9 1hat means not Pust setting it up once and walking awa/9 Acti#e management means making changes to /our portfolio that are in step with the e#ol#ing econom/9 :5ore details about building an acti#el/ managed Aftershock portfolio are offered in Chapters A and 119;

C$AP1." H

&old

1$. ?(C. A(4 -313". <I(&

%h/ do in#estors bu/ gold6 ?r should we ask wh/ do so few in#estors want to bu/ gold now and wh/ will so man/ more in#estors want to pile into gold later in the Aftershock6 "ight now0 the idea that gold is a good longEterm in#estment is contro#ersial and prickl/9 People generall/ don't like it9 &old ma/ be fa#ored b/ some uncon#entional in#estors0 but b/ far0 most Americans do not currentl/ own gold and the/ ha#e no interest in doing so9 1heir con#entional wisdom :C%; portfolios are generall/ loaded with stocks0 bonds0 and perhaps real estate9 1he idea of adding a significant amount of gold to the mi) seems unnecessar/0 e#en sill/ to them0 Pust as it seems sill/ to man/ financial ad#isers and the famous in#estors the/ re#ere0 like %arren Buffett and others9 1his is what we meant earlier in the book when we said that Aftershock in#esting is so uncomfortable9 It Pust doesn't feel right compared to the comfort of con#entional in#esting0 and /ou won't find strong mainstream support for it9 It is hard #er/ hard to go against %arren Buffett9 %e released oursel#es from that difficult/ man/ /ears ago when we were writing America's Bubble .conom/ in 7@@D9 %ith the correct macroeconomic #iew0 it reall/ was not that hard to see all the bubbles :stocks0 real estate0 etc9; rising and then beginning to fall9 %ith this same macroeconomic #iew0 it is also not that difficult to see that gold will e#entuall/ be the biggest0 most profitable bubble of our lifetime9 And there are multiple wa/s that /ou0 or an/one at an/ le#el of wealth0 can benefit immensel/ from that rising bubble in the coming Aftershock9 $owe#er0 before we get to all that0 we first need to tackle the reasons wh/ gold is currentl/ seen as such a longEterm loser b/ C% in#estors like %arren Buffett and so man/ others9 1hese are smart and successful people with stunning in#estment track records in the past9 $ow could the/ be so far off track now when it comes to the future of gold6 Are the/ right0 or are we right6 %e in#ite /ou to re#iew the basic macroeconomic e#idence and decide for /ourself9

&old %as &olden for Centuries

&old has been highl/ #alued for a long0 long time9 %e are talking millennia0 not centuries9 (o one knows e)actl/ when gold was first disco#ered and used b/ humans0 but there is e#idence that it ma/ ha#e occurred as earl/ as H0@@@ /ears ago9 %e do know that .g/ptian pharaohs and priests used gold as an adornment beginning around A@@@ BC0 although at that point the/ still used barle/0 not gold0 as a means of trade9 1o the best of our current knowledge0 gold was first used as mone/ in about G@@ BC9 +ince then0 no other form of mone/ has come close to gold's longe#it/ or worldwide appeal9 "egardless of the culture or the era0 e#er/ form of gold from gold nuggets to gold coins and gold bars0 to gold Pewelr/ and e#en gold teeth ha#e all commanded uni#ersal respect and bu/ing power for more than 70G@@ /ears9 In that time0 people ha#e found gold to be so beautiful0 enduring0 and scarce that it became more highl/ re#ered than merel/ mone/0 and the ele#ated prestige of gold still continues toda/9 8o#ers seal their #ows with gold rings9 <ings and queens still wear gold crowns9 ?l/mpic winners still recei#e gold medals :although no longer solid gold;9 And a gold watch at retirement still s/mboliMes respect and accomplishment9 .#en our language continues to recogniMe the special status of gold with phrases like =our golden moment> and =his word is as good as gold9> ?#er the long haul of histor/0 no other worldl/ substance has retained such a high and uni#ersal regard as gold9 1o sa/ that this precious metal has sta/ing power would be an understatement9

Paper 5one/ 3sed to Be =Backed> b/ &old

4uring the long e#olution of mone/0 beginning first with bartering and e#ol#ing to toda/'s electronic mone/ transfers0 gold has pla/ed a prominent role9 -or centuries0 gold0 sil#er0 and other metals were used for mone/0 replacing the more perishable forms of currenc/0 such as barle/0 seashells0 and salt9 After a while0 as world trade e)panded and economies grew0 bags of metalsEbased mone/ got too hea#/ to lug around :see the following sidebar; and paper mone/ was created to make mone/ more portable and easier to produce9

$ea#/ 5etal

4id /ou know that gold is one of the hea#iest metals around6 %ith a specific gra#it/ of 1I9A0 gold weighs 1I9A times more than an equal #olume of water9 1hat means Pust one cubic foot of gold :about the siMe of a basketball; weighs 107@F pounds9 1hat's more than half a ton, (o wonder we e#entuall/ switched to paper mone/9 ?f course0 the ease of production of paper mone/ naturall/ made people leer/ of its #alue9 &old and sil#er could be weighed and a trading #alue determined based on its ph/sical siMe and purit/0 but not so with paper9 1his problem was addressed b/ certif/ing that the paper currenc/ was =backed> b/ gold or sil#er0 meaning there was a certain amount of precious metals set aside to back up the claim that the paper had an/ real #alue9 3pon demand0 this paper could be turned in for the amount of gold or sil#er it represented9 .#en when we went off of the gold standard in 1IAA0 we still used gold to back our international transactions up until 1IG19 (ow the 39+9 dollar is no longer backed b/ gold for either domestic or international transactions0 and the -ederal "eser#e can print mone/ whene#er it wants9 But e#en so0 gold is still important toda/ because people all around the world still think it is important9 &old continues to be considered a safe store of #alue b/ nearl/ e#er/ countr/9 1his includes the 39+9 go#ernment0 which currentl/ owns more than I0@@@ tons of gold with an appro)imate market #alue of more than RCD@ billion9

Current Con#entional %isdom on &old as an In#estment: %arren Buffett +a/s +ta/ Awa/,

Con#entional wisdom on gold has e#ol#ed as the uses of gold ha#e e#ol#ed9 -or a #er/ long time0 C% thought gold was wonderful and wanted to own as much of it as possible9 .#en in modern times0 C% still #alued gold to #ar/ing degrees for most of the twentieth centur/9 But more recentl/ especiall/ since the earl/ 1IH@s stock market boom C%'s interest in gold as an in#estment has cooled off considerabl/9 5ainstream in#estors ma/ ha#e a small percentage of their con#entional portfolios in gold0 particularl/ since the financial crisis of 7@@H0 but the/ generall/ sa/ that gold is a bad longEterm in#estment for the following reasons: 3nlike bonds0 gold earns no interest9 3nlike stocks0 gold earns no di#idends9 3nlike real estate0 gold earns no rent9 &old is not a safe ha#en0 like bonds ha#e been9 &old has no =real> #alue0 it is mostl/ all speculati#e9 1he price of gold is #olatile0 and in#esting in gold is unpredictable and unsafe9

In short0 C% thinks of gold as Pust a #olatile commodit/ perhaps a bit attracti#e under the right shortE term conditions0 but too dangerous in the long run9 Instead0 C% in#estors like %arren Buffett are constantl/ telling us to stick with stocks9 %h/6 %ell0 for starters0 gold has not done as well as stocks o#er the past four decades0 as 5r9 Buffett pointed out in his -ebruar/ I0 7@170 article in -ortune magaMine9 5r9 Buffett used the comparison in -igure H91 to show gold's relati#e performance9 &old still does well0 especiall/ compared to bonds0 but not quite as well as stocks9 -igure H91 &old #ersus +tocks from 1IFD to 7@@@ %hat R1@@ in#ested in gold or stocks in 1IFD would be in 7@@@9 +tocks outperformed gold from 1IFD to 7@@@9

$owe#er0 since 7@@@0 after the stock market boom of the 1IH@s and 1II@s0 the +KP D@@ has remained essentiall/ flat9 5eanwhile0 during those same /ears0 gold has climbed almost D@@ percent :see

-igure H97 ;9 -igure H97 &old #ersus +tocks since 7@@@ %hat R1@@ in#ested in gold or stocks in 7@@@ would be worth toda/9 +ince 7@@@0 gold has far outperformed stocks9

%hat does 5r9 Buffett ha#e to sa/ about gold outperforming stocks in the past decade6 $e ad#ises us to pa/ no attention to that9 $e sa/s rising gold is nothing more than a bubble9 -unn/ how he doesn't think stocks are a bubble0 e#en though the 4ow went up o#er 10@@@ percent between 1IH@ and 7@@@ while gross domestic product :&4P; went up onl/ 7F@ percent9 5r9 Buffett implores us to stick with stocks instead of gold because the main reason people bu/ gold now is in the hope that more people will bu/ gold later9 $e sees no fundamental economic reasons for gold to e#er rise0 so if it does e#er rise0 it has to be mostl/ because of speculation9 In the -ortune magaMine article he wrote: =&old has two significant shortcomings0 being neither of much use nor procreati#e9 1rue0 gold has some industrial and decorati#e utilit/0 but the demand for these purposes is both limited and incapable of soaking up new production9 5eanwhile0 if /ou own one ounce of gold for an eternit/0 /ou will still own one ounce at its end9> *ou see0 according to current C%0 since gold does not ha#e utilit/ #alue0 it is not a worthwhile in#estment9 (ow 5r9 Buffett would certainl/ agree that gold will ha#e shortEterm increases0 as will man/ in#estments0 but it is not as good longer term as stocks are now9 -undamentall/0 his concerns ha#e a certain amount of merit9 But gold has risen in the past0 e#en for long periods of time0 despite its not ha#ing a utilit/ #alue9 5ore importantl/0 the recent past of 1IFD to 7@@@ is not necessaril/ a good indicator of what's going to happen in the ne)t couple of decades9 1he fundamental economic conditions could be0 and will be0 #er/ different9 1hese conditions will work #er/ poorl/ for stocks and #er/ well for gold9 Although 5r9 Buffett has a better anal/sis than most C% in#estors who dislike gold0 the bottom line for most C% in#estors is that0 whate#er the price of gold is toda/0 that is the price at which gold is about to =top out0> while stocks0 at whate#er price the/ are toda/0 are almost alwa/s poised for longEterm growth9

%h/ Con#entional %isdom on &old Is %rong

As we said before0 in the past C% lo#ed gold9 C% in#estors onl/ stopped lo#ing gold relati#el/ recentl/0 in fa#or of the stock market bubble0 the real estate bubble0 and the big runEup in bonds since 1IH@9 1he iron/ here is that one of the reasons that C% does not like gold because it is not dri#en b/ an income stream0 such as interest0 di#idends0 or rent :in particular interest; will be the #er/ reason that gold will do so well in the future0 when high interest rates pop the other asset bubbles9 As discussed in detail in earlier chapters0 rising interest rates :caused b/ massi#e mone/ printing and the inflation it will create; will ha#e a #er/ negati#e impact on stocks0 bonds0 real estate0 whole life insurance0 annuities0 and other interestEsensiti#e assets some of which are alread/ partiall/ fallen bubbles9 "ising inflation and rising interest rates will also pop our two remaining bubbles: the dollar and the go#ernment debt bubbles9 But there is one asset that rising inflation and rising interest rates will not be able to push down: &?849 1herefore0 b/ default0 when most other assets are falling0 gold is going to look increasingl/ attracti#e as people around the world begin to bail out of their sinking in#estments and pile into the gold lifeboat9 &old will be seen as a safe ha#en when the 39+9 and world bubbles pop9

&reatl/ 8imited +uppl/ and +harpl/ "ising 4emand %ill 4ri#e $uge Price &rowth

A ke/ reason that gold will do so well as the other bubbles fall is its #er/ limited suppl/9 %orldwide0 onl/ about 70D@@ tons of gold are currentl/ mined each /ear plus onl/ about another 10F@@ tons of gold per /ear are rec/cled0 according to the %orld &old Council9 $ere is another wa/ of looking at the relati#el/ small siMe of total world gold9 It would take less than three and a half ?l/mpicEsiMed swimming pools to hold all of the gold e#er mined about 1FD0@@@ metric tons0 most of which :about HD\; was mined in the twentieth centur/9 4espite the rise in gold prices in the past decade0 the total output of gold mines0 e#en with new mines coming on line0 has actuall/ declined or barel/ increased in recent /ears :see -igure H9A ;9 -igure H9A &old +ince 7@@D &old mining output has not increased greatl/ despite a massi#e increase in the price of gold9 +ource: %orld &old Council9

5ost Americans don't especiall/ like to in#est in gold right now0 but keep in mind that the 3nited +tates is onl/ 1@ percent of the world's gold market9 China and India now make up more than half the world's gold market0 and the/ clearl/ lo#e gold9 1here are now gold #ending machines on the streets of BeiPing0 and Chinese banks hand out lots of brightl/ colored brochures pushing gold to their customers9 1he Indian people like gold so much0 the/ e#en ha#e a goldEbu/ing season when gold0 mostl/ as Pewelr/0 is traditionall/ purchased9 $igh inflation in China and India has increased recent purchasing9 Plus0 in China0 which has seen the highest growth in demand0 interest paid b/ banks is #er/ low0 the stock market has done poorl/0 and real estate is #er/ e)pensi#e for most people9 +o0 the alternati#e in#estments to gold are not good9 +o e#en if we don't generall/ like gold0 the rest of the world is #er/ proEgold and the/ will not hesitate to rush into more gold in the future9 1hat will make American in#estors highl/ interested0 too0 especiall/ when our bubbles burst and the/ start looking for someplace to put what is left of their mone/9 4espite the C% assertion that there will not be enough demand to soak up future suppl/0 Pust the opposite is true: 4emand will far outpace suppl/0 and that will rapidl/ push gold prices sk/ward9 %hen the other bubbles pop0 there will be a tremendous amount of mone/ e)iting stocks0 bonds0 and other

in#estments9 1he tin/ siMe of the gold market relati#e to stocks and bonds worldwide means that when people turn to gold0 the/ will dri#e gold prices up fast and high9 1hink of all the millions of in#estors around the world who will be tr/ing to Pump into those three and a half swimming pools9 .)plosi#e demand and tin/ suppl/ will create the biggest asset bubble we ha#e e#er seen9 And as we will e)plain later in the chapter0 after this bubble goes up0 it is not going to come down an/time soon9

%h/ 1his In#estment Is +o 3ncomfortable to 5ake (ow: &old Is the AntiE+tock

In general0 gold does poorl/ when stocks do well0 and gold does better when stocks do poorl/9 1his is ke/ to wh/ C% doesn't like gold the/ want their stock bubble back, 1herefore0 for C%0 in#esting in gold is equi#alent to shorting America's bubble econom/9 People don't like that because the/ want America's bubble econom/ to last fore#er9 It won't9

%hat's a +a##/ Aftershock In#estor to 4o6

1he first step0 once again0 is to logicall/ face facts9 Continuing to bet hea#il/ on a C% portfolio as we approach the Aftershock is simpl/ not rational9 All the C% arguments against owning gold :it doesn't earn interest0 it doesn't pa/ di#idends0 etc9; are all irrele#ant if stocks and bonds are going to fall with rising inflation and rising interest rates9 1hose are the same conditions that will make gold soar9 4o /ou reall/ need to worr/ about not earning interest when /our in#estment is rising D@@ percent or more6 "emember three things: :1; the other bubbles will popJ :7; Apple's stock alone is worth more than all of the gold held b/ the 39+9 go#ernmentJ and :A; the 39+9 go#ernment bond market alone is nearl/ A@ times larger than the #alue of all the gold that the go#ernment holds9 Bottom line: &old in#estments are #er/ small relati#e to stock and bond in#estments9

&old Is (ot Bust a Commodit/

&old holds an unusual position in the minds of man/ people around the world as a store of monetar/ #alue9 $ence0 it is not reall/ a commodit/ in the same sense as wheat or Minc or oil9 -or this reason0 long term0 it will act #er/ differentl/ from other commodities in terms of its price9 ?ther commodities are dri#en b/ commercial demand9 &old will be dri#en b/ demand for it as a store of monetar/ #alue in times of great fear of other financial assets9 In the short run0 before the bubbles pop0 the price of gold ma/ at times follow the rise and fall of other commodities9 But as the world's bubbles continue to pop0 gold's attraction as a traditional store of monetar/ #alue will set gold increasingl/ apart from commercial commodities9 *es0 the demand for gold as Pewelr/ will fall since Pewelr/ is a discretionar/ good0 but that loss of demand will be more than offset b/ a big increase in in#estment demand9 -urthermore0 a great deal of gold Pewelr/ that is purchased in Asia and the 5iddle .ast is often for in#estment purposes since it can be easil/ resold when the mone/ is needed9

%hat About +il#er6

%e ha#e been focusing on gold in this chapter0 but much of this discussion applies to sil#er as well9 +il#er is different from gold in that it is a h/brid in#estment9 It is both a precious metal in#estment and an industrial commodit/9 About half of sil#er's production each /ear is consumed for industrial purposes0 hea#il/ electronics9 1hat means that it is also much more #ulnerable to downturns in commodities prices caused b/ economic downturns9 1hat bodes poorl/ for sil#er9 $owe#er0 it is also cheaper and easier for man/ people to bu/ and is #er/ much considered a monetar/ asset9 .#en our coins were made of sil#er up until 1IFD9 +o we e)pect that monetar/ #alue to keep sil#er following gold0 but in a se#ere downturn sil#er will not track gold as well as it does now0 gi#en that industrial demand is still #er/ high9 $owe#er0 one offset to the downward pressure is that sil#er is hea#il/ mined as a b/Eproduct from other metal mining0 most notabl/ copper9 In fact0 o#er G@ percent of sil#er production is as a b/Eproduct9 +o when demand for commodit/ metals such as copper falls0 so will production of sil#er9 1his will help offset some of the downward pressure on sil#er9 1he bottom line is that both gold and sil#er will do #er/0 #er/ well9 1here ma/ be times when one outperforms the other0 but at the height of the Aftershock0 gold will be king and sil#er will be the prince9 "egardless of which precious metal /ou personall/ prefer0 the world thinks of gold as (umber ?ne and sil#er as (umber 1wo :think of the ?l/mpic firstE and secondEplace medals;9

&old :and +il#er; %ill "ise in 1hree +tages

3nlike an/ of the other in#estments we describe in this book0 onl/ gold will do well in all three stages0 despite its continued #olatilit/9 If /ou are in it for the longer term0 there is reall/ no bad time to bu/ gold9 Bu/ now0 bu/ later0 or bu/ now and later9 It is all good9 An/ price we pa/ for gold before the Aftershock is going to look like a bargain to us in the Aftershock9

+tage 1: 1he "ecent Past and (ow

&old is up almost D@@ percent since 7@@10 and since the financial crisis of 7@@H0 gold almost doubled0 although it pulled back in late 7@119 1he price of gold has been quite #olatile0 which worries some in#estors0 while others ignore the shortEterm action and see gold primaril/ as a good longEterm in#estment9

+tage 7: +hortE1erm -uture

&oing forward0 gold will generall/ continue to do well0 but e)pect considerable #olatilit/ to continue9 1here also is some reason to think there ma/ be a bit of manipulation of the gold price on occasion9 4on't count on gold's rising more than about 1@ percent per /ear during this time9

+tage A: 5ediumE1erm -uture

As inflation and interest rates rise0 e)pect to see stocks0 bond0 and real estate #alues begin or continue to fall9 Because gold is not interest rate dependent0 rising interest rates will not negati#el/ affect gold9 !uite the contrar/0 in#estors worldwide will be increasingl/ attracted to gold in a flight to safet/ as the interest rateSdependent assets fall9 %e call this rational fear0 and it will push gold up significantl/9

&old Bust Before and 4uring the Aftershock: "ational -ear Becomes "ational Panic

1o summariMe what we alread/ discussed0 there are se#eral good reasons wh/ gold will shoot up Pust before and during the Aftershock: 19 1he gold market is #er/0 #er/ small compared to the stock and bond markets9 .#en a small shift of capital out of these larger markets and into gold will dramaticall/ boost its price9 And a large inflow of capital into gold will ha#e a #er/ huge0 positi#e effect0 indeed9 79 &old is alread/ #iewed #er/ positi#el/ as an in#estment in the 5iddle .ast and Asia0 which are currentl/ the biggest consumers of gold9 %hen the 39+9 dollar bubble pops0 in#estors in those countries will mo#e rapidl/ into gold when their economies tank e#en worse than the 39+9 econom/9 A9 It is #er/ difficult to quickl/ increase gold production9 &old mining will not be able to keep pace with demand9 C9 &old is often used as an illegal ta) a#oidance technique around the world9 1hat is likel/ part of its attraction in China and India9 %e0 of course0 do not ad#ocate illegal ta) a#oidance0 but there's no den/ing that the world finds this appealing0 further boosting the demand for gold9 D9 &old has traditionall/ been seen as an inflation hedge in the past0 and in this case will be an e)traordinaril/ good hedge against inflation in the future0 so an/ significant rise in inflation in the 3nited +tates or in other countries will dri#e the price of gold higher9 F9 As the world's banking s/stem comes under increasing stress0 gold will ha#e increasing appeal9 G9 4ollarEbased in#estors will get a double benefit b/ bu/ing gold9 If /ou bu/ gold with dollars0 /ou are taking ad#antage not onl/ of the price rise in gold0 but also the fall of the dollar9 As an e)ample0 if gold goes up four times0 and the euro goes up two times against the dollar0 /our net increase is eight times9 1he bottom line is that there won't be man/ in#estment options as good and eas/ as gold when the

Aftershock hits9 1he rising gold bubble is /our best bet for wealth protection and profits in the Aftershock9

$ow to Bu/ &old

1here are man/ wa/s to bu/ gold some good0 some not so good9 %e think the three best wa/s to bu/ gold are:

19 Bu/ Ph/sical &old from a 8ocal Coin 4ealer or a "eputable ?nline 4ealer

5an/ people prefer to bu/ gold coins rather than larger gold bars9 Coins are easier than bars to find a bu/er for later when /ou want to sell9 +ome of the easiest coins to trade are the Canadian 5aple 8eaf0 the American .agle0 and the +outh African <rugerrand9 Coins are usuall/ one ounce in weight0 but often also come in smaller halfEounce and tenthEounce siMes9 *ou can bu/ these from local coin shops0 but the/ will be a bit more e)pensi#e per ounce than bu/ing online9 $owe#er0 there are no shipping and insurance charges at the coin shop9 +ome states ma/ charge sales ta) or0 like 5ar/land0 ma/ require that /ou bu/ at least R10@@@ worth of gold in order to be ta) e)empt9 *ou can find local coin shops in the *ellow Pages or online9 1he 39+9 5int web site : www9usmint9go# ; also has a searchable database of coin shops based on /our location9 &etting to know a local coin dealer now ma/ help /ou later when /ou want to sell some coins9 5an/ people prefer to bu/ bullion online or b/ phone9 5ailEorder gold tends to be cheaper because the #endors ha#e lower o#erhead than a ph/sical store9 *ou can simpl/ t/pe =gold bullion> into the search bar of /our fa#orite Internet search engine and in#estigate /our options0 such as www9<itco9com and others9 ?nline outlets and retail stores require certified checks or cash to bu/ gold0 or will ask /ou to wait until /our check clears /our bank before the/ ship or let /ou pick up /our gold9 *ou can keep ph/sical gold in a safe deposit bo) at a bank :e#en a small safe deposit bo) can hold quite a lot of gold;0 or in a lockable safe at home0 which /ou can bu/ at an/ office supplies store9 .#entuall/0 as the #arious stages of the Aftershock occur0 /ou ma/ ha#e to keep all ph/sical gold at home for ma)imum safet/9

79 Bu/ &old .)changeE1raded -unds

"etail coin stores :online or in /our neighborhood; often charge a much higher sales commission or =spread0> often ranging from A to F percent per ounce9 ?ne wa/ to a#oid this is to bu/ gold e)changeE traded funds :.1-s;0 which are traded like stocks on the (ew *ork +tock .)change with the price roughl/ tracking oneEtenth of the price of an ounce of gold0 making them a #er/ quick and con#enient wa/ to bu/ and sell gold9 -irst on the scene in the fall of 7@@D0 gold .1-s now hold more than 10@@@ tons of gold9 1he most popular .1- is &84 and is a product of +tate +treet &lobal Ad#isors9 Its competitor is IA3 and is #er/ similar9 A different t/pe of gold .1- is P$*+0 which is actuall/ a closedEend fund0 rather than strictl/ an .1-9 It holds ph/sical gold in Canada9 $owe#er0 &84 and IA3 also hold ph/sical gold9 &84 holds its gold in 8ondon9 1he/ actuall/ list the serial numbers of the C@@Eounce gold bars :8ondon &ood 4eli#er/ Bars; that the/ hold on their web site9 &old .1-s ha#e some ta) disad#antages and e)penses0 but their trading con#enience and small entr/ point make them quite popular with in#estors at e#er/ le#el9 .1-s can also be bought on margin9 &old .1-s are safe for now0 but could become less safe in the future0 at which point owning onl/ ph/sical gold might be best9

A9 Bu/ &old 3sing a &old 4epositor/

An alternati#e to bu/ing ph/sical gold or gold .1-s is bu/ing gold from a gold depositor/0 such as 5one) in (ewport Beach0 California9 %ith a gold depositor/0 /ou ha#e ownership of the gold without necessaril/ taking ph/sical possession0 although /ou can at an/ time9 As soon as /ou bu/ it0 the/ sign legal ownership o#er to /ou and deposit it with a separate legal entit/9 If the depositor/ were to go bankrupt0 the gold would still be /ours9 &old depositories sol#e the problems of gold storage and safet/0 and also gi#e /ou the opportunit/ to bu/ gold on margin :see the section on le#eraging gold later in this chapter;9 As we mentioned earlier0 at some point0 /ou ma/ do best to take ph/sical possession of /our gold0 which is #er/ eas/ with a depositor/ and not reall/ feasible for most in#estors with current gold .1-s9 -or e)ample0 /ou ma/ first bu/ gold .1-s because the/ are eas/ and con#enient9 8ater0 /ou might sell /our gold .1-s and switch to a gold depositor/ because of the ease of le#eraging at a higher rate as the gold bubble rises0 and because of ease of deli#er/ when /ou want to take ph/sical possession later9 -inall/0 taking ph/sical possession of /our gold ma/ make the most sense if and when the go#ernment begins to take ad#erse actions against gold0 such as restrictions on the purchase or sale of gold or #er/ high ta)es on gold transactions9 +ome in#estors ma/ e#entuall/ choose to bu/ their gold offshore0 depending on their circumstances9

%hat About &old 5ining +tocks6

&old mining stocks ha#e the ad#antage of multipl/ing the profits that a gold mining compan/ can deri#e from mining gold9 $ence0 the/ can rise faster than the price of gold itself because /ou recei#e a multiple of earnings made from selling gold9 "e#enues rise as the price of gold rises0 but operating costs do not9 1herefore0 as gold prices go up0 gold mining companies can do #er/ well9 $owe#er0 the downside of gold mining stocks is that the/ can be affected b/ three ke/ issues that are outside of the price of gold9 1he first is the o#erall stock market0 which0 when it falls0 will tend to take e#er/one down0 at least for a while9 1he second issue is that each gold mining compan/ faces the same compan/ risks that an/ compan/ can face9 "emember0 like 5ark 1wain said0 =A gold mine is a hole in the ground owned b/ a liar9> 1hird0 man/ mining companies0 particularl/ the larger ones0 are not pure gold pla/s9 1he/ often get the maPorit/ of their re#enues from other metals0 such as iron and copper9 %hile man/ gold mining stocks will go down temporaril/ when the stock bubble full/ pops0 later on man/ gold mining stocks will do e)tremel/ well in some cases e#en better than the price of gold itself9 +o there is a lot of mone/ to be made in gold mining stocks if /ou are aware of the risks we Pust mentioned9 8ong term0 when the stock market falls and gold rises0 there will be e#en better opportunities to bu/ gold mining stocks9 *ou need sophisticated in#estment research or competent guidance before going into an/ gold mining stock9 Another option is to purchase a di#ersified fund or .1- that holds a #ariet/ of gold mining stocks0 such as the .1- &4Z9 B/ the time the gold bubble is rising rapidl/0 the stock bubble will ha#e been prett/ well deflated so /ou will be bu/ing gold mining compan/ stock at low prices9 &old mining stocks ma/ be more attracti#e if /our in#estment #ehicle allows in#estments in gold mining stocks but not directl/ in gold9 But remember0 great care is needed to a#oid the downward pressure of a collapsing stock market on gold mining stocks9

8e#eraging &old

?ne thing we'#e seen in recent /ears is that le#eraging :borrowing mone/ to fund part of the purchase of an in#estment; can light a fire under the growth of /our assets9 $edge funds and pri#ate equit/ funds used le#erage to create astounding returns for se#eral /ears9 But that fire can also burn /ou0 as the hedge funds and pri#ate equit/ funds certainl/ found out9 1he same goes for le#eraging gold9 1here is no quicker wa/ to make mone/ on gold0 and no quicker wa/ to lose it9 1he greater the price #olatilit/0 the greater the risk0 because e#en if /ou are right in the long term0 /ou can be squeeMed out b/ margin calls in the short term due to sharp shortEterm declines in the price9 1he price ma/ Pump back to its high #er/ quickl/0 but /ou ma/ ha#e lost much of /our mone/ in the dip if /ou couldn't make the margin calls on /our highl/ le#eraged gold in#estment and had to sell /our position at a low price9 Because we belie#e there will be greater #olatilit/ in the beginning of the gold bubble0 we suggest /ou keep /our le#erage more limited in the earl/ stages9 $owe#er0 as the gold bubble begins to take off with the dollar bubble pop0 /ou could consider increasing /our le#erage9 If /ou decide to bu/ gold on margin0 the amount of margin /ou can get is controlled b/ the go#ernment0 like an/ brokerage account9 But0 depending on the #olatilit/ of gold0 /ou can le#erage three to fi#e times9 1hat means at a A_ le#erage /ou can get RA@0@@@ worth of gold for R1@0@@@ cash9 1here are also significant interest costs associated with le#eraging9 &old now and in the future will likel/ be highl/ #olatile0 so be careful9 %e can't tell /ou how much le#erage to use since the amount of le#erage /ou can take on is #er/ much a factor of /our wealth and willingness to take risks9 All we can sa/ for sure is that for most people le#erage is like alcohol: 3se it in moderation9

?wning &old as Part of a %ellE4i#ersified Acti#el/ 5anaged Aftershock Portfolio

As much as we like gold0 we would ne#er recommend that /ou put all /our eggs in one basket9 %ithout re#iewing an indi#idual's specific financial situation0 it is hard to sa/ what percentage the/ should hold in gold9 5an/ people are comfortable and can handle the #olatilit/ of 7@ percent in gold0 but others ma/ be more comfortable with less and some would be more comfortable with more9 1he rest of /our portfolio requires ongoing acti#e management0 as described throughout the book and summariMed in Chapter 119 As we get closer to the coming Aftershock0 mo#ing to a higher percentage of gold will be prudent9 -or those who want to do that sooner rather than later0 there is no longEterm harm0 as long as /ou are prepared for the significant shortEterm #olatilit/ in gold and /ou don't mind sitting out an/ additional shortE term upside that ma/ be left in the stock and bond markets9

1he Biggest0 Baddest Bubble of 1hem All

&old might seem like the silliest of all in#estments9 People spend tons of capital0 time0 and effort tr/ing to haul a bunch of rock out of the ground at enormous e)pense and smelt out tin/ bits of gold0 melt them together0 and then do absolutel/ nothing with it Pust store it in some #ault9 $ow much sillier can it get6 But gold is not Pust metal in the groundJ it is considered a uni#ersal store of #alue0 and that will make =sill/> gold a trul/ smart and spectacular Aftershock in#estment9 $uge amounts of mone/ will be made and lost in gold9 &old will be a rising bubble on its wa/ to becoming one of the biggest asset bubbles of all time9 +econd onl/ to the fall of the dollar bubble0 the bursting of the gold bubble man/ /ears from now will be quite impressi#e0 as well9

$ow $igh %ill &old &o6

5an/ people like to ask us this question and we hesitate to answer9 %hat we can sa/ is that gold is up b/ more than D@@ percent since 7@@@0 during a period of onl/ moderate inflation and moderate in#estor an)iet/ a #er/ negati#e en#ironment for gold9 %e ha#e to assume that in the ne)t se#eral /ears0 when inflation will be higher and returns on bonds and stocks will be low a #er/ positi#e en#ironment for gold that it could rise e#en more than the D@@ percent it did in the past 1@ /ears in a #er/ negati#e en#ironment9

Confiscation b/ Inflation

%ill gold be confiscated or become illegal to hold indi#iduall/0 as it was during the &reat 4epression6 (ot likel/9 &old was much more important to the dail/ functioning of the econom/ during the &reat 4epression than it is now9 It is almost an irrele#anc/ nowJ it wasn't then9 Also0 toda/0 if the go#ernment needs mone/0 the/ ha#e a much more powerful tool for confiscating assets than confiscation of gold and that is: Confiscation b/ Inflation9 %hen the go#ernment prints mone/0 it is essentiall/ confiscating certain assets0 such as bonds0 which will fall quickl/ as inflation and interest rates rise9 *our stocks0 real estate0 pension0 life insurance0 and annuities will also decline as interest rates continue to climb9 $ence0 /ou ha#e little to fear from direct go#ernment confiscation of /our assets0 and much more to fear from indirect confiscation b/ inflation unless /ou protect /ourself9 It's absolutel/ confiscation of people's assets0 and it's a whole lot more powerful than confiscating gold9 But the upside to confiscation b/ inflation is that0 unlike go#ernment confiscation of the past0 for those who are pa/ing attention0 this kind of confiscation will be eas/ to a#oid9 But e#en if it doesn't do as well0 and onl/ increased 7@@ percent0 how much better is that going to be than watching D@ percent :or more; of /our C% portfolio e#entuall/ go to 5one/ $ea#en6

%hen %ill the -uture &old Bubble Pop6

(ot for a long time9 1hat's because it will be a long time before in#estors feel confident in other assets9 -or that to happen0 we will need to start seeing some real economic reco#er/0 not the current mone/ printing and go#ernment borrowing that is dri#ing the fake reco#er/ we ha#e now0 and certainl/ not the Aftershock econom/ we will ha#e after the dollar bubble pops9 %e are going to need real economic growth dri#en b/ fundamental producti#it/ impro#ements in order to get the 39+9 econom/ full/ back on its feet9 %hen that happens0 the gold bubble will come down9 $owe#er0 the gold bubble will not e)actl/ =pop> the wa/ we will see man/ other bubbles crash9 Instead0 as the 39+9 econom/ reco#ers0 other economies will continue to struggle for a while longer9 In#estors in those countries will not be eager to sell off their gold quite /et0 not while the/ still ha#e no or limited growth9 +o rather than quickl/ popping0 the massi#e gold bubble will slowl/ decline o#er a period of man/ months0 e#en /ears0 gi#ing us plent/ of time to make our e)its9 1hat means0 like man/ big bubbles of the past0 /ou will see this one rising and falling0 and /ou will ha#e time to bu/ in on the wa/ up before the Aftershock and time to sell out on the wa/ down before the full worldwide reco#er/9 ?f course0 that's onl/ if /ou know it will pop and are not co#ering /our e/es to the signs of a pop0 unlike most people9

%hat If I Cannot Afford to Bu/ &old6 1apping the Power of &randma's .n#elope
If /ou don't ha#e a lot of spare cash to put into gold0 do not despair9 $ere is a timeEtested wa/ to get a piece of the action0 e#en if onl/ on a smaller scale9 +ome gold is better than no gold9 &et /ourself an oldEfashioned en#elope like our great grandparents used to sa#e up enough mone/ to pa/ the rent or bu/ a new pair of shoes9 %rite the word &?84 on the outside and hide /our en#elope someplace safe9 .#er/ time /ou ha#e a little spare cash e#en if it is Pust 7@ bucks stick it in /our gold en#elope9 1r/ to do it regularl/0 like dail/ or weekl/9 If /ou ne#er seem to ha#e an/ cash to spare0 cut back on something /ou reall/ don't need and start feeding that golden en#elope whate#er /ou can9 .#en Pust a few dollars here and there will e#entuall/ add up9 As soon as /ou ha#e enough to bu/ a gold coin0 take /our en#elope out to /our local coin shop and bu/ /ourself a gold coin9 %hen /ou get home0 hide /our gold coin someplace safe and start feeding /our gold en#elope again9 .#en if /ou do this onl/ once0 /ou will ha#e thousands of dollars more in the Aftershock than /ou do toda/9

PA"1 III

*?3" A-1."+$?C<

&A5. P8A(

C$AP1." I

Aftershock

Bobs and Businesses

1he economic cheerleaders want us to belie#e that if we will Pust be patient and wait a little longer0 strong future Pob growth will soon return9 It is true that the big Pob losses we saw right after the financial crisis of 7@@H ha#e stabiliMed0 and some Pobs ha#e begun to return9 5anufacturing Pobs0 for e)ample0 ha#e made significant gains since the -ed began its first round of massi#e mone/ printing :!.1; in 5arch 7@@I9 But more recentl/0 the growth of manufacturing and other Pobs has begun to slow again9 And some Pobs0 such as construction0 hardl/ came back at all9 As of this writing in Bune 7@170 o#erall new Pob creation has been declining e#er/ month this /ear9 If this is an/ kind of reco#er/0 it is one without much Pob growth0 and that kind of =reco#er/> is no reco#er/ at all9 +trong and sustained Pob growth is essential to an/ significant future economic growth not onl/ for the countr/ but for most people's personal economies0 as well9 +lower Pob growth means less income for man/ Americans and less ta) re#enue for federal and state go#ernments0 which is a recipe for a deeper slowdown0 not strong future growth9 1hat means finding and keeping a good Pob in this e#ol#ing econom/ of falling bubbles will become increasingl/ challenging as time goes on9 5uch of this /ou can do nothing about0 but /ou do ha#e some control o#er which Pobs /ou tr/ for and what /ou can do to keep /our current Pob or prepare /ourself to mo#e to another potentiall/ more secure Pob before the falling bubbles full/ pop9 %hile the pressures on the slowEgrowing Pob market will continue and increase0 all Pobs and businesses are not created equalJ clearl/0 some will fare better than others as the #arious bubbles continue to pop9 1he purpose of this chapter is to gi#e /ou an o#er#iew of what is happening with Pobs and businesses0 and what to e)pect ne)t9

1he "ising Bubble .conom/ Created $uge Bob &rowthJ (ow the -alling Bubble .conom/ 5eans -ewer Bobs

As the conPoined real estate0 stock0 pri#ate debt0 consumer spending0 dollar0 and go#ernment debt bubbles all rose in tandem from 1IH@ to 7@@@0 the 39+9 Pob market boomed0 adding a whopping C@ million new Pobs during this time period9 (ew emplo/ees were in such high demand in the late 1IH@s and 1II@s that emplo/ment agencies and headhunters could hardl/ keep up9 But when the Internet bubble popped in 7@@@0 much of that strong Pob growth began to unwind9 1he housing bubble pushed up Pob growth again0 but nothing like the 1IH@s and 1II@s0 and so when it popped0 Pobs related to real estate0 like construction and real estate sales0 took an immediate and lasting hit9 But our Pob problems didn't end at the edges of the real estate landscapeJ we had other falling bubbles0 as well9 Because the rising real estate bubble was so ke/ in dri#ing up the pri#ate debt bubble and the consumer spending bubble0 when real estate began to pop0 much of the hot air escaped from those other bubbles0 too9 %ith less home equit/ to tap into and rapidl/ tightening credit0 consumers naturall/ spent less0 which onl/ made matters worse for businesses and Pobs9 +o0 along with the decline in housingErelated Pobs0 big Pob la/offs were seen across the board0 from the airline industr/ to shopping mall closures9 And because the falling bubbles ha#e not been reinflated0 despite massi#e go#ernment stimulus to temporaril/ support them0 man/ of those bubbleEdri#en Pobs ha#e not come back either9 1he bottom line is0 e#en with the present massi#e go#ernment stimulus and the earlier rising housing bubble0 we did not gain an/ net Pob growth from 7@@@ to 7@1@ :see -igure I91 ;9 %hile the number of Pobs from 1IH@ to 7@@@ increased b/ C@ million0 there was Mero Pob growth from 7@@@ to 7@1@9 In fact0 we lost Pobs almost 7@@0@@@9 5ost of the nonfarm Pobs created during the rise of the real estate bubble are now gone9 -igure I91 (o (et Bob &rowth 7@@@S7@1@ -rom 1IH@ to 7@@@0 C@ million new Pobs were created9 1hen from 7@@@ to 7@1@0 7@@0@@@ Pobs were lost9 +ource: Bureau of 8abor +tatistics9

Con#entional %isdom about -uture Bobs Is Based on -aith that the -uture %ill Be 8ike the Past
As with stocks0 bonds0 real estate0 life insurance0 and nearl/ e#er/thing else0 con#entional wisdom's faith in future Pob growth is deri#ed from the assumption that what we had before :during the rising bubble econom/; we will surel/ ha#e again9 C% lo#es to e)trapolate trend lines at least the trend lines the/ like9 %hen things are going well0 C% sees more great growth aheadJ and when things are going not so well0 C% sa/s don't worr/0 the pre#ious good trend line will naturall/ return #er/ soon9 -or C%0 good trend lines alwa/s continue0 e#en if the/ happen to get temporaril/ sidetracked for a while9 -or e)ample0 fi#e /ears ago when the number of go#ernment Pobs was growing significantl/0 C% said go#ernment Pob growth would alwa/s be strong9 C% sa/s all good Pob trends last fore#er9 (ot onl/ that0 C% also likes to belie#e that whate#er is the current popular area of discussion such as green Pobs or nanotechnolog/ Pobs will ha#e strong Pob growth in the future9 1he C% winning formula for future Pobs is the current trend line :or the recent past0 if that looks better than toda/; plus whate#er is in fashion at the moment9 ?ne of the reasons that C% feels so confident about its #iews about the future is that e)trapolating out the trend lines has worked prett/ well for C% in the recent past9 (aturall/0 in a rising multibubble econom/0 most positi#e trend lines ha#e been remarkabl/ reliable0 and it has not been all that difficult for C% to be right on man/ nearEterm positi#e predictions in the recent past9 1his0 along with the need to ignore unpleasant facts that threaten the status quo0 has become the strong foundation on which C% now rests its firm faith that all good trends0 including all good Pob growth trends0 ne#er end9 %hile this ma/ sound like a bit of an e)aggeration0 if /ou look back at C% o#er the past three decades0 /ou will see almost all the C%Eoriented anal/sts and economic cheerleaders continuousl/ telling us that e#er/thing is basicall/ #er/ good and will continue to be #er/ good0 e#en if we ha#e a little down c/cle occasionall/9 *ou ne#er hear them sa/ that a currentl/ good trend is unsustainable because it is based on an unsustainable rising bubble econom/9 At this point0 rising bubbles are considered both the norm and our American birthright9 And0 naturall/0 that will alwa/s include lots of good American Pobs9 .#en when C% acknowledges that man/ 39+9 Pobs ha#e been mo#ed o#erseas in recent /ears due to cheaper labor costs0 there is no acknowledgment of how the rising 39+9 bubbles created man/ Pobs0 nor how the falling bubbles ha#e taken them awa/9

%h/ Con#entional %isdom on Bobs Is %rong

Bust as for stocks0 bonds0 real estate0 life insurance0 and nearl/ e#er/thing else0 C%'s #iews on future Pob growth are wrong for the same reasons that C% is wrong about all the rest: good past trend lines cannot be e)trapolated into the future indefinitel/9 1he future is not the past9 (ot e#en the present is the past9 &ood trends do not continue fore#er because markets alwa/s e#ol#e0 and this is certainl/ true for the Pobs market as well9 1he 39+9 Pobs market has alwa/s e#ol#ed o#er time0 dri#en b/ real underl/ing fundamental economic dri#ers0 not the latest fashionable interests9 -or e)ample0 more than a centur/ ago0 most Americans were acti#el/ in#ol#ed in growing food0 either for income or to feed themsel#es9 $owe#er0 farming Pobs e#ol#ed and declined0 as more manufacturing Pobs were created in the rise of the Industrial "e#olution9 1here are countless other e)amples of how the Pob market has e#ol#ed o#er time0 based on the e#olution of the econom/9 In our current recession0 unless the econom/ goes back full/ to how it was before0 the Pobs are not going to come back full/ to how the/ were before9 +ince economies ne#er go backward0 onl/ forward0 Pobs e#ol#e forward as well9 As discussed earlier in the book0 the combination of the falling bubbles and the realit/ that there is no =natural growth rate0> plus the coming future inflation :due to massi#e mone/ printing b/ the -ed; is mo#ing us forward to a new economic realit/ that we ha#e not e)perienced before9 It certainl/ will not mo#e us back to the old rising multibubble econom/0 no matter how badl/ we ma/ want our bubbles back9 ?nce these Pobs are lost0 it is hard to bring them back without fundamental changes to the econom/9

4oes &o#ernment +timulus Create Bobs6

1he answer is most definitel/ /es, 1he stimulus of massi#e borrowing and massi#e mone/ printing does lead to more Pobs as long as /ou keep pouring in more and more stimulus mone/ to keep those new Pobs going9 But not long after the stimulus ends0 so will the Pobs9 %h/6 Because big go#ernment stimulus does nothing to change the underl/ing reasons that Pobs ha#e declined in the first placeJ therefore0 when the heat of the stimulus is withdrawn0 the positi#e impacts of the stimulus will cool down quickl/9 1hat might not be the case in a normal0 health/ econom/ going through a rough patch9 In that case0 a big temporar/ stimulus might help to get things back on track9 But that won't work in a falling bubble econom/9 As soon as the stimulus is withdrawn0 we are soon back where we were before or worse than before9 "emember what we said earlier in the book: 1r/ as we might0 a falling bubble cannot be turned into a rising bubble for #er/ long0 if at all9 %e ma/ be able to keep the bubble from falling further temporaril/0 but not fore#er9 Bubbles e#entuall/ pop9 In the short term0 the current go#ernment stimulus programs :massi#e borrowing and massi#e mone/ printing; are helping to slow the rate of Pob loss0 and the/ ma/ e#en create new Pobs in some areas0 but the stimulus alone will not be enough to permanentl/ sa#e us from the deteriorating Pobs market9 .#en additional =incenti#e> programs0 such as ta) credits to encourage emplo/ers to hire more emplo/ees0 are likel/ to ha#e limited impact9 3ntil demand returns because the fundamentals of the econom/ change0 the Pobs market will generall/ continue to e)perience slow or no growth9

%hat's a +a##/ Aftershock In#estor to 4o6

As we said at the start of this chapter0 not all Pobs are created equalJ some Pobs will do better than others0 depending on what sector the/ are in9 +o understanding how each Pob sector will fare in the future :e)plained below; is ke/ to understanding which Pobs will likel/ hold up best as the bubbles continue to fall9 Although Pob opportunities in the Aftershock will not be the same as in the recent past0 there are similarities to what has happened since the financial crisis and what will happen as we get nearer to the Aftershock9 Best Pob prospects are in the medical industr/0 while the capital goods industries0 such as construction and manufacturing0 will be hit #er/ hard9 -igure I97 shows what has alread/ occurred9 -igure I97 &ains and 8osses b/ 1/pes of Bobs0 5a/ 7@@G to 5a/ 7@11 +ome Pob t/pes ha#e made gains0 while man/ ha#e sustained big losses9 +ource: Bureau of 8abor +tatistics9

%hile the bubbles are still partiall/ inflated and the go#ernment is still pumping in stimulus to keep them afloat0 now is a good time to start planning /our ne)t mo#e0 whether it is a mo#e to a new Pob in a different sector or the same sector /ou are alread/ in0 or a new wa/ to make /ourself more #aluable to /our current emplo/er or /our customers9 But before we get to the details about each Pob sector0 there are two important points to keep in mind0 whether /ou are an emplo/ee or a business owner9 -irst0 keep /our e/es open9 4on't belie#e e#er/thing /ou see and hear from the economic cheerleaders about the soEcalled =reco#er/9> %e don't ha#e one9 +econd0 please understand that this is not the recession of the late 1IG@s and earl/ 1IH@s9 %hat we ha#e now is a falling multibubble econom/0 not Pust a t/pical economic slowdown9 4on't e)pect big impro#ements to come quickl/9 +ome &eneral Considerations for .mplo/ees and Bob +eekers 3nderstand that the o#erall econom/ and the Pob market are both e#ol#ing o#er time9 A Pob that seems secure toda/ ma/ not be around in a few /ears9 1here is no need to panic0 but now is the time to prepare for the changes ahead :see details about the Pob sectors below;9 Be willing to mo#e from one Pob to another or from one Pob sector to another0 but do not quit an/ Pob

without ha#ing another one lined up9 Consider /our options for getting some e)tra Pob training0 technical certificates0 or academic degrees if the/ will help /ou mo#e to a betterEpa/ing or more secure Pob0 but onl/ if this can be accomplished fairl/ quickl/0 such as in one to three /ears9 4on't start a 1@E/ear program and e)pect to be done with it before the Aftershock hits :for more details0 see the section on college0 later in this chapter;9 If /ou lose /our Pob0 consider taking a lowerEpa/ing Pob or doing temporar/ work0 consulting0 or e#en an internship :see the internship sidebar later in the chapter;9 4on't hold out for man/ months0 waiting for the same Pob that /ou Pust lost to magicall/ rematerialiMe9 1he further the bubbles fall0 the less likel/ that will happen9

+ome &eneral Considerations for Business ?wners Consider selling /our business if it is in one of the more dangerous sectors of the econom/ :see details in the ne)t section;9 If /ou were alread/ planning to sell /our business in the future0 mo#e up /our time frame and sell it sooner0 rather than later9 It takes a fair amount of lead time to sell a business9 +tart now0 before man/ of /our potential bu/ers figure out what /ou alread/ know about the future econom/9 1he longer /ou wait to sell0 the harder it will be to find a bu/er and the lower the selling price0 if /ou are able to sell it at all9 &et as much cash as possible9 If /ou must hold the note0 make sure it is #er/ short term9 1r/ to keep it to less than fi#e /ears two to four /ears preferred9 1he more time that goes b/0 the less likel/ /our bu/er will be able to make /our pa/ments9 Collect as much as /ou can up front9 If /ou want to keep /our business or start a new one0 look for wa/s to cash in on or at least sur#i#e in the falling bubble en#ironment :more details on this later in the chapter;9

1he -alling Bubbles %ill $a#e 2ar/ing Impacts on 1hree Broad .conomic +ectors

In assessing the impact of the falling bubbles0 we find it helps to think of the 39+9 econom/ in terms of three broad sectors: 19 Capital goods sector cars0 construction0 maPor industrial equipment0 and so forth9 79 4iscretionar/ spending sector fine dining0 entertainment0 leisure tra#el0 high fashion0 Pewelr/0 art0 collectables0 cosmetic surger/0 and the like9 A9 (ecessities sector basic food0 shelter0 basic clothing0 energ/0 basic health care0 basic education0 and so on9 In a normal economic downturn0 we would e)pect to see the capital goods sector slow significantl/0 the discretionar/ spending sector decline somewhat0 and the necessities sector to be mostl/ spared9 But this is not a normal economic downturn9 1he impact of the Aftershock will be felt b/ all sectors0 e#en the necessities sector9 1his time0 all three sectors will suffer significant Pob and business losses0 with the capital goods and discretionar/ spending sectors performing worst0 and the necessities sector faring better0 but not entirel/ spared9 All three sectors will ha#e some safe Pobs and profitable businesses0 but competition for these will grow as time goes on9 "ight now0 there are still Pobs a#ailable but not as man/ as needed9 .#en with the creation of some new Pobs since the 7@@H crash0 Pobs ha#e not been coming back equall/ in all sectors0 as shown in -igure I97 9

1he Capital &oods +ector :Autos0 Construction0 5aPor Industrial .quipment0 .tc9;
In the Aftershock0 high interest rates0 coupled with a big economic slowdown0 will be #er/ bad news for the capital goods sector9 "ising inflation and rising interest rates will make borrowing mone/ #er/ e)pensi#e for consumers and businesses9 1his will ha#e a #er/ negati#e effect on the capital goods sector0 which depends on its customers ha#ing access to lowEcost capital9 $igh interest rates will also add to the reasons wh/ full economic reco#er/ will take far longer and be far more difficult than in pre#ious recessions9

Bobs in the Capital &oods +ector

Bobs in capital goods industries will be the worst hit in the coming Aftershock9 If /ou ha#e one of these Pobs now0 there probabl/ isn't a lot /ou can do to protect /ourself other than to gear up to mo#e on to a Pob in another sector9 *our best bet ma/ be to rethink /our career now with an e/e toward Poining an industr/ that will do better when the bubbles burst9 %e certainl/ don't recommend quitting one Pob until /ou ha#e another in hand0 but we also don't recommend waiting too long to make a mo#e0 if /ou want to do so9 If a maPor career makeo#er is not /our st/le0 /ou ma/ want to consider making a mo#e to a more stable area within /our current industr/9 -or e)ample0 if /ou work in the construction industr/ which has alread/ taken a terrible hit and is not coming back an/ time soon /ou ma/ find that mo#ing into repairEoriented work0 rather than new construction0 will keep /ou bus/ while others sit at home9 ?f course0 man/ construction workers will also get this idea after the bubbles full/ pop0 so the sooner /ou begin /our transition toward repair work0 the better9 5ost t/pes of maintenance and repair work0 such as automobile repair0 will be in increasing demand0 as people bu/ far fewer new cars and instead tr/ to hang on to their older cars for as long as possible9

5ost Businesses %ill -are Poorl/ in the Capital &oods +ector

%e won't dress it up for /ou9 1he bottom line for business owners in the capital goods sector is not prett/9 If /ou can sell now and get out0 /ou probabl/ should9 (o one can predict e)actl/ when the Aftershock will hit0 but e#en if it takes another two or three /ears0 the marketplace for /our business is unlikel/ to impro#e much during that time9 1he #alue of capital goods sector companies will not rise much under current conditions and will fall in #alue later0 as unemplo/ment continues to rise and the econom/ continues on its slowEgrowth or noEgrowth track9 +o if /ou ha#e a business in the automoti#e0 construction0 industrial equipment0 or an/ other capital goods industr/0 the longer /ou wait to get out0 the more #ulnerable /ou will be to significant losses9 As with selling homes and commercial real estate0 /our pool of potential bu/ers will get smaller and smaller as time goes b/0 so the sooner /ou go fishing in that pool for a possible bu/er0 the better9 +elling an/ business takes time9 +tart now9 4on't wait until the econom/ gets worse and most of /our potential bu/ers ha#e figured out that the/ should not own a business in the capital goods sector9 %hat will /ou do after /ou sell6 ?ptions include using /our proceeds to in#est in the kind of Aftershock portfolio discussed in this book9 *ou can also be on the lookout for une)pected business opportunities in the Aftershock :discussed later in this chapter;9 If /ou decide to Pust hold it all in cash while /ou think about what to do ne)t0 be careful where /ou put it9 Banks will be #ulnerable leading up to and in the Aftershock and -ederal 4eposit Insurance Corporation :-4IC; will likel/ onl/ co#er up to R1@@0@@@ per bank account9 Also0 as inflation rises0 the bu/ing power of /our cash is e#aporating9

1he 4iscretionar/ +pending +ector :1ra#el0 "estaurants0 .ntertainment0 etc9;

As the econom/ continues to fall0 Americans are not going to run out to the mall e#er/ night after work :if the/ ha#e work; and squander their #er/ limited cash and e#en more limited credit on highEpriced designer handbags or the latest C4s9 4iscretionar/ spending is0 well0 discretionar/9 5an/ items and acti#ities that we ma/ currentl/ still enPo/ will simpl/ be left off our shopping lists after the bubbles continue to fall and e#entuall/ full/ pop9 ?#er time0 this will slow man/ businesses to a crawl and force others completel/ out of the game0 further dri#ing up unemplo/ment9 But discretionar/ spending will still hold up better than the capital goods sector of the econom/ because some people will still ha#e mone/0 and the/ will keep spending their mone/0 but the/ will spend at a lower le#el than before9 +o0 instead of discretionar/ spending disappearing altogether0 the people who can still spend will simpl/ bu/ lowerEpriced discretionar/ items9 -or e)ample0 instead of shopping for designer handbags at +aks -ifth A#enue0 the/ ma/ downgrade to %almart or 1arget9 1he restaurant business will face this trend as well9 As the bubbles fall0 fewer people and businesses will spend mone/ on eating out9 1hat will certainl/ affect all restaurants9 But some people and businesses will ha#e mone/ to eat out and will be quite happ/ to go to restaurants0 as long as the/ don't ha#e to spend as much as the/ used to9 +o the restaurant industr/ will continue to be a huge industr/ in the 3nited +tates0 but business will begin a longEterm shift toward the lower end9 -or e)ample0 5e)ican and Chinese restaurants will continue to sur#i#e and will gain increased market share0 while highEend seafood and steak houses will be much harder hit9 1o a large e)tent0 this same trend will happen throughout the discretionar/ spending sector9 Instead of brand names0 we'll want bargains9 %e will still want to bu/ some stuff that we don't absolutel/ need0 but we will bu/ less of it and we will want it at lower prices9 Because consumer spending dri#es more than twoEthirds of the 39+9 econom/0 an/ decline in consumer spending has a big impact on the o#erall econom/9 1his is a new situation for the 3nited +tates9 Back in the 1I7@s0 when the nation was much less wealth/ and was heading into the &reat 4epression0 consumer spending represented a much smaller portion of our o#erall econom/9 +o when the stock market bubble crashed in 1I7I0 and the econom/ took a maPor downturn0 the large dip in consumer spending back then had a much smaller impact on the o#erall econom/ because it Pust didn't make up that large a part of the econom/9 ?ther industries took a big hit0 but people still had to eat basic food and bu/ basic clothing0 so most of these industries Pust kept on going9 %e are in a different situation toda/9 +o much of what we currentl/ bu/ :and that keeps our econom/ going;0 we can easil/ do without9 %e ma/ not like to skip the latest0 highEpriced fashions0 but if we ha#e to0 we can easil/ shop at lowerEend and discount stores9 %e can also sur#i#e quite nicel/ without R1@@0@@@ kitchen makeo#ers0 complete with granite countertops and stainless steel appliances9 As incomes and assets e#aporate0 Americans will learn to manage without these pric/ pleasures9 %hile the discretionar/ spending sector will be hit less hard than the capital goods sector0 the fact that discretionar/ spending has become such a big part of the current 39+9 econom/ means a downturn in this sector will greatl/ accelerate the popping bubbles and make our postbubble reco#er/ e#en harder9

Bobs in the 4iscretionar/

+pending +ector

%e'#e alread/ mentioned how the slowdown in the discretionar/ spending sector will harm man/ businesses in the restaurant0 retail0 and home impro#ement industries9 1he tra#el industr/ has alread/ taken a big hit0 and that will continue as the bubbles fall9 8eisure tra#el will be especiall/ stalled0 while more Americans will tra#el to locations that are closer and cheaper such as into their li#ing rooms to watch 129 5aPor entertainment destinations0 such as ?rlando and 8as 2egas0 will hang on due to

liquidation of assets and to foreign #isitors coming to spend their more #aluable currencies in our cheaper pla/grounds9 ?nce the dollar bubble full/ falls and the Aftershock begins0 leisure tra#el b/ Americans going o#erseas will face the double whamm/ of minimal discretionar/ spending and a dollar that has fallen dramaticall/ against foreign currencies9 Business tra#el will suffer0 as well9 4omestic business tra#el will decrease as the bubbles continue to fall and companies become more interested in cutting costs9 ?#erseas business tra#el will be hit b/ high costs and the low #alue of the dollar0 so onl/ the most important o#erseas trips will continue9 ?nce the Aftershock hits0 our imports will be wa/ down and there won't be much need for business tra#el o#erseas at that point9 If /ou are currentl/ emplo/ed in the discretionar/ spending sector and are in a position to retrain for another career0 this would be a good time to look for a Pob elsewhere0 such as the necessities sector9

Businesses in the 4iscretionar/

+pending +ector

5ost businesses in this sector will e)perience some downturn as the bubbles continue to fall0 and in the final pop and Aftershock0 man/ will not sur#i#e9 Businesses that ha#e the best chances of sur#i#al during these increasingl/ leaner times will include lowEend restaurants0 lowEend clothing stores0 discount shops0 used clothing and household furnishing stores0 and businesses that cater to local or ine)pensi#e tra#el9 If /ou own a business in the discretionar/ spending sector0 /ou might want to gi#e some thought to selling it9 If /ou were alread/ thinking of selling /our business0 /ou ma/ want to mo#e that time frame up and sell sooner rather than later9 %aiting until man/ business owners start to realiMe that the/ need to sell will not be a good time to put /our business on the market9 8ots of sellers and not man/ bu/ers will mean prices will go wa/ down9 In addition0 /ou will be fighting against some demographics9 5an/ businesses are owned b/ aging Bab/ Boomers0 and as the/ get closer to retirement0 the/ will become more riskEa#erse and more likel/ to want to cash out of their businesses9 $a#ing more businesses for sale when /ou want to sell /our business will make it harder for /ou to find a bu/er9 If /ou wait too long0 /ou ma/ risk facing the coming price drops9

+ome 8imited &ood (ews: 1he (ecessities +ector :$ealth Care0 .ducation0 -ood0 Basic Clothing0 1ransportation0 &o#ernment +er#ices0 and 3tilities;

$ere is where we actuall/ agree :somewhat; with con#entional wisdom9 Bobs and businesses in health care0 education0 and the go#ernment will do relati#el/ better than in the other sectors9 But e#en Pobs in the necessities sector will not be perfectl/ protected before and during the coming Aftershock9 $istoricall/0 man/ of the Pobs in this sector don't pa/ #er/ well0 and the/ will pa/ a bit less after the bubbles pop0 when there are more workers a#ailable than Pobs9 But if /ou ha#e a Pob in this sector0 at least /ou ha#e a Pob0 and it will be much more reliable than most other Pobs as the bubbles fall and later in the Aftershock9 .#en at lower pa/0 necessities sector Pobs will be a godsend for families with a spouse who used to make more mone/ than his or her mate but is now unemplo/ed9 1he lowerEpaid0 stillEemplo/ed spouse0 working as a nurse0 teacher0 medical administrator0 or other necessities sector emplo/ee0 will likel/ retain his or her Pob and be able to carr/ the famil/ through the worst of the downturn9 But please understand that e#en in this sector0 not all Pobs will be equall/ protected9 5an/ necessities sector Pobs will not sur#i#e in the Aftershock9 %h/6 Because the/ ma/ not be =necessar/> enough9 +o e#en in this sector0 /ou will need to plan ahead9 1he necessities sector is composed primaril/ of health care0 education0 utilities0 basic food0 basic clothing0 and go#ernment ser#ices0 usuall/ run b/ go#ernment or other nonprofit entities9 1he pri#ate companies that suppl/ these go#ernment and nonprofit entities ha#e the potential to sur#i#e0 as well9 ?f course0 as the bubbles fall and e#entuall/ pop full/0 the necessities sector will also take a hit because it currentl/ contains a larger portion of discretionar/ spending :spending on highEend items within the necessities categor/; that will e#entuall/ be cut9 +o e#en within this relati#el/ good sector0 some Pobs will not sta/9

$ealth Care Bobs and Businesses

$ealth care is currentl/ a #er/ strong element of the 39+9 econom/0 and it will continue to be the best bet in the necessities sector as the bubbles fall and full/ pop0 but there will still be some negati#es0 especiall/ as unemplo/ment rises and health care re#enues decline9 $ealth care capital goods0 such as radiolog/ machines and hospital construction0 will not do #er/ well9 $owe#er0 businesses pro#iding ser#ices and supplies to the health care industr/ will continue to do oka/0 e#en though the/ too will e)perience some downturn9 $ealth care ser#ices Pobs that will do the best include: (urses Primar/ care doctors Ps/chiatrists (urse practitioners Ph/sicians' assistants 5edical technicians0 support personnel0 administrati#e staff0 and others in#ol#ed in primar/ care medicine :not specialties;

+pecialists and their supporting staff and ser#ices will not do well0 with surgeons taking the biggest hit due to falling demand9 .lecti#e procedures0 such as cosmetic surger/0 alread/ had a downturn during the financial crisis9 If /ou can0 transitioning out of these kinds of nonessential medical Pobs into more basic areas of health care would be ideal9

$ealth Care Could Become 7@ Percent of the &4P %hen the Bubbles Pop
$ealth care will be one of the safest ha#ens for business owners and workers in the Bubblequake and

Aftershock9 Currentl/0 the huge health care industr/ accounts for about 1F percent of the nation's &4P9 As other industries decline0 especiall/ in the discretionar/ spending and capital goods sectors0 the more stable health care industr/ will naturall/ take up a larger percentage of our econom/9 %e'#e seen this before on a smaller scale9 -or e)ample0 during the oil bust in the 1IH@s0 the percentage of the $ouston econom/ represented b/ nonEoil industries grew dramaticall/9 Add to this an aging population with increasing demands for health care0 and it is quite possible that health care could take o#er a staggering 7@ percent of our econom/ after all si) of the bubbles pop0 e#en if we ha#e what could be a D@ percent cut per person in medical care costs0 primaril/ b/ limiting procedures and reimbursable rates9 1hat means that not onl/ will the safest Pobs and businesses be in health care in the Aftershock0 but also that the nation's hopes for regaining significant producti#it/ growth in the postbubble econom/ will lie with dramatic producti#it/ ad#ancements in the health care field9

&o#ernment Bobs and Businesses

After health care0 the ne)t best positions in the necessities sector will be go#ernment ser#ices Pobs0 such as police and firefighters9 As in past recessions0 go#ernment ser#ices will still be needed9 $owe#er0 unlike in past recessions0 in the Aftershock0 go#ernment ser#ices will ha#e to take deep cuts when the go#ernment can no longer borrow mone/ after the go#ernment debt bubble pops9 Before the Aftershock0 go#ernment ser#ice Pobs will hold on and ma/ seem protected0 but the/ could be pulled out from under /ou later0 when things get worse9 1his will be particularl/ true for pri#ate companies that ha#e contracts with the federal go#ernment or states9 Businesses and indi#iduals who suppl/ capital goods or construction ser#ices to the go#ernment will be hit9 "oad construction and maintenance0 and transportation in general0 will do poorl/ as the mone/ for these e)penditures dries up9 Businesses that can make the switch to repair work and repairErelated ser#ices will fare far better9

.ducation Bobs and Businesses

Along with health care0 the demand for public education will continue0 so businesses that suppl/ education or health care products or ser#ices to the go#ernment will benefit from strengthening their marketing and business ties to these areas and increasing their percentage of sales in these sectors9 Bobs in education will be more secure than in0 sa/0 the restaurant business :discretionar/ spending sector;0 but do not make the mistake of thinking that all education Pobs will be full/ protected as the bubbles fall9 As ta) re#enues drasticall/ drop at both the state and local le#els0 funding for education will fall9 8ong term0 Pobs at primar/ and secondar/ schools will hold up better than those in higher education9 +ome number of elementar/0 middle0 and high school math and science teachers will still be in demand0 but as class siMe e)pands0 man/ math and science teachers will not find a Pob9 5usic and art teachers will face more la/offs0 along with e)tracurricular personnel9 ?nce the bubbles are full/ popped and the Aftershock begins0 we ma/ find that seniorit/ and union membership won't matter much9 Instead0 if /ou want to get or keep a Pob in education0 /ou will need to be #er/ good at /our Pob0 be willing to teach more classes to more students0 and be lo/al to /our school's administration9 1he picture for higher education will be tougher9 +trong departments in practical fields0 like engineering and computer science0 especiall/ at top colleges and uni#ersities0 will fare better than those in =soft> departments :sociolog/0 .nglish0 etc9; at liberal arts schools9 4on't count on tenure to sa#e /ou if /our department has to take big budget cuts9 If /ou are luck/ enough to be retained in a strong department0 be prepared to teach more classes for less pa/9

Broader Bob 1rends

?ne of the ob#ious Pob trends as we near the Aftershock will be growth in cash businesses and Pobs9 .)pect that Pobs in restaurants will increasingl/ be paid with cash and man/ people will be able to find temporar/

Pobs or consulting Pobs that pa/ cash and will be willing to work at lower rates9 1he underground cash econom/ will likel/ grow substantiall/0 as it has in other countries e)periencing a maPor economic downturn9 Bobs in repair0 as we mentioned earlier0 will be more resistant to the downturn and are the t/pe of Pobs that can be easil/ paid for in cash9

-ree Internships (ot

Bust for College +tudents An/more

-ree internships ha#e been a good route for college students to potentiall/ get a paid Pob b/ working for free9 -or the student0 an internship pro#ides an opportunit/ to get a foot in the door of an emplo/er0 as well as getting some onEtheEPob training9 -or the emplo/er0 the internship offers a chance to get to know the intern in the work en#ironment before deciding to hire or fire0 while also getting some work out of them for free0 making the internship an effecti#e winEwin for both parties9 %hat is beginning to happen now0 and will be more common in the future0 is unpaid internships for adults who are not college students9 In an increasingl/ tight Pob market0 workers who are willing to work for free for a period of time will ha#e a competiti#e ad#antage9 8ike college students0 the/ will ha#e the chance to get their foot in the door0 while also gaining training and onEtheEPob e)perience9 1he #alue to the potential emplo/er is ob#ious: free labor9 As the bubbles continue to fall0 and e#en more so after the/ full/ pop in the Aftershock0 unpaid internships for nonScollege students will become increasingl/ common9 If there is a Pob /ou are going after now and the/ don't currentl/ offer an unpaid internship0 there is no harm in suggesting one9 1he compan/ ma/ not be set up to accept /our offer0 but /ou ne#er know9 .#er/one likes a freebie9 Also0 another current trend that will continue into the Aftershock0 and especiall/ afterward0 will be higher pa/ and growth in demand for highl/ skilled blueEcollar Pobs9 Although highl/ skilled blueEcollar workers will be hurt like most Pob seekers0 this area will still offer reasonable pa/ and decent opportunities e#en during the Aftershock9 1his is especiall/ true if these skilled Pobs also in#ol#e difficult working conditions0 such as being an electrical lineman who has to repair electrical lines in storms9 +uch Pobs will continue to pa/ relati#el/ well and there will be decent demand0 mostl/ because man/ people with skills don't like those kinds of Pobs9 .#en now0 there are lots of #acancies for these t/pes of Pobs and significant turno#er in man/ of them9 Although conditions will tighten considerabl/ in the future0 this will still be an area for emplo/ment simpl/ because of the skills required and man/ people's unwillingness to work under bad conditions9

?pportunities after the Bubbles Pop: Cashing In on 4istressed Assets

In nearl/ e#er/ industr/ in all three sectors of the econom/0 there will be some opportunities to benefit from falling asset #alues9 Bust as highEpriced office furniture from bankrupt dotEcom companies ended up at auction sales for pennies on the dollar after the relati#el/ small Internet bubble popped0 there will be countless auctions of e#er/ description after our multibubble econom/ pops9 ?pportunities to make large profits b/ bu/ing0 selling0 and ser#icing distressed businesses and other assets will actuall/ become one of the good sectors in the postbubble econom/9 As alwa/s0 timing will be ke/9 ?ne of the biggest mistakes man/ people will make is bu/ing distressed businesses or other assets too soon9 In this #er/ unusual economic downturn0 in#ol#ing the fall of multiple bubbles0 we will face #er/ high interest and inflation rates that will take a lot longer to come down than an/one might imagine9 It will be eas/ to mistakenl/ think the worst has passed and the time is right to start bu/ing up distressed businesses and assets0 when actuall/ the price of these bargain properties will likel/ fall e#en lower9 -or ma)imum profits0 think /ears0 not months9 5an/ people in the real estate market are making this mistake right now9 1he/ think that because an asset has lost 7D to D@ percent of its peak #alue0 it is a bargain9 1hat is true onl/ if it is not going to fall further9 1hat said0 there can be some shorterEterm opportunities to =flip> a distressed asset e#en before the Aftershock hits and assets fall e#en further0 if /ou can find a willing bu/er9 ?nce the Aftershock hits0 the ser#icing of distressed assets and businesses will be an instant and longE term winner9 People and companies who bu/0 restructure0 manage0 and resell distressed businesses and other assets will ha#e the opportunit/ to make huge incomes and profits0 including: Accountants and financial anal/sts in#ol#ed with forensic accounting and distressed properties accounting9 Consultants0 bankers0 managers0 and others in#ol#ed in the acquisition0 restructuring0 and management of distressed businesses and other assets9 Bankruptc/ attorne/s9 8iquidation companies and auction houses9

+hould I &o to College6

-or high school students or recent graduates0 planning to go to college still makes sense9 .#en though the econom/ will be falling during that time and /ou will likel/ emerge from college in a difficult work en#ironment with fewer Pobs and business opportunities than before0 it is still a good idea to get a college education if /ou can9 1he longer /ou wait0 the less likel/ /ou are to go back to school0 and a college degree will still mean something0 e#en in the Aftershock9 %hile a college degree is no guarantee of landing emplo/ment0 it will definitel/ increase the odds of getting a Pob after /ou graduate and will also impro#e /our chances of getting a higherEpa/ing Pob9 ?b#iousl/0 /ou will do better picking a field in the more fa#orable Pob sectors mentioned earlier9 If /ou alread/ ha#e a secure0 fullEtime Pob0 going back to college ma/ not be worth it0 unless /ou get /our degree in a /ear or two9

Pa/ing for College

Con#entional wisdom's approach to sa#ing for college :like C% ad#ice on most in#esting; made sense during the rising bubble econom/9 $owe#er0 in the falling bubble econom/0 traditional sa#ings plans and college in#estment instruments0 such as D7I plans0 are not going to fare well as inflation rises and interest rates climb9 Instead0 put /our college sa#ings into a wellEdi#ersified Aftershock portfolio0 as described throughout this book and especiall/ in Chapter 119 In terms of student loans0 we suggest /ou get these while /ou still can if /ou need them to go to college9 "ight now0 student loans cannot be discharged in bankruptc/0 and student loan lenders0 both pri#ate and go#ernment0 go after student loan pa/ments fairl/ aggressi#el/9 +o do not borrow more than /ou can reasonabl/ handle in monthl/ pa/ments after /ou graduate9 $owe#er0 Pust as the go#ernment has become more rela)ed about the repa/ment of mortgages0 we will probabl/ see the go#ernment be much more rela)ed about the repa/ment of student loans when the multibubble Aftershock hits mostl/ because it will be #er/ difficult to collect and politicall/ more popular9 Also0 after our falling bubbles finall/ full/ pop0 there will likel/ be less mone/ a#ailable for student loans9

C$AP1." 1@

Aftershock

"etirement

and .state Planning

"etirement means different things to different people tarpon fishing in Aruba0 1H holes e#er/ da/ before lunch0 finall/ ha#ing the time to learn +panish but in financial terms there's onl/ one real definition: no more upside income potential9 As long as /ou're working0 /ou ha#e the power to increase /our income0 b/ getting a promotion or a raise0 or changing companies or e#en careers9 But on the da/ /ou lea#e the workforce0 /ou're limited to whate#er /ou'#e managed to sa#e b/ that point0 and a stream of essentiall/ fi)ed income9 :-or the record0 the numbers on retirement sa#ings are prett/ dismal9 Among people ages D@ to DI0 the median retirement sa#ings is Pust R7I0@@@9 $ow long could /ou get b/ on that amount6; 1hat's wh/ it's so crucial to plan for retirement0 whether it's D /ears awa/ or AD /ears9 -or those who are nearing retirement or alread/ retired0 the information in pre#ious chapters ma/ seem daunting9 But don't panic9 *ou can still do plent/ to protect /ourself and e#en come out more comfortable than /ou would ha#e before b/ adopting an Aftershock approach to /our retirement9 %e need to stress again that setEitEandEforgetEit in#esting does not work for retirement an/more9 -or /ears0 people ha#e been told to Pust put their mone/ in stocks and bonds and don't worr/ about it9 %e'#e alread/ seen some retirement accounts get hammered in 7@@HS7@@I due to this strateg/0 but the future is going to be much0 much worse for people who refuse to change with the changing in#estment en#ironment9 3nfortunatel/0 the #ast maPorit/ of retirement plans are still focused on stocks0 bonds0 and real estate9 And Pust like with whole life insurance and annuities0 as those maPor markets decline0 so will those retirement plans9 &i#en that risk0 /ou ha#e to acti#el/ manage /our in#estments o#er time9 1his is true if /ou're in /our A@s or C@s0 and e#en if /ou'#e put /our retirement mone/ into gold and other Aftershock in#estments9 After all0 those in#estments won't necessaril/ remain /our best option 7@ or A@ /ears down the road9 .#en if /ou're in /our F@s0 /ou want /our in#estments to hold up into /our H@s and I@s if necessar/0 don't /ou6 And ma/be e#en lea#e something to /our lo#ed ones0 too6 %e sa/ this often because it's so important: successful in#esting is a lot more comple) than it used to be0 a rising bubble econom/9 (ow0 acti#e management is ke/9

1/pes of "etirement Plans

&enerall/0 there are two t/pes of in#estments in retirement plans: those /ou can control and those /ou can't9 %e're going to focus on what /ou can control9

4efined Benefit Pension Plans

A few decades ago0 most retirement plans offered b/ an emplo/er were defined benefit plans0 also known as pensions9 1hese are still around in some isolated cases0 but the/'re increasingl/ rare9 3nder defined benefit plans0 the compan/ took care of e#er/thing /ou Pust had to show up at work e#er/ morning0 get /our gold watch on /our retirement da/0 and the pension checks would show up until /our d/ing da/0 along with /our spouse's :or /ou could opt for a lump sum pa/ment;9 It was the compan/'s responsibilit/ to in#est the pension plan and make sure it had enough mone/ to co#er the pa/ments for their retirees9 If the plan fell short0 the compan/ would ha#e to dip into assets and earnings to co#er the difference9 Because this was a #er/ bad thing0 pension plan in#estments are usuall/ #er/ conser#ati#e t/picall/ in bonds and more conser#ati#e stocks9

4efined Contribution Plans: C@1:k;0 C@A:b;0 CDG

In the past A@ or C@ /ears0 Congress has created a number of new retirement structures0 and man/ emplo/ers ha#e shifted responsibilit/ for managing retirement plans to their emplo/ees9 1hese generall/ work the same wa/0 but the/ ha#e different names C@1:k; accounts are for pri#ate companies0 C@A:b;s are for nonprofits0 and CDG accounts are generall/ for go#ernment workers and contractors9 "egardless of the name0 these accounts let emplo/ees choose their own in#estments0 and their contributions grow ta) free o#er time9 In the decades since these accounts were created0 the/'#e been incredibl/ popular because the/ allow emplo/ees to take ad#antage of a booming stock market9 Another ad#antage of these accounts is that man/ emplo/ers match their emplo/ees' contributions up to the legal limit of D percent of an emplo/ee's salar/9 1his is a maPor incenti#e to contribute the ma)imum amount allowed e#en if /our compan/ onl/ matches 7D percent of /our contributions0 that effecti#el/ gi#es /ou an immediate 7D percent return9 A #ariation on the traditional C@1:k; plan is the "oth C@1:k;0 introduced in 7@@19 Contributions to a "oth C@1:k; are not ta) deferred /our contributions come out of /our salar/ after ta)es9 But the ad#antage is that /ou don't ha#e to pa/ an/ ta)es when /ou make withdrawals9 And as with a traditional C@1:k;0 /our in#estments can grow in a ta)Efree en#ironment9 1his can be a big ad#antage o#er traditional C@1:k; plans0 especiall/ for /ounger in#estors9 1he biggest drawback of a C@1:k;0 especiall/ from an Aftershock perspecti#e0 is the limited number of in#estment options9 Because /our emplo/er administers these programs0 /our emplo/er also decides the mutual funds and stocks in which /ou can in#est9 And in some cases0 /ou ma/ get stuck with onl/ a handful of options9 .#en those with more e)pansi#e options tend to include onl/ traditional in#estment strategies9

Indi#idual "etirement Accounts :I"As;

1here's a lot to like about indi#idual retirement accounts0 especiall/ from an Aftershock perspecti#e9 Contributions are still ta) deductible and grow ta)Edeferred as with a C@1:k; but rather than being run b/ /our emplo/er0 I"As are selfEmanaged0 gi#ing /ou far more control o#er /our retirement sa#ings9 *ou can open an I"A at Pust about an/ brokerage firm fullEser#ice or discount and /ou can in#est them in Pust about an/ asset categor/ out there: stocks0 bonds0 real estate0 and e#en gold bullion9 *ou can probabl/ guess that this is our fa#orite retirement #ehicle0 as long as it's emplo/ed wisel/9

1he (ondeductible

I"A

-or indi#iduals who don't qualif/ for a traditional or "oth I"A0 or those who want to make more than the ma)imum allowable contribution0 a third option is the nondeductible I"A9 A nondeductible I"A works like a traditional I"A e)cept that there is no ta) deduction for contributions9 1his sounds like a raw deal9 %h/ put mone/ in a retirement account if /ou ha#e to pa/ ta)es on contributions and on gains when /ou withdraw6 1he answer is ta)Edeferred growth9 %ith a nondeductible I"A0 /our in#estments still get to grow in a ta)Efree en#ironment0 allowing /ou to put off ta)es on earnings until /ou withdraw at a qualified age9 1his ma/ sound tri#ial0 but b/ ha#ing more principal in /our account0 an/ earnings on that principal are compounded9 It can make a significant difference in the long run9 1he tradeEoff0 of course0 is that nondeductible I"As come with all the restrictions of other I"As9 *ou can't withdraw before age DI^ without pa/ing a penalt/0 and minimum distributions are required b/ age G@^9 But some people need an incenti#e to sa#e for retirement0 and if that's /ou0 a nondeductible I"A is better than nothing9

?ther "etirement Plans

1here are a couple of other categories of retirement plans for workers in specific categories9 -or e)ample0 ci#il ser#ice emplo/ees ha#e their own plan0 called the -ederal .mplo/ees "etirement +/stem :-."+;0 which combines both a defined benefit plan and a defined contribution 1hrift +a#ings Plan :1+P;0 as well as mandator/ participation in +ocial +ecurit/9 :+ome longEtenured federal emplo/ees ma/ still qualif/ for an older plan9; 1he in#estment options for 1+P are e)tremel/ limited Pust fi#e funds: two for bonds and three for #arious stock indices9 +imilarl/0 small businesses and selfEemplo/ed people ha#e their own t/pes of plans: <eogh0 +a#ings Incenti#e 5atch Plan for .mplo/ees :+I5P8.; I"As0 and +implified .mplo/ee Pension :+.P; I"As9 1hese ha#e #arious ad#antages and drawbacks0 which are too comple) to e)plain here9 If /ou're in either of these categories0 please understand the rules before opening an/ of these accounts0 and remember acti#e management is a must9

1he Con#entional %isdom on "etirement Plans

1he con#entional wisdom sa/s that stocks0 bonds0 and real estate are all reco#ering or will reco#er soon9 +o most people are not worried about their retirement accounts9 As long as people simpl/ hold on to their di#ersified stock and bond mutual funds0 this thinking goes0 the markets will be fine and pensioners and C@1:k; in#estors will be able to retire comfortabl/ for /ears to come9 -or pension funds0 this con#entional wisdom goes se#eral steps further9 .#en amid concerns about underEfunded corporate pensions0 people tend to rest eas/ about them9 After all0 corporate pensions are o#erseen b/ managers with man/ /ears of e)perience0 and the/ primaril/ in#est in bonds0 which are thought to be a more stable asset class0 right6 "atings agencies like +tandard K Poor's :+KP;0 5ood/'s0 and -itch pro#ide obPecti#e anal/sis on corporate bonds0 and man/ pension funds are restricted to bonds with the highest ratings9 .#en if those bond holdings go bad0 the compan/ is still on the hook to co#er the pa/ments of their retirees9 And if all else fails and the compan/ goes bankrupt0 there's a last line of defense: the 39+9 go#ernment9 5ost pensions in this countr/ are insured b/ the Pension Benefit &uarant/ Corporation0 or PB&C0 which collects premiums in return for co#ering pensions in the e#ent that the/ fail9 :If the PB&C fails somehow0 it's prett/ much understood that the go#ernment will do what it has to do to guarantee pensioners get what was promised them0 e#en if it has to resort to more borrowing and printing mone/ to do so9; 1his is a prett/ e)hausti#e list of protections for pension plans9 And the important thing to keep in mind is that e#er/ single line of defense must fail before pensions collapse9 1hat has ne#er happened before in histor/0 so it's understandable that man/ people think it ne#er will9 It's our Pob to help /ou understand wh/ it will9

%h/ the Con#entional %isdom on "etirement Is %rong

1he truth is that retirement plans are in big trouble9 5an/ pension plans throughout the 3nited +tates ha#e been notoriousl/ underfunded and poorl/ managed9 1here are protection le#els in place0 but those were designed to handle indi#idual failures0 not widespread multiple pension plans going bad en masse9 In fact0 each le#el of protection has serious #ulnerabilities9 8et's start with managers9 %hile man/ pension managers are chosen for their qualifications and Pudgment0 in practice these people rarel/ outperform market inde)es9 And if the/ ha#en't outperformed the market in the past under stable conditions wh/ would the/ be able to keep their pension funds afloat in the case of a serious market crash6 (e)t are asset categories9 Being in#ested primaril/ in bonds doesn't help much because we know that rising inflation and rising interest rates will be poison to the bond market9 "atings6 1he ratings agencies showed catastrophicall/ poor Pudgment in the recent past0 when the/ contributed to the 7@@H financial crisis9 1he/ ha#en't changed much about how the/ operate0 /et people still e)pect them to deli#er good results9 :%hat's that line about the definition of insanit/6; If and when bond issuers go bankrupt0 bondholders will still ha#e a high priorit/ in liquidation proceedings0 but if man/ companies go bell/ up at the same time0 there will be a lot of sellers and #er/ few bu/ers9 1heir assets will bring in onl/ pennies on the dollar9 Bad news for bondholders9 Corporate backing for pensions is the same stor/ corporations will face failed pensions and collapsed earnings at the same time9 Bankruptc/ will be the onl/ option9 8ast is the federal go#ernment0 which will certainl/ do its part at least for a while in making sure pensioners get what the/ need9 But the PB&C is not well funded to begin with and will quickl/ be o#erwhelmed9 1he go#ernment can still step in and help for a few /ears0 but e#entuall/ there are simpl/ too man/ guarantees to co#er not Pust with pension plans but e#er/where and the -ed can't keep printing mone/ fore#er9 And down goes the last line of defense for pension plans9 ?f course0 long before a compan/ goes bankrupt or the federal go#ernment has to step in0 bonds can lose an enormous amount of their #alue as interest rates rise0 as detailed in Chapter D9 +tocks and real estate are also #er/ #ulnerable0 as described in Chapters C and F9 +o0 e#en if there were no corporate bankruptcies or no need for go#ernment bailouts0 pensions can lose much of their asset #alue and0 hence0 their abilit/ to pa/ those pensions9 3nfortunatel/0 defined contribution plans like C@1:k;s aren't in much better shape9 Because most offer relati#el/ few options based on traditional in#esting strategies0 the/ make it #er/ difficult for an indi#idual to beat a total market failure while also protecting against inflation9 %hen stocks0 bonds0 and real estate all fall0 C@1:k; plans will fall with them9 In 7@@H0 for e)ample0 C@1:k; plans fell in #alue b/ C@ percent9 1his is Pust a taste of what's ahead9

%hat About +ocial +ecurit/ 6

If /ou'#e been in the workforce for a while0 /ou probabl/ qualif/ for +ocial +ecurit/ benefits9 *et e#en if /ou work up until age FD0 the benefits probabl/ aren't much9 In fact0 +ocial +ecurit/ was ne#er meant to pro#ide for all retirement needs :let alone comforts;0 but it has pro#ided something of a safet/ net to millions of retirees for generations9 In recent /ears0 the program's future has come into question0 and for good reason9 +ocial +ecurit/ is an unfunded program0 meaning that the +ocial +ecurit/ ta)es /ou pa/ toda/ are being used directl/ to pa/ current beneficiaries9 In other words0 it's a transfer pa/ment0 not a pension plan9 -or decades0 +ocial +ecurit/ was running surpluses and the go#ernment was borrowing those surplus funds to finance other parts of the budget9 (ow the surpluses are gone0 and things aren't going to get an/ better in the

Aftershock9 1here's a good chance that man/ people reading this will ne#er collect a nickel in +ocial +ecurit/ benefits9 1he go#ernment will still offer some le#el of assistance0 particularl/ for the elderl/0 but it will be meansEtested9 :1hat is0 /ou won't get it if /ou don't reall/ need it9; .#en that le#el of support will depend on significant income ta) hikes on the middle and upper class9 +ince the go#ernment will no longer be able to borrow mone/ easil/0 and since printing mone/ will become selfEdefeating0 the go#ernment will ha#e to strike a delicate balance: ta)ing enough to pro#ide for those in need but not so much to discourage people from working0 particularl/ if the alternati#e is to collect hardship pa/ments9 1he bottom line6 1he da/s of uni#ersal +ocial +ecurit/ benefits will soon be o#er9

%hat's a +a##/ Aftershock In#estor to 4o6

%ith such an ugl/ outlook for pensions and other retirement plans0 it's hard to know how to proceed9 3nfortunatel/0 the simple answer in most cases is to get out of /our emplo/er's plan0 so /ou ha#e more control and can put it into assets that will hold up in the Aftershock9 $owe#er0 when and how to get out are crucial questions9 Because of the ta) ad#antages in most retirement accounts0 /ou often face steep penalties if /ou pull /our retirement mone/ out earl/9 In addition0 as we write this0 stocks and bonds are still doing oka/ not great0 but oka/ and /ou need to strike a balance between ma)imiMing /our portfolio for the ne)t few /ears and making sure /our retirement sa#ings will hold up in the Aftershock9 1o determine /our best option0 we'll break down each categor/ of retirement plan and the best wa/ to protect /ourself as much as possible9

4efined Benefit Pension Plans

5an/ defined benefit plans offer a lump sum at retirement as opposed to an annuit/9 1his is great news for those approaching retirement in the ne)t few /ears9 1aking a lump sum and putting it into Aftershock in#estments which /ou acti#el/ manage0 of course is an eas/ wa/ to minimiMe the risk of e#erEshrinking pa/ments down the road9 Better /et0 /ou can put the lump sum into an I"A account and enPo/ the benefits of ta)Edeferred growth9 :+ee the section on I"As for more information on this approach9; -or those who don't ha#e the option of a lump sum pa/ment and are instead forced to take regular pa/ments0 the situation is more grim especiall/ for people near retirement or alread/ retired9 "emember0 those are fi)ed pa/ments0 so when inflation kicks in0 it will eat awa/ much of their #alue9 5arket crashes0 widespread bankruptcies0 and an e#entual go#ernment default will make the situation worse9 1he truth is that /ou can't depend on these pension pa/ments to pro#ide li#ing e)penses indefinitel/9 %hen things get reall/ bad0 /ou can e)pect the federal go#ernment to step in and pro#ide hardship pa/ments0 with pensioners among the first in line9 But those pa/ments will be limited probabl/ not much more than R70@@@ per month :in 7@17 dollars; since the go#ernment will ha#e to rel/ on ta) re#enues to co#er their cost9 But it will be better than nothing9 People facing this scenario ma/ need to plan on reducing li#ing e)penses as the/ approach their retirement /ears9 *ounger readers with defined benefit plans ma/ not be as concerned about retirement0 but it's worth looking into /our options now regardless of /our age0 so /ou know what /our options are9 4oes /our plan allow for earl/ withdrawals6 Pa/ing a relati#el/ small penalt/ now or in the ne)t few /ears is almost certainl/ better than being wiped out later9 %hat about earl/ retirement6 %hat are the costs and the benefits6 If /ou're thinking about changing Pobs0 or if /ou lose /our Pob0 can /ou roll o#er /our retirement benefits into a selfEdirected I"A6 (o matter how close /ou are to retirement0 if /ou're co#ered under a defined benefit plan0 /ou need to know the choices /our emplo/er is making on behalf of /our future9 And if /ou work at a small compan/0 /ou can alwa/s request changes to the plan9 .#en if /our emplo/ers aren't sold on the Aftershock and man/ emplo/ers are resistant to these ideas the/ might be willing to offer options for emplo/ees who want to protect themsel#es with alternati#e Aftershock in#estments0 such as gold9

4efined Contribution Plans

As we said abo#e0 the biggest problem with C@1:k;s and other defined contribution plans is that the/ limit /our options9 If /ou can onl/ in#est in traditional stock and bond funds0 /our retirement account is going to suffer when the stock and bond markets collapse9 In most cases0 emplo/ees with C@1:k; plans ha#e no good Aftershock options9 At some point0 ob#iousl/0 /ou'll need to get out9 But not so fast9 1here are some mitigating factors that can make holding onto a C@1:k; worthwhile0 at least in the near term9 -irst of all0 /ou can alwa/s ask /our emplo/er for more di#ersit/ in in#estment options0 including a gold or foreign currenc/ fund that is more likel/ to hold its #alue in the Aftershock9 If /ou work at a smaller compan/ and se#eral emplo/ees feel the same wa/0 /ou might ha#e enough swa/ to con#ince /our emplo/er to make a change9 .#en if /ou are stuck with limited options0 there are still legitimate reasons to continue making contributions to a C@1:k; in the meantime0 before the Aftershock9 -or one thing0 if /our emplo/er offers matching contributions0 that alone ma/ be reason enough to keep making the minimum contribution to get that match for the ne)t few /ears0 while things are still relati#el/ stable9 After all0 emplo/er contributions are free mone/9 Another factor to consider is whether /ou are close to being full/ #ested in /our plan0 or at least will be more #ested than /ou are now9 .mplo/ees in that situation should sta/ with their current plan0 as the increased #esting could mean a substantial difference in potential income down the road9 If /ou're going to remain0 what should /ou in#est in6 In the immediate future0 cashEt/pe in#estments0 such as mone/ market funds and shortEterm 1reasur/ funds0 are the safest options9 1hese funds still ma/ lose #alue as inflation and interest rates rise0 but the declines will be mild at first0 and /our emplo/er's matching contributions should easil/ co#er the difference9 Better /et0 in#esting in 1IP+0 or 1reasur/ InflationEProtected +ecurities0 will gi#e /ou some protection against inflation in the short term9 ?f course0 sooner or later0 if /our C@1:k; plan doesn't offer options that will hold up in the Aftershock0 /ou will need to get out before things get too ugl/ e#en if /ou ha#e to take some penalt/9 Borrowing from /our C@1:k; fund is one option0 but it's not a particularl/ good one9 1heoreticall/0 /ou could in#est the borrowed funds wisel/ and come out ahead0 but this strateg/ can be #er/ risk/0 gi#en shortEterm fluctuations9 If /ou lea#e /our Pob for an/ reason0 the repa/ment term for C@1:k; loans shortens dramaticall/9 1hat's a prett/ big gamble0 and it could lea#e /ou on the hook for ordinar/ income ta) on the borrowed amount0 plus a 1@ percent penalt/ on an/ borrowed funds if things don't work out as /ou e)pected9 $ardship withdrawals are also a#ailable0 but the/ also come at a steep price0 and the/ are not a#ailable for those looking for other in#estment opportunities :e)cept0 in some cases0 for bu/ing a home;9 -or older workers0 the choices are a little easier9 If /ou're alread/ older than DI^0 or will be soon0 some C@1:k; plans will allow /ou to take an inEser#ice withdrawal based on /our age0 e#en if /ou're not read/ to retire9 1hat wa/ /ou can simpl/ take a lump sum pa/ment0 preferabl/ rolling it o#er into an I"A account0 where /ou can in#est as /ou wish9 .#en if an ageEbased withdrawal is not allowed0 earl/ retirement ma/ be the right option for /ou0 depending on /our financial situation and life plans9 In fact0 C@1:k; plans e#en allow /ou to retire as earl/ as DD and begin withdrawals without penalt/9 :?ne ca#eat: If /ou roll these funds into an I"A0 /ou'll still ha#e to wait until /ou turn DI^ to begin taking withdrawals without a penalt/9; -or /ounger emplo/ees0 the answers aren't as simple0 but /ou still ha#e some solid options9 -irst0 some emplo/ers offer a partial rollo#er0 allowing /ou to take out a portion of /our C@1:k; funds usuall/ not more than D@ percent and put it into a qualif/ing I"A of /our choosing9 1his ma/ not sol#e all /our problems0 but it's a prett/ good start9 +econd0 if /ou change Pobs0 /ou can roll o#er /our C@1:k; funds into an I"A9 -or some people who are on the fence about their current emplo/er0 this ma/ be enough to help them make their decision9

(ote: *ou can also take this option if /ou're fired or laid off9 %hile that's certainl/ not an ideal situation0 the sil#er lining is that /ou can in#est /our retirement wisel/ and perhaps come out richer for it in the long run9 If none of these options is a#ailable0 /ou can alwa/s simpl/ withdraw /our C@1:k; funds earl/9 *ou'll face a 1@ percent penalt/ for the amount /ou take out0 and the funds will be treated as ordinar/ income9 If it's a significant amount0 it could easil/ push /ou into a higher ta) bracket for the /ear9 But if the alternati#e is to lose nearl/ all of /our retirement sa#ings0 this ma/ be a price /ou're willing to pa/9 8ike we said0 /ou likel/ ha#e a few more stable /ears between now and the Aftershock0 gi#ing /ou some time to preser#e and e#en grow /our portfolio9 1his is a big step0 so it's worth looking into all the ramifications ahead of time so /ou're prepared to get out when the time comes9 *ou can easil/ make up for the losses if /ou in#est wisel/9 %e should also emphasiMe that for /ounger emplo/ees who ha#en't /et opened a C@1:k; assuming there is a significant emplo/er matching contribution it can still be worth doing so e#en if /ou'll ha#e to take the penalt/ to get out in a few /ears9 "emember0 that matching contribution is essentiall/ free mone/0 and if /ou're sticking with cashEbased in#estments like mone/ markets and shortEterm 1reasur/s0 e#en a 7D percent return :let alone a D@ or 1@@ percent return; is still a #er/ impressi#e gain0 especiall/ in these slow economic times9 ?ne note for readers in other emplo/ment categories: 1his ad#ice also applies if /ou ha#e a C@A:b; plan0 which carries the same rules and penalties for earl/ withdrawals9 If /ou ha#e a CDG plan0 /ou ha#e an added ad#antage /ou can still withdraw funds earl/ without the added 1@ percent penalt/0 though /ou'll still owe ordinar/ income ta) on all withdrawals9 +imilarl/0 people with <eogh plans0 +I5P8. I"As0 and +.P I"As should follow the same ad#ice in#est in AftershockEsafe assets9 But the great ad#antage of selfE emplo/ment is that /ou get to make the choices /ourself9

A (ote about Compan/ +tock and +tock ?ptions

+ome companies encourage emplo/ees to in#est their retirement mone/ in compan/ stock b/ offering it at a discount to the market price9 But allocating a large amount of /our retirement portfolio in /our emplo/er is a risk/ proposition under an/ circumstances9 If /our compan/ hits a rough patch0 /ou could lose both /our Pob and /our retirement sa#ings at the same time9 *ou might think this is unlikel/0 but it's happened all too frequentl/ in recent /ears0 and will onl/ become more common in the future9 *ou are alread/ in#ested in /our emplo/er's success b/ working there9 (o need to double down9 .mplo/ee stock options are a different stor/9 ?ptions allow /ou to lock in the price at which /ou can bu/ compan/ stock9 1he best part is that if /ou don't want to bu/ when the time comes0 /ou don't ha#e to9 *ou usuall/ ha#e a long window of time before /ou need to make this decision9 In the long term0 there ma/ be some upside to emplo/ee stock options0 but there isn't an/ downside the/'re riskEfree9

I"A "ollo#ers

?ne of the great features of I"As both traditional and "oth is the rollo#er function9 If /ou ha#e a C@1:k; or C@A:b; or CDG0 for that matter and are lea#ing /our emplo/er0 whether it's due to a Pob change or in#oluntar/ termination0 /ou can transfer /our C@1:k; funds into a selfEdirected I"A account without pa/ing ta)es or penalties9 1his gi#es /ou far more in#estment options than a t/pical retirement plan0 letting /ou put the funds in Aftershock holdings9 1his is also a great option for those who are entering retirement9 *ou can take /our withdrawal in a single lump sum and roll it into an I"A0 in#est the funds as /ou wish0 and continue to enPo/ the ta) ad#antages for the life of the account9 $ere's another nice option: 1he total contribution /ou can make into /our I"A is capped each /ear0 but there's no limit to the number of I"A accounts /ou can ha#e9 *ou can put some funds into a gold I"A and another portion into a discount brokerage account0 and still another portion into a fullEser#ice brokerage account :/ou Pust can't go o#er the ma)imum total for the /ear;9 1he onl/ potential drawback to this is that /our broker ma/ charge fees for transfers and for setting up new accounts9 But if /ou ha#e substantial retirement funds and /ou want to di#ersif/0 I"A accounts pro#ide a great #ehicle for that9

It's the In#estments that 5atter0 (ot the Account

%e routinel/ hear from concerned readers that one of their primar/ fears is that0 no matter how well the/ in#est0 the/ could still lose e#er/thing if the financial institution holding their I"A0 C@1:k;0 or an/ other t/pe of account goes bankrupt9 %e alwa/s tell these people the same thing that's not likel/ to happen9 %hat the/ should worr/ about is their in#estments0 not their accounts9 *es0 we will see plent/ of financial institutions go under in the Aftershock9 But at least in the immediate aftermath0 all remaining assets will simpl/ be transferred from one institution to another9 :As former account holders with %acho#ia or -irst 3nion alread/ know0 it's not catastrophic9; In the longer term0 especiall/ as we get close to a go#ernment default0 /ou'll want to eliminate all but the most liquid of funds :i9e90 checking accounts;9 But that's still a wa/s out9 1hings will ha#e to ha#e been #er/ bad for a while before we get to that point9

-ederal .mplo/ee "etirement Plans

Because the federal go#ernment guarantees the retirement plans for its workers0 those plans will hold their dollar #alue though not necessaril/ an inflationEadPusted #alue until the go#ernment defaults0 which won't happen until we are well into the Aftershock9 1he downside is that retired federal workers could face serious problems before that9 After all0 once inflation kicks in0 it will eat awa/ much of the #alue of their monthl/ pa/ments9 1he biggest problem with the defined benefit plan for federal workers is that the/ don't allow /ou to take lumpEsum pa/ments9 Instead0 the go#ernment makes distributions on an annuitiMed basis0 which means that /ou can't depend on these plans o#er the long term9 -ortunatel/0 as we discussed in the defined benefit section0 if these plans run into problems0 federalEser#ice pensioners will be at the front of the line when the go#ernment makes hardship pa/ments9 -or federal emplo/ees who take part in the 1hrift +a#ings Plan which effecti#el/ functions like a C@1:k; /ou can take a lumpEsum withdrawal when /ou retire0 or a oneEtime0 ageEbased withdrawal if /ou are older than DI^9 1hat gi#es /ou some measure of control and lets /ou pick Aftershock assets9 But if /ou're /ounger than that and still working for the go#ernment0 /ou're out of luck9 1he 1+P doesn't allow earl/ withdrawals for current emplo/ees9 .#en if /ou were willing to pa/ the 1@ percent penalt/0 /ou can't do it9 1his puts /ounger federal emplo/ees in a bind the/ ma/ ha#e to consider changing Pobs o#er the ne)t few /ears or risk a significant loss down the road in the retirement sa#ings the/'#e alread/ accrued9 :Again0 if /ou're in#oluntaril/ separatedfrom /our Pob0 this could be a sil#er lining9;

"etirement !KA
!uestion : Answer : +hould I use a retirement calculator to see if I'm on the right track6 "etirement calculators can be #aluable tools0 but the/ won't be accurate unless the/ include Aftershock assumptions0 and we don't know of an/ that currentl/ do9 In fact0 while calculators are a wa/ to gauge /our progress0 it's more important to get the fundamentals right and in#est properl/ in an AftershockEbased portfolio9 $ow much should I contribute to m/ C@1:k; in the meantime6 As long as /our emplo/er matches /our contributions0 putting in the minimum amount to get the emplo/er match gi#es /ou a guaranteed return free mone/ which is a big ad#antage9 $owe#er0 if /ou normall/ contribute be/ond the minimum matching amount0 /ou're better offer putting that e)cess into an I"A or other account0 so /ou don't ha#e to worr/ about penalties for withdrawal later9 %hen should I cash out m/ C@1:k; and take the penalt/6 1his situation needs to be monitored #er/ carefull/0 but depending on how things progress we think /ou'll need to pull /our mone/ out in the ne)t two to four /ears9 As we'#e written earlier0 the first sign will be inflation going abo#e D percent and0 as it rises further0 global in#estors starting to mo#e awa/ from the dollar9 It's important that /ou watch for these signs and be prepared to get out quickl/9 But remember: It's better to be out too earl/ than too late9 +hould I take +ocial +ecurit/ benefits earl/6 *es9 In the past0 it was best to wait9 But0 as we'#e e)plained0 +ocial +ecurit/ will e#entuall/ be meansEtested0 so it's best to take what /ou can while /ou can9 .#en if /ou qualif/ for meansEtested pa/ments down the road0 /ou'll almost certainl/ get more mone/ b/ taking pa/ments as soon as /ou can9 %hat about m/ home equit/6 %on't that help me get through retirement6 $istoricall/0 home equit/ has been a maPor part of people's sa#ings0 especiall/ in the 3nited +tates9 +ome middleEclass American families ha#e up to I@ percent of their sa#ings tied up in their homes0 and man/ people rel/ on home equit/ during retirement9 If /ou'#e read Chapter F on real estate0 /ou alread/ know the problem with this approach9 $ome equit/ is not going to count for much when interest rates rise and the real estate market crashes9 "efinancing will become #irtuall/ impossible0 and the interest rates will be staggering enough to scare awa/ most homeowners limiting their abilit/ to pull mone/ out of the equit/ the/'#e built up9 Alread/0 since 7@@H0 American homeowners ha#e lost DD percent of their home equit/9 1hat doesn't mean their homes ha#e lost DD percent of their #alue0 but an/ time /ou owe mone/ on a propert/0 a fall in the #alue of that propert/ has a compounding effect on /our equit/9 .#en those few who own their homes outright0 while the/ ma/ be in a better position than most0 won't find much help from it in co#ering retirement e)penses9 Clearl/0 home equit/ isn't going to sa#e man/ people9 !uestion : Answer : +o then I shouldn't consider a re#erse mortgage6 As e)plained in Chapter F0 a re#erse mortgage is a losing proposition9 It puts /ou on the line for significant debt while still ha#ing a lien on a house that #er/ likel/0 in most

!uestion : Answer :

!uestion : Answer :

!uestion : Answer :

!uestion : Answer :

markets has lost much of its #alue9

A &ood "etirement

?ne of the m/ths about retirement is that /ou spend less mone/ than during working /ears9 In fact0 /our spending often goes up9 -irst of all0 retirees ha#e much more leisure time0 and it takes mone/ to fill up that time with tra#el and acti#ities0 things that man/ people consider necessar/ for a good retirement9 1hen there's the cost of inflation9 1his isn't an actual increase in e)penditures0 but for retirees who depend on a fi)ed income0 it can be problematic when things cost more9 And it's not going to get an/ better when the dollar bubble bursts9 1he good news is that if /ou're still working0 /ou ha#e time to sa#e aggressi#el/ and in#est intelligentl/9 1his means di#ersif/ing funds0 and mo#ing assets into AftershockEsafe in#estments in the ne)t few /ears9 But most of all it means acti#e management9 %hat works toda/ ma/ be poison tomorrow9 -or those who are read/ to retire soon and enPo/ their pension0 or perhaps are alread/ on a pension0 the Aftershock couldn't come at a worse time9 But that doesn't mean /ou can't protect /ourself now0 while /ou still ha#e some time9 In fact0 if /ou in#est well0 /ou can reEorient /our portfolio to limit /our downside risks during the Aftershock and e#en come out ahead :see Chapter 11;9 %ellEplaced in#estments now can sa#e /ou from a lot of diffi cult/ down the road

.state Planning: 5aking the 5ost of *our Assets for *ourself and *our $eirs

-or hundreds of /ears0 estate planning was simple9 *ou created a will that stipulated how /our assets were to be distributed after /ou died9 But things became much more complicated in the earl/ twentieth centur/0 when income ta)es and estate ta)es were first introduced9 1hese e)tra costs moti#ated people to plan their estates in wa/s that helped them a#oid ta)es and the increasing cost of probate9

Probate

If /ou don't lea#e a will0 /our local probate court distributes /our assets according to =intestac/> laws0 which #ar/ from countr/ to countr/ and state to state9 1/picall/0 this means equal distribution among heirs with no personal control o#er who gets what9 -or e)ample0 /ou might want one of /our children in particular to inherit /our wedding ring0 or /ou might want to lea#e a certain amount to charit/9 %ithout a will0 intestate distribution doesn't allow that9 1oda/0 e#en if /ou ha#e a will0 /our heirs ha#e to go through probate to implement its pro#isions9 Probate can be an ugl/ process it often results in long dela/s before a will can be e)ecuted0 along with legal fees that can eat awa/ much of an estate9 If a Pudge ends up appointing an e)ecutor and attorne/ for the will0 some of those professionals will tr/ to wring as much mone/ out of the estate as possible9 It's well worth /our efforts to a#oid a complicated probate situation9 If /ou ha#e limited assets0 /ou can accomplish much of this through a process known as =titling9> In practice0 titling simpl/ means establishing control and ownership o#er something9 -or e)ample0 /ou can hold a bank account Pointl/ with a spouse or another heir0 stipulating a right of sur#i#orship9 1hat wa/0 if /ou die0 /our spouse simpl/ takes o#er the account outright0 and it doesn't become part of the estate9 8ife insurance is another e)ample if /ou specif/ a beneficiar/0 that becomes a simple transaction when /ou die: 1he insurance compan/ pa/s the beneficiar/ directl/9 If /ou're planning to distribute assets this wa/0 it's critical to keep /our records up to date9 If /ou'#e remarried or had a new child0 outEofEdate documents could lead to problems9 1itling assets appropriatel/ works well and remo#es the potential for disputes0 but it has limited application9 If /ou ha#e comple) inheritance situations0 /ou can't handle them through titling alone9 Another0 more powerful method is to use a re#ocable li#ing0 or inter #i#os0 trust9 *ou put the assets /ou want to distribute into a trust0 and /ou control it during /our life9 ?nce /ou die0 the trust is controlled b/ the trustee or b/ the successor of the trustee to continue to protect or to distribute the assets according to /our instructions9 It's an effecti#e wa/ to distribute assets and a#oid probate9 *ou can keep the entire inheritance process pri#ate9 1he process of creating a li#ing trust usuall/ requires an attorne/0 though some people do it themsel#es9

.state 1a)es

.state ta)es can be comple)0 but the/'re a lot less rele#ant toda/ than the/ were in the past9 As of 7@110 the first RD million of an/ estate is e)empt from an/ ta)es0 and the remainder is subPect to a flat AD percent ta)9 1hat means that most people don't need to worr/ about this issue9 .#en some people who ha#e estates abo#e the RD million limit will simpl/ make a large donation to their fa#orite charit/ to get the o#erall estate below the cap9 $owe#er0 the rules are changing all the time0 and it's difficult to predict how the/ might change e#en a few /ears from now9 A word of caution here: It's illegal to engage in an/ acti#it/ the I"+ deems a deliberate attempt to a#oid pa/ing ta)es9 %e don't condone ta) e#asion and are not recommending it under an/ circumstances9 1hat said0 there are some completel/ legal wa/s to pass assets to /our heirs while minimiMing ta)es9 -or e)ample0 people often minimiMe their potential ta) liabilit/ b/ gi#ing gifts to their heirs while the gi#er is still ali#e9 1he I"+ sets a cap each /ear on the amount one person can gi#e to another without a ta) consequence :as of 7@110 the cap was R1A0@@@;9 1hat sounds small0 but if /ou ha#e multiple children and grandchildren0 it can add up9 Another common practice is to put appreciating assets into a generationEskipping trust9 1his means that heirs are considered =life tenants> of the trust the/ can benefit from the interest generated b/ the trust0 but not the principal0 which gets passed on to the ne)t generation9 In /ears past0 the principal passed through ta) free9 $owe#er0 Congress has since created a special =generationEskipping> ta) to close this loophole0 but again0 onl/ for amounts o#er RD million9 A more recent de#elopment in estate planning is the famil/ limited partnership9 1his structure consists of a general partner who retains control o#er the assets :t/picall/ a parent;0 and limited partners who ha#e an ownership stake but no control :t/picall/ the children;9 A limited partnership offers se#eral ta) ad#antages9 -or e)ample0 it allows /ou to transfer ownership of assets to children o#er time through the standard annual gifts up to the I"+ cap within the partnership0 meaning /ou retain control of the assets9 Abo#e that amount0 /our famil/ will ha#e to pa/ gift ta) onl/ on the =fair market #alue> of an/ ownership transfers9 And because the limited partners recei#ing the assets don't ha#e control o#er them0 this fair market #alue is often considerabl/ less than the actual asset #alues9 1o use this approach0 /ou need a qualified appraiser to assess the #alue of an/ gift in a famil/ limited partnership to determine the appropriate ta)able amount9

.state Planning in the Aftershock

1he biggest issue for estate planning in the Aftershock is that most traditional assets stocks0 bonds0 real estate0 whole life insurance0 and annuities will be worth onl/ a fraction of their former #alue9 -or people who lose most of their wealth0 estate planning will be moot because the/ won't ha#e much left to gi#e to their heirs9 ?f course0 if /ou're reading this book0 we're going to assume that /ou ha#e protected /ourself with safe in#estments and still ha#e plent/ of wealth to distribute9 %hen the go#ernment can no longer borrow or safel/ print mone/0 its onl/ recourse will be to dramaticall/ raise ta)es on those who are emplo/ed and ha#e assets9 1hat means the estate ta) will become a much bigger issue and impact more people9 %e e)pect progressi#e estate ta) rates in line with income ta) rates0 which will be higher than current le#els9 1here will probabl/ still be an e)emption ma/be e#en as high as the current RD million but it won't necessaril/ be adequatel/ inde)ed for inflation9 And remember0 RD million in the Aftershock won't be what it is toda/9 .state planning is rarel/ simple0 but in an Aftershock en#ironment it gets e#en more comple)0 especiall/ for estates with #arious t/pes of assets9 If /ou ha#e multiple assets /ou're tr/ing to protect0 /ou will likel/ need multiple strategies9 -or domestic assets0 such as a house0 car0 or furniture0 an inter #i#os trust is usuall/ the best approach9 -or assets like a famil/Eowned business or real estate holdings0 a famil/ limited partnership is generall/ the best wa/ to go9 *ou can use Point titling with right of sur#i#orship for assets like bank accounts that /ou want to be transferred quickl/ after death9 5an/ of these assets won't be worth too much0 but /ou will likel/ still want to transfer them appropriatel/ for other reasons9 -inall/0 /ou ma/ still need a will for an/ residual assets9 5an/ readers of this book will no doubt hold a significant portion of precious metals9 %hile e)changeE traded funds are a fine wa/ to in#est in gold for now0 for securit/ reasons /ou ma/ want to own gold bullion when the Aftershock hits9 ?ne of the ad#antages of ph/sical assets like gold is that the/'re relati#el/ eas/ to secure in a safe place that no one else knows about9 1he problem for estate planning is that if no one knows where /ou keep the assets0 the/ can't be transferred after /ou die9 And while /our heirs ma/ be trustworth/ enough to know the location in ad#ance0 this is a risk /ou ma/ not want to take for these assets0 ph/sical possession essentiall/ amounts to ownership9 As a result0 man/ Aftershock portfolios will likel/ be hea#il/ in#ested o#erseas in multiple ta)Eha#en countries9 &ood estate planning in these circumstances generall/ would require the use of long term o#erseas trusts to protect the assets and ensure the proper transfer of these assets to heirs9 As a result0 man/ Aftershock portfolios will likel/ be hea#il/ in#ested o#erseas in multiple ta)Eha#en countries9 &ood estate planning in these circumstances generall/ would require the use of long term o#erseas trusts to protect the assets and ensure the proper transfer of these assets to heirs9 -inall/0 /ou'll need to take capital losses into account9 Capital losses are an almost negligible aspect of estate planning toda/0 but the/'ll be critical in the Aftershock0 as all kinds of assets will lose a great deal of their #alue9 "ealiMing capital losses in /our home and other assets could help offset an/ income from wages or gains and substantiall/ reduce ta) liabilit/9 1here are some fairl/ restricti#e rules on the books toda/ about using capital losses to offset income0 but in an Aftershock en#ironment with such widespread capital losses these rules could be rela)ed9 so this strateg/ has its limits9

C$AP1." 11

*our Aftershock

In#estment

Portfolio

As we said before0 1he Aftershock In#estor is the guide to in#esting e#en if there is no Aftershock9 .#en if the bond market doesn't melt down0 there are still big longEterm problems to contend with9 .#en if the stock market doesn't melt down0 there are still big longEterm problems to contend with there0 as well9 1he same is true for real estate9 It won't take require a big multbubble pop for these assets to fall in the future9 +o /ou needn't bu/ into our entire point of #iew to take heed of our warnings9 As we often sa/0 /ou certainl/ don't need h/perinflation to cause maPor problems for stock0 bond0 and real estate markets9 .#en interest rates that were not at/pical in the booming 1IF@s and absolutel/ benign compared to the incredibl/ high rates of the 1IG@s and earl/ 1IH@s will cause real problems for all these markets at their #er/ high prices toda/9 *ou need to be prepared for them interest rates to rise9 At the #er/ least0 /ou need to be prepared for lots of #olatilit/9 %e think there will be an Aftershock at the end of this #olatilit/0 but e#en if there is not0 /ou need to at least be prepared for the #olatilit/ in the near future and the likelihood of diminished returns from traditional in#estments9 +o0 to do that0 let's summariMe what we'#e discussed in this book about a di#ersified Aftershock portfolio9 In particular0 what is the o#erall portfolio strateg/0 what are its components0 and what's is the best wa/ to implement that portfolio6

Aftershock Portfolio +trateg/

1he o#erall strateg/ of the Aftershock portfolio is: 19 Preser#ation of capital 79 5inimal #olatilit/ A9 "easonable returns

Preser#ation of Capital

1he term preser#ation of capital should be defined since it is used b/ man/ mone/ managers9 5ost often what con#entional wisdom :C%; mone/ managers mean b/ preser#ation of capital is lots of safe longEterm bonds0 some safe blueEchip or highEdi#idend stocks0 and ma/be an annuit/9 %e ha#e discussed each of those in detail in the book0 so /ou know b/ now that keeping those in#estments for a long period of time will not preser#e /our capital9 It will do Pust the opposite9 +o C% sa/s safe bonds and safe stock are the wa/ to go9 %e sa/ those aren't safe for the long term an/more9 %hat we mean b/ preser#ation of capital is protection against a longEterm decline in the stock and bond markets and high inflation down the road9 1hose are the real threats to /our hardEearned wealth9 1he fact that stocks and bonds are not good long term doesn't mean that the/ ha#e peaked toda/9 In fact0 the/ probabl/ ha#en't9 1iming is alwa/s an issue in in#esting0 and it's hard to time the market9 %e'll talk more about how to handle the timing issue later in this chapter9

5inimal 2olatilit/

5inimal #olatilit/ isn't too hard to define0 although e)actl/ how little #olatilit/ /ou want depends on /our financial tolerance for #olatilit/9 Also0 there's no free lunch9 1o get higher returns /ou will ha#e to accept somewhat higher #olatilit/9 But /ou can shoot for a happ/ medium that is less #olatile than the stock market but still gi#es /ou returns that are comparable to a modestl/ rising stock market toda/9 Ideall/0 an Aftershock in#estor will ha#e returns that look more like a nonE#olatile upward mo#ement as opposed to the highl/ #olatile and #er/ risk/ +tandard K Poor's :+KP; inde)9 It should be more of an arrow through a %9 .#en if /ou make the same returns as the +KP D@@0 do /ou reall/ want all that #olatilit/6 And0 of course0 there is some risk :we think a #er/ big risk; that at some point one of those downward mo#ements on the stock market isn't going to full/ rebound9 ?nce we get to the point where the normal remed/ for boosting the stock market :massi#e mone/ printing and massi#e borrowing; that has worked so well in the past has increasingl/ less positi#e effect :and e#entuall/ has a negati#e effect; a big stock market drop could sta/ down and not rebound9 1his market isn't being kept up b/ economic fundamentals0 it is being kept up b/ artificial means that the go#ernment has used effecti#el/0 in combination with stock cheerleaders0 to maintain a bubble stock market #aluation9

"easonable "eturns

"easonable returns are hard to define9 In the current market0 D\ might be reasonable to man/9 -or others it's quite low9 1he ke/ is what le#el of risk /ou are taking to get what le#el of return9 If /ou are getting a high return0 /ou are likel/ taking a high le#el of risk9 In con#entional in#esting this is called the riskEadPusted rate of return0 which is often e)pressed as the +harpe ratio :the higher the +harpe ratio of an in#estment0 the better the rate of return /ou are getting relati#e to the risk /ou are taking;9 ?f course0 we are seeing certain in#estments as risk/ long term that the market is currentl/ not seeing as risk/9 +o our riskEadPusted rate of return would be different from standard in#esting anal/sis9 (onetheless0 the concept is correct0 and we are ad#ising a lower rate of risk taking now for most people and that will result in a lower rate of return9 But it's better than losing /our mone/9 Also0 /ou can also make #er/ high returns as we near the Aftershock0 but /ou will be taking more risk and will get higher #olatilit/9

<e/ Components
+o what are the ke/ components of an Aftershock portfolio0 and how do we weight them6 1he primar/ components of an Aftershock portfolio toda/ are gi#en below9 "emember0 this will change o#er time0 which we will discuss with each component9 19 &old 79 $ighEdi#idend stocks A9 +horterEterm 1reasur/s C9 1IP+ :1reasur/ InflationEProtected +ecurities; D9 -oreign currencies F9 Commodities G9 +hort stock e)changeEtraded funds :.1-s; H9 +hort bond .1-s

&old

1his is an important element of an/ Aftershock portfolio0 and it will become increasingl/ important in the future9 %hen we sa/ gold0 we mean ph/sical gold and not gold mining stocks9 As discussed in Chapter H0 this can be held #ia an .1-0 such as &840 IA30 or P$*+0 which makes it easier to purchase9 1he big problem with a #er/ large allocation to gold right now is the #olatilit/9 $owe#er0 gold has been a #er/ stable performer on a /earEtoE/ear basis0 and the fundamentals of gold ha#e ne#er been better9 As the Aftershock comes closer0 and /ou are more con#inced it is coming0 /ou should be increasing /our gold holdings accordingl/9 But bu/ some now e#en if /ou aren't #er/ sure of the Aftershock9 It could easil/ go down for a while after /ou bu/ it0 but best to get /our toes wet9 *ou will need to be more comfortable bu/ing gold e#entuall/9 "ight now0 man/ people don't bu/ gold because the/ missed it at a lower price earlier9 4on't fall into that trap9 Bust start now b/ bu/ing a smaller amount9

$ighE4i#idend +tocks

Isn't this one of the assets we said the cheerleaders would suggest6 *es it is9 1he difference is that we are not recommending it as a longEterm hold9 It will work well in the current #olatile and slow growth stock market9 $owe#er0 like all stocks0 /ou will need to mo#e out o#er time since highEdi#idend stocks do go down when the market goes wa/ down9 %hat the/ do is pro#ide /ou with a buffer against the #olatilit/ of the current market and pro#ide a decent di#idend income as well9 %e particularl/ like electric utilit/ stocks0 but since the/ ha#e done well in the past /ear0 the/ likel/ won't do quite as well in the near future9 $owe#er0 the/ are still a better choice now than riskier stocks9 ?ne eas/ wa/ to in#est in a di#ersified group of electric utilities is through the .1- Z839

+horterE1erm 1reasur/s

1his is another temporar/ asset categor/9 8ike highEdi#idend stocks0 which are more defensi#e in nature0 shorterEterm bonds are more defensi#e in nature than longEterm bonds9 1he/ are not as #ulnerable to changes in interest rates as are longEterm bonds and the/ pro#ide /ou with a buffer against an/ downward mo#ements in bonds9 Again0 like highEdi#idend stocks0 the/ will go down when the bond market goes down a lot0 so /ou will need to mo#e out e#entuall/9 But in the meantime it pro#ides a good wa/ to ride the bond bull until it finall/ turns for good9 ?ne eas/ wa/ to in#est in shortEterm 1reasur/s is through the .1- 2&+$9

1IP+
1IP+ are an in#estment /ou can keep for the longer term9 Accordingl/0 it ma/ also ha#e a more difficult ride shorter term if inflation e)pectations decline for a while0 as the/ could for the remainder of this /ear9 .#en though we think we will ha#e higher inflation0 it won't necessaril/ be pro#en for a while9 (onetheless0 1IP+ ha#e done well in the past0 including a 1A\ rise in 7@119 +o we like this asset because it will rise when inflation rises9 1hus0 /ou are fairl/ well protected9 +horter term0 though0 /ou could get lower returns9 "iskE a#erse in#estors ma/ e#en want to skip shortEterm 1reasur/s and Pust use 1IP+ instead9

-oreign Currencies

1hese are a trickier categor/ because the/ are fairl/ #olatile0 especiall/ now with the .uropean debt crisis9 It is a longerEterm pla/9 1here is probabl/ too much #olatilit/ now for most people to work with this asset categor/ and not enough upside to make it worthwhile9 $owe#er0 longer term0 when inflation rises and foreign in#estors become war/ of the 3nited +tates as a safe ha#en0 the dollar will fall0 and this will be a good bu/9 It's hard to in#est in an/ gi#en currenc/ because it can be affected b/ countr/Especific issues9 $owe#er0 a good and relati#el/ stable one for the future will likel/ be Canadian dollars9 1he .1- for those is -ZC9 Another option is to short the dollar inde)9 1he dollar inde) is a basket of foreign currencies measured against the dollar9 As the dollar inde) falls0 the short would go up9 1he s/mbol for that .1- is 34(9

Commodities

Commodities are a lot like currencies0 and we would offer the same ad#ice9 It's a longerEterm pla/9 It's also a more specific pla/ since we don't think most commodities will do well in the long term due to the worldwide downturn9 $owe#er0 the falling dollar will help agricultural commodities9 4BA is an .1- that holds a basket of agricultural commodities9 $owe#er0 this is reall/ onl/ for more sophisticated in#estors0 and the window of greatest opportunit/ is a wa/s off since commodit/ prices will fall before the/ reco#er due to the falling dollar9

+hort +tock .1-s

1here are probabl/ few instruments more difficult to work with than short .1-s or in#erse .1-s9 1he/ are simple to bu/0 but the/ are difficult to profit from in the current market because it is highl/ #olatile and has been on a modest upward trend in the last couple /ears9 In#erse .1-s are also reconciled dail/0 so that's a technical issue that means the/ don't alwa/s follow the longEterm trend e)actl/9 $ence0 the/ are best used when the trend is strongl/ in /our fa#or0 and that can be hard to predict9 Clearl/0 at some point0 there will be a time these can be used to make mone/0 but it won't be until we start to see real weakness in the stock market9 If /ou do use in#erse .1-s in the ne)t couple of /ears0 don't be afraid to take profits9 5arkets can mo#e against /ou quickl/0 and /ou can quickl/ lose whate#er /ou ha#e gained9 ?ne of the most popular in#erse stock .1-s is +$0 which shorts the +KP D@@9 Also0 /ou ha#e to be especiall/ careful about double short .1-s9 1hese are le#eraged0 so /ou can make twice as much mone/0 but /ou can also lose twice as much mone/9 Plus0 the dail/ reconciliation can ha#e a greater effect in tracking longEterm trends with le#eraged .1-s than nonEle#eraged9

+hort Bond .1-s

1he same issues that appl/ to in#erse stock .1-s appl/ to in#erse bond .1-s9 Bonds ma/ turn earlier simpl/ because interest rates ha#e fallen so low that e#en a modest upward mo#ement could damage bonds quite a bit and create nice gains for in#erse bond .1-s9 $owe#er0 man/ in#estors ha#e been hurt b/ thinking the bull in 1reasur/ bonds has run its course0 including the <ing of Bonds himself0 Bill &ross9 ?ne of the most popular in#erse bond .1-s is 1B-0 which shorts the 7@E/ear 1reasur/ bond9 (otice that we like .1-s6 -or one thing it is often the onl/ wa/ to in#est in certain assets0 like gold9 1he/ also tend to be relati#el/ cheap since the/ are not managed like a mutual fund9 1he/ are #er/ similar to an inde) fund in cost and structure9

4o It *ourself or Bring in $elp6

It's not an eas/ decision9 .ither wa/0 there are problems9 It's hard to manage a portfolio /ourself9 .motion gets in the wa/9 Plus0 it takes a certain amount of time and a lot of mental energ/9 It's not that it takes a lot of time0 but it's hard not to focus on it a lot of the time9 And all that focus energ/ can wear on /ou9 +o we tried to outline a plan in this book that will reduce /our focus time b/ protecting /ou from a big decline in the stock or bond markets0 but like we said0 there is no setEitEandEforgetEit option right now9 Bringing in help makes sense0 but in toda/'s market0 that's almost alwa/s going to be a cheerleader of some sort9 It's hard to find a sensible alternati#e9 And /ou don't want a cheerleader who sa/s the/ will in#est the wa/ /ou want9 If the/ don't understand it0 the/ can't reall/ do it0 e#en if /ou are telling them how9 And if /ou are telling them how to do it0 wh/ are /ou hiring that person6 +o if /ou can find the right person0 then great9 ?therwise0 /ou sort of ha#e to do it /ourself9

1iming Better to 5o#e 1oo .arl/ than 1oo 8ate

*ou ma/ kick /ourself because of the mone/ /ou =lost> if the market rises after /ou sell9 Certainl/0 other people will kick /ou for sure,,, 1he/ don't like to see people selling out of the market9 It's bad for business if /ou're a stock salesman0 and it's bad for others who hold stocks0 which is a lot of people9 4on't e)pect their support0 whether it turns out in the short term /ou were right or wrong9 If /ou were right and stocks go down0 it's like salt in the wound to others9 If /ou're wrong and stocks go up0 then that's more reason for others to feel good about owning stocks and pro#ing to the poor fools who aren't as smart about stocks that the/ were wrong9 1he last part of this chapter is de#oted to the broader issues that will affect timing and how the market ultimatel/ declines9 +ince we ha#en't had a longEterm market decline since the &reat 4epression0 the factors affecting this decline are different than e#er before0 e#en different from the 4epression9 3nderstanding how the market will decline and the forces dri#ing it will help /ou better understand how to time /our indi#idual e)it from stocks and bonds9

&o#ernment Inter#ention Is 5aking An/ Portfolio 4ecision and 1iming 2er/ 4ifficult

1he biggest change since the great stock collapse during the 4epression is that go#ernment inter#ention in the stock0 bond0 and real estate markets now is enormous9 (e#er before ha#e we seen such massi#e inter#ention0 both indirectl/ and directl/0 in those markets9 And that inter#ention is being done worldwide0 sometimes0 in a #er/ coordinated fashion9 1he 3nited +tates certainl/ doesn't ha#e a monopol/ on go#ernment inter#ention9 1his go#ernment inter#ention makes timing e#en trickier0 since it can be more difficult to predict the e)act timing of inter#ention9 It isn't difficult to predict that the go#ernment will inter#ene or how it will inter#ene0 but it is difficult to predict the e)act timing9 Although go#ernment inter#ention sometimes responds quickl/ to market forces0 it isn't dri#en b/ market forces in the same wa/ a normal market would be9 $ence0 Pust following the financial news doesn't tell /ou when or how much the go#ernment will inter#ene at an/ gi#en time9 It's much like a #er/ unusual fire9 *ou can predict that the fire department will tr/ to put it out0 but since it has ne#er dealt with such an unusual fire before0 it is difficult to predict e)actl/ how it will react at an/ gi#en time in its attempt to put it out9

&o#ernment Inter#ention0 (ot 5arket -orces0 %ill $a#e the Biggest Impact on *our Aftershock Portfolio for the (e)t -ew *ears

Because go#ernment inter#ention has been so massi#e0 as discussed earlier in this book0 it will be the most important factor impacting /our Aftershock portfolio9 It will be what fundamentall/ dri#es in#estor confidence0 consumer confidence0 economic reco#er/0 housing0 and e#en retail sales9 Although there are other factors dri#ing those aspects of the econom/0 the siMe of the go#ernment inter#ention in the econom/ and the markets is so large that most of those other factors are dri#en at least in part b/ the go#ernment inter#ention as well9 "emember the chart in Chapter A that compared the amount of growth in our econom/ to the amount of increased go#ernment borrowing from 7@@G to 7@116 Increased go#ernment borrowing was far larger than the entire growth in the econom/ during that period9 &o#ernment inter#ention is huge9 It's of absolutel/ historic proportions9 And that has Pust an indirect impact on the stock and bond markets9 1hrough its mone/Eprinting operations0 it is also ha#ing a #er/ direct impact on the stock0 bond0 and mortgage markets9 +o let's take a closer look at this allEimportant inter#ention what's dri#ing it and how it is likel/ to pla/ out o#er time9

5ost .conomists and Anal/sts 4on't .#en Admit $ow 5uch &o#ernment Inter#ention and 5arket Interference 1here $as Been
But0 first0 it's important to point out that man/ people are loath to belie#e that the -ederal "eser#e and the 39+9 banking s/stem ha#e taken such e)traordinar/ and enormous measures to artificiall/ prop up the stock0 bond0 and real estate markets in the past few /ears0 especiall/ considering how de#astating the longE term consequences of this inter#ention are likel/ to be9 1his resistance is understandable0 not Pust because of the selfEinterest in#ol#ed0 but also because it flies in the face of how the banking s/stem has operated for most of modern histor/9 &oing back to the nineteenth centur/0 the powers that be in the 39+9 banking s/stem ha#e generall/ operated with relati#el/ high integrit/0 both financiall/ and academicall/9 1his integrit/0 in fact0 was crucial in attracting and keeping depositors9 In a =sur#i#al of the fittest> banking en#ironment0 banks that weren't honest and accountable couldn't e)pect to last #er/ long9 And when the -ed was established in 1I1A0 ensuring the integrit/ of the entire banking s/stem was a top priorit/9 And for the most part0 it did an e)cellent Pob9 &i#en this histor/0 wh/ should an/one accept that things changed would an/one e)pect that things would change from A@ /ears ago6 1hat the integrit/ of the -ed and other pla/ers in the financial communit/ would act so irresponsibl/0 with such dire implications for the 3nited +tates and the global econom/ as a whole6 %e'll go through the moti#es one b/ one0 but first0 let's remember a mone/ manager named Bernie 5adoff9 5adoff had been in business since 1IF@0 had a terrific track record0 and was belo#ed b/ man/ of his clients and colleagues in the financial communit/9 $e was one of the inno#ators behind the (asdaq market and ser#ed as its chairman for man/ /ears9 $e was an upstanding leader in the in#estment communit/0 and man/ considered it an honor to in#est with his firm9 (o one could ha#e belie#ed that0 as 5adoff himself put it0 =it was all one big lie9> If we don't want to end up like Bernie 5adoff's clients0 it's important that we don't make the same mistake the/ made9 1he fact that the pla/ers at the -ed and in the banking s/stem ma/ look the part and ma/ ha#e a good track record doesn't mean the/ can get us out of the mess the/'#e created9

%h/ +o 5uch Interference and %h/ 4on't 1he/ +top6

+o what went wrong that made the go#ernment and the banks turn to market interference6 And0 more importantl/0 wh/ can't the/ Pust stop doing it and let things return to normal6 %e'#e alread/ discussed how producti#it/ growth slowed down in the 1IG@s9 At this point0 possibl/ facing an endlessl/ stagnating econom/0 a little artificial stimulus for the markets didn't seem like such a harmful idea0 and it might not ha#e been9 But borrowing large amounts of mone/ and not pa/ing it back :both go#ernment and pri#ate borrowing; is like a drug: 1he more /ou use it0 the more it takes to achie#e the same results9 And after a while0 it becomes impossible to get off without serious0 painful consequences9 And the 3nited +tates has been on this drug for se#eral decades now9 +o when we talk about the consequences of ending market interference0 we're not talking about minor withdrawal s/mptoms but consequences that affect our #er/ wa/ of life9 -irst0 for man/ in the financial sector :and elsewhere;0 it's not Pust a matter of losing their Pobs but their entire careers9 Add to that the loss of most of their life sa#ings0 as well as potentiall/ compromising their children's futures9 5ore broadl/0 letting go of the wa/ things ha#e been done for the past A@ /ears means0 in a wa/0 letting go of the American 4ream that is0 the stabilit/ and upward mobilit/ of the upper and upperEmiddle classes9 -amilies that ha#e been wealth/ for generations will see much of that disappear9 -or such people0 it's criticall/ important to protect the status quo9 1he/ will take risks well be/ond what would normall/ be acceptable0 and the/ will welcome an/thing that keeps their li#es undisturbed and relati#el/ prosperous0 altering their thinking to downpla/ an/ longEterm consequences9 +o now that we understand the wh/0 let's look at the how9 1here are three techniques in particular that can be emplo/ed to manipulate the markets: misleading indices and statistics0 market manipulation0 and market holida/s0 which are discussed below9

<eeping the 5arket Interference %orking for as 8ong as Possible: 5isleading Indices and +tatistics

8ook at the financial news on an/ gi#en da/ and there's a decent chance /ou'll read about the market mo#ing according to an economic indicator that has recentl/ been announced9 &ood news sends the markets upJ bad news sends them down9 5anipulating ke/ statistics is an important tool to ease worries about the econom/0 and can pro#ide a reliable shortEterm fi) for struggling markets9 <e/ areas for manipulating statistics include indices on growth0 inflation0 unemplo/ment0 and -ederal "eser#e open market acti#it/9 Abo#e all0 authorities in the banking s/stem want to a#oid the appearance of a recession that is0 a decrease in economic production from quarter to quarter9 +o one of the fa#ored tools used to disguise what might easil/ be called a recession is the =seasonal adPustment9> It's a relati#el/ simple matter to take a raw number0 then =correct> for seasonal adPustment and make it look better than it is0 or e#en make a negati#e number look positi#e9 8ater0 it might be announced that the seasonal adPustment is being remo#ed retroacti#el/0 but b/ then the obPecti#e has been achie#ed0 and market panic has been a#oided9 ?ne of the easier indices to manipulate is the Consumer Price Inde) :CPI;0 which measures inflation9 1his figure is based on the prices of a wide #ariet/ of goods and ser#ices around the countr/0 monitoring how the/ change o#er time9 +o all that has to be done to manipulate this figure is to alter the mi) of goods and ser#ices in order to understate inflation0 as well as using factors like =substitutabilit/> and =qualit/ adPustment> to massage the raw numbers9 In fact0 in the past couple of decades0 the measurement of the CPI has changed so much that toda/'s CPI registers inflation at about G percentage points lower than it would be under the old measurement, Another misleading factor in measuring inflation is shrinking asset prices such as real estate or commodities that ma/ be due to falling demand and ha#e little to do with the #alue of the currenc/9 But because these assets represent large portions of the inflation measurement0 their decreasing prices can co#er up an/ real inflation in the measurement9 %e'#e talked a lot in this book about how the -ederal "eser#e increases the mone/ suppl/ through bu/ing bonds9 ?f course0 e#er/one knows that increasing the mone/ suppl/ leads to inflation though the/ ma/ pretend not to in some cases so it can be in the -ed's best interest to understate these numbers when the/ might otherwise cause concern in the markets9 %e won't go so far as to make accusations here0 but it's certainl/ possible that the -ed has done or will do what man/ banks and pri#ate companies :.nron0 an/one6; ha#e done in recent histor/: offEbalanceEsheet accounting9 B/ not reporting e#er/ bond purchase openl/ and accuratel/0 the real increase in the mone/ suppl/ can be obscured0 maintaining confidence in the dollar9 And then there's a more crude wa/ for go#ernments to mislead the public and sta#e off worries: Pust lie9 %e can be fairl/ certain0 for e)ample0 that the go#ernment of China does this regularl/0 with statistics created b/ go#ernment emplo/ees under orders from their superiors9 1hese lies can be spotted prett/ easil/ b/ those with access to reliable information0 though9 -or e)ample0 we can monitor the use of electricit/ in China if electricit/ use is going down0 it's a sign that the econom/ is contracting0 regardless of what the go#ernment sa/s9 It is likel/ there is some manipulation of electricit/ statistics but likel/ not as great as gross domestic product :&4P; or inflation numbers9 Perhaps an e#en more reliable wa/ is to look at e)ports to China from other countries9 If e)ports to China are slowing0 that's a bad sign for the countr/'s econom/9 :In fact0 this is e)actl/ what has happened recentl/0 indicating that China's econom/ ma/ be slowing e#en faster than the go#ernment is willing to admit9; &ranted0 in most of the de#eloped world0 outright l/ing like this is somewhat unlikel/0 and would likel/ be ineffecti#e9 But attempts to mislead like this are not inconcei#able0 and it's important that we be rigorous in finding reliable0 accurate information at all times9 +o if this is the case0 wh/ don't Pournalists0 anal/sts0 and academics catch it and report on it6 "emember

what we said earlier about the moti#ations for continuing on the path of manipulation9 1he truth is that there is #er/ little reward out there for professionals who call the go#ernment and the financial communit/ out on its misleading or outright wrong figures9 Aside from often wanting to belie#e the cheerleaders themsel#es0 those who speak out are often labeled =doomEandEgloom> pessimists and ridiculed throughout the financial communit/ and in public0 possibl/ e#en blaming such people for falls in the markets9 %e ha#e some small e)perience with this0 as do some of the people we'#e profiled in our AB. Awards throughout our books9

%hen All .lse -ails 9 9 9

5isleading numbers and market manipulation can go on for quite some time0 but sooner or later the/ aren't enough to keep things afloat9 .#entuall/0 losses become too large to hide with a little mathematical creati#it/9 .#en if the go#ernment outright lies0 indicators elsewhere will e#entuall/ be too strong to ignore Pust like we're beginning to see now in China9 4irect manipulation can't prop up the markets fore#er either9 ?nce people lose confidence in the markets0 it's #er/ difficult to restore it9 .#en bu/ing stocks to prop up their price might create a shortEterm upswing0 but the losses that follow make this tactic unsustainable in the long run9 1he amount of capital that would be needed to sustain prices would be astronomical0 which brings us to the ne)t failure: quantitati#e easing9 .)panding the mone/ suppl/ is alwa/s going to be a recipe for inflation9 &o#ernments do it because it's a shortEterm fi)0 but e#entuall/ it catches up with them0 and it can snowball #er/ quickl/9 In the earl/ going0 in#estors ma/ cheer quantitati#e easing and respond b/ bu/ing up assets9 But once inflation reall/ takes off and panic sets in0 there comes a point when quantitati#e easing becomes counterproducti#e9 1he inflationar/ response to an/ increase in the mone/ suppl/ becomes almost immediate0 as the flight to safet/ becomes e#en more frantic9 %e're left with no stimulus0 Pust a de#alued currenc/9 Inflation is reall/ the ke/ here9 ?ur guess is that people will be relati#el/ content to stick with traditional assets as long as inflation is low and the dollar remains stable9 ?nl/ when inflation becomes a maPor concern do we e)pect most people to get spooked and cause the stock0 bond0 and real estate bubbles to pop0 and pop #er/ rapidl/9 %ith 39+9 markets collapsing0 e)pect foreign in#estors to pull out en masse9 1his is the Aftershock9 And it will necessitate more dire measures than what we'#e discussed so far9

1he 8ast "esort: 1he +tock 5arket $olida/ :the 3ltimate "eason %h/ *ou (eed to 5o#e .arl/ "ather than 8ater;

"ight now0 we ha#e an oscillating market9 It goes up a little0 then down a little0 then up more0 then down more9 But what we're not seeing is significant sustained gains o#er time9 Instead0 we ha#e a market that0 left to its own de#ices :without continuous mone/ printing or the hope of mone/ printing;0 will trend downward9 .#entuall/0 that oscillating market will turn into a consistent down market0 with losses for the 4ow potentiall/ approaching D@@ points a da/ or more9 At this point0 the go#ernment will need fast action9 1he old wa/ of doing things massaging numbers0 manipulating prices0 and flooding the market with capital will not be nearl/ enough to stop the plunge9 As it happens0 there are alread/ s/stems in place to shut down the stock market in this situation often referred to as =circuit breakers9> 1he idea is to shut down the market for onl/ a few hours and address whate#er issue is causing the plunge in prices9 In this case0 we might see this initial shutdown last up to a da/ or two before reopening9 ?f course0 the problem in this case is a bubble econom/9 1hat's not something that can be fi)ed o#ernight9 +o when the market does e#entuall/ reopen0 the plunge continues0 and the go#ernment will need another shutdown0 one that will last more than a da/ or two9 In 1IAA0 -ranklin 49 "oose#elt declared a national bank holida/ in order to shore up the problems that had been leading to runs on banks throughout the countr/9 4uring that time0 the .mergenc/ Banking Act was passed0 and when the banks reopened the following week0 depositors came rushing back with renewed confidence9 8ikewise0 when the stock market has to be shut down0 the go#ernment will be franticall/ looking for whate#er reform it can implement to send in#estors rushing back to stocks9 But without being able to assuage fundamental in#estor fears about the econom/ and the markets0 the name of the game here will be finding wa/s to encourage purchases and discourage sales9 Brokerage firms will ha#e no qualms about pla/ing along0 and what we might see for some time is that clients who want to sell their stocks ha#e a difficult time getting past their broker's secretar/ or #oicemail0 while those who want to bu/ will get top priorit/9 %hate#er happens0 the go#ernment and the financial industr/ will surel/ go to great lengths to pre#ent an/one from selling stocks when the market reopens9 %hat we will not hear from the -ed0 or from most of the financial industr/0 is that stocks and other assets ha#e been in a bubble all this time0 that the implosion was ine#itable and irre#ersible9 Instead0 we'll hear all kinds of e)cuses0 perhaps blaming the crash on culprits such as highEspeed trading0 which ma/ ha#e irresponsibl/ flooded the market with sellers :since the/ do more than half of the trading on the market and the/ do it quickl/0 the/ will clearl/ be in#ol#ed in an/ crash;9 Another likel/ target will be the short sellers0 among the fa#orite scapegoats from 7@@H9 In addition0 we'll almost certainl/ hear that it's a temporar/ irrational panic0 and that e#er/thing will be fine once people come to their senses and bet on the 39+9 markets again9 An/thing to con#ince the public and themsel#es that it's Pust a temporar/ crash and not a bubble econom/ popping0 will be discussed and praised at length9 1his might sound unimaginable in 7@170 not to mention horrif/ing0 that the stock market could Pust close down for an e)tended period9 But what we'll probabl/ find0 when the market can't sta/ open without huge losses0 is that the public will be surprisingl/ content with this action or rather0 with an/ action that might stop this downward spiral9 5eanwhile0 bonds and real estate will ha#e their own shutdowns9 But that won't happen because of go#ernment action9 %ith soaring interest rates that the -ed can no longer control0 lending will dr/ up0 and the bond market will effecti#el/ shut down on its own9 %hen the bond market shuts down0 there's no

mortgage mone/ a#ailable0 and thus essentiall/ no real estate market left to speak of9 1he one oddit/ will be the gold market0 which will beha#e in e)actl/ the opposite wa/9 %ith assets tanking across the board0 people will rush to what the/ consider the intrinsic #alue of gold and precious metals9 1his is the last thing the -ed wants0 and so measures will ha#e to be taken to discourage gold purchases9 A prohibition is possible0 but more likel/ we might see a puniti#e ta) on proceeds from gold sales9 1he -ed might e#en prohibit the redemption of paper gold0 such as through gold .1-s0 into ph/sical gold9 1he idea is to pre#ent in#estors from lea#ing traditional assets and rushing to gold instead9 But again0 once in#estor confidence is lost0 it's #er/ difficult to gain it back9 And the reason wh/ discouraging gold purchases won't be successful is the same reason shutting down the stock market won't be successful: 1he 3nited +tates is not the onl/ countr/ in the world9 1he 39+9 go#ernment can pass all kinds of regulations and restrictions on market acti#it/0 but it can't do much to pre#ent those same transactions in o#erseas markets9 &old0 of course0 will be eas/ to bu/ and trade elsewhere in the world regardless of what the 39+9 go#ernment does in fact0 restrictions in the 3nited +tates would Pust send the price of gold up e#en more9 .#en if 39+9 stock markets are shut down0 39+9 stocks will still be readil/ traded o#erseas as well9 And this is wh/ it will be clear to an/one who's pa/ing attention that 39+9 stock prices are plummeting e#en while the market in the 3nited +tates is on a holida/9 "emember what we said about the limitations of l/ing9,

1he Aftermath: +o 1hen %hat6

%e can't sa/ e)actl/ how long the stock market will be closed0 but it could be months0 not da/s9 It can't last fore#er because at some point man/ of the people who got caught holding on to their stocks when the market closed will need to sell their stocks9 1he/ ma/ need to co#er une)pected e)penses0 a lack of cash flow0 or an/ of the other problems that come up that force people to sell their assets no matter how low the price ma/ alread/ be9 %hen the market does finall/ reopen0 it will look dramaticall/ different than it does toda/9 It's not Pust a matter of losing all the bubble #alue that's been building up for A@ /ears9 In#estor confidence will ha#e been de#astated9 %ill the financial industr/ or what's left of it0 an/wa/ admit at this point what the problem reall/ was6 %e're not optimistic9 1he problem will continue to be things like irrational fear0 political mistakes0 and other nefarious forces9 It's the earlier prices that were the correct ones0 if onl/ e#er/one would realiMe it9 .)pect that drumbeat to continue for a long time9 But0 sooner or later0 people will understand what happened: %e had a bubble econom/ and it's not coming back9 And the road to reco#er/ will be a long and difficult one9 It won't be fueled b/ low interest rates and o#ere)tended debt0 but b/ slow and stead/ growth dri#en b/ real producti#it/ gains the same wa/ we built the 39+9 econom/ into the most powerful in the world9

1he 5oral
In case we ha#en't made this clear /et0 let's sa/ it one more time: 1he ke/ is to get out earl/9 *ou ma/ often hear about opportunit/ costs and kick /ourself when a stock rises after /ou'#e sold it9 But it should be clear b/ now that an/ potential shortEterm gains are nothing compared to the cost of sta/ing in the markets too long9 1he fall is likel/ to be sudden and unpredictable0 and it's eas/ to get trapped9 1hose who wait until things ha#e alread/ started to collapse will find themsel#es surrounded b/ a massi#e sellEoff0 and e#er/one cannot fit through the e)it door at the same time9 -or those who do get out earl/0 though0 life can be prosperous for /ears to come much more so e#en than before the Aftershock9 1hink of all the people who put their assets into gold during the 7@@H crisis when it was below RH@@NoM9 1he/'re prett/ ecstatic right now0 and gold will onl/ go up faster when times get trul/ tough for other in#estments9

*ou're (ot Alone People Are Alread/ 5o#ing ?ut in Big (umbers

If /ou think /ou are alone in being ner#ous about the stock market0 /ou are not9 .normous numbers of indi#idual in#estors are lea#ing the market9 "emember the chart on the massi#e continuous outflows from stock mutual funds o#er the past few /ears despite the big rebound in the market6 5an/ people sa/ this is stupid mone/ lea#ing the market9 As we said earlier0 this is not stupid mone/ lea#ing the market0 as stock cheerleaders would ha#e /ou belie#e9 It is people who aren't in#esting ?P5 :other people's mone/; so the/ reall/ need to protect their capital and be careful not Pust keep their highEpa/ing mone/ management Pobs b/ in#esting in a stock market that is not performing and has increasing risks of a longE term downturn9

1he -act that the Alternati#es Aren't 2er/ &ood 4oesn't 5ean *ou +hould 4o (othing

A lot of in#estors are concerned about the econom/ and agree with much of what we sa/9 $owe#er0 since the alternati#es like gold are uncomfortable0 and other alternati#es like 1IP+ or cash don't earn much mone/0 the/ decide it is best to do nothing and Pust sta/ in the market9 3nfortunatel/0 this is a big mistake long term9 As we Pust e)plained0 /ou can get caught in a market downdraft and not be able to get out quickl/9 Also0 the fact that there are no good alternati#es doesn't mean /ou should sta/ in and lose a lot of /our mone/9 1here's a popular m/th that there is a bull market somewhere all the time9 1his simpl/ isn't true and hasn't e#er been true9 %hen Charlie 5errill :coEfounder of 5errill 8/nch; told his colleagues in 1I7H that it was time to get out of the market it wasn't because he had spotted a bull market elsewhere9 $e didn't tell his colleagues to mo#e out of stocks and put the mone/ in another in#estment9 $e told them to get out period9 *es0 there weren't man/ good alternati#es other than cash9 .#en gold was a bad alternati#e9 And0 /es0 he was earl/9 5an/ who took his ad#ice probabl/ kicked themsel#es for missing out on the big gains in stocks that their friends were getting after the/ sold too earl/9 But0 he was still right9 8ong term0 his colleagues that simpl/ got out of the market were much better off than those who sta/ed in9 $a#ing a good alternati#e to stocks was quickl/ shown to be irrele#ant9 1he ke/ was to get out before /ou lost /our mone/9

1he Cartoon that +ums It All 3p

%e end this book with our best and most important cartoon9 .#er/bod/ lo#es a bubble and no one wants to lose it9 1hat's perfectl/ reasonable9 But when the bubbles burst0 it's time to mo#e on and recogniMe that a new era of in#esting has begun9 3nfortunatel/0 what man/ people want is to think that the bubble will somehow come back9 1his is fantas/ :a great fantas/0 but a fantas/ nonetheless;9 .#en worse0 it makes /ou blind to other bubbles9 +o we use the cartoon below as a fun wa/ to tell an important message9 8ea#e this book with a laugh9 $umor has been and alwa/s will be a #aluable commodit/9 *ou'll need e#en more of that in the future and0 unlike other commodities0 it won't fall in #alue0 e#en with a greater suppl/9 1here will alwa/s be strong demand for good humor9

+ta/ing Afloat in a +inking .conom/

It's one thing to read about the changing macro econom/J it's another to actuall/ do something about it9 5ost people will take no new actions until it's too late9 -or those who want to prepare for0 not Pust react to the coming Aftershock0 we offer the following ser#ices: *ou are welcome to #isit our website www9aftershockpublishing9com for more information as we approach the Aftershock9 %hile /ou are there0 /ou ma/ sign up for a twoE month free trial of our popular Aftershock In#estor's "esource Package :I"P;0 which includes our monthl/ newsletter0 li#e conference calls0 and more9 ?r /ou ma/ reach us at G@AEGHGE@1AI or infoYaftershockpublishing9com 9 %e also offer Pri#ate Consulting for indi#iduals0 businesses0 and groups9 Please contact coauthor Cind/ +pitMer at CCAEIH@EGAFG or tellmemoreYaftershockconsultants9com for more information9 1hrough our in#estment management firm0 Absolute In#estment 5anagement 0 we pro#ide handsEon0 AftershockEfocused asset management ser#ices on an indi#iduall/ managed account basis9 -or details0 please call G@AEGGCEAD7@ or eEmail absoluteYaftershockpublishing9com 9

.pilogue

If0 after reading this book or an/ of our books0 /ou think America has made mistakes0 /ou're right9 If /ou think America has somehow lost its abilit/ to change and impro#e itself0 /ou're wrong9 In fact0 the 3nited +tates is still0 and will likel/ be for decades to come0 the most resilient0 fle)ible0 and d/namic econom/ in the world9 1hat's due in part to one of the world's most fle)ible0 d/namic0 and strongest political s/stems9 %hile the short term ma/ be filled with man/ seemingl/ insoluble problems0 don't be fooled9 1he long term is #er/ bright indeed9 5ore than an/ other countr/0 the 3nited +tates has been able to forge a path toward greater producti#it/ and higher standards of li#ing9 5an/ countries ha#e benefitted from the groundbreaking work of the 3nited +tates9 China didn't grow so fast because it was able to inno#ate on its own9 It grew so fast because it adopted the methods of free markets and efficient industrial production0 man/ of which were pioneered or perfected b/ the 3nited +tates9 ?ther countries around the world ha#e grown and benefitted as well b/ simpl/ watching the 3nited +tates and learning how it's done9 (ot onl/ can the/ learn directl/ from our uni#ersities0 but the/ can #isit our countr/0 see our go#ernment0 form Point #entures with our corporations0 and recei#e our in#estment and the business acumen that often comes with it e#er/thing /ou need to mo#e an/ de#eloping econom/ forward9 (o0 we're not the onl/ countr/ who has pioneered better methods for greater producti#it/9 But no nation has pioneered in more wa/s than the 3nited +tates9 -rom our re#olution for democrac/0 which has inspired and changed the world0 to our economic s/stem that has led to the most rapid increase in producti#it/ in human histor/0 we ha#e led the world in man/ of its most important and beneficial changes9 1hat we ha#e been distracted b/ our economic bubbles and awa/ from our relentless focus on producti#it/ in the pursuit of eas/ mone/ is understandable9 It's a regrettable and costl/ mistake9 But it's a mistake we will learn from9 B/ focusing again on impro#ing producti#it/0 the econom/ will rebound to a much0 much higher standard of li#ing than toda/9 1he 3nited +tates has shown time and again it can lead itself0 and the world0 forward in impro#ing both producti#it/ and qualit/ of life9 1he two are b/ no means mutuall/ e)clusi#e9 In fact0 the/ are mutuall/ dependent9 But0 like all our changes in the past0 the ones in the future will be no different9 1he/ will not be bestowed on us9 %e will ha#e to make them9 1he/ will be difficult and contro#ersial9 1hat's nothing new for the 3nited +tates9 %e ha#e done it before0 and we will do it again9 %hat's new for the 3nited +tates is that in this bubble econom/0 we ha#e lost that willingness to change and to be contro#ersial9 1o throw out a king and establish a democrac/ in 1GGF was about as contro#ersial as an/ countr/ had e#er been9 (ow0 we ha#e become more like other countries9 It's not that all other countries ha#e done poorl/0 but the/ surel/ ha#en't done as well as the 3nited +tates9 ?ur abilit/ to change quickl/0 effecti#el/0 and beneficiall/ has been far be/ond what an/ other countr/ has shown in the past two centuries9 1hat abilit/ is still there but will need to be rekindled9 After this bubble econom/ falls0 the rekindled spirit of America will rise again9

Appendi): Additional

Background

on +tocks and Bonds

In Chapter C :on stocks; and Chapter D :on bonds;0 we purposel/ left out some of the more technical details in order to not interrupt the flow of the chapters9 (ot e#er/one wants so much information0 and we wanted to focus primaril/ on the e#ol#ing macroeconomic stor/ that will lead us to the coming Aftershock9 After all0 it is prett/ eas/ these da/s to look up definitions online or in con#entional in#estment books0 but harder to find information about what is reall/ going on0 from our nonScon#entional point of #iew9 %e saw no point in gi#ing /ou /et one more mainstream in#estment guide9 +o here are some of those more technical details we left out of the chapters9 1his is hardl/ an e)hausti#e guide0 but it will gi#e /ou a bit more background on stocks and bonds if /ou ha#e an interest9 -or more information than the brief e)planations here0 we recommend /ou #isit some educational web sites0 such as www9in#estopedia9com and others9

+tocks

Basicall/0 when /ou bu/ a stock0 /ou are making a bet that the future earnings of a compan/ will grow9 1he compan/ initiall/ sells stock certificates in order to raise capital0 and the stockholders then own a part of the compan/9 After the initial offering0 compan/ stocks can then be sold and bought on the stock market in a giant trading game0 where those who want to bet on more future growth are bu/ers and those who are done with their bet :at least for the moment; are sellers9 8ike an/ in#estment0 traders naturall/ want to sell for more than whate#er the/ paid to bu/ that is the onl/ wa/ to make a profit on /our stock in#estment9 ?nce /ou sell and realiMe a profit on /our in#estment0 /ou generall/ ha#e to pa/ ta)es on that capital gain9 ?f course0 there is much more to the stor/9 $ere are the stock topics we will discuss in this appendi): 3nderstanding the public offering <nowing the difference between common stock and preferred stock ?ptions for bu/ing stocks 5aking sense of stock and compan/ data 3sing a registered in#estment ad#iser +ecurities In#estor Protection Corporation :+IPC; protection <nowing /our options for =short> selling0 including put options and longEterm equit/ anticipation securities :8.AP+;

3nderstanding the Public ?ffering

1he goal of an/ wellErun compan/ is to keep growing9 In order to do this0 a business requires capital9 In the earl/ stages0 a business might rel/ on earnings0 pri#ate equit/0 bank loans0 or bonds9 But0 e#entuall/0 man/ businesses turn to the public offering0 allowing common in#estors to bu/ shares in the business in e)change for the opportunit/ to profit from the compan/'s growth9 1hese in#estors ma/ also get a #oice in determining the compan/'s direction0 but with onl/ a percentage of the compan/'s #alue up for grabs0 and shares going in #arious portions to numerous in#estors0 the #oice is a small one9 1o begin an initial public offering0 or IP?0 a compan/ generall/ goes through an in#estment bank0 which assesses the #alue of the compan/ and underwrites the sale9 1hat is0 the in#estment bank purchases the portion of the compan/ that's being sold assuming all risk for the compan/'s #alue then di#ides up the shares and sells them to the general public0 the =primar/ market9> 1he bank then collects a small fee while passing on the proceeds to the compan/9 B/ =small fee> we mean percentageEwise9 If /ou were an in#estment bank selling R1F billion worth of -acebook shares0 for e)ample0 a G percent fee would amount to more than R1 billion9 (ot a bad pa/da/9 ?nce the initial shares ha#e been purchased0 the/ are tradable on the open market0 or =secondar/ market9> All the maPor stock markets /ou'#e heard of the (ew *ork +tock .)change0 the (asdaq0 the 8ondon +tock .)change0 for e)ample are secondar/ markets9

<nowing the 4ifference between Common and Preferred +tock

Common stock is generall/ what we mean when we discuss the stock market9 A common stock represents an ownership share in a compan/0 which0 in addition to in#esting the shareholder in the future of that compan/0 often grants the shareholder certain #oting rights0 such as in electing the compan/'s board of directors9 (ote that we said that common stock in#ests the shareholder in the future of that compan/9 1hat's important because0 generall/ speaking0 the compan/ doesn't owe common stockholders an/thing other than due diligence in managing the compan/'s affairs9 If the compan/ grows and the #alue goes up0 the shareholders are happ/9 If it falters and the price goes down0 the/ ma/ be unhapp/ and the/ ma/ complain0 but there isn't much the/ can do about it0 other than sell their shares at a cheaper price and take their mone/ elsewhere9 1his is wh/ common stock is among the most #olatile in#estments: plent/ of room for growth0 but plent/ of room for losses0 too9 Common stocks are traded on stock e)changes all o#er the world9 1he oldest e)change in the 3nited +tates is the Philadelphia +tock .)change0 established in 1GI@9 1he largest e)change in the countr/0 and in the world0 is the (ew *ork +tock .)change :(*+.;0 located on %all +treet0 along with the American +tock .)change0 or the =Ame)9> ?ther maPor e)changes in the 3nited +tates are located in Boston0 Chicago0 Cincinnati0 and +an -rancisco9 *ou'#e probabl/ also heard of the (asdaq0 the world's first electronic stock e)change9 A primar/ e)change for highEtech business0 the (asdaq has among the highest trading #olume of an/ market in the world9 5an/ common stocks pa/ di#idends on a quarterl/ basis0 di#iding up their profits among shareholders9 +ome pa/ more than others9 $ighEdi#idendEpa/ing stocks can be a strong incenti#e for in#estors0 but keep in mind that di#idends are optional0 and if a compan/ starts to struggle0 common stock di#idends are often the first thing to go9 Preferred stock0 in addition to representing a share in the compan/0 also represents a debt obligation from the compan/ to the shareholder9 Before an/ di#idends are paid to holders of common stock0 the compan/ must pa/ a fi)ed di#idend to preferred shareholders9 And in the e#ent of liquidation and an/ monetar/ distributions that might come from it0 preferred shareholders are in line ahead of common shareholders0 who usuall/ won't recei#e an/ compensation at all :although preferred shareholders are still behind bondholders;9 ?f course0 the preferred shareholders don't alwa/s get their di#idends either9 1his is what makes preferred stock a useful tool for companies that need to raise capital9 Because preferred stock is a h/brid in#estment not quite a stock0 not quite a bond companies ha#e some fle)ibilit/ in choosing to defer di#idend pa/ments when capital is running low9 Preferred stocks are rated Pust like bonds0 but the/ naturall/ come with lower ratings to begin with0 and a compan/'s credit won't be affected too significantl/ b/ holding off on di#idend pa/ments to preferred stockholders9 :4oing the same thing to bondholders would be a default and carries maPor consequences9; +o preferred stockholders don't ha#e all the rights that bondholders ha#e0 and the/ also don't ha#e all the rights that common stockholders ha#e9 5ost notabl/0 preferred shareholders ha#e no #oting rights in the compan/0 e)cept in certain special circumstances9 Also0 preferred shares usuall/ come with a call feature0 which allows the compan/ to repurchase the shares at its discretion9

?ptions for Bu/ing +tocks

If /ou want to bu/ a stock0 /ou don't walk down to %all +treet0 hop on the trading floor and make /our bid9 *ou ha#e to ha#e a broker e)ecute the trade for /ou9 1raditionall/0 a broker offered an arra/ of ser#ices for clients0 getting to know their portfolios and pro#iding research and in#estment ad#ice0 and charging hea#/ commission fees in return9 1hese fullEser#ice brokers are still in abundance0 but a popular alternati#e that has de#eloped in recent /ears is the discount broker9 1hese brokers are for in#estors who don't need or want the handEholding of a fullEser#ice broker0 and instead Pust need a wa/ to e)ecute trades based on their own research and anal/sis9 4iscount brokers often charge a #er/ low0 flat fee for trades0 and often ha#e #er/ low minimum account balances0 so the/ are a popular wa/ to get in#ol#ed in stock trading for people who aren't read/ for :or don't want; a traditional broker9 But the/ also pin all responsibilit/ on the in#estor9 Another ad#antage of discount brokers is that0 unlike man/ fullEser#ice brokerage firms0 discount brokers don't risk their own mone/ in the market9 1his is important because accounts at a discount brokerage ma/ be in less Peopard/ in the e#ent of a maPor market downturn9 Plus0 discount brokers sidestep the temptation to unload their own bad positions on their clients0 a temptation that has gotten man/ fullE ser#ice brokerage firms in trouble9 %hether to go with a fullEser#ice or discount broker is a personal decision0 but if /ou're going to go with a fullEser#ice broker0 first0 be sure the/ reall/ know what the/'re doing and ha#e /our best interests at heart9 -urthermore0 e#en though someone else is doing much of the work for /ou0 /ou still ha#e a responsibilit/ to be an informed in#estor and to not let /ourself be pressured into positions /ou know aren't good for /ou9 Before deciding on a fullEser#ice broker0 it is important to check with the Central "egistration 4epositor/ :C"4;0 which will pro#ide /ou with information about an indi#idual broker's histor/0 including emplo/ment histor/ and an/ complaints filed b/ former clients0 as well as an/ rele#ant information about brokerage firms9

5aking +ense of +tock and Compan/ 4ata

If /ou decide to go with a discount broker and make /our own trades :or e#en if /ou ha#e a traditional broker and want to be better informed;0 /ou ha#e a wealth of realEtime information a#ailable to /ou thanks to the Internet9 8ooking at the data for a particular stock ma/ be daunting0 but the numbers aren't reall/ so complicated9 *ou'll see things such as the bid price :the last price a bu/er was willing to pa/ for it; and the ask price :the last price a seller was willing to sell it for;9 *ou'll probabl/ also see the range of prices the stock has sold for o#er the last /ear0 the a#erage dail/ trading #olume0 and the priceEtoEearnings0 or PN.0 ratio9 5ost financial web sites ha#e a ke/ for /ou to look up the more difficultEtoEunderstand numbers and how the/'#e been calculated9

3sing a "egistered In#estment Ad#iser

-or those looking for a little more help with their in#estments0 a registered in#estment ad#iser0 or "IA0 ma/ be the answer9 "IAs are basicall/ mone/ managers and will make decisions about /our in#estments based on /our goals and their own in#estment philosoph/9 "IAs often require large minimum in#estments0 t/picall/ at least R1@@0@@@ and possibl/ going as high as se#eral million dollars9 An "IA will manage /our in#estments through /our brokerage account0 with authoriMation to bu/ and sell assets on /our behalf9 1his sounds like a setEitEandEforgetEit strateg/0 and indeed "IAs can make trades without notif/ing the client e#er/ time0 but this doesn't mean in#estors should forego all responsibilit/ for their in#estments9 It's important to find an "IA who not onl/ understands /our financial goals but also shares /our macroeconomic #iew of the near and longerEterm future9 And it is also important to sta/ up on what's happening with /our mone/ and continuall/ confirming that it's in good hands9 "IAs collect their fees based on the total amount of funds under management0 generall/ ne#er more than A percent :usuall/ around 19D percent;9 1his gi#es an "IA a strong incenti#e to make mone/ for clients because0 unlike with a broker who collects fees based on commissions0 the success of an "IA's in#estments directl/ impacts the "IA's fees9 If /our assets shrink0 so does the "IA's takeawa/9 Be careful that /our "IA does not o#erl/ crowd /our portfolio with mutual funds9 Aside from the problems with mutual funds0 which we'll get to later0 remember that a mutual fund is a managed fund0 and /ou are alread/ pa/ing /our "IA for that9 If /our "IA hea#il/ uses mutual funds0 /ou are essentiall/ being charged twice for management0 pa/ing double the fees9

+IPC Protection

In order to protect in#estors when their brokerage firms go bankrupt0 Congress set up the +ecurities In#estor Protection Corporation0 or +IPC0 in 1IG@9 1he +IPC is a nonprofit organiMation that collects insurance fees from member brokerage firms in return for insuring customer accounts up to RD@@0@@@ each9 An/ brokerage firm that is part of the (ational Association of +ecurities 4ealers :(A+4; is a member of the +IPC9 1his pro#ides some peace of mind for in#estors0 and man/ brokers carr/ their own insurance on accounts in addition to the +IPC insurance9 But the problem is that these insurance policies0 like e#er/thing else0 are designed with the rare occurrence in mind9 1he/ aren't designed for a s/stemEwide failure in the markets9 1his is a big reason wh/ we prefer brokers that don't risk their own mone/ in the markets the/ are more likel/ to sur#i#e the future Aftershock9

3nderstanding +hort +elling0 Put ?ptions0 and 8.AP+

+hort selling is what some in#estors do when the/ think the price will go down9 +hort selling is effecti#el/ three transactions rolled into one9 1he first transaction is the sale of a stock at the current market price0 or close to it9 1he second transaction is borrowing that stock generall/ from the broker e)ecuting the trade in order to gi#e it to the bu/er9 -inall/0 the third transaction is bu/ing the stock later when the loan period is o#er to repa/ the broker and hopefull/ make a profit :assuming the bu/ing price is lower than the earlier selling price;9 4uring the period between selling the borrowed stock and bu/ing the stock to repa/ the loan0 the in#estor has a =short> position in the stock or commodit/9 :In contrast0 if the in#estor owned shares of the asset0 that would be considered a =long> position9; If the asset price goes down during that period0 the in#estor makes mone/ b/ bu/ing it for less than he or she sold it for9 ?n the flip side0 if the asset price une)pectedl/ goes up0 the losses are potentiall/ unlimited0 since the short seller is obligated to bu/ the stock to pa/ back the original loan :plus an/ fees that might be associated with the loan;9 Put options are an alternati#e to short selling9 An in#estor can purchase a put option on a securit/0 which gi#es him or her the option to sell that securit/ at a specified price :the strike price; to the seller of the option during a specified time period9 If the price of the stock goes down during that time0 the bu/er of the put option can simpl/ bu/ the stock and sell it to the other part/ at the agreedEupon price0 pocketing the difference9 If the price doesn't go down and the bu/er doesn't e)ercise the option0 the loss is limited to the price of the put option9 A put option is the opposite of a call option0 which gi#es the bu/er the right to bu/ a securit/ at a specified price9 Put options :and call options0 for bu/ing instead of selling; are generall/ limited to terms of a /ear at most9 8.AP+ are like put options for a longer period of time9 8.AP+0 which is short for longEterm equit/ anticipation securities0 can ha#e terms e)tending more than two /ears9 ?ne quirk is that equit/ 8.AP+ alwa/s e)pire in Banuar/0 so the term is determined b/ the e)piration /ear of the option9 1he further out the e)piration date is0 the more e)pensi#e the option will be9

Bonds

A bond is essentiall/ a loan made to the bond issuer in e)change for future repa/ment of the principal of the loan plus interest9 2arious factors affect the interest rate offered on the loan0 which were discussed in Chapter D9 ?nce a bond is issued0 it ma/ be sold and bought on the bond market0 which adds la/ers of comple)it/ for a number of reasons9 Primar/ among these is the fact that current interest rates change0 making pre#iousl/ issued bonds either more #aluable or less #aluable0 depending on the details of the bond9 In addition0 other things change as well9 -or e)ample0 the creditworthiness of the bond issuers ma/ change o#er time0 which impacts the #alue of the bond on the bond market9 Also0 changes in the inflation rate matter0 too0 because if inflation goes up0 it subtracts from the #alue of the bond9 Chapter D pro#ides a basic e)planation of bonds and the bond market9 -or this discussion0 we will now focus on: 1he call 39+9 1reasur/s QeroEcoupon bonds and +eparate 1rading of "egistered Interest and Principal +ecurities :+1"IP+; 1reasur/ InflationEProtected +ecurities :1IP+; +a#ings bonds 5ortgageEbacked securities 5unicipal bonds Corporate bonds Certificates of deposit 5one/ market funds Bond sensiti#it/ to changes in interest rates and inflation

1he Call

.#en if an in#estor does not sell a bond for a gain when pre#ailing interest rates go down0 ha#ing a relati#el/ high interest rate locked in is a prett/ nice perk9 1his perk is eliminated if the bond has a call feature9 +ome indentures gi#e the bond issuer the option of pa/ing off the principal before the maturit/ date0 thus ending the debt obligation and an/ future interest pa/ments to the bondholder9 In man/ cases0 this option ma/ be triggered at a certain length of time into the bond's life span9 %h/ would a bond issuer want to do this6 Bust like if /ou wanted to pa/ off a mortgage earl/ and refinance at a lower rate0 the bond issuer would be at a great ad#antage b/ refinancing if interest rates go down9 It's eas/ to see that this feature benefits the bond issuer0 and onl/ the bond issuer9 If interest rates go down0 the issuer has e#er/ incenti#e to e)ecute the call feature0 refinance0 and lea#e /ou to find another suitable in#estment9 If interest rates go up0 howe#er0 when /ou would want the call feature to be e)ecuted0 the issuer has no moti#ation to refinance9 1he bond issuer can keep pa/ing /ou at a lower interest rate until the maturit/ date9 5an/ indentures ma/ specif/ a premium to be paid in the e#ent of a call0 but it is sure to be paltr/ compared to the interest that would be earned o#er the remaining life span of the bond9

39+9 1reasur/s

As the name suggests0 39+9 1reasur/s are bonds issued b/ the 1reasur/ 4epartment of the 3nited +tates9 %hen people talk about public debt in the 3nited +tates0 the/ are talking about outstanding 39+9 1reasur/s9 1reasur/ securities are owned in huge amounts b/ big go#ernment agencies and corporations0 such as the go#ernments of China and Bapan0 as well as our own -ederal "eser#e0 but these securities can be purchased b/ indi#idual or institutional in#estors9 Backed b/ the full faith and credit of the 39+9 go#ernment0 39+9 1reasur/s ha#e traditionall/ enPo/ed the highest in#estment grade awardable9 As a result0 the/ tend to offer among the lowest /ields of an/ bonds0 but this is acceptable to man/ in#estors0 who #iew our 1reasur/s as risk free9 1his #iew took a small hit in the summer of 7@11 when +tandard K Poor's downgraded the 1reasur/s credit rating to AA]0 after G@ /ears at AAA0 but 39+9 1reasur/s are still considered a rockEsolid in#estment0 especiall/ gi#en the current turmoil and potential risks in .urope9 Another reason wh/ 1reasur/ securities can afford to offer low /ields is that the interest paid on them is not subPect to state and local ta)es9 1his makes 1reasur/s especiall/ attracti#e to in#estors in states with high income ta) rates0 but less so to those in states like 1e)as or %ashington with no indi#idual income ta)9 1reasur/ interest is0 howe#er0 subPect to federal income ta)9 +tandardEissue 1reasur/s are di#ided into three categories based on their lengths of maturit/9 1reasur/ bills0 or 1Ebills0 usuall/ range from I@ da/s to 17 months0 1reasur/ notes from 7 to 1@ /ears0 and 1reasur/ bonds up to A@ /ears9 <eeping this terminolog/ straight can be difficult0 and /ou might hear some people use the terms interchangeabl/ if the/ don't know the difference9 If /ou ha#e trouble remembering which is which0 the blanket term 1reasur/s works Pust fine :as long as /ou know when the maturit/ date is0 of course;9 5ost 1reasur/ securities make pa/ments Pust like an/ other bond9 1Ebills0 howe#er0 don't make interest pa/ments due to their short maturit/9 Instead0 /ou bu/ the bill at a discount0 and recei#e the full face #alue at the maturit/ date9 1he difference between the price /ou pa/ and the amount /ou recei#e is the interest9

QeroECoupon Bonds and +1"IP+

A MeroEcoupon bond is Pust what it sounds like: a bond with no coupons9 Interest is accrued and rein#ested in the bond to be paid back in one sum at maturit/9 In man/ cases0 this means ta)es must be paid on the interest before the in#estor recei#es it9 1his drawback can be eliminated b/ purchasing MeroEcoupon bonds through an indi#idual retirement account :I"A;9 +1"IP+ are another kind of MeroEcoupon bond9 Back when bonds were issued on paper0 the/ would literall/ ha#e their coupons =stripped> b/ brokers before sale9 An e)ample of this t/pe of bond is 39+9 1reasur/ +1"IP+0 which are not sold b/ the 1reasur/ itself but through pri#ate brokers9 1he bond is separated from its coupon pa/ments and sold b/ itself at a discount9 As a result0 ta)es on rein#ested interest are not an issue with these bonds9 1he difference between the amount paid on the market and recei#ed at maturit/ represents a capital gain9 1he market #alue of MeroEcoupon bonds tends to be subPect to more #olatilit/ than that of regular bonds9 Be careful about purchasing MeroEcoupon bonds if /ou're not planning on holding them until maturit/9

1IP+

1IP+ are designed to keep the bondholder's in#estment current based on inflation9 1IP+ come with fi)edE interest pa/ments Pust like other 1reasur/s0 but the principal amount is adPusted twice a /ear0 according to the current Consumer Price Inde) :CPI;9 -or e)ample0 if /ou in#ested R1@0@@@ in 1IP+ at a rate of @9D percent0 /ou would continue to recei#e that @9D percent annual interest until maturit/0 but /ou might be earning @9D percent interest on R1@0D@@ or R110@@@ at some point0 depending on current inflation9 1he fi)ed rate of 1IP+ tends to be relati#el/ low0 and in fact we ha#e e#en seen it effecti#el/ drop below Mero recentl/9 %hen fear of inflation is up0 man/ in#estors are willing to take a small hit now in order to protect themsel#es from inflation later9 :1his doesn't mean that bondholders will get a bill when the coupon pa/ments are due9 %hat happened is that bidders agreed to pa/ a small premium for these bonds at auction0 and the premium effecti#el/ canceled out the e#en smaller coupon pa/ments at the current rate and then some9; If inflation rises significantl/0 the par #alue of these bonds goes up and a bondholder can come out ahead9 %e will discuss inflation and its effect on bonds a little later9

+a#ings Bonds

3nlike other 1reasur/ securities0 39+9 sa#ings bonds are not e)changed on the open market9 1he/ are tied to the bondholder's +ocial +ecurit/ number :or ta) identification number;0 which means no one but the bondholder can redeem them9 +a#ings bonds can be purchased in man/ different denominations :R7D and up;0 which0 along with the fact that the/ can be owned b/ minors0 has made them a fa#orite in#estment tool for parents and grandparents to gi#e to children0 often to sa#e for education9 +a#ings bonds are MeroEcoupon bonds0 so both principal and interest are paid in one sum when the bond is redeemed9 Interest is accrued regularl/0 and the current #alue of an/ gi#en sa#ings bond can be calculated at www9treasur/direct9go# 0 though there is a small penalt/ if /ou redeem before fi#e /ears ha#e passed since issue9 Current sa#ings bonds offered are the +eries .. :formerl/ +eries .; and +eries I bonds9 +eries .. bonds ha#e a maturit/ of 7@ /ears0 but continue to earn interest for another 1@ /ears after maturit/9 -ormerl/0 the interest rate on +eries .. bonds was adPusted based on current rates0 but bonds issued after April 7@@D earn a fi)ed rate9 Patriot bonds are a paper #ersion of the +eries .. bond9 As of Banuar/ 7@170 these bonds :along with all paper 1reasur/s; are no longer a#ailable9 +eries I bonds are sa#ings bonds that are linked to inflation0 much like 1IP+9 +eries I bonds come with two different interest rates: a fi)ed rate that doesn't change o#er the course of the bond's term0 and a #ariable rate that is adPusted twice a /ear based on the CPI9 1he adPustable rate might be negati#e during times of deflation0 but the combined rate of the bond cannot fall below Mero percent9

5ortgageEBacked +ecurities
5ortgageEbacked securities include those issued b/ go#ernmentEsponsored agencies &innie 5ae :&o#ernment (ational 5ortgage Association;0 -annie 5ae :-ederal (ational 5ortgage Association;0 and -reddie 5ac :-ederal $ome 8oan 5ortgage Corporation;0 as well as some securities issued b/ pri#ate corporations9 &innie 5aes are unique among the group in being backed b/ the full faith and credit of the federal go#ernment0 Pust like 1reasur/ securities9 5ortgageEbacked securities are issued using a pool of home mortgages as collateral9 Because most mortgages are paid monthl/0 most of these securities pa/ interest monthl/ as well9 Because mortgage loan principal is prepaid in #arious wa/s and at #arious times :such as e)tra pa/ments or pa/ing it off all at once;0 the time to maturit/ #aries widel/9

5unicipal Bonds

5unicipal bonds0 or munis0 are issued b/ state and local go#ernments to finance new proPects or to impro#e infrastructure9 5unis ha#e the ad#antage that interest paid is e)empt from federal ta)es0 and in some cases from income ta)es in the state in which the bonds are issued9 1here are two principal t/pes of municipal bonds9 &eneral obligation bonds are backed b/ the full faith and credit of the issuing go#ernment0 based on its abilit/ to raise re#enue through ta)es9 "e#enue bonds are backed b/ re#enue to be raised from the specific proPect the bonds are funding for e)ample0 if the bonds are being used to finance the building of a toll road or an airport9 1he ta) ad#antage is generall/ the ke/ attraction for these bonds9 1he higher ta)es /ou normall/ pa/0 the more attracti#e munis become9 1he wa/ to assess the #alue of a ta)Ee)empt interest rate is to calculate its ta)ableEequi#alent /ield9 1he formula is to take the /ield of the ta)Ee)empt bond and di#ide b/ 1 minus /our ta) bracket percentage9 -or a bond e)empt from state ta)es0 /ou would combine federal and state ta) percentages in the calculation9

Corporate Bonds

Pri#ate corporations also issue bonds in order to finance andNor e)pand their business operations9 5an/ companies that issue corporate bonds also ha#e shares traded in public stock markets9 But owning a corporate bond is #er/ different than owning a share of a compan/9 %hen /ou bu/ stock in a compan/0 /ou are bu/ing ownership in the compan/0 and the #alue of the share will rise or fall in accordance with the compan/'s market #alue9 *ou might recei#e di#idends from compan/ earnings0 but this is not at all guaranteed :especiall/ if the compan/ has no earnings;0 and di#idend pa/ments can be #er/ low compared to the stock price9 But when /ou purchase a corporate bond0 /ou are making a loan to the compan/0 which has an obligation to return /our principal and make interest pa/ments9 If the compan/'s fortunes rise0 /ou will still get onl/ the amount that was agreed to in ad#ance9 *ou might lose /our in#estment if the compan/ goes bankrupt0 but as a creditor /ou will be ahead of shareholders :e#en preferred shareholders; in line to recei#e mone/ in a bankruptc/ settlement9 +o while purchasing bonds has a speculati#e element to it0 it is not nearl/ as speculati#e as purchasing stock9 5ost corporate bonds are unsecured0 meaning the debt is not tied to an/ collateral0 and the bondholder is rel/ing on the general credit and continued sol#enc/ of business9 +ecured bonds ma/ be backed b/ claims on specific assets of the compan/0 possibl/ including new equipment that the bonds were used to purchase9 ?ther bonds ma/ be backed with stocks and other securities0 or can e#en be guaranteed b/ a compan/ other than the bond issuer9 ?wners of secured bonds will take priorit/ o#er owners of unsecured bonds in the e#ent of bankruptc/9 Corporate bonds are a#ailable on the (ew *ork +tock .)change or o#er the counter :directl/ from the issuing companies;9 1he ad#antage of corporate bonds is that the coupons tend to be higher than go#ernmentEissued bonds9 But0 of course0 these higher /ields come with higher credit risk9 +ome in#estors will take the higher risks along with the higher pa/ments0 e#en going after Punk bonds issued b/ companies with poor credit ratings9 But if capital preser#ation is /our goal0 corporate bonds are generall/ not /our best bet unless /ou stick with rockEsolid companies with great track records0 and onl/ if /ou get out well before the Aftershock hits9

Certificates of 4eposit

Certificates of deposit :C4s; beha#e similarl/ to MeroEcoupon bonds0 in that /ou deposit mone/ for a certain amount of time0 and recei#e principal and interest back at maturit/9 1he differences are that C4s are offered specificall/ b/ financial institutions to their customers and that the/ are usuall/ insured b/ the federal go#ernment9 C4s fall under the categor/ of time deposits0 meaning /ou lock up /our mone/ for the specified period0 and the/ cannot be sold on the open market or called b/ the issuing bank before maturit/9 C4s tend to offer lower rates than comparable bonds0 but interest rates can #ar/ depending on a number of factors0 including the siMe of the principal0 the length to maturit/0 and the siMe and reputation of the financial institution0 among other factors9 ?n the plus side0 interest is usuall/ compounded monthl/0 which can be an ad#antage for deposits of longer time periods as long as interest rates don't rise9 3nfortunatel/0 both inflation and interest rates will rise0 and C4s will not fare so well9 Because the/ are guaranteed b/ the go#ernment0 C4s ha#e a reputation for being #irtuall/ risk free9 1hat is not a reputation that will sur#i#e the coming Aftershock9

5one/ 5arket -unds

If /ou'#e e#er had an account at a brokerage firm0 /ou ha#e probabl/ had cash in a mone/ market fund9 5one/ market funds in#est in a highl/ di#ersified pool of securities0 with maturities usuall/ no more than two or three months9 1hese include go#ernment bonds0 C4s0 and commercial paper :shortEterm0 unsecured debt obligations issued b/ corporations with rockEsolid credit;9 1he aim for a mone/ market fund is to keep a constant share price of R10 with /ields paid as di#idends that can be rein#ested9 1he short terms of the in#estments and the solid credit ratings of the issuers make mone/ markets #er/ low risk0 relati#el/ speaking9 If in#estments do fail and the share price of the fund falls below R10 it is referred to as breaking the buck0 something that is ne#er supposed to happen9 It was an especiall/ rare e#ent before +eptember 7@@H0 when 8ehman Brothers' bankruptc/ and the ensuing panic led to the 1reasur/ 4epartment's setting up an insurance program for man/ mone/ market funds9

Bonds 2ar/ in 1heir +ensiti#it/ to "ising Interest "ates

Changes in interest rates impact some bonds more than others9 8ongEterm bonds are much more reacti#e to interest changes than are shortEterm bonds9 8ongEterm bonds can punish or reward the bondholder long after interest rates ha#e changed9 +o it does not take much of an increase in interest rates to push the #alue of longEterm bonds down significantl/9 Changes in interest rates also ha#e a greater impact on the #alue of bonds issued b/ less reputable companies than on highEgrade bonds issued b/ solid corporations and agencies because of the combined concerns about both rising interest rate risk and credit risk9 Bonds rated from AAA to BBB are considered in#estment grade9 An/thing below BBBSor Baa is considered to be speculati#e9 1raditionall/0 most e)perts would ad#ise sticking onl/ with bonds among the A to AAA categories because the/ are considered the safest bets to get /our mone/ back0 e#en if the/ don't come with the highest interest rates9 $owe#er0 in this economic en#ironment0 it's sometimes necessar/ to look past a good rating9 .#en #er/ good ratings can drop #er/ quickl/ and une)pectedl/0 as we'll see later on9 1o limit the risk of rising interest rates0 man/ in#estors turn to inflationEprotected or floatingErate bonds0 such as 1IP+9 1hese are less sensiti#e to interest rate changes than fi)edEinterestErate bonds because the/ adPust with pre#ailing rates9 1herefore0 rising interest rates are not e)pected to lower the #alue of inflationE protected or floatingErate bonds as much as the/ will lower the #alue of fi)edErate bonds9 But do not be fooled into thinking that these floatingErate bonds will be risk free9 As interest rates go up0 credit risk will also go up significantl/9 "emember: It doesn't matter how good /our interest rate is if /our bond issuer is unable to pa/9 3nder normal economic circumstances0 bankruptcies are relati#el/ rare0 especiall/ among larger corporations and banks0 not to mention go#ernments9 And e#en when bankruptcies happen0 e#en debtors holding unsecured bonds still usuall/ end up getting back at least a portion of their principal from the settlement9 +o it is understandable that bonds0 especiall/ those issued b/ go#ernments and blueEchip companies0 ha#e traditionall/ been #iewed as safe from credit risk9 But there is one circumstance that is alwa/s bad for bonds: inflation9

Inflation0 Interest "ates0 and the Aftershock

1he con#entional wisdom is somewhat di#ided when it comes to the impact of inflation on stocks9 :+ome sa/ stock prices will rise with inflation0 which is true to some e)tent0 but it doesn't account for the rising interest rates that can kill earnings and hurt stocks in the long term9; But prett/ much e#er/one knows that inflation is poison to bonds9 If mone/ is losing #alue quickl/0 then t/ing it up for a considerable length of time at a fi)ed interest rate is a losing proposition9 %ith inflation at 7 percent0 a bond with a A percent coupon has a real interest rate of onl/ 1 percent9 But if inflation rises to D percent0 suddenl/ /our real rate of return is minus 7 percent9 *ou ma/ ha#e more dollars in the end0 but /ou are losing bu/ing powerJ /ou are losing wealth9 And the picture looks e#en worse if /ou spent /our coupon pa/ments along the wa/9 1he principal /ou get back when the bond matures will not be worth nearl/ as much as it was when /ou in#ested it9 (ow imagine inflation goes to 1@ percent annuall/0 or 7@ percent0 or higher0 and /ou see how destructi#e inflation can be9 But it is e#en worse than that9 "ising inflation0 as we ha#e said repeatedl/ in earlier chapters0 e#entuall/ causes interest rates to rise9 "ising interest rates onl/ hurts the #alue of e)isting bonds e#en more9 (ow /ou ha#e the double whamm/ of both falling #alue of /our mone/ due to inflation and falling #alue of /our bonds due to rising interest rates9 And0 unfortunatel/0 the bad news doesn't stop there9 (ot onl/ is inflation making /our mone/ worth less and not onl/ are rising interest rates making /our bonds worth less0 /ou also now ha#e to face another rising menace: increasing credit risk9 *ou see0 the entities that issued /our bonds ma/ #er/ well go out of business under these difficult conditions0 or at least be unable to repa/ /ou9 %e saw in the last chapter what rising inflation and higher interest rates can do to compan/ earnings9 3nable to refinance their debt without pa/ing high interest rates0 and caught in a spiral of la/ing off workers to sta/ afloat0 how will companies generate the new re#enues to pa/ off their e)isting debt obligations6 It is going to become harder and harder to do so9 And the problem will not stop with Pust corporate bonds from companies that can no longer pa/ their debts9 It will also e)tend to go#ernments that can no longer pa/ their debts0 whether it is state munis or 39+9 1reasur/s9 .#en C4s and mone/ markets will be in trouble9 As we'#e alread/ said0 there are factors dela/ing the onset of inflation9 But once it gets going0 it can snowball #er/ quickl/9 %hen inflation passes D percent0 as measured b/ the CPI0 and then approaches 1@ percent0 it will become impossible to ignore9 Interest rates will rise regardless of what the -ed wants0 as lenders become cautious to tie up their cash and get it back at a lower #alue9 %e alread/ know that inflation eats awa/ at a bond's #alue0 and the rising interest rates that follow hurt bonds in the secondar/ market9 -or e)ample0 with 1@E/ear 1reasur/ rates ho#ering around 797 percent as of 5arch 7@170 imagine how much the #alue of these bonds would fall if inflation hit double digits less than halfwa/ into their li#es9 But this is onl/ the beginning of the problem9 In a bubble econom/ o#ere)tended with debt and artificiall/ proppedEup markets0 inflation is the first big trigger to send it all toppling down9 1he first casualt/ will be the housing market9 (ew home purchases will be out of reach for most at higher interest rates9 And homeowners who are alread/ in precarious debt situations will not be able to make pa/ments on adPustableErate mortgages9 %hen real estate prices fall accordingl/0 e#en homeowners who were once in relati#el/ stable positions will find themsel#es underwater0 and new debt defaults will spike upward9 Banks will be forced to write off huge amounts of loans9 5ortgageEbacked securities will fail9 Insurance and deri#ati#es meant to protect against failure will turn out to ha#e little #alue when e#er/one is o#ere)tended9 -ailures lead to go#ernment bailouts9 Bailouts mean more mone/ printing9 5ore mone/ printing means more inflation9 And the #icious c/cle continues9 Clearl/0 inflation cannot go up significantl/ without also raising interest rates9 %ho in the world will lend an/one an/ mone/ if the/ cannot at the #er/ least be compensated for what the/ will lose to inflation6

1hat means if inflation is 1@ percent0 interest rates will ha#e to be at least 11 percent for lenders to make e#en 1 percent on their mone/9 Interest rates will ha#e to e)ceed inflation9 %hen interest climbs0 in addition to harming businesses0 real estate0 stocks0 and corporate bond #alues0 we will ha#e one other de#astating problem: +tate go#ernments and the federal go#ernment will ha#e to make interest pa/ments on their debt with newl/ borrowed mone/ at the higher and higher interest rate0 adding e)ponentiall/ more and more to the total public debt as time goes on9 .#entuall/0 the/ will not be able to borrow more at an/ interest rate le#el because in#estors will ha#e no confidence in their abilit/ to repa/9 At that point0 the public debt bubble will pop and the borrowing will end9 %ithout newl/ borrowed mone/ and without the abilit/ to print more mone/ :due to high inflation caused b/ earlier mone/ printing;0 state and 39+9 go#ernments will not be able to pa/ on their debt and will be in default Pust like o#ere)tended homeowners0 businesses0 consumers0 and in#estors9

Inde) A Absolute In#estment 5anagement Achuthan0 8akshman Aftershock Aftershock :%iedemer; +econd .dition update Aftershock wisdom in#esting Buffett0 %arren con#entional wisdom0 ke/ to denial0 protecting status quo with falling bubble econom/0 in#esting in

4/namic 4i#ersified Aftershock Portfolio0 creating hedge funds

ke/ to

deflation0 m/th of future inflation mone/ printing

natural growth rate0 m/th of producti#it/ growth0 slowing

=Airbags0> temporar/ American +tock .)change :Ame); America's Bubble .conom/ :%iedemer; Annuities9 +ee also Insurance0 whole life0 and annuities Argentina0 econom/ in B

Bank of .ngland Berkshire $athawa/ Bernanke0 Ben Best0 A9 59 Bond ladder Bonds acti#e management

mortgageEbacked securities 1Ebills and 1reasur/ notes0 shortEterm 1IP+ in Aftershock and be/ond

before and during Aftershock

confidence in

con#entional wisdom on wh/ it is wrong e)iting failure0 three stages of

stage 1: recent past and now stage 7: shortEterm future stage A: mediumEterm future risk

credit interest rate time technical details

call certificates of deposit :C4s; corporate bonds mone/ market funds mortgageEbacked securities municipal bonds sa#ings bonds sensiti#it/ to rising interest rates +1"IP+ 1IP+ 39+9 1reasur/s MeroEcoupon bonds t/pes of

total return

calculating capital gains changes in coupon Book #alue Bubble blindness Bubble econom/9 +ee also 39+9 econom/ Aftershock wisdom

America's

consumer discretionar/ spending bubble dollar bubble pri#ate debt bubble real estate bubble stock market bubble bubble blindness

definition of downward spiral of temporar/ =airbags> rising future inflation future inflation and rising interest rates go#ernment debt bubble recogniMing Bubblequake Buffett0 %arren C

Call :bond; Capital goods sector0 impact of falling bubbles on businesses

Pobs

CaseE+hiller $ome Price Inde) Central "egistration 4epositor/ :C"4; Certificates of deposit :C4s; Chanos0 Bim China bubble econom/ in

econom/'s effect on commodities

gold in

growth rate in

quantitati#e easing in

realistic #iew of :Chanos;

Commodities0 in#esting in Common stock Consumer discretionar/ spending bubble Consumer Price Inde) :CPI; Con#entional wisdom :C%;0 ke/ to Corporate bonds Credit risk Current /ield 4 4efined benefit pension plans 4efined contribution plans 4eflation0 m/th of changing demographics declining a#ailable credit

eliminating e)tra printed mone/ falling prices reduced mone/ suppl/ due to debt writeEoffs and bankruptcies 4iscounted cash flow :4C-; model 4iscretionar/ spending bubble 4iscretionar/ sector0 impact of falling bubbles on businesses Pobs 4ollar bubble 4ow Bones Industrial A#erage 4utch tulip bubble . .conomic C/cle "esearch Institute :.C"I; .conomists .mergenc/ Banking Act .state planning0 Aftershock assets capital losses estate ta)es probate .urope0 financial crisis in .uropean Central Bank :.CB; .)changeEtraded funds :.1-s; short bond short stock

.)ile on %all +treet :5a/o;

-

-ederal debt9 +ee also &o#ernment debt bubble -ederal .mplo/ees "etirement +/stem :-."+; -ederal "eser#e stock market0 inter#ention in

-inancial ad#isers -isher0 Ir#ing =-ool in the +hower> analog/ :-riedman; -oreign currencies0 Aftershock in#esting in -oreignEheld 39+9 assets0 growth of -riedman0 5ilton &

&old acti#el/ managed portfolio

Aftershock strateg/ for

bubble

bu/ing

coin dealer or online dealer e)changeEtraded funds gold depositor/ gold mining stocks le#eraging con#entional wisdom on

wh/ it is wrong histor/ of in#esting in rising price0 three stages of

before and during Aftershock stage 1: recent past and now stage 7: shortEterm future stage A: mediumEterm future &o#ernment debt bubble9 +ee also -ederal debt growth of

&raham0 BenPamin &reat 4epression &reece0 econom/ in &reenspan0 Alan &ross domestic product :&4P; $ =$amptons .ffect> 1he $edge -und 5irage :8ack; $edge funds I Indi#idual retirement accounts :I"As; rollo#ers +a#ings Incenti#e 5atch Plan for .mplo/ees :+I5P8.;

+implified .mplo/ee Pension :+.P;

Inflation future

and rising interest rates Initial public offering :IP?;

Insider selling Insurance0 whole life0 and annuities Aftershock strateg/ for

acti#e management annuities bondEdependent insurance health0 auto0 and home insurance life insurance longEterm care and disabilit/ insurance con#entional wisdom on annuities longEterm care and disabilit/ insurance whole life insurance wh/ it is wrong e)iting in#esting in Interest rate risk bond ladder0 creating Interest rates0 Aftershock and International equities0 in#esting in Internet stock bubble In#estment outlook bonds .urope gold international equities sil#er and commodities oil stocks In#estment portfolio0 Aftershock getting out earl/ ke/ components commodities e)changeEtraded funds :.1-s; foreign currencies gold stocks0 highEdi#idend 1IP+ 1reasur/s0 shorterEterm managing stock market holida/

strateg/

minimal #olatilit/ preser#ation of capital reasonable returns timing

go#ernment inter#ention inflation misleading indices and statistics Iran Ital/ B

Bapan0 quantitati#e easing in Bobs and businesses0 Aftershock college degree0 obtaining

con#entional wisdom about

wh/ it is wrong declining

economic sectors0 impact on

broader Pob trends capital goods sector discretionar/ spending sector necessities sector Pob sectors

opportunities <

<eogh retirement plan </nikos -und 8 8ack0 +imon 8e#eraged bu/out model of stock #aluation 8ife insurance9 +ee Insurance0 whole life0 and annuities 8iquidation #alue 8ongEterm care and disabilit/ insurance 8ongEterm equit/ anticipation securities :8.AP+; 5 5a/o0 5ike 5errill0 Charlie 5iller0 Bill 5onetar/ base 5one/ managers 5one/ market funds

5one/ printing9 +ee !uantitati#e easing 5ortgageEbacked securities 5ultibubble econom/9 +ee Bubble econom/ 5unicipal bonds general obligation re#enue (

(asdaq (atural growth rate0 m/th of (ecessities sector0 impact of falling bubbles on education Pobs and businesses

go#ernment Pobs and businesses health care Pobs and businesses (ew 5onetarist 1heor/ (ew *ork +tock .)change :(*+.; (orthwestern 5utual0 in#estment portfolio of ? ?il P

Patriot bonds Pension Benefit &uarant/ Corporation :PB&C; Preferred stock Preser#ation of capital Presidential election :7@17; PriceEtoEearnings ratio :PN.; PriceEtoEre#enue ratio Pri#ateEcompan/ #aluation Pri#ate debt bubble Probate Producti#it/ growth0 slowing Put options !

!uantitati#e easing :!.; b/ Bank of .ngland

in China

b/ .uropean Central Bank :.CB; ignoring =-ool in the +hower> analog/ :-riedman; in Bapan

" "eal estate bubble con#entional wisdom about wh/ it is wrong e)iting incomeEproducing propert/ problems with selling future prospects for commercial0 incomeEproducing farmland price0 inflation and primar/ home mortgage0 =underwater> in rental properties0 incomeEproducing second homes and #acation properties when to bu/ limited land0 m/th of opportunit/ costs prices0 dri#ers of real estate in#estment trust :".I1;0 in#esting in realit/ of "etirement0 Aftershock acti#e management of in#estments compan/ stock and stock options con#entional wisdom on wh/ it is wrong !KA retirement plans0 t/pes of defined benefit pension plans defined contribution plans indi#idual retirement accounts :I"As; federal emplo/ee plans plans for small businesses and selfEemplo/ed "eturns0 reasonable "iskEadPusted rate of return "oth C@1:k; + +a#ings bonds +a#ings Incenti#e 5atch Plan for .mplo/ees :+I5P8.; I"As

+ecurities In#estor Protection corporation :+IPC; +hiller0 "obert +hort selling +il#er and commodities0 in#esting in +implified .mplo/ee Pension :+.P; I"A +ocial +ecurit/ +pain +prott Asset 5anagement +tock market crash of 1I7I +tock market holida/ aftermath +tocks0 in#esting in acti#e management before and during Aftershock con#entional wisdom on wh/ it is wrong definition highEdi#idend market failure0 three stages of stage 1: recent past and now stage 7: shortEterm future stage A: mediumEterm future popularit/ of recommendations for technical details common stock initial public offering :IP?; 8.AP+ options for bu/ing preferred stock put options registered in#estment ad#iser :"IA;0 using short selling +IPC protection stock and compan/ data #aluation bookNliquidation #alue bubble discounted cash flow :4C-; model &raham0 BenPamin le#eraged bu/out model priceEtoEearnings ratio :PN.;

priceEtoEre#enue ratio pri#ateEcompan/ #aluation +1"IP+ 1

1a)Eequi#alent /ield 1hrift +a#ings Plan :1+P; 1ime risk 1reasur/ bills :1Ebills; shortEterm

1reasur/ bonds 1reasur/ notes 1reasur/ inflationEprotected securities :1IP+; 1reasur/s0 shorterEterm 3 39+9 econom/9 +ee also Bubble econom/ current reco#er/ of

-ederal "eser#e's ne)t steps go#ernment borrowing mone/ printing potential triggers of downtrend in China &reece Iran time0 passage of 39+9 1reasur/s 2 2olatilit/0 minimal % %hole life insurance9 +ee also Insurance0 whole life0 and annuities * *ield to maturit/ Q QeroEcoupon bonds