The Aftershock Investor: A Crash Course in Staying Afloat in a Sinking Economy (39 page)

TIPS are an investment you can keep for the longer term. Accordingly, it may also have a more difficult ride shorter term if inflation expectations decline for a while, as they could for the remainder of this year. Even though we think we will have higher inflation, it won’t necessarily be proven for a while. Nonetheless, TIPS have done well in the past, including a 13% rise in 2011. So we like this asset because it will rise when inflation rises. Thus, you are fairly well protected. Shorter term, though, you could get lower returns. Risk-averse investors may even want to skip short-term Treasurys and just use TIPS instead.

These are a trickier category because they are fairly volatile, especially now with the European debt crisis. It is a longer-term play. There is probably too much volatility now for most people to work with this asset category and not enough upside to make it worthwhile. However, longer term, when inflation rises and foreign investors become wary of the United States as a safe haven, the dollar will fall, and this will be a good buy. It’s hard to invest in any given currency because it can be affected by country-specific issues. However, a good and relatively stable one for the future will likely be Canadian dollars. The ETF for those is FXC. Another option is to short the dollar index. The dollar index is a basket of foreign currencies measured against the dollar. As the dollar index falls, the short would go up. The symbol for that ETF is UDN.

Commodities are a lot like currencies, and we would offer the same advice. It’s a longer-term play. It’s also a more specific play since we don’t think most commodities will do well in the long term due to the worldwide downturn. However, the falling dollar will help agricultural commodities. DBA is an ETF that holds a basket of agricultural commodities. However, this is really only for more sophisticated investors, and the window of greatest opportunity is a ways off since commodity prices will fall before they recover due to the falling dollar.

There are probably few instruments more difficult to work with than short ETFs or inverse ETFs. They are simple to buy, but they are difficult to profit from in the current market because it is highly volatile and has been on a modest upward trend in the last couple years. Inverse ETFs are also reconciled daily, so that’s a technical issue that means they don’t always follow the long-term trend exactly. Hence, they are best used when the trend is strongly in your favor, and that can be hard to predict. Clearly, at some point, there will be a time these can be used to make money, but it won’t be until we start to see real weakness in the stock market. If you do use inverse ETFs in the next couple of years, don’t be afraid to take profits. Markets can move against you quickly, and you can quickly lose whatever you have gained. One of the most popular inverse stock ETFs is SH, which shorts the S&P 500.

Also, you have to be especially careful about double short ETFs. These are leveraged, so you can make twice as much money, but you can also lose twice as much money. Plus, the daily reconciliation can have a greater effect in tracking long-term trends with leveraged ETFs than non-leveraged.

The same issues that apply to inverse stock ETFs apply to inverse bond ETFs. Bonds may turn earlier simply because interest rates have fallen so low that even a modest upward movement could damage bonds quite a bit and create nice gains for inverse bond ETFs. However, many investors have been hurt by thinking the bull in Treasury bonds has run its course, including the King of Bonds himself, Bill Gross. One of the most popular inverse bond ETFs is TBF, which shorts the 20-year Treasury bond.

Notice that we like ETFs? For one thing it is often the only way to invest in certain assets, like gold. They also tend to be relatively cheap since they are not managed like a mutual fund. They are very similar to an index fund in cost and structure.

It’s not an easy decision. Either way, there are problems. It’s hard to manage a portfolio yourself. Emotion gets in the way. Plus, it takes a certain amount of time and a
lot
of mental energy. It’s not that it takes a lot of time, but it’s hard not to focus on it a lot of the time. And all that focus energy can wear on you. So we tried to outline a plan in this book that will reduce your focus time by protecting you from a big decline in the stock or bond markets, but like we said, there is no set-it-and-forget-it option right now.

Bringing in help makes sense, but in today’s market, that’s almost always going to be a cheerleader of some sort. It’s hard to find a sensible alternative. And you don’t want a cheerleader who says they will invest the way you want. If they don’t understand it, they can’t really do it, even if you are telling them how. And if you are telling them how to do it, why are you hiring that person? So if you can find the right person, then great. Otherwise, you sort of have to do it yourself.

You may kick yourself because of the money you “lost” if the market rises after you sell. Certainly, other people will kick you for sure!!! They don’t like to see people selling out of the market. It’s bad for business if you’re a stock salesman, and it’s bad for others who hold stocks, which is a lot of people. Don’t expect their support, whether it turns out in the short term you were right or wrong. If you were right and stocks go down, it’s like salt in the wound to others. If you’re wrong and stocks go up, then that’s more reason for others to feel good about owning stocks and proving to the poor fools who aren’t as smart about stocks that they were wrong.

The last part of this chapter is devoted to the broader issues that will affect timing and how the market ultimately declines. Since we haven’t had a long-term market decline since the Great Depression, the factors affecting this decline are different than ever before, even different from the Depression. Understanding how the market will decline and the forces driving it will help you better understand how to time your individual exit from stocks and bonds.

The biggest change since the great stock collapse during the Depression is that government intervention in the stock, bond, and real estate markets now is enormous. Never before have we seen such massive intervention, both indirectly and directly, in those markets. And that intervention is being done worldwide, sometimes, in a very coordinated fashion. The United States certainly doesn’t have a monopoly on government intervention.

This government intervention makes timing even trickier, since it can be more difficult to predict the exact timing of intervention. It isn’t difficult to predict that the government
will
intervene or
how
it will intervene, but it is difficult to predict the exact timing. Although government intervention sometimes responds quickly to market forces, it isn’t driven by market forces in the same way a normal market would be. Hence, just following the financial news doesn’t tell you
when
or
how much
the government will intervene at any given time.

It’s much like a very unusual fire. You can predict that the fire department will try to put it out, but since it has never dealt with such an unusual fire before, it is difficult to predict exactly how it will react at any given time in its attempt to put it out.

Because government intervention has been so massive, as discussed earlier in this book, it will be the most important factor impacting your Aftershock portfolio. It will be what fundamentally drives investor confidence, consumer confidence, economic recovery, housing, and even retail sales. Although there are other factors driving those aspects of the economy, the size of the government intervention in the economy and the markets is so large that most of those other factors are driven at least in part by the government intervention as well. Remember the chart in Chapter 3 that compared the amount of growth in our economy to the amount of increased government borrowing from 2007 to 2011? Increased government borrowing was far larger than the
entire
growth in the economy during that period. Government intervention is huge. It’s of absolutely historic proportions.

And that has just an indirect impact on the stock and bond markets. Through its money-printing operations, it is also having a very direct impact on the stock, bond, and mortgage markets. So let’s take a closer look at this all-important intervention—what’s driving it and how it is likely to play out over time.

But, first, it’s important to point out that many people are loath to believe that the Federal Reserve and the U.S. banking system have taken such extraordinary and enormous measures to artificially prop up the stock, bond, and real estate markets in the past few years, especially considering how devastating the long-term consequences of this intervention are likely to be.

This resistance is understandable, not just because of the self-interest involved, but also because it flies in the face of how the banking system has operated for most of modern history. Going back to the nineteenth century, the powers that be in the U.S. banking system have generally operated with relatively high integrity, both financially and academically.

This integrity, in fact, was crucial in attracting and keeping depositors. In a “survival of the fittest” banking environment, banks that weren’t honest and accountable couldn’t expect to last very long. And when the Fed was established in 1913, ensuring the integrity of the entire banking system was a top priority. And for the most part, it did an excellent job.

Given this history, why should anyone accept that things changed would anyone expect that things would change from 30 years ago? That the integrity of the Fed and other players in the financial community would act so irresponsibly, with such dire implications for the United States and the global economy as a whole? We’ll go through the motives one by one, but first, let’s remember a money manager named Bernie Madoff.

Madoff had been in business since 1960, had a terrific track record, and was beloved by many of his clients and colleagues in the financial community. He was one of the innovators behind the Nasdaq market and served as its chairman for many years. He was an upstanding leader in the investment community, and many considered it an honor to invest with his firm. No one could have believed that, as Madoff himself put it, “it was all one big lie.”

If we don’t want to end up like Bernie Madoff’s clients, it’s important that we don’t make the same mistake they made. The fact that the players at the Fed and in the banking system may look the part and may have a good track record doesn’t mean they can get us out of the mess they’ve created.

So what went wrong that made the government and the banks turn to market interference? And, more importantly, why can’t they just stop doing it and let things return to normal?

We’ve already discussed how productivity growth slowed down in the 1970s. At this point, possibly facing an endlessly stagnating economy, a little artificial stimulus for the markets didn’t seem like such a harmful idea, and it might not have been. But borrowing large amounts of money and not paying it back (both government and private borrowing) is like a drug: The more you use it, the more it takes to achieve the same results. And after a while, it becomes impossible to get off without serious, painful consequences. And the United States has been on this drug for several decades now.

So when we talk about the consequences of ending market interference, we’re not talking about minor withdrawal symptoms but consequences that affect our very way of life. First, for many in the financial sector (and elsewhere), it’s not just a matter of losing their jobs but their entire careers. Add to that the loss of most of their life savings, as well as potentially compromising their children’s futures.

More broadly, letting go of the way things have been done for the past 30 years means, in a way, letting go of the American Dream—that is, the stability and upward mobility of the upper and upper-middle classes. Families that have been wealthy for generations will see much of that disappear. For such people, it’s critically important to protect the status quo. They will take risks well beyond what would normally be acceptable, and they will welcome anything that keeps their lives undisturbed and relatively prosperous, altering their thinking to downplay any long-term consequences.

So now that we understand the why, let’s look at the how. There are three techniques in particular that can be employed to manipulate the markets: misleading indices and statistics, market manipulation, and market holidays, which are discussed below.

Look at the financial news on any given day and there’s a decent chance you’ll read about the market moving according to an economic indicator that has recently been announced. Good news sends the markets up; bad news sends them down. Manipulating key statistics is an important tool to ease worries about the economy, and can provide a reliable short-term fix for struggling markets. Key areas for manipulating statistics include indices on growth, inflation, unemployment, and Federal Reserve open market activity.

Above all, authorities in the banking system want to avoid the appearance of a recession—that is, a decrease in economic production from quarter to quarter. So one of the favored tools used to disguise what might easily be called a recession is the “seasonal adjustment.” It’s a relatively simple matter to take a raw number, then “correct” for seasonal adjustment and make it look better than it is, or even make a negative number look positive. Later, it might be announced that the seasonal adjustment is being removed retroactively, but by then the objective has been achieved, and market panic has been avoided.