The Aftershock Investor: A Crash Course in Staying Afloat in a Sinking Economy (19 page)

Clearly, being 100 percent out of all stocks
before
the Aftershock hits is essential. However, we are not there yet. That means there is still time before inflation moves up high enough and interest rates rise high enough to kick off the coming multibubble pop and the Aftershock that will follow. Before that occurs, some stocks will hold up better than others. So in the shorter term, it is still okay to own some stocks—as long as they are part of a
well-diversified, Aftershock-based, actively managed portfolio
.

As we say throughout this book, conventional wisdom will no longer protect you. So the first thing every stock investor must face is the fact that this is a bubble and it is going to pop. Once you have a firm grasp of that, the next logical questions are what to do about it and when?

In a rising bubble economy or in a growing nonbubble economy, successful investing means picking stocks that are going up or about to, and then hanging on to those stocks until you are ready for some profit taking. However, that kind of buy-and-hold or set-it-and-forget-it investing, based on the old ways of valuing stocks, doesn’t work too well in a falling bubble, even if that bubble’s fall has been temporarily slowed and boosted by massive government stimulus. In a falling bubble or in a temporarily supported bubble that will fall again soon, that is not going to fly.

Instead, if you are going to own any stocks between now and the Aftershock, then your portfolio requires
active management
. The word
management
seems pretty straightforward. It means you have to make some good decisions and execute those decisions correctly. That is tricky enough. But it gets even more challenging because you also need “active” management, meaning you have to
keep
making correct decisions and keep executing those decisions correctly, again and again, as the economy and the investment environment evolve over time.

For the next year, stocks will be driven by more money printing. When the Fed prints more money, such as a QE3, stocks will go up. It might only require talk of more money printing to push the market up, but if there is no printing, just talk, it will go back down. Also, QE3 will only work for so long to keep up the market, just like QE1 and QE2. It is a temporary fix. Eventually, the QE money tree will have less impact on stock values because more people see it as just a temporary fix. That could easily happen as soon as a QE4—it may not work very well to boost stock prices. Hence, QE-driven stock prices will only last so long, and playing the QE trade by buying when QE is announced won’t work as well in the future. The decreasing impact of money printing on the stock market will also ultimately lead to a long-term decline in stock prices.

So what about exiting stocks after QE3? Unfortunately, exiting stocks is a bit different from exiting bonds. Ideally, we wanted to do a chart, just like we did for bonds in Chapter 5, that broke stocks down into different categories and we would tell you what is a good time to exit each category. Unfortunately for stocks, there is an enormous level of correlation between all types of stocks.

Because of this high degree of correlation, it is likely that when stocks fall, they will all fall at the same time. Some stocks have a higher beta, meaning they will both rise faster and fall faster than average. These include financial stocks, high-technology stocks, and other stocks that are often placed in the “high-growth” category. But that does not in any way change the overall direction for all stocks just before and during the Aftershock. There will be no safe havens in the stock market when the stock bubble pops. There will be no “timed exits” where we can say hold on to these stocks for a while longer but sell these other stocks now. Yes, some will take less of a hit than others, but
all
will decline.

Currently, we recommend high-dividend stocks, such as electric utilities, as a temporary safe haven because they are defensive and pay good dividends, but when the market falls a lot, they will fall, too. They work best in a market that is moving upward at a slow rate but with high volatility, as has been the case in the past couple of years. Also, high-dividend stocks are becoming high priced because many investors are looking for their dividends and safety. Hence, there may not be a lot of upside left, and the good returns from high-dividend stocks are likely to fall.

Given what we now know about stocks and what’s going to happen to them, it would be wise to keep up on economic conditions and especially watching for rising inflation. The Consumer Price Index can be followed on the web site for the Bureau of Labor Statistics at
www.bls.gov
. (You can also keep up with us at
www.aftershockpublishing.com
, and even register for our Aftershock IRP newsletter.)

As we mentioned, we expect plenty of stock manipulation from the Fed to prop the markets up, and while this is bad news for the long term, it will be good for stocks in the short term. So keeping a portion of your portfolio in the stock market for the time being can be a good move. There’s nothing wrong with riding a bubble while it’s inflating (or reinflating), as long as you get out before it pops. But as we have said repeatedly, it’s far better to be out of stocks too early rather than too late. If you are particularly risk-averse, don’t worry too much about missing the last boost in the stock market before the crash. In the long run, you’ll still be much better off than most.

A good way to move out of stocks is to move out a little bit at a time, selling off more and more each month and moving into gold and other safe investments as we approach the Aftershock in the next couple years. This way, you can benefit from temporary rises in the stock market without exposing yourself to too much risk. It’s also a good strategy to stay diversified while the Aftershock is less imminent, allowing you to protect yourself more only as you become more convinced of the crash ahead.

In the meantime, stocks in safer sectors like health care and electric utilities will generally be a safer bet than stocks in the volatile financial or technology sectors. Also, choosing stocks that pay high dividends can mitigate potential drops, and it will be easier to pull out of these stocks before suffering big losses.

We mentioned before that selling short can be a risky practice. The big problem is timing. We know stock prices will fall, but we don’t always know exactly when. This is one reason we like long-term equity anticipation securities (LEAPS), which can be used to short stocks over a period of up to two years. Timing is still sensitive here though. If we’re still two to four years away from the Aftershock, it might be a little early right now to begin investing in LEAPS. This is an advanced type of investment and not for people with little knowledge of the market.

An easier option than shorting specific stocks or buying put options and LEAPS is to invest in inverse index exchange-traded funds (ETFs). There are ETFs that short various indices like the S&P 500, so when those indices fall, these funds rise. While timing is still sensitive here, inverse ETFs can be a good way to hedge stock positions in the meantime before pulling out completely. However, please be cautious with inverse ETFs that are double leveraged. These funds will drop a whole lot whenever the market temporarily moves up.

The bottom line for stocks is that in the long run, they will all drop sharply in the Aftershock. In the shorter term, if you want to be in the market, you must limit your risks with active portfolio management, based on the correct macroeconomic view of what is occurring and what will happen next. (Please see Chapter 11 for more details about creating a diversified, actively managed Aftershock portfolio.)

Why do investors buy bonds? To radically oversimplify, the main appeal of bonds is that they are not stocks. Investors buy bonds to preserve capital (also known as avoiding losing money on stocks) and to earn some fixed income (because you can’t count on steady profits from stocks). If the stock market were a jackrabbit, full of excitement and profit potential, bonds would be your steadfast turtle—slow, reliable, and safe.

Financial advisers tell us to have a greater ratio of bonds to stocks as we get older. While a younger person’s portfolio might be 30 to 40 percent bonds, older investors usually go for 60 percent or more bonds, especially as they near retirement. Because the profit potential for bonds is limited, there is a broad assumption that their risk potential is limited as well. Under normal conditions, this is usually true; bonds are generally less risky than stocks. But, as you know by this stage of the book, future conditions will be anything but normal. As inflation and interest rates significantly rise in the lead up to and during the Aftershock, our steadfast turtle will inevitably become investment road kill.

Conventional wisdom (CW) says stick with bonds; they were good to us before and they will remain good to us in the future. The new Aftershock investing wisdom says some bonds may be okay for now, but you better keep your eyes open and get ready to get out as the investment environment continues to evolve. Just as we explained in the previous chapter about stocks, it is not necessary to give up on bonds immediately. However, please do not fool yourself into thinking bonds will provide you with lasting safety. Just as with stocks, owning bonds requires
active portfolio management
based on a clear and correct macroeconomic view of what is occurring and will happen next.

The big problem that investors will face in the future, as inflation and interest rates rise, is that
both
the stock market and the bond market will become increasingly less attractive. So far, that has not generally been the case, and most conventional investors who look to recent history as their guide will not be prepared for what is ahead. That’s why we keep telling you throughout this book that it’s time to trade in your old conventional investing for a new Aftershock-aware, actively managed portfolio.

Remember: “Past performance does not predict future results.”

Basically, a bond is a loan. Bonds are fixed-income securities issued by private or public entities in exchange for your lending them money. But unlike a typical loan you might make to a friend or a bank might make to you, a bond can also be bought and sold for a profit or a loss on the bond market. This makes bonds more than a loan; a bond is a security that can be traded.

Based on the type of borrower, there are several types of bonds. The most common of these are:

• United States Treasurys
  , issued by the federal government. These come in many varieties, based on maturity dates (short, medium, or long term) and other features, such as inflation protection (Treasury inflation-protected securities or TIPS).
  
• Municipal bonds
  , issued by states and local government.
  
• Corporate bonds
  , issued by private companies.
  
• Mortgage-backed securities
  , issued by government-sponsored agencies, such as Fannie Mae (Federal National Mortgage Association), as well as by private corporations.
  
• Savings bonds
  , issued by the federal government.
  
• Certificates of deposit
  , issued by private financial institutions.
  
• Money market funds
  , a collection of short-term securities pooled together, issued by financial institutions.
  
• Floating-rate notes
  , change as an interest rate index changes. With some corporate bonds, the coupon changes, while with TIPS, the principal changes.
  

As we mentioned in the previous chapter on stocks, some of our readers may need or want more background on bonds and some may not. To keep the book from becoming too boring, we have put some additional background material on bonds in the Appendix. This chapter will focus on how bonds make money and how to avoid losing money on bonds as we approach the Aftershock.

Bonds earn money two ways:

Together, the net of the coupon (the interest rate) plus the capital gain (gain or loss) equals a bond’s total return.

When you buy a bond, you agree to lend the issuer a certain amount of money over a certain length of time. In return, the bond issuer agrees to make regular interest payments to you over the life of the loan until its maturity date. This is called the
coupon
. Interestingly, the interest payment to bondholders is called the
coupon
because, decades ago, bonds were issued on actual paper and interest was paid when investors literally clipped coupons off their paper bonds and took them to the bank to receive each interest payment. This inconvenient and risky procedure was eventually replaced by electronically issued bonds and interest payments, but the old name remains.