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Aftershock – Protect Yourself and Profit in the Next Global Financial Meltdown (2nd Edition)

Foreward from me:This is a summary of the book. It is biased by my view of what is important, and what is not. I’ve included some graphs that are shown in the book and also ones I’ve found on the internet that are relevant to the points the authors make. I have included a few of my own comments which are prefaced.

Chapter 1: America’s Bubble EconomyReal estate was at a high in 2006. Stocks closed at a high in Oct. 2007. The authors saw a bubble in the sense that high asset growth was not firmly pinned to real economic drivers. In real estate, typically driven by a growing population or growing income by buyers, this was not the case. By the third quarter of 2008 the housing market crashed and the Dow dropped from 14.2k to under 7k. Economic indicators:

Stocks: Dow Jones Housing: Case-Shiller Top 20 Cities Comercial Real Estate: Dow Jones US Real Estate Index Dollar: The Dollar Index (DXY) Gold: GLD Foreign Stocks: FTSE 100 (London) Commodities: CRB (commodity index)

Oil dropped from $135/brl in Jan 2009 to $40/brl in Dec 2009. The authors predictions have been wrong about the timing on the bubbles popping, primarily due to government involvement (printing money). Now they predict the problems will come in the next two to four years (2013-2015). Specific trigger points are hard to predict.


Chapter 2: Phase 1: The Bubblequake6 bubbles:

1) Real Estate2) Stock Market3) Private Debt4) Discretionary Spending5) Dollar6) Government Debt

Housing BubbleFrom 2000 to 2006 home prices increased by 1005 while income grew by only 2%. In 2007 the percentage of equity Americans have in their homes dropped to below 50% for the first time sine 1945. By then end of 2010, 25% of mortgages are under water. Historically, the last time home prices fell was from 1916-1921, they dropped by 30%.

Stock MarketThe Dow Jones rose 300% from 1928 to 2009 along with substantial growth in the economy (personal income more than doubled from 1950 to 1970). It rose 1400% from 1981 to 2007. Since 1980 population has grown by 25% and personal income has grown by 10%. Financial assest as a fraction of GDP have from 450% prior to 1980, to 1000% today.

Private DebtPeople were comfortable with rising home prices and a growing stock market, and took on large debts. Lenders were comfortable making risky loans with the assumption that home prices and growing stock market would cover any loses.

Discretionary SpendingConsumer spending accounts for 70% of the US economy. This bubble has been fueled by easy lending, and will be particularly hard hit when that stops, and home prices and stock market fall.


Dollar bubble

Government Debt Bubble2006: $8.5T2011 (end): $15T

Chapter 3: The Medicine Becomes Poison: Dangerous Inflation Ahead

Inflation is caused by supply and demand. More monetary printing equals larger supply. But monetary printing (supply) that matches economic growth (demand) does not cause inflation. However, if economic growth is slow or not occurring (today) monetary printing will lead to inflation. The authors predict inflation will rise above 10%. Here is why:QE1 - $1.6T printed to buy Treasury Bonds in 2009QE2 - $0.6T printed to buy more bonds in 2010US Monetary Supply prior to QE - $0.8T (375% increase)

Funny description of QE (my own input): http://www.youtube.com/watch?v=PTUY16CkS-k

QE provides short term benefits:1) US government can raise money at lower interest rates2) Helps the stock market because money that would have gone into bonds will go into stocks.3) Keeps interest rates low, which is good for businesses4) Low interest rates are good for home buyers

The Fed is thinking when the economy picks up again it will reduce the money supply by selling bonds to investors and taking the money off the books. They are banking on an economic boom. It is hard to pull money out of a fragile economy however.


Inflation will come on much like the housing bubble, slowly, then suddenly. When inflation occurs, the Fed will print more money:

1) Because government debt will be expanding due to inflation2) Fed will pay banks to hold onto excessive reserves to try and curb inflation3) Inflation will put downward pressure on the economy. The Fed will likely choose short term

medicine as it is doing now.

This will not lead to hyper-inflation (>1000%). At some point we will have to reverse course (stop printing money).

Many economist think $2-3T is not enough. Paul Krugman thinks the Fed should print $8-10T. Most economist today are not stupid, but like a general fighting a war from the command center and not on the ground, they are out of touch. Approaching the current climate using lessons from the Great Depression.

Inflation often lags an increase in monetary supply by 18-24months or more in a bad economy. (No references for that statement).

The authors present and refute several arguments to why inflation will not happen The authors claim the deeper cause for inflation, the cause for monetary printing by the Fed is the

failed tax system. Either too little revenue in taxes, or too much spending, resulting in a large and growing debt.

My Input, Consumer Price Index for All Urban Consumers (indicator of inflation):

1940 1950 1960 1970 1980 1990 2000 2010 2020

-4

-2

0

2

4

6

8

10

12

14

16

Series2

Year

CPI A

nnua

l % C

hang

e

Nothing happening yet….


Chapter 4: Phase 2: The Aftershock – Pop Goes the Dollar and Government Debt Bubbles Biggest impact of the housing, stock, private debt, and discresionary spending bubbles is the

downward pressure they put on the dollar and government debt bubbles. Last chapter focused on growing supply of dollars. This chapter focusing on falling demand. Foreign owned US assets grew from $661B in 1981, to $22.3T in 2010 This growth is demand for US assets was initially in step with growth in the US economy and

productivity. But more recently this was due more to foreign speculation. Dollar bubble has already started to decline. Euro has risen from $0.87 in 2000 to $1.35-1.45 as

of spring 2010. European debt crisis will play a role in this, but the authors predict the Euro will do well with

respect to the dollar. The faltering US economy, due mainly to the bursting housing, stock, private debt, and

discretionary spending bubbles will give foreign investors less motivation to invest in the US, putting further pressure on the dollar

Losses in riskier US investments (stocks) will drive foreign investors to less risky ones (bonds) Most foreign investors, like US investors, want to believe the US economy will pick back up

again. But as inflation and interest rates rise this psychology will eventually change As foreign investors start pulling their money out of US investments this will lead to a devalued

dollar, causing more investors to pull their money out of US dollars, leading to a positive feedback loop.

Authors predict this trend will start in 2013, and by 2016 a mass exit of foreign investments Currently about 61% of foreign exchange reserves are held in US dollars, 26% in Euros, 13% in

other. The US dollar index, a basket of foreign currencies whose value is tracked against the dollar, is

down more than 30% since 2001, and more than 60% compared to the Euro over this time. The US debt is currently $15T, while annual income (taxes) is only $2T. Debt-to-income ratio of

7-to-1 with no plan or ability to pay it off short of borrowing or printing more money Often times people consider the debt-to-GDP ratio. But the GDP is not the governments income


What if we wanted to pay of the debt? Given the debt is $15T, if we were to pay $500B a year, it would take 30yrs to pay of the debt. To make these payments we would have to eliminate the annual deficit that is currently $1.6T/yr, and make the $500B annual payments. This would require a total additional revenue or spending cuts of ~$2T/yr. So we would need to increase taxes by 100% in order to do this, or cut all spending by the government for the next 30yrs. It is unlikely either of these will happen, and at some point we won’t be able to make these payments….

Once the debt and dollar bubble start to pop the Fed will be forced to print more money to make up for lack of bond sales, which will cause higher inflation and higher interest rates on government bonds. Eventually the only way to solve the high inflation problem will be to do what many other governments have done to fight inflation: spending cuts and tax increases.

When the dollar and debt bubbles pop, inflation and interest rates will be high, unemployment will soar, the US stock market and housing market will be crash even further, and consumer spending will dry up.

Six stages of psychological denial:1. Denial2. Market Cycles (people begin to notice dangerous market trends)3. Fantasized Great Depression4. Back to Basics (what went wrong?)5. Imagined Armageddon6. Revolutionary Action

Personal comment – This last stage is interesting. The authors predict big changes to improve global financial stabilization, increased productivity/efficiency, prevention of future asset bubble formation, ect. This will be a ripe time for innovation and entrepreneurism. This is what America is founded on, and will be a time when good ideas and smart people can bring things back to life. The quote “No Mud, No Lotus” comes to mind.


Chapter 5: Global Mega-Money Meltdown

In the fourth quarter of 2008 US GDP fell by 6.2% on an annual basis; UK by 5.9%, Germany by 8.2%, Japan by 12.7%, South Korea by 20.8%. During the Great Depression the US GDP fell by 25%.

The US will suffer the least. Our economy is more flexible, diverse, and stable than most other countries. Wetern European countries will suffer the second least, followed by Japan, Eastern European countries, and Russia. Developing nations such as India and Brazil will be next. Poor countries in Africa will be hit very hard, as will China.

Analyze the world economy in two categories: manufacturing and resource extractiono Manufacturing can be further divided into high-end manufacturing and low-end

manufacturingo Low-end manufacturing will be directly impacted by America’s bubble economy. When

the US economy suffers we will import less, and economies based on exports to the US (China) will suffer.

o This will have a multiplier effect: for every manufacturing job created in other countries, approximately two additional jobs are created to support these people, giving a multiplier effect of 3x.

o High-end manufacturing will also suffer due to a decrease in consumer products, which are often built by high-end machines, and a decrease in demand for high-end products, like cars.

o This will happen very quickly as inflation hits and the value of the dollar dropso Countries whose economies are based on resource extraction will also be hit due to the

same reasons. These countries will actually be hit even harder because demand will drop, and so will the price of these goods, and also because they will be competing with resource extraction in the US (due to the decrease in the value of the dollar), so increased supply as well as decreased demand.

Countries like Germany, France, Scandinavia and Japan will not default on their debt, but the US will

China will suffer the worsto Decreased exportso China has a stock-pile of US dollars. When the value of the dollar drops, so goes China’s

economyo China also has real estate, stock and banking bubbles that will pop.

The average sales price of an apartment in Beijing is 57x the average workers annual income. At the height of our real estate bubble the average price of a house was barely 4x the average workers income.

65.4 million homes across 660 cities in China had zero electricity consumption for six months in succession.

Construction accounts for ~30% of China’s economy. At the height of the US real estate bubble construction accounted for 15%

o When the US, Europe and Japan reduce their imports, the huge growth China has experienced due to exports to these countries will be experienced in reverse

o “The next Tianamen Square is likely o have more widespread support than last time, and the Chinese government will have a much more difficult time controlling it.”

o The authors expect this to happen sometime in the next few years


The Middle East will be hit just like China. Demand for oil will drop, causing prices to drop to somewhere between $10 to $25/barrel.

Investments in the green tech will also dry up, as will a lot of the subsidies. The price of imported goods to the US will soar. The authors predict gasoline prices will reach

$12 to $15/gal on an inflation adjusted basis in 2011 dollars. In general, stay away from foreign investments, as most foreign economies will be hit harder

than the US.

Chapter 6: Covering Your Assets – How Not to Lose MoneyRule #1 – Get ready to exit stocksRule #2 – Stay away from real estate until after the dollar bubble popsRule #3 – Stay away from long-term bonds and all fixed-rate investments

Long-term: beginning sometime between 2013 and 2016Short-term: prior to 2013

Long-term predictions Inflation will eventually top 10% Interest rates will rise even higher Things will look good in the short term Real estate will generally continue to decline

This Recovery is 100% Fake In 2007 GDP was $14T In 2010 GDP was $14.6T In 2007 the government borrowed $163B In 2010 the government borrowed $1.4T (almost 9x) The entire increase in GDP can be attributed to borrowing

Real Estate If possible sell any vacation, investment and commercial property

o Despite what cheerleaders say prices have not hit bottom Primary residences are trickier


o If possible, sell and rento The authors have not sold their primary residenceso If you do stay in your home, don’t expect prices to recover in the near futureo Get a fixed-rate mortgageo pay it off as slowly as possibleo If you are underwater on your home, try and do a short sale rather than be forclosed on

You can fight foreclosure, and with so many properties being foreclosed you can postpone this for a while. Read “The Homeowner’s Guide to Foreclosure: How to Protect Your Home and Your Rights”

Sell farmland, unless you have a personal or sentimental attachement

All of this could start happening by 2013, but more likely in 2015 or 2016

Other debt Credit card debt is usually adjustable rate, so when interest rates rise, so will credit card rates.

o The sooner you can pay off credit card debt the bettero If you can’t pay it off, consider not paying at all. Credit card companies may go out of

business when the bubble pops. And a lousy credit score won’t be so bad when the bubbles pop because borrowing money will be pretty difficult all around

Reduce spending now. Putting some money away now will help out when times are tough.

Remember what really makes life worth while. Its not the money, but the people you spend your time with. Family and friends will need your support in the years ahead, so focus on that more than dwelling on the hard economic times to come.

Chapter 7: Cashing in on Chaos

Three rules for future investments:1) Consider the macroeconomic environment2) Invest for the long term3) Go against conventional wisdom

Best Long-term investments, after short-term volatility (1-3yrs)10% inflation is the sign to shift to long term

1) LEAPS (Long-term Equity AnticiPation Securities) options for one to two year periods. Can buy puts which is a short, or calls which is a long. www.cboe.com/products/leaps.aspx or www.optionseducation.org/basics/leaps/default.jsp

2) Bear funds. Like mutual funds that are betting on stocks falling (shorting). Don’t track the long-term trends as well as LEAPS.

3) Foreign Currencies. Be careful, many of these will actually do worse than the dollar. Look for ETFs (exchange traded funds). Euro FXE, Swiss FXF, FXC Canadian, FXY yen. UDN is a diversified fund that invests in world markets and will track the value of world markets vs. the dollar. TBTF or TBT (double short) is a short fixed-income bond. When interest rates rise these fall, so shorting these may be profitable.

4) Gold. Strongest recommendation. Why?

http://www.optionseducation.org/basics/leaps/default.jsp

http://www.cboe.com/products/leaps.aspx


a. The gold market is small compared to stocks and bonds. A small shift into gold will be very significant

b. Value of dollar will drop, making gold even more valuable in the USc. India buys 2x as much gold as US. Gold is more of a world market than US stocks and

bonds.d. Gold production cannot increase very rapidly.e. Gold has traditionally been seen as an inflation hedge. If inflation occurs, gold will be a

good place to put moneyf. Value of gold has increased every year for the past 10 years. This is before much of the

economic problems predicted in this book. Hence, it has done well even with a lack of inflation and economic downturn, or large economic downturn predicted.

g. How to buy goldi. Buy physical gold from local coin dealer or order online. Canadian Maple Leaf,

American Eagle, and South African Krugerrands are examples of gold coins.ii. Gold ETFs. Like stocks, but for gold. GLD and IAU are examples of this. PHYS is

one that is backed by 100% physical gold.iii. Gold Depository. A way to buy actually gold, but not actually hold it. If you

request, gold can be shipped to you. Monex in Newport Beach is an example of a Depository.

5) Silver. Will lose some value due to drop in demand for silver as a commodity, but will make up for it as a precious metal.

6) Oil and Natural Gas. Demand will drop, but price in US dollars will rise.7) Coal. Demand will rise as oil prices increase. US is a large world supplier of coal, and value of US

dollars will drop making this more appealing to other countries.8) Investment grade diamonds will do well.

Chapter 8: Aftershock Jobs and Business

Think of the US economy in three parts:1) The Capital Goods Sector: cars, construction, major industrial equipment2) The Discretionary Spending Sector: fine dining, entertainment, travel, high fashion, jewelry, art3) The Necessities Sector: basic food, shelter, clothing, energy, health care

These assumptions and advice are predicated on the situation where all the bubbles have popped. These are long term views.


The Capital Goods Sector High interest rates and slow economy will be BAD news If you can change careers, try and do so If you can’t think about shifting your focus into areas that may be better off

o Example: If you are in construction think about moving into repair oriented work rather than new construction

The Discretionary Spending Sector Discretionary spending is discretionary, and when people don’t have money to spend, they will

spend less on discretionary things Some people will still have money though, so this area won’t be hit as hard as capitol goods Example: High end restaurants will probably suffer more than cheaper ones Discretionary spending is a large part of the US economy, so when this bubble pops a large part

of the US economy will go with it.

The Necessities Sector Limited good news here Historically jobs in this sector don’t pay well, and they will continue not to, but at least there will

still be jobs Health care jobs will do well for primary care or necessities, not so much for specialists Government services such as police, firefighters and teachers will do ok. But with shrinking

revenues these will also be reduced

Distressed Assets There will be lots of opportunities for servicing distressed businesses and selling their assets.

One will have to be patient and wait until things have settled and interest and inflation stops rising to begin buying these assets however.

Chapter 9: Understanding Our Problems in the first step towards solving our problems

Below is an interesting discussion about the direction the field of economics has gone, and is going. It is not so much about predicting the future of the economy, but more about reflecting on the field of economics in general.

Economist don’t really understand why economies grow. They can tell you if it is growing or not, and where it is growing, but they can’t really tell you why. And if they can’t tell you why it is growing, they will have a hard time telling you how to get it to start growing again. As long as they tell you it is growing most people are happy, and they get paid. More money has been spent on economics research in the past 30 years than in all of previous history (not just in the US). But there have been very few economic breakthroughs. The last 30 years have been some of the least productive in the last 100 years, despite the enormous amount of funding.

This is because a lot of money can be spent on researching very narrow or obscure issues. In many scientific disciplines focusing on narrow issues can be greatly beneficial because it is often tied to deeper fundamental scientific theories. In economics narrow issues are not tied to a strong overall understanding of economics. Analogy: its like having a bunch of geologist study the Appalachian Mountains in order to understand how mountains form. If you don’t understand continental drift you will have a hard time figuring out how mountains formed.Key Breakthroughs in the History of Economic Thought


1) Free Marketsa. Adam Smith

2) More Focus on Economic Evolution and Property Rightsa. Karl Marx

3) Understanding Supply and Demand (Beginning of Microeconomic Theory)4) Understanding the role of Capital and the Payment of Capital5) Macroeconomics (Monetary and Fiscal Policy)

a. Fiscal Policy - John Maynard Keynesb. Monetary Policy - Milton Friedman

6) Mathematical Models7) Empirically Tested Mathematical Models

Economics is in need of a breakthrough, like continental drift. When Alfred Wegener proposed the idea of continental drift he was strongly opposed by much of the established community. The rigorous demand for academics to get tenure has reduced creativity and innovative ideas rewarding those that fit the mold and don’t question the status quo. This problem is not unique to economics. Physics, among other scientific disciplines, also faces this problem. The last 30 years have been some of the least productive for breakthroughs in physics. We have come a long way in understanding

Where does economics need to go? Its needs a paradigm shifting breakthrough. It needs to move from philosophy to science. We need to develop a understanding of the evolution of economics, rather than assuming it is

cyclical

Four Key Element to make economics more scientific1) Information Dynamics

a. Learning. Consumers and producers learn and evolve to current situations2) Better Understanding of Technological Change

a. Key changes in technology have big impact on productivity. How these changes play out must be understood and included in economic models and forcasts

3) Property Rightsa. Both governmental and nongovernmental

4) A New Methodology for Economic Analysis and Predictionsa. Current economic models assume you can reach a state of equilibrium. This does not

match realityb. Numerical simulations, such as those used to predict weather patterns, are quantitative

and testable. They should be applied more in economics. A physicist from Santa Fe Institute, Doyne Farmer, is doing this.

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