Contents Acknowledgments Introduction: Code Red Part One Chapter One: The Great Experiment How I Learned to Stop Worrying and Love Inflation Alphabet Soup: ZIRP, QE, LSAP Quantitative Easing, a.k.a Money Printing Debasing Your Currency Navigating a Code Red World Key Lessons from the Chapter Chapter Two: Twentieth-Century Currency Wars The 1930s: First Mover Wins The Euro: Today’s Gold Standard The 1970s: Weaker Currencies, Higher Inflation Today versus the 1930s and 1970s Currency Wars and Japan Key Lessons from the Chapter Chapter Three: The Japanese Tsunami The Quake and the Sandpile Banzai! Banzai! Three Arrows Let’s Export Our Deflation Reform and the Demographics of Doom The Hard Part: Structural Reform Six Impossible Things A Modern Currency War Gentlemen, They Offer Us Their Flank Key Lessons from the Chapter Chapter Four: A World of Financial Repression Inflation and Interest Rates Financial Repression: Back to the Future Taxes by Another Means Will Real Inflation Please Stand Up? Inflation Is Your Friend Repression Hurts Retirees Everything Is Overpriced Key Lessons from the Chapter Chapter Five: Arsonists Running the Fire Brigade The Cult of Central Bankers Promoting Failure No Apologies, Only Promotions Key Lessons from the Chapter Chapter Six: Economists Are Clueless Assume a Perfect World Objects in the Rearview Mirror Are Larger than They Appear The Definition of Insanity Using Leading Indicators Making Decisions in Real Time Too Loose for Too Long The Return of the 1970s Key Lessons from the Chapter Chapter Seven: Escape Velocity Stuck in a Liquidity Trap The Economic Singularity The Minsky Moment The Event Horizon The Glide Path Where’s the High Inflation? Escaping the Liquidity Trap Overstaying One’s Welcome Key Lessons from the Chapter Chapter Eight: What Will Happen When It All Goes Wrong How Are Your Navigation Skills? A Red Balloon Full of Nitroglycerin The Mechanics of Exit QE = Hotel California When Deleveraging Gives Way to Credit Expansion, Watch Out for Inflation Key Lessons from the Chapter Chapter Nine: Easy Money Will Lead to Bubbles and How to Profit from Them Excess Liquidity Creating Bubbles Humans Never Learn Anatomy of Bubbles and Crashes Anatomy of Bubbles and Crashes Keep Moving, There’s Nothing to See Carry Trades and Bubbles What You Can Do in Bubbles Key Lessons from the Chapter Part Two: Managing Your Money Chapter Ten: Protection through Diversification A Portfolio for All Seasons Avoid Making Mistakes Betting on Tail Risks Key Lessons from the Chapter Chapter Eleven: How to Protect Yourself against Inflation Inflation and Taxes Are Toxic for Investors Inflation: Who Wins, Who Loses Annuities, Stocks, and Bonds Buy Companies That Benefit from Inflation Build a Moat around Your Stocks Beware of False Moats Buy at the Right Time Key Lessons from the Chapter Chapter Twelve: A Look at Commodities, Gold, and Other Real Assets The Commodities Supercycle Is Dead The Biggest Buyer Stumbles What Really Moves Gold Prices Key Lessons from the Chapter Conclusion Afterword About the Authors Index Cover image: © iStockphoto.com/trigga Cover design: Wiley Copyright © 2014 by John Mauldin and Jonathan Tepper All rights reserved Published by John Wiley & Sons, Inc., Hoboken, New Jersey Published simultaneously in Canada No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose No warranty may be created or extended by sales representatives or written sales materials The advice and strategies contained herein may not be suitable for your situation You should consult with a professional where appropriate Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002 Wiley publishes in a variety of print and electronic formats and by print-on-demand Some material included with standard print versions of this book may not be included in e-books or in print-ondemand If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at http://booksupport.wiley.com For more information about Wiley products, visit www.wiley.com Library of Congress Cataloging-in-Publication Data: Mauldin, John Code red : how to protect your savings from the coming crisis / John Mauldin and Jonathan Tepper pages cm Includes bibliographical references and index ISBN 978-1-118-78372-6 (cloth)—ISBN 978-1-118-78363-4 (ebk)— ISBN 978-1-118-78373-3 (ebk) Money—United States Saving and investment—United States Currency crises—United States Financial crises—United States I Tepper, Jonathan, 1976- II Title HG540.M38 2014 332.024—dc23 2013035536 This book is dedicated to our mothers Mildred Duke Mauldin (1917–and still going) No matter what life throws at her, she perseveres with grace and a smile One can grow up with no greater example of the importance of showing up no matter what She makes life better for everyone who has ever known her Mary Prevatt Tepper (1945–2012) She was a wonderful mother and a saint who helped thousands of poor and needy through Betel International This debilitating spiral has spurred our government to take massive action In poker terms, the Treasury and the Fed have gone “all in.” Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel These once-unthinkable dosages will almost certainly bring on unwelcome aftereffects Their precise nature is anyone’s guess, though one likely consequence is an onslaught of inflation Moreover, major industries have become dependent on Federal assistance, and they will be followed by cities and states bearing mindboggling requests Weaning these entities from the public teat will be a political challenge They won’t leave willingly —Warren Buffett Berkshire Hathaway 2008 Letter to Shareholders Turning to the commodity currencies, Canada and Australia will start to feel the pinch as well if their currencies rise too much And both countries have housing bubbles that will burst at some point, allowing their central banks to lower interest rates and the value of their currencies And what of the United States? The U.S dollar is the reserve currency of the world and is the medium of global trade What would happen if the United States began to supply fewer and fewer dollars to world markets? Today, this seems like idle speculation, but as the United States becomes more energy independent, its need to buy oil will drop And we expect an amazing thing to happen: the United States will actually become a net exporter of energy within a decade Already, we are seeing sizable exports of energy-related products from the United States The summer of 2013 saw the Port of Houston become the largest port in terms of exports in the United States, finally surpassing New York Energy and chemical exports are the reason The shale boom in the United States is very real Every quarter, new reports appear describing new or expanded oil fields in the United States Every year or so, government agencies revise their estimates of the amount of energy contained in U.S oil fields Those estimates have been rising dramatically Liquefied natural gas terminals that were being built to import liquid natural gas are now being converted to export it With natural gas in the $4 range in the United States and $14 in Japan, it does not take a sharp accountant to see the arbitrage potential We are also witnessing a revival of manufacturing in the United States, for several reasons China’s relative wage advantage is beginning to evaporate, the cost of bringing Chinese products to the United States is rising, and new manufacturing tools and techniques are making it cheaper to produce products in the United States A robot works for the same wages in the United States as it does in China, and you don’t have to worry as much about logistics For these and other reasons, the potential for the U.S dollar to become much stronger than the market currently expects is very real, in my opinion That is not a critical problem in and of itself, but politicians, export businesses, and unions could turn it into one The global recession of the early 1930s turned into the Great Depression because of trade protectionism One country after another enacted protectionist laws, and other countries retaliated, soon stifling global trade I have said for years that my biggest worry about the future is a return to a protectionist state of mind Protectionism will be seen as an easy fix for those who are so inclined when the Japanese yen rises above 150 and the Japanese government and central bank show no sign of slowing down Those tensions will exist not just in the United States but in all countries affected by the Japanese devaluation It is my sincere hope that cooler heads will prevail and forestall a protectionist movement and the very destructive outcome of a global trade war There are a hundred other potential paths we could take, and of course to explore them would require us to write another book But rather than wait for another book, I invite you to sign up for my free weekly letter, where I try to piece together the puzzles that make up the global picture You can subscribe for free at www.MauldinEconomics.com As businesspeople and investors, we have to be focused on the opportunities right in front of us while also keeping a watchful eye on the horizon for stormy weather The proper attitude in today’s environment is cautious optimism And despite the fact that we’ve written about the likelihood of a difficult environment in the near future, I am actually quite optimistic My optimism is for the overall human endeavor, based on how our individual desires for a better life for ourselves and our children translate into a better future for all of us In trading terms, you might say that I am long on humanity but short government The future potential of biotechnology, robotics and automation, artificial intelligence, communications, nanotechnology, global trade, new forms of energy, and a whole list of new services and inventions that will transform our lives and those of our children and grandchildren is simply overwhelming once you really begin to dive deep into the possibilities At the end of the day, I think all of that positive development will overwhelm the shortsightedness of governments and central banks But getting to the other side of the Code Red environment will require more than the same-old same-old approach to business and investing You’ve taken the first step toward understanding what we are facing by simply reading this book and trying to put together a plan for yourself Jonathan and I will continue to provide updates and course corrections at www.thecoderedbook.com We look forward to learning what the future holds for us and sharing the experience with you About the Authors John Mauldin is the president of Mauldin Economics, a research and publishing firm; president of Millennium Wave Investments, an investment advisory firm registered with multiple states; and a registered representative of Millennium Wave Securities, a FINRA-registered broker-dealer Each week, over a million readers on multiple outlets turn to John Mauldin to better understand Wall Street, global markets, and the drivers of the world economy John is a renowned financial expert, a New York Times best-selling author, a pioneering online commentator, and the publisher of one of the first publications to provide investors with free, unbiased information and guidance, Thoughts from the Frontline—one of the most widely read investment newsletters in the world He is also a soughtafter contributor to numerous financial publications, as well as a regular guest on multiple television outlets His books have appeared on the New York Times business best-seller list four times He is the father of seven children, five of whom are adopted, and he is now beginning to actively collect grandchildren He is convinced that the dividends will be extravagant He lives in a high-rise in uptown Dallas, Texas, and travels the world, speaking and seeking out opportunities Jonathan Tepper is the CEO of Variant Perception, a macroeconomic research group that provides economic and investment insights to hedge funds, banks, and family offices Jonathan is the co-author, with John Mauldin, of Endgame: The End of the Debt Supercycle, a book on the sovereign debt crisis Jonathan has worked as an equity analyst at SAC Capital, as a vice president in proprietary trading at Bank of America, and as a portfolio manager at Hinde Capital Jonathan is a founder of Demotix, a citizen-journalism web site and photo agency In 2012 he sold Demotix to Corbis, a Bill Gates–owned company In 2012, Jonathan was a finalist for the Wolfson Economics Prize, an open challenge for economists to find the most efficient and least disruptive way to break up the euro The prize is the second most lucrative prize for economists after the annual Nobel Prize Jonathan is a Rhodes Scholar He earned a BA with Highest Honors in History and Honors in Economics from the University of North Carolina at Chapel Hill, and an MLitt in Modern History from Oxford University Index A Abe, Shinzo Against the Gods (Bernstein) All-Weather portfolio long-term returns of Alternative minimum tax (AMT) American Tower Annuities, stocks, and bonds, investing in during periods of inflation in the 1970s annuities bonds money market funds and savings accounts stock and bond returns stocks and mutual funds Appleby, Sir Humphrey Armstrong, Scott “Arrow’s Caveat” B Bank of England (BoE) Bank of Japan (BoJ) See also Japan Banking Act of 1933 (Glass-Steagall Act) Bankruptcy Basel III Bass, Kyle Bernanke, Ben 60 Minutes interview “Deflation: Making Sure ‘It’ Doesn’t Happen Here” (2002 speech) “The Gold Standard, Deflation, and Financial Crisis in the Great Depression: An International Comparison” (paper) Bernholz, Peter Bernstein, Peter Bianco, Jim Blanchflower, David Blinder, Alan “Quantitative Easing: Entrance and Exit Strategies” Bond market bubble Bonner, Bill Brazil Bretton Woods system Browne, Harry Bubbles, profiting from anatomy of bubbles and crashes Stage 1: Displacement Stage 2: Boom Stage 3: Euphoria Stage 4: Crisis Stage 5: Revulsion carry trades and excess liquidity creating identifying, central bankers’ record of investing during investor irrationality shapes of market bubbles Buffett, Warren Buiter, Willem Burns, Arthur Bush, George H W C “Calling Recessions in Real Time” (Hamilton) Canadian housing market Carney, Mark Central bankers cult of promoting failure promotions China “China’s Investment Boom: The Great Leap into the Unknown” (Pivot Capital) Cialdini, Robert Clinton, Bill Coca-Cola Commodities, gold, and other real assets China commodities supercycle iron ore long-term returns gold prices, movement of Commodity currencies Commodity-producing companies Confirmation bias Congressional Budget Office (CBO) projections GDP gap assumptions Consumer Price Index (CPI) Corzine, Jon Couzin, Iain Credit Suisse Global Investment Returns Yearbook 2013 Currency wars twentieth century 1930s 1970s euro Japan today vs 1930s and 1970s Cyprus D Dalbar, yearly study by Dalio, Ray The Death of Economics (Ormerod) Deleveraging giving way to credit expansion Diversification, protection through diversified portfolio All-Weather portfolio Permanent Portfolio mistakes, avoiding borrowing money to improve returns home market bias overexposure to stocks overpaying of fees trying to time the market tail risks, betting on Dodd-Frank Act Dollar, devaluing Draghi, Mario “Dual Mandate” Dunne, Philippa E Economists economic models insanity of loose monetary policy making decisions in real time GDP estimates before and after revisions initial estimates of 1990–1991 GDP growth revised estimates of 1990–1991 GDP growth U.S real GDP growth yield curve optimistic projections return of the 1970s using leading indicators housing starts vs recessions leading, coincident, and lagging indicators turning points Efficient Market Hypothesis Efficient scale companies you could buy Eggertsson, Gauti Eichengreen, Barry El-Erian, Mohamed Emergency Economic Stabilization Act of 2008 Endgame (Mauldin & Tepper) Escape velocity deleveraging economic singularity event horizon glide path hyperinflation liquidity trap Minsky Moment Euro European Central Bank (ECB) F Fallacy of composition Farm bills, actual vs scored cot of Farmland bubble Federal Reserve balance sheet projected growth of size and composition of and quantitative easing mechanics of exit problems with exiting timing of exit remittances to Treasury, historical Federal Reserve Bank of New York Ferguson, Roger Fergusson, Adam Financial Crisis Inquiry Commission Financial Instability Hypothesis (Minsky) Financial repression banks, effect on historically QE purchases as percentage of GDP in U.S., U.K., and Japan real interest rates since 1945 inflation and interest rates overpriced goods real returns vs interest rates retirees, effect on taxes by another means consumer inflation—official vs ShadowStats Fiscal dominance Fisher, Irving Fisher, Richard France Friedman, Milton Future Babble (Gardner) G Geithner, Tim Geographic monopolies Gibson’s Paradox Glass-Steagall Act (Banking Act of 1933) Glide path Global Crossing Global interest rates Gold bubble (1970s) Gold prices, movement of Gold standard, leaving/returning to Gorton, Gary Graham, Benjamin Graham-Leach-Bliley Act Grant, Jim Great Depression Great experiment dollar, devaluing inflation creation of, by central bankers quantitative easing (QE) Great Financial Crisis of 2008 Greece Greenspan, Alan Grice, Dylan Grillo, Beppo Gross, Bill H Hamilton, James Harney, Alexandra Harvey, Campbell Hedonics Henwood, Doug High switching costs examples of companies with Hilsenrath, Jon “Home Bias in International Stock Return Expectations” (Kilka & Weber) Home market bias Hot Commodities (Rogers) Housing bubbles Hunt, Lacy Hussam, Reshmaan N Hussman, John Hyperinflation I “The Illusion of the Perpetual Money Machine” (Sornette & Cauwels) “An In-Depth Look at Deleveragings” (Dalio) Inflation creation of, by central bankers due to deleveraging giving way to credit expansion growth of government spending leading to protecting against annuities, stocks, and bonds buying companies that benefit from inflation buying at the right time false moats, retirees stocks, building a moat around taxes and Inflation Proofing Your Investments (Browne) Influence (Cialdini) Intangible assets brands examples of companies with patents and copyrights regulatory approvals Interest rates and velocity Ireland J Jacks, David Japan Abenomics currency wars and exchange rates against yen inflation spike in 1970s percentage of debt monetized by BoJ in 1930s deflation, exporting earthquake (2011) “three-arrow” approach balance sheet, projected size of competing with Korea for Chinese market export overlap with neighbors negative balance of trade yen vs dollar since 1990 fiscal reform tax revenue and expenditures future problems government bond issuance and interest expense modern currency war quantitative easing in stock market bubble (1980s) structural reform “Japan’s Silver Democracy (Harney) Jensen, Niels Johnson, Lyndon B Juncker, Jean-Claude K Kahneman, Daniel Keynes, John Maynard Kindleberger, Charles Kindleberger-Minsky model King, Mervyn Kirkegaard, Jacob F Kohn, Donald Krugman, Paul Kuroda, Haruhiko L Large-scale asset purchase (LSAP) programs Lay, Charlie Lehman Brothers Leverage Liquidity global excess vs emerging stock market returns preference trap Loungani, Prakash Low-cost producer examples of companies M Malkiel, Burton Managed futures funds Manias, Panics and Crashes (Kindleberger) Mantega, Guido Marks, Howard Marshallian K Martin, William McChesney MF Global Minsky, Hyman Mishkin, Frederic Monetary Regimes and Inflation (Bernholz) Monetizing debt Money market funds and savings accounts Money, Markets & Sovereignty (Steil & Hinds) Money printing See Quantitative easing (QE) Morris, Charles Munger, Charlie N Nasdaq bubble National Bureau of Economic Research (NBER) Network effect examples of companies with Nixon, Richard O Obama administration Obamacare Oil bubble (2007–2008) Operation Twist Owners’ Equivalent Rent P Paradox of thrift Partridge, Lee Pension Benefit Guaranty Corporation Permanent Portfolio long-term returns of Personal consumption expenditures (PCE) deflator Personal digital assistant (PDA) Pettis, Michael Phillips curve Pioneering Portfolio Management (Swensen) Pivot Capital Portugal Prince, Bob Protectionism Q Quantitative easing (QE) exiting mechanics of problems with timing of “Quantitative Easing: Entrance and Exit Strategies” (Blinder) Queen Elizabeth II R Rational Investor Paradox Reagan, Ronald Recession Reinhart, Carmen Rentier capitalists Retirees, inflation and “Reversing Unconventional Monetary Policy: Technical and Political Considerations” (Buiter) Rogers, Jim Rogoff, Kenneth Romer, Christina Ross, Wilbur L Jr Rouwenhorst, Geert Russia S Sbrancia, M Belen Sedlá ek, Tomáš See’s Candies Seigniorage The Signal and the Noise (Silver) Silver, Nate Singh, Manmohan Smartphones Smith, Vernon Social Security Solvency II directive (EU) Sornette, Didier Soros, George S&P 500, real vs inflation-adjusted growth Spain Stock and bond returns Stocks building a moat around moat 1: intangible assets moat 2: network effect moat 3: low-cost producer moat 4: high switching costs moat 5: efficient scale and mutual funds Stockton, David Subbarao, Duvvuri Summers, Larry Swensen, David Swiss National Bank T Takahashi, Korekiyo Taleb, Nassim, antifragility hypothesis Tax bracket creep This Time Is Different (Reinhart & Rogoff) Toyota Tversky, Amos U “Ultra Easy Monetary Policy and the Law of Unintended Consequences” (White) V Velocity interest rates and Vicsek, Tamás Volcker, Paul W Walmart stock since IPO Weinberg, Carl When Money Dies (Fergusson) White, William Why Stock Markets Crash (Sornette) Williams, Grant Wolf, Martin Wood, Christopher Woodford, Michael World War II Y Yellen, Janet Yield curve inverted Z Zero interest rate policy (ZIRP) Zervos, David ... of Congress Cataloging-in-Publication Data: Mauldin, John Code red : how to protect your savings from the coming crisis / John Mauldin and Jonathan Tepper pages cm Includes bibliographical references... governments try to induce consumers to spend to help the economy, while they take money away from savers who would like to be able to profitably invest Rather than inducing them to consume more, they are... forcing them to spend less in order to make their savings last through their final years! Savers and investors in the developed world are the guinea pigs in an unprecedented monetary experiment There