How to Invest Before the Collapse Version B

HOW TOINVEST BEFORETHE COLLAPSE

BY JAMES RICKARDSBestselling author of Currency Wars and The Death of Money

MISSING CHAPTER

2 Copyright James Rickards, 2014. All Rights Reserved.

How to Invest before the Collapse

Introduction

After studying the evidence for a coming financial collapse, some investors might be tempted to give up, buy guns, ammo, and canned goods and move to a bunker in Idaho. But history teaches otherwise.

Catastrophes have happened throughout history and society has always picked up the pieces and found new ways to move forward. Sometimes the landscape is radically altered, but its not the end of the world. Radical changes in global finance, trade, and capital markets are coming, but investors who prepare now will preserve wealth and be well-positioned for the new system to come. This chapter offers some practical advice on how to do that.

History is a great teacher. In 1914, the international monetary system abruptly collapsed as countries abandoned the classic gold standard and resorted to money printing and deficit spending to finance the First World War. The period immediately after the war, 1919 to 1923, was marked by hyperinflation and deflation, expansion and depression, depending on the exact country and year one selects. Between 1922 and 1925, the major trading and financial powers reconstituted a gold standard, but it was a hybrid involving gold and foreign exchange and was called the gold-exchange standard for that reason. It was badly flawed and soon led to the Great Depression of 1929 to 1940.

But all was not lost during this period of turmoil. Some of the greatest commercial real estate investments of all time, the Empire State Building and Rockefeller Center, were launched between 1930 and 1933 in the depths of the Great Depression. The stock market rallied strongly from 1933 to 1936 in the middle of the Great Depression. Gold rose almost 75% from $20.67 per ounce to $35 per ounce in 1933 immediately after the longest sustained period of deflation in U.S. history. These results may



seem anomalous at a superficial level, but they were available to investors who understood the dynamics of inflation, deflation, interest rates, commodities, and real assets.

Similar dynamics took hold in the 1970s. In 1971, Richard Nixon ended the convertibility of dollars into gold for trading partners of the U.S. This unleashed a decade that included a stock market crash in 1974, three recessions in quick succession, in 1973, 1979, and 1980, and 50% inflation in a mere five years from 1977 to 1981. Again, astute investors did not have to be passive victims of the turmoil. Leverage investment in farmland was highly profitable. Commodities boomed. Gold increased 2,200% from 1971 to 1980.

Of course, the turmoil ahead will not be exactly like that of the past. Writer Mark Twain is often credited with saying, History does not repeat, but it does rhyme. In fact, theres no evidence Twain actually said this, but he did say something similar:

That no occurrence is sole and solitary, but is merely a repetition of a thing which has happened before and perhaps often.

The technical name for this phenomenon is Historic Recurrence, and it is as useful for investors to understand as it is for writers and historians. The key for investors is to comprehend the dynamics behind the headlines one reads every day. A firm grounding in history and dynamics gives investors the best chance of preserving wealth and not being a victim in the turmoil ahead.

The biggest single difficulty in investing today is that both inflation and deflation are in play. The deflation potential, through deleveraging and liquidity preference, is a natural result of the structural depression that has gripped the world since 2007. The inflation potential, through central bank policy, is the only feasible solution to non-sustainable public debt and deficits.



The two forces deflation and inflation are pushing against each other like tectonic plates under the San Andreas Fault. The fault line can be quiet for sustained periods of time, as it has since 2009. But when enough energy builds and one vector begins to slide over the other, an earthquake results. The direction of the energy release toward inflation or deflation is unknown, but the earthquake itself is entirely foreseeable. The key for investors is to prepare for an earthquake without knowing exactly where all of the debris will land once the earthquake stops. There are ways to do this.

What follows is an overview of investment strategies in stocks, bonds, foreign exchange, commodities, fine art, land, alternatives, and cash. With the right degree of diversification, careful selection, and a healthy dose of patience, investors can earn income, preserve wealth, and be well-positioned for growth in the years ahead.

Stocks

The stock market is the traditional favorite of investors and for good reason. A diversified stock portfolio has produced high, real returns over sustained periods of time. However, the stock market has ceased to perform this real-return function since the late 1990s.

Stocks today are only slightly higher in real terms than they were in 1999. During that period, investors suffered two collapses the dot-com crash of 2000 and the financial panic of 2008. Gains since 2009 have been high in percentage terms, but participation has been low, and most investors have not shared in the gains.

Lately, indices have been driven to record highs by a toxic combination of high leverage, low volume, and robotic executions. This is catalyzed by a combination of easy money and high technology.



The Federal Reserve intends for the indices to go up to create the so-called wealth effect designed to stimulate spending. But the wealth effect has broken down because investors liquidity preferences have shifted as a result of the dual shocks in 2000 and 2008. What is happening is clearly a bubble, yet the Fed has shown itself incapable of identifying bubbles until after they burst. This is the best way to understand the stock market today a bubble about to burst.

The next crash may be tomorrow or it may be a year or two away. TV talking heads will continue to promote stocks right up until the day the bubble bursts.

Nevertheless, there are some ways to participate in stocks that will weather the storm better than others. Investors could give consideration to companies with real assets in their core business. This includes companies in transportation, natural resources, energy, and agriculture.

Its best for the individual investor to stick with large, established firms in their respective industries. Quality railroad names include Union Pacific, Norfolk Southern, and Canadian National Railway. In the natural resources sector, some high-quality companies include ExxonMobil, Chevron, and EOG Resources (oil & gas), Freeport-McMoRan (gold and copper), and Potash (agricultural chemicals).

Instead of trying to pick individual stocks (which most mutual-fund managers cant even do well), investors can consider owning broadly diversified exchange-traded funds (ETFs). For example, the iShares U.S. Oil & Gas Exploration & Production ETF gives investors exposure to dozens of established energy companies.

Investors should avoid companies with high leverage, which becomes a burden in deflation. They should look for companies with significant amounts of cash that can fund internal operations if the commercial paper market shuts down again as it did in 2008.



Companies with good prospects in emerging and frontier markets in Asia and Africa will also offer good returns. An example here is Phillip Morris International, which is the international offshoot of cigarette giant Altria (formerly Phillip Morris). Phillip Morris International is the worlds largest cigarette seller outside of the United States. Its a company that will benefit from the worlds growing middle class.

Bonds

Investors should avoid credit risk in corporate, municipal, and junk bonds. However, certain sovereign bonds offer good risk-adjusted opportunities. Major sovereign bonds mitigate credit risk, leaving only the interest rate and currency risks that investors can manage.

Much has been written and said to the effect that interest rates are near all-time lows and that the bond market is a bubble. A lot of this analysis is superficial. Investors must distinguish between nominal rates and real rates. It is true that nominal rates are near all-time lows, but real rates are historically high once disinflation and potential deflation are taken into account.

For example, if nominal rates are 10% but inflation is 13%, as it was in the late 1970s, then the real rate negative 3%. If nominal rates are 3% but inflation is 1%, then the real rate is positive 2%. In the second case, the nominal rate is much lower (3% versus 13%) but the real rate is much higher (2% versus -3%). Investors should care more about real rates because that is how wealth is made or lost in a world of inflation and deflation.

It is also a quirk of bond math that a fixed percentage-point decline in yields produces larger percentage gains when rates are at lower absolute levels. For example, when rates go from 3% to 2%, the capital gains on the bonds are much larger than when rates go from



9% to 8%. In both cases, the yields dropped 1%, but in the first case (similar to todays rates) the capital gain is much larger. If yields on U.S. Treasury 10-year notes moved from the current level of about 2.6% to 1% (still higher than Japanese 10-year notes today), it would be one of the strongest bond market rallies in history.

Taking into account the prospects for disinflation, the high credit quality of U.S. government bonds, excellent liquidity, and the potential for capital gains, an allocation to 10-year U.S. Treasury notes has a place in an investors portfolio today.

Foreign Exchange

When investors allocate to certain asset classes such as stocks and bonds, they must also decide how much foreign exchange exposure to take. An investor buying stock in a Spanish bank, for example, will not only have the normal stock exposure, but will also be taking exposure to the euro since that bank keeps its accounts and reports its profits in euros, and trades on exchanges denominated in euros.

It is also possible for investors to get direct exposure to currencies independently of stocks and bonds denominated in those currencies, using derivatives traded on the Chicago Mercantile Exchange, certain ETFs traded on the New York Stock Exchange, certain specialty mutual funds, or simply by holding cash in foreign currency denominated bank accounts.

The world is now engaged in a currency war in which certain major economic powers are attempting to steal growth from their trading partners by cheapening their currencies. This is unlikely to be a successful strategy and typically results in inflation for the parties engaged in the war. Other countries or economic zones understand the futility of currency wars and are trying to promote growth and exports through technology, investment, and sound



money policies. Understanding which countries are engaged in which policies is the key to selecting currencies that will preserve wealth instead of eroding it.

Foreign currencies that investors should consider owning are the euro, Swiss francs, Korean won, Canadian dollar, and Singapore dollar. Currencies to avoid are the Japanese yen, Chinese yuan, and the Australian dollar.

Commodities

The principal commodity investments for wealth preservation in uncertain times are gold and silver. However, gold and silver are not interchangeable as stores of wealth. There are important differences. Here is some practical advice for investing in both and some things investors need to know.

There is no fixed ratio of gold to silver prices. Both have fluctuated widely over time as has the ratio itself. Gold is a pure monetary metal. It has almost no practical uses except as money or a store of wealth in the form of jewelry. Silver is an important industrial metal as well as a monetary metal. Therefore, its dollar value can be more volatile than gold and is affected by the business cycle as well as monetary policy.

Gold and silver should be held in physical form as coins or bars. So-called paper gold contracts such as ETFs, COMEX futures or bank unallocated forwards should be avoided because of counterparty and contractual risk. Investors should not use leverage to purchase precious metals because the metal is highly volatile today and leverage only serves to amplify this volatility.

The physical gold or silver should be kept in secure storage outside the banking system because there is a strong conditional



correlation between dramatic price increases in precious metals and the kind of financial stress than can result in the banking system being closed and inaccessible. Secure storage can be arranged through reputable non-bank firms such as Brinks, Dunbar, Loomis, or local vaults that are bonded and insured.

Coins should be new, preferably issued by the U.S. Mint as American Gold Eagles or Silver Eagles. Buyers should not pay a premium for numismatic value. Sales pitches involving pre-1933 gold coins are mostly scams. Small quantities can be purchased online from the mint at www.usmint.gov. Larger quantities can be purchased from reputable dealers, some of whom are recommended on the U.S. Mint website. Dealer commissions vary, but 3% to 7% is customary.

A reasonable allocation of investible assets to precious metals is about 10%. Of this, most should be in gold, but some allocation to silver is practical in case the metal is needed for barter-type exchanges. A U.S. Mint monster box consisting of 500 one-ounce Silver Eagles, currently about $10,000 for the box, is a good addition to any survival kit in the event of an economic collapse and temporary disruption in banking and exchange channels.

Fine ArtMost investors reaction to buying fine art is that they cannot afford the millions of dollars needed to purchase individual pieces of true museum quality art. While true, this need not be a deterrent to art investing because a small number of high-quality art funds have been organized that allow investors to purchase fund units for $200,000. Those proceeds are pooled with others to allow multi million-dollar collections to be obtained. Investors then receive a pro rata share of any sales proceeds, net of fees, when the art is sold.



Such funds must be carefully selected. Many art funds are organized by dealers, which is not ideal from an investors perspective. Some such funds have a built-in conflict of interest if the dealer is using investor proceeds to finance his own dealer inventory. It is better to invest in art funds organized by art and financial experts who are not dealers, and whose interests are better aligned with their own investors.

Art funds offer attractive returns, especially in inflationary environments, but they are not liquid. They function somewhat like private-equity funds, where investors must commit their money for five to 10 years depending on the specific terms of the fund. However, they do offer the potential for sizeable gains and are tax deferral until the art is actually sold. One reputable fund with a good track record based on the success of a prior fund is the Twentieth Century Masters Collection (http://thecollectorsfund.com).

LandLand is an asset class with the potential to perform well in inflation and deflation. For this purpose, an investor should consider vacant land or farmland with current income. In both cases, investors should purchase land with good development potential, in prime locations, and with a low cost of carry from property taxes.

In an inflationary episode, the nominal price of the land should go up at or above the rate of inflation, thereby preserving wealth.

In a deflationary episode, the nominal value may go down, but development costs can go down even faster. This means an investor can undertake development at rock-bottom prices and then later sell the developed property in the next upward cycle following the deflation.



Governments must avoid deflation at all costs, so if a deflationary episode occurs, it will likely be followed by government-induced inflation. The investor who develops land at the bottom of the deflation-inflation cycle will reap the largest gains in the subsequent inflation.

AlternativesSome of the investments already mentioned including gold, silver, fine art, and land are properly considered alternative investments, but in this section, we specifically focus on hedge funds, private-equity funds, and start-ups or angel investing.

Hedge funds are an asset class that works fine in theory but awful in reality. The theory is that hedge funds pursue strategies that work well in up and down markets and deliver returns that are not correlated to stock and bond markets. The reality is that most hedge funds do not deliver on their promises, underperform indices, and charge high fees.

The key to hedge-fund investing is manager selection. A small percentage of all hedge funds actually do live up to the promise of the asset class, but finding those managers is extremely difficult without extensive experience in the hedge-fund industry.

Investors should avoid hedge funds that are heavily involved in credit and asset-backed securities because they will do poorly when the existing system of banking and credit unravels in the years ahead. One of the best strategies is to invest with a seasoned global-macro strategy manager who is opportunistic and nimble in moving among currencies, markets, and long or short positions. One of the best in this category is the wPraxis 3x strategy managed by Willowbridge Associates.



Private-equity funds are best avoided for the time being because the leverage being used inside these funds is excessive, and valuations of target companies are inflated. However, once a serious market reversal occurs, perhaps in 2015 or soon thereafter, newly organized private-equity funds will be able to make cheap acquisitions from distressed sellers, which can lay the foundation for good returns going forward.

Investing in start-up companies is highly risky and typically results in a 90% failure rate. However, a few discrete successes that produce returns that are high multiples of the amounts invested can make up for such losses and produce positive overall returns. The best advice here is to select areas that are familiar to you and entrepreneurs that you know personally or are introduced through reliable contacts.

CashGiven the dangers facing the global banking system, cash, typically held in the form of bank deposits, might seem an unusual choice. But cash has many benefits including the fact that it is an excellent hedge against deflation. In deflation, the value of cash goes up in real terms.

In addition, cash has valuable embedded optionality, which is often overlooked by investors. This comes from the fact that an investor holding cash has the ability to pivot swiftly into other asset classes when new information becomes available, whereas a fully invested party may have difficulty pulling out of one investment to redeploy in another direction.

Cash should be spread among several banks and never deposited in excess of amounts covered by FDIC insurance. Currently, the insured amount is $250,000 per customer for each institution. However, this amount is subject to change. An investor can increase his or her insurance coverage by spreading a large deposit among several banks.



ConclusionIt is important for investors to understand that the suggestions offered here are intended to offer reasonable income, to preserve wealth, and to offer potential gains through a coming period of unprecedented economic collapse.

They will not necessarily produce the greatest gains in the immediate future. High short-run gains will come from bubble activity that is prone to sudden and unexpected collapse, resulting in losses of 30% or 50% or even more in very short periods of time. Since no one knows the exact timing of a collapse, such bubbles are best avoided.

It is also the case that not all of these strategies will produce high returns in all conditions. This is an all weather portfolio designed to preserve wealth through inflation, deflation, confiscatory taxation, and high volatility.

For example, if inflation is suddenly and unexpectedly high, the bond allocation may underperform, but gold will outperform. Likewise, if deflation is persistent and begins to overwhelm central banks, gold may temporarily underperform, but the bonds will produce large gains. Land is positioned to do well in inflation and deflation for the reasons noted above.

A diversified portfolio of the above asset classes might look like the following:

15% stocks with underlying real assets

15% 10-year U.S. Treasury notes

10% gold and silver



10% fine art

15% land with good development potential

10% alternatives such as global-macro hedge funds

25% cash, diversified among dollars, euros, Swiss francs, etc.

This is a suggested portfolio only, and there is ample scope for variation around these particular themes. For example, a more concerned investor might want to reduce the portion suggested for stocks and bonds and increase the allocations to gold, silver, land, etc.

The key to success with this portfolio is diversification, nimbleness with occasional allocation shifts, and patience. Investors who see this period through and dont run with the herd will emerge in the end with the greatest wealth preservation and the opportunity to grow in the world that follows.

How to Invest Before the Collapse Version B

Documents

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great depression

classic gold standard

period of turmoil

astute investors

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similar dynamics

dynamics of inflation