The Coming Great American Fall (Part 1)...

No, I’m not referring to the changing of the season from summer to autumn…

I’m referring to the collapse of the greatest civilization the world has ever known.

To preface, let me say that I tend to be a contrarian and see things from the “glass is half empty” side of things. So take that with a grain of salt anytime I post about the demise of America. However, what I’m trying to do with this blog is give you a blend of “wake-up calls” and useful financial information – as not everything you get in the mainstream media is accurate . . . imagine that.

I read the following article the other day online and it appealed to my inner contrarian, so I thought I’d share with you. You may disagree or find the notion of America in decline as absurd, but I think it’s worth a read and reflection. This is one of those “wake-up calls.” I think we can learn a lot from history, but as you’ll read below, apparently we in America aren’t very good students of history. Any emphasis in the below article is mine – FYI.

For your consideration...

The Rise and Fall of America
by Robert Kiyosaki
Monday, October 18, 2010

Alexander Tytler (1747-1813) was a Scottish-born English lawyer and historian. Reportedly, Tytler was critical of democracies, pointing to the history of democracies such as Athens and its flaws, cycles, and ultimate failures. Although the authenticity of his following quote is often disputed, the words have eerie relevance today:

A democracy is always temporary in nature; it simply cannot exist as a permanent form of government.

A democracy will continue to exist up until the time voters discover they can vote themselves generous gifts from the public treasury. From that moment on, the majority always votes for the candidates who promise the most benefits from the public treasury, with the result that every democracy will finally collapse due to loose fiscal policy, which is always followed by dictatorship.

The average age of the world's greatest civilizations from the beginning of history has been about 200 years. During those 200 years, these nations always progressed through the following sequence:

• From bondage to spiritual faith;
• From spiritual faith to great courage;
• From courage to liberty;
• From liberty to abundance;
• From abundance to complacency;
• From complacency to apathy;
• From apathy to dependence;
• From dependence back to bondage.

Tytler's Cycle and the U.S.
In looking at American history, we can see Tytler's sequence in action. In 1620, the Pilgrims sailed to America to escape the religious bondage imposed by the Church of England. Their spiritual faith carried them to the new world.

Because of their deep faith, the Pilgrims left England in spite of the high percentage of deaths incurred by earlier American settlements. For example, when Jamestown, Virginia, was founded in 1607, 70 of the 108 settlers died in the first year. The following winter only 60 of 500 new settlers lived. Between 1619 and 1622, the Virginia Company sent 3,600 more settlers to the colony, and over those three years 3,000 would die.

In 1776, the Declaration of Independence was signed. From spiritual faith the new Americans were garnering great courage. By crafting the Declaration of Independence, the colonists knew they were essentially declaring war on the most powerful country in the world -- England.

With the onset of the Revolutionary War, the colonists were moving from courage to liberty, following Tytler's sequence. By demanding their independence and being willing to fight for it, a new democracy was born. This new democracy grew rapidly for nearly 200 years.

Then, in 1933, the U.S. was thrown into the Great Depression and elected Franklin Delano Roosevelt as president. Facing total economic collapse, Roosevelt took the U.S. dollar off the gold standard. At the same time, Germany, also in financial crisis, elected Adolf Hitler as its leader. World War II soon followed.

In 1944, with WWII coming to an end, the Bretton Woods Agreement was signed by the world powers and the U.S. dollar, once again backed by gold, became the reserve currency of the world.

After the war, America passed England, France, and Germany to become the new world power. Having entered the war late, the U.S. emerged as the creditor nation to the world. Our factories weren't bombed and the world owed us money. The U.S. grew rich financing the rebuilding of England, France, Germany, Italy, and Japan. The American democracy was transitioning from liberty to abundance -- maybe too much abundance.

In 1971 President Nixon violated the Bretton Woods Agreement by taking the U.S. dollar off the gold standard because America was spending more than it was producing and the U.S. gold reserves were being depleted.

In 1972 Nixon visited China to open the door for trade. What followed was the biggest economic boom in history -- a boom fueled by the U.S. borrowing money through the sale of bonds to China, one of the world's poorest countries at that time. The sale of these bonds financed a growing U.S. trade deficit. China produced low-cost goods, and we paid for them with money borrowed from the Chinese workers.

American factory production, which had fueled the American boom after WWII, was "shipped" overseas along with high-paying American jobs. America was shifting from abundance to complacency. Rather than produce, we borrowed and printed money to maintain our standard of living.

In 1976 America celebrated its 200th anniversary as a democracy. Rather than produce, we kept borrowing to finance social-welfare programs. Over the next three decades or so, America slid from complacency to apathy.

In 2007 the subprime crisis reared its ugly head. And by 2010, unemployment increased to double-digits, even as the rich got richer. Once-affluent people walked away from homes they could no longer afford. The U.S. moved from apathy to dependence.

Today we're dependent upon China to finance our debt as well as fill our stores with cheap products. At the same time, millions of Americans are becoming dependent upon the government to take care of them. If Tytler is correct, the American democracy is presently moving from dependence back to bondage.

Filling the Void
History reminds us that dictators and despots arise during times of severe economic crisis. Some of the more infamous despots are Hitler, Stalin, Mao, and Napoleon. I find it interesting that the U.S. is now dependent upon Chairman Mao's creation, the People's Republic of China, for the things that we buy and the money that we borrow.

To me, this is spooky, foreboding, and ominous. While the Chinese people, as a rule, are good people, my business dealings with Communist Chinese officials have left me disturbed and concerned about the rise of the Chinese Empire. As you know, China doesn't plan on becoming a democracy. With money, factories, a billion people to feed, and a massive military, could they put the free world into bondage?

Although I don't like the way the Chinese do business, I continue to do business in China. I have to. They're the next world power. I cautiously believe that trade, business, and understanding offer better options for world peace and prosperity than isolationism.

Now the Western world must seek to grow stronger financially as China continues to gain power. To do this, our schools need to offer more sophisticated financial education to children of all ages.

This is not the time to be complacent or apathetic. This is the time to think globally.
Putting up trade barriers would be disastrous. Instead, it's time our schools train students to be entrepreneurs who export to the world rather than employees looking for jobs that are being exported to low-wage countries.

Please be clear. I don't fear the Chinese. I fear our own growing weakness. Only a weak people can be oppressed. Today, America has too many people looking to the government for financial salvation.

In 1620 the Pilgrims fled the spiritual oppression of the Church of England. Today Americans may need to flee the financial oppression of our own government as our democracy dies. If we follow Tytler's cycle for democracy, our financial dependence will lead us to financial bondage.

Some Information on Bonds...

The economic times we live in have created a lot of fear and uncertainty. What you’ll historically see in such times is this: a “flight to safety” as people pull money out of equities (stocks) and put it in bonds or hold in cash.

So why put money in bonds? Let’s have a look at what bonds are so we can understand why they are “safe.”

While we think of bonds as investments, they ironically represent debt. What happens is that when the government or a company wants to raise money, one way they will do so is to issue bonds – meaning, investors will purchase bonds (usually in $1,000 increments) from the issuer (the government or company) in exchange for a promise of future payments plus interest as their return on investment. Bonds can be for a duration of anywhere from 3 month to 30 year bonds. They all vary depending on the issuer. Typically, you’ll also see either a semi-annual (twice a year) or single interest payment on the bond; and at the end of the term of the bond, you’ll get your initial investment back. So a bond represents debt for the issuer. They issue a bond to get money now for a project and have to pay you back over time. They are in debt to you (the bond holder).

From the standpoint of the government, the Treasury issues new bonds frequently to finance the national debt. We can’t pay for our spending as we go, so we’ll issue debt now to get money now, and will pay it back later. Many countries purchase our debt issuance. For instance, China holds a large amount of U.S. treasuries issues. Thus, the U.S. is in debt to China for financing our spending. See a long-term problem here? But I digress…

The below gives you an idea on bond payments and the cash flows that come from them (single annual coupon payment).

So why is a bond “safe”? Because the issuer is bound by the terms of the bond issue and you get predictable income in return (assuming the issuer doesn’t default on the promise to pay). In an uncertain environment when you may have a negative rate of return on your stock investments, it sounds pretty good to have a “sure thing” like bonds, huh?

A lot of people have been thinking so too.

Last year, retail investors put over $380 billion into bond mutual funds. This year, another $240 billion has gone in. In contrast, over $75 billion has come out of equity (stock based) funds this year. Last year, it was more to the tune of $150 billion coming out of equities…yikes! That’s a lot of money moving out of the stock market and into the bond market…

Let’s stop right here and make a big distinction between bonds and bond funds.

So far, I’ve been referring to “bonds” in a generic sense. Up until now, talk of bonds has been academic for the purpose of understanding the structure of a bond and how its “safety” is derived. From here on out, I will be talking about “bond funds”.

When I say “bond funds” we are talking about funds (similar to a mutual fund) that are comprised of many types of bonds and bonds with many different durations (for instance a bond may be comprised of 3 month bonds, 1 year bonds, corporate bonds, municipal bonds, 30 year Treasuries, etc.). Funds that hold bonds typically don’t buy them and hold them for the entire life of the bonds. Bond funds employ strategies to buy and sell bonds before they reach maturity based on changing interest rate structures, yield to maturities, and call provisions. Sound confusing? It is, actually. Bonds surprisingly are a lot more complex than stocks if you choose to do anything other than to buy and hold them.

What’s important to understand; however, is that bonds work different than stocks in regards to interest rates and the interest rate can affect the price/value of the bond. If you are to understand one thing about bonds and bond funds, understand this: Bond values and interest rates have an inverse relationship. That means that when one goes up, the other goes down – and visa versa. For instance, if interest rates rise, prices of bonds decrease. Conversely, if interest rates decrease, prices of bonds increase.

Why? It has to do with the valuation of a bond. Think about it…if you hold a bond that is promising a 5% coupon rate, but you can now purchase a bond with a 6% coupon rate in the market, the better deal is to go with the 6% rate, right? Who would buy your 5% bond now? Well, you can’t adjust the interest rate to match the 6%, but you can adjust the price of the bond to entice buyers to buy your bond…so you’d lower the price to attract a buyer.

Additionally, it’s also important to know that the longer the maturity of the bond, the more sensitive the return will be to a change in interest rates. So a one-year bond is going to be less sensitive to an interest rate change than would be a 30-year bond. To compensate for this “interest rate risk”, longer term bonds have more yield (pay more interest) than do shorter term bonds. The reason: to entice investors to buy longer term bonds, they need to pay them more interest for them to justify the risk being taken.

Very theoretical stuff, I know. Let’s try a quick example just to drive home the point. If you own bonds with a five-year, 10-year, and 30-year maturity and interest rates go up 1 percent in one year, the following would happen: the five-year bond will lose 0.5 percent of its value, the 10-year bond would fall 4 percent, and the 30-year bond would lose 12 percent! Ouch!

As of this writing, yields on US Treasury Bonds were: 0.11% for 3 month; 0.16% for 6 month; 0.36% for 2 year; 0.51% for 3 year; 1.13% for 5 year; 2.53% for 10 year; 3.96% for 30 year. These yields get plotted on a “yield curve”…something that would look like this:


Now that you have this understanding and background, I’ll share with you my concern about the current state of the bond markets.

As we noted, in times of economic uncertainty, what you have is a “flight to safety” and a lot of people move out of equities and move into bonds. As was noted, a ton of money has moved into the bond markets lately. Here’s the concerning part: Currently, the Federal funds rate and thus interest rates of many “safe” bonds (government bonds) are at major lows. With lowering interest rates and a large market demand for these safe bonds, prices have been pushed higher. Now, do you think that the Federal funds rate will stay low forever? No! Even though we have historically low rates, and even face another round of money injection into the economy (the Fed’s “Quantitative Easing” being talked about), eventually, the Fed will take action and we will be facing an inflationary environment with interest rates on the rise. So, as was discussed, if interest rates increase, prices of bonds decrease. The risk that is now forming in the bond markets is that bond funds will see large loses once interest rates begin to climb – because the value (the price) of those underlying bonds in the fund will decline. Participants in those bond funds will start to realize investment loses.

Now, far be it for me to call a spade a spade, but I’d venture to say we’re experiencing a bond bubble. It’s as if we have a complete reversal of the dot-com bubble of the late 1990s. Everyone was high on stocks and money was pouring in. Now everyone is scared and money is pouring into the bond markets. This looks like classic herd mentality to me.

In light of the above information, I’d recommend that you research your current investment mix to see what your exposure is to bonds…specifically long-term bonds. FYI - Any mutual fund that you hold typically has a bond component as well - this problem is not just specific only to bond funds.

I’m not advocating that you bail out of bonds or bond funds altogether, but you need to understand and know what your risk exposure is to a bond bubble burst. Any bond fund or mutual fund that contains bonds that are TIPS (Treasury Inflation-Protected Securities) or low-duration bonds (short maturity bonds) will be relatively safe. TIPS provide protection against inflation, as they are structured so that the principal (the value) increases with inflation and decreases with deflation (i.e., the principal is positively correlated to inflation). As was already mentioned, bonds with shorter terms (3 month or 1 year bonds, for example) aren’t as affected by changes in interest rates and aren’t as subject to as much loss. Thus, low-duration bonds have less volatility because you are not locked into a long-term yield. This would be more advantageous in a rising interest rate environment.

As a side note, when interest rates begin going up, that is generally a sign that the economy is on more solid footing. A way to offset some of the bond risk is to invest in funds that have high yielding dividend stocks, say anywhere between a 4 and 7 percent dividend yield. This will provide a consistent stream of income from the routine dividend payments, and will also benefit from capital appreciation in an improving economic environment.

If you want to read more about bonds and the hypothesized bond bubble, just do a search for “bond bubble” online and I’m sure you can find people far more intelligent than myself discussing these issues at length.

Top 5 Things An Investor Should Know...#2

Before continuing our “Top 5 Things An Investor Should Know”, let’s review #1: Unregulated Capitalism is a Bad Thing. Why? Because investors need to have a level playing field. Without a level playing field, we find ourselves no longer in a capitalistic system – only imperialism. Personally, I maintain we are already on the road to imperialism unless things change. But I digress…

Now before we jump into #2, let me give a brief background on an important underlying and controversial theory (that is, it’s controversial in the finance world – we’re a boring bunch) that will come into play in this post: the Efficient Market Hypothesis (EMH). Simply put, the theory suggests that the financial markets are “efficient” based on the information exchange available in the markets. For example, the price you pay for a stock reflects all current information available in the markets for that particular stock, company, industry, and economy. The price you pay reflects the current / updated value of that stock. Three versions / degrees exist of EMH (stick with me, this may help clarify some more). The weak form of EMH says that pricing in the markets already reflects common information publicly available (historical prices, dividends paid, financial reports, analyst reports, etc.). The semi-strong form says that pricing in the markets reflects all common public information AND instantly changes to reflect new information (the word “instantly” is key here). The strong version of EMH affirms all of the others and also says that pricing takes into account “insider” information; i.e., information that is not made public.

There is debate on both sides of the table as to whether or not EMH has legs to stand on. For example, “if markets are efficient, how come we get ‘bubbles’?” An efficient market would never have “bubble” events if everything is always at an optimal point, right? At the same time, technology has opened up a whole new world for the flow of information and the speed at which market prices are updated. Traders (and computer programmed traders) can execute trades much faster. On the whole, it would appear that the market pricing reflects value much faster and more “up-to-date” – so we have reason to believe that markets operate much more efficiently with technology than without. There’s plenty more from both sides of the debate, but I won’t bore you here (if not already!).

Myself, I tend to believe some elements of EMH exist in the markets, but there is evidence that markets are not entirely efficient. So I take a little of both…

If you grasp the above theory a little bit, then these concepts will help you understand the following…

Now - on to #2 of the “Top 5 Things An Investor Should Know”.

#2: You Can’t Beat Wall Street at Making a Quick Buck

Make no mistake: the financial firms on Wall Street are some of the most sophisticated, smartest, and most motivated institutions on the planet. Big money is made daily. Financial firms of all kinds have thousands of Ph.D.s, CFAs (Certified Financial Analysts), mathematicians, and computer science whizzes on staff all concentrated on studying the daily movements of the markets, the minutia of company financials and industries, and the economy at large. They have some of the fastest and most technological sophisticated computers available with computer algorithms programmed to take advantage of mispricing in the markets within fractions of a second (ever heard of high frequency trading?). They also have tons of money available at their disposal in which to invest based on their conclusions. They have war chests solely for lobbying politicians and getting favorable legislation. They have former employees in government positions and they have former government employees on staff.

So, do you think you and I stand a chance of making a fortune by buying a stock that was mentioned in the Wall Street Journal, or on CNBC by the sensationalist talking heads, by a recommendation from a stock broker (who is probably recommending it to all of his clients), or even by buying one of those infomercial computer software trading packages you see on TV? PUULLLLEEZZZZ.

Odds are, if you are looking to flip a stock quickly and make a pile of money, you will lose.

Why? Elements of the efficient market hypothesis (EMH) would suggest that such a large number of professionals engaged in investing activities would move prices to an optimal level – and fast. If there are a ton of people engaged daily, hourly, minutely, in exploiting mis-pricings then prices in the markets are corrected quickly. Thus, the profit available in a stock has already been picked clean by the Wall Street vultures before you and I even get wind of the stock, not-to-mention buy the stock and hope to sell it quickly for a large profit. Understanding this, will save you time, energy, and money.

The age old investment advice you hear is: “buy low and sell high.” Even though it’s such a common thing to hear, it hardly rings true for the average investor. Most investors “buy high and sell low” because they hold out too long. Most of us buy a stock due to hype or a “hot tip”, see it go up, and then try to wring out just a few more pennies of profit before selling for a gain. However, it never happens. Instead we find ourselves holding on for just a few more pennies whereupon the stock crashes before it can be sold. Now we are too emotionally involved in the stock and hang onto it…hoping that it will go back up. Then the stock tanks further. Finally we sell defeated. Ironically, days later after selling, it recovers in a rally. Oh the irony. Oh the painful sting. The sickness in the gut. This happens over and over to people daily. Sound familiar to any of you?

Did you know that most common investors don’t even beat the average market returns?

Why?

Fear, Emotions, Anxiety, Greed, Herd mentality, Lack of long-term vision - all factors that typically contribute to selling low and buying high. Much of this is studied by those in “behavioral finance.” I won’t pretend to know much about behavioral finance, but what I can say is that there is a HUGE difference between you and I as investors and those on Wall Street making investment decisions. We operate on emotions and impulse; Wall Street operates on calculated planning and objective factors in their investing.

So what should the average investor do?

1) Don’t try and beat Wall Street at their game of fast money. Don’t think you can make a quick buck. For one, financial institutions have millions of dollars in the coffers to fall back on if a trade doesn’t pan out. You and I don’t have that luxury. A big loss can hurt us big and set us back. Trying to get rich quick, or build back your nest egg that was lost in the last two years in one shot increases your exposure to risk and losing even more. Understand that building wealth takes time. Trying to get rich quick will more than likely burn you…

2) It’s important to have a financial plan and stick to it for the long-term rather than let fear and greed work its way in. As I’ve mentioned before, turning off the TV sensationalist talking heads will help decrease your anxiety levels as well. Keeping an eye on a longer horizon will help decrease anxiety and allow you to make more objective decisions. Plus it will help you weather the storms that come along by allowing you to focus on the long-term goal.

3) Diversification is still one of the best ways to protect yourself and your investments. For example, holding a small handful of stocks only is a bad way to diversify. Better to hold some mutual funds or index funds across asset classes to diversify the risk.

I’ll go more in depth on some of these things in future posts. For now, suffice to say, don’t get caught up in trying to make a quick buck!