An Investment Plan For the Upcoming Crash and Burn Period

The following is from "Harry Lightning," who left a very thoughtful comment in response to the Zero Hedge post: Jim Grant: "Uncomfortable Shocks" Lie Ahead As The Great Bond Bear Market Begins"  Jim Grant was saying that interest rates might rise--to 4 or 5%. My comments below are shown in brackets. Everything else is the commenter.

"Jim Grant's drawback has been his perpetual fighting of the trend in bonds, not willing to concede an inch as to why bonds have dropped substantial amounts of yield while all along the US government has been piling up incredibly large amounts of debt that any thoughtful observer realizes can never be paid off without a default. I have agreed with Grant's thinking on this matter from an academic point of view while at the same time going along with the trend. Yes, Mr. Grant, the bond market will collapse one day due to a credit default, but that day was far into the future since the time when you first started trumpeting the bond collapse diagnosis.

I believe Mr. Grant to be wrong now as well. Yes, I do believe that there will be an unbelievable collapse in the US bond market a la Argentina's many examples during the last 50 years. But I do not see that happening until the highly over-valued stock market breaks down first [and govt ramps up massive QE programs and massive deficits].

There are a number of reasons for the stock market to fall 25 or more percent from present levels, the descent probably has already begun albeit in a less than consistent manner. That is often the way bear markets begin, in a back and forth tussle between bulls and bears that bears finally win, causing capitulation of the bulls.

I cannot see any rationale short of a credit collapse that would cause both bonds and stocks to collapse simultaneously. Rather, I think it more likely that the stock market starts falling first as a result of investors refusing to invest at hyper-valued levels. That is the process that has begun this year. As stocks fall, disinflationary and even deflationary forces will become apparent as a result of the negative wealth effect that the falling stock market creates. Not enough time has passed for investors to forget the period of September 2008 through March 2009, and as such, there are a lot of itchy trigger fingers ready to pull as stocks fall more consistently when the bear market asserts itself more fully.

Eventually stocks will fall so far as to cause a flight to safety in the bond market that propels bond prices to record highs, and yields to new lows.  At that point, with an economy in shambles from a stock market that has lost half its value or more and an investment community that then finally starts to question whether the US will be able to generate the revenues to pay down its debt, the US bond market will be seized with credit concerns, and bonds will collapse as too many investors all seek to get through a narrowing door.

The US government will make several attempts along the way to save its stock and bond markets from their inevitable fall, but the result in the latter point of the cycle will be to cause hyper inflation. Which will be the final nail in the bond market's coffin, cutting the value of longer dated US debt down to something like 30 to 50 cents on the dollar. And that is how the US will get rid of its debt problem, by redeeming its outstanding debt for significantly less than the nominal value. [The government can create inflation if it starts sending money to individuals for income support for example. I feel that's likely in the future during the upcoming downturn.]

As I wrote above, this cycle has occurred before, most notably in Argentina. An over-valued stock market cannot be supported any longer by fundamental valuation relative to corporate earnings. Stock values fall, causing a negative wealth effect that supports the decline in stock prices and a growing disinflation that turns into deflation. Bond yields start falling with stock prices as capital transfers from one market to the other, and the falling rates of inflation support the lower bond yields. In the terminal stage of the decline in stock prices and bond yields, the government launches massive quantitative easing operations in a vain attempt to stimulate the economy and reverse the deflationary forces that control economic decision-making. At that point a credit concern arises which quickly causes bond yields to start rising, short-circuiting any Keynesian pump-priming that the money printing was trying to initiate. The vast amount of money injected into financial markets at this time causes the dollar to collapse, quickly reversing the deflationary trend with a hyper-inflation that further pummels the prices of financial assets. With the real estate market destroyed as higher mortgage rates in a weak economy accompany the rising bond yields caused by the government-induced hyper-inflation, the US government then moves to re-structure its massive debt, redeeming outstanding notes and bonds for less than half their nominal value. That represents the end of the business cycle, and whatever economic model to control the US economy then emerges.

Which makes life very easy for investors. A few easy trades and a lot of patience, and you can build the kind of lasting wealth that only is available at times of maximum distress. Because its only at those times that the maximum potential for wealth transfer occurs, from the haves to the have-nots.

I think that the trade now - and I warn you that this is what I would do for myself rather than a blanket recommendation for anyone else - is to:

1)  get out of stocks now and buy longer-dated non-callable US Treasuries [consider buying TLT, the 20+ Year Treasury ETF] . US longer-dated debt may move a bit higher still in yield, maybe to the 3.25% mark on 30 year bonds. But the bigger risk is that yields start falling sharply from here, so rather than look for another ten basis points in yield its better to get on the train before it leaves the station. 

2) Hold that position for as long as stocks continue to trend lower. Initially that stock trend will be difficult to decipher, as it has been seen during the last six weeks, there still are a lot of bulls with money to burn. When stocks start falling sharply and each day seems to bring a bigger fall than the day before, that's when you will know the down trend is firmly established. Bond yields eventually will benefit from the transfer of capital from equities, so wait for new low yields in your bond holdings, lower than the 2.09% recorded for the 30 year US Treasury during the month of July 2016. [I believe that US short-term interest rates will likely to go to zero or even negative with long-term rates at 1% to 1.5%  The Federal Reserve will likely start lowering interest rates, then starting another QE program which will drive interest rates to extreme lows at first].

3) Once bond yields make new low yields, the time will be ripe to take your profits off the table, and you will reap a grand reward while most everyone else will have suffered terrible losses because they got out of stocks and into bonds too late. Once you have your bond profits off the board, then life becomes a bit difficult.

Because while the US government goes through the debt clearance exercise [ramping-up QE to astronomic levels, doing bail-outs that balloon the Federal deficit, probably instituting helicopter money and income support for the public which all hurt the USD will turn deflation into inflation, then possibly a burst of hyper-inflation.] that eventually will restore its economy, there will be little of anything valuable in which to invest. [It seems to me that holding both gold and cash at this point would make sense during this period if the dollar is falling.]

But to your credit, you will be cash rich when every asset under the sun will be cheap, so at that point look for income producing real investments. Maybe buy a business that has a steady customer base regardless of the economy, like a food store. Usually at moments like those in the business cycle, the problem becomes too many good opportunities rather than too few.

I believe the predominant trend for the future will be disinflation and deflation until the bond market makes new low yields."