Your Grace, I feel I’ve been remiss in my duties. I’ve given you meat and wine and music, but I haven’t shown you the hospitality you deserve. My King has married and I owe my new Queen a wedding gift.

—Lord Walder Frey to the guests at the wedding of Edmure Tully and Roslin Frey in Game of Thrones

The guests invited to the wedding of Edmure Tully and Roslin Frey in Game of Thrones were lulled into a false sense of security by their host, Lord Walder Frey. They never expected Lord Walder to harm them after he offered them guest right, a tradition that provides that after a man invites a guest into his home, neither the guest nor the host can harm each other for the length of the guest’s stay. Guest right was considered one of the most sacred and inviolable social rules in their world, yet they were about to learn that nothing is sacred in the land of Westeros. The wedding celebration was a set-up all along and a bloodbath known as the Red Wedding ensued.

There is no such thing as guest right in the financial markets though investors continue to behave as though they are entitled to safe harbor protection from central bankers. They mistakenly believe that the invitation by central bankers to take greater risks after the financial crisis will protect their investments from losing value, but that is a terrible error of judgment on their part. While The Committee to Destroy the World may not be deliberately plotting to slaughter them like Lord Walder, it is nonetheless creating the conditions for another Red Wedding in the markets.

Investors must take the world as it is, not as they would like it to be. While the previous two chapters set forth a series of policy changes that could set the world on a more productive path, idealism is not an investment strategy. Neither is denial nor relying on the continued generosity (or fecklessness) of central bankers. Just as markets are guided by greed and fear, monetary policy will continue to be guided by people who have no genuine understanding of the real world while fiscal policy will always be made by politicians guided by self-interest and the next election cycle. Policymakers will continue to create havoc—but investors need not succumb to their mistakes. Speaking as a hedge fund manager, I have to make money for my clients all the time. I don’t have the luxury of waiting for politicians and central bankers to come to their senses—and neither do you.

The world is currently populated by far too many unqualified people who are managing money and, in many cases, responsible for enormous pools of capital. We live in a world that too easily allows people to fail upward and makes excuses for failure. It remains shocking that investors remain loyal to managers who produce years of underperformance or blow up portfolios due to inadequate risk controls.

In January 2015, numerous macro hedge funds suffered huge and in some cases catastrophic losses when Switzerland decided to break the peg between the Swiss franc and the Euro currency. Exposing investors to this risk was inexcusable; the Swiss National Bank’s balance sheet had already swelled to 86 percent of Switzerland’s GDP as Swiss authorities tried to defend the peg and the European Central Bank was widely expected to imminently launch a huge quantitative easing program that would place further pressure on the Swiss franc. Yet these macro hedge funds were caught totally flat-footed and lost huge amounts of money (including one well-known $830 million fund, Everest Capital, that literally vaporized 100% of its capital overnight, and another, the Fortress Group’s Macro Fund, that closed later in the year after losing more than $100 million on this trade). Even more disturbing was that many macro funds had been underperforming for years, yet investors had stuck with them. Inertia seems to be an unfortunate characteristic of many investors, particularly large institutional ones. It is little wonder that large pension funds remain terminally underfunded.

The biggest challenge facing investors is that nobody knows what the future holds. Despite the pundits parading on television confidently predicting the future, the reality is that they don’t have a clue what is going to happen. But saying “I don’t know” doesn’t get you invited back for future interviews (though providing consistently bad advice apparently does). In a sound-bite world, the only thing worse than being wrong is being uncertain. Unfortunately, hubris can lead straight to the poorhouse. In order to invest profitably over the long run, investors need to maintain humility, recognize the limits of their knowledge, and acknowledge that the only certainty in this world is uncertainty. They must construct a view of the world that is as accurate and comprehensive as possible but also flexible and hedged. Once they complete that task, they must “connect the dots” and pursue investment strategies that are consistent with that world view. In a networked and globalized world, that view must include not only economics but geopolitics, culture, technology, science and the environment. All of these areas work together to influence markets. Everything is connected.

In order to formulate a realistic investment strategy, investors must acknowledge the following characteristics of the post-crisis global economy and markets at the beginning of 2016:

1. There is too much public and private sector debt in the United States, Europe, Asia, and emerging markets that is never going to be repaid in constant dollars.
2. The value of fiat currencies is being actively debauched by the deliberate policies of central banks. Everybody’s buying power is being demolished. This means that monetary inflation is raging regardless of what “official” inflation statistics report. Deflation is a fairy tale central bankers tell themselves to justify their inability to raise interest rates because of the damage that would cause an over-indebted world.
3. Central banks have distorted markets by artificially suppressing interest rates to levels that render fixed income investments certificates of confiscation in nominal and real (i.e., inflation-adjusted) terms. The government is slowly stealing savers’ money via inflation and currency devaluation.
4. Governments are not pursuing pro-growth fiscal policies capable of generating robust economic growth. This is a political and moral failure rather than an intellectual failure. There are countless policies available to stimulate growth but political leaders don’t have the courage or integrity to implement them and their constituents are too focused on their narrow self-interests to demand them. Slow growth will hurt future economic growth and depress future equity returns.
5. Geopolitical instability is rising to dangerous levels in the Middle East, Eastern Europe, and the South China Sea. War is raging around the world while narcissistic Western elites diddle in Davos and engage in false illusions of stability. The world is one wrong step away from a serious military conflict that would seriously disrupt financial markets.
6. All financial assets are grossly inflated in value—not only stocks and bonds but real estate, art, and collectibles. Put another way, the income flows generated by these assets are insufficient to support their valuations seven years after the financial crisis.

After an epic bull market that began in March 2009, investors are likely to experience a much tougher road in the years ahead. They will have to adjust to a prolonged period of below-trend growth as the suffocating weight of debt saps the vitality from the global economy. Interest rates will likely stay low for a prolonged period of time because economic growth is destined to remain low. If economic growth is somehow able to defy the downward gravitational pull of the rising tide of debt, interest rates will rise and exert their own pressures on corporate profits and growth. Either way, the prospects for high returns in most asset classes are poor.

The most likely scenario—persistent sluggish growth—will leave equity prices in the hands of central banks that have come to believe that their job descriptions include boosting equity prices to promote financial stability. Unfortunately, their policies are promoting precisely the opposite—financial fragility. And they have run out of ammunition to employ when the next recession or crisis arrives. With trillions of dollars/euros/yen weighing down their balance sheets and their official interest rates stuck at zero, central banks are left with limited means of stimulating economies or bailing out markets the next time they are called upon. Betting on central banks was a successful strategy since the financial crisis, but it is unlikely to remain one much longer. Printing money only works for so long before it ends in tears. Investors will need to start relying on themselves rather than on unelected former tenured economics professors to secure their economic futures.

In a slow growth world, however, not all investments grow slowly or perform poorly. The key to investment success is properly diagnosing the macroeconomic environment and choosing the proper investments to profit from that environment. One key concept investors need to understand is the difference between “nominal” and “real” returns. Governments thrive on their citizens’ failure to understand this difference. “Nominal” returns on capital are measured in constant dollars unadjusted for inflation. “Real” returns on capital are measured in inflation-adjusted dollars. As described in the Introduction, the U.S. government promotes the fiction that the prices of goods and services are increasing when real world prices (other than energy since mid-2014) actually are rising at double-digit rates. For this reason, investors need to earn at least high single digit returns on their capital to keep up with rising prices; lower returns leave them with very low or even negative real or inflation-adjusted returns, meaning their dollars buy less of what they need to live every year. The reason there is so much political discussion about low wage growth is that American workers keep falling behind in terms of what their paychecks buy them in the real world. No less is true with respect to their investment returns although this technical point receives far less media attention.

Ironically, the policymakers who complain about wealth inequality and the impoverishment of ordinary Americans are the very ones responsible for policies that suppress interest rates and investment returns and damage these same constituencies. The Federal Reserve destroyed bonds as an investment class with zero interest rates and quantitative easing. For evidence of this, we need look no further than the performance of the two largest bond funds in the world. For the 3-year period ended May 1, 2015, the PIMCO Total Return Fund and the Vanguard Total Bond Index Fund generated annualized returns of only 2.78 percent and 3.46 percent, respectively. On a nominal basis those returns are unimpressive enough, but on an inflation-adjusted basis they are effectively zero. By May 1, 2015, the PIMCO Total Return Fund had lost more than 65 percent of its assets from its peak of $293 billion in April 2013. While many have attributed these outflows to the departure of Bill Gross as the fund’s manager, the real reason is consistently poor performance that started well before Mr. Gross’s exit.

While these large bond funds market themselves based on relative performance (i.e., how they perform against their peers), investors should tire of being told that “in the kingdom of the blind, the one-eyed man is king.” They can’t eat relative real returns of zero. While PIMCO’s and Vanguard’s returns reveal that these funds have been reduced to little more than glorified money market funds, they are actually much riskier than money market funds because they employ huge amounts of derivatives and leverage to earn these paltry returns. This means that their risk-adjusted returns are even worse than they appear and investors should be looking for alternatives. If these funds were half as adept at investing as they are at marketing, investors would have nothing to worry about. Then again, that could be said of most of the products sold by Wall Street.

In order to deal with the headwinds facing global markets in the next few years and protect their capital, investors need a plan. That plan should involve structuring a portfolio that can generate income and protect capital on both a short-term and a long-term basis. While reasonable men and women can differ on the proper portfolio mix, the following is one model portfolio for a typical individual investor based on the state of the post-crisis world. Investors should discuss their investments with a professional to insure that their portfolio is suited for their specific needs and circumstances.

1. Gold, precious metals, tangible assets—10–20 percent
2. Cash—10–20 percent
3. Absolute return strategies—20–40 percent
4. Dividend paying equities—20 percent
5. Income generating securities—10–20 percent

The first thing readers will notice is that there is an allocation to “income generating securities” but not to bonds per se such as investment grade and municipal bonds and Treasuries. Many absolute return strategies will provide some bond exposure. But beyond that, investors should minimize their bond exposure. Bonds have been rendered certificates of confiscation by post-crisis central bank policies that artificially suppressed interest rates around the world to zero (or less). As discussed above, the largest bond funds in the world have struggled to generate positive returns since 2012.

Some highly regarded investors believe that interest rates will drop sharply over the next few years. Since they are already very low, interest rates would have to drop sharply to generate high returns. For example, it would require the yield on the 10-year Treasury to decline from 2% to 1% over 12 months to generate a total return of 12.8% (and 13.7% for 10-year zero coupon Treasuries). For the 30-year Treasury bond, a decline from 2.9% to 2.0% over a 12-month period would generate a 22.4% return (32.8% on 30-year zero coupon Treasuries). Such sharp declines in interest rates would almost certainly mean that the economy entered a recession (or worse) and that equities and other risk assets suffered severe, if not catastrophic, losses. Alternatively, only small jumps in interest rates would result in big losses for investors.

While I believe there is a reasonable likelihood that rates will move lower as the U.S. and global economy struggles in the years ahead, I believe the risk/reward with respect to high quality bonds (Treasuries, investment grade corporate, and municipal bonds) is poor. The most likely scenario is that bonds will continue to offer poor real (inflation-adjusted) returns for a prolonged period of time in the best of circumstances and pose a serious risk of generating negative returns if central bank policies trigger higher inflation and higher interest rates. If central bankers have demonstrated anything, it is that they will double down on failed policies until they trigger a crisis. That crisis could manifest itself in higher inflation that will seriously hurt bond returns.

The second thing that is not readily apparent from the proposed model portfolio is that investors should hold as many of their assets as possible in U.S. dollars. While the value of all paper currencies will continue to be destroyed by central banks, the U.S. dollar should fare much better than other major currencies like the Euro and the Japanese yen. China will also continue to cheapen its currency in order to remain competitive. To the extent investors hold assets that are denominated in fiat currencies, that fiat currency should be the U.S. dollar.¹

One of the biggest threats to all paper investments is that the currencies in which they are denominated are being actively devalued every day by the failed monetary policies of the world’s central banks and the complete absence of meaningful pro-growth fiscal policies of the sort laid out earlier in this book. The only way to protect yourself is to first, diversify some of your assets out of paper currencies, and second, concentrate your paper currency holdings in the U.S. dollar.

With those two provisos, the following is a discussion of my model portfolio.

Gold

I end every issue of The Credit Strategist with words to the effect “Buy gold and save yourself.” Gold remains highly controversial among the thinking and non-thinking classes but it is going to be worth a lot more in the future than it is today. Gold spiked to $1,900 an ounce in late 2011 as a result of a number of exogenous factors, including fears about the viability of the European currency union and the flow of money into newly created investment vehicles such as the SPDR Gold Shares ETF (GLD). By mid-2015, it had sold off by roughly 40 percent even as central banks kept pouring trillions of newly created paper money into financial markets and the global economy.

As of late 2015, gold was among the most out-of-favor investments in the world and was vulnerable to trading lower primarily (but not exclusively) because of a rising dollar. But investors were taking a very short-sighted view. Long-term investors who are interested in protecting their wealth should continue to buy gold. Gold should comprise between 10 percent and 20 percent of any portfolio. As James Grant has argued, gold is an investment in global monetary disorder, a condition of which we can be assured for many years. Gold is a hedge against both inflation and deflation and an excellent way to pass wealth down through generations.

The first thing to understand is that gold should be considered a currency, not a metal or commodity, in today’s world. But unlike other currencies (with the exception of digital currencies such as bitcoin), it is the anti-fiat currency. In mid-2014, the U.S. dollar began to rise against the Euro, the Japanese yen, and other currencies as U.S. monetary policy began to diverge from those of other major central banks in Europe, Japan, and elsewhere. The Federal Reserve ended quantitative easing in October 2014. In contrast, the Bank of Japan and European Central Bank were about to double down on their versions of this doomed-to-fail policy, which they did in October 2014 and January 2015, respectively.

While the dollar is likely to continue rising against the Euro and the yen long after the publication of this book, the question remains: What will happen to the value of the dollar itself in a world where the Federal Reserve has made no secret of its desire to increase inflation as its official policy? The answer to that question is that it will decline against the value of gold and other tangible assets over the long run. The explosion in financial asset prices since the financial crisis is a manifestation of the destruction of the value of all fiat currencies including the dollar. It is no accident that the wealthiest people in the world are shifting money out of paper currencies into high end real estate, collectibles, art, and other tangible assets. Eventually gold and other precious metals will appreciate sharply along with these beneficiaries of dollar depreciation.

There are several ways to own gold. The preferred way is to own physical gold through the purchase of coins and gold bars. I also recommend the Central Fund of Canada (CEF) and the Sprott Physical Gold Trust ETF (PHYS), which often trade at a discount to the spot price of gold. The SPDR Gold Shares ETF (GLD) is a third way to own gold but tends to attract more speculative fund flows than the other two.

Gold mining shares are another way to gain exposure to gold. In January 2016, the Philadelphia Gold and Silver Index (XAU) was trading at its lowest level since November 2000, when gold was priced at $266 per ounce. While investing in gold mining companies involves exposure to the operating issues involved in investing in any business, it provides another way to invest in gold while also providing exposure to a deeply distressed sector that offers significant upside potential when the price of its primary product recovers. Investors should focus on well-capitalized miners and avoid highly leveraged ones that could suffer from a prolonged period of low gold prices.

Absolute Return Strategies

Investors who continue to rely on a rising stock market courtesy of the kindness (or errors) of central bankers are likely to be very disappointed in the years ahead. The S&P 500 enjoyed an enviable run since hitting its post-crisis low in March 2009, more than tripling in value by mid-2015. This performance was due to two primary factors: (1) a strong recovery in corporate earnings from 2009 recession lows; and (2) massive liquidity flowing into the market courtesy of the trillions of dollars of new money created out of thin air by the Federal Reserve and other global central banks. Unfortunately, those policies failed to create sustainable economic growth and reached the point of diminishing returns not only from an economic but also from a market standpoint by the end of 2015. In fact, it is arguable that the post-crisis bull market ended around the time the Fed terminated its quantitative easing program in October 2014.

Looking forward, traditional investments are unlikely to produce attractive returns over the next decade. The days of investing in an S&P 500 index fund and closing your eyes and hoping for the best are over. Two of the most highly respected strategists in the investment world, Rob Arnott at Performance Analytics and Jeremy Grantham at Grantham Mayo van Otterloo (GMO), are forecasting that stocks are likely to produce negative real (inflation-adjusted) returns over the next 7–10 years (more on this below). Among other things, that means that index investing is going to disappoint a lot of people and active managers are going to have an opportunity to regain the reputations that were tarnished during the great post-crisis bull market.

Since 2008, investors reluctantly but steadily increased their investments in risk assets theoretically capable of providing higher returns like stocks, junk bonds, venture capital, and real estate. This was the result of policies that drove interest rates down to zero, rendering fixed income investments unattractive. But now they face years of low returns on risk assets because the Federal Reserve cannot suppress interest rates forever. Either the economy will begin to grow at better than 2 percent, which would lead interest rates to rise and pressure the value of financial assets, or the economy will continue to struggle and keep interest rates low and depress returns on financial assets. The third scenario, the so-called “Goldilocks” world in which the economy grows just enough to keep markets and financial assets afloat, is highly unlikely since a significant amount of post-crisis growth and investment gains were based on debt that is becoming harder for companies and governments to service. Goldilocks will end up being devoured by the bears and it won’t be a fairy tale.

Stocks have been trading at the upper end of historical valuation ranges since 2013. After they finally experienced their first 10 percent correction in four years in August 2015, they were still trading above historical mean valuations and certain sectors such as social media and biotechnology stocks remained in bubble territory. The high yield credit markets, which were approximately $2.35 billion size at the end of 2014 ($1.5 billion in bonds, $850 billion in bank loans), were heading toward a period of higher defaults and lower returns in the 2016–2019 period as it became clear that the post-crisis credit boom reached its limits in late 2014. In other words, neither stocks nor bonds are likely to offer investors attractive risk-adjusted nominal or real returns over the next few years. Even more significant, commodity prices began to collapse in mid-2014 as a result of two factors: (1) the rise in the U.S. dollar; and (2) a slowing global economy driven by a sharp slowdown in China and other emerging markets. Commodities were sending a signal that the post-crisis recovery in global growth was stalling, causing serious problems for investors.

This has led many investors to invest in what are called “alternative strategies” that take many different forms. What these strategies generally have in common—or are supposed to have in common—is the ability to generate attractive risk-adjusted returns regardless of the performance of the stock or bond markets. These strategies are offered by mutual funds, ETFs, and hedge funds as well as by money managers in managed accounts. Many of these strategies require an investor to commit capital for a long period of time and to sacrifice liquidity. Strategies such as private equity and hedge funds (provided they charge reasonable fees) can be attractive, but only a minority of managers of these strategies generate consistently attractive risk-adjusted returns, as I discussed in Chapter 5 with respect to the returns of the private equity industry. There is a limited number of talented managers who can deliver the types of returns that investors will need to survive in the years ahead; but you have to be able to identify them and perform the proper due diligence on their strategies and businesses.

The institutionalization of the alternative investment space has predictably resulted in the compression of investment returns. Institutions impose limitations on managers in the name of controlling risk that often hamper the ability of truly talented managers to generate high returns. Sadly, the people performing this due diligence often lack the qualifications to do so since they never managed money themselves. The days of being able to “pig out” on great investment ideas, as the legendary investor Stanley Druckenmiller famously advises, are over except in rare circumstances where investors are willing to trust a manager to use his or her judgment to generate true alpha. With 10,000 hedge funds now in existence, only a small number are deserving of such trust. The by-product of an increasingly overcrowded and institutionalized industry is significantly lower returns.

Investors need to be extremely selective in choosing alternative managers and must learn how to properly measure risk-adjusted returns. Risk-adjusted returns adjust nominal returns for factors such as leverage, position concentration, fees, liquidity, and similar factors. As noted in Chapter 5 in the discussion regarding private equity returns, nominal returns are often far less attractive than risk-adjusted returns because managers are taking enormous risks to generate those returns. If a strategy requires high amounts of leverage, for example, it is much riskier than a strategy that does not require leverage. Investors need to understand precisely what risks their managers are taking to generate their returns, particularly in the alternatives and hedge fund spaces where many absolute return strategies are offered.

The key to any absolute return strategy is that it not depend on the stock market moving in a particular direction. A long-only strategy, for example, requires a rising stock market to flourish while a short-selling strategy needs the opposite. While there are many different types of absolute return strategies, all of them generally share the ability to go both “long” and “short” the market. The most popular type are “long-short” equity strategies that are really just stock-picking strategies that are only as good as the manager executing them. During the bull market that began in 2009, most “long-short” managers were forced into becoming “long-only” managers since shorting stocks became extremely unprofitable. And it is no secret that active managers of all sorts employing these strategies failed to keep up with a raging S&P 500 as well as other benchmarks during the post-crisis bull market and began losing serious money when the bull market ended in 2015. If a fund is “long-only” but charging performance fees (i.e., a management fee plus a performance fee), it is taking unfair advantage of its clients. Only strategies that truly hedge or require a unique skill should be charging performance fees because those are the only strategies that will protect investors from catastrophic losses in a bear market and generate consistent and attractive risk-adjusted returns net of fees over long periods of time.

Investors are well-served by searching out truly unique strategies such as the Third Friday Total Return Fund, L.P. that I manage and is described in the box on page 351. Third Friday’s investment strategy was developed over a 20-year period and has successfully weathered several market cycles. At the risk of talking my book, there may be 10,000 hedge funds but there are only a handful with track records and pedigrees comparable to Third Friday’s. On a risk-adjusted basis, Third Friday’s returns rank among the best in the hedge fund world.

Equities

Investors should have 20 percent of their portfolio invested in stocks. This is lower than the traditional allocation recommended by financial advisors, but the return prospects for equities over the next decade are poor. Furthermore, many absolute return strategies will include additional exposure to equities, so the 20 percent figure is not as low as it appears on its face.

If equity exposure takes the form of index products (such as an S&P 500 mutual fund or ETF), investors should treat it as a “buy and hold” investment and should not attempt to trade it. Over long periods of time, equities should continue to generate high single digit total rates of return (consisting of capital gains plus dividends). As David Rosenberg of Gluskin Sheff & Associates, Inc. teaches, it is time “in” the market rather than “timing” the market that generates solid long-term equity returns. Individuals holding specific stocks need to employ disciplined buy and sell strategies that include stop loss limits to prevent outsized losses in specific stocks and sectors. Investors who failed to employ such strategies with respect to energy stocks and master limited partnerships suffered catastrophic losses between mid-2014 and late 2015 after oil dropped by more than 60 percent. Many of these stocks dropped by as much as 80 percent during that period. There is no reason to buy-and-hold stocks in the face of those types of declines.

As noted above, two of the most highly respected strategists in the investment world, Rob Arnott at Performance Analytics and Jeremy Grantham at Grantham Mayo van Otterloo (GMO), are forecasting that stocks are likely to produce extremely low returns over the next 7–10 years.

As of December 31, 2015, GMO’s 7-year real (i.e., inflation-adjusted) return forecasts are the following compared to the 6.5 percent long-term historical return for U.S. equities:²

Performance Analytics had similar 10-year real return projections as of mid-year 2015:³

Both firms forecast that only non-U.S. equities are likely to generate meaningful returns over the next decade, and even those returns are relatively muted.

The post-crisis bull market was only partially the result of a recovery in corporate profits from the 2009 recession; the primary contributors to stock gains were unprecedented central bank liquidity operations and massive financial engineering conducted by Corporate America. Since 2009, U.S. corporations have repurchased more than $2 trillion of their own stock. For the 454 companies listed continuously on the S&P 500 between 2004 and 2013, stock buybacks consumed 51 percent of net income and dividends accounted for an additional 35 percent, leaving only 14 percent for other purposes such as research and development and construction of new plants and facilities and capital expenditures. This was a sharp break with earlier periods; in 1981, buybacks only accounted for 2 percent of the S&P 500’s total net income, rising to 25 percent in the 1984–1993 period for the 248 firms continuously listed in the S&P 500 and 37 percent in 1994–2003. Between 2004 and 2013, some of the country’s best known corporations such as IBM returned more than 100 percent of their income to shareholders in the form of stock buybacks and dividends, leveraging up their balance sheets with cheap debt in the process.⁴

While defenders of stock buybacks argue that they are done when management deems their shares to be undervalued, companies repeatedly buy more stock as the price rises. The primary reason buybacks are done is because they increase short-term share prices, enrich management, and give short-term oriented investors what they want. They feed the fiduciary culture discussed in Chapter 8 that privileges short-term thinking without taking into account the long-term costs of sacrificing capital that could be spent on productivity-enhancing investments rather than on buying back increasingly overvalued stock. Laurence Fink, chairman of Blackrock, the world’s largest investment manager, sent the correct message to the leaders of the Fortune 500 in 2014 when he wrote them that “in the wake of the financial crisis, many companies have shied away from investing in the future growth of their companies” by reducing capital expenditures and research and development in order to return capital to shareholders. This trend has only been exacerbated by the pressure by activist shareholders.

It is unrealistic to expect that central banks and corporations will be able to continue supporting stock prices over the next few years as robustly as they have since the financial crisis. The Federal Reserve terminated quantitative easing in October 2014 (although its history of policy mistakes suggests that it could begin buying bonds again at any time and theoretically could toy with negative interest rates if economic or market conditions deteriorate badly enough). Corporations are also reaching the limits of their ability to borrow money to buy back stock and will need to manage their balance sheets and replenish their capital stocks in order to remain competitive globally.

As noted earlier, Société Générale strategist Andrew Lapthorne has shown that net corporate debt was 40 percent higher in mid-2014 than in 2007 but has been disguised by low interest rates,⁵ demonstrating that the ability to keep borrowing unlimited amounts of money to return capital to shareholders is reaching its limits. Based on these factors and elevated late 2015 stock valuations, the 7–10 year outlook for equity returns is unattractive, which is why I am only recommending a 20 percent weighting rather than the much higher weightings that most investment strategists suggest.

As noted above, even after the first stock market correction in four years in August 2015, certain long-term valuation measures suggested that the market was significantly overvalued. After the sell-off, the S&P 500 Market Capitalization/GDP Ratio, about which Warren Buffett has spoken favorably, was 1.14x compared to a historical average of 0.75x. The Shiller Cyclically Adjusted Price Earnings Ratio, which measures the market over a rolling 10-year period, was trading at 24.7x compared to a historical average of 16.6x. Returns in the periods after markets reach such heights tend to be disappointing.

One issue that receives less attention than it should but points to the market being even more overvalued than it looks is that the quality of earnings has deteriorated in recent years as companies employ various accounting tricks to inflate their earnings. This subject receives virtually no attention from Wall Street analysts or the financial media. For example, companies increase their reported earnings by so-called “non-GAAP” adjustments that include non-recurring or non-cash charges that distort cash earnings. In addition, earnings are inflated by the massive stock buybacks described above, by artificially low interest rates, and by favorable stock option accounting. On a cash basis, most corporations are earning far less than their reported earnings. By any reasonable measure, the overall stock market remained extremely expensive in late 2015 after its first correction in four years while certain sectors—social media, Internet, and biotech stocks—were solidly in bubble territory. For that reason, it is prudent to limit portfolios to only 20 percent equity exposure until valuations improve markedly.

There may be opportunities in non-U.S. equity markets, however, such as Europe and Japan, that will benefit from cheaper currencies. But betting on markets that are going to rise because their currencies are being hollowed out by cheaper money is a dangerous game best left to professionals.

Japan, for example, could see its stocks rally due to several factors. First, the government has no choice but to continue to weaken the yen in order to deal with Japan’s terminal debt and demographic challenges. A cheaper yen will boost Japan’s export businesses. Second, Japan’s corporations became very competitive globally as a result of having to operate with an expensive currency for so many years. As a result, they are poised to generate strong profits if they can sell more of their goods under a weak currency regime. Third, corporate governance in Japan is finally starting to improve and recognize the rights of shareholders to a greater extent, rendering the country far more hospitable to foreign investors than ever before. Japan faces significant challenges but its stock markets could provide strong returns over the next decade. Investors should be sure to hedge their yen exposure when they invest in Japanese stocks.

India is another market that offers a great deal of promise due to attractive demographics, a reform-minded prime minister and a progressive central bank president.

These Asian markets are more attractive than Europe, which should benefit from a weaker currency like Japan but faces major debt burdens and continues to struggle to enact meaningful labor and regulatory reforms. Further, the European banking sector remains plagued by capital shortfalls and massive bad debts that could pose systemic risks in the near future. The Euro remains a straitjacket for weaker southern European countries like Spain, Italy, and Portugal that will retard their recovery and likely lead to further debt crises in the years ahead.

Income-Generating Securities

With interest rate sensitive instruments unattractive, investors are forced to look for alternatives to generate income. Other parts of our model portfolio will provide income, including dividend-paying stocks and absolute return strategies. The types of investments that should be made to generate income directly are comprised of the following:

1. Bank loans.
2. Closed-end mutual funds and mortgage REITs trading at a discount to NAV and paying high dividends.
3. Event-driven high yield bonds, bank loans, and convertible bonds.

Bank loans are floating rate, senior in the corporate capital structure and collateralized by a variety of assets. They generate returns in the mid-to-high single digits (and in certain cases higher); unfortunately, they are generally only available to institutional investors. There are mutual funds and ETFs that provide individual investors with access to these loans but investors should choose carefully based on the manager and his or her long-term track record.

Closed-end fixed income mutual funds and mortgage REITs can be attractive if they trade at a discount to the net asset value of the fund. This means that the fund can be purchased at a lower price than the value of the securities owned by the fund and that it is likely paying a high dividend. Such funds can generate high single digit to low double digit returns. Investors can benefit from the high yield and the closing of the gap between the value of the fund and the value of the underlying assets.

Event-driven high yield bonds, loans, and convertible bonds are expected to be refinanced at par or at a call premium prior to maturity. The universe of event-driven bonds and loans shrunk steadily between the end of the financial crisis and early 2015 but was growing again in late 2015. Event-driven bonds and loans are often stressed or distressed and need to be refinanced in order to give a borrower relief from financial pressures such as an imminent debt maturity, covenant violations, or similar issues. In contrast to run-of-the-mill high yield bonds that are generally bought by “buy and hold” investors, event-driven bonds have short (1–2 years) to intermediate (3–4 years) durations (duration measures a bond’s sensitivity to changes in interest rates). As the high yield credit markets heads into a likely period of higher defaults in 2016-2019, there will be greater opportunities to invest in event-driven situations. As always, it will require an experienced and skilled manager to navigate these complex investments.

I do not recommend investments in long-dated investment grade bonds or Treasury securities. Not only are the yields on these securities extremely low—offering minimal-to-negative real (inflation-adjusted returns)—but there is a significant chance that rising inflation will cause interest rates to rise over their life and trap investors with large mark-to-market losses. The Federal Reserve has succeeded in destroying the value of fixed income investments for years to come. The income-generating investments I have suggested offer sound alternatives until something better comes along.

Conclusion

The next few years are going to be one of those periods when investors would do well to worry more about the return of their money than the return on their money. But that doesn’t mean they should throw up their hands and give up. Many investors will do extremely well in the difficult environment that is likely to persist in the coming years if they keep their wits about them and resist the advice offered by the financial media and Wall Street. These sources of investment advice consistently lead investors over the cliff and into shark-infested waters. Investors will do fine if they keep their eye on the ball, listen to people who are interested in telling the truth rather than currying favor with the media or the consensus, and focus on what is really going on in the economy and the world. The world is reaching a tipping point in terms of its ability to suffer the fools who have been guiding its monetary and fiscal policies. All you have to do is look around to see the consequences of their mistakes and realize that you can follow them and be a victim or you can think for yourself and save yourself and your family from their incompetence. The choice is yours.