“Today, only a handful of people know what it really means… and they’re scared. Soon, you will know,” warns the ominous trailer for The China Syndrome.

The film is a 1979 thriller about a news reporter and her cameraman, played by Jane Fonda and Michael Douglas, who learn about a safety cover-up at a nuclear power plant outside of Los Angeles.

The plant proves to be unsafe, confirming the predictions of a shift supervisor, played by Jack Lemmon.

The “China syndrome” is an imaginary, worst-case scenario whereby the nuclear reactor core melts through its containment structures and into the ground. When it reaches the water table, a giant, radioactive cloud is produced.

The core continues to burrow down into the earth… all the way to China.

Such an event would render a vast area uninhabitable for generations.

Eerily, the movie was released just two weeks before the worst accident in U.S. nuclear power plant history – a partial core meltdown in a reactor at the Three Mile Island Nuclear Generating Station.

A small amount of radioactive gas was released, but, luckily, not enough to cause any harm to local residents.

Indeed, life often imitates art.

February 2016

Growing wealth while guarding against market shocks

The Bank of Japan (BOJ) has joined the negative interest rate movement. As a result, the 5-year Japanese government bond traded with a negative yield to maturity for the first time ever. Will we eventually see negative rates in the United States?

Annual Chinese exports declined for the first time since 2009.

The S&P 500 has experienced three consecutive quarters of year-over-year declines in earnings and four consecutive quarters of year-over-year declines in revenues.

European banks have come under significant pressure in the last few months. Deutsche Bank’s stock is now hovering around the level it hit during the global financial crisis.

by ALAN GULA, CFA

The China SyndromeMARKET TREMORS

Anticipating a Meltdown in China and Its Deflationary Fallout

And as it turns out, the financial markets have their own “China syndrome.” Except in this doomsday scenario, the disaster originates in China, and the rest of the world is blanketed in deflationary fallout.

Unlike the fictitious scenario described in the movie, though, this catastrophe is actually possible.

In fact, the meltdown is starting to play out before our very eyes.

To estimate just how ugly the situation in China might get, let’s assess the size and source of the problem.

CENTRALLY PLANNED OUTPUTChina’s economic expansion over the past few decades has been nothing short of astonishing.

The country’s economy has become the largest in the world in terms of trade. The combined value of China’s imports and exports total $4.3 trillion, exceeding the $4.0 trillion of total trade for the United States.

Although China’s total economic output, or gross domestic product (GDP), is still second to that of the U.S., its trajectory has been remarkable. According to data from the International Monetary Fund (IMF), China’s share of global nominal GDP has reached 15.5%, up from just 1.7% in 1990.

One has to wonder how this growth was even possible.

The answer is that it was unnatural.

China has a centrally planned economy. As such, the government sets a GDP target, and local authorities have to meet that target. The easiest way to meet the state’s directives is to build.

Unfortunately, China has over built.

Ghost cities are a well-documented phenomenon in China. Planners had hoped that inhabitants of older cities, or even the rural population, would one day move into these newly erected metropolises.

Alas, the vast majority of the country’s residents can’t afford to live in them, so the cities remain largely uninhabited.

There are literally tens of millions of empty apartments in China. And without residents in a city, the roads, malls, office buildings, and sports stadiums sit empty, eventually falling into disrepair.

Naturally, constructing bridges and buildings requires enormous quantities of raw materials. According to some estimates, China used more cement from 2011 to 2013 than the U.S. used in the entire 20th century.

Unproductive investment, or malinvestment, also extends beyond housing and infrastructure. Many of China’s industries are now imperiled by overcapacity, leading to losses at many companies.

In a capitalistic economy, unprofitable companies would fail and excess capacity would be eliminated. The free market automatically aligns supply with demand.

2

In contrast, the market’s corrective forces are suppressed in a command and control economy such as China’s.

The Communist Party fears the instability associated with mass layoffs. Therefore, state-owned enterprises (SOEs) are propped up. Production continues, inventories swell, and prices plummet.

Overcapacity is sending deflationary impulses around the world. According to the Chinese Iron and Steel Association, its price index plummeted more than 30% in 2015.

The situation in China is actually pretty sad when you consider that annual GDP growth was boosted at the expense of the long-term wealth and prosperity of the Chinese people.

In short, the fastest-growing major economy in the world is a giant deception.

But did we really expect any less from the Communists?

The collapse of the Soviet Union serves as evidence of the shortcomings of central planning.

Basically, it’s impossible for bureaucrats to appropriately allocate capital and resources within

an economy, which is an immensely complex system.

Centrally planned economies often grow in an inefficient and artificial manner, causing instability. In China’s case, a fundamental source of instability is its engine of growth.

CRITICAL MASS OF DEBTChina’s investment boom has been fueled by one of the largest and most rapid credit expansions in world history.

According to the McKinsey Global Institute, China’s total debt-to-GDP ratio stood at 158% at the end of

2007. That figure had ballooned to 282% by the second quarter of 2014. For comparison’s sake, U.S. debt-to-GDP is around 270%, based on the same methodology.

Here’s where it gets terrifying.

According to Michael Every, Head of Financial Markets Research Asia-Pacific at Rabobank, China’s debt-to-GDP may have recently eclipsed 350%.

China’s debt ratio is growing exponentially… which actually makes perfect sense.

An increasing amount of debt issuance and malinvestment is being required to hit the central

33

Kunming, China – China’s credit boom has left a sea of unoccupied apartments and vacant office space.

Barnaby Chambers

4

planners’ GDP targets.

China is like a nuclear reactor that has to be crammed with more and more uranium fuel pellets just to achieve the same power output.

Worse yet, recent Chinese economic output is almost certainly below official GDP figures. In other words, China is reaching the limits of its debt-fueled growth.

Defaults and bankruptcies are desperately needed in order to liquidate “zombie” companies or restructure debts loads. Naturally, anyone who has loaned money to these companies will face massive losses.

China’s banks seem to be on the hook. Since China doesn’t have fully developed debt capital markets, its banking system has largely facilitated the credit boom.

From a bank’s perspective, a loan is an asset. China’s total banking system assets have reached an eye-watering $30.3 trillion, up from around $5 trillion at the end of 2005.

China’s banking system has become absolutely enormous – nearly double the size of the U.S. banking system in terms of assets. Defaults have been virtually non-existent in the past decade, but an increase in non-performing loans suggests that losses loom for Chinese banks.

Given the size of the banking system, even a small fraction of outstanding loans being written down could pose grave consequences.

A traditional banking crisis may not be in the cards because of the government’s control over

the banking system, the supply of credit, and SOEs. However, the central planners won’t be able to avoid a hard landing, which is a rapid shift from high-growth to slow-growth.

Ever since the first Shockproof Investor, which was published one year ago this month, I’ve forecast a Chinese hard landing within the Macro Monitor (page 8).

Legendary macro hedge fund manager George Soros now agrees with my view. During the January 2016 World Economic Forum in Davos, Switzerland, Soros declared that a Chinese hard landing is “practically unavoidable” because it has already begun.

Virtually everyone within China sees the writing on the wall, which is why so many are trying to get their money out of China. Capital flight opens the door to a worst-case scenario.

COOLANT FLUID OUTFLOWSThey say that money flows to where it is treated best.

In actuality, money flows to where there is speculation, thereby exacerbating boom and bust cycles. In China’s case, the money stayed home because of the credit boom and the perception that there was no risk.

Now that China’s central planners have created a radioactive hellstew of debt and overcapacity, the money is leaving.

According to the Institute of International Finance, China experienced net capital outflows

5

in 2015 totaling $676 billion - a huge sum.

Demand for foreign currency and associated selling of the Chinese currency (yuan) creates pressure on the exchange rate. However, up until the end of 2015, the yuan was loosely pegged to the U.S. dollar.

The yuan now tracks a basket of currencies, including the U.S. dollar, but the main point is that China’s currency is heavily managed.

So, in the face of outflows, China has had to utilize foreign exchange (FX) reserves to prevent the yuan from falling too rapidly. The chart below shows the 17% decline in China’s total FX reserves since the middle of 2014.

China’s FX reserves peaked around the time that the Federal Reserve began to taper its third quantitative easing stimulus program.

It’s clear that the equilibrium value of the yuan is much lower, and this was a big impetus for China’s devaluation of its currency in August 2015.

The U.S. dollar bull market dragged the yuan higher, and China needed to do something to ease the pressures created by a stronger currency.

China continues to burn through FX reserves, so it’s also clear that the outflows have continued since the devaluation.

Capital outflows are like coolant fluid leaking

Trillions of U.S. D

ollars

4.0

3.5

3.0

2.5

2.0

1.5

1.0

-16.6%

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

CHINA’S FOREIGN EXCHANGE RESERVES

SOURCE: Bloomberg

6

out of a reactor. Of course, coolant fluid is necessary to prevent a meltdown.

Imagine the Chinese President Xi Jinping sitting in a control room with red lights flashing and buzzers blaring. What would you do?

China may choose to devalue its currency, but the debt and zombie companies will remain.

As Shockproof Investors, our greatest advantages over the market are our patience and discipline. We’ll need both as we await the fallout from the financial market shocks emanating from China.

In the meantime, there will still be opportunities.

DISTRESSED INVESTINGIt’s clear that we’re going to see a trough in the global credit cycle, but it will be very different from the 2008 Credit Crisis.

China was able to sidestep the global financial crisis, largely because of a massive stimulus program. This time around, the country won’t be so lucky. A plethora of companies will, in fact, default on their debt.

The problem has grown unfathomably large, making widespread bailouts impossible.

China’s banks will surely feel the pain, causing them to curtail lending. The companies that need to borrow more just to pay the interest on their debt (most of them), will face existential risk.

Meanwhile, economies with high exposure to commodity prices, such as Canada and Australia, will likely face full-blown credit crises.

Let’s not forget about Europe, which has its own bad loan problem.

Many companies in the United States will default as well. The trailing 12-month high-yield (speculative grade) default rate will likely rise to 10%, just as it did in 1991, 2001, and 2009.

The Yuan Mega-Shock

In January of 1994, China devalued its currency, the yuan, by 33%.

With the Bank of Japan now joining the European Central Bank in implementing negative interest rate policy (NIRP), China may have the cover it needs to carry out a significant devaluation.

After all, NIRP and quantitative easing (QE) are de facto currency devaluation tools.

Mark Hart, a hedge fund manager who foresaw the implosion in the U.S. subprime mortgage market and the European sovereign debt crisis, thinks a large, one-time devaluation is likely.

In an interview on RealVision, a video on-demand platform for financial content, Hart noted, “There are not a lot of great options… They’re between a rock and a hard place; debt deflation on one hand and a devaluation of the currency [on the other].”

The risk for China is that it devalues too little and then still has to burn through more foreign exchange reserves to prop up the yuan. This would severely damage policymakers’ credibility.

Therefore, Hart believes that a 50% devaluation of the yuan would be appropriate and sufficient to attract capital inflows once again.

However, such a gargantuan yuan devaluation would send a deflationary shockwave around the world.

7

Now, this sounds like a doomsday scenario. But one company actually welcomes these developments…

Rising global credit distress is fabulous for Oaktree Capital Group LLC (OAK), which I profiled in the March 2015 issue.

Oaktree is in the process of deploying committed capital in a pair of distressed debt funds (Opportunity Funds Xa and Xb). These funds still have a significant amount of “dry powder,” but the capital will be invested much more aggressively as the credit markets deteriorate.

It’s worth noting that Oaktree’s crisis-era distressed fund achieved a gross internal rate of return of 22%.

At the time we initiated a position in OAK, I said

that we could be patient and opportunistically add the second half of the position.

Well, that time has come.

We raised cash in December before the worst start to a year in stock market history. The wise move gives us the flexibility to buy beaten-down securities, such as OAK.

Action to Take: Add to your holdings of Oaktree Capital Group LLC (OAK) up to $44.00 per share. Increase your position to around 5% of your total portfolio.

Please Note: Oaktree Capital Group LLC (OAK) is structured as a partnership and may not be suitable for retirement accounts. Please consult a tax advisor for specifics.

8

ISSUE STATUS NOTES

Debt Supercycle PeakingThe world is in the latter stages of an unprecedented accumulation of debt relative to economic output. Total global debt is around 290% of GDP. This is currently the most dominant macro driver of all.

Central Planning Accelerating

The financial markets are increasingly being used by central bankers as tools for economic planning. Supply and demand forces no longer determine equilibria in asset prices, interest rates, and currency exchange rates. When central authorities distort the free market’s price discovery mechanism and exert such a heavy influence on capital and resource allocation, then malinvestment and stagnation are the results. Ironically, this leads to even more central planning.

Robotics, Algorithms, and Automation Accelerating

Technological advancement is having a significant impact on the labor market, and, in turn, economic growth and inflation trends. Digital Fortunes is covering this topic in depth. If you're not already subscribed, click here to join today.

Demographics Long-Term TrendThe aging of the global population is being driven by a secular decline in global fertility and mortality rates. For the first time in history, the global population over the age of 65 will be greater than the number of children under the age of five. Demographic shifts have major social and economic consequences.

The Eurozone Smoldering

The failed euro experiment is an unmitigated disaster. A single currency system across countries with disparate languages, cultures, economic profiles, fiscal situations, and political regimes is unworkable. The euro prevents necessary rebalances from occurring and interconnected banking systems create contagion pathways.

U.S. Dollar Carry Trade Unwinding

A dramatic rise in the U.S. dollar, the reserve currency of the world, is deflationary in nature and bearish for commodity prices. It also stresses speculators who have used dollars as a funding currency (dollar carry trade) and foreign entities that have borrowed in dollars. According to the Bank for International Settlements, a total of around $9 trillion in U.S. dollar credit has been extended to non-banks outside the United States.

Global High-Yield Debt Mispricing Correcting

The global reach for yield has been particularly beneficial for high-yield bonds. In 2014, the yield for the benchmark BofA Merrill Lynch U.S. High Yield Master II Index hit 5.16%, likely a generational low in junk bond yields. Debt issuance has risen to meet investor demand. High-yield energy debt is the focus now, but the mispricing is pervasive, so the upcoming default wave will be shocking.

China's Hard Landing Forecast

China's striking credit boom since 2008 has fueled epic real estate and infrastructure malinvestment. Central planners will be unable to orchestrate a smooth transition from debt-driven investment to consumption-based growth. Considering China has the second-largest economy in the world, a hard landing has the potential to cause horrific market shocks that would reverberate around the globe.

Japanese Yen and Sovereign Debt Crisis Forecast

Japan has one of the oldest and most rapidly aging populations of any nation in the world. Its government debt-to-GDP is also 240%, the highest ratio of any country. The Bank of Japan is in the process of monetizing virtually all Japanese government bond issuance, yet the economy has been in and out of recession and real wage growth has stagnated for quite some time.

Australian Credit Crisis ForecastThe prices for iron ore and coal, Australia's top two exports, have plummeted. Combine the impact of collapsing exports with a proper housing market bubble, and you have the makings of a catastrophe down under.

TREN

DSCR

ISES

MACRO MONITOR

9

FIXED INCOME &PREFERRED STOCKS

50%FOREIGN STOCKS

20%

U.S. STOCKS

15%

CASH, HEDGES & SPECULATIVE

15%FIXED INCOME & PREFERRED STOCKS

50%

TARGET WEIGHTS

OVERALL RISK TARGET

DYNAMIC ASSET ALLOCATION MODEL

Dynamic asset allocation involves actively managing the mix of asset classes and sub-categories in response to the ever-changing market environment.

Myriad macro risks remain.

The risk target was lowered in December largely because of the U.S. corporate bond market’s diver-gence with equities.

The dynamic asset allocation and security selection within The Shockproof Portfolio reflect this lower risk target.

Change from previous month: None.

By design, the target asset allocation is currently dominated by volatility-dampening fixed income and preferred stocks.

Credit risk exposure is low and emerging market equity exposure is zero.

We raised cash in December 2015.

Change from previous month: None.

10

HOLDING CATEGORY EXPENSE RATIO YIELD TARGET

ALLOCATIONPRICE

(1/29/2016)CAPITAL

GAIN/LOSS ACTION

iShares MSCI USA Minimum Volatility ETF (USMV)

U.S. Stock 0.15% 2.0% 4.5% $41.24 2.4% Buy

DoubleLine Shiller Enhanced CAPE Fund (DSENX)

U.S. Stock 0.90% 2.6% 10.0% $11.38 -3.6% Buy

Ellington Financial LLC (EFC)

U.S. Stock N/A 12.5% 3.0% $16.21 -12.4% Buy

iShares MSCI EAFE Minimum Volatility ETF (EFAV)

Foreign Stock 0.20% 2.6% 20.0% $63.50 -1.8% Buy

SPDR DoubleLine Total Return Tactical ETF (TOTL)

Fixed Income 0.55% 2.9% 30.0% $49.08 -1.6% Buy

5-Year U.S. Treasuries (CUSIP: 912828WC0)

Fixed Income N/A 1.3% 5.0% $101.88 -0.4% Buy

Nuveen Quality Preferred Income Fund 3 (JHP)

Preferred Stock 1.76% 7.8% 15.0% $8.54 -2.4% Hold

Oaktree Capital Group LLC (OAK)

Hedge N/A 3.7% 5.0% $43.76 -17.8%Add (Limit:

$44.00)

Central Fund of Canada Limited (CEF)

Hedge 0.30% 0.0% 5.0% $10.73 -18.4% Buy

Cash Cash N/A 0.0% 2.5% N/A N/A

TOTAL 100%

THE SHOCKPROOF PORTFOLIOThe goal of The Shockproof Portfolio is to help you grow your wealth while guarding against market shocks and financial

crises. However, just as there’s no one-size-fits-all asset allocation, there’s no single portfolio appropriate for all investors. The Shockproof Portfolio, therefore, is a guide to help you construct your own personalized shockproof portfolio. This

portfolio’s objective is to produce a long-term, risk-adjusted return superior to that of the Vanguard Balanced Index Fund (VBINX), a passive mutual fund with a 60/40 stock-to-bond ratio. FOR FULL PORTFOLIO DETAILS, CLICK HERE.

Returns exclude the effects of brokerage commissions and taxes. The Shockproof Portfolio's inception date was 2/2/2015.

SECURITY DESCRIPTION ACTION ENTRY PRICE STOP LOSS RETURN

Simon Property Group (SPG) High-Yield Stampede Hold Short $177.26 $210.00 -6.5%

SPECULATIVE AND SHORT POSITIONSThe recommendations below may be appropriate for investors looking for higher risk-reward setups and/or hedging opportunities.

The Shockproof Portfolio S&P 500 (SPY) Vanguard Balanced Index Fund

Cumulative Total Return

6%

4%

2%

0%

-2%

-4%-2.4%

-0.1%

-2.1%

Feb '15 Apr '15 Jun '15 Aug '15 Oct '15 Dec '15 Feb '16

*as of 1/29/2016

BUY

02/1

2/20

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