“The previous generation’s Deflationary Shakeout occurred between 1930 and 1942. Ours will begin between 2008 and 2010."

The third season of the 80-year economic cycle is a depression era in which we see rising unemployment and falling prices. The economy contracts and shakes out those companies that didn’t win the race for market leadership in the preceding economic boom. Those few who survive this shakeout absorb the excess market share as well as the most productive workers and facilities from their failing competitors. There are some emerging growth industries, but their innovations are more modest than radical, designed to incrementally improve and extend existing products and services.

This season of the previous 80-year cycle occurred between 1930 and 1942. Stock prices fell dramatically, losing 90% of their value, from late 1929 and into 1932. Consumer prices fell equally dramatically from 1930 into 1933. Real estate values plummeted.

I predict that the stock market is likely to peak by late 2008, and that the next Deflationary Shakeout will begin between 2008 and 2010. Shortly afterwards we could see the “crash of 2011.” Investors who are accustomed to long-term prosperity and remain unprepared for this turnaround will fare badly. The savvy investor, however, can make a profit.

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“Savvy investors can profit in this season by moving capital from stocks to select long-term bonds before the crash. After the crash, select real estate and small companies are a good investment."

One great investment is long-term bonds. The gains are modest by comparison with stock yields in a boom period, but they are a steady investment with a reliable return. Furthermore, the deflation that occurs during this period raises the actual worth of bond yields. From 1930 to 1942, for instance, a return of 6% yielded more like 9% in real purchasing power.

Though the U.S. economy will be in crisis, you can shift your investments into select international markets. After 2009 or so, I am very bullish on Japan and two of the “Tiger economies,” China and Korea. In Europe, Spain and to a lesser extent Portugal will still have positive demographics for an economic boom. Of the Latin American countries I recommend investing in Argentina and in Chile. For more information, you can choose from several topics on international investing.

While large companies are hit hardest in a deflationary shakeout, after the crash small company stocks are a good investment. From 1932 to 1946, for instance, small caps outperformed large caps by about 6 to 1 on cumulative returns.

The Deflationary Shakeout of the 30s also saw the beginnings of a massive shift in population from urban areas to the suburbs. We can anticipate something similar after 2009, with the population shifting to exurban areas and small resort towns. After the stock crash deflates real estate prices, buying property in these areas will be a good investment.

To recap, your best investments during a Deflationary Shakeout are:

• Very high quality corporate bonds
• Select international stocks, such as Japan, China, Korea, Spain, Portugal, Argentina and Chile
• Small cap stocks after the crash
• Exurban real estate after the crash