Profiting From Deflation and Inflation

As central banks in Europe, Asia, and the U.S. continue to fight the perceived threat of deflation I think it is useful to talk about what deflation is and how it is possible to profit from it. Deflation can be extremely disruptive to an economy, and it has happened before. If you know what to look for it may be the source of opportunity rather than hazards.

Four of the major symptoms of deflation are;

1. A trend towards lower consumer, commodity and producer prices

2. Falling consumer demand and spending with increased savings rates

3. A tighter credit market

4. Negative risk adjusted rates of return (have you checked your 401K lately?)

Ultimately, deflation represents a shift from spending and investing to interest and savings. You can judge for yourself whether we are seeing the signs of deflation in the US and European economies or not.

Reduced aggregate demand in the economy should theoretically reduces prices, which increases buying power or deflates the currency. In this situation, savers benefit because the value of cash and cash equivalents increases. Borrowers suffer as the money they spend on debt interest costs them more. Deflation is like a tax credit on savings and a penalty on interest.

One of the reasons deflation is feared from an economic perspective is because so much growth is funded by debt and leverage. If debt becomes cost prohibitive and investors are unwilling to take larger risks then companies built for an inflationary economy cant grow like they have in the past. This is bad for most stocks. In the video I will show an example for why deflation would hurt even strong stocks like AAPL should it continue to spiral.

However, despite the risks, deflation is not necessarily all bad if you have prepared your portfolio for it. In this article I will walk through some of the things savvy investors should consider if deflation starts to take a real hold on the economy.

Another side benefit of the current economic trend is that we have a great deal of information from the Feds management team about how they would deal with deflation should it occur. This can provide a certain amount of prescience for managing your portfolio. For example, here is an excellent article written by Ben Bernanke, before he was the Fed chairman, about deflation and how he suggests the fed should deal with it. It is an interesting read now that we have seen what he has done so far as Fed Chairman to fight deflation over the last 6 months.

Profiting From Deflation Part Two

Since the time this was originally published the major central banks around the world have gone to extreme measures to fight deflation and its negative economic effects. Six months after the initial scare CPI numbers continued a trend of falling inflation levels or disinflation. CPI number showed the first annual decline in consumer prices since 1955.

Deflation can be a risk in the US that few analysts are talking about. The signs of a deflationary period including a preference for cash and cash equivalents, falling consumer spending and a bearish equity market. This doesnt mean that deflation is currently in effect it just means we may be heading there. We suspect the Fed and other major central banks will continue to fight this possibility but it doesnt mean we cant turn those risks into a few opportunities.

For example, the yield on the 10-year note is still at multi-decade lows. Demand for safer assets, cash equivalents and the expansion of the Feds balance sheet is driving the value of government bonds up and yields down. The bull market in bonds is available for retail traders through ETFs, savings bonds and government notes and bond futures. In todays video, I will go into more detail about how these work and why they may be an attractive way to diversify your portfolio. If you need more information about how ETFs work, click here.

This article was just one illustration for how you can turn the effects of a shift in assets towards cash and away from growth oriented assets like stocks or commercial bonds to your advantage.

Profiting From Deflation Part Three: What about inflation?

Whether there are higher risks for deflation or inflation in the U.S. economy is being hotly debated right now. This is a good discussion to have and there is a lot to learn about each condition and the risks and opportunities each presents. It is even more important to understand that planning for either economic condition is probably the best thing investors can do right now.

Currently, the U.S. economy is showing more signs of deflation than runaway inflation. However, the Federal Reserve is working very hard to create money supply through quantitative easing to fight those risks. Most economists are likely to agree that deflation is more dangerous than inflation and therefore the Feds efforts seem to be prudent.

A problem arises if the efforts currently underway to prevent deflation actually results in an inflation panic. Increasing the supply of money as quickly as the Fed has in 2008 and 2009 could definitely lead to higher inflation rates in the near term. Inflation and low economic growth is problematic for investors for a number of reasons.

1. Inflation motivates spending rather than investing as consumers dollars lose purchasing power. That behavior drives down bond and stock prices and drives yields up.

2. Inflation usually increases interest rates. No rational investor would lend for interest rates that do not compensate for risk AND inflation. The higher risk or inflation rises the higher the required interest rate will be.

That anti-investing behavior both summarizes the risks of inflation and identifies its opportunities. If prices are rising, commodities are likely to rise in value and stock shorts or put buyers are likely to benefit. In the video, I will illustrate how investors can take advantage of this economic situation and how another asset class can be added to a high-inflation investing strategy.