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Thursday, December 27, 2007 9:49 AM


How does one invest for inflation and deflation?


Minyan Eric Writes:

I cannot tell you how much I enjoy your analysis. I have worked for the Fed in DC and hold a high level finance position in the private sector now. You have finally moved me over to the deflationary, Japanese scenario with your last post even though I know you've been on this for quite a bit. Would you be able to create a post about how you either 1) profit from this or 2) protect your assets as be head toward that scenario?

Thanks again,
Eric
Eric, Thanks for the kind words and the questions. I will do my best to address your questions below.

Before answering, the article to which Eric refers is called Not Your Father's Deflation: Rebuttal. A followup article was Peter Schiff Replies to Deflation Rebuttal.

Rather than looking at things just from a deflationary viewpoint let's consider investment themes for various scenarios.

Investment Themes For Hyperinflation
  • In hyperinflation the last place one wants to be is in cash.
  • Commodities in general are a standout.
  • Gold is a standout.
  • Precious metals are a standout.
  • Property is a winner.
  • Equities are a winner.
  • Treasuries are distinct losers if not an outright short.
  • Foreign currencies
  • Energy
The single best asset for a hyperinflation scenario is actually property. With housing or commercial real estate one can borrow with next to nothing down. No other asset class offers as much leverage. With no skin in the game one might amass $1 million dollars worth of property that might sell for an unbelievable amount in a few short years if not sooner.

Is there a catch? Why yes there is. One needs to be able to make mortgage payments on the loan. That means the timing of the hyperinflation better be spot on. It also means that property values better keep on rising from the moment the leverage is taken or income must rise enough to afford the mortgage if it does not.

Should ever one get in a position via excess leverage to not be able to sell the asset for more than one paid while not being to afford the mortgage payment, foreclosure or bankruptcy occurs. Losing a job ad being underwater on leveraged property is an instant enormous headache.

Leverage is obviously the biggest pitfall for the hyperinflationary investor. But even without excessive leverage, housing has been getting clobbered for two years, longer in Florida. Commodities, however have been on a tear. Commodities also benefit from what appears to be near insatiable demand from China.

Can anything go wrong with commodities? Actually yes. China and emerging markets could put on the brakes regardless of what happens to the US dollar. Furthermore, with the US headed into a recession, demand for base metals could collapse. Also note that treasury bears (except for nimble traders) have not exactly fared well to say the least.

Regardless of what happens to base metals or treasuries, peak oil just might keep energy prices high. Thus there are additional reasons to be bullish on energy regardless of the inflation/deflation debate.

Hyperinflation involves a complete collapse in confidence of a currency but with currencies there are always relative values. Commodity producing countries have strong currencies that hyperinflationists think have more room to run.

Is there a completely safe way to invest for hyperinflation? I think so but the ideas might seem rather boring to many. For example: Everbank has MarketSafe® Gold and Silver CDs. I talked about those products in A Safe Way to Own Gold and Silver.

The Everbank MarketSafe® products are principal protected CDs whose return is tied to the performance of gold and silver. Even if gold and silver collapsed, one's principal is protected as long as one does not exceed the FDIC limit. The products are suitable for investors with a safety first attitude, yet wanting a hyperinflation hedge.

A second safe way to play for hyperinflation is in Treasury Inflation Protected Securities. Here is a second article about TIPS.

Where are we now?

Collapsing property values simply are not synonymous with hyperinflation. So inquiring minds might be asking: Did we already have a hyperinflation (of credit) and is a hyperinflation by monetary printing going to follow? The articles above might help resolve those questions.

Regardless of what one thinks is coming, one look at millions of foreclosures happening right now suggests there is plenty of reason to be cautious here.

Investment Themes For Deflation
  • In deflation, debt is the enemy.
  • Risk is to be avoided.
  • Cash is raised.
  • Treasuries are sought out as a safe haven.
  • CD ladders offer a good investment structure.
  • Gold, acting as money does well.
  • Select equity shorts or PUTs are a standout.
  • Renting as opposed to owning a house should be considered.
  • Currency plays
One can see the effect of excessive risk with the housing implosion regardless of what one thinks is going to happen down the line. Rising unemployment and/or falling income with no way to pay the bills is the chief concern. Before even thinking of investing in a deflationary environment, one should pay off all credit card debt, live below ones means, and have a cash cushion equal to one year's salary to pay the bills.

After decades of inflation the overall deflation theme may be hard to take, but it is what it is. The single best performing asset in this environment might be equity puts. However, just like those overleveraged in housing found out, timing must be precise. Anyone shorting or buying puts on strong stocks have gotten killed. Even index PUTs and index shorts have fared miserably for all but nimble traders. On the other hand, those in housing related shorts have done well. Those in gold have also done well.

Inquiring minds will note that gold is in the hyperinflation category and the deflationary category as well. That is because of gold's unique property with a dual role as a money and a commodity. Gold is money. The case was made in Misconceptions about Gold. Money is hoarded in deflation so gold should act well in deflation.

Do not make the mistake of thinking that gold always does well. It does not. It fell from over $800 to $250 in a decade's long crash. There was positive inflation all the way. Thus gold is not an inflation hedge no matter what anyone says, except perhaps in the very longest of timeframes. The key here is that gold does well at extremes. Those extremes are severe inflation and deflation.

When it comes to housing, a huge case can be made for renting vs. owning. The bigger the bubble, the better the case. California is in a tremendous bubble. I would not be buying in California any time soon. Florida has already crashed but further declines are likely. Another factor is availability of rental houses. The area where I live has few rental choices. I own but do so with open eyes. I also expect to have the house paid off within 5 years or so. My current leverage is small.

One possible currency play is the Yen. Leverage will be unwound in deflation and right now there is a massive leveraged carry trade in the Yen. The unwinding of that carry trade is likely to be very good for the Yen vs. the US dollar. I like the Yen here very much as a long term play.

A second possible currency play is related to the unwinding of leveraged dollar short positions as well as extreme anti-dollar sentiment, that fueled a mad dash into the Euro. I like the dollar vs. the Euro here.

Is there a completely safe way to invest for deflation? Yes, but once again the ideas are going to sound boring. CDs are still paying around 5%. One can build a CD ladder by buying 1, 2, 3, 4, and 5 year CDs and rolling over the proceeds into more 5 years CDs as each matures. The ladder can be for as long as one wants. It can be 3 years or 10 years, not just 5. The longer the duration the more risk there is but at least the principal is protected.

Once again, the super cautious wanting to protect against anything can try the MarketSafe® products mentioned earlier, or even TIPS.

There are other possibilities as well for those wanting more risk. If one accepts the peak oil argument, then energy should be a relative standout, at least compared to other commodities. And unlike homebuilders or banks, oil is not headed to zero and will eventually recover in a long enough timeframe.

Still another possibility are long/short funds that take on market risk when warranted and off when not. Sitka Pacific Hedged Growth strategy is one such option.

Sitka Pacific Hedged Growth was up about 10% after fees a few weeks back when the S&P 500 went flat for the year. It is still up about 10% on the year, even after this December rally. Volatility is low compared with the S&P. Currently the strategy is 33% cash, and market neutral (equal weighted longs and shorts) in the remaining portion. Bear in mind I have a vested interest in this idea given that I am a registered investment advisor representative for Sitka Pacific.

Hussman Funds
are another possibility. John Hussman decides to put on or take off risk based on his perception of valuation and market action. I am an avid reader of his weekly columns.

To some, 10% returns simply do not cut it. For others 10% returns with low volatility are fantastic. It all depends on one's risk tolerances. While, strategies can be debated all day long but there is never any guarantee. Risk takers often act as if there is. Certainly there seems to be an amazing belief in the Fed's ability here in spite of the horrendous and obvious mistakes the Fed has made. That faith is unwarranted in my opinion, but we shall eventually see.

Furthermore, it is one thing to take risks with one's own capital, and it is another to take excessive risks with OPM (Other People's Money). Bear Stearns (BSC) had two hedge funds go to zero. I am quite sure more hedge funds are headed the same way regardless of what happens.

The key now is survival. Opportunities are easier to make up than lost capital no matter which way you are betting. Look at Citigroup (C), Morgan Stanley (MS), Ambac (ABK), MBIA (MBI), E*Trade (ETFC), Merrill Lynch (MER), Countrywide (CFC) and all of the homebuilders for proof.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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