an article resonates with Xing's description of repairing fish bowl

hhli3

What Deflation Means for Investors
Simon Maierhofer, On Friday May 28, 2010, 11:26 am EDT
Despite a chorus of voices claiming otherwise, deflation will probably become public enemy number one.

It wouldn't be the first time the investing masses were wrong.  If you plot public opinion against a chart of the S&P 500 (NYSEArca: SPY - News) or Dow Jones (NYSEArca: DIA - News), the not so subtle message is that investors embraced stocks at the 2000 and 2007 market tops and despised them in March 2009. Buy high and sell low has been the track record for the herd.

With such a sub-par track record of crowd behavior, why would you want to follow the lemmings of popular opinion and jump on the inflation bandwagon?

Aside from a contrarian viewpoint, there is convincing evidence - evidence that's visible right now - that deflation will trump inflation.

Inflation - It Barks, But Doesn't Bite

Deflation, like a rare disease, is often misdiagnosed and misunderstood. Unlike inflation, which tends to eat into your return, deflation is more aggressive and attacks the principal.

Aside from a few extreme instances, such as 1922 in Weimar and 2007 in Zimbabwe, inflation is like a dog that barks but doesn't bite. It's aggravating but not dangerous.

Deflation is more like a python that sneaks up and suffocates the economy. It squeezes the life out of it, one constriction at a time.

Just as a picket fence will keep a barking dog away but presents no barrier against the python, inflation-geared protection does nothing to protect against deflation. In fact, it can even be harmful.

Deflation Threat - A Simple Concept

Government spending and money printing has been identified as key causes for an alleged inflationary environment. As the government prints more dollars, the dollar loses its value, or so it is commonly believed.

To illustrate: The government is using a fire hose to fill up a barrel. Under normal conditions, it's just a matter of time until the barrel overflows (causing inflation). The twist today is that the barrel has a hole; in fact it might not even have a bottom. Regardless of how powerful the hose, the barrel isn't getting full. There is no inflation today.

What is the Hole?

Since the April 26 top, the U.S. markets (NYSEArca: VTI - News) have lost about $5 trillion of market capitalization. That's $5 trillion of wealth evaporated in 20 trading days.

On the other side of the ledger, the U.S. government has spent between $1 - 2 trillion on various bailouts.. Europe just unleashed a $1 trillion plan. Nevertheless, the stock market has erased more wealth in 20 trading days than the U.S. and Europe spent combined in over two years.

The 2008 global equity (NYSEArca: EFA - News), real estate (NYSEArca: RWO - News) and commodity (NYSEArca: DBC - News) meltdown erased an estimated $50 trillion worth of wealth. Most of this wealth (and credit) is denominated in U.S. dollars.

As wealth and credit implode, there are fewer dollars in circulation. The law of supply and demand simply states that shrinking dollar supply results in higher prices for the remaining supply. Is the dollar supply shrinking? Is the demand for dollars increasing?

Yes, it is. The destruction of dollar denominated money supply is evidenced by the money supply (M2) contracting on a year-over-year basis for the first time in 15 years. Bloomberg reported that the rate of inflation has fallen to a 40-year low.

No Mojo

The dwindling U.S. denominated money supply is one part of the equation. A loss of money's velocity is another. Lower money velocity means that one dollar is touching fewer lives today than it did 10 years ago.

A dollar earned by an employee, spent in a restaurant, paid in wages to a waiter, who uses it to buy an iPod does more for the economy than a bailout dollar given to banks (NYSEArca: KBE - News), where it's kept as a stagnant number on the balance sheet.

The chart below shows the velocity of money measured by the GDP to M1 ratio. Despite a stock market in rally mode, the velocity of money has slowed without letup since the beginning of the banking crisis.



Dollar in Demand

The credit contraction felt around the globe in 2008 was a clear display of deflationary forces. Asset classes from oil (NYSEArca: USO - News) to small cap stocks (NYSEArca: IWM - News) and nearly everything in between went south.

The entire financial industry needed actual dollars to service its debt and remain liquid. Banks were forced to sell real estate, stock or commodity holdings at deeply discounted prices. The only asset class to keep its value was cash.

The Europe (NYSEArca: FEZ - News) debt debacle reminds us how vital cash is - that's why the European Central Bank and the IMF made $1 trillion available for entire governments.

Soon, the major players will find out that inflating credit is not the solution. You can't make a nation which is unable to service its debts more creditworthy by extending more credit. If the EU, IMF or anyone else lends Greece (or any other country) money, the loan will increase that country's public sector debt.

The interest on the additional loan will increase the country's deficit. The debt burden will become larger and more of a default risk. The only solution is more cash. But the governments won't be able to print cash fast enough to keep up with the resurging credit crunch.

The Many Faces of Deflation

Consumers' mindset is the key ingredient to inflation. Just as bread doesn't rise without yeast, deflation doesn't intensify without consumer's frugality.

The 'buy today because tomorrow it will cost more' attitude kept feeding the 2000 tech and real estate bull. This fear of losing out on future gains also contributed to the recent 75% run in the Dow Jones (DJI: ^DJI), S&P 500 (SNP: ^GSPC) and Nasdaq (Nasdaq: ^IXIC).

Despite the 75% bottom-top rally in stocks, inflation has been a non-issue. Imagine what will happen to prices when the 'don't buy today, tomorrow will be cheaper' mindset resurges.

Stock's performance over the last month suggests that the wait and see attitude has already taken hold. The S&P has significantly fallen below its 200-day moving average for the first time since December 2007. Investors sell today and think tomorrow. Consumers think today and buy tomorrow. This negative feedback loop tends to have catastrophic consequences for stocks and the economy.

On April 16, 2010, the ETF Profit Strategy Newsletter felt compelled to 'point out that historically, there has never been a more pronounced sell signal. Prices should work their way toward S&P 1,150, possibly even lower.'

The 'possibly even lower' part, along with the long, mid and short-term outlook for stocks and the US dollar and corresponding trading strategies is addressed in each bi-weekly update.

The last deflationary period occurred during the Great Depression, which was a deflationary depression. As the parallels between today and the Great Depression are mounting, it behooves us to heed the warning signs. A 'white picket fence' may make you feel secure, but is no match against deflation.

cc2265