Money Tips and Strategies: Deflation Is Gathering Strength

I thought this article was well written and thoughtful. Jim Powell has been for the most part concerned about inflation until recently. It appears that he is now seeing the handwriting on the wall. If you do not feel you understand the implications of deflation, I believe you will enjoy the read.

Subscriber Bulletin
Friday, July 9, 2010. Copyright © 2010
by James B. Powell & Associates, LLC

Deflation Is Gathering Strength

I have been warning readers for several months that deflation (the destruction of money) could gain the upper hand over inflation (the creation of money). I now think the tipping point has been reached and deflation is becoming the dominant monetary trend. That is of enormous importance to us because - as I will discuss in a minute - dealing with deflation will require different strategies than we would use with inflation.

The evidence for deflation is overwhelming. Our economy is now hemorrhaging money at a faster rate than the Fed is creating it.

Here are the main engines of deflation that are at work:

Unemployment is increasing.
Real wages are falling.
Household net worth is dropping.
Real estate sales are off 30%.
Commodity prices are down sharply.
Foreclosures and bankruptcies are rising.
Most asset values are still declining.
Four U.S. states are effectively bankrupt.
Several countries in Europe are also close to default.
The U.S. economy is starting another leg down.
Bond yields are approaching historic lows.
At the same time, the Fed's stimulus and bailout programs are ending.

All in all, it's a classic deflationary pattern that is taking billions of dollars out of the economy. The lost dollars are not just going somewhere else, they are disappearing.
Deflation has gained so much momentum that I think it will continue - and probably get worse - for several months. The slide could even last a year, or possibly much longer (see the box).

How Long Will Deflation Last?

Although I don't expect it, there is a chance that deflation will last several years.
That's what happened in Japan after its stock and real estate bubbles collapsed in 1989. For nearly two decades, the Japanese government poured money into the economy almost continuously - just as the U.S Fed is doing now. Interest rates were reduced nearly to zero and key industries received subsidies. Nevertheless, deflation persisted through 2009.
The American economy is far more diverse and resilient than Japan's. Nevertheless, Japan shows how persistent deflation can be if it becomes firmly established.

How long deflation will prevail will depend upon how quickly the Fed steps in to fight the problem, and whether or not the steps will be successful.

If this were any other time in U.S. history, I would have little doubt that the Fed could defeat deflation by flooding the economy with money. But the Fed has been doing just that for 3 years - and it has not been working. Nearly $4 trillion has been spent and deflation has been gaining strength instead of weakening.
Nevertheless, I expect the Fed will seek to introduce another round of record-breaking spending in a last ditch attempt to push deflation aside. However, round two won't be as easy to do as round one. The Fed is already grossly overextended. In addition, the public is strongly opposed to further deficit spending, and Washington is getting the message. That's why Congress defied expectations and just decided not to extend unemployment benefits.

However, because deflation can lead to a depression if it gets out of hand, the Fed may cast public opinion aside and act right away in hopes of stopping it. If so, a blizzard of new money may flow into the economy as soon as this fall. Such a cure may be worse than the disease.

However long deflation lasts, the trillions of dollars the Fed will create to fight it will lead to a period of ruinous inflation.

Because inflation seems unavoidable longer term, I believe the best use of a deflationary period is to acquire precious metals, blue chip stocks, rental residential real estate, and other inflation hedges at bargain prices. When deflation ends, you can either sell the assets and collect your profits, or keep them for even greater gains as inflation starts to rise. If you are prepared to make use of a deflationary period, it can be a windfall instead of a disaster.

A complete list of what to buy can be found in the May 2009 GCOR. For a condensed list of both inflation and deflation investments, see the table on page 6 in the April 2010 issue.

Why Inflation Will Eventually Prevail

Although deflation may be the dominant monetary condition this year, rising inflation is a virtual certainty longer-term. That's because debasing the dollar is the only possible way Washington, the banks, and consumers can possibly "pay" their colossal debts.
Therefore, if you continue to maintain your investment program for a inflationary environment, I'm confident that you will eventually become a very big winner. In the meantime, you must avoid the dangers of deflation and make them work for your benefit.

The Best Deflation Strategy

To profit from a deflationary downturn, it is only necessary to take the familiar rules about inflation and reverse them. Cash will rise in value instead of depreciating. Real assets will go down in price, not up. Interest rates will drop rather than rise. It's all fairly simple. However, it has been so many years since the last deflation occurred, few investors remember what it was like.

Because the ability to make bargain purchases is the key to making a deflationary cycle pay off, you should hold more cash than you would ordinarily wish to have with inflation and a weaker dollar on the horizon.

When I recommend having plenty of cash available I'm referring to actual folding money in addition to funds kept in banks. If a deflationary recession becomes something worse, many already-shaky banks will find themselves in serious trouble. The Fed may declare a bank holiday while it tries to fix the mess. In that event, ATMs, credit card approvals, check verification, online banking, and the accounts themselves will be off line. Of course, safety deposit boxes will also be unavailable. That's when "mattress liquidity" will prove its value.

A Deflation Checklist

First, being unprepared for inflation (or a possible dollar devaluation) is a much bigger threat to your wealth than missing out on deflation profits. (Please read that again.)
Therefore, the best way to use this deflationary period is to get ready for the inflation cycle that is on the way. All the inflation/devaluation hedges that I have been discussing in recent months remain attractive. If deflation brings their prices down, all the better. There is nothing I would like more than to see gold drop below $1,000 and for silver to slide into the low teens.
Remember, during deflation, cash is king. With greenbacks on hand you can pick up bargains, demand discounts, and hire people at attractive rates.
Apart from your day-to-day needs, I think you should keep some of your cash in a strong commodity currency. I continue to favor the Canadian dollar which is backed by a treasure trove of valuable raw materials (see the April 2010 GCOR). The Australian dollar is also strong for the same reasons. Best of all, an asset-based currency is much more likely than the U.S. dollar to keep pace with inflation. You can open an account in either currency at EverBank World Markets (www.everbank.com).
You should take steps to keep your cash safe from the turmoil that deflation is likely to cause. Don't be concerned that interest rates are on the floor because deflation will drive up the buying power of your cash. For example, if you earn a miserable 1% on a T-Bill, but the price of what you want to buy (stocks, futures, real-estate, toys) drops 20%, you will make the equivalent of 21% on your money. Choose six or nine month T-Bills and CDs. I would not select fixed income investments that mature beyond that point because inflation may arrive by then, and interest rates will start to climb back up.
Any collectibles that you have been meaning to sell should go on the block before deflation starts to push their prices down. And when inflation returns, consumers are likely to be in such poor financial shape they won't have money for frills.
Because cash is becoming increasing valuable, so are dividends paid by high quality blue chip stocks. We have several such companies in our portfolios.
Likewise, rental housing that generates reliable income looks attractive - provided that you live in a region where prices have stopped falling. If not, wait until they do.
I would steer clear of all other real estate right now. Home sales dropped a whopping 30% this spring. The commercial real estate market is also in serious trouble. There will be a time when deflation will present you with superb real estate opportunities - but we are not there yet.
During a deflation it is not wise to take on debt except for anything that generates income. Only borrow money to buy assets that pay for themselves.
If you are in business, you should pay particular attention to the deflationary conditions that are devastating consumers. Retail sales may hold up for awhile, but a significant rebound is probably many years away. On the other hand, any business that helps people get by for less money should do well. That situation should continue even after inflation begins.

I will continue to keep you up to date about any new economic developments that you should know about. Remaining informed is the key to avoiding big mistakes and making good profits during this difficult time. Please share your knowledge with everyone who is important to you.
You can expect to receive the next issue of GCOR in early August.
Best wishes,

Jim Powell, Editor and Publisher
Global Changes & Opportunities Report

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