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October 9, 2007, marked the day when the Dow Jones reached a peak at 14,198.83. On October 10, 2008, the Dow reached as low as 7,882.51 which is a decline of about 45%. These are tough and humbling times to be an investor or simply someone trying to save for retirement or a down payment on a house.

A 45% decline in the Dow over 1 year does not happen often. When we take a longer term look at investing, we can appreciate that we'll have years when we won't have gains, but at the same time, we'll have years when our gains will be terrific and we'll have years when our gains will be average. But ultimately, the goal of investing is to have gains and not lose them, and that makes years like this tough.

America and the world have seen massive wealth destruction both in real estate and business/stock wealth over the past 12 months, especially over the past month and a half.

This kind of wealth destruction is normally deflationary like what happened in the early 1930s: Falling prices for goods and services, falling house prices, falling stock prices, falling commodity prices.

Deflation:

Deflation is the opposite of inflation. Therefore, under the usual contemporary definition of inflation, 'deflation' means a decrease in the general price level.

Deflation is considered a problem in a modern economy because of the potential of a deflationary spiral and its association with the Great Depression, although not all episodes of deflation correspond to periods of poor economic growth historically.

I'm mentioning this because the topic of whether we will have a deflationary recession/depression or inflationary recession/depression will have very big consequences on our investment strategies.

It is and has been my belief that we are likely to be getting a more inflationary recession/depression over the next few years. So, as we are seeing the signs of deflation happening, commodities falling, house prices falling and stocks falling, we can take a look at what our Fed Chairman had to say about this.

He has provided us with his take on deflation and how it affected America in the great depression of the 1930's. He does not want America to have deflation and has provided us with his views on how to prevent deflation if it was to occur from a speech he gave in November of 2002 known as his "Helicopter Speech." Here are some samples from that speech that bear reading now as this credit crisis and wealth destruction occurs.

The U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. (ME: That's inflationary) We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

Of course, the U.S. government is not going to print money and distribute it willy-nilly (although as we will see later, there are practical policies that approximate this behavior).

Normally, money is injected into the economy through asset purchases by the Federal Reserve. To stimulate aggregate spending when short-term interest rates have reached zero, (Me: At 1.5% now and may very well go to 0% as he suggested) the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys. (Me: Buying $700 billion of toxic mortgage backed securities and now taking equity stakes in banks directly) Alternatively, the Fed could find other ways of injecting money into the system--for example, by making low-interest-rate loans to banks or cooperating with the fiscal authorities. ( ME: AIG) Each method of adding money to the economy has advantages and drawbacks, both technical and economic. One important concern in practice is that calibrating the economic effects of nonstandard means of injecting money may be difficult, given our relative lack of experience with such policies. Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.

(Emphasis with underline and bold all mine.)

Our Fed and Central banks around the world are doing all they can to both alleviate the credit crunch and perhaps, without saying it, inflate away some of the debts outstanding via their actions.

So what's it going to be: Inflation or deflation?

Let's look at where we are now. Inflation in September showed year over year CPI increase in the US at 4.94%. This is down from 5.6% in July. If you have been holding anything yielding less than 4.94%, you have lost purchasing power. The hidden tax of inflation has eaten into your wealth.

US Treasuries maturing 3 years or less are all currently yielding less than 3%. It's no wonder Warren Buffett is selling his treasuries and buying stocks in great American businesses as per his recent Op-Ed in the NY Times. The world's greatest investor is not interested in negative rates of return, especially given the actions of the Treasury and Fed to print money and flood the system with ever more dollars that will likely lead to higher inflation.

In Warren's Op Ed to the NY Times, he states, and I think this is important, "Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts."

So what is an investor to do to protect his or her wealth in an inflationary recession/depression when real rates of return are negative? Here is a starting point.

1. Invest in business that have strong franchises and can earn high returns on capital or don't need to invest in a lot of capital each year just to stay in business. These businesses should be able to pass off the higher costs of production to their consumers and still make high returns on capital. Many of these businesses pay dividends whose rates are now far higher than money market and treasury yields.

2. Consider having silver or silver mining shares in your portfolio. Or, own physical silver, if you can find any as there is a big shortage at retailers currently. Precious metals have always been considered a hedge against inflation, so it only makes sense that under current conditions, one has some precious metals in their estate, even if it's just 2% - as much as 15%.

One of the most interesting things about silver that makes it so compelling now is the price in relation to gold. About 160,000 tons of gold have been mined in the history of the world of which nearly all of it is still around today. That's close to 5 billion ounces of gold out there. It's been estimated that there have been 44 billion ounces of silver mined in the history of the world. Modern industry has used up a lot of silver through its various uses and some has been lost to simple abrasion. So, it's been estimated that there may be only about 25 billion ounces of silver left in the world. That includes all silverware, jewelry, medals and of course, coin and bullion. Also, industry uses more silver than gets mined every year so the above ground supply can continue to shrink.

So, 5 billion ounces of gold in the world and perhaps as much as 25 billion ounces of silver make the ratio of gold to silver 1 to 5. Yet as I write, gold is 782.90 an ounce and silver is 9.35 an ounce making gold over 83 times more than silver! This means that silver is either drastically undervalued to gold or gold is simply way overvalued. I think the price of silver is drastically undervalued Vs gold and that is why I own shares of iShares Silver Trust (NYSEARCA:SLV) and for more speculation, shares of Silver Standard Resources (NASDAQ:SSRI).

Source for this info about silver came from here and other sources I've read over the years in either books or articles.

Disclosure: Long SSRI and SLV.

Source: What's It Going to Be: Inflation or Deflation?