How to Construct a Deflation Proof Portfolio

Though I remain firmly in the inflationist camp in terms of how this economic crisis will unfold -- meaning I expect rising consumer prices, rather than falling asset prices, to be the primary source of the economic crisis (see my previous SeekingAlpha article on this) -- there is no denying we are seeing all the signs of deflation at the moment: MZM is contracting, equities markets are collapsing, the dollar is strengthening, and demand for US government treasuries is very high.

So what's an optimal portfolio for this bout of deflation look like?

1. Inverse ETFs. For those who love exchange traded funds (ETFs), now is an opportunity for inverse ETFs to shine. Broad indices are set to fall, and hence inverse ETFs -- meaning ETFs that go up when the underlying assets in the ETF go short -- are great for deflation. Ones that have done well this year:

• MZZ -- Twice the inverse of the S&P MidCap 400 Index. Up 105.75% this year.
• SMN -- Twice the inverse of the daily performance of the Dow Jones U.S. Basic Materials index. Up 124.13% this year.
• SKF -- Twice the inverse of the Dow Jones Financial Index. This is one of my favorites from a fundamental analysis perspective, and is up 52.44%.
• SDS -- Twice the inverse of the S&P 500 Index. Up 85.68% this year.
• DXD -- Twice the inverse of the Dow Jones Industrial Average. Up 70.37% for the year.

I like all those ETFs, although I personally would feel most comfortable with SKF, as financials are certain to fall from my perspective.

2. US Dollar. I'm always reluctant to say dollar strength, in light of the terrible fundamentals on the US dollar and my inflationary outlook, though while MZM (money to zero maturity, a money supply indicator) is contracting -- which it currently is -- I think we'll see the dollar strengthen. UUP, the ETF for dollar bulls, is up 10.55% for the year.

3. US Treasuries. I'm still wary of the entire bond market, and thus would not recommend US treasuries. With that said, it has become apparent traders/investors as a whole are favoring short-term treasuries as a safe-haven. To the extent the market continues to behave this way, treasuries will do well in deflation. I'd urge investors to consider arguments for why the bond market is due for a collapse. As a person who views inflation as a larger concern than deflation, the well-being of the bond market is of particular concern to me, as it could lead to a run on the US dollar.

4. Japanese Yen. My personal favorite, as it is the only thing I've found that can satisfy both inflationists and deflationists. The yen has been rallying along with the US dollar, and has even been rallying faster than the US dollar. FXY, the ETF monitoring the Japanese Yen, is up 14.69% for the year. I expect Yen bullishness to continue, and favor a portfolio diversified across Asian currencies.

What do you think? What's in your ultimate deflation portfolio?

Disclosure: I am long Japanese Yen.

Comments

[DaveW:]

Simit,
I've been enjoying your articles,this one is no exception. I'm perplexed at the lack of writing on these inverse instruments. Most authors on SA are struggling to put together defensive portfolios with choices ranging from large-cap income producers, to consumer staples to MLP dividend producers. Yet, very little on the most obvious of all: shorting this disintegrating and deleveraging global market.

I'll add one to your list, FXP, the ultra-short China ETF. I like it, as I do SKF, as both are still well off previous highs, which will be surpassed in coming days/weeks.

I do have a question for you. At this point, it is hard to tell if this next leg down will be THE bottom or just another bottom on the way down to the THE bottom. My question: how do you treat these shorts on days like today, when they will be moving over 25% up? Sell half and wait? Sell all and wait to reshort after a bounce? thanks again for the aricle.

-Dave

2008 Oct 24 09:19 AM

[DaveW:]

err, appreciate the aricle as well as the article, the pst as well as the post...

2008 Oct 24 09:21 AM

[siempresuamor:]

Thanks for your comments, my portfolio is similar to what you list here, my only fear is that it seems to be too obvious, for example even the ultimate diversification of 1 to 1 oil share vs an inverse oil appears to post a 5-7% gain, just sell high everyday and you could lock that much daily without the 15-20% risk everyone else is taking. I'm only hoping congress won't find a way to stop us from buying ultra-short stocks like they are trying to stop shorts. The ignorance of the average millionaire/billionair... investor never ceases to amaze me.

2008 Oct 24 10:03 AM

[Smarty_Pants:]

To be fair, there is a difference between what is feasible for managed money and personal money.

For someone managing billions, simply moving 'everything' out of something and into something else is a big undertaking that takes time and is likely to distort prices while underway. Most fund managers have a difficult time beating the averages without being fully invested. Running up brokerage fees to change gears simply makes the hurdle a bit higher, so they are reluctant to do such things.

For smaller personal accounts the use of inverses is a good idea as the size being moved is easily absorbed by the markets.

It is still a good point to raise. There are options available now that weren't in prior downturns.

I myself sold out between August and November of 2007 and have been in and out of QID since that time with nice profits currently sitting mostly in cash waiting for the dust to settle before taking any more big risks.

As long as the FED/USTreasury are in crisis mode there is no safer place to put your money than cash. The current market whipsaws are only good for nimble, very short term traders. That's too much work for my tastes.

2008 Oct 24 10:26 AM

[Simit Patel:]

@DaveW, thanks for the good words, glad you are finding the articles useful. i am primarily a currencies and commodities trader, but in general i am not in and out of the markets on a daily basis. my 3-4 year outlook is inflationary, so wherever i see inflationary opportunities i trade there and stay there until the trend looks deflationary. so there is a ton of volatility on the yen now but i will stick with it until momentum shifts on the daily chart. i use moving averages as my primary momentum indicator.

@siempresuamor, yes i am expecting congress to put restrictions on many of these inverse ETFs....surprised they haven't done so already. successful speculators though are too ripe of a target for blame, unjustified as it may be, so i would suspect inverse ETF traders to be a target.

@Smarty_Pants, i hear what you are saying. i think the asian ETFs (asian stocks, bonds, and currencies) are good for traditional style investing in this deflation. though gold remains my favorite long-term pick, i think gold holders will be the biggest winners over the next 5 years.

2008 Oct 24 10:50 AM

[proseadvocate:]

Historically, long term government bonds have been the best deflationary investment. However, the last such period was an entirely different environmnet where the Dollar was backed by Gold reserves. Only after the Govt made owning gold illegal, and ended the backing of its own paper, and then an inflationary world war, were we able to pull out. Today, we have no hard assets backing the Buck nor any real resources. Therefore, I too am more concerned about inflation [once the stock bubble bust has subsided] and people begin to bid up the prices of staples again, like food and petrol.

2008 Oct 24 12:38 PM

[Ellen:]

Hi Simit,

Thanks for your informative, well-reasoned postings.

What about adding a percentage of precious metals to this portfolio (owned in allocated or physical ownership, not certificated)?

Thanks, Ellen

2008 Oct 25 08:24 AM

[patio:]

I still believe deflation is here for a good while, so please explain the following ( I love your articles as well- you have broad perspective, not so adamant like many others ):
- the Fed is printing like mad, we know that, but so are others globally; so the dollar is rising on a relative basis so far. What events would reverse that?
- the printed money is not flowing to the consumer; banks aren't lending as easily ( 20% down, higher rates; need good credit score, etc ). If the American consumer stops consuming, relatively speaking, how do prices go up? And I might add, the American consumer I believe finally gets it, we are done living beyond our means. So even if stimulus money shows up, it will be used to pay down debt or saved. All IMHO of course.
Thank you.

2008 Oct 25 08:48 AM

[yblarrr:]

Good article! But would have been better 6-12 months ago.

2008 Oct 25 10:57 AM

[sunseeker:]

Good article....I hold/trade SDS and QID. If these are next to be banned, would anyone speculate on how this would be done, or affect current positions?

2008 Oct 25 12:07 PM

[Simit Patel:]

@ellen, yes no doubt -- i'm still a buyer of precious metals, especially physical ones where we are seeing a shortage and it is difficult to get delivery. hard to justify from trading perspective as we are in a deflationary environment, but from an investing perspective, i think delivery of precious metals is a great idea -- a good insurance policy at the very least.

@patio, demand for US dollars is a key issue as well. right now we are seeing money supply contract and demand for US dollars rising (thus the rise in treasuries and US dollar), though i doubt that will continue. if we see a decline in US dollars and a decline in demand for US dollars, i think we will see stagflation, which will be characterized by declining US bond and equities markets, a weak dollar, rising commodities and precious metals, and rising CPI.

@yblarrr, yes no doubt -- though i think it is quite likely we still have room to go. :)

@sunseeker, this is why i am generally not a fan of US markets. too much regulation makes it impossible to play. unfortunately regulation is a worldwide occurrence. still, i favor opportunities in the forex market, as well as in asia.

2008 Oct 28 10:41 AM

[Stephun:]

Whether the economy goes into deflation or not on the consumer side, over the next few years the obvious trade is to be short real assets. Short term I believe too many people are expecting this to be a bear market rally, and are therefore square or short, making it unlikely that it will fall precipitously before year end. Deleveraging is obviously the driving force of all this madness, and while that continues, given that the vast majority of borrowing is USD denominated, the USD will continue to rally.

I remain bearish stocks, but would hold off until Q1 or Q2 to go short once again. My favourite trade is unquestionable being short US 10y bonds. The ONE and only reason they are only yielding shy of 4% at present is risk aversion. China's demand for treasuries has fallen off a cliff given their own economic issues and a sudden halt to their building of USD reserves, Japan has lost its current account surplus after years and will stop buying treasuries at the same breakneck pace. The middle east and Russia are now earning half as many USD as they were given crude's sharp fall. All of this is happening immediately before the treasury needs to issue record amounts over the coming months and years to finance these bailouts. Remember yields of 10+% on treasuries in the 80s. Going short US 10Y futures has limited downside, and quite massive upside.

2008 Nov 01 08:48 AM

[Leif Peterson:]

This is a great article, and for many reasons is timely because it addresses deflation -- which will likely be the primary issue for the next 5-10 years. Right now, the US economy is truly (not essentially or effectively) a bottomless pit for which very few are broadcasting the problem. Don't worry about doom and gloom; that was passed a while ago. It's more like the second great depression is already here but is unobservable. If you had an over-the-horizon backscatter radar for the economy you would probably run.

Regarding the inverse ETFs mentioned, one must realize that due to extreme volatility in today's markets, these will sell in a heartbeat if stop loss is not set at at least -20%. However, there will come a point where an equilibrium is reached and e.g. large mutual funds won't be able to unload equities so that their price drops to zero, because they can't zero out customers retirement accounts. I truly believe you can't short a stock to zero, especially one of the ^DJIA-30. (here, I am speaking about the millions of clones who continue to contribute to mutual funds through their employer and never bother checking how things are going).

When compared with the huge losses in equities and home values since 2007 (several trillion), costs of ongoing wars, derivatives, hedge funds, greed, over-leveraging, auto industry, the bailouts are not even a blip on the radar scope. That, plus the fact that only a fraction of the bailouts will reach the consumer is all the more reason to become concerned. Don't take my word for it, start studying on how to profit in times of deflation. Currently, I am long Fidelity Treasury (short-term) Money Market (FDLXX), US Dollar Bull (UUP), Japanese Yen (FXY), Chinese Yuan (FXI), China Mobile (CHL), Exxon-Mobil(XOM), and USCOX. I believe most equities are going to crash and burn much worse in the months to come, and think UUP will explode throughout 2009 and 2010. Happy Trading!

2008 Dec 20 12:32 AM