How to Construct a Deflation Proof Portfolio

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 |  Includes: DXD, FXY, MZZ, SDS, SKF, SMN, UUP
by: Simit Patel

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.