Deflation Coming For Stocks (And Dividend Stocks) Too?

by: Larry Trefz

The hyperinflationary paradigm that helped propel gold prices to near $2,000 per oz. has been shaken to its foundations as gold prices crashed over the last few days.

On the surface it was a no brainer: The Fed prints money, inflation turns to hyperinflation, the dollar collapses and those holding gold are the new rich.

The problem with this construct is the fact that when the central bank engages in monetary easing, the newly "printed" money goes to the money center banks. The vast majority of these "new bucks" get trapped in the financial system propping up the prices of assets and commodities. However, very little makes it all the way down to the average person on the street.

The economy is largely driven by consumers (about 70%). The fact that commodity and asset prices are propped up by Fed easing, while the average person's wages and incomes have declined, does not create an environment for dramatic inflation. This is because the people as a whole simply don't have the amount of money to spend, relative to the cost of commodities and assets, to drive prices up in order to fuel significant inflation.

Basically, the Fed's monetary easing actions are somewhat self-limiting due to the imbalances created by the way the "newly printed money" is disbursed.

Gold may be the canary in the mine in regards to how far the misconception of imminent hyperinflation due to Fed "printing" has gone in creating bubbles. Doing a Google search for "stocks hedge against inflation" will show the extent of this belief.

The fact is that monetary easing and deflation can go hand-in-hand for a long period of time. The economic situation of Japan over the last couple of decades clearly shows this. Japan was the inventor of the modern version of quantative easing (QE), back in 2001. The Yen has since increased almost 300% over the last three decades. This is in the face of a huge debt load (Japan's debt to GDP is over 200%). Japan also has interest rates near zero--another sign of deflation.

The lack of any serious inflation and even some recent indications of deflation, after the much bought-into hyperinflationary construct, has helped to bring the price of gold crashing down. U.S. stocks, on the other hand, have run from a March 2009 low of 666 on the S&P 500, to almost 1,600 in the last few days.

Most investors clearly remember countless market experts, over the time period of the recent bull run, touting stocks (especially dividend stocks) as a great hedge against the inflation that was imminent from the effects of QE1, QE2 and QE3.


Should the lack of inflation continue to be seen and the hyperinflationary construct be shown as false in the current time, I would look for a significant downturn in stocks, similar to what has been seen in gold (NYSEARCA:GLD).

While stocks and gold clearly differ as investments, there can be no denying that the inflationary construct has significantly added to the current levels seen in U.S. stocks. The improvements in the U.S. economy cannot be discounted- but neither should investors ignore the current signs of global slowdown.

Given the extent of the bull run in stocks without any significant correction in recent times, a return to 1,200 on the S&P within the next few months does not seem unrealistic and would be seen by many investors as a much needed correction.

ETFs that can be used to trade the U.S. equity indexes include: (NYSEARCA:SPY), (NYSEARCA:SDS), (NYSEARCA:DIA), (NYSEARCA:DXD), (NYSEARCA:IWN), (NYSEARCA:TWM), (NASDAQ:QQQ)

Disclosure: I am short SPY, GLD, IWM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Disclaimer: Nothing in this article is to be taken as professional financial advice, nor is it a solicitation to buy or sell any type of securities. All financial decisions are your own, seek professional advice before taking action.