Investing With Deflation Expectation

Apr.26.13 | About: SPDR S&P (SPY)

The stock market is signaling a potential decline and the prevailing wisdom is that there is a deflation expectation. What is going on? What about the Federal Reserve adding $85 billion to the balance sheet every month under the program dubbed QE. Isn't that supposed to counteract deflation? How can I factor this deflation expectation into my individual stock investment analysis?

Please take a look at the table below of the Federal Reserve Balance Sheet since 2008:

Timeline Total Assets Comment
August 2008 $900 Billion Before QE
December 2008 $2200 Billion

After QE1

October 2010 $2300 Billion Before QE2
July 2011 $2900 Billion After QE2
October 2012 $2800 Billion Before QE3
April 2013 $3200 Billion Ongoing QE
March 2014 $4100 Billion Projected
Click to enlarge

During QE1 the balance sheet increased by $1300 billion, going from $900 to $2200 billion, which is more than double the initial balance. Going from $2800 billion to $4100 billion as part of the current QE will increase the balance sheet also by $1300 billion. However, the current QE will not double the balance sheet even though the magnitude of the balance sheet increase is comparable to QE1.

To have the same effect as QE1 the balance sheet would need to increase to $4600 billion in a comparable time period. So there is a diminishing effect with each additional QE, and larger and larger balance sheet increases would be needed to produce comparable effects on the economy.

Presumably, the Fed will continue to add to the balance sheet as long as it is needed to counteract deflation expectation. The goal is to reach a point where the economic growth becomes self-sustaining, creating demand and inflationary pressures, which will allow the Fed to discontinue QE. So the discontinuation of QE will probably not be a momentous event for stocks. However, the economy is not a precision tool with fine tuning controls. So there may be some disruption during the hand off.

How did QE affect stocks? Please take a look at the table below of the SPDR S&P 500 ETF (NYSEARCA:SPY) as a proxy for the S&P 500 index, for the periods corresponding approximately to the QE:

Timeline SPY Comment
August 2008 130 SPY declining from October 2007 high of 155
December 2008 90 After QE1, SPY still declining
October 2010 120 SPY recovers from the lows after QE1
July 2011 135 SPY recovers further during QE2
October 2012 140 SPY recovery continues
April 2013 155 SPY reaches October 2007 high
Click to enlarge

The increase of the Fed balance sheet has corresponded to an overall upward trend in SPY since the March 2009, low of 66. However, during this period the SPY has declined periodically by 10% to 20%. For example, SPY declined by about 16% between April 19, 2010, and June 28, 2010, and again between July 18, 2011, and August 15, 2011.

Since the cumulative behavior of the stock market has a significant impact on the behavior of individual stocks, the effect of variables such as QE and deflation expectation can be transmitted to an individual stock through the response of the general stock market. Thus, while analyzing and investing in an individual stock such as Nokia (please read Nokia: A Sliver of Light), it is prudent to account for the overall market expectation.

Looking ahead one year, if I am expecting an individual stock would appreciate by 5% based on fundamentals and expect the overall market to decline by 10%, it may be better for me to stay in cash. This is because the appreciation in the stock price may be washed away by the decline of the overall market.

On the other hand, if I am expecting a stock to appreciate by 50% over the next year and the market to decline by 10%, then it may be better for me to stay invested, as I will come out ahead, even with the market declining.

Disclosure: I am long NOK. 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.