Investment Opportunities in a Deflationary Environment

 |  Includes: DIA, SPY
by: Nikhil Raheja

The stock markets are down more than 40% since September`07. Oil prices are down more than 70% since July 08. Gold prices are down 10-20% and seem undecided. Silver is down more than 40% since March 08 and so are

the industrial commodities. This downtrend is a symptom of the lesser consumption and production in the country since 2005. This is what we have witnessed so far…

The US suffered a huge stock bubble burst starting March 2000. When it happened, it was hardly predicted by many of the experts on major business channels. They expected the bubble to last their lifetimes. Soon after, the Government drove down interest rates from 6.5% to 1%. The central bank lowers the interest rates by increasing the money reserves with the banks. As the money supply increased, a huge boom developed that saw higher production and more construction of houses. The excess consumer loans led to higher consumption and speculation in housing. The new money eventually increased prices, and with high prices came higher interest rates. The increase in interest rates acts as a pin that pricks the bubble. That caused the credit in the economy to decrease, and lowered economic activity and consumption.

As the Federal Reserve noticed the bust, it rushed to reinflate the bubble, but due to the heavy losses on the bad mortgages created, banks were going bankrupt. The banks could not add liquidity to the market despite receiving billions from the government. As a result, we entered a deflationary phase that is driving down the value of stocks and real estate. Until the home prices bottom out, banks will not recover from the losses and would be unable to assist the government in adding liquidity to the market and creating another bubble. The unemployment rate is likely to spiral higher every month during this crisis.

Government’s Role

The biggest fallacy in the post war era has been that the governments must do something during recessions. The witchcraft goes like this - the government must run huge fiscal deficits in the hope of creating inflation, so asset prices stop falling and the risk averseness goes away. If the government does become successful at creating inflation, it simply postpones the crisis rather than solving it.

The economy functions in a cyclical fashion, where people buy previously manufactured products while they produce more for future consumption. Let’s suppose the federal government of a country, during a depression, chooses to create inflation by spending money, “since the resources are going to waste”. The government issues a blank check which is used to splurge on roads, bridges, travel and alcohol, but it does not produce anything, so the society does not benefit from this consumption since it consumes the available resources while producing nothing for the future. While this succeeds in creating inflation, what follows is a scarcity of available products/resources preventing entrepreneurs from producing goods for the future. Also since the government has spent all the borrowed money, it must now raise more to pay back the debt. That leads to higher taxes and a greater burden on the productive forces of the economy.

The Government can do no more than prolong the crisis.


During deflation, the best investments to be made are in safe, fixed income securities - for example, the money market fund.

Non-Market Based Investments

Some businesses with good business models have done well over the last 2 years. These businesses have reliable cash flows with minimum risks. One good business model is that of a hard money lending firm. These firms lend money for short term purposes and protect themselves through varied guarantees. Many such firms welcome private capital.

Stocks & Bonds

The stocks should rally until the DJIA reaches at least 10,000 points. The stocks to buy during such a time would be those of retailers. The mining industry is also rallying and should continue as long as industrial metals gains value.

The best opportunity to make money should arise as the market tops in autumn this year. The DJIA is likely to end up at not over 2000 points by 2012. This would be led by the decline in home prices, causing the lenders to hold back again and taking junk bond yields over 30%. The single worst investment to be made over the next 30 years is in bonds. The bonds yields have fallen for the last 30 years and have proved to wonderful opportunities; it is time for them to be the opposite.

The stock prices of retailers in the country such as American Eagle Outfitters (NYSE:AEO) and Aeropostale (NYSE:ARO) seem overvalued and may fall as earnings drop. The hoarding of income by consumers is likely to last a few years and will take down several retailers. We expect many of the top brands to disappear by 2012. Already, Steve & Barry’s, and Circuit City have filed for bankruptcy. Many short positions against these retailers should be expected.


Many commodities have seen major bull markets since 2001-02. Prices for nickel rose almost 10 times from 2001-07. Since then they have dropped 80%. Copper prices rose 6 times between 2001 & 2007 and have fallen 60% till date. Lead prices jumped 8 times between 2001 and 2007, but have since come down 75%. Uranium rose 12 times, and is down 60% today. Zinc rose 7 times and has dropped 75% since then. These commodities have risen in the last 2 months, but their ascent should come to an end as the stock market peaks later this year. Until then, the above commodities could be traded.

However, some commodities like sugar have not fallen much in comparison. Sugar rose more than 3 times between 2003 and 2005, but has come down only 33% since then. Sugar production is likely to be higher since sugarcane is one of the crops to have held up well over the last few years. Also, gold and silver have been in much news due to expectations that the increased money supply would drive them higher. Gold rises as people notice rising consumer prices. They buy gold because gold holds its value. However, we have deflation now, and as prices fall, people would have no reason to buy gold, also the dollar would gain value. Gold is likely to lose 30-50% of its value over the next 2 years.


As the crisis reaches the entire world, many developing countries with poor finances succumb to it. Iceland’s currency, the Krona, lost more than half its value against the Dollar. As the credit crunch gains steam again, many other currencies will see significant losses, for example the Hungarian Forint. Hungary’s banks carry loans denominated in foreign currencies such as the US Dollar and the Japanese Yen. As the Dollar and the Yen gain value, it would be extremely difficult for Hungary to pay back those loans. If the Hungarian Government decides to bail out the banks on its own, it would endanger its currency.

Disclosure: Short Gold.