Inflation or Deflation: How About Both?

Excerpt from Raymond James strategist Jeffrey Saut's latest essay, published Monday (Sept. 8th):

“Discovery consists of seeing what everybody has seen and thinking what nobody has thought”

. . . Albert von Nagyrapolt, The Science Speculates

Last Monday’s missive, titled “Thinking about thinking,” began with this quote from Arthur Zeikel:

Thinking, good thinking that is, is a lonely sport. This may explain why so many of us do it so poorly. Good thinking is also an inefficient process. It takes a lot of thinking to come up with those few good, new ideas that are clearly worth thinking about – ideas that can be exploited in the marketplace.

This week we expand on those thoughts with a quote from Albert von Nagyrapolt that reads, “Discovery consists of seeing what everybody has seen and thinking what nobody has thought.” To frame today’s discussion we begin with this quote from the brilliant Marc Faber, whose service we highly recommend:

Surely, it is academically interesting to discuss for hours whether we are in a ‘deflationary’ or ‘inflationary’ economic environment. The different views on this issue have become extremely polarized with the deflationists maintaining that equities and commodities will collapse and that government bonds will rally. The believers in higher future inflation rates on the other hand argue that large fiscal deficits and expansionary monetary policies will boost selected asset prices and eventually flow into rising consumer prices and lead to higher interest rates. But, as I have tried to show by comparing oil with natural gas prices, in an economic system some prices may be rising, while others decline. This process is continuous and particularly evident in the price movements of various asset classes when there are massive excess capacities, which constrain new capital investments, and zero interest rates, which force cash holders to ‘speculate’ in one, or the other, asset class.

Inflation, or deflation, the argument rages; yet on CNBC last Thursday I opined that we are currently experiencing both. Indeed, “seeing what everybody has seen and thinking what nobody has thought.” Well, maybe not nobody, but clearly not very many. Consider this, it appears to me that the country’s top quintile of wage-earners (the folks with the most assets) are experiencing deflation as their home prices have collapsed, their 401K’s are substantially below where they were in October 2007, their bonuses have been “whacked,” and the list goes on.

Meanwhile, the lower-income households are experiencing inflation with their heath care costs rising, food prices escalating, insurance premiums climbing, etc. Even here in the Tampa Bay area, electric rates were recently increased by 7.5%. Our “bet” is that the inflationary forces will eventually win out because that’s the way it has always played since the Great Depression.

Plainly, we don’t think it is different this time as we expect the typical business cycle to play. To wit, the current inventory re-build should lead to increased capacity utilization and capital expenditures. That should be followed by a pickup in employment, which in turn should foster more consumers spending. To be sure, we haven’t thought, and don’t think, this will be the typical post WW II “V” shaped economic recovery because the sectors that have pulled economic activity sharply forward out of past recessions have been the “debt driven” sectors.

However, with consumers currently in a de-leveraging mindset, it is difficult to envision housing and autos doing the “heavy lifting” this time. Nevertheless, we have averred since the anticipated March stock market “lows” that economic growth would be stronger than most expect. Our sense was that since the working age population grows by about 1% per year, and productivity increases by roughly 1.8% per year, that it would take GDP growth of greater than 2.8% to create jobs. Accordingly, we have suggested GDP growth would likely track above 3% coming out of the current recession because it had to. And, you can already see most of the economic numbers supporting that thesis.

For example, 3Q09 auto production is up more than 300% (QoQ annual rate), which should provide a significant “lift” to 4Q09 GDP numbers. Moreover, numerous companies have announced hiring plans like Caterpillar’s (CAT/$46.11) recent revelation that it is re-hiring 70 of the 800 permanent employees laid off last spring. CAT is also bringing back 200 temporary employees. Speaking to housing, after years of housing “horrors,” the homebuilders are now lean enough that they should be able to operate at today’s reduced sales levels. As for the “dollar doubters,” the dollar’s share of world reserves remains constant at some 65%. Meanwhile, the Euro’s share of world reserves is steady at about 25%. Further, the lion’s share of world trade continues to be conducted in U.S. dollars. As for intellectual capital, the U.S. invests more than anywhere else with an average educational level of over 12 years.

So how do we invest currently? Well if past is prelude, we think large-cap, dividend-paying stocks are the investments of choice. As can be seen in the attendant chart, in this market, like all new bull markets, and according to Dow Theory this is a new bull market, the small-caps have performed the best since the March lows. From here, however, large-caps tend to play catch up. Consequently, we are buyers of large-caps on the belief that if we get a correction the large-cap, dividend-payers should correct less. And, if there is no correction, the large-caps should play catch up (see our previous missives for ideas along this line).

Then there is the strategy of investing in sectors that have “lagged.” Of the 10 macro S&P 500 sectors, only the Telecommunication sector (we like it) and the Utilities (we don’t like it) have produced negative returns year to date (YTD). However, of the 98 S&P subsectors, 14 remain negative for the year. Of those, we like the Distillers (-1.4% YTD), the Defense sector (-4.1%), Waste & Disposal Services (-1.1%), Integrated Oil & Gas (-10.4%), Fixed Line Telecom (-7.7%), and the Water sector (-15.5%). In past missives we have mentioned numerous investments in each of these sectors.

Then too, we continue to like special situations. In Friday’s verbal strategy comments we highlighted the investment story on DineEquity (DIN/$22.57/Strong Buy), as well as 11% yielding Daylight Resources Trust (DAYYF.PK/$7.27/Outperform) that is followed by our Canadian-based energy team. As always, Blue Sky issues should be vetted before purchase. Today we revisit 5% yielding Olin (OLN/$16.55) on its recent upgrade rating by one of our research correspondences. Said recommendation will be discussed more completely in Thursday’s verbal strategy comments. Yet at this stage of the stock market cycle, we think the best investment strategy is to layer some kind of non-correlated investments into stock portfolios. After studying numerous vehicles, our choice for this strategy is Quaker’s Long/Short Fund (QLSAX/$9.69). Quaker’s Long/Short Fund’s performance speaks for itself and can be retrieved from Quaker Fund’s website. We also continue to like Japan, which according to Bloomberg recently exited “from recession.”

The call for this week: This week we exit the three-week “Dead Zone,” so often referenced in these missives, whereby many of Wall Street’s “finest” go on vacation with their kids before school begins. With the return of the Pros, we should get a better idea of the stock market’s near-term directionality. Our sense is they will show up in “buy ‘em” mode since stocks just won’t go down and the Pros are staring at their October fiscal year end where performance pressure, bonus pressure, and ultimately job pressure should push them into more stocks. Accordingly, we have added some long ETFs to portfolios. And don’t look now, but gold is moving in on new all-time highs, which is why we continue to recommend OCM Gold Fund (OCMGX /$21.55), managed by our friend Greg Orrell.

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Comments

[chap08:]

I agree with your "both inflation and deflation" thesis with inflation eventually winning, but that's about it. You should recognise that the inflationary and deflationary forces are extreme, so don't expect a picnic.

You are also far too optimistic on the dollar. Those inflationary forces will be felt in the dollar's value against hard assets, if not against other currencies. Related to that, is the point that you only seem to able to see as far as the continent of North America. If this is really the advice that you give your clients, then you are letting them down.

Sep 09 10:57 AM

[NUCLEAR1929:]

it depends if you are buyer or seller, if you bought 2ct diamond ring for $30,000 in 2007 (inflation) and now to raise cash to pay back debt you go to a pawn shop and you get for this diamond $6000 (deflation)
got it?

Sep 09 11:07 AM

[Pat C:]

I have honestly just given up trying to figure it out. There is so much HFT, derivatives, hedging and speculation going on with big $$ behind it. Dollar drops, gas goes up, exports increase, inflation/deflation? good? bad? who knows anymore....... we need a change.

Sep 09 11:37 AM

[Barbarous R...:]

Trying to measure the absolute rate of "inflation" is an impossible task. As the author notes, different prices are rising and falling all the time. It is impossible to come up with a representative basket of goods and services which means anything.

All we can really say, is that with an aggressively expanding money supply, the purchasing power of each individual dollar is aggressively declining. That is a mathematical fact. Stated another way, prices in the aggregate are rising relative to where they otherwise would have been. On a relative basis, but not necessarily on an absolute basis.

This is still a very destructive situation. A benign looking CPI merely distracts attention from the real issue. The newly printed money is not evenly distributed to all participants in the economy -- the lucky early recipients get the benefit to the detriment of everybody else. In particular, those on fixed incomes and with poor credit.

Regardless of the direction of individual prices, a growing money supply simply results in an unfair arbitrary transfer of wealth (i.e. purchasing power) in the economy.

To conclude otherwise is missing what's really going on.

Sep 09 12:02 PM

[The Simple ...:]

You raise a good point Mr. Saut. It has been observed throughout the recession period that we can have broad asset price deflation combined with commodity price inflation. This is to some degree a mean reversion which is correcting a preceding period of rising asset prices and flat to falling commodity prices.

The early stages of the process have been characterized by high volatility and sharp price movements, and much of the correction has already taken place. The investor's job, as always, is to quickly and accurately identify the trends and position his portfolios accordingly, and not hesitate to reposition when the markets prove him wrong.

Sep 09 01:49 PM

[thiazole:]

So how is that different from any other time in history? Have pawn shops ever paid more than what you bought something for?


On Sep 09 11:07 AM NUCLEAR1929 wrote:

> it depends if you are buyer or seller, if you bought 2ct diamond
> ring for $30,000 in 2007 (inflation) and now to raise cash to pay
> back debt you go to a pawn shop and you get for this diamond $6000
> (deflation)
> got it?

Sep 09 05:31 PM

[MikeX:]

The credit bubble FED has created for 50 years is akin to South Sea Bubble. When it deflates, it is going to be major deflation. After years of inflation talk, look at where we are with still negative inflation. Home values are down, stocks are down, commodities are down. We cannot borrow our way to prosperity. Every borrowed penny will be paid back. When we do that it is going to cause delfation. When the FED panics then and prints 10, 20 times more money, then maybe we can have some inflation.

In a deflationary crash, even though FED makes credit easier, it is hard to turn the boat around due to the following reasons:

1. Lenders (banks) do not want to lend because they think they may not get their money back. This is because the money supply is shrinking rapidly. All prices around you were based on inflated bank credit. People borrowed and bought things and inflated prices along with salaries. It is very possible that all prices and salaries can be cut in half if the money supply shrinks 50%. Then it will be very hard to pay back a fixed rate loan.

2. Borrowers do not want to borrow because they think they may not be able to pay it back. This is normal because people see job cuts, companies cut costs, prices fall, so how can they be sure that they will make same salary in the future to pay back what they owe.

3. For inflation to happen, people must have alot of money to chase too few products. What we have now is the opposite. We have wage reduction. We have high debt levels. We have excess capacity producing too many products. The supply exceeds the demand. The prices will fall, not go up. All companies are selling less, good results are just a result of cost cutting. When one company does it, it is good. But when all companies do it, cost cutting is detrimental to the economy. Earnings will go lower. Imagine an IT company produces software and hardware, but cuts costs: layoff workers, freeze salaries, stop investments. Their customer is a bank. If the bank cuts costs what will they do? They will say: Hey we are not buying new software from this IT company this year. We will run with fixer upper systems we have, sorry. This mentality will effect everyone's earnings! It may sound good for the bank, but it is bad for the IT guy. There is a chain reaction.

Almost all of the money supply in the economy is in terms of bank credit. This monetary system is prone to a deflationary crash. There is a herd effect in the population. People borrow and spend alltogether and they stop borrowing alltogether. This creates cycles like kontradiev wave. The herd effect causes great booms and great busts. This is explained in Conquer the Crash:

www.tradingstocks.net/...

Conquer the Crash foresaw the financial crisis back in 2002 and explained in detail how it would unfold. It is like a history book about the future. Must read.

Sep 09 06:36 PM

[TinyTim:]

"in an economic system some prices may be rising, while others decline. This process is continuous "
"Our “bet” is that the inflationary forces will eventually win out because that’s the way it has always played since the Great Depression."

Agreed. Nothing says the deflationary / inflationary process has to be uniform, especially over many sectors.
Inflationary forces win out only because it's the more expedient approach politically. Especially now, when the huge debt can be monetized and the can kicked down the road.

Sep 09 08:38 PM

[Gregman2:]

"Well if past is prelude..." Is prelude anything like 'prologue'?:-)

Sep 11 01:37 AM

[Kirk Spano:]

kirkspano.com/content/.../

Sep 11 05:56 AM

[Ya Hoo:]

Fine. So it was pointed out that deflation is occurring and inflation in certain areas is present. This should be no surprise. Look the US economy has loss trillions of dollars from the the downturn of stocks, housing, and some commodities. Were did all that money go? Well in the great depression it evaporated into thin air: in this great recession it went to the federal reserve in the form of "fiat" or printing money with the only intention to reflate the economy and protect the financial (banking) institutions by spending money created out of thin air. Spend it before it escapes. When the stimulas money is spent the ecomonys's wheel will begin to spin again. If we are lucky the momentum of the stimulas will keep them going, if not look for economic problems,more stimulas bucks, and cash hoarding. If it works, and the ecomonic engine begins picking up on it owns....look out there will be inflation and higher interest rates. That will be a good day for the precious metals guys, the working poor, and for everyone else who owns non cash assets.

Sep 19 07:52 PM

[Economic Ph...:]

The author needs to tie the analysis to the money supply in order to be credible. Inflation and deflation is not prices increasing or decreasing it is the money supply increasing and decreasing with prices as its effect.

Sep 25 06:15 PM