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It’s looking more and more apparent by the day that deflation is returning to the financial markets – and with a vengeance.

Yes sir, deflation is back – it’s out to kick ass and chew bubble gum, and apparently it has just run out of gum.

The reflation trade is being exposed as the fraud we thought it was. It was just a mirage. A standard fare retracement that did its job exquisitely: making market participants believe that the worst was behind us.

So now that deflation has returned, how should you invest? Here are the 5 most important things you need to remember when making your investment decisions for the rest of 2010 and beyond:

1. In Deflation, Cash is King

In a deflationary period, the price of EVERYTHING declines – which makes good old cash the place to be.

Since most of us have been investing during times of inflation, albeit mild for some long stretches, we are still accustomed to the thought of “yield” in order to compound interest or just stay ahead of inflation.

In deflation, when asset prices are declining all around you, return ON capital is not nearly as important as return OF capital. So you have to retrain your investing mind a little bit to realize that a 0.1% return, or even a 0% return, is just fine – because asset values are collapsing all around you.

Although your cash looks to be the same amount in nominal terms, it’s actually greatly increasing in value with every triple-digit plunge on the DOW. That’s because your cash can buy more. As asset prices plummet down the toilet all around you.

Quick case study – in early 2008, I changed jobs, and was extremely lucky to have my 401K retirement money tied up in cash as I rolled it over to an IRA. During that long and drawn out transfer process, I was not earning one cent in yield.

But ultimately I came out way ahead, because the tie up in cash was the best thing that could have happened to me – it saved me from decimating myself with my own trading heroics, as the biggest stock market collapse of our lifetimes was occurring.

2. The US Dollar Will Continue to Rally

So what cash should you be in? Paradoxically, the US dollar has been the strongest performer during deflationary waves. And ironically, that may be because it’s not the strongest currency, but rather, the sickest.

When deflation hits, a lot of debt “goes away to money heaven” – here today, it’s gone tomorrow, never to be heard from again. Since most debt is denominated in US dollars, the supply of available dollars decreases, which actually sends the dollar up.

Gold may be a decent cash equivalent, though I am still wary after experiencing this “safe haven’s” collapse in 2007-2008. The dollar was the strongest currency then, and I expect it to be again until further notice.

click to enlarge

US Dollar Index Chart

The US Dollar has rallied since late 2009 – its trend is UP until further notice.

(Source: StockCharts.com)

3. Stocks Will Get Creamed

Stocks are not a good place to be during a deflationary depression (check out the price performance of stocks during the Great Depression).

Conservatively, you can expect stocks to take out their previous March 2009 lows, as was the pattern during the Great Depression. Stocks didn’t go straight to the basement – they shed value in a serious of waves down, with brief price rally breaks meant to sucker investors back into the market.

Stock Prices Great Depression 1929

Stock prices collapsed in amazing fashion during from 1929-1932.

(Source: StockCharts.com)

We just saw one helluva bear market rally, which probably means we’re about to see one helluva next wave down. Conservatively, you can expect a sub-600 S&P, and a sub-6000 DOW. And maybe much lower.

Last time, not many stocks were spared. The market tipped its hand, and I wouldn’t expect many stocks to do alright this time around either. The best bet would be to avoid stocks altogether.

4. Precious Metals and Energy Will Get Slammed Worse (Mostly)

Gold prices have been holding up extremely well of late, which may bode well for gold bugs. Originally I thought gold would get slammed as it did in 07-08, just not as bad this time around. I may have been too harsh in my predictions for the yellow metal.

Gold Price Chart

Gold has held up more than admirably over the past few trading sessions.

(Source: StockCharts.com)

Other precious metals though are getting creamed – as is energy – due to their industrial uses. When this demand evaporates, prices go down because there’s just too much supply available.

For example, silver is more volatile than gold, due to its industrial demand – that works like leverage – great when prices are going up (if you’re long) – but very bad when prices go down. I think we’ll see single digit silver again before we see silver north of $25.

Same goes for oil – peak oil or not, if demand hits the road for a year or two, we could see an instant replay of what happened to natural gas. Where all of a sudden there’s more supply than anyone knows what do do with, and prices collapse.

Crude oil collapsed into the $30s last time, and I suspect it could drop even lower this time around.

5. Financial Institutions Will Fail

Remember when banks going under were a Sunday afternoon tradition rivaling the NFL? It’s going to happen again, but likely much worse.

So it will be very important to have enough savings on hand to get through possible bank closures. Don’t count on the FDIC – that’s an institution that’s likely to fail also. (Why? Read why the FDIC will soon need a bailout.)

FDIC Logo

Doesn’t this make you feel safe?

Very short term, US government bonds will be the safest place to stash your cash. You can buy them direct online at TreasuryDirect.gov.

Just remember: Don’t chase yield and buy anything beyond 3-month paper, otherwise it could be worthless before it matures.

Deflation Investing Summary

Cash – ironically, US dollars – will be the safest place to store wealth during the next wave of deflation. Most stocks and most commodities will get creamed. Many financial institutions are toast. It’s not going to be pretty.

I wish I had better news for you – but I don’t. Just because bad stuff is going to go down globally, it doesn’t mean bad stuff has to happen to you personally.

Take the appropriate measures to protect yourself now, and you’ll be way ahead of the game when we eventually make it through to the other side. You’ll be ready to buy stocks for pennies on the dollar – your dream house for $0.10 on the dollar – you get the idea.

For more tips about how to handle the joy of complete deflationary financial destruction, check out deflation expert Robert Prechter’s Deflation Investing Primer.

Disclosure: Long the US Dollar, Short the S&P 500, both via ETFs

Source: Deflation Investing Strategy: Five Things You Should Know