Deflation Takes the Reins

The investment climate has changed dramatically in the last two months.

For most of the last seven years the dominant theme has been dollar and US markets negative, with commodities and emerging markets positive. This continued for the first half of 2008 with commodities, most notably oil, crushing US equities as the dollar hit record low after record low.

However, starting in August the dollar began a strong rally while commodities began a strong correction. Given the massive amount of leverage in the marketplace I first thought this trend reversal was the result of a short-covering rally in the dollar and over-leveraged investors in the commodities space liquidating their portfolios.

However, given the continued strength in the dollar as well as commodities’ inability to launch a significant rebound, it looks as though we may actually be at the beginning of a genuine shift in investment climate. US equities are outperforming most international indexes … and the US dollar has rallied against every major world currency you can name.

Do not get me wrong. I think the dollar is a horrible currency with poor fundamentals. The fact the US is clearly in a severe recession and adding greatly to its debt load with the Fannie/Freddie deal are all very dollar negative.

However, as investors we MUST be flexible with our strategy. And you must take your directions from the market. If the dollar has indeed begun a bull market, it won’t do you a lick of good to continue buying dollar hedges. Similarly, if US markets are outperforming their emerging counterparts, loading up on emerging markets will only add to your stress.

Right now, deflation has taken the reins. Assets across the market — particularly in housing — are losing value steadily. The large banks and financial firms continue to hold billions and billions in assets and securities that, if marked to market, would indicate deflation.

The regulatory bodies have tried to paper over this deflation with various inflationary tactics — printing money like crazy, issuing low interest loans to financial firms, swapping Treasuries for junk with Wall Street, etc. None of these have worked. They have built up inflationary pressures, but currently deflation is decidedly in control.

At some point in the near future, the Fed will have to really ramp up the inflationary tactics. We could very well see Ben Bernanke apply his “helicopter” hypothesis —  the notion that he would print so much money it’d be as if he was dropping it from the skies —  to a real world situation. When he does this, gold, silver, and other inflationary hedges — namely commodities —  will explode higher.

However, currently prices across the board are falling. This is dollar positive and negative for commodities. Invest accordingly.

Comments

[Chris B:]

So if the author's advice is to follow the trend despite the fundamentals, how is that any different than the same advice given in early July? Trends reverse all the time, and if you have a follow-the-leader investment approach, you will consistently buy at the top and sell at the bottom.

2008 Sep 17 11:32 AM

[Nikola:]

Well... let's quote The Man himself: United States has the technology to fight deflation.

Look up! It's Ben!

2008 Sep 17 12:10 PM

[bbzz24:]

lots of pensions money directly or hedge fund money indirectly was poured into EMEA. with the credit crunch still ongoing and the need to bring in more collateral for all heavily leveraged positions in the U.S., lots of positions had to be liquidated and the USD bought back. on top of that anyone who was not naive to believe in decoupling liquidated non USD positions, so the dollar rallied.
there is no fundamental change in the U.S. for good, nor a economic slowdown in EMEA will significantly impact growth there +/-2% GDP growth is not much of a deal.
either go fundamental or follow the hot money.

2008 Sep 17 12:38 PM

[Jason Rines...:]

Personally, I think the article was well written. Not novel or new ideas or thoughts but well written. Perhaps the article title should have been a question if equities may make a comeback or not any time soon. Chris B, I always like and admire your comments. You had mentioned other inflationary forces in addition to Phils creation of inflation mention. Which of the inflationary forces you have mentioned in other posts do you likely think will be predominate in 2009?

2008 Sep 17 12:43 PM

[mark mchugh:]

I agree with iThinkbig, well-written. I also agree that you need flexibility in your approach. But there are times, infrequent as they may be, that you should cling to your thesis. These strong-dollar fundamental guys are psychotics.

2008 Sep 17 02:31 PM

[Chris B:]

iThinkBig:
The spread between a low fed funds rate and lending rates are among the only things keeping the financial sector alive right now, and that will continue in 2009. If the fed raised rates to fight inflation, it would finish off several crippled banks, which they feel would be a worse fate than 5-6% inflation for a year or two. Thus, we can expect them to keep rates low for a long time, just like after the tech bust. Accordingly, our top task right now is to figure out what bubble will be inflated by these low rates.

As retro-2007 as it may sound, the realization that the US is trapped with low rates for the next 2 years may prompt investors to rediscover the carry trade with higher-yielding currencies than the dollar.

The deflationary cash shortage you've heard so much about has not been felt much outside of financials. Non-financials' earnings statements and balance sheets aren't horrible at all. As strong companies go on sale as a result of the financial sector, I'm tempted. Greater difficulty getting fianancing is only going to help the blue chips fend of their weaker competitors.

I'm waiting out the election though. McCain means war, and that changes everything.

2008 Sep 17 04:05 PM

[Rokjok777:]

Again, the Japanese example is instructive. Cash is king, and people will just chase yield. Dollar-denominated Phillipine bonds, anyone? Equities are toxic. Maybe rename this site....there will be no Alpha for quite a while to come....

2008 Sep 17 05:44 PM

[dlaw:]

I felt this trend was SO IMPORTANT and SO IGNORED that I was compelled to start a blog with a first post very much like the one above.

The author is only a couple weeks behind me :-)

The evidence is clear: there is a dollar SHORTAGE.

The world is desperate for hard currency and secure credits. They're so desperate they're even buying gold.

Very bad times.

2008 Sep 17 06:53 PM

[Kunst:]

dlaw: The evidence is clear: there is a dollar SHORTAGE.

OK, I'll bite. What evidence?

2008 Sep 17 09:14 PM

[Metzenbaum ...:]

"printing money like crazy"

Can you reference that, please?

It's here: www.federalreserve.gov.../

Percent change at seasonally adjusted annual rates M1 M2
----------------------...
3 Months from May 2008 TO Aug. 2008 7.1 1.5
6 Months from Feb. 2008 TO Aug. 2008 2.8 3.4
12 Months from Aug. 2007 TO Aug. 2008 1.6 5.4

Unless THE FED IS LYING !!!

2008 Sep 17 09:35 PM

[bearfund:]

dlaw, um, people aren't buying gold because they're desperate for good money and there aren't enough dollars. They're trading dollars for gold because the dollar isn't good money. There are plenty of dollars, though you'll have a tough time getting any of them if you're a bad bank and the only collateral you can offer are CDOs. Gold is money, nothing else.

2008 Sep 18 12:35 AM

[X-15:]

Money is evaporating

2008 Sep 18 12:41 AM

[fxtrader07:]

@Chris B: you are spot on. Ignoring fundamentals because some trend (short-term, intermediate?) goes in the other direction has zero to do with investing and and investor#s point of view. the most successful ones ignore the crowd repeatedly. If one just follows trends one will at best get average returns. most likely one will lose out terribly
@dlaw: in a way there is a dollar shortage - but specifically, it is a cash shortage. There is an abundance of 'long term' dollars (i.e. treasury bonds).
That#s why the author is absolutely wrong and confusing things. A run for cash has led to broad liquidation and while that may continue it doesn't make a true trend. The central banks will fight the problems with printing dollars like mad. And much like everybody rushed into oil this summer and then was left holding the bag it will be the same with the dollar cash and treasury bills. It may tajke half a year or one year or even two but happen it will. and then you will feel the glut of dollars and the shortage of real assets and the flow will go into opposite direction with a vengeance.

2008 Sep 18 04:33 AM

[Jimbo:]

Chris B: What makes you think that Obama! means peace? At least you implied that with your comment on McCain. I submit that if Obama! is elected, he will stumble into war just as Neville Chamberlin did. These are very dangerous times ad several dictators are waiting to test the U.S.

2008 Sep 18 11:19 AM

[Chris B:]

Jimbo,

1) "Bomb, bomb, bomb Iran" hawkishness versus Obama's more careful stance.
2) Republican donors in the oil and defense industries.
3) Democratic priorities are to spend money on their own projects, such as healthcare, etc.
4) McCain's unwaivering support for NATO expansion and missle placement right up to Russian borders vs. Obama's again careful stance.
5) Safe to say Iraq will remain unstable for at least the next decade or two - how much longer will we be fighting there under each candidate? 3 years or 8?
6) Which candidate would fight China over Taiwan? They're silent on the issue, but my instinct says McCain would.
7) The old debate over Obama's "naive" willingness to meet with potentially hostile world leaders vs. McCain's Bushlike refusal to talk to them. Which candidate can deliver diplomatic solutions? Which would attack with the military first?

NOTE:
A counterpoint to these observations is Obama's willingness to fight inside Pakistan to get Al Quaeda. Although that's obviously necessary if we ever want to capture OBL or stabilize Afganistan, it would quickly create an Iran-type relationship with a nuclear power. Given the predominant attitudes in Pakistan, that may be inevitable anyway.

2008 Sep 18 01:14 PM