Why Are Investors Swallowing the Deflation Myth?

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Includes: DIA, QQQ, SPY, TBT, TLT
by: Tony Daltorio

Dumb and Dumber is the title of the 1994 comedy film starring Jim Carrey and Jeff Daniels. The title could also be applied to the current behavior of both institutional and individual investors. Both type of investors are cowering in the corner, afraid of the bogeyman – deflation. Both types of investors are eagerly purchasing Treasuries at zero per cent or even negative interest rates.

One of the few things I can say for sure about investing is that the crowd always ends up being the long-term losers. And the deflation trade is extremely crowded right now. I challenge anyone to show me when the consensus opinion was ever right in the long term.

It is the few investors who think outside the mainstream consensus that usually end up being the big winners. If you want to be a successful long-term investor, you have to THINK FOR YOURSELF.

Individual investors need to remember where the “sage” advice is coming from that they receive on media outlets such as CNBC. It comes from Wall Street. At 2007's year-end, the five largest Wall Street securities firms paid their employees $66 billion in bonuses. All of these bonuses came from phantom “profits” that we've since discovered to actually be huge losses.

Perhaps these actions by Wall Street are even criminal. At the least, they are immoral. Yet, people still take advice from Wall Street as if Wall Street was Moses coming down from the mount with stone tablets. I cannot believe people are so gullible. Truly dumber.

Dumb and Deflation

Investors' gullibility is really showing with the way they have swallowed the entire deflation myth hook, line and sinker. It's hard to believe that people can't see that Treasuries yielding zero per cent means that Treasuries are trading at BUBBLE valuations. How can an investor spot a bubble?

One major attribute of every bubble in history is that it is “sold” with a great story. We have that today – a great “story” is being told - the fairy tale known as deflation. Deflation has been made out to be this horrible monster of mythical proportions by the government and by the mainstream financial media.

The “story” is being spread by mainstream financial media outlets such as CNBC, where if they are not talking about Apple Computer (NASDAQ:AAPL), they're talking about deflation. By the way, I have always amused by the name of CNBC's chief economic correspondent, Steve LIESman. What an appropriate name!

Scary tales of a global recession and collapsing financial markets are spiced up with dark remembrances of the Great Depression of the1930s and Japan in the 1990s. These fairy tales have driven investors to protect themselves against the deflation “monster” by blindly purchasing “risk-free” Treasuries at any price.

Another attribute of every bubble in history is that they are believed to enjoy the support of the governing authorities. The governing authority in this case is the Federal Reserve. I'm sure we all recall how the “Greenspan put” of the 1990s emboldened stock speculators, leading to the dot-com bubble.

Now we had the recent announcement by the Fed that they would be purchasing government bonds. This announcement has led Wall Street to believe that there is now a “Bernanke put”, placing a floor under the Treasuries market. This has led directly to the bubble-like valuations in Treasuries.

Bubble Blowers

One of the biggest culprits in this government bond bubble has been the institutional investors on Wall Street. Many institutions have sold off all other types of bonds and replaced them with Treasuries. Many other institutions have “diversified” into Treasuries since they have held up in value while just about everything else has collapsed in price.

Whatever happened to buy low and sell high? The bond bubble is just the latest example of “herd” behavior on Wall Street. People on Wall Street only feel comfortable inside the “herd”, doing what everyone else on Wall Street is doing. You'll rarely see an independent thought.

The other big culprit in this government bond bubble has been so-called sophisticated hedge funds. They are playing a game of “musical chairs”. They are planning to “ride the wave” while bigger fools buy Treasuries from them. They, of course, hope to get out before the music stops.

When the music does stop, this hedge fund behavior will only lead to everyone rushing for the exits at the same time. As usually happens, most will not get out in time. I continue to maintain the following – I don't care whether a bubble is created by greed or as in this case – fear. A bubble is still a bubble and will end badly as bubbles always do.

I Smell Smoke

The smoke that is wafting toward my contrarian investor's nose smells like future inflation to me. The so-called investors that are acquiring Treasuries now are forgetting about all of the weapons that are at the disposal of “Helicopter Ben” and the Federal Reserve.

With the paper currency system that we have currently, a long-lasting deflation is simply impossible. Why? Because there is no limit to how much money the Federal Reserve can create out of nothing. There are also no constraints on what the Fed can do with the money.

Wall Street is acting as if the Fed can only buy Treasuries and can only pump money into our economy through the banking system. That is typical of Wall Street thinking – no one thinks outside of the box.

What is there to stop the Fed from sending money directly to the populace through a check or debit cards? Nothing! What is there to stop the Fed from purchasing other assets directly – stocks, real estate, commodities, junk bonds, or whatever they wish? Nothing!

That smoke that I am smelling is Ben Bernanke and the Federal Reserve thinking outside-the-box on how to start an inflationary camp fire. The Fed will eventually succeed in starting the fires of inflation. I can't wait to see the Fed roasting those deflation and Treasury “marshmallows” on that camp fire!

The danger will occur if Ben doesn't put out his inflationary “camp fire” soon enough and it turns into a raging forest fire, which consumes the US dollar. This forest fire will not only anger Smokey the Bear but probably leave many Wall Street firms in ashes.

The deflationists should simply heed the words of Ben Bernanke from his famous November 2002 “Helicopter Ben” speech. Here are two direct quotes below from that speech:

Quote #1 -

The US government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices of those goods and services.

Quote #2 -

We conclude that, under a paper money system, a determined government can always generate higher spending and hence positive inflation.

Ben Bernanke and the Fed seem to be very determined to me to start that inflationary camp fire. Why isn't Wall Street following the old adage - “Don't fight the Fed”? Why are they fighting the Fed? I guess they are just dumb.