Worthy Investments During Deflationary Collapse

Includes: FXE, GBB, UDN, UUP
by: Nikhil Raheja

As outlined before, we expect a huge crash in the market in the coming months. The nature of the collapse in the market should be deflationary, resulting in a severe downfall, the likes of which have not been witnessed since the Great Depression. The best investment philosophy for this recession is extreme safety.

The downtrend should mimic the events of late 2008, where anyone caught with risk assets such as stocks, bonds, commodities, real estate, currencies and municipal debt suffered a large capital loss. Again, the key prelude to the start of the crisis is extremely positive sentiment, where stock brokers and mutual funds refuse to acknowledge the threat of an impending recession. As of January 15th, we know that the positive sentiment in the market right now is the highest since 1987, surging above that in 2000 and 2007. As this sentiment changes direction, markets start to fall rapidly and the majorities are caught unawares, thereby losing large amounts of money.

Why will all assets collapse?

Every financial asset is valued based on future expected returns, so if the future expected returns fall, the valuations for the asset fall, and vice versa. For ex- If future expected rents fall, the houses will be valued lower, or if the future expected profits from businesses fall, the current price for the stock would fall. In addition, the interest rates affect valuations too, since the future profits are discounted back to their current values using the market interest rates. The higher the interest rates in the market, the lower the current prices, and vice versa.

Since we expect the interest rates to rise and the expectations of future profits to fall, the result will be much lower asset prices. This will be a repeat of the events of 2008 where stocks were valued much below their 2007 level, due to lower expectations from the future.

Opportunities for investors

US Treasuries
Safe Non-Market based Businesses
US Dollars
Put options

Opportunities for Traders/Seasoned investors

Short stocks/bonds/commodities
Currency Futures
Interest Rate swaps
Put Options
Long the Volatility Index

Opportunities for investors

US Treasuries: The best investment to make during a time of deflationary expectations is in Treasuries.The US treasury debt, both long and short maturities, should rise in prices, yielding capital gains for the investors. As fears spread across the world about private investments, investors should flock to treasuries, while dumping anything that is risky. An investor may buy US government treasuries here or may choose derivative products such as Exchange traded funds that follow the returns of the US treasuries, through their broker.

Safe Businesses: As credit is restricted during the crisis, most businesses will find themselves short of liquidity and will pare down their operations.As a result, unemployment will rise and consumer spending will decline, leading to significant losses amongst those dependent on consumption. Despite the gloom, there would be some businesses that outperform the rest. One such business model that performed well during the first leg of the crisis in 2008 was “Hard money lending”.

Hard money lenders lend to businesses for short period of times, and ensure their capital is safe through the use of various backstops. We, at Keystone State Capital are a perfect model of a successful hard money lender that outperformed 95% of the investment funds in the world in 2008, and are not expected to face many problems during the next leg of the crisis. In fact, the lack of credit available to most businesses allows us to receive greater collateral on the loans we offer, thus making the loans even safer.

US Dollars: Investors could sell their investments and hold that money in Dollar Deposits at a safe banking institution. The safe banks are always the biggest, since the government ensures that the big banks do not fail, while letting the smaller ones collapse. The investors must ensure they do not deposit more money in any one bank than is insured by the FDIC. The maximum deposit insurance amount is $250,000 per depositor, per insured bank, through December 31, 2013.

Put options: A put option is a financial contract between two parties, of which one party buys the right to sell a certain financial asset at a certain price to the other in the near future. The seller of the option is said to have sold Puts, and is thus obligated to purchase the asset if the buyer of the Puts intends to sell them.

An investor may consider buying puts on the S&P 500, to protect himself/herself in the event of a major collapse in stock prices (which we do anticipate). The advantage of buying puts as opposed to short selling is that if the asset in question rises instead of falling, the maximum loss suffered by the investor is capped by the total premium paid to the other party for buying the puts.

Opportunities for Traders/Seasoned investors

Short stocks/bonds/commodities: The skilled traders may short stocks, bonds, commodities, municipal debt or any other related derivates. The risks with shorting is that if the instrument being shorted rises, then the individual may lose his entire margin, and more. The reason why all of the above instruments would fall is outlined on the first page of this letter.

Currency Futures: Traders may buy a currency futures contract, going long the Dollar, and short the Euro/Pound/A$. The Dollar index, an index that tracks the exchange rate of the Dollar against 6 major currencies gained 30% during the 2008 crisis. The index should gain another 30-50% in this leg of the downturn. Contrary to popular belief, the Dollar is not dead; in fact it should be one of the best performing assets in the world for the next few years.

Interest Rate Swaps: Interest Rate Swaps are derivative contracts where one party promises the other a fixed interest rate on a certain principal, while the other promises the first a floating rate of return, based on a particular index, like the 30 year mortgage rate, or the LIBOR.

Several developing countries borrow US Dollars to fund their trade deficits. As fears in these countries rise, the interest rates rise on their US Dollar debt. With a rise in interest rates on the Debt, an investor situated to receive a floating rate interest on that debt will receive a higher interest, while paying out the same fixed interest rate. Countries like Latvia, Hungary, Lithuania, and Dubai, in a repeat of the events of 2008, should see their interest rates on the foreign debt rise, and thus benefit the trader receiving floating rates and paying fixed interest rates.

Put options: Traders may also buy Put options to lower the loss potential of shorts. Longer expiration options, LEAPS, can help the traders buy options expiring in 2012, and thus reduce the risk.

Long the volatility index: The volatility index provides an indication of the expected volatility in the options market. If option sellers feel higher uncertainty in relation with the future, they raise the premiums charged to the buyers. This causes the volatility index to rise. Investors may buy the Volatility index futures or call options to bet on higher volatility in the future.

Disclosure: None

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