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Deflation: How Does It Affect Asset Values?

By Vadim Pokhlebkin, Elliott Wave International (NYSEARCA:EWI), Mon, August 16, 2010
For answers, let's turn to EWI President Robert Prechter.
With the Federal Reserve openly talking about the threat of deflation, an important question becomes: What happens to asset values in a deflation?
People seem to take for granted that financial values can be created endlessly seemingly out of nowhere and pile up to the moon. Turn the direction around and mention that financial values can disappear into nowhere, and they insist that it is not possible. “The money has to go somewhere…It just moves from stocks to bonds to money funds... For every buyer, there is a seller, so the money just changes hands.” That is true of the money, but it’s not true of the values...
For prices of assets to fall, it takes only one seller and one buyer who agree that the former value of an asset was too high. If a million other people own it, then their net worth goes down even though they did nothing. Two investors made it happen by transacting, and the rest of the investors made it happen by choosing not to disagree with their price. Financial values can disappear through a decrease in prices for any type of investment asset, including bonds, stocks and land.

Anyone who watches the stock or commodity markets closely has seen this phenomenon on a small scale many times. Whenever a market “gaps” up or down on an opening, it simply registers a new value on the first trade, which can be conducted by as few as two people. It did not take everyone’s action to make it happen, just most people’s inaction on the other side.

A similar dynamic holds in the creation and destruction of credit. Let’s suppose that a lender starts with a million dollars and the borrower starts with zero. Upon extending the loan, the borrower possesses the million dollars, yet the lender feels that he still owns the million dollars that he lent out. If anyone asks the lender what he is worth, he says, “a million dollars,” and shows the note to prove it. Because of this conviction, there is, in the minds of the debtor and the creditor combined, two million dollars worth of value where before there was only one. When the lender calls in the debt and the borrower pays it, he gets back his million dollars. If the borrower can’t pay it, the value of the note goes to zero. Either way, the extra value disappears.
 
The dynamics of value expansion and contraction explain why a bear market can bankrupt millions of people. Only a very few owners of a collapsing financial asset trade it for money at 90% of peak value. Some others may get out at 80%, 50% or 30% of peak value. In a bear market, the vast, vast majority does nothing and gets stuck holding assets with low or non-existent valuations. The “million dollars” that a wealthy investor might have thought he had in his bond portfolio or at a stock’s peak value can quite rapidly become $50,000 or $5000 or $50. The rest of it just disappears.
 
You see, he never really had a million dollars; all he had was IOUs or stock certificates. The idea that it had a certain financial value was in his head and the heads of others who agreed. When the point of agreement changed, so did the value. Poof! Gone in a flash of aggregated neurons. This is exactly what happens to most investment assets in a period of deflation.


Disclosure: 65% sh, 35% money market