Deflation, Inflation?

Friday’s (1/27/12) action was not too exciting, though some breakouts held (BodyCentral). I don’t watch the entire market FYI (can’t follow 10,000 stocks) but I try to get an idea for what’s happening with a sampling of stocks. Perhaps BODY’s issue was getting past lockup and with no serious selling pressure it rose. The company has been doing well selling to the fickle teen/young 20-something set which requires a company to be right on the cutting edge with great affordable styles (Think Forever 21 – a company I’d consider buying if it were public). BodyCentral is HQ’ed in the Southeast and have no stores yet in the Boston area or San Francisco (the 2 places you will most likely find me) so I haven’t witnessed it personally. But my resident expert (Mrs. G) has told me she likes the styles at BODY so I’m guessing they’ll do well this quarter and maybe some buyers are trying to get ahead of that.

The “bond replacements” were mostly flat, or a bit down, as were the MLP’s; large cap tech was flat to slightly down. US Treasuries and TIPS were a bit up. If the indices overall are slightly up and bonds are too, it tells me that both the recovery and the deflation camps are adding a bit to positions. There is however, one big problem. Volume. I pointed out early last week that it felt like 2007 when the indices crawled up all year but I felt ‘awful” the entire time, like I knew something bad was going to happen. This has sort of that feeling but not quite. The problem now is that every possible argument for direction either way is out in the open. Friday Barry Ritholtz tweeted that a certain negative magazine cover story was the “single most bullish thing” he’s seen this year. So we’re seeing the negative news which is historically a contrarian signal. Then we have the advisors a bit too bullish for other students of the market. The deflationists see deflation – David Rosenberg, whom I enjoy reading, is a big believer in that (he recommends the 2011 portfolio I have mentioned previously – income, income producing equities, and gold). We also have the inflationists like Bill Fleckenstein, whom I enjoy reading, Jim Grant, Fred Hickey and Jim Rogers.

In my opinion, the more nuanced debate is this: will central banks crank up the printing press before deflationary forces hit (asset prices, not everyday cost of living) and cause a spectacular “Krugman gets his rocks off” last blow out rally then a big bust, or does deflation hit hard, then followed by printing money, then the move up then bust? There are those like Nobel Prize-winning economist and NYT writer Paul Krugman who feel we must print and that there will not be a big inflation problem after. Others simply prefer high inflation to a bust, and others, the Austrian school people in particular, would prefer a bust to clean out the system, endure the pain for a short while and start fresh.

One of the economists I enjoy reading also is Marc Faber – both he and fellow Swiss Felix Zuluaf previously believed in the straight inflationary scenario, but if I am to understand recent comments from both, and especially Faber, they can visualize a delfationary bust before the money printers like Ben Bernanke get fully cranking on monetary stimulus.

A word about “deflation”: interestingly, a little bit of deflation would be good for all of us. If technology advances or best practices caused the cost of items we buy to drop, that would be good right? However, I don’t feel that the government talking heads are focused on cost of living. Their goal is to prop up asset prices, and they are confusing asset prices falling with deflation. In a free market house prices may have to fall more, along with some stocks but this is unacceptable to central bankers. Put plainly, they’d rather have your grocery, oil and gasoline bill double (money printing often causes the currency value to drop making imports like oil and food more expensive), and feel you won’t mind as long as your 401k goes up 15%. If that’s true then support your local central banker!

Game plan considerations:

If Bernanke plans to keep interest rates low and you live in the US, you could consider an allocation to long term treasuries – you may lose purchasing power, which is really  bad, but most Americans don’t take the time to understand inflation and currency value effects so it won’t matter. They’ll see 3-4% interest payments and be happy -so what if gas is $5/gallon? TIPS could be interesting – as the inflation adjustment coupled with the Fed-eliminated local interest rate risk could make these attractive somewhat in a diversified portfolio. Also, as Rosenberg states, if deflation is the theme and you’re talking about local currency, MLP’s and other income investments could be helpful. 4-6% yield when the bank pays ZERO is attractive. Dividend paying global and foreign stocks can diversify some currency risk, provide some income, and possibly hedge inflation. Adding gold or gold stocks to the portfolio could hedge against a higher inflation risk.

Your other alternative is to follow a risk management trading system with a game plan. Typically, these plans have exit strategies which prevent serious losses. These plans also should have strategies to stay in winning positions to maximize gains. Combining a risk management strategy with the asset classes above, maybe spiced up with trading in some wild stocks could give you all the fun you need this year.

At the time of this writing, I or my clients own the following investments mentioned in this column: Gold, GDX, AMLP, TIP

Note: this article is meant to be some helpful thoughts to share and not investment advice specific to you. Please consult your own advisor regarding investment and financial decisions. See our disclosures page