The Perfect Financial Storm - Part 7: Storm Tactics for Deflation

The worst is over. The Federal cavalry has arrived. The Fed has lowered interest rates. The President and Congress are going to cut taxes with Greenspan's blessing. The Nasdaq had rebounded. Relief is on the way. The storm clouds will begin to dissipate. The much hoped for "Soft Landing" has been achieved. Relax. There will be no pain!

The 2001 Consensus Forecast

This seems to be the consensus on Wall Street and Main Street. Despite ominous economic data that contradicts Wall Street's sunny weather forecast, optimism in the financial markets is still widespread. Economists extrapolate continued economic growth, albeit at a slower pace, and analysts project profit growth and rising markets for the second half of the year. To most, what we experienced last year was a momentary squall.

It all sounds so reassuring. The financial hype stems from the belief that the Fed will fix everything from investment portfolios to the economy. In the words of one financial anchor, "Been there, done that. It's not a big deal." In other words there is nothing to it. These prognostications are both seductive and soothing. The arguments for a soft landing are appealing, but the odds of achieving one are remote. Over the last fifty years, the Fed delivered only one soft landing (1994). Even then there was pain in the derivatives market; while we narrowly escaped a financial calamity.

Unfortunately, the truth is we are likely to experience severe storms in the financial markets and in the economy. The question is – Will they be deflationary or inflationary in nature? There are too many imbalances and malinvestments to be corrected. Tax cuts and interest rate cuts will only delay the timing of the storms' arrival. Those storms are surely on the way. And yes, there will be pain. It is time to gird yourself for rough weather.

U.S. Layoffs Paint Stormy Picture

As this table illustrates, layoffs are starting to accelerate in the new and old economies. On January 29^th, DaimlerChrysler announced job cuts of 20% of its North American workforce. A Wall Street analyst predicting stronger growth and rising stock markets for the second half of the year immediately followed their press conference. You don't fire 26,000 workers if the economy is expected to turn around in a few months. Layoffs cost money. Companies give careful consideration before making them. Strategically, they must look beyond the present to what lies beyond their horizon.

The Hype in Hypothetical

Yes, the economy is still creating jobs, but many of them are hypothetical. The job numbers reported each month are estimated and massaged statistically. The unemployment numbers are still low, but they don't reflect unemployed workers whose benefits run out after six months. After six months, the government assumes in its numbers that people become hypothetically employed. So the job growth numbers are more likely to be overstated and the unemployment rate understated.

The Numbers Don't Lie

As the these graphs indicate, the leading indicators are all heading south. In fact, the manufacturing sector looks like it has already headed into recession. Yet, there are still strong elements within the economy which include housing and the service sectors. We are probably in the last year of The Seven Fat Years of Economic Prosperity. Lower interest rates, the concomitant refinancing of home mortgages, and the coming tax cuts has bought us another year.

The Headwinds of Change

As I have illustrated in previous installments of "The Perfect Financial Storm?", there are several headwinds already buffeting our financial system. How we deal with them will determine whether the coming storms will bring deflation or inflation. These headwinds are as follows:

1. Consumer and Corporate Debt
2. Collapse of Corporate Earnings
3. Bursting Bubbles in Stocks and Real Estate
4. Trade Deficit
5. Growing Energy Crisis

These are the five headwinds that have begun to buffet the American economy. Their existence makes a soft landing unlikely. There is a real chance that for the first time since the 1930's, the American economy may face deflation. Webster's defines deflation as a contraction in the supply of the currency. On Wall Street and Main Street, it will mean a prolonged period of falling prices, determined by the psychological make-up of consumers. Consumers drive two-thirds of our economy. Once they start putting the brakes on their spending plans, the economy could face deflation. Once deflation emerges, it can be difficult to reverse. Governments exert very little control over consumer demand.

Loss of Consumer Confidence

In Japan interest rate cuts and fiscal spending has failed to arrest deflationary forces. The Japanese Nikkei is still 65% from where it was in 1989. Despite fiscal and monetary policy initiatives, consumers in Japan continue to save most of their discretionary income. The shock of evaporating asset prices in the stock and real estate markets, bank failures, and corporate bankruptcies caused a loss of confidence. Once confidence is lost, it is hard to regain. The outcome is retrenchment. This means consumers cut spending, reduce debt, and increase their savings. Prices drop and keep dropping for long periods of time as debt and assets are liquidated.

The Case for Deflation

One of the chief proponents of the deflationary thesis is economist and money manager, A. Gary Shilling. To Shilling's credit, he has been preaching it since the early 1980s. His 1983 book, Is Inflation Ending? Are you Ready?,[1] predicted the deflationary forces that we experienced during the last two decades (e.g. computers, entertainment systems, and until recently, energy prices). He wrote about deflation when everyone else was talking about inflation.

Shilling believes the economy is now entering a period of chronic deflation characterized by a plethora of declining prices that will impact investments, businesses, and everyone's personal affairs. In his 1999 book, Deflation: How to Survive and Thrive in the Coming Wave of Deflation, Shilling cites 14 forces that will create a benign outcome for the economy. Deflation will be triggered by the conversion of U.S. consumers from decades of borrowing and spending to a new paradigm of savings.[2]

Deflationary Forces

1. End of Cold War led to global cuts in defense spending.
2. Major country government spending and deficits are shrinking.
3. Central banks continue to fight the last war — inflation.
4. G-7 retirements lead to reduced benefits and slower growth in incomes and spending.
5. Restructuring continues in English-speaking lands and will spread.
6. Technology cuts costs and promotes productivity.
7. The Internet increases competition and slashes prices.
8. Mass distribution to consumers reduces costs and prices.
9. Ongoing deregulation cuts prices.
10. Global sourcing of goods and services curtails costs.
11. The spreading of market economies increases global supply.
12. The dollar will continue to strengthen.
13. The Asian Contagion will intensify global glut and reduce worldwide prices.
14. U.S. consumers will switch from borrowing and spending to saving.

Source: Deflation: How to Survive and Thrive in the Coming Wave of Deflation, A. Gary Shilling

Today, many argue that lower interest rates will remedy the situation. History tells us otherwise. The government tried this without much success during the 1930s. There were too many imbalances created during the boom that preceded The Great Depression. Stock and real estate prices were too high, credit had to be liquidated, and there were too many malinvestments to be washed out. Fiscal and monetary policy failed to pull us out of The Depression. Many would argue they only exacerbated the situation. It took a World War, accompanied by massive fiscal spending, to create enough demand to reverse deflation. The important point to realize is that once deflationary forces become ingrained in the minds of consumers, governments can no longer rectify the situation. The reason is that all of the excesses of debt accumulated during the previous boom must be cleansed from the system.

The booming markets and the economy of the Clinton years were fueled by a vast expansion of credit and an accompanying expansion of the money supply that is truly biblical in its proportion. It is similar to the 1920's, but worse. The new paradigm economy of the Clinton years was a myth. As a means to explain the asset bubbles in the economy and in the financial markets, Washington and Wall Street promulgated it.

The Seven Fat Years of Economic Prosperity™

The acceleration of our economy, which began in 1995, did not come from rising income and savings – which would have been healthy. The economic boom was fueled by a credit binge and sharp increase in the money supply. The consequences were excessive valuations in the stock and real estate markets and extravagant consumption fed by debt. The combined imbalances now pose an unparalleled risk to our country. They are a ticking time bomb. All that is needed to trigger the explosion is a catalyst.

Preparing for Possible Deflation

In my last installment, Storm Tactics, I wrote about some of the obvious measures that are necessary to deal with the coming storms. Getting out of debt is imperative. Debt is your worst enemy during periods of deflation. Accumulating cash to take advantage of lower asset prices or financial emergencies was another. If those two objectives are achieved, then you are fortunate enough to have the option to invest.

In times of deflation, all of the excesses of the boom that preceded it are corrected. Just as broad public participation helped to fuel the boom in stocks and real estate, the public's abrupt withdrawal will accentuate its decline as confidence begins to evaporate. Right now the public is suffering from a severe case of schizophrenia. They are bullish on stocks and pessimistic on the future of the economy. The public is a broad believer in "The Greenspan Put" (a floor underneath the stock market).

Get Ready for Phase Two

But there will come a day unlike any other, a day when the markets won't bounce back, a day when downturns aren't followed by an immediate bounce. There will be no immediate gratification. This is when the second phase of the bear market will really begin. On that day, millions of inexperienced investors will have no hand to hold them. Reassurances from the financial media will ring hollow. Investors will stare into the abyss as the reality of what is before them sets in. They will react with sheer panic to the realization that the market isn't coming back. The day of reckoning will be at hand when they learn two important truths: what goes up comes down, and 20% annual returns are unrealistic.

Deflationary Investment Tactics

Bonds

In a deflationary economy, the investment of choice will be high-grade A to AAA rated bonds. Bonds will deliver something the stock market can't – predictable income streams and certainty. Bond investments promise to pay back a fixed amount of principal at maturity. As stock prices collapse, public psychology will shift from risk to embrace conservative investments. The focus will switch from capital appreciation to income and a guarantee of principal.

Preference should be given to U.S. government debt because of its safety. High-grade corporate bonds rated A or better are also suitable. Treasury notes are preferable because they are backed by the taxing power of the government. Corporate bonds carry more risk, but pay higher interest. Maturities should be kept no longer than 2-7 years. There is a possibility that public policy mistakes, or events out of their control, could lead us on the path to inflation. If that happens, interest rates would rise along with inflation. This would cause the market value of bonds to fall. Keeping maturities short eliminates much of this risk. Maturities should be laddered from 2 to 7 years and watched closely for signs of inflation.

Gold and Silver

The second investment that will hold up in a deflationary cycle will be gold and silver. This might seem contradictory. But, as fear sets in and the dollar comes under pressure, confidence could erode in paper assets with the exception of treasuries. During The Great Depression, as one financial institution after another went under, the public lost confidence in paper investments. Gold stocks flourished during this period as gold was confiscated and investors weren't allowed to own it.

Gold and silver have held their value throughout long periods of history and unlike other investments, have a long track record. Precious metals are the ultimate currency. They are not fiat created and their value is universally recognized. During the numerous currency crises of the past decade, gold and silver investments held their value and provided a safe haven in Mexico, Asia and the former Soviet Union.

In past global crises, the dollar was considered a safe investment haven. It became a magnet for foreign money. However, the U.S. was not undergoing its own economic crisis at the time. A collapse of the U.S. stock markets and a severe recession could trigger a loss of global confidence. Given these circumstances, gold and silver may offer investors alternatives to their own currency. There is always the danger that governments will try to inflate their way out of a recession, thereby reducing the intrinsic value of the dollar.

There are other reasons why gold and silver could do well during a deflationary period. Gold and silver prices have been kept artificially low. Silver and gold are running supply deficits. Manipulation has kept their price suppressed. Silver prices are being kept low by large short positions on the COMEX. The derivative book of New York and certain European investment banks are manipulating gold prices. I addressed this issue in Rogue Wave/ Rogue Trader and will go into greater depth in the next installment of Storm Tactics. In the interim I suggest reading "The Gold Derivatives Banking Crisis" at gata.org and Ted Butler's articles at gold-eagle.com. What happens to gold and silver will depend on confidence in the dollar. How much gold and silver to hold in portfolios will be determined by its strength or weakness.

I first recommend physical gold and silver. Next is investment in gold and silver mining companies who have not hedged their production beyond one year. Those companies who have large hedge positions could find themselves in financial trouble when the runup in gold and silver prices takes place. For this reason, before investing in gold and silver mining companies, you should inquire as to the extent of their hedging.

If buying gold and silver bullion, I recommend physical delivery. If not taking physical delivery, as might be the case with large metals investment, I recommend COMEX registered warehouse receipts. Refer to Ted Butler's May 8, 2000 article, The Best Silver Investment.

Summary

I have recommended a combination of treasury notes, short-term cash combined with investments in gold and silver as a safe haven during a deflationary period. There is a strong possibility that the American economy could be buffeted by a series of storms that take us from deflation to inflation. So you want to be completely hedged for either outcome.

Thematic Investment Opportunities

There are three thematic investment opportunities that might work in either a deflationary or inflationary environment. They would only be appropriate for investors with a long-term time frame of 3-5 years where there isn't a need for immediate income or principal. Only those with strong investment knowledge and convictions, and who aren't bothered by market volatility in the short run, should pursue them. These investments include energy, utilities and defense stocks. All three relate to power. Two power the economy; while the other projects power.

Wind Changes Direction
Weather Changes Outcome

Two Observations

One lesson I have learned as a sailor is that wind and weather conditions can change abruptly. The wind can increase or decrease its force, and at the same time, change its direction. We call them "puffs," which are short gusts of wind. These short gusts can either be lifts or headers. A lift is an increase in the force of the wind, which helps to accelerate the boat in the direction that is desired. A header shifts the wind away from the direction that the boat is headed. In racing the difference between winning and losing is determined by being alert to the direction of the wind, adjusting the sails, and maximizing the speed of the boat to take advantage of lifts and headers to accelerate the boat's speed.

Another observation I have made from sailing is how often the weather can change and turn out differently from the forecast. A calm and sunny day can quickly turn into extreme conditions that produce high surf and confused seas. The same holds true for the financial markets. Each year I read the major financial publications' forecasts. The consensus is usually a linear extrapolation of the previous year's trends. The consensus forecast gives you a feeling for the general conditions of the market at a single point in time. In weather forecasting, if it's summer, we usually hear it will be a warm and balmy day. If it's winter, the forecast usually calls for cold temperatures with rain or snow. Weather forecasters, like financial forecasters, predict the obvious conditions of the season.

What We Learned From 2000's Forecast

Last year the forecast called for a robust economy to be accompanied by healthy gains in the stock market. These forecasts reflected a continuation of the trends of the previous year. During the first quarter, it looked like that forecast was right on the money. The economy grew at above-average rates; while technology stocks and the Nasdaq rose to new record highs. Once again, the prevailing conditions of the season were being played out in the financial markets. The record year for tech stocks in 1999 was being repeated by 20% gains in the Nasdaq during the first quarter of 2000. By the end of March, trouble suddenly erupted for the stock market. The technology sector went into a sharp tailspin erasing all of its gains. Investors were now facing big losses instead of the predicted profits. The Dow had peaked in January, while the Nasdaq was treading water.

The financial media soothed investors' fears that this event was normal – only a momentary correction in a bull market. The media and Wall Street were ignoring the fact that the Nasdaq had been selling at close to 250 times earnings. Debt levels were piling up at the consumer and corporate level, the trade deficit was at record levels and energy prices were rising. All of these events were considered to be temporary aberrations from the forecast and should be ignored by investors.

By May and June the stock market was back in rally mode and the economy was humming along. The consensus forecast was back on track – there would be warm and sunny skies for the rest of the season. By third quarter trouble was brewing and by the fourth quarter we were in a storm. The year ended up on a "record" note. The Nasdaq experienced its worst year in history losing nearly 40%, while the Dow suffered its first negative year since 1981. 2000 didn't follow the consensus forecast.

Today's Consensus Forecast

So here we are again in 2001, looking at a forecast that ignores facts. It's just more of the same rhetoric. This time the forecast has been tempered by actual events. The gains for stocks are modest and economic growth will be moderate. There are troubles right now in the economy and on the bottom lines of corporations, but they will go away by the second half of the year. The consensus calls for a better second half of the year. I call this forecast the "Soft Landing and Growth in the Winter Scenario."

My industry, and the financial media that is attached to it, have a hard time dealing with recession and bear markets. Bear markets hurt TV ratings; while recessions hurt corporate profits, which hurt stock prices. Falling stock prices hurt mutual fund sales.

Right now the financial industry and the media are placing all of their hopes on Greenspan's Federal Cavalry. Greenspan and Company will rescue the economy and bail out investors from their losses. So what is widely promulgated today is a better second half of the year. The economy will pick up momentum, profits will begin to rise again and the stock market will resume its upward trajectory. Indeed, this may be the case this year. Short rallies do take place within a bear market. Lower interest rates and tax cuts may ameliorate financial and economic pain. However, they will not arrest a trend that is unfolding due to the credit imbalances and malinvestments made during these past years.

In my opinion, in 2001 we will experience the ebbing prosperity of the final year of what I believe has been The Seven Fat Years of Economic Prosperity.™ I give the chances of a soft landing and benign deflation a probability of 25%. That is why we must consider alternative scenarios of stagflation and inflation.

Future Installments

The next installment of Storm Tactics will include investment strategies for stagflation and inflationary times. Before heading out to sea, mariners take a barometric reading. Before fighting a battle, a general surveys the battlefield. Before investing, a wise investor seeks to understand the investment environment. It's time to do your homework. Prepare for the storms—they're coming.

References:

[1] Shilling, A. Gary, Is Inflation Ending? Are You Ready?, McGraw-Hill, New York, 1983.
[2] Shilling, A. Gary, Deflation: How to Survive and Thrive in the Coming Wave of Deflation, McGraw-Hill, New York, 1999, p.xv.

Book Reading Recommendations:

• Averting the Defense Train Wreck in the New Millennium by Daniel Goure and Jeffrey M. Ranney
• Deflation: How to Survive and Thrive in the Coming War of Deflation by A. Gary Shilling
• The Prize by Daniel Yergin
• The Coming Oil Crisis by C.J. Campbell

Internet Resources:

TreasuryDirect, Silver-Investor, FallStreet, Gold-Eagle, Prudent Bear

Notes for Readers:

CAUTION: This article is for information purposes only. It is general in nature and does not take into consideration any reader's personal circumstances and/or investment objectives or needs. Therefore, it has limitations and you should be aware of this. You should always seek competent, experienced professional advice before acting on anything you are unsure about. Few forecasts or strategies are ever one hundred percent correct. Most every consideration, action or strategy involves a particular or unique type of risk. Seldom is anything really a sure thing. No specific individual advice is implied or offered to any reader. This article and others on this web site deal with possibilities and unfortunately, not certainties.