Investment Scenarios: Inflation vs Deflation ~ market folly

Monday, August 11, 2008

Investment Scenarios: Inflation vs Deflation

I've said all along that you need to be thinking ahead and preparing your portfolio for various potential economic and market scenarios. And, I've roughly broken down these scenarios into two environments: inflationary & deflationary. So, after much reading, pondering, and hypothesizing, I've come up with my broad gameplan for each scenario.

Inflationary Environment
In an inflationary scenario, the following positions should be poised to benefit:

- Long Gold: As a speculator's instrument, many argue that gold is an inflation hedge. Long also other precious metals and commodities in general.

- Long Oil: In a truly inflationary environment, oil is supply inelastic; any increase or decrease in price would not result in a corresponding increase or decrease in supply.

- Short Leverage: A common theme regardless of environment, really. Leveraged companies, companies who provide leverage, companies with leveraged consumers.... short them all. A deleveraging environment is ahead of us.

- Long Technology: Regardless of environment, technology will evolve and there will be demand for such advancements.

- Short Fixed Income: Weak domestic currency/monetary system means it will underperform and thus should be shorted.

- Long Emerging Markets: A weak domestic currency/monetary system implies higher returns can be found abroad in countries experiencing vast growth.

- Avoid staying in cash: Inflation means your currency is worth less every day. Fight it by not staying in it if at all possible.

Deflationary Environment
Many people are becoming increasingly concerned that deflation is in our future. And, this concern is duly warranted considering that deflation typically rears its ugly head after periods of prolonged globalization and global growth. Such growth leads to increased investment, a massive increase in production, and thus excess capacity all around the world. Such excess capacity then brings forth lower prices. In deflation, companies suffer while the consumer is the real winner. In a deflationary scenario, the following positions should be poised to benefit:

- Short Equities: In deflation, traditional investments should suffer simply because the underlying companies will see lower margins and losses. And, more often than not, certain companies will become insolvent.

- Short Housing: Rent rather than own. As prices collapse, stand back and let the landlords watch the values of their properties plummet.

- Long Fixed Income: Mainly sought after as a safe haven (much like gold in an inflationary environment). While by no means a 'top pick' for investing during deflation, it is an option for those who do not have access to short selling (the preferred position). Although fixed income yields should decline due to fed easing (to combat deflation), the underlying should theoretically depreciate much less than equities (which you do not want to be long). Seek better quality bonds.

- Short Leverage: Regardless of environment, deleveraging should be a big theme playing out in the future. Short any companies that have anything to do with leverage. In deflation, leverage begins to unwind and as such currency plays can be found. A massive leveraged carry trade in the Yen has taken place over the years and as such would be unwound in deflation, thus benefiting the Yen.

- Short Emerging Markets: The global boom that once fueled these nations quickly turns sour for them. Global excess means prices come down and companies suffer.

- Long Technology: Regardless of environment, technology will advance and will be in demand.

- Avoid debt and raise cash

- Long Gold: In extreme conditions (in any direction), gold can make sense. In deflation, it can make sense when acting as currency.


Whether in an inflationary or deflationary environment, portfolios can be poised to outperform. While the theme of deleveraging seems all but inevitable, the exact scenario(s) that will unfold are hard to predict. But, the possible outcomes stand roughly divided by the two scenarios outlined above. And, both environments offer unique investment opportunities poised to outperform. (See here for an additional set of stipulations regarding each type of environment).


The Stock Speculator said...

I saw you post at stock trading to go and figure I would have a look.

I think the only problem with your thesis is that nothing is working right now. That makes it tough, for me, to know what the best strategy is or if your arguments hold.

Is it possible that the market is sniffing out deflation? I have my suspicions. If this recession is as bad as I believe it is, inflation won't be our problem.

Hedging now is just impossible to figure out:

Look at gold. By any measure it should be $2,500 an oz.

Look at oil - if inflation is here oil certainly wouldn't have hedged you. Today's close $88.30

You could also move out of the US Dollar, but where do you go? Every thing else is a fiat currency as well. Euro? Yen? All garbage.

I think we are in a transitional period and until we see certain sectors moving again, it will be very hard to make an argument one way or the other.

Some smaller points:

BRIC looks done for now.

Cash may not be king, but nothing else is working either.

It's a smart post. Nice work.

market folly said...

yea you bring up a good point, i think the market we are in now is unlike one we have ever seen due to so many external factors colliding at once.

gold, for instance, theoretically should be going up. it went up for a while based on the "fear" trade, but then receded, why? well its because of deleveraging and the redemption/liquidations faced by hedge funds. many funds used gold as a hedge and are unwinding their losing positions. with those positions, they are also unwinding their hedges, thus freeing up lots of gold or whatever they might have used to hedge with.

i think a lot of it is just forced selling and it is contributing to the market selloff more than people think. i discussed that in more recent posts about deleveraging and hedge fund redemptions, etc.

volatility throws a kink in any laid out plan though, that's for sure.