Best Investments During Deflation

Today we're laying a loose framework for the best investments during deflation. Why? Because deflationary signals have reared their ugly head as of late. Not to mention, many prominent investment managers have voiced their concern about the dreaded scenario. While inflation versus deflation has been the great debate over the past two years, the deflationistas have been boasting quite loudly as of late.

We've detailed how David Gerstenhaber's global macro hedge fund Argonaut Capital thinks deflation is the greater risk. Additionally, Broyhill's Affinity hedge fund has been betting on deflation as of late. PIMCO's bond king Bill Gross has been buying treasuries in order to combat these fears. And for more, The Reformed Broker has a quick summary of the New York Times' deflation round-up as well.

While investing during the dreaded 'D' word is not impossible, the options to preserve and grow capital are certainly limited. So, what is the best investment for deflation? Very broadly and in no particular order, here's some potential answers:


Cash/US Dollar: The phrase "cash is king" is often cliche. It's not cliche during deflation, it's rule number one. Assuredly, cash is one of the few 'safe' investments you can make in this scenario. Over the normal course of investing, most investors focus on their return on capital. This time around, the focus is simply on return *of* capital. While many wouldn't consider this an investment, having physical cash notes saved and on hand can be crucial during extreme situations including: bank failures, a collapse in credit, or the government defaulting on its debt. Not to mention, the US dollar has been a strong performer during deflationary times. Holding the physical currency is easy enough, but those wishing to further their wager can play the PowerShares US Dollar Bullish Index (UUP).


Pay Off Debt: Again while 'paying down debt' doesn't sound like an investment, it most definitely is during deflation. In a period where literally every single dollar matters, each dollar of debt can become crippling.


Buy Long-Term Bonds: Alternative to cash, fixed income is also seen as an option for those who seek protection. While fixed income yields decline due to Federal Reserve easing in an effort to combat deflation, the underlying bond should appreciate (or at the very least, depreciate much less than equities). US Treasuries are highly coveted here as they are the safest and most in-demand. If one were to go the corporate bond route, seeking high quality bonds is preferred. The thesis behind this play is laid out by Broyhill's Affinity hedge fund in their presentations: ten reasons to buy bonds as well as their bet on long-term treasuries. The most logical wager here would be the iShares Barclays 20+ year Treasury (TLT).


Short Equities: Traditional investments will start to suffer as underlying companies will see lower margins and losses. Not to mention, highly leveraged companies make ideal short selling targets and certain companies can face the risk of becoming insolvent. If your conviction is strong enough, you could simply short the S&P 500 index (SPY). There is, however, one potential safe haven in equities (keyword being 'potential'), which brings us to the next investment:


Buy High Quality Dividend Paying Stocks: Understand that during deflation, equities in general are one of the major investments to avoid. However, high quality stocks could be a potentially dim light in an otherwise dark scenario. While the majority of companies will lose pricing power and succumb to weak margins, large cap high quality companies that dominate their industries may be able to maintain pricing power. Not to mention, many of these stocks pay dividends which generate valuable cash during deflation. Seek companies with pristine balance sheets.

GMO's Jeremy Grantham recently voiced concern about deflation and one of his few investment recommendations was to buy high quality stocks. For ideas, hedge fund T2 Partners recently issued a presentation on 3 large cap stocks. Sectors to look toward include healthcare, technology, and telecom as those have outperformed in Japan during their deflationary lost decade. Microsoft (MSFT) is one name that has been repeatedly mentioned by strategists and managers. Keep in mind though that despite being high quality blue-chip companies, these are still equities. As such, there is obviously inherent risk in owning them during deflation.


Short Housing/Avoid Real Estate: In deflation, prices fall. As such, rent rather than own. Stand back and let the landlords watch the values of their properties plummet. You can short the iShares Dow Jones US Real Estate (IYR) for some exposure.


Short Leverage: Deleveraging should be a big theme playing out in the future, environment notwithstanding. As mentioned earlier, short the equity of companies that have poor balance sheets and are highly levered. In deflation, leverage begins to unwind and 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.


Long Technology: Regardless of environment, technology will advance and will be in demand. The technology sector was highlighted as one of the few areas to possible allocate capital in high quality equities. Companies that have strangleholds on their industry should have an advantage. A basket of technology stocks could be purchased via the technology exchange traded fund (XLK). However, that gives you exposure to a lot of companies and it's probably more preferable to single out high quality technology names with pristine balance sheets such as Microsoft (MSFT), Intel (INTC), and Cisco Systems (CSCO).


Gold: Conventional wisdom says to avoid precious metals during deflation. During the Great Depression from 1929-1932, commodities in general crashed. However, in very extreme circumstances (emphasis on extreme), some have argued that gold can make sense when acting as currency. The majority of proponents for owning gold during deflation would cite its store of value or hedge against uncertainty. While gold can be played via the SPDR Gold Fund (GLD), many hedge funds advocate physical gold. That said, those doing so are mainly seeking inflationary protection.


Buy TIPS: Treasury Inflation Protected Securities, or TIPS, serve as long-term protection from inflation. Buying TIPS during deflation? What's the point? This is an option if investors believe that deflation will eventually lead to inflation two or three years later. As policy makers attempt to combat deflation, the natural antidote is inflationary medicine. As such, investors looking further down the road can fend off these inflationary pressures with TIPS. And even if deflation persists for an extended period of time, TIPS still produce income via yield and investors can regain their bond's face value at maturity. This can be played via iShares Barclays TIPS Bond Fund (TIP) for those looking for an easy solution.


That sums up some of the best ways to position a portfolio when confronted with deflation. Recent 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. This excess capacity then brings forth lower prices. In deflation, companies suffer while the consumer is the real winner. The above present theoretical options of how to invest during such a scenario. Make no mistake though, investing during deflation can be quite difficult and painful.

Back in August 2008 when the crisis was heating up, we penned a very broad outline of investment scenarios for inflation versus deflation. During the pinnacle of the crisis, it wasn't quite clear which situation would play out so it made sense to lay a framework for each context. (And arguably, it's still not entirely clear. Many have hypothesized that we'll see a compromise of views: deflation in the near-term and inflation in the long-term). A few months ago, inflation was all the rage. Now, deflation is the primary concern. Investors have been flip-flopping more frequently than politicians as of late.

Regardless of outcome, it makes sense to be prepared for either environment. Check back tomorrow as we'll turn the tables and outline the best investments during inflation in order to present both sides of the argument. In the mean time, be sure to see what hedge funds are investing in these days with our daily coverage.

Dynamics of Gold, US Dollar & Gold Equities

Since many hedge funds have exposure to gold in some fashion, we're posting up some interesting research from Raymond James on the topic of precious metals. Their commentary was published amidst the massive rally in the US dollar that definitely impacted the performance of gold. Given the action early in the year, they took advantage of the opportunity to look at the dynamic between gold, the US dollar, and gold related companies.

Maybe the most intriguing bit of research was their focus on equity stakes of gold miners and how they performed during the various swings in the price of gold. We note this correlation because while John Paulson's new gold fund will invest in derivatives on the price of gold, the main strategy is to acquire equity stakes in gold miners. Paulson is actually using these equity stakes as a wager against the US dollar. So, while many will examine the dynamic between the US dollar and gold, it is also worth taking a look at how shares of gold miners are affected as well.

If Paulson thinks the US dollar will decline, then he is essentially wagering that the price of gold will increase. More importantly though, it appears as if he thinks equity stakes in gold miners will produce greater returns based on the correlation. But, as you will see from the research below, you also have to look at company specific risk. This comes after Paulson & George Soros recently bought shares of a gold miner.

At any rate, you can examine Raymond James' research below. Of the companies they cover in the space, Aura, Osisko, Great Basin Gold, and San Gold performed the best "on average, across all three post 'risk aversion' rallies." The companies that suffered most over the big gold sell-off were Lake Shore, Golden Star, Aurizon and Yamana. Based on their research, Raymond James favors developers Anatolia and Detour, mid-tier producers San Gold and Crocodile, and large producers Agnico-Eagle and Eldorado.

Embedded below is Raymond James research on the dynamic between gold, the US dollar & gold related companies:



You can directly download a .pdf here.

Raymond James' gold research joins a bevy of other publications that we've posted on the topic of everyone's favorite precious metal. Resources include: global macro hedge fund Woodbine Capital's research on gold, Passport Capital's rationale for owning physical gold, as well as our in-depth look at John Paulson's new gold fund.

Taking A Look At Gold, the US Dollar, & Crude Oil

The guys over at MarketClub just put out three interesting videos covering three hot topics: gold, the US dollar, and crude oil. Let's first start with their coverage of crude oil since it's trading near a crucial level.

Crude Oil

Firstly, Adam checks out the crude oil market and right off the bat he highlights that while crude has been in an overall uptrend since March of this year, the recent decline could be worrisome. He specifically notes the $67 level as crucial seeing how that was the most recent level of major support back in late September. While crude initially traded higher from thos levels, it has since spiraled down and is getting close to testing support. If it takes out $67 to the downside, Adam notes that you should exit the market as support will have broken. You should also note that Adam previously identified a pattern in crude oil where it is sold off every 75 days or so and then was bought right back up again. We're in the midst of one of those downtrend areas right now and buying needs to come in for this pattern to remain in tact. If crude heads lower, it will have breached a support level and nullified this patterned uptrend as well, a definite sign to exit the commodity. Click the chart below to watch the crude oil analysis.




Gold

Secondly, you can see their technical analysis on gold here. Adam feels that it's best for you to just stay out of the precious metal for now if you're not already in it because of what he calls "silly season." He's referring to the period from December 15th until the new year where many traders and money managers simply take off for the holidays. As such, volume in markets decreases and it only takes a little bit of money to really whipsaw things around. Not to mention, they are seeing conflicting indicators on their screen as the weekly trend is going down but their daily indicators are pointing up. These divergences combined with the lack of market participants over the holidays means it's best to sit on your hands they say.

US dollar

Lastly, you can see their analysis of the US dollar here. The dollar has been in a definitive downtrend over the past few months and their monthly indicators have been bearish since May of this year. Their weekly signals on the other hand, have turned up as the dollar has been rallying as of late. While some may interpret this as bullish, they note that trading against the primary trend (which is still down) is not advisable. We'd tend to disagree with him on this point as illustrated in the chart below you can see that the dollar has clearly broken out of its downtrend (green line) from the past few months. Not to mention, it is now trading above its 50 day moving average (blue line) and both the RSI and MACD are heading higher.



To his credit, Adam highlights the potential divergence in the MACD as its been slowly building higher since June. This means that the dollar is definitely something to keep an eye on in his view, but until the primary trend reverses, he thinks it's best to sit on the sidelines. We're obviously starting to see a common theme here in staying on the sidelines. It's typically not worth the risk of playing around in the anemic holiday markets. Conflicting signals and lack of true trading participants going into the holidays means you should probably avoid getting whipsawed around. Overall, Adam took at a look at some hotly traded assets but conceded that maybe it's best to just not trade them at all until the new year and we can't argue there.