Hedging DeflationTRADING NOTES: A subscriber writes: "You've mentioned deflation a number of times in your newsletter, but at no point have you told us how the average investor should prepare for this period. For example, what asset classes one should concentrate on to prevent major damage to a portfolio. Gold? Sincerely, Nigel."
Nigel, I've written on this topic in the newsletter and in the column I once freelanced to the Sunday San Francisco Examiner column, but perhaps it's time to revisit it for those who have subscribed only recently. First, let me say there is no easy way to profit from a deflation; it will be challenging enough simply to preserve one's capital on the way down. I've often said that the geniuses will come through it with 50% of what they presently hold as assets. The biggest losers will be stocks and residential real estate, but making money on falling stocks is relatively risky, and making money on collapsing home prices next to impossible. I brainstormed the latter scenario with Howard Hill, an expert's expert on mortgage markets, but we failed to come up with a promising game plan. If Howard cannot think of a plausible way to "short" the housing market, there is probably no way to do so.
I expect a decade of deflation, and this one is likely to be far trickier for investors to navigate than deflations of the past, since it will be the first to run its course with the backdrop of a bogus global money system. The dollar and most European currencies were sound when the U.S. entered the 1930s deflation, and this helped to stabilize the economy, albeit it at a moribund pace. This time, however, with hollowed-out money all but universal, and a relative dearth of hard collateral to settle debts, there is no predicting how deflation will play out. But it is an unchallengeable fact that the dollar, the euro, the yen and pound sterling have been rendered intrinsically worthless by a vast infusion of credit money from the world's central banks. Which is to say, money is no longer "money," but rather a form of debt - an IOU from the respective governments that printed it.
$100 Equals $1
If the logic of this statement seems obscure, try pondering this: The $100 bill in your wallet is intrinsically worth no more than the $1 bill next to it. The conceptual basis for this assertion may be difficult to grasp right now, but you must trust that it is fundamentally true. The logic will be easier to
understand, I am sure, when all forms of debt begin to implode. In such circumstances, it will become apparent that even the U.S. government is insolvent and unable to pay its debts. Facing default, there will be just two possible avenues of escape: hyperinflation, or deflation. Hyperinflation would have the effect of reducing the real burden of debt, but it would also destroy savers as a class. Imagine being able to pay off your mortgage with the $10,000 bills you'd be carrying in your wallet at that time to buy groceries. That might sound appealing, but consider the other side of the equation: Every mortgage lender in the country would be in bankruptcy, bond markets and all other forms of lending would have ceased to function, and the stock of Fannie Mae, whose bankruptcy would dwarf the total of all others up to that point, would be trading in reorganization at two cents per share.
The other escape route would be deflation -- essentially, allowing bankruptcies to take their course, with no help to debtors from cheapened dollars. This would crush debtors, lay waste to tens of thousands of businesses and wipe vast assets from the balance sheets of lenders. But it would have the virtue of leaving our financial institutions -- including the bond markets -- more or less intact.
In Gold We Trust
So how to secure one's nest egg against the gathering storm? A good rule of thumb is to make safety paramount, sticking with low-yielding but relatively safe Treasury paper that matures in 2-5 years. Some have suggested German bonds, in part to hedge the dollar's fall, but I believe euroland's statist, fiat economies will be in worse shape than ours once there is no U.S. consumer to lean on. As a corollary, I think that the dollar's impending collapse will be relative to gold rather than to other currencies. Because euros, yen and sterling are worthless, there will be no discriminating as to degrees of worthlessness. Real estate investments should not be ruled out, although the only winners will be companies with good tenants and rock-solid cash flow. Speaking of cash flow, the ideal investment in a deflation might be a casino. Not Bellagio, Mirage or some other bloated Shangri-La that needs to attract billionaire baccarat players to make money, but a grind joint with ten thousand slot machines and a huge parking lot for buses. In the end, though, there is just only one investment that qualifies as an absolute no-brainer. In a world whose currencies have been gutted and hollowed to the core, that investment is gold: coins, ingots, mining shares and all other forms of the asset that until recently had been shunned for more than two decades.
October 4, 2002
Rick Ackerman is a financial writer whose essays have appeared in Barron's, The Sunday San Francisco Examiner and numerous other publications. Ricks's detailed strategies and forecasts for stocks, options, and indexes appear daily at Market Wise Black Box.
Mr. Ackerman is also a Contributing Editor to MarketWise Guide.
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