It may be somewhat controversial to state the biggest risk to the economy is DEflation, not INflation, however, this is where the evidence leads. To say this is a contrary opinion is an understatement.
First, we need to properly define inflation/deflation. Many people see the prices of food at the supermarket or coffee at Starbucks increase and conclude there is inflation. Conversely, some people (okay, very few) point out natural gas is still off significantly from its highs and say this is deflation. Neither is correct, however, since so many people use price changes as the definition; let’s agree to refer to this as “price inflation.”
It should be noted, price changes are usually a result of inflation/deflation, but not the definition. Price changes can be caused by many other factors. Inflation is the increase in supply of money and credit; deflation is the decrease in the supply of money and credit relative to the amount of goods and services. Let’s refer to this as “monetary inflation.”
Despite TARP, QE1, QE2, QE3 and Operation Twist, the Federal Reserve can’t even get price inflation up to its 2% target rate. Economists would agree massive money printing, all things equal, should lead to inflation, but it hasn’t.
Why? Because these money supply increasing measures are being offset by monetary deflation pressures; more money went to “money heaven” due to the decline in real estate prices than all the money printing put together. The rule of thumb used to be money takes 18 months to work its way through the economy. It has been six years since TARP.
It’s like the old Wendy’s commercial, “Where’s the beef?” With all this printing, “Where’s the price inflation?”
Precious metals, a traditional price inflation hedge, are way off their highs of over two years ago, and going lower. Energy prices, which also typically rise when there is price inflation, are falling — not just oil and natural gas, but also coal and uranium are significantly lower. Let’s look at real estate.
The Standard & Poor’s Case–Shiller Home Price Indices are repeat-sales house price indices for the United States. There are multiple Case–Shiller home price indices and as the old saw goes, all real estate is local. For our purposes, we will use the S&P/Case-Schiller U.S. National Home Price Index, which shows a five year annual price inflation of 3.14%, which is when the proponents of price inflation should have seen significant price increases with all the money printing going on. 3.14% could hardly be considered a high inflation rate, especially since the five year period starts after one of the greatest real estate price drops in history. More importantly, the last quarter shows a price inflation rate of only 0.17%. The bear market rally in real estate is over and prices will soon be declining again.
Where’s the price inflation?
The Thomson Reuters/Jefferies CRB Index, or TR/J CRB, is comprised of 19 commodities: Aluminum, Cocoa, Coffee, Copper, Corn, Cotton, Crude Oil, Gold, Heating Oil, Lean Hogs, Live Cattle, Natural Gas, Nickel, Orange Juice, Silver, Soybeans, Sugar, Unleaded Gas and Wheat.
This is a highly diverse group of commodities where the prices are set by market forces, not individual companies. The market determining the price of cocoa is radically different than Hershey determining the price of a chocolate bar; they may be related, but then again, they may not be related. The diversity also evens out price changes in an individual commodity due to non-monetary forces, for example, the outbreak of war in the Mid-East may affect crude oil prices, but since crude is only one of 19 commodities, the index doesn’t change radically and is therefore a good indicator of the direction of raw materials. The TR/J CRB Index peaked in 2008 and is down roughly 40%, and continues to fall.
Where’s the price inflation?
Many respond, “But, I am paying more at the supermarket; food prices are going up…” This brings up two points worth mentioning — alternative reasons for price changes and government statistics.
In recent years, many agricultural crops have hit decades’ long high prices. Is this due to monetary inflation, or are rising prices due to the severe drought the U.S. has been experiencing? While California is still in the middle of an extremely severe drought, the grain growing regions of the U.S. are mostly over the drought. And with the grain drought over, prices are tumbling, e.g., corn fell from $5.25 per bushel in the beginning of May to $3.50 at the end of July.
The official price inflation for food prices in 2013 was 1.4%, again, definitely not a high rate, especially with crop prices falling so much in 2014, but before we go too far with government statistics, let’s discuss their composition.
The definition or inputs used in calculating government statistics have changed over time. For example, in the U.S., the official unemployment rate has been in the low 6% range for a while, yet the unemployment rates kept by John Williams at Shadow Government Statistics are radically different. He keeps the numbers the same way as they were kept in Jimmy Carter’s presidency. Using the old method, unemployment remains stuck near all-time highs over 23%. Quite a difference!
Employment is certainly a government statistic which has been radically manipulated, but is price inflation also radically manipulated? The evidence says no.
The Billion Prices Project at MIT is an academic initiative that uses prices collected from hundreds of online retailers around the world on a daily basis to conduct economic research. Price Stats is the commercialization of this data. Here is chart which plots price inflation in the U.S. comparing their data to the official government data: http://www.pricestats.com/us-series
Two points of interest from this chart. First, the prices are pretty darn close to the official U.S. Consumer Price Index, with no clear trend of always being higher or lower. Second, Price Stats’ data anticipates changes in price trends not only because they observe prices sooner, but also because it uses online prices which tend to react to price changes more quickly. Price Stats data is currently showing almost zero price inflation.
We have had essentially constant inflation since World War II with only several months of deflation so it seems it just can’t happen, however, we have had significant deflation before in the U.S. In the Great Depression, the U.S. had a five year period where price deflation was more than 25%. In the five year period from 1929 through 1933, prices fell by more than 25%!
This price deflation is not limited to the U.S.; Europe is leading the way today. Annual inflation for countries in the European monetary union was just 0.4% in July with 1/3 of the countries reporting price deflation. The ECB is aiming for 2% (as is the U.S. Fed) and neither can hit their low target. Central banks are not as potent as many consider them to be.
Yields on two-year German debt went negative August 7 and the yield on 10-year German government debt fell below 1% last week for the first time ever. Interest rates are typically the monetary inflation rate plus the real rate of interest, say, 3%. A 1% nominal interest rate implies a negative 2% monetary inflation rate.
The extremely low interest rates have completely distorted the markets. According to Bill Bonner, a publisher of newsletters, Amazon has raised and spent $347 billion, over a third of a trillion dollars, to generate sales of only $340 billion. Since Amazon was formed in 1994, its total post-tax income totals $2.3 billion, a return on capital of 0.6% per year.
The current stock market peak also includes story stocks such as CYNK, a company with one employee, no product, no earning and yet valued at more than $6 billion, rising over 36,000% in a single month!
This is one of many companies people on Wall Street refer to as “never never” stocks because they will never return cash to investors. You can’t create real wealth with a printing press. If you could, poverty would not exist.
And yet, the only sizeable asset class which is experiencing price inflation is the stock market. As the stock market is hitting new highs, over 1/3 of Americans are in collections for some unpaid bill. How long before Aunt Millie’s china or Uncle Fred’s classic car gets sold? How much longer does the average American hold on to their junk silver coins and gold Eagles before having to sell them just to put food on the table?
Consumers have borrowed too much. Corporations have borrowed too much. Western governments (and definitely Japan) have borrowed too much. And our “leaders” have determined that the solution to too much debt is to … borrow more money, which is simply ridiculous.
Every group is over indebted, so they sell assets to pay off their debts. When assets are sold, everything else being equal, it drives prices down. This distress selling leads others to sell, so that they, too, can pay off their debts (or margin calls). The cycle feeds on itself in what is known as the debt deflation theory.
The theory was developed by Irving Fisher following the Wall Street Crash of 1929 and the ensuing Great Depression. After distress selling, bank loans get paid off (check, as consumer debt outstanding is falling) and there is a reduction in the velocity of money. Another check; the velocity of money has decreased from nearly 2 to almost 1.5 in the past decade.
Next up in debt deflation theory is a more severe price deflation and a contraction in the amount of business being conducted. First quarter GDP in the U.S. was a negative 2.9%. Germany’s GDP shrank by 0.2% in the second quarter. Germany accounts for more than 25% of the European monetary union’s output. Another check. Price deflation is on deck and ready to come out swinging.
Wal-Mart, the largest retailer in the world, recently reported its fifth straight quarterly sales decline, though one bright spot for Wal-Mart was an increase in its Internet sales of 24%. The Internet, with its ease of price comparison shopping, is a deflation enabler.
When people spend less, corporate earnings decline. When corporate earnings decline, companies don’t hire new employees and, eventually, lay people off. The more people who are unemployed, the less money there is to spend, and the cycle continues until the debt bubble is extinguished.
The credit cycle is the cause of the economic cycle. Debt bubbles result in deflation. Bubbles don’t correct, they burst.
To fully describe how bad the economy will become would likely have readers classify the writer as certifiably insane, or worse. Let’s just point out in the 1930’s, the Great Depression, the unemployment rate was 25%, thousands of banks closed and millions were fed standing in line for handouts. The U.S. also had trade and budget surpluses back then; today we have trade and budget deficits. We are entering the Greater Depression; it will be worse!
To give you some idea of how low the stock market can get, let’s look at dividend yield. The Dow’s dividend yield in the Great Depression exceeded 17%; the recent low dividend yield was barely above 2%, which is lower than at the stock market peak in 1929. Even the low in stock prices in March 2009 (and high in yield) was only 4.68%. We have a long, long way to go to the downside.
Without having to write a book, let’s proceed on the basis there will be deflation, what do you invest in?
For the most conservative among us, the answer is simply, CASH! As borrowers default and unpaid debt goes to “money heaven,” the value of cash will increase. Simultaneously, the value of assets will decrease as borrowers sell (or are forced to sell) anything and everything to pay their debts. In deflation, believe it or not, the thing that goes up in value is cash. Your cash is actually worth more.
CASH IS KING in deflationary times!
Most people can understand the concept that in inflationary times, you want to buy assets (preferably, non-depreciating assets) with debt to profit from rising prices. The value of the assets – real estate, collectibles, precious metals, etc. – goes up in inflationary times and the real value of the debt is decreased. The nominal value, say $1 million is still $1 million, however, a typical mortgage paid over 30 years may only cost $1/2 million in real dollars due to a depreciating dollar. The winning formula in inflationary times is to borrow money and buy assets.
And yet, for deflationary times, most people have a hard time believing the opposite is the winning formula – sell assets NOW before they decline in price and get out of debt (and into cash). If we use the correct definition of monetary deflation – fewer dollars, and assume goods and services are static, it means the value of a dollar will increase. Fewer dollars to purchase the same quantity of goods and services also means the price of nearly everything will come down. Deflation makes debts more expensive because the real value of the debt goes higher, making it harder to pay debt.
Somehow this still doesn’t resonant with the general public because we used dollars in the example, so let’s exchange gold for dollars. If we somehow had fewer ounces of gold, and assumed goods and services stayed static, it means the value of the remaining ounces of gold will increase.
In price INflation periods, people typically spend their money as quickly as possible in order to buy goods and services before they increase in price. In price DEflation periods, again, just the opposite, people will wait longer and longer before making a purchase as they expect the price to decrease (which is why money velocity has been decreasing).
This is truly a once in a lifetime event and if you want to speculate, there is enormous wealth to be made, however, it will come by shorting. Shorting is just the opposite of buying. Instead of buying a stock, hoping it goes up, and then selling, one would sell the stock first, hope it goes down, and then buy the stock. The profit (or loss) is still the difference between what you bought the stock for and what you sold it for, regardless of which action you take first.
The biggest losers will be companies which are heavily in debt, companies which rely on debt (or low cost debt) to survive, and companies who lent the money to indebted companies as the level of defaults will rise significantly.
Recommendations (prices are as of the close August 15, 2014, this was posted on Sunday August 17):
Short SPDR Barclays Capital High Yield Bond ETF (JNK). The vernacular term for high yield bonds is “junk bonds.” The name, and stock symbol, says it all. Current price is $41.18 and the three year price projection is below $5.
Short iShares U.S. Real Estate EFT (IYR). Real estate could be the poster child for industries with too much debt. There are some real estate niches which might do better than others, e.g., health care facilities or apartments, but betting on a decline in this large real estate ETF is about a sure thing as can be. Current price is $73.28, three year target is less than $10.
Short KWB Bank Index (BKX). Bank stocks topped out in March, five months prior to the major indices. KWB Bank Index is currently at $69.01 and it should easily go below $15 in the next three years.
Short Financial Select Sector SPDR Fund (XLF). Current price is $22.58 and should easily go below $5 within the next three years.
Short iShares Russell 2000 Index Fund (IWM). This index represents the smallest 2000 companies of the Russell 3000 stocks. Smaller companies typically don’t have the financial flexibility of larger companies. A contraction in lending will hurt these companies. Small stock indices have lagged the large cap indices, which is a harbinger of the future. Current price is $113.39 and three year target is below $20.
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