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Deflation - Thought Exercise


Uccmal
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I am trying to figure out the best way to invest in a deflation.  I am not interested in commentary about the possibilities.  Its just a thought exercise. 

 

Also:  It has to be something a retail investor can buy.  I cant buy swaps like Fairfax does.  Obviously FFH is one answer. 

 

Stocks that have consistently paid and raise their dividends is another. 

 

Thoughts?

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I am trying to figure out the best way to invest in a deflation.  I am not interested in commentary about the possibilities.  Its just a thought exercise. 

 

Also:  It has to be something a retail investor can buy.  I cant buy swaps like Fairfax does.  Obviously FFH is one answer. 

 

Stocks that have consistently paid and raise their dividends is another. 

 

Thoughts?

 

I've been thinking about this for a while: You want stable cash flows – a stable rate of return and ideally the possibility to reinvest those cash flows at this high rate of return. Key is that the cash flows have to be sustainable in a low growth environment (and even then you have to be concerned with "reinvestment risk"): Health stocks, utilities, certain kinds of real estate, zero-coupon bonds etc.

 

People keep focusing on dividends – but this is plain wrong. Dividends only matter if and when they can be sustained. It amazes me to no end that XOM is so stable compared to the oil price because people only think in dividend yields. How will XOM earn this dividend in a low growth environment? In a deflationary environment, oil majors will become real value traps.

 

ps: Gary Shilling has a whole chapter on this in his book "The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation"

 

 

 

 

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Guest Schwab711

Do you mean real or nominal deflation?  I definitely see real deflation, nominal not much so with QE and all.

 

Packer

 

This is extremely important. Even with this though, not all deflationary environments are the same (whether we pick to discuss real or nominal deflationary environment). A description of the type of environment would be helpful (demand/supply driven, ect).

 

Without more info, generally speaking I've read that equity in the US generally returns 12% no matter what interest rate environment we're in (possibly a cause for the long bull-market we're in?). 1980's 14% govn't interest rates, equity still returned 12%. ZIRP, equity still returned 12%.

 

I would think insurance would be a nice place to be since premiums likely lag inflation (deflation) but costs are decreasing. This is  happening for some types of insurance currently. Life insurance companies have enjoyed the fact that life expectancy has been increasing at a faster rate than predicted, so each time a policy is sold they are benefiting from a type of deflation.

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Do you mean real or nominal deflation?  I definitely see real deflation, nominal not much so with QE and all.

 

Packer

 

I don't think there is such a thing as real deflation because deflation relates to prices and so the context is always nominal. Maybe your question could be rephrased as: "Do you mean negative real economic growth? I definitely see negative real economic growth, but deflation not so much with QE and all."

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Maybe the following if you are into LEAPs (and don't want to risk your principle on deflationary bets when the opposite might occur):

 

- Call LEAPs on iShares 20+ Year Treasury Bond (TLT)

 

- Speculate short term on the US dollar increasing further (given Fed is saying it will raise in the face of global deflation while Europe, Japan, etc are loosening - this could drive up the US dollar further) by buying Call LEAPs on PowerShares DB US Dollar Bullish ETF (UUP)

 

 

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Do you mean real or nominal deflation?  I definitely see real deflation, nominal not much so with QE and all.

 

Packer

 

I don't think there is such a thing as real deflation because deflation relates to prices and so the context is always nominal. Maybe your question could be rephrased as: "Do you mean negative real economic growth? I definitely see negative real economic growth, but deflation not so much with QE and all."

 

To further clarify, you can have price A) inflation or B) deflation, and economically, you can have 1) positive real growth or 2) low/negative real growth. The combinations are:

 

A1: stocks do well;

A2: (stagflation) gold does well;

B1: probably a mix of stocks and bonds do well;

B2: government bonds should do well (unless the markets decide the government just has too much debt and will never repay).

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By real deflation I mean the unit prices for a product or service declining (goods/service deflation) in number of hours worked to obtain it.  This includes both declines in prices (nominal deflation) and increases in productivity.  If we were on a gold standard or there was fixed or slowly growing amount of currency, we would be in deflation however the increase in money supply (financial repression) has to this point prevented price deflation but resulted in real deflation (output/money supply).

 

My strategy would be different for real vs. nominal deflation.  For nominal deflation, long T-bonds are the best strategy.  For real deflation, something like LBOs may be the best as you can borrow at low rates to finance an asset that can take advantage of productivity gains but has a locked-in customer base.

 

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Also

 

1. purchase stocks at lower p/e ratios and thus rely less on growth in earnings and more on the initial earnings yield (this is similar to buying high dividend payers);

2. buy companies that have pricing power via brand and that make stuff that is very cheap for the customer relative the customer's overall budget (eg, Coke, or a manufacturer of small parts that are required for expensive machines but where that manufacturer monopolizes the market) - these companies should be able to better maintain their margins in the face of deflation;

3. make sure the company has low debt (ie has not mortgaged its future by incurring higher yielding long-term debt in the past); 

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By real deflation I mean the unit prices for a product or service declining (goods/service deflation) in number of hours worked to obtain it.  This includes both declines in prices (nominal deflation) and increases in productivity.  If we were on a gold standard or there was fixed or slowly growing amount of currency, we would be in deflation however the increase in money supply (financial repression) has to this point prevented price deflation but resulted in real deflation (output/money supply).

 

My strategy would be different for real vs. nominal deflation.  For nominal deflation, long T-bonds are the best strategy.  For real deflation, something like LBOs may be the best as you can borrow at low rates to finance an asset that can take advantage of productivity gains but has a locked-in customer base.

 

Packer

 

Packer

 

OK, that's interesting. Not sure if you are following Valeant, but that company is effectively a LBO company borrowing at low rates, locking-in a customer base, and increasing productivity of the acquiree. But I would think you would want to finance very long-term in this environment otherwise if there is a change to inflation/hyper-inflation, you are in trouble when you attempt to roll-over.

 

 

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Since Asset heavy businesses are supposed to be bad holdings in an inflationary environment, why can't they be considered good holdings in deflationary environment?

 

Because they tend to be businesses with high fixed costs and no pricing power and will see their profits killed in a deflationary environment.

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I've read the "buy companies with low debt loads" advice in several places but I don't quite understand it. This seems to be too broad a statement and only applies to companies without pricing power. Yes, real debt isn't reduced by deflation (or might even rise) but at the same time capex requirements should go down in a deflationary environment. Credit should remain cheap (i.e. low nominal rates). So, as long as companies have really stable cash flows  (in nominal terms, i.e. they grow them in real terms) even large debt burdens shouldn't be a problem – they will be able to roll it over at even lower rates.

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Since Asset heavy businesses are supposed to be bad holdings in an inflationary environment, why can't they be considered good holdings in deflationary environment?

 

Because they tend to be businesses with high fixed costs and no pricing power and will see their profits killed in a deflationary environment.

 

Yes, businesses without pricing power are bad in most environments, but how abt something like Railroads or utilities or telecoms or even airlines if they can maintain their pricing discipline.

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I played around with Y-Charts and thereby noticed that I'd never looked at a long-term CPI chart on a logarithmic scale. Take a look. Seems to me very hard to make an argument against a deflationary tendency here. I've read Gary Shilling's book "Age of Deleveraging" for the last two weeks and I think he nailed it. Some people say that he's been "wrong" about deflation for 30 years now. I think he's been right for 30 years. He doesn't make an argument for immediate deflation but for the tendency.

 

This also fits nicely into Ray Dalio's theory of long-term super-cycles (see p. 6-9 – the US is in stage 5, I guess).

 

It's quite interesting to think about Buffett's investing career from a compounding perspective – he surfed the curve perfectly.

 

EDIT: What this also shows is that the usual FED critique is kind of unfair. Yes, the FED might have created asset bubbles. Yet, what they've done first and foremost is to stem the US economy against this long-term tide and thereby trying to dampen its impact. Imagine what could have happened if the deleveraging had accelerated with similar speeds like the expansionary phase in the 70s and 80s.

 

It also shows very nicely the lessing impact of the FED's monetary measures. The curve really has begun flattening out in spite of ZIRP and QE.

long-term-cpi.png.80c0bb31825fc46678e3f2b093fb0f10.png

CPI-GDP-long-term.png.25e91de9621678a4e07e02208e36cd12.png

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