Deflation vs. Inflation and Some Intermarket Relationships to Consider

[I was away last week with no internet access and basically completely out of touch with the markets. I had expected to be able to be in a different spot later in the week to post, but wasn't. I returned late Friday afternoon to see the market had pulled back early in the week only to make new highs Friday. So, hopefully anyone who traded the SPXU trade either put a breakeven stop in at my prior suggestion, or did so when the last week's low was broken as mentioned in the prior post. However, since I wasn't able to post and make it official, I will just call this a stop out at 52.15 for blog records. I will follow-up with more general market stuff this week, as it seems most likely to me (as per recent posts) that the completion of the current leg up off last week's lows will be the end of this market rally.]

For today I wanted to discuss a more leisurely, but also more important, topic especially for those who are at or near retirement, or who have a significant amount of wealth in the financial markets in one way or another. I will try to give a sensible macroeconomic view of what is occurring in the markets with regards to deflation, and try to give some ideas on how to protect your wealth during such an environment. I will try to keep the narrative to a minimum, but I know from experience that unless you have very actively sought out information about some of what I will be talking about regarding our monetary system, that you were almost certainly never taught this in any educational setting, and you will likely not have an actionable understanding of it, if relying on mainstream news type sources for your information.

First off I don't think most in our country have ever put a lot of thought into what "money" is. But dollar bills are obviously not valuable in and of themselves. Also, you cannot even legally exchange a dollar bill for any tangible good from the US Treasury (like gold) anymore. So what is a dollar worth? What IS a dollar? In short, all our dollars are notes of debt. They represent the debt of our Treasury, and is only backed by Treasury bonds purchased by the Fed (bonds also being debt). So a dollar is actually a credit. You are a creditor to the govt. and the dollar represents that. So dollars are probably not best viewed as "money" because they are not real, tangible goods.

Now many people also don't have much clue about how our monetary and banking system work. It is not taught in schools, etc, and I think that is intentional at some high level, because if we all understood it, we probably would see the insanity of it and such a system would never work. So as a brief lesson.......

Our government issues bonds (debt) that the Fed has to buy legally as our central bank. Then the Fed can print actual paper notes (dollar bills) backed by those bonds which represent that debt. If it stopped there, then that is not too hard to follow, but the system has evolved on a legal basis so that that paper money is only a fraction of what I will call the "money supply".

Money Supply = dollar bills + credit

The term for our banking system is called fractional reserve lending. A bank only has to keep a small fractional amount of cash (used to be 10%, I believe) as a reserve against the total amount of loans the bank makes. So if the bank has a million $ bills, then it can have about $10 million in loans or CREDIT all backed by that $1 million. This is great for banks for a while because instead of collecting interest on the loans of their assets which is only a million, they are collecting interest on $9 million extra. So the point is that what you or the next guy typically call "money" is paper dollar bills. But that is only the part of it. The rest of the "money supply" is credit in the form of loans. (Also, it is acutally worse than that, in that as laws have evolved and greed has overtaken sound lending, that there is actually net negative cash reserves compared to credit extended).

So how does that relate to inflation and deflation? Quite simply you can view inflation as any time that the total money supply is increasing, which results primarily from low interest rate borrowing, and abundant lending which increases the credit portion of money supply. Then you can view deflation as any time that the total money supply is decreasing. This happens not because dollar bills disappear. What disappears is the credit again. This occurs due to decreased lending and borrowing. Quite simply, "money" that comes out of the ether can return to the ether at some point in time. It is this "fiat" aspect of our "money" that most of us don't understand, are not educated on, and why the periodic deflations of history surprise and confound almost everyone in the masses.

So keeping it short, the economic environment that we are currently in is one of fundamental deflation. Consumers, the private sector/business, and government are all indebted to the max. Now many are beginning to default on loans. They borrowed but they can't pay it back. So what happens? Well, all the dollar bills are still here, but the credit of that loan now has to be dealt with. The end result is that a credit that cannot be paid back, must disappear. This is happening on a massive scale in the housing industry. Credit in the form of home loans is disappearing from our money supply as more and more people default and the reality sets in that whatever "value" was represented by that loan is no value at all.

Now, despite the ignorance, or more likely deceit, of those like Bernanke, et al, who testified that it was unlikley that the subprime housing defaults would filter down to the economy at large, the hard numbers seem to scream that it has and it is not done. The subprime defaults are only a portion of the total loans that are currently non-performing. A non-performing loan is one that is not being paid by the borrower. So there is obviously a greater problem and risk of credit default and total money supply contraction than just that subprime issue.

Without going further, I hope this small illustration helps get the picture of what is going on here. Despite popular wisdom that the Fed or govt. is "printing money" and that that will surely lead to inflation, understand that any of that printing or monetization that is occurring is a lesser force than the astronomical amount of credit that will simply disappear due to default when everyone has to show their cards. And that last phrase is important, because to date, the banking industry as a whole has not had to show their cards. If they did, then we would all see that some loans are not performing and that credit would be wiped out. Because of the amount of leverage these banks have, that would bankrupt MANY of them (from my understanding of the average numbers - if only about 5% of loans are completely defaulted in a bank's portfolio, then that will wipe out all the bank's actual assets since they may be loaning out 20 times the amount of their actual cash assets).

So this whole bailout notion seems to me, to have been a HUGE gamble, of trying to create credit via govt. selling bonds which the Fed buys, then basically distributes into the banking system at close to zero interest to the banks taking the money, in hopes that the new credit will be used to loan people money and in turn create even more new credit, etc, etc. Well unfortunately, we as a country are at the wall in terms of debt. The cat is already out of the bag, that many home loans will default. And greedy banks may be, but completely stupid they aren't. They are not going to loan to people now, when it is obvious to everyone that there is a big risk of those loans defaulting, not too mention that fewer and fewer people have jobs to pay back loans, and asset values have diminished as well.

So despite the unprecedented attempt at credit creation, it amounts to a redistribution of money from us taxpayers to banks who are too smart to loan it, but are desperate none the less to try to "earn their way" back above key reserve levels before they are forced by Congress to show their cards and say that "you can't keep pretending that those loans still exist and have the stated value". So, what do the banks do? Sell newly created shares to the public/etc. then speculate like mad in equities (up to this point = BUY BUY BUY) with this freebee money to try to profit as well as boost the value of their own shares as the market rises.

If you think the last paragraph was an oversimplification, you may be right, but probably only a little bit. I really think if you were to have full disclosure and "follow the money", then you would see that what is above is closer to truth than not.

For a brief summary then, what we currently are seeing from actual hard numbers on economic activity and data relevant to money supply, is that confidence is returning to the public and monetary system, but the actual underlying credit contraction has probably just started in the last few months. Now the point, is that the entire system could not work without confidence. But that is not sufficient. There is a mathematical and psychological reality that sets in at a certain point, where the credit has to contract and return to the ether. As a herd we only remain confident so long before we face the facts.

It is this very return to confidence in the face of reality, that is a fundamental tenant of wave theory regarding financial markets. In this case I think we have seen an initial phase of realization and panic regarding debt and credit. Now we are in the midst of (and I think near the end of) a reactionary phase of relief and hope that the worst has past. Large scale psychological trends of this nature tend to unfold in 3 or 5 phases in wave theory. It seems like we are done with a first and about done with a second (an A and a B, or a 1 and a 2) phase of this typical pattern. With history as a guide, the 3rd phase and beyond are when it hits the fan.

So that is what I believe is the factual and psychological reality. Maybe you don't believe that, but if you haven't spent some legitimate time trying to understand the situation, then it may be in your best interest to do so FAST.


Now on to how to actually protect wealth in a continuing deflationary environment.....

First off, with history as a guide stocks will get killed. And regarding that, earnings have fallen so far in relation to dividends, that dividends are more than earnings as a whole. So unless earnings improve dramatically and pretty quickly, expect to see dividends being cut by many companies in the not too distant future. So the coupled prospects of capital loss and cut dividends probably make stocks a horrible choice.

Contrary to what might be conventional wisdom, bonds got beat up badly in the 1930's deflation. Understand that bonds are debt and that a deflation is basically a massive debt default. Many low grade bonds go under completely. And fear of default pushes prices lower on many bonds that make it through. So, staying in or increasing bond exposure will almost certainly not be wise. There are different types of bonds (corporate, municipal, Treasury, etc) and not all will be the same, but across the board, the lessons of past deflations are that most bonds will decrease in value and some may default.

Many think gold might be a good way to go. From my understanding, gold tends to rise most correlated with economic growth (which also correlates strong with inflationary or credit expansion periods). So a deflationary period is the opposite of that, so I wouldn't expect gold to gain in value on a historical or a theoretical basis. Not to mention the historically ultrabullish sentiment on gold in 2008 as a long term contrary indicator. However, I personally would choose investing in gold over stocks or bonds in this period if a gun was to my head. After all precious metals have been tangible money for a few thousand years.

Hopefully you put 2 and 2 together from the discussion above, but in a deflation, the dollar bills are still there, but the total value of the money supply has lessened substantially due to credit default. This makes the value of actual dollar bills increase on a relative basis. This coupled with the fact that economic demand and hence prices of most goods and assets fall, your dollars will have greater purchasing power as well. This makes the dollar my vote for the safest investment for the foreseeable future. Actual physical dollar bills are probably the safest, though deposits at a safe bank or another form of cash balance, etc. may be fine as well. In addition, there are ETFs or Rydex funds that can be used to get exposure to the greenback.

There are other options to consider as well like short-term Treasury bills, or foreign bonds, etc, and you may want to look into those, but I will not give guidance on that. Above all realize that keeping the money you make is a respectable achievement. Additionally, imagine the opportunity maybe 3 or 4 years down the road, if stocks are down 2/3 in value and gold by 40 or 50% and quality bond yields are in the double digits. So just maintaining current cash values for a couple years can put you in a good position when things bottom out.

For reading material, Robert Prechter's Conquer the Crash should be a good place to start. Peter Schiff's Crash Proof is also pretty good, though they certainly aren't coming from the exact same perspective. If you are dealing with relatively large sums of money and have conviction, then you could look into a professional organization such as SafeWealth.


Now, history also teaches us that despite the best efforts of intelligent people to tie up all the loose ends and figure things out, unexpected things happen. One particular thing that is a major wild card in my mind may be completely unheard of to most. But, in the same way that Europe was reorganized into a "European Union/Community" with a common currency in the Euro, the powers that be have for quite some time been working towards actualizing a "North American Union" (US, Canada, Mexico) with a common currency that is tentatively referred to as the "Amero." So in the event that economic catastrophe is used as an impetus to further such globalization interest, I really have no idea how that would affect the dollar or other currencies. In fact, I don't even know much at all about how the implementation of the Euro affected European currencies, so any readers knowledgeable on this subject, please refer me to some literature, etc.


Most people are not motivated to protect wealth until it is all but gone. I hope that everyone reading this doesn't fall into that trap. Also, the fact that your holdings may be down 30 or 40% from peak values is irrelevant. That is the past. Your job is to do the best with the future. So I encourage any and all of you to do your due diligence in this regard. Like it or not, money (and those who control supply) run our lives; maybe you don't have the time to educate yourself enough to confidently make major changes in your investments, but you need to consider the alternative.....