Deflation Knocking
Research for Online Investors

by John Dalt

7/22/10

Deflation is defined as a decrease in the general price level of goods and services.  Paper currencies that are not backed by any store of value as a reference point (fiat money) can be inflated or deflated by monetary supply and economic decisions made by market participants.

The bond market is pricing a deflationary period into our future.  Why else would anyone be willing to accept less than 3% return for 10-years?  The FOMC minutes released last week expressed concerns about deflation and the fragile state of the U.S. economy.  The Fed has pumped money into banks, but the banks are reinvesting it back into bond funds rather than loaning it to businesses.

Business is not expanding, but choosing to meet present demand with the infrastructure and workforce in place.  The uncertainty in the future creates an aversion to risk.  Why make an investment for capacity expansion if increased demand is not predictable?  It is better to work to increase productivity with assets in place if…if demand increases.

Personal decisions are driven by observation.  Real estate has been in a decline since 2008.  Prices in some markets have fallen by more than 50% for certain once desirable properties.  Those who bought prior to 2008 would take a certain loss if they had to sell their home today.  Some who bought last year may have seen the value of their home decline below what they paid, though they thought the purchase price at time was ‘rock bottom.’

Much has been written about inflation resulting from the increase in money supply from the Federal Reserve, but if the banks have no demand from business for expansion or consumers for consumption the money sits in the vaults (or buys treasuries).

Real estate is just one example of a product that is available in larger quantities than the demand, so supply and demand is out of balance.  This is corrected by lower prices until the demand rises to consume the available supply.  It works in department stores with out of season sales of excess inventory, and it will eventually work in real estate.

Another cause of deflation is if there is decreasing demand for the available product.  Sometimes our ‘Rat Brain’ takes over and we withdraw from activity because we don’t know how to interpret the present situation.  We can go back to the real estate example where we have an oversupply of homes for sale.  What happens if the number of buyers shrinks?  Even if the number of homes remained static, fewer buyers would mean lower prices because the demand would decrease.

Finally, we understand our present danger of deflation is a relatively simple supply/demand imbalance.  We are used to thinking of supply/demand causing higher prices, but today we see the other side of the equation that is always present.

1. Money is plentiful but has low utilization due to fear.
2. Supply is plentiful for most items so there is no need for increased production.
3. Business and consumers are reluctant to invest or spend, which reduces demand for available goods.

There is one economic condition that can act as a rubber band in the move from deflation to inflation.  Governments are spending borrowed money in social safety net and stimulus programs.  This borrowed money is ‘first in line.’  As business and consumers gain confidence and expand capacity or increase spending the demand for money will increase.  This will act as a spring to push interest rates higher.  This is what happened in the ‘70’s as the demand for money increased and the private sector was crowded out by government borrowing.  Interest rates spiked into the high teens as the competition for available money increased.

Our Trade of the Year could be in trouble if deflation fears pull buyers from the safety of precious metals.  Our long-term subscribers owned AGQ in June, but sold for a 10% gain.  We are waiting for a lower entry point.  We still like the investment, but traders will punish silver in a deflationary environment.

To the mailbag: Even with scrubbers, coal is not as clean as natural gas. With the discovery of over 100 years of natural gas deposits in the U.S. and Canada, it only makes sense to us NG for our power generation, both in our cars and for electricity. We could be free from foreign oil within 5 years.---subscriber R.S.

John’s Reply:  I absolutely agree with using natural gas.  I thought it was good information to have.  Coal is cheap and plentiful.  Natural gas is cheap (now) and plentiful.  I know coal is dirtier, but the cheapest after nuclear.  We need a balanced approach, but must stay with inexpensive sources to stay competitive.  China understands this; they are building nuclear and coal generating plants.  I read today, companies are building LNG export facilities, should be ready late next year.

The information presented in this newsletter is based on generally available news releases, corporate filings, current events, interviews and the editor’s opinions.  It may contain errors and you should not make investment decisions based solely on what you believe you have read here.  Do your own research, it is your money.  If you lose it, it is your responsibility, not ours or your grandmothers!  The editor may or may not have a position in any securities discussed.  The editor may have held a position in a security earlier, or in the future.

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