What Portfolio Assets to own in a Deflation

Most people equate inflation with rising prices, and therefore assume that deflation means falling prices. Price fluctuations, however, are only symptoms of the fluctuating volume of money and credit. The price of goods rises when the supply of credit and money increases, making each unit of money worth less. Conversely, prices fall when the money and credit supply shrinks, making each unit of money worth comparatively more. 

Historically, depressions in the U.S. have been preceded by an expansion of available credit in the banking system. During the recent bull market, the U.S. experienced an unprecedented expansion of this type. Banks are willing to loan to almost anyone, and nearly everyone feels confident enough to take out large loans to satisfy their consumer desires. Buyer optimism abounds. 

At some point this huge mass of debt will be unable to sustain its own weight. When that tipping point is reached, once again, psychological trends will create economic trends. Lenders will suddenly become unwilling to lend to anyone but the most creditworthy borrowers, and people who are currently struggling under a large debt load will either rush to pay off their debts or default on their loans. These two reactions will feed each other in a downward spiral, and the result will be a deflationary crash as the volume of available credit contracts rapidly and the public mood changes to conservatism and pessimism. Most economists, if not all, are more concerned about inflation than deflation. 

The U.S. Federal Reserve Bank has recently decreased its interest rates to historically low levels, purportedly to reduce the risk of runaway inflation. Of course, the Fed cannot decrease interest rates below zero, which is where rates are headed. Unfortunately, almost no one is taking precautions against deflation, simply because they don’t believe it can ever happen. U.S. bank depositors have been lulled into a false sense of security by the existence of federal deposit insurance. But this insurance, which is paid for by the banks themselves, will not protect depositors when the deflationary crash arrives. And worldwide, global central banking has also made the worldwide supply of credit top heavy and ready for collapse.

Safe and Unsafe Investments in Preparation for the Crash 

Remember two things when arranging your financial affairs: first, even in times of great financial crisis such as the Great Depression, the majority of the population is not reduced to destitution. Second, those who prepare for bad times during good times are bound to be ridiculed. Be patient and you will be rewarded. For this reason, be sceptical of conventional investment wisdom, because it was formed during a spectacular bull market and is not at all appropriate for investing in a deflationary depression. Avoid these investment ideas:

• Bond investing — This is a prime example of conventional wisdom that will go wrong during a recession. Graphs that appear to illustrate the safety of high-grade bonds during bear markets actually reflect only the bonds that maintained their high ratings; the vast majority of bonds are downgraded during a depression, and many default, resulting in total loss of investment principal. Government bonds, though they may be tax-exempt, are also risky, because governments often default on their obligations during a crisis.

• Real estate — This is risky because real estate is highly illiquid. American consumers are over-leveraged and have tapped out their homes’ equity. In a crash, banks will foreclose on thousands of mortgages. If you’re tempted to take out that home equity loan to pay for something else, ask if it is worth losing your house — that may be the ultimate price. 

• Collectibles — Invest in collectibles for pleasure, not for profit. In a deflationary depression, no one will have enough money to buy Beanie Babies at inflated prices.

• Stocks — Investors should have learned about the perils of the stock market from the bursting of the Internet bubble. However, many believe that the Fed will manage the economy well enough to prevent further market declines; that simply isn’t true. Therefore, holding long positions in stocks is extremely risky. Experienced investors can consider short-selling stocks or perhaps investing in mutual funds that specialize in short selling. Remember, though, that during a market wide panic, the trading system may break down or be suspended, affecting short sellers as well as other investors.

• Commodities — Graphs of commodity prices during the Great Depression illustrate that commodities are as risky as stocks. Unless you actually own an oil company or a cotton plantation, you don’t own something physical when you buy commodities, but rather a futures contract, which is nothing more than a paper promise to deliver.
  
  

Here, on the other hand, are essential items for a secure investment portfolio: -

• Cash — Currency on hand is the only asset that doesn’t suffer price declines during defl ation. With interest rates at historical lows, no one wants to put large amounts of money away into savings accounts or CDs today. But during a deflationary crisis such as the one experienced by Japan, cash actually appreciates in value as all other asset values plummet. If you don’t want the 2% annual interest gain on your CD, you can take a 30% loss instead by investing in stocks, bonds or commodities.

• Precious metals — You can physically own this hard asset. Even if the price of gold and silver drops, it will never drop to zero, as stock prices may. Therefore, precious metals (in hard form, not futures contracts, ownership certificates or asset-backed bonds) are a crucial part of a survival-oriented investment strategy.

• Safe cash equivalents — Most people consider money market funds to be the same as cash, but not all money market funds are the same. The safest funds hold only short-term U.S. Treasury debt. You can skip the middleman (the fund) and simply purchase Treasury bills. Direct ownership takes more time but may offer more safety 

Finding Companies You Can Trust with Your Money 

Whatever investment vehicles you choose, be confident in the professional advice you are getting and in the ability of the companies you’re working with to continue to operate in the worst economic times. Most importantly, choose a safe bank, investment company and insurance company. This is more difficult than it sounds — big-name companies aren’t necessarily the safest. 

Because banks are no longer required to keep deposits on reserve for withdrawal, it won’t take very much to precipitate a major bank run, because the banks will quickly run out of money to satisfy depositors if just a few more than expected wish to withdraw their money. 

Many banks have unwisely invested in derivatives. In addition, recently banks have been lending money to anyone with a pulse and thus loan portfolios are weaker than they might appear. Seek banks that keep large cash reserves on hand. Many large banks in the U.S. satisfy this requirement, and the safest banks in the rest of the world are in Switzerland and Singapore (not coincidentally, these countries’ government-backed debt is the safest). 

Buying Low, Selling High

Consider how your strategy should change as the depression bottoms out and the economy eventually recovers. If you have cash or cash equivalents, you can buy hard assets when their prices drop. Massive foreclosures will result in a glut of real estate being sold at bargain prices, as happened during the Great Depression. 

Many kinds of assets will go on sale as desperate investors seek cash. Having prepared, you can cash in on these deals. If you own a business or have an entrepreneurial bent, positioning your company properly at the bottom of a depression will virtually ensure prosperity for years to come.