Search This Blog

Thursday, August 5, 2010

He's One of the First with Personal investment Advice on Dealing with Deflation...and He's Mostly Wrong

With the conventional wisdom now firmly rooted in the deflation camp having made a 360 in a matter of months, there will be doubtless a flood of personal finance articles on how to cope with the coming deflation. Many of those articles will be in the same publications and even by the same authors as the "inflation is coming here's how to cope articles.".

One of the first out of the box with this is James B Stewart whose investment advice I reviewed in an earlier post. He doesnt do much better on this subject although he claims otherwise despite the clear evidence that goes the other way.

so how should individual investors protect themselves from even a small risk of deflation? If you have been reading and acting on this column, you already are well on your way. Back in February, when inflation fears were widespread, I wrote a column with a strategy for lower inflation and rising interest rates. I thought the Fed would be raising rates by now, which would lower inflation expectations.Inflation worries have all but disappeared, which means that advice proved sound. But not for the reason I expected. Interest rates haven't gone up—they're even lower—and they don't seem likely to rise soon. That environment requires some further adjustments.
In February, I urged investors to reduce exposure to traditional inflation hedges such as gold, commodities, energy and Treasury Inflation-Protected Securities. Gold, precious metals and oil prices are off their peaks, but investors should continue to avoid them.
Deflation is an ideal environment for high-quality fixed-income assets because the value of the income stream rises as prices drop. In February I urged fixed-income investors to shorten maturities. That meant moving into higher-quality bonds, such as investment-grade corporate and Treasurys, as well as federally-guaranteed bank certificates of deposit. To protect against deflation, investors should maintain the focus on high quality, but lengthen maturities. This is easily implemented as short-term bonds and CDs mature. There also is nothing wrong with holding cash or cash equivalents, even with money-fund rates close to zero. Cash gains in value as prices fall.
The trouble is the advice in February was dead wrong in fact he miised an enormous rally in long term bonds as long term interest rates dropped sharply (see chart of tlt the long tern treasury etf lower yields=higher prices. His recommendationn was shorter maturities the short term treasury bond etf (shy)was +.07% the long term t bond etf (tlt, chart below ) +11%.

As for his advice to avoid commodities and tips didnt do to well either :
energy (dbe) unchanged
gold (gld) +10%
tips +2.5%

Mr Stewart now has switched his view on bonds to lengthen materials but holds onto the other view.

Where did he go wrong on this and why may that continue to be the case:
TIPS logically would go down in value with views of low inftion but in deflation but the story is more complicated you cannot lose principal even if there is cumulative deflation over the life of the bond (not too likely for longer maturities. So in fact the tips have a bit of a deflation hedge. You cant lose prinicpal and with rates so low even if  inflation is zero you would do better than investing in short maturities in the current environment unlike locking in long maturies if inflation reemerges you benefit while the long bond holder suffers losses.

In the commodity area Stewart misses the point that the deflation threat is most significant in the developed world. The developing world is still growing and has large needs for commodities. Commodities have a mixed record as an inflation hedge and likely some would rally in a deflationary environment due to supply/demand factors.from emerging market demand. In fact just as the conventional wisdom has shifted to deflation forecast, wheat has rallied significantly. Below is the chart for the agriculture etf (dba).

So really the most reliable advice in light of an inflation forecast is to lengthen which Mr. Stewart has finally come around to. Others have been aggressively acting in anticipation in months not only buying long term bond but even more aggressively buying"stripped treasury bonds or the zero coupon bonds which are most sensitive to interest rates change and return large gains in the current environment.

No comments: