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Profit From The Fed's Failure
As the financial calamities that began to surface in earnest in 2007 have progressed through 2009, the Federal Reserve and central banks around the world have gone to great lengths to fix the system. Many truly unprecedented actions have been undertaken to a scale never before seen in history, in an attempt to prevent a bad situation from spiraling into complete catastrophe.
IN PICTURES: Eight Ways To Survive A Market Downturn
Naturally, the Fed's actions have caused much concern over the resulting substantial increase in the monetary base, and the potential this holds for dramatically increased rates of inflation in the future. But while the initial reflex reaction to the Fed's actions is to fear imminent inflation, I think investors would do well to prepare at least part of their portfolio for continued deflationary pressures for the foreseeable future.
Mission Impossible?
A key reason why our financial woes have already lasted so long is that the bulk of the credit crisis has been occurring outside of central banker domain. Back in January of this year, The Guardian published a slick slideshow that does an excellent job illustrating the nature of the problem (Click Here to view it).
In a nutshell, our economic woes have been suffered due to the higher tiers of the global money-creation pyramid that have been collapsing downwards through the system. The sheer size of this credit destruction dwarfs even the unprecedented amounts of new money central banks have been injecting into the bottom of the system since the crisis began. In other words, a billion dollars worth of new currency pumped into the bottom of the pyramid can do little to stop a trillion dollars worth of credit from vaporizing at the top. (For more, see Deflationary Shocks: Helping Or Hurting The Economy?)
The Market Still Refuses to Play Ball with Team Bernanke
For a different graphical representation of this situation, ShadowStats.com provides a Money Supply Growth chart that shows how their M3 proxy (as estimated by the site, since it is no longer reported by government since 2006) is still seeing a rapid decline in its growth rate, despite drastic increases in the rate of growth of M1.
So, it come as little surprise that lagging inflation indicators such as the CPI are still essentially in freefall. As ShadowStats.com reports, it is clear that the U.S. rate of inflation was, as of June 2009, still declining at the most rapid pace many of us ever seen in our lives. Some may argue this trend is set to quickly reverse into a period of rapid inflation, but while I have little doubt serious inflation will eventually occur, I see no sign of it developing yet. I think it could reasonably take years before we reach that point. (For more, check out the All About Inflation Tutorial.)
Where To Go From Here?
A simple way to attempt to profit from this situation, and avoid company-specific risk that comes with shorting individual stocks, is to short SPDRs (NYSE: SPY), or if you want to be more aggressive, buy the UltraShort S&P500 ProShares ETF (NYSE: SDS), which seeks to return twice the inverse of the S&P 500's daily percentage change.
Shorting commodities is also generally a good idea for a deflationary environment, but be wary of shorting oil and gold. Political tensions can cause oil prices to counter a market correction and spike upwards on short notice, and due to gold's traditional status as a safe haven it may also be bid up during another market crash, or at least fall less than most other commodities.
I think at this point silver is one of the better candidates to fall the most should we get another steep across-the-board decline like we saw last October. Investors who want to trade that play can short the iShares Silver Trust ETF (NYSE: SLV) or double up with the leverage of the UltraShort Silver ProShares ETF (NYSE: ZSL).
Of course, if you just want to stay in cash equivalents until you are comfortable the threat of deflation is gone, there's no shame in that. Returns on three-month T-Bills have outperformed the major domestic indexes over the past eight years.
The Bottom Line
If you are seriously worried about imminent rapid inflation, by all means stay in inflationary trades. But I would suggest that keeping at least part of your portfolio prepared for deflation would be a wise move, because if these monetary deflationary pressures continue to fly in the face of the market's rebound, it is only a matter of time before we have another serious downward correction. (For more, see The Upside Of Deflation.)
Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!
IN PICTURES: Eight Ways To Survive A Market Downturn
Naturally, the Fed's actions have caused much concern over the resulting substantial increase in the monetary base, and the potential this holds for dramatically increased rates of inflation in the future. But while the initial reflex reaction to the Fed's actions is to fear imminent inflation, I think investors would do well to prepare at least part of their portfolio for continued deflationary pressures for the foreseeable future.
Mission Impossible?
A key reason why our financial woes have already lasted so long is that the bulk of the credit crisis has been occurring outside of central banker domain. Back in January of this year, The Guardian published a slick slideshow that does an excellent job illustrating the nature of the problem (Click Here to view it).
In a nutshell, our economic woes have been suffered due to the higher tiers of the global money-creation pyramid that have been collapsing downwards through the system. The sheer size of this credit destruction dwarfs even the unprecedented amounts of new money central banks have been injecting into the bottom of the system since the crisis began. In other words, a billion dollars worth of new currency pumped into the bottom of the pyramid can do little to stop a trillion dollars worth of credit from vaporizing at the top. (For more, see Deflationary Shocks: Helping Or Hurting The Economy?)
The Market Still Refuses to Play Ball with Team Bernanke
For a different graphical representation of this situation, ShadowStats.com provides a Money Supply Growth chart that shows how their M3 proxy (as estimated by the site, since it is no longer reported by government since 2006) is still seeing a rapid decline in its growth rate, despite drastic increases in the rate of growth of M1.
Where To Go From Here?
A simple way to attempt to profit from this situation, and avoid company-specific risk that comes with shorting individual stocks, is to short SPDRs (NYSE: SPY), or if you want to be more aggressive, buy the UltraShort S&P500 ProShares ETF (NYSE: SDS), which seeks to return twice the inverse of the S&P 500's daily percentage change.
Shorting commodities is also generally a good idea for a deflationary environment, but be wary of shorting oil and gold. Political tensions can cause oil prices to counter a market correction and spike upwards on short notice, and due to gold's traditional status as a safe haven it may also be bid up during another market crash, or at least fall less than most other commodities.
I think at this point silver is one of the better candidates to fall the most should we get another steep across-the-board decline like we saw last October. Investors who want to trade that play can short the iShares Silver Trust ETF (NYSE: SLV) or double up with the leverage of the UltraShort Silver ProShares ETF (NYSE: ZSL).
Of course, if you just want to stay in cash equivalents until you are comfortable the threat of deflation is gone, there's no shame in that. Returns on three-month T-Bills have outperformed the major domestic indexes over the past eight years.
The Bottom Line
If you are seriously worried about imminent rapid inflation, by all means stay in inflationary trades. But I would suggest that keeping at least part of your portfolio prepared for deflation would be a wise move, because if these monetary deflationary pressures continue to fly in the face of the market's rebound, it is only a matter of time before we have another serious downward correction. (For more, see The Upside Of Deflation.)
Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!
by
Chris Gallant
Chris Gallant is a contributor for Investopedia. Chris graduated from the University of Alberta School of Business with a major in finance. Prior to writing for Investopedia, Chris spent time working with the Alberta Ministry of Finance, taught Business classes at the undergraduate level and helped manage a charitable equity fund for the University of Alberta.
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