Deflation

This week’s entry is the second in a series of blogs on inflation and deflation, what are good / bad investments for those conditions and when inflation or deflation might occur. This week I focus on deflation.

Definitions of inflation, hyperinflation and deflation from the last blog (Inflation - March 21, 2010)

Definition of inflation from Yahoo Education: “A persistent increase in the level of consumer prices or a persistent decline in the purchasing power of money, caused by an increase in available currency and credit beyond the proportion of available goods and services.”

Definition of hyperinflation from Yahoo Education: “Extremely high monetary inflation.”

Definition of deflation from Yahoo Education: “A persistent decrease in the level of consumer prices or a persistent increase in the purchasing power of money because of a reduction in available currency and credit.”

Deflation can be caused by the following:

1. Increase in the supply of goods is growth deflation. This can lead to a decrease in the Consumer Price Index (CPI). A good example of this is Natural Gas (NG). Recent technological advancements have allowed the development of NG deposits previously thought to be unreachable and this has led to a decline in the price of NG. The Exchange Traded Fund (ETF) that tracks the future one month contracts of NG (UNG – United States NG Fund) is down from $60 in June 2008 to the current price of around $7. This can be good for the economy - when prices go down because of the increase of goods everyone’s wealth can increase. Since you are now paying less for NG, you can buy other goods or invest the money you saved.

2. Reduction in spending of consumers. When people refuse to spend money on goods it can lead to a decline in prices unless the money supply increases faster than the economy is growing. For example, when the unemployment rate increases consumers will start saving more money (the saving rate goes up) and the only way goods sell is if the price is decreased (i.e. the store has a 50% sale on goods to reduce their inventory). This can have a circular effect the result of which is to drive down prices. The consumer will not buy anything unless it is on sale (price reduction). For example, I will not buy a new automobile unless there is $3000 rebate and zero percent financing.

3. Reduction in investment value or liquidity in the market. For example, the stock market or real estate has a significant decrease in value, and consumers have less money to spend. For example, the home owner can no longer use his house as an ATM (take out money) because its value has decreased. He can’t go buy a new BMW by refinancing his house.

4. Bank credit deflation. Reduced availability of bank credit because of new rules regarding credit worthiness, the high bankruptcy rate, and central bank policies can make it more difficult for businesses and consumers to get loans. I cannot get a loan to buy a new automobile, house or start a small business. A corporation cannot get a loan to buy capital equipment. This can spur the decrease of the price of goods.

5. Reduction in government spending. For example, the federal government has to decrease spending on goods because its debt load (payments) makes up an increasing part of the budget. There is also a reduction in tax collection (the unemployed/underemployed pay less taxes, spend less on taxable goods, etc.) The resulting decrease in demand for goods feeds into a downward trend in prices. For example, states’ budgets have decreased because of lower tax collection, which can drive down the price of goods and services, and in turn drives unemployment higher.

The best investments for periods of deflation are the following:

1. Medium to long duration bonds. The Feds may reduce interest rates with the intention of stimulating the economy; this would drive up the value of a bond as interest rates decline. (Paradoxically, while this is usually one of the best investments for deflation, it would not work well now with interest rates at historic lows.)

2. Currencies, stock or assets of countries that do not have deflation. If you own assets or currencies in countries that do not have deflation, your assets will increase against the currency decreasing. For example, if you own the currency of Brazil which does not have deflation, you will have more money to purchase assets in the US.

3. Short Equities. During deflation companies have decreasing revenue and lower margins. This usually leads to decreasing stock prices for the majority of stocks. You could use ETFs to short or leverage short (i.e. 3X short) the market. For example, you could short the S&P 500 using ProShares Short S&P500 ETF (SP) or leverage short the S&P 500 using ProShares UltraShort S&P500 ETF (SDS).

4. Short leverage assets (for example real estate). As prices collapse the value of the asset will continue to decline. You will want to short any company or asset that is highly leveraged. The value of the asset will continue to unwind and companies or assets that are highly leveraged will continue to decrease in value.

5. Cash is king. You want to raise cash and have less debt. Assets will decrease over time and will become cheaper. If you have cash you will be able to buy a lot of assets at reduced prices.

6. High paying annuities. If you can lock in a high paying annuity it will continue to pay cash as interest rates decline and the value of the annuity will increase.

The worst investments for deflation are the following:

1. Highly leveraged assets. As the value of an asset is decreasing, it gets more costly to pay the debt. This is the worst investment that you can be in during deflation. For example, you own a house that is 100% financed, the value of the house is decreasing and it is more costly to pay the debt (woe to you if you will not be getting a raise or if your pay actually decreases!). You do not want to be forced to sell assets to generate cash during deflation.

2. Debt. Any debt will be more costly to pay off during deflation. Remember cash is king in deflation periods. If you have cash you can buy a lot of reduced cost assets.

3. Long Stock. You have to be very selective in the stocks you buy. There will be revenue, profit and margin pressure during deflation which will drive down stock prices. Companies that are highly leveraged (have a lot of debt) will not be good investments (it is more difficult to pay for debt when there is deflation).

Please add your insight. For example, when will the US have inflation or deflation? I would like to have an on-going discussion of financial and investing ideas.

Next week, I will write about when I think we will have inflation, deflation or stagflation. Future topics may include:

- What investments will be good investments with rising inflation and interest rates?

- Warning signs of inflation or deflation

- Shorting US currencies

- What sector will do the best in 2010?

- Update on performance of blog trades

- Financial rules / lessons (school of hard knocks)

- Other topics

In April I will be starting a financial website (www.paulsgang.com) and in the summer I will be kicking off a financial podcast with Fullstacks, Mr. C and C4.

© 2010 Paul Cusick

My favorite financial books that I have read in the last 3 months:

The Ascent of Money: A Financial History of the World

The Greatest Trade Ever: The Behind-the-Scenes Story of How John Paulson Defied Wall Street and Made Financial History

The Big Short: Inside the Doomsday Machine

Paul

Inflation / Deflation

This week I am starting a series of blogs on inflation and deflation and what are good / bad investments for those conditions. This week will be focused on inflation and hyperinflation.

Definition of inflation from Yahoo Education: “A persistent increase in the level of consumer prices or a persistent decline in the purchasing power of money, caused by an increase in available currency and credit beyond the proportion of available goods and services.”

Definition of hyperinflation from Yahoo Education: “Extremely high monetary inflation.”

Definition of deflation from Yahoo Education: “A persistent decrease in the level of consumer prices or a persistent increase in the purchasing power of money because of a reduction in available currency and credit.”

Inflation is caused by the following:

1. Money supply grows faster than the rate of potential output of the economy, or real GDP. This, combined with low interest rates, can eventually lead to unsustainable levels of growth as cheap money is available. In the long term this will cause inflation. The Fed will increase the money supply because they are lenders of the last resort. If the federal deficit keeps increasing and there are not enough buyers of the debt (or if the Fed wants to keep interest rates low), the Fed will need to buy the debt by printing more money and adding it to the money supply.

2. Rise in production cost of goods. For example, increases in raw materials and / or increases in labor cost.

3. Change in availability of supplies. The Arab Oil embargo of the mid 1970s is a classic example of change in availability of supply. This caused an increase in the price of gas, paint, and petroleum based products. This was one of the major causes of the mid 70s to early 80s inflation period.

4. The consumer demands more goods and services than are available. This can lead to the seller increasing the price of the good or service and driving up inflation.

5. Inflation can be artificially created through a circular demand by workers to increase wages (for example, when a change in supply increases cost of goods) which causes an increase in production costs which will increase prices that will lead to further demands of higher wages. You do not want to be on a fixed income when this happens.

The main cause of hyperinflation is the Fed printing money at a much faster rate than the growth of GNP. A great example of this is post World War I Germany.

The best investments for inflation or hyperinflation are the following:

1. Commodities, precious metals or gold (see blogs Gold – January 3, 2010 and Natural Gas – February 8, 2010). You could use Mutual Funds, Exchange Traded Funds (ETF) or commodity producing and / or mining company stocks for investment in commodities, precious metals or gold.

2. Real estate. This could include personal or income property (with a fixed rate mortgage) or Real Estate Investment Trust (REITS). In Germany during the post World War I period of hyperinflation, a home owner could not find his banker to pay off his mortgage because he could have paid it off with one day of salary. You want to own a lot of leveraged assets when there is hyperinflation.

3. Foreign stock or currencies of countries which do not have inflation or hyperinflation. For example, if the BRIC countries (Brazil, Russia, India, and China) do not have inflation or hyperinflation you could use BRIC ETFs for foreign stock investing (see blog BRIC ETFs … - January 13, 2010).

4. Very short term CD or Treasury securities if you need cash for future investments or for cash flow.

5. Shorting US currency and US treasury or long term bonds (if interest rates also increase) (see blog … Shorting US Treasuries - January 13, 2010).

The worst investments for inflation or hyperinflation are the following:

1. Investments in cash. For example, CDs, saving accounts, etc.

2. Long or medium maturity duration bonds (see blog Bonds – February 27, 2010).

3. Long term fixed rate annuities or anything that pays a fixed income.

Next week, I will write about what causes deflation and investments for deflation.

Future topics may include:

- What investments will be good investments with rising inflation and interest rates?

- Prediction when we will have inflation or deflation

- Warning signs of inflation or deflation

- Shorting US currencies

- What sector will do the best in 2010?

- Update on performance of blog trades

- Financial rules / lessons (school of hard knocks)

- Other topics

In April I will be starting a financial website (www.paulsgang.com) and in the summer I will be kicking off a financial podcast with Fullstacks, Mr. C and C4.
Please add your insight. For example, when will the US have inflation or deflation?

I would like to have an on-going discussion of financial and investing ideas.

© 2010 Paul Cusick

Paul

Zero Coupon Bonds

This blog is going to be another short and ‘sweet’ one. I just completed my taxes and I am starting to work on my oldest son’s college financial documents this week. I will have limited time to work on my blog and will continue to write some short blogs on bonds investing. Today I’ll talk about zero coupon bonds.

Last blog (dated February 28th) I talked about zero coupon bonds and average bond duration. Zero coupon bonds are the only type of bonds for which maturity equals the duration. For example if the zero coupon bond maturity is 10 years the duration will be 10 years. What are bond coupons and zero coupon bonds? The term bond coupons came about when bonds were historically issued as bearer certificates - if you had possession of the certificate, you were considered the owner of the bond. Coupons were attached to the bond, for example if the bond maturity was 10 years and the interest was paid once a year you would have ten coupons for each interest payment. At the due date you would cut the coupon from the bond and present it for payment. Zero coupon bonds have no coupons; you buy the bond for less than the face value and get repaid the face value at time of maturity. There are no yearly interest payments. For example, if you paid $750 for a bond that has a face value of $1000 and maturity of 5 years, you will be paid $1000 after five years.

Zero coupon bonds have interesting US tax consequences. Even if the bond holder does not get interest payments every year the IRS requires you that you “impute” an interest income every year and report this income every year on your income tax statement. Usually the issuer will send you a 1099 form. If you are interested you can get information on zero coupon bonds and tax consequences from the IRS Publication 17: http://www.irs.gov/publications/p17/. You could buy zero coupon bonds in your tax exempt account (i.e. IRA) and have no tax consequences.

The largest categories of zero coupon bonds are the following:

• Treasury securities
• Zero coupon corporate bonds
• Zero coupon municipal bonds
• Saving bonds

Treasury and municipal bonds also have interesting US tax consequences. Holders of municipal bonds may not have to pay local, state or federal taxes (this makes it cheaper for municipalities to fund projects since the interest rate will be lower than the market rate). Treasury bond holders may not have to pay local or state taxes either. Please review IRS publication 17 or talk with your tax accountant about the tax consequences of buying these bonds. If you are interested in calculating tax-free vs. taxable yield comparisons, you can use the following calculator: http://www.investinginbonds.com/calcs/taxcalculator/taxcalcform.aspx. Using the calculator and selecting my state, taxable income and filing status, I learned that if a municipal bond has a 3% tax free yield, the equivalent taxable yield would be 4.61%. This is a very simple tool for calculating yield for tax free bonds.

Zero coupon bonds may be a good alternative if you are working to a specific time frame such as a child's college tuition payments or your retirement, and if you intend to hold the bonds until maturity. For example, if the interest rate is 7%, maturity is 20 years and the face value is $20,000 you will pay around $5,050 for the bond and receive $20,000 when it matures in 20 years. The beauty is it’s very predictable; you pay $5,050 and receive $20,000 in 20 years.

Investors also buy treasury zero coupon bonds because they are very safe - they are backed by the full faith of the US government and treasury (the treasury can always print money to pay the bond holders). Zero coupon bonds have the same interest rate risk as all bonds and, if you need the cash flow, you can always sell the bond on the secondary market.

Next week, I will write about when I think inflation and interest rates may go up and why. I’ll also address what investments will be good investments with rising inflation and interest rates. Future topics may include:

- Shorting US currencies
- What sector will do the best in 2010?
- Update on performance of blog trades
- Financial rules / lessons (school of hard knocks)
- Other topics

In April I will be starting a financial website (www.paulsgang.com) and in the summer I will be kicking off a financial podcast with Fullstacks, Mr. C and C4.
Please add your insight. I would like to have an on-going discussion of financial and investing ideas.

Paul