Inflation/Deflation outlook

1. Look Both Ways:
Inflation or Deflation
[Type the document subtitle]
Kruse Asset Management on the inflation/deflation
debate and how to protect yourself.
J. Stuart Kruse, CFA
10/5/2009

2. Look Both Ways: Inflation or Deflation?
Most people are very familiar with the concept of inflation, which is the process in which
the cash that you hold today becomes increasingly less valuable with time, and thus buys
fewer goods and services in the future than it could buy today. During modern times,
slight inflation has been the norm, but just a few decades ago inflation was a huge
problem that was eroding the savings (and purchasing power) of all people holding US
dollars.
In general, economists believe that inflation is a monetary supply and demand issue.
Stated another way, it is the result of too many dollars (over supply) chasing too few
goods (high demand). Items that are in great supply are devalued (dollars) and items
whose demand cannot be met (good and services) have a price increase and bam:
Inflation!
Then it should come as no surprise that deflation is thought to be the opposite of
inflation: too little money trying to buy an excessive amount of goods. If there is an
over-supply of goods, they must be devalued (or deflate via lower prices) and the under-
supplied currency should increase in value (or purchasing power)…supply and demand.
So what forces are at work today and which ones will prevail?
Currently, we are at an unsustainable point of equilibrium between a high-supply of
money (due to liberal monetary policies) and a low demand of goods (due to our most
recent recession and increased savings rate). Normally these two forces are in opposition
with each other and it is not that difficult for the Federal Reserve to pull off the balancing
act and maintain a slight inflationary atmosphere. But as the opposite forces become
more powerful, as they are today, the balancing act becomes more difficult.
Think of it like this: you are overseeing a tug-o-war match between two groups of people.
You are not impartial. You want one group to win, but not so much that the group gets a
big head. So you stand in between the two groups and pull on the rope a little one way or
another to make sure the event goes as planned and your favored side wins, just barely.
Easy enough if there are 7-year old kids on each side. If there are 22-year olds on each
side of the rope, however, it is decidedly more difficult to influence the outcome, and in
spite of your efforts, it now looks like your favored side might lose. What do you do?
You can call in reinforcements. The problem with that is that your helpers tend to
become very loyal to the side you place them on, and it is hard to stop them once they get
going. As the game begins, the rope starts to move one way and then another. After a
while, a team will gain a stronghold and begin consistently moving the rope to its side.
As momentum builds to one side there is generally a release by the other team and the
rope flies to the winning side as the losing side releases hold.
The Fed faces this same problem. When the deflation and inflation side are “7-year
olds,” that is, when neither is that powerful a force, the act of maintaining a slight
inflationary atmosphere (making sure inflation just barely wins) is much easier. When

3. deflation and inflation are as powerful as they are today, however, the balancing act
becomes much more difficult, if not impossible. The deflation side was starting to win,
so the Fed had to call in help (lots of help) just to stop the deflation team from gaining a
stronghold. By the time the Fed is sure that deflation has stopped, so much momentum
will have probably built up on the side of inflation that, with all that extra force tugging
away, it will be very challenging to stop the rope from flying over to the inflationary side.
Right now, the Federal Reserve is pulling hard in favor of the inflationary side of the
rope, focused mostly on curbing deflation. It is doing this by attempting to offset the
reduction in demand with an increase of monetary supply. There are good reasons to stop
deflation, of course. Indeed, many economists believe that a generally deflationary
environment is a self-fulfilling downward spiral that is difficult to break out of, which
could result in a repeat of Great Depression-like scenarios.
The theory goes like this: if prices are decreasing (deflationary), and if there is an
expectation that that trend will continue, then people with cash will not spend on goods
and services today. Those goods will be less expensive in the future and waiting rewards
consumers. Because there is less demand, however, those goods build up in quantity,
become less valuable, and fall in price. Also, the number of transactions will decrease,
and by definition, the velocity of money will be lower. Lower monetary velocity and a
greater quantity of available goods and services will then cause more deflation and
decrease spending even more. The cycle is a self-fulfilling downward spiral to ugliness.
It is this type of deflationary death spiral, coupled with a mishandling of monetary policy,
that most economists believed solidified the hold of the Great Depression over our nation
in the 1930s. In spite of many economic policy changes after deflation took hold, that
cycle was only ultimately broken by extensive governmental spending due to World War
II.
Mr. Bernanke, a student of the Great Depression and the Fed’s current Chairman does not
wish for history to repeat itself on his watch, and has stated so on many occasions. As
such, the Fed has entered the “Great Ease” of monetary policy and supply-side economics
in attempt to “reflate” any short-term deflationary forces. It has also said repeatedly that
it will continue this easy economic policy until it is sure that the risks of deflation and a
Great Depression II have passed.
This policy can result in three possible outcomes:
1. Ineffective and useless: the policy may fail. After pouring trillions of dollars into
our economy and keeping the lowest Fed funds rate possible for extended periods
of time, the Fed may be ultimately ineffective in stimulating our economy out of a
deflationary cycle. The US enters “GD II.”
2. Perfect World: the policy succeeds. The Fed’s policies may “reflate” the
economy correctly and with perfect foresight. It may effectively increase interest
rates and decrease the money supply to match the unfolding economic growth in

4. exact lock-step – knowing that if it were to tighten too quickly, it may have to
repeat this entire debacle. Only this time there would be more fear and distrust
from consumers creating an even bigger hurdle to correct the next go-round.
3. Most Likely Case: the Fed is likely to err on the side of caution, leaving interest
rates too low and keeping the faucet open on the money supply for too long. This
is mostly because changes in monetary policy generally do not begin to take
effect for at least nine months after their implementation. So, you might think
about it like this: Many summers ago, you had severe heat stroke and you don’t
want that to happen again. Consequently, you wait for the temperatures to cool,
the leaves to turn brown and fall off the trees and the first snow fall before you
declare summer is over. Now you are freezing and you realize that you have no
coat, so you order one from the internet but takes nine months to make and
deliver. The Fed will likely wait until the snow before ordering its coat (raising
rates and decreasing the money supply) and freeze through the winter.
Well, you’re not going to have heat stroke again, and the Fed will avoid deflation, but at
what cost? Distressing levels of inflation. By the time the Fed takes its foot of the
stimulus gas peddle, it will be too late to stop the inflation car from launching itself off
the ramp of inflation. It might be a few months from now or a few years, but it is likely
to arrive.
When inflation does manifest in our economy, if you have followed recent trends and
moved your savings to “safe and secure” investment instruments like cash, bonds and
annuities1, you may suffer in the same way as if you lost 40% of your net-worth in the
stock market decline. Your dollar buys ½ of what it did not too long before, but instead
of seeing the dramatic effects spelled out for you on C-NBC or in your account
statements, your purchasing power will be silently eroded by the force of inflation. Less
publicized, but just as real. Even more so because decreased awareness of what is
happening disables your ability to adjust accordingly.
In general, people don’t get hit by a train if a train has just passed or if they know it is
coming. Most people get hit if they have:
• Fallen sleep on the tracks (complacency),
• Don’t look for the train (turn a blind eye), or
• Are tied down to the tracks (locked into long-term, illiquid investment like
annuities and long-term bonds).
The same is true for your investments. It is rarely the case that people are plagued by the
same issue twice (and almost never in a row). In recent history there was the “tech
bubble” when the masses where lured into the speculative returns of “tech companies”
and invested in products that they knew little about. These masses concentrated their
wealth into one sector, technology, and turned a blind eye to the dubious valuations. The
tech market corrected 80%.
1
In general, annuities lock-in a fixed payment, acting like a long-term bond.

5. Next came the real estate bubble and condo-flipping. Money was easy and cheap
(because the Fed was trying to engineer its way out of the bursting of the previous
bubble). Banks became complacent and lent people money that they couldn’t pay back
on houses that weren’t worth as much as they thought and then leveraged the investments
to insane levels. Guess what? That bubble burst too. We saw the largest real estate
decline in recent history.
After that, money poured into commodities looking for a home. Oil rose from
$30/barrel to $140/barrel in a few short years. All commodities were rising: silver,
platinum, gold, corn – there were even rice shortages and rationings for a short time. Not
much later, oil was back in the $40/barrel range, and many commodities prices had
returned to a normal level.
During that same time, the global economy slowed and we entered a world-wide
recession. Even diversification didn’t work for a relatively short period (a long period
from the perspective of those watching their assets melt away). Stocks, bonds, real
estate, commodities, emerging markets all went down big and in unison. The only safe
haven was cash and some short-term government bonds (even derivations of those were
threatened in the forms of money markets and bankruptcies).
So what is likely to be the next wave to threaten your livelihood? The declining global
stock market? How about a sudden collapse in real estate prices? Those trains just
passed. Commercial properties? Maybe, but we can all see that coming, so I don’t think
we will get killed by that train.
The next significant threat will likely stem from current economic policy that is
attempting to engineer and control a “free market.” The force to correct the current
problem could easily create an even larger imbalance later. Moreover, it is likely to
affect something that everyone is currently holding, but thinks is safe. Cash and
Government Bonds. Inflation causes those over-supplied, over-horded asset to be
equalized back to normal levels with the rest of the investible universe. As a result, there
will be other such casualties such as mid- and long-term bonds, preferred stock and
annuities (which tie you down to a fixed payment for life and will be worth less and less
with each payment).
The forces of the markets generally do not reward the excessive collection of one asset
class. We saw this with technology, real estate, commodities and debt. Right now, there
is more cash “on the sidelines” than ever before, and it is improbable that the current
holders of that cash will be blessed with deflation. The opposite is more likely true.
So what should you do?
1. Diversify: diversify your assets. Diversification has not worked for only a few
short periods in history and we just went through one of them, so that is a good
start.

6. 2. Hard Assets: invest in commodities, real estate, and currencies. If you wish to
protect yourself from inflation, then you need to own assets that will “inflate”
along with the rising tide. In general, you need to own “hard assets” such as:
a. Commodities: commodities go up directly with inflating prices. Make
sure, however, that you own a basket of commodities. Don’t just buy gold
and/or oil (or even a commodity index, which is often 70%+ oil-related).
You can buy a variety of ETFs (Exchange Traded Funds) that move with a
variety of commodities in different sectors: industrial and precious metals,
agriculture, livestock, etc. If you don’t know about ETFs, ask your
financial professional.
b. Real Estate: land will appreciate with inflation and your purchasing power
will be protected. This can be done via ETFs or REITs (Real Estate
Investment Trusts).
c. Currencies: if the U.S. dollar is inflating, then perhaps you should own
other forms of currency (from countries that are not devaluing their
currency by pumping cash into their economies). The Euro and the Swiss
Franc are potential candidates. Buying different currencies will hedge the
effect of US inflation and loss of purchasing power. This can also be done
via ETFs or by literally exchanging US dollars for those other currencies.
3. Global Equities: yes, the U.S. is a still a good place to invest, but just because
you are more familiar with the U.S. doesn’t mean that you should limit yourself to
investing only in companies that you know locally. There are other countries that
are not pumping their economy full of debt, so spread your investments around.
The U.S. stock market represents approximately 60% of the global investible
opportunities. There is a strong argument that, at equilibrium, only 60% of your
equities should be invested in the U.S. If you want to protect yourself from issues
domestically, however, you should consider over-weighting internationally.
Adjust your investment strategy accordingly.
4. Market Neutral Strategies: don’t know which way the market is moving? Don’t
care. Market neutral strategies are designed to hedge your portfolio in any
environment. This can be done by purchasing one stock and shortingi a related
stock in the same sector. It is the relative difference between the two stocks’
prices that is important, not the general direction of movement. This strategy’s
performance is independent of the market’s direction.
5. Principle Protection: if some of these above strategies seem a little too risky for
you, then you can buy a “structured product” that links a CD to an index and has a
feature of principle protection (you will be taking on the credit risk of the issuing
bank). If that index (say commodities) goes up, you win and participate 100% or
more in that victory. If, on the other hand, if the index falls, you get your money
back at the maturity of the note. You don’t win or lose, but live to fight another

7. day and by that time the landscape is sure to have changed, and you can redeploy
that money accordingly. Furthermore, CDs are currently protected by FDIC
insurance up to $250,000 per account. The down side is that CD returns are
taxable at the ordinary income rate, so think about using them in retirement
accounts.
6. Short-term Bonds: If you are going to buy bonds (and you probably should),
focus on “ladder” short-term maturities. Do not “chase yield” locking yourself
into a long-term commitment just because those bonds pay more. While bonds
will pay a periodic interest payment provided the issuing company is still viable,
that fixed income is devalued in a rising interest rate environment. For example,
if inflation hits 8% (extreme for today, but not in comparison to our history), in
only five years from now those payment will be devalued by almost 25% and in
10 years they are more than cut in half. Just think what happens if you lock in a
30-year bond or buy a lifetime annuity. That income stream that you depended on
today may seem like nothing in the future.
Be a student of history, with an eye to the future by watching that tug of rope carefully.
Don’t trap yourself in long-term or illiquid investments that protect you from recent past
catastrophes. Do keep a disciplined diversification plan that is inclusive of asset classes
that can protect you from future problems. There are many trains out there, so instead of
getting hit by one, let’s get on it and let it take us to where we want to go.

8. i
“Shorting” is selling a stock that you currently don’t own at what you hope is a higher price so that you can buy it back
later at a lower price. Opposite of being “Long” or owning the stock first, if the stock price declines, you make a profit.