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In Thursday's
newsletter we took a detailed look at the inflation-versus-deflation
argument, pointing out how neither were actually here yet, and how
any forecasts of either were wild guesses at best. See, pundits
love to predict the worst-case and best-case scenarios, even though such
extremes are rarely seen. In reality, something much more moderate and
tempered is likely.
 Nevertheless,
the Micro Cap Press analytical staff does agree that the period
of modest inflation (1% to 2%, with a peak of 2.8% in December) isn't apt
to last indefinitely.
If the Fed's
worries are on target and the economic engine is indeed slowing
down, consumer demand could taper off enough to pull inflation down to
the 0% area. If instead that flood of cheap dollars in a low-interest rate
environment finally gets traction, we may see inflation rates creep up
to 3% to 4%. In either case though, inflation is going to be tempered
by what's pulling at the other end of the rope in this tug-of-war.
With that as
a backdrop, though we've yet to see deflation or inflation materialize,
it's not too soon to start making a plan for either. Here's a quick "how
to" for both possible outcomes.
To be clear,
the
advent of either is not an 'all or nothing' situation, meaning
not
every pick in your portfolio has to be made with consideration for inflation
or deflation. In fact, many stocks won't be affected at all
by rising or falling prices. So at most, these picks should be used
as a hedge for your portfolio, intended simply to fight volatility.
With that in
mind, here are the key considerations for both scenarios.
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In
Inflationary Environments.... |
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In inflationary
environments, that country's currency is likely to decrease in value (relatively),
meaning
the greenback is going to get weaker. The PowerShares Bearish U.S.
Dollar Fund (NYSE:UDN) would be one way of taking advantage of such a long-term
result.
 Basic
materials also become more expensive, meaning profit margins widen for
materials suppliers (miners, timber, chemicals, etc.) The key to making
this work well is that inflation can't be so great that raw materials are
simply overpriced for most buyers. Given the push/pull effect we described
above though, that's not likely.
While there
are several household-name basic materials plays to choose from, we would
encourage investors to think small and obscure. Areas like timber and paper
- which have been admittedly volatile - are able to pack more punch
than a stock everyone knows and follows.
It's not just
materials stocks that benefit from inflation though. Food also suffers
inflation, which can be good news for the likes of grocers, processors,
and distributors. Wal-Mart, for example, has already put the brakes on
many of their 'rollback' prices, letting off on the margin-shrinking pressure
that it had put on Supervalu (NYSE:SVU).
And of course,
for those wanting/needing fixed-income exposure, the iShares TIPS Bond
Fund (NYSE:TIP) will do the trick while staving off the inflationary risk
of bonds. Just know that your returns here are going to be very muted in
comparison to similar alternatives.
Don't forget
about utilities either; rates tend to go up in inflationary environments.
Water utility stocks are looking particularly attractive anyway,
as most have pending rate hikes on the way. A bout with inflation could
justify even more rate increases.
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In
Deflationary Environments... |
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If
any future deflationary environment is like past ones, then interest rates
are going to sink. That makes owning bonds attractive, since as yields
go down, bond prices go up. Granted, yields can't go a whole lot
lower from where they are now, but Bernanke did acknowledge last
week that there is some more room for long-term rates to sink.
There are a
couple of different ways to play it, but 10-year bonds/treasuries seem
to be in the sweet spot. In fact, that's the maturity being targeted by
the Fed as buyback candidates, per the quantitative easing announcement
last week. Or, if you're more of a fund or ETF investor than a treasury
owner, then look at the iShares 7-10 Year Treasury Bond Fund (NYSE:IEF).
Yes, the yields
are painfully low, but the goal here is defense - not offense.
Plus, whatever your yield is, if we are indeed seeing deflation - inflation
rates with a minus sign on front of them - you're effectively 'earning'
your stated yield plus the positive version of deflation number.
(Deflation of 2% means you're effective yield is an extra 2% on top of
your stated interest rate.)
 Another
key upside to a deflationary environment... U.S. currency will become
more valuable. That's great if you're long the dollar or an equivalent
ETF like the PowerShares U.S. Dollar Bullish Fund (NYSE:UUP). There's a
flipside to that coin though.
While a more
powerful dollar is great for U.S. consumers buying foreign goods, it makes
it very difficult for foreign consumers to buy U.S. goods. The solution
is two-fold....
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Buy U.S. stocks
that don't rely heavily (if at all) on foreign customers, or even better...
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Buy foreign stocks
that rely heavily on U.S. customers. This second option serves up needed
international diversification anyway.
Not every 'deflation
defense' stock pick has to have a currency or interest rate angle to it
though. As we suggested earlier, some stocks breeze through deflation pressures.
Yes,
there are the old standby's .... consumer staples. Fair enough, but
boooorrrring. You should probably throw healthcare stocks into that
mix as well, since the industry in indeed always in demand and not price
sensitive. And, most of these stocks will do just fine. Considering
everyone else knows the same thing though, there's not a great deal of
upside from the group as a whole if and when deflation strikes. There is
another sector that could do surprisingly well despite inflation though,
and it's one rarely considered..... technology.
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In
Either Environment - Technology |
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Surprised?
That's not a defensive area that would have been named as such fifteen
years ago, but it is now. Why? Because technology is to businesses
what water is to people. Well, that, and the fact that consumer
technology marketing has been quite effective at turning the "I want that"
mentality into an "I need that" mentality. (Don't think so? Think about
the ridiculous number of iPads and flat-screen HDTVs that were sold in
the midst of the recession.)
 As
for technology being inflation-proof, deflation-proof, or even recession-proof
within the business world, imagine what would happen IBM, Siemens, or UnitedHealth
Group had to give up their current databases and go back to the old way
of keeping track of their business operations. It would be like a return
to the stone ages - not going to happen. It would be almost
as impossible to just replace the current database infrastructure with
another one.
So what?
There's a common element among the databases of Siemens, UnitedHealth,
and IBM..... Oracle (NASDAQ:ORCL). Oracle manages those databases, and
thousands of others. And of course, Oracle collects ongoing fees year-in
and year-out for doing so.
Point being,
there
are some technology business models that will drive consistent revenue
no matter how badly their customers are suffering, and regardless of the
reason. These tech companies are just too involved in the daily operations
of their client companies to be ousted.
Again
we'll stress we've seen neither inflation nor deflation yet, despite
table-pounding prognostications for both. Until it becomes clear one or
the other is inevitable, the wisest action to take may be none.... even
if the talking heads on TV sound so sure of themselves. The ideas presented
above are just some suggestions to keep in your back pocket when/if the
time comes.
We'll also remind
you that inflation and deflation are forces to defend against, not forces
to bet an entire portfolio on. By and large, most companies and their
stocks will deal reasonably well with either. The stocks and themes presented
above should simply replace those holdings that are particularly sensitive
to inflationary or deflationary tides.
Sorry to get
off the micro cap and stock-pick track, but this inflation/deflation discussion
was an important one to voice no matter what kind of investor you are.
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Updated: 8:15 pm PDT (03:15 GMT), November 2, 2010
