Are You Ready for Deflation? (Interesting Article-You "Perma-Bear!)
As Dow Crosses 9000, Investors Must Decide
Whether to Expect Falling Prices or Inflation
By JEFF D. OPDYKE
Staff Reporter of THE WALL STREET JOURNAL
OK, is it deflation or inflation?
Investors are getting mixed signals these days on which path the economy is taking. This week, Alan Greenspan, the chairman of the Federal Reserve Bank, again highlighted the risk that falling prices could send the U.S. into a dangerous spiral of Japanese-style deflation. The Fed's preoccupation with deflation has investors piling into bonds, which will increase in value if rates keep tumbling. Ten-year Treasury notes closed Wednesday at 3.29%, their lowest yield in 45 years.
At the same time, prices for many key expenditures, including health care and tuition, continue to rise. For many consumers, these incessant price increases make inflation seem more of an immediate threat than falling prices.
For investors, this is far more than an arcane macroeconomic debate. After the three-year bear market, many investors are starting to wade back into the stock market again. The Dow Jones Industrial Average is up 13% in the past two months -- it closed Wednesday above 9000 for the first time since August. Investors deciding where to deploy their funds must make a fundamental calculation on whether the economy is headed toward falling prices or rising prices. Each scenario calls for a very different portfolio.
"This is the most important investment decision" an investor needs to make right now, says Ray Dalio, president at Bridgewater Associates, a Westport, Conn., investment-management firm.
Deflation is usually bad news for stocks. It means companies lose their ability to raise prices, which squeezes corporate profits. So those fearing deflation are loading up on long bonds, which would provide a steady cash flow in a world of falling prices. They are also buying zero-coupon bonds which appreciate in value when interest rates fall.
In contrast, the stock market generally thrives in a period of mild inflation. Such periods, like the 1990s, often have strong economic growth and rising consumer income, both of which are good for corporate profits. Investors betting on inflation are snapping up Treasury Inflation Protected Securities, bonds whose return automatically rises whenever inflation does.
What follows are two competing investment strategies, one structured for deflation, the other for inflation.
Deflation
Falling prices aren't a common occurrence in the U.S. The last recorded bout of deflation was more than 50 years ago and was mild. The most infamous case occurred during the Great Depression.
In periods of deflation, cash is king. That's because the dollars you have today will buy more tomorrow as prices fall. That favors owning U.S. government bonds with the longest maturities, since they pay the highest rates and are locked in for the longest period of time.
In a deflationary world, zero-coupon bonds will be the rock stars. These bonds don't pay interest -- it's built into their price at maturity, similar to a savings bond. Investors would pay about $670 today to buy a zero-coupon bond that gives them $1,000 at maturity in 2013.
One downside: Even though you don't get interest payments from zero-coupon bonds, you're still required to pay income taxes yearly on the internal interest your bond is earning.
To get income during deflationary times, stick to traditional bonds. The 30-year Treasurys generate the biggest income stream and will get the biggest price pop from deflation, since when interest rates go down, bond prices go up.
Foreign bonds should do well, too. The dollar likely would weaken in a deflationary period, so investors could offset that risk by owning investments denominated in a foreign currency. The easiest way to buy foreign bonds is through mutual funds such as BlackRock International Bond or American Century International Bond.
Steer clear of corporate bonds, however, since in deflationary times, consumers put off many discretionary purchases as they wait for even lower prices. That puts pressure on a company's sales and earnings, increasing the likelihood of default.
Real estate would be a terrible investment, since prices would come down. That means forget the second home or vacation property.
If there is a run of mild deflation, then investors may want to own the dividend-paying stocks of companies that can drive sales based on volume and innovation, instead of price increases. That would include drug companies such as Schering-Plough. Utility stocks also should be winners since their services are necessary and they produce generally stable dividends.
In a period of more persistent deflation, however, investors should consider avoiding stocks completely. Even dividend-paying companies will have a hard time keeping their earnings at a level that will allow them to pay those dividends. Companies focused on commodities, such as energy stocks and gold-mining firms, also will get hammered.
Inflation
If inflation remains mild, then a broad swath of stocks are expected to do well. The easiest way to benefit is to own a low-cost index fund mimicking either the Standard & Poor's 500-stock index or the broader Wilshire 5000.
If inflation kicks into high gear, however, avoid stocks completely and buy hard assets, such as real estate, gold, even collectibles like art and Persian rugs.
The safest play is Treasury Inflation Protected Securities, so-called TIPS. Their returns adjust over time to provide a return over inflation.
TIPS "are the perfect riskless asset," says Douglas Fore, associate director of the TIAA-CREF Institute, the research and education arm of the big provider of retirement-planning services.
Other bonds will do poorly, however. When interest rates rise, bond prices tumble. That's because today's bonds carry low yields, and when rates rise, they will be worth less to investors.
Commodities of all sorts tend to perform strongly during inflationary periods. However, they aren't the easiest assets to own, since they're usually structured as futures contracts that expire in time.
Real estate is often a strong performer during inflationary periods, since the price of land usually escalates. This means owning a home or investing in a second home or vacation property might make sense. You can play real estate more indirectly by owning a real-estate investment trust or a mutual fund such as Alpine Realty Income & Growth Y.
Write to Jeff D. Opdyke at jeff.opdyke@wsj.com1
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Updated June 5, 2003 |
