Deflation: Who Would Have Thought?

freedom - 1

The more I invest, the more I realize that I do not know much about ANYTHING. For the longest time, my mind was fixated on the thought of early FI, so I did what many on the journey are taught to do…

I kept on investing… rain or shine.

They say you can’t time the market, but it also doesn’t take a genius to figure out if we are closer to a top or the bottom of a cycle. In the current state of affairs, our own bull market has now reached Year 7 and I’m guessing I’m NOT the only one who feels like this massive run is getting a little long in the tooth…

Ultimately, I don’t believe there is a single universal “right” or “wrong” answer as it pertains to investing. In other words, you just have to keep on doing what is best for your own unique situation.

With that said, it’s no secret to readers of this blog that I’ve had a change of heart as of late — I’ve liquidated out of most of my stock positions and I’m sitting mostly on cash these days…

Deflation… Say What?

Ask most investors what they worry most about, and a majority will answer with “inflation”, or something of the sort. Naturally, we all worry about inflation whether it’s when we go out grocery shopping, or when we are filling up the tank at the gas station.

When you look around you, it seems like inflation is just about everywhere! Real estate is up. Stocks are still soaring. The bond markets are at an all-time high. The amount of derivatives the big banks are playing with is a staggering 1 quadrillion dollars… Yes, that’s $1,000 trillion… an unfathomable amount that I’m not sure anyone is capable of really processing.

So, it’s all about: Inflation, Inflation, Inflation…

Since the very beginning of my own early FI journey, I’ve aggressively tried to hedge against inflation with both stocks and real estate.

Check!

But what about deflation?

Hmm, I never thought about deflation… Just what in the world is that?

History shows that Americans haven’t experienced true prolonged “deflation” since the Great Depression… So why should I care now?

Deflation, as it turns out, is the biggest thing on my mind these days. When you look at the following chart, it’s clear that the current velocity of money is at an historic low (you can find money velocity charts anywhere but I like the following because it also plots the Nasdaq):

From Thorsten Consulting:

moneyvelocityvsnasdaq

M2 includes M1 (cash and checking deposits) along with “near money” (savings accounts, money market funds, CDs, time deposits, etc.).

According to the Federal Reserve Bank of St. Louis:

The velocity of money is the frequency at which one unit of currency is used to purchase domestically- produced goods and services within a given time period. In other words, it is the number of times one dollar is spent to buy goods and services per unit of time. If the velocity of money is increasing, then more transactions are occurring between individuals in an economy. The frequency of currency exchange can be used to determine the velocity of a given component of the money supply, providing some insight into whether consumers and businesses are saving or spending their money.

The classical Equation of Exchange most commonly expressed:

MV = Py

Where M = Money Supply; V = Velocity; P = Price Level; y = Real GDP

Where the product Py = Nominal GDP

In other words:

MV = Nominal GDP

So, you can print all the money that you want… but if no one is spending it, you aren’t “stimulating” the economy. It might as well be buried in the ground… or just sitting in the digital accounts of the big banks (which is where most of it probably lies)…

They say that money velocity is the “joker of the deck” because it’s something that no one can control; velocity is more behavioral, so if the consumer doesn’t have confidence in the system (economy), they aren’t going to be spending their hard earned dollars…

Although the government has gone through great lengths to prop up the markets over these last 7 years (real estate, stocks, bonds, etc.), those gains are all “paper wealth”, and it doesn’t look like anyone is really convinced that they are any “wealthier”… This time around, no one is taking the bait and “making it rain” everyday and night at the clubs, restaurants, gadget stores, etc..

I know I sure don’t feel like I’m “rich”! And I’m guessing the great majority of the public doesn’t either because the reality of the situation is that stocks, real estate, bonds, etc. are investments that the bulk of the middle class doesn’t have access to. Most folks are living paycheck to paycheck and just barely scraping by… In Silicon Valley, I see some displays of ostentatious “wealth”, but even then, most of the $200,000/year income folks I know are even more frugal than me…

My own vibe is that a decent amount of everyday folks have indeed become much bigger savers than spenders… And that’s no way to grow GDP, or to stimulate one’s economy.

As An Investor…

As an investor, I’m in the interest of making money (obviously). But to do so, I’ve realized that I have to pay more attention to the news and what’s going on in the world.

And as I started to probe deeper, I’ve come to the conclusion that it’s deflation that is actually my biggest concern right now, not inflation.

For an investor to have strong confidence in the marketplace, one must have conviction that the economy is robust and healthy… For all the Quantitate Easing (QE) programs that have been launched, and after 7 years of Zero Interest-Rate Policy (ZIRP), is there really a legitimate recovery?

Why then, have wages been stagnant, if not dropping throughout the course of this recovery?

real-median-income

The topic of unemployment is a sensitive one; the government officially says ~5.5%, whereas many pundits feel like it’s substantially higher.

I have no clue, but if you look around, it’s easy to find charts that suggest the following:

194214_5_

Let’s shift gears to industrials, which typically provide a good insight into trending economic conditions.

From Zero Hedge:

CAT LT sales

That can’t be good…

Further, when President Obama took office in 2009, the national debt was about $10 trillion. Today, that debt now sits at about $18 trillion. Is that sustainable? Or are we on the precipice of disaster?

The debt problem isn’t exclusive to the U.S., of course, but it’s a serious problem that all countries are battling with. Just look at Greece.

Japan has a debt-to-GDP of over 200%. And we all know about Japan and their lost decades of stagflation that they have been battling… Could the same thing happen here as well?

I’m no economist, politician, or even remotely that bright, but all the above has forced me to look at things from a different angle.

A deflationary one.

King Dollar

But money velocity, stagnant wages, faulty recoveries, deficit spending, etc. alone aren’t enough reasons to cause me to defect to the deflationary camp; it’s just steering me away from thinking about inflation all the time.

The U.S. Dollar Index (DXY), however, is currently very robust and doing extremely well and rising:

As of July 22, 2015:

Screen Shot 2015-07-22 at 2.49.05 PM

With all the problems in Europe and China, the de facto safe haven for most investors is the U.S. Dollar. The euro has been weak. Ditto for the yen and most other foreign currencies.

The same applies to commodities as well — gold, silver, platinum, copper are breaching 4 year bear market lows relative to the dollar… WTI crude is down below $50/barrel again…

We are witnessing an epic deflationary chapter unfolding right before our eyes here!!!

A few months ago, I’m guessing that most investors never would have thought they would have another chance of snatching up blue-chips like Exxon Mobil (XOM) for under $82/share, or Chevron (CVX) for under $94/share

Not to mention, the very likely possibility that you will be able to soon purchase physical gold bullion for under $1,000/oz… Or, gold mining stocks like Barrick Gold (ABX) that are now trading at 24 year lows!

All hail the world’s reserve currency. King Dollar is the place to be right now!

Being Prepared

Although I’m sitting on a lot of cash right now, I’ll admit that it’s not my preferred place to be long-term. Back in May, I began aggressively selling out of my stock positions because I had a certain unease about the market. To date, those fears have not abated, and if anything, I’m even more reluctant to get back into investing now than I was then…

As always, I think it’s important for investors to proceed with caution when it comes to investing. Recently, I surpassed my childhood goal of becoming a net worth millionaire. Obviously, this is an accomplishment that I would like to preserve… Unlike in 2008, this time around, I will have a lot more to lose if a market crash happens!

As it pertains to deflation, I do feel that if there is another collapse (yes, I’ve got to play devil’s advocate from time to time… I can’t always be a permabull) that we will first witness a massive deflationary environment with all the debt deleveraging that will take place. At least until the government can intervene and inject some “medicine” to save the markets.

In other words, perhaps another “opportunity of a lifetime” for investors to snatch up more high quality assets will present itself!

Future Moves

Markets are dynamic and things change. Quickly.

All along, I’ve been fixated on inflation and all the assets that I’ve acquired to date have been strong inflationary hedges. When it comes to that other side of the coin, I’ve mostly remained ignorant and ignored deflation.

Completely.

Until now.

With gold and oil crashing, you can be certain that I’m paying close attention to the commodities markets. Although this mantra is often overstated, I will ALWAYS believe it to be true:

Buy low and sell high.

I believe in market cycles. I got into real estate at a very opportune time and made a fortune. I’ve watched my retirement portfolio increase by 200% since the stock market bottomed out in 2009 (like most investors have).

It was all luck.

Right place at the right time.

So, I’ve cashed out of stocks… I’m not that greedy and don’t mind taking profits off the table. If real estate weren’t so illiquid, perhaps I would do the same as well… Cash flowing real estate isn’t immune to a market downturn, but it’s perhaps the best place you can be as a real estate investor.

From my experience, it’s all waves and cycles. That’s all investing is!

Right now, there’s a lot of pain in commodities… But I’m going to try and remain patient as long as I can… My intentions are to snatch up some bargains when there is full capitulation and blood in the streets.

You can make money in an upmarket but you can make a ton more in a downmarket!

It’s my preferred method of investing…

Yes, I’m sitting on a lot of cash now… But that’s only a temporary position. Right now, I’ve got my eyes and ears alerted to deflation.

In the meanwhile, I hope that inflation is somewhat tame as it relates to groceries. I’ve got to stopby the market later today and pickup some popcorn.

Things are about to get REAL INTERESTING over the next few months! 😉

 

Happy Investing!

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8 Comment authors
Sitting on the Sidelines (The Art of Patience)FI FighterJohngeorge puckThe Dude Recent comment authors
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Midwestern Landlord
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Midwestern Landlord

If we have learned anything over the last 15 years, markets tend to go up and down in vicious cycles. Greed then fear. Greed then fear. Obviously impossible to perfectly time, however I agree with you that it does not take a rocket scientist to see at what end of the spectrum we are currently at. I tend to avoid the stock market all-together because I believe in solid, income producing real estate much more. I am not looking for appreciation in real estate, I am looking for cash flow. So if values go down, it is not an issue for me. If rents go down, it hurts a little, but at the end of the day people need a place to live. It’s not as if I am trying to sell ice to an eskimo. Combine that with low interest 30 year fixed rates (which I have in place) and I believe that to be a winning formula.

Couple more thoughts on your article:
“If real estate weren’t so illiquid, perhaps I would do the same as well… Cash flowing real estate isn’t immune to a market downturn, but it’s perhaps the best place you can be as a real estate investor.”

I understand the premise, however, I would not underestimate the power of holding class A properties with low rate 30 year fixed rate financing (which you have some of). I would never sell these assets given the financing structure.

Low Current Velocity of Money – My main thought on that is you are correct, a majority of people are paycheck to paycheck. They are just trying to get by. The way the system is today, a small percentage of the population holds a large portion of the wealth. Kind of hard to get high velocity of money in that environment.

Alexander @ CashFlowDiaries
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I dont blame you one bit Jay for doing what you are doing. It actually makes sense after reading this article. It really is just a matter of time before it comes crashing down again but how hard will it fall is what bothers me.

As MidWestern indicated as well, I have a few class A properties here in Austin as well as some good class C properties in the Mid West and luckily, because I bought them all cheap I am not concerned so much with what happens with the appreciation. It really is that cash flow that I will concentrate on and as long as I can lower rents a few hundred dollars and still break even at worse, I would consider that a huge win and just ride that out.

We’ll see what happens like you say. Should be very interesting but I like the way you think on this and it sounds like when the time comes, you will be aggressive in picking up some bargains. Smart!

Retire29
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I have a really hard time believing deflation is in the cards with such an accommodating Fed. If Yellen defers in September, the dollar will probably lose 1% overnight. Defers in December? Maybe lose another .5%. I know we’re seeing some high-profile deflation (commodities, energy) and very low wage inflation, but the dollar can’t strengthen forever, can it?

Eric

The Dude
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The Dude

Great post FI. I love your thinking here. Very well done.

I tend to agree with Retire29. I don’t think we’ll see much deflation in the U.S. I think we’ll see some deleveraging internationally, particularly China. Perhaps we’ll see a tad bit domestically, but I think something major would need to happen like energy taking a big hit. I don’t know what effect the Iranian sanctions being lifted will have on energy prices or whether or not this could precipitate another drop in energy prices. What I do know is the world is awash in oil right now and it’s unlikely to change anytime soon. Arguably the more important question is what the lower oil prices say about international economies and ultimately what effect that will have on the U.S. economy. If international economies are slowing down and the U.S. Dollar is strengthening, then exports will also be impacted.

There are a lot of people who make a really big deal about our national debt. I personally am not worried about it as long as we can continue to grow our economy. We are certainly not at risk anytime soon of becoming Greece. Greece is in a very unique situation since they have virtually no control over monetary policy. They are at 25% unemployment and have basically no way to kick start their economy and grow their way out of their debt. This signals another problem with the Euro economy. They are making very questionable decisions that will impact their growth. Bernake wrote a great piece about this recently. A slow Eurozone will impact US growth.

No Nonsense Landlord
Guest

Once the baby boomers retire, you will start to see average wages get pummeled. The baby boomers did not grow up with the entitlements that there are today. Many served in the military. Many have had, or still have, solid jobs.

The next generation grew up with more entitlements. Having more kids than they could afford. Skipping high school and college to live a minimal life on welfare.

And forget the rest of the generations…

Of course it’s not everyone that does not achieve what the baby boomers have, but a larger percentage of the newer generations have not achieved what the greatest generation to ever have lived in the USA has.

george puck
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I think we have to be careful about proclaiming a deflationary environment.

Many of the commodities being based in US dollars are being forced down in price because the dollar getting stronger. I dont know that we are seeing deflation if you measure it in say Can$, or Euros.

Plus as others have mentioned I think the fed just dumps money into the economy if we actually see inflation.

One thing of note, there was deflation in Weimar Republic right before hyperinflation hit.

I am not suggesting we will see the return of hyperinflation, but I am saying that deflation doesnt necessarily continue.

I expect that sooner or later we will see a devaluing of the dollar, I think some of the strength in the dollar has been due to a lot of the odd things going on in other parts of the world. Ie a flight to safety from countries like Russia, China, the middle east and Europe who are trying to shelter their assets during some uncertainty in the different places in the world.

I suspect that we will see that reverse. Either our economy will slow of the fed will print money or both.

The CEO of Core Labs is suggesting Us crude production peaked in April, and that guys like Boon Pickens, Harold Haim and Rich Kinder all have said that the price of oil is in equilibrium closer to $70 than $40.

I could see a pullback in the US stock markets, I have sold some stocks that made large runs and increased my cash. I think we might get a 10-20% pull back. But i dont see a full fledged panic. And I am looking right now for potential stocks that have already corrected. It looks to me as though pipeline MLP’s have oversold. ( I added to my position in KMI today, pipeline even though its not technically an MLP) If I had some taxable accounts available I would look at ETP or perhaps Williams as well.

I wouldnt get into too much of a defensive mode in terms of selling everything. If anything I would look at my assets that have moved up the most, and think about selling a few. Having read most of your posts, holy cow I would look to sell a couple of the side hustles, and might consider selling some of your out of state properties whose cash flows are volatile and whose property values have gone up.

I suspect if you really looked at your portfolio, you could sell some assets and pay off a couple of your class A bay area properties. Hold those for 30 years, they will always cash flows and I guarantee over 30 years+ you will have done incredibly well in terms of total return.

The only way you get hurt on a roller coaster is to jump out while it is moving.

Have you ever read “Random Walk on Wall Street”, if not I would highly encourage you to check it out. The book is fairly old, but it is an excellent work that describes the importance of being invested in the market and riding out the downturns in the market.

John
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John

When you say you are in cash it is bonds, CDs, TIPS or just plain cash lying in the bank account?
As a fellow Bay area resident I can attest that the prices of houses in SF and Silicon Valley makes me very worried. How large is your cash position (% or $$ numbers)?

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