The “other side” of the deflation trade

Graphite here. I remain an ardent deflationist and continue to see strong risks of a continued collapse in asset values in world real estate and equity markets. That said, one key practice in speculation, no matter how strong one’s conviction in a particular trade, is to understand the other side of that trade and how the market could move against your position.

This can sometimes present a challenge for deflationists because so much of the opposing camp is composed of die-hard Panglossian buy-and-holders betting on a V-shaped recovery, rounded out with a few gold bugs who present little or no argument other than that the Bernanke Fed will embark on a suicidal campaign of massive money printing.

Although Marc Faber has issued calls for hyperinflation before, the discussion in the video below represents a much more measured discussion of a serious alternative to the near-term bearish case for stocks and the economy:

“My sense is that — here I’m talking about the economy — that the economy, near term, can recover, and maybe the recovery will be somewhat lengthier than expected a crack-up boom, because the first stimulus package in the U.S. probably will be followed by a second one, and money printing will lead to even more money printing next year. So it can last, say, 12 to 18 months, and then we will get another set of problems ….”

Faber goes on to recommend buying financial stocks, on the expectation that the banks will continue to get free money from the government and parlay that largess into significant profits. His long-term view remains as bearish as ever, but he presents an important alternative perspective on how soon the economic calamity will arrive and what form it will take.

That said, I think Faber is wrong that the market will continue to enthusiastically take up the Fed’s offers of liquidity and use them to fuel speculation for very much longer. No one is laboring under the delusion that the garbage stocks like AIG, FNM, and FRE which have led this last leg upward are worth anything more than zero — and while from a contrarian perspective that could indicate that there is room remaining for investors to develop an even more desperate belief in a new bull market, I think it is much more likely a manifestation of the new trend toward skepticism which will come to permeate the entire market as the bear runs its course.

Whatever your perspective, it’s always fun to see Marc Faber’s characteristic chuckle at the suggestion that our wise overseers will competently steer us through the crisis.

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9 thoughts on “The “other side” of the deflation trade

  1. I loved where she said, “last time you were on you said to buy a farm and a gun,” and he says, “now you need a machine gun.”

    And, “is there anything that could possibly derail your incredibly pessimistic scenario?” “Ahhh, no.”

    The point about Bernanke and any Fed member being a puppet is right on. These guys, like almost all politicians save Ron Paul or a Rockefeller or two, are just puppets of that crew in the lifeboat.

    The main case for the resumption of the crash implies a somewhat different view of exchange-based prices than Faber presents here. It is not so easy for the Fed or any governmental body to manufacture optimism. Money, yes, but not what people do with that money. Right now, to steal a line from Mish, banks are acting responsibly for the first time in ages, because they are not lending. The new money is just sitting on deposit with the Fed earning risk-free interest.

    Sentiment, plain old fear and greed, are what drives markets. For everyone save a few giant money center bankers, money is still exceedingly scarce and more so all the time. The printing is scary for your average investor, so he may be interested in hard assets in the market, but when he loses his job or his income otherwise drops and his debts stay the same and he can’t refinance, his bit of fiat money is more valuable to him than ever before in his life. He’s still going to be prone to panic in the markets. The dollar may someday go the way of the Weimar deutchemark, but it’s still a dollar for now.

    The waves of sentiment are key: we are at very high levels of market optimism here, despite a continued deterioration in the real economy. Market optimism must wane soon, simply because it has very little room on the upside. When traders swing from optimism to pessimism, the market falls, simple as that, no matter what monetary machinations are going on. With the general trend toward deepening pessimism (IMO), the stock market will eventually fall until it finds fundamental support in terms of dividends: people will want to be paid for the then universally accepted risk of high capital losses. That’s how secular bear markets bottom.

    That could happen in a couple of years at very low prices, maybe 150-200 on the S&P (about a 7% yield on say $10-15 dividends), or many years from now at higher prices, after earnings have increased from the inflation that follows deflation (whenever that may be). The first outcome was 1932 (3 year deflationary bear market), and the second was 1982 (the end of a 16 year inflationary bear market). Both bear markets delivered solid yields and values in the end, and both fell about 80% in real terms, though one fell 89% in nominal terms and the other only fell about 20% (if you count ’82 as the real low and not ’74, the nominal low).

    I just checked historical CPI here: http://inflationdata.com/inflation/Consumer_Price_Index/HistoricalCPI.aspx?rsCPI_currentPage=6

    CPI was 17 in 1929 and 13 in 1932. That was a gain of 30% in purchasing power, as the Dow fell from 381 to 41. Real loss: 86% if you sold in late June/early July 1932.
    CPI was 32 in 1966 and 96 in 1982. That was a loss of 2/3 in purchasing power, as the Dow fell from 1000 to about 780. Real loss: 74%.

  2. Faber is a smart guy so I wonder why it is that he is missing the fact that future earnings at banks are going to be smothered with festering past losses. He acts like their balance sheets are sound so that they can look forward to just having great earnings. I totally disagree with that and as soon as FASB reinstated M2M accounting the share prices of a lot of banks are going to crash.

  3. I think he is assuming that the Fed and Treasury will simply absorb all of the banks’ bad debts, with round after round of bailouts and printing.

  4. The problems with the banks’ balance sheets are old news to every market participant by now, and yet financial stocks which should obviously be worth zero (AIG, FNM, FRE, C, BAC, even Lehman, whatever their pink sheets symbol is) have been fetching a consistent bid for six months now. So Faber has already been proven correct that moral hazard and belief in government backstops can levitate the zombie banks for a significant period of time. As Janet Tavakoli puts it, the only reason to buy AIG equity is because you think the government will protect it “no matter what,” and that the future of the company is “a rigged game.” In that sense, the bid underlying the financials can be seen as a call option on the moral duplicity and corruption of public officials. I just disagree with Faber that this game can or will be maintained for another 12-18 months.

  5. Graphite: Not that it matters much but for how long do you really think the Govt. can keep on printing money to back AIG, FNM, FRE, BAC, C etc … 6 Months? I think until the next election …

  6. Re continued bailouts, Faber is wrong. It was already a struggle to get through the previous bail outs, it won’t be easy to get any more passed especially considering the ill feeling generated by the first ones. Add to that in October michael moores about to reveal all to joe public :-( )

  7. Graphite: RE ” No one is laboring under the delusion that the garbage stocks like AIG, FNM, and FRE which have led this last leg upward are worth anything more than zero — and while from a contrarian perspective that could indicate that there is room remaining for investors to develop an even more desperate belief in a new bull market”

    The move up in the Financials and Housing stocks could be a real good indicator of a Market Top being created as the last specualtors pile on … lemmings before a waterfall ….

  8. “It Could Get Ugly Very Fast”: Banking Crisis Grows, FDIC’s Funds Shrink

    http://finance.yahoo.com/tech-ticker/article/315700/%22It-Could-Get-Ugly-Very-Fast%22-Banking-Crisis-Grows-FDIC%E2%80%99s-Funds-Shrink

    “The failure of some of the nation’s largest banks in 2008, including Washington Mutual, Wachovia and IndyMac, and scores of smaller banks this year came at a price. The Federal Deposit Insurance Corporation’s fund that insures the country’s deposits now stands at $10.4 billion, down from $45.2 billion the prior year.”

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