Tuesday, December 23, 2008

Deflation, Reflation, and INFLATION

We are hearing so many talking heads screaming about how deflation is the phenomenon that we are least able to control. Others refer to the current increase in the money supply as given by the Federal Reserve, the so called bailouts, and the stimulus--both past and forthcoming as simple REflation. They argue that we are reflating because of the "wealth effect" whereby much wealth has recently been destroyed through losses in the equity markets and commodities markets alike. You can call it whatever you like, but we are creating money and that will lead to inflation. Yes we have seen a decline in prices---on the upside we blamed speculators and on the downside we are calling it deflation. The commodities markets simply overshot on the upside and have since over-corrected. With gasoline at $1.50 per gallon are we going to see increased consumption? I am not even going to answer that question.

So here is my thesis on where we are in the FLATION cycle. We have seen the rapid decline in prices as described the preceding paragraph. Investors have been scared senseless and money is waiting on the sidelines---some have even referred to it as a CASH BUBBLE. Some are afraid for their jobs and are consuming less, some are scared of the markets and are investing less, and some are probably just stuffing cash in the mattress. All of this leads to less rational financial markets. The banks are afraid to lend at the current time. Toxic has become a word that no-one upon no-one wants to have describe anything on their balance sheet---especially any new entry. So we have cheap money--but perhaps the most limited access that we have ever seen. We know that more government intervention is on the way. We are going to see a huge stimulus, help for the homeowner, and a huge investment in infrastructure. The question is not whether the economy will get going again---it is a matter of when and how fast.

It is impossible to know everything in this game--so I try to trade what I do know. I have no idea WHEN money will begin to multiply normally again. But I know that it WILL. And I know that when it DOES, I can make money in commodities and certain equities. My natural gas play got a nice boost today and I expect more. I have always heard that the markets can stay irrational longer than you can stay solvent, so I took a small position in natural gas and have been adding to it. Careful position sizing makes good sense and keeps me in the game. I believe that we are going to see money flow again in the summer of 09. As I said last night, China is still growing. We have financed by far the most of any country and as the dollar falls, we will gain some boost from exports, just as we did last summer. I believe that it may not be one thing that gets us going again. My fear is that we are going to see many factors such as a rise in exports, increased demand out of China for commodities, and decrease in unemployment domestically from the stimulus contribute to economic growth---all at the same time and light the flame of HYPERINFLATION.

Many are making the argument that banks are taking the government money and just rebuilding their balance sheets. Lets assume that these pundits are right and the bloodletting and subsequent government injections wind up to a zero sum game (they don't but we will assume it for this example). If it was a zero sum game AND you had a stimulus, an auto bailout, a huge investment in infrastructure investment--you would still be creating inflation. Now add in the money that is on the sidelines (and I will point to the speculation that we saw in the summer as it related to oil) you are going to drive prices through the roof again. People are going to be pulling money out of the mattress and buying commodities. And this was our zero sum game example. The reality is that it is not a zero sum game. Many investors that have normally invested in stocks have been scared into the T-Bills and Certificates of Deposit. When you see that money return to equities and commodities---I will now use the "wealth effect" argument. The wealth will be recreated faster than ever in our history and it is going to be virtually impossible to control.

Just for the sake of argument, assume that I am right and we see things start to grow economically in the summer of 2009 and we see speculators return to bullish mode. Which political party is going to start screaming for CONTRACTION? Just as people are getting their jobs back are we going to use the necessary tools to fight inflation at the right time? NO WAY. Just as we see the light at the end of the tunnel out of the greatest economic fear in our lifetimes are we going to call for CONTRACTION?

My summary on the FLATIONS is simply this. Prices are DEflating (short-term), banks balance sheets are REflating (short term and with no multiplier effect--YET), AND INFLATION IS ON THE WAY AS DE AND RE WILL CAUSE IN!!!!!!


Anonymous said...

You are going to lose a lot of money. Instead of assuming you are right, lets just call it like it is....you are wrong

Thesis...call it what it is, an uneducated guess.

Tom C said...

Spot on imo.

Re: anon, its no coincidence there has never been a true deflation since the 1930's. no gold standard. 1st print, then inflation. simple.

Tom C said...

also im not sure if you have visited itulip.com, but they have a similar theory, Ka-Poom. First Ka: disinflation (a decrease in the rate of inflation, NOT deflation) and then Poom: money printing gone wild catches up and we go mini-weimar.

Anonymous said...

hyper inflation is kinda tough with unemployment headed up, salaries decreasing, companies deleveraging, and americans in debt up to their eye balls. Printing money does not help if you can't lend it to the mass insolvent.