Digest readers know our opinion on the inflation/deflation debate... We believe reckless government spending and massive deficits will eventually lead the U.S. into a period of runaway inflation. But the market is moving against us...
Treasury yields are less than 3%. The consumer price index fell an annualized 0.1% over the past two years. Banks aren't lending, and people are being more cautious with their money. Where did we go wrong? Surely, trillions of dollars injected into the U.S. economy must spur inflation.
Well, we hadn't accounted for the "Tea Party risk." Conservatives are poised to regain control of Congress. And the market is starting to price in that possibility. What would happen if these radicals gained power? It would be a replay of the 1994 Contract With America. Six weeks before the 1994 congressional election, conservatives (led by Newt Gingrich) promised to shrink the government, cut taxes, and generally encourage entrepreneurial activity. In the preceding years, government debt had spiraled out of control. People were fed up. The Republicans won, and the U.S. went from a debtor nation to running a healthy surplus. In other words, the country shifted from inflationary to deflationary policies. The same thing could happen in November.
Many of the world's best investors are positioning their portfolios for deflation. Jeremy Grantham, the prescient head of Grantham, Mayo, Van Otterloo, said he is willing to "throw in the towel on inflation." In his latest commentary, Grantham notes world governments are focused on austerity instead of more stimulus. He also points out high unemployment and stagnant real estate prices would keep people from taking cash out of their homes. Grantham is buying U.S. blue chips, as is our own Dan Ferris. Grantham is also focusing on emerging-market equities.
Bill Gross, manager of the world's largest bond fund at PIMCO, says "Deflation isn't just a topic of intellectual curiosity, it's happening." Gross is buying U.S. government debt (bonds perform well during periods of declining interest rates). Treasuries account for around 51% of Gross' $239 billion fund – the highest allocation in the past six years. Gross also tells investors to focus on "relatively certain" cash flows like dividends (equity) and interest payments (debt) from high-quality companies.
David Tepper, manager of the $15 billion Appaloosa Management hedge fund, has around 70% of his fund in "BB" and "BBB" bonds – the lowest investment-grade and highest "junk" bonds. "I'm concerned that slower growth may lead to a much tougher environment for pricing," Tepper says. "That can mean deflation in some industries, even if we get inflation in the overall economy."
Even if the conservatives take control of Congress, we will never see an extended period of deflation. People in this country will not accept declining real GDP. The government won't allow half of the banks in the country to close, small businesses to fail, or unemployment to soar. It's too painful. It's only a matter of time before they fire up the printing press again.
If the government moves to austerity following the November elections, it will only postpone inflation. Our government's obligations are primarily statutory, not discretionary. If you look at what the government will spend between now and 2018, it's all Medicare and Social Security. Those costs aren't subject to the will of whatever political party is in power. The laws and statutes are already in place. But the new government will cut taxes, which will only worsen our nation's financial situation and make the impending inflation much worse. Currently, the government is spending 40% of GDP every year and only raising 19% in taxes. That's a huge deficit.
Let's look at deflation from a different angle (never mind our country's poor financial condition). For deflation to occur, the public must prefer to hold cash. And for the public to prefer cash, the currency must be sound. But central banks can't maintain a sound currency. And no government in power will run a balanced budget. It's the same thing that happened before GM went bankrupt. The company couldn't afford its debt and was riddled with problems. Management said it would change everything. But it was too late. The problems in the system have been built up over the past 30 or 40 years. Could you imagine what would happen in this country if the government said it was canceling Social Security? We'd have riots in the streets. We're skeptical anyone can change anything. We're too far gone.
So how do you protect yourself? First, buy gold. Then, buy Dan Ferris' World Dominator portfolio. These are the best companies in the world... and one of the few undervalued sectors in the market. During deflation, these companies would still perform better than their competitors (though business would be down). Plus, they'll increase their market shares as competitors go under.
The World Dominators also will manage their capital structures better to achieve great returns on capital. In fact, they're already starting... Look at McDonald's recent bond issuance. And ExxonMobil just bought back another $2 billion in XTO Energy debt. The World Dominator portfolio is one of the best investments you can make today. We highly recommend you fill your portfolio with these stocks. You can learn more about World Dominators here.
New highs: Western Digital (WDC), EV Energy Partners (EVEP), Vanguard Natural Resources (VNR), Altria (MO).
In the mailbag, questions about some of our strategies. Plus, what's the best way to make 1,100% in 10 years? Send your e-mail to feedback@stansberryreseach.com.
"In your July 30 column, you indicate your readers should consider 'stink bids.' You describe it as an 'offer to buy a stock that's well below the market price.' In your experience, what level of discount from the market price could one realistically hope to achieve with a stink bid? In other words, are we realistically talking a 10% discount or a 90% discount or, presumably, somewhere in between? Your guidance would be appreciated." – Anonymous
Goldsmith comment: The optimal "stink bid" depends on the volatility of the stock in question. The higher the volatility, the further out you go. For example, a bid 20% lower than the market on a small-cap mining stock could realistically be filled. Mining stocks are volatile. Meanwhile, a bid 20% lower than the market on a blue chip like Wal-Mart will likely never fill. A bid 5% below market is fair for a low-volatility stock.
"I find Mr. Hroback's Annaly comment in the 7/30 Digest puzzling. Here is what I recorded from Porter's 11/7/08 PSIA when I bought the stock at $13.77 on 11/14/08:
"Buy below $14... Do not use a fixed stop because of possible volatility... Expect to sell at around $20 or @ 2X book value.
"The market value has increased 26% (15% annualized) and the average annual dividend has been 18% and increasing." – Paid-up subscriber Richard Shaw
Goldsmith comment: No matter how clear our instructions, some folks still stray.
"I am looking to make $2,000-$3,000 per month in income as I am unemployed. Which of your newsletters would be best for this purpose? I have at least $10,000-$15,000 to invest, to start. I would appreciate feed back." Anonymous
Goldsmith comment: Unfortunately, your goal is impossible. Producing $2,000 a month on $10,000 is a 20% return... every month. That's more than a 140% annualized return for the first year. If you continued generating $2,000 a month for five and 10 years, that's a cumulative 1,100% (64% annualized) and 2,300% (37% annualized) return, respectively. These are astronomical returns that no one can consistently produce. And your hypothetical returns would be even larger, as you would also invest your profits using the same cash-generating strategy.
However, I would recommend you start reading Retirement Trader. Doc Eifrig recommends several income-generating strategies that will help you produce super-safe income of around 20% a year. You can learn more about Doc's strategies, here.
Regards,
Sean Goldsmith
Baltimore, Maryland
August 2, 2010