Special Issue:

When Deflation Comes,
Cash Is King

When everybody is certain the economy and stocks will move a particular way, usually just the opposite occurs. That's just what happened this summer when deflation suddenly overtook inflation as America's primary economic problem. Mr. Murphy, of Murphy's Law, seems to take particular pleasure in messing up the plans of investors.

Deflation, of course, is just the opposite of inflation. Instead of seeing the value of money fall and the prices of goods rise, cash becomes much more valuable and prices decrease.

Deflation is clearly in control today as homes, oil, and even precious metals plummet in price. Now food costs are beginning to sink. Jobs are being lost in most industries. Most experts think that wages will also begin to fall within a few months.

The public is starting to show the effects of the deflationary squeeze. People are selling motor homes, pleasure boats, and many other big ticket items to raise badly needed cash. A disturbing 10% of Ohio's adult population is on food stamps. Of course, retail sales are also weakening.

..."> Association for Investor Awareness - Week of 11/26/2008 - AIA Advocate for Absolute Returns - Investment Strategies, Analysis & Intelligence for Seasoned Investors.
Association for Investor Awareness - Week of 11/26/2008

Special Issue:

When Deflation Comes,

Cash Is King

When everybody is certain the economy and stocks will move a particular way, usually just the opposite occurs. That's just what happened this summer when deflation suddenly overtook inflation as America's primary economic problem. Mr. Murphy, of Murphy's Law, seems to take particular pleasure in messing up the plans of investors.

Deflation, of course, is just the opposite of inflation. Instead of seeing the value of money fall and the prices of goods rise, cash becomes much more valuable and prices decrease.

Deflation is clearly in control today as homes, oil, and even precious metals plummet in price. Now food costs are beginning to sink. Jobs are being lost in most industries. Most experts think that wages will also begin to fall within a few months.

The public is starting to show the effects of the deflationary squeeze. People are selling motor homes, pleasure boats, and many other big ticket items to raise badly needed cash. A disturbing 10% of Ohio's adult population is on food stamps. Of course, retail sales are also weakening.

The Best Deflation Strategy

Although most people are hurt by deflation, investors can profit from a deflationary downturn. To do so it is only necessary to take the familiar rules about inflation and reverse them. Cash rises in value instead of depreciating. Real assets go down in price, not up. Interest rates drop rather than rise. It's all fairly simple. However, it has been so many years since the last deflation occurred, few investors remember what it was like.

The best way to make money from a deflationary downturn is to use the opportunity to buy deeply-discounted assets that you will sell for much higher prices when the economy starts to recover. Wise investors are doing just that by purchasing blue chip stocks at fire sale prices – a strategy we have been recommending for many months.

You Must Have The Green To Make The Scene

Because the ability to make bargain purchases is the key to making a deflationary cycle pay off, you should hold more cash in your trading account than you would do ordinarily. You won't earn much interest, but you will more than make up for the shortfall with the money you will save when buying high-quality assets at today's declining prices.

Where To Stash Your Cash

For most people, the best place to keep liquid assets is in FDIC insured certificates of deposit from secure banks. If your bank should fail, the government will print whatever amount of money is needed to make sure that insured accounts are restored. In an extreme case, you might need to wait a few days for your money, but you will get it.

As we said in our October 2 newsletter, you can get a list of current CD rates offered by top banks from Bankrate.com. www.bankrate.com Stick with banks that have at least a 3-star (***) rating. Here's an updated list of what's available now:

The Best CD Rates In The U.S. From Secure Banks
Bank 1-Yr APY 2-Yr APY Address Min Deposit
GMAC Bank 4.16% 4.35% http://www.gmacbank.com/ $500
Nationwide Bk 3.97% 4.16% http://nationwidebank.com $500
EverBank 3.92% 4.07% http://everbank.com $1,500
Centennial Bk 3.90% 4.30% http://www.centennialbank.com $10,000
Capital One 3.78% 3.92% http://www.capitalone.com $5,000

Getting Around FDIC Limits

To boost the public's confidence in America's banks, Congress just increased the FDIC insurance limit from $100,000 per account to $250,000. Please note that the $250,000 limit will expire on December 31, 2009. After that date the limit will drop back to $100,000. Consequently, you should not put more than $100,000 in a CD that will mature after the higher insurance limit ends.

The new $250,000 limit is high enough for most people, but many investors have more to protect. One way around the FDIC insurance ceiling is to deposit money in different banks. However, multiple accounts are troublesome to set up and monitor.

Now some innovative banks are doing the legwork themselves by creating insured accounts in several places for their customers. The individual accounts are then packaged into jumbo CDs that are sold to the bank's preferred clients. Because no account exceeds the $250,000 limit, the new CDs are FDIC insured even if they may be worth several million dollars.

If your bank doesn't offer these combined account CDs, you might wish to contact EverBank and ask about their Insured Advantage Certificates of Deposit. The bank constructs the insured CDs in amounts up to $50 million. Terms run from three months to five years, and returns are usually a bit above market rates.

T-Bills Shine

If you will accept lower interest rates, T-bills are also safe places to keep cash. The shortest T-bill maturity is 90 days. However, locking up some funds for three months at a time should not be a problem if you have ready cash available elsewhere.

Foreign Currencies Offer Double Protection

Another option for holding cash is the Merk Hard Currency Fund (MERKX). http://finance.yahoo.com/q/pr?s=MERKX Merk offers investors a diversified foreign currency portfolio that will rise in value if the dollar resumes its slide, as we expect will happen in a few months.

Some Cash Should Be The Folding Variety

When we recommend having plenty of cash available we are referring to actual folding money in addition to funds kept in banks. Some of the best bargains you will be offered during the economic troubles are likely to be at local sales where greenbacks will speak louder than checks.

You should also have a good supply of paper currency on hand because the digital money in your bank may as well be on the moon if anything disrupts the network. If the financial service industry continues to unravel, the Fed may need to declare a bank holiday while it tries to fix the mess. In either case, ATMs, credit card approvals, check verification, online banking, and the accounts themselves will be off line. That's when "mattress liquidity" will prove its value.

It is also possible in a banking emergency that regulators will restrict the amount of money customers can withdraw. That's what happened when 200 banks failed in 1988. In some areas, withdrawals were limited to $1,000 a month. We would have a hard time living on that allowance, and we bet you would too.

This year Goldman Sachs, Countrywide, and many hedge funds also suspended or put limits on withdrawals. The accounts were based upon failing investments not deposits. However, some commercial banks are in similar distress.

Keeping cash in safety deposit boxes is another way to go, but they have limitations. When many financial institutions failed during the banking crisis of the 1980's, some customers could get to their safety deposit boxes and others couldn't. If you want to use a safety deposit box to hold cash, it would be better to open one in a local trust company than in a bank.

Inflation Will Eventually Return

Deflation is the dominant monetary condition now, but a return to inflation is a virtual certainty longer-term. That's because the Fed is fighting the credit crunch and the economic downturn by flooding the economy with money. At some point, the sheer number of dollars will overcome the deflationary forces that are currently at work.

Because the amount of money being created by the government is unprecedented, when inflation returns it may be higher than we have ever seen in this country. On September 22, John Williams of Shadow Government Statistics (www.shadowstats.com) predicted that high inflation may return as early as next year. He also said that the more the government spends, the sooner the problem is likely to hit.

The conclusion to be drawn is clear: while you are making good use of the deflation cycle that is here today, you should also get ready for the period of inflation that is on the way. As we will show in the next section, many investments that are cheap today should deliver excellent gains during longer term.

And Investments Purchased Now Should Soar

Blue chip stocks that investors accumulate now at bargain prices should make spectacular gains when deflation ends and the economy gets going again. Look for leading companies that do business worldwide selling products that everyone needs. Examples that we have discussed in recent months include Coca-Cola (KO) http://finance.yahoo.com/q/pr?s=KO, Procter & Gamble (PG) http://finance.yahoo.com/q/pr?s=PG, Colgate Palmolive (CL) http://finance.yahoo.com/q/pr?s=CL, Kraft Foods (KFT) http://finance.yahoo.com/q/pr?s=KFT, General Mills (GIS) and http://finance.yahoo.com/q/pr?s=GIS, Johnson & Johnson (JNJ) http://finance.yahoo.com/q/pr?s=JNJ – to name only a few.

We think you should avoid buying small, obscure companies now. Such stocks are attractive when the economy is strong and blue chips are overpriced. But when you can get the best of the best companies at bargain prices, as you can do today, they are the stocks to buy.

Real estate is a traditional hedge against inflation. If you live in a city where the real estate plunge seems to be bottoming out –and there are many such places- we think you should get ready to do some bargain hunting. Because there are millions of people who will no longer qualify for home loans, rentals will offer the most potential for appreciation. 

Precious metals should also do well when inflation takes hold again. Just be certain not to over invest in them. We are entering the most difficult economic period in over 75 years and gold is up only 9.6% from its pre-crisis level. On September 29 when the bailout vote failed and the stock market plummeted, gold only gained $5.50. However, gold should shine when the value of the dollar begins to decline again.

Strong foreign currencies look very good. Even without the new bailout costs, the dollar was destined to fall in value due to the government's soaring debts. Now the downside for the dollar is much worse due to the additional trillions of dollars the government is spending to revitalize the banking industry.

Fortunately, you currently have a window of opportunity to exchange some of your dollars at fairly good prices. Because the dollar is a traditional safe harbor during times of trouble, it moved up when the financial crisis swept around the world. However, the panic buying won't last forever. When it ends, the dollar will be valued solely on the basis of its declining fundamentals.

The alternative currency of choice is the Swiss franc. The euro was pushed off center stage by political and economic problems in the European Union. After the conflict in Georgia, Russia's shared border with several EU countries is also casting a shadow over the euro.

On the other hand, Swiss currency has little geopolitical risk, so that's where you should be. Once again, EverBank is a good place to go for insured Swiss franc accounts and CD's, all of which pay interest.

The Bottom Line This Week

The deflationary recession that is at work today is an adversity that can be turned into an advantage by knowledgeable investors who have the courage to buy what everyone else is selling.

High quality stocks and other assets that are purchased at today's steep discounts can be expected to rebound strongly when the economy begins to recover. The same will be true of real estate, precious metals, and solid foreign currencies.

All of us at The Association for Investor Awareness
wish you and your family a very Happy Thanksgiving!


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Copyright 2010 The Association for Investor Awareness, Inc. All Rights Reserved

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Posted 11-26-2008 9:07 AM by Research & Editorial Staff