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How to Bullet-Proof Your Portfolio for Deflation


Plan accordingly for falling prices.

When it comes to portfolio construction, perhaps the most important and basic question investors must answer is this: Are we confronting an environment of rising or falling prices in the future?

It's the inflation boogeyman that's stalked the narrow canyons of Wall Street recently but, on Monday, San Francisco Fed President Janet Yellen shut that monster back in its closet with a smart speech that supported a much more cautious view of the US economy. (See also: The Problem with Janet Yellen's Recovery Outlook)

Yellen, who some argue is one of the more astute forecasters at the Federal Reserve, said that the summer probably marked the end of the US recession, and that the economy is back on track to expand in the second half of the year. However, she also argued that the recovery will prove tepid, "vulnerable to shocks" with an unemployment rate that will remain "elevated for a few more years."

Yellen, a voting member of the Fed's Federal Open Market Committee, also sided with those who worry about a downward spiral in prices rather than inflation. (See also: Why We're Facing Deflation)

"My personal belief is that the more significant threat to price stability over the next several years stems from the disinflationary forces unleashed by the enormous slack in the economy," she said.

If Yellen is right, and deflation remains the principal risk we now face, then how best to construct a portfolio?

In general, according to strategists and investment advisers, it's going to mean staying more bullish on bonds than stocks, including long-term Treasurys and munis. Investors would also want to pack their portfolios with yellow metal, advisers add, and maintain a healthy slug of cash.

Dedicated deflationists come armed with scary data: Rents are declining for the first time in 17 years. Consumer credit is contracting at a rate not seen in 65 years. Wages and salaries are shrinking at an unprecedented annual rate of nearly 5%.

In brief, writes David Rosenberg, Gluskin Sheff's chief economist and strategist, "We have a deflation on our hands of epic proportions."

The key to the inflation process, says Rosenberg, is not what the Fed is doing to the money supply but the extent to which the "liquidity" is being circulated in the real economy, if at all.

The fact is that velocity is still contracting. "You can bake a cake as a central banker, but that doesn't mean anybody is going to eat it," Rosenberg writes in a recent research note.

As for investment implications, Rosenberg is telling his clients to focus on income and capital preservation. He's more bullish on bonds than stocks, noting that investment-grade credit is discounting 2% real growth versus 4% for US equities.

For the risk involved, Rosenberg argues, corporate bonds are more attractive relative to equities, which offer historically low earnings and dividend yields.

It's also worth pointing out that the S&P 500 index is trading north of a 26 times P/E multiple on trailing operating earnings, the strategist points out. History shows that at these high valuation levels, the market declines in the coming year 60% of the time, Rosenberg says.

Mike Shedlock, a registered investment adviser for SitkaPacific Capital Management, is also a member of the deflation camp, believing that a decline in prices looks a lot more likely, he thinks, than runaway inflation.

A deflation-fighting portfolio, Shedlock says, would have long-term Treasury bonds. The thinking there is that, should we suffer a deflationary environment, there will be a flight to safety by investors. Also, the fixed-income stream would be worth more relative to falling prices, Shedlock notes.
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