August 16, 2011
Approaching the Black Hole of Debt Deflation
The Investment View from Prescott, Arizona
The world is discovering that much of the prosperity we all enjoyed over the past 30-40 years was due to the extra money sloshing around that was put into the economy by the use of credit and creation of debt.
When a bank has deposits of $1 million dollars they are allowed to create many times that amount in loans. This is called the “fractional reserve system”. If the bank makes ten $1 million loans there may now be ten borrowers that each act like they have a million dollars, too.
A lot of that borrowed money will go into real estate, from which the Realtors, carpet layers, surveyors and builders all make some money. Those folks then buy cars, take vacations, etc, further stimulating the economy. Some loans will be used to start new businesses and hire employees who all feel better off and begin spending money.
The ripple effect of borrowed money generates a powerful economic stimulus. When that stimulus is no longer there the withdrawal can be pretty bad – somewhat like a junkie who feels like he needs another fix.
With everyone, including our government, realizing we can’t borrow for ever, we are all going through “credit withdrawal”. The economic term is deflation as the reduction of credit reduces the amount of money circulating.
You may remember from Econ 101 that inflation is when there are more dollars than goods and the price of the goods gets bid higher and higher as consumers with extra dollars spend them, competing to get the goods they want. Often those extra dollars come from the granting of credit as I described above. The rising prices that result are the hallmark of inflation.
Deflation is the opposite, too many goods chasing too few dollars. The price of the goods keeps dropping until the sellers attract the dollars they need. Falling prices sound good to consumers, but they are terribly tough on businesses. It brings a relentless decline in the ability or willingness to borrow or lend.
As prices fall, profits get squeezed until goods eventually are being sold at a loss. Most entrepreneurs will try new lines of 
lower-priced items, add new features or look for ways to save money, like laying off workers to generate some profit.
And if profits aren’t found, business owners will either choose to slowly bleed to death while waiting for the turnaround, or just shut down and walk away. Few entrepreneurs give up easily. But whether they slowly go bankrupt or shut the business down, production of goods is reduced, which is what the capitalist model demands. With too many goods some of them have to go!
But in this process production declines, jobs are lost, and profits are not paid out. This persistent decline in production and the decline in the standard of living lower production creates is the hallmark of a depression. In several recent newsletters I have commented on the global slowdown in production, and I am concerned that instead of coming out of a recession that we are slipping into a world-wide depression.
I know everyone is worried about inflation, what with the feds printing so much new money and all, but despite the government efforts to expand the money supply, we still have a serious tug of war going on between inflation and deflation.
You see, it really doesn’t matter how many dollars are out there, if no one is willing to spend them or lend them. It has the same deflationary effect as not having enough dollars.
Deflation is a much tougher problem than inflation, and slipping into a deflationary spiral is a possibility. Let’s again go back to our Econ class to see how that spiral would work.
Deflation reduces the availability of credit. A depression involves a persistent decline in production. Since a decline in production further reduces the overall ability to repay and service debt, declines in production accelerate deflation. Since a decline in lending reduces new investment in productive enterprises, deflation contributes to depression (lower productivity). And the spiral goes on as these self reinforcing issues gain traction.
Because both credit and production provide positive support for the prices of investment assets, their prices fall during a deflationary depression. As asset prices fall, people lose wealth which reduces their ability to offer credit, service debt and support production, deepening the spiral.
A downward spiral begins feeding on pessimism just as the previous boom of the 1990s fed on optimism. The resulting cascade of debt liquidation can produce a deflationary crash which can often be as harsh to those who need cash to pay debts as the junkie’s withdrawal is to him.
The term depression is very apt, since the downward spiral becomes a psychological malady causing owners of dollars to hoard them and not spend or lend.
We have all benefited from the enormous build up of debt the past 30-40 years, but we are in payback mode. Almost everyone will see their life impacted negatively as deflation unfolds, but the people who do the best will be the ones who lose the least as our economy contracts.
A Slice of Life
I don’t know if you have ever been to a Shrine Circus, but one of my fondest memories as a child was my dad taking me there when I was a kid growing up in Chicago.
We have six tickets at the office for the upcoming Shrine Circus at Westworld in Scottsdale on September 16-18th. If you have a child or three that you would like to take to the Circus, just call to have tickets reserved for you. You can pick them up at your convenience. They are already paid for, so they are free to clients and friends who read this newsletter.
The Shrine Circus will have shows on Friday at 6:30 p.m., and both Saturday and Sunday at 11:00 a.m., 3:00 p.m. and 6:30 p.m.
The Emergency Notification System
Our county Sheriff’s office maintains an emergency notification system to notify residents in the case of emergency such as wildfires, floods, amber alerts, toxic spills or leaks and other natural disasters.
Until recently, all the Sheriff’s office had to work with was land line numbers from the phone book which meant that many people were hard to notify. Technology is changing all of that. With proper information residents can be quickly notified of disasters by email, text or calls to cell phones.
Consider going to the Sheriff’s website, listed below, to enter your cell phone, email etc., into the system. I’m hoping it never needs to be used, but if there is some kind of emergency, this information could be vital to you or your loved ones.
http://www.ycsoaz.gov/?page_id=1582
How’s the Market Doing?
The market crash last week was not unexpected. I had written about the deteriorating investment conditions for several months. But the quickness of it was still a surprise.
From the top on April 29, 2011 to the low last week, the S&P 500** lost 17.9% if its value. Small company, emerging markets and international Indexes all lost more than 20%, so it was certainly a bad time for stock investors.
I expect a breather as the market tries to regain its footing, however, there are several things suggesting there is still another shoe to drop before this decline is over so this is not the time to be loading up on risky investments.
Gold went up a lot over the past month while all the other metals (silver, platinum, palladium and other rare earth metals) went down. The questions this raises are (1) is gold’s rise now ahead of itself, meaning it is ready for a decline? Or, (2) is gold the leader and the other metals just need to catch up?
Gold (a currency of sorts) has run up in price as governments printed money madly and in the process devalued those currencies. Since gold can’t just be printed, it can’t be devalued this way and often goes up as other currencies go down.
With a wink and a nod among central bankers that said “it’s your turn”, the European Central Bank just announced that they will back the struggling economies of Portugal, Italy, Ireland, Greece and Spain (sometimes called the PIIGS) with 800 billion yet-to-be-printed Euros, more than our Fed spent in our recently completed QEII. As a result, I don’t think the run-up for gold is done, even though gold could be due for a correction before its upward trend continues.
Mental Floss
Q: How high would you have to count before you would use the letter A in the English language spelling of a whole number.
A: One thousand
What’s Going On In Your Portfolio?
I hope most investors had their seatbelts on this last week or two as the markets roared ahead one day and crashed the next. The S&P 500** posted four back to back swings of over 4%, a rare level of volatility.
Our growth accounts* had pretty much retreated from the stock market before the carnage set in, and we benefited by the declines by owning an inverse fund, one that goes up as the stock market goes down for part of last week. Of course inverse funds go down as the stock market goes up, too, so our week for the Careful Growth* portfolios was pretty much a wash, which I am grateful for, considering all the losses occurring around us.
Flexible Income* accounts saw us exit our high yield bond and energy-income holdings and move into a rising dollar fund as investors from around the world voted the dollar to be the safest place to be as world markets crashed.
Gold hit all-time highs a few days ago, so our sizeable gold holdings in both growth* and income* accounts have served us well.
Although the S&P 500** had lost over 13% in just 6 trading days at the beginning of August, Hepburn Capital clients felt barely a ripple in their account values due to the mix of investments we held.
If you have friends who were hit hard in this downturn, suggest they come in to talk with me before the next wave down in the markets. Forwarding this newsletter is a great way to break the ice. Click here to Forward this email to a friend.
Please don’t keep me a secret. Telling your friends about me is the greatest compliment you can give me.
Our Spotlight Strategy
With Balanced Strategy we strive to provide high total return. Your money will be invested in a 50/50 mix of HCM’s Flexible Income and Careful Growth strategies.
* The model accounts mentioned in this article are hypothetical examples of how the strategy may work as designed. Activity in client accounts may be different from that in the model in amount of each investment, specific timing of trades, and actual security used, which may vary from account to account. Not all trades are profitable. It should not be assumed that current or future holdings will be profitable. A list of all trades in these accounts for the past 12 months will be provided upon written request.
** The S&P 500 and Nasdaq Indexes are unmanaged lists of stocks considered representative of the broad stock market. Investors cannot invest directly in the S&P 500 Index.
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