Positioned for Stock Market Pullback

As commodity prices continue to pull back, I believe it is more and more likely that we enter a period of deflation since the scales in my previous analysis begin to tip towards price declines. This potentially has a material impact on stock valuations with an outlook of slower earnings growth and smaller PE multiples. It also favors bonds since the real yield on bonds will increase in a deflationary environment.

The length and depth of the deflationary period may be determined by the future actions of the Fed. If the Fed aggressively pursues QE3, then we could see a relatively short and shallow dive into deflation of under a year and less than negative 1% as measured by CPI starting in 2012. If the Fed chooses to let the markets run their course, then the deflationary period could be longer and deeper and stock market compression results in slower consumer spending due to a decline in wealth. Since I do not expect the Fed to voice any opinion on the QE3 for at least a few months, I believe the markets may increasingly factor in deflationary pressure going forward.

The PE multiple of the SP500

Source: http://www.multpl.com/

Borrowing from Schiller, the PE multiple of the SP500 is about 23x, relatively high compared to the mid-teen historical average. As outlined by Ed Easterling of Crestmont Research, during periods of stable prices the PE of the market increases. If, however, either inflation or deflation occur the PE of the market likely declines. See the following chart, which highlights the impact of inflation/ deflation of PE ratios.

Source: Crestmont Research

Under my sagflation thesis, I expect prices to fluctuate between inflation and deflation as fundamental economic forces and an activist monetary policy increase price instability. This implies wild gyrations in the stock market as the discounting of future earnings swings significantly due to changing expectations about future price trends and passes through the PE sweet spot of 0-4% inflation to either 5+% inflation or deflation, which typically result in low teens to single digit PE multiples.

So where is my money? A large weighting towards Treasuries with exposure to consumer staples whose costs likely decline, utilities in the domestic natural gas markets (where prices have remained low), tech companies with good dividend yields and that provide stable cash flow, fertilizer materials for growing food with a high dividend yield, and generic pharmaceutical.

The following is summary:

62% in 30-Year Treasury
6% IBM
5% BWP
5% KMB
4% TNH
4% FGP
4% CALM
3% UTL
2% TEVA
2% CA