Strategy Going Forward

Increasing concern about the world's economy likely produces further pullbacks in the markets, in my view. The removal of government stimulus in most regions, outright spending cuts or tax increases by many governments, and tightening monetary policies are a recipe of slower economic growth and possibly deflation. Given the high debt levels of many countries, this economic slowdown could prove disastrous as yields on sovereign debt rise and slowly strangle government budgets already under pressure.

"I argue that the fundamental trends should naturally lead to deflation but the Fed is using all its power to stave off deflation and thus causing inflationary bubbles to emerge in the economy, thus causing price volatility."
                                        April 26, 2011 blog entry.

I update this view with the argument that the Fed appears to be hesitating, reluctant to roll-out QE3 due to a fear of encouraging stagflation. Thus I believe deflation is becoming an increasing risk, despite the CPI data year-to-date of inflationary pressures. Or, in other words, price volatility is increasing.

Yesterday the market cheered the decline in oil prices, reasoning that lower oil prices should stimulate the economy. I agree but think prices are long way from stimulation since prices remain above their five-year average. Instead I expect oil prices to continue to fall due to slower demand and possibly more supply, encouraging deflationary pressures in the economy.

                                                    Five-Year Oil Prices - WTI Crude Oil

                                                                                        Source: Oil-Price.net

Wages and salaries appear flattish due to excessive unemployment, financial assets are turning deflationary with the pullback in the equity markets, tangible assets are mostly deflationary due to the excess supply of housing and overhang of foreclosed properties, currency has become less inflationary as its decline slows due to austerity measures and the US dollar is viewed more as a safe haven, government austerity measures are likely a deflationary force in the economy, price increases for goods and services likely slow (pushing down CPI) going forward as the economy slows.

Within the broad deflationary investment outlook I have begun to map out potential future steps for my investments.

(1) Maintain 60+% position in 30-year Treasuries maturing in 2041 until yields fall below 3%, unexpected bullish economic signals are announced, or the Fed announces QE3. Additionally I plan to maintain my ~20% cash position and ~20% equity positions in high dividend yield defensive names.

(2) Once I begin to move out of Treasuries my first step is likely to pick up equity positions in high quality companies with attractive dividend yields due to a pull back. I believe the growing risk of deflation likely causes a compression in the average of P/E of stocks, pulling in all names despite quality. This step should occur before the market bottom and on a day when a significant negative surprise is driving the market lower (eg. China's economy stalls, the yield on a major European country's debt spikes, or Japan default risk spikes).

(3) The last step becomes the trickiest. The goal is to move into high beta stocks shortly after the market bottom. The market bottoms well before things begin to look brighter so for this step I likely rely on technical support levels in the SP 500 of 1,000, 800, and possibly even 683 (bottom on March 6, 2009) if things get really bad. The Lehman collapse and financial markets paralysis was really bad, but sovereign debt defaults and mass strikes/ riots in the streets like we have started to see in Greece and the Middle East I think would be worse. Not that I think this will happen, but just to point out there is always a worse scenario.

So I'm the bear but in this increasingly polarized world of jittery debt markets and where hard decisions need to be made about how to shrink deficits and debt I see great potential for very ugly scenarios.