The Most Important Call?

There is a great debate going on in parts of finance land, a debate that has been raging for months. Is the future of our economy, and global financial markets, going to be driven by inflation or deflation? Some of the analysts whose views I hold in high regard (Cam Hui, John Mauldin) think this is the most important call to get right for our investment portfolios. Cam goes so far as to maintain an “Inflation-Deflation Timer” model.

Why is this important? If inflation is in our future, holding bonds is going to get you hurt, and many types of stocks aren’t going to fare much better – in particular dividend stocks. In this environment commodities and precious metals are likely to be the winners. On the other hand, if deflation carries the day, bonds will provide superior total return, and many stocks will perform poorly, as would commodities.

This is a vexing problem. There are plenty of smart people, a lot smarter and more experienced than you or I, coming down on each side of this debate. Meaning, there is no easy answer by following the “smart money.” Of course it wouldn’t be so easy, in the markets nothing is easy. Some see in Japan the model of an economy following the bursting of a huge asset bubble, and forecast persistent deflation for the US and other developed economies. Others think the fiscal and monetary responses to the crisis, in particular the large and ongoing deficits and accumulated debt, will spark inflation and severely devalue the US Dollar,  Euro, and Sterling.

What, then, is an investor to do? A simple axiom is, when in doubt, don’t do anything you don’t have to do. Wait and see. An important part of investment success is what you don’t do. How then to position your portfolio when both deflation and inflation threaten? My response is, split the difference. For my bond allocation, I hold both conventional and inflation indexed bonds. For my stock allocation, I hold both defensive value-style stocks and commodity producers.

We will come back to this theme often. At some point, the scale is likely to tip in one direction or the other. When I see it, I go on the record. As usual in the markets, the key to success is to spot the emerging trend early, act decisively, and if the markets prove you to be wrong, reverse course quickly.

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