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In this article we will explore the ability of stock market valuations to predict both eventual investment returns and the risk of subsequent losses.  This is a topic about which we've written before: bearishly prior to the 2008 crash, bullishly in late 2008 after the bulk of the crash had taken place, and then bearishly again -- prematurely, it would seem -- in late 2009.  (These past articles are included for historical context; all necessary background will be provided below). 

Summary

• While continued low inflation or another bout of price deflation are both possible, there are several factors -- none of which require an economic recovery -- that could prevent deflation or even cause inflation to surprise to the upside. 
  
• In the event that deflation does take place, we believe it will be met with a powerfully inflationary policy response.  As a result, any foray into deflation will likely be relatively brief.
  
• Any deflation-fighting policies enacted will further strengthen the already robust, fundamentally-driven case for a significant eventual loss of dollar purchasing power against things that people need to buy.
• Rather than speculating on inherently unpredictable short-term events, we prefer to own a diversified basket of investments that stand to benefit from our high-confidence, fundamentally supportable long-term forecasts.
  

Definitions

In this article we employ the standard usage of the terms "inflation" and "deflation" as protracted changes in the aggregate price level of consumer goods and services. Some analysts describe changes to the money supply, system credit, or asset prices as inflation or deflation.  These are all important factors that exert an impact on general consumer price levels, as we described in a previous article on the mechanisms of deflation, but we think it only confuses matters to use the same term to describe multiple phenomena.  For this reason, and because this article concerns itself primarily with the purchasing power of US dollars, we will stick with the most commonly accepted definition of inflation and deflation as changes to consumer prices.

Neither Deflation nor Continued Low Inflation Are Certainties

Our monetary and political system is so biased towards inflation that it took an unprecedented private sector credit collapse -- along with the attendant financial market panic, severe economic downturn, and energy price crash -- in order to cause just six months of CPI deflation back in 2008.

The implosion phase of  private sector deleveraging is already behind us.  We do believe that a credit bubble still exists, but that it has moved to the government debt sector.  As we will discuss below, a crisis in government debt would not be deflationary in the way that the private sector credit collapse was.  So it is far from assured that there will be another wave of deflationary force sufficiently massive enough to overcome our systematic inflation bias and push us into outright deflation.

Meanwhile, there are several potential circumstances that could overcome the current economic weakness and continued (though much slower than late 2008) debt deleveraging that are both currently keeping inflation low:

-- More quantitative easing.  At the last Federal Reserve policy meeting, it was ordained that the proceeds from maturing mortgage-backed securities and bonds (purchased during the prior round of quantitative easing) would be rolled over into purchases of US Treasuries.  This policy move put to bed any talk of an "exit plan" for the Fed's wildly stimulative monetary policy.  It also sent a signal that the Fed is willing to use quantitative easing ("QE" -- a fancy term for the direct creation of new money in order to buy assets) not just as a crisis measure but as an ongoing policy tool.

This latest move takes place at a time when inflation is still positive and the stimulus-driven recovery, while feeble and getting weaker, is still somewhat intact.  More quantitative easing could well take place if the current lull continues, but in our opinion, QE2 would be almost a sure thing if the economy were to take another leg down or the CPI were to start dropping. 

The first round of QE appeared to help put a fairly quick end to CPI deflation, but there are too many factors involved to be certain of causality.  Still, logic dictates that if QE causes new money to be created and circulated, prices of at least some items will go up more than they would have.  In addition to increasing the amount of money being circulated, quantitative easing could also cause a loss of confidence in the dollar -- also a potentially inflationary outcome.

The money created by QE1 tended to just sit in reserves, so it did not get into general circulation in sufficient amounts to create much overall CPI inflation (although one could argue that it was sufficient to forestall further deflation).  But that need not be the case with QE2.   If the Fed monetizes US Treasuries, then the newly created money being supplied to the government can be disbursed to consumers via fiscal stimulus measures (see next section).  If that doesn't work, the Fed could monetize other assets or make purchases from non-banks in order to get the new money into wider circulation.  While not specifically quantitative easing, the Fed could further widen monetary circulation by directly granting loans to private parties.  The options available to the Fed are many, and the Fed has both stated and demonstrated that it is willing to use non-standard policies to boost inflation.

Another round of QE seems likely if the current stagnation continues, almost assured if we actually dip into deflation again, and could very well head off deflation or even cause a surge in inflation.  Just based on the possibility of further QE alone, we'd be very hesitant to declare future low inflation or deflation a sure thing.

-- More fiscal stimulus.  Unemployment is stubbornly high, voters are unhappy with the weak economy, and high-profile economists are screaming that another Great Depression is guaranteed without huge further stimulative efforts.  Under these circumstances, it's not unrealistic to expect more fiscal stimulus.  If we were to dip into actual deflation again, the case for increased stimulus would become stronger still.

Scattered mentions of austerity pop up here and there, but in most cases we believe that this is just empty electioneering.  The reality is that few politicians are willing to be the ones to force meaningful belt-tightening, especially should they find themselves in the midst of a deflation scare or serious economic downturn.

More stimulus is likely at some point, but given the widespread public bitterness towards Wall Street, future spending will probably not be aimed at propping up the financial industry.  Instead, the next round of stimulus is likely to target jobs, wages, and general spending within the economy.  Such spending programs would be more likely to stoke inflation than the prior bank-bailout stimulus.

-- A falling dollar.  There is a widespread belief that inflation can't take place in the absence of rising wages, but this is not the case.  A decline in the foreign exchange value of the dollar could drive up import and commodity prices for Americans, causing a loss of dollar purchasing power even in an environment of stagnant wages.

Currency-driven inflations against a backdrop of (often extreme) economic weakness have been quite common historically, so we are puzzled as to why this possibility is completely ignored by most analysts.

A currency-driven inflation would likely not consist of an across-the-board increase in prices.  Prices of items affected by exchange rates, such as food, energy, and imported goods, would rise even as items that weren't affected as much by exchange rates -- notably, housing -- stagnated or declined.  The price indices, averaging out all items as they do, might not even look like they were rising much, but this would feel very much like inflation as people would find that their money was losing purchasing power against the things that they needed most.

A sufficiently large dollar decline could additionally undermine confidence in the currency, leading people to exchange their dollars for more reliable stores of value and driving prices up further.

-- A US government debt crisis.  We believe that a crisis of confidence in US government debt at some point is a high-probability event.  The reason, in very brief, is that the US has amassed enough foreign debt that there is no politically feasible way to pay it off in real terms. Eventually, we believe, our creditors will come to understand this reality and will begin to price it into our debt.

A crisis in Treasury debt would look very different from the deflationary private-sector credit bust of 2008.  Back then, Treasuries and the dollar were the so-called "safe havens" to which panicky investors fled.  If the US government's solvency came into question, that safe haven status would be lost and investors would likely be clamoring to get out of the very same assets that they piled into in 2008.  A resulting flight out of US dollars could have the inflationary effects described in the "falling dollar" section above.

The inflationary potential would likely be exacerbated by the belief -- probably correct -- that the Fed would monetize Treasuries in order to keep a lid on rates, thus substantially increasing the money supply.

The timing of a crisis in US sovereign debt will be driven more by crowd psychology than by anything else, so we don't think it's possible to predict ahead of time when it will take place.  But we believe that something like this will occur, that it is likely the next big crisis that our nation will have to face -- and that it has the potential to be highly inflationary.

-- Rising commodity prices.  A steep drop in the dollar's value would not be required to drive up prices of energy, food, or industrial materials.  Increased economic activity in foreign countries (even if US did not participate) could lead to rising commodity prices -- as could the gyrations of the markets, which we've clearly seen can often be completely unpredictable in the short term.   In spite of the lack of a robust recovery in the US, prices of many commodities have been surging lately.

None of the potentially inflationary outcomes listed above requires robust economic growth to take place.  In fact, some of them -- quantitative easing, fiscal stimulus, and a government debt crisis -- are more likely in the absence of an economic recovery.  A stronger recovery would likely cause more inflation as a result of increased bank lending and consumer spending, but a recovery is by no means a prerequisite for inflation.

Any of these outcomes could do more than just offset the deflationary pressures in the economy and keep us from dipping into deflation.  Depending on their magnitude, they could also cause a fairly serious increase in inflation, at least in the goods that Americans most need.  Continued low inflation -- which many analysts consider to be guaranteed -- is almost as far from being a sure thing as outright deflation.

Any Deflation Will Sow the Seeds of Its Own Demise

The US government is able and willing to do whatever it takes to prevent a serious deflation.  This conclusion is so self-evident that we don't even understand why it's a matter of debate.

We very thoroughly dealt with this topic in an article we wrote at the depths of the deflation panic in January 2009, so we aren't going to rehash it here.  We will just note that right around the time the article was written, the government intervened with even more massively inflationary policies and the price deflation soon came to an end.  Both ensuing policy and the results of that policy have overwhelmingly supported our thesis that the government can and will head off long-term price deflation.

If we were to experience another round of deflation at this point, the government would surely intervene with a similar if not even more dramatic policy response.  And to the extent that didn't have the desired effects, the government would step up the inflationary policy until something succeeded. 

Such policies work with a lag, so it's possible that prices could deflate for a while.  But we would expect that lag to be on the scale of months, not years as suggested by so many analysts -- including those who are predicting a similar experience to Japan's, which we have shown to be a completely inappropriate comparison.

Whatever the exact nature of the deflation fighting policy, at its core would be an effort to create more money and to get that money to be spent in the general economy.  Over time, an increase in the amount of money being spent in excess to economic production eventually leads to a reduced value for each unit of money -- inflation, in other words.  So the policy response to more deflation would sow the seeds of even more purchasing power loss in the future.  The worse the short-term brush with deflation was, the more money would be created, and the more inflation eventually to come.

Focus on High-Confidence Outcomes

Several of the factors that could cause an increase in inflation -- the dollar's exchange rate, the risk premium on US Treasuries, and commodity prices -- are determined by financial markets.  And it's abundantly clear that while markets almost always eventually move toward their fundamental values, they tend to react more to crowd psychology in the near term.  So while fundamentals are an excellent predictor of long-term market outcomes, it's really impossible to use them to reliably determine short-term outcomes.

The looming possibility of more quantitative easing or fiscal stimulus makes it even tougher to predict near term deflation or continued low inflation with any certainty.  And yet all over the analytical community, people are doing just that.  In a time of great monetary and market instability, we believe that trying to predict how high or low inflation will be several months out is an inherently low-confidence forecast.

We can forecast with high confidence, however, that if we do experience deflation or sufficiently protracted economic weakness, that more stimulus and QE will be employed until inflation is created.

We can also forecast with high confidence (based on the US' foreign indebtedness; the structure of its economy and political system; and prevailing policymaker attitudes towards inflation, stimulus, and debt) that the US dollar will at some point experience a substantial reduction in purchasing power against the things that Americans need to buy.

But while we consider these high-level outcomes to be nearly inevitable, it's much more difficult to pinpoint either their timing or the manner in which they will take place -- to say nothing of how soon the market will start pricing them in.  Our approach, then, is to own a diversified basket of investments that we believe will benefit should our high-confidence forecasts come to pass. 

We believe that this strategy will increase our chances of eventual success, but it has another positive aspect as well.  Because our varied investments often move in different directions from one another in the short term, and because some are far less volatile than others, we can take advantage of the market's inevitable ups and downs by tactically rebalancing into those areas with the best values at any given time. 

Another bout of deflation probably wouldn't be fun for us, but it would allow us an opportunity to increase our exposure to any good inflation-hedge investments that had been beaten down due to deflation fears.  This is what we did in late 2008 and early 2009, and we will continue to use this approach in an effort to turn short-term market moves -- even if they are "against" our long-term theses -- to our advantage.

Modifying our investment stance as valuations change isn't the same as speculating on short-term market outcomes, however.  The latter entails trying to guess where the herd will turn next, and we think that's just too risky.  We prefer to stay in alignment with the fundamentals and to try to take advantage of the ups and downs while we wait for the market to price those fundamentals in, as it always eventually does.

That means looking past the widespread inflation complacency and deflationary hand-wringing, and staying focused on the loss of dollar purchasing power that we strongly feel still lies ahead.

In our prior article on the government's willingess and ability to create inflation, we noted that Japan is often held up as an example of a country that was unable to inflate despite having a fully paper-based monetary system. But while the crash of Japan's credit-fueled stock and real estate bubbles resembles our own situation, the monetary policy responses in each case have been markedly different.

It's true that the Japanese authorities did not create any enduring price inflation after their credit crash. But a quick look at the data shows that this is because they opted not to do the one thing that can reliably create eventual inflation: rapidly grow the supply of money in circulation.

The modern-day monetary system employed in the United States is based on currency that can be created at the bureaucratic touch of a button. In charge of that button is a group of people with a firmly entrenched belief that deflation is the worst of all possible monetary outcomes.

We believe that this state of affairs is simply incompatible with the existence of the type of protracted "deflationary spiral" about which it has become all the rage to worry. Deflation is a choice in the current monetary regime, and it is a choice that our government simply cannot make.

Back in June we wrote an article entitled "US Stock Market Priced for Poor Returns" in which we argued that stock market valuations are predictive of long-term returns when measured in such a way as to smooth out earnings volatility. As evidence, we presented the following chart comparing quintiles of market valuation against average 10-year forward performance (please see the original article for an explanation of our methodology):

While we invest in many sectors and asset classes, the recent steep selloff in precious metal mining stocks inspired us to write an article focusing in on that particular sector's long-term fundamentals. The resulting piece was emailed to clients on September 16, 2008 and is excerpted below.

In early 2007 we wrote an article summarizing the risks in the U.S. stock market. The article cited a study by legendary value investor Jeremy Grantham in which it was shown that, on average, long term stock market returns have corresponded quite well with valuations at the time of investment.

Here we reproduce Grantham's study with updated data and a variation or two, followed by some thoughts about where we are now in the markets and what to do about it.

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This article is adapted from a letter to investing clients originally written on January 9, 2008.
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Going into 2007, we already knew that whenever the economy slows down, the government floods the system with money in an attempt to "reflate" asset prices and economic activity. This is accomplished via monetary policy, which when all is said and done effectively entails printing money, and fiscal policy, which effectively consists of the government spending money it doesn't have. We knew this would be the policy response because that's exactly what the powers that be did during the prior downturn, and because those actions were considered to have been a huge success in keeping the prior recession mild (despite all the imbalances that the reflation efforts eventually induced).

What we didn't know was just how panicky and violent the policy response would be at the very first sign of trouble.

We have some thoughts on what may take place in 2008, but first we want to review the major predictions and observations we made in 2007.

Looking back over the articles we wrote last year (of which there were embarrassingly few -- something we intend to change in 2008!), the major themes we discussed largely turned out to be correct.

Back in March, we wrote an article in which we outlined a possible financial market roadmap -- a sequence of events that we thought the markets were likely to follow. Here is the roadmap we spelled out at the time:

An important aspect of our investing approach involves identifying big-picture trends to help us understand what's been happening in the financial markets and what's likely to take place in the future. To that end, we've outlined what we believe to be a possible "roadmap" to chart out where the financial markets have been and where they are headed in the months and years ahead.

It is often noted that in the long-run, stocks are the best asset to own. It has also been noted that “in the long-run we are all dead.” So the question becomes how long an investor must wait for that attractive long-term performance to be realized. If one is not careful, it could be a long time.

Our investment objective is simple. We strive to outperform the market indices over longer time periods, after all fees, while taking less risk. While it’s easy to spot bubbles or buying opportunities in retrospect, there is no such clarity “in the moment” and we are forced to make prospective decisions about where to be invested. Without the benefit of hindsight, market risks are of paramount concern to us.

Holders of cash and its equivalents (CDs, T-bills, and the like) may not earn much in the way of interest, but they are at least certain to get all of their principal back. For this reason, many people assume that holding all cash is the safest and most conservative possible investment stance.

But there is a hidden threat to cash holders: while they are assured of getting all their money back, the money they get may be worth less than it was when they first deposited it. This is what's known as "purchasing power risk."

We believe purchasing power risk to be a serious issue for today's cautious investors.