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Nadeem Walayat Financial Markets Analysiis and Trend Forecasts

Legendary Investors Bet Big on the Inevitable Inflation

Stock-Markets / Investing 2009 Aug 19, 2009 - 04:07 PM GMT

By: Q1_Publishing

Stock-Markets

Best Financial Markets Analysis ArticleThe most powerful people in the financial world are doing anything they can to prevent it.

Central bankers fear it. CEO’s hate it. Banks get destroyed by it.


Don’t worry though, they have banded together to beat it…at any cost. And you can rest assured, they will beat it. As for the costs, well, that’s a problem for tomorrow.

Over the past few weeks though, a few of world’s most successful investors have been getting prepared to protect themselves and profit from those eventual and virtually inevitable costs.

I’m talking about the deflation. You know deflation. It’s when the money supply goes down and the price of everything goes down too. It’s commonly blamed for the Great Depression.

The thing is though deflation could be a short-term issue, but it won’t be. There’s an all too simple solution to it – print more money. And that’s exactly what has been going on. The Federal Reserve is just a few months away from completing its $300 billion Treasury bond buying binge and, along with the Treasury has run the total potential cost of all the bailout up to more than $23 trillion.

Now, I know what you’re thinking: If they can print money, monetize debt, and guarantee anything they want to prevent deflation, why would anyone bet against them?

Well, there are a lot of reasons – none of them very good. That’s why today we’ll look at why most investors are underscoring the ability of the Fed to print more money and how three of the world’s best investors are betting billions the Fed will be more than willing to print its way out of the current mess and right into a completely different one.

Debunking the Deflation Myth

First though, we’ve got to look at how widespread the deflation myth has become. The main culprit is, as with most investing myths (i.e. houses are good investments), is the mainstream media.

Consider this observation from the Washington Post today:

The [Consumer Price Index] released last week hinted at least disinflation and possibly deflation, which is one of the worst things that can happen to an economy -- its sustained contraction, when prices and wages fall hand-in-hand, as happened in the Great Depression.

They’re connecting deflation with the Great Depression. Granted, the Great Depression was a deflationary period, but, as we looked at last week, deflation was hardly the cause of the Great Depression.

Still though, this type of editorial leads to the common rationale – inflation is good, deflation is bad.

Deflation is a natural occurrence in our monetary system, but it’s hardly a risk. Earlier today, Bloomberg columnist Matthew Lynn released one of the best summaries of why deflation isn’t necessarily bad and how easy it is to prevent. More importantly, there are a lot of people who have a vested interest in avoiding deflation.

Lynn points out in Deflation Theory is a Lemon We’ve All Been Sold:

[Deflation] is bad for chief executives. It is easier to keep your profits rising in a mildly inflationary environment. You can just jack up your prices a bit, and you can often cut workers’ wages by stealth by holding wages steady.

The banking industry, which has come to rely on inflation to make highly leveraged loans sustainable, also dislikes deflation. Likewise, it is bad for governments, which use inflation to reduce the value of their debts.

As we’ve seen, those are three powerful forces and they’re more than willing to work together. Whether it is legislation which prevents competition under the guise of consumer protection, the direct handouts of cash, and everything in between, they are all willing to work together and have a vested in preventing deflation.

That’s why now, when deflation is the fear du jour, is a time to start getting ready for the inflationary consequences. It’s not just me though, there’s a lot of smart money getting prepared for it.

A True Contrarian’s Bet

Leading the way has been leading contrarian investor, David Dreman. Almost two months ago, Dreman said he was “terrified of bonds” because of the illiquid nature of most bonds and the inflation lurking just over the horizon.

Now, he’s at it again and he’s talking specifics. In an interview on CNBC, he outright predicted10% to 12% within the next four years:

I think we’re factoring in some pretty major inflation…

There’s been a report that there has been $21 trillion of new debt that was recently put out. The Treasury has been printing money 24-7 and that’s got to have its toll.

Dreman’s specific advice to protect against and profit from it all is something you should expect from someone who literally wrote the book on contrarian investing. Dreman suggested:

The worst buys of the past few years, such as real estate and stocks, may prove to be the best investments a few years from now…

We’ve chronicled Dreman’s moves throughout this downturn and determined, for investors who look beyond the next month or two, that Dreman is as accurate as ever. He told Prosperity Dispatch to have a serious look at banks back earlier in the year. We noted how he was “fired” from one of his top funds in early April, which only really happens at extreme inflection points in the markets. Now, he’s buying real estate.

If anything, Dreman may be a bit early, but he’s rarely wrong. After a rough 2008, his 2009 has turned out exceptionally well. Now, he’s talking about real estate and banks? All I can say is he’s not someone I’d be willing to bet against.

Fortune Building 101: Bet Big and Wait

Another investor you probably wouldn’t want to be on the other side of the trade is John Paulson. Just ask the traders and investors who were on the other side of his $15 billion win betting against subprime loans. Now, Paulson has his firms sizable investments set to profit from inflation.

A few months ago Paulson revealed a bet big on gold and gold stocks through official disclosure. His funds amassed billions of dollars worth SPDR Gold Shares (NYSE:GLD) and big stakes in Market Vectors Gold Miners ETF (NYSE:GDX) and a few gold stocks. The announcement sent gold stocks climbing.

Now he’s betting on profiting from inflation another - banks. A few days ago Paulson & Company revealed it had trimmed its gold bet (primarily in the GDX) and had built up a stake in Bank of America (NYSE:BAC) currently worth $2.8 billion.

Although we don’t know whether Paulson is in Bank of America for the long haul, we do know he was among a group of private investors which bought the assets of Indymac. Those assets have become OneWest Bank. OneWest is still private. So it can be sold with a few phone calls. And since inflation is good for banks at this point, there’s no doubt that investment will pay off very well when inflation does set in.

When it comes to Paulson though, there is one more thing to consider. As we noted in the height of the Paulson-fueled gold euphoria a few months ago:

[Most investors seem to forget] Paulson began betting against subprime mortgages in 2005. That was well before the housing market peaked and nearly two years before subprime markets started to falter in 2007.

He was right, but he was early. He stuck to his bet even though the housing market continued to do well. Eventually, it paid off.

There’s no reason not to expect a similar situation to play out all over again. It’s going to be a while, but it is coming. And just like with Paulson’s sizable other medium-term bets in the past, it has the potential to pay off in a big way.

Bull Market in Bonds is Over

There is still yet another way to profit from inflation. That’s by positioning yourself to profit from the end of the 20-year bull market in bonds like one of the best bond investors in the world has started to do.

Bill Gross, who manages more than $700 billion as Co-CIO of PIMCO, has been getting prepared for inflation too. Last month Gross reduced the $169 billion Total Return Fund’s exposure to mortgage bonds from 54% to 47%. That’s the lowest level since April 2007 (the last time inflation started to become a real concern). At the same time he increased the fund’s cash position by 5% of the fund’s total value.

These are the moves of someone getting ready for the inflation. And when you’re strictly limited to bonds like Gross, cash may not be great, but it’s better than bonds.

As further evidence, Gross also weighed in on the inflation/deflation debate in his Investment Outlook where he said, “Reflating nominal GDP by inflating asset prices is the fundamental, yet infrequently acknowledged, goal of policymakers.”

Soon…Real Soon

In the end, it’s quite reassuring to be in good company when it comes to finding ways to protect yourself from inflation.

In the short-term, I expect the debate between deflation and inflation to rage on. That’s just how the markets work. Price levels will likely remain the same. The mainstream media will jump on board sounding the “all clear” (ironically, the AP just published an article headlined: Inflation a no-show in July, likely to stay muted). Then most investors will simply get bored and move onto something more exciting.

Then when the last one throws in the towel, inflation will really start to set in and most investors will miss out on it all.

That’s why the best advice I can probably give you here is the same I told members of our premium advisory service when we looked at a way to turn inflation into a potential 462% gain. I told them it may not seem like it in a week, in a month, or maybe even a year, but at some point in the not-too-distance future, you’ll be glad you took the opportunity to [protect yourself and profit from inflation.

Good investing,

Andrew Mickey
Chief Investment Strategist, Q1 Publishing

Disclosure: Author currently holds a long position in Silvercorp Metals (SVM), physical silver, and no position in any of the other companies mentioned.

Q1 Publishing is committed to providing investors with well-researched, level-headed, no-nonsense, analysis and investment advice that will allow you to secure enduring wealth and independence.

© 2009 Copyright Q1 Publishing - All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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