Tuesday, August 10, 2010

Deflation

From time to time we're hearing voices mentioning or even forecasting deflation. While few are predicting deflation now, most admit that the possibility is there and in fact rising. To hedge against that possibility investors are nailing down income-producing vehicles now, figuring that yields will be even lower in the future. We are seeing that with many preferred stocks. Most are at levels they haven't seen in a long time, or in some cases ever. While utility stocks have risen for the same reason and rose on Friday after the initial knee-jerk selling, they should be doing even better. Soon they will.

Although yields have fallen, this continues to be a better time to invest for dividends than it is to invest for capital gains. In a slow-growing economy, stock prices and corporate profits will do only a little better than track nominal GDP growth, so dividends and income will count for a good deal of total return.

I do not share a deep concern about deflation. Unlike our experience in the 1930s and Japan's since the late '80s, the Fed and Treasury have both the tools to combat deflation and the willingness to use them. There are few winners when deflation takes hold, but many losers. Stocks decline and businesses and individuals postpone purchases because prices will be lower later. Deflation feeds on itself. It is in the interests of most to see that it doesn't occur. The Fed is well aware of that. The Fed would prefer modest inflation and it has the tools to bring it about.

After Tuesday's Fed meeting it is clear rates will stay low well into next year. Income investors frustrated with returns and tired of chasing bonds higher and higher will increasingly turn to high yielding stocks, utilities especially. Our Reduced Risk portfolio holds these as well as high quality trust preferreds. It is well positioned for this market environment.

David Vomund