Both leading up to and in the wake of the Federal Reserve meeting on Wednesday, there has been a greatly deal of fear among investors that the market may be headed for a bout with either deflation or a wave of inflation. These suspicions have lead to a wave of irrational fear, and resulted in increased market volatility as investors grow skittish.
First, to clarify: fears that deflation may be on the way are essentially unfounded. Not that deflation is impossible, but simply because it is unlikely going forward. It is particularly unlikely because the US has been experiencing deflation (defined as a decrease in the money supply) for the last nine months.
What is especially interesting about the growing fear of deflation is that it seems to be coming just as money supply numbers – namely M3 – appears to be bottoming (NowAndFutures.com). Although the Federal Reserve stopped reporting M3 several years ago, its components are still published. Different groups of economists have used those components to recreate an accurate picture of M3, which can be found at websites like www.nowandfutures.com and www.shadowstats.com.
Much of this fear is focused on US savings. After all, since 2007 many Americans have seen their net worth cut by half or more and many failed to take advantage of the 2009 rebound. People have been wanting, wishing, even praying to see their portfolios return to post-crash levels.
Years ago Americans lamented at their inability to buy affordable homes at low interest rates. They failed to understand why their parents could buy homes at reasonable prices with mortgage rates around 6.5%. Now Americans can buy homes that are, in many cases, half their prices from two years ago, and at rates below what their parents paid (as low as 4.5% for a 30-year mortgage). Unfortunately, most are missing out on abundant opportunities in housing because they are focused on stock prices and economic phenomena like credit deflation or oil futures contango.
The reactions of most market participants to 2008 have been completely counterintuitive. Investors ought to have learned from that experience that the financial markets are indeed capable of declining on a broad basis, and diversified portfolios are quite capable of seeing substantial losses. Incredibly, investors have become convinced that they weren’t sufficiently diversified, and have begun spreading money not just across securities, but across asset classes, many of which they fail to understand.
Instead, investors would have done well to change their logic and realize that diversification as a theory is flawed, and adjusted their investment style accordingly.
Few people, even business school graduates, fail to understand that diversification hinders returns. The primary objective of modern portfolio theory is not to show gains, but to protect investors against losses. In other words, it is meant to maintain portfolio stability – in modern portfolio theory, “risk” is not defined by loss, but by volatility. In keeping with this theory, diversification serves to slow portfolio movement in EITHER direction. In guarding against losses, it also limits gains.
We’ll wrap up this week with an economic update. At this point we are thoroughly convinced that Washington is only thing holding the US economy back. Unemployment numbers, which have received far too much attention, remain high, in our opinion, mostly because the government is continuing to pay people NOT to work. However, at the same time many companies have admittedly been unwilling to take on additional employees because they are unsure whether their already-high costs will remain stable (Why I’m Not Hiring, Michael P. Fleischer). This does not excuse the fact that there is substantial demand for products that corporations aren’t willing to meet through expanded production (Dealers Beg for Cars as Automakers’ New Discipline Curbs Sales, Theo Keith).
As we’ve discussed repeatedly in previous articles, much of this stagnation on the part of business, their hesitation about expanding, is due to uncertainty about what new regulations Washington will heap upon their shoulders. For the most part, business in the US can be equated to a horse chomping at the bit, ready to break out of the gate. Unfortunately, they can do little until Washington gets out of the way.
