Deflation & Contrarian Investing

Even contrarian investment faces a huge challenge from deflation...

JUST WHAT are the upside possibilities for investors amid this grim situation, if not outright deflation? asks William Rees-Mogg for The Daily Reckoning.

There is no doubt that investors of all kinds are looking to the dark side of all possible expectations. Deflation as experienced during the 1930s would seem to make any investment gain impossible outside government bonds.

But I call myself a contrarian investor, and contrarian thinking secured me against over optimism in the boom years of the 1990s and early 2000s. Surely I now have a duty to look at the contrarian investment view, even when it contradicts an instinctive feeling that there is a great deal of trouble still ahead of us.

Contrarian investing has never meant a simple reversal of the immediate situation. Contrarian investors do not say to themselves, or to their fellow contrarians, "GM, Ford and Chrysler are in terrible trouble, let us pile into their shares." In a week when almost all the news is bad, one has to be a cautious if one is to avoid further nasty surprises.

Contrarianism is a matter of hedging one's expectations, so as to avoid surprises. And the first contrarian-investment point can be made about the stock market.

Deflation & Contrarian Investing: Rock-Bottom P/E Ratios?

There are a large number of companies which meet two criteria. They can be expected to survive the crisis and their shares are much cheaper than they were. I am not a stock picker, but a glance at the stocks listed on the New York Stock Exchange shows that there is a good choice of shares which offer a price earnings ratio below 10 and a share price below half the high level for 2008.

Which of these shares are in good shape I do not know, but collectively they offer good value. They may, or may not, be near the bottom, but in three years' time I feel that they will, collectively, seem to have been bargains. In emerging market stocks there are some even more striking bargains, with price earnings at 5 or even below!

Of course, even with these low P/E ratios, one has to avoid shares in companies which are in the eye of the storm – such as companies which make automobile components or sell real estate.

Looking at the broader economy, the strongest macroeconomic reassurance comes from the "automatic stabilisers". In the deflation of the early 1930s, most countries had private spending which accounted for between 80% and 90% of national income. When spending was cut by private individuals to protect their own finances, there was little public spending to maintain the balance. That created a competition in mutual impoverishment, well recorded in Maynard Keynes's General Theory (1936).

Contrarian Investing: The 1930s Deflation

Governments in the early 1930s tended to cut their own spending, in a premature effort to balance their budgets. When private individuals cut back nowadays, governments not only maintain their expenditure, but actually increase it as a part of a contracyclical policy. At some point in the future, this may lead to governments having to cut back to avoid inflation, but the initial consequence is that government spending acts as a contracyclical, anti-deflation force.

This does not mean that Governments have all been converted to Keynesianism; it is rather that the old doctrine of balancing budgets in order to maintain fixed-rate convertibility has virtually disappeared. There is no longer international pressure on Governments to make deflation worse by deflating themselves.

I would add a third contrarian argument. One should never underestimate the capacity of human beings to respond to a challenge. Homo Sapiens has got through 50,000 years of evolution by surviving individual and collective challenges of a fearsome kind. As a species we may have made many mistakes, but we are survivors.

Democracy, as the dominant political structure of the 21st Century, gives humanity a flexibility of organisation and requires Governments to be responsive to human needs.

There is a time lag between any economic crisis and its resolution. But no contrarian ought ever to despair. Human experience can be summed up in proverbs. One such proverb is that it is always darkest before the dawn.

And with talk of deflation now reaching even the mainstream media, it is pretty dark right now.