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Is Deflation The Clear Winner?
By Bill Bonner | Published  07/29/2008 | Currency , Futures , Options , Stocks | Unrated
Is Deflation The Clear Winner?

Yesterday, the Dow dropped 239 points. Oil rose $1.46. Gold remains at $927. And the yield on a 10-year Treasury note is barely above 4%.

It’s that last item that puzzles us.

People are buying Treasuries for safety. Money markets, which hold short-term Treasury bills, are at record levels. We understand why you might want to have money in a money market fund...but where’s the margin of safety in a 10-year note paying less than the rate of consumer price inflation? Even in the money market funds, you’ll lose money when the dollar goes down – whether it goes down against other currencies or against consumer items. And what do you get in exchange for the risk? Not much. The 91-day T-bill rate is only 1.66%.

Currently the inflation rate – according to official statistics – is near 5%. Buying a 10-year note at a full percentage point lower is not a safe investment – it is a speculation, a bet on the direction of rates in the future. If they go...the value of the T-notes goes down.

Lately, that’s begun to look like a reasonable bet.

“Falling prices ease worries about stagflation,” says a headline in the International Herald Tribune . Oil is down about 15% from its peak. Food has fallen a similar amount. Could it be that inflation has topped out? Could it be that the “civil war” between inflation and deflation is finally reaching a conclusion...with deflation the clear winner?

Could be. Then again, it could not be.

“The question for investors is whether the slump in oil and commodity prices will last or is simply a temporary retreat brought on by overstretched increases,” continues the IHT . If the increase in prices won’t last, we can all forget about girding our loins for the fight against inflation. We can simply buy Treasury notes and wait for the current downturn to pass, right?

Maybe. Maybe not.

Inflation is at about two and half times the Fed’s key lending rate. Overseas, many countries are facing much higher rates. Russia has an inflation rate of 14%. China’s rate is over 7%. Inflation in India is running about 12%. And Dubai has inflation at 22%. Dubai, by the way, is a bubble. It has only .02% of the globe’s population. But it is home to 10% of the world’s construction cranes and seems hell-bent to prove to the world that there are bigger fools than Americans – as if that needed proving. It now has the world’s only 7-star hotel...and the world’s tallest building too. In the harbor, it’s building a series of artificial islands in the shape of a map of the world.

The gods must be watching...and getting ready to teach Dubai a lesson. What would it take to kick Dubai in the pants? A lower oil price...

For the last few weeks, oil has been going down...and the news has been overwhelmingly deflationary. The S&P is down 14% for the year. The credit crunch continues to pinch businesses and investors. This morning, we got news that Merrill Lynch announced $5.7 billion in write-downs. Wall Street will hand out an estimated $10 billion less in bonuses this year. Mortgage-backed securities are selling at only one-fifth the rate of a year ago. And the IMF says there is “no end in sight for the credit crisis.”

Now, it’s beginning to hit the wealthy, too, says the Financial Times. Prime mortgage delinquency rates are increasing. So are late payments among the best credit card customers. AMEX, which targets good-quality borrowers, saw its earnings fall 37% in the second quarter.

Meanwhile, investors are selling stocks short at record levels. The pros think stocks are a bad bet. This puts the stock market under a lot of tension. A rally to the upside can be explosive, as the shorts need to buy in order to cover their positions. On the other hand, the pros may be right; deflation is a big threat to stocks. The amateurs may be right too – they’re moving to cash and bonds.

Cash is probably a good move. You’re protected against defaults and write-downs. And you can take cover if inflation gets worse. Moving to bonds is another matter. They are a leveraged bet against inflation. And yes, for all we know inflation is dead forever. But we wouldn’t want to bet on it.

*** One of the biggest humbugs in capitalism is private equity.

We have chuckled about it before, but we come back to it today because the granddaddy of private equity – Kohlberg Kravis Roberts – is preparing to sell shares to the public on the NYSE.

The idea of private equity is that a group of smart, well-financed, slick operators can get the better of the chumps in the public markets. The idea is probably right, but it makes nonsense of the whole premise of modern market theory – that the markets always know more than any individual or group of players. If the markets put a price of $100 on a stock – that’s what it is worth, no more, no less; at least, that’s the theory.

But the private equity hustlers nevertheless go into the public market, buy a company at a price set by the market, clean it up, cut it up, and then sell it back to the market at a higher price.

Supposedly, the private equity boys have “added value” by nipping and tucking on the corporate body before selling it back to the yahoos. But what do the financiers know about running a company? How is it possible that they are able to take a company out of the control of the people who know it best – founders, CEOs, managers – and improve it? And even if they were to get lucky with one, what makes these dilettantes think they can do it 160 times – which is the number of buyouts completed by KKR? We don’t recall the details, but we remember a study showing that private equity surgeons had added no net value to the companies they sliced up...and that share prices tended to sink after the initial return to the market.

And then you have to wonder about the chutzpah of it. Public shareholders were getting smacked both coming and going – once when they sold a company to KKR for too little...and again when they bought it back for too much. And now cometh KKR into the public markets to smack the poor lumpeninvestoriat again. This time, KKR says, in effect: we’re smarter than you are...but we’re going to let you buy our shares anyway. Of course, if KKR really were smarter, why would they want to cut the little guys in? If they could reliably add value and produce above-market gains they could raise all the capital they could possibly need. Of course...they can’t. And now, with the chumps wising up, it’s getting harder for private equity players to raise money.

Nor is this the first time KKR has sold shares to the public. The IHT reports:

“KKR Private Equity Investors had its debut on the Amsterdam bourse at $25 on May 3, 2006, when KKR sold 200 million shares of the unit, valuing it at $5 billion. The shares have fallen more than 57% since then, to close Friday at $10.50.”

Bill Bonner is the President of Agora Publishing. For more on Bill Bonner, visit The Daily Reckoning.