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Is Deflation on the Horizon?
By Bill Bonner | Published  09/21/2006 | Stocks | Unrated
Is Deflation on the Horizon?

This is either the first day of autumn or the last day of summer; we don't know. But in France, the mornings are now very gray, with fog settling in the valleys. Along the Champs Elysées, the chestnut trees are still green, but the light has an autumnal look about it. The days are mild; the nights are cool.

Everything passes away...like it or not. You can sink into a gloomy funk about the end of summer - but what's the point? It is like being saddened because you are getting old. Better to enjoy the sweetness of decay...

Yesterday, the Fed decided to sit tight again. Inflation is under control, said the feds; there is no need to raise rates.

What may not be under control is deflation...or at least the very early stage of it. Oil has dropped to $61. Gold is down to $586. The yield on the 10-year note is only 4.73%.

And the housing market continues to soften. In LA, home sales are down 25% from the year before. Friends report 'For Sale' signs in abundance.

"I'll probably take a loss of $100,000 on that house I bought near Miami," said a friend this morning.

He just bought the place two years ago for $500,000. Now, he is trying to get rid of it. Statistically, there is no proof of a $20% drop in housing prices. But out on the speculative frontier - eager sellers seem to be taking some significant losses.

Meanwhile, one market that is not deflating is the stock market. Falling bond yields give stocks a boost. Investors compare the returns they are likely to get from stocks to the returns offered by the bond market. As yields from bonds go down, stocks look like a better bet.

We spent time yesterday talking with a friend who is a full-time investor of his own money.

"I've looked at this business [investing] from practically every possible vantage point," he explained. "It's really very simple. You take the returns offered by bonds...or you take more risk and get higher returns. Not always...but over the long run. The risk premium from stocks is very well researched and well known. It is maybe only a couple of percentage points, but over the long run that is a lot of money. Now, everyone in America knows about it, so it is not as great as it used to be. But it is still there...and still worth getting.

"So the question is, how do you get it? That too is simple. You just buy an index fund. Or buy the S&P Index itself. Or, if you want to do a little better, you can follow a mechanical system for selecting the stocks that are likely to do better than the index itself, such as the Dogs of the Dow approach. I've done that for many, many years. There is no question that it works.

"Better yet, find someone who does a lot of homework to figure out which companies are likely to do better than a purely mechanical system. This is tricky. Because you have to be careful to get the right person. Warren Buffett, for example, picks stocks by doing intensive research over a long period of time, and sticking to a value investing approach. Value investing works too. It can work very well; it certainly has for me. Value investing is essentially what the Dogs of the Dow system gives you...but it is very crude without any room for individual judgment or deep research. If you can do the research yourself...or find someone you trust to do it...you'll probably get a better return. I follow many of your advisors, for example...and many of them are very good. They're getting some good results. Especially lately. [Our own Justice Litle, who writes the Outstanding Investments letter, is rated #1 by the Hulbert Financial Digest].

"The only thing you have to remember is that the risk premium isn't free. You have to be prepared to stick with stocks throughout the entire cycle - which is about 30 years. If we're at a high point now...and the market itself turns down...you can still do okay in stocks, but you may have to wait until, what, 2036 to realize it."

Ah, there's the rub, isn't it, dear reader? Here at The Daily Reckoning, we think stocks are near an epic peak. The market reached its zenith in January 2000 and has gone mostly nowhere since, all except the NASDAQ...but even that is considerably down.

Stocks have enjoyed a long season in the sun...and an extended Indian summer. But nothing lasts forever. Summers end. Autumn...winter...still lie ahead. Many of our smartest friends and associates are still making money in the stock market. But we will wait for the market to die...and be reborn...before we get into it broadly. This stock market still has a lot of leaves left to drop.

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