By Tom Dyson, publisher, The Palm Beach Letter

Monday, December 15, 2008

This week, my colleagues and I have had one of the most heated e-mail exchanges about investments we've had in a long time.

It's an important subject because it basically determines whether a given investment goes up or down. And it affects every asset class... so there's no hiding from it.

We were arguing over "inflation" and "deflation." Some of us think there's going to be inflation. Some of us think there's going to be deflation. And the rest don't think it's worth arguing about.

Most people are familiar with inflation. It's when the value of your dollar declines vs. things like gasoline, real estate, and food. Inflation is murder on cash held in the bank or under the mattress. Inflation helps borrowers because the $100 you borrow now actually is worth less and less in the future.

Deflation is much less well known. Put simply, it's when the value of your dollar rises vs. things like gasoline, real estate, and food. Deflation kills borrowers because the $100 you borrow now is worth more when you have to repay it.

I believe inflation is on the way, but we're not going to dig into this debate today. Instead, I'm going to propose a simple strategy to profit whatever happens. This strategy is called "The Principle of Ever Changing Cycles."

Robert Bacon is a professional racecourse gambler. He formed this strategy at the track and then wrote a book about it titled The Secret of Professional Turf Betting. This book sells for hundreds of dollars on the Internet, but it's easy to find in second-hand bookshops.

Say a professional gambler discovers a perfect system for winning at the racetrack. He makes a fortune and then decides to sell his system to the public. The public, seeing how rich he is, buys up every copy of his book. The first people to use the system win money. After a while, everyone at the racetrack is using the same system. The system still picks the same percentage of winning horses as it always did, but suddenly, no one wins any money... except the professional gambler. He turned his system upside-down when he realized everyone was using it... and started betting against the system. He made a second fortune.

This is the Principle of Ever Changing Cycles. The more popular an investment theory becomes, the less chance it has of being profitable. Price is the reason. The crowd's money drives the odds so low on the popular investment, the payoff doesn't compensate for the risk. Meanwhile, the odds rise on the other investments... and overcompensate for the risk.

This principle is at work in the cycle between inflation and deflation. All you have to do is place your bets where the market overcompensates you for the risk you're taking.

Below is a chart of inflation-protected Treasury bond yields versus regular Treasury bond yields. Inflation-protected Treasury bonds (or TIPS) are loans to the government, like regular Treasury bonds. But they come with a feature that adjusts the returns for inflation.

It's not necessary to explain how these bonds work here. All you need to know is that the difference in the yield between the two types of bonds tells you what the market expects inflation will be. For example, right now, the January 2010 TIPS bond yields 6.95% while the regular January 2010 Treasury bond yields 0.39%. Thus, the market believes that inflation will decline by 6.56% over the next 12 months.

Here's how the yields compare:

	TIPS	Treasury	Implied Inflation Rate
One Year	6.95%	0.39%	-6.56%
Two Year	5.50%	0.66%	-4.84%
Three year	4.45%	1.12%	-3.33%
Four Year	3.97%	1.07%	-2.90%
Five Year	3.75%	1.48%	-2.27%
Six Year	3.57%	1.80%	-1.77%
Seven Year	3.25%	2.05%	-1.20%
Eight Year	3.13%	2.52%	-0.61%
Nine Year	2.75%	2.67%	0.01%
10 Year	2.48%	2.68%	0.20%
20 Year	2.62%	3.45%	0.83%
Source: Fidelity Investments

If you compound these deflation rates, you'll find investors expect inflation to fall 11.7% over the next five years. In other words, the markets expect a massive dose of deflation.

We've had 11 price deflations in the last 138 years (most lasting less than a few years). Investors are currently betting on the worst price deflation in 76 years... the worst since the Great Depression. Everyone is scared to death of deflation. So according to the Principle of Ever Changing Cycles, what is the correct bet?

You guessed it... inflation.

If you're wrong, you won't lose much because the market is already pricing in the worst deflation for 76 years. If you're right, you'll make a fortune as inflation bets are priced like long shots in the horse race.

I recommend you take this opportunity to dump any investments you have in Treasury bonds. Gold stocks – like most stocks – will do well during inflation. If prices deflate by less than 11.7%, you'll make a mighty return...

Good investing,

Tom

Further Reading:

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