The Stock Surfer

Investing, Saving, and Deflation

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Today, as I enjoy yet another way to absorb caffeine (we just got a french press), I'd like to take a step back from the usual blog topic of trading and think about saving and investing. [Note: This article is posted also on my personal blog, www.thestocksurfer.blogspot.com, with charts and other content.]

I had been thinking about the overlap of saving and investing for a while but was unsure how to articulate my thoughts. Kevin Depew of Minyanville somehow got in my head and put it to paper (into a podcast, actually). Here's a highlight and I encourage you to read the whole thing if you have the time.

Kevin Depew: The blurring of the distinction between savings and investing goes back a long way. Probably you can trace it back to the death of pension plans and defined benefit plans...But the transference of the ability to control your own retirement destiny is the way it was sold and through investing in 401(k) plans. Well, what that did was that it sent the message, whether intentional or not, that the place to save your money is in the stock market. Well, the stock market is not a savings vehicle by any stretch of the imagination. When you invest in stocks, you're taking ownership in the company and, hopefully, as an owner in that company you're going to benefit from the dividend stream and the future earnings that that company accumulates. Savings is different. Savings is money that you can't afford to lose, by definition, and that's why you save it. And so somehow it became, you know, nobody really has savings anymore. They have some investments that have lost money over the past year or things of that nature, but they don't have really savings.

SAVING AND INVESTING

As Depew said, with the advent of 401k plans, many people now consider investing as synonymous with saving. I would add that the modern myth of mutual funds and index funds has also played a part. What is that myth? It's the conventional wisdom that stocks over the long run will go up 7-8% per year, simply buy and hold and then retire courtesy of an all-knowing online calculator. The reality is that stocks do not behave in ways that can be easily modeled, nor do bonds nor mortgage backed securities nor credit default swaps. For a further debunking of this myth, please read Fooled By Randomness by Taleb or When Genius Failed by Lowenstein.

The blurring of investing and saving hit me the other day while watching CNBC, and someone commented about how people are worried about their savings because the stock market has gone down. That comment should sound strange--one doesn't save money in stocks, one invests money in stocks. But it doesn't sound strange because we've been blurring the distinction for as long as I've received a paycheck. In this blog I usually write about trading, but I hope that doesn't lead anyone to think there's not more to the money picture.

THE CHALLENGE OF DEFLATION

The current economic environment is difficult to say the least. Talk of another global rate cut is everywhere, but we're increasingly faced with a situation where rate cuts are not having an effect (or, the desired effect) on stocks. As I've written about in this space previously (first way back on February 29th and several times since), what happens when the usual inflation-inducing tools don't work anymore? Deflation. (Depew, again, has been all over this theme.)

Despite the government's best efforts, credit is contracting and will continue to contract as both institutions and consumers delever their balance sheets. In layman's terms, we're shifting our focus to saving and paying off debt rather than taking on debt to spend. This trend becomes a feedback loop: We spend less, so the economy slows down, which means more businesses struggle, unemployment rises, which leads us to spend less, and so on.

I'm not saying it's gloomy for everyone, but the psychology of a slowing economy can affect everyone. My wife and I recently decided against making a somewhat frivolous purchase. She noted to me that even though our personal financial situation has not become gloomy, making a frivolous purchase seemed irresponsible because of what's going on in the economy. That is exactly how the psychology of deflation works. Even those who can spend the money are less likely to do so. It just feels right to save.

INDIVIDUAL STOCKS AS INVESTMENTS AND TRADES

Now back to stocks. As people wake up to deflation and a sliding market, the desire (or ability) to own stocks takes a big hit in general. Sure there's cash on the sidelines but no one wants to risk it. Valuations that once seemed reasonable (like a P/E of 20) no longer seem reasonable no matter how solid the company. People are not confident that the "E" (earnings) are going to be good enough. Furthermore, our idea of a good "P" has been shattered.

I remember setting up alerts to tell me when stocks like Electronic Arts (ERTS) or THQ (THQI) reached prices that would make them great buys. All of those alerts have been triggered, but the prices don't look so compelling anymore. For 5 years ERTS was a good buy near 40, but ERTS said goodbye to 40 and now 20 looks as a better entry. It's an example of the "anchoring bias" to consider 40 an appropriate price. It will take a while to determine new "appropriate prices" because all our anchors have been cut loose. This is price discovery, and it's disorienting. Click here for a chart.

When it comes to individual stocks, I usually lean toward trading rather than investing because history is riddled with stocks that have nice runs and then fall flat, like ERTS or Starbucks (SBUX) or Whole Foods (WFMI). These are decent companies but have been indecent stocks for a while now. Here are SBUX and WFMI over the past 5 years, compared to a stock I still like for an investment, Activision (ATVI). Notice the relative strength (click for chart).

Now of course ATVI could have a similar fall from grace, so I need to think ahead of time about conditions under which I would sell the stock. But if it is an investment (rather than a trade), I could see a time like this as an opportunity to build a position based on solid fundamental prospects.

The stage is being set for trading opportunities on the long side, with the huge caveat that it'd be best to wait for a general turn in the market and even then hedge your bets. Friday was not the capitulation day that traders look for, nor was there a meaningful reversal to the upside. That's a probable recipe for more pain this week. Good luck out there.