Blog : The Deflation Bomb

by Ed Zwirn on April 19th, 2013

Talk at a typical dinner table about the economy and you are likely to hear that the dollar is going to tank and that hyperinflation will set in shortly afterward. There is of course some logic at work here: U.S. government deficits remain alarmingly high, and the moral to the story is said to be that the economy will pay the cost before long.

But morality aside (and the "dismal science" of economics has little to do with morality), the evidence at this point seems to show that the opposite is occurring. Despite the best efforts of the U.S. government and the Federal Reserve, the dollar remains stubbornly high against all major international currencies and price pressure in the domestic U.S. economy seems almost nonexistent.

The official measure of inflation, the consumer price index, showed an unexpected decline of 0.2% for March, according to an announcement issued this week, dragged lower by declining prices at the gas pump. Gold, which is supposed to be valuable as a hedge against inflation and market risks, is currently down more than 20% from it's all-time high and off 10% since April 2011, crude oil is down 15% since February and even lumber futures have fallen 10% in the past month.

This is both good news and bad news for investors in penny stocks.

On the one hand, true deflation, defined by the kind of persistent price drops seen in Japan over the past few decades and in the U.S. in the 1930s, is an overwhelmingly negative signal about the state of the economy, and the pressure put on pricing, particularly insofar as commodities are concerned, can only hurt hot penny stocks which are involved in exploratory energy strategies. This pricing pressure extends from penny stocks to the broader stock market, as investors decide between stocks to buy based on whether people are willing to pay top dollar for the latest phone, or for that matter, the latest penny stock technology to use for their companies.

On the other hand, by the perverse logic of the current stock market, the news on the pricing front represents a huge positive for penny stocks. With the core measure of inflation (a useful figure for those of us who don't need to drive or eat) remaining well below the Fed's long-term target, Bernanke and company are effectively prohibited from raising target rates for short-term funds and, more importantly, are forced into continuing the $85 billion monthly bond-buying program that has been a major market prop since it was introduced in 2011.

At least for the short term, the stimulus of the Fed will probably prove to be a stronger influence on the stock market, which is seeing an increasingly short-term outlook, than the counter tendencies at work in the economy itself. The danger of inflation may have to wait a generation to become real, and nobody buys penny stocks in the hopes of passing them on to their as-yet unborn grandchildren. If you want to go for such long-term gain, keep in mind that the reason god created blue chips was precisely to take care of that. With penny stocks, any business plan that appears sustainable through the next cycle could prove to be the big winner you've been seeking.