Blog : Penny Stocks and the Deflation Paradigm

by Ed Zwirn on December 14th, 2013

Sometimes you can get a better handle on the penny stock market by taking note of the kinds of information that don't cause any wild market swings. If a report comes out that largely confirms expectations it will be unlikely to cause market tremors.

Take Friday morning's producer price index report. The PPI declined for the third consecutive month in November, falling 0.1% after falling 0.2% in October. Excluding food and energy, core prices edged up 0.1% in November after increasing 0.2% in October. A 0.7% decline in gasoline prices was the largest single input to drive prices down.

All of these numbers fell in exactly with the consensus forecasts. The stock market, understandably more interested in the upcoming Federal Reserve announcement, digested this report without even yawning, with the Dow Jones Industrial Average edging up 0.1%, the NASDAQ gaining even less than that. Penny stocks outperformed, with the small-cap Russell 2000 up a whopping 0.3% on the day. 

This has obvious implications for Fed policy going forward.  Major U.S. industrial producers may be cranking out product, but their margins may be crimped as pricing power remains constrained, with end users unwilling (or unable) to up the ante. This in-and-of-itself is a strong counter indicator to those who would predict a Fed tightening in the offing.

I bring up these boring numbers and the boring reaction to them to illustrate the extent to which the market has already priced in (or as Peter Leeds puts it in his penny stock market commentaries, "baked into the pie") deflationary expectations.

But deflationary expectations have a much more basic effect upon the economy than that. Under an inflationary atmosphere, the incentive is to buy things as quickly as you can before the price goes up. In the opposite case, you want to hold on to your money, with the prospect that it will go up in value.

The fact that cash balances held by U.S. companies are at a record level is usually attributed to rising profits coupled with fear of risk. Constrained by this fear, companies are holding back on spending, the logic goes, with cash balances being the beneficiary.

As true as this explanation undoubtedly is, it is only part of the story. The overwhelming expectation on the part of those with dollars in their hands is that these dollars will at the very least hold value and possibly gain.

This disincentive against spending is a major structural imbalance that must be solved before there can be any talk that the economic recovery is gathering significant steam. The Fed stimulus is of course pumping up the volume, but this is counteracted at least in part by the reluctance of those with money to spend it.

Peter takes a different tack on inflation in his interesting interview that just appeared in the Bowser Report. "Things are going to cost more, from fuel to parts to labor. These companies are going to have to charge more, so they will pass the inflation on to the consumer. Some companies will come out on top or break even, while others will be in a very difficult situation," he predicts.

Maybe, but in the meantime we are faced with the opposite. The money supply will have to increase markedly and (given the realities of  both Fed monetary policy and government fiscal policy). This can only come from a marked increase in private sector spending. This is not going to happen for as long as company treasurers have the incentive to hoard cash.

As the decades-long experience of Japan, where both prices and the economy have languished at the same time, has shown us, incentives like that can prove hard to reverse. What starts out as an anomaly driven by spot economic conditions can gradually turned into ingrained psychology as markets price in deflationary expectations. It is not for nothing that both the U.S. and Japanese central banks have both factored in inflation/deflation expectations as part of their monetary formulas.

In an ideal world, it would not primarily be the Fed's job to pump up the economy. That would properly be left to the titans of industry, who could spend all that mound of cash they now hold to an extent that would make the current rally for everything from penny stocks to blue chips look like tame stuff indeed. This will only happen, however, when the inflationary incentive to spend kicks up. Until then, look under mattresses for all that cash.