Regardless of what side of the inflation/deflation debate you're on, one thing is certain: false forms of value are being destroyed, and there is a "flight to safety" -- safe ways of preserving purchasing power. In our current environment, this has caused the US dollar to strengthen in the second half of 2008, and US government treasury bonds to rally as well.

So what's this mean for other asset classes, like commodities? To answer this question, we will need to understand the origins of money.

The Origins of Money

Long, long ago, before the advent of paper money, people bartered goods. In other words, if you made shoes and I made pants, we might be able to work out a trade in which you would make a pair of shoes for me and I would make a pair of pants for you. In this way we would both be able to increase our wealth.

Of course, what if I wanted shoes but you did not need pants? We might then be able to have difficulty in making a trade. Unless, of course, you were able to accept my pants and trade them with someone else who wanted pants. And that is precisely what began to happen as economies developed. In such an environment, what became money was simply the most easily traded commodity. Such commodities typically had a few attributes:

1. durability -- did not deterioriate over time, thus allowing wealth to be accumulated and an economy to be built on savings
2. divisibility -- easily divided, thus enabling transactions of all sizes
3. recognizability -- so that people could accept it as money with confidence
4. portability -- so that people could take their money with them
5. scarcity -- because too much of it would encourage speculation and making savings difficult

Many commodities were tried as money, though in the end, two stood out as clear winners: gold and silver. Thus you will sometimes find passionate gold and silver investors who say "gold is money."

What This Means If You Believe Deflation is a Concern

If you view the crisis as deflationary in nature, the asset classes most appealing to you will be as follows (listed in order):

1. real cash -- i.e. US dollars, euros, etc
2. government issued bonds
3. precious metals
4. commodities
5. consumer goods
6. real estate
7. financial goods (stocks, bonds, derivatives)

Deflationists argue the supply of paper, government-issued money in the economy is contracting, and thus it is not in danger of being devalued by excessive supply -- and so its purchasing value will increase as the market moves to find real stores of value.

What This Means If You Believe Inflation is a Concern

If you believe inflation is a concern -- meaning that the government has excessively expanded the supply of paper money in the economy -- then the asset classes of choice will be as follows:

1. precious metals
2. commodities
3. consumer goods
4. real estate
5. financial goods
6. real cash
7. government bonds

Of course, this would depend on how much inflation there is -- cash would higher on the list in the event if there is not much inflation. And with respect to financial goods, those correlated to healthy companies will be higher on the list.

How to Trade This

The easiest way of trading this is to trade asset classes against each other; for instance, if you're a deflationist, going long cash while shorting financials (which simply amounts to selling stocks and holding your money in a bank account). Conversely, you can look for potential arbitrage opportunities in which the market is not behaving as macroeconomics would posit that it does. In our current times, for instance, commodities have fallen more than financial assets; the chart below shows the SPY against DBC (an ETF tracking an index of commodities). Commodities, represented by the blue and gray candles beneath the red and green candles, have fallen 16% more than the S&P over the past 200 trading days. For this reason, many investment advisors are quite bullish on commodities, citing it as some of the best buying opportunities.


Of course, as the old saying goes, the market can stay irrational longer than you can stay solvent, so such strategies looking to take advantage of economic inconsistencies may benefit most if coupled with trend-following technical analysis.

Disclosure: Long gold and silver.

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