Those who've followed the inflation debate already know the difference between money and credit. But there's another compelling argument showing why investors shouldn't worry much about inflation in the near future.

Shrinking liquidity?
Independent Strategy's David Roche has come up with an interesting way to present the evolution of money, and how the Federal Reserve and other central banks have their work cut out for them in dealing with the current crisis.

Roche uses an inverted "liquidity pyramid" to illustrate the way the financial markets interact. At the bottom tip is actual central bank reserve money -- which makes up a small portion of the world's economic activity. Banks leverage that reserve money by making direct loans to borrowers, which increases liquidity within the economy.

But at the top, the two widest parts of the pyramid come from securitized debt and derivatives. Both of these have increased liquidity still further, dwarfing the amount of money held by central banks and therefore making it extremely difficult for central banks to impose any control. In other words, the system itself created so much liquidity in the form of derivatives and securitized products that the central banks are having a very hard time reversing the tide. The liquidity pyramid that underpinned the 2002-2007 boom has now collapsed.

To understand why printing money may not generate inflation, consider that money may also be destroyed in the collapse of debt securities, clogged derivative markets, and tightened lending standards, as well as vanishing bank capital. This may actually result in a net decrease in the availability of credit and liquidity to consumers and corporations.

To me, this process of liquidity destruction seems far from over. At some point in the future, a recovery in the derivative and securitization markets could bring back inflation risks. But those markets are far from operating at optimal levels, so inflation will not rise anytime soon. Derivative and securitization markets should see more regulation and less leveraged financial firms, which will curtail their recovery and their future growth. That doesn't bode well for financial stocks, but it will make high-quality bonds look attractive.

Buy bonds, sell stocks
Treasury bond yields have backed up substantially this year as money has flowed into other beaten-down areas of the bond market as well as stocks. But I see the corresponding fall in Treasury prices as an opportunity to buy since we still have a deflationary problem.

On the other hand, deflation is typically bad for stocks, because revenues decline while debt still has to be repaid at its full value. It can be especially bad for banks, as it reduces the value of the banks' collateral, potentially resulting in large losses if borrowers end up defaulting on their loans.

Yet as much as stocks have fallen lately, they're not cheap by some measures. In researching current valuations for stocks, I came upon some interesting numbers from Ned Davis Research. The numbers show the S&P 500 Price/Earnings (GAAP) ratio:

S&P 500 GAAP Price-to-Earnings Ratio


25-Year Average


50-Year Average


83.2-Year Average


April 30, 2009


Copyright 2009 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All rights reserved.

I thought that was a typo, but it's not: 131.05 is the right number. In large part, it stems from the writeoffs that financial institutions have taken in recent quarters; the figure includes substantial negative earnings from financials and other companies that have had to take writeoffs.

Even with those big writeoffs, though, how do you rationalize a P/E of 131.05? You don't even have to be a value investor to know that's expensive. If multiples fall even close to more common historical levels, there'd be a lot more pain for shareholders.

So if you've profited recently from the spectacular rally in the financial sector, it may be time to move on. I've listed the top 10 KBW Bank Index components below:


3-Month Return

Weight in KBW Bank Index

Bank of America (NYSE:BAC)



Wells Fargo (NYSE:WFC)



JPMorgan Chase (NYSE:JPM)



US Bancorp (NYSE:USB)



Bank of New York Mellon (NYSE:BK)



PNC Financial



State Street



Citigroup (NYSE:C)



Capital One Financial (NYSE:COF)



M&T Bank



Sources: Morningstar, KBW.

Others have noted that Wells Fargo, JPMorgan Chase, and US Bancorp appear to be in better shape than the rest, based on their financial strength. I'd add Bank of New York Mellon to that list as well. Yet many of these other banks have also seen shares jump strongly in just the past three months.

As I see it, given the possibility of further liquidity destruction going forward, those moves are simply not sustainable. Investors would be well-advised to take their gains and look elsewhere to protect their capital.

More on the inflation/deflation debate:

Fool contributor Ivan Martchev does not own shares in any of the companies in this story. Try any of our Foolish newsletters today, free for 30 days. The Fool has a disclosure policy.