The $8 Billion Bet Against a "Lost Decade"

Whether or not the U.S. will experience a bout of Japanese-style deflation is a subject of much interest -- and controversy -- these days. PIMCO, the $1.1 trillion bond fund manager, is putting its money where its mouth is with an $8.1 billion bet against deflation. Let's walk through this trade before I point out a "no-deflation" bet that is better suited to individual investors.

Here's how the trade works: PIMCO received $70.5 million for selling insurance against deflation. If the Consumer Price Index (CPI) declines over the next 10 years, PIMCO pays its counterparty the percentage decline times the notional value of the contract. The total notional amount here is $8.1 billion. PIMCO felt it was being well paid for writing this insurance in March and April of this year, but the price of the contracts it sold has since risen by two-thirds.

Heads I win, "tail risk" you lose
The trade is a bet against a "tail risk" -- sustained deflation. Tail risks refer to events that have a low -- but non-zero -- probability of happening, i.e. they are located on the tails of the curve that models the probability distribution. PIMCO's trade is similar to the wager that Warren Buffett made on behalf of Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) by selling billions of dollars worth of long-dated insurance against declines in major stock market indexes, including the S&P 500.

Will PIMCO's bet pan out, or will the price level be lower in 10 years than it is today? The latter is certainly possible; we have seen it before in the U.S. In fact, it occurred over every 10-year period leading up to the months between June 1930 and August 1940. Some of the 10-year cumulative declines were substantial: Over the 10-year period ended in May 1933, the CPI fell by 25.4%.

Of course, the modern example of deflation in a major economy is Japan, which has suffered two lost decades in the wake of a massive property and share bubble that culminated in December 1989. Since mid-2003, Japan has experienced a near-unbroken seven-year stretch during which the trailing-10-year change in the CPI has been negative. Admittedly, these declines have been mild in comparison to those of the Great Depression; the largest cumulative price drop over a 10-year period was only 3% (July 1997 to June 2007).

The U.S. isn't turning Japanese
There is good reason to believe that things are unlikely to play out that way in the United States. The Fed has made it abundantly clear that it has adopted a "kitchen sink" approach to averting an outright deflationary episode. In addition:

• While flawed, U.S. policymakers' response to the crisis has been prompt. U.S. banks recognized the losses on soured loans/securities and were then recapitalized. The Fed cut interest rates to the bone and flooded the financial system with liquidity. Japanese bureaucrats and politicians took years to address the problems in the financial sector.
• Moreover, as Edward Chancellor of asset manager GMO pointed out this week, Japan is the exception, not the rule, in experiencing a lengthy bout of deflation following a credit boom and collapse. Chancellor says Japan is the only example in a sample of 20 credit booms and banking crises that two Bank of International Settlements economists analyzed in a paper in this month's BIS Quarterly Review.

A tightrope betwixt inflation and deflation
As I see it, the U.S. is walking a tightrope with twin ravines on either side: deflation or galloping inflation. Ultra-low Treasury yields suggest investors are taking the deflationary scenario seriously. The trouble with a bond-focused strategy is that it effectively amounts to a bet on deflation. Consider that, based on current yields, Treasury bonds will provide near-zero real returns under even minimal inflation -- just look at the real yield on the 10-year inflation-indexed Treasury security, which is less than 1%. Under a high inflation scenario, the real returns on Treasury bonds would be absolutely awful.

"High-quality income" theme
Instead, I suggest a strategy that amounts to a bet against deflation, but which should perform adequately if deflation were to materialize: high-quality income stocks with a sustainable dividend, such as the ones in the table below:

*Based on closing prices on Sept. 15 and next 12 months' EPS. Source: Capital IQ, a division of Standard & Poor's.

Let's be clear: I'm not saying investors should replace all bond holdings with stock investments. Unlike a government bond, neither principal nor dividend is guaranteed when you invest in shares. Investors must be careful to check share valuations to ensure that they are getting (more than) their money's worth in terms of intrinsic value.

Betting against is the smart bet
PIMCO will soon introduce a Tail Risk Hedging Fund for clients, but, in this case, by selling insurance against deflation they are taking on tail risk rather than hedging it. That looks like a smart bet. For individual investors who aren't in the business of selling derivatives based on the CPI, high-quality, income stocks provide an alternative, flexible bet against deflation.

In this market, dividends will be a major component of future stock returns, so it's a great time to take advantage of the fact that dividend stocks are cheaper than ever.