The Biggest Threat Facing Investors; Part I: How and Why

From my point of view, prices in Europe have come down over the past few years. A meal at a four- or five-star Italian restaurant is considerably cheaper in Europe than a meal at an equivalent American restaurant. In Florence, one of the most expensive cities in Italy, a two-bedroom apartment right in town goes for $500,000… try getting the same condo in a major American city… it won’t happen.

In retrospect, the spike we had in oil prices this year was a blessing for Europe because higher fuel prices pushed up inflation. In Britain, for example, if it were not for the increase in oil prices, inflation would not be an issue. And this is where most reporters of the financial news go wrong. If we take oil and volatile food prices out of the equation, inflation is not rising.

House prices in the U.K. are falling just like in America. As for wages, with the amount of unemployment being created by the soft economy, pressure on wages is downward, not upward. The biggest gauge of inflation, gold bullion, is not acting like inflation is a problem. As for the bond market, the price of long-term bonds indicates that inflation may not be a problem for years to come.

This brings me to what I believe is the single, biggest threat facing investors today: Deflation. Deflation is defined as a period when prices in general are decreasing. Falling prices are a problem because many assets decline in price during deflationary periods, while debt stays fixed.

The most basic example of deflation at work is the price action of a house. If a consumer buys a house at $300,000 with a $280,000 mortgage, the consumer has $20,000 in equity. If the price of that house rises to $330,000, the consumer has $50,000 in equity, feels better, spends more… many even buy another bigger house. This is exactly what happened from 2001 to 2005.

But if that $300,000 house with a $280,000 mortgage was bought in 2005, then today the mortgage would be worth more than the house. The debt doesn’t go away, but the value in equity in the house does disappear. The consumer who bought the home feels poorer, spends less and considers walking away from his/her home because the equity is becoming more negative each passing day.

Deflation can ruin an economy. And while you won’t read about deflation anywhere else but here these days, I’m convinced that the Federal Reserve is very concerned about deflation. That is why the Fed is inflating so much via historically low interest rates and an expanding money supply.

On Monday: when and where this will affect investors and the stock market.