The Deep Value Investing Philosophy During The Fed’s Ongoing War On Deflation A Possessive Apostrophe Is Needed Here. by Victor Wendl, Wendl Financial

The definition of inflation is a general increase in the price levels for goods and services. Deflation is simply the opposite of inflation, where prices are declining, not rising. The Federal Reserve (Fed) is of the belief that targeting inflation at a rate of two percent is the optimal level for keeping the United States (U.S.) economy chugging along. Let’s compartmentalize for a moment whether the Fed is even measuring the true rate of inflation correctly. Taken from the Fed’s website, “Having at least a small level of inflation makes it less likely that the economy will experience harmful deflation if economic conditions weaken.” Former Federal Reserve Chairman Ben Bernanke had a religious devotion to the “inflation good deflation bad” mentality as indicated by his academic work. Bernanke’s collection of research papers blame the Fed in the 1930s for not increasing the money supply to fight off deflation so as to avoid the Great Depression. Determined not to repeat the same mistake during the crisis in 2008, Bernanke aggressively implemented a quantitative easing program while simultaneously hammering interest rates to the floor. No monetary tool at the Fed remained idle in order to avoid deflation and the perceived risk that falling prices result in a collapsing economy.

Looking at deflation from more of a bird’s eye view rather than simply looking at Bernanke’s favorite example of the 1930s Great Depression, a different conclusion might be reached regarding falling prices’ perceived linkage to a contracting economy. A previous study showed no connection between deflation and a depressed state in the overall economy. The study looked at more than 100 years of economic data spread out over 17 different countries. No correlation existed between deflation and a contracting economy across all international markets, including the US. Even when the microscope was put over the 1929–1934 deflationary period, half of the countries in the study experienced economic growth despite collapsing prices. There does not appear to be compelling evidence that the Fed adds value to the economy by targeting a particular inflation rate in order to avoid the scourge of deflation.

As I mentioned in a previous blog, successful entrepreneurs focus on their own individual businesses. Monitoring macroeconomic variables as they do at the Fed is not a productive use of an entrepreneur’s time. Individual investors should have the same mentality when it comes to their portfolios. Rather than guessing the future rate of inflation and what effect it might have on financial assets, investors should focus on the minutiae of which stocks and bonds are of good value to purchase. Sliding the macroeconomic textbooks in a drawer and focusing on what stocks trade at a price point below some measure of intrinsic value is the behavior pattern of successful investors. One de minimis estimate of intrinsic value applied to a stock is its net current asset value calculation.  The chart below shows the average annual return following the rigorous value investing criterion of purchasing only stocks trading below net current asset value. The performance results are independent of Fed policy and do not require an investor to have an opinion on the future rate of inflation.

Deep Value Investing Deflation

*Net Current Asset Value Portfolio has no more than a five percent weighting in any one stock. Dividends and transaction fees are included in all of the calculations. During years where few stocks could be found, funds remained idle in U.S. Treasury Bills.

That subset of the Fed hierarchy who serve on the Federal Reserve Open Market Committee (FOMC) spend their days analyzing changes in various macroeconomic indicators, looking for clues as to the direction in which the overall economy might be headed. The FOMC is the primary decision-maker as to where short-term interest rates should be targeted. As already mentioned, its attempt at targeting the inflation rate is not consistent with statistical evidence in terms of stimulating the overall economy. Pushing interest rates to the floor in order to target a two percent inflation rate has resulted in retirees’ receiving little to no interest on their savings. This zero interest rate policy (ZIRP) has been in effect by the FOMC over the past 84 months. Unfortunately, an individual investor cannot control the behavior of the masterminds at the FOMC, but he or she can control what stocks to include in a portfolio. As indicated on the chart, embracing a deep value investing philosophy by purchasing only stocks trading below net current asset value outperforms the broad market average over the long term. This holds true both before and after the FOMC scrapes its targeted interest rate off of the floor.

It is a peculiar financial world we currently live in. The FOMC pores over the changes in food, clothing, and energy prices purchased by consumers. These prices are manipulated by the Fed, forced to move in a direction that may be in conflict with where Mr. Market feels they should be headed. Over the past seven years, entrepreneurs in this country have been manipulated into misallocating resources via the forced feeding of ZIRP soup by the FOMC. Because of their low interest rate policy, the Fed’s mandate of seeking long-run employment and price stability has morphed into an orgy of enticing reckless speculation with regard to overpriced stocks. Getting paid to manipulate interest rates and blocking a clear view of honest price discovery in stocks seem to be a waste of taxpayer money and a major irritation to investors who embrace a strict value investing philosophy.