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Deflation and Your Portfolio

This week’s blog is on deflation and the potential effect on your portfolio. First, a look at how the market performed for the week, then some key points to note from the market’s performance, and finally, some things for you to consider based on the week’s activities.

What happened this week?

For the week ending on Friday February 20, 2015 the Dow (DJIA – green/blue line) closed at 18,144.29 (+0.75%), the NASDAQ (orange line) closed at 4,955.97 (+1.7%), and the S&P 500 (red line) closed at 2,110.30 (+0.8%).

Graph courtesy of Fidelity Investments. Feb 16 , 2015 to Feb 20, 2015.

week ending feb 20 graph

The U.S. stock market ended the week on a positive note for the third week in a row. The stock market continues to be boosted by positive news from Europe. Greece was granted a 4 month extension on their bailout loan, which was due to expire February 28 and had many investors worldwide nervously anticipating an extension. In addition, the ceasefire in the Ukraine appears to be holding, though a bit tenuously. In short, the stock market is on shaky legs!

What does it mean? (Key things to note)

With the Greek debt temporarily in investor’s rearview mirrors, oil prices kind of holding steady (or at least not plummeting at alarming rates!), and fingers crossed on the ceasefire holding up in Ukraine, another issue has become apparent. The threat of Deflation.

Deflation is when an economy experiences lowering prices. For the past few months, we have seen the price of oil plummet, and along with the oil of price, other prices have fallen too. You may be surprised to find that deflation is something that economists are worried about, and that you should worry about as well. In my previous blog titled “The Rebalancing Act” I talked about the domino effect that plummeting oil prices will have on companies, all the way down to you and me remaining employed. That domino effect is the reason deflation is a concern to economists, and should concern you as an investor. As companies’ profits decline because of falling prices, the return from their stock and other investment instruments will also decline, and become less attractive to investors. This leads to a decline in stock prices and portfolio values. So you see, there is plenty for us to be concerned about with respect to Deflation.

What steps should you take?

It is important to note that in the U.S. most Deflation scares have turned out to be false. Keeping that in mind, a few strategies to adopt for a deflationary environment include increasing government bond holdings and reducing your exposure to stocks and mutual funds of highly leveraged companies i.e. companies with a lot of debt and little cash. Yields from government bonds and other fixed income investments become more attractive in comparison to the falling prices of stocks, and investments with a lot of debt are sensitive to a deflationary environment as profits decline and the ability to repay loans becomes harder.

There is no need for drastic change, but it does not hurt to review your portfolio and see how your investments would respond in a deflationary environment.

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