Just a few days ago, my wife and I returned from a wonderful vacation on St. John. Since we spent almost every minute in sun filled activities, she had to listen to my daily reminders about sunscreen. Finally, the day before our homebound departure – when peeling skin threatened to overtake the coveted tan – she started to use all kinds of potions to stop the peeling process, without success.

This little anecdote - funny for the reader, unfortunate for my lovely wife – shows the importance of preventative measures. The right preventative actions taken at the right time can turn an unwanted, even dangerous, situation into a positive experience. When it comes to investing, knowledge and the correct application of knowledge can turn unwanted losses into profits.

Imagine if someone had told you to sell all your stocks in September 2007, or even September 2008, and you acted on that piece of advice. Stocks lost as much as 50%, following a period of relentless selling. Yes, prevention and preparation are powerful.

When it comes to investing, there is no time to rest. Even though the market has been rallying, it would be treacherous to expect this trend to continue. In fact, the market is devious and will deliver the next knock-out punch when least expected.

When planning ahead, investors need to know whether to align their portfolio to withstand inflationary or deflationary forces. While neither is pleasant, deflation certainly has the potential to be more detrimental to a portfolio of stocks, bonds, commodities, or broad index funds.

Before you go out and by ETFs like the iShares Barclays TIPS (NYSEArca: TIP), SPDR Barclays Capital TIPS (NYSEArca: IPE) or SPDR DB International Government Inflation Protected Bond (NYSEArca: WIP) to counteract inflation, you should consider the following:

Whether you own stocks, bonds, real estate or commodities, the issue of inflation vs. deflation is a must know subject. Preparing for the wrong scenario is like installing a burglar alarm to protect your house against an earthquake.

Inflation vs. deflation over the past two years

It doesn’t take a rocket scientist to figure out that deflationary forces ruled the roost, since the market peaked in 2007.

The Dow Jones, S&P 500 and Nasdaq all lost around 50% - top to bottom. Broad commodity ETFs, like the PowerShares DB Commodity ETF (NYSEArca: DBC) and iShares S&P GSCI Commodity ETF (NYSEArca: GSG), dropped between 60% and 70% from their 2008 watermark.

Even oil prices (NYSEArca: USO) dropped in excess of 75% at one point. To the surprise of many, gold (NYSEArca: GLD) has not been able to move past its March 2008 high of $1,017/oz. At one point, silver prices (NYSEArca: SLV) declined more than 60% from their March 2008 highs. Real estate ETFs, such as the iShares Dow Jones US Real Estate ETF (NYSEArca: IYR), paint the same picture.

Previously in 2008, the ETF Profit Strategy Newsletter identified the economic condition as a deflationary depression. Most investors disregarded the prediction of a market bottom below Dow (NYSEArca: DIA) 6,700, given in early 2009. Yet, it happened and deflation continued to take its course. The significance of the recent rally, and whether the bottom was temporary or permanent, will be discussed in a moment.

Inflation vs. deflation in the present

The most recent Consumer Price Index (CPI) released by the Bureau of Labor Statistics reflects the following deflationary forces:
- Over the last 12 months the index has fallen 1.3 percent. (This is the largest decline since April 1950)
- The food index decreased for the fourth consecutive month, falling 0.2 percent, as the indexes for all major grocery store food groups declined.
- The Consumer Price Index for Urban Wage Earners and Clerical Workers was 1.9 percent lower than in May 2008.
- The Chained Consumer Price Index for All Urban Consumers (C-CPI-U) has decreased 1.4 percent over the past year.

If you don’t think deflation is an issue, take a look around. Everything has gotten cheaper (compared to a year ago): food, cars, electronics, housing, etc.

Inflation vs. deflation in the future

Inflation is directly link to the value of the underlying currency. As such, the value of the US dollar will dictate whether deflation is to continue or not. The popular view on Wall and Main Street is that the government’s continued efforts to stimulate the economy by printing new money will devalue the dollar and cause inflation.

Here’s what the June 4th issue of the ETF Profit Strategy Newsletter had to say concerning the future prospects of the US dollar:

“Against popular belief, the US dollar should actually remain strong, at least for the next 1-3 years. Why? Extreme bearish sentiment surrounding the US dollar is pointing towards a rally which should begin shortly, if it hasn't already.” The greenback bottomed and has been trending up since.

Aside from the bearish sentiment, what other factors support a stronger US dollar? The newsletter continues, “The sheer amount of outstanding US debt should prove bullish for the longer term. Here's why: The US dollar is by far the most inflated currency. It is also the most commonly used currency in the world. As such, most of the debt - and toxic assets - in the world is US dollar denominated. As those toxic assets continue to deflate, US denominated wealth will continue to shrink.

The law of supply and demand teaches us that scarcity of any product results in higher prices. In other words, the fewer dollars in circulation the more valuable the remaining dollars will become. Inflation should stay subdued until the demand of a growing economy will once again outpace the manufacturing capacity (this is years away).”

Is the current rally the beginning of inflation?

Many argue that the recent rise in stock prices – the S&P 500 (NYSEArca: SPY) and Nasdaq (Nasdaq: QQQQ) were up as much as 40% – is sustainable and a sure sign that inflation has begun.

The ETF Profit Strategy Newsletter begs to differ. In fact, it predicted a 30% – 40% rally for Q1/Q2 2009 previously in 2008 and sent out a Trend Change Alert on March 2nd, four days before the S&P 500 bottomed. While Wall Street was caught up by a doomsday atmosphere in March, the newsletter felt that a relief rally was due after an 18 month, 50%+ meltdown.

Increasing investor enthusiasm, as we’ve seen over the past months, does not bode well for stocks. New bull markets climb a wall of worry, not an escalator of optimism.

The deflation of stock prices (along with other asset classes) is supported by long-term indicators with a track record of accuracy and the strengthening US dollar. Over the past 12 months, there’s been a strong inverse correlation between the US dollar and US equities. When one rises, the other one falls.

The March and June issues of the ETF Profit Strategy Newsletter contained a detailed outlook for the US stock market, along with target levels for the end of this rally and the ultimate market bottom. They also included a chart that outlines the performance of US stocks over the next few years.

Prepared investors will be able to navigate the coming months and years just fine. While those who fail to take protective measures, like our aforementioned vacationer failing to apply sunscreen, will get burned.