Some call Prem Watsa the Warren Buffett of Canada. He is the CEO of Fairfax Financial (OTC: FRFHF), an insurance holding company modeled in much the same way as Berkshire Hathaway. And over the last 30 years, he compounded the book value of this business by more than 21%.

Not only does he have a remarkable track record, but as early as 2004 he accurately predicted, and was warning of, the impending doom facing the housing market.

#-ad_banner-#Recently, he began warning of a new danger to the markets: deflation.

The United States is six years into an incredible bull market: the S&P 500 has nearly tripled from its March 2009 bottom, and the markets continue reaching new highs every month.

On the surface everything looks rosy. Underneath, though, Watsa warns of serious trouble brewing.

In Fairfax’s most recent investor conference call, Watsa referred to the fact that current levels of inflation are now at 60-year lows. That by itself is somewhat alarming, but remember that those low levels were reached despite the fact that the United States and almost the entire world has been engaged in easy-money policies on an unprecedented level.

Once quantitative easing is completely ended, he says the United States and the entire world are in great danger of facing a long period of deflation. In fact, several countries in Europe are already facing a deflationary environment.

An investor might wonder why deflation is such a big problem. After all, isn’t it good when prices drop? Doesn’t that equate to giving all consumers a raise?

The answer to that is unequivocally no. Lower prices mean lower profits for corporations.  Lower profits mean that costs have to be cut, people get laid off and unemployment levels rise.

On top of that, lower corporate profits mean that stock prices are going to come down, which makes everyone feel less wealthy and further reduces personal spending.

To understand the severity of deflation and its effects on a market, simply look at Japan, which experienced a prolonged period of deflation, from 1990 through today.

If Watsa is correct then investors should be reducing their exposure to equities immediately.  I think that isn’t a bad idea even without deflationary concerns when you consider that the market is at all-time highs and is six years into a bull run.

A serious correction is likely in our near future.

One stock that you might want to own going into a deflationary environment is Fairfax itself.  Watsa has positioned Fairfax to both profit from a collapse in equity prices and to profit directly from deflation.

Fairfax has nearly $7 billion of cash and short-term securities ready to be invested in opportunities that might arise in a big market selloff. Additionally, Fairfax owns more than $100 million in derivatives that are set to generate big profits should the consumer price index (CPI) decline — which is what will happen in the event of deflation. Those CPI-linked derivatives would be worth billions if deflation actually occurs as Watsa has forecast.

There are times to be aggressive and there are times to be defensive. I believe today is the latter, and more importantly so does Prem Watsa.

Risks To Consider: Making macro calls is not an easy task and although he has a three decade track record of excellence, it is possible that Watsa is wrong on this one.

Action To Take –> Start reducing exposure to U.S. equities and consider investing in Fairfax.

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