Hulbert: What Stocks Do Well from Deflation

From MarketWatch:

By Tuesday’s close, the Dow Jones Industrial Average had fallen 107 points, erasing nearly half of its big gain during the previous session.
But are investors acting rationally when they dump stocks because of deflationary concerns?
Though it would certainly appear that they are, I’m not so sure. The job of a contrarian is to question widely-held assumptions, and the notion that deflation would be bad for stocks is so universally held these days that virtually no one appears to be subjecting it to any critical scrutiny.
One firm that has nevertheless done so is Ned Davis Research, the quantitative research firm. Lance Stonecypher, Senior Sector Strategist for the firm, recently analyzed sector performance during previous periods of significant deflation, both in this country as well as in Japan. Since there haven’t been many such periods, his conclusions of necessity must remain somewhat tentative.
But some fairly consistent themes nevertheless did emerge.
Perhaps the primary conclusion that Stonecypher reached was that, during past deflationary periods, the industry groups that performed the best fell into two categories Necessity and Defensive. Examples include Consumer Staples and Health Care.
Though Ned Davis Research doesn’t provide specific stock recommendations, examples of widely-held stocks in these two industry groups include Johnson & Johnson, Procter & Gamble, PepsiCo, Coca-Cola, and McDonald’s.
Digging further, Stonecypher also found that small-cap stocks have tended to markedly lag the large-caps during deflationary periods. The most pronounced periods of deflation in U.S. history came during the early 1930s, the late 1930s, and immediately after World War II. On average in those three cases, he found, small-cap stocks lagged the large caps by 13% per year.
Finally, Stonecypher suspects that the companies whose stocks perform the best during deflationary periods are those with the lowest debt/equity ratios. This makes sense in theory, he argues, because deflation makes it more difficult for debt to be repaid. (He was unable to confirm this theory, however, since he doesn’t have industry sector debt-to-equity data for the 1930s.)
The bottom line? It is possible to be gravely concerned about the prospects of outright deflation and still invest in equities. If you harbor such concerns but don’t want to give up completely on stocks, you might want to shift some of your equity holdings into the Consumer Staples and Health Care sectors, as well as shunning small-caps in favor of large-cap stocks with the lowest debt-to-equity ratios.

During the 1960s and 1970s, stocks like Wal-Mart (WMT) did very well by offering price-conscious consumers a place to go in order to fight inflation. While WMT’s pricing policies are controversial now, the company prospered thanks to its market position during the U.S. economy’s 15-year bout with inflation. The overall U.S. stock market didn’t do well at all.

Posted by on September 8th, 2010 at 11:10 am


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