Hulbert: What Stocks Do Well from Deflation
Posted by Eddy Elfenbein on September 8th, 2010 at 11:10 am

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.

Similar Companies Doesn’t Mean Similar Stocks
Posted by Eddy Elfenbein on September 8th, 2010 at 11:06 am

Ok class, today’s lesson is on the pitfalls of similar stock performance. It’s tempting to think that all companies in a certain industry group behave the same way. The reason why is that in the short term, they often do.
Once you start following a sector closely, you’ll see that, say, all the major banks will go up or down together on a particular day. In fact, if bad news hits one company, then all of its competitors will behave similarly that day albeit not as much. Oddly, one would think that bad news hitting a competitor would be a positive, but such is often not the case.
I want to bring up the case of the major drug stocks. Here’s a chart of six major drug stocks over the past month. The stocks are Merck (gold), Pfizer (red), GlaxoSmithKline (orange), Abbott Laboratories (yellow), Eli Lilly (blue) and Bristol-Myers Squibb Company (black).

Notice that Lilly is at the bottom and GlaxoSmithKline is at the top. Yet, except for those two the other four are very bunched together. You can even see that the “nooks and crannies” of each line seem to match-up. This is actually a very good example of how the market works.
Let’s say you’re a hedge fund manager and you only have these six stocks to choose from. Since you’re being paid a lot to manage people’s money, you want to stand out from the crowd. As a result, you’re not so much looking for the best investments first, but you’re looking for the least-correlated investments. What attracts you is Lilly falling away at the bottom and Glaxo soaring above at the top.
For the hedge manager, the ideal trade would have been to be long Glaxo and short Lilly—hence the overall line would have been somewhat smooth and this trade probably would have been done with a great deal of leverage. Remember that leverage hates volatility. If you’re leveraged up 20-to-1, then a small 5% decline wipes you out.
Let’s say that you’re a mutual fund manager and you want quick-and-easy exposure to the major drug sector. You can buy an ETF but that makes you look lazy. You can also aim to get one of the four stocks in the middle. That way, you have the exposure and as long as you stay away from the worst performer, you’re fine.
Now let’s take a step back. Here’s the same chart except it goes back to the beginning of 2008.

Now we see a different story. The lines really do separate from each other. The only winning trade is Bristol-Myers, and Glaxo goes from the best stock to the third-best.
The point is that these companies aren’t the same despite near-term correlation. Even after less than three years, we can see major price discrepancies among these stocks. The lesson is that quality wins out, but it does take some time.

Erin Burnett: “You Have Definitely Gotten My Temper Up”
Posted by Eddy Elfenbein on September 7th, 2010 at 3:51 pm

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