Some analysts say that deflation's bad rap might be undeserved.
Deflation is generally thought to be bad for stocks. Exhibit A in this argument: Japan, a country whose stock market has been in the doldrums since it began a terrifying deflationary slide more than two decades ago.
But U.S. market history shows that price multiples stay relatively high and stocks turn in their best performance during periods of mild deflation.
“Our conclusion is that mild deflation is one of the best environments for the stock market,” said Andy Engel, a senior research analyst at The Leuthold Group LLC, a research firm.
In a report last month, Leuthold cross-referenced consumer prices with stock market performance going back to 1926. The firm, using rolling 12-month periods, calculated every quarter during that time.
During the 34 periods with mild deflation — defined as anywhere from zero inflation to 2.4% deflation — the average gain in the S&P 500 was 18.2%.
FORWARD INDICATOR
Mr. Engel thinks the stock market, a forward indicator, performs well during mild deflation because it anticipates an improvement in economic fundamentals during these periods of slow economic growth.
“If deflation is mild, companies can still see some earnings growth yet benefit from low interest rates” that typically exist during deflationary spells, said Ed Easterling, head of Crestmont Research, which has also studied the effects of inflation and deflation on stock market values.
Periods in which inflation ran from zero to 3% also produced above-average stock returns, according to The Leuthold Group.
Mr. Easterling and Leuthold have also found that periods of mild deflation or low inflation are associated with above-average price-earnings multiples.
“Low rates and low inflation drive high multiples,” Mr. Easterling said.
The periods of mild deflation Leuthold looked at are “similar to what we're threatened with now” — a slowing economy that exhibits little or no inflation, with a risk of sliding into deflation territory, Mr. Engel said.
“The initial point where you see this deflation develop will cause a lot of people to be fearful,” he said, “but it's really an indication of the slowing economy and [a sign that] you're probably close to a bottom in the economy and the market.”
John Evans, managing partner and founder of Marietta Investment Partners LLC, isn't so sure that mild deflation would be benign.
Any level of deflation would be a negative, said Mr. Evans, whose firm manages $340 million in assets. “It would raise the specter of a depression, weigh on consumer confidence [and] be a negative for whatever political party is in power,” he said.
Mr. Evans, who hadn't seen the Leuthold study, wonders if some of those periods of mild deflation included market rebounds from big sell-offs in the 1930s.
In fact, most of the 12-month periods of mild deflation studied by Leuthold — 21 of 34 — came from the 1920s and 1930s.
Of course, it's not clear how today's market might react to a deflationary episode.
Minor deflation, if expected to be temporary, would not have a large impact on market multiples, Mr. Easterling said.
“Yet, if the trend of deflation appears to persist downward,” stock prices would be likely to fall, he said.
Historically, with deflation of 2.5% or more, the average total return on the S&P 500 was a loss of 6.6%, according to The Leuthold Group, with market multiples averaging just 10.8 times normalized earnings.
Of the 16 periods suffering this kind of severe deflation, 13 occurred during the Great Depression, according to Leuthold.
A “contagious” deflationary period causes revenue and earnings themselves to decline, Mr. Easterling said. Costs would fall, too, “but the whole income statement would compress,” and that lower base of earnings, “if it were expected to continue, would cause a correction” in stock prices, he said.
HISTORICALLY RARE
Few analysts see such a prolonged bout of declining prices — a rare occurrence historically.
Periods during which inflation falls nearly to zero, like the one the U.S. is experiencing now, tend not to end up as significant deflation, according to an International Monetary Fund working paper issued last month.
The study looked at 25 periods in advanced economies where sluggish economic performance produced disinflation.
At the other end of the spectrum, periods of high inflation also produced lackluster market performance, though not as bad as severe deflation.
Once inflation exceeded 3%, market performance fell to below average, according to the Leuthold study.
High inflation erodes the value of earnings and financial assets, analysts said.
Even with just mild deflation or inflation, returns from stocks might be muted.
In all the cases of slightly positive or negative inflation numbers that Mr. Easterling studied, using data from 1900 through 2009, market performance was “modest,” he said.
“In all of the situations, none brought an increase in [price-earnings] ratios,” Mr. Easterling said.
Using a 10-year normalized earnings figure, he said that the S&P 500 is trading at close to a 17 multiple.
EXPECTATIONS
“I'd expect [a multiple in the] low to mid-20s in a low-inflation environment,” Mr. Easterling said, so there isn't a lot of room for price expansion.
He expects average annual returns in the “mid-single digits” from the S&P 500 for the next several years.
E-mail Dan Jamieson at [email protected].
