Monday Morning: Deflation concerns are overinflated

If you want to know anything about how the stock market reacts to inflation or deflation, ask Steve Leuthold, chairman of The Leuthold Group, a research firm in Minneapolis.

Mr. Leuthold wrote the definitive book on inflation and the stock market.

“The Myths of Inflation and Investing” (Crain Books, 1980) explores the performance of stocks during inflation and deflation.

It is as fine a piece of original research as you’ll find, since Mr. Leuthold compared stock returns with inflation back to 1790. Unfortunately, the book is no longer in print, and because of that, I keep my copy safely hidden. (Disclosure: I got my copy because I edited it.) Mr. Leuthold’s research demolished the myth that stocks are a good inflation hedge. In fact, during periods of significant inflation – that is, when the consumer price index rose by 12.1% or more a year – the market returned less than 5% a year.

Stocks didn’t protect purchasing power, his research showed. In fact, stocks performed best in periods of relatively stable prices. And they performed well in periods of mild deflation.

Mr. Leuthold has updated his research because of the fear of deflation that many investors and stock market experts are exhibiting.

However, he doesn’t believe deflation is likely, even though the Federal Reserve Board says fighting deflation is now one of the targets of its policies. In fact, Mr. Leuthold argues that the chance of deflation in the near to intermediate term is “virtually non-existent,” and he lists reasons for this.

First, even though the rate of inflation in April – as measured by the consumer price increase – was 0.3% less than the March figure, it was still up 2.2% over the same period a year ago. Mr. Leuthold would define that as “mild inflation.”

Second, the Federal Reserve has been “showering the economy with liquidity and easy credit for the past several years,” he says. They will “grease the skids” for strong growth in the near future.

Third, the federal tax cut and deficit spending will stimulate demand, and that could augment “demand-pull” inflationary tendencies.

Fourth, the weaker dollar will also help push up domestic prices as imports become more expensive.

But what if we get deflation?

Mr. Leuthold updates his work in the June issue of Perception, The Leuthold Group’s monthly research report. The research indicates that stocks perform best in times of very low inflation, defined as 0.1% to 2% inflation. In such periods, stocks produced total returns averaging 15.3% a year.

But periods of mild deflation also produce solid stock market returns.

“The 24 years of mild deflation saw the stock market rise on average by 14.6%,” he writes in Perception. “Eliminating the seven years in which the CPI was unchanged for the year [0% inflation] actually improves average stock market performance during this mild inflation environment to 19.1%.”

The third-best environment is “where we are today, in mild inflation territory [2.1% to 3%],” he adds.

In that environment, the total return of the market has averaged 11.8% a year, compared with the average of 10.5% during the entire 131-year time frame.

So stock investors need not fear deflation, as long as it’s mild and controlled. In fact, that environment would be positive for stock returns.

But don’t take it from me. Take it from the man who wrote the book on deflation.

Mr. Leuthold doesn’t say this, but it’s entirely possible the recent run-up in stock prices could be signaling not only that the economy is about to turn, but also that we can expect relatively stable prices as the economy recovers.

Mike Clowes is editorial director of InvestmentNews and sister publication Pensions & Investments.