What Stocks Would Do Well Amid Deflation?

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Mark Hulbert

Sept. 8, 2010, 12:01 a.m. EDT · Recommend (1) · Post:

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By Mark Hulbert, MarketWatch

CHAPEL HILL., NC (MarketWatch) -- The specter of deflation once again reared its ugly head on Tuesday, contributing to a big tumble in the stock market.

By Tuesday's close, the Dow Jones Industrial Average /quotes/comstock/10w!i:dji/delayed (DJIA 10,341, -107.24, -1.03%) 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?

/quotes/comstock/10w!i:dji/delayed DJIA 10,341, -107.24, -1.03% $INDU

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 /quotes/comstock/13*!jnj/quotes/nls/jnj (JNJ 58.70, -0.23, -0.39%) , Procter & Gamble /quotes/comstock/13*!pg/quotes/nls/pg (PG 60.14, -0.15, -0.25%) , PepsiCo /quotes/comstock/13*!pep/quotes/nls/pep (PEP 65.48, -0.09, -0.14%) , Coca-Cola /quotes/comstock/13*!ko/quotes/nls/ko (KO 57.63, +0.07, +0.12%) , and McDonald's /quotes/comstock/13*!mcd/quotes/nls/mcd (MCD 75.80, +0.71, +0.95%) .

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.

Mark Hulbert is the founder of Hulbert Financial Digest in Annandale, Va. He has been tracking the advice of more than 160 financial newsletters since 1980.

Add Comment › · Recommend (1) · Post: Alert Email Print More Mark Hulbert Sept. 7, 2010 Advisers who do well in up or down market Sept. 3, 2010 Are stocks really undervalued? Sept. 2, 2010 Don't leave the bond party -- yet Sept. 1, 2010 September by the numbers Sept. 1, 2010 Contrarian take on gold market Explore related topics Dow Jones Industrial Average Johnson & Johnson The Procter & Gamble Co PepsiCo Inc Coca-Cola Co McDonald's Corp Comments Screener About Mark Hulbert

Mark Hulbert is editor of the Hulbert Financial Digest, which since 1980 has been tracking the performance of hundreds of investment advisors. The HFD became a service of MarketWatch in April 2002. In addition to being a Senior Columnist for MarketWatch, Hulbert writes a monthly column for Barron's.com and a column on investment strategies for the Journal of the American Association of Individual Investors. A frequent guest on television and radio shows, you may have seen Hulbert on CNBC, Wall Street Week, or ABC's World News This Morning. Most recently, Dow Jones and MarketWatch launched a new weekly newsletter based on Hulbert's research, entitled Hulbert on Markets: What's Working Now.

First Take H-P unlikely to keep Mark Hurd from Oracle

Hewlett-Packard's lawsuit against Mark Hurd, its former chief executive who is going to Oracle as a co-president, enters into a murky legal arena in the state of California.

4:27 p.m. Sept. 7, 2010 | Comments: 45

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Low debt/equity?Like Apple??"

- jmmx | 1:20 a.m. Today1:20 a.m. Sept. 8, 2010

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/quotes/comstock/10w!i:dji/delayed Dow Jones Industrial Average (DJIA) /marketstate/country/US The market is open5:36:07 am The market is closed5:36:07 am 10,341 Change -107.24 -1.03% Volume 149.04m Real time quotes var embeddedchart568898974Chart = new EmbeddedChart('#embeddedchart568898974', NormalChartStyleNoDecimals, 190, 90, '1dy', '5mi', null, null, null, 'US:DJIA'); jQuery.data($('#embeddedchart568898974').get(0), 'embeddedchart', embeddedchart568898974Chart); Add to portfolio $INDU Find a Broker Create alert /quotes/comstock/13*!jnj/quotes/nls/jnj Johnson & Johnson (JNJ) /marketstate/country/US The market is open5:36:07 am The market is closed5:36:07 am $ 58.70 Change -0.23 -0.39% Volume 5.63m Real time quotes var embeddedchart1643762236Chart = new EmbeddedChart('#embeddedchart1643762236', NormalChartStyleNoDecimals, 190, 90, '1dy', '5mi', null, null, null, 'US:JNJ'); jQuery.data($('#embeddedchart1643762236').get(0), 'embeddedchart', embeddedchart1643762236Chart); Add to portfolio JNJ Find a Broker Create alert /quotes/comstock/13*!pg/quotes/nls/pg The Procter & Gamble Co (PG) /marketstate/country/US The market is open5:36:07 am The market is closed5:36:07 am $ 60.14 Change -0.15 -0.25% Volume 7.42m Real time quotes var embeddedchart428224031Chart = new EmbeddedChart('#embeddedchart428224031', NormalChartStyleNoDecimals, 190, 90, '1dy', '5mi', null, null, null, 'US:PG'); jQuery.data($('#embeddedchart428224031').get(0), 'embeddedchart', embeddedchart428224031Chart); Add to portfolio PG Find a Broker Create alert /quotes/comstock/13*!pep/quotes/nls/pep PepsiCo Inc (PEP) /marketstate/country/US The market is open5:36:07 am The market is closed5:36:07 am $ 65.48 Change -0.09 -0.14% Volume 5.29m Real time quotes var embeddedchart1596708389Chart = new EmbeddedChart('#embeddedchart1596708389', NormalChartStyleNoDecimals, 190, 90, '1dy', '5mi', null, null, null, 'US:PEP'); jQuery.data($('#embeddedchart1596708389').get(0), 'embeddedchart', embeddedchart1596708389Chart); Add to portfolio PEP Find a Broker Create alert /quotes/comstock/13*!ko/quotes/nls/ko Coca-Cola Co (KO) /marketstate/country/US The market is open5:36:07 am The market is closed5:36:07 am $ 57.63 Change +0.07 +0.12% Volume 7.20m Real time quotes var embeddedchart71993664Chart = new EmbeddedChart('#embeddedchart71993664', NormalChartStyleNoDecimals, 190, 90, '1dy', '5mi', null, null, null, 'US:KO'); jQuery.data($('#embeddedchart71993664').get(0), 'embeddedchart', embeddedchart71993664Chart); Add to portfolio KO Find a Broker Create alert /quotes/comstock/13*!mcd/quotes/nls/mcd McDonald's Corp (MCD) /marketstate/country/US The market is open5:36:07 am The market is closed5:36:07 am $ 75.80 Change +0.71 +0.95% Volume 185.00 Real time quotes var embeddedchart1891690390Chart = new EmbeddedChart('#embeddedchart1891690390', NormalChartStyleNoDecimals, 190, 90, '1dy', '5mi', null, null, null, 'US:MCD'); jQuery.data($('#embeddedchart1891690390').get(0), 'embeddedchart', embeddedchart1891690390Chart); Add to portfolio MCD Find a Broker Create alert Featured Commentary » Next: Mark Hulbert

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