The Long Road to Deflation for Stocks

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Nick Godt's Market Medics

Sept. 10, 2010, 12:01 a.m. EDT · Recommend (6) · Post:

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By Nick Godt, MarketWatch

NEW YORK (MarketWatch) -- One interesting clue that Japan's "Lost Decade" offers for U.S. investors wondering what awaits them: The road to deflation is a long one.

The newest season of the CW's teen soap "Gossip Girl" features settings in Paris and Fashion's Night Out. Costume designer Eric Daman shows off two show-stopping dresses worthy of Serena van der Woodsen and Blair Waldorf. WSJ's Elva Ramirez reports.

Another clue: Even in that environment, stocks can score some gains along the way, depending on how the global economy is doing.

Yes, Japanese stocks did slump in the 1990s, even as stocks in the U.S. and on global exchanges soared during the tech bubble. But there were periods, and even several years, where the S&P/TOPIX 150, an index of large-cap Japanese stocks, did score big gains.

And perhaps just as the U.S. is experiencing now, core consumer prices in Japan first went through disinflation, meaning the rate of inflation decreased for 8 years, from 1990 to 1997, before actual deflation occurred.

By the end of the lost decade, the TOPIX had slumped nearly 1%, while the S&P 500 index /quotes/comstock/21z!i1:in\x (SPX 1,109, +4.84, +0.44%) had gained 15.3%.

But after sliding 35% in 1990, losing 2% in 1991, and another 20% in 1992, the TOPIX jumped 15% in 1993, 9% in 1994, 4% in 1995, and a whopping 67% in 1999.

As deflation really took hold, the TOPIX then proceeded to fall further overall from 2000 to 2009. But there were also big gains in some of the in-between years.

Sam Stovall, market strategist at Standard & Poor's, plunged into the historical archives of Japanese stock performance, sector by sector, and dug out more interesting gems.

Yes, as was to be expected, inflationary hedges such as the energy and materials sectors under-performed the broad market, losing 13.1% and 10.1% respectively during the Lost Decade. And defensive sectors, such as healthcare and consumer staples outperformed, up 3.4% and 2.6% respectively.

But while it's not a complete surprise, it's interesting to note that the TOPIX's information technology sector did rise 11.6% during the 90s, as Japan's tech exporters did join in the whole celebration of the bubble years.

The translation for today's investment environment is that even if the U.S. economy continues to head towards a double-dip recession and deflation, first, the process may take a long while and second, stocks with global exposure should theoretically perform better.

Continued strong growth in emerging markets, such as China and India, and strength in export economies such as Germany, suggests this much.

Some blue-chip stocks come to mind, be they manufacturing-oriented, such as 3M , or consumer-oriented, such as Coca-Cola /quotes/comstock/13*!ko/quotes/nls/ko (KO 58.39, +0.10, +0.18%) .

U.S. government bonds and gold, which have benefited both from weakening U.S. prospects and expectations that the Federal Reserve will provide more stimulus to try and reflate the economy, are likely to see further gains as the situation worsens.

But as Alec Young, equity market strategist at S&P notes, it would pay off more for many long-term retail investors to keep bonds and gold as hedges in portfolios and to at least participate more in equities over the long run.

The question is, will they be able to stomach it? Should it become clear that we're on the road to either a double-dip recession and/or deflation, the market will likely take a nasty turn.

And the U.S., of course, is not Japan. It's hardly conceivable that further weakness and deflation in the world's biggest economy wouldn't also impact global growth and create more havoc in various markets.

Meanwhile, many retail investors have piled into bonds and hunkered down after seeing stocks lose more than 50% from peak to trough twice over the past 10 years.

After another serious bout of selling, telling them to get back in because, within 10 years, some sectors should perform better than others, and than government bonds, is going to be a tough sale.

Nick Godt is MarketWatch's markets editor, based in New York.

Investors who are rejoicing that Nokia Corp. has found a new chief executive might want to rethink their euphoria a bit.

12:33 p.m. Today12:33 p.m. Sept. 10, 2010 | Comments: 3

During the 90s, US stocks soared while she and Europe's economies grew. Oddly, Japan's stocks dropped even though Japan was a net exporter to those growing countries while it's citizens saved money. I think demand for their high quality goods kept them from an outright deflationary depression. Sadly our growth is slow, debt levels high, savings rate low, and we're Not a net exporter. Doesn..."

- M35StarCluster | 11:39 p.m. Sept. 9, 2010

"Energy stocks lead U.S. stock gains http://bit.ly/axAOWE" 11:47 a.m. EDT, Sept. 10, 2010 from MarketWatch

"Nokia Corp. names #Microsoft executive as new CEO http://bit.ly/dsYMMb" 11:08 a.m. EDT, Sept. 10, 2010 from MarketWatch

"President Obama names Goolsbee to head White House Council of Economic Advisers http://on.mktw.net/dleyTp" 10:13 a.m. EDT, Sept. 10, 2010 from MarketWatch

"PG&E shares fall 3% after San Bruno explosion http://on.mktw.net/d53e3a" 8:55 a.m. EDT, Sept. 10, 2010 from MarketWatch

"U.S. stocks open mildly higher ahead of inventory data http://on.mktw.net/9hWMf4" 8:33 a.m. EDT, Sept. 10, 2010 from MarketWatch

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