Deflation Hurts, but Stock Returns Can Take It

Few are excited about the potential of an extended deflationary period, which is "a much more devastating type of recession" than the inflationary one of the 70s that came along with oil-price shocks, says Marian Kessler, co-portfolio manager of the Becker Value Equity Fund. Already the effects have been felt by consumers facing negative home-equity and taking hits on their 401(k)s to the tune of 20%. But that deflation does help boost real returns and ease the burden of high costs for gasoline, food and other consumer goods.

The consumer price index fell 1% in October, just four months after it climbed 1%, so that should be evidence there is no guarantee that deflation is here to stay. The relationship between various economic and fiscal elements have been unsteady to say the least over the past few months, making it difficult to predict where things will go. And a negative change in prices will only help long-term real stock performance if it is sustained.

Casey Mulligan, a professor of economics at the University of Chicago, writes on his blog that deflation can be caused by investors stumbling out of the stock market and into "safer" assets like insured bank deposits and Treasuries. If banks, the Federal Reserve and the Treasury don't provide enough of such assets, consumer prices fall to make those assets more valuable.

While the "flight to quality" has already taken shape, Mulligan notes that banks and financial regulators have already taken significant action to accommodate demand. Banks have taken billions of dollars in additional deposits, the Treasury issuing more notes to fund its bailout initiatives and the Fed taking several steps to boost liquidity.