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How to Protect Yourself From Deflation

Stocks in this article: FLR PG WMT

These days, inflation fears are out. What's in? Concerns about prolonged deflation, a persistent and general decrease in prices.

While deflation may not sound so bad at first -- in mid-December, gasoline prices were down nearly 60% from July's record highs and holiday discounts abounded -- but it can have serious consequences for the economy and your wallet.

Deflation vs. disinflation: Deflation differs from disinflation, which is a mere slowing of the rate of increase in prices. That's an important distinction. Disinflation can be good for the market. A study by the Minneapolis-based Leuthold Group found that from 1872 through the last deflation threat in 2002, the S&P 500 posted a 15.3% gain in years of slight inflation and a 14.6% advance in years of flat to mild deflation.

By contrast, prolonged deflation can turn into a self-fulfilling downward death spiral, as it did during the Great Depression and during the 1990s in Japan, which saw its stock market suffer a long descent during the "lost decade."

How does deflation happen? When times get tough, consumers and businesses cut back on spending, which leads to downward pressure on prices as businesses try to attract customers. Those price cuts squeeze companies' bottom lines. They struggle with costs, debt and payroll; they cut production, and they lay people off. Consumers lose their jobs, or worry about losing them, and they cut back even more. And the cycle spirals on.

Rate cuts and spending: In October and November, consumer prices fell at the fastest pace since the Labor Department started tracking them in 1947, as the deteriorating economy pulled prices down for oil, consumer goods, homes and stocks. What seems like a boon to consumers, however, has economists and analysts concerned.

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