This Trojan Horse Could Slash Your Portfolio

With all the problems we're facing right now, many policy leaders have focused their attention on a major economic threat: increasing price instability. Yet while the downside of inflation is easy to understand, policy leaders seem much more worried about the other side of the price coin: deflation.

Fed Chairman Ben Bernanke's near-obsession with deflation has earned him the ire of those who see building inflationary pressures as the much greater threat. Nevertheless, waves of falling prices have worked their way through the economy, starting with collapsing home values, and moving on to crashes in crude oil, natural gas, and a host of agricultural commodities. Now, the stock market has joined the carnage in earnest.

So as we cringe month after month when we look at our brokerage statements, should we welcome lower prices with open arms? Or is deflation truly the bigger threat to our well-being?

What's good for consumers ...
On its face, you might think falling prices would be excellent for average people. Just look at how many problems high prices for gas and food have created for tight-budget families. While big oil companies like ConocoPhillips (NYSE: COP  ) and Chevron (NYSE: CVX  ) racked up record profits, workers struggled to put $4 gasoline in their cars to get to work. Concerns that most Americans had to spend all their disposable income on necessities caused discretionary retailers like Coach (NYSE: COH  ) and Starbucks (Nasdaq: SBUX  ) to take 50% haircuts in the past year alone.

In contrast, with gasoline futures trading at less than half their peak levels, retail gas could keep falling and soon approach the $2.50 per gallon range for the first time since early 2007. In theory, that should give consumers more money to spend on luxury items, boosting parts of the economy where people first cut back.

All that sounds great. So what's the catch?

... is bad for business
The problem with lower prices, however, is that although consumers benefit in the short run, their gains come at the expense of businesses. Lower prices often mean smaller profit margins, which can force businesses to cut costs in other areas. Salary reductions and even job cuts follow, and increases in unemployment can snowball, as people without work have to cut back wherever they can on spending, further reducing income for the businesses they used to buy from.

Meanwhile, even as many consumers are already dealing with a huge reversal of the wealth-effect benefits they enjoyed for years during the big moves up in the housing and stock markets. The money that homeowners are spending on underwater mortgages won't be available for other uses until the housing market rebounds -- and that could take years. Meanwhile, cash-poor consumers who might otherwise keep spending can't get the credit they need to do so.

The problems of deflation can rear their head well before these phenomena start appearing. All it takes is the fear of falling prices to stifle economic activity. Look no further than the credit crunch to see that. Banks look at the coming recession and realize any money they loan will be at higher-risk than usual, so they simply don't lend. Similarly, businesses won't invest in capital improvements or new facilities if they project falling profits. Companies like Corning (NYSE: GLW  ) and Wal-Mart (NYSE: WMT  ) have already announced cutbacks in their capital budgets for the immediate future.

Hitting you in your portfolio
For investors, this shows up in stock prices. Relatively high earnings multiples rely on consistent growth, and that growth has already slowed considerably. Even once-hot emerging markets have throttled back on growth estimates significantly. Doubts about  China or India as the saving grace for multinational corporations like McDonald's (NYSE: MCD  ) are only adding to the market's fear.

That's why policymakers keep trying to walk the tightrope between inflation and deflation -- and why it's crucial that they succeed. Having enjoyed the benefits of stable prices for 25 years, the last thing we need is to add price instability to the list of our current economic troubles.

For more on the panic of 2008, read about:

Deflation isn't the answer for the economy, but cheap stocks can present amazing values for investors. Our Motley Fool Inside Value newsletter is working overtime right now to find the cream of the bumper crop of beaten-down bargains. Specific stock recommendations, advice on the general economy, and much more are yours free with a 30-day trial.

Fool contributor Dan Caplinger has seen some deflation hit his portfolio lately. He owns shares of Starbucks, as does the Motley Fool. Wal-Mart and Starbucks are Motley Fool Inside Value recommendations. Starbucks and Coach are Motley Fool Stock Advisor picks. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy won't panic on you.


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