Winning Stocks for the Great Deflation

Last Wednesday, the Bureau of Labor Statistics (BLS) rode through the market with a terrible warning cry: "Deflation is coming! Deflation is coming!" Indeed, the BLS announced the steepest one-month drop in the 61-year history of the consumer price index (CPI).

Unprepared, investors took fright -- the S&P 500 lost over 6% that day partly on the basis of that fear. In this rotten environment, with oil prices now back down at tolerable levels, the threat of deflation should hardly come as a surprise. But why should we fear inflation, and -- if it does materialize -- what can we do to protect ourselves against it?

Deflation: It doesn’t get any worse
For one thing -- contrary to inflation -- there are limits to a central bank's ability to fight deflation. Think about it: Interest rates have a natural lower bound -- zero -- beyond which monetary authorities can no longer lower rates. Last month, the Fed lowered the Fed funds (the rate depository institutions charge each other on unsecured loans) to 1%, which means it has very little room left to pull that lever.

In periods of severe deflation such as the Great Depression, the value of the collateral that borrowers put up against bank loans decreases substantially. This spurs banks to curtail their lending out of fear of being unable to recover their principal in default, which further impedes economic recovery. That's a nasty prospect in an environment in which credit availability is already tight.

Between October 1929 and March 1933, prices (as measured by the Consumer Price Index) fell by more than a quarter. We have quite a ways before we reach that disastrous level of price erosion, and I don't expect that we will get there (although it's not impossible). All the same, it's worth thinking about sectors (and stocks) that we expect will outperform in a deflationary scenario, even if we are unlikely to reach the depths plumbed during the Great Depression.

Finally, the expectation of deflation causes consumers and businesses to postpone consumption and investment because they plan to purchase the same goods later at better prices. Another nail in the coffin of economic recovery.

Stuck in that sort of economic house of horrors, what should investors do to protect themselves against the ravages of deflation?

Stock types vs. economic sectors
Received wisdom tells us that dividend-paying stocks are a safe haven, but that's an idea I'm not enthusiastic about. It's true that a stable dividend becomes relatively more valuable as prices decline, and may provide support for the stock price, but I always prefer to reason on the basis of business performance rather than focus on the stocks that investors will prefer.

Traditionally, the sectors that perform relatively well in economic downturns are consumer staples, health care, and utilities; the demand for their products and services remains relatively unaffected by economic conditions.

However, given the expected severity of this recession, I think branded consumer goods will fare less well than they have in recent slumps (however, low-cost retailers could do very well indeed). I’m also lukewarm on utilities, which could have a hard time earning their cost of capital during the next few years due to increases in the cost of debt financing.

Build it and the profits will come
That leaves us with certain retailers, health care, and a dark horse: infrastructure. The latter could be a big winner over the next few years if the new government enacts a massive program of public works to rebuild America's aging infrastructure. After all, when monetary policy and consumers are tapped out, the government can still try to spend its way out of a downturn (unfortunately, the effectiveness of Japan's fiscal experiment with government spending on infrastructure is a matter of some controversy).

Following that line of thinking, I screened U.S. markets for mid- and large-cap stocks in construction and engineering, consumer staples, and health care. I added an extra criterion to identify safer companies, selecting only from the lowest quintile in each sector in terms of the debt-to-equity ratio. Here are seven of the 28 companies I came up with (these names are adequate ideas for further research, not recommendations):

In infrastructure, the other names that made the cut are: Jacobs Engineering, AECOM Technology, and Quanta Services.

Of course, pondering stock investments assumes that other aspects of your financial house are in order first. The best advice I found for managing an economic downturn was in an article from 2003 (the last time deflation was a threat) where Clifford Gladson, USAA's SVP of Fixed Income Investments, advised:

Invest in yourself…"[It’s] the best investment you can make," as staying employed in such a downturn is "the most important thing."

More Foolishness:

• Stocks to Buy (and Sell) in a Global Slowdown
• Failing Like Japan