Deflation May Herald Onset of Bear Market

Even as the U.S. stock market has turned increasingly shaky in recent months, Wall Street has comforted itself with one stubbornly held belief.

Major market declines, many experts said, occur only when inflation and interest rates are rising. Since neither of those factors has been present, stocks couldn’t possibly descend into a “bear” market, they said.

But with share prices worldwide now in a deepening slide, a growing number of experts now think the biggest threat to the nearly 8-year-old U.S. bull market isn’t the usual one.

Instead of the twin evils of escalating inflation and higher interest rates, the stock market could be sunk by just the opposite: a U.S. recession, or near-recession, caused by the deflationary forces of faltering foreign economies, plunging commodity prices, cut-rate imports and widespread currency devaluations.

In this scenario, the economic upheaval buffeting East Asia, Russia and parts of Latin America would slowly infect the United States. Weakening demand for U.S. goods overseas, coupled with slowly eroding domestic consumer confidence, would derail corporate profits and chill Wall Street’s mood.

And interest rates, rather than rising, would be falling even as stocks sink.

In Wall Street parlance, this would mean an “ice”-driven bear market, a radical departure from the “fire”-driven bear markets of the past, meaning inflationary fire as the economy overheats.

Fear on Display as Markets Plunge

Fear of the ice scenario was displayed Thursday as markets around the world tumbled. Investors sold shares on concern that Russia’s morass of economic and currency problems would spread to many more countries.

Meanwhile, yields on long-term U.S. Treasury bonds fell Thursday to their lowest levels since the late-1970s, continuing a slide that has occurred as investors have sought “haven” securities amid world market upheaval.

“Investors in the U.S. are becoming very aware that deflationary pressures in other parts of the globe are starting to show up” in the United States, said Hugh Johnson, chief investment officer at First Albany Corp. “The outlook for the economy and profits is getting darker.”

A bear market is generally defined as a drop of 20% or more in major stock indexes such as the Dow Jones industrial average. A “correction” in a bull market is considered a fall of roughly 10% to 15% before the market regains its footing.

By those definitions, the Dow, now off 12.6% from its July 17 peak, so far is in a correction, not a bear market.

However, unlike the Dow, which consists of 30 large and well-known issues, smaller stocks are officially mired in a bear market. The Russell 2,000 small-stock index is off a whopping 25.5% from its April 21 high.

Many Pin Hopes on Correction

Despite the market’s travails, many investors cling to the belief that as long as inflation and interest rates remain under control, the stock market overall will suffer no more than a normal correction.

“Usually, extended bear markets are driven by recessions, inflationary fears and rising rates,” said Robert Bissell, chief investment officer of Wells Capital Management in Los Angeles. “You look at every one of those elements and they’re not here.”

Analysts note that rising interest rates have been present either immediately preceding or during most bear markets since World War II.

In 1987, for example, the Federal Reserve began pushing up rates on Sept. 4, about six weeks before the Black Monday sell-off on Oct. 19.

But other professionals note that while many bear markets have shared common traits, no two have been caused by identical forces.

“There are no rules,” said Robert Sobel, a business historian and senior fellow at the Milken Institute in Santa Monica, who has studied bear markets extensively.

Johnson added: “You don’t necessarily have to have rising rates [to have a bear market]. That’s just not true.”

There were at least two bear markets or near-bear markets in the post-war period that began when interest rates either were steady or falling, said Sung Won Sohn, chief economist at Norwest Corp. in Minneapolis.

Beginning in December 1961, the Standard & Poor’s 500-stock index fell 28% in 6 1/2 months, Sohn said. Economic growth was sluggish, and interest rates overall were relatively flat in that period.

In September 1976, the S&P; began a 19.4% descent over an 18-month period, even though the Federal Reserve early in that decline was actively reducing rates, and the economy was growing.

Rather than being triggered by higher interest rates, several bear markets have been fueled primarily by major external shocks, Sohn noted. The Arab oil embargo played a key role in the 1973-74 bear market, and the approaching Gulf War sparked the 1990 downturn.

“People tend to blame interest rates, but to a certain extent the Federal Reserve has gotten a bum rap,” Sohn said. “They were contributing factors but did not actually cause the economic recessions and bear markets [in much of the post-war era]. More likely, the direct cause was some outside factor.”

Today, the Asian financial crisis, which dates to July 1997, is the external event that could provoke another severe downturn in U.S. stocks--perhaps the first bear market since 1990, some say.

Many analysts have warned that the U.S. stock market has grown increasingly ripe for a bear market in any case. They point to the rabidly bullish psychology that has gripped the market in recent years, pushing stock valuations to historic highs relative to underlying corporate earnings, dividends and other fundamental criteria.

Sobel notes the usual progression as a bull market ages:

Early in a bull market, investors buy only well-known blue-chip stocks because they have limited faith in the market and don’t want to stick their necks out.

As time progresses, their confidence grows and they branch out to buy stocks of companies that are lesser-known but that have strong earnings and legitimate prospects.

Enamored of ‘Concept’ Stocks

In the end stage of a bull market, investors lunge at so-called concept stocks of companies with no earnings but big dreams--such as the craze lately for Internet-related stocks.

“We’re buying stocks now that have no earnings and no immediate prospect of earnings but that look good for the year 2010,” Sobel said.

But from a fundamental viewpoint, what worries many Wall Streeters most is the corporate earnings outlook for U.S. companies in general.

A handful of experts has predicted for months that the market had more to fear from deflation than inflation. They have argued that deteriorating economies abroad would eventually poison the economies of the U.S. and Europe.

Countries across Asia devalued their currencies last year, and Russia effectively devalued its currency last week. When that occurs, goods produced in the U.S. or Europe suddenly become much more expensive in those countries. At the same time, Asian or Russian exports become cheaper abroad.

That hurts companies in two ways. First, enfeebled foreign economies can’t afford to buy U.S. or European goods. Second, U.S. and European companies may have to drop prices to compete with lower-priced goods exported from foreign countries that have devalued their currencies.

One of the most vocal experts warning about deflation has been Edward Yardeni, economist at Deutsche Bank Securities in New York. He points out that deflationary pressures already are showing up across Europe. In France, for example, the consumer price index registered its largest monthly decline last month in more than 40 years. In Germany, inflation is expanding at its lowest level in 11 years.

In the U.S., a widely followed index of commodity prices fell to a 21-year low Thursday as gold slumped to an 18-year low.

While lower commodity prices are good for consumers, they can devastate commodity-dependent economies and regions.

In the U.S., for example, the Farm Belt is facing the prospect of a record harvest of corn--while corn and other grain prices already are at their lowest levels in a decade. Low prices will devastate many farmers, rippling through the Farm Belt economy.

The most frightening scenario, of course, is a new version of the Great Depression.

Deflation was a central element of the 1930s. As goods prices fell, corporate profits plunged and companies were forced to lay off workers. In turn, mounting layoffs caused consumer spending--already crippled by the stock market crash of 1929--to sink further, thus fueling a vicious cycle.

Thus far, the Asian crisis has had a silver lining for the U.S. Its dampening effect has offset the impact of strong domestic economy and sparked a new housing boom as mortgage rates have followed bond yields lower.

But if global deflationary forces exert further downward pressure on U.S. corporate earnings--already growing at their weakest pace since 1991--then investors may decide that stocks should be valued far below today’s levels, even if interest rates continue to decline, some experts warn.

That is the Japan scenario: Its stock market has been mired in a bear market since 1990, after falling from record high levels built up amid the euphoria over the Japanese economy in the 1980s.

Even as Japanese interest rates have fallen to progressively lower levels in the 1990s, the country’s economy has struggled to cope with the deflationary pressures exerted by the stock market’s plunge and the concurrent collapse in real estate values.