Why Investors Should Be Terrified of Deflation

August 13, 2010
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In recent months, some investors and traders have openly wondered “Why would deflation be so bad.”

Well, that’s a pretty involved topic. But from a simple market standpoint, we can look to the Japan experience:

We’ve become so used to Japanese Government Bonds [JGBs] yielding next to nothing, that’s it’s easy to forget that back at the peak of the market in December 1989, the bond yield was above 7 percent.

That is, [the] Japanese market used to look much like the rest of the world.

Now, the 10 year JGB yields just 1 percent. The Nikkei 225 index, measuring the biggest blue chip companies there, has fallen from a peak above 39,000 to below 10,000.

- James Mackintosh, How deflation could crash the S&P 500

As James Mackintosh at the FT points out, Japanese investors were in denial “for a very long time” as to the true long-run impacts of deflation on the Japanese economy. And during that period of denial, as JGB rates fell from 7% to 1%, the Nikkei lost more than 75% of its value.

So how does that translate to the U.S. experience here and now? What can we expect if America truly “turns Japanese?”

As of August 12th, the yield on 10 year US Treasurys was just under 2.74%. It last touched the 7% mark — the point from which JGBs began their great fall — in the mid-1990s.

So here’s the kicker.

If deflation becomes a full-blown reality (admittedly still a big “if”)… and if 10 year yields do indeed match the JGB experience of falling to 1%…  and if U.S. equities register a comparative performance to Japanese equities in that time… then researcher Gary Jenkins at Evolution (via James Mackintosh) argues that the S&P would fall to the 400 level.

That’s a drop of more than 60% from here.

Full-blown deflation is not here yet of course. Mohamed El-Erian of PIMCO estimates we have a 25% chance of seeing it.

But now you know why investors should be terrified if it comes — because in periods of true deflation, valuation multiples get crushed to powder.

JS

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