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The Fear of Deflation
Is Latest Jitter on Street

By GREG IP
Staff Reporter of THE WALL STREET JOURNAL

Bull markets usually end with inflation. Investors seem to worry this one will end with deflation.

After several days of calm, foreign turmoil slammed into the U.S. markets again Friday. A 4.2% drop in Japanese stocks and a 6.4% plunge in Brazil sent the Dow Jones Industrial Average tumbling Friday as many as 195.48 points before recovering to close down 101.92 points at 7581.32, though up 139.24 on the week.

The Dow Jones industrials now stand 134.09 points below where they were before the Bloody Monday plunge of two weeks ago Monday.

Almost ignored in Friday's chaotic trading was a jobs report that on its own would ordinarily have routed the market: The unemployment rate dropped to a 24-year low of 4.7% in October, far more jobs than expected were created, and wage growth jumped. Such a report indicates rising inflationary pressure and would ordinarily increase the likelihood that the Federal Reserve would raise interest rates. Yet bond prices, after selling off initially, were little changed on the day, with the yield finishing at 6.15%. Analysts said such a report would normally have produced a much bigger rise in yields, but a "flight to quality" from stocks held them down.

"The fear of deflation is gaining momentum over the fear of inflation," says Scott Slayton, equity-derivatives strategist at Morgan Stanley Dean Witter.

It's not that people think rising wage growth is good for stocks. It's just that when you combine that with the Asian currency devaluations and softer overseas demand, which make it even harder to raise prices, inflation may be contained but profit margins could be squeezed.

Investors "are trying to factor in the profit impact of more-massive spreading deflationary pressure," says Jim Paulsen, chief investment officer of Norwest Investment Management & Trust. The overseas turmoil will hurt profits by increasing price competition and reducing sales, he says. While postwar bull markets have typically ended with rising inflation and interest rates, "this is nothing like the postwar period. In fact, very little about this decade has been like the postwar period. We couldn't even get inflation to rise in this recovery."

It's still a minority view that stocks are more at risk from falling rather than rising prices. Indeed, a central-bank interest-rate increase in Britain and a jump in oil prices on renewed tensions in Iraq last week show that inflationary threats can pop up in many places.

But at present, stock investors are reacting more to the threat that economic and profit growth will be derailed by Asia's troubles. Semiconductor manufacturer Texas Instruments, whose prices and sales are perceived as vulnerable to Asia's troubles, has become a bellwether of this trend, notes Dan Mathisson, head of stock trading at D.E. Shaw Securities. It tumbled Friday 4 3/4 to 112 3/4 . And other stocks are being clocked because of price and margin pressure. Computer disk-drive maker Western Digital plunged 6 5/8 to 23 5/8 on Friday after it said second-quarter results would be much less than analysts' estimates because of "significantly higher-than-normal competitive pricing pressures."

Gerard MacDonell, a financial-markets analyst at the Bank Credit Analyst Research Group in Montreal, says, "The history of the 1970s and 1980s has been one huge Fed policy shock followed by another, so we're inclined to interpret everything as a Fed policy shock." But he says the threats appear to lie elsewhere this time. BCA research shows that the annual increase in wages has risen to 3.9% in the three months ended in October from 2.5% at the beginning of 1994, while the annual increase in consumer prices has fallen to 1.9% from 2.3% over the same period.

Says Mr. MacDonell: "You have upward pressure on costs from the labor market, and at the same time the reason we're not getting higher inflation is there's a ceiling on selling prices set by the strong dollar and Asian shock. Directionally, this is a no-brainer: This is definitely negative for margins. The question is the magnitude."

Until recently, what was viewed as good for bonds was good for stocks, because softer growth implied lower inflation, lower interest rates and thus higher valuations for stocks. But Mr. MacDonell says with inflation already so low, the perceived benefits of additional declines ebb away.

But Rosanne Cahn, chief equity economist at Credit Suisse First Boston, is more sanguine about profits. Quarterly surveys of her firm's analysts have found that for the past year a minority of industries they follow are able to raise prices but a majority face rising wages. "Yet profitability is terrific. The answer that squares that is the productivity element: [Companies] are hiring less rapidly than their output is going up. And that's all still in place. If anything, those efforts will now be redoubled."

Ms. Cahn says as inflation drops, it's natural that more and more individual items will actually have price drops. But that doesn't necessarily bring deflation. The 1950s were marked by stable producer prices, two big steel strikes, two serious recessions, the Korean War and routine drops in individual prices, "yet it never tipped into deflation or depression." Stocks performed "fabulously," with an average annual 13% capital gain for 10 years.

Christine Callies, stock strategist at CSFB, also doubts that the historic pattern of bull markets ending with rising inflation and interest rates is about to change. "The stock market usually runs into difficulty on the shoals of data that can move quickly or dramatically," such as interest rates. "Profit margins change slowly over time, particularly in an extended business cycle."

Still, with pricing pressure in abundance, Mr. Slayton says investors should go after companies that can raise prices. There aren't many; Mr. Slayton counts just seven of 50 sectors with the ability to raise prices materially. Among his favorites are oil-field service stocks, airlines and upscale hotels. Indeed, while the Dow Jones industrials are 9.2% below their Aug. 6 high, the Philadelphia Stock Exchange's oil-service index has since risen 22% while the American Stock Exchange's airline index is up 12%. "You want to be exposed to domestic, not foreign, situations," he adds, such as AMR Corp. and US Airways Group, rather than UAL or Northwest Airlines, which have a greater reliance on Asian business.

Friday's Market Activity

The Dow Jones Industrial Average tumbled 101.92, shedding 1.33%, to close at 7581.32. It marked the fourth time in the past two weeks the average posted a three-digit loss for a session, and the 11th time since the market reached its current high of 8259.31 on Aug. 6.

Intel gained 3 15/16 to 77 7/16 on Nasdaq. The company conducted its semiannual meeting with analysts, at which it stuck to its previous outlook for fourth-quarter results.

Western Digital's tumble hurt stocks in the disk-drive sector, with Read-Rite falling 1 15/16 to 19 3/16 on Nasdaq, Hutchinson Technology losing 7/16 to 26, Applied Magnetics falling 2 1/4 to 21 3/8, and Innovex shedding 2 5/32 to 25 7/8 on Nasdaq.

The broader technology sector suffered its own slowdown, with Seagate Technology surrendering 1 9/16 to 26 1/4 on the Big Board. Quantum dropped 5 3/8 to 30 3/16, while 3Com tumbled 2 13/16 to 38 1/8, hurt by a downgrade by Robertson Stephens, and Cisco Systems declined 1 1/8 to 83 9/16, all on Nasdaq.

Heftel Broadcasting moved ahead 1 7/8 to 75 1/8 on Nasdaq, extending the rise that began Thursday when the company reported third-quarter earnings and declared a 2-for-1 stock split.

Varco International added 1 3/16 to 65 7/8 . The company, which makes drilling equipment, said late Thursday it would split its stock on a 2-for-1 basis.

Central Parking climbed 5 1/4 to 60 3/4 . The parking services concern agreed to acquire Kinney System, a parking facilities operator, for about $206 million in cash and stock.

ITT added 11/16 to 80 5/16. Starwood Lodging Trust confirmed that it sweetened its bid for the hotel and gaming concern, the latest move in the takeover battle. Hilton Hotels, a bidder for ITT, slipped 1/8 to 31 1/2, while Starwood lost 1 to 57 13/16.

Fred Meyer rose 1 3/16 to 32 3/16. The supermarket chain said it will acquire Quality Food Centers, paying $1.7 billion, and closely held Ralphs Grocery for $3.1 billion. Quality Food shot up 6 7/8 to 58 1/2 .

Nine West Group fell 2 3/16 to 33 1/2 . Merrill Lynch lowered its rating on the footwear maker.