Deflation and Stock Prices

Abstract

While the literature on inflation and stock prices is plentiful, there is little literature on deflation and stock prices. This paper explores the empirical data and makes a theoretical analysis of the likely impact on stock prices when expectations change from inflation to deflation. Deflation has a bad name among some economists and most investors. However, from a stock market perspective, deflations' bad name may not be well-deserved. Several observations support this: 1) The 1930s was a statistical outlier and not representative for a deflationary period and deflation does not seem to create recessions, causality goes the other way; 2) real stock returns are positive and around average in the periods leading up to and following the onset of deflation; 3) when moving from low inflation to mild deflation, P/E ratios are virtually unchanged; and 4) peak P/E ratios seem to be reached at inflation rates close to zero. The author proposes three possible explanations for the seemingly disconnect between the empirical data and the "default" ex ante belief of most economists and investors: availability heurist, deflation illusion, and tax related issues in connection with the tax hypothesis.