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Japan was unsuccessful in containing deflation for much of the 1990s. Interest rates were maintained near-zero for almost 15 years, with July 2006 marking the first time this policy was abandoned. Only in 2008 did Japan again sustain positive inflation rates.

One of the systemic side-effects of this long period of low interest rates is the so-called carry trade, with investors taking loans at very low interest rates in Japan and investing in higher yielding assets in countries with higher interest rates, typically emerging market economies. The 2008 financial market crisis has resulted in the unravelling of this carry trade, with many of these borrowed and sold yen unravelling causing a huge spike in the value of the yen relative to other currencies.

Systemic reasons for deflation in Japan

• Fallen asset prices. There was a rather large price bubble in both equities and real estate in Japan in the 1980s (peaking in late 1989). When assets decrease in value, the money supply shrinks, which is deflationary.

• Fear of insolvent banks: Japanese people are afraid that banks will collapse so they prefer to buy gold or (United States or Japanese) Treasury bonds instead of saving their money in a bank account. This likewise means the money is not available for lending and therefore economic growth. This means that the savings rate depresses consumption, but does not appear in the economy in an efficient form to spur new investment. People also save by owning real estate, further slowing growth, since it inflates land prices.

• Imported deflation: Japan imports Chinese and other countries' inexpensive consumable goods, raw materials (due to lower wages and fast growth in those countries). Thus, prices of imported products are decreasing. Domestic producers must match these prices in order to remain competitive. This decreases prices for many things in the economy, and thus is deflationary.

Investing in a deflationary economy

A period of deflation results in an increase in the burden of debt. Stores of value such as gold or cash are thus best kept out of the markets as their relative value appreciates even without interest income. This is generally a bad thing for the rest of the economy, so it is important to watch for signs that economic and fiscal policy are working to correct this potential downward deflationary spiral

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LAST WEEK Iwrote that iconoclastic economists have been warning of deflation for almost five years, based on subtle signs that Alan Greenspan hasn't been supplying enough liquidity to meet the needs of the U.S. economy. And now — finally — these warnings have come true in the form of declines in the consumer price index, the producer price index and several other widely followed measures of prices. So suddenly everyone's talking about deflation — and not just the iconoclasts.

Deflation isn't kind to stocks. For openers, deflation introduces complex distortions into the economy that make it harder for businesses to do business, and that's bad for all stocks. But more to the point, when the price of everything goes down, corporate earnings have to go down, too. And that means that stock prices will follow.

Think about it. Say Acme Widget sells a million widgets at $100 each, and it costs them $50 to make them — so their net earnings will be $50 million. Now let's say that prices fall across the whole economy by 10%, including the price of widgets — and the prices of all the things that Acme has to buy to make them. That means they'll only get $90 for each widget, but their costs will only be $45 each. If they still sell a million of them, net earnings will fall from $50 million to $45 million. All else equal, with earnings down 10%, Acme's stock will drop 10%. Probably more, because in a deflation all else will not be equal, and Acme will probably have a hard time selling a million widgets.

Some version of this effect of deflation should be expected to hit just about every company. So if you're strongly convinced of a deflationary future, and you have the flexibility to get out of stocks altogether, you might want to do just that.

But if you aren't sure whether deflation will really continue, or if you're a portfolio manager whose mandate requires you to invest in stocks — then you should at least hedge a little. You should at least understand which stocks are likely to be hurt the most, and which are likely to be hurt the least, in a continuing deflation — and position your stock portfolio accordingly.

The secret to stock picking in a deflation is simple: The winning companies are those whose products' prices will decline the least — but whose production costs will decline the most. If costs decline more than selling prices, these companies could actually increase their earnings in a deflation. The losing companies are those whose products' prices will decline the most, and whose costs will decline the least. If costs decline less than selling prices, the earnings of these companies will fall even faster than the general deflation of prices in the economy.

That's easy to say, but the dynamics of it are more complex than you might think. To see how they work, let's take a look at two widely held companies, Microsoft (MSFT: 24.44, +0.32, +1.32%) and General Motors (GM). Microsoft is a perfect example of a deflation winner, and General Motors is the perfect example of a deflation loser.

Let's start by looking at the differences between Microsoft's and GM's ability to keep their products' pricing afloat against the undertow of deflation.

GM is in a terrible position because its products are commodities, interchangeable with the virtually identical products of competitors from around the world. In a deflation — when the Federal Reserve creates too little money for the needs of the economy — commodity prices are always hit first and hit hardest because they are universal and liquid, and people can easily exchange them for the money there is too little of.

But Microsoft is in a great position, because its products are unique — why, some people would even say they are too unique. There's no commodity substitute for Windows or Office. So Microsoft can hold the line of pricing long after GM has had to throw in the towel. In fact GM has been throwing in a lot more than the towel lately — it's been throwing in free financing and all the trimmings. Call it a promotion to kick-start sluggish demand if it makes you feel better, but that's deflation playing out right under your nose.

Now how about the cost side?

On the one hand, GM derives advantage from the falling costs of the commodity materials that go into its manufactured products. But on the other hand, it's stymied by its enormous labor costs — and the fact that a large fraction of its work force is unionized. That means workers are covered by long-term contracts that guarantee rising wages for many years into the future, deflation or no deflation.

What's worse, GM is cursed by hidden labor costs that extend beyond salaries. The auto maker is on the hook for pension and postretirement health-care benefits for as long as its employees live, with the amount of the benefits keyed to salary levels. The cost of these benefits isn't going to go down with deflation — but the securities portfolios that are invested today to pay those costs in the future will. Historically GM has had difficulty getting even its retirement commitments fully funded — now, if there's a protracted spell of deflation, it could spell disaster.

Microsoft, by contrast, has a small and flexible labor force, and no pension issues. It's true that Microsoft won't enjoy the benefits of falling commodity prices, because commodities aren't an input to its products. But at the same time, its nonunionized labor force is more flexible in terms of negotiating wages, and more accustomed to receiving significant fractions of its compensation in the form of contingent incentives such as stock options.

And Microsoft doesn't have to worry about pension benefits. Its retirement benefits are provided by a 401(k) plan to which the company and its employees make contributions during the employee's working life, and the benefits in retirement are strictly a function of the performance of the investments chosen by the employee. Microsoft is totally off the pension hook.

But there's one other major factor that works in Microsoft's favor in a deflation, and it could be a deathblow to General Motors: debt. Microsoft doesn't have any, while GM has a GMC truckload — $144 billion worth, on which it pays interest of $9.4 billion a year.

In an ocean of deflation, that kind of debt is a boulder chained to GM's neck. Because auto prices are going to fall, and some of GM's costs may fall. But that $9.4 billion won't. As deflation marches on, that constant $9.4 billion payment in nominal dollars represents more and more in terms of real — that is, deflation-adjusted — purchasing power that GM must expend to pay for assets that will become worth less and less.

Meanwhile, Microsoft not only has no debt, but it also sits on a mountain of cash — $36 billion, to be exact. And in a deflation that's the opposite of debt. That cash will just get more and more valuable every year, allowing Microsoft to have its pick from among a world of deflated assets any time it wants, and insulating it from the need to take on debt in a deflationary world of too little money in circulation.

GM has $9.5 billion in cash, and in their otherwise dire circumstances that's a very comforting thing. But bear in mind, they will need it. As deflation marches on and GM's revenues fall while its debt-service needs remain constant, it will automatically become increasingly leveraged — so GM will find further debt financing increasingly difficult and expensive.

I'm using Microsoft and GM here simply as examples of general principles. Obviously there are many company-specific factors that must be considered in addition to the effects of deflation. That said, these general principles can easily be applied to other companies. So here's your deflation-investing checklist:

Remember, deflation is going to be tough on all stocks. But if you follow this checklist, at least you'll avoid the worst of the damage. And you might even find a real winner. Because when you think about it, this checklist makes good sense whether or not you see deflation in our future.

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Stock markets, whether in Europe, Asia, or the United States, all appear headed lower throughout the remainder of 2009. With global equity markets moving in sync since topping in 2007, a view of the DJIA will suffice.

The decline from the 2007 high above 14,000 was in 5 waves (an impulse) and the recovery from the March low is a corrective 3 wave affair. Market movements in the direction of the larger trend occur in 5 waves. Similarly, 3 wave market movements are classified as corrections. The rally from the low is corrective (in this case a complex correction), and will therefore be entirely retraced.

Is it possible that a larger degree brings the Dow back to 10,000 or so before the larger bear resumes? Anything is possible but other markets appear to have already turned, which favors the downside from the current juncture. Also, corrections tend to end near the 4th wave of one less degree, which is the case here (see arrow). The position of the 200 day SMA (in red) also supports bears. The smaller chart is a 240 minute bar chart and shows the wave count at a smaller degree of trend. An acceleration of the decline this month is expected.

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by Robert Reich