Deflating Stock Market's Values

Inflation, while the US economy's main event for two decades, is actually a rare phenomenon. Charles Clough, chief investment strategist at Merrill Lynch, sees it going away, perhaps replaced by deflation. That would help push long-term interest rates down, boosting prices of long-term bonds but not necessarily stocks. Excerpts from his television interview on CNBC, with anchor Ron Insana on Aug. 12,. follow:

We've all learned to identify [economic] growth with inflation. That is something we learned to do in the 1970s and the 1980s.

But inflation is a very rare phenomenon. If you look back over economic history it is usually associated with wars. And the inflation we had in the 1970s and '80s was a very unusual event.

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It took decades of bad monetary policy to create it.

Our sense in this expansion is that things are quite different. The longer the economy expands, the more deflationary things become.

In other words, there is more likelihood that prices will start to go down. And the reason is, this expansion is investment-led. We have a pile of excess savings ... going into investment. And there are gluts and overproduction everywhere.

The Thais [for example, in devaluing their currency] have just decreased the price of their exports by 25 percent because there is too much excess capacity there.

So our sense is inflation is not the threat. Deflation is.

[Despite its negative impact in the Depression of the 1930s], deflation can be a very positive source of growth.... Perhaps there is no period in history that is quite the same, but the most comparative would be the period between 1869 and 1913. Industrial prices fell at a 1 percent annual rate, and for most of those periods we had pretty good growth....

We are seeing capacity build faster than demand can keep up....

We think stock prices are high. We are at 22 or 23 times [annual] earnings. You don't get up that high very often. I think we are beginning to see some companies struggle to maintain the kind of earnings we have seen. So our sense in stocks is they are not really cheap. We were much more enthusiastic about stocks when prices were lower. We are very price-sensitive here, and we are more cautious about the downside [of the stock market].

I do think there are areas of the stock market that still provide good value, and will do very well in our environment, if we are right about interest rates - that they will eventually fall, perhaps substantially.

Financials [such as banks] would do well. REITs [real estate investment trusts] would do well. Some building products industries that do have shortages of supply, like cements, would do very well....

We like the [long-term Treasury] bond a lot in this environment.

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