Published: July 9, 2010

For as long as anyone can remember, the Federal Reserve has been tasked with keeping a close eye on inflation. But these days, Ben Bernanke and his peers are not worried about prices rising so much as they fear falling prices.

In some respects, deflation can be a lot worse than inflation. And even though we are unlikely to see prices drop on a nation-wide level, certain industries must deal with it in this low-growth environment.

Housing Prices take Down a Sector

To get a sense of the corrosive effects of deflation, look back at the housing market implosion. We all became familiar with the notion of homeowners being "underwater." Sinking home values meant that many homes were worth less than the money still owed to the bank. That led a lot of homeowners to walk away, leaving mortgage lenders holding the bag. That's why banks want you to put 20% down. It's a cushion against deflation.

For some industries, deflation is a normal part of doing business. Generic drug makers, for example, must account for annual price decreases as more and more drug makers start making these copycat drugs. Their challenge is to always find ways to lower costs to keep profit margins intact.

Why deflate?

Industries enter into a price spiral for a fairly prosaic reason: too much capacity. When a company needs to keep a factory at full output, it will need to cut prices on goods to find customers and that often kicks off a price war as rivals fight to retain market share. This is why economists track monthly data regarding factory utilization. As long as there is ample idle capacity in any industry, price wars may be just around the corner.

On an economy-wide level, factories need to be operating at least 80% of capacity in order to see pricing power. Anything above that invites the prospects of inflation as bottlenecks start to kick in and prices begin to rise. Anything below 80% implies that companies have little or no pricing power. The chart below shows a recent positive trend, but note that many firms have idled factories. If the economy improves, some of the factories would start back up -- so we need not worry about inflationary pressures any time soon.

Even though the trend is improving, any pullback in the economy would send this figure moving back down, which would be trouble for many industries that are just now getting pricing power. Take auto makers as an example. Ford Motor (NYSE: F) has been able to boost sales and profits in recent quarters simply because demand has climbed back up to meet industry capacity. (A large number of factories were closed, which helped). But if the economy falls back, look for another round of $2,000 and $3,000 rebates on cars and trucks and kiss Ford's profit forecasts goodbye.

Steel makers are another example. Companies have a high degree of fixed costs, so pricing power becomes crucial. With the economy on the mend, steel prices began to rise and that has led many analysts following U.S. Steel (NYSE: X) to think per share profits might nearly triple next year to around $6. But what if prices don't rise? Well, U.S. Steel lost more than $11 a share in 2009. That's deflation.

The key factor here is balance sheets. If an industry is suffering from deflation, companies with lots of cash can ride out the storm. But for those sitting on a lot of debt, deflation can be lethal.

You can also find trouble lurking on the income statement. Steadily falling gross margins are a possible sign that companies are cutting prices to retain market share. And when coupled with rising costs for inputs such as labor, deflation can provide a double-whammy.

Action to Take --> The upside of deflation: many industries will see their costs drop as input prices deflate. For example, what's bad for steel makers is good for auto makers like Ford Motor and appliance makers like Whirlpool (NYSE: WHR). Lower prices for Monsanto's (NYSE: MON) Round-Up has netted big savings for farmers.

In the past few years, makers of flat panel TVs built too many factories, creating a global glut. A comparable TV now sells for half of what it did a few years ago and lower prices enable retailers to move more merchandise, so consumer electronics vendors like Best Buy (NYSE: BBY) are a clear beneficiary.

As noted above, falling gross margins could clue you in to the fact that a deflationary spiral is kicking in. But the converse is true as well. Look for companies with steadily rising gross margins to find deflation beneficiaries.

-- David Sterman
Staff Writer
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