Growing Alarm Over Deflation Could Be a Buying Opportunity

Big-name investors were bracing for inflation just months ago. But as the economic recovery shows signs of slowing, deflation has become the main bet for a growing number of financial market luminaries.

As deflation displaces inflation as a talking point, though, investors should note the real fixture of Wall Street remains extrapolation. And the most rewarding bets might be to go against the grain since reality tends to veer toward the messy middle.

A severe financial collapse two years ago, for example, led to predictions of a return to the Stone Age. When a recovery emerged sooner and stronger than most had anticipated, Wall Street projected a "Goldilocks scenario" of booming earnings yet benign inflation.

Unwieldy debt loads in minor Southern European economies like Greece created fears of an outright breakup of the eurozone, which proved grossly exaggerated. And now, signs that the economic recovery is slowing are leading to calls for a deflationary spiral or double-dip recession.

Shunning Stocks Despite Increasing Strength?

The prospect of deflation has led investors to pile into safe assets like bonds, bringing yields on U.S. Treasurys to rock bottom. In a scenario where prices are falling, a steady income stream (however small) from a safe asset is tough to trump, according to this line of thinking.

But that has created a situation where investors are shunning stocks despite what's increasingly shaping up to be a very impressive second-quarter earnings season. Guidance, too, has been solid, and the risk that companies would use the cover of a slowing economy to ratchet down next year's earnings expectation is waning.

Some companies reported lackluster revenue growth at the start of the earnings season. But strong results in economically sensitive sectors like media paint a more bullish picture.

Media giant Time Warner (TWX)raised full-year guidance after impressive results. And earnings at CBS (CBS)leaped tenfold compared to last year, thanks to a rebound in sectors like local advertising that offer a good proxy for business activity.

Ahead of a Big Wave of Capital

Even the biggest bears like Gluskin Scheff economist David Rosenberg estimate that the S&P 500 companies will earn $77 a share next year. While a sharp dive from the record highs of $96 that Wall Street analysts are expecting, that's still enough to put a valuation on the S&P 500 of 1,155 with a reasonable 15 multiple.

If the tide turns, investors might find themselves followed by the massive pile of capital that's currently content with lower returns in safe assets. And the time to sell would be when a rise in stocks is exaggeratedly lauded as the return to a new gilded era, if prior machinations are any guide.