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Chicago Tribune Gail MarksJarvis Column

Posted on: Sunday, 6 November 2005, 15:00 CST

By Gail MarksJarvis, Chicago Tribune

Nov. 6--FOR INVESTORS, INFLATION IS BEST TAKEN IN MODERATION: Bouts of inflation don't always end badly for investors.

But sharp inflation--like the 10 percent to 13 percent variety of the 1970s and '80s--can poison stocks and bonds so badly that even slight whiffs of inflation throw a scare into investors.

So it's not surprising that a 4.7 percent surge in the consumer price index over the past 12 months has caused investors to cower, investment managers to re-examine client accounts for vulnerable investments, and market historians to dig through their archives for hints to the future.

The Leuthold Group of Minneapolis, for example, examined inflationary periods back to 1926 and found encouraging signs for investors if inflation stays within the 5 percent level that some analysts expect over the next few months. Typically, when inflation reaches the 10.5 percent mark, investors take a bashing as the stock market goes into negative territory.

But between 4.5 percent to 6.5 percent, where inflation is now, there's a lesser threat. In about a third of such periods, the stock market went negative, but more often the market climbed over 10 percent, said Leuthold analyst Andrew Engel.

A little inflation can be good for stocks. Typically, companies can raise the prices they charge customers. That can nudge profits up, delight investors and send stocks higher.

But if inflation mounts and interest rates climb sharply, businesses and consumers can suffer. As rates rise, businesses have to pay more interest when they borrow. Those extra costs can curtail their profits and cause them to cut back on expansion plans and staffing--especially when expensive fuel and commodities also are taking a toll, as they are now on some businesses.

Likewise, if consumers must pay more to use credit cards, and no longer can receive easy cash through low-interest home equity loans and refinancing, they may skip purchases.

The economy, consequently, can slow and corporate profits shrink, sending stocks down.

That's what investors have worried about lately, causing the market to go into negative territory in October. Yet last week investors were more sanguine--counting on consumers and businesses to weather what is considered a temporary bout of inflation, primarily from high energy prices.

That thinking led Ned Davis Research of Venice, Fla., to dig through historical records for insight into similar periods. The analysts looked at times when so-called core inflation--or an inflation measure that excludes the costs of food and energy--is low compared to the overall consumer price index. And the results were not encouraging. On average, during such periods the Dow Jones industrial average provides just a 3 percent return.

Ned Davis responded to that, plus weaknesses in the stock market and economy, by suggesting investors cut back on stocks. For an investor that would typically keep a "balanced portfolio" of 55 percent of their money in stocks, 35 percent in bonds and the rest in cash, Ned Davis now suggests only 40 percent in stocks and 40 percent in bonds. And for safety, the strategists suggest doubling cash, to 20 percent of the portfolio.

The Leuthold Group is equally defensive, suggesting only 38 percent of a portfolio go into stocks. And Standard & Poor's strategists also cut their recommended stock allocation to 45 percent, instead of 50 percent previously.

Typically, when investors see weaknesses in the stock market, they move money into bonds. But strategists are reluctant to do that now.

With interest rates rising, T. Rowe Price vice president of allocation Charles Shriver has only 34 percent of a balanced portfolio in bonds and the rest in stocks. He thinks inflation is close to peaking, which leaves room for solid stocks to do well--especially large-cap growth, he said.

Rising interest rates can be cruel to bonds, and a recent survey by Merrill Lynch showed bond investors so bearish, "It makes one pause," analyst Michelle Charles said. Only 9 percent of investors trusted long-term bonds.

Investors who buy safe government bonds and hold them until they mature don't have to worry. But if interest rates continue to rise, bond funds will lose money, and investors who want to sell a bond will take a loss. That's because old bonds that pay low interest are no longer attractive to investors when they can instead buy newer bonds that pay significantly higher interest.

That's why Park Ridge financial planner Gary Bowyer is making sure his clients invest at least 10 percent of their portfolio in what are called TIPS, or Treasury inflation-protected securities. These bonds are adjusted by the federal government to pay investors more when inflation is rising. Bowyer suggests the Vanguard Inflation-Protected Securities Fund. Investors can also buy U.S. government Series I bonds, with inflation protection, through www.treasurydirect.gov.

In stocks, experts said, investors must be selective.

Ariel Fund managers recently re-examined the stocks within its fund to weed out companies that have high levels of debt, said Ariel Capital Management LLC Vice Chairman Charles Bobrinskoy. If interest rates move up, companies with excessive debt levels will face higher costs. Individuals can look for yellow flags in their own stocks by checking Standard & Poor's debt ratings, avoiding companies with BB or lower ratings.

Ned Davis Research notes that in periods like now, when core inflation lagged the consumer price index, consumer discretionary stocks like auto firms and retailers were the worst investments. And they have been this year: During the last three months, the sector lost almost 10 percent. Historically, investors also suffered losses in telecommunications, financials, technology, basic materials and utilities. Energy, health care, consumer staples and industrials were strongest.

This week kicks off a new Your Money column by award-winning reporter Gail MarksJarvis. Look for her column on personal finance, investing and your questions in the Business section's Your Money chapter each Sunday. Contact Gail MarksJarvis at gmarksjarvis@tribune.com or leave a message at 312-222-4264.

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TROW, MER,

Source: Chicago Tribune

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