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INVESTING
Inflation Got You Worried?
by Carla Fried Butch Cassidy had the Sundance Kid. The Lone Ranger had Tonto. And in the pantheon of financial sidekicks, you can bet your IRA that when the Fed starts pushing up short-term interest rates, inflation lurks nearby. And inflation can add to the risk of owning stocks. A little bit of inflation isn't bad because it allows companies to raise prices, which can boost their profits. "It's a sign that the economy is doing well, that things are improving," says Anthony Chan, chief economist for Banc One Investment Advisors. But too much inflation -- or simply a pickup in the inflation rate -- can hurt stocks. Two of the worst bear markets in recent generations -- the 1973-74 and 1980-82 downturns -- were marked by double-digit gains in the consumer price index. The 1990 bear market coincided with a rise in the CPI from less than 5% to more than 6%.
Inflation, by itself, isn't the bugaboo of stocks. The problem is that higher inflation usually means higher interest rates. The Federal Reserve typically lifts short-term rates to rein in inflation by slowing economic growth. Meanwhile, inflation-conscious investors push up yields for longer-term debt by selling bonds (bond prices move inversely with interest rates). Higher yields hurt stocks by making bonds relatively more attractive.
Still under control
So, how serious is the inflation problem? A surprising 0.6% rise in the May CPI pushed the inflation rate for the trailing 12 months to a stronger-than-expected 3.1% (the annual increase in the CPI has been 3% or lower in 11 of the past 12 years). But a closer look at the numbers suggests that much of the past 12 months' run-up has been the result of jumps in food and energy prices. The so-called core rate, which excludes those volatile items, rose just 1.7% for the 12-month period through May. "The core rate is accelerating, but moderately," says Mark Zandi, chief economist at Economy.com. He sees the core rate climbing steadily, reaching a rate of 2.5% within the next two years.
You shouldn't overhaul your stock portfolio, however, just because inflation is accelerating. Douglas Brown, of Advisors Group of Chicago, points out that over the long haul stocks have provided the best defense against rising prices. "In terms of the real return -- what you earn after factoring in inflation -- stocks have always given you one of the best inflation hedges," he says.
Still, this might be a good time to buttress the inflation-hedging capabilities of your stock portfolio. Frank Armstrong, a financial adviser in Coconut Grove, Fla., and author of The Informed Investor, keeps 10% or so of his clients' stock assets in classic hedges such as commodities and real estate. He believes that these inflation hedges have a permanent place in a well-diversified portfolio. For straightforward exposure to real estate investment trusts, Armstrong favors Vanguard REIT Index fund (symbol VGSIX; 800-635-1511). The fund, which tracks the Morgan Stanley REIT index, benefits from low expenses of 0.24% a year. Over the past five years to July 13, it returned an annualized 15%, versus the dismal performance of Standard & Poor's 500-stock index, which had an annualized loss of 3%.
Our favorite fund in this sector is Third Avenue Real Estate Value (see "The 25 Best Funds," May). Manager Mike Winer doesn't buy many REITs. Instead, he invests in real estate operating companies that sell at discounted prices. The fund (TAREX; 800-443-1021) returned an annualized 18% over the past five years, a stunning 21 points per year ahead of the S&P 500.
Out of the ordinary
An even more esoteric fund for guarding against inflation is Pimco Commodity Real Return Strategy. The fund, which doesn't actually own stocks, seeks to outpace the returns of the Dow Jones AIG Commodity Index. Fund manager John Brynjolfsson does so by actively managing inflation-index bonds and other debt instruments, which serve as collateral for the fund's commodity positions. The fund's Class D shares (PCRDX; 800-227-7337), which are available without a sales charge from many discount brokers, gained 29% in 2003, its first full year, and 8% in the first six and a half months of 2004.
T. Rowe Price New Era (PRNEX; 800-638-5660) is a fund that takes a more traditional approach to investing in commodities. It owns shares of companies that operate in natural-resources businesses, such as energy producers, drillers and miners. Manager Charles Ober has about a fourth of the fund's $1.5-billion assets in foreign companies "because that's where the natural resources are." New Era generated an annualized return of 9% over the past five years, 12 points per year better than the S&P 500.
You can also take a contrarian approach to the inflation problem. The thinking is that Alan Greenspan and partners are so determined to quash inflation that the Fed's actions will lead to slower economic growth -- or maybe no growth at all. Under that scenario, investors would shift money to large, blue-chip companies, especially to those that sell goods and services that are purchased in any kind of economic environment.
Stuart Freeman, chief stock strategist at A.G. Edwards, cites Abbott Laboratories as a prime example of "a boring quality name that has been virtually ignored for the past year, but one that looks interesting now." At $40, Abbott (ABT) sells at about 18 times analysts' 2004 earnings estimate of $2.28 a share. That, notes Freeman, compares with a historic price-earnings ratio range of 15 to 31. Yet Freeman sees Abbott generating steady earnings growth of 12% a year. Freeman also thinks PepsiCo (PEP) and drug retailer Walgreen (WAG) will benefit from the renewed interest in big, steady growers.
A top-notch fund for investing in blue chips is Jensen Portfolio (JENSX; 800-992-4144). It returned an annualized 6% over the past five years, handily whipping the S&P and the average annualized return of -5% among large-company growth funds.
--Research: Jessica Anderson
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