Small doses of inflation can actually help stocks


November 06, 2005|By GAIL MARKSJARVIS

Editor's Note: 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 each Sunday.

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 and 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, both 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.

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. 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.

Typically, when investors see weakness in the stock market, they move into bonds, but strategists are reluctant to do so 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.

Readers may leave messages for Gail MarksJarvis at 312-222-4264.

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