Investing to Beat Inflation

by John Dobosz

 In October, the nation's first baby boomer, Kathleen Casey-Kirschling, applied for her Social Security benefits. The 61-year-old woman was born one second after midnight on January 1, 1946.

Following Ms. Casey-Kirschling into retirement over the next two decades will be about 80 million people born between 1946 and 1964, a generational swath that encompasses everyone from Bill Clinton and George W. Bush to Sandra Bullock and Rob Lowe.

Welcome to your retirement, boomers. It's going to be a long one.

Making sure that your savings last as long as you do could be a challenge for some people. And even if your nest egg grows, will it grow fast enough to keep you ahead of inflation?

Going back 40 years to 1967, do you know which had a higher annualized gain: the S&P 500 Index or the Consumer Price Index (CPI)? Although you may be tempted to say inflation, you'd be wrong.

From September 1967 to September 2007, the S&P 500 produced an annualized return of 7.14%, compared to the annualized gain of 4.67% in the CPI over the same period.

If the message you take away from this is that stocks keep you ahead of inflation, then you're only half right. During the 1970s, stocks--despite a couple of bear and bull markets--were essentially flat, while the CPI more than doubled. The good times for stock investors came after 1982, when harsh monetary policy from the Federal Reserve helped to wring inflation and its expectations out of the financial system.

Lots of investors look at what's happening now with the dollar, gold, oil and other commodities and argue that substantially higher consumer price inflation is just around the corner. Even Federal Reserve Chairman Ben Bernanke has acknowledged its possibility and that it would be "costly" to fix.

"During the past 25 years, we've had two huge disinflationary forces at work," says James Stack, editor of InvesTech Research. Namely, the spread of the personal computer and the opening up of labor markets around the globe have helped to keep a lid on inflation, he says.

Technology and the personal computer have helped make workers more productive, while labor markets in China, India and Eastern Europe have helped to offset the traditional inflationary pressures that build during an economic expansion, since American firms have been able to outsource production to countries with a lower wage base than the U.S.

However, now that personal computers are nearly ubiquitous and China and India have matured rapidly, those release valves may no longer open, and inflation could once again percolate higher.

In September, consumer prices were 2.8% higher than they were a year before. That's still mild and just about in line with the 25-year average inflation rate.

But what if higher fuel and energy prices do what seems logical--drive up prices in general? Is your portfolio prepared?

Inflation can be a double whammy, since it not only lowers the worth of your dollars in the future but it also tends to depress overall equity returns, says Sam Stovall, chief investment strategist at S&P Equity Research.

To find out the impact of rising inflation on individual sectors of the market, Stovall looked at eight periods since 1969 when inflation has accelerated and moved above 4% before turning lower. He tabulated things like average absolute returns and frequency of outperforming the overall market. As a whole, the S&P 500 lost an average of 1% during these periods of rising inflation, but there were some clear winners and losers among sectors.

Predictably, energy was the best sector during higher inflation, gaining an average of 24%, followed by materials and telecommunications services, which posted average advances of 12% and 10%, respectively.

The biggest loser has been the financial sector, underperforming the market 75% of the time during high inflation and posting an 8% average decline. Consumer discretionary stocks underperformed 62% of the time with an average loss of 6%.

"Classic defensive stocks seem to work well during inflationary times," says Stovall.

Smaller stocks can also keep you ahead of inflation, points out Stack. "From 1974 to 1982, when the overall market was flat, the smallest 20% of companies on the NYSE were up about 600%," he says. Good growth stocks, too, can stay ahead of inflation.

Whether or not we will see another six-fold increase in prices over the next 40 years, we do not know. But you should invest like we will--just to be safe.

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