The tug of inflation

Buy a house, a tank of gas, or a load of lumber these days and you might feel an unfamiliar twinge. They seem a lot more expensive than they used to be.

What's afoot? Inflation - an old stock-market foe is beginning to make noises again after two decades of hibernation. So far, it has only boosted the prices of some goods. But there's an unusual twist: While hard assets like gold and oil have risen, so, too, have financial assets like stocks and bonds. And that leaves investors in a quandary. If commodity, stock, and bond prices are already sky high, where should they put their money to earn good returns?

The answers may push individuals and money managers into less traditional areas of investing.

"Extrapolating the past 20-year trend of disinflation into the future is an investment error," says Brent Harris, chairman of PIMCO Funds in Newport Beach, Calif., which offers several funds designed to outperform inflation. "Real return is what should be forefront in most investors' minds."

In other words, after 20 years of being able to ignore inflation, investors are going to have to take it into account as they allocate their money.

So far, inflation is roaring in only a few sectors of the economy. While platinum has soared 121 percent, soybeans have risen 115 percent, and an index of Real Estate Investment Trusts has climbed 42 percent since May 2001, the consumer price index (CPI) has gone up only 4.2 percent during the same period. The challenge is figuring out what happens next.

Astute investors are asking two questions: 1) Will the dollar continue to decline? 2) Which assets will continue to inflate?

The value of the dollar matters because much of what Americans buy comes from abroad. And in the past two years, the dollar has been slipping badly: down some 25 percent against a basket of foreign currencies, including the euro and the yen. That makes imported goods more expensive. If the dollar falls further, the rise in prices could boost inflation.

And that's exactly what some analysts predict. "This is not a run-of-the-mill problem where the currency corrects 25 percent" then stabilizes, says David Tice, Dallas-based manager of the Prudent Global Income Fund. "We have an economy that's very dependent upon ever-increasing amounts of debt. Look at borrowing in this country for automobiles and housing. At the federal level, we are creating credit as if it is going out of style. Given that, we think the dollar can decline substantially more from here."

That's why Mr. Tice's income fund has invested in government bonds in countries that are major trading partners of the US. These bonds tend to increase in value as the dollar weakens.

There are other ways for investors to protect themselves from inflation. For example: TIPS (Treasury Inflation-Protected Securities) are US government bonds that increase both principal and interest payments in line with the CPI/U, which measures prices for urban dwellers. Thus, if the price of consumer goods goes up, TIPS owners get a boost in their rate of return. That's a level of inflation protection that most bonds and money-market funds don't provide.

Still, there are no guarantees. If real interest rates rise faster than inflation, TIPS can lose value if they're not held to maturity. "TIPS have generally been less volatile than traditional bonds," but investors have already seen periods when their inflation-protection doesn't match the actual rise in prices, warns Duane Cabrera, head of the personal financial planning group at Vanguard, based in Valley Forge, Pa. For example, the year-over-year change in the CPI/U is running about 1.9 percent, he points out, but college costs have been rising about 5 percent annually.

Investors should also discuss the tax consequences with their investment advisers, Mr. Cabrera notes.

On the stock front, investors can also turn to natural-resource stocks or mutual funds that invest in them. A slightly more exotic option: exchange-traded funds, which act like mutual funds but trade like stocks.

Commodities offer another avenue for profit during inflationary times. Individual investors probably want to avoid commodity trading, often a wild and woolly experience. But certain mutual funds offer shareholders a chance to profit when commodity prices go up. The PIMCO Commodity Real Return Fund, for example, provides exposure to the performance of the Dow-Jones AIG Commodity Index while generating income from TIPS. Another option: the Oppenheimer Real Asset Fund, which is actively managed and tracks the Goldman Sachs Commodity Index.

There's no clear winner between these stock funds and the commodities their companies have invested in. When commodity prices are falling, natural-resource firms can protect themselves by hedging their risks, says Kevin Baum, portfolio manager of the Oppenheimer Real Asset Fund. On the other hand, hedging may keep them from benefiting when commodity prices rise. And the stocks can be more volatile than the commodities themselves. Gold funds typically are three times more volatile than the price of gold itself.

Sometimes, the commodities and funds tied to those commodities move in opposite directions, Mr. Baum says.

PIMCO's Mr. Harris is quick to note that many commodity prices have been soaring. So the key question is: Which ones will continue to rise in price? Individual investors should maintain strict discipline when they pick commodities funds, he says.

Traditionally, real estate has offered a safe harbor during inflationary times. And the explosion in the number of publicly traded REITS (Real Estate Investment Trusts) during the past seven years has provided average investors with a way to invest in almost any sector of the real-estate market. REITS own property that collects rents, which flows to REIT investors. And unlike most bond interest payments, which are fixed, rents generally rise over time.

But REITs have also risen in recent months, so some professionals are cautious. Others are downright bearish. "Every previous major bear market has been accompanied by a bear market in home prices," warned John Templeton, founder of the Templeton Funds, in a recent interview in Equities magazine. "When home prices do start down, they will fall remarkably far."

Some investment professionals - such as Jane Siebels of Green Cay Asset Management - are hedging both ways. She currently owns commodity-related stocks but is shorting (selling) based on real estate.