Propheteering

Disco, bell-bottoms and platform soles recently made a comeback in fashion circles, and now a leading market watcher believes an even more fearsome icon of the 1970s will soon return to financial circles: high inflation.

That’s a pretty grim notion, because financial markets of that time were slower than a Barry White LP played at 16 rpm. The stocks of large companies just moped through much the 1970s as raging oil prices and high inflation in general spoiled profit margins for most industries.

The next round of 10% to 20% annual inflation, according to newsletter editor Stephen Leeb, will probably make another generation of shareholders wish they had never heard of the Dow Jones industrials.

But, of course, he has a plan to make money off the bad times he foresees. If he’s right, his new book, “The Agile Investor: Profiting From the End of Buy and Hold,” will be worth its weight in gold futures. Or at least $23.

Leeb’s view of the next five or 10 years is a bit extreme and requires investors to accept several leaps of logic. But his basic message is that in a high-inflation world, you should throw out the stocks of large consumer-product and service companies and instead lay in a supply of energy and gold-mining shares. Bet the rest of the house on real estate stocks and assorted small-cap stocks, and by the time the new millennium arrives you’ll be humming the words to “Saturday Night Fever” all the way to the bank.

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For now, few Wall Street pros concur with Leeb’s point of view. Most credit Federal Reserve Board Chairman Alan Greenspan with taming the beast of inflation.

“Inflation is the last war and it’s been won. It’s over,” says H. Vernon Winters, chief investment officer at Mellon Private Asset Management in Boston, which handles billions of dollars for rich folks. If anything, Winters believes, deflation is a greater threat than inflation. He thinks stocks and bonds will far outperform “hard” assets like gold and real estate over the next decade.

Likewise, Frank C. Dohn, senior investment officer at Bankers Trust of California in Los Angeles, doubts the country will see annual inflation much above 3% in the next five years. He expects the U.S. work force to grow less demanding as baby boomers age--a trend that will ease pressure on everything from wages to home prices, he says.

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Leeb, however, believes that smart-money guys like Winters and Dohn have their heads in the sand. He points to last week’s government report that U.S. average hourly wages in 1996 rose nearly 4%, the fastest pace since 1990.

The have-nots of the world are about to demand much faster economic growth from the haves, Leeb contends. Those unfortunate souls who missed out on buying Intel at a split-adjusted $5--and you know who you are--are going to pressure their politicians to knock off the fight to keep inflation low and instead deliver faster growth and fatter paychecks, starting a new inflationary spiral.

Leeb thinks that leaders in Washington, London, Tokyo and elsewhere will give in to stay in office. He expects global economic growth to zoom to an annual rate of 4.5% or higher in coming years from an anemic 2.25% last year. That will set the stage for higher U.S. inflation that will ultimately crest at more than 20% a year sometime in the next 10 years, he says.

Leeb also believes that the markets in essential commodities--such as oil, aluminum, silver and copper--are about to pull out of their decade-long slump and rocket higher on the wings of explosive demand from Asia’s industrializing nations. Even after last year’s jump in oil prices, energy costs today are just barely above 25-year lows on an inflation-adjusted basis, he says.

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Finally, Leeb believes that the vast overhang of world debt will force many governments either to flood their economies with money in an attempt to keep debt interest rates low, or face chaos. Rapid money-supply growth is a classic cause of inflation.

Leeb, editor of the twice-monthly newsletter “Personal Finance” ([800] 832-2330, $79 a year), admits in his book that the high-inflation scenario is as hard to imagine as a snowstorm on a hot summer’s day, but he is convinced that it will come true nonetheless. And just as the Dow industrial average was no higher in 1981 than in 1965--a casualty, during that long period, of ever-rising inflation--Leeb believes the resurgence of inflation in the next few years will mean the Dow may soon peak and not hit new highs for more than a decade.

Like any good gloom-and-doomer, however, Leeb has packed a can opener with his survivalist cans of oil-packed tuna. So here’s how to make high inflation your friend, if indeed it comes roaring back.

The first rule in Leeb’s guidebook is to buy and hold shares in large companies only when the trailing 12-month rate of change in the producer price index--a measure of wholesale inflation--is below 4.25%; shun large-cap stocks when that inflation measure rises above 4.25%.

In 1996 the PPI rose 2.8%, but Leeb warns it is a volatile measure that can move up quickly.

This coarse market-timing method, he says, would have produced an average annual compound return of 15.5% from 1951 to 1995 in a portfolio consisting of the stocks in the S&P; 400 industrials index--well above the buy-and-hold return in that period of about 9% a year.

Leeb’s next covenant stems from his belief that stocks of small companies beat stocks of large companies in periods of high inflation, because small companies can raise prices easier in high-inflation environments, and thus grow earnings faster.

His rule: Shift your stock portfolio entirely to small stocks when the trailing 12-month rate of change in the consumer price index tops 7%.

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From April 1973 to November 1982, when the CPI galloped at an average of 8.7% a year, Leeb says, the average small stock scored gains of 22.6% while the average large stock gained just 7.7%.

Through November of last year, the trailing 12-month CPI stood at 3.25%, so we’re still a long way off, under his guidelines, from shifting from large stocks to small stocks.

Leeb, who holds advanced degrees in math and psychology from the University of Illinois, lives in New York and considers himself a “technophobe.” He won’t let his kids on the computer, for instance, out of a fear that the Internet will spoil their ability to conjugate Latin.

His proposals for investors who buy into the resurgent inflation idea:

* Prepare to jump into small-stock mutual funds like Baron Asset Fund ([800] 992-2766) and PimCo Equity Advisors Cadence MicroCap ([800] 800-7674).

* To take advantage of inflation in real estate prices and earn some income to boot, he advises purchasing real estate investment trusts like BRE Properties (ticker symbol: BRE), an owner of apartment buildings in California that is growing earnings at a 10% annual clip and sports a 5.4% yield. He also likes New Plan Realty (NPR), a REIT with properties nationwide that has raised its dividend every quarter for 13 years, has a 5.8% yield and earnings growth of 10%. “It sure beats a bond if you think inflation is coming back,” Leeb says.

* To put higher energy demand on your side, buy stocks in large oil companies such as Chevron (CHV) and Texaco (TX), which are expanding worldwide distribution to meet explosive demand in emerging countries and can easily pass on oil and gas price increases.

Leeb also advises that investors take a look at oil services companies like Schlumberger (SLB), the blue-chip drilling equipment outfit, which is expected to grow earnings at 25% annually for the next five years. In the last major energy cycle of 1976 to 1981, he says, Schlumberger stock jumped sevenfold.

Now, ready for the rebuttal? Mellon’s Winters contends that two key global forces are keeping inflation down: First, the industrialization of a couple billion Chinese, Indians and Malaysians--who are happy to make dolls and wall fans for 50 cents an hour instead of farming--is holding down worldwide wage inflation.

Second, he believes that improvements in technology are inherently deflationary because the efficiencies they breed result in productivity increases while allowing firms to kick more wage-grubbing workers out the door.

Winters agrees that some commodity prices might rise, but he points out that certain commodities are being used less and less. Copper, for instance, once went into every phone line. Today, fiber-optic cables--made basically from sand--are replacing copper wires.

Winters’ conclusion: U.S. inflation will be 2.5% or less annually over the next five years. The best asset classes to own: stocks and bonds, with an emphasis on the securities of banks and insurance companies that are supplying the world with capital.

For his part, Dohn would add the stocks of high-tech companies like Microsoft and Oracle to his low-inflation-expectation portfolio, along with the stocks of capital-goods giants like General Electric, Caterpillar and Thermo Electron.

Street Strategies explores investment tactics. Jon D. Markman is a Times staff writer. He may use strategies described in the column in his own account. He can be reached at [email protected]