Street Sense: The fundamentals of stock market investing
Low Rates Now; Inflation Later?
Huge government spending and economic stimuli in response to the Sept. 11 tragedy could be inflationary.

When the government opened its checkbook following the Sept. 11 terrorist attacks, it signaled the first crack in the low interest rate/low inflation environment we've enjoyed in recent years.

Certainly, paying out tens of billions of dollars for industry bailouts, grants to allies and stepped-up military spending is an appropriate response by a government that must now wage war on terrorism while also trying to stimulate the sagging domestic economy with tax cuts. Unfortunately, we learned during the Lyndon Johnson years that tax cuts and huge spending increases at home and abroad are a recipe for renewed inflation.

This month, I'll explain why investors should begin to adjust their thinking about investing, taking these new realities into account.

Clearly, the Federal Reserve will continue to lower interest rates until the economy improves, but with budget surpluses a thing of the past and the return of deficit spending, the financial markets will surely react to the inevitable reappearance of inflationary pressures.

INVESTING IN INFLATIONARY TIMES

What will a round of inflation mean to the average investor?

First, the bond market won't be an attractive place to put money. Bonds perform best when inflation is subdued. Money will flow into short-term Treasury bills and money market funds, which are essentially riskless.

Inflation is bad for almost every segment of the stock market. Anyone who remembers the financial markets of the late 1970s and early 1980s will recall that stocks and bonds didn't begin to rally until the Reagan administration and the Federal Reserve broke the back of inflation in 1982 and touched off one of the biggest, most sustained rallies in the history of the financial markets.

A little inflation will keep the financial markets on the defensive and weak. However, if inflation truly rears its ugly head, investors will turn away from most industries and instead flock to companies that are associated with so-called "hard assets." The most widely recognized hard assets are precious metals such as gold and silver, but energy companies that have large reserves of oil and natural gas can also serve as safe havens during inflationary times.

THE ALLURE OF DOMESTIC ENERGY

Energy companies with domestic production also have another attraction. Heightened tensions in the Middle East associated with terrorism and the campaign against terrorists could threaten the flow of energy to the United States. If Middle Eastern oil supplies are jeopardized, the stock market will place a higher value on energy-producing companies whose reserves are primarily located in North America. There are literally hundreds of companies involved in the domestic energy industry, from the actual energy producers to providers of oilfield supplies such as drillpipe, valves and offshore platforms.

YOU CAN "PARK" YOUR MONEY

Even with these "hard asset" alternatives, it's not easy to invest during inflationary times. Real estate hasn't proven itself to be a good hedge against inflation. And a prudent individual shouldn't put his entire portfolio into gold, silver and energy-related stocks. That would defeat the idea of staying diversified.

To cut risks during a time of rising inflation, it's advisable to "park" a good portion of your liquid assets in very short-term financial instruments that serve as a substitute for cash. By doing this, you can ride out the storm without much exposure to the vagaries of the stock and bond markets.

The inflationary pressures touched off by the events of Sept. 11 are just beginning to be discussed, but they're very real. History tells us that a period of almost unlimited government spending, such as we're now seeing, has inflationary consequences. The wise investor doesn't fight history. 

Ophthalmology Management Associate Editor Jerry Helzner has written more than 50 articles on stock investing for Barron's. He has been a regular stock market columnist for other business publications and was a member of the equity research department of a major regional brokerage firm.