?Dangerous Time? to Avoid Stocks, CLSA?s Napier Says

Stock investors can look forward to another few years of gains as central banks engineer a return to inflation, providing a tailwind for global markets, according to CLSA Ltd. strategist Russell Napier.

An acceleration in inflation from zero to 4 percent is historically associated with gains in stocks as the benefits of rising prices accrue to profits instead of labor earnings or debt holders, said Napier, the author of ?Anatomy of the Bear,? a study of bear markets.

Thereafter, a bearish cycle that began in 2000 will resume as the Federal Reserve allows inflation to spiral out of control and foreign investors stop buying U.S. sovereign debt, sending the Standard & Poor?s 500 Index to an eventual bottom of about 400, Napier predicts. An index of U.S. consumer prices dropped 1.3 percent in May from the previous year, the Labor Department said on June 17. That was the steepest decline since 1950.

?We?re likely to get strong broad money growth, and I think it?s a very dangerous time be out of the equity markets,? the Edinburgh-based strategist said in a telephone interview yesterday. After a few years of gains ?the Fed will launch its final attack on inflation and it will take us into a fairly terrible situation. They?ll let go and we?ll head for inflation.?

The MSCI World Index has rallied 37 percent since dropping to a more-than 13-year low in March amid signs the worst of a global recession has passed. The deepening credit crisis caused the gauge to sink by a record 42 percent last year, which was its first annual decline since 2002.

Tobin?s Q Ratio

The best bets for investors remain Asian equity markets, which are likely to be driven by domestic demand-related growth and will be less affected by problems in Western countries, said Napier, Institutional Investor?s top-ranked Asia strategist from 1997-1999.

Even though the U.S. stock market is already above fair value on measures such as the Q ratio, which compares market capitalization to the replacement cost of assets, and a 10-year price to earnings ratio, equities will likely continue on the current rising trend, Napier wrote in a report this month.

Tobin?s Q, a mean-reverting indicator of whether the market is overvaluing or undervaluing company assets compared with the replacement cost, was 18 percent above its historic average in June, according to data compiled by U.K.-based Smithers & Co.

Inflation Hedge?

The 10-year price-to-earnings ratio of the S&P 500, another long-run indicator of stock values, was 15 percent above its average, according to Smithers and data compiled by Yale University?s Robert Shiller.

Stocks aren?t a good hedge against inflation, however, because accelerating prices eventually lead to a collapse in equity markets, Napier said, citing a 1977 Fortune magazine article by investor Warren Buffett. The ideal stock market environment is when there is disinflation, a move from high to low levels of inflation, as occurred between 1982 and 2000, the strategist said.

Napier started his career in 1989 as a fund manager for the Scottish firm Baillie Gifford & Co. As CLSA?s Asian strategist, he called the bottom of Asian equity markets in mid-1998.

Economists such as David Rosenberg at Gluskin Sheff & Associates Inc. and formerly of Merrill Lynch & Co., have cited the output gap as a reason the U.S. economy is headed for deflation, and an end to the equity rally. The output gap is the difference between the productive capacity of an economy and its actual output. In the current situation, where capacity exceeds demand, prices are bound to fall, Rosenberg said.

?Looks Fatigued?

?While many investors are consumed with the rapid expansion of the Fed?s balance sheet and money supply, the ongoing contraction of the household balance sheet is a far more pronounced event that renders deflationary risks the more predominant near-term risk,? the economist wrote in a June 19 report. ?The rally really looks fatigued.?

Napier counters that central banks have the ability to manufacture inflation, citing a Milton Friedman comment that ?inflation is always and everywhere a monetary phenomenon.?

The U.S. M2 money supply, the broadest indicator currently tallied by the government, has climbed 1.9 percent in 2009 from the year after logging a 9.6 percent increase in 2008.

?Because they?re printing so much money and because they?ve seized control of the commercial banking system I think we?re likely to get strong money growth,? Napier said. ?It wouldn?t surprise me at all if the main inflation we get is in asset prices.?