High on Energy, Wary of Inflation

Stephen Leeb of Leeb Capital Management delivers a cautious outlook on stocks -- and reveals his best picks for long-term investors

Oil prices and inflation are two major factors affecting the investment outlook, according to Stephen Leeb, president of Leeb Capital Management. As a result, he sees the Dow stuck in the 10,000 range for some time -- much as it stayed around 1,000 for more than 15 years before the early 1980s.

Leeb, author of The Oil Factor, believes that, under the conditions, energy stocks make a good place for money. Of the major oil companies, he prefers ChevronTexaco (CVX ), but he likes smaller companies in oil and oil services even better and names among them TEPPCO Partners (TPP ). He points out that most Wall Streeters expect oil and natural gas prices to drop -- which he doesn't -- and that energy stocks are thus a sound investment now.

Partly because of the dollar's weakness, Leeb sees gold in a long-term bull market and cites Bill Gates and Warren Buffett as investors shorting the dollar. One interesting way to play gold, he says, would be the exchange-traded fund StreetTRACKS Gold Shares (GLD ).

These were a few of the points Leeb made in an investing chat presented Feb. 3 by BusinessWeek Online on America Online, in response to questions from the audience and from Jack Dierdorffof BW Online, the moderator. Following are edited excerpts from this chat. AOL subscribers can find a complete transcript at keyword: BW Talk.

Q: Steve, do you see stamina in the market as it is evolving into this new year?


Stamina? I think the market is unlikely to develop much momentum on either the upside or downside -- at least until investors have a clearer picture as to where inflation is going and how the Fed will respond to whatever inflation is. That said, I do think the market has a number of positives, as well as a fairly strong economy to go with it. With oil prices still in the mid-40s and the Fed not sure how to react to the kind of inflation high energy prices may cause, investors will have enough to worry about to offset the basic background positives. It should add up to a stock-picker's market.

Q: How much of a factor is oil in the market these days?


I think oil is probably the most important factor in the market. Let me put it this way: For oil to decline to $25 a barrel, I believe it would lead to a massive bull market. On the other hand, were oil to rise -- and unfortunately I believe this is the more likely scenario -- to $60 a barrel, it would make the going extremely tough.

Q: Are big oil stocks still a good investment?


I think big oil stocks are still a very good investment, though in general big oil companies are less leveraged to oil prices than small oil companies and oil services companies. I do think anything in energy is a good investment right now, in part because Wall Street believes that oil and natural gas prices are likely to decline over the next few years and virtually every energy stock reflects this assumption. Once it becomes clear -- and I think it's inevitable it will become clear -- that energy prices are in a long-term uptrend, energy stocks will rise very dramatically from current levels.

Q: How about Exxon Mobil (XOM )?


Among the major integrated oil firms, Exxon Mobil is certainly an excellent choice. But our favorite among the big ones is ChevronTexaco (CVX ), because it's a bit more leveraged to rising energy prices, and there are more synergies to be wrung out from their merger. So both are good, but I'd pick Chevron before Exxon Mobil.

Q: Where are gold prices headed long-term?


Well, if you don't believe me, take it from Warren Buffett and Bill Gates, both of whom have very significant short positions against the dollar. Historically, gold and the dollar have been inversely related. In other words, lower dollar, higher gold, and for good reason. After all, the dollar is the world's reserve currency, and when the dollar goes down, the world tends to lose faith in currency across the board. And gold, with its multimillennium history, becomes ever more a store of value in the case of a declining dollar.

A related reason I like gold is that I expect real interest rates -- that is, the difference between interest rates and inflation -- to be zero or negative for a long period of time. I think, dips notwithstanding, gold is in a long-term bull market.

Q: How about financial stocks? And what do you think of Citicorp (C ) at this point?


I think Citicorp is a very cheap stock and is a real standout. By and large, I expect financial services, especially banks, to underperform in the next 12 months. But Citigroup, because it is so diverse and because it's cheap, will be a standout.

Q: What about Pfizer (PFE ), Steve? Big Pharma in general?


I want to like Pfizer -- its p-e is extremely low -- but its problem is Celebrex, which is very well advertised, but there's no way of predicting its reliability and the competition for Lipitor. Two other pharmas that also have AAA ratings, faster long-term growth, and fewer problems are Johnson & Johnson (JNJ ) and Novartis (NVS ). These would be my two candidates for core positions in the pharmaceutical industry.

Q: What are your thoughts about asset allocation? Should we be 60% fixed, 40% stocks if ready to retire?


I have kind of a controversial view on asset allocation. I really wouldn't own bonds other than as a way to protect my portfolio. For your income needs, I'd much rather buy stocks with high yields that have growing income streams. Names range from Wells Fargo (WFC ) to ChevronTexaco to FPL Group (FPL ). I feel inflation will be rising in the years ahead -- and maybe rising dramatically. Under that scenario, bonds will cost you money, and the income that you get will be worth less and less. So, again, I emphasize the only reason to hold bonds would be to protect yourself against a -- heaven forbid -- horrible event that devastates the economy.

Q: Do you like homebuilders such as Toll Brothers (TOL ) and D.R. Horton (DHI )? Do you see a housing bubble?


I do like them. Though they've had tremendous runs, they're still relatively cheap stocks. My favorite would be TOL, because it's relatively small, yet has a very strong niche in the high-end market, which I think is much less likely to be affected by rising rates than the overall homebuilding market.

And no, I don't see a housing bubble. I think that housing is a massive market. And there are certainly aspects of housing, such as homes in Long Island, New York apartments, and the like, that are certainly bubble-like in their prices. But no, I don't see anything nationwide that looks like a housing bubble. Even in New York, one characteristic of a bubble is missing, in that people are not buying homes or apartments simply to speculate.

Q: What are your criteria for buying a stock, Steve?


Well, basically we want dominant companies whose valuations are cheaper than that of the S&P 500 -- easier said than done. It is axiomatic that if you have a collection of companies whose long-term growth is going to be at least that of the S&P 500, and whose p-e's are less than the S&P 500, you're going to outperform the market -- perhaps not on a quarter-by-quarter basis, but certainly over the long haul. The catch is, you're going to have to do enough research to be sure on your growth estimates.

Q: I bought Apex Silver Mines (SIL ) on your advice. Still bullish?


Yes, I'm extremely bullish on Apex. Silver stocks have had a rough run of late. But over the long haul, Apex with 500 million ounces of silver and comparable amounts of zinc is likely to multiply many times from current levels. This is a stock I would simply put away and ignore daily and even monthly fluctuations, while holding out for the long haul.

Q: Back in the energy patch -- Kinder Morgan (KMI ) has a 6.3% yield. That seems high for now -- is it a good buy?


I think Kinder Morgan and other pipeline companies are very good buys. As I was saying about income stocks before, these are companies with not only decent yields but also the potential for dividend growth. Just a caveat about Kinder, though: Its financials are pretty complicated and, to be honest, I'm not sure I entirely understand them. For that reason we've been recommending TEPPCO Partners (TPP ) in the same area. Its yield is comparable to Kinder's, and its financials are more transparent.

Q: What do you think of ETFs (exchange-traded funds)? Do you use them?


I think they can be very useful. As a money manager, however, I feel it is our responsibility to find the best stocks underlying the ETFs, so we use them very little for our clients. Still, for the individual investor who has a very positive feeling on energy or real estate or even wants to short real estate, ETFs can be very useful. Even for me, one ETF I would buy would be the one for gold (GLD ). GLD offers individual investors the ability to buy the underlying metal directly.

Q: Procter & Gamble (PG ) has been holding, but what does the recent drop mean? Merger proposed here, too, of course, with Gillette (G ).


I think the merger between PG and Gillette is an exceptionally good one, and is likely to increase Procter & Gamble's growth to nearly 12% or 13%. Don't just take it from me -- also take it from Warren Buffett, who is Gillette's largest shareholder and has said publicly that he plans to add to his PG shares when they're exchanged for his Gillette shares. At the end of the day, he's likely to have a position in PG well north of $5 billion. Even for him, that's a big position.

Q: Do you like any tech stocks, such as Intel (INTC ) and Texas Instruments (TXN )? Are most overvalued?


I think if you were to ask 10 Wall Street strategists what they thought about tech, nine would say "overvalued." I don't agree. I think China and India offer tremendous markets for tech companies, and some of these large companies like INTC and TXN are far less cyclical than in the past.

Just a historical note: Tech stocks suffered through an approximately 80% bear market between 2000 and 2002. The only comparable bear markets in U.S. stock market history was the Dow at the end of the Depression and small-cap stocks during the 1968-1974 period. In the wake of both bear markets, the Dow and small-cap stocks entered multiyear uptrends. I expect -- and I know this is a very contrarian view -- that tech stocks are going to surprise virtually everyone by remaining in a long-term uptrend.

One final point is that these are very volatile stocks and there will be some very scary moments. But I'd be a buyer during periods of weakness, especially in the high-quality tech arena.

Q: What about interest rates and inflation? How do you see those factors affecting the market?


I see interest rates and inflation putting caps on stocks -- not necessarily leading to a bear market but certainly capping the averages. A brief word on inflation: I believe it could go much higher than people think. Over the last 90 years, we've had three bouts of double-digit inflation in the U.S., each spaced by 30 years. Given our high level of government spending, the tremendous amount of leverage in the economy, and what I think will be a very strong uptrend in energy prices, I don't think there's any room to be complacent about inflation. It could again go much higher than virtually anyone thinks. Again, this is over the next several years, not the next few months.

Q: So can you give us a forecast of where you see the market at the end of 2005?


I don't think the Dow is going to be much above or below 10,000. Much like the Dow spent more than 15 years around 1,000 (between the mid-1960s and early 1980s), I think 10,000 will be a very long middle point. The message for investors is pick your stocks with care.

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