Stocks to Fight the Coming Inflation Wave

The recession has erased approximately $10 trillion of individual and nonprofit net worth in less than a year and has forced investors to rethink many of their strategies that had assumed high rates of inflation. The rapid sell-off of assets combined with the sharp reduction in consumer spending has put tremendously uncomfortable deflationary pressure on the economy.

Deflation is the inverse of inflation -- where too many goods and services chase too few dollars, resulting in lower prices.

Well, that doesn't sound too awful
While lower prices may sound like a good thing at first blush, a sustained period of deflation spells disaster for an over-leveraged economy like ours since existing debts become more expensive. In such an environment, companies are obliged to cut prices to keep customers, reduce employee salaries, cut benefits, or initiate layoffs simply to stay afloat. If such desperate measures fail, many companies would be put out of business, as was the case in the Great Depression.

Federal Reserve Chairman Ben Bernanke, one of the world's foremost scholars on the Great Depression, understands the utter damage done by deflation in the 1930s, which is precisely why he's using every tool at his disposal to reinflate the economy by flooding it with more dollars and lowering interest rates. The Treasury Department and Congress have taken complementary measures to kick-start the economy through TARP and the proposed stimulus package.

A lot of attention has been given to the government's plans, but unfortunately little attention has been given to how the government plans on paying for all of this.

Elementary, my dear Watson
A simple assessment of the facts shows that the government is heavily reliant on cheap credit in the form of U.S. Treasury debt securities to fund its initiatives. The Treasury, for instance, recently announced it would need to borrow a massive $493 billion in this quarter alone and that it would increase the frequency of 30-year Treasury bond sales and reintroduce the seven-year note for the first time in over 15 years.

It's a sweet deal for them. Current Treasury yields range from 0.27% for the 3-month bill to 3.68% for the 30-year bond, so they'd be crazy not to use Treasuries, but it's simply not a sustainable model for funding economic programs. For one, Treasury yields are this low because panicked and unsure investors around the globe flooded into our government-backed bonds for safety. 

This created a bubble in Treasury prices (bond prices and yields move in opposite directions), but that trend may begin to reverse as investors are already emerging from their bunkers and discovering some quality corporate bonds offering much better yields -- recently, a two-year bond from Dow Chemical (NYSE: DOW  ) posted a yield to maturity near 8% and an Alcoa (NYSE: AA  ) bond maturing in June 2011 fetched almost 11%. Yes, these bonds are riskier than similar two-year Treasuries that are yielding 1%, but both corporate issues remain "investment-grade" and those yield spreads are enough to make investors consider such alternatives.

If income-thirsty investors flee from Treasuries or if a major foreign buyer like China stops buying new Treasuries, the government yields would increase and make borrowing more expensive. In this case, the Federal Reserve would be compelled to print even more money to make ends meet. That would further expand the monetary base -- bank reserves and currency in circulation -- which has already doubled in less than a year, flooding the economy with even more cash.

Sure, these efforts may have slowed deflation in the short run, but once asset prices moderate, the Fed is relying on its ability to raise interest rates to sop up all that extra cash it had created by selling Treasury bonds.

If that sounds overly simplistic, you're right. In fact, the Fed doesn't seem to have an exit strategy yet. As Bernanke recently noted in a lecture at the London School of Economics, their current approach is to "Put out the fire first and then think about the fire code."

As well-intentioned as that comment may be, the apparent lack of an exit plan compounds existing market uncertainty and calls into question the Fed's ability to pull liquidity out of the market at the right time. If it can't, I believe high inflation is a certainty.

No love for inflation
Even with all these signs pointing to future inflation, the market sure isn't buying it yet. According to recent Barclays Capital data, the yield spread between Treasury Inflation Protected Securities (TIPS) and regular Treasuries implies 2.5% deflation this year followed by 0% inflation through 2014. That is, in a word: Unlikely.

Unless you believe the economy will remain in a recessionary state for the next five years, all signs seem to be pointing not to sustained deflation, but to the likelihood of higher inflation. And with the market currently betting to the contrary, now is the time to go shopping for inflation-fighting assets.

A new hope
Fortunately, investors have many options for fighting inflation, including TIPS and commodity-linked exchange-traded funds, but another great option is dividend-paying stocks with plenty of room to pay increasing dividends. With the S&P dividend yield near 20-year highs, it's the perfect time to find stocks with:

  • Dividend yields equal to or greater than the 10-Year Treasury (3%).
  • Plenty of room to increase their dividend.
  • The added potential for capital appreciation.

Company

Dividend Yield

5-Year Trailing Dividend Growth Rate

Levered Free Cash Flow Payout Ratio

Johnson & Johnson (NYSE: JNJ  )

3.2%

14%

57%

ConocoPhillips (NYSE: COP  )

4.1%

19%

19%

United Technologies (NYSE: UTX  )

3.3%

19%

25%

Waste Management (NYSE: WMI  )

3.7%

8%*

40%

Procter & Gamble (NYSE: PG  )

3.1%

11%

61%

Data from Yahoo! Finance, DividendInvestor, and Capital IQ, a division of Standard and Poor's. Payout ratios based on most recent cash flows data.
*Four-year trailing growth rate.

These stocks may not have the juiciest yields on the market, but they have a rich history of boosting dividend payouts and have more than enough free cash flow to continue to raise their payouts to help you battle the coming inflation wave.

Foolish final word
Even though we're witnessing the effects of deflation at the grocery and at the pump, don't think for a second that inflation is a thing of the past. Indeed, economic data indicates that inflation will be returning more quickly and with more force than you may think, so now's the time to prepare for it with strong dividend-paying stocks.

I've just offered a few stock ideas for your consideration, but if you're thirsting for more, our Motley Fool Income Investor service can help. At Income Investor, advisor James Early and senior analyst Joe Magyer find the most promising dividend payers in the market. At present, their picks yield more than 7% on average and 75% of their picks are currently beating the S&P 500.

A 30-day trial to Income Investor is free. If you'd like to learn more about the service, just click here.

Todd Wenning met American patriot Patrick Henry ... in Colonial Williamsburg. Todd owns shares of Procter & Gamble, but of no other company mentioned. Waste Management and Johnson & Johnson are Motley Fool Income Investor recommendations. Waste Management is a Motley Fool Inside Value selection. The Fool owns shares of Procter & Gamble. The Fool's disclosure policy secretly swaps its jester cap for a tri-corner when no one's looking.

 


Read/Post Comments (5) | Recommend This Article (40)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 17, 2009, at 6:19 PM, opedbyme wrote:

    Defilation/inflation potato/patato call it whatever I'm just fearful that the stock market could fall precipitously. How do you prepare for that possibility? I'm staying the course but with everyone and I mean EVERYONE bad mouthing the economic state the world is in....maybe it's time to but a bog fat 200 carot diamond and put in ounder the pillor. How many more Stanford Fnancial Invenstments are yet to be discovered.

  • Report this Comment On February 17, 2009, at 8:11 PM, trenton1ryan wrote:

    3% won't do you any good for the kind of hyper-inflation we're going to experience. You need 6%-minimum.

    When oil starts to take off, the world is going to feel the devil bite its ass. We're all quietly trying to push through all this, but when inflation throws its ugly wrench into this thing, the fecal matter is sure to hit the rotating oscillator.

  • Report this Comment On February 18, 2009, at 12:45 AM, eeceefool wrote:

    Can someone explain to me why a 3-4% yield would be attractive when you can lose that much on the stock in just one day or one week? If you want income, it seems like online savings accounts at 3% are safer. Am I getting something wrong here? Paid to wait doesn't seem like enough risk incentive.

  • Report this Comment On February 18, 2009, at 8:27 AM, wpbuck wrote:

    It will take quite a while for a $787 billion stimulus package and liberal monetary policies to counteract $10 trillion in lost capitalization. How can you see the inflation boogie man hiding behind these numers?

  • Report this Comment On February 28, 2009, at 2:40 AM, nicko168 wrote:

    Based on the past weeks, the stock market has been a place for the guys to rally & show their frustration towards "Robin Hood".So, no matter what stocks u thinking of..forget it....

    Ultimately, do you know who's the real fools? Ha..Ha..

    Real fools are the one who plunge their own economy to zero together with the $787 billion stimulus plan. Why?

    They'll be slapping their own face caused it opens up the opportunities & competition to the "third" world to buy all the "CHEAP" US Companies..Arabi, China, Kuwait & maybe Iran, Iraq etc...

    Based on the recent news, US companies are selling off thier valuable assets (technologies, bank etc) in order to pull through the crisis & who are they selling to? Make a guess....AIG went to China, Singapore etc selling off their stakes..Another is selling their US technologies or commodities caused they're ridden by billions of dollars debt....At the end of the crisis, what will the US companies who once holds the supremacy in technologies, banking etc become? "Zero" is my answer...

    Who the losers? The real losers are the next generation facing the real US....

    There's a old chinese teaching:

    "To break one chopstick is easy..

    To break a bunch of chopstick, is difficult"

    To the real fools, WATCH OUT!!! Ha..Ha...

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 832903, ~/Articles/ArticleHandler.aspx, 11/1/2014 4:18:51 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement