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Show Inflation Who's Boss

It's an ugly statistic: The current yield on a 10-year US treasury bond is 3.8% -- before tax, of course. At the same time, the consumer price index, which tracks the price of a basket of common goods, went up by 4.3% in the past year, and it shows no signs of slowing down.

For U.S. treasuries -- one of the world's most beloved investments -- inflation has rendered real returns no more appealing than a firm slap in the face.

As Warren Buffett once remarked, "I've worried about inflation every day since I learned about the phenomenon 60 years ago." While I wouldn't lose too much sleep over it, inflation certainly has measurable effects on your investments. Still, don't assume you have no control over it -- because you do.

Not now, I'm busy making ends meet
Inflation is of particular concern right now, because we're heading toward an economic slowdown (if we haven't gotten there already). Jobs and income tend to grow scarcer during such times, and when prices go up and income goes down, the economy effectively adds insult to injury.

Factor in a Federal Reserve that remains bent on slashing interest rates like there's no tomorrow, and we've got ourselves one heck of an inflation beast to deal with. What to do?

If you've got a good portion of your nest egg in stocks, there's good news: Stocks naturally provide a bit of an inflation hedge. For some companies, price increases can lead to an equal increase in earnings, so in the end, shareholders don't feel the full wrath of inflation. Some stocks provide much better inflation hedges than others, though. Here's what to look for.

Inflate your returns
When a company can raise prices to keep pace with inflation, or surpass it, you've got some serious inflation protection on your hands. Just last week, food giant Sara Lee (NYSE: SLE  ) hinted that it would tackle the monumental rise in commodity prices by passing the costs on to consumers. People need to eat, regardless of price, and personally, it'd take one hefty hike to get me to give up my Jimmy Dean sausage in the morning. Problem solved.

Other inflation slayers could include Procter & Gamble (NYSE: PG  ) , Altria Group (NYSE: MO  ) , Starbucks (Nasdaq: SBUX  ) , and Johnson & Johnson (NYSE: JNJ  ) . These companies can all name just about any price they wish, and consumers will happily oblige, either because they must have the products today, or they're just downright addicted to them.

But Ford (NYSE: F  ) can't say the same. Car buyers are so price-sensitive that the automaker has absolutely no room to shift increasing costs onto consumers. If prices go up, people simply won't buy cars until their old ones resemble Flintstone-mobiles. Arcelor Mittal (NYSE: MT  ) , the world's largest steel producer, announced plans last week to raise prices by as much as 15%. What can companies like Ford do about that? Nada. Suddenly the tides are turned, and these companies, rather than their customers, become prisoners of pricing. Investors should avoid stocks like these whenever possible.

One more TIP
If you're closer to retirement, or if stocks just aren't your thing, don't lose hope! Many bond instruments have built-in inflation hedges that can handily pay off during times like these. TIPS, or Treasury Inflation Protected Securities, are bonds with an added bonus payment upon the bond's maturity to match any damage caused by inflation during the life of the bond. There are ETFs that make it all too easy to get in on the action, such as iShares Lehman TIPS ETF, as well as a handful of mutual funds that provide similar services.

If you're shaking in your boots about the Fed cutting rates, oil bouncing against $100, and those commercials claiming the price of gold will be halfway to Jupiter in the next few years, take heart. Keep an eye on how inflation pressures might affect your investments down the road, and you'll end up owning inflation, rather than it owning you.

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  • Report this Comment On June 12, 2008, at 11:49 PM, thedofca100 wrote:

    It's interesting that this writer believes Starbucks is an inflation slayer. Perhaps his friends can afford Starbucks at any cost, but it's one of the things my friends have already cut out of the budget. The daily latte has become the weekly latte. Starbucks pushing their 99 cent coffee seems to indicate to me some troubles ahead. They even handed out coupons giving a free cup of coffee every Weds. to everyone with the coupon. I think it's ominous.

  • Report this Comment On October 26, 2008, at 4:28 PM, gamma65 wrote:

    Farmland is one of the best inflation hedges - "Gold with Yield"

    The equity and bond markets have benefited from a long period of low inflation, but ongoing and massive central bank liquidity injections point to a far less benign environment of elevated inflation ahead. Research by our firm, Agcapita Farmland Investment Partnership (Calgary, Canada based agriculture private equity firm) shows investors must be prepared to rotate into asset classes with different characteristics. During the last commodity bull market & high inflation period in the 1970’s, equities materially underperformed farmland.

    - Western Canadian farmland went from around $100/acre to $550/acre (550% total return and 176% in inflation adjusted terms);

    - Cash held in a money market account barely kept ahead of inflation (6% inflation adjusted return); and the

    - S&P 500 index returned less than 2% per year (a loss of almost 50% in inflation in adjusted terms)

    We believe the world is still in the early stages of this current commodity bull market. When agriculture commodities prices are compared against their previous inflation adjusted highs they are significantly discounted implying scope for further increases:

    - Corn is US$ 4/bushel currently compared to US$16/bushel in 1974,

    - Wheat is US$ 6/bushel currently compared to US$27/bushel in 1974

    - Canadian farmland is C$ 660/acre currently compared to C$1,100/acre in 1981

    Another interesting metric is the long-term average ratio of the Commodities Research Bureau Index versus the S&P 500 which is currently around 1.5 times. Simplistically, this ratio indicates how much S&P 500 stock you can buy with a fixed basket of commodities. Some important points:

    - During the commodity bull market of the 1970s, the ratio was consistently higher than 2 times for over 10 years – it peaked at almost 4 times.

    - The ratio is currently at around 0.5 times - significantly below the 1.5 times long-term average, just slightly above the 0.15 all time low reached in 1999/2000 and still very far below the almost 4 times multiple reached in the last commodity bull market. We still appear to be at an all time low relative valuation between “hard assets" versus "stocks.”

    - If history is a guide, the ratio of hard assets to stocks will have moved much higher before this commodity bull market is over.

    - How? Stocks will continue to fall and/or commodities will continue to climb – most likely a serious combination of both as investors, fearing inflation, rotate out of stocks into commodities – the cycle of “inflation, rotation, hard assets”.

    Agcapita allows farmland investors to cost effectively allocate a portion of their portfolios to hard assets in the form of Canadian farmland via its professionally managed Agcapita Farmland Investment Partnership. Agcapita Farmland Investment Partnership is the third in a family of private equity funds which has grown to almost $100 million in assets under management. Agcapita’s investment team has over 40 years private equity and fund management experience and over $1 billion in total career transactions and previously managed a group of emerging market funds with almost C$500 million in assets for one of the largest banks in Europe.

    Legendary global investor Jim Rogers joined Agcapita’s advisory board because of his belief in the western Canadian agriculture investment premise. Amongst his many accomplishments, Jim was co-founder with George Soros of Quantum Fund, is the bestselling author of “Investment Biker” and “A Bull in China”, has circumnavigated the globe twice and is founder of the Rogers - Van Eck Hard Assets Producers Index and the Rogers International Commodities Index.

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