Here's a simple question we can answer in a few minute's time: Is the Federal Reserve's injection of hundreds of billions into the U.S. economy the only thing that stands between us and crippling deflation? Or is all that money dooming us to hyper-inflation that will someday have us looking back wistfully on $20 bread loaves while we swing clubs at each other, trying to corner the market on squirrel bits?
It's not how much money, it's how often it's spent
While I enjoy playing amateur doomsday economist as much as the next guy, I have to say that I think the inflation arm-wavers have got it all wrong. They point to scary charts showing a vast explosion in money provided by the Fed, for example, and jump to the conclusion that this will inevitably lead to major inflation. For a while, during that late 2008 commodity bubble, I thought that might happen, too. I was waving my arms. (It was less cool then.) But unfortunately, as the months wore on, some pesky evidence got in the way of my opinion.
Prices for all kinds of goods and services stagnated, and even started falling. It was fairly obvious that the spike in money supply wasn't stoking inflation because for that to happen, the money in question needs to be cycled through the economy. It needs to be spent, and the more often that happens, the more likely you'll see inflation.
Since we're not seeing much of that, it seems to me that the economic theories on the velocity of money can explain what we're seeing. Simply put, it's not the amount of money that matters for inflation; it's the amount of money and how often it is used during a given period of time. During this epic credit crunch, the resulting consumer spending pullback, the rise of unemployment and savings, and those dropping prices suggest a pullback in the velocity of money. More money -- even a lot more -- just may not matter if it's not chasing a fixed supply of goods and services.
Planning for inflation anyway
While I'm not in the inflation alarmist camp, I still acknowledge that the end result of all this stimulus could be inflation down the road. And inflation can make life tough for investors. Where do you look for returns if the costs of all goods and services are going up?
In late 2008, the answer for many seemed simple: commodities. Oil. Metals. Minerals. Doesn't matter what happens to inflation if you own these, right? Because if industry needs them, industry pays the going rate, no matter where it goes.
At least that was the logic of some out there, and although it made little more sense than the excuses for the real estate bubble ("They aren't making any more land."), the results were extraordinary. Oil, gas, and other raw materials and commodities saw huge run-ups in late 2008. Remember $140 dollar oil barrels? Remember the predictions for $200 oil that seemed rational at the time? Remember the gold bugs doing their victory strut as that odd, yellow metal attracted financial survivalists while the rest of the financial world collapsed?
A lot of money piled into commodities, and people who bet on the raw materials themselves -- especially at the height of that bubble -- got walloped as badly as any internet-bubble investor or home flipper once the recession took hold. Turned out that what was supporting those prices wasn't real demand, but perceptions about massive future demand, and after those hopes evaporated, asset prices did, too.
I'll take stocks, thanks
Let's not be too snarky about it. Predicting where commodity prices are going is a game that will eventually up-end the smartest people in the room. That's why I don't engage in it.
When I look for inflation hedges, I keep it simple, and I keep looking at stocks. Owning individual companies -- especially those that have iron-clad brands or other wide moats -- can be a perfect inflation hedge because these firms are able to raise their prices as needed over the long term.
As Charlie Munger put it: "I remember the $0.05 hamburger and a $0.40-per-hour minimum wage, so I've seen a tremendous amount of inflation in my lifetime. Did it ruin the investment climate? I think not."
Although I think McDonald's (NYSE: MCD ) and Yum! Brands (NYSE: YUM ) are good choices in such an environment, burgers and pizzas aren't the only places to find price-protected stock returns. It costs a lot more than a quarter to squeeze the Charmin these days, and more than a few cents per change to wrap the baby in the latest Pampers. That ability to raise prices along with inflation has helped Procter & Gamble (NYSE: PG ) and Kimberly Clark (NYSE: KMB ) make shareholders happy for decades. If smokes and booze are more your bag than baby tissue, do a long-term price check on the cigarettes sold by Altria (NYSE: MO ) or Fortune Brands (NYSE: FO ) . You simply cannot get your smoke on, or get your buzz on, for a buck anymore, but the fortunes at these companies have hardly suffered as a result because they can raise prices along with inflation.
Foolish final thought
Whatever you think of the inflation situation, it pays to have your options explored. While I look to solid brands and other companies that have the ability to raise their prices as necessary. I also look to strong companies that serve the energy, commodities, and materials businesses, that may benefit from a more inflationary future. One of these is Dynamic Materials (Nasdaq: BOOM ) , a company with a wide moat that serves businesses in the energy and materials sectors. It doubled shortly after we bought it for our real-money portfolio at Motley Fool Hidden Gems. The stock is still down from when I originally tapped it (just before the commodity bubble popped) but for many of our members, it's been a stellar performer off of its lows -- where we told our members it was a screaming buy. And we think it has great prospects even from today's prices.
At Hidden Gems, we're taking advantage of today's volatile markets by putting a quarter of a million dollars into our favorite small caps. In addition to Dynamic Materials, we recently recommended -- and purchased -- a company that would probably please both the inflation-hedging commodity and materials crowd. It's a small company with decades-long, established relationships, supplying vital materials to some of those big name brands I mentioned above. It's paying off its debt thanks to big increase in free cash flow, but, because of the uncertain economy, the Street is still afraid. Smells like opportunity to us, which is why we bought shares on Wednesday.
If you'd like to see how we're preparing a small-cap portfolio for the future, inflation or no, a risk-free trial is on me. Simply click here to get started.
Seth Jayson is co-advisor of Motley Fool Hidden Gems. At the time of publication, he had no position in any company mentioned here. Kimberly Clark and Procter & Gamble are Income Investor recommendations. Dynamic Materials is a Hidden Gems recommendation. Fortune Brands is a Stock Advisor pick. The Fool owns shares of Dynamic Materials and Procter & Gamble. The Fool has a disclosure policy.