Are You Preparing for Financial Armageddon?

Here's a simple question we can answer in a few minutes' time… or not: Is the government’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 barrels of oil? 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. (Only gold seems to have stayed high, but then, gold is a bizarre commodity, priced more on sentiment than stuff like oil or iron, which have industrial supply and demand dynamics to contend with.)

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 upend 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 ironclad brands or other wide moats -- can be a perfect inflation hedge because these companies 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."

Speaking of minimum wage, if you think pricey goods will turn off consumers, you might want to direct your attention to trade-down apparel retailers like Aeropostale (NYSE: ARO  ) and American Eagle Outfitters (NYSE: AEO  ) , which stand to benefit from customers that Abercrombie & Fitch (NYSE: ANF  ) is losing because of its high price points.

While companies built for lower sales might offer some shelter from the storm, it’s strange how well some premium brands have held up -- like Urban Outfitters (Nasdaq: URBN  ) . Companies with must-have products and a broad portfolio that offers consumers a move-up experience can fare even better. Walk down the hallway in the mall to the Apple (Nasdaq: AAPL  ) store to see what I mean. Even if prices on individual products fall, Apple is quite happy to move consumers up from iPod to iPhone to MacBook Pro.

If you're interested in more traditional inflation-hedge stocks, you can consider looking at companies that "sell picks and shovels to the miners." If you’re a long-term bull on oil, consider specialized service companies like Transocean (NYSE: RIG  ) and Oceaneering International (NYSE: OII  ) , which provide the ways and means for big oil companies to extract from the difficult fields that we depend on for the future.

Foolish final thought
Whatever you think of the inflation situation, it pays to have your options explored. And I like to aim small -- at least smaller than Transocean, because solid, profitable little niche companies have more room to run if we get that inflationary future. One we watch (and own) at Motley Fool Hidden Gems is Dynamic Materials, which provided a quick 100% gain after the market came to its senses and realized that a premium supplier of specialized metal cladding will eventually reap the benefits of a return to energy and commodity investment. If you believe in an inflationary future, then finding the companies that serve the commodities is a better long-term bet than simply betting on the raw materials.

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. We keep a tight eye on our companies, and purchase them only when they meet our strict criteria for price and quality. And we give you access to our tools and thinking to help you make the best choices. If you’re interested in our latest feature -- a full-fledged video valuation of Buffalo Wild Wings -- you can get it, along with access to the rest of the service, with a risk-free trial. Simply click here to get started.

Seth Jayson is co-advisor of Motley Fool Hidden Gems. At the time of publication, he had shares of American Eagle Outfitters, but no position in any other company mentioned here. Dynamic Materials and Buffalo Wild Wings are Motley Fool Hidden Gems recommendations. Apple is a Stock Advisor recommendation. The Motley Fool owns shares of Dynamic Materials. The Fool has a disclosure policy.

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