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As Prices Soar, How Can Investors Cope?

Here's how you can deal with the looming inflation threat.

Christopher Davis, 05/06/2008

When the tech bubble burst in 2000, the Federal Reserve responded by slashing interest rates. That move helped keep the economy afloat, but it helped fuel another bubble in housing. After the housing bust triggered a broad credit crisis, the Fed answered again with steep rate cuts. That measure may have been necessary to prevent a financial meltdown, but it also could make higher inflation a greater possibility. The Fed's attempts to prop up asset prices by flooding the economy with cash could result in too much money chasing too few goods--the classic recipe for inflation.

Of course, if you've filled your gas tank or bought a carton of eggs lately, you probably don't need me to tell you that rising prices are already a problem. You're paying more for both food and energy thanks to surging commodity prices. And there are signs those higher prices are working their way through the broader economy: In February, the U.S. government announced that wholesale prices were 7% higher in January 2008 versus the year before. Consumer prices didn't rise quite as quickly, but its 4.3% annual pace was higher than recent historical norms.

Mention "high inflation" and many folks have flashbacks to the 1970s (if only bellbottoms and avocado-colored appliances were the lone unfortunate legacies of the decade). Thankfully, fashions have since gotten more sensible, and more importantly, corporate America has become much more efficient. The U.S. economy is a lot more global and less energy intensive than it was back then. (In the 1970s, the U.S. economy was much more industrial and used more energy, so it was hit harder by the decades' oil shocks.) And while the Fed may have flooded the market with cash, banks aren't exactly eager to lend it out, reducing the potential inflationary impact.

Still, that's not to say there's nothing to worry about. For one, while a slowing U.S. economy has been enough to check inflation in the past, heavy demand from fast-growing economies like India and China may stand in the way of that happening this time around. Moreover, we don't need a return to 1970s-style inflation for it to be a problem. For instance, if inflation rose 5% annually over the next 10 years, it would take $163,000 to match $100,000 worth of purchasing power today (at 3%, the historical average, you'd need about $134,000 10 years from now just to keep even with inflation).

So, what can you do to ready yourself against the prospect of higher inflation? Read on to find out.

Be Wary of Traditional Inflation Hedges
Typically, commodities and real estate rule the roost when inflation is high. That certainly was the case in the 1970s. But these traditional inflation hedges don't look like attractive bargains right now, so the past may not be prologue this time around.

While commodities have fared well in inflationary environments, history also demonstrates the importance of investing at the right time. You would've been a pretty happy camper had you invested in gold over the past five years, but keep in mind that the yellow metal languished for two decades before its recent rally. Now, gold, oil, and other commodities trade at or near historically high levels. There's nothing that says they couldn't go higher--commodity prices are notoriously difficult to predict--but there are plenty of signs of a speculative bubble. According to a March 31, 2008, article in Barron's, more than half of bullish commodity bets have been made by speculators who've used exchange-traded funds or notes to pile in. Often, when speculators move in en masse, it usually means that rallies are closer to their ends than beginnings.

Real estate doesn't look pretty, either. Residential real estate clearly is in deflationary mode. Commercial real estate never got as overheated as the housing market, so its supply/demand balance isn't as out of whack. But based on Morningstar's equity research, many REIT benchmarks don't look appealing from a valuation standpoint. (Morningstar.com Premium Members can get a handle on the attractiveness of a sector by looking at an exchange-traded fund focused on the area. Based on the valuations of an ETF's underlying holdings, you can find out whether a portfolio looks over-, under-, or fairly valued.)

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