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The Short Answer

As Prices Soar, How Can Investors Cope?

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

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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. You can find out how  iShares Dow Jones U.S. Real Estate (IYF) stacks up by clicking here under the Premium Features heading.)

If commodities and real estate won't work, how about TIPS? TIPS, short for Treasury Inflation-Protected Securities, launched in the 1990s and are widely used as inflation hedges because their face values, and resulting coupon payments, are tied to the consumer price index. TIPS, along with U.S. Treasuries in general, have surged in recent months amid all the market volatility, sending yields to ridiculously low levels and prices to highs. As of April 25, yields on some short-term TIPS were actually negative, while a TIPS bond maturing in January 2025 weighed in at a skimpy 2%. By contrast, a plain-vanilla U.S. Treasury bond maturing in February 2025 yielded 4.4%. (The SEC yield of  Vanguard Inflation-Protected Securities (VIPSX) is 0.75%, a full percentage point lower than any of the firm's bond or money market funds!)

We're not arguing that commodities or real estate or TIPS aren't worthwhile additions to a portfolio. It just makes sense to wait for times when prices aren't at extremes. Yes, it's always tough to get the timing right, so if you must jump in, consider entering slowly with dollar-cost averaging. By putting your money to work in regular intervals, you can mitigate the risk of investing at the wrong time.

Invest in Stocks--But Think About Moats
No, inflation isn't really good for stocks, especially in the short- and intermediate-term. Inflation hurts productivity and growth. And it raises input costs, making it more expensive for companies to do business. That's a particularly big problem if you can't easily pass along higher costs to customers. Just ask the airlines. Higher inflation also leads to higher interest rates, making it tougher for companies that rely on borrowing to finance their operations.

However, not every company is at the mercy of the economic environment or its competitors. Companies with economic moats--those with strong competitive advantages and market power---are better able to raise prices. Most of these outfits are large, blue-chip firms, which also represent some of the best values in the stock market today after being ignored in favor of smaller or more-speculative names in recent years. So, even if higher inflation doesn't come to pass, there's still a strong valuation case to be made in favor of larger companies with economic moats or strong competitive advantages. By extension, the funds that invest in those stocks also make sense.

So, how do you find them? Stock investors can start with large, blue-chip companies. It's these sorts of names that often have moats. Not all do, of course, and it's also true that even some smaller names have moats. Premium Members of Morningstar.com can find a list of companies that Morningstar's equity analysts believe have the widest moats here. Remember that you won't be doing yourself a favor if you buy a wide-moat company trading at a lofty price tag. You can sort by Morningstar Rating; stocks rated 4 or 5 stars are those that Morningstar analysts believe are undervalued.

On the fund side, you can invest alongside managers who look for firms with strong competitive advantages. An easier choice, though, is to opt for a low-cost index fund or ETF that tracks a disproportionate amount of companies with moats. For example, every holding in  Bridgeway Blue Chip 35 Index (BRLIX) has an economic moat (and 80% have wide moats, a designation that Morningstar equity analysts reserve for companies with the strongest competitive advantages). A more diversified option is the  iShares S&P 100 Index ETF (OEF), which tracks the largest 100 companies in the S&P 500 Index. More than 99% of the holdings have either wide or narrow economic moats, according to Morningstar equity research.

Christopher Davis does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.