Wall Street Journal, 08.10.2008

How to Handle the Inflation Monster

By DAVE KANSAS
August 10, 2008

For younger people, all the chatter about inflation must seem alien. Indeed, the U.S. hasn't really had a serious bout with rapidly rising prices in nearly 30 years.

But during the past few months, the once-tamed beast of inflation has shown it still has some bite.

Inflation is bad for investors on several levels. It erodes your savings, it makes stock-market returns less valuable and, if you're not getting cost-of-living adjustments in your salary, inflation simply makes you feel poorer.

In the year through June, the government's widely watched consumer price index rose 5%, the biggest one-year rise since 1991.

Policy makers tend to focus on the less volatile core CPI, excluding food and energy prices, which is up 2.4%. Unfortunately, humans must eat and, in the modern world, energy is just about as essential. It is those prices that have risen sharply for much of the past year.

To be sure, oil prices have recently made a brisk retreat from record highs, which could reduce inflationary pressures going forward, but prices for a barrel are still up 61% from a year ago.

These figures have prompted renewed concern at the Federal Reserve about inflation. With CPI growth at 5%, the Fed could normally be expected to raise short-term interest rates. But it is instead more focused on boosting the economy, especially the ailing financial and real-estate sectors. Still, in leaving short-term rates unchanged at 2% last week, the Fed said in prepared remarks that rising costs remain a concern.

So, with inflation likely to remain a worry, what's an investor to do? Things that worked in the past may not work so well today. For instance, during the inflationary 1970s, real-estate investing proved a shrewd strategy. Today, however, real-estate prices continue to fall in many markets, and analysts expect home woes to continue for some time.

Real estate aside, there are smart, basic strategies that investors should consider when trying to inflation-proof their portfolios.

Invest in commodities. With oil plunging 21% from its record high, this might seem counterintuitive. But grains, metals and lumber are also commodities. Investment professionals recommend commodities exposure of 5% to 10% as a way to diversify your portfolio and hedge against inflation. This is most easily done by investing in commodity-focused mutual funds or exchange-traded funds.

Commodities continue to benefit from rising global demand, especially from China and India. And since commodities are priced in dollars, they provide a fillip when the dollar is weak, as it has been the past couple of years.

Buy TIPS. The government's Treasury Inflation-Protected Securities are designed to take the inflation equation out of bond investing. When inflation is quiescent, this isn't always the best strategy. But with consumer prices on the rise, moving a portion of your fixed-income portfolio into TIPS or a TIPS-focused fund can make a lot of sense.

These bonds are indexed to the CPI, meaning that the interest payments are adjusted higher when the CPI rises. Traditional bonds don't provide this kind of protection, and if inflation is rampant, their value can quickly erode. While TIPS are more expensive than a couple of years ago, they provide peace of mind in inflationary times.

Invest in sectors with pricing power. Traditionally, pharmaceutical and health-care companies are the best bet for companies with pricing power and steady earnings. But this strategy is made more complicated by the coming elections.

A big Democratic win in November could focus more political attention on this sector, which might harm the outlook. Still, with big pharmaceutical companies like Merck and Pfizer paying healthy dividends in the 5% to 6% range, this is an investment strategy to consider.

Other sectors with pricing power, primarily because of industry consolidation, include railroads and steelmakers.

Be careful when hunting for yield. With inflation rising, there's great temptation to hunt for higher yields among corporate bonds or dividend-paying companies. But higher yields can signal danger ahead.

For instance, Freddie Mac, the government-sponsored mortgage company, recently sported a dividend yield of 13%, massively higher than the Dow Jones Industrial Average's dividend yield of 2.9%. But with more bad earnings news this past week, the company slashed its quarterly dividend to five cents from 25 cents. Now, the flailing stock (down nearly 90% in the past year) sports a more humble dividend yield of 2.8%, and even that might be at risk.

Similarly, the yields on below-investment-grade corporate bonds can seem very tempting. Pulte Homes, a home builder, has some bonds expiring in 2011 that currently yield nearly 9%. And A.H. Belo has bonds expiring in 2013 offering yields north of 8%. But these high yields reflect concerns in the marketplace about the two companies: Pulte is in the reeling real-estate market, and A.H. Belo publishes newspapers, a business that is struggling mightily in the Internet age.

Investors can trim their risk by opting for mutual funds focused on such high-yield or "junk" bonds, to spread their money among numerous issuers. But keep in mind that with the economy slowing, companies that issue high-yield bonds may have trouble meeting debt payments.

Dave Kansas is the president of FiLife.com, a personal-finance Web site owned by Dow Jones & Co. and IAC Corp.