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The Inflation Sensation


Here's how to adjust your portfolio for an inflationary environment.

Federal Reserve Chairman Ben Bernanke is not concerned about rising inflationary pressures in the US. In fact, it's just the opposite: his concern has been that inflation is too low and that the economy runs the risk of suffering deflation, or a persistent drop in prices.

However, there is growing concern among some investment strategists about what they see as the steady increase in inflationary indicators. For instance, this morning, the government reported that the costs of living for Americans rose more than expected.

Specifically, the Labor Department said that the consumer-price index -- the main gauge of inflation -- increased 0.4%, exceeding the 0.3% estimate. The so-called core rate, which excludes more volatile food and fuel costs, rose 0.2%. That's the biggest gain since October 2009.

The bottom line, says Miller Tabak's Peter Boockvar: "The inflation worm has turned at the consumer level and will continue to rise in 2011."

But, more broadly, some economists wonder whether Bernanke and his allies on the FOMC are even thinking about inflation the right way. That is, perhaps their specific gauges of rising prices might be too limited.

Dr Ed Yardeni of Yardeni Research is one such skeptic, as the noted strategist recently told his clients: "I share the growing concern among the Fed's critics that the official measures of consumer price inflation may be understating actual inflation and that excluding food and energy from these measures is OK as long as you don't eat or drive."

Example A in the critics' evidence: The Billion Prices Project at MIT, which suggests that consumer prices are rising at a faster clip than the official price data indicate. This project is an academic initiative that collects prices from hundreds of online retailers around the world on a daily basis to conduct economic research. It monitors daily price fluctuations of about 5 million items sold by about 300 online retailers in more than 70 countries.

While the CPI might have risen just 1.5% last year, the BPP price index for the US rose more than twice as fast at 2.5%. (Here's more about the prospect of surging grocery bills).

Investors, if they're worried about an inflationary future, need to think about how to construct a portfolio that thrives during a period of rising prices. Specifically, if you believe that the Fed's monetary experimentation will necessarily lead to inflation then the question becomes what assets best bullet-proof your hard earned capital against this threat. Minyanville recently checked in with economists and strategists to hear how they would engineer such an inflation-centric portfolio.

Michael Pento, Euro Pacific Capital's senior economist, is concerned about a bout of inflation and how it will impact investors. "Inflation is here and it will get worse," he says. "We have a Federal Reserve that is depreciating the value of the currency and a government determined to make the country insolvent."

Investors can protect their capital against an inflationary backdrop, he says, by owning hard assets such as commodities -- one possible vehicle Morningstar highlights is the US Commodity Index (USCI), an exchange-traded fund that provides exposure to the broad commodities space -- as well as the classic inflation hedge: the golden metal.

In fact, if investors analyze the recent inflationary cycles this nation has experienced, Pento says, then there are reasons to believe that lining one's portfolio with some of the barbarous relic could prove a smart bet.

Specifically, he points out, the price of gold increased from $35 an ounce in 1971 to $850 an ounce in 1980 -- an increase of 2,328%. At the beginning of this last inflation cycle, circa 2001, gold traded at $265 per ounce. Today, it stands at $1, 370 -- an increase of 416%.

"This present battle with inflation is still in its infancy," says Pento, who counsels investors to own exchange-traded funds that track the price of bullion like the SPDR Gold Trust (GLD) as well as those that provide exposure to the gold miners such as the Market Vectors Gold Miners ETF (GDX).

In the equity market, Sam Stovall, the chief investment strategist at Standard & Poor's Equity Research, notes that the S&P 500 has continued to move higher but so have interest rates: the yield on the 10-year Treasury note has jumped from 3.31% on December 31, 2010 to 3.62% as of February 16.

Stovall believes that higher interest rates are more likely the result of improving economic growth than acceleration in inflation. Regardless of the catalyst, however, he says investors should now focus on companies with low debt-to-equity (DTE) ratios. That's because when these companies roll over that debt, they won't be incurring that much higher interest expense.

So equity investors should now remain focused, Stovall advises, on sectors with the lowest median long-term DTE ratios such as Energy (XLE), Industrials (XLI), and Technology (XLK) and avoid sectors with the highest DTE ratios such as Consumer Staples (XLP) and Utilities (XLU).

A rising-rate environment is likely to continue for some time to come, according to Stovall. Specifically, the S&P team sees the yield on the 10-year note averaging 4.15% by the fourth-quarter of this year, and approaching 6% by the end of 2012. Therefore, an investor might be wise to catch this wave early by looking for stocks that may benefit from further rotation triggered by rising rates.

To that end, Stovall screened for stocks with below-market DTE ratios that also carry favorable S&P investment rankings. The 10 with the lowest DTE ratios are: Apple (AAPL), Celgene (CELG), Chevron (CVX), Coach (COH), EMC (EMC), Exxon Mobil (XOM), Family Dollar Stores (FDO), FedEx (FDX), Jacobs Engineering Group (JEC), and Thermo Fisher Scientific (TMO).

Another idea to consider: as interest rates rise, bond prices fall. So, for that reason, Miller Tabak's Boockvar says investors concerned about an inflationary future can think about betting against Treasurys. There are a number of ETFs available for such purposes. The vehicle Boockvar prefers: ProShares Short 20+ Year Treasury ETF (TBF). Year-to-date, it's up 4%.

Treasury Inflation-Protected Securities, or TIPS, are also a traditional go-to investment for those worried about rising prices. The principal of these bonds increases with inflation, as measured by the CPI.

TIPS exposure is available through ETFs like the iShares Barclays TIPS Bond Fund (TIP) or, although Francisco Torralba, an economist at Ibbotson Associates, cautions market participants that the securities now appear relatively overvalued.

"The yields on TIPS are now extremely low by historical standards," the economist says.

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