Are You Ready for Inflation?

With millions of people out of work and the economy not acting the way anyone wants, the prospect of looming inflation is just about the last thing on anyone's mind right now. But already, you can find several signs of higher prices, and unfortunately for investors, many of the traditional hedges against inflation have already gotten bid up through the roof.

Theory vs. practice
Inflation isn't supposed to be a problem during periods of slow economic growth. The theory is that because consumers don't have much purchasing power during tough times, companies can't successfully pass through price hikes to their customers. Instead, companies rein in their profit margins in order to try to sustain demand. And if they don't, the resulting drop in demand puts downward pressure on prices anyway, again keeping inflation in check.

But reality doesn't match up with what that theory predicts. When the cost of coffee rose last year, Starbucks (NAS: SBUX) and Kraft Foods (NYS: KFT) successfully raised prices on their customers. McDonald's (NYS: MCD) did the same thing with some of its menu offerings. US Airways (NYS: LCC) started the 10th airfare hike of the year recently, passing on high fuel costs.

Add all that up, and you have a Consumer Price Index that's up almost 4% from last year's levels. And even with prices at the gasoline pump having come down lately, you can't count on the higher-price trend reversing soon.

How to handle it
A rising CPI does have a few incidental benefits. For instance, seniors are likely to receive their first boost in Social Security payments next year, as the jump in CPI reverses two years of frozen monthly benefits.

But the biggest problem with the inflation threat right now is that the traditional ways of fighting it are already extremely expensive. Even after gold's recent correction, the yellow metal has doubled since late 2008 and is up around 20% this year alone. And although some look for gold to keep rising from here, it's already too late to capture the best of the gains from the past 10 years.

The same holds for the inflation-adjusted Treasury market. Both individual TIPS and the iShares Barclays TIPS Bond ETF (NYS: TIP) are at very high levels despite having declined somewhat from last month's highs. To get five years of inflation protection, investors have to be prepared to accept a negative real return of -0.57%.

The answer that's left
Among cheaper alternatives, the best inflation fighter left at your disposal is the stock market. In particular, two types of stocks are particularly well-positioned to deal with inflation.

One includes producers of raw commodities. Although raw-materials makers face higher costs of obtaining the things they produce, rising prices for their products can boost profits and open up new potential avenues for growth. For Teck Resources (NYS: TCK) , for instance, some projects to mine zinc, coal, copper, or gold that aren't viable at lower prices become profitable when inflation strikes. Similarly, Mosaic (NYS: MOS) sees higher demand for fertilizer when farmers see the benefit of inflation in the proceeds they receive from crop sales.

The other group includes companies that have to deal with significantly higher production costs but can pass nearly all of them on to their customers. Companies that have invested in building brand awareness can get a big payoff from their investment during inflationary periods, because brand power often equates to pricing power. Companies such as shoe giant Nike (NYS: NKE) fall into this category of strong-brand stocks.

Get ready
Further rises in inflation may not be imminent, but you should still be ready for them when they do come. By taking steps now to protect your portfolio, you'll be well ahead of the crowd once the reality of higher prices starts hitting the mainstream economy.

If you're worried about inflation -- and you should be -- you should know about the companies that will soar because of it. Check out this free special report from The Motley Fool to find out about a tiny gold stock that's already digging up massive profits.

At the time thisarticle was published Fool contributor Dan Caplinger has noticed inflation most in ice cream prices. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Starbucks. Motley Fool newsletter services have recommended buying shares of Starbucks, McDonald's, and Nike, as well as creating a diagonal call position in Nike. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy keeps getting better for you.

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