The Specter of Inflation Looms in 2010

01/25/2010 12:00 pm EST

Focus: MARKETS

Richard Lehmann

Publisher, Forbes/Lehmann Income Securities Investor

Richard Lehmann, publisher of the Forbes/Lehmann Income Securities Investor, says income investors should begin to protect themselves against inflation in 2010.

We enter the new year relieved that the trauma of 2009 is behind us, or is it?

While there is limited concern that the problems of the recent past will resurface, there is legitimate concern that the remedies applied in 2009 will come to haunt us. These are the unintended consequences that occur when major policy actions are taken without precedent or thorough planning.

Who has forecast that those consequences may well be worse in the long term than the positives gained for the short term? Keep in mind that for politicians, the only term that matters is their term in office.

As for the Federal Reserve, we are told they helped precipitate the financial crisis by keeping interest rates too low thereby causing the housing bubble. Are we now to believe that the remedy for the fallout from that crisis is even more low Fed interest rates?

History tells us that all these policy moves will result in inflation. Income investors who believe the happy talk being put out by government spokesmen or media pundits will pay a price. Given the volume of TV ads for gold, I suspect there is significant skepticism out there.

We know the Fed cannot control long-term interest rates, and it is these debt holders who will revolt first and demand higher yields. This will pull even more money into long-term/short-term interest rate arbitrage, and thus force up short-term rates as well. The remedy for this uncertainty is diversification over a variety of income drivers [that] which are not all sensitive to the same economic factors.

For 2010, we make some basic assumptions: inflation will begin, interest rates will rise, the stock market will rise, and commodities will rise.

To protect against interest rate rises, buy some adjustable-rate bonds and preferreds. You give up about 2% in current yield, but you avoid a capital erosion once rates begin to rise. Convertible securities are the answer to a diversification that provides exposure to the stock market.

Stocks are more likely to rise than fall should inflation begin. Commodity stocks are another diversification that should be added, especially energy-related oil trusts or limited partnerships.

While gold is not an income-producing asset, it does provide excellent protection against capital erosion when inflation comes. Investors should build a position in gold over time of at least 10% of their holdings, especially when the inflation threat is so glaring. Don’t be discouraged by the current high prices; over time, gold will never be your worst investment decision.

Once inflation comes, real estate investment trusts (REITs) and other financial and housing-related investments become attractive and should be pursued, but wait for events to unfold. Remember that once inflation starts, it lasts quite a while and can run to extremes.

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