Re-Building Your Portfolio (WSJ)

Even the experts can’t recognize whether increasing or falling prices lie inside our future. That leaves investors in a quandary: how to construct a portfolio at a time of great uncertainty. A wrong bet could be damaging. If your stock portfolio is made for deflation, for example, your assets will slump if the country experiences a bout of inflation instead. The answer is to get ready for the economic scenario you think is most probably, and build in some insurance if you’re wrong then.

Such a strategy always means some investments will suffer no matter how the economy turns. The first can do best within an inflationary period but won’t be smashed if deflation instead tips the day. The second reason is for traders who dread deflation, but want some security against potential inflation — if it is down the road even. And the 3rd is aimed at investors who believe the economy will muddle through without severe inflation or deflation. If you believe all the government spending in response to the financial crisis will ultimately beget inflation, you want a portfolio that thrives in an interval of surging prices.

Commodities will be the primary play, because from corn and oil to copper and pork bellies should gain. Plus, commodities — particularly gold — hedge against the dollar, offering a 2-for-1 benefit if a weak dollar accompanies inflation, as some expect. Since commodities contracts can be considered a hassle for specific investors, consider a finance such as Pimco’s CommodityRealReturn Strategy Fund, which offers exposure to a broad swath of agricultural and industrial commodities. Though it seems counterintuitive, cash can prosper pretty, too. The Federal Reserve would fight rising inflation by pushing up short-term interest rates likely, allowing investors with cash to capture the escalating rates through short-term certificates of deposit and money-market accounts.

Michele Gambera, chief economist at Ibbotson Associates, says his research shows that within the last five rounds of significant inflation, results on cash matched up the inflation rate, meaning it isn’t dropping its purchasing power. Online banks and local credit unions have a tendency to provide higher rates. Treasury inflation-protected securities, or TIPS, are an apparent investment since their principal adjusts upward along with inflation. Sharp inflation is normally a poor for stocks, because rising rates of interest pinch corporate profits and undermine economic growth potentially. But a few stocks can do fine likely. Start with metals and energy stocks because higher charges for their commodities will boost earnings, says Mark Kiesel, a managing director at Pacific Investment Management Co., or Pimco.

Include as well U.S. Examples of companies to consider: miners such as Freeport-McMoRan Copper & Gold and energy giant Exxon Mobil, or companies indirectly linked with item prices, such as driller Diamond Offshore Drilling, farm-equipment company Deere, and seed provider Monsanto. Insurance Component: Long-term Treasury bonds and municipal bonds. Both will likely soar in value amid deflation because their long amount of fixed obligations would be a good source of income as charges for goods and services broadly fall, and as paychecks shrink.

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And Treasurys, specifically, would likely turn into a haven for foreign traders, further pushing up their price. Portfolio preparation is simpler for deflationists: Put a chunk of money into long-term Treasury bonds and far of the others into cash plus some municipal bonds. If broad-based deflation materializes, long-term Treasurys are likely to surge.

The bonds’ fixed-income stream, meanwhile, would be well worth more in accordance with falling consumer prices progressively. Some investment-grade municipal bonds could serve a similar role, while also providing tax advantages for high-income earners. But beware: Deflation may likely mean some taxing authorities struggle to service bonds reliant on a specific income stream, like user fees. Instead, stick to “investment-grade bonds linked with necessary services like drinking water and sewage, power or necessary Federal government offices like, say, a courthouse building,” says Marilyn Cohen, leader of bond-investment firm Envision Capital.

Round out your deflation collection with a huge slug of cash. Though it won’t generate much of a return in a low-rate, deflationary environment, profit the lender shall gain value as prices fall. Insurance Component: Commodities react most drastically to surprise inflation, so they must be part of your insurance.