Deflation? Inflation? Protect against both

(Money Magazine) -- You know that stocks have a knack for climbing a wall of worry. You saw that firsthand last year, when in the midst of the global financial crisis, the Standard & Poor's 500 index skyrocketed more than 70% from its March 2009 lows.

But what about multiple, simultaneous walls of worry? Are you confident that your portfolio can overcome those?

Despite last year's big stock gains, jobs remain scarce, wages are growing slowly, and the housing market has yet to bottom out. Plus there's the fear that as the federal government starts to withdraw stimulus this year the economy could suffer another setback.

Some economists think this could lead to deflation, or falling prices -- something the U.S. hasn't seen for any real length of time since the Great Depression. "We could see annual economic growth of just 2% over the next decade, as well as significant deflation," says economic consultant A. Gary Shilling.

On the other hand, plenty of economic thinkers worry that in a few years -- if not sooner -- the economy is likely to face the opposite problem: high inflation because of vast government borrowing in the wake of the financial crisis. With some $12 trillion in debt and counting, the argument goes, an inflationary spiral is just around the corner.

Rob Arnott of Research Affiliates thinks there's a risk that inflation could hit 5% to 8% in the next three to five years. We haven't seen the upper end of that range since the early '80s.

In between Arnott and Shilling are plenty of forecasters who think the worst of the economic storm is over. And history shows that a well-diversified portfolio can withstand most modest bouts of inflation or deflation. But at the extremes, it's a different story. Right now, you face the extremely rare threat of being clocked first by deflation followed by inflation.

"With the risk of more credit strains ahead, and possibly rising inflation in the next few years, it's a good time to be defensive," says John Hussman of the Hussman Funds.

This doesn't mean you should drastically remake your strategy to guard against deflation now, only to swing in the opposite direction if and when inflation strikes. Rather, shift a small chunk of your portfolio -- say, 10% to 20% -- toward assets that can protect you in the event of either crisis. Here are six investments that will help you do just that.

1. Stocks with pricing power

Both deflation and inflation threaten the consumer economy. When prices are in free fall, shoppers hold off purchases because they anticipate even bigger discounts down the road. And when prices climb, the purchasing power of households sinks.

In either case, you want to tilt your portfolio toward firms that make or sell products that people have to buy no matter what: medicine, for instance, or groceries. So expect "defensive" industries such as health care, consumer staples, and agriculture to hold up well, strategists say.

At the same time, by sticking with dominant players in those areas -- firms with enough heft that they can pass along price increases to customers without hurting sales -- you'll stock your portfolio with companies that can maintain earnings growth in most economic conditions.

Among individual stocks, solid examples include healthcare conglomerate Johnson & Johnson (JNJ, Fortune 500), the pharmaceutical giant Novartis (NVS), and the food distributor Sysco (SYY, Fortune 500), all of which were recently recommended by Money's stock strategist Pat Dorsey.

Or you can target defensive areas more broadly -- and safely -- through sector-specific exchange-traded funds, such as iShares S&P Global Healthcare (IXJ), Consumer Staples Select Sector SPDR (XLP), or PowerShares DB Agriculture (DBA).

2. Cash-rich blue chips

If deflation strikes, you want to own shares of large companies with tons of cash on their balance sheet and little or no debt -- as opposed to firms that borrow heavily. That's because it can be difficult for companies to secure or refinance loans in troubled times.

Plus, in a deflationary economy, firms would be paying back loans with increasingly valuable dollars.

The good news is that shares of cash-rich blue chips might also be a decent hedge against inflation now. Why? These stocks are currently trading at better valuations than other shares, including those of smaller companies, says Chris Cordaro, chief investment officer at Regent-Atlantic Capital in Morristown, N.J.

And in inflationary times, the market favors cheap stocks. Indeed, Liz Ann Sonders of Charles Schwab has studied the relationship between inflation and price/earnings ratios and says "rising inflation almost always puts downward pressure on valuations."

A bonus: Many cash-rich blue-chip stocks pay regular dividends. And the value of those payouts can support your returns when share prices are flat -- or tumble -- owing to either extreme inflation or deflation.

The easiest way to invest in these stocks is to go with a mutual fund that favors firms with strong balance sheets. Several options can be found in the Money 70, our recommended list of mutual funds and ETFs.

Among them: Jensen (JENSX), which holds a concentrated portfolio of blue chips, led by names like Microsoft and Abbott Laboratories, both of which are sitting on roughly $9 billion in cash; and FMI Large Cap (FMIHX), another focused portfolio, with a large stake in Wal-Mart, which recently had $8 billion in cash on its balance sheet.

3. Emerging-markets stocks

Developing nations are leading producers of raw materials and commodities, whose prices tend to keep pace with inflation. That makes emerging-markets stocks a good inflation hedge, says Pittsburgh investment adviser Lou Stanasolovich.

Developing markets can also provide diversification in the event of deflation, since fast-growing nations, such as China and India, are likely to keep expanding -- in part based on rising domestic demand -- even if the U.S. lags. Indeed, the Chinese economy is forecast to grow around 8% or more every year for the next decade, according to IHS Global Insight.

Of course, after returning 70% over the past year, these stocks are pricey -- and they're riskier than owning U.S. equities. What's more, you may already have a fair amount of exposure (in general, you should consider keeping about a quarter of your foreign equity portfolio in these shares).

If you need to boost your stake, dollar-cost average small amounts gradually. A good choice is T. Rowe Price Emerging Markets Stock (PRMSX). Or you can opt for an all-in-one foreign portfolio, such as Vanguard Total International Stock (VGTSX), which keeps a 25% stake in the emerging markets.

4. Inflation-indexed bonds

Bonds are particularly sensitive to inflation, since rising prices eat away the value of modest fixed-income returns. For instance, in the 1970s, government bonds actually lost nearly 2% a year in real terms because inflation was running so hot.

Unlike in the '70s, there's now an easy way to protect against inflation without getting clobbered if deflation strikes: Treasury inflation-protected securities (or TIPS), which adjust their principal value to keep up with inflation.

You can invest in TIPS through a fund such as Vanguard Inflation-Protected Securities (VIPSX). Or you can buy individual bonds for no fee at treasurydirect.gov.

What if deflation occurs instead? The principal value of these bonds would be adjusted downward when it comes to calculating your interest payment. But as long as you hold the issue to maturity, you'll get back the full principal. That's an argument for buying individual TIPS.

In fact, individual TIPS will also allow you to employ a traditional deflationary strategy -- which is to buy long-term Treasury bonds, whose value would rise if interest rates fall or stay low in deflationary times.

5. Foreign bonds

Owning international bonds -- in both the developed and emerging markets -- is another potential hedge against inflation. For starters, many foreign securities give you a shot at higher yields than you can find in the U.S., says Andy Engel, portfolio manager at the Leuthold Group. Three-year Brazilian government bonds, for example, recently yielded 12%, vs. 1.6% for equivalent Treasuries. (Brazil's outsize yields, of course, are a reflection of the risks investors see in that economy.)

By investing in foreign bonds, you're also ensuring that not all your investments will be held in U.S. dollars. In the event of extreme inflation or deflation, it's hard to predict how the dollar will perform, since much will depend on how bad inflation or deflation is here relative to overseas. But by keeping a portion of your bond portfolio in international securities, you can protect yourself if the dollar falls because of either economic threat.

To gain exposure to bonds issued in developed countries, check out T. Rowe Price International Bond (RPIBX). And for higher-yielding, but higher-risk emerging-market issues, consider Pimco Emerging Local Bond (PLBDX).

6. Commodities and real estate

Although there are long stretches when physical assets like commodities can lose money or be stagnant, they can offer solid protection against high inflation over short periods. That's because when inflation is surging, natural resources like oil, food, and raw materials soar in price too.

From 1973 to 1981, for instance, when inflation climbed an average annual 9%, the Goldman Sachs Commodity Index returned 12.1% a year.

But during times of deflation, real assets tend to fall in value, which adds to their risk. (You can argue this is less of a concern today in one hard asset -- housing -- since residential real estate has already been deflating for years).

Whether inflation or deflation strikes, the best case for investing a small portion of your portfolio in real assets is to boost diversification, since these investments typically move out of step with equities, says Tom Idzorek, director of research at Ibbotson Associates.

With a small stake in commodities and real estate -- say, 3% to 5% -- you can lower your overall risk regardless of the economy.

An easy way to gain exposure to commodities is T. Rowe Price New Era (PRNEX), which buys shares of firms that benefit from inflation. Another option: iShares S&P North American Natural Resources Sector Index (IGE), an ETF that tracks an index of energy and materials companies.

As for real estate, given the risks that remain in the commercial market, go for a diversified fund that doesn't focus on a single commercial-property segment. Two sound options are Vanguard REIT Index (VGSIX), and iShares Dow Jones U.S. Real Estate (IYR).

All of these moves taken together should help your portfolio withstand a rare economic one-two punch. So if the deflationary and inflationary threats turn out to be milder than expected, no worries: These tactical moves will help you better diversify your core holdings of stocks and bonds. And no matter what the economy is like, there's nothing wrong with that.