Well, it’s happened again. The financial dialogue has shifted from fear of deflation in the summer of 2010 to renewed inflation warnings as we greet 2011. And it’s no wonder. Prices for everything from food and clothing to gasoline and electricity are rising very quickly and inflation is one of the major factors that can put your retirement at risk.

Photo: Watching frogs boi

Rising commodity prices have led to what is being called the Food Crisis of 2011. Riots have broken out in many parts of the globe as citizens demand that their governments take action to curb the accelerating cost of feeding a family. Here in North America, a trip to the grocery store is weighing a lot heavier on our budgets these days as well. Government data tells us inflation is contained, but the cash register says otherwise.

Inflation Sensation

There are plenty of reasons why commodity prices are rising, but the bigger questions may be:

1. How much longer will the rising price trend continue?
2. What can investors do about it?

There are two problems that come with strong trends like the recent rise in everything from wheat and corn to cotton and oil:

• They can continue a lot longer than you might think.
• They can end and reverse quickly and violently.

All of this makes answering question #2 about what actions investors can take much more difficult. Following are a few options for Canadian investors to consider for either scenario.

Investing in an Inflation Boom

If you think that commodity prices will continue to rise, there are a number of ways to invest in order to take advantage of inflation:

• Buy real return bonds. You can buy them individually or look at an ETF like XRB (iShares Real Return Bond Index Fund).
• Buy agricultural stocks like Agrium (AGU) or Potash (POT).
• Buy energy stocks or an energy ETF like XEG (iShares S&P/TSX Capped Energy Index Fund).
• Buy a broad materials ETF like XMA (iShares S&P/TSX Capped Materials Index Fund). Its top holdings include Potash, Barrick Gold and Teck Resources.
• Bet against bonds by shorting bond ETFs or buying an inverse bond ETF like HTD, which is a 2x leveraged inverse ETF that rises as the price of the 30 Year US Treasury falls. There is also a relatively new inverse ETF (CIB) that rises as the 10 Year Canadian bond falls, but I don’t usually look at trading ETFs until they have a more established track record and a decent amount of volume.

These are all good strategies for taking advantage of a boost in commodity price inflation. The problem is that they have been working for months now and the question arises as to whether the run is nearly done. You can find plenty of people to offer very sound arguments for both sides of the inflation argument.

A prudent approach might be to take some money off the table if you’ve enjoyed some significant gains and let the rest run. If you’ve missed the rally, it might be better to sit on your hands and wait for a better entry point. If you just can’t keep your finger off the buy button, though, it may be wise to keep your position size relatively small and watch for signs of reversal.

Investing in an Inflation Bust

The last time we saw this type of run up in commodities was 2008. That didn’t end well, with commodities falling roughly 40% during the last 6 months of 2008. The financial crisis triggered the decline at the time. Still, prices had run up much higher than they have so far, so there’s a case to be made that this rally could continue a little longer.

If you believe that the commodity boom is about to bust, you can cut back on your exposure to that sector, but you can also invest in the bust. Here are a couple of options:

• Buy inverse ETFs, which rise when the underlying index or sector that they track falls. A few examples of single inverse ETFs include HIX (TSX index) , HIU (S&P 500) HIF (TSX Financial), HIE (TSX Energy), and HIG (TSX Global Gold companies). The index or sector that each one tracks is in parentheses.
• Buy bonds. Typically, a crisis situation will see money flow into perceived safe havens like bonds. You can buy individual bonds or a broad bond index like XBB (iShares Dex Universe Bond Index Fund). Bear in mind, however, that there was a brief period of time at the onset of the recent financial crisis when bond prices fell along with everything else. It wasn’t long, though, before the flight to safety sentiment kicked in, send bond prices to historic highs and yields to unprecedented lows.
• Buy leveraged inverse ETFs. Horizons Beta Pro offers a slew of ETFs that are leveraged 2x the underlying index. These are too risky for me, but if you’re an active trader and you understand the product, they are another option.

Another thing for Canadian investors to keep in mind is that the Canadian stock market is heavily weighted toward the energy and materials sectors. So if you own a lot of funds or ETFs that track the TSX, you are likely already heavily weighted in commodities and materials. Now may be a good time to check out your true asset allocation, looking into the actual holdings of some of the funds you own to make sure you aren’t too heavily exposed to commodities.

Whether you believe commodities will continue much higher or are ripe for a correction, it pays to understand your options before either scenario plays out. Even if you’re not an active investor, 2008 taught us that falling asleep at the investing wheel can wreak havoc on your investments. Make sure your rebalancing strategy will lighten the blow if markets and commodities face a hard reversal again.

How are you handling the rise in commodity prices?