Companies with horrific balance sheets are a dime-a-dozen these days. Fundamentals of the economy are bad and getting worse. Seems like a short-seller’s’ paradise, right? Not necessarily. Inflation and bailouts may be the factors that ultimately decide the battle between Bull and Bear.

Inflation: The Great Debt Eraser

Inflation is a debtors’ dream-come-true, because it allows them to pay off their assets with devalued currency. Inflation means revenue and salaries rise, asset-prices go up, but debt stays the same. So debt-bloated companies all over the US may be in a stronger position they appear. Some of these “pigs” may end up with a fat portfolio of cash-flow rich companies, and a bunch of debt that means nada. Translation: A combination of big-bailouts and inflation could equal a headache for short-sellers.

That’s the problem with being short this market, it’s completely dependent on the whims of Geithner, Bernanke, and whoever else is whispering in Obama’s ear. Some might even describe the situation as akin to stabbing Adam Smith’s invisible hand with a rusty screw-driver. But investors have to deal the cards we’re dealt, so we’ll move on…

Analysts are now calling for inflation at levels greater than the 70′s. But our current problems dwarf any we have ever faced before, even on an inflation and GDP-adjusted basis. Richard Fisher, president of the Dallas Fed, made this scary statement in a May 2008 speech:

“For the existing unfunded liabilities to be covered in the end, someone must pay $99.2 trillion more or receive $99.2 trillion less than they have been currently promised. This is a cold, hard fact”. Here’s the full speech at the Dallas Fed’s site.

$99 trillion in liabilities is daunting enough. But now the administration and Fed have signaled that they are essentially all-in, and that bailouts are coming to for all: Pensions, state governments, insurers, commercial real estate, home builders, auto-manufacturers, auto-suppliers, and everybody’s favorite, banks. Do we have enough money to pay for all of that? No, of course not. Will foreign governments do us a solid, and pony up? Maybe, but at what cost? Probably a high one, in terms of yield and politics.

So what’s the government’s remedy? Quantitative-easing (QE) of course, which has already begun. To “fix” this problem, we’re going to need a whole lot o’ QE. That will amost certainly result in a lot of inflation when/if the recovery begins, unless the Fed acts to reign it in quickly. And tightening money supply is never a politically popular move. People like inflation, it’s like makeup for economies, smoothing over wrinkles and imperfections.

But the real reason that inflation is a bastard, is that savers are the ones who get screwed, as the purchasing-power of their cash evaporates. Meanwhile, those with loads of debt fare better. The value of their assets rise, while their liabilities decrease in relative terms. So the responsible middle-class taxpayer, who tighten their belt now, are being set up to fail if/when inflation rears its ugly head.

It’s unfortunate that we’re in this situation, and QE is arguably a bad choice. But that doesn’t really matter now, since it looks like we’re already headed down that path. So prepare accordingly.

Inflation Fighters

The most obvious way to protect against inflation is gold and silver. I own a meager stash of precious metals, and some miners in retirement funds. I ordered my bullion from Apmex.com, they were the cheapest I found online and service was good (I have no affiliation with them). If you’re looking for a good precious-metals mutual fund, Evergreen Precious Metals (mostly gold) is worth a look, boasting a 17% avg annual return over the past 10 years. These metals have paradoxically provided protection during both inflationary and deflationary periods in history. They’re both a safety and dollar-printing play.

Owning cheap shares of public companies may also protect against inflation and bailouts. I like companies with good revenue to EBITDA ratios, low price/book, sustainable dividends, etc. A very select few retailers fit into this category, but have rallied too much to chase now, in my opinion. I bought some Men’s Warehouse in Feb, from $10-$11.40ish. That’s a good example, but like I said, retailers have run too much now. Wait for pullbacks and hope you get them in this crazy market.

disclosure on stocks mentioned: short SPG (though my target price has risen with inflation and bailout expectations). Long GLD, EKWAX.
Nothing in this post is intended to be taken as investment advice. I am not an investment advisor, just posting my own opinions. Trade at your own risk.