The stock market is now in “bear” market territory having declined over 20% since last October. In itself, that is bad news. However, beneath the surface, worse news seems to be percolating ever more vigorously.

On July 11, reports emerged that Fannie Mae and Freddie Mac, the giant home mortgage financiers, may need government bailouts. These two companies own or guarantee roughly half of the nation’s $12 trillion mortgage market. On that news, the stock market fell more than 200 points.

As the government works to solve the year-old credit crisis, the primary tool has been to keep the economy’s wheels greased with ever-increasing amounts of cash. If the financial markets seize up because of illiquidity, the economy could be in serious trouble – unemployment lines could grow long. The July jobless rate of 5.7% was the highest in four years. By making liberal amounts of money available to the banking system, and encouraging those banks to make new loans, the economy may be able to swim out of the quicksand.

The question, then, is: Where is this increasingly vast sum of money coming from?

There are three possible sources. The government can borrow the money by selling bonds. It can raise taxes. Or it can effectively print new money. The most politically expedient approach seems to be the third option. The money supply has been growing rapidly.

Inflation, at many times in world history, has wiped out investors’ savings. Inflation tends not to generate nearly as much media excitement as a 200-point stock market decline. Rather, escalating costs of living is rot that eats away at investors’ portfolios 24 hours a day, 365 days a year. It is only when we look back over a period of time that we may comprehend – too late – just how much damage has been done.

Combating inflation in a portfolio is a challenge. There are clearly some measures that we would not want to take. Intermediate- and long-term bonds, for example, expose investors to considerable risk of losing their purchasing power irreversibly. Notable, “guaranteed” annuities that are not indexed to the CPI can leave their investors badly compromised.

Cash-like instruments have traditionally kept investors about even with inflation. At present, however, that clearly is not the case. Cash yields less than the current 5% inflation rate. Subtracting taxes paid on interest earned likely puts most such investors into the red. In other words, those who hold cash probably will be able to buy less on December 31, 2008 than they could at the start of this year.

Stock investors, however, have an advantage. Equity has traditionally been an effective hedge against rising prices. If we have inflation, the replacement costs of a company’s factories, stores, patents, and other business infrastructures rise. Eventually, that tends to be reflected in higher stock valuations. As well, higher production costs are passed along to consumers in the form of higher fees and selling prices. The shareholder, then, has a built-in mechanism for protecting his purchasing power.

There is, of course, a price to be paid for the expected inflation protection afforded by equities. The stock owner does not know when he will be made whole after a period of inflation. The market might lag for years, or it might reflect intermittently the higher costs of living. Much of the bull market gains starting in 1982 merely reflected accrued inflation losses from the earlier decade.

FMI on inflation and what it might meant to you, contact Dow Investment Group, LLC, 358 US Route One, Falmouth, Maine; phone 207-878-3000 or 800-578-9981 direct office line; visit www.dows.com.