The Austrian economists anticipated the present crisis. Should we listen to them when it comes to their predictions about what comes next? In one voice they are saying we will experience inflation unlike we’ve seen in the USA in over 100 years. Inflation is defined as the increase in the supply of money and credit. We are certainly experiencing an increase in the supply of money at present. But the draw-down of credit is counter-acting the monetary inflation and we are hovering in inflationary stasis at present.
Fed Chairman Ben Bernanke said the same thing on February 18th:
Some observers have expressed the concern that, by expanding its balance sheet, the Federal Reserve will ultimately stoke inflation. The Fed’s lending activities have indeed resulted in a large increase in the reserves held by banks and thus in the narrowest definition of the money supply, the monetary base. However, banks are choosing to leave the great bulk of their excess reserves idle, in most cases on deposit with the Fed. Consequently, the rates of growth of broader monetary aggregates, such as M1 and M2, have been much lower than that of the monetary base. At this point, with global economic activity weak and commodity prices at low levels, we see little risk of unacceptably high inflation in the near term; indeed, we expect inflation to be quite low for some time.
He acknowledged that they are inflating. But he threw a red herring into the mix by talking about weak economic activity and low commodity prices (Heh, except gold, right Ben?) trying to infer that they are somehow the cause of inflation. No, they are the result of inflation. Next, he went into how they will correct their inflation:
However, at some point, when credit markets and the economy have begun to recover, the Federal Reserve will have to moderate growth in the money supply and begin to raise the federal funds rate. To reduce policy accommodation, the Fed will have to unwind some of its credit-easing programs and allow its balance sheet to shrink. … However, the principal factor determining the timing and pace of that process will be the Federal Reserve’s assessment of the condition of credit markets and the prospects for the economy.
Bernanke recognized that the plane is in a nosedive and at the last minute he plans to push on the stick and go airborne again. I hope it is not a cloudy day when he has to judge how far the plane is from the ground. He wrapped up his thoughts on inflation and how to avoid it:
As we consider new programs or the expansion of old ones, the Federal Reserve will carefully weigh the implications for the exit strategy. And we will take all necessary actions to ensure that the unwinding of our programs is accomplished smoothly and in a timely way, consistent with meeting our obligation to foster maximum employment and price stability.
What do *you* think the chances are that the Fed will get all of the necessary actions right? Have they gotten the necessary actions right up to this point? Let us examine a scenario where they are not able to get it right and we do indeed experience undesirable inflation, which I will define to be anything above 5% annually.
How might the various asset classes be affected in times of inflation? To answer this question, I utilized Simba ‘s spreadsheet for back-testing portfolios (which I imported into Google Spreadsheets) to do a correlation between CPI (Consumer Price Index, the government’s official inflation number) and various stock fund, bond fund, and gold returns. The data in the spreadsheet uses annual returns of Vanguard index funds along with the yearly closing price of gold from the years 1971 – 2008. The spreadsheet already calculated the cross-correlation between each of the mutual funds and it lists the annual CPI index. So it was very easy to drop the CPI into one of the mutual fund slots and instantly see the correlation between every asset class and inflation. Here are the results, sorted by correlation:
T-BILL (money mkt)
Long Term Govt Bnd
Short Term Trsry
5 Yr T
Small Cap Grwth
Large Cap Grwth
Total Market US
Large Cap Value
Small Cap Value
The table shows those asset classes that were most closely correlated with the CPI at the top. Note in the third column that a value of 1 would mean the asset is perfectly correlated, -1 would mean perfectly correlated inversely (it went down exactly as CPI went up), and 0 means there was no correlation: it was random.
So we see that those assets that were most highly correlated with CPI were T-bills, gold, long-term government bonds (inversely), short-term Treasuries, and commodities. Everything else was below 0.25 correlation. Interestingly, micro cap stocks were totally uncorrelated with inflation.
So how did a portfolio of those assets perform during the years 1973-1981 in which CPI was 8.7, 12.3, 6.9, 4.9, 6.7, 9, 13.3, 12.5, and 8.9%?
I constructed a portfolio along the lines of the Harry Browne Permanent Portfolio (HBPP invests 25% each into total US stock market, long-term bonds, money market, and gold) but I added some small cap value, micro cap, and eliminated the long-term bond fund. I then back-tested that portfolio during those inflation years. Here is the portfolio what I came up with:
The "Inflation Portfolio" had a CAGR (Compound Annual Growth Rate) of 15.5% and a risk (as measured by standard deviation) of 10.5%. Plotting that on a chart, here’s what it looks like compared with some other portfolios and the assets themselves:
The chart shows plots for various portfolios during those inflation years. The plot point directly above HBPP simply substituted BRSIX for VTSMX in the HBPP. The major components of the Inflation Portfolio are also plotted separately showing how volatile gold and BRSIX were themselves. When tempered together with VMPXX, the risk came down considerably while retaining significant returns. You can see all of the rest of the details in the Google spreadsheet that I created for this scenario and you can test out other hypotheses yourself.
The Inflation Portfolio worked from 1973 through 1981. If we see inflation return, would it work again? Some folks are discussing these findings at the Bogleheads forum if you want to chime in.
Please note this is not a recommendation to invest your net worth in the Inflation Portfolio!
With the stock market down some 40% last year, many people are asking, "Where did the money go?" Sure there are some stock market losers. But remember the winners, those who sold their stocks in October 2007? They got their money. Remember also that for every share of stock sold, there was a share of that stock bought. But Fannie Mae used to trade for $80 a share and is now just pennies a share. Is the money just totally gone? Where did that market capitalization go? Furthermore, we need to push deeper, past the issues of money and valuations and ask, "Have we really lost wealth?" The answer may surprise. We will get to that last question in a moment. But first, let’s follow the money.
Where did the money go?
The USA Today ran a story that read, "$2 trillion wiped out of retirement funds " so far in 2008. Really? Two trillion dollars is wiped out? Lost? This is a fascinating notion. You wake up one day and wealth is suddenly gone. Vanished. Like some ice cube that has melted on a hot street. Here one moment and gone the next. As we shall see, the ice cube metaphor may be even better than it first appears. Stocks have melted.
The NPR Planet Money podcast a few weeks ago sought to answer the question "What is money?" and recently asked "Where did the money go?" To help us visualize the "loss" of money, they acted out a little skit with three market participants. At the start of the skit it was noted that among them the sum total of money was $400. Russ had $200, Alex had $200, and Lois had a house. (It was a little green Monopoly game piece house.) Russ Roberts (of EconTalk fame) decided he wanted a house. So he offered Lois $200 for hers and she accepted. Russ has the house, Lois has $200. Some time passed and then Russ wanted to sell his house. Alex was the only one who made an offer and it was for $100. Russ took the offer but was obviously unhappy about "losing" $100. At the end of the skit, Alex owned the house and $100, Lois had $200, and Russ had $100. The sum total of money was $400. Therefore, the net amount of money remained unchanged although some of the market participants had varying emotions about their transactions.
Lois was happy to receive the $200 for her house because she said she had originally purchased the house for $100. But she said that she still had to live somewhere and would now have to go and buy another house. Russ was obviously unhappy because he has $100 less than when he started. And still no house. Alex was probably the happiest because he has a nice house and still has $100 of his original $200 remaining. But with the net amount of money remaining the same, they didn’t really ask the question, "Why did the house only get an offer of $100?" Why not a $300 offer? Don’t house prices continuously rise and never fall? It was a fun exercise to walk through, but it still left me unsatisfied. What’s behind the rise and fall of prices? Let’s try to figure that out. But instead of houses, let’s switch over and talk about gold for a moment.
Gold and the Market
Gold is different than houses. We can’t live in gold. Instead, gold is money. Ancient money. Gold would still be money today if the governments would stop prohibiting it from being money. Consider these characteristics of money: money must be marketable, easily transportable, relatively scarce, relatively imperishable, easy to store, easily divisible, and uniform in quality. Gold meets all of these characteristics and has been used as money by default through the ages. Ironically the dollar, the world’s reserve currency, doesn’t meet all of these characteristics. It misses the scarcity test.
So let’s trade two things: dollars and gold. It used to be that a dollar represented a fixed amount of gold, but today we can trade one for the other at different amounts. If you have dollars and I have a one ounce gold coin, you can make me an offer to trade some of your dollars for my coin. I can accept or refuse. If you offer me $200, I will refuse. If you offer me $2000 I will accept. Somewhere in between these two ranges we may reach an agreement (or we may not). The more people there are around to offer bids and ask for bids, the greater the chance that someone can reach an agreement on a fair trade. As an example, say your bid for my gold coin is $600 but Troy bids $800. You may consider increasing your bid to $850 in light of his bid. But before you do, Bill next to me accepts Troy’s $800 bid for his coin. You witness that and decide to limit your bid to me to $800 also. Why pay more, right? Or if you are really trying to game me, you may hold your bid at $600 thinking that no one else is around now that will bid something higher.
This is the workings of the market. Bidding and asking is how we reach agreed-upon prices. This is why stock prices are what they are: dynamic. It is a continuous mixture of people wanting to sell at the highest asking price and people wanting to buy at the lowest bid price. But they know they are competing with other sellers and buyers for those same shares.
Competition is the heart of the market. It is the heart of the gold market and the heart of the real estate market and the heart of the stock market and even the heart of the currency market.
In the NPR skit, Alex was able to buy the house from Russ for only $100 because there were no other offers higher and Russ really wanted to sell. A motivated seller they say. Perhaps he needed to move because of a job relocation. There are motivated sellers in all markets just as there are motivated buyers. Are there more motivated sellers than motivated buyers? Prices will fall as bids dry up. Prices will fall as the number of offers rise and the amount asked for sinks. Are there more motivated buyers? Prices will rise as bidders compete. Prices will rise as owners hold tight.
Presently in our global stock markets our global real estate markets and our global commodity markets we have not just a boatload of motivated sellers but a whole fleet of cruise ships full of motivated sellers. We have banks, brokers, hedge funds rushing for the exits at the same time, needing to sell just to get the dollars to pay off debts and client redemptions. We even have investors motivated to sell simply because they see so many other motivated sellers selling.
As naturally happens when motivated sellers outnumber motivated buyers, prices drop. We might call this an asking war , the opposite of a bidding war. Sellers lowering their asking prices in the face of other low asking prices. Asking prices for stocks go lower. Asking prices for houses go lower. Asking prices for copper goes lower. But motivation in a particular market is only part of the story. We need to also consider motivation across markets. I may want to sell my house not because of physical reasons but because of economic reasons. Perhaps I want to trade house wealth for stock wealth. I may prefer at present to rent and hold 10,000 shares of an index fund rather than owning a house. I probably will not find the exact trade I’m looking for; that is, someone to offer to trade me their 10,000 shares for my house. Instead, I’ll have to trade through money. I sell the house for dollars and then sell the dollars for the index funds.
But the net amount of money in the system doesn’t change as a result of motivations. The buyer gets to keep the net amount that the seller loses out on. Alex has the $100 instead of Russ. When prices kept going up, did anyone ask, "Where did that money come from?" Not likely. We don’t care how we got it. Yet we darn sure want to know how we lost it. But both answers are the same. The net amount of money remains constant among the total pool of buyers and sellers.
[Note that I am for purposes of this discussion ignoring the effect of fractional reserve banking and the creation of money when lent and the destruction of money when a loan is paid back. This effect is indeed serious and makes an enormous impact to the economy as a whole.]
Now we know where the money went. It is still there. Not a satisfying answer to owners of stock mutual funds in their 401K plans who say, "Oh great, more motivated sellers means any bids I seek for my shares will be lower if I were to try to sell today." Penny’s 401K plan may have a cost basis of $100,000. And last year when she checked the bids on her portfolio it may have fetched nearly $300,000. But based upon recent offers, it may only receive bids for $150,000. That seems like lost wealth to Penny. Is it?
It depends. It might not be lost wealth to Penny. We need to look at what Penny would have wished to trade her shares of stock for? A house? If so, Penny is in luck because houses she liked that used to fetch $300,000 bids are now asking only $150,000. So Penny’s 401K plan would buy the same amount of house even though its dollar value has fallen in half. Similarly, Penny may have wished to use her 401K to travel or to eat or to pay her gas bill. Dollar values for each of these things may have fallen, but their values may have stayed relatively close to the value of her stocks over that time.
We are living in a world where bids for practically every asset are lower in comparison to bids for dollars. Many motivated sellers of stuff, many motivated buyers of dollars.
So the problem is the thing we are using as money, which itself is becoming more "valuable." The banks, brokerages, and hedge funds that need to get dollars are not just motivated sellers of stocks and commodities, but they are also motivated buyers of dollars. There are lots of motivated dollar buyers. Prices of dollars rise. Everything else seems more expensive compared to dollars as a result.
But we the investing public with 401K plans are typically not motivated buyers of dollars. We are more typically motivated buyers of the things that dollars buy. Food, travel, cars, shelter, heat, etc. When we trade one of these for the other, we might expect roughly the same item-for-item transaction this year as we did last year. The thing in the middle is what has changed: the money. The demand for the dollar by banks, brokers, and hedge funds has skewed the monetary valuations of both the things that we need to sell and the things that we want to buy. But in the end, it might possibly be that our wealth remains somewhat unchanged just like the amount of money remains unchanged among buyers and sellers.
Which brings us back to the ice cube metaphor. With melting stock prices, melting real estate prices, and melting copper prices, just like a melting block of ice the water still exists — only in a different form. The wealth once stored in stocks is now stored in dollars. Ice melts to water. Stocks melt to dollars. There is one more thing. Something I really don’t want to think about in this analogy. What happens when the water evaporates?
Wow, how time flies when you’re making money having fun. Tonight is the one year anniversary of Jim Cramer’s Mad Money show on CNBC. Tune in at 6, 9, or 12 and find out what he has cooked up. (Probably some Bear Stew based on today’s market!) Then come back here and comment on the show.
Keep up the energy Jim and have a great 2nd year!
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On January 25th I wrote a blog entry called “2006â€™s Biggest Cramer Crackle!” I was referring to Rediff.com (REDF). It jumped up 29% in price on the next opening day. I was actually assuming that the thing would settle back down. Glad I didn’t predict that it would because it actually is UP 60.2% FROM THAT OPENING PRICE. The other stock mentioned that day Danone (DA) is also up 6.8% from its next day’s opening price.
There were other large Cramer Crackle stocks since January 25th:
Sirenza Microdevice (SMDI) Cramer Crackle: 20.4%
Omnova Solutions (OMN) Cramer Crackle: 33%
NMT Medical (NMTI) Cramer Crackle: 21.6%
Acadia Pharmaceutical (ACAD) Cramer Crackle: 26%
Pan American Silver (PAAS) Cramer Crackle: 6.2%
Bookham Inc (BKHM) Cramer Crackle: 22%
LifeCell Corporation (LIFC) Cramer Crackle: 11.6%
Hexcell Corporation (HXL) Cramer Crackle: 10.1%
That’s pretty good advice for the following stocks that FELL after their Cramer Crackle prices:
(as of closing Wednesday 8 Feb)
Pan American Silver: -5%
See! You don’t always want to buy them the next morning.
Here’s some winners (Percentages post-Cramer Crackle as of 8 Feb):
NMT Medical: 2.0%
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Today, Wednesday (actually during yesterday’s after-hours trading) we saw one of the largest Cramer Crackles (the difference between the closing price and the opening price after a Cramer mention) since the first Mad Money episode aired. Did you get some? Cramer pumped Rediff.com as the Yahoo, nay the Google, of India. He mentioned it at 6:13:11 PM ET on Mad Money. Then at 6:14:20 you started seeing it on the bottom of the screen $15.70 up .68, $16.80 up 1.78, $17.31 up 2.29, $17.80 up 2.78. All this by 6:15:37.
Can’t you just see these guys sitting at their computers with their stock order entry form open and filled out with everything except the ticker symbol? By the time Cramer gets the letter F out of R-E-D-F, they’re already hitting the Submit button on their market order for the stock.
The strategy of buying in the afterhours doesn’t always work for the Cramer Crackle play. But this time it did. Whoever got some at $17.80 was able to sell it on Wednesday for between $18.81 and $21.40, that’s up between 5.7% and 20.2% respectively.
The stock’s 90 day average number of shares traded is 393,952. On Tuesday evening between 6:00 and 7:00 it traded 543,250 shares. And the total volume on Wednesday was 12,935,244.
By contrast, Danone (DA) the other featured stock on the same show, had only a 1.3% Cramer Crackle.
The two portfolios in the Portfolio Smackdown! diverged today. The ETF portfolio suffered hits from the Asia (VPL) and Emerging Market (VWO) downturns today, -2.7% and -1.9% respectively. While the MMM Cramer 2006 portfolio rose due to strength in the energy sector. Nabors (NBR) rose 1.9% and Talisman (TLM) rose 2.37%. Bottom line: the ETFs stand at a 3.4% gain and MMM Cramer is at an 8.4% gain. Notice at the bottom of the Portfolio page are the previous trades made in the portfolio and the dates the trades were enacted.
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