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:

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:

VISVX (Small Cap Value) 15%
BRSIX (Micro Cap) 15%
PCRIX (Commodities) 10%
VMPXX (Money Market) 45%
Gold 15%

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!

Then look at this…

Returns in the stock market are randomly distributed over time.

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.

Motivated Sellers

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.]

Lost Wealth?

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.

Runaway Train by Uncle Feather
Echo Mover by Black Adam
Cheese Grater by Chub Creek Music
Race Car by EL84
Dip by Chub Creek Music
Money by Theory in Motion
Groove IT by Denis Kitchen

Keep up the energy Jim and have a great 2nd year!

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Chris Bliss: Must-See Finale juggling to the Beatles shows what you can accomplish with hours and hours and hours of practice.

How much time have you practiced selecting the right investments? Practice could make the difference between 8% and 7%.

You can hear it now, My name is Paul… and I was a juggler.

Thanks b.m. for the link.

Obviously, you’d needed to have listened to the show to figure out which segment is which. If none of these things fit what you want to say about the show, you can always email me your comments to (feedback AT MadMoneyMachine.com).

When you click the Submit Vote button, you’ll be taken to the Current Results page (where you will see probably the web’s most annoying banner ads ever!). Have a look, but then hurry back here by clicking the Back button in your web browser!

And guess what? This vote doesn’t require you to enter your email or nuthin’!

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%

Jim Cramer talked about this effect on his Real Money radio show on Monday 6 February. He said that you should never pay more than 25 cents than the previous closing price.

That’s pretty good advice for the following stocks that FELL after their Cramer Crackle prices:
(as of closing Wednesday 8 Feb)
Omnova: -11.9%
Pan American Silver: -5%
Bookham: -11.7%
LifeCell: -6.3%
Hexcel: -4.3%

See! You don’t always want to buy them the next morning.

Here’s some winners (Percentages post-Cramer Crackle as of 8 Feb):
Sirenza: 3.9%
NMT Medical: 2.0%
Acadia: 6.1%

And better still, it is on the Skype service, so if you have Skype you can contact the Mad Money Machine for free at the Skype address: MadMoneyMachine!

If you leave a voicemail please know that I may use it on the Mad Money Machine show!

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.

Wow, folks sure miss the .com days don’t they?

Sold 314 GameStop (GME) at $39.98 and bought 288 Citi Trends (CTRN) for $42.51 at 10:30.

You’ll see it on the Portfolio page tonight.

Jim also says to take some GME off the table. I think we may swap completely out at 10:30 ET tomorrow just to keep the bookkeeping easy. Stay tuned…

Also, Investor’s Business Daily is free this week. Take advantage of it! Hint: You can download past issues too. Get ‘em while the gettin’s good.

Will put out a new podcast either tomorrow or Friday so be on the lookout for MMM-005! And I’ll pick the winner of Cramer’s Book and the RARE Mad Money notepad. If you haven’t entered the drawing yet, listen to the MMM-004 podcast (below) for details, but do it quickly!

As I mentioned previously, I swapped out of Cynosure (CYNO) today and into Palomar (PMTI). Sold 479 CYNO at $18.00 and got 221 PMTI at $39.08 at 10:30. (Pretend money, remember). So in addition to a 10.3% gain in the portfolio, we also have $1,370 of tax loss that we can apply to any tax gains we may happen to take later this year.

Darn, I should have put real money into this thing!

Should we ring the register on ENG, STX, or GME? Lemme know!

Also, he said Friday that until the Guidant (GDT) deal is done he’d stay away from Johnson & Johnson (JNJ). So strike it from our Common Ground report below.

BTW: as of this writing the link to the slideshow at the bottom of the article didn’t work. I’ll send her an email…

The MMM Cramer Portfolio is already pulling ahead of the ETF portfolio after only 3 trading days, thanks to GME and ENG. CYNO and SLE are the only two under water at the moment. The MMM Cramer Portfolio is up 4.2% and the ETFs are up 2.9%. That’s fantastic after only three days.

BTW: Jim’s newest monthly column is up at nymag.com. In it he gives some headlines we should expect to see in 2006. BTW: he also covered the material in yesterday’s radio show. He says CBS is ripe for a takeover and that Citigroup and GS will merge.

Hey, while I’m here I have a favor to ask: would you please VOTE for my podcast? I’m trying to gain some traction here against the big corporate types. So if you like rooting for the little guy, please VOTE.