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This article originally appeared in the January issue of Registered Rep. Magazine.

One of an investor's biggest bugaboos is inflation. Like a termite infestation, virulent inflation can eat at the integrity of a portfolio, turning it into a porous structure that leaks capital.

When most investors think of inflation, it's usually that measured by the Consumer Price Index (CPI). CPI and its sibling, the Producer Price Index (PPI), measure price inflation, the change in the dollar value of a basket of domestic goods and services. Historically, however, inflation was defined as an increase in the supply of money. Or, more accurately, a boost in the amount of apparent money. In the days when gold or silver was coin of the realm, unscrupulous rulers could surreptitiously cause non-precious alloys to be used in minting, thereby increasing the coinage in circulation without a requisite hike in specie. The excess “money” could then be used to pay for military adventures, social programs or other whimsies.

Nowadays, so-called monetary inflation is attributed to the creation of money through fractional banking. In a fractional system, financial institutions make loans in amounts exceeding readily available reserves on deposit at the central bank.

Most of the time, price and monetary inflation are fellow travelers, but there are times when these two metrics diverge. It's possible, for example, for prices to actually deflate while the money supply grows at a fast pace, say quicker than the rate of industrial output. Just think back to the go-go days of the 1990s. Then, the Fed's easy money policy encouraged lending and spending while improvements in industrial efficiency put downward pressure on goods prices.

There's yet more divergence when a bubble, such as that in the housing market, bursts. In a crash, prices may deflate but monetary inflation can, in fact, remain. Monetary inflation was represented by those highly levered mortgage loans which remained due as housing values sunk. The apparent money supply would have remained high even as borrowers walked away from underwater properties. Banks, forced to foreclose and to sell homes at now-lower market prices, might have been compelled to raise rates to cover their losses had the Fed not intervened to stave off wholesale economic collapse.

Investments, as many ruefully discover, are inflation-sensitive. Stocks and precious metals, especially, fare better in an inflationary environment while bonds — most particularly, long term-notes — cheapen. In the face of deflation, though, cash and bonds are generally favored over equities and bullion.

Of course, the real problem for investors isn't really inflation (or, conversely, deflation) itself, but its predictability. After all, knowing, or at least being reasonably assured of its appearance allows one to plan a liquidation and reinvestment strategy.

Real-time analysis isn't possible with conventional price metrics such as CPI and PPI. The gaps between data points are too wide and they crop up only after six-week delays. The lack of granularity in the data, too, makes analysis and consequent investment planning difficult.

If inflation was a market, technical and fundamental, analysis could be used to better predict its course. Luckily, we can take a day-to-day measure of monetary inflation through the precious metal and foreign exchange markets. In particular, a Monetary Inflation Index (MII) can be created to plot changes in the global purchasing power of the U.S. dollar against gold and the second most widely held reserve currency, the euro. [Among the reserve currencies used to calculate the value of the International Monetary Fund's Special Drawing Rights (SDRs), the U.S. dollar is weighted most heavily at 41.9 percent; the euro is next at 37.4 percent, followed by sterling at 11.3 percent and the yen at 9.4 percent. SDRs are used as an alternative to bullion to settle transactions between IMF members.]

Since 1999, gold has appreciated at an average annual rate of 14.6 percent in euros while rising at an average annual rate of 15.8 percent against the U.S. dollar. Put another way, the greenback's depreciated in gold purchasing power at a faster overall rate than the euro. There have been plenty of fits and starts along the way, though. At times, the dollar's gold purchasing power was greater than the euro's; at other times, euros could buy more gold.

Using a January 1999 base of 100, the MII's value as of October's month-end (200.12) implied an average annual inflation rate of 5.7 percent. Over that same period, CPI's annual growth rate compounds to 2.5 percent (see Chart 1). The chart's dashed red line represents the trend mathematically implied by MII's data points. A rising line represents dollar inflation; downtrends denote disinflation or, ultimately, deflation.

While MII's trend line is consistently positive and acute, it belies the past three years' volatility in the monthly data. After breaking down from the cycle top in the spring and summer of 2008, monetary inflation bounced along in a rising trend, then shot up in 2009 to surpass its previous peak. The subsequent fall-off in 2010 formed a congestion area (the rectangle described by the dashed green lines), a base from which a breakout move is now likely. The question to be pondered is, of course, just where the breakout is headed — towards inflation or deflation?

Real-time inflation readings in 2011 pointed to higher ground, a recent collapse in MII to the long-term trend line is giving pundits the willies. Is deflation, in fact, rearing its ugly head?

We can get a sense of inflation's velocity by drilling down to look at a rolling 12-month rate. Over the past year, the change in MII averaged 1.8 percent, while the mean for contemporaneous CPI readings was 2.9 percent (see Chart 2). Now, it's important to keep in mind that MII at certain times predicts changes in CPI, so some variance ought to be expected. Note, for example, the February-to-November 2009 spike in MII which was mirrored by CPI for urban workers (CPI-U) between July and December 2009. Lately, the trajectories of the two inflation rates have become more congruent. In other words, the lag between the changes in MII's rate and those of CPI has shortened. It's the shape of the curves, rather than the absolute value of the data points, that links the two metrics. [Also shown on Chart 2 is the trajectory for the Producer Price Index for Finished Goods (PPI-FG) and the Consumer Price Index less energy and food (Core CPI-U).]

What Are the Odds?

The application of probability theory can help us get a handle on inflation's prospects. The MII's high-water mark was reached at 224.31 in August 2011 when gold was trading for $1,306 an ounce and euros were being swapped for greenbacks at $1.44. Inflation's low tide was logged in October 2000 at 62.06, with gold worth $267 an ounce and euros selling for less than 83 U.S cents.

More immediate time horizons, however, are needed to gauge inflation's prospects in the near term. For example, we can look at MII's variance over the past 100, 200 and 500 trading days to set the odds for future excursions from its mid-November 189.39 level.

Short Term (100 trading days: March 2012)

Over the past 100 trading days — corresponding to 139 calendar days — MII has averaged 197.20. The index peaked in August at 224.31 before dipping to an early October low of 167.13. With an annualized volatility of 29.3 percent, there's roughly a 1-in-7 chance of MII ending up at a new high in March. The 2-in-7 odds of finishing under the 100-day low reflect the index's recent downward momentum, i.e., a strengthening of the U.S. dollar. Granted, the probabilities aren't very high, but clearly the short-run prospects for the buck lean more to the bullish side — by a 2-to-1 margin. That's a disinflationary scenario.

It's entirely possible, of course, for MII to trade outside its 100-day limits before March. With the index's current volatility, in fact, the odds are roughly double to those of a spring finale at breakout levels.

Still, the most likely scenario — that is, at 4-in-7 odds — is MII winding up between the marks in March.

Intermediate Term (200 trading days: July 2012)

Doubling the time horizon doesn't double the chances of a breakout move. Looking back over its 200-day history, MII's average price was 193.64 — not much different from the index's 100-day mean. For this scenario, the all-time index high of 224.31 remains the upper threshold while a slightly lower low, reached in February 2011, pegs the downside barrier at 163.98.

In a breakout ending next summer, the odds still favor a move to the downside, though the margin has narrowed compared to those in a 100-day horizon. Notably, the chances of MII ending up somewhere in the middle remain better than 2-to-1.

Statistically, MII is more likely to exceed the high/low thresholds sometime in the next 200 trading days (253 calendar days) as opposed to ending there in July 2012. That's, in fact, about twice as likely, despite the index's slightly lower 200-day volatility (25.6 percent vs. 29.3 percent for its 100-day history).

Long Term (500 trading days: November 2013)

With a 500-day horizon, the odds are turned upside down. While the prospect for deflation — or more properly, disinflation — was higher in the near term, inflation seems more likely further out. MII's 27.8 percent volatility over the past 500 trading days gives rise to 1-in-4 odds of a new high in November 2013, while the chances for a new low drop to 1-in-9.

Now, about that low. Note MII's price range over the past 500 days. It's much broader than that of the previous time periods we've examined. That's largely due to the 109.82 nadir touched in June 2010. And that, in turn, accounts for MII's 5-in-8 odds of ending up somewhere between the marks.

Now What?

With some breakout probabilities now established, the question becomes, “Where's inflation/deflation ultimately headed?” To answer that, think of the consolidation range from which the inflation index has bounded. The depth of the two-year congestion area shown in Chart 1 suggests an MII upside target at the 246 level. And, as we've seen in the probability tables, it's later — say, in a couple of years — rather than sooner that investors should gird their portfolios against this depredation. In the meantime, investors are probably better off with long dollar and cash positions.

Securities that throw off cash are the ticket here. High dividend yields, for example, can be accessed cheaply through exchange-traded portfolios such as the iShares S&P U.S. Preferred Stock Index Fund (PFF) or the PowerShares Preferred Portfolio (PGX), both of which generate per-annum yields in the 7 percent-range currently.

More conservative investors may consider utility shares, proxied by the Utilities Select SPDR (NYSE Arca: XLU), which spins off cash at a 4 percent annual clip at half the price volatility of the preferred stock portfolios.

An even more cautious course can be plotted with fixed-income plays such as the Vanguard Short-Term Bond Fund (BSV) which yields about 2 percent for an annualized standard deviation of less than 4 percent now.

Then, if the inflation scenario unfolds in the next couple of years, these placeholder allocations can be reduced or supplanted by products such as the iShares Gold Trust (IAU) and the PowerShares DB U.S. Dollar Bearish Fund (UDN).

Caveats

The odds and objectives illustrated are, like all forecasts, speculative. They're based upon extant market conditions and political/economic circumstances. Obviously, the farther we look out to the horizon, the less clarity we have. Unforeseen developments can intercede to significantly alter the monetary inflation rate.

Still, it's better to have some framework upon which to build a portfolio. Otherwise, it's nothing more than guesswork.

Source: A Bookmaker's Approach To Inflation