Here's something that's probably not on your Christmas wish list, but should be: a little bit of contagion.

Contagion is a word you don't hear often, unless you work at the CDC or on Wall Street. Definitions of contagion, according to dictionary.com, include: "the communication of disease by direct or indirect contact" and "the ready transmission or spread as of an idea or emotion from person to person: a contagion of fear."

Contagion in the investing world (be careful not to ask Santa for disease contagion) is the fear that a run on one stock or asset class will spread into other stocks and asset classes, resulting in a sudden and large drop in market prices. High on the list of moral duties at the Fed and the Treasury is preventing contagion.

Here's a general guide to how these things work. It's been going on for a long, long time, so if you learn it now, it may help you your whole life:

• Markets go up and creative bankers invent clever ways to juice returns through "financial innovations" (Enron's off-balance-sheet entities, liar loans, interest-only loans, negative depreciation loans, CDOs, SIVs, etc.).
• Skeptics call for greater regulation, citing the risk.
• Regulators ignore skeptics, afraid to step in front of an upwardly moving market that is creating wealth for a lot of people. Regulators claim that "free markets" are self-correcting and price assets appropriately (i.e. it is impossible to forecast bubbles).
• Eventually markets go so high that, like Icarus, they are brought down by themselves.
• The peddlers of the "financial innovations" run to regulators for a bailout, citing unprecedented and unforeseen market conditions and the threat of contagion.
• As long as the peddler is not too tainted (e.g. Ken Lay) and the threat of contagion is credible enough, regulators move into action.

In watching Fed and Treasury, look for them to selectively use:

• "free markets" as a justification for not regulating (when markets are going up), and
• "the interest of the greater good" as justification for regulating (when overpriced asset come down and threaten contagion).

Greenspan was the master of this tactic¹, but Treasury Secretary Hank Paulson is a quick study. Paulson, who has repeatedly argued against regulation of hedge funds and mortgage markets is now calling for government intervention. According to the Wall Street Journal:

"The regulators didn't have clear enough visibility with what was going on in terms of these off-balance-sheet SIVs," Mr. Paulson said to reporters...In the short term, Treasury officials said the financial markets were in danger of a large-scale dumping of assets by the banks, which would have hurt capital markets and potentially spilled over to the broader economy [contagion!]. To avoid that, Treasury stepped in to facilitate discussions among the banks...Some have criticized the Treasury for essentially helping big banks avoid the financial pain associated with risky bets that didn't pan out. The reaction in Washington, though, was more muted. Democrats sought to use the Treasury's willingness to get involved to bolster their demands that the Bush administration do more to help homeowners who are also suffering from the subprime downturn [more government intervention by the Republicans means the Democrats should get theirs, too].

So what's my beef with how this world works? Not much, in that knowing about it, I am able to make a lot of money trading various stock and commodity positions in a way that is favorable to me. However, despite the benefit it provides me personally, I wish it didn't exist. I am concerned about the greater good (wink, wink). My concern centers on inflation.

It's simple really. If bubbles go up (like housing) and then aren't allowed to come down, the result will be inflation. Housing prices have gone up way too far. By almost any metric, they are overpriced. First time buyers cannot afford new homes. Mortgage payments as a percentage of income are elevated. Owning a house vs. renting one is extremely expensive. Whatever way you look at it, housing is overpriced.

If free markets are allowed to run their course, house prices will come back down, possibly causing a short-term recession, but paving the way for long-term economic growth. It will be painful, quick, and healthy.

But that's cruel, politicians will argue. People will suffer. Consequently, politicians and regulators are trying to help. Bernanke wants to lower rates to keep the subprime meltdown from spilling over into the broader economy, Hank Paulson wants to save the big banks from suffering major losses, and the Democrats want to help bail out subprime borrowers.

The road to hell is paved with good intentions. Each of these policies is inflationary. If housing prices don't come down, everything else will have to go up in value. How else will people be able to afford these houses relative to their incomes? Either house prices must come down, or incomes must go up. With banks running into liquidity problems, we're going to need a lot more help (a.k.a. money) from the government, which means more money supply, more credit, and a weaker dollar - all of which is going to lead to more inflation.

Markets, of course, are starting to get one step ahead of the regulators, driving up the price of oil, food, gold, and more. Oil is already at $87 a barrel and could easily go to $100 or more. Nonetheless, market watchers expect the Fed to lower interest rates again on October 31st.

Until the regulators, led by Bernanke, change their tune and start taking the threat of inflation seriously, it will continue to be advantageous to your portfolio to own:

• oil & gas companies, like Devon Energy (DVN) and SouthWestern Energy (SWN)
• gold companies, like Nemont Mining (NEM), Tanzanian Royalty (TRE [a well-run gold company doing a lot of prospecting in Tanzania]), and GoldHawk (CGHRF.PK [another well-run mining company that started production Oct. 1 at a Peruvian gold mine it acquired for a good price]
• metals companies, like CVRD (RIO), and Liberty Minerals (LBEFF.PK [a Canadian company opening new metals mines]).

If the smaller companies (TRE, CGHRF.PK, and LBEFF.PK) can get their new mines up and running according to plan and without cost overruns, and metal prices continue to move up, their stock prices could do extremely well. These companies are good inflation hedges.

I also continue to like generators of capital, such as Unico America (UNAM), a small California insurance company which trades just under book value (http://seekingalpha.com/article/49078-unico-american-corporation-true-value-again-and-again).

Don't worry about people claiming that oil and metal prices are already too high. Unless Bernanke gets serious about inflation, prices should move higher. Why? Because interest rates are a lot more accommodative than most analysts are saying. Overall inflation (WITH food and energy) is higher than core inflation. Yet, everyone is measuring by core inflation. I think it's incorrect to do so.

Core inflation was developed to take out temporary spikes in food and energy. But what if food and energy are on a long-term uptrend and core inflation is on a long-term downtrend (driven by globalization)? If that is the case, one misses the true trends by taking out food and energy. Greenspan recently said that the theory of using core inflation is starting to lose some credibility (he can tell the truth now that he's no longer in office).

But Bernanke is doing the opposite, arguing more than ever for the validity of core inflation. Bernanke is under tremendous pressure to provide liquidity (via lower interest rates) to the banks. To do so, he must argue that higher oil and a falling dollar are not important. Only core inflation matters.

It seems as if hedge funds are the first to catch onto this inflation theme. Eventually, they will be followed by PIMCO (but don't hold your breath), and finally coming in last will be Bernanke.

A recent AP article gave clues about the direction he is leaning:

Bernanke once again pledged to "act as needed" to help financial markets [in other words provide inflationary liquidity]...

"The further contraction in housing is likely to be a significant drag on growth in the current quarter and through early next year," he said [I believe he's using weak housing throughout 2008 to justify future rates reductions]...

On the inflation front, Bernanke noted that the prices of crude oil and other commodities have been rising and that the value of the dollar has weakened. Oil prices galloped to a record high of $86.13 a barrel on Monday...

Fielding questions after his speech, Bernanke said, "Part of the reason that we have some confidence in inflation remaining well controlled is we expect to see the economy growing more slowly at the end of this year" and early next year [again the weak economy from housing is Bernanke's justification for the Fed keeping liquidity flowing].

He said Fed policymakers were prepared to "reverse" the rate reduction if inflation turned out stronger than expected [this statement is probably his most important, but is it true?. If core inflation goes above 0.3%, will he backtrack or follow through with this threat/promise and force the economy into a recession? Watch the core inflation number! It's the most important economic number right now].

To understand the pressure Bernanke is under, and why I believe he and other regulators will continue to flood the market with liquidity (in spite of high oil prices), look at the current state of the real estate markets.

One of my readers wrote saying he is a real estate agent, and that volume is off 2/3 from normal. "And prices are soft," he wrote. "The lenders will only provide an equity loan at 80% of value [if you have a credit score in] the 750 fico range...if not forget it. When purchasing you need 725 [fico] and 20% down...who has 20% in savings for a down payment? Not many...this is a huge problem and the main reason homes are not selling. Not many can qualify under the new standards!"

Another reader, also a real estate agent, wrote:

There are going to be a massive amount of foreclosures. About 47% of homes on the market here are vacant.

Many of these same sellers did refinancing, pulling huge amounts of cash out of these homes, leaving them with negative equity in the face of falling prices. In effect, these homes were sold to the banks and eventually the home debtors will walk away with their cash. Thanks to the new Mortgage Debt Forgiveness Act, there will be little impact from this fraud [compare that to Paulson calling for more government action!].²

However, the lenders will continue to tighten and those defaulting will be out of the home market and credit market for seven years.

When I drive through a prospective neighborhood, I try to ascertain the yearly median income. I multiply that times three to get a neighborhood sales price range. Here in Phoenix, we need to come down 40 - 50% more [again, either housing prices must come down or incomes must go up]. Since I have lived in the same home for 30 years, I know this is pretty accurate for my own neighborhood. Like you say, sellers are reluctant to drop price. We have a long way to go.

Unless housing is allowed to run its course, the government will only cause inflation, or more likely stagflation,. So although you probably didn't think you wanted it, you might want to add a little contagion to your Christmas list.

In case you don't believe me, here are some final thoughts on stagflation from Wikipedia (emphasis added):

Stagflation...a term...used to describe a period of out-of-control price inflation combined with slow-to-no output growth, rising unemployment, and eventually recession. Stagflation is a problem because the...principal tools for directing the economy...offer only trade offs between growth and inflation. A central bank can either slow growth to reduce inflationary pressures, or it can allow general increases in price to occur in order to stimulate growth. Stagflation creates a dilemma in that efforts to correct stagnation only worsen inflation, and vice versa. The dilemma in monetary policy is instructive. The central bank can make one of two choices, each with negative outcomes. First, the bank can choose to stimulate the economy and create jobs by increasing the money supply...but this risks boosting the pace of inflation. The other choice is to pursue a tight monetary policy...to reduce inflation, at the risk of higher unemployment and slower output growth.

In neo-classical economic theory, stagflation is rooted in the failure of the overall market to allocate goods and services efficiently. The root cause of this is generally thought to be excessive government regulation...

Stagflation in the U.S.A. was defeated by the then Federal Reserve chairman, Paul Volcker, who sharply increased interest rates to reduce money supply from 1979-1983 in what was called a "disinflationary scenario." Starting in 1983, fiscal stimulus and money supply growth combined to create a sharp economic recovery which is in line with standard macro-economic models; however, there was a five-to-six-year jump in unemployment during the Volcker disinflation. It appears that Volcker trusted unemployment to self-correct and return to its natural rate within a reasonable period, which it did.

Paul/Volcker in 2008!

[1] Greenspan often uses a justification for not answering a question, then ignores the small justification to answer a different question. This tactic was classic Greenspan during Congressional testimony when he was head of the Fed, and he still uses it today - just about every time he is interviewed. This week on CNBC, when asked if oil prices were too high, he said that he couldn't second guess markets. They priced things appropriately. Several questions later, when asked about housing prices, he said they were going lower. I haven't yet seen an interviewer who can get around it (except the great John Stewart).

[2] "Let me be clear, despite strong economic fundamentals, the housing decline is still unfolding and I view it as the most significant current risk to our economy," Paulson said in a speech delivered at Georgetown University's law school. "The longer housing prices remain stagnant or fall, the greater the penalty to our future economic growth." Sounds great until you read what my reader wrote about the fraud resulting from government action already taken.