The Fed: Of Shoes, Pipe Dreams, and General Motors

By Adam Lass & Sara Nunnally

Plus... Oil Stocks: Big Oil Stands Its Ground

Blue-Chip Investing
“If the public reacts to a short period of higher-than-expected inflation by marking up their long-run expectation considerably, then expectations are poorly anchored.” It’s an outrage, but really, there’s nothing Mr. Bernanke can think of to do about it.

Material Profits
With 60% of the world’s top-10 companies in the oil industry, investors may want to assume that high oil and gasoline prices are going to be around for a while.

“Undoubtedly, the state of inflation expectations greatly influences actual inflation and thus the central bank’s ability to achieve price stability.” This is Ben Bernanke’s excuse for why he has done absolutely nothing worth speaking of since being handed the big chair at the big bank.

I find this attitude a bit peculiar coming from a man charged with (and I am quoting from the first tenet of the Fed’s own mission statement here): “Conducting the nation’s monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates.”

At a recent conference sponsored by the National Bureau of Economic Research, Mr. B. was willing to concede that “experience suggests that high and persistent inflation undermines public confidence in the economy and in the management of economic policy generally.” He even went on to note that this could decrease the willingness of folks to take risks or invest.

And yet Mr. Bernanke insists that the Fed, despite its specific charge to control inflation, is really quite powerless here. Because, you see, despite his advanced degrees in economics, Mr. B. doesn’t really believe in either of the two popular theories of inflation.

The first is that inflation happens when you have too many dollars in circulation compared to either your vast hoard of gold (if you are a bit of a Luddite -- or your productivity -- if you are a modernist). The second theory (held mostly by young radicals) states that a pervasive outside influence like the cost of oil will eventually influence core costs.

Here’s how such “practical” inflation might work. Think of a shoemaker. He requires a good bit of leather to do his job. Maybe a bit of thread and a nail or two. A well-lit workbench in a shop that is cool in the summer and warm in the winter doesn’t hurt. A place to sell shoes to customers who can afford them rounds things out nicely. In the end, our cobbler hopes to make profit so as to feed, clothe and house his passel of future cobblers.

So what happens when the costs of raising cattle for leather, shipping said leather into the shop, lighting and heating that shop, and shipping shoes to the market go up? Also the cost of keeping the aforementioned passel at home in feed?

Now I know just what you are going to say: Our cobbler raises his prices in the (vain?) hope of keeping ahead of things, right? Wrong!

As per Mr. Bernanke, it is not the reality of rising costs that causes our hammer swinger to raise his prices. Rather, it is something that the Fed simply cannot control: it is his perception of those costs.

If prices rise about as much as he thinks they ought to, then Bernanke posits that our craftsman will tell the kids to think good thoughts and chew leather tonight. But if prices rise more than he thinks they ought to, if for some strange reason he feels that somehow he does not deserve to allow oil execs to live on yachts while his kids clamor for more hamburger-helper helper (sic), then the rascal will do the one thing he ought not, and raise his selling prices, even if it means losing customers.

“If the public reacts to a short period of higher than expected inflation by marking up their long-run expectation considerably, then expectations are poorly anchored.” And indeed, “expectations appear to remain imperfectly anchored.” In other words, it’s an outrage that our lowly friend should cause such disruption, but really, it’s nothing a central banker can do anything about.

A stronger dollar is the Fed’s primary purview. It would immediately translate into lower energy costs for our poor cobbler and end this cycle immediately. But the Fed as currently constituted is lost in opiated sociological pipe dreams and simply incapable of any action whatsoever.

Apparently this sort of drivel is the best we can hope for until after the ‘08 election when a new board is nominated, so I advise you to trim your sails accordingly. That means that all retail must choose either volume at a loss or profit on diminished sales.

Already May sales were disappointing, while June is predicted to come in on both sides of that painful divide. Today we hear from Lazard Capital Markets’ Todd Slater that “the consumer continues to be plagued by pressures on discretionary spending from gas inflation and housing deflation. Simply put: “There’s nothing they’ve gotta have.” Lazzard says to look for “slammed second-quarter earnings.”

Specific actions to take? Run, don’t walk, away from any and all retail stocks, including (most especially!) over-inflated General Motors (GM:NYSE).

P.S. Thanks for the catch, Mark B.! Yes, all you WOW subs, they are, of course, your El Paso Calls, not puts that hit 121% yesterday. Chalk it up to sharp wits and floppy fingers.

The latest list of top companies in the world, as determined by Fortune’s Global 500 is once again dominated by oil companies.

In fact, six of the top-10 companies are oil producers, and three of the remaining four are auto manufacturers. Only one is a retail company, and though it’s the only stock without a strong tie to oil, it still took the No. 1 spot on the list.

Of course, only one retail stock has the size to do that: Wal-Mart (WMT:NYSE).

With 60% of the world’s top-10 companies in the oil industry, investors may want to assume that high oil and gasoline prices are going to be around for a while.

Remember, on Monday, I told you that the International Energy Agency expects OPEC supply to become very tight very soon. In fact, the IEA sees some trouble in 2010 and beyond.

I think investors should start looking elsewhere for oil producers. I mentioned Russia, the OCS, and Indonesia.

I’ve found an interesting company with operations in Alaska, Canada, Texas, Australia, and Indonesia. In fact, it just awarded a second rig contract for its Bengara-II Production project.

This project sits on 900,000 acres in East Kalimantan, Indonesia. The company plans to drill four wells this year, and the drilling equipment is expected to arrive by late July or early August.

As compelling as a new oil discovery in Indonesia is, this stock has only one producing field to its name, and that means lots of money is being spent on exploring new possibilities, and only a little is being returned to the purse.

That in and of itself is not a turnoff, particularly for more aggressive investors, but there’s something else. The company has a trading volume today of only 5,600. Way too low to be able to get in and out of this stock easily.

GeoPetro Resources is also traded on the Toronto exchange under the symbol GEP-S, which has slightly more liquidity with a volume of 25,000 today, and the chart shows pretty volatile movement.

In all, keep your eye on GPR… It’s not quite ready for a recommendation, but it could be soon.