Jubak's Journal
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How the Fed lost the inflation fight
(Page 2) of 2
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The Federal Reserve's inflation-fighting tools are designed to head off not just actual inflation, but inflationary expectations. The Fed believes, rightly in my opinion, that the true danger is psychological. Once consumers and businesses come to believe that future inflation is guaranteed, they will set off a self-reinforcing price spiral in which everyone raises prices now because they know prices will be going higher in the future and those current price increases then just buttress that belief in future inflation, leading to yet more price increases. Once these expectations have been created, it's very, very tough to reverse them. Paul Volcker's Fed had to resort to double-digit short-term interest rates and a deep recession to reverse the inflationary expectations of the 1970s and early 1980s, and to drive inflation down from 9% in 1980 to 3.2% in 1985.
Usually the Fed can head off those expectations by demonstrating -- very publicly -- that it won't stand for inflation. The interest-rate increases by the Greenspan Fed are a kind of line drawn in the sand. Because people expect the Federal Reserve to do whatever is necessary, no matter how painful, to fight inflation, they don't expect future inflation. That's why the yield on the 10-year Treasury note has come down from 4.73% in June 2004 to 4.18% on Sept. 21. The financial markets expect the Federal Reserve to keep inflation in check.
The wild card is Washington
But there's a major source of inflationary expectations that isn't under the Federal Reserve's control. That source: the White House and the Congress.
The sheer size of the annual budget deficit -- no matter whose accounting you use -- is damaging enough to any effort to prevent inflationary expectations from becoming embedded in the economy. As one spending plan gets piled on top of another, more and more people find it easier and easier to believe that the conscious plan in Washington is spend and spend, and then inflate and inflate, to make it easier to pay down the huge debt that's been built up.
But I think the damage goes deeper than that. Watching our government at work, it's hard to believe that money, especially the U.S. dollar, has any value at all. Certainly the politicians don't behave as if it did. If money has value, how do you justify the recently passed transportation bill, filed with more than $30 billion in vanity projects designed to get politicians re-elected -- and the recent refusal by House Majority Leader Tom DeLay, R-Texas, to even consider giving back a dollar from that bill to pay for Hurricane Katrina?
If dollars have value, how do you justify no-bid contracts for clean-up and rebuilding to politically connected companies, some of which have been under investigation for over-charging on no-bid contracts in Iraq? If dollars have value, how do you account for Congress recently upping the spending limit to $250,000 from the previous $15,000 on government-issued credit cards passed out to Federal Department of Homeland Security employees, even though no one knows how many cards have been issued and even though there seems to be no organized effort to make sure that government workers turn in their cards when they leave government employment? The best figures show some 500,000 cards were in circulation at the peak, but the number could be as high as 700,000.
Think the Federal Reserve's measured interest-rate increases and the occasional warnings from Alan Greenspan are any match for the example of our national government, spending our money as if it was so worthless that there's no point in even keeping track of it? Washington, D.C. is one source of inflationary expectations that the Federal Reserve can't control.
Updates
Buy Ensco International (ESV, news, msgs)
Ensco International is a hurricane play, pure and simple. Drilling rigs were in short-supply before the big storms hit the Gulf of Mexico; they're in even shorter supply now. And short supply means higher day-rates for drilling companies that have rigs to hire. Ensco International is a buy on the timing of the contracts for its fleet of 43 jack-up rigs. Only 39% of its fleet is under contract through 2006. In times of weak demand, that would be a problem, because investors would be rightly worried about how many of those new rigs would wind up hired and at what rates. But with ocean drilling rigs in very short supply, the lack of contracts becomes a plus because it will allow Ensco International to sign 61% of its rigs to contracts at higher day rates. For example, the company recently signed a new contract at a day rate of $81,000, up from the mid-$50,000 range for the old contract. I'm adding the shares to Jubak's Picks with a March 2006 target price of $51 a share. I'd set a stop loss at $36.40. (Full disclosure: I own shares of Ensco International.)
Buy Plum Creek Timber (PCL, news, msgs)
If the Federal Reserve has lost control of inflation, as I argue in my Sept. 23, 2005 column, then investors want to increase their exposure to hard-assets stocks. And very little is harder than timber and timberland. As Plum Creek Timber so clearly says on its Web site, the company's primary business is "to grow, harvest and sell timber." With timber demand soaring and timber prices climbing in the wake of hurricanes Katrina and Rita, that's not a bad business to be in. Before the storms, timber revenue climbed 17% in the first six months of 2005. But that doesn't mean this owner of 8 million acres can't also run a very lucrative real estate operation. The company owns more than 8 million acres of land. About 230,000 acres of that real estate is highly desirable land, suitable for development, near fast growing markets in Florida and Georgia. Morgan Stanley recently calculated that the company's real estate holdings were worth about $38 a share. Plum Creek Timber, which was spun off from Burlington Resources (BR, news, msgs) in 1989, now pays a 4% dividend. (Because of the unusual nature of this real-estate development trust, part of that dividend is eligible for lower capital gains tax rates.) I'm adding this stock to Jubak's Picks with a June 2006 target price of $43 a share. (Full disclosure: I own shares of Plum Creek Timber.)
New developments on past columns
5 stocks in growth pockets
Joy Global (JOYG, news, msgs) is up 33% since I added it to Jubak's Picks on June 7, 2005 -- but I think the stock has got further to run. After all you don't make up for a 25-year slump in the mining equipment sector overnight. During that downturn, mining companies have shunned new equipment as the industry consolidated, and as equipment from shuttered mines was transferred to more productive mines. But now with the companies in the coal and iron mining sectors looking to increase output anyway they can, mining companies are buying equipment again. And, thanks to that same long down turn, they've only got three suppliers left to buy from. Lehman Brothers estimates that sales for Joy Global in this cycle will peak somewhere around $2.5 billion annually, resulting in peak earnings of $3.75 a share in 2009. In the last 90 days, Wall Street analysts have raised their consensus estimate for the fiscal year that ends in October 2005 to $1.95 from the previous $1.78, and to $2.71 from $2.36 for fiscal 2006. As of Sept. 23, I'm setting a new target price of $56 a share by June 2006, up from the previous target of $48. I'm raising the stop loss on this stock to $40 a share.
A golden way to play the dollar's fall
Well, the gold markets are certainly acting like inflation has slipped out of the Federal Reserve's control. Gold recently climbed to $470 an ounce on a combination of increased demand for the commodity from jewelry makers and from investors looking to hedge inflation and other market risks. With turmoil in the energy markets and soaring energy prices as a driver, I expect gold to continue to appreciate in price as a risk hedge over the next 12 months. Goldcorp (GG, news, msgs) is a particular attractive gold stock in these circumstances because the company is increasing production and because the company is one of the industry's low-cost producers. As of Sept. 23, 2005, I'm setting a new target price of $24 a share by March 2006, up from the previous target of $19 a share. (Full disclosure: I own shares of Goldcorp.)
Will Katrina tip the U.S. into recession?
In my Sept. 2, 2005 column, I argued that the longer Gulf Coast oil and natural gas production was shut down, the more damage Hurricane Katrina would do to the U.S. economy. As of Sept. 21, with Hurricane Rita bearing down on another segment of the oil and gas infrastructure that lines the Gulf Coast, the U.S. Minerals Management Service reported that 73% of the oil production and 47% of natural gas production in the Gulf of Mexico was still "shut-in" because of Katrina. The cumulative shut-in oil production for August 26 through Sept. 21 was 27 million barrels and the cumulative shut-in gas production was 125 billion cubic feet. According to Briefing.com, that compares to shut-in production of 12.9 million barrels of oil and 58 billion cubic feet of natural gas over the first 19-day period after Hurricane Ivan last year. As of Sept. 22, the Minerals Management Service was reporting that 74% of all manned oil and gas platforms and 65% of all drilling rigs currently operating in the Gulf of Mexico had been evacuated because of Hurricane Rita.
Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Ensco International, Goldcorp, and Plum Creek Timber. He doesn't own short positions in any stock mentioned in this column.
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