Melvin: Patience Is Key During Stagflation - TheStreet

Melvin: Patience Is Key During Stagflation

The Fed has run out of bullets -- make sure you don't.
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If there is a worse job in the financial world at this moment than being the Chairman of the Federal Reserve, I cannot think what it might be. The latest minutes show that the economy is on the verge of having to deal with a condition that was said to be highly unlikely.

The combination of rising commodity prices and a weak economic environment is leading us into stagflation, an economic condition that has not existed in the U.S. since the 1970s. The question at this point is what is left for the Fed to do to combat it, and what can investors do to protect their capital.

The Fed's Empty Holster

With regard to combating stagflation, the Fed is pretty much out of bullets at this point. The aggressive rate reductions have accomplished nothing beyond saving a few investment and commercial banks from what some might observe would be a well deserved extinction.

On Main Street, people are still losing their jobs, while food and energy costs continue to climb. The cuts did not fix the real estate market or invigorate the economy. They did not even bring mortgage rates down. Now the government looks for the much-ballyhooed stimulus checks to save the day. Somehow, I suspect those paltry sums go to the grocer, the gas pump and to catch up past-due car and credit-card payments.

They cannot really raise rates to fight off inflation either. Even the Fed governors acknowledge that growth will slow and unemployment will climb. It would not work anyway. Demand from other nations is driving prices for commodities and energy far more than at any time in the past. India and China are still growing at very rapid rates and are starting to develop more of a middle class than at any other time in economic history.

Even if we raise rates, it won't slow demand form other nations. We just do not have that kind of economic power anymore. A global economy is a wonderful thing, until it is not. Besides, as inflation continues to grow, the bond market will do a fine job of raising interest rates.

Delinquencies Start to Spread

Just to keep it interesting there is still a lot of toxic highly levered garbage on the balance sheets of many banks and investment firms. There continue to be writedowns related to real estate and mortgage securities. Now they are facing increasing delinquencies in their auto and credit-card lending portfolios.

Oppenheimer and Company analyst Meredith Whitney was out again this week saying that the financial crises will likely extend into 2009 and possibly beyond for the banking industry. She expects another $170 billion of loan losses this year. She also said that in her opinion, knee-jerk reactions from regulators will have an adverse impact on the industry with negative implications for consumers and financial institutions alike.

Many on Wall Street think her view is overly bleak. I, on the other hand, am willing to give her the benefit of the doubt. Wall Street has been critical since her first negative forecast. That one, and pretty much all the ones since, have been right. I will stick with the hot hand and continue to avoid major bank stocks.

Picking Your Spots

So what do we do in this type of environment? Let s look at the last time we had stagflation. The obvious play is commodities, but they have had such a run, that I am too much of a chicken to buy them. A lot of people got rich in the commodities markets the last time we had stagflation. A lot of them went broke, as well. If I want to lose that much money that fast, I will get married again! Warren Buffett and a lot of other value investors got very rich back then by being patient and buying stocks at ridiculous prices compared to their asset values. I think we will get the same chance again.

As I pointed out

on Wednesday, the number of stocks on my Schloss screen of low-price-to-book, low-debt companies has tripled in just two months. Peter Lynch started the meteoric rise of the Magellan Fund back in the late 1970s. What was one of his biggest holdings back then? He bought, literally, hundreds of small bank and thrift stocks when they traded well below book value and at single-digit P/E ratios. He called them the "Jimmy Stewart banks," referring to the Bailey Savings and Loan in Bedford Falls. We are not there yet, but the opportunity for the small banks gets closer every day. I cannot wait to ring that bell!

More aggressive investors can continue using put spreads to short the high multiple retail and casual dining stocks like

Urban Outfitters

(URBN) - Get Report

and

Chipotle Grill

(CMG) - Get Report

.

High multiples on growth that will be at least temporarily halted seem like a lock from the short side here. I would be a seller on any rally in those sectors. I am chicken short as always, so I use put spreads to set up my short trades. I like the idea of shorting the

S&P 500 Depositary Receipts

(SPY) - Get Report

on rallies against a portfolio of too-cheap-not-to-own stocks. Ditto the

Lehman 20-Year Treasury

ETF

(TLT) - Get Report

against a portfolio of municipal bonds in the unlikely event the bond market stages a notable rally.

Right now, I think the key is not to get hurt and make sure you have the bullets to fire when the current carnage comes to an end. Ballplayers can play hurt. Investors and traders will find it much more difficult.

At the time of publication, Melvin had no positions in the stocks mentioned, although positions may change at any time.

Tim Melvin is a writer from Stevensville, Maryland, who spent 20 years a stockbroker, the last 15 as a Vice President of Investments with a regional firm in the Mid Atlantic area. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Melvin appreciates your feedback;

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