In trading and investing, it's important to be prepared for what may happen. In this article, we are going to discuss a few investments that I have my eye on as the Fed is currently trying to balance financial stability and its fight against inflation. It's unlikely to work, as I wrote in a recent article.

Hence, what I am preparing for is a situation where the Fed will have to give up its fight against inflation for the sake of the aforementioned financial stability.

In this article, I will give you four stocks that I believe will add tremendous value to investors' portfolios. Most investments also benefit from secular tailwinds, which makes them less dependent on the Fed and even more powerful buys in a scenario where the economic demand is expected to rebound - fueled by a more dovish Fed.

So, without further ado, let's dive into it!

The current wave of inflation is the worst wave since the 1980s. Most traders and investors, including myself, haven't dealt with inflation this high. In the years after the Great Financial Crisis, inflation was low. Effective Federal Reserve rates didn't make it past 2.50%, and it was pretty much "easy sailing" for investors who had a lot of tech and growth exposure.

Now, we're in a different situation. To summarize the article I referred to in the introduction, the pandemic caused supply chains to break down. Aggressive central bank easing and government stimuli caused an increasing amount of money to chase a decreasing number of goods. Add to this multiple structural supply deficits in energy and material markets, labor shortages, and geopolitical issues like the war in Ukraine, and we have an inflationary environment some (or most?) of us haven't witnessed before.

The problem is that the Federal Reserve - nor any other major central bank - can directly impact the supply side of the economy. Except for the supply of money, of course. The Fed cannot print oil, it cannot get China to refrain from its strict Zero-Covid policy, and it cannot water the crops that currently experience droughts, to name a few things.

The Fed can slow demand by raising rates. And that's working great. Economic growth, as measured by the ISM manufacturing index, is on its way to 50. This indicates zero growth. Note that various indicators are already pointing at a recession.

The 10-year minus 3-month yield curve is now dangerously close to zero percent, which indicates a high recession probability. This is what the New York Fed wrote back in 2006:

Our preferred combination of Treasury rates proves very successful in predicting the recessions of recent decades. The monthly average spread between the ten-year constant maturity rate and the three-month secondary market rate on a bond-equivalent basis has turned negative before each recession in the period from January 1968 to July 2006.

TradingView (10Y/3M Yield Curve)

TradingView (10Y/3M Yield Curve)

At this point, it needs to be said that the Fed has changed. People with much better connections than me have told me that the Fed isn't watching these indicators anymore. At least not extremely closely. The issue is that the Fed has become highly politicized, which matters given what I'm about to discuss next - and the fact that we're going into important Midterm elections in the US.

There may come a point where the Fed abandons its fight against inflation for the sake of financial stability. The NFCI - Chicago Fed's National Financial Conditions Index - provides a weekly update on the US financial conditions in money markets, debt and equity markets, and the traditional and shadow banking system. Financial conditions have tightened the most since the pandemic. Since the Great Financial Crisis, financial conditions have tightened on several occasions: The debt crisis of 2011, the manufacturing recession of 2015/2016, and the pandemic. Add to that the current crisis, which I think will get a fancy name after it's over.

Add to this that the Bank of England is already buying longer-dated bonds to calm markets, even before it was able to accelerate its quantitative tightening program.

The situation is getting a bit out of control, and it is resulting in a global bear market. Or as Mohamed El-Erain put it:

The rapid pace of interest-rate hikes in response to inflation “is not stepping on the brakes, this is slamming the brakes,” El-Erian said on Bloomberg Television Tuesday, in response to an earlier remark by Bob Michele, chief investment officer of J.P. Morgan Asset Management. Michele had spoken about the ripple effects the Fed’s recent actions could have on the economy.

“The economy is starting to go through the windshield, the financial system is starting to go through the windshield,” El-Erian said.

We are now at a point with rising financial stability problems and persistently high inflation, which means the Fed isn't done hiking. The market knows it. And participants are worried.

If things get worse, we may be closer to a Fed pivot than people may think:

Goldman Sachs strategists say any volatility shock will lead to further deterioration in market liquidity, something that global central banks are unlikely to tolerate. Supply of liquidity has been poor, they note, with top-of-book market depth in several places close to its worst levels in five years.

In other words, we're still in the first wave of inflation but need to discuss a potential second wave that could start once the Fed pivots. It would create similar problems to the ones we are facing today, pressuring the consumer and eventually forcing the Fed to become hawkish again.

We could be in for a prolonged period of above-average inflation waves.

The stocks I'm about to give you in this article would benefit from that. However, I expect them to do well in general, even if my macro thesis is slightly off, which makes the risk/reward a bit better.

So, let's take a closer look.

This company was part of a recent article where I looked closely at the bull case for oil, incorporating recent developments, including OPEC's production cut plans.

Oil doesn't just do well when inflation is high, it also benefits from a secular tailwind as supply is subdued. The largest oil companies are now spending more on buybacks and dividends than capital expenditures.

While I could have picked a number of fantastic oil companies, I like DVN as it is one of America's largest onshore oil producers. The company produces 616 thousand barrels of oil equivalent per day. Half of it is oil.

The company's cash flow breakeven at WTI $30, which is extremely low. It has also hedged just 20% of its oil production. Hence, the company is in a terrific spot to generate sky-high free cash flow, used for its base dividend, special dividends, and buybacks. The company has a healthy balance sheet, which is why debt reduction is not being prioritized.

The company is trading at roughly 4.7x 2023E EBITDA. In my last article, I made the case that 6x NMT EBITDA would be fair.

I expect Devon Energy to do well going forward and outperform its energy peers as it is just a "better" energy company than most peers.

Number two connects inflation and another secular trend.

Earlier this month, I wrote an article titled "The Ultimate Net Zero Trade: Why I'm So Bullish On Caterpillar". I believe that copper isn't just a commodity that does well when economic growth improves, it is also a commodity with a huge secular tailwind. In order to successfully reach net zero by 2050, models show that copper demand needs to explode as it is a key component of electric mobility, infrastructure, and related.

Between 2021 and 2040, annual copper demand is expected to expand by 53% to almost 40 million metric tons. This is driven by the electrification of transport and infrastructure - that's the backbone of net zero.

The problem is that supply is expected to rise by 16% during the same period. This is expected to cause a shortfall of more than 5 million tons - in a best-case scenario.

Moreover, copper quality is falling. In the 1900s, copper ore grade was close to 2.0%. By 2030, it's headed for 0.50%. In other words, the copper supply will have a hard time catching up.

Freeport is a major copper miner with a $41.7 billion market cap. The company has operations in North America, South America, and Indonesia. This year, the company is on pace to mine 4.2 billion pounds of copper. On top of that, the company produces 1.7 million ounces of gold and 80 million pounds of molybdenum.

Needless to say, the company's stock price is a proxy for the copper price as the chart below shows.

TradingView (Black = FCX, Orange = COMEX Copper)

TradingView (Black = FCX, Orange = COMEX Copper)

However, FCX is better than trading copper. The company is a cash machine. At a copper price of $3.0 per pound, it does close to $4.0 billion in operating cash flow. That number is set to soar toward $8.0 billion at $4.0 per pound of copper.

Just like oil companies, FCX isn't expected to boost CapEx. In 2022, CapEx is expected to be $3.1 billion. That's the same number the company expects in 2023.

The moment the Fed pivots, we will see the return of higher inflation expectations, and higher demand expectations. I believe FCX will have no problem breaking its recent highs, to work its way up to $65 per share.

Number three is somewhat related.

Earlier this month, I wrote an article bullish on gold miners.

Essentially, I believe that a Fed pivot could finally stop the steep surge in the dollar, which has done a number on gold, silver, and the companies that mine it.

Just like the market, in general, gold and gold miners are in a tough spot. Despite high inflation, gold investors have not enjoyed capital gains. The problem is that the dollar has become too strong. It caused gold to fall quite significantly from its recent highs. As gold miners trade at a higher beta, mining stocks have lost close to half of their value.

The biggest bull case for gold and its miners is a pivoting Federal Reserve. While the consensus is that the Fed won't start to ease until at least the second half of 2023, voices calling for an earlier pivot are slowly but steadily getting louder.

I believe that Agnico Eagle Mines is one of the best ways to play the long side of the gold trade - if not THE best. This Canadian miner with a market cap of $19.4 billion

Seeking Alpha's Taylor Dart wrote a fantastic article on the company last month, which I highly recommend. This is a part of the article:

It is ahead of plans on synergies and reported a massive increase in reserves at what could be a million-ounce per annum mine. Meanwhile, it has a track record that most can't match, going from a one-mine company to an eleven-mine company in 16 years with very modest dilution, with an additional three mines in the wings. Given the extreme valuation disconnect (~7.0x cash flow) for a business with peer-leading margins, organic growth, and jurisdictional risk, I see AEM as a Strong Buy below $40.00.

Just as importantly, its track record lets investors sleep easy at night knowing that this is a team that doesn't make aggressive, stupid, or risky bets. Instead, the company is laser-focused on paying/growing dividends, returning additional capital, and steadily and sustainably growing its business.

Over the past 10 years, gold mines have been a terrible investment. On a total return basis, the VanEck Gold Miners ETF (GDX) lost 51%. AEM shares also did poorly, yet they only lost 8%. During the next rebound, I expect AEM to continue its outperformance, reaching $70 per share in the US, and beyond.

Number four is a combination of rebounding economic demand and supply shortages.

Even worse than copper and gold, aluminum is struggling with massive supply issues. It takes about 15-megawatt hours to produce a ton of aluminum. This beats copper and steel by a mile.

Europeans are shutting down production due to high energy costs, and I doubt that production capacity will normalize anytime soon (not for the next few years, which is my BEST-case scenario).

Moreover, China has been a major driver of lower global inventories due to its own economic challenges and transition towards a less polluting economy.

As I wrote in an earlier article:

While Asia (mainly China) has always been the major driver of inventories, LMT inventories in Europe are pretty much at zero as a result of the energy crisis that started in 2021. Even Asian stockpiles have declined from roughly 1.5 million tons to roughly 250 thousand tons.

Alcoa has shut down its Spanish smelter. The company sees 4 million tons in supply shortages by 2030, which I believe could be even worse.

In other words, once economic demand comes back, it will hit much lower inventories than in 2020 and curtailed production. I expect that this will be highly bullish for aluminum.

TradingView (Black = AA, Orange = COMEX Aluminum)

TradingView (Black = AA, Orange = COMEX Aluminum)

Valuation-wise, this is what I wrote in my most recent article:

Even if expectations come down further - we need to be aware of the high likelihood that this happens - the company is very attractively valued. Since its spin-off, the company has traded at 4x NTM EBITDA most of the time.

I believe that even under these circumstances, the company is at least 40% undervalued.

If demand rebounds - as measured by economic indicators like the Empire State/Philly Fed, I expect aluminum prices to rapidly accelerate, providing a similar upswing the stock experienced after the 2020 lockdowns.

The market is stuck between a rock and a hard place. Economic growth is slowing, inflation remains high, and the Fed is making things worse by aggressively hiking into the aforementioned weakness.

Based on this context, we're getting closer to a point where the Fed will be forced to pivot. Financial stability is becoming a huge issue, which means the bank will have to pick between either protecting financial stability or fighting inflation. If it picks the latter, it may fail to achieve any of its goals. If it picks the first option, inflation will likely rise again.

In this article, I discussed the economic situation and presented four investment ideas. All of these ideas should do well in the future, regardless of what the Fed decides. However, in the case of a pivot, I expect inflation and demand expectations to come back. At that point, I think all stocks mentioned in this article will "fly", generating strong triple-digit returns for their shareholders in the 2-3 years ahead.

However, please be aware that all of these picks are volatile. We're also dealing with a high economic uncertainty that could come with more downside before the Fed is "forced" to pivot. So, please bear that in mind.

Other than that, I think we're dealing with four tremendous long-term investing opportunities, that also benefit from secular tailwinds on top of everything else.

(Dis)agree? Let me know in the comments!

This article was written by

Disclosure: I/we have a beneficial long position in the shares of DVN either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article serves the sole purpose of adding value to the research process. Always take care of your own risk management and asset allocation.