Bmo Cm Basic Points April 2009

Basic Points Where Will America Go to Grow?

April 21, 2009

Published by Coxe Advisors LLC Distributed by BMO Capital Markets

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BMO Capital Markets Disclosures Company Name Aluminum Corporation of China American International Group Anadarko Petroleum Apple Computer Bank of America BHP Billiton Canadian Oil Sands Citigroup Companhia Vale do Rio Doce ConocoPhillips ExxonMobil Fannie Mae

Stock Ticker ACH AIG APC AAPL BAC BHP COS.UN C RIO COP XOM FNM

Disclosures 3,4 2 1 3,4

Company Name Freddie Mac Goldman Sachs Google Imperial Oil Microsoft Morgan Stanley Potash Research In Motion Rio Tinto Suncor Wells Fargo

Stock Ticker FRE GS GOOG IMO MSFT MS POT RIMM RIO SU WFC

Disclosures 2 2 3,4 1 1,2 1,3,4

(1) BMO Capital Markets or its affiliates owns 1% or more of any class of common equity securities of the company. (2) BMO Capital Markets makes a market in the security. (3) BMO Captial Markets or its affiliates managed or co-managed a public offering of securities of the company in the past twelve months. (4) BMO Capital Markets or its affiliates received compensation for investment banking services from the company in the past twelve months. (5) BMO Capital Markets or its affiliates expects to receive or intends to seek compensation for investment banking services from the company in the next three months. (6) BMO Capital Markets has an actual, material conflict of interest with the company.

Don Coxe THE COXE STRATEGY JOURNAL

Where Will America Go to Grow?

April 21, 2009 published by

Coxe Advisors LLC Chicago, IL

THE COXE STRATEGY JOURNAL Where Will America Go to Grow? April 21, 2009

Author:

Don Coxe 312-461-5365 [email protected]

Editor:

Angela Trudeau 604-929-8791 [email protected]

Coxe Advisors LLC. www.CoxeAdvisors.com 190 South LaSalle Street, 4th Floor Chicago, Illinois USA 60603

Where Will America Go to Grow? OVERVIEW The economic news in North America and Europe is as bad as the most pessimistic bears predicted, and seems to get worse each month. Yet New York and most global stock markets have been rallying powerfully. The S&P’s six-week Spring rally was a percentage record-breaker. Equity investors who have been rushing back into the market point to the stock market’s historic pattern of bottoming just before the recession does, and rallying while the recession fades. Pollsters report that investors are now more optimistic than at any time since Lehman’s collapse. President Obama, who became Fear-Merchant-in-Chief to overtake and win against McCain, and stayed in that role until his “Stimulus Package” passed, then appropriately became Cheerleader-in-Chief. More than 60% of voters support him and want to believe in his newfound optimism. Many are doubtless putting their money where his mouth is. We have been arguing that those investors who didn’t sell last fall shouldn’t give up now. Although we have reluctantly come to believe that the President’s “Stimulus Package” may vie with the AAA Mortgage CDO for the title of most mislabeled financial offering of our time, we retain our confidence in Ben Bernanke, and still hope that the gargantuan liquidity injections from the Fed and most other major central banks will be enough to refloat the sinking US and global economies. This month we revisit that counsel from a different perspective. All past bear markets and recessions were nearing their ends when some sector or sectors of the stock market and the economy began to take off, eventually providing the leadership—and muscle—the overall economy needed to get growing again. In other words, shrewd equity investors who took a bet on buying stocks, primarily because they saw opportunities for outsized profit gains in those industries, not only got their timing right, but outperformed for years. We are leaving last month’s Recommended Asset Mix unchanged. Cautious though we are, we are not re-issuing April’s time-tested advice for equity investors—“Sell in May and go away.” Although we suspect that an increasing number of voters will become less credulous about the relevance of President Obama’s policies to the realities of the nation’s present and future challenges in coming months, we doubt that the downside from here is either deep enough or certain enough to validate a timing-based sale now.

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Where Will America Go to Grow? Is the stock market a good predictor of 1) the timing of the next recovery and (2) the nature of that recovery? The answer to (1) is Yes, but it usually takes a few false rallies before it gets its forecast right. The trick for investors is in figuring out whether this rally is the right one, or just another “Come on in, the water’s fine!” call that fails to warn of the sustained profusion of sharks. The market’s record in answering (2) is considerably better. In fact, it’s been spot-on since 1974.

The trick for investors is in figuring out whether this rally is the right one...

The story line for each new economic and financial cycle included some new winners and some new losers in its plot. Those shifts in shares of GDP and corporate profits gave each new cycle its stamp. The stock market senses these shifts before they become vindicated by financial performance. While the bad news from big companies in high-profile industries dominate Page One, on Page Sixteen are brief accounts of the improving outlook for companies in industries whose growth should be particularly robust in the next cycle. Here’s how that process worked in the recessions we’ve lived through:

Apart from Japan’s demographically-driven Triple Waterfall Crash that begin in 1990, there have been three recession-powered Mama Bears since World War II.



As the Mama Bear Market of 1973-74 was bottoming out in late November, mining and oil stocks were moving up, led by gold miners. Those stars through the gloom of what was then the worst bear market since the Depression became investors’ favorites through the turbulent ups and downs of the rest of the decade, prospering through the ensuing stagflation that crippled the economies of the industrial world.



Their powerful outperformance would turn out to be the up-leg to a Triple Waterfall Crash that would begin when stagflation was terminated by Volcker and Reagan, launching a sustained disinflationary bull market that was wondrous for virtually every stock group except commodities.



By February 1976, the S&P had climbed by a third from its December ’74 low, but its returns thereafter to the end of the decade were substantially below Cash. But the returns to holders of gold, silver and oil stocks remained great.

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However, to stay on the winning side, they had to cash out those profits in 1980, because a two-decade inflation-hedge Triple Waterfall collapse was dawning. The winning trade became shorting gold and silver, and going long T-Bonds.



Then came the brutal Mama Bear Market of 1981-82, with the S&P down 48%. As it was beginning to bottom out, defense stocks began to surge in response to the Reagan arms build-up, and high-grade consumer stocks began to show improving relative strength, as investors concluded that a powerful economic recovery was inevitable once Volcker declared victory over inflation and 16% interest rates were no more. The leaders in those industries led the bull market that began August 13, 1982, as the Dow finally burst through 1,000 to stay—and then kept rising, interrupted briefly by the Greenspan Baby Bear Crash of 1987.



Coming out of that Baby Bear, bank and brokerage stocks led, correctly anticipating further Fed easing and a continuation of the Reagan boom.



The recession of 1990 that doomed the Presidency of the first George Bush ended as a major new bull market in technology stocks was beginning. What would later send it to previously-unimaginable valuation peaks was Greenspan’s panicky flooding of the economy with liquidity after the Long-Term Capital crash in 1998, and the appearance of Y2K Terror in 1999.



The most recent Papa Bear market arrived in 2000, forecasting the recession that hit seven months later just as Bush was elected.



The Commodity Triple Waterfall Crash that had begun in 1980 finally ended just as 9/11 proclaimed a new kind of war. The drastically-reduced population of Defense stocks joined the ranks of US stock market leaders again. Base metal stocks bottomed out right after 9/11, as some shrewd investors realized that the metal miners’ miseries (which had been more severe than the suffering in other commodity groups) had been, in significant measure, due to the major event of 11/9—the day in 1989 when the Berlin Wall fell, signifying the coming end of the Cold War. Since military procurement spending had, during the Reagan buildup, been the major source of non-cyclical metal demand, the coming of peace was terrible news for copper, zinc, nickel, aluminum and steel. Once the USSR imploded, the great Gulag mines and other metal production facilities across Russia’s 11 time zones suddenly faced zero demand from the military, which had been more than 35% of Soviet GDP. (The Left—in the US and across the world—had been reviling America for spending 6% of its GDP on Defense, but studiously averted its gaze from the epicenter of Socialism, where the USSR armament spending was six times that percentage of GDP.) Many of

The winning trade became shorting gold...

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the mines that managed to stay in production after Communism’s crash became formidable price competitors with capitalist companies by making desperate deals with Marc Rich to sell their output in world markets.



We proclaimed in February 2002, that what would become “The Greatest Commodity Bull Market of All Time”—a new super-cycle—had already begun. By that time, oil and mining stocks were already on wheels. The problem for most US investors was that there were almost no US gold or base metal stocks left, and nearly all of the S&P’s commodity capitalization was represented by the big integrated oil stocks. As splendid as these stocks would be in coming years, none of them had what would become the defining characteristic of value in this decade—long-duration reserves in politically-secure regions of the world. (Indeed, a painful percentage of Exxon Mobil’s and ConocoPhillips’ reserves were located in Russia, and had to be written down as the KGB came back from the dead to become Russia’s new ruling class, and began settling old capitalist scores on terms to their liking.)

The US had discovered a new export industry to participate in the global trade boom— Wall Street-created derivatives.

Yes, there were a few US agriculture-related stocks in the S&P, but it would be four years before grain prices entered major rallies, sending the seed, fertilizer and farm equipment stocks into powerful bull markets.

However, the force that propelled the Dow and S&P to new peaks was the astounding rally in financial stocks. The US had discovered a new export industry to participate in the global trade boom—Wall Street-created derivatives. The sharp increase in jobs in this new export sector made up for the jobs lost to foreign competitors in the goods-producing industries. By 2006, 41% of US corporate profits were being booked by banks, brokers, mortgage companies, insurers, hedge funds, and private equity firms. (The financial sector’s share of profits was in the 20% range during the 1970s and 80s and the 25% range during most of the 1990s.) Congress’s vast interventions into the housing market to promote trillions in mortgage lending to impecunious individuals, (with emphasis on non-Asian minorities having low or no credit ratings) was fueled by Wall Street’s record panoply of unconscionable excesses. Washington and Wall Street justified themselves to critics of the debasement of mortgage-lending principles as being high-minded donors of The American Dream to the unjustly disadvantaged. The array of new products rewarded politicians connected with Fannie Mae and Freddie Mac (F&F) who promoted them, the Street that fashioned them, and investors who rushed for the higher interest rates on these pseudo-scientific confections. Step right up! Everybody wins!

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...the financial and housing booms were “such stuff as dreams are made on.”

Without the surging growth in newly-spawned CDOs and CDSes, and their bastard brethren, the US economy and US stocks might have passed a placid decade. There would have been no recession, because economic growth would probably have been just enough to keep unemployment from rising to worrisome levels, and there would have been, apart from LBO loans, no big bankruptcies that would threaten the financial system. But the financial and housing booms were “such stuff as dreams are made on.” The real growth in economic activity was mostly elsewhere. For the first time, global economic growth and trade driven by booms in China and India far outpaced US GDP growth. The US trade deficit kept climbing, as US factories’ share of US consumption kept falling. The outsourcing of US production for US consumers to producers in China, Taiwan and South Korea swelled global figures at the expense of US jobs and US GDP. US-oriented equity investors were missing out on the fundamentally-driven booms across the Pacific: Toronto Stock Exchange (TSX Composite) January 1, 2002 to June 30, 2008 15500 14500

14010.39

13500 12500 11500 10500 9500 8500 7500 6500 5500 Jan-02

Oct-02

Jul-03

Apr-04

Jan-05

Oct-05

Jul-06

Apr-07

Jan-08

Australian Stock Exchange Index (ASX200) January 1, 2002 to June 30, 2008 7000 6500 6000 5500 5082.1

5000 4500 4000 3500 3000 2500 Jan-02

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Jul-03

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Apr-04

Jan-05

Oct-05

Jul-06

Apr-07

Jan-08

Shanghai Stock Exchange (SSE Composite) January 1, 2002 to June 30, 2008 6500 5500 4500 3500

2669.89

2500 1500 500 Jan-02

Oct-02

Jul-03

Apr-04

Jan-05

Oct-05

Jul-06

Apr-07

Jan-08

South Korea Stock Exchange (KOSPI Composite) January 1, 2002 to June 30, 2008 2100 1900 1700

1577.9

1500 1300 1100 900 700 500 Jan-02 Sep-02 May-03 Jan-04 Sep-04 May-05 Jan-06 Sep-06 May-07 Jan-08

Taiwan Stock Exchange (TWSE) January 1, 2002 to June 30, 2008 9500 8500 7500

7228.41

6500 5500 4500 3500 Jan-02

Oct-02

Jul-03

Apr-04

Jan-05

Oct-05

Jul-06

Apr-07

Jan-08

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...many of the bank stock rallies smell suspiciously like dead cat bounces rather than cool-eyed appraisals of tomorrow’s economy.

As Larry Summers observed in his speech to the Washington Economic Club on April 9th, we now know that US economic growth in the late 1990s and this decade was heavily dependent on bubbles—first technology and then financial. (He was Chairman of Clinton’s Council of Economic Advisers, and neither he nor Alan Greenspan warned America of the tech bubble. He was also one of the most powerful promoters of the campaign to repeal Glass-Steagall, which led to creation of the new investment banks, such as Bank of America, which sought—for a while successfully—to take market share from the long-standing investment banks, Goldman, Bear Stearns, Lehman and Morgan Stanley, and became major factors in the second bubble.) His successors in the White House—and Alan Greenspan—may have learned something from the 1990s, because they made strong efforts to rein in F&F as far back as 2004, but were blocked by Congress, led by Barney Frank and Chris Dodd. Chuck Grassley, ranking Republican on the Senate Finance Committee, offered only token help to the White House in the efforts to avert the looming disasters for F&F. (Grassley was back in the news recently with his recommendation for AIG: amid the rage about the bonuses, he displayed characteristic Senatorial wisdom and restraint: he stated that the problem would be solved if the AIG executives committed suicide to atone for their “crimes.”) Since the S&P’s record run-up from its March 9th low was led by the financials and homebuilders, it might appear—based on the relative strength performance in earlier bear markets—that investors now believe the next recovery will be like its predecessor, meaning that Wall Street is headed back to global pre-eminence. However, many of the bank stock rallies smell suspiciously like dead cat bounces rather than cool-eyed appraisals of tomorrow’s economy. Those who believe that the banks and homebuilders are about to return to previous levels of financial strength and profitability should be barred from managing their own—let alone anyone else’s—money. Before there can be tempting rewards for the two industries that together created the financial crisis, there will be payback time. (Not that most of their loans will be paid back.) Much of the trillions of taxpayer money propping up those industries will have to be written down and refinanced before either the stockholders or CEOs are enriched anew.

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Moreover, star investment bankers in the big, bloodied firms which have been the biggest recipients of TARP funds have been migrating en masse to brand-new boutiques which seek to grab market share in advisory fees from the big banks. Citi is little more likely to return to its former glory than Pompeii. As for Vikram Pandit, the only way he’ll make the kind of money he was being paid is to win a Mega Millions lottery. (The odds of winning over the years by buying lottery tickets week after week may well exceed those from buying CDOs at face value week after week.)

Citi is little more likely to return to its former glory than Pompeii.

We doubt that the stock market has fully priced in the doleful data about household wealth destruction. Last week, The Financial Times reported a McKinsey Global Institute study that reminds us of the scale of the challenge. “From 2003 until the third quarter of 2008, US households sucked $2,300 billion of equity from their dwellings. About $890 billion was used for personal consumption or for home improvements—a sum exceeding the Obama Administration’s emergency stimulus package….Since its peak in 2007, household net worth has fallen by $13 trillion, almost equivalent to one year of US output.” It could be a long slog back to traditional American consumer exuberance. We remain of the view that this bear market, like all other financially-driven bears, can only end when financial stocks have not only stopped falling, but have demonstrated sustained relative strength. No economic recovery and no true bull market will arrive until the financials are strong enough to make a positive contribution to the economy and to financial market activity. In past cycles, the bank stocks came back from disaster largely on their own—and those recoveries helped kick-start recoveries in the stock market and the economy. This time, the shares of the big banks collectively have bounced back big, but only because of trillions of subsidies in various forms from the taxpayers and the Fed. Although neither their stock prices nor their CEOs’ compensation will once again attain the stratospheric levels they achieved in this decade, they must cease to be voracious consumers of taxpayer funds before the stock market can believe in their sustainability and the real economy reasserts itself. Which other equity groups are showing good relative strength? Most prominent are two sectors which are heavily-levered to growth in world trade—technology and commodities.

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Where Will America Go to Grow? Relative Strength of Technology and Basic Materials to S&P:

Technology and Basic Materials...have not traded together historically, because their basic business models are opposed.

These two groups have not traded together historically, because their basic business models are opposed. Basic materials companies’ earnings gains have historically been based on rising price levels for units of output of commodities whose reserves are limited and whose supply cannot be expanded rapidly. Conversely, tech companies’ earnings have been based on rapid growth in output of units of products whose prices are under near-continuous downward pressure from global competition. So why should they trade together now and into the next recovery? Nasdaq 100 relative to S&P 500 November 1, 2008 to April 20, 2009 120 115 111.99

110 105 100 95 90 3-Nov

23-Nov

13-Dec

2-Jan

22-Jan

11-Feb

3-Mar

23-Mar

12-Apr

BHP BIlliton (BHP-NYSE) relative to S&P 500 November 1, 2008 to April 20, 2009 150 140 131.16

130 120 110 100 90 80 3-Nov

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2-Jan

22-Jan

11-Feb

3-Mar

23-Mar

12-Apr

CVRD (RIO-NYSE) relative to S&P 500 November 1, 2008 to April 20, 2009 150 140 129.45

130 120 110 100 90 80 3-Nov

23-Nov

13-Dec

2-Jan

22-Jan

11-Feb

3-Mar

23-Mar

12-Apr

Potash Corp. (POT-NYSE) relative to S&P 500 November 1, 2008 to April 20, 2009 140 130 120

113.96

110 100 90 80 70 60 3-Nov

23-Nov

13-Dec

2-Jan

22-Jan

11-Feb

3-Mar

23-Mar

12-Apr

Imperial Oil (IMO-NYSE) relative to S&P 500 November 1, 2008 to April 20, 2009 135 125 116.59

115 105 95 85 3-Nov

23-Nov

13-Dec

2-Jan

22-Jan

11-Feb

3-Mar

23-Mar

12-Apr

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Where Will America Go to Grow? Suncor Energy Inc. (SU-TSX) relative to S&P 500 November 1, 2008 to April 20, 2009 155 145 135

...the leading info-tech companies are, more than most other major American industries, now tied directly into growth of economies abroad.

125 117.69

115 105 95 85 75 3-Nov

23-Nov

13-Dec

2-Jan

22-Jan

11-Feb

3-Mar

23-Mar

12-Apr

Probably because the leading info-tech companies are, more than most other major American industries, now tied directly into growth of economies abroad. The overinvestment in productive capacity that helped trigger the Triple Waterfall collapse has been largely worked off through obsolescence. Now, the same new Third World middle class which created the commodities boom is also the driving force behind the growth in sales of cell phones and other tech hardware, along with the supporting software. Nasdaq’s Big Ten info-tech companies now derive most of their earnings from industrial and commercial expansion abroad. However, Nasdaq is still in the mid-stage of its Triple Waterfall, which means shakeouts of weaker companies will continue, and margins of the stronger companies will be under sustained pressure; it can rise significantly, but will not return to its peak. That doesn’t mean there won’t be some strong rallies, and that some superlative performers won’t be great investments in absolute and relative terms for the next recovery. But among tech’s brightest stars, such as Research in Motion and Apple, the only certitude is that the more success they achieve, the more certain is new—and potentially tougher—competition. Even Google may not be immune to new challenges to its dominance. Microsoft, the PC monopolist, is a special case, but the fact that it trades at a mere nine or ten times earnings suggests that investors have begun to worry that the next generation of handheld devices may hold something it has not had to face: real competition.

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For mining and oil companies, the big challenges aren’t from other companies or from new technologies, but from (1) the current doubts on global demand for the materials they produce, and (2) from the difficulties they face in increasing—or even replacing—current production from the shrinking supply of economic reserves in politically-secure regions of the world. The agricultural companies are another kind of scarcity story. They sell to millions of consumers whose ability and willingness to pay for their products comes from the global demand and pricing of their crops. The companies’ perils come from protectionism and politics: Their opponents are the NGOs, politicians, and celebrities such as Prince Charles [who seems to devote himself to making even confirmed monarchists wonder whether republicanism is worth a second look]. These new reactionaries yearn to bring back the days of quaint, small, mixed farms producing a variety of crops fertilized with manure, when farmyards were noisily and odoriferously alive with chickens, pigs and cows.

We believe the next economic cycle, like its predecessor, will be driven primarily by how much growth in global trade exceeds actual global GDP growth.

What does the powerful relative strength of the shares of tech and commodity companies tell us about the US economic outlook? We believe the next economic cycle, like its predecessor, will be driven primarily by how much growth in global trade exceeds actual global GDP growth. Therefore, the non-agricultural US economy and the major US stock indices will be global underperformers.

The Collapse in Global Trade In The New York Times last week, (“World Trade Shrinks”, April 11, 2009) Floyd Norris updated the alarming statistics on global trade. Using data from 15 major global economies, he showed how powerful was the growth in trade in this decade—and how horribly it has plummeted since mid-2008. For the group, total exports from those countries grew from 2002 until mid-2008 at double-digit rates, frequently reaching the 20% range, and dipping below 10% for only a few months. Then it fell off a cliff.

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Where Will America Go to Grow? The data for year-over-year percentage decline of exports in February are of Draculate horror proportions: China Taiwan Japan Canada France Germany Britain Brazil USA India

The CRB fell faster in late 2008 than during the onset of the Great Depression.

– 41% – 41% – 38% – 33% – 33% – 32% – 32% – 25% – 22% – 22%

Note that this list is not distorted by the collapse in oil prices. Only one oil-exporting nation—Canada—is included, and Canada is an industrialized nation. Therefore, the potent pummeling to those other economies’ exports far offsets the benefits to their trade balance and consumers’ living costs from the plunge in oil prices. Norris quotes Barry Eichengreen of the University of California, who says trade is collapsing more severely than in 1929-30. With global trade so sickly, most commodity producers should, in theory, have outlooks appropriate for a factory whose biggest profits last year came from producing McCain-Palin buttons. There is no questioning the savagery of the impact on the prices of their output: RJ-CRB Futures Index January 1, 2007 to December 31, 2008 500 450 400 350 300 250 229.54

200 Jan-07

Apr-07

Jul-07

Oct-07

Jan-08

Apr-08

Jul-08

Oct-08

The CRB fell faster in late 2008 than during the onset of the Great Depression.

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So why have commodity stocks been outperforming major stock markets—and commodity prices—for the past six months? Several factors are worth considering: 1. Commodities and commodity stocks kept rising for eight months after the Dow and S&P had entered their bear markets. As the last-remaining profitable asset class for long-only hedge funds and other levered players, they doubtless attracted a disproportionately-large percentage of fast money before “The Midnight Massacre of July 13th” triggered panic liquidation. Perhaps long-term investors were waiting until the effects of the Lehman bankruptcy on the $65 billion of hedge fund assets had been worked off and now believe the commodity stock hammering was overdone.

...monetary expansion [in the 1970s] was tortoise-paced compared to even a dull month for the Bernanke Fed...

2. The unprecedented scale of reliquification and bailouts from Washington, London and Europe argues that this will continue to a recession—not a Depression. Although the economic forecasters who have the responsibility for proclaiming the beginning and end of recessions informed the world late last year that the US recession had begun in December 2007, the vertiginous plunge in the global economy was anticipated by only a handful of long-time bears. The power and suddenness of the collapse made at least a few long-term investors conclude that the global economy might also snap back quicker than the born-again bearish consensus is predicting. Therefore, commodity prices should turn upward before most experts become convinced the economy has touched bottom. 3. “Quantitative Easing” became the new term for monetary policies in Washington and abroad. Many sophisticated investors consider this a euphemism for seriously inflationary monetary growth. The last time excessive monetary growth was launched to fight a global recession came in the 1970s. Although the rapid monetary expansion then was tortoise-paced compared to even a dull month for the Bernanke Fed, it unleashed stagflation, majestic gold and silver Triple Waterfall run-ups, and years of outperformance by commodity stocks. Why couldn’t commodity investments be even bigger winners this time?

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The G-20 Meeting in London did more than repeat pious platitudes against protectionism...

4. Last year’s plunge in raw materials prices triggered panicky production cutbacks and major slashes in exploration and development in the mining and oil industries. It didn’t take long for analysts to crawl out from under their desks and opine publicly that commodity prices could go back quite swiftly to their former peaks once the global recession ended. Example: Daniel Yergin’s Cambridge Energy Research Associates, which had persistently underestimated oil price gains from 2003 through 2008, recently raised its estimates for oil prices sharply for the next decade, because of the abandonment or delay of so many big-ticket oil projects. 5. High-profile bids for commodity production assets emerged amid the carnage. Most notable was Chinalco’s bid for Rio Tinto facilities in Australia, which investors believe has Beijing’s backing. Since these bids came at a time that China announced it was rebuilding its “strategic” reserves of oil, foods and metals, investors began to reconsider analysts’ forecasts for Depression-style collapses in raw materials prices. 6. Remarkably, the strong commodity stock performance came against the backdrop of the strongest rally in the value of the dollar in this decade. Almost every commodity investor knows that, for decades, the most reliable of inverse correlations has been of the performance of commodities compared with the dollar. Commodity stocks should therefore have continued to lead the stock market down noisily, instead of quietly rallying. What happens to commodity stocks when the dollar bear re-emerges? 7. As one country after another fell into recession, various gloomsters began predicting a full-scale retreat from free trade to protectionism. Although President Obama, goaded by a reactionary Democratic Congress, has on occasion been a publicized sinner on trade, and has thereby provided convenient excuses for backsliding among such long-time agnostics on free trade as France, the percentage of global trade subject to outright protectionism remains (rather surprisingly) quite small. The G-20 Meeting in London did more than repeat pious platitudes against protectionism: it lined up huge financing for Third World economies in order to arrest the decline in global trade. Those of us those who think the recession should be over within a year predicate this vestigial optimism on the hope that protectionism will not gain a renewed stranglehold on the global economy. 8. Adding these considerations up, this looks like a good time to search for values among the raw materials producers.

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We realize that readers may be smiling: we’ve had such a lengthy love affair with commodities, were suddenly and furiously rebuffed, and yet we’re eager to come back for more? Answer: we “fell in love” with commodities because we believed that China and India would, in the coming decades, regain their multi-century status as the world’s largest economies. That means their demand for raw materials will put continuous, powerful pressure on global commodity supplies. We aren’t economists, and hadn’t anticipated the sudden onset of the worst recession since the Depression. On the assumption that this downturn will end, then the commodity story will be more relevant than ever. Moreover, we have growing doubts that the US economy will regain its characteristic global leadership, so most US stocks lack the attractive long-term fundamentals of the leading commodity stocks.

China’s stimulus program... unlike Obama’s, is the real thing— targeted and temporary

There remains the question whether “wishing makes it so.” If stock market prices are firm, and shares of basic materials companies are outperforming, does that mean the global recession’s lifetime, in comparative terms, now approximates that of a Somali pirate who grabs a breath of fresh air while SEAL snipers are watching? More than one economist has cited the powerful stock market rally—and particularly the outperformance of bank stocks—as a good reason to believe the recession will end sooner, rather than later. They point out that rising stock prices lead to rising levels of equity offerings—the first step in redressing the perilous position of global debt to global equity. Goldman is, once again, out in front, with a $5 billion equity sale that could permit the firm to repay its TARP financing (and free the firm to pay its top performers what it thinks they’re worth—a privilege not available to banks subsisting on government financing). Some economists have begun to cite the good performance of commodities as evidence that the collapse in global trade may be over, and that an economic pickup could occur within a few months. In particular, reports that China’s stimulus program (which, unlike Obama’s, is the real thing—targeted and temporary) is already working, have sent buyers into metals futures and metals stocks. History says that the stock market could be somewhat premature about the timing of the upturn in global trade, but has not erred in its choice of stock market leadership in the next economic cycle. So the next thing for investors to ponder is…

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Where Will America Go to Grow? Which Sectors Will Be Hiring Heavily When the US Recession Ends? GDP is simply output per worker multiplied by the number of workers, minus the trade deficit. So which sectors will soon be hiring again? 1. Can State and Local Governments Create New Jobs? California, a particularly conspicuous profligate, is asking for a federal rescue, and the line forms to the left.

During this decade, state and local governments’ budgets soared along with real estate prices. Employees’ unions had little difficulty extracting hefty increases in wages and benefits. In particular, many states found that an excellent way to disguise the generosity of their sweetheart union contracts was to increase pension and other retiree benefits that would not show up in actual spending until later. (Illinois is now $50 billion in debt, and its biggest problem is its underfunded pension and retiree health benefits. Because so many collective bargaining agreements provide for retirement at young ages, Medicare is not an offset for ballooning health costs.) Now, the many loose-spending states and municipalities are finding that those years of boosting expenditures even beyond the bubble-driven increases in property taxes have them in a bind. California, a particularly conspicuous profligate, is asking for a federal rescue, and the line forms to the left. So states and municipalities are raising taxes, asking employees to work four days a week for several months, and, in some cases, threatening to open the jails, even for felons convicted of violent crimes. (This latter stratagem seems to be a new version of the justly cherished “Washington Monument” strategy. When a Republican President threatened to impose deep cuts on the budget sent up by a Democratic Congress, the immediate response within the bureaucracy was to recommend shutting down the Washington Monument.) Last week, Moody’s downgraded the debt of nearly all states and municipalities, citing serious deficits almost everywhere. Municipalities already face taxpayer wrath because the house values they use for today’s property tax bills come from those golden days when everybody knew that house prices never go down. Most states and municipalities are constitutionally forbidden to budget for deficits. Raising taxes now will not only trigger ratepayer fury, but will, according to published calculations, seriously offset the Obama “stimulus package.” Therefore, looking to the early years of the next cycle, we believe that states and municipalities will not be contributing to the solution of the unemployment problem by rapid rebuilding of their staff complements.

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Doubtless, one of their responses to budget crises will be to cut payrolls by offering incentives for earlier retirement. Since state and local pension plans in the aggregate are already Cadillacs compared with the Chevrolet models in private plans in the aggregate, enriching benefits can only cut current costs by degrading states’ balance sheets even further. The next actuarial valuations of their plans will hit future state budgets hard. True, states will be boosting spending on infrastructure without imposing extra taxes on their residents using Congressionally-generated funds. But the states only function as pass-throughs on federally-funded projects, and those funds do nothing for states’ straitened finances. The “Stimulus Package” may only offset the cutbacks on roads and bridges financed locally. So far this year, state and municipal highway contract projects offered for bidding are down 24%.

We now understand the Audacity of Hype— when that hype comes from the Ruling Class.

Conclusion: the sector that was a significant help to the economy in recent decades by its steady gains in middle class payroll employment is already becoming a drag and threatens, in some cases, to become an anchor. (California is now experiencing out-migration, as businesses and individuals flee to states with sounder fiscal situations and lower taxes. What was once the nation’s leader in attracting inward migration has joined such other high-tax population losers as New York, Pennsylvania and Illinois. But the national economy cannot move forward based on the relatively sound finances of Utah, Idaho and Wyoming.) 2. All Those Beautiful Jobs From “Clean” Energy The Obama budget calls for hundreds of billions in government spending on alternative fuels and other forms of “clean” energy. This will be financed, in part, by “cap and trade” taxes on carbon-generated energy, such as coal, oil, and natural gas-generated electricity. When the President spoke to the press after meeting with his economic team, he spoke of some optimistic signs in the economy. Specifically, he cited new jobs in alternative and clean energy. These jobs are already coming, he said, as we reduce our dependence on foreign oil. He naturally made no mention of the thousands of jobs lost in the oil and gas industry because of low current prices for natural gas, and because he overruled Bush’s repeal of the ban on offshore drilling for oil and gas. (We had predicted last year that offshore exploration would be a key growth sector for the US economy during the recession and well into the next cycle. We had not expected ideology to triumph over pragmatism during an economic crisis. We now understand the Audacity of Hype—when that hype comes from the Ruling Class.)

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Where Will America Go to Grow? When Congressional Republicans suddenly found last summer that they had a hot political issue in offshore drilling, and chanted “Drill, baby, drill!” at their convention, it looked for a few weeks as if liberal elitists were at bay. Nancy Pelosi managed to prevent a vote in Congress on repealing the ban on offshore drilling. When she was challenged, she replied, “I’m just trying to save the planet.” ...oil, a commodity that has a deeply Texan taint.

Joe Biden contributed his characteristic wisdom to the debate. He said the oil industry “wants to rape the Continental Shelf.” That the oil and gas drilling industry is losing tens of thousands of workers doesn’t seem to upset the latte liberals as long as people in white coats get more jobs in non-profit institutions in the North and on the Coasts doing research on schemes to replace oil, a commodity that has a deeply Texan taint. In assessing the Obama budget, it becomes immediately clear that the full-scale fight against global warming is The Cause scheduled to (1) create new jobs and new investment to stimulate the economy, (2) give Washington new, permanent control over a wide range of private sector capital investment programs, including mining, refining, the design of automobiles, setting energy-saving design specifications for buildings, and intervening in banking to promote financing for fashionable projects, (3) win friends in Europe to get help for America’s military operations abroad, so that fighting the Taliban will not prove to be Obama’s millstone, as Iraq was for Bush, and, (4) generate automatic, gigantic stealth tax revenues that operate independently of annual budget reviews….all while saving the planet (and its polluting people) from otherwise-inevitable catastrophe. The driving force behind this program came from a long-awaited excuse for expansion of federal power over the economy: the Environmental Protection Administration last week decreed that Carbon Dioxide is a pollutant. That puts it right up there with Chlorine Gas, Sulphur Dioxide, Hydrogen Sulphide, Ozone, and other products of industrial and transportation activity that have long been subject to regulation because of their serious impact on human and plant health. Fighting air and water pollution is a cause we can all support. We were among the many Canadians who, for years, tried to get American Presidents and Congresses to take Acid Rain seriously. Living in Southern Ontario, we were downwind from numerous toxic coal-fired electricity plants that were having devastating impact on our hardwood forests. (Because of the location of the plants and wind patterns, Canadian forests suffered more than American forests, so it was hard to get Congressional attention to “a Canadian problem.” Eventually, real progress was made, and Ontario’s forests recovered. So we believe strongly in using the power of the state to protect the air we breathe and the water we drink.)

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But putting Carbon Dioxide—part of the air we actually and naturally breathe in and, with extra CO2 —out—on the same list with those industrial-generated toxins? Isn’t that somewhat like amending an anti-noise bylaw aimed at motorcycles and huge trucks to include a potent penalty for belching? The Obama Answer: We—and the planet—are doomed unless we cut back on CO2. That is now the unanimous opinion of all respectable scientists, as proven by decades of data showing escalating global temperatures. The Nobel Prize Committee ended what was left in the debate by awarding its Peace Prize to Al Gore. “The time has come,” the leader said, “To talk of warming things: Let Business pay a climate tax And folks, by using things That make the sea grow boiling hot, As CO2 takes wings”.

The roughly 1.2 billion citizens of the industrialized countries are expected (under Kyoto) to reduce their emissions. The other 5 billion, including China and India…aren’t…

James Hackett, Anadarko’s CEO, has had the guts to emerge from the oil industry’s foxhole on this topic, inviting enemy fire. He says the global warming-driven policy of preventing development of US oil and gas in favor of massive spending on research in wind and other alternatives, backed by hundreds of billions in taxes on businesses and consumers through “cap and trade” schemes will cripple the US economy in two ways: it will prevent the creation of hundreds of thousands of good-paying jobs in the oil exploration and development sectors, and will impose huge burdens on America’s industrial economy, at a time China and other nations will be merrily adding new oil and coal-fired plants, generating low-cost electricity to make their factories even more competitive. (In three years, China constructs as many megawatts of cheap [3 cents per kwh] coal-fired electrical generation as the US has in operation, and a new plant starts adding to global pollution every week.) Peter Huber, writing in City Journal notes, “The roughly 1.2 billion citizens of the industrialized countries are expected (under Kyoto) to reduce their emissions. The other 5 billion, including China and India…aren’t…. Windmills are now 50-storey skyscrapers. Yet one windmill generates a piddling 2 to 3 megawatts; Google is building 100 megawatt server farms. Meeting New York City’s energy demand would require 13,000 of those skyscrapers spinning at top speed, which would require scattering about 50,000 of them across the state to make sure you always hit enough windy spots…Even if solar cells themselves were free, solar power would remain very expensive because of the huge structures and support systems required to extract large amounts of electricity from a source so weak that it takes hours to deliver a tan.”

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Where Will America Go to Grow? Such science-based objections cut no ice in the crusade to impose on the economy a whole new structure of controls, subsidies and taxes to offset a global climate change on which scientists disagree.

Since the cooling began, the global warmists have retitled their cause “Climate Change.”

Last week, the President rejected the growing demands to postpone “cap and trade” until the economy recovers. He reiterated his conviction—that drew such cheers across Europe—that fighting global warming is our top priority, and must not be delayed. The air war is on, and it threatens to make the Battle of Britain look like a quaint exercise. A few observations: 1. As the Cato Institute noted in a full-page ad, President Obama was just plain wrong when he asserted the science of global warming was beyond debate. The ad was signed by 116 scientists from around the world. (http://www.cato.org/ special/climatechange/) 2. The cooling that has already occurred in this decade has driven global temperatures down to 1980s levels. 3. As many climatologists admit, the long-term temperature statistics showing rising temperatures in the world’s cities have an inherent bias: urban records tend to be based on data from airports, and the more tarmac is created, and the more grass disappears, the more heat is generated. Moreover, Michael Crichton demonstrated, long-term data from weather stations located far from major cities generally failed to confirm the temperature increases shown for cities. 4. Finally, we have many centuries of data to show a close correlation between sunspot activity and recorded temperatures. The correlation is so close that even a one-year cessation of rapid activity has generally shown cooling effects globally. As scientists have routinely noted, in the 25 years leading up to this decade, we experienced the most intense, sustained sunspot activity for which we have records—and global temperatures rose. In the past two years, we have experienced the lowest level of sunspot activity in nearly a century—and temperatures have fallen sharply—and North Pole ice coverage has climbed dramatically. Since we have been commenting on this for nearly two years, we obviously have staked out our claim for what we call history-based skepticism about a popular new theory. Since the cooling began, the global warmists have retitled their cause “Climate Change.”

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We agree with that: all the records show that the world’s climate is in constant change. Greenland was a grape-growing region a thousand years ago. “Saving the planet” is a quixotic rallying cry if it means trying to keep Earth’s climate and topography frozen to Sixties levels, no more than saving Earth’s Art means banning all post-Sixties music and art. Freeman Dyson, of the Institute for Advanced Study in Princeton, was the subject of a recent cover story in The New York Times Magazine. He has a long career as a distinguished scientist routinely active in liberal causes, so his vehement rejection of the global warming thesis has attracted considerable attention from leaders in both sides of the debate. In a recent essay, he writes about the prospects of a “New ice-age…the burial of half of North America and half of Europe under massive ice sheets. We know that there is a natural cycle that has been operating for the last eight hundred thousand years. The length of the cycle is a hundred thousand years. In each hundred-thousand year period there is an ice-age that lasts about ninety thousand years and a warm interglacial period that lasts about ten thousand years. We are at the present in a warm period that began twelve thousand years ago so the onset of the next ice-age is overdue…..Do our human activities in general, and our burning of fossil fuels in particular, make the onset of the next ice-age more likely or less likely?”

...all the records show that the world’s climate is in constant change.

Dr. Dyson deals with a threat to humanity—but not to the planet—that is more predictable than global warming. We cite him only to point out how little about the earth’s climate future truly serious scientists know. The sunspot debate deals with data for the last 800 years—a twinkling of the geological eye. Nevertheless, sunspots could prove to be of significance for a five-tofifteen year time horizon, which is why we discuss them in an investment journal. As the sunspots became “nonespots” and stories of extra-cold weather became commonplace, we have heard from more and more clients, “Why don’t more scientists agree with you, since your evidence is based on incontestable data over many centuries, and theirs is based on computer models of recent decades and projections into the future?” The biggest reason is that even those scientists who admit that the evidence of correlation between global temperatures and sunspot activity is powerful, they feel they cannot accept it as conclusive because the relationship could, in theory come purely from coincidence.

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Where Will America Go to Grow? That’s why we were so interested last week in reading the report of an interview with Harvard (and Smithsonian) astrophysicist Dr. Willie Soon. (http://www. thecrimson.com/article.aspx?ref=527650)

...skepticism is in order.

In brief, he says high levels of sunspot activity—such as the earth experienced during the past century—increase the volume of water vapor, the greatest of all greenhouse gases, warming the earth in two ways: First, when vapor condenses, it increases cloud cover and that prevents terrestrial heat from escaping into the atmosphere. Secondly, it also increases the density of ultra-high cirrus clouds (5-8 km) that prevent heat from escaping into space. He concludes, if sunspots don’t return by year-end, global warming scientists will probably be forced to recalculate their forecasts. Don’t bet on that triumph for science-based science. Al Gore has another megamoney-making book coming, and that means nearly all the media and politicians will be warning of warming. Moreover, the United Nations has scheduled a December conference in Copenhagen on the global warming crisis. Like the UN’s sequel to the Durban anti-Israeli bashfest, there can be little doubt about the conclusions from that cool Yule Conclave of the Correct.

Are the American Banks Really Back On Track? The Bank stocks led the market coming off the March low, helped by good news. Those rallies made it look as if happy days were here again. But skepticism is in order. KBW Bank Stock (Large Cap) Index (BKX) January 1, 2007 to April 20, 2009 130 110 90 70 50 31.48

30 10 Jan-07

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SPDR KBW Regional Banking Index (KRE) January 1, 2007 to April 20, 2009 60 50

...“toxic assets” have become “legacy assets”...

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Goldman’s profit announcements last week suggest that at least one of the biggest of what used to be “pure investment banks” is back in business. They help explain why Goldman stunned the markets last month by financing a Japanese theme park. That Goldman plans to repay its $10 billion TARP financing so it can resume its bonus-based compensation system is superficially reassuring. But even if it does pay back the loans, it will continue to benefit big from Washington aid because its deposits and short-term borrowings remain government-backed. It was a big winner at taxpayer expense when AIG paid 100% of its CDS liabilities. All that glitters on the Street is not Goldman, but it didn’t take long to return to regain its shiny status. Wells Fargo’s pre-announcement the previous week was superbly timed to send bank and other stocks sharply higher. However, most of those splendid profits came from fees for refinancing mortgages at the new, low rates. We can only assume that these mortgages were not among those that were poisoning its balance sheet, and were in fact among the best loans on its books. (We note that, among the long list of neologisms the imaginative Administration has been introducing, “toxic assets” have become “legacy assets,” and “Deficit Budgets” have become “Investments.”) The rebranding of financially friendless CDOs as “legacies” will, in theory, make them treasures the private sector will eagerly buy. Legacies used to be real assets that got taxed on death. Now they include the “assets” which have been killing banks. The still-huge spreads in the corporate debt market are attracting more commentary from equity strategists. Why are stocks so robust, led by the new vigor of the banks, when the corporate debt markets remain tuberculous?

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Where Will America Go to Grow? Our first decade of portfolio experience came from managing balanced funds, so we quickly learned to watch for conflicting signals from the two main asset classes—bonds and stocks. Through the turmoil of the Seventies, and the Reagan rallies, whenever bonds looked sicklier than stocks, it almost always turned out that the bond-buyers were smarter than their equity counterparts. The displacement of true bond investors by CDS bettors is hardly healthy...

That relative performance of classes of professional investors continued through the intervening decades. Then came the explosion of Collateralized Debt Swaps, which attracted new breeds of bettors on corporate credit, who could place their bets—not to hedge their exposure to the underlying bonds—but to profit within a market dominated by other non-owners of the bonds. Alan Greenspan was a cheerleader for this “innovation,” partly because the inflow of speculative capital helped to narrow bond spreads. No longer were real bondholders the price-setters in the markets. Result: the historic reliability of signals from the cash bond markets was weakened. With the collapses of Lehman and AIG, the CDS market took on a tortured life of its own. That has meant the bondholders are moving back into their historic price-setting roles. We suspect that, at a time that most equity investors are focused on subprime CDOs and the day-to-day data from the housing market, the sickly performance of Collateralized Loan Obligations and of tradable corporate bonds hasn’t been attracting the attention we believe such debt instruments deserve. The displacement of true bond investors by CDS bettors is hardly healthy: it is as if the Super Bowl were automatically awarded to the favorite of Las Vegas oddsmakers, thereby saving all the costs and potential player injuries from playing the game. What about TARP, PPIP, and the other programs to clean up bank balance sheets? We note with dismay that the two PPIP auctions to date have almost been non-events: the first was smaller than investors hoped, and the second was truly trivial. We were told in private conversations with some attendees at James Grant’s splendid Conference in New York this month that the reason hedge funds and other players haven’t jumped in is because of Congress’s dirty display of “Pitchfork Politics.” One firm that was readying itself to bid called the Treasury Department for assurance that, if it profited greatly from its bet, it wouldn’t be nailed by a Congressional clawback of its “obscene” profits from a deal that was so heavily levered with taxpayer funds. The mere thought of being humiliated on TV by an angry mob of Congresspersons or Senators was enough to make the investor extremely cautious. Whoever answered the phone at Treasury told the caller to wait on the phone for a minute while he checked. He got back to the investor to state, “I think you can feel safe about it.” That wasn’t good enough for the investor, so he passed.

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We watched the scenes on TV of Acorn’s busload of protestors that toured the homes in Connecticut of the AIG bonus recipients, stuffing insulting messages in mailboxes and screaming threats on front doorsteps. (Acorn, which was a conspicuous promoter of subprime loans to non-Asian minorities, and the nationwide leader among “community groups” that rounded up inner-city voters for Democrats, triggering vote-fraud challenges in several states is, according to reports among the recipients of funds from the Obama stimulus program to assist “community groups.” Great OKs for funding from Acorns grow?) Those weeks of banana-republic-style ochlocratic excesses on Capitol Hill may be fading among some voters’ memories. But in the beleaguered investment community, the memory could prove indelible.

...equity investors who did not buy at the March bottom should resist the temptation to rush back into US stocks.

We do not blame President Obama or Secretary Geithner, who conducted themselves with distinction under extreme duress. In particular, Mr. Geithner displayed in interviews on the Sunday talk shows the kind of cool professionalism and knowledge that showed why the President was so eager to not only recruit him, but then to stand by him during the embarrassment of the unfolding stories of his years of tax evasions. However, it remains unclear whether the daily scenes of rage from Barney Frank and his ilk have permanently poisoned the programs that were the Administration’s best hope for resolving the financial crisis. We hope for the healing of time. But financial markets may not show sustained patience. By far the most encouraging sign in the financial data is the rapid escalation in the growth of M-2, which suggests that not all the monetary creation and federal bailout money is being vaporized by toxic assets, or remaining immured in the banking system as ornaments on otherwise ugly balance sheets. We thought of The Cabaret song in the tawdry Berlin nightclub at the dawn of the Hitler era, “Money Makes the World Go Round.” It was a sadly ironic number reflecting the weltanschauung of that tragic era. A few years after the monetary madness of the Weimar era, Hjalmar Schacht had restored value to the Deutschemark, but the Depression meant that the money did not in fact move around and neither did the economy. As dubious as we may be about the Treasury measures and the Obama “Stimulus Package,” we take consolation in this shard of evidence that what the Fed is doing may actually be working. The stock market has certainly taken notice of this “green shoot” of the green stuff. After a record rally, we think equity investors who did not buy at the March bottom should resist the temptation to rush back into US stocks. April

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Where Will America Go to Grow? The Importance of the Durability of the Oil Contango Crude Oil Spot January 1, 2008 to April 20, 2009 150

Are [oil] futures prices sheer speculation, or are they the collective best judgment of those who have the most at stake?

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Crude Oil Futures (at April 20, 2009) June 2009 to December 2016 85 77.48

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Oil stocks tend to trade off spot prices. But, as clients are well aware, we have consistently advised investors to rank producers based on the value of unhedged reserves in the ground (or undersea) in politically-secure regions of the world. Why, for example, should Suncor and Canadian Oil Sands, who have reserves lasting through this century, trade on the basis of today’s spot prices? Are those futures prices sheer speculation, or are they the collective best judgment of those who have the most at stake?

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We believe that those distant month contracts primarily reflect the intersection of the beliefs of major producers and consumers about oil’s future. The population of oil speculators has shrunk drastically since “The Midnight Massacre.” What is particularly interesting about the steep slope of the contango is (1) that the producers, at a time of tremendous stress on their budgets, have not rushed en masse to drive down the prices of “out months” to lock in such attractive prices, and (2) that consumers are willing to pay up so consistently for futures contracts to assure themselves of supply at prices they are willing to include in their own long-term business forecasts.

The population of oil speculators has shrunk drastically since “The Midnight Massacre.”

As important as those concepts are, there is another aspect to the oil futures curve: as long as oil stays in such sharp contango, investors in most commodity funds will find to their surprise that their holdings of barrels of oil are shrinking, month by month when oil enters its next sustained bull market. Why is that? The typical commodity fund, such as the Goldman Sachs fund, rolls its investment in each asset as the spot month expires, buying the next month’s offering. It doesn’t for example, switch between some out months into spot and then back again. Here’s a simplified version of the process. Suppose an investor holds, through a fund, 100,000 barrels of oil which, at contract expiry, trades at $51 a barrel and rolls it into the next month, which trades at $53 a barrel. The value of the sale is $5.1 million, which is invested in next month’s crude. The investor now owns 96,226 barrels. In other words, as long as the contango lasts, the investor cannot expect to profit from a long-term investment in the commodity. This is precisely what happened to the big funds when oil swung from backwardation to contango on its rush from $75 to $145. Some shocked pension funds moaned about “capital destruction.” We make this point to illustrate one reason why we argue that pension funds should not treat commodity investing as an “alternative investment” that must be conducted by investing in actual commodities through the best-known funds. Owning the shares of commodity producers is a far more reliable way to participate in a commodity boom—particularly the shares of those companies which are able to expand their output at a time of rising prices through having politically-secure reserves: the investor wins two ways at once.

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Where Will America Go to Grow? That said, commodity funds have their place in pension investing, because most commodities stayed in backwardation during the decades of commodities’ Triple Waterfall, and most commodities are in backwardation today.

...if—or when— inflation 1970s style returns, then most commodities will surely swing into contangos...

However, if—or when—inflation 1970s style returns, then most commodities will surely swing into contangos, as speculators buy out month contracts as bets on future inflation. That’s the way commodity bettors made their bucks back then. But as long as deflation remains the over-arching fear, commodity fund investors should get reasonable returns—but probably not as rewarding as those earned by investors in strong commodity-producing companies.

The World’s Troublemakers Challenge The President We wrote last fall that the unfolding tragedy in Pakistan could become a global disaster. While most policymakers and pundits focus on the fast-emerging nuclear threats from Iran and North Korea, the government of the most populous Mainland Asian Muslim nation looks helplessly at the fast-rising power of the Al Qaedabacked Taliban. Its army has ceased to be controlled by the government, and remains preoccupied with its traditional enemy—India. Now that control of Swat has been handed over to the Taliban, the Dark Ages are returning rapidly. Already, 131 girls’ schools have been closed, and pictures of public floggings of young women who displayed what these pious people call “public indecency”—whether in displaying bare arms or in leaving their homes for even a few minutes unaccompanied by their husbands—are being published daily. President Obama and his Asian negotiator, Richard Holbrooke, have been publicly forceful that the war against Al Qaeda and the Taliban in Afghanistan cannot be won unless Pakistan’s government reins in the Taliban in its frontier regions. In recent weeks, the Taliban has grown bolder, extending its bombings into the cities, even including Lahore. The terrorists who took over the Taj Mahal and other hotels in Mumbai (five days after we and our clients left), came from Pakistan, were directed by a Kashmir-based group, and may have been actively aided by the ISI, the powerful state-within-a-state that controls the army, the intelligence services—and the nation’s nuclear weaponry. Meanwhile, India is embarked on its month-long national Parliamentary elections. Prime Minister Manmohan Singh—“India’s Deng Xiaoping”—at age 78 enters a bitter campaign just weeks after his second experience with open-heart surgery. His main opponent is the Hindu Nationalist Party (BJP), which, in its term in office, continued the liberalizing policies Singh had introduced as Finance Minister in the Congress Party’s previous term in power.

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Mr. Singh’s health, and the Congress Party’s often-weak control over its fractious coalition, have meant that India has not been moving forward as rapidly on liberalization since 2004 as most external observers seem to assume. The government has responded to the global crisis with some protectionist measures designed to appeal to key voting groups. Moreover, as readers of Aravind Adiga’s Booker Prize-winning The White Tiger have learned, the Singh government made scant progress in controlling the pervasive corruption that the multi-party political process fosters. What would doubtless most reassure global investors would be a fairly decisive win for either of the two leading parties, so that the government would not be dependent on support from Communists, Maoists or notably corrupt regional factions. Another worry: the Mumbai massacre and the Taliban’s rise in Pakistan may be giving respectability to extremist Hindu groups, which oppose government programs designed to help the Muslim minority, and have been responsible for persecution and murder of Christians.

The challenges from Iran, North Korea, Afghanistan, and now Pakistan will test Obama’s coolness and determination.

Despite those concerns, we are still cautiously optimistic that the world’s largest democracy will somehow once again demonstrate that it remains a largely-tolerant and largely-progressive beacon of political and economic freedom in a Continent that boasts pathetically few true democracies. We were talking to an Indian friend at the Grant Conference. He is now deeply concerned. He thinks that investors should be downgrading India in their portfolios, because the collapse of the Zardari government in Pakistan could unleash a catastrophe that would engulf the subcontinent. Joe Biden predicted just after the election that the new President would be tested by some foreign challenger within his first six months in office. For once, Mr. Biden got it right. The challenges from Iran, North Korea, Afghanistan, and now Pakistan will test Obama’s coolness and determination. The Somali pirate drama—a TV spectacular—was good news for Obama, because the risk was contained in a small space, there were only three pirates holding Captain Phillips, and this was the kind of confrontation made to order for the SEALs—the world’s premier seaborn operations force. The way the President managed the situation was textbook-perfect, and Americans got a chance to rejoice in a victory—and found a new hero in Captain Phillips just as the story of “Sully,” the peerless USAir Captain (and, inconveniently, a staunch Republican) was fading from the mainstream media.

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Mature democracies seem to have the ability—or good luck—to produce real leaders just when the going gets tough.

Last month, we criticized the President for “riding madly off in all directions.” This month, we commend him for displaying on his European tour what he does better than anybody—campaign—and for his insistence that the war in Afghanistan is not just “a good war” but a war that must be won. Those enemies of America across the world who may have thought he was too callow and ideologized to be a serious challenge may now have to rethink their assumptions. Mature democracies seem to have the ability—or good luck—to produce real leaders just when the going gets tough. Obama’s clumsy mishandling of the British file (sending back the bust of Churchill given by Tony Blair, giving Gordon Brown 25 DVDs that don’t work on British TVs, and not bowing to the Queen while apparently bowing to the Saudi prince) could have precipitated sneering and cynicism in the nation that has been America’s key ally for a century. However, he and Michelle still wowed the Brits with their panache—and the alliance is, thankfully, still intact. We remain worried that his belief that he should take advantage of the deep recession to fashion the statist society of the future will not only prolong the recession, but weaken the American economy for at least a decade. We are unhappy that Paul Volcker has been marginalized, and remain disappointed with Obama’s willingness to defer to Nancy Pelosi, who, though smart and experienced, is not conspicuously endowed with either pragmatism or a desire to build a consensus at a time of crisis. We decline to join those who have reawakened the Far Left’s assault on Larry Summers. Like most geniuses, he can be erratic, and he doesn’t suffer fools gladly—a real liability for a political figure. However, he is as smart and wellinformed as any American economist since Milton Friedman, and he’s likely to be an excellent interpreter of the economy’s challenges to a President who must deal with big economic and financial problems while beset with so many challenges abroad. Besides, with the wise and experienced Volcker receding into the background, he’s all we’ve got… and he could be taking Bernanke’s place at the Fed next year.

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Where Will America Go to Grow? RECOMMENDED ASSET ALLOCATION Recommended Asset Allocation (for U.S. Pension Funds) US Equities

Allocations 18

Change unch

Foreign Equities European Equities 6 Japanese and Korean Equities 2 Canadian and Australian Equities 9 Emerging Markets 11

unch unch unch unch

Bonds US Bonds 8 Canadian Bonds 5 International Bonds 11 Long-Term Inflation Hedged Bonds 10

unch unch unch unch

Cash

20

unch

Years 4.00 4.25 3.75

Change unch unch unch

Bond Durations US Canada International

Global Exposure to Commodity Stocks Precious Metals 35% Agriculture 33% Energy 22% Base Metals & Steel 10%

Change unch unch unch unch

We recommend these sector weightings to all clients for commodity exposure—whether in pure commodity stock portfolios or as the commodity component of equity and balanced funds.

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Where Will America Go to Grow? INVESTMENT RECOMMENDATIONS 1. F. Scott Fitzgerald had it wrong, at least for American stocks: you do get a second, and even a third chance. Stocks leading that six-week rally looked down, couldn’t see the bottom anymore, and promptly retreated to lower levels. Think about what you’ll most want to own when The Real Thing arrives, and accumulate them at leisure, while the market tries to decide whether the economic recovery is a month, a quarter, or a year away. 2. Larry Summers adroitly brushed off a question about future levels of unemployment by saying, “Economic forecasters are divided between those who know they don’t know, and those who don’t know they don’t know.” Galbraith said the function of economic forecasting has been to make astrology look respectable. We know we don’t know, but we know we didn’t feel comfortable with the speed of optimism’s return. Those last two deep Mama Bear recessions didn’t end with such alacrity—nor did optimism return so speedily. 3. We do believe that the stock market is giving the correct signals that techs and commodities will lead the next recovery. 4. The other winner will be (sound of trumpets) commodity stocks. They were heavily outperforming the S&P until the late stages of the recent rally. We think they’ll move back to #1 slot—at least on relative strength. 5. Gold has been a bitter disappointment to its boosters in recent weeks. Bullion is down 4.6% this year, and most of the leading stocks are down far more than that. These setbacks came at a time when gold was getting more publicity as a haven investment than it has received in decades. Gold has been hurt by two rallies—first the dollar, then the bank stocks. More recently, investors have been spooked by the deal for the IMF to sell 403 tonnes of gold, at a time Indians, traditionally the most reliable buyers, are on strike. That 500 tonnes of scrap gold has come to the markets this year is a bad news/good news story: it’s a huge amount for markets to absorb, but it proves anew that gold is a precious asset in tough times. Gold stocks remain core investments within equity portfolios, reducing overall portfolio volatility. They will be superstars when the dollar finally falls, and people begin to get genuinely worried about inflation’s return. The stocks will outperform bullion on the upside.

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6. Copper’s remarkable performance (up 48% in three months) worries us. Yes, China is coming back, but the industrial world is looking as bleak as a group of paid mourners at a funeral. We do not recommend adding to base metal exposure. 7. Within the energy group, we believe the bookends—refiners and oil sands—are most attractive. Why refiners? (1) Most oil analysts despise them; (2) They have to continue to refit their refineries to provide for greater percentage usage of that great nuisance, ethanol; (3) Americans are driving less; however (4) Refiners should hold up better than other oil sectors if there’s one last oil shakeout coming. Oil sands: You just possibly may never be able to buy oil for the 2020s as cheaply as you can today by buying the oilsands stocks. These are cornerstone investments for long-term oriented investors. 8. It’s planting season as we write, and the snow is largely gone. Low corn prices are discouraging farmers from planting as much corn as last year. Higher soybean prices (and cold wet weather) are encouraging them to plant more beans. Both these crucial crops are priced profitably for farmers, so don’t believe the talk that they’ll be cutting back dramatically on fertilizers. However, the extra emphasis on beans is bad news for the nitrogen fertilizer companies. (Beans don’t need nitrogen.) Overall, we still think the agricultural stocks have the best risk/reward profile. 9. The steep yield curve entices investors to buy long-term bonds and enriches all those bankers who have any wiggle room for making real loans after succumbing to the allure of all those fascinating, sophisticated ways to make ghastly bets. However, what the market giveth, the market taketh away once the economy begins to recover and inflation begins to return. Stay below your duration benchmark: give up yield now for performance later.

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THE COXE STRATEGY JOURNAL © Coxe Advisors LLC 2009. All rights reserved. Unauthorized reproduction, distribution, transmission or publication without the prior express written consent of Coxe Advisors LLC (“Coxe”) is strictly prohibited. Coxe is an investment adviser registered with the U.S. Securities and Exchange Commission. Nothing herein implies that the firm is recommended or approved by the United States government or any regulatory agency. Information, opinions, estimates, projections and other materials (referred to collectively herein as, “Information”) contained herein are provided as of the date hereof and are subject to change without notice. From time to time, Coxe publications may contain Information with regard to securities, commodities, derivatives or other investment assets (each referred to herein as an “Investment,” or collectively, the “Investments”), or investment strategies. Due to staggered publication dates, any Information contained herein may differ from Information contained in prior or subsequent publications. Information discussed herein may have been obtained from various unaffiliated third party sources believed to be reliable, but has not been independently verified by Coxe. Coxe makes no representation or warranty, express or implied, in respect thereof, takes no responsibility for any errors and omissions which may be contained herein, and accepts no liability whatsoever for any loss arising from any use of or reliance on such third party Information, whether relied upon by the recipient or user, or any other third party (including, without limitation, any customer of the recipient or user). Foreign currency denominated Investments are subject to fluctuations in exchange rates that could have a positive or adverse effect on the investor’s return. Unless otherwise stated, any pricing information in this publication is indicative only. No Information included herein constitutes a recommendation that any particular Investment or investment strategy is suitable for any specific person. Coxe publications are not intended as, and Coxe does not provide, investment advice tailored to the particular circumstances, investment objectives, and risk tolerances of any entity or individual. Coxe does not continuously follow any Investments or their issuers even if mentioned in a Coxe publication. Accordingly, users must regard each Coxe publication as providing stand-alone analysis as of the date of publication and should not expect continuing analysis or additional reports related to such Investments or their issuers. The Information contained herein is not to be construed as a solicitation for or an offer to buy or sell any referenced Investments, or any service related to such Investments, nor shall such Information be considered as individualized investment advice or as a recommendation to enter into any transaction. Coxe and any officer, employee or independent contractor of Coxe, may from time to time have long or short positions in any Investments discussed. Coxe’s principal, Mr. Coxe, and other access persons privy to information contained in a Coxe publication prior to publication, are restricted from entering into any transaction concerning any Investments discussed therein for the five days before and after publication, and are required to hold any such positions for a minimum of one month. Coxe may enter into distribution agreements with various unaffiliated third parties to redistribute its publications. To the extent that any publication is reproduced, redistributed, or retransmitted, Coxe is not privy to, and makes no representations regarding, such unaffiliated third parties’ positions in any Investments discussed therein. Any distributor authorized by agreement with Coxe to redistribute this publication is not affiliated with Coxe. Third parties having permission to reproduce, redistribute, or retransmit Coxe publications may offer to effect transactions in some or all discussed Investments. Coxe makes no recommendation with respect to the use of any particular brokers or agents, and no such recommendation should be inferred by virtue of any distribution agreements that Coxe may enter into with third parties.

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