Bmo Cm Basic Points Nov 2009

Basic Points The Power of Zero

November 12, 2009

Published by Coxe Advisors LLC Distributed by BMO Capital Markets

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Don Coxe THE COXE STRATEGY JOURNAL

The Power of Zero

November 12, 2009 published by

Coxe Advisors LLC Chicago, IL

THE COXE STRATEGY JOURNAL The Power of Zero November 12, 2009 Author:

Don Coxe 312-461-5365 [email protected]

Editor:

Angela Trudeau 604-929-8791 [email protected]

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

www.CoxeAdvisors.com

The Power of Zero OVERVIEW So what was all that Depression fuss about? The US economy grew 3.5% in the Third Quarter, and all the major economic numbers now being reported suggest this one will be even stronger. Stock prices are soaring. In case, you’ve forgotten: Sixteen months ago we were heading into the Midnight Massacre, when Messrs. Bernanke and Paulson launched the rescue of Fannie, Freddie and Wall Street.

Only Lehman was allowed to experience the Schumpeteresqueslaughter reserved for capitalist cupidity and stupidity.

That swiftly evolved into the Age of Bailouts, with Congress enlisted in emergency funding for Wall Street’s biggest, boldest and brashest bankers on a scale that made IMF rescues of entire nations look like chump change. Only Lehman was allowed to experience the Schumpeteresque-slaughter reserved for capitalist cupidity and stupidity. Operating with scripts and strategies conceived on the fly, varying prescriptions of emergency assistance were extended, under panic conditions, to Citigroup, Merrill Lynch, Morgan Stanley, AIG and Goldman Sachs. Since then, the Obama Administration and the Pelosi-led Congress have been moving to take charge of some of the commanding heights and strategic valleys of the US economy. Highlights: takeovers of General Motors and Chrysler, a deficit of 12% of GDP, $790 billion in handouts and assistance under the rubric of economic stimulus, a costly new national health care system, and a vast array of tax and trade global warming programs whose tentacles will reach into almost every sector of the economy. To date, his rescue operations are succeeding. As Joe Biden put it, “A year ago we were talking about falling into Depression. Now we’re talking about the shape of the recovery.” But deeply-wounded investors should be cautious about throwing caution to the winds. Among the signs that the stimulus package didn’t repair the potholed yellow brick road to prosperity is the upside breakout in the Bad News Asset: Gold. This month, we begin our analysis by discussing the anniversaries of the births of two new eras. First, the Age of Global Capitalism, which began 20 years ago with the Fall of the Wall. Second, the apparent ending of that era a year ago with the return of Big Government as Economy Manager with the election of Barack Obama. We weren’t sure then how he was going to deliver

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everything his thrilled backers wanted, but we knew that he wanted to be a transformative President and he cited Reagan as such a leader—even though he said Reagan had the wrong views. we have decided to focus on a humble number—Zero...

With that background, we search for an appropriate investment strategy for tumultuous times. While the talk is of trillions in stimulus, foreclosures, bailouts and deficits, we have decided to focus on a humble number— Zero—which is roughly the rate on government short-term funds, high-grade money market funds and inflation across the US, Canada, Japan, and most of Europe. We are leaving our cautious Asset Mix unchanged. Risk assets—other than US real estate prices—are bubbling upward everywhere, but the big banks’ balance sheets remain overloaded with the unmarketable unmentionables, and US regional banks—the backbone of the real economy—are now being engulfed by their exposure to commercial real estate and consumer loans as unemployment continues to climb.

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The Power of Zero I. Capitalism’s Triumph Every week, someone publishes an analysis of the global economy by noting that the triumph of free trade and free markets across most of the globe began in the Reagan-Thatcher era. Now, they agree, it’s over. Each month, Washington’s reach into the American economy expands rapidly, while the economy expands—at best—grudgingly. It is certainly true that almost no one predicted the suddenness and scale of US government intervention in the West’s flagship economy that had been, until last year, a testimony to the wisdom of Milton Friedman and the courage of Ronald Reagan. (The cheerful Reagan charmed voters by teasing his opponents. He summed up Democratic economics as, “If it moves, tax it; if it keeps moving, regulate it; and if it stops moving, subsidize it.” He summed up the goal of his policies toward the Soviets: “We win; they lose.”)

“If it moves, tax it; if it keeps moving, regulate it; and if it stops moving, subsidize it.”

The political bipartisanship began with the Midnight Massacre of July 13, 2008 but lasted only until the grandiose goals of the new Administration were revealed. The Pelosi-Obama stimulus package passed with no Republican votes in the House, despite heavy lobbying from some segments of the business community, notably General Electric, which became Obama’s most dedicated corporate cheerleader—itself and through MSNBC—after receiving many billions in low-cost loans to its flagging finance subsidiary, GE Capital. The GM and Chrysler rescues were accomplished with minimal Republican support. By then, the concern that the Administration was actually seeking a major transformation of the structure of the US economy was developing rapidly among conservatives and moderates. In addition, the pitchfork politics in the House had terrified many business leaders that they and their families could be the next victims of the fast-spreading rage against the bailed-out rich. Twenty-seven years ago, when the newborn Reagan and Thatcher Revolutions seemed headed for death from double-digit interest rates, Chairman Volcker declared victory over inflation and began expanding the money supply and cutting interest rates. For those who didn’t manage money during that recession, the fed fund rates at the time that great easing began must seem surreal: 18%.

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The Power of Zero Question: How did the economy survive with rates so high? Answer: with great difficulty. Why not, they asked, take those huge risk-free upfront returns from Cash?

Those rates were not only punitive for businesses and potential homebuyers, but they meant that money market funds were well-nigh-irresistible investments—huge, risk-free returns with zero market volatility. We can recall the challenges we faced in convincing pension fund clients about our asset mix in late 1982: zero Cash, with the balance being roughly equally divided between long-duration bonds (19 years) and equities—with minimal exposure to commodities. Why not, they asked, take those huge riskfree upfront returns from Cash, rather than bet on a sustained, steep drop in interest rates and inflation and a sharp, sustained economic recovery? Because, we argued, inflation and long-term interest rates were already falling sharply and would continue to do so, following commodity prices down, lowering costs for businesses and consumers, particularly for energy. Those three interlinked slides would virtually guarantee a strong economy and strong stock prices for years to come. We insisted that short rates would plummet. That wasn’t all that would fall from the Reagan and Thatcher revolutions…

II. The Fall of the Wall Those three interlinked declines—rates, inflation, and commodity prices—and that one robust rise—economic activity in the free market economies across the West, led by the USA—were the underpinnings of the Reagan-Thatcher accomplishments and the “triumph” of capitalism. Of particular importance, the strength of the US, British and German economies was matched by the robustness of their interlinked foreign policy in the face of Communist threats to Western Europe. Thatcher and Reagan, with Helmut Kohl’s support, installed Pershing nuclear missiles in Western Europe, despite strong opposition from France, and widespread “anti-war” demonstrations on Ivy League campuses and across Europe. The free market team’s stand against the faltering Bolsheviks, and their strong economies at a time of economic stagnation in Russia and its occupied territories in Western Europe, led to political unraveling in the Communist world; the Wall fell and two years later the Communists were gone—even from the Kremlin. (On his trip to England in 1979, Deng Xiaoping learned why free economies were outperforming Russia and China, and he returned to launch the Sino-Capitalist Revolution which keeps astonishing the world,

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even as faith in capitalism fades across much of the OECD. He had learned why Hong Kong, Taiwan and South Korea could keep creating jobs and wealth by rejecting socialism—whether on the Maoist, Bolshevik, or Indian models.) Putin calls the collapse of Bolshevism, “The greatest geopolitical catastrophe of the 20th Century.” It was certainly bad news for him and his fellow KGB officers, but they regrouped amid the chaotic Yeltsin era and eventually took control of Russia. The KGB were the Jesuits of Russian Communism, and they worked loyally to advance the Kremlin’s goals. But their relationship to the Party was—like the Jesuits’ relation to the Vatican—at times problematic. Example: Khrushchev once claimed that he had personally shot Beria, the KGB leader, who wasn’t deemed sufficiently submissive to the Central Committee, (although the later version was that he’d died before a firing squad). Like the Jesuits, the KGB considered themselves the elites, and remained loyal to each other. Now that they are the ruling class, they no longer have to answer to bureaucrats and theorists.

The KGB were the Jesuits of Russian Communism...

It was also bad news for leftists across most of the Free World. They had convinced themselves that, as the leader of Canada’s New Democratic Party put it after returning from a trip to Russia shortly before the Fall, “I admire their economics, but not their politics.” It turned out that everywhere, like Germany under National Socialism, “Good Communists” were as rare as “Good Nazis.” Free markets and free economies worked: socialism didn’t. There were no Nobel Peace Prizes for Reagan or Thatcher. Instead the prize for the end of the Cold war went to … Mikhail Gorbachev. (The Nobel Committee’s apparent love of losers is shown by its award of the prize to the most conspicuous American foreign policy loser—Jimmy Carter—and rejection of the most conspicuous American foreign policy winner—Reagan. By coincidence, last week was also the anniversary of Carter’s most memorable flop—the seizure of the American Embassy hostages by Ayatollah Khomeini’s radicals. They were imprisoned and abused for the 444 days it took to elect Reagan. Carter had withdrawn support for the Shah and expressed America’s joy at the Khomeini revolution.) Gorbachev’s Nobel was the beginning of the rewriting of the history of Reagan and Thatcher’s roles in Communism’s fall. The culmination of this process is arriving in the torrent of new books that airbrush out those doughty antiCommunists from the portrayals of friendly people reaching out to hug each other from both sides of the Wall—Pyramus and Thisbe writ large.

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The Power of Zero

It was, in the sophistication of its vin blanc et brie analysis, a causality claim comparable to the rooster’s renowned boast that his crowing had brought the sun up.

In that sense, President Obama is riding the tide of history’s restatement, and vindicating the Nobel decision about who was the real peacemaker of that era. Speaking to the cheering throng in Berlin this year, he said that “the world” forced down the Berlin Wall. He didn’t mention NATO, Reagan, Thatcher, or Kohl. It was, in the sophistication of its vin blanc et brie analysis, a causality claim comparable to the rooster’s renowned boast that his crowing had brought the sun up. Which “world” did he have in mind? A coalition of China, India, Russia, Vietnam, Burma, the United Nations and Iceland?

III. The Obama Triumph A year ago, Grant Park in Chicago was the scene of the Democrats’ most historic get-together since the party’s Left spoiled then-Mayor Daley’s party to celebrate his party’s national convention. Back then, there was an unseemly riot, which helped elect Nixon. This time, there was pride, cheering, hugging and wondrous exultation. We can attest that it was a great time to be a Chicagoan, and a great time for America. So how has the President anointed that night performed? He remains the most charming and charismatic President of modern times, and is still, quite probably, liked by more Americans—and more people abroad—than any American President. He and his radiant wife are, as The New York Times notes, America’s greatest global brand. But the reality of the Presidency is that handsome is as handsome does. His approval ratings have descended from the Heavenly to the ordinary. All polls disclose that while most Americans still like and admire him personally, they disapprove of his policies. Gallup published a poll on the First Anniversary of his election, comparing what Americans thought of him then and now. Here are key findings: Percent Then Now

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He will heal political divisions

54

28

He will control federal spending

52

31

He will improve the healthcare System

64

46

He will increase respect for America abroad

76

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Other polls confirm that the basic political dynamic of America hasn’t changed much from its historical pattern: 40% of Americans still call themselves conservatives, 20% liberals, and the rest style themselves as moderates. Obama won by convincing an overwhelming majority of moderates that he would rule from the center, and—most importantly—he wasn’t George Bush. Despite a brilliant campaign, adoration from the media, a divided Republican party, and a flagging economy, he was actually behind the Bush-baggaged McCain in the polls until Lehman imploded, and suddenly it looked as if the world could end. As Larry Summers would later joke, a new Messiah was what was needed. (It hasn’t come to an end, although a recent New Yorker cartoon shows a gentleman consoling a friend, saying, “It isn’t the End of the World.” Just around the corner, riding furiously toward them, are the Four Horsemen of the Apocalypse.)

...many global investors are alarmed about Obama’s policies and are reducing their exposure to US assets accordingly.

He won in a landslide, as the undecideds, en masse, became converts. A year ago, Obama was impressing the nation (and, we admit, us) by unveiling his economic policy team that included the magisterial Paul Volcker. Volcker has been rarely seen since; three weeks ago, he corrected an interviewer who said that the financial community felt that in recent months he’d been marginalized. Volcker said, “I did not have influence to start with.” The rescue of the plummeting financial system was actually orchestrated by Bush appointees—Ben Bernanke and Hank Paulson, with the help of Tim Geithner. Their policies have continued—for good and ill—and Bernanke and Geithner remain as partners. The jury is still out on the Pelosi-Obama stimulus package, as it is on his plans to run trillion-dollar deficits for a decade—and on Congress’s national health care bill—which remains in negotiation, despite its narrow victory in the House. Based on our recent trip to visit European clients, and numerous emails from foreign clients across much of the world, many global investors are alarmed about Obama’s policies and are reducing their exposure to US assets accordingly. The dollar’s decline may be one symptom of these doubts about the actions of Obama and the Democratic Congress.

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The Power of Zero US Dollar Index (DXY) November 10, 2008 to November 10, 2009 90 88

Few Americans would have expected that America would make Italy look restrained and prudent in comparison.

86 84 82 80 78 76

75.10

74 Nov-08

Jan-09

Mar-09

May-09

Jul-09

Sep-09

Nov-09

The US deficit/GDP ratio is above 12%—at World War II levels, and is the highest in the G-7, except for the UK. It is, for example, more than twice Canada’s. Few Americans would have expected that America would make Italy look restrained and prudent in comparison. There is widespread disappointment about how all that money has been spent, but as Keynes observed, paying workers to dig ditches and then refill them is better than not spending the money at all when consumer and business spending collapse and Depression looms. Last week, The Economist, which backed Obama enthusiastically during the election campaign, published a full-page critique of his pro-union policies titled “Love of Labour.” Contrasting his recovery policies with Reagan’s response to the Air Traffic Controllers’ strike, it said, “Mr. Obama is the most pro-union president since Jimmy Carter, at least.” It went on to describe the implications of Obama’s backing for the unions’ top priority—card check— which would abolish secret ballots for union representation. Abroad, his popularity remains high (except in Israel, where his approval rating is a mere 4%), as evidenced by his Nobel Peace Prize. However, as his attempt to replicate Tony Blair’s success at charming the IOC into awarding Chicago the Olympic Games demonstrated, he has been notably unsuccessful in translating that popularity into significant diplomatic successes. Perhaps the biggest difference between him and Reagan is in his views about American history. He was raised in the post-Sixties era, when the Left—abroad and within the US—routinely demonized America for its alleged racism and imperialism.

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His own beliefs, as expressed in his speeches worldwide, certainly don’t condemn America with the fervor of the hard Left, but show little of the powerful pride in America’s history that animated Reagan. Obama has told countries around the world about all the ways that America has misbehaved or disappointed them—and has apologized….most recently to the Iranian mullahs for Eisenhower’s role in dumping Mossadegh in 1953. For his public apologies he has generally been greeted with applause—but he has captured almost no new support for his foreign policy initiatives. The exception to his Administration’s pattern of passivity and apologetic coaxing came with the return of Hillary Clinton to prominence, in Pakistan, after months of seeming ineffectiveness by Obama’s appointee, Richard Holbrooke. On her recent trip there, she displayed coolness, gutsiness and a sensitivity toward Pakistan’s great internal challenges that did America proud.

His own beliefs... show little of the powerful pride in America’s history that animated Reagan.

On balance, a year after he won the Presidency, and while he still enjoys widespread good will, Obama has only begun to prove his effectiveness (1) in managing the US economy without damaging the nation’s longer-term financial position, and (2) in protecting America’s interests abroad. Last week’s three off-year elections certainly do not prove that voters have suddenly forgiven Bush and are ready to reinstate Republicans. Obama was not on the ballots, unemployment was still climbing even after the economists said the recession had ended, and the Democrats’ deficits had scared a majority of independents into switching their preference to the Republicans. The next elections are a year away, by which time the economy should be stronger, the rage over the 1990-page health care bill might have dissipated, and the Republicans will still lack a Newt Gingrich-style leader to put together the various resentments and enthusiasms into a winning coalition. It took rare talent for the current leadership to lose the 23rd Congressional District in New York the Republicans had held for 72 years. Obama may fear serious voter backlash about the scale and wisdom of the new programs being legislated, but at least for now, he doesn’t need to fear the Republicans. The Republican Party is leaderless, and frequently clueless, so Obama doesn’t need to be a Roosevelt or Reagan to stay on top.

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The Power of Zero The Highs and Lows of Zero Rates

Zero is a seeminglysmall number, but it is demonstrating its power to change the world.

Zero is a seemingly-small number, but it is demonstrating its power to change the world. We have seen many examples in individual countries of The Power of One: this is that kind of power on global scale. We are regularly told that we should expect a roaring recovery—Reagan-style. But if Reagan were alive, and Margaret Thatcher were in good health, they would be astounded at how their two nations’ economies are struggling at a time of zero interest rates—when they had to launch recoveries at a time of record-high rates. The US and British economies are performing at roughly the level they were during the late stages of the 1981-82 recession—when corporations’ and consumers borrowing costs’ were infinitely higher. That inflation could be in the zero range would also astonish them, even though the biggest factor in their first election victories was the runaway inflation of the Carter and Callaghan era—when “malaise” was the Presidential euphemism for the spreading despair. So why shouldn’t the economic recovery be at least as strong as Reagan’s—if not even more robust? It’s because those Zero rates tell us that the financial system’s problems that triggered the economic collapse aren’t going away quickly—and could even be getting worse. Reagan and Thatcher didn’t have to deal with serious demographic problems that meant housing prices could not—for the first time since World War II—leap in response to plunging interest rates. Reagan and Thatcher didn’t have to mortgage their nations’ futures to bail out bad banks, which, upon being rescued, diverted the succor they were given to rebuild their devastated capital to speculation and bonuses, thereby making their saviors—politicians and taxpayers—look like suckers. Nor did they have to face the certainty that interest rates and inflation would have to go up sometime—and that could be very inconvenient for both the politicians and the economic recovery.

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US interest rates and inflation could remain at current levels, were America to mimic Japan’s experience from 1990 to Koizumi’s election. But those early years of Japan’s Triple Waterfall Crash occurred at a time of rapid global growth that meant Japan’s trade surpluses grew robustly, and the immense levels of domestic savings were adequate to finance Tokyo’s endless fiscal deficits. (Currently, Japanese investors are not quite able to absorb all the debt coming from record deficits, but they’re certainly embarrassing their American counterparts: they’re absorbing 94% of new government debt offerings.) In contrast, America’s trade deficits are a permanent feature of the US economy, and even the current uptick in US household savings is no match for the fast-growing flow of new Treasurys, which means the US becomes more dependent on foreign bond-buyers by the month.

“Those aren’t real forecasts: they’re Mickey Mouse numbers.”

The Administration’s forecast through 2019 assumes that foreign creditors’ appetites for Treasurys will grow at least as fast as the national debt. It predicts sustained real GDP growth of 3% per year, with no recessions, no increases in taxpayer cost for health care, and—despite sustained deficits and a doubling of the national debt-to-GDP ratio (excluding Fannie and Freddie debt) from 41% to 82%—long Treasury yields will not rise more than 1%. (We spoke at a Canadian financial conference last month at which Niall Ferguson was the star. He flashed that forecast up on the screen and said, “Those aren’t real forecasts: they’re Mickey Mouse numbers.”) Despite the current deficit of 12% of GDP, and despite increasing grumbling about Washington’s willingness to incur huge deficits in bad times and good, the foreign support of the dollar by buying Treasurys continues. There has been one little-remarked change in the investment strategy of America’s Sugar Daddy #1: in recent months, China has been rolling over its maturing Treasury notes into T-Bills. It thereby chooses to forgo interest of 2%–3.4% in favor of near-Zero yields. What power, one wonders, does Beijing think, comes from a Zero return in a weakening currency? And why is that putative power growing so relentlessly?

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The Power of Zero

...it is based on redistributive justice: it takes wealth from savers and gives it to the bad banks that caused the crisis.

A fast-growing Monetary Base at a time of Zero yields is the best a central bank can do to prevent a Depression and get the economy moving again. But it is based on redistributive justice: it takes wealth from savers and gives it to the bad banks that caused the crisis. To add insult to that injury, many of the most prominent of those bankers are paying themselves huge bonuses for being so brilliant and creative as to take the free money and invest it up the yield curve—or across the wide range of risk assets, which are rising robustly together. Goldman is the biggest winner from this wealth transfer: even its mid-term debt only costs around 2%. Its CEO told the audience in a London church that he does “God’s work.” This is the bank that, according to reports about the tense bailout days, would have been dead within hours had Paulson and Bernanke and friends not rescued AIG and Morgan Stanley. Goldman’s bonuses for this year will exceed the GDPs of 107 nations. Ain’t free enterprise grand? A Zero yield has been the Bank of Japan’s policy for most of the time since its Triple Waterfall Crash commenced nearly 19 years ago. Our personal favorite member of the BOJ’s Board then, was its only female, Eiko Shinozuka. She consistently voted against near-Zero deposit rates. She claimed to represent the generation that had pulled Japan out of its desperate condition after World War II through its hard work and high savings rate. With state pensions being so modest, and with the children of postwar generations being less willing to perform the historic role of looking after their parents and grandparents, people had to save for their old age—and nobody on Planet Earth seemed to live as long as the Japanese. Amazingly, these people did save remarkable amounts, and their favored deposit institution was the Post Office, particularly after the banks began to implode. As interest rates on deposits fell by more than 90%, “her people” were driven into penury to prop up the bad bankers. She reiterated those vigorous objections at almost every BOJ Board meeting, and the male gerontocrats who made up the rest of the Board thanked her for her contribution—and continued to make the near-Zero-cost contributions to the banks. Led by the Fed, central banks across the OECD have been Japonized. They drive rates of bank deposits and money market funds toward Zero to stimulate borrowing and enrich a flagging, flabby banking system.

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Not that the top dogs at the big, bad, bonused bailout banks (Hereinafter called the B5) show penitence, gratitude or humility about this process: they consider controls on their bloated incomes “socialistic,” and warn loudly about the dire consequences for a free enterprise economy if Washington and Whitehall suppress their astonishing bonuses. Wherever his spirit rests, Benjamin Franklin must be livid. When the hardearned savings of ordinary people are looted to enrich greedy bankers, and when they are told that this process is necessary to make America prosperous again, no wonder so many citizens have displayed so much anger at “Tea Parties.”

...the big, bad, bonused bailout banks (Hereinafter called the B5)...

But the problems of the thrifty members of the lower- and middle-classes who are losing so heavily from Zero yields may not continue endlessly in a Japonaise stasis. They could get worse: today’s extreme monetary policies and humongous deficits are laying and fertilizing the seeds of the next inflation, which will be characterized, in the early stages, by sharp increases in the prices of such necessities as food and fuels. Milton Friedman correctly predicted in 1973 that fast monetary expansion at near-Zero real yields would ultimately trigger inflation—and he was vindicated when US CPI reached double-digits during the next recession. We recently participated in a panel discussion organized by the Canadian Consulate in Denver. The lead speaker was David Dodge, retired Governor of the Bank of Canada. (Longtime readers will remember that we were calling him “North America’s Greatest Central Banker” during the years when Alan Greenspan was being accorded mythic powers.) We were there to discuss when and how governments and central banks should employ exit strategies from their current expansionary policies. With one exception (a portfolio manager who insisted government deficits should be expanded until unemployment reached zero), the panel agreed that the level of current monetary expansion and deficits was unsustainable and potentially dangerous. Mr. Dodge was particularly eloquent on the high risks of maintaining current monetary and fiscal policies. He is really worried about the potential for worrisome inflation and much higher interest rates that would choke off any recovery.

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The Power of Zero

Zero T-Bills form the base of a debased debt market.

The first sign that the foreign central banks who’ve been trying to protect their currencies from over-appreciation against the dollar may be reassessing their forex strategies came with last week’s announcement by the Reserve Bank of India that it was swapping a portion of its holdings into 200 tonnes of gold the IMF is selling. That helped send gold to new highs. MacroMavens, a routinely brilliant and thoughtful contrarian research publication produced by our friend Stephanie Pomboy (who presciently predicted the Crash with her in-depth studies of banks’ balance sheet problems and the unfolding real estate collapse), issued the following chart last month: Global Forex Reserves Real vs. Nominal (adjusted for the dollar decline) February 1, 2003 to October 23, 2009 3.2 3.19

2.9 2.6 2.3 2.0 1.7 1.4

1.06

1.1 0.8 Feb-03

Oct-03

Jun-04

Feb-05

Oct-05 Nominal

Jun-06

Feb-07

Oct-07

Jun-08

Feb-09

Oct-09

Real

Source: Stephanie Pomboy, MacroMavens, LLC.

The chart displays the extent of the monetary masochism of the banks abroad whose purchases keep yields across the curve on Treasurys, Fannie and Freddie at unrealistically low yields. Zero T-Bills form the base of a debased debt market. As troubling as Zero is for savers, it also poses problems for portfolio strategists….

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The Problem of Zero in Portfolio Construction Although portfolio construction for pension and endowment funds has become far more sophisticated and mathematical in recent years, its basic process can be easily summarized. In the classic capital asset pricing model for balanced portfolios, the investor sets the projected long-term rate of return for the “Risk-Free Asset” (Cash) and then assigns expected return rates based on volatility and endogenous risk assumptions for the other asset classes that are under consideration for inclusion in the Fund. The expected rates of return rise along with the perceived risks in each asset class. An Efficient Frontier is then created that mathematically balances risk and reward to achieve the minimum needed rate of overall portfolio return. A pension fund meets its regulatory requirements for funding if the value of its current holdings, plus the compounded projected returns of the asset classes meet its liabilities.

How does a portfolio optimizer deal with the Problem of Zero?

We have participated in many such portfolio designs over the decades, and well recall how high rates of return on Cash bedeviled the process. When the risk-free rate was as high—or higher—than the historic long-term rate of return on equities, it meant committees had to use the long-term rates on Cash to build the model. That was accomplished by assuming a lower rate going forward, because the duration of Cash is near-zero. Moreover, as of August 1982, when the Reagan bull market began, the Constant Dollar Dow Jones was at 1929 levels, indicating that the only real returns that had been earned on equities in 53 years were dividends. How does a portfolio optimizer deal with the Problem of Zero? The obvious answer might be, “Easily. It means all asset classes are hugely attractive relative to Cash and no allowance for Cash will be made apart from minimal liquidity concerns.” A more thoughtful answer should be, “Zero Cash means big problems for overall construction. Assuming that a Fund needs to earn a nominal 7% overall, net of fees and costs, then the higher the Cash component, the higher must be the rate of return assumptions for the other asset classes. Without tinkering with those assumptions, then the higher the Cash component, the higher the risk and volatility the portfolio must assume. Such asset classes as Junk Bonds, Leveraged Loans, and small Emerging Markets might have to be quite big commitments for the Fund to meet its objectives.” This is a challenging time to be designing pension fund portfolios—or asset mixes for individual investors.

November

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The Power of Zero

...capitalism has failed its most basic test—delivering higher returns to investors than was paid on risk-free government bonds.

According to BCA Research, US stocks have delivered an annual compounded real rate of return of negative 4% for the past decade, while 10-year Treasurys have given a positive annual real rate of 3.6%. (Embarrassingly, gold was the top-performing asset class, delivering an annual real rate of return of 10.8% in that same time period. Commodities futures did 5.2%. How many consultants or equity analysts during the perfervid period when tech stocks were heading skyward told pension plans gold bullion would do three times as well as US stocks for the next decade? Or, for that matter, how many told their clients Emerging Markets shares would outperform the S&P by a compounded real rate of 11.5%?) Amid all the enthusiasm about soaring stocks and an economic recovery, it is wise to retain one’s perspective about what has happened to investors. Last week, the Bank of America summed up the disappointments of our era for institutional investors. It noted that there were 42 trading days left this year, and the S&P would have to rise 42% to deliver a Zero rate of return for the past decade. By some calculations, on a compounded basis, long Treasurys have outperformed the S&P since the beginning of the Reagan bull market. The problem with those data is that they assume sustained reinvestment of interest at the long end of the curve, but most bond managers would have been below benchmark duration for extended periods, which meant their cash income would have been reduced. Apart from that nitpick, what that number shows is that capitalism has failed its most basic test—delivering higher returns to investors than was paid on risk-free government bonds. And this was the best of all times in the best of all capitalist worlds: classic economic liberalism was becoming the fashion everywhere outside North Korea, most of the Arab world, and Cuba. There were more playing fields for multinationals than ever, corporate tax rates were generally declining, there were no major wars, the supply of highlyeducated engineers, MBAs and CFAs was at record levels, and business was more respected than it had been since the onset of the Depression.

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And yet a robot reinvesting 30-year Treasury coupons would have outperformed the S&P Index—which itself outperformed most managed accounts. Constructing a pension fund portfolio and projecting its forward returns in the Age of Zero could be termed “a faith-based initiative.” One of the biggest cheerleaders for the 1990s US bull market was Jeremy Siegel. The first edition of his best-selling Stocks for the Long Run came out in 1994. His data demonstrated the near-certainty of stocks as winners showing inter alia “For horizons of 20 years or more, bonds are riskier than stocks.”

These bankers toil not much, but they spin like mad...

Then came Nasdaq’s Triple Waterfall Crash and a recession, and his “Absolute Law” had joined the phlogiston theory in history’s trash heap. After the 2008 Crash, we were hit with blizzards of advice about how wise it was to hold Cash. Some money managers got heavily into Cash before the Crash, and many other managers assured worried clients that they would be holding higher levels of Cash until the next bull market was established (whenever that happened). The amount of Cash and Excess Bank Reserves in the US economy is at all-time records, mostly because of Bernanke’s panicky doubling of the Fed’s balance sheet. But this is a construct, not a solidly-based financial reality. It recalls a well-known passage in the Bible: Consider the lilies of the field, how they grow. They toil not, neither do they spin: And yet I say unto you, not even Solomon in all his glory was arrayed like one of these. Cash was splashed among the B5 to array their balance sheets, which were looking Gandhian in their skinniness. But the B5 re-deposited a huge slug of those funds with the Fed as excess reserves: why go through all the nuisance involved in making loans to individual companies? They also bought up the Treasury curve. These bankers toil not much, but they spin like mad: they keep trying to convince us that they didn’t cause the Crash, and they really deserve their big bonuses.

November

17

The Power of Zero US Monetary Base (adjusted for Changes in Reserve Requirements) January 1, 1970 to October 30, 2009

Source: St Louis Federal Reserve, database: FRED® (Federal Reserve Economic Data)

Fed Funds (Effective Federal Funds Rate) January 1, 1970 to November 6, 2009

Source: St Louis Federal Reserve, database: FRED® (Federal Reserve Economic Data)

30 Year Mortgage Rates April 1, 1971 to October 1, 2009

Note: Shaded areas indicate US recessions; seasonally adjusted Source: St Louis Federal Reserve, database: FRED® (Federal Reserve Economic Data)

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Wall Street keeps reassuring us that it will eventually earn satisfactory returns on its trillions in complex mortgage-backed derivatives. But the courts could pose a problem for the holders of these dubious products. Wall Street packaged vast numbers of mortgages of quality ranging from hopeless to malodorous to acceptable to high quality. Because of their variety—regional and otherwise—the Street arranged to create a servicing agency that would handle the payments and enforce the covenants.

As millions of the mortgages in those putrescent packages went into arrears...

As millions of the mortgages in those putrescent packages went into arrears, they were foreclosed. In two recent court decisions, the mortgagors have been able to defeat or delay foreclosure by arguing that the agent could not prove it had a direct financial interest and could not produce the real owner(s). These decisions—which could put a large percentage of US home mortgage debt at risk from something other than mortgagor default—are under appeal. Those courts agreed with mortgagors’ assertion that they have a common-law right to negotiate with their mortgagee about altering the terms of the loan prior to completion of foreclosure. Produce, the judges, demanded, the mortgagees. It certainly makes sense to us that a person’s home is his castle, and it can only be put at risk in a transaction made between consenting adults. So tens-of-trillions in face value of mortgages in arrears held by those who didn’t know to whom they were lending—or whether the borrower even had a job or was in jail—might not, according to this theory, be legally foreclosed because the mortgagor and mortgagee never knew each other. All those math and physics PhDs who built the products, and the bankers who distributed them, never thought about a principle in mortgages that dates back to the 14th century and the emergence of Courts of Equity. (That’s where the word “equity” comes from.) Equity was based on the Chancellor’s religious-based concern for welfare of people of the middle- and lower-classes who suffered under the rigors of Common Law. If more US courts decide that those ancient protections for homeowners need to be protected against derivatives, the results for the B5, Fannie and Freddie would be very…..interesting.

November

19

The Power of Zero Zero and Market Volatility Why is it that all risky asset classes suddenly seem positively correlated to each other? They dance to the global risk music of the markets.

The answer is that near-Zero borrowing costs at a time banking systems are being flooded with funds—both from government-insured deposits and the buildup of liquidity from the Fed—constitute an historically-unique inducement to the big banks and to their leading hedge fund clients to borrow and speculate. Last week, according to The Wall Street Journal, the World Bank expressed alarm about “asset price bubbles in equity markets across Asia, and in real estate in China, Hong Kong, Singapore and Vietnam,” and the IMF chimed in with fears “that surging Hong Kong asset prices are driven by a flood of capital ‘divorced from fundamental forces of supply and demand.’’’ Hong Kong, of course, pegs its currency to the dollar, which means it outsources its monetary policy to Ben Bernanke. The Zero rate automatically means a weak dollar—here and in Hong Kong. To a somewhat lesser degree it means a weak renminbi. Central bankers have soothed us with assurances that rapid monetary growth will not trigger inflation as long as economies remain weak. But they said that in the 1970s, and commodity inflation proved them wrong. The price of oil in recent months has traded almost in inverse lock-step with the value of the dollar. This isn’t the longer-term adjustment that characterized the 1970s—it’s occurring in real-time. This daily activity mocks the reliance traders used to place on actual data about oil supplies and demands—particularly the weekly data about US supplies of oil and refined products. Many of the metals—notably aluminum—no longer trade primarily based on LME inventory data. They dance to the global risk music of the markets. Stocks trade together globally on a day-to-day basis. Yes, Emerging Markets continue to outperform the S&P, rising more than New York on bullish days, and not falling as hard, on days risk is being unwound.

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The Barons of the B5 are reporting record trading profits, which means, as Nouriel Roubini warns, that systemic risk is increasing, not decreasing. The locus of this new risk has moved from toxic, untraded products whose values are shielded against market pricing to marketable investments of nearly all stripes. That the Canadian dollar should rise and fall with metal and oil prices is not surprising, but the euro also rises and falls, though not as much, as the loonie on days of dollar weakness as dollars are borrowed and invested outside the dollar zone in commodities and stocks across the world. Problem: if the US economic recovery falters, a myriad of global risk assets could be simultaneously subjected to the same kind of risk-unwinding devastation as occurred after the Midnight Massacre and the collapse of Lehman, which were US-specific events. But this time, the Fed and most other central banks would not be able to unleash needed liquidity by lowering rates.

...the thousands of regional US banks on which an economic recovery depends.....have to make their money the old-fashioned way—and that’s tough these days.

The banking crisis was tied initially to subprime and other illiquid and unmarketable assets. The Fed, the Bank of England and the European Central Bank have taken trillions in overpriced toxic assets from the banking system, directly, and through support of mortgage lenders such as Fannie and Freddie, the Federal Home Loan Banks, and various European lenders. (The Financial Times cites a Bank of England study that pegs total government and central bank aid to private financial institutions at $14 trillion, which it calls “socialism for the rich.”) That unprecedented process was designed to prevent a Depression, revive the banks, and free their capital for productive lending. However, the B5 banks have used the funds to reload their trading desks, concentrating on marketpriced assets and derivatives tied to those assets. As for the thousands of regional US banks on which an economic recovery depends, they have not participated in the sudden explosion of trading profits that have restored the B5 banks and their bloated bonuses. They have to make their money the old-fashioned way—and that’s tough these days.

November

21

The Power of Zero KBW Regional Bank Index ETF (KRE) relative to S&P 500 November 10, 2008 to November 10, 2009 110

...Main Street was watching in horror the trillions going to Wall Street while the lenders communities needed most were cutting back on lending...

100 90 80 70 60

57.34

50 Nov-08

Jan-09

Mar-09

May-09

Jul-09

Sep-09

Nov-09

As clients are aware, we have long believed that the real US economy depends far more on the health of Main Street banks than on the machinations of the B5. And Main Street is hurting: more and more regional banks are folding, and the FDIC Fund that insures bank deposits is the next government money pool to face drainage. (The huge Federal Housing Act pool is also being drained rapidly, but it’s lumped into overall Treasury statistics and can be replenished without special legislation.) CIT’s bankruptcy is a synecdoche for Main Street America’s problems. As the largest factoring company, it has been—for many decades—a reliable backstop for small and medium-sized businesses across America. Companies assigned their receivables to CIT, thereby allowing them to continue to sell their output profitably, even to sophisticated giants such as Walmart and Amazon, which are famously successful at boosting their cash flows by delaying their payments to suppliers for months. Their local banks would assist in financing inventories and making loans for capital investment secured by real estate liens and owners’ personal guarantees. CIT is now operating in bankruptcy, but it is hardly in shape to perform its historic functions as demand for factoring rises in response to an economic recovery. The “Tea Party” rages about the stimulus and bailout programs were signs that Main Street was watching in horror the trillions going to Wall Street while the lenders communities needed most were cutting back on lending, and were buckling under the weight of their heavy exposure to local construction loans backed by mortgages on properties whose values were plunging.

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The spreading bankruptcies in shopping centers haven’t just devastated major operators like the Bucksbaums. Many of the shops in those centers are locally-owned, and as vacancies spread across the centers, the surviving shops suffer sharp declines in walk-in business—and they default on their bank loans. The KRE has fallen to a new low on Relative Strength against the S&P at a time of a booming stock market and record bonuses within the B5. This is really bad news for small and medium-sized businesses, which are the traditional engines of job creation. And the proprietors of those businesses are, as industry surveys show, very worried about the effect of today’s gigantic deficits on tomorrow’s income tax rates.

The...KRE is... the most reliable indicator of whether the panoply of political programs is truly kick-starting a sustainable US recovery.

The realization that the trillion-dollar deficits are destined to continue, even when the economy gets back to sustained growth, frightens them. They hear that they will be subject to much higher taxes on “the rich,” and hear that the term “rich” means people who earn more than $500,000 a year. (According to The Wall Street Journal, if the tax rate in 2007 were 100% on Americans earning over $500,000 a year, that would have generated just over a trillion in Treasury receipts.) The 1990-page health care legislation not only has the “millionaire’s taxes” on those earning above $500,000, but imposes high extra taxes on small businesses which do not offer health care to their employees. Doubtless, local bankers will be looking at the effects of these permanent tax increases and mentally marking down their customers’ ability to service their loans in future years. There will not be the kind of sustained US economic recovery that will drive a sustained US bull market until the shares of the Main Street (KRE) banks begin to outperform both the B5 banks and the S&P. The relatively obscure KRE is, we believe, the most reliable indicator of whether the panoply of political programs is truly kick-starting a sustainable US recovery—and whether the optimism of US equity investors is justified.

November

23

The Power of Zero KBW Regional Bank Index ETF (KRE) relative to KBW US Bank Index (BKX) June 22, 2006 to November 10, 2009 180

The life insurance industry wasn’t built on issuing term policies to cardiac cases in the Intensive Care Units.

160 140 120 102.79

100 80 Jun-06

Oct-06

Feb-07

Jun-07

Oct-07

Feb-08

Jun-08

Oct-08

Feb-09

Jun-09

Oct-09

No one can predict the limits on the capacity of the Fed and Congress to keep finding new money to spend on rescues and stimulus. When the crisis was in its early stages, Bernanke told Congress, “We’ll do whatever is necessary” (to rescue the economy). Obama and Congressional leaders have made similar pledges. But there are limits on what even the Fed and Congress can do. At some point, conditions have to return to normal and the regional banks have to take up the slack. Then—and only then—will investors be able to safely conclude that the recovery has become the reality to be used in valuing all financial assets. The life insurance industry wasn’t built on issuing term policies to cardiac cases in the Intensive Care Units. We continue to recommend that clients take advantage of the stock market’s Zero-based budgeting of financial risk—and scale back their exposure to US economy-related shares. With the forward P/E on the S&P reaching 19, it seems to be priced on the assumption that if Goldman is paying record bonuses, the economy’s underpinnings are now strong enough to support fast economic growth. Can stock prices fall even as liquidity flows surge amid Zero rates and Zero monetary restraint? The Greenspan bubbles that collectively came to be known as the Greenspan Put gave us Nasdaq at 5,000 and other enormities. Barring a multi-year recovery that drives unemployment to relatively painless levels, this bubble could make Greenspan look like a piker. A tale from Main Street (or, more precisely, Chicago Avenue)….

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Sunday in the Park With Feds The Park National Bank has long been a fixture on Chicago’s Gold Coast. We walk by it nearly every business day. With a lovely building, a spacious parking lot, and a location near Washington Square Park, it has always represented prudence and prosperity—just what an upscale community expects from its local bank. Then, on Sunday November 1st, it was taken over by the Feds. It was wellcapitalized, and then it was toast. Why?

...it’s probably the first time that [Geithner] praised a bank for good management and gave it a big gift for future programs after it had ceased to function.

It was owned by a failed bank holding company that had two bad banks in Texas, three in California and one in Illinois. Among the now-necrotic investments those banks made during the bubble years were the preferred shares of Fannie and Freddie. As The Wall Street Journal reported, “When regulators shuttered the flailing [sic] banks after closing hours…the FDIC leaned on Citizens National Bank and Park National Bank…to foot the bill. ‘The two banks were unable to pay the amounts assessed and were closed by their chartering authorities,’ the agency said.” It is a measure of these frenetic times that Park National’s demise came only hours after Tim Geithner—at a ceremony in Chicago—awarded the bank $50 million in tax credits to “to help spur community-development projects in low-income communities.” (Geithner knew nothing of the closure. The FDIC keeps bank closures secret until they actually happen. It’s not the first time Geithner’s been chatting with management of a bank about to vaporize, but it’s probably the first time that he praised a bank for good management and gave it a big gift for future programs after it had ceased to function.) But the good news is that after some bank deaths, there is resurrection. US Bancorp bought the collection of nine good and bad banks, the FDIC wrote off $2.5 billion, and Park National has reopened as a branch of Minneapolisbased US Bancorp. What? We worry?

November

25

The Power of Zero Zero Rates and Gold Gold November 1, 2000 to November 10, 2009

...the most-cited argument against investing in bullion has been that it’s sterile...

1,115.50

1,100 950 800 650 500 350 200 Nov-00

Nov-01

Nov-02

Nov-03

Nov-04

Nov-05

Nov-06

Nov-07

Nov-08

Nov-09

Fed Funds November 1, 2000 to November 10, 2009

Source: St Louis Federal Reserve, database: FRED® (Federal Reserve Economic Data)

For as long as there has been a free market in gold, the most-cited argument against investing in bullion has been that it’s sterile: it pays no interest or dividends, so why should anyone own it? It’s not as if it were a painting by Rembrandt or even Renoir that has unique scarcity value. There’s lots of gold, there’s lots of gold mines, and nearly all the gold that’s ever been mined is still above ground and is either in vaults or in jewelry.

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So why, at a time when consumer inflation seems little more threatening than attacks from vampires, is gold leaping to new all-time highs even if adjusted for compounded inflation back to the date of the release of the classic Dracula (1931). Some possibilities: 1. It’s a risk asset, so it’s benefiting from the rush to risk. 2. Borrowing at Zero to buy something with Zero yield is income-neutral. 3. It’s the only asset that, based on history, outperforms under both horror stories—Depression and Hyperinflation.

So why, at a time when consumer inflation seems little more threatening than attacks from vampires, is gold leaping to new all-time highs...

4. Its upside breakout came at the time of Halloween. 5. India announced purchase of half the hoard on offer from the IMF, which had been weighing on gold prices, and there are rumors that China will take up the rest. This was the second surprising announcement from India within a fortnight. The other was that the United Arab Emirates had displaced such nations as the US, China and Germany as India’s biggest trading partner in recent months. Apart from tea, and gold in the form of baubles, bangles and beads, what big-ticket exports other than bullion could India be sending to that collection of gold-loving states? It’s no longer exporting rice or sugar. 6. Statistics from across the world confirm that the economic recovery is gaining steam, so the specter of inflation is moving stealthily from deep in the primeval forest toward the main path. Travelers beware. 7. Barrick CEO’s statement in London about the continuous decline in new gold mine output, suggesting, “There is a strong case to be made that we are already at ‘peak gold’.’’ The golden rule of commodities has been that the cure for high prices is high prices: when the price of stuff goes up, big new production always follows, and the price goes down. Gold’s price has more than quadrupled, but new-mine production keeps falling. With central banks apparently switching from the sell to the buy side, this may be a new world for the oldest store of value. 8. All of the above.

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The Power of Zero

We do not share these morbid fears, but no longer characterize them as the particular problems of the perpetually paranoid.

Is gold overvalued? In terms of a reliable historic indicator, it may depend on how you define a gentleman. The Economist once sought to find a true value of gold with a study showing that, for most of the time since the Middle Ages, an ounce of gold would buy a gentleman’s suit in London. That was not the case on Jermyn Street from 1981 through 2007 even for the lessprestigious tailors. With the recent decline in the pound, it is now applicable to the shops located more than two blocks from St. James’s Street. (It hasn’t, we believe, applied at Savile Row since King Edward’s time.) As gold and silver rise to higher peaks, we hear more and more stories that serious investors are demanding bullion—not financial paper, whether in futures or in the gold ETFs. (The GLD has been termed, “The small investor’s central bank.”) Some prominent skeptics question whether the ETFs actually own all the gold they claim, or whether they depend on counterparties to make delivery. The core attraction of gold for those who fear an epochal financial crisis is the absolute reliability of bullion—the only asset that is no one’s liability. These investors are now shying away from any investment that relies on counterparties or on regulation by any financial authorities. Roosevelt made ownership of gold illegal by Presidential order. Could such intervention occur again? Impossible, say bankers. A skeptic might well note that no one predicted the scale of intervention into financial markets from governments and central banks that began with the Midnight Massacre, so why should gold claims that need to be satisfied with futures contracts or other counterparty arrangements be forever immune from attack? We do not share these morbid fears, but no longer characterize them as the particular problems of the perpetually paranoid.

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The Power of Zero INVESTMENT ENVIRONMENT David Dodge began his speech in Denver by saying, “This is a rebound, not a recovery.” He considers it a snapback from an oversold position, fueled by record amounts of monetary expansion, subsidies and deficits. He was not very confident about the prospects of a sustained recovery, without some setbacks. We find ourselves bemused by the confidence displayed by forecasters who (1) didn’t predict the Crash, and (2) use charts and tables from past economic recoveries in proof of their assertions that the best is yet to come—and nothing really painful lies in between.

“Stein’s Law”, which has never been repealed, may be ready to be proved anew...

We freely admit we don’t know what’s going to happen to the US economy over the next five years. But we do believe that Americans aren’t going to live happily ever after if regional banks’ finances continue to weaken. The challenges: 1. The root cause of the financial and economic collapse—the demographicallydriven plunge in real estate prices at a time of serious over-leverage in the housing sector—remains a clear and present danger to banks and other financial institutions. 2. All the US government’s home mortgage lending institutions are experiencing rising losses, despite the slight uptick in house prices. That barely-observable bounce is due to most drastic price maintenance program in history—taxpayer bailouts of lending institutions, the Fed’s huge subsidy to mortgage rates through purchases of Fannie and Freddie paper, and 10-year notes, and the First-Time Homebuyer Subsidy of $8,000. It took all those trillions to get house prices to rise 4% from their panic lows. Why should investors be confident the rally will continue? “Stein’s Law”, which has never been repealed, may be ready to be proved anew: “If something cannot go on forever, it will stop.” 3. Bernanke will have used up his entire declared quota of purchases of long Treasurys and mortgage-backed paper within a few months. Then what? 4. Commercial real estate grows sicker each month, as office and condo vacancy rates rise, and more and more regional banks go to the wall. 5. The biggest contributor to the 3.5% economic growth of the Third Quarter came from the Cash for Clunkers program. That is gone.

November

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The Power of Zero

The current noise on Detroit assembly lines could turn out to be a death rattle.

6. The only US auto company to report positive cash flow in the Third Quarter—Ford—still struggles with a boom-year-negotiated UAW contract that means its labor costs are much higher than the other members of what used to be known as The Big Three. Since the UAW and Washington effectively own those competitors to Ford, there’s slim chance the union will do anything to strengthen Ford: if Ford collapses, so much the better for the union-owned Big Two. Chrysler has no hot new products in the pipeline and an ambiguous management agreement with Fiat. GM is adjusting to a shrunken product base and its finance subsidiary, GMAC, has already received four emergency cash infusions from Washington since the bankruptcy. Hyundai, no friend of the UAW, is the hottest company in US sales. The current noise on Detroit assembly lines could turn out to be a death rattle. 7. What may have been the most useful consumer economic stimulus—the collapse in gasoline prices—is fast becoming a cherished memory. Gasoline prices have already retraced roughly half their plunge. That most useful of all “tax cuts” is being chipped away, as other taxes at federal, state and local levels face inevitable increases. 8. Although overall consumer inflation remains near the Zero level, food prices continue to rise relative to other costs, and natural gas prices are no longer at remarkably cheap levels. 9. And it looks to be a cold winter—atmospherically and otherwise. So what should investors do? Although commodity stocks underperformed the S&P from June through September, they have resumed the outperformance they displayed for most of this decade. Meanwhile, China’s rush to lock up global supplies of industrial commodities continues at breakneck speed. Niall Ferguson predicts that by mid-2010, China will be a net seller of Treasurys because of its fast-growing allocation to commodities. Nor is China alone: Indian companies are now scouring the globe for commodity-producing assets, and Saudi Arabia is buying grain land in many parts of the world. As much as we are concerned by the insouciance of US equity investors, we remain convinced that investment in commodity stocks has both lower endogenous risk and higher long-term potential than US equities generally.

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As we learned from the aftermath of the Midnight Massacre, commodity stocks can be savaged at least as ruthlessly as other stocks when the margin clerks take charge. However, owning the shares of the companies which own the resources that China, India, Korea and other major new economic powers need most is, surely, the soundest of long-term-oriented equity strategies. Meanwhile, astronomers who have for years assumed that solar activity would remain at such levels that the world would have to cut back sharply on its CO2 and methane emissions to prevent disastrous global warming have begun to ponder the dramatic evidence that the sun has become virtually silent. Even David Hathaway, NASA solar physicist and sunspot expert, admits that he and many of his colleagues are now discussing the possibility (still unlikely) that the collapse in sunspots and solar winds could mean that Planet Earth faces something like the Maunder Minimum (1645-1760). According to NASA’s own statistics, the world was really cold for that period—known as the Little Ice Age. In the new “SuperFreakonomics,” the authors remind us that 30 years ago, many of the leading experts were warning the world faced a new Ice Age, and were advocating radical policies to warm Earth up.

The Copenhagen Kaffeeklatsch looms: it seeks to bind the industrial world into promising a scaleddown Bonnie and Clyde leap into a government controlled economy...

The Copenhagen Kaffeeklatsch looms: it seeks to bind the industrial world into promising a scaled-down Bonnie and Clyde leap into a governmentcontrolled economy in which the overarching priority is cutting down on greenhouse gases. There will be sustained constraints on economic activity to produce tiny reductions in global temperatures decades in the future. The evidence that the trend to warming has ceased in the past decade—and is actually reversing—is rejected. It is as if a patient were told his leg had to be amputated because of a risk of infection, even though the patient’s temperature had fallen from its peak and his other bodily signs were tending toward normal. Al Gore, who admitted to Congress that his net worth had risen from $1 million to $100 million through his varying involvements in green investments, warns in his latest screed that new evidence shows that the warming is actually worse than previously estimated. He reiterates his claim that hurricane activity continues to increase dramatically, although, as George Will writes, this year the East Coast’s hurricane experience was half the average of the last fifty years.

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The Power of Zero Whenever there is a huge disparity between what nearly everybody who matters believes and the actual conditions of the economy or the world, investors who are prepared to bet that reality will eventually assert itself can win big. ...investors who are prepared to bet that reality will eventually assert itself can win big.

This could be one of the biggest such disjunctions in modern history. Yes, the sun could suddenly go back to emitting sunspots at the rate of the previous century. Yes, scientists still maintain that, despite eight centuries of evidence of a correlation between sunspot activity and recorded temperatures on Earth in the 80% range, there is no scientific proof that this is anything but coincidence. Damon Runyon observed, “The race is not always to the swift, nor the battle to the strong, but that is the way to bet.” In a chat with a knowledgeable investor last week, he commented on Warren Buffett’s willingness to pay so much for Burlington Northern. That railroad, he observed, has two main businesses: transporting manufactured goods from the West Coast to the East, and transporting steam coal from the Rockies. Coal stocks are, perhaps, potentially the biggest losers from the Administration’s climate change legislation and regulations. If investors began to conclude that the scientific community were going to reconsider its view on global warming because of the plunge in solar activity, many companies’ shares would benefit big, but probably none more than those of the US coal companies.

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The Power of Zero RECOMMENDED ASSET ALLOCATION Recommended Asset Allocation (for U.S. Pension Funds) Allocations 17

Change unch

Foreign Equities European Equities Japanese and Korean Equities Canadian and Australian Equities Emerging Markets

5 2 11 14

unch unch unch unch

Bonds US Bonds Canadian Bonds International Bonds Long-Term Inflation Hedged Bonds

12 8 11 10

unch unch unch unch

Cash

10

unch

Years 5.25 5.00 4.50

Change unch unch unch

US Equities

Bond Durations US Canada International

Global Exposure to Commodity Stocks

Precious Metals Agriculture Energy Base Metals & Steel

33% 33% 22% 12%

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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The Power of Zero INVESTMENT RECOMMENDATIONS 1. Remain underweighted in US equities—as a percentage of total equities within global portfolios, and as a percentage of assets in US balanced portfolios. Underweight US bonds in global portfolios. The Obama long-term financial projections for the US are high risk and unsustainable. Forthcoming elections—or a currency crisis—could induce some discipline, but within the OECD, the US should probably no longer be accorded top ranking for bonds and stocks. 2. Within the US market, underweight US economy-related stocks and overweight stocks tied to global economic activity. Watch the performance of the KRE compared to both the BKX and S&P. As long as the KRE underperforms both of these indices, US-economy-related stocks remain suspect. 3. Overweight Emerged Markets (such as China, Brazil, India, and Korea) within global and international equity portfolios. These markets should no longer be routinely discounted heavily for political risk or accounting practices relative to the US. The credibility gap has narrowed in the past year. China continues to report robust economic activity and skeptics continue to proclaim—as they have for years—that it’s unsustainable. The time to sell China, and, for that matter, base metal and energy stocks, is when the last remaining Sino-skeptic has become unemployed. 4. Overweight the precious metal miners relative to bullion or the ETFs. The time to overweight the ETF is when precious metal prices have entered corrections. The XAU and other gold stock indices have underperformed bullion for the past two months because of a succession of bad news announcements for such heavyweights as Barrick, Kinross and Agnico-Eagle. True, we can’t be sure there won’t be more reports of disappointing execution among the miners, but they have the reserves in the ground, and the best of them have “unhedged reserves in politically-secure areas of the world”. Investors who believe current prices could hold should do NAV calculations on the miners based on current gold and silver prices, and they will see excellent opportunities in the stocks.

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5. Overweight the leading agricultural stocks. The farm equipment, seed and fertilizer stocks are core investments for the next cycle. With one of the coldest and wettest Octobers on record, Midwest farmers’ crops at October-end were overdrenched, overdue and overrun with blights and moulds. Recent warmer and dryer weather has improved yields, and the heaters are working overtime to dry out what has been harvested—and corn and soybean prices have pulled back slightly from their recent highs. Global carryovers will not increase this year, which means world food “surpluses” remain precarious—as evidenced by the sharp run-up in rice. 6. The base metals stocks have been the global commodity stars. The best stock market values now could be in the small-caps that are long on ore and short—or nil—in earnings. In retrospect, we should have recommended overweighting in this sector, but we were spooked by the collapse of the Baltic Dry Index and its subsequent failure to rally—and the relatively high levels of inventory on the LME. It appears that China has used some of its surplus dollars to get China overstocked on metals. 7. Overweight Canadian oil sands stocks within equity portfolios. The Canadian oil sands stocks continue to suffer bad press among the defenders of the planet about alleged environmental misdeeds and risks. Each dead duck listed in shocked reports sent across the world has been worth millions in reduced market cap for the companies. (The actual total number killed in this supposed replay of the Exxon Valdes is what a few hunting parties would collectively bag on a good weekend.) A major Canadian institution recently joined this parade of the super-chic by publishing a supposedly unbiased study on oilsands emissions that was prepared by two of that nation’s pre-eminent greenhouse gasbags. The institution could have achieved the same results by retaining Gore—but Gore costs more. Treat those fashionable emissions with caution—and treat your portfolio to oil sands stocks.

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The Power of Zero 8. Overweight Canada in both equity and fixed income portfolios, and remain long the loon against the greenback. In recent global rankings, Canada ranked #1 in the G-7 for its central bank, its private banks, and its Minister of Finance (who is the longest-serving in the G-7—a remarkable feat for a minister in a minority government). The principal knock on Canada is that it is dull. Dull has become the new shiny. 9. In balanced portfolios with an equity bias, do not hold high Cash exposures. Hold long-duration, high-quality bonds. If this rebound becomes a sustained boom, you will lose—rather modestly—on this exposure, but your equity holdings will appreciate substantially, and you will be a net winner. If it becomes a bust, you will win on the bonds, thereby reducing your overall portfolio loss. Long bonds now reduce short-term cyclical risk. As of October, speculators were hugely short 30-year and 10-year Treasurys and hugely long 2-year Notes—consistent with a bullish call on stocks and the economy. If that call swings to bearish, there will be a rush to the long end.

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