Bmo Cm Basic Points Sept 2009

Basic Points Dem Blues

September 3, 2009

Published by Coxe Advisors LLC Distributed by BMO Capital Markets

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Don Coxe THE COXE STRATEGY JOURNAL

Dem Blues

September 3, 2009 published by

Coxe Advisors LLC Chicago, IL

THE COXE STRATEGY JOURNAL Dem Blues September 3, 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

Dem Blues OVERVIEW The stock market’s September Song is traditionally the blues. If this year’s music of the markets follows the customary dance card, it will be a sharp mood swing from the splendid revels and boleros of spring and summer. Why should the blues be back? With the S&P up by a half since March, then the recession must be yesterday’s story, and the next bull market has begun. That’s what most of the major indicators—ISM, Leading Economic Indicators and their like—tell us. Using Fed Chairman McChesney Martin’s hoary punch bowl analogy, the trebling of the Fed’s balance sheet and sustained near-zero interest rates have done their work: the equities party this time isn’t just “interesting”—as it was in previous cycles—but nearly Rabelaisian. Except that it’s not just stocks that are rising: so are foreclosures, unemployment, bankruptcies, bank failures, and government deficits at all levels. The story of our time has become a Tale of Two Ditties: Roll Out the Barrel, and Brother, Can You Spare a Dime? This month, we update major cautionary themes we have been discussing in recent issues, in the light of months of ebullient stock markets, an increasingly bullish economic consensus, and a potentially historic shift in voters’ views of the financial and economic implications of President Obama’s policies. Each week, we read analyses from strategists and economists comparing this recession to its predecessors all the way back to the Depression, on the implicit assumption that we remain in an historic continuum. Yes, each downturn has some different characteristics than others, but the unstated axiom in the reasoning is that the US and other OECD economies today can be understood best by understanding how they have behaved at past turning points. In our view, this recession is unlike any other since the onset of the Industrial Revolution in two crucial respects: • it is the first to hit North America and Europe in which deteriorating demography is a key ingredient—and none of the policymakers and almost none of the elite economic forecasters even mention it; • it is the first in which the continued strength of the economies of China, and, to a lesser extent, India and East Asia, is widely recognized as the condition precedent to a global recovery, yet the consensus remains unwilling to draw the obvious conclusions from this historic transformation. September

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We believe that these unprecedented factors make forecasting the shape and strength of the US and European recoveries unusually difficult. Policymakers within the OECD nations are resorting to programs and remedies with roots in Keynesian and Friedmanesque formulas that either should have been used to prevent or end the Great Depression, or that have been employed in subsequent recessions with apparently successful results. But what if the world is changing so decisively that massive deficits and Depression-era interest rates will not produce—on a sustainable basis—the anticipated good results for the US and other major OECD economies whose demographic decay is even more serious than America’s? This month’s title is a riff on America’s unique music form. We use it to discuss (1) the implications of the continuing US demographic decay and (2) a possibly momentous shift in American confidence in the Democrats’ ambitious programs to reshape the economy after it escapes the recession. President Obama’s approval ratings have fallen precipitously since our last issue, as have the ratings for the Democratic Congress. If, with the postelection glow gone, the recovery were to falter, it would be very difficult for the President and his party to rally public support for new stimulus or bailout legislation, and investors worldwide might begin to factor a failed Presidency into their appraisal of US financial assets. The image of a handsome, smart, creative, popular President who would blow away the Bush Blues was wondrous for Americans’ view of themselves and the world’s view of America. If that image were to crack in Dorian Gray fashion, it could be a real negative for US equities and America’s ability to finance its coming decade of deficits. We believe most equity groups in the US are due for a correction that could be quite prolonged, but we remain bullish on Emerging Markets as an asset class, and on commodities and commodity stocks. Given that outlook, we think balanced portfolios should reduce endogenous risk. We are adjusting our Asset Mix to increase bond exposure—both in percentage and duration terms—and are reducing recommended levels of US and European Equities, and Cash.

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Dem Blues The world’s power balance is changing dramatically. If it continues to unfold as some leading forecasters predict, it would be one of a mere handful of gigantic power shifts that have shaped the history of the West. Here is a capsule summary of the tectonic shifts that reshaped the West:

The world’s power balance is changing dramatically.

1. Rome managed to unite the societies of the Italian Peninsula, and thereafter conquer most of the then-known world in an empire whose economic activity flourished for six centuries under the protection of Pax Romana. Rome’s legions achieved dominance over the major food-producing regions of the Mediterranean; the Silk Road became the linkage between Europe and Central and Eastern Asian civilizations, and those connections would define trading relationships for most of the centuries, until Europe discovered the sea route to Asia at the end of the 15th Century. The Roman Empire began to decline when...

Its internal contradictions and the costs of imperial overstretch led to the decay of Augustan values. Farmers abroad began to find ways to avoid sending their output to Rome. Piracy flourished anew in the Mediterranean. Inflation became endemic, and successive emperors resorted to currency debasement so the Roman denarius was no longer automatically accepted by traders abroad. The barbarians were able to sack Rome in 410 A.D. mostly because Romans had long since lost faith in their system.



The Goths and Vandals were mere looters, not empire-builders, so, during the Dark Ages after Rome’s fall, that power vacuum at the top was filled by a new military and economic power.

2. Islam’s astonishingly swift advance into Western Europe was finally halted by Charles Martel at Poitier in 732. But the Caliphates would remain an enduring challenge to their neighbors for another thousand years. It took until 1492 for Spain to dislodge the last remaining bastions of Muslim power in Western Europe. Constantinople and Trebizond fell to the Turks, and the Ottoman regime in Istanbul continued to control the Eastern Mediterranean until the new Rome—in the form of the Catholic Church—was able to assemble “The Holy Fleet” of Catholic states and crush the Turkish fleet in the Battle of Lepanto in 1571, (ranked as one of history’s decisive sea battles). Thanks to Arabic advances in mathematics,

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Dem Blues

Napoleon’s rise and fall had the unexpected effect of paving the way for the first truly global empire—Britain.

and control of the Silk Road, the Islamic world, despite its internal rivalries, was the most prominent economic force in the Mediterranean and Southern Europe, until the discoveries of the New World and the sea route to Asia. After losing control of Greece in 1821, Ottoman power declined, and by the late 19th Century Turkey was so weakened that it was dismissed as “The Sick Man of Europe.”

Europe was not able to offer a new candidate for international leadership during the centuries of Turkish power until it produced a nation with the requisite combination of military and economic pre-eminence. That took centuries.



Nation states only began emerging in Europe during the late Renaissance. Prior thereto, the growth of commerce proceeded from regional trade systems, such as the Hanseatic League, and the networks of Italian citystate banking and trading houses. No nation was able to project its power militarily on a sustained basis, thereby giving it control over trade patterns. The Hapsburg Dynasties and the Holy Roman Empire lacked cohesion, popular support, and integrated economic strategies. They were, however, noteworthy patrons of art and music. (Think Haydn, Beethoven and Mozart.)

3. Napoleon’s rise and fall had the unexpected effect of paving the way for the first truly global empire—Britain. For the first time in Europe’s history, a nation was able to prevent conquest by superior armies and ultimately destroy its attacker because of its navy, backed by its wealth and technology as the pre-eminent industrial economy. Despite the loss of its 13 colonies, Britain retained possession of a globe-girdling empire—“a domain created, [in De Valera’s words] in a moment of world absent-mindedness.” The British Navy’s prowess meant that Britain was able to maintain its far-flung empire, control piracy, source many of the materials needed by its industrialists, and maintain a free trade policy until… 4. Germany emerged as the industrial and military challenger to Britain. The German states were still only loosely united in 1866 when Prussia, under Bismarck’s leadership, conquered Austria. Five years later, Prussia overwhelmed France in less than nine weeks after the French leaders, in a display of utter folly, declared war in 1870.

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Bismarck took advantage of that victory to achieve German unification. His shrewd strategizing managed to contain Papal influence and overcome the historic enmity between the Catholic and Protestant states. The German Empire emerged as a global power able to challenge Britain. Bismarck had his own policy for German greatness: autarky. The new Germany had to become as self-sufficient as possible, so it could, if necessary, withstand a blockade by France on land and Britain at sea. In search of raw materials, it acquired African and Southeast-Asian island colonies, and it began to build a technologically-advanced navy that could challenge Britain’s rule of the waves. Backed by bourgeoning accomplishments from German scientists, an industrial colossus was born.



It was inevitable that Germany would eventually challenge Britain for world leadership. Both nations believed there was room for only one at the top.



When the Clash of the Titans finally came, both sides lost heavily, as the industrial and financial might of Britain and Germany bled into the trenches of World War I. Into this vacuum flowed the USA, the world’s newest—and largest—industrial power.

Bismarck had his own policy for German greatness: autarky.

5. America’s pre-eminence has continued to this day. In the Reagan era, it was able to best its only challenger—the USSR—without a major war through policies which would have evoked admiration from Bismarck: building and maintaining a superior military, (including the world’s strongest navy), and a superior industrial and technology-based economy that was also largely self-sufficient in food. During the lifetime of our readers, the USA has been the foremost power— economically and militarily. Who’s next at the top? Basic Points has frequently cited the prophecy of Oxford Chancellor Chris Patten, that the US will yield its economic leadership to both China and India in the first half of this century. This recession has put that process on fast-forward. History suggests that America’s unchallenged military pre-eminence will fade along with its economic ranking. Already, as Niall Ferguson observes, China’s fast-growing navy challenges traditional American hegemony in the Pacific.

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Dem Blues The Turning of the Page

It’s Asia that’s lifting the world...

The night-and-day contrast between the performance of the US and Chinese economies is finally beginning to attract the attention it deserves. On August 24th, The New York Times briefly averted its gaze from the search for green shoots, and took a lengthy look across the Pacific. It quoted Neal Soss, chief economist for Credit Suisse in New York: “The economic center of gravity has been shifting for some time, but this recession marks a turning point. It’s Asia that’s lifting the world, rather than the US, and that’s never happened before.” The report continued, “The United States is also being shoved aside as the make-or-break customer for export-driven nations like Germany and Japan. China overtook the United States as Japan’s leading trading partner in the first half of 2009, while in Europe manufacturers are looking east instead of west…Deutsche Bank released a report titled ‘Eurozone Q2 GDP: Made in China?’ French exports to China and other East Asian economies rose 18.7% in the second quarter…a sharp turnaround from the 16.2% drop in the previous quarter.” It concludes with a quote from Simon Johnson, formerly of the IMF: “It reflects how the world is changing, and economic power does translate, of course, into political power.” Indeed. President Hu Jintao lacks President Obama’s eloquence, but his progress in asserting China’s influence abroad means that nations across the world are looking at the numbers—including Obama’s plunging polls—and drawing their own conclusions about which nation they wish to take more seriously. The 19th Century French leaders watched enviously as the world began listening to Disraeli, Gladstone and Palmerston—and then Bismarck. Until recently, there were few forecasters who believed that the US would have to yield its hegemon status to China within a foreseeable time frame—if ever.

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Naturally, most forecasters deride this prediction. They note that there have always been naysayers who announced the coming end of the American era. One reason John Kennedy managed to win the Presidency was because so many Americans had accepted the view that was then so popular in intellectual circles that the vigor and vitality of Communism would make the USSR the world’s #1 economic and military power within a few years. Sputnik sparked something approaching panic among many Americans. How could a country so recently devastated by war not only get the Hydrogen Bomb, but also be the first into space? When Khrushchev banged his shoe at the UN and shouted, “We will bury you!” he had many US believers— notably in prestigious universities. Ho Chi Minh won his war mostly because a majority of Americans no longer believed the war was winnable, and a large percentage of American elites believed the US had entered decline.

Carter busied himself in turning out the White House lights, and musing about malaise.

Nixon’s disgrace, the Ford interregnum, commodity shocks, and stagflation combined to elect Jimmy Carter, who encapsulated the new consensus that American pretensions of pre-eminence were dangerously outdated in the new bipolar world. Even his trademark garb bespoke the national chastening: the cardigan was the sweater named for one of the British commanders who ordered the Charge of the Light Brigade. Carter busied himself in turning out the White House lights, and musing about malaise. His decision to withdraw all support from the Shah in favor of the Ayatollah Khomeini triggered the second oil shock, an inflationary recession, and the humiliation of the 444-day imprisonment of US embassy personnel in Tehran. At that point, the USSR looked like the only major nation with the right combination of military excellence and the strategic determination to gain and maintain power globally that were the requisites of global leadership. Fortunately, a President the elites ridiculed as a B-Movie actor managed to send Carter into retirement—and send the US to new heights of global power in both military and economic terms. So we should, perhaps, be cautious about assuming the US is on its way to second-rate status. However, it must get out of this recession and get back on the path to prosperity. When will that happen?

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Dem Blues Thinking About Tomorrow Six months ago, the regnant economic forecast held that the US would be the first of the major Western economies to emerge from recession. It was as if Santa Claus had suddenly been found and funded, and was now delivering on bagfuls of “Dear Santa” letters dating back to the Walter Mondale era.

When the recovery came, America would rejoin the global growth club, which was down to just two members—China and India. Neither came even close to falling into recession. The shared wisdom that America would lead the OECD back to prosperity was based, in part, on the appraisal of Washington’s rush to rescue American banks and stimulate the economy. The multi-trillion-dollar rescues of the Bernanke-Obama team, based on Keynesian and Friedmanesque models would, experts agreed, yank the US from its deep financial-driven recession, while Europe would remain sluggish—at best. That optimism asserted itself coming out of the March stock market lows, with the S&P soaring by 50%. However, although most economists believe the US has already emerged from recession, and total corporate profits, driven by ruthless cost-cutting, are soaring, new doubts are emerging about the sustainability of this force-fed recovery: • jobless claims, which had been declining week-by-week, suddenly upticked modestly in mid-August; • bank lending for economic activity isn’t growing; • foreclosures keep increasing; • the stimulus of extremely cheap gasoline is fading with the doubling of oil prices; • state and municipal governments are collectively in crisis, led by California, whose economy is larger than Canada’s; • the Pelosi-Obama stimulus program turned out to be a perfumed gallimaufry of old programs that had been silting up in party circles and pressure groups for decades. It was as if Santa Claus had suddenly been found and funded, and was now delivering on bagfuls of “Dear Santa” letters dating back to the Walter Mondale era. Of the $900 billion allotted by Congress in a crisis atmosphere, only $1 billion had been spent by June on those widely-advertised “temporary and targeted” programs that would put people to work building roads and bridges. (We are told that another $9 billion should be spent by year-end.)

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That is the Democratic Congress’s contribution to a quick, sustained recovery: doing things the old Washington way—earmarks and all—but doing them with a virtually unlimited budget. Enter Dem Blues. As deficits—current and projected for the next decade—soared to previously unimagined levels, voters began to reconsider their enthusiasm for Obama. Was “Yes, We Can!” not the great unifying force that would end the nation’s polarized politics, but the sales pitch for enacting the old, moldering, gaseous liberal agenda in the name of “Change You Can Believe In”?

...the White House was looking to a tomorrow—whose economy would not be a Carbon Copy of the present.

The Clintons’ theme song was Don’t Stop Thinking About Tomorrow. For the new hip-retro era, the theme song could be Everything Old is New Again, which includes: Don’t throw the past away You might need it some rainy day Dreams can come true again When everything old is new again Just right for the Administration that believes it would be a shame to waste a good crisis, and uses that series of rainy days to bring back the past’s pet schemes. As for the Clintons’ theme song, this Administration hardly wants to get voters “thinking about tomorrow,” when the taxpayers will be beset with endlessly rising demands to finance those trillions and trillions in annual increases in the national debt. As recently as 2006, the Democrats were blaming Bush for maiming the economy with deficits “that could never be repaid.” The Clinton era, in this roseate recollection, was a pre-Lapsarian Eden that Democrats could regain. No more deficits: deficits were evil. Now, we were told, as deficits soar to levels that make Bush’s look like the unreformed Scrooge, they are “investments.” In actuality, while the spending orgy on yesterday’s priorities was convulsing Congress, the White House was looking to a tomorrow—whose economy would not be a Carbon Copy of the present. Its Green sunlit uplands, warmed the right way by sunshine, not CO2, would be populated with millions of happy people performing Green jobs in wind, solar and renewable power, such as ethanol, and technologies as yet undreamt-of, but which would be born almost magically in American laboratories in response to vast “investment” by Washington.

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Dem Blues

Although trillions are hard to explain, voters understand that when billions are no longer worth talking about, maybe things are moving too fast.

Those uplands gambolers of the future would be protected by a health plan that would cover everyone and cost less—without putting any caps on trial lawyers, the #1 Democratic Party financing lobby. (The biggest single cost difference between Canadian and US health care systems is the contingent-fee system for American trial lawyers which isn’t allowed in Canada—or, for that matter, anywhere else in the common-law world. Only in America are lawyers’ fees and expenses payable by their clients, regardless of the outcome at trial. That difference means that corporate defendants routinely choose to settle without a trial, a practice that encourages costly, vexatious litigation. ) When we last published (June 8th), the Obama global warming and health programs looked to be on their way to the Oval Office for signature, backed by the President’s extraordinary popularity and persuasion skills. At that point, he was still the most-admired President since Roosevelt. What a difference three months make. The “Cap and Trade” bill (aka “Cap and Tax”) made it through the House of Pelosi, but it is in trouble in the Senate. The real sickness is in health care reform. Despite almost-daily Obama speeches and/or press conferences, public support for a major new plan has withered. Although he blames the Republicans, his own party is deeply divided. The Democrats have seemingly overwhelming majorities in both House of Congress, and should, one might have thought, been able to whoop through a new health program with little more delay than was accorded those other trillions in expenditures. However, Speaker Pelosi says no bill that does not contain a government health plan could pass the House, and Senator Dorgan says no bill that does contain a government health plan could pass the Senate. The shock to Obama and the Congressional Democrats came in August, at Town Meetings on Health Care across the land. Frightened, angry voters grabbed the headlines. Sitting Democrats were stunned by the fear and fury they encountered—not just from Republicans, but from their own supporters. When the Congressional Budget Office announced that the Obama program would achieve no meaningful cost savings, but would be part of an upwardly revised $9 trillion deficit over the next decade, public support withered. Although trillions are hard to explain, voters understand that when billions are no longer worth talking about, maybe things are moving too fast.

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According to last week’s Gallup, even the 50% of voters (down from a postelection high of 70%) who say they still approve of Obama are upset by the soaring deficits and their sense that he’s trying to do too much. They question his ability to reform education with vast expenditures spent on unionized schools, create a new health care system that will insure everyone but cost less, avert global warming, revive the US auto industry, reform Wall Street and kick-start the US economy into sustained growth. Obama has kept much of his non-liberal support by sticking with his determination to win the Afghan war with a new strategy and new leadership. He recently addressed the Veterans of Foreign Wars, promising victory in this “Good War.” But—and for that no fair-minded person should blame him—the Taliban has apparently regained the advantage across much of Afghanistan, and is also proving hard to dislodge from Pakistan. Obama’s determination on Afghanistan is eroding his support among the hard left wing of his own party.

It is rather sad to watch his magic fading like the Cheshire Cat’s smile...

It is rather sad to watch his magic fading like the Cheshire Cat’s smile, because the deeply-indebted United States cannot afford a failed Presidency. It would certainly help if he would stop blaming Bush for all the economy’s ills and admitted that his primary problem is the one that apparently cannot speak its name: the birth dearth.

The Birth Control on Economic Growth At the core of the financial collapse was the multi-decade collapse in birth rates—in America and across the industrial world. This is the first recession in which the inadequate supply of new first-time jobholders with the financial qualifications to become first-time home-owners was a proximate cause of the downturn. Backed by powerful Congressional Democrats through Fannie Mae and Freddie Mac, by the Greenspan Put, and Wall Street’s kamikaze resort to Long-Term Capital-style financial engineering, the criteria for mortgage lending were successively debased and debauched. Trillions in loans based on the conviction that house prices could only rise were granted to people who would never have qualified in earlier cycles. They were meant to make up for the dwindling supplies of new twenty- and thirty-somethings with the education, jobs and family stability to spark and maintain a sustainable housing boom.

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Dem Blues The housing boom seemed to Washington and Wall Street as answer to the lack of 1990s-style economic stimulus from another technology boom.

You can’t have a consumer boom if your society’s fertility rate is in sustained decline.

Nasdaq Composite Index January 1, 1992 to September 1, 2009 5,500 4,500 3,500 2,500 1972.63 1,500 500 Jan-92

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Japan, which as recently as 1989 was considered a threat to American global economic pre-eminence, demonstrates two painful lessons for America: • You can’t have an economic boom based on an industry that is in a Triple Waterfall Crash; • You can’t have a consumer boom if your society’s fertility rate is in sustained decline. There are many differences between America and Japan. One of the more obvious is that, although the economy had been struggling since 1990, the Japanese continued to vote for the party that had been in power nearly all the time since the MacArthur era. Obama certainly doesn’t believe that he’ll keep control of the White House and Congress if the economy doesn’t recover by 2012. Last week, the Japanese showed they had finally had enough of not getting enough economic progress. The new government is promising change. However, unless the regime bravely confronts the nation’s die-off, whatever policies it implements will fail. Japan’s Triple Waterfall crash, which began 20 years ago, was driven by demographic collapse, and its continuation proves the impossibility of achieving a strong consumer-based economy when the supply of new consumers declines every year.

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Near-zero yield long government bonds may make headlines, but they don’t offset the below zero replacement rate of babies. (At the peak, long Japanese government bonds yielded 8%; yields fell more or less continually thereafter and seem to heading asymptotically toward zero.) The Japanese decline from global wunderkind status continues—twenty years after the Triple Waterfall peak. Almost unnoticed by the seers, Japan became the model for most of the OECD, which took a decade longer to drive fertility rates far below replacement levels—and keep them there. The US was the seeming exception to this bleak picture of permanent decline: it was able, during the 1990s, to keep its economy going by large-scale immigration, and from the higher birthrates among minorities. (The contrast with Japan is striking: Japan is famously opposed to offsetting its population decline through immigration.)

The Japanese decline from global wunderkind status continues— twenty years after the Triple Waterfall peak.

GDP is the sum of output per worker multiplied by the number of workers, less the net foreign trade balance. Japan has always managed to maintain a trade surplus as a partial offset to its desiccating demography. The consumer-led recession has reduced the never-ending US trade deficit, but nobody thinks the US could run trade surpluses to make up for weakening demography. Nikkei 225 Index January 1, 1982 to September 1, 2009 40,000 35,000 30,000 25,000 20,000 15,000

10,530.06

10,000 5,000 Jan-82

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Dem Blues Meanwhile, on mainland Asia, the contrast with Japan could hardly be more impressive:

...the combined GDPs of China, India and Brazil have grown so rapidly that they now represent roughly one-fifth of world output— equal to the US.

Shanghai Composite Index January 1, 2002 to September 1, 2009 5,750 4,750 3,750 2,845.02

2,750 1,750 750 Jan-02

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Bombay Sensex 30 January 1, 2002 to September 1, 2009 22,500 18,500 15,398.33

14,500 10,500 6,500 2,500 Jan-02

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Were these Asian giants in US-style recessions, global financial markets would almost surely still be in major bear patterns, and optimism about economic recovery would be as rare as confirmed sighting of extra-terrestrials; industrial commodity prices would be at levels challenging the financial viability of all but the best-financed producers. The major Asian economies, plus Brazil, (and not the USA), are collectively the deus ex machina for all forecasts of a global recovery from the 2008 Slough of Despond. According to economist Robert Samuelson, the combined GDPs of China, India and Brazil have grown so rapidly that they now represent roughly one-fifth of world output—equal to the US.

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People entering the workforce make the difference. According to the United Nations statistics, the only large economies with positive fertility rates are India (2.8) and Indonesia (2.6). (The US rate is flat at 2.1, down from 2.5 in 1970 and 3.5 in 1960. Other OECD fertility rates for comparison purposes: France 1.9, Germany 1.4, UK 1.6, and Italy, Spain, and Japan 1.3.) Consider recent US recoveries, and how they were stimulated by earlier fertility rates: 1. Coming out of the 1982 recession, (22 years after 1960, when the fertility rate was 3.5). 2. Coming out of the 1991 recession, (22 years after 1970, when the fertility rate was 2.5).

...the ratio of new twenty-somethings relative to the number of new seventy-somethings will continue its long decline.

There was some muted American cheering in December 2007, when the government announced that, for the first time in 35 years, the fertility rate had reached 2.1, which meant it had reached the population replacement level. That’s the good news. The bad news is that the break-even level doesn’t do much for future economic cycles because the ratio of new twenty-somethings relative to the number of new seventy-somethings will continue its long decline. That’s not just negative for the future of the homebuilding industry: it’s the fundamental reason why US GDP growth in each new cycle will be constrained by the costs of government benefits for the elderly—and by sustained shortages of experienced skilled labor. Perhaps this lengthy recital of population statistics is making readers’ eyes glaze over, or, perhaps readers are objecting to our optimism about China’s future when its fertility rate—at just 1.35 per woman—is far below the US rate. That perilously pitiful Chinese rate would, if there were no major countervailing factors, prefigure future economic pygmydom for China, because it is lower, from a reproductive maintenance standard, than almost any other country. It comes, of course, from the single child policy. The population of young males relative to young females is rising. If sustained indefinitely, it would guarantee both a deeper plunge for future Chinese fertility rates and the inevitable Japonization of China.

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Dem Blues

The Old World, therefore, has two distinct disadvantages of dynamism compared to the New World...

However, China has time to reform its demographic policies, because it has its own, nearly unlimited, supply of new young workers: the numbers of new industrial workers and new first-time urban homebuyers will continue to grow rapidly for at least the next 15 years because of inward migration from farms to cities. Demographers estimate that by 2025, China will have 1,000 cities with a population of at least one million residents. That awe-inspiring trend helps to increase Chinese GDP in two ways: it reduces the population of farmers living on pitiful plots of one to three hectares, producing barely enough food for themselves; they are sent to modern factories and stores in new cities, so there is increased output both of the former farms—which become part of a much larger and more efficient agricultural base—and the city, where the workers’ production is then measured in GDP. This historically-unique large-scale inward migration that offsets demographic decay through per capita GDP expansion isn’t open to the OECD nations whose GDP is stalling out from demographic decay. The Old World, therefore, has two distinct disadvantages of dynamism compared to the New World in an age of worldwide industrialization: 1. The relative lack of babies who stimulate demand for homebuilding, renovation and consumer spending now, while laying the foundation for faster economic expansion later when they enter the workforce and form their own families; 2. Their relative lack of inward migrants—who are already citizens, and are, in general, more likely to be able to integrate rapidly and effectively into their new environment than external immigrants from poorer countries with language or cultural issues that can impair rapid absorption. Admittedly, China and India have great internal challenges arising from historic ethnic, language and cultural barriers, or from establishment of control over regions and communities that historically rejected being included within China or India. India’s occupation of Kashmir, a largely Muslim state, is a costly drain on its military and financial resources. China has problems with Tibetan and Uighur peoples who reject its overlordship. However, among the billions of citizens in those societies, these problem groups are, at worst, nuisances.

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The US Recovery: Will It Be a V, U, W or X? 1. Questions about the Inventory Cycle and the Shape of the US Recovery Economists who believe the US is already in a strong V-shaped recovery base much of their case on the reassuringly familiar mathematics of the inventory cycle: when economies fall into recession, the net reduction in inventories is often the statistic that tips the economy over to negative growth. Similarly, once businesses stop reducing their inventories and make even modest additions to fill up gaps in their warehouses, that turn from negative numbers to even—or slightly positive numbers—is a relatively powerful snapback number that signals the return of Happy Days.

The remarkable exception to this pattern has been crude oil.

Inventories are expressed in terms of sales months. So on the down cycle, even though companies are cutting inventories, if sales are slumping faster, then the inventory-to-sales ratio rises, forcing even more drastic stock reductions in the following month. US Q2 numbers released last week showed that inventory destocking remained a big negative for GDP. One client told us recently of a major oil services company that had cut its inventories of a particular line of equipment from four months to six days—in just seven months. Inventories respond to two forces: sales and cash needs. By making sales from inventory and not replacing the materials sold, corporate cash is generated—at a time when bank financing is problematic. Conversely, when treasurers and their bankers are reasonably content with the components of their corporate quick ratios, and, if there are signs of rising prices, companies can see advantages in using cash to rebuild inventories. What happened in this cycle was that deflationary forces stimulated panicky liquidation of raw, manufactured and semi-manufactured goods, at a time of corporate tail-chasing as sales kept plummeting, and treasurers tried to keep their inventories in line with the falling sales. The remarkable exception to this pattern has been crude oil. Until August, the extremely steep oil contango was a huge inducement for oil refiners with adequate finances to buy excess supplies of crude, and then find the tanks—or tankers—to store it. That contango was assisted by the willingness of major consumers to buy oil futures and options to hedge themselves against much higher oil prices.

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Dem Blues

optimism...that we are about to be bathed in the beautiful math bath of rising inventories that make GDP look like it’s on steroids...

In recent weeks, the contango has shrunk. The spread between spot crude and December 2010 crude, which had been in double-digits, has now narrowed to $6 a barrel. But the fact that there is no bargain-priced oil anywhere on the futures curve despite declining OECD consumption remains a Damoclean sword over all those confident forecasts that deflation is here to stay. Moreover, crude goods are not a major percentage of total inventories across industrial economies. As long as prices of manufactured goods and parts stay under pressure, wholesalers and retailers will be paid to stay lean. In other words, the near-universal optimism among US economists—that we are about to be bathed in the beautiful math bath of rising inventories that make GDP look like it’s on steroids—is not the stuff that investors should dream on—let alone invest on. Of course, when—or if—prices of crude and semi-finished goods start to rise, forcing manufacturers and wholesalers to begin restocking, then the US will face a different kind of challenge. A new generation of bond vigilantes will surely arise, and Ben Bernanke and friends will be forced to unveil their exit strategy. How will Obama and the Congress respond to a rise in interest rates if house prices remain low and unemployment remains high? We have written previously about the Fed’s inflation time bomb. It still ticks, although so softly one must incline one’s ear—and accept the raillery from others who say that any sound is purely imaginary. But inflation is tomorrow’s problem—investors have more immediate concerns.

2. The Case from the Skeptics Nouriel Roubini is the most publicly prominent of the small group of “doomsayers” who correctly predicted the Crash and recession, based on their prescience about the extent of the housing and financial collapses. Writing last week in the Financial Times, he predicts a “U-Shaped” US recovery. He argues that employment continues to fall, and that “this is a crisis of solvency, not just liquidity, but true deleveraging has not begun yet because the losses of financial institutions have been socialized and put on government balance sheets. This limits the ability of banks to lend, households to spend and companies to invest.” He is generally backed in this analysis by those other two prominent prescients (who are personal friends), David Rosenberg of Gluskin Sheff, and Stephanie Pomboy of MacroMavens.

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Roubini’s case for a double-dip recession is also based, in part, on the fact that oil and food prices are “rising faster than economic fundamentals warrant, and could be driven by excessive liquidity chasing assets and by speculative demand.” David Rosenberg looks at the economic and chart data, and concludes that the US is in the middle of a 18-year equity bear market and a long-term commodity bull market. We are sympathetic to this analysis, based on our experience during the 1970s. The commodity bull markets of that era were partly driven by the weak returns from conventional equities, but also from investors’ growing convictions that governments and central banks couldn’t cope with stop-go economies, geopolitical shocks, and stubborn inflation.

...demography’s impact has only begun to challenge the idea that bricks and mortar are havens.

Those who deride our bullish commodity views sneer, “So where’s the inflation? Bond markets were collapsing in the 1970s and interest rates were soaring, despite massive monetary creation. This time, central bank rates are near-zero and even long-term Treasurys are trading at yields that assume no real inflation for years to come. Inflation-indexed bonds are going nowhere (although they do, of course, qualify for the real asset category in institutional portfolios). Commodity consumption is falling almost everywhere except in Asia, and those economies are all dependent on exports to the US and the rest of the OECD, so unless the US and Europe recover strongly, raw material prices will fall to new lows. As for rising gold prices, that’s just a bunch of economic Neanderthals scaring people about a coming collapse of the dollar, which won’t happen, because there’s no other currency to take its place.” Our take on these criticisms: 1. The vigor of central bank response to the financial crisis makes the excess monetary creation of the 1970s look positively penurious. Despite the assurances from Chairman Bernanke, investors who look at the $9 trillion US deficit projection for the coming decade are wise to hedge themselves with hard-asset-based investments. 2. Real estate filled that function in earlier cycles, but demography’s impact has only begun to challenge the idea that bricks and mortar are havens. In earlier cycles, homeowners couldn’t get 100% financing even if they had reliable employment records. This time, the overbuilding is of scary proportions. The reliable Dennis Gartman last week cited a report from a research firm that says “15.2 million of American mortgages or just over 32% of all mortgaged properties were ‘upside down’ as of June 30th.”

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Dem Blues

...retail investors collectively have been bailing out of gold jewelry as fast as they buy bullion...

It’s not just the subprimes, AltAs and all the [Barney] Frankly foolish loans that are in trouble: a big chunk of conventional mortgages are as well, thanks to Fan, Fred and the Federal Home Loan Banks. The Boomers wiped out in the tech-mania apparently decided in this decade that the only sure-fire investment left was residential property, and they rushed into it with gusto. The pricking of that bubble has discredited residential real estate as an inflation hedge for years to come. And as for all those pension funds which rushed into commercial real estate, the consequences of the pricking of that overlevered bubble have only begun to spread across the US economy. 3. Those reassuring long-term Treasury yields are, in significant measure, the product of Bernanke’s purchases, and the continued willingness of Asian economies to maintain their currencies’ relationships with the dollar. Now that the world knows that the current US deficits have morphed from temporary to permanent, prudent investors may decide that some other long-term bet makes good sense. The 3.3% yield on the 10-year Treasury, which has meant low mortgage rates, was the key factor underlying last week’s report that, for the first time since the troubles began, house prices actually rose slightly in June. What happens when overseas investors conclude that they aren’t being paid enough—in a dubious currency—to finance the endless deficits? As for TIPS, they’re dollar-denominated, so they have deep endogenous risk, albeit with a built-in hedge that becomes increasingly difficult to quantify. 4. Yes, commodity prices are ultimately driven by supply and demand. But most analysts project higher long-term prices for oil and metals, for reasons we’ve set out in Basic Points too often to recite anew. As for the grains, China, with some serious drought problems, is buying US soybeans like there’s no tomorrow, and India has announced it will offset any shortfall in domestic food production with purchases from its exchange reserves. As we’ve noted above, the only rational debate about the next global food crisis is when it will arrive. 5. Finally, as for gold, retail investors collectively have been bailing out of gold jewelry as fast as they buy bullion, so this isn’t a consumer inflationfear bubble about to burst. Central banks have long since ceased trying to sell all their “excess” gold holdings. As club members, they aren’t about to swap Treasurys for gold, but China has modestly boosted its gold exposure, and the next global recovery will almost certainly shift investor perceptions of the relative attractions of paper money to precious metals.

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However, as the crash last year demonstrated, if the US financial system implodes anew, prices of commodities and commodity stocks will also plunge. What that debacle unleashed was the unwinding of exposures to all marketable risk assets and the forcible deleveraging of dollar-denominated debt across the financial system, driving the drooping dollar into a sudden rally. US Dollar Index (DXY) January 1, 2008 to September 1, 2009

The H1N1 flu is gaining strength across the US and much of the world.

90 86 82 78.51

78 74 70 Jan-08

Mar-08 May-08

Jul-08

Sep-08

Nov-08

Jan-09

Mar-09 May-09

Jul-09

Sep-09

During the horrendous bear markets for equities, currencies, corporate debt, and commodities, “The China Story” became just another suddenlydiscredited investment concept. How could China continue to grow when its exports collapse? Suppose that, by late winter, the US economy’s green shoots appear to have been largely buried. Bernanke’s options are limited—Japanese-style—by zero-interest rates. Congress, still smarting from voter rage at bank bailouts, cannot agree on further stimulus packages. Mortgage foreclosures keep climbing, along with unemployment. This is, essentially, the SuperBear thesis. We would add one other factor to that grim foreboding: The H1N1 flu is gaining strength across the US and much of the world. The National Institutes of Health is warning health care providers, governments and businesses that it will likely become a serious threat to the US economy before the season for routine flu peaks in winter. Add in the strong possibility that Iran successfully tests a nuclear bomb, and the US Administration, under pressure from Congressional Democrats, announces it cannot schedule new troop allocations for Afghanistan for the reopening of the fighting in Spring.

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Dem Blues Obama’s approval ratings could well sink to late-Bushian levels, and polls would show a big swing to Republicans for the 2010 mid-term elections, even though the Republican Party would still lack a leader. ...the money supply isn’t growing as fast as, say, corn: indeed, in the past four months the annualized growth of M-2, (0.6%) more closely resembles the growth rate of a cactus...

That concatenation of economic, strategic and financial challenges would be a replay of the gloom in the 1970s that destroyed the British Labour government, elected Thatcher, destroyed the Ford Presidency and elected Carter. By mid-1982, US stock prices were at new 18-year lows. We certainly doubt that all that bad news will come to pass, but remain concerned that the stock market has been throwing caution to the winds. We still cling to the hope that the economy will bottom out, Asian strength will continue to shrink the trade deficit, and that housing will not drag the rest of the economy down forever. The sheer scale of global monetary liquification and bailouts argues against a new plunge into a deeper abyss. But, the critics ask, why is most of the Fed’s extra monetary creation sitting on its balance sheet, having been recycled back to the Fed from the banks, which choose not to use it in making further loans? In effect, according to this analysis, the liquidity gain is a mirage: now you see it, now you don’t. The critics have a good point: despite the trebling of the Fed’s balance sheet and the continuation of near-zero fed funds rates, the money supply isn’t growing as fast as, say, corn: indeed, in the past four months the annualized growth of M-2, (0.6%) more closely resembles the growth rate of a cactus; since June it’s actually been negative (-3.6%). Investors assumed that Bernanke was following the Friedman formula of inducing M-2 growth above normal GDP levels to offset recessionary pressures. The data of recent months suggest that Roy Young, (Fed Chairman from October 1927 to August 1930) might have returned from his justly-earned obscurity and his unremarked grave. However, it could be that Mr. Bernanke is up against the same monetary challenge the Bank of Japan faced: the Zero barrier. How do you set and manage negative interest rates? Well, Sweden’s Rijksbank is experimenting with negative yields on reserve deposits, as a goad to bankers to do something with the reserves the Bank has created. The top man in Stockholm is an old school friend, we are told, of Ben Bernanke, so just maybe the Fed will try that strategy too. “We will do whatever it takes” is the Bernanke motto.

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Perhaps the only reassuring statistic that suggests monetary policy is working is the steep yield curve. That is financial adrenaline for the comatose banking system. Combined with the capital infusions and the excess reserves sequestered on banks’ balance sheets (even though the money has been recycled back to the Fed), we are inclined to accept Bernanke’s cautiously optimistic assessment that the system is in the early stages of healing from its massive self-inflicted wounds. But as long as the banks choose to leave so much of their reserves frozen with the Fed, it’s hard to see anything approaching a V-Shaped recovery. (It’s also an argument the Congress could consider when it’s considering appropriate compensation for bankers. How much should a bank boss be paid for attracting government-guaranteed deposits and then shipping them to the Fed for a microscopic return?)

How much should a bank boss be paid for attracting governmentguaranteed deposits and then shipping them to the Fed for a microscopic return?

Maybe it’s a “U” or maybe a “W”, but it will certainly bear no resemblance to China’s profile. The more sluggish the recovery, the more the gap between “Chindia” and the US closes.

The Grains Again Although we are hardly happy with the current state of the US economy, not all the US economic data are doleful. The US remains the world leader in agricultural output and profitability. Those Asian tigers have voracious appetites for protein, and American farmers, whose productivity continues to rise relentlessly, are, at least for now, the world’s best hope for averting a catastrophic food crisis. On that front, the news would seem reassuring: Corn January 1, 2005 to September 1, 2009 850 750 650 550 450 350

319.25

250 150 Jan-05

Sep-05

May-06

Jan-07

Sep-07

May-08

Jan-09

Sep-09

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Dem Blues Wheat January 1, 2005 to September 1, 2009 1,100

...global carryovers of feed grains will actually decline this year, despite a bumper year for US crops.

950 800 650 487.25

500 350 200 Jan-05

Sep-05

May-06

Jan-07

Sep-07

May-08

Jan-09

Sep-09

Soybeans January 1, 2005 to September 1, 2009 1,600 1,400 1,200 1,000

955.50

800 600 400 Jan-05

Sep-05

May-06

Jan-07

Sep-07

May-08

Jan-09

Sep-09

However, the USDA reports that global carryovers of feed grains will actually decline this year, despite a bumper year for US crops. Wheat and soybean carryovers will increase. The sudden financial crisis slashed grain prices in two ways: • Grain speculators and—more importantly—commodity funds—were forced to slash exposures to the key traded grains; • Shocked Asian consumers cut back their demand for meat and vegetable protein. The grain rallies this Spring came in response to the unusually cold winter and late planting season across the Upper Midwest. However, using high technology, farmers got their crops planted in remarkably quick time once the downpours ceased.

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What was then feared was that the small green shoots would etiolate under the expected blistering heat of July. Then July turned out to be one of the coolest on record across much of the Upper Midwest. With lots of rain, the crops flourished wondrously. Now, the only weather change that could avert a barn-bursting harvest would be a killing September frost. The same dry, cold Arctic highs that came steadily down to the Midwest to meet the hot air from the Gulf, producing those heavy rains, dried out large areas of the Canadian prairie wheat and canola farmland en route; drought conditions in much of Western Canada reached serious levels. Across other parts of the world, the erratic weather conditions have been frequently farmer-unfriendly this year.

...the sun did almost nothing this summer—spotwise.

In particular, the Monsoon—India’s large-scale equivalent of the Nile—was, until last week, a large-scale disappointment this year. Rains have been adequate in the south, but have been inadequate in the middle and north of the subcontinent. These variations are what one might expect from a weather system based on the varying temperatures across the Arabian Sea at a time of somewhat cooler global temperatures. The most-publicized result to date is the sky-high price of sugar: India is the world’s second largest cane sugar producer and the world’s biggest sugar importer.

Nonespots? We have mentioned this year’s unusual weather conditions in several places in this essay. We conclude, therefore, by updating our observations on the sun. The short answer is the sun did almost nothing this summer—spotwise. Until this week, there had been no sunspots for 50 days, and overall solar activity this year still could be the lowest in nearly a century. If this solar silence lasts another year, astronomers will be forced to recalibrate their forecasts. No mainstream astronomer predicted such a lapse in solar activity. NASA has long maintained its estimate that, since the dawn of the Industrial Revolution, sunspots have accounted for roughly 40% of the observed increased in global temperatures—the rest came from anthropogenic sources. But nobody really knows.

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Dem Blues Clients interested in further information can consult our website, where we post material on the sunspot and climate change debate from reputable scientists. Despite its recent robust rally, the S&P is today lower than it was a decade ago.

Since we began writing on this subject, there has been an observable decline in world temperatures and an observable increase in ice at both poles. But no one can prove that the small amount of cooling most of the planet has experienced is caused by the dramatic collapse in sunspot activity. There is no gainsaying that, based on more than four centuries of evidence, sharp, sustained declines in sunspot activity have been accompanied by sharp, sustained periods of global cooling. But the scientific community takes the position that no causation has been proved, so the relationship between extra heat from the sun and extra warmth on earth could have been purely coincidental. If war is too serious a business to be left to generals, the sun’s effect on earth’s climate could be too important an issue to leave to the astronomers and environmentalists. Governments are betting trillions to fight global warming, when a more serious climate problem could be emerging. The global warming we’ve had to date has been mostly food-friendly—longer growing seasons. A return to the world’s cold weather of the 17th and 18th centuries before the current sunspot cycle arrived would be a major challenge for global food production. So we continue to believe this seemingly arcane issue is worth following.

Bonds As The Right Trade Now? Hinges of History are traditionally times of above-average risk—and potentially above-average reward for investors. Despite its recent robust rally, the S&P is today lower than it was a decade ago. Its behavior recalls the disappointments of the 1970s. Stocks finally broke out of their 16-year bear market with the Reagan Rally. On the day before Volcker finally declared victory against inflation and began slashing rates, the Constant-Dollar Dow was back to late-1929 levels, erasing 53 years of widely-cited evidence that stocks were the asset class that would always outperform inflation. Remember that those 53 years were also the era in which America was the world’s leading economy, and included the period from 1944 in which it was also the world’s strongest military power.

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We have few clients who were practicing investment professionals during the 1970s. The Cult of Equities became Wall Street’s enthusiasm during the Reagan-Thatcher years and became a secular religion during the late 1990s, as business schools disgorged hordes of true believers. Corporate pension funds had long relied on fixed income investments, but began diversifying into equities during the go-go Cornfeld era. By the 1990s, capital asset valuation models were marginalizing bonds, as the conviction grew that long-term investors would always be paid for assuming greater risks. Almost unnoticed was the gigantic contribution to total returns from the multi-decade drop in long bond yields. When FASB 87 was imposed on corporate pension funds, the rule for projecting future returns from asset classes was the retrospective return each class had delivered in the previous five years—or longer. We recall the debate about the financial viability of major corporate pension plans during the early years of this decade. Some major companies—such as IBM—were able to dismiss their critics who ridiculed the assumed 8% annual projected rate of earnings on their investment quality bonds by pointing out that 8% is what they’d earned on their bondholdings since 1990, so that was a reasonable expectation for the future. Problem: Long Treasurys yielded as much as 9.5% in 1990, but the yield fell as low as 5% in 1998 and by 2002 were 4.5%. The companies noted that the returns from holding a long noncallable bond from 1990 were spectacular, but made no mention of the obvious fact that they could not be replicated in this decade unless rates plummeted to Japanese levels.

With the deified Alan Greenspan’s imprimatur, The Pension Benefits Guaranty Corporation reluctantly accepted those giddy valuations...

With the deified Alan Greenspan’s imprimatur, The Pension Benefits Guaranty Corporation reluctantly accepted those giddy valuations—and corporate America’s reported per-share earnings swelled agreeably. Treasurys have decisively outperformed US stocks over the past 10 years. That challenges the basic capitalist principle that equities must outperform over the long-term, or a private enterprise economy cannot exist: wise investment in economically risky assets has to deliver better results than owning Treasurys. Because we (perhaps stubbornly) continue to believe that risk will be rewarded, we have, for most of this decade, recommended overweighting in equities compared to bonds, and have also recommended below-benchmark durations.

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Dem Blues Yes, we wish we had changed those recommendations 14 months ago.

We repeat our long-held view: this is a cyclical bull rally within a secular bear market.

Nevertheless, after such a robust run for equities, and after considering the economic and political risks discussed in this journal, we believe a trade into high-quality noncallable bonds makes sense. If all goes well, we’ll have a V-shaped recovery and bonds will underperform. But if we experience a US double-dip recession, long Treasurys (and longduration high-grade corporates and munis) will once again move to the head of the class. At that point, we would expect to reverse the trade. Fortunately, bond trading is not a costly undertaking, and investors can add to their exposures and change their durations with a few keystrokes. And they can reverse those trades if—or when—the stock market has corrected and today’s most bullish strategists are wringing their hands. Our recommendation is hardly extreme: it reduces equity risk and builds in greater recession protection without violating the concept of investing for the long-term with an equity bias. We repeat our long-held view: this is a cyclical bull rally within a secular bear market. US political and financial excesses have been so great that it will take time—and political wisdom—to put the economy and stock market on a sustained, noninflationary growth pattern. Fortunately, the 1970s show us that equity investors can still earn good returns despite double-dip recessions, bad politics, and loose monetary policies: by owning well-managed commodity-producing companies. Forgive us if we review two painful times in our career when this strategist’s lot was not a happy one. We suffered the worst experience of our career from early-1999 to late-2000. Having said Nasdaq was seriously overvalued at 2600, we were ridiculed in many circles as Nasdaq responded to Greenspan’s frantic liquidity injections by doubling in months. Our sustained criticism of tech companies’ multiples and earnings statements because of (1) the ease of competitive entry into more and more tech product lines, and (2) their refusal to account for stock option costs, was a costly call. What about last year’s Crash? Wasn’t that an even greater humiliation for a commodity bull?

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It was profoundly painful, but the difference, we believe, is that real stuff will always be worth something—and commodities had already had their Triple Waterfall Crash from 1980 to 2001, which meant that their debt to society—and investors—was paid, and the survivors had learned to control their capital expenditures. Moreover, the emergence of China and other Asian powers as major economic forces meant that commodity demand would grow faster than OECD GDP during this decade. The world was changing in a way that was commodity-friendly, and we never changed in our view that scarcity would eventually return. Moreover, the continued shrinkage of unhedged reserves in the ground in politically-secure areas of the world would undergird the valuations of the well-managed companies. This was not a replay of the tech bubble, because tech companies grew through sustained sizable increases in sales of units, whereas mining and oil companies’ ability to grow units of output was constrained both by capital and by availability of low-political-risk, high-quality reserves.

...real stuff will always be worth something...

We still believe that. Despite the violent commodity selloff, few raw material prices are back to levels at which efficient producers cannot earn profits. The industries continue to consolidate into ever-stronger hands. Consider how quickly the mining majors cut back on copper production when copper broke $2 a pound. Notice how firm the producers are as unions increase their wage demands. Notice also the trend we have been discussing toward the new autarky, as major commodity-consuming countries make acquisitions of mines and oilfields across the world. Again quoting Niall Ferguson: “[Chinese] investments in African minerals and infrastructure look distinctly imperial… And now the official line from Prime Minister Wen Jiabao is to ‘hasten the implementation of our ‘going out’ strategy and combine the utilization of foreign exchange reserves with the ‘going out’ of our enterprises.’ That sounds like a Chinese campaign to buy up foreign assets—exchanging dodgy dollars for copper mines.” There is, quite simply, no way that the Newly Industrializing Economies can continue to narrow the gap between their inhabitants’ incomes and expectations and the wealth of the OECD countries without continued increases in consumption of commodities.

September

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Dem Blues

...most of these “savings” are ephemeral: they go to pay down debts for previous consumption.

Investors’ preoccupation with the outlook for the US economy could mean missing the reality of where the world’s economic power is heading. Yes, the US remains the biggest economy in the world, but it is also the only huge economy in which consumer activity is 70% of GDP—at a time when consumer debt is roughly twice the level of consumer income. The utterlyinevitable reduction in consumers’ willingness to take on more debt to buy more stuff means that Thrift is a menace to prospects for a sustained recovery. The optimistic talk that the recent increase in the personal savings rate is the precursor to the next consumer spending boom ignores the reality that most of these “savings” are ephemeral: they go to pay down debts for previous consumption. They aren’t the stuff of real savings in the form of investments, 401(k)s and other provisions for the future—which is coming fast for overindebted Boomers. We now know that the Boomers whose savings were wiped out in the tech collapse collectively made the seemingly rational decision that they would make up for that disaster by investing heavily in housing—the only asset that had never gone down in price. It took the form of buying bigger houses than empty-nesters needed, buying Sun Belt homes for their retirement bliss, and, when the speculative mania began, to buy extra houses, flip condos, and buy other highly-leveraged “investments.” Despite the horrors of house price collapses, a current Rasmussen poll reveals that 59% of Americans believe that buying a home is the best investment a family can make. It would appear that the average American has been burnt too seriously in the two major equity bear markets of the past decade. As for Americans’ rush from stocks to housing, those disastrous Boomer strategies were employed—on even grander scale—in countries whose demography was worse than America’s, such as Britain, Ireland and Spain. (We learned on a trip to London in 2008 that house prices in windy, wet Wales were up 40% in 2007, and wondered when this bubble would burst.) In Eastern Europe, many of the formerly Communist countries with desperately depleted demographies adopted the new wisdom with gusto. They found they could get mortgages denominated in Euros at much lower rates than their cautious central banks were providing in their own currencies.

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The Germans resisted this trend, and continued in their stolid savings, and constrained consumption habits. No surprise that Germany is rapidly emerging from its recession, with many of its factories humming on exports to Asia. Although most of the press commentary about the big stock market recovery is about the sharp rally on Wall Street, Emerging Markets shares have generally outpaced America’s. Some of these markets are looking pricey, but not in comparison with the S&P—and certainly not in comparison with speculative low-priced US stocks. Chats with value-oriented US investors confirm our view that the leadership in the US rally comes from the riskiest class of stocks—small, over-indebted, and driven by the Audacity of Hope of Outsized Gains. Citigroup—a giant multi-strategy hedge fund run by a hedge fund manager—shot up 70% this summer and frequently accounted for 10% of NYSE volume. Even Fannie Mae and Freddie Mac—the Frank Zombies—are outpacing the broad market. Last Fall’s excessive Fear is became this summer’s excessive Greed.

Citigroup—a giant multi-strategy hedge fund run by a hedge fund manager...

Except among insiders: month-after-month, corporate insiders have been selling far more of their companies’ shares than they’ve been buying. In August, they sold 30 times as much stock as they bought. What do the bosses know—or fear—that economists, strategists and retail investors don’t? The S&P rally from its low is huge compared to past leaps from recession lows, and is comparable even with the storied Depression rally that was followed by a collapse to new lows. Although we believe that the US stock market rally has been overdone, we are not in the “Depression likelihood” camp for the following reasons: 1. The Bush-Bernanke-Obama responses are cumulatively gigantic compared to monetary and fiscal interventions then. 2. The signs of renewed US protectionism are mostly limited to meeting union demands—such as to ban Mexican truckers, reject the free trade deal with Colombia, and include “Buy American” clauses in state-sponsored infrastructure projects. Obama and his close advisors aren’t Bush-style free traders, but they also aren’t Smoot and Hawley in sheep’s clothing. 3. Regional bank failures are growing, but they aren’t comparable to Depression numbers.

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Dem Blues

Zero return money market funds are invitations to investors to take on excessive risk.

4. One beneficial temporary effect of demographic decline is that the number of young people leaving school and entering the workforce for the first time isn’t skyrocketing the way it did during the years when female fertility rates were very high—in the Depression, and, for that matter, in the years before the deep recession of 1974-75, when young unemployed males were rioting across Europe. 5. Government income transfer payments are now large in relation to both employment income and GDP compared with Thirties levels. 6. Back then, Europe entered recession first, followed by the US and as the downturns accelerated, signaling a world Depression. This time, the US went down first; France and Germany are apparently emerging from recession, and most of the leading Third World countries have either escaped recession or are emerging from it, so a Global Depression is an extremely remote probability. 7. The 2008 commodity price collapse didn’t take raw material prices back to Triple Waterfall Crash levels. Most of the key commodities—including the grains—are at profitable levels for most farmers—with pork being the most conspicuous exception. 8. Gold’s upward revaluation this time means that central banks collectively have modest gains in asset values. Roosevelt unilaterally raised gold from $20.67 to $35.00 in 1933—which may have been his most successful recovery program. 9. The US prairies aren’t experiencing disastrous dust bowl conditions arising from extreme heat, as they experienced in the Depression. Grain Belt temperatures generally have never gone back to those heights, even during the years in which global warmists were shouting that we faced frying. And this year is among the coolest since records were kept across much of the Upper Midwest. Nevertheless, we are of the opinion that US stock prices are rallying far faster than the recovery is progressing because of the Bernanke Liquidity Gush which maintains short rates in the zero range. Comparing this rally to the Reagan Rally—which was the real thing—is somewhat illogical: back then, short rates, even after the rally was building steam, were in the high double digits, which meant investors had high returns on risk-free investments. Zero return money market funds are invitations to investors to take on excessive risk.

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We are currently of the view that there will be a stock market correction that will turn many of today’s snorting bulls into bear cubs. We also remain wary of the behavior of the dollar. It is so much stronger than conditions warrant, and the future embedded deficits are so far beyond any experience that we cannot assume that thrifty foreigners will continue to write blank checks to fund such scary profligacy. The Treasury now auctions more most months than it used to auction in a year. At some point, buyers will demand higher—perhaps much higher—rates. A whiff of higher rates could be the anesthetic that sends the bull to dormancy.

...there will be a stock market correction that will turn many of today’s snorting bulls into bear cubs.

In the meantime, a quasi-recession bond structure reduces a balanced portfolio’s endogenous risk, without slashing equity exposure unduly. We aren’t real economic bears: we believe that the stock market is overoptimistic and will correct soon. That will be a buying opportunity and will be a time to cash bond profits.

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Dem Blues RECOMMENDED ASSET ALLOCATION Recommended Asset Allocation (for U.S. Pension Funds) US Equities

Allocations 17

Change -1

Foreign Equities European Equities 5 Japanese and Korean Equities 2 Canadian and Australian Equities 11 Emerging Markets 14

-1 unch unch unch

Bonds US Bonds 12 Canadian Bonds 8 International Bonds 11 Long-Term Inflation Hedged Bonds 10

+4 +3 unch unch

Cash

10

-5

Years 5.25 5.00 4.50

Change +1.75 +1.25 +1.00

Bond Durations US Canada International

Global Exposure to Commodity Stocks Precious Metals 33% Agriculture 33% Energy 22% Base Metals & Steel 12% 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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Change unch unch unch unch

Dem Blues INVESTMENT RECOMMENDATIONS 1. Upgrade equity portfolios to reduce endogenous risk. Trade upward in quality, and, in balanced accounts, increase bond exposure. There is, at present, too much froth for comfort. After the grandest recession /recovery stock market rally on record, this is hardly a good time to commit new money into equities. 2. Emphasize Canadian stocks in North American portfolios. Canada has the best banks, and the best range of commodity-oriented stocks. And it has the best North American currency. 3. Continue to overweight commodity-oriented companies in diversified equity portfolios. They have been underperforming the US market since US stocks began to reach the top of the troposphere, and their most volatile and gaseous members soared into the stratosphere. If the economic bulls are right, commodity prices will soar. If it takes more time—and some signs of restraint in Washington—to launch a sustained US recovery, then commodity stocks will have the attraction that comes from producing goods priced by the new Asian economic leaders. 4. The regional banks index (KRE) has not participated in the broad rally recently, and is sharply underperforming the S&P, mostly because of widespread construction loan losses. The BKX has more than doubled since March, but it is dominated by the banks that got the most help from Washington, so we have trouble seeing that steroid-based performance as the signal to buy stocks. Until the KRE starts to show good relative strength, the rally remains suspect, and investors should be lightening up on financial stocks. 5. Until this week, gold had been range-bound this year, so gold shares sharply underperformed the market. On Tuesday, bullion staged a sudden upside breakout from its pennant pattern, which could signal a sustained move through $1,000. As we were going to press, it had moved through $990. Gold shares are attractive havens, because gold is the only asset that can be expected to outperform under both extreme scenarios— financial collapse and runaway inflation. Remain overweight gold within commodity-oriented portfolios. 6. Whether by coincidence or otherwise, crude oil has been trading rather closely to the S&P. Oil consumption statistics do not support a valuation of $70 for crude oil. We recommend caution on oil stocks here.

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Dem Blues 7. Natural gas is, along with pork (but not of the Washington variety), the most conspicuous loser among the commodities. Technology, (in the form of large-scale application of new techniques for developing huge shale gas deposits) and cool summer weather have depressed gas prices. Even a cold winter may not be enough to get gas prices to levels at which most producers could show good profits. Underweight gas-prone companies in commodity portfolios. 8. The prospect of record US corn crops has depressed the price of agricultural companies’ shares. However, the food sector remains the least cyclical and speculative of the main four commodity stock groups and should be emphasized. We are still only one big crop failure away from a global food crisis. 9. The bull market in corporate bonds has narrowed spreads remarkably. In effect, virtually all risk classes have been in simultaneous bull markets—a sure sign that liquidity is the basic driving force. The steep yield curve argues for longer durations in bond portfolios, but unmistakable proof that the US had emerged from recession risks would send investors scurrying to midterms and force Bernanke’s hand. Since we think a V-Shaped recovery is the least likely outcome, we now recommend increasing bond durations, and are reversing the trading recommendation issued in June, when we were increasing our recommended equity exposure in line with our view that both the bond and stock markets were going to price in an economic recovery. The stock market did: the bond market didn’t.

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