Basic Points

Financial Heroin

December 16, 2009

Published by Coxe Advisors LLC
Distributed by BMO Capital Markets

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Don Coxe THE COXE STRATEGY JOURNAL

Financial Heroin

December 16, 2009
published by

Coxe Advisors LLC Chicago, IL

THE COXE STRATEGY JOURNAL Financial Heroin
November 12, 2009 Author: Don Coxe 312-461-5365 DC@CoxeAdvisors.com Angela Trudeau 604-929-8791 AT@CoxeAdvisors.com

Editor:

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

www.CoxeAdvisors.com

Financial Heroin OVERVIEW
During this season of giving thanks, we invite you to join us in thanking Ben Bernanke, Claude Trichet and Mark Carney. They have done good things for the economy this year—and much better things for the prices of the risk-based assets held in so many portfolios. We do not hold it against those crisis managers in the US and Europe who were so kind to the insiders in giant banks who faced impalement on swords forged of their own greed and stupidity. We do, however, hold it against those Congressional Republicans who voted against the legislation to rein in bonuses for them, because without Washington’s rescues at taxpayer expense, these big blunderers wouldn’t have had the chance to prove that, in a Zero Interest Rate Environment, they are geniuses who deserve huge pay packets. Last month we discussed The Power of Zero, which we suggested was the most important number in the financial universe. We end this year by considering the dilemma Ben and friends face in timing the decision to move rates away from the Zero level—which added so many zeroes to the incomes of levered investors—and has reduced, albeit less dramatically, the number of zeroes in the unemployment statistics. This month, we devote some commentary to the investment merits of Canada, whose politics and governance are becoming, on a comparative basis, even less interesting than America’s as the relative performance of the Canadian financial system keeps improving. America’s approach to the politics of finance is more fun to watch: it has Barack Obama, Nancy Pelosi, Barney Frank and the Big Bad Bonused Bailout Banks. Canada has Stephen Harper—who might manage, on a good day, to display 5% of Obama’s charisma—and a collection of sound, unspectacular, profitable, well-managed banks, (including BMO, which sends this journal to you). As we write, the climate debate has become centered in Hans Christian Andersen’s fairytale city of Copenhagen, which is hosting 20,000 guests, 140 private planes and 1,200 limos—the trappings of the heroic attempt to save the planet. This historic venture is enriching so many of those who have the vision to do the Right Thing about the Wrong Things—such as oil sands, offshore drilling, cars and coal. We now know so much more about the lengths to which visionaries will go to save the planet, their positions and their paychecks after the publication of thousands of their emails to each other, many of which suggest that Hans Christian Andersen is reborn and lives in East Anglia. We also know more about the radical global warmists from their rioting at the Conference. The holidays should be much happier for investors this year than last. We wish our clients and friends a Merry Christmas, Happy Chanukah, and a Happy and Prosperous New Year, and send Tiny Tim’s blessing: “God bless us every one.”

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S&P 500 January 1, 2008 to December 15, 2009
1,500 1,400 1,300 1,200 1,100 1,000 900 800 700 600 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09

1,106.50

Toronto Stock Exchange Composite (TSX) January 1, 2008 to December 15, 2009
16,000 15,000 14,000 13,000 12,000 11,000 10,000 9,000 8,000 7,000 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 11,534.94

MSCI Global Ex-US January 1, 2008 to December 15, 2009
2,300 2,100 1,900 1,700 1,500 1,300 1,100 900 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 1,590.55

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Financial Heroin
Our title came to us during a speech by a justly respected former central banker. In October, we were on the panel at a conference organized by Canada’s Consul-General in Denver. The star speaker was David Dodge, who was, until 2007, Governor of the Bank of Canada. (Long-time followers of our work may recall how often I cited him as “North America’s wisest central banker,’’ which was a seriously-meant comparison with the much-worshipped Alan Greenspan, who had been knighted by the Queen and was for so long credited with mystical powers that he might even have been beatified by the Vatican had he chosen to renounce his dalliance with the Atheistic Objectivism of Ayn Rand.) The topic for the speaking panel was “The Challenge Of Reducing Fiscal And Monetary Stimulus”. Freed of the speaking constrictions of governorship, but governed by his polite unwillingness to embarrass a successor or provoke furious debate in Parliament, Mr. Dodge spoke of how serious the financial crisis had been, assigning the blame largely to overlevered investment banks, and then addressed the risks for the global economy from the central banks’ policy of keeping liquidity so high and rates so low for so long. He argued that the central banks should begin to tighten policy even while unemployment remained uncomfortably high and economic growth was relatively subdued, warning that the alternative was being forced into imposing painful monetary tightness and high interest rates that would choke off an economic recovery. Although he was restrained in his rhetoric, he let the audience know that the risks of a grim outcome from the current record levels of monetary ease could become very high within the near future. I was due up next, and was pondering my remarks as Mr. Dodge proceeded. As he outlined the challenge, I suddenly thought of one of my father’s tales of his wartime experience.

“North America’s wisest central banker’’

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Financial Heroin
I began my remarks by telling the audience that my father was a doctor in the Canadian Army in WWII, and served in the Italian campaign. He became greatly respected for his anaesthesia and pain management under battlefield surgery and rehabilitation conditions. (He was cited after war’s end for perhaps having performed more anaesthetics under such conditions than any other Canadian doctor.) In discussing his experiences, he told me that he swiftly learned that the best—and frequently the only—reliable drug for the critically wounded was heroin. Soldiers who writhed in agony under other medications almost always responded to heroin. The problem wasn’t deciding whether to administer it: if morphine didn’t work fast, you didn’t waste time, you injected heroin. The problem for the doctor came when the patient had begun to recover from surgery, and was receiving heroin. How quickly could the dosage be reduced and when would it be terminated? Although few soldiers were freed of heroin without experiencing pain and distress, it was necessary to take the drug away as rapidly as possible. Otherwise they would become addicts and their lives would be ruined—for soldiering and everything else…. I paused at that point, and then said, “Zero interest rates are Financial Heroin.” Mr. Dodge looked surprised, then nodded his head, and was kind enough to comment later that this was an excellent analogy for the central bankers’ current dilemma. How much heroin has been pumped into Uncle Sam’s veins in recent months?

“Zero interest rates are Financial Heroin.”

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US Monetary Base (adjusted for Changes in Reserve Requirements) January 1, 1970 to November 30, 2009

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

US M-2 January 1, 1970 to November 30, 2009

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

Fed Funds (Effective Federal Funds Rate) January 1, 1970 to November 25, 2009

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

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Financial Heroin
As Ben Bernanke promised Congress in the dark days after Lehman, “We will do whatever is necessary.” That’s the way army doctors treated wounded soldiers—Canadians and Germans alike—in the field dressing stations. Like all analogies, this one has a limitation: the army only injected heroin into the veins of seriously wounded soldiers. Bernanke and friends are injecting it into the entire economy; one small component of it—highly-levered banks and speculators on the front lines of finance—is not only absorbing a disproportionate share of the supply, but has recently been displaying the kind of ecstasy associated with overdosing on powerful drugs. A year ago, we thought that recovery for the financial system and the economy would be characterized by massive, sustained deleveraging. The Crash had starkly shown the devastation that runaway deleveraging at a time of shrinking liquidity could inflict on financial assets and the economy. The fragility of the financial system in 2007–8 came, in large measure, from the migration of a model of financing from the so-called shadow banking system into the daylight version. The new stars of the Street were overlevered hedge funds and private equity firms. They drove the bull markets in complex new mortgage products, flawed-model derivatives—and in compensation for the brashest bettors. So profitable were they, that they were able to hire elite investment bankers and traders from the Big Banks—and to supply the justification that the big bonuses paid by the big banks were necessary to keep their biggest producers. In retrospect, Wall Street should have tried to follow the advice of the Tenth Commandment, rather than of Long-Term Capital Management and Enron. Perhaps, if some professor at Wharton or Harvard had updated the commandment, it might have prevented a financial collapse and a deep recession. We suggest the following restatement: Thou shalt not covet thy client’s house, nor his lifestyle, nor his male employees, nor his female employees, nor his bullish bets, nor his asinine bids at contemporary art auctions, nor anything that is thy client’s.

Thou shalt not covet thy client’s house...

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The big banks refashioned their balance sheets to mimic their hottest clients, using the window of opportunity provided by the abandonment of the rules in the Basel Accord I that had given the financial world its longest period since the 1960s without the collapse of a large bank. Although only Paul Volcker (who had led the committee that created Basel I) expressed alarm about over-leverage and over-reliance on models, the regulators let the big banks bet big. In terms of balance sheet caution and coverage, Basel II was to Basel I what a bikini was to a burkha. Not only was the leverage allowed to soar to Babel and Dubai tower heights, but the risk models were based on the same Black-Scholes models that felled Long-Term Capital Management—and the balance sheet design was based on Enron’s innovation—off-balance-sheet special purpose borrowing. The refashioning of Wall Street (and the City of London and many of Europe’s biggest banks) to the designs of the most spectacular financial collapses of the late 1990s was, we thought, such ghastly gluttonous groupthink that we, like many other critics, assumed that their subsequent near-death experiences would induce some remorse among the remorseless, and some penitence among the publicly unrepentant. Although it would, perhaps, be too much to expect a commitment to civic virtue and financial conservatism, we had thought that the financial nudity seen in mid-2008, which had to be covered by the costly TARP, would no longer be a threat to the health of the economy; the Rube Goldberg financial engineering of such monstrosities as Citigroup would be unwound as the Fed sustained the markets’ ability to absorb the effluent. The first sign that the Street was not going to tiptoe toward creeping decency was its successful partnership with some of the Congresspersons who had gone to bat against Bush when he and Greenspan tried to rein in Fannie and Freddie against the Financial Accounting Standards Board’s attempt to promulgate a new rule that would force the banks to mark to market their holdings of dubious and downright toxic assets. The bankers were left to value their capital based on their own internal models—whose Panglossian optimism had drawn their organizations to the edge of collapse.

In terms of balance sheet caution and coverage, Basel II was to Basel I what a bikini was to a burkha.

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Financial Heroin
Freed of the constraints which a free market based on full and fair disclosure would have imposed, these captains of free enterprise then rushed for the trillions in free BenBucks and levered up anew, this time buying (mostly) respectable stuff—such as Treasurys and tradable corporate bonds. The cash the Fed created to save them from the consequences of their own folly sits as T-Bills or fed funds on their balance sheets, providing little more stimulus to the real economy than sending out daily re-broadcasts of Jimmy Carter speeches on economic malaise. They sit on their piles of rotting subprime paper, loath to sell even portions of them at prices that would (1) trigger huge immediate losses, and, (2) prove that their remaining holdings were grossly overvalued. They appear to be modeling themselves on how John Law managed the later stages of the Mississippi Bubble: the key to keeping the game going after the real asset base had collapsed was price maintenance of the securities. Once Law was unable to prop up the prices and keep large sellers from unloading, the whole scheme imploded. In this case, the Street has a seemingly neutered FASB and powerful Congressional committee chairmen to keep the bubbles afloat. That’s what has been happening to the biggest beneficiaries of the taxpayerfinanced bailouts. No wonder that the latest polls show that “Tea party politicians” rank just behind Democrats in popularity, and well ahead of Republicans. No wonder that for the past three months, the IBD/TIPP polls of consumer sentiment have shown rising economic pessimism, even as the Dow was surging skyward. Because, once you leave Wall Street and Washington’s Lobbyists’ Row on K Street, there’s a whole lot of hurtin’ goin’ on…

...providing little more stimulus to the real economy than sending out daily re-broadcasts of Jimmy Carter speeches on economic malaise.

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The Pain is Mainly on Main Street
As the “Too Big To Fail” banks rejoice in their financial heroin injections, there are few signs of euphoria on Main Street. Indeed, the bankers on Main Street collectively remind us of those impressionist portraits of lonely, angstridden absinthe drinkers. These charts of the relative performance of small regional banks to the big national banks and the S&P show that, in banking terms, as the rich get richer, the poor get poorer. The population of big banks is now holding steady, after the liquidation of Bear Stearns and Lehman, and the hastilyarranged Morganatic Marriage of Merrill Lynch to Bank of America. On Main Street, the small, low-flying banks of the genus parva banca have begun to succumb to a collective die-off.
KBW US Regional Bank Index ETF (KRE) vs. KBW Bank Index (BKX) January 1, 2009 to December 15, 2009
120 110 100 90 80 70 60 50 40 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 72.97 96.07

On Main Street, the small, low-flying banks of the genus parva banca have begun to succumb to a collective die-off.

KBW US Regional Bank Index ETF (KRE)

KBW Bank Index (BKX)

KBW US Regional Bank Index ETF (KRE) vs. S&P 500 January 1, 2009 to December 15, 2009
130 120 110 100 90 80 70 60 50 40 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 S&P 500 72.97 122.49

KBW US Regional Bank Index ETF (KRE)

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Financial Heroin
According to James Grant, JP Morgan’s Jamie Dimon has predicted that, because of commercial real estate losses, “several hundred additional smaller regional banks go—not make it.” The bank has died: it was too small for TARP. This cool analysis from a baron about the fate of peasant bankers recalls Gray’s Elegy Written in a Country Churchyard. It could be updated as follows: Elegy for a Deceased Village Bank For it, no more the blazing lights will burn, No business small attempt to show the sharps That would a loan on inventories earn. The bank has died: it was too small for TARP. These banks made loans to people they knew for properties in communities they knew. The losses are cyclically-driven: at the end of every real estate boom, lots of regional banks fail due to construction financing for projects that turned out to be uneconomic at the prices prevailing in the early years of the next cycle. Those bank losses can be called the cost of the American way of banking—many, many banks, including many small regional banks. Main Street bankers watch in awe and envy as the Big Bad Bonused Bailout Banks (whom we have relabeled as B5) repay TARP loans out of their huge profits on the reinvestment of Zero-cost deposits. The rush to repay those emergency infusions does not reflect over-capitalization among the B5 or an eagerness to repay to the taxpayers the largesse they received when they were collectively in extremis: they continue to assert they cannot resume traditional lending to businesses and consumers, while levering up to buy Treasurys and risk assets. The repayment urge is driven by a powerful financial hormone—the lust to free the big banks from Washington’s constraints on executive pay and bonuses. The new mottos are “It would be a shame to waste a good crisis-induced subsidy,” and “Nothing that’s bold’s eschewed again.” Few Main Street banks qualify for TARP or other relief. In this age of financial elephantiasis, they are Too Small to Bail. They do benefit directly from the increased ability of their customers to service loans as interest rates remain at low levels. They also benefit indirectly from the economic activity of the broad-based stimulus programs in the form of fiscal deficits, bailouts, and handouts, and, of course, from the government guarantee on their customers’ deposits, and Bernanke’s healing yield curve. But that takes time, and many of these banks are Too Weak to Wait.

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The regional bankers, and many of their customers, worry about the longerterm impact of that other form of stimulus which comes from governments— deficits, bailouts, and handouts. These massive overruns collectively acquire an earthly version of eternal life in the form of their permanent place in the fastest growing component of the economy—the national, state and local debts. Since Obama is budgeting a decade of endless debt increases to build the kind of Green, sharing economy he wants, the regional bankers and small businesspeople see the inevitability of higher taxes, reduced economic growth, and higher inflation. The central bankers (and governments) are, effectively, in the situation of those oft-cited mythical droppers of dollars from helicopters. To paraphrase Portia: The quality of stim’lus is not strained, It droppeth as the gentle rain from Heaven Upon the place beneath: It is twice blessed; It blesseth him that gives and him that takes: ‘Tis mightiest in the mightiest. That gentle rainfall is unduly concentrated on bankers, investors and speculators. The blessing is supposed to accrue to the politicians and central bankers who are dropping the trillions into the economy, but that part of the political calculus does not seem to be working out well for Pelosi, Geithner, or even Bernanke. Think of the US economy as a four-wheel-drive vehicle: The front wheels are the real economy: Big Business and Small Business. The rear wheels are the financing mechanisms: Big Banks and Small Banks. If the left rear wheel is in splendid condition and is maintained at optimal pressure, while the right rear wheel has mechanical problems and is underpressurized, the vehicle will not perform satisfactorily, and will be accidentprone. We believe the underperformance of the Small Banks compared with the Big Banks, the stock market and the corporate bond market, at a time of modest economic growth, is reviving the kind of endogenous risk in the financial markets that shrank so rapidly from October 2008 through March of this year.

That gentle rainfall is unduly concentrated on bankers, investors and speculators.

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Financial Heroin
We also believe these dichotomies will increase the pressure on the Fed and some other OECD central banks to keep pumping out the financial heroin— thereby increasing the likelihood of widespread addiction and dependency. Volcker said the “single most important contribution” they’ve made in the last 25 years was introducing ATMs. The screams of a recovering soldier whose heroin is withdrawn may be nothing compared to the screams from Congress and the Left if the Fed decides it must begin reducing its injections. If Ben the Heroin Hero stops the infusions in time, he will deserve to be mentioned in the same breath as Paul Volcker—a real hero…. Because he will have done the brave thing—at the risk of the loss of his job and of the Fed’s independence. Already the Pelosi Congress is considering legislation that would (1) subject Fed monetary policies to review by the Congressional Budget Office, and (2) strip the Fed of its supervisory authority over financial institutions, handing that power to a new agency created by Congress—presumably in the image of its Creator. The same politicians who applauded so vigorously as Fannie and Freddie debased the lending requirements for mortgages and expanded their balance sheets so recklessly, now seek to apply that expertise to supervision of the entire banking system. Last week, Volcker, the man who has done more than anyone in modern history to design and deliver sound regulation to international banking, told a London audience what he thought was good and what was bad about today’s banks. Volcker said the “single most important contribution” they’ve made in the last 25 years was introducing ATMs. ATMs meet, he said, the test of being “useful.” Apart from that, he had nothing good to say about commercial banks that behaved as investment banks. He agreed with the head of Britain’s Financial Service Authority that such banks are “socially useless.” He said derivatives, such as credit swaps and collateralized debt obligations, had taken the economy “right to the brink of disaster.” He noted that the economy had grown faster during the 1960s when such instruments didn’t exist. One shocked member of his financial audience challenged his dismissal of modern finance, and the magisterial Volcker huffed, “You can innovate as much as you like, but do it within a structure that doesn’t put the whole economy at risk.” He reiterated his support of Soros’ view that “proprietary trading should be pushed out of investment banks to hedge funds where it belongs.”

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Volcker is right. The collateralized debt obligations, collateralized mortgageback securities, and other computer-spawned complexities and playthings were not the solutions to basic needs in the economy, but to unslaked greeds on Wall Street. Without them, banks would have had no choice but to continue to devote their capital and talents to meeting real needs from businesses and consumers, and there would have been no crisis, no crash, and no recession. Bernanke would doubtless concur, although he doesn’t dare say so in public. He is engaged in a multi-trillion-dollar rescue operation to save the global economy from collapsing under the weight of toxic derivatives and bad trading bets. When will he take the risk of stemming the heroin flow? As the 1970s demonstrated, the longer central banks wait to scale back on above-trend money growth, the worse the ensuing inflation—even when the economy slides back into recession. It would seem that the appropriate year-end advice for levered bettors on US stocks and corporate bonds is, “Enjoy yourself, it’s later than you think.”

Without them... there would have been no crisis, no crash, and no recession.

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Financial Heroin
Before the Heroin Dripping Stops
1. Systemic Risks ...nobody does this much-needed probing of the system’s belly and bowels better than our friend Stephanie Pomboy It was the collapse of the financial system that gave us the crash in stocks and commodities and a deep recession. So any discussion of the Environment must include consideration of Systemic Risks. One reason why that financial collapse caught so many investors unaware is that there have been so few accomplished analysts of the diseases and malignancies affecting the digestive tracts and arteries of the financial system. David Rosenberg, Nassim Taleb and Nouriel Roubini are probably the most noted practitioners of what might be called Financial Gastroenterology. In our view, nobody does this much-needed probing of the system’s belly and bowels better than our friend Stephanie Pomboy of MacroMavens. She has graciously consented to let us use material from one of her latest publications, The Incomparable Ben Bernanke:
Total Credit Issuance January 1, 2002 to December 15, 2009
$ Billion 2,000 1,900 1,800 1,700 1,600 1,500 1,400 1,300 1,200 1,100 1,000 900 2002 2003 2004 2005 2006 2007 2008 2009 2010

Source: Stephanie Pomboy, MacroMavens, LLC.

She points out that credit issuance over the past 12 months is at an all-time record and notes, “Ben has restored the nation to its primary occupation—the manufacture of paper stuff….Fully 90% of the $109 billion increase in corporate profits in the 3rd Quarter came from the financial sector.”

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In defending him against his harsh Congressional critics, she observes, “They just want the replacement bubble they (or rather their constituents) bought and paid for! I mean, Greenspan never had these problems. He made replacing one bubble with another look easy.” After digesting (if that is the correct term) her analysis, we began to chew on the question of what all that paper issuance and all those reported profits had done for the Big Banks:
KBW Bank Index (BKX) relative to S&P 500 June 1, 2009 to December 15, 2009
120 115 110 105 100 95 Jun-09 Jul-09 Aug-09 Sep-09 Oct-09 Nov-09 Dec-09

...as those financial gastroenterologists continue to warn us, there’s worse than gas pains ahead for the financial system.

98.87

Their insipid stock-price performance despite huge profits based on Bernankebubbles raises serious questions about their eagerness to repay TARP loans out of their fed-subsidized profits. It would appear that the biggest bankers in the biggest banks are continuing to manage their organizations as if they were private companies owned by a few insiders and traders. If so, then, as those financial gastroenterologists continue to warn us, there’s worse than gas pains ahead for the financial system. 2. As If There’s No Tomorrow If, as we assert, stocks and corporate bonds are overvalued because of ZeroBased Investing, then when will this high-risk extra leverage be unwound? And what will be the effect on asset prices when Bernanke and Trichet start raising rates? Be careful what you wish for.

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Financial Heroin
The selloff in stocks and bonds after the announcement of the nonfarm payrolls suggests that what the markets most fear is not negative or even zero economic growth, but fast economic growth. Bernanke, Obama & Co. could soon be of the same view as the despairing Lady Macbeth: “Nought’s had; all’s spent.” In other words, the big bettors are betting the big Bernanke bets will not win big. After previous deep recessions, the snapbacks were dramatic, as inventory liquidation turned to inventory accumulation, and layoffs turned to callbacks. Despite all those trillions spent and all that monetary stimulus, the US economy has moved only from the critical care ward to the ambulatory convalescent wing. With winter coming on, Bernanke, Obama & Co. could soon be of the same view as the despairing Lady Macbeth: “Nought’s had; all’s spent.” 3. Investing Under Bubble Conditions So, after all this chatter, you may be impatient to be told how to invest, knowing that Bernanke and Co. are going to keep the heroin flowing as long as they can. In one respect, the Street consensus is where it was during the late stages of the past two bubbles—technology and housing: lip service to the idea that asset prices could be a tad aggressive, and a correction would be healthy, but NOT advising significant reduction in equity exposure and switching to the asset class that wins in stock selloffs—long bonds. Nevertheless, we are not scornful of the Street for this unwillingness to outline an exit strategy for investors before Bernanke & Co. move to their exit strategy and begin the painful process of withdrawing the financial heroin. Why? Because the sheer scale of deficits and monetary stimulus is so far beyond what was ever experienced that one finds it somewhat problematic to warn clients that a deep double-dip recession that would look like a Depression is around the corner. And, because once the recovery really gets underway, equity prices could remain quite strong for a while even in face of rising rates.

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In brief, as long as you don’t try to delude yourself that you’re a value investor when you’re buying the typical non-commodity and cyclical components of the S&P or the Russell 2000, you can console yourself in the knowledge that this particular bubble may not be ready to burst for some months. However, the amount of Bernanke pumping needed to keep it afloat is increasing, which suggests even he can’t keep this bubble alive much longer if the real economy fails to take wing. Despite a huge upside breakout of the Monetary Base in the past two months, the S&P has moved up just a tad. Even that move is suspect, because it has been accompanied by a plunge in short sales of non-financial stocks, and lackluster volumes. Fortunately for investors, if you’re interested in investing in North America, you have a real alternative: the worse the US may look to global investors, the better its biggest trading partner appears... ...you can console yourself in the knowledge that this particular bubble may not be ready to burst for some months.

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Financial Heroin
Canada, the North Star in NAFTA
Amid the excitement in financial markets when the BLS announced that November’s job losses were far less than in earlier months, restated October’s number downward, and cut the unemployment rate from 10.3% to an even 10%, seemingly few investors noted the announcement from Ottawa: Canada had gained 79,000 jobs in November. The usual back-of-envelope conversion factor for Canada to US statistics is ten, to reflect roughly the sizes of the two economies. So what would the impact have been if the BLS had announced that US employment had risen by 790,000 jobs? We ask this rhetorical question to make a serious point: you do have a North American Free Trade Area alternative to investing in US stocks and bonds—and its attractions are increasing almost as rapidly as the federal government’s share of the American economy. In brief: 1. The TSX Index is more attractive than the S&P because more than half its weight is in sound banks, and oil, gas, and mining stocks. 2. The Canadian economy is currently more attractive than the US economy because of (1) its sound banking and financial system, (2) its commodity orientation, (3) its public debt/GDP ratio is lower than the US, (4) its current fiscal deficit/GDP ratio, which is far lower than the US, and (5) because the politicians in Ottawa who share the Pelosi-Frank-EmmanuelObama ambitions to play an ever-increasing role in the direction of the economy are in the Opposition—not in control. 3. Canada has the largest reserves of fresh water in the hemisphere, excellent ports on both seacoasts, the largest oil reserves outside Saudi Arabia, and a somewhat better K-12 public education system than the US. 4. Canada’s national retirement program, the Canada Pension Plan, is not, like Social Security, backed by book entries in the national debt, but by a professionally-managed fund that invests globally, virtually free of political influence. It is—by far—the best-funded social pension system in the G-7 and, is somewhat comparable to Chile’s and Norway’s. It covers all Canadians except residents of Quebec, who have a parallel benefit structure, but a somewhat lower level of funding.

Canada had gained 79,000 jobs in November.

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Toronto Stock Exchange (TSX) (currency adjusted) relative to S&P 500 January 1, 2001 to December 15, 2009
300 250 219.10 200 150 100 50 0 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09

S&P/TSX Capped Financials Index (TTFS) (currency adjusted) relative to KBW Bank Index (BKX) January 1, 2001 to December 15, 2009
600 500
479.22

400 300 200 100 0 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09

Canadian dollar (CAD versus USD) January 1, 2001 to December 15, 2009
1.1 1.0 0.94 0.9 0.8 0.7 0.6 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09

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The Strong Loonie: A Problem for Investors?
For most foreign investors, “Buying Canada” has meant investing in Canadian banks (and some leading non-bank financials, such as Manulife, Sun Life, Great-West Life and Power Corporation), and buying commodity stocks. In part, the attraction in the later years of this decade, has been the strong Canadian dollar—the loonie. We learned about that aspect of global investing from Swiss clients during the 1980s. They told us how crucial currency was in buying equities. Their light-hearted rule of thumb was, “There are three considerations in global equity investing: the first is currency, the second is currency, the third is, what makes this an attractive company?” They pointed out that “Outperforming the Toronto or New York Exchange means nothing to us if the Canadian or US dollar’s decline against the franc wipes out the apparent gain. Besides, wealthy clients usually have strong view about currency risk and would take business away from their managers if they lost money on currency—the one area in which many clients considered themselves better experts than the fund managers.” When we tried arguing that a weak currency could mean lower profits for Canadian companies, they dismissed that argument out of hand: “We’ll happily pay a higher P/E for companies operating in a strong currency, even if it constrains their earnings growth, because those earnings are real.” That explains why strong Canadian resource companies whose output is US-dollar-denominated are highly respected globally—even though most of their costs are incurred in a strengthening Canadian dollar. Moreover, Canadian mining and oil companies are, in effect a play on booming Asian economies such as China, India and Korea even if most of their sales are to the US—because the price of their output is, in effect, set by Asian demand. An Alberta oil sands producer ships no oil to Asia, but the US dollar price is set—at the margin—by Asian demand. Besides, many major Canadian resource companies operate globally, earning profits in many currencies. Canada’s trade with China is booming, and major new port facilities are under construction in British Columbia to facilitate further expansion.

“There are three considerations in global equity investing: the first is currency, the second is currency...”

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Canada has had its own relationship with China that predates Nixon’s “opening” of the Middle Kingdom. China recognized “Red China” long before the US, and Canadian missionaries—particularly medical missionaries—were highly esteemed in China. Dr. Norman Bethune, a Canadian Communist, provided notable service as a battlefield physician to Mao Zedong’s army in 1938-9. He was so admired that Mao published an extremely laudatory essay after his death, and erected a statue in his honor. Canada was also a major supplier of wheat to China at a time the US was embargoing its exports. In a nation in which resentments for past perceived slights are long remembered, Canada has few blemishes. The sectors of the Canadian economy that are particularly hard hit by the strong loonie are autos, steel, and tourism—but these industries have a trivial weighting in the TSX. Most of Canada’s manufacturing base is foreign-owned, so investors who buy the TSX aren’t exposed to the currency problems that hurt the Canadian subsidiaries of such global giants as P&G, Colgate, or Nestlé.

Why haven’t some Canadian banks shared the fate of Citibank or Bank of America— if not Lehman?

Those Strong Canadian Financial Stocks
Most Canadians—let alone most Americans and Europeans—are unaware that Canada has been starring in some G-7 rankings published by international journals: #1 ranked central bank #1 ranked banking system #1 ranked Minister of Finance These rankings suggest that the Canadian financial system is exemplary—at least by G-7 standards and in comparison with the US—which is, for most foreign investors, the only really crucial comparison. Why is the Canadian financial system so strong and well-managed? Why haven’t some Canadian banks shared the fate of Citibank or Bank of America—if not Lehman? We believe the differences between Canada and the US go all the way back to their national origins. The US is the inheritor of a revolution against British rule. At that time, Britain also ruled the colonies that make up today’s Ontario, Quebec and Atlantic Canada. The American revolutionaries sought to “liberate” the colonials in

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present-day Quebec, who had only fallen under British rule in 1759 at the Battle of the Plains of Abraham. France was on the side of the rebels, so it seemed logical that the French settlers would have welcomed American rule. They didn’t, for a variety of reasons, and the former British North American colonies evolved into two quite different nations over the next century. Canada was put together from the colonies which, in general, had experienced little contact or interest in each other. However, the astonishing scale of American land armies during the American Civil War convinced Canadian politicians and the British Foreign Office that it was time to create a semi-independent nation that could stand on its own feet—with help from Queen Victoria and her army and navy. Canada was constituted under a statute passed by the British Parliament called the British North America Act, in 1867. (It is said that on the day the Canadian Constitution was passed in Westminster, there was a higher attendance level and greater interest shown by the Parliamentarians in a dog-tax law that was next on the agenda.) In that statute, Canada was dedicated to delivering “Peace, order and good government.” That remains in the nation’s Constitution. That pragmatic and administratively-oriented credo contrasts sharply with the words that 91 years earlier announced the birth of the USA, which was dedicated to protecting the basic human rights of “Life, liberty and the pursuit of happiness.” The writer of that ringing document, Thomas Jefferson, would have roared with laughter at Canada’s quiet objectives—and would then have denounced them. Jefferson believed that every nation—including the USA—needed revolutions from time to time to prevent national governments from gaining too much power over their citizens. “That government is best which governs least” was his firm view. Canada has never been ruled by governments which espoused Jeffersonian minimalism. Occasional threats of invasion and annexation from American advocates of Manifest Destiny, the challenge of uniting the nation from sea to sea, the enthusiasm of Canadians of British descent for fighting abroad in Britain’s wars—from South Africa to the Somme, the exceptionalism and later the threats of separatism from Quebec, the lack of industrial giants like Rockefeller or Carnegie, and the harsher climate have all combined to make Canadians more deeply dependent on their governments—provincial and federal—than the typical American.

“Peace, order and good government.”

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The result of such divergence was that Americans embraced capitalism with more fervor and success than Canadians, and America was more clearly the land of opportunity for ambitious young people who wanted to be richer than their ancestors. Canada’s financial system has always reflected this sense of insecurity that has underpinned the national commitment to protect the economy from the financial collapse of banks. Result: Canadian banks have always been far less numerous and far more tightly regulated than US banks. However, the system has worked to Canadians’ benefit. Canada didn’t lose banks during the Depression, whereas thousands of American banks collapsed. There have been some restructurings of failed financial institutions in Canada in recent decades, but the big five—and more recently, six—national banks have been towers of financial strength compared to the average big US bank. Although Canadian bankers naturally like to pat themselves on their backs for this success, much of the credit should really go to the Bank of Canada and the nation’s tradition of highly-experienced, nonpolitical regulators in Ottawa. When Citigroup was formed in 1998 as a $250 billion colossus, Canadian banks rushed to Ottawa and demanded the right to merge. “How can we compete against such a giant?” they wailed. Forgotten amid the denunciations of “Ottawa bureaucrats” and “petty politicians” by some bankers were how well they had been protected against competition since Confederation. Canadian banking may be the longestlived, most stable, and most profitable oligopoly in the history of finance. Foreign banks for decades couldn’t take Canadian deposits and their right to maintain office space was controlled. When negotiations on NAFTA were proceeding, Canada continued its ban on American banks’ ownership of more than a small minority interest in Canadian institutions. Meanwhile, other negotiators outmaneuvered American objections to Canadian banks’ outright acquisition of American banks. Those “bureaucrats and politicians” bankers sometimes deride ensured that Canadian banks’ highly-profitable dominance of the Canadian financial system would continue. As Canadian bankers lobbied in Ottawa, talk of merger approval dwindled and died. Since there were only five big banks with operations across Canada and abroad, this would have meant shrinking the number of Canadian banks to two or three. There was near-zero public enthusiasm for that proposal, and there was widespread alarm among small businesspeople. December 23 Canada didn’t lose banks during the Depression, whereas thousands of American banks collapsed.

Financial Heroin
Because they were required to stick fairly closely to the leverage rules of Basel I that big American and European banks were violating, and because of their sustained profitability from their oligopoly on their home turf, the big Canadian banks came through the US financial crisis of 2007-8 in good shape. The most amusing of the ironies was that by late 2008, all members of the Big Five of Canadian banking had higher stock market capitalizations than Citigroup—which—they had told Ottawa a decade earlier—would put them out of business. From our perspective, Canadian bankers have displayed political tonedeafness on occasion, but they are collectively wiser and are better risk managers than their American or British counterparts. It also helps that the Ottawa regulators in the Bank of Canada and agencies within the Department of Finance are more professional than those in the Treasury Department or other US agencies. Why? Because under the US spoils system, each new regime appoints not only the top layers in the various departments and agencies, but some of the important layers underneath. Those departing political appointees from the previous Administration then take lucrative jobs within the financial community, or as lobbyists. The Canadian civil service has a tradition of professionalism and careerism. Only the very top layer of the key departments includes outright political appointees, and most of them have blue-ribbon backgrounds that justify their appointment. Nothing like the Congressional log-rolling and hectoring that poisons the process in Washington occurs in Ottawa—with the rarest of exceptions. A Deputy Minister of Finance in Ottawa is customarily a true professional who has served political masters from both major parties and given them his or her best advice and information. That’s one big reason why financial regulation works so well in Canada compared to the US. There is no Canadian political counterpart to Barney Frank, Maxine Waters or Chris Dodd, who can get high-level appointments to entities such as Fannie Mae, who override decision-making within those operations in favor of their own political interests, and who block regulators—even at Alan Greenspan’s exalted level—from intervening to prevent financial disaster. We certainly don’t argue that all Canadian politicians are saintly and sound. But a sustained history of protecting the civil service from unseemly political partisan interference means regulation has a good chance of succeeding in

There is no Canadian political counterpart to Barney Frank, Maxine Waters or Chris Dodd...

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Canada—whereas it has, sadly, little chance in the US. Bizarrely, the pending legislation in Congress on financial regulation would greatly expand this day-to-day interference and influence peddling and make an ineffective regulatory environment even worse. The reality is that when you buy a Canadian bank stock, you are buying a participation in a good economy that works under traditions of regulation that have evolved over 140 years. You are also buying the Canadian dollar. When working on Toronto’s top trading desk in the 1980s, we learned that some Japanese and European investors would send us overnight orders to buy or sell large blocks of the bank stocks as a group depending primarily on their short-term view for the Canadian dollar. Peace, order and good government: dull? But that gap between glamour in Washington and cautious professionalism in Ottawa has existed for most of the time since Canadian Confederation. With the exception of Pierre Trudeau, Canada’s political leaders have lacked the glamour, panache and punch of America’s more colorful politicians. But banking and financial regulation shouldn’t be heavily involved with glamour, panache, and eagerness to assume large, heavily-levered risks for large personal reward. When their bets went sour, the taxpayers were on the hook for trillions. And, within less than a year, the bettors were back, announcing record profits, and protesting that any constraints on their compensation were un-American. Some years ago, Washington’s National Press Club ran a contest for a newspaper headline that would attract the least readership. The hands-down winner: “Interesting new policy proposals from Canada.” Last October, Ben Bernanke and Hank Paulson might well have wished that Canadian dullness and caution had permeated Wall Street. Finally, we offer a NAFTA Note: the combination of a strong loonie and strong Canadian financial stocks means than Canadian banks and non-bank financials have splendid opportunities to increase their market share in the US at a time US financial stocks are in their weakest position relative to Canadian companies since the Depression. If nature abhors a vacuum, the holes in US financial companies’ balance sheets offer opportunities to financially muscular Canadian competitors. That sucking sound is Canadian money and financial products being drawn into the US market. That sucking sound is Canadian money and financial products being drawn into the US market.

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The Changed Climate for the Climate Change Chattering Class
Since we last published, Global Warming has been on the front page nearly every day. While it is imprinted within our genes that we must resist the urge to devote extensive discussion to what you read and hear about most, this has been one of our major themes for three years, so we cannot resist talking about the latest developments. Besides, so much of it is so delicious!

This is the center that produced the data that produced the UN document that produced the “consensus” that produced the Nobel Prize for Al Gore and friends.

Those Three Thousand E-Mails
The most-publicized scientific consensus of our time is that there is no possible debate about global warming: it is settled science. The final nail in the coffins of the few fools left out there who continued to question the data and computer models showing that the world would soon be irremediably hot was the awarding of the Nobel Prize to Al Gore and the UN’s Intergovernmental Committee on Climate Change. This unanimity among scientists became the basis for imposing controls on carbon across economies, which is the purpose of the Copenhagen conference. If economic growth suffers, that is the cost of saving the planet. Besides, we’ll eventually develop new technologies that will stimulate good growth—not the polluting kind. But then the anonymous hackers released the thousands of e-mails from the epicenter of Global Warmism—the Hadley Research Unit at the University of East Anglia. This is the center that produced the data that produced the UN document that produced the “consensus” that produced the Nobel Prize for Al Gore and friends. And, we learned, it is the center that not only managed to “lose” all the data showing that the world had been getting warmer, but that it replaced the actual data with computer-created models. And it never told anybody outside its own in-group. Perhaps only the Flat Earth Society, it appears, has a smaller historically-documented data base. (As we now know, leading global warmists refer to their opponents as “Flat Earthers.”) Those who questioned whether the Hadley Unit was straying from pure science into political advocacy were demonized as tools of reactionary forces. (As recently as last week, the usually reasonable Tom Friedman of The New York Times insisted that the Hadley scientists reacted so strongly because they were beset by lies financed by Big Oil. So A Really Big Lie That Gets A Nobel is justified if it’s responding to lies from small climate groups almost nobody (except Hadley researchers) has heard of that might be funded by Big Oil.

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The reality is that the Hadley Unit has been mixing science and politics since its birth in 1990—it’s just changed sides. It was actually founded by none other than Margaret Thatcher. As Lawrence Solomon explains in the Financial Post, she was trying to promote the building of nuclear power plants, and among her opponents, of course, were the coal miners. She had majored in chemistry at Oxford and retained her interest in science. She arranged to set up and fund this research centre to collect global data which would, she hoped, eventually convince everybody except the coal miners that nuclear power—the only greenhouse-gas-free system—was the only sensible electric power program. It may be the worst decision she ever made. Her hopes of disinterested science that would lead all but the insane to adopt nuclear power were dashed. As with so many foundations and universities, the dominance of the Left in academia meant that this centre became the leading advocate of the global Left’s leading cause after the Fall of the Wall— global warming. The enthusiasts correctly saw that this could be the lever to deliver to the Enlightened the control of “capitalist” economies whose voters obstinately refused to elect socialists or even leftists. (Of course, not all the scientists and enthusiasts who wrote the emails have such extreme goals, but the temptation of huge grants and real political power was too much for them.) As recently as 2007, a government-commissioned review of Hadley’s effectiveness stated: “It is beyond dispute that the Met Office Hadley Centre occupies a position at the pinnacle of world science and in translating that science into policy advice to governments.” Whenever we hear from the global warmists, what they say is “Beyond dispute”, it’s just as if the Pope or a Cardinal were speaking Ex Cathedra: the matter is settled. This month’s posting of thousands of Hadley emails on the web is, depending on your viewpoint, a criminal violation of privacy (Senator Barbara Boxer), nothing much at all (The New York Times), not even worth mentioning (The Economist), the greatest challenge to science’s legitimacy of our time (Bret Stephens, Wall Street Journal) or proof that global warming is a fraud (too many to cite).

The enthusiasts correctly saw that this could be the lever to deliver to the Enlightened the control of “capitalist” economies whose voters obstinately refused to elect socialists or even leftists.

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But this dispute about scientific misbehavior isn’t going away. Even some global warmists admit dismay about the e-mail discussions of ways to suppress opposition and to “juice up” data. That these scientists would resort to such anti-scientific behavior belies the claim of the warmists: it’s settled. Furthermore, their schemes to suppress publication of research challenging their own work challenge the most sacred of all scientific principles—the free and open search for truth. One of the scientists who participated extensively in various schemes to prevent scientists who questioned their data and conclusions from getting published or getting jobs, defended himself in a newspaper interview by saying, “All that the emails show is that some scientists behaved badly. Maybe Newton was an ass, but the theory of gravity still works.” Note the implicit assumption: a theory that has been challenged by thousands of scholars, and is at risk because of recent evidence of cooling temperatures, is as valid as Newtonian physics. Has the scientist found evidence of apple trees shedding fruit that thereupon flew upward and disappeared in the clouds? This scientist must be particularly close to Supreme Warm-monger Al Gore, because in his debate with Sarah Palin, Mr. Gore sneered, “It’s like Gravity. It’s There.” Many commentators have noted the eerie similarity between these scientists’ eagerness to censor and suppress dissent and the Catholic Church’s treatment of Galileo—the classic case of science vs. religion. There is no doubt that leading global warmists behave as if they were priests of a secular religion. They proclaim their eagerness to take over the organization of a vast section of the world’s economy—the modern version of Plato’s vision of a commandand-control society ruled by an oligarchy of the Enlightened. We disagree strongly, however, with those who claim that these revelations prove that global warming is a fraud. That the Catholic Church and Spanish Inquisition were wrong in burning at the stake the dissenters of their day does not prove that God does not exist.

“Maybe Newton was an ass, but the theory of gravity still works.”

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That Al Gore (of the potent partnership of Gore & Blood) has become astonishingly wealthy by managing “Green” investments that rely heavily on government subsidies and lucrative carbon offset deals does not prove that global warming is fraudulent. He is simply the modern version of the Vatican shill Tetzel, who came through Wittenberg in 1517, raising money for St. Peter’s Basilica through sale of indulgences. Indulgences were ways of buying your own way out of thousands of years in Purgatory or freeing a deceased family member. He had a line that Gore might envy: As soon as the gold in the casket rings The rescued soul to Heaven springs. His fundraising was for a great cause—paying Michelangelo to complete the Sistine Chapel. We all owe a debt to Friar Tetzel. But his somewhat dubious marketing techniques had disastrous results for the Church he served. He so enraged a young, idealistic priest named Martin Luther that he launched the Reformation, shattering the unity of Christendom. Carbon offsets are sold on a similar principle, although with rewards that are measured purely in earthly terms. The modern sales pitch amounts to: “Pay Blood & Gore, then sin some more”. The Colorado scientist who wrote to his East Anglia allies in anguish about the remarkably huge and remarkably early snowfall that canceled a World Series game, admitted that “We can’t explain the cooling that’s going on. It’s a travesty.” (As all baseball fans know, that occurred on October 10th.) That’s really where the debate should stand. Why did the scientists give up on the evidence from tree rings and switch to models? Were they ahead of their time immersing themselves in the modeling craze of the 1990s—with Long Term Capital Management merely following in their (non-carbonic) footprints? Why did they have to concede, under pressure, to a Canadian critic that the three hottest days in the past century weren’t in the 1990s, as they originally claimed, but in the 1930s?

The modern sales pitch amounts to: “Pay Blood & Gore, then sin some more”.

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What about the seeming correlation between the virtual disappearance of sunspots and the recent cooling? Four centuries of documentation show (as NASA concedes) a correlation of more than 80% between sunspot activity and temperatures on Earth. Why should they assume that the powerful sunspot activity of the past two centuries would continue indefinitely? Why do they reject evidence that the world was warmer a thousand years ago than now? It remains, of course, possible that global warming exists and that CO2—with some help from methane—is the prime cause. In essence they are telling us that what the world needs is to apply the Atkins Diet to the air: low carbs in what we eat and what we breathe. When Al Gore was asked to comment on the emails, he said he hadn’t read all of them, but they were “as Shakespeare said, full of sound and fury signifying nothing.” Besides, he asserted, they were all at least ten years old and are of no relevance for today’s debate. All the emails were date-stamped and some were as recent as this November. How could Mr. Gore be so sure they were all at least ten years old? Some tongue-in-cheek observations about his rebuttal: 1. Gore’s quotation comes from the last and most famous of Macbeth’s soliloquies. It is spoken as Macbeth is girding himself for the final battle with Macduff. He expresses his final despair about Life, but Gore only quotes the second half of that sentence: “Tis a tale told by an idiot Full of sound and fury, signifying nothing.” Yet, the emails are entirely composed by the scientists on whose analyses and forecasts Gore and the UN have relied. 2. Macbeth had murdered Macduff’s wife and children and was confident that he could kill Macduff in any battle because the Three Witches had told him he would not fall until “Birnam Wood shall come to Dunsinane”. The Witches, the best-regarded forecasters of their time, dabbled in weather forecasting: “When shall we three meet again? In thunder, lightning, or in rain.”

...what the world needs is to apply the Atkins Diet to the air: low carbs in what we eat and what we breathe.

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The staff at East Anglia could, perhaps, be considered their successors, and their resort to “tricks” to cover up data that challenged their conclusions about future climate conditions argue that, like the witches, they are creative in creating their forecasts. 3. Macbeth, who has seen what looked like Birnam Wood moving toward Dunsinane (because Macduff told his soldiers to cut tree branches to cover themselves), for the first time wonders whether his own data base had been misconstrued. He sighs, “Out, out, brief candle Life’s but a walking shadow.” The only scientifically-cited alternative to the claim that man-made heat is warming the world excessively is the fact that we have experienced—until 2007—two centuries of strong sunspot activity. Sunspots, which are energy bursts from the sun’s core which move to its surface, appear as shadows on the sun. They could be characterized as “walking shadows.” 4. Finally, Mr. Gore’s selective quotation impales him: the words come from a hero-villain who drew excessive conclusions about his own invulnerability from a forecast made by the leading seers of his time. Although Mr. Gore may be running out of credible scientific support for his misplaced dogmatism, he can still fall back on his one real scientific achievement—inventing the Internet—and on the billions he and his partner in the firm of Gore & Blood are investing in green projects and in the creation and trading of carbon offsets. Mr. Gore may be running out of credible scientific support for his misplaced dogmatism, he can still fall back on his one real scientific achievement— inventing the Internet...

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The Environmental Protection Administration Takes Charge
As warmists were jetting to Copenhagen, the US EPA announced that it had made the finding that CO2 is a pollutant dangerous to human health. That means the EPA has the power and responsibility to regulate all CO2 emissions across the US economy, and in any products entering the US. Until this announcement, the warmists were relying mainly on getting passage through Congress of Obama-backed legislation that would include both capping greenhouse gas output and providing trading mechanisms for emitters. That legislation was in trouble because of its huge impact on the US economy. It was heavily supported by such major Obama financial backers as General Electric that seek to profit big time from producing green energy products, but was opposed by such major employers as the truckers, chemical producers, coal producers, and oil producers and refiners. The EPA says that, according to a Supreme Court decision, it has the sole right to decide what is a pollutant and how to control it. (The Supreme Court said that, under existing legislation originally enacted under President Nixon, the EPA has the authority to define and regulate airborne pollutants.) So the EPA now certifies that CO2 which is absolutely necessary for plant life and occurs naturally in the air we breathe, is in the same category as such man-made pollutants as sulphur dioxide (that causes acid rain, asthma, and lung cancer), hydrogen sulphide (which, when leaked even briefly, has killed people), and methyl isocyanate gas—which, when leaked at Bhopal, killed and sickened thousands of people. That means the EPA has the right and duty to approve all construction designs for large multi-family buildings, engines and emission devices for cars and trucks, and all factories and electrical generating plants that are found to emit more than 250 tons of CO2 per year, and all dairy operations. (Bovine flatulence is such a potent source of greenhouse gas that Sir Paul McCartney has called on all citizens to observe a meatless Monday to help save the planet.) It is fair to say that, unless a future Congress amends the law, the EPA will be the most powerful bureaucracy any democracy has ever spawned anywhere since the collapse of Communism. As shocked business groups are already complaining, this open-ended, unrestrained power to a bureaucracy is yet another huge constraint on capital investment at a time US capex is flagging. We can safely predict that many more factories will be opened in China, which is among the conspicuous winners in Copenhagen.

Bovine flatulence is such a potent source of greenhouse gas that Sir Paul McCartney has called on all citizens to observe a meatless Monday...

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Financial Heroin INVESTMENT ENVIRONMENT
A year of bull markets in bonds and stocks is a welcome successor to last year’s disasters. It took a while for Zero borrowing rates to take effect, with the S&P and other major equity indices slumping in winter, bottoming in Spring and soaring thereafter. Helping to pull them skyward was a splendid year for corporate and other risk bonds. The Zero rates’ economic stimulus is hard to measure, but their impact on tradable risk assets is as obvious as the Washington Monument. No discussion about what the future holds for investors would be complete without consideration of gold’s powerful performance in recent weeks. So we shall begin our discussion of the Environment with the classic monetary metal. ...gold’s performance could be the clearest, purest example of Zero-Based Investing.

Gold
As the only major financial asset that never pays interest or dividends, gold’s performance could be the clearest, purest example of Zero-Based Investing:
Gold January 1, 2009 to December 15, 2009
1,250 1,200 1,150 1,100 1,050 1,000 950 900 850 800 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 1126.00

With a 25% rise this year, Gold has beaten the S&P roughly 7%. As measured by the XAU, gold mining stocks’ total return is 35%. But gold’s investment return was exceeded by the amount of publicity and debate it generated. Its late-year blow-off past $1200 briefly made it a Page One story—thereby automatically guaranteeing a sharp correction.

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The media were filled with authoritative explanations: Hyperventilating Commentators’ Explanations:

The classic expression for getting rich quick is to find a gold mine— but it takes time, experience and capital to bring on a mine.

• • • •

the collapse of the dollar; the repudiation of Obamanomics; a warning of a coming financial collapse, leading to Depression; a signal of the runaway inflation to come; China has only begun to convert its dollar holdings into bullion: the best is yet to come; a short squeeze on gold ETFs which are misrepresenting how much bullion they hold: beware of counterparty risk: buy bullion, not paper; a coming Armageddon in the Mideast.

Sophisticated Explanations

• •

gold is the only asset that is nobody’s liability and is therefore a haven in an increasingly uncertain world; capitulation by hedged gold miners, notably Barrick; India’s purchase of 203 tonnes from the IMF, removing the overhang in bullion markets; China’s announcement that its gold holdings are higher than were previously revealed; “Peak gold” discussions, as investors ponder the failure of gold mines to maintain—let alone increase—their production despite record bullion prices. The classic expression for getting rich quick is to find a gold mine—but it takes time, experience and capital to bring on a mine. Reported gold companies’ reserves haven’t been rising, but soaring gold prices will change that: millions of tons of low-grade “resources” that haven’t been booked as ore reserves will be reclassified if gold prices remain near or above current levels; recognition of the longer-term implications of central banks’ astounding levels of creation of fiat money at a time they are collectively becoming net buyers of gold—after decades of sustained selling; respect for gold’s future because prices have managed the remarkable feat of setting new records at a time jewelry demand—traditionally the main support for gold—is slumping sharply; portfolio diversification by sophisticated investors who seek a haven at a time of zero returns on Cash—with no indications that central banks are about to abandon their Zero policies.

Clients can undoubtedly add other justifications and explanations to their lists. 34 December
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We were in Toronto the week gold prices were setting records daily, and were asked—on TV—to explain the dramatic run-up. Various prominent commentators were falling all over themselves to issue ever-higher targets for bullion prices. We admitted that we couldn’t explain the sudden rush and the dramatic daily leaps. When asked for our price target, we suggested…. “As an historian, I seek some historic data to assist our predicting. When gold broke through $1,000, we began considering appropriate targets. As every English schoolboy knows, 1066 was the Norman Conquest—the first gold target. The next important date was Magna Carta—1215—and gold has now managed to attain that level. The next big date is the Provisions of Oxford 1258 [when Simon de Montfort forced important constitutional changes on Henry III]. “My one-year target for gold is 1345—the onset of the Black Death. “Apart from that, I really can’t say how high gold could ultimately go, although longer-term it should reach 1485, when Richard III fell in the Battle of Bosworth, launching the Tudor monarchy, and giving us the enduring quote, “My Kingdom for a horse!” The interviewers laughed, and changed the topic. Next day, Goldman issued its authoritative target price for next year: 1350. We were called for comment, and graciously accepted that prediction because it was the end of the Black Death. The point of these musings is that no one really has any idea of the longerterm price of gold that can be justified by sober analysis. All that we can sensibly say is that gold’s price entered a 20-year Triple Waterfall collapse in 1980, falling from $825 to $250, and has risen every year in this decade. If it can maintain its strength at a time jewelry demand is shrinking, then investors and speculators are in charge; their motivations include momentum and malaise: Gold looks good because it keeps going up, and they’re scared about what the Fed and Obama and other central banks and governments are doing, and have no great confidence that there will be a sustained, noninflationary economic recovery, so gold is a good place to hide. “My one-year target for gold is 1345— the onset of the Black Death.”

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Financial Heroin
Gold has been the best-performing major commodity since the financial crisis began:
Gold relative to CRB Futures January 1, 2007 to December 15, 2009
220 200 180 160 140 120 100 80 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 178.70

...gold has its best claim as a constituent of foreign exchange reserves since Bretton Woods booted it out sixty-five years ago.

We see no big reason why that outperformance should be over. After its breathless run to $1220, it’s entitled to correct back toward $1,000—or even a bit below that chiliastic level—without ending its bull market. Finally, gold may even be decoupling from the dollar. The sheer scale of foreign exchange reserves in China, Hong Kong, India and other countries whose currencies are pegged, directly or otherwise, to the dollar may be opening a whole new demand for gold. Just to maintain even tiny percentage exposure to gold in forex reserves means these nations must remain on the buy side. The euro was once seen as a worthwhile alternative to the dollar in Asian forex accounts, but the unfolding problems of its Eastern European and Mediterranean members are exposing the euro’s internal contradictions as a viable alternative to the dollar. In a world in which nearly all paper money has problems, and in which the sheer supply of paper money is expanding far faster than global GDP, gold has its best claim as a constituent of foreign exchange reserves since Bretton Woods booted it out sixty-five years ago.

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Commodities and Commodity Stocks
Reuter-Jeffries CRB Futures Index December 15, 2008 to December 15, 2009
290 280 270 260 250 240 230 220 210 200 190 Dec-08 Feb-09 Apr-09 Jun-09 Aug-09 Oct-09 Dec-09 274.27

...we learned to our sorrow that commodities and commodity stocks are among the bloodiest victims when the margin clerks take charge.

Are commodities in bubble conditions? That the CRB has delivered virtually identical year-over-year returns to the S&P is obviously of concern to us, since we have been warning of a coming S&P correction since late summer. Of the commodities we follow, crude oil, copper, gold and silver have outperformed the S&P, the grains have roughly broken even, and natural gas, of course, has sharply underperformed. In other words, this isn’t a replay of the 1970s—yet. Nevertheless, we are concerned that in recent weeks, the total Speculative Open Interest in US commodities has moved into overbought range. Zero is having its effect. As for the relative performance of the commodity stocks to the S&P, the base metals have hugely outperformed, most of the oils and agriculturals have outperformed modestly, (although there have been a few significant losers), and the gold miners have collectively marginally outperformed. We believe there is little evidence of a large new commodity bubble. That said, we learned to our sorrow that commodities and commodity stocks are among the bloodiest victims when the margin clerks take charge.

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Financial Heroin
However, the basic reasons for overweighting commodity stocks remain valid: 1. They are proxies for unhedged reserves of necessary raw materials in politically-secure locations. As such, they benefit over the longer term from the trend to global shrinkage of both reserves and politically secure locations. The takeout of XTO by Exxon illustrates this point. XTO was the only US oil and gas producer in the Coxe Commodity Strategy Fund, because we liked its reserves and its land positions. It wasn’t as popular with the Street, which is always more interested in near-term earnings than long-term value. 2. Commodity stocks are, collectively, proxies for participating in the growing wealth of the growing Third World middle class—the most important demographic of our time. 3. Wherever they are headquartered and wherever they distribute, the price of whatever they sell is influenced or controlled by demand from China, India, Taiwan, Korea and Indonesia—and these economies and their populations will continue to gain in wealth and in share of global GDP at the expense of the economies and residents of the US and Europe. 4. Real assets that are really needed for people and economies to survive are really comforting to own at times of extreme financial uncertainty.

Real assets that are really needed for people and economies to survive are really comforting to own at times of extreme financial uncertainty.

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Financial Heroin RECOMMENDED ASSET ALLOCATION
Recommended Asset Allocation (for U.S. Pension Funds)
US Equities Foreign Equities European Equities Japanese and Korean Equities Canadian and Australian Equities Emerging Markets Bonds US Bonds Canadian Bonds International Bonds Long-Term Inflation Hedged Bonds Cash Allocations 17 5 2 11 14 12 8 11 10 10 Change unch unch unch unch unch unch unch unch unch unch

Bond Durations
US Canada International Years 5.25 5.00 4.50 Change unch unch unch

Global Exposure to Commodity Stocks
Change unch unch unch unch

Precious Metals Agriculture Energy Base Metals & Steel
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.

33% 33% 22% 12%

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Financial Heroin INVESTMENT RECOMMENDATIONS
1. Remain underweighted in US equities—as a percentage of equities within global portfolios, and as a percentage of assets in US balanced portfolios. Underweight US bonds in global portfolios. The long-term financial projections for the US are scary, even if one accepts the Obama assumptions: ten years of large deficits, no recessions, strong, sustained economic growth, and a mere 1% increase in Treasury yields. Those numbers make no allowance for the costs of health care, which will be huge. Debilitating tax increases are inevitable, even if the global warming “cap and tax” legislation does not pass. 2. Within US equity portfolios, underweight US economy-related stocks and overweight stocks tied to foreign economies. US stocks outperformed after Obama’s election, but that created what could be called erogenous risk for investors. As long as the KRE continues to underperform both the BKX and S&P, risks of a double-dip economy remain. 3. Overweight Emerged Markets (such as China, Hong Kong, Brazil, India and Korea) within global and international equity portfolios. These markets should no longer be discounted heavily because of assumed gaps between their accounting and American practices. The credibility gap has been narrowed significantly. The FASB’s capitulation to Congressional pressure on big banks’ balance sheets is a sign that Volcker-style virtue is outdated. 4. Remain overweight commodity stocks within balanced accounts and equity-only accounts. Strong commodity-oriented companies are tied to global growth trends, led by the Asian powerhouses, which means they have less endogenous risk than companies tied to the US and Europe. 5. Emphasize gold stocks in commodity stock accounts. Gold and other precious metals appear to have entered a period of aboveaverage volatility, but the unprecedented creation of paper money and national debts means ownership of the metals and producers will tend to reduce endogenous risk in most portfolios. The stocks will tend to outperform bullion on the upside; the bullion will outperform on the downside.

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6. Continue to overweight the agriculture stocks. The best-performing commodity group in the past three months has been the agricultural stocks, led by the machinery and fertilizer stocks. Street analysts turned negative on these groups during the summer, when it looked as if US crop production would reach painful levels. Then the weather intervened. We remain of the view that the best of the agriculture stocks are among the best-quality core positions among all equities. 7. Maintain exposure to the energy stocks, but continue to emphasize oil producers and to de-emphasize natural gas producers. Oil and natural gas are both in oversupply at the moment. The difference is that crude oil prices remain strong despite oversupply, as oil companies and speculators hoard oil in anticipation of stronger demand next year—and in fear of a new Mideast war. Shale gas may be too readily available to be good short-term news for either the profits or stock prices of oil and gas producers—but Exxon’s move on XTO shows what having huge shale reserves can do for takeover values in politically-secure terrain. 8. Base metal stock prices are somewhat riskier than those of other commodity groups, but are worth holding. The producers are dependent on China’s willingness to continue to buy more metal than it needs for current consumption. 9. Within balanced portfolios, emphasize long-duration, high-quality bonds at the expense of Cash. Canadian bonds should be used by foreign investors, where possible, as alternatives to Treasurys and US corporates. Cash isn’t a true risk reducer, because it delivers no yield and cannot rise if there’s a new panic. If you must own something that pays you nothing, buy gold. In contrast, long-duration bonds are the best hedge against a renewed economic downturn. 10. Canada offers better government, better governance, a better currency, and a better stock market than the USA. Buy Canadian. The flip side to this is a wise balance sheet policy for Canadian companies. Borrowing in American dollars makes sense for Canadian exporters and resource companies—and for some other Canadian industries. Take advantage of (1) Bernanke’s heroin injections into US debt markets, and (2) Canada’s new financial prestige to reduce your endogenous currency risk by bulking up your borrowing in greenbacks.

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

Published by Coxe Advisors LLC
Distributed by BMO Capital Markets

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