Basic Points

IBM@1 = Big Ben’s Big Blues

September 9, 2010

Published by Coxe Advisors LLP
Distributed by BMO Capital Markets

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Don Coxe THE COXE STRATEGY JOURNAL

IBM@1 = Big Ben’s Big Blues

September 9, 2010
published by

Coxe Advisors LLP Chicago, IL

THE COXE STRATEGY JOURNAL IBM@1 = Big Ben’s Big Blues
September 9, 2010

Author: Editor: Coxe Advisors LLP. 190 South LaSalle Street, 4th Floor Chicago, Illinois USA 60603

Don Coxe 312-461-5365 DC@CoxeAdvisors.com Angela Trudeau 604-929-8791 AT@CoxeAdvisors.com www.CoxeAdvisors.com

IBM@1 = Big Ben’s Big Blues OVERVIEW
We return to the blues theme we used a year ago (Dem Blues). Since then, the number we’ve been using for our analysis has been Zero. This time it’s One: the 1% coupon on Big Blue’s recent $1.5 billion three-year bond issue, which came—oversubscribed—at par. IBM was AAA back when its System 360 dominated the industry, but today it doesn’t even make its own PCs and it is a mere Single A. The coupon on that bond tolls trouble for “Big Ben” Bernanke and most investors—particularly pension funds. (IBM’s bond yield is slightly less than half its stock’s.) The only major economy of the past century that experienced bond yields in that range has been Japan, a demographic disaster whose future is modeled on the passenger pigeon. Last September, we expressed concern at the stock market’s ebullient conviction that the recovery was a sure thing. We recommended that clients reduce equity exposures in favor of bonds. The recommendation was ill-timed: The S&P was 1016 on publication date, and it continued on its merry way for seven more months, peaking at 1215. Then the economy slid back into first gear, interest rates plummeted, and gold soared. So now clients, like Scrooge, get a second chance. This time, the reasons for caution are even stronger, so we are reducing recommended exposures to non-commodity stocks accordingly. As for bonds, many institutional bond managers find the Depression-level yields available in quality bonds insulting. What is left for their investors after management fees? However, for balanced funds and individual investors, long-duration government bonds offer portfolio insurance against renewed economic weakness. Our next issue will come in October, a month known for Halloween and other kinds of scary events.

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IBM@1 = Big Ben’s Big Blues

US Ten-year Treasury Yield September 8, 2009 to September 8, 2010
4.2 4.0 3.8 3.6 3.4 3.2 3.0 2.8 2.6 2.4 Sep-09 Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sep-10 2.65

Has the US economy fallen into Jackson Hole?

US Three-year Treasury Yield September 8, 2009 to September 8, 2010
1.8 1.6 1.4 1.2 1.0 0.8 0.6 Sep-09 Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sep-10 0.79

Has the US economy fallen into Jackson Hole? The optimism of late winter began to melt with the arrival of Spring. By June, instead of green shoots busting out all over, the jobless claims had begun a renewed climb, and the historically-reliable Journal of Commerce-ECRI Industrial Price Index had peaked and rolled over.

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IBM@1 = Big Ben’s Big Blues
Journal of Commerce JoC-ECRI Industrial Price Index Growth Rate * August 1, 2009 to August 31, 2010
80% 70%

...revelations of fraud, foul play and foolishness sent yields on Greek bonds to Olympian heights...

60% 50% 40% 30% 20% 10% 0% Aug-09 Oct-09 Dec-09 Feb-10 Apr-10 Jun-10 Aug-10 9.83%

* The IPI growth rate compares latest week's index with the IPI average over the past year. Source:

By late summer, some tech giants which had reported blowout Q2 earnings began issuing warnings that Q3 would be painful. State and local governments stopped stimulus-driven hiring and began firing. Christina Romer, the cheerful cheerleader of stimulus packages, suddenly departed from the Obama team. Larry Summers, who had proclaimed the economy was “approaching escape speed” was no longer a fixture on Sunday morning talk shows. The President’s approval rating slid to lows that panicked Congressional Democrats into putting his global warming legislation into the deep freeze. At first, the blame was on a sovereign debt crisis originating in Greece. Unfolding revelations of fraud, foul play and foolishness sent yields on Greek bonds to Olympian heights, where they joined the Collateralized Debt Swap yields on Greek banks. With the banking Mediterror spreading to Italy, Spain and Portugal, the European Central Bank and the governments of the Eurozone raced to issue a rescue package. As skepticism about sovereign debts began to spread across the world at a time of a slowing US economy, financial stocks slumped, setting off stock market plunges worldwide.

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KBW US Bank Index (BKX) September 8, 2009 to September 8, 2010
60 58 56 54 52 50 48 46 44 42 40 Sep-09 Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sep-10 45.84

...a profusion of hastily-fashioned Obamacronymic support programs.

KBW US Regional Bank Index ETF (KRE) September 8, 2009 to September 8, 2010
32 30 28 26 24 22 20 18 Sep-09 Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sep-10 22.11

The epicenter of the 2008 crash—US mortgage Collateralized Debt Obligations—moved back to Page One, despite a profusion of hastilyfashioned Obamacronymic support programs. Some of those programs were designed to save mortgagors from lenders; some were designed to induce lenders to make loans to borrowers who had neither jobs nor downpayments; all the programs created jobs for bureaucrats in banks, social agencies, and Washington.

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Meanwhile, on Main Street, a fast-rising rebellion against fast-rising government debts changed the political calculus. The Tea Party, a spontaneous uprising triggered by a TV rant from CNBC’s Rick Santelli, rather suddenly made political incumbency a political liability. The days when a Congressman or Senator could brag about all the goodies he or she had delivered, turned into nightmares for big names with big spending credentials. Because Democrats controlled nearly every power center in Washington except the Supreme Court, they were the primary victims of the new financial Puritanism—sometimes even in their own primaries. However, the Tea Partiers were also angry at establishment Republicans: In Florida, the formerly popular Governor Crist fell to a rising Latino star in the Senate primary, and veteran Republican politician Bill McCollum was beaten by an upstart health care executive in the gubernatorial primary. Even John McCain got a serious scare running for re-election in Arizona against a novice. Result: There will be no more multi-billion-dollar stimulus packages this year. The latest poll shows that only 6% of voters believe the Obama-Pelosi package actually reduced unemployment. (A wag at the Cato Institute noted that 6% of voters also believe Elvis lives, and he knows Elvis’s step-brother, who assures him Elvis is dead.) This means the full burden of turning around the sinking economy falls on the Fed. An angry electorate has rejected the crisis cooperation between the Fed and the Administration that began in the waning months of the Bush era and continued through the first half of this year. (That rage is, of course, more emotional than rational: had the TARP program not been implemented, many of the biggest banks would have failed, with horrendous economic consequences. Indeed, a large proportion of the loans made under crisis conditions have already been repaid.) Nevertheless, with public fear of runaway deficits now the transcendent political reality, the Administration and Congress cannot launch big new rescue programs. It’s up to Ben now.

...6% of voters also believe Elvis lives...

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Fed Up?
That the Fed Funds rate has stayed near Zero for so long—and that bond yields have fallen so far and so fast—is not due to massive new monetary stimulus. The Monetary Base is roughly where it was in December—when the S&P was slightly higher than today, and the yield on the 10-Year Treasury Note was 3.8%, compared to today’s 2.6%. The financial markets—not the Fed—have been driving down yields since the stock market peaked. (Year-todate, investors have poured $190.7 billion into bond funds and withdrawn $7 billion from equity funds.)
US Federal Funds Rate September 8, 2008 to September 8, 2010
2.0 1.8 1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 0.18

the Fed Funds rate.... is not due to massive new monetary stimulus.

Source: Federal Reserve Economic Data; Federal Reserve Bank of St. Louis

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US Adjusted Monetary Base updated September 2, 2010
j y
Averages of Daily Figures, Seasonally Adjusted Billions of dollars
2300

2200

2100

2000

1900

1800

1700

1600

Jul

Aug

Sep 2009

Oct

Nov

Dec

Jan

Feb

Mar

Apr

May 2010

Jun

Jul

Aug

Sep

To the average of two maintenance periods ending:
01/27/10 02/24/10 03/24/10 04/21/10 06/02/10 06/30/10 07/28/10 08/25/10

Compounded annual rates of change, average of two maintenance periods ending:
08/26/09 44.8 54.0 43.8 31.6 24.8 20.9 19.0 17.7 24.3 16.2 5.4 2.4 0.5 0.4 0.7 40.9 10.5 4.1 1.0 0.7 1.1 -21.1 -15.5 -14.8 -12.4 -10.1 -18.3 -16.5 -13.2 -10.4 -9.4 -7.0 -4.7 -6.5 -3.2 1.5 11/18/09 01/27/10 02/24/10 03/24/10 04/21/10 06/02/10 06/30/10

Source: Federal Reserve Economic Data; Federal Reserve Bank of St. Louis

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Credit and Liquidity Programs and the Federal Reserve’s Balance Sheet (Data are shown through July 28, 2010)
Securities Held Outright Selected Liabilities of the Federal Reserve

...the banking industry has produced in recent decades is the ATM.

Source: Federal Reserve System Monthly Report on Credit and Liquidity Programs and the Balance Sheet; August 2010, Board of Governors of the Federal Reserve System

Ned Davis notes that the May 6th “flash crash” has been a big contributor to this asset shift: “In the 11 straight weeks leading up to the ‘flash crash’ the public poured a strong $26.6 billion into equity mutual funds, but in the 16 straight weeks since the ‘flash crash’ they have sold in each and every week, pulling out $55.9 billion net.” The “flash crash” is yet more evidence that Wall Street doesn’t get it. Having most of the responsibility for the 2008 crash that sent millions of people into unemployment and triggered the worst downturn since the Depression, the Street continues to whine that it needs room for its “innovations,” and insists that its big bonuses are the American Way to Prosperity. We heartily concur with Paul Volcker’s analysis that the only socially useful innovation the banking industry has produced in recent decades is the ATM. Stock trading in billionths of seconds by robots to capture minute price differences is a waste of engineering talent and a mortal threat to the financial system when robots run amok. We hope that the bosses at Accenture, who advise many leading financial organizations, were suitably horrified about the value of the new trading platforms when their stock briefly traded at 14 cents per share during the “flash crash.” Perhaps we need a new law that says that if there’s another such financial obscenity, all those trading shops will be shut down for good and their owners will have to sell the assets of their businesses for 14 cents to the Social Security Trust Fund.

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Dr. Bernanke and friends have ample justification for resorting to what is already labeled QE2—the second round of Quantitative Easing of Treasury Rates. Round One began in early 2009 and ended last March, with the Fed buying $1.4 trillion in government and agency bonds. ...near-Zero interest rates that have been punishing savers since January 2009... What is chilling is the evidence that record-low mortgage rates driven by the plunge in Ten-Year Note yields have not arrested the decline in house prices or the increase in foreclosures. In other words, the near-Zero interest rates that have been punishing savers since January 2009 have benefited bankers and corporations— such as IBM—but have not restored respectability and salability to housing. The longer this Japonisation of the debt markets continues, the greater the debilitation of the pension systems—public and private—across North America. [Our June 2005 issue was titled Japonaiserie. We said, “The Nikkei's runup and plunge were one-half of a foolish twosome. The other half was a real estate bubble and collapse. Could the real estate bubble which has spread across Western economies be a delayed mimicking of the other half of the ghastly Japanese experience?] What was billed as a benign bailout and benefit program is, in reality, a gigantic transfer of wealth from the unsophisticated thrifty (who save through government-guaranteed bank deposits) to the greedy group of gamblers and fools who—in large measure—created the crisis: Wall Street’s trading platforms. (It has also been good to IBM and other corporate bond issuers, and to well-managed banks that are doing their part to make credit available to responsible borrowers, but that cross-subsidy is socially justifiable because it does in fact lead to higher levels of economic activity. The rain falleth on the just and the unjust alike.)

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The reason we dwell on this collateral damage is that almost no one (except Tom Hoenig of the Kansas City Fed and James Bullard of the St. Louis Fed) is calling for the Fed to restore anything approaching normal interest rates to protect the incomes of those at the bookends of the fixed income market— small savers and pension funds. These hard-hit savers who have been the backbone of the debt markets for decades are being systematically sacrificed to benefit homeowners who sought to enrich themselves by buying more house than they needed and the brain-dead lenders who eagerly lent them more money than they could afford. Can the Fed make QE2 or some other combination of inventions or stratagems work well enough to avert a renewed housing collapse and a renewed recession? Or is the .95% yield on the IBM bonds a sign that the real economy is flirting with Depression—as our friend David Rosenberg argues so consistently and cogently? It is clear that the Fed and the Treasury will continue to pour money into the twin sinkholes that polluted the housing landscape—Fannie Mae and Freddie Mac (F&F). Now that they—and the Federal Housing Authority—are financing or guaranteeing roughly 90% of residential mortgages, there is no possibility that Washington will either stop the process or go after such political eminences as Franklin Raines and Jamie Gorelick who received more than $200 million for mismanaging Fannie during the years when its books were cooked and it was expanding its market share by increasing the risk component of its portfolio. Republicans, who never fought hard enough to rein in the Democratic-led Congress as F&F were running wild, have finally made one useful recommendation: end the charade that the taxpayers’ exposure to F&F debt through Treasury guarantees is an off-the-balance-sheet item excluded from calculations of the National Debt. This adoption of Enron or Citigroup financial reporting may fool some unsophisticated Tea Partiers, but it won’t fool serious investors—at home or abroad.

...end the charade that the taxpayers’ exposure to F&F debt through Treasury guarantees is an off-the-balance-sheet item...

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In one respect, Bernanke & Co. are making things better for us all: in a process unique within the Washington power structure, they are slowing down the growth in the national debt while the other power centers are rapidly raising it. As The Wall Street Journal reports, by driving down Treasury yields, they reduced the government’s interest costs by 22% in 2009—while the debt outstanding was rising 30%. An optimist would say that less pain from a record debt gain is financial prestidigitation on epic scale; a pessimist would say that the Bank of Japan did precisely that for a decade, and Japan still ended up with the worst debt/GDP ratio in the industrial world. The housing optimists cite affordability as the reason for believing house prices should be stabilizing—or even rising. They cite the Q2 uptick in the July Case-Shiller Index as a hopeful straw in the wind; we believe it reflected the fast-forward effect of the temporary tax credit on house purchases, which has since expired. Since mortgage rates are priced off the Ten-Year Note, Bernanke & Co. could, at least in theory, make house-buying irresistibly painless by driving the Ten-Year yield below 2%. We believe that this is a very likely Fed response. It has the advantage that if house prices really rallied, the federal subsidy in underpriced debt would be gradually reduced as homeowners moved or died. Already, economists are discussing which Fed innovations lie ahead if the economy etiolates further. Among the suggestions for neat new ways to debase the Monetary Base: buying up large parcels of credit card and automobile debt. (Who knows? Maybe the Fed will become the nation’s biggest used car dealer. “Buy from Big Ben, Who’s Got the Biggest Deals!”)

Maybe the Fed will become the nation’s biggest used car dealer.

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Should Obama Be Blamed for the Weakening Economy?
We suspect that future historians will largely absolve him—and will also largely absolve Bush. The Democrats controlled Congress during the late years of Bush’s term, and resisted all Administration attempts to rein in F&F and reduce Washington’s wide-ranging inducements to banks and mortgage brokers to make loans to impecunious borrowers. Presidents love to brag that they create jobs and prosperity, but Congress writes the laws and spends the money. The congressional barons, jealous of their prerogatives, served Obama poorly by passing thousands of pages of ill-designed laws that undermined the effectiveness of his recovery programs. Because of the crisis, he came in as a key player, prior to inauguration, exuding coolness and competence, as Wall Street’s biggest names were falling on their own swords. He cooperated effectively with the Bush crisis managers, making the transition almost seamlessly smooth. He chose intelligent, experienced advisors for his economy team, reassuring the nation and foreign investors that the nation wasn’t in the hands of dreamy amateurs. His failure came from his analysis of previous Presidents’ problems when Congresses rebelled against detailed legislation prepared in the White House, insisting that lawmaking was not an Administration prerogative. His strategy was to promote a concept heavily in speeches across the land, relying on his personal magnetism, while outsourcing the actual drafting to the Democratic Congress. He never claimed to be an expert on the economy, and he had the sense to appoint Paul Volcker and Larry Summers, both of whom are brilliant and experienced, to roles in the new Administration. His reappointment of Tim Geithner was also logical, because he had been one of Hank Paulson’s top crisis managers, and was as close to indefatigable as any public servant can be. (His tax dodging only showed up after he’d been named, and with the entire economy on the edge of collapse, this was no time for penny-pinching morality. Geithner was a holdover from the Bush Administration who knew where the problems were, including the bodies already buried.) The appointment of Christina Romer was also commendable: she had friends on both sides of the aisle, great experience, and radiated optimism amid the gloom. We suspect that future historians will largely absolve him— and will also largely absolve Bush.

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Unfortunately, putting Volcker and Romer in roughly the same general area of responsibility as Summers was like putting two fine trout into a pool inhabited by a barracuda. Mr. Summers had never been renowned for respecting dissenting opinions. Unlike Obama, who, as a former law journal editor, enjoys the cut and thrust of arguments, Summers is a team player of the Putin School of Management. In retrospect, the President showed the proper blend of decisiveness, patience, and public optimism needed during the darkest hours of the crisis. His stimulus package might even have had observably acceptable results if he and his staff had drafted it.. Unfortunately, he outsourced it to Nancy Pelosi and the House Committee Chairmen, and, as veteran pols, they weren’t about to let a good $900 billion go to waste. They did what Congresspersons know best: they looked after those who’d elected them. Unfortunately—for him and the nation—that led to bills that run into thousands of pages, with trillions in bills to be paid by future taxpayers, drawn with the eager help of lobbyists for key Democratic constituencies who could barely believe their luck. The result, as even prominent Obama backer Martin Wolf of the Financial Times admits, was deeply disappointing. Surprisingly, Larry Summers was largely taken in by those Congressional pros: he repeatedly spoke glowingly of the tremendous “multiplier” effects that would come from funding “shovel-ready” projects, such as much-needed roads and bridges. True, the nation didn’t get new bridges to nowhere, as the Republicans had delivered to Alaska when Ted Stevens was in control of Senate appropriations: there weren’t many bridge or road projects of any kind: as of last count, a mere $27 billion of 2008 spending went on federal road and bridge projects. The rest was, by and large, lovingly spent on Democratic constituencies and priorities from long-moldering wish-lists. The Keynesian Multiplier Effect from economically-enhancing projects that was supposed to trigger sustained growth wasn’t really given a fair chance to prove its relevance for the nation’s economic crisis. Sadly, Mr. Obama realized his error too late: last week he announced a $50 billion stimulus package that could be modeled on the successful $500 billion program China launched to prevent a recession there: his program would help to rebuild the nation’s decaying interstate highway and railway

... putting Volcker and Romer in roughly the same general area of responsibility as Summers was like putting two fine trout into a pool inhabited by a barracuda.

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systems. By cutting down on traffic jams and speeding up delivery of commodities and manufactured goods, his program would deliver jobs now and greater economic growth later. We are told there is joy in Heaven when a sinner repents, but we fear that this program will founder amid the tumult of elections. The same Congressional Committee mauling befell Obama’s #1 legislative priority—a national health care reform bill. There was bipartisan agreement that the existing system was deeply flawed; there was widespread support for making insurance available to the uninsured; there was little—if any—love for the health insurers. The final 2,000 page bill was probably only read in full by lobbyists and committee staff members. Obama himself never claimed to have read anything more than summaries. He was even vague about what the bill had to contain if he were to support it. Despite more than 60 public speeches on the absolute necessity of passing the bill, he never really explained what it contained or why this particular monstrosity was the best the nation could get. Result: legislation that has a dramatically negative impact on the willingness of small and medium-sized businesses to hire employees. The very sectors of the economy whose risk-taking juices should be flowing most vigorously are paying down debts and accumulating cash, fearful of soaring health care costs and punitive provisions for non-compliance. Republicans were initially too frightened of the Obama groundswell to fight the bill, and participated in some early discussions about the makeup of the legislation. Even midway through the long struggle, leading Republicans said they’d be prepared to support it if it included reasonable provisions about tort law reform. Obama expressed willingness to meet them halfway on this issue. But then the second-most-important Democratic financing constituency (next only to unions) got deeply involved with its Congressional allies. The trial lawyers not only insisted there be no constraints on their ability to sue (such as the upper limits on damages in some state programs), but that the bill include hundreds of mandated behaviors and systems that could be enforced by plaintiffs’ lawyers in court.

We are told there is joy in Heaven when a sinner repents, but we fear that this program will founder...

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The Health Care bill may be the best thing for the plaintiffs’ bar since cigarettes—and much bigger than BP’s Macondo disaster. This bar bonanza guarantees that all talk of controlling health care costs in the future is just that—talk. The Health Care bill may be the best thing for the plaintiffs’ bar since cigarettes... From our personal knowledge and research, we can attest that the single biggest cost advantage the Canadian health care system has over its American counterpart is legal costs—direct and indirect. Example: a Canadian neurologist’s annual malpractice insurance costs, we are told, roughly $3,500. In the US, it routinely runs to $200,000. No wonder American doctors order far more and far costlier tests for their patients: missing even one test can mean a $25 million trial judgment. That doesn’t happen in Canada because trials are generally held before judges—not juries, which are subject to lawyers’ manipulation about the scientific issues in the case; moreover in Canada “pain and suffering” damages are controlled, and contingency fees are virtually banned. (John Edwards is blamed by the American Society of Obstetricians and Gynecologists for single-handedly changing the odds in cases of babies born with cerebral problems: he never lost a jury trial and is credited with more than doubling obstetricians’ insurance costs.) The other fallout from the health care bill is that health insurers have been boosting their rates by 40% or more. They justify these horrendous increases by claiming that they are going to have to take any applicant regardless of existing health conditions—and they know from (Republican) Mitt Romney’s Massachusetts plan that many people wait until they actually need medical care before signing up. They also don’t believe that doctors in hospitals will agree to permanent 25% pay cuts for Medicare recipients. The insurers are being attacked by Bill O’Reilly on Fox News, with the kind of outraged venom for which he is renowned (and feared). Using statistics on the bonuses being paid to CEOs, he shouts that their pay is “obscene,” and demands a Congressional investigation. The President’s falling approval rating is widely trumpeted by Republicans as evidence that his “extremism” is rejected by the voters. The gobsmacked enthusiasm he evoked in the campaign has naturally given way to the recognition that he is a young politician with no business or managerial experience—but most voters still like him personally and wish him well.

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Just as Reagan came into office after a dreadful decade for the American economy and American stocks, so Obama arrived as a disappointing decade for America was turning into a disaster. Republicans don’t like to admit that Reagan’s popularity at this stage of his Presidency was no higher than Obama’s. Both Presidents were suffering through grueling recessions that were not of their making, and the unemployment rates at this point were almost identical. George Jonas of the National Post argues that voters elect conservatives to office to manage effectively, and boot them out when they prove to be ineffective managers or scandal-prone. Conversely they elect liberals and boot them out when they do exactly what they promised—to expand the government’s role in the economy and their lives past society’s collective level of comfort. Obama, a certified liberal, managed to get Congress to pass transformative health care and financial regulation, and, had the recession not proved so painful, his global warming and union card check laws would also have been enacted. No one should say he has betrayed his election promises. However, polls show that a decisive percentage of voters feel he pushed too far, too fast, and is “too liberal” in a nation that is historically center-right. If the Republicans win one or both houses of Congress in November, Obama will no longer have to bear the blame alone if the economy does not come roaring back. Clinton’s career was probably saved by the moderation forced on him by the Republican landslide of 1994. A seemingly-moderate Obama would be a formidable challenge for any of the Republicans currently considering a Presidential challenge. [Voters] elect liberals and boot them out when they do exactly what they promised...

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The Lost Decade?
Although investors are well aware that the S&P is down nearly one-third in the past decade, and that long-term interest rates are down by roughly 50%, few seem to understand how the world has changed. Strategists routinely discuss S&P targets for the time just beyond the horizon when the US gets back to a normal growth track.
S&P 500 September 8, 2000 to September 8, 2010
1,600 1,500 1,400 1,300 1,200 1,100 1,000 900 800 700 Sep-00 Sep-01 Sep-02 Sep-03 Sep-04 Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10 1,098.00

...the same equity group which outperformed during the last economic recovery... will outperform during the next cycle.

What if the world has changed, and US equity performance in the next economic cycle doesn’t replicate the performance of the cycles in the late 20th Century when the US was the dominant global economy? We believe that the same equity group which outperformed during the last economic recovery and has been outperforming since the S&P peaked in Spring—commodity stocks—will outperform during the next cycle. If so, this is bad news for the US economy and US stocks, because the US economy and the S&P are underweight commodity companies compared to consumer, financial and technology companies.

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We have compiled a list of ten great US blue chips that together exemplified America’s competitive might as the millennium dawned. This is unscientific and is meant only to show how shares of some of the strongest and bestknown exemplars of American capitalism have performed during the ten-year bear market for the S&P.
THEN IBM General Electric AT&T Johnson & Johnson Procter & Gamble Merck Coca-Cola Boeing Microsoft Intel Bank of America 113 52 48 46 54 64 58 44 58 41 25 NOW 124.00 14.70 27.00 58.00 59.00 35.00 56.00 62.50 24.00 18.20 12.40

By way of comparison, here is a list of some of the greatest commodityproducing companies in the world—same time period:
THEN Exxon Mobil Conoco Anadarko BHP Billiton Freeport McMoRan Potash Corp. Monsanto Deere Barrick Gold Newmont 41.75 30.60 17.00 9.90 9.87 8.26 12.00 16.75 15.37 19.56 NOW 59.30 53.00 47.64 66.75 71.32 147.00 53.00 63.70 46.47 61.49

(We have not included dividends, which in some cases—such as Exxon—are formidable.) Nor did we include Apple and Google. True: Apple outperformed all but one of our commodity stocks, and Google wasn’t public in 2000. But Apple had gone nowhere from 1988 until mid-1999 and wasn’t considered as even a red chip—let alone a blue chip—and its stock price plummeted along with the other techs from 2000 through 2003. What happened thereafter is truly

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magical and we admit you never heard about it from us. Apple’s allure is of Edenic proportions: Steve Jobs is to Apple what its copper, iron ore and oil reserves are to BHP. Steve Jobs is to Apple what its copper, iron ore and oil reserves are to BHP. From a capital preservation and capital growth perspective, the stock performance of the commodity greats vs. the non-commodity greats is impressive. But was that due to a brief commodity bubble that has no longerterm investment significance? We believe that comparing the highest-quality commodity stocks to a group of the highest-quality industrial blue chips during “The Lost Decade” makes a crucial point: in this long-term equity bear market, commodity stocks have been far better investments than traditional equities. Not only was this true during their first bull run—from 2002 through mid-2008, but it has been true since the S&P peaked in April. Why? Because, although those traditional blue chips are great global enterprises, their performance is heavily influenced by US economic and financial conditions. As the shrewd (and deliciously irreverent) Stephanie Pomboy of MacroMavens demonstrates, total US corporate profit growth over the long term is remarkably correlated to the value of US residential real estate, which means to us that the commodity stocks’ outperformance of the S&P should be even greater in future years than in the past decade.
Twin Bubbles... Corporate Profits vs. Residential Real Estate ($ Billions) 1965 – 2010
25,000 2,000
1,639.30

20,000

1,600
16,507.20

15,000

1,200

10,000

800

5,000

400

0 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Residential Real Estate Corporate Profits

0

Source: BEA, Fed, flow of funds, Stephanie Pomboy (MacroMavens, LLC)

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The performance of commodity “blue chips” is driven by: 1. global equity performance 2. global commodity performance As stocks, the commodity companies’ collective beta is the stock market, so they are blown and buffeted by broad stock market trends, particularly in New York and London. But their alpha comes from the price of the commodities on which their earnings are dependent—and most commodity prices are now heavily influenced by demand from China. In a deflationary and increasingly regulated US and European environment, traditional companies have less pricing power than commodity companies, whose pricing springs from scarcity.
THEN Copper Crude Oil Natural Gas Potash Corn Wheat Gold Silver 0.91 33.38 4.83 130.00 1.94 2.67 280.00 5.04 NOW 3.49 74.50 3.85 350.00 4.65 7.24 1,259.00 20.10

...their alpha comes from the price of the commodities on which their earnings are dependent...

The effect of the gigantic US shale gas discoveries on the dismal relative performance of natural gas to other commodities is clear, and explains why we have not been recommending natural gas-levered stocks within the Energy group for more than a year. Note the continuing absurdity of the accounting convention in which six mcf of gas are always considered equivalent to a barrel of crude oil, based on their respective heating effectiveness: back in 2000, they were close: $28.98 worth of gas was considered, for valuing reserves, to be worth $33.38. Today $23.10 in gas comes out as being worth $74.50 for accounting purposes. Oil and gas companies which use this blended boe calculation without breaking out the oil and gas values should be downgraded by investors: it’s the oil patch’s version of the distortions in Wall Street balance sheets that laid the foundations for the Crash. By comparing the great commodity companies to the great US-based global companies, the investor can identify which nation’s economic performance is most important for stock price performance. For the American non-commodity blue chips, it’s the USA; for the commodity companies— including the oil majors—it’s China, together with the other major Asian emerging and emergent economies. September 2010 21

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The Deflationary Decade, You Say?
The Lost Decade has tragic longer-term consequences for Baby Boomers as a population cohort and for pension funds. This was the decade in which both of the Boomers’ two defining retirement investing programs blew up. This was the decade in which both of the Boomers’ two defining retirement investing programs blew up. First was the Triple Waterfall collapse of tech stocks.
Nasdaq Composite Index January 1, 1990 to September 8, 2010
5,000 4,000 3,000 2,000 1,000 0 Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 2,225.44

As coincidence would have it, Nasdaq’s sustained rally from its October 1998 low after the collapse of Long-Term Capital to its peak at 5048 on March 25, 2000, started as a Boomer voyage of discovery with the index at 1492 just two days from Columbus Day, the anniversary of the discovery of the New World. At its peak, Nasdaq was trading at more than 300 times actual forward earnings (adjusted for stock option costs), and new tech billionaires were being spawned each week. It was the most disgraceful extravaganza in the history of finance. Sadly, it would hold that title for just three years. As Silicon Valley was licking its wounds and counting its fallen, in the other center of financial excess, things were just beginning to heat up for an even bigger disaster. With the PhDs in science no longer flocking to the West Coast in search of instant riches, the greediest bosses in the financial industry sensed that their time had arrived. The Wall Street banks had been learning how to develop risk control models from the Black-Scholes formulas that brought

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down Long-Term Capital, and how to get around the constraints of Paul Volcker’s Basel Rules by using the Enron accounting model for off-balancesheet assets of lower quality to drive actual leverage half-way to the moon. What was needed to make these formulas work was to create complex new products faster than Silicon Valley had ever developed them, and peddle them to banks and hedge funds. Main Street banks were good for the basic tranches, because they could get guarantees from Fannie and Freddie, but whizbang mortgage originators like Countrywide and New Century Financial who asked few questions and got even fewer honest answers from prospective homebuyers supplied the erotic exotica of the upper tranches. The homebuyers understood the nudges and winks: home prices could only go up, so everybody involved in these [slightly] irregular transactions was going to win big. Fannie Mae and Freddie Mac were always there to help through purchases of subprimes, and Barney Frank and Chris Dodd, chairmen of the important Congressional committees, made sure that any objections raised by those damn Bushies were brushed aside. And so the Boomers believed that they could make up what they’d lost on sure-thing tech darlings that were now, in many cases, as extinct as dinosaurs, by buying the absolutely surest of sure things: houses. They levered up to buy more home than they needed, and then levered up to buy other residences to flip. Condoflip.com became a hot website. At the peak, in a showing of houses in a new suburb of Seattle, every house went in minutes and the average buyer was snapping up four homes—fully financed by mortgages. The seemingly impossible was happening: while the stench of dead techs was still in the air, a worse collective delusion than Nasdaq had appeared—on a scale that Silicon Valley could never have conceived in its most phantasmagoric dreams… …with unimaginably worse consequences. When the tech mania was exposed, people lost their savings, pajamahadeen traders had to find real jobs, and pension funds lost their surpluses. But when Wall Street’s scam was exposed in all its rotting trillions, giant corporations went bust across the world, everyone’s home—from Greece to San Francisco—was worth less, and, by 2008, more than a quarter of all homes in the US, UK, Ireland, and Spain were worth less than the mortgage and associated loans on them, and governments and central banks across the industrial world had entered sustained crisis mode.

...while the stench of dead techs was still in the air, a worse collective delusion than Nasdaq had appeared...

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When Will the Lost Decade End?
Just over the horizon looms what Obama hopes is the Promised Land, but what many prominent economists think is a new disaster. ...George Steinbrenner was shrewd to the last: he died this year. The tax debate in Washington has been full of sound and fury but has signified nothing. Republicans keep demanding further tax cuts—Reagan-style—and Democrats keep demanding higher taxes “for the rich” (a somewhat evanescent label that can apply to those earning more than $50,000 a year, but most certainly to anyone earning $200,000 a year.) Democrats think “higher taxes for the rich” is a political winner, because nearly half the population pays no income tax. Democrats’ economic policies remain unchanged from those summed up by Reagan: “If it moves, tax it; if it’s still moving, regulate it; if it fails, subsidize it.” What is coming down the tracks unless Congress acts fast is a monstrous tax increase on New Year’s Eve, as the Bush tax cuts expire. According to the Chamber of Commerce, “Marginal tax rates will increase for every taxpayer. Capital gains tax rates will climb 33%. Dividend rates for stockholders will jump as much as 164%. The child tax credit will be cut in half and the marriage penalty will return.” But what really frosts the C of C is the big income tax boost on upper income taxpayers, a large number of whom run small and medium-sized businesses. (Oh, and the federal death tax rate goes from zero to roughly 50%. As many wiseacres observed, Yankees owner George Steinbrenner was shrewd to the last: he died this year.) The federal government’s share of GDP spending has climbed from 20% to 25% in the past three years, and that has to be financed somehow. Why not just return to the tax rates of the prosperous Clinton era? That argument would make some sense if the economy were growing at 4% or more. But one has to be either a tenured academic or a real despiser of business people (or both) to believe that a big tax increase coming at the time of a big increase in health care costs while the nation hovers on the edge of a really deep recession is brilliant policy.

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The one tax that would make economic sense would be a national sales tax, but that has as much political appeal as a ruthlessly-enforced 50 mph speed limit. Our take is that the voters will send a message that they are too frightened of economic collapse to impose a big tax increase now. In our view, the Republicans have been too disorganized and incoherent to deserve a lusty mandate, but their commitment to maintaining the Bush rates will make them—if but briefly—the more sensible of the parties in the eyes of the 51% or so of the population who actually pay income tax. We expect that Congress will postpone the impact of the tax changes for another two years—as recommended by Obama’s recently-retired Budget Director. That could come this Fall, or early in the next Congress. If not, then we think the markets will swiftly begin to price in a double dip. ...national sales tax... has as much political appeal as a ruthlessly-enforced 50 mph speed limit.

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Gold and Silver in the Lost Decade
Gold September 1, 2000 to September 8, 2010
1,200 1,000 800 600 400 200 Sep-00 Sep-01 Sep-02 Sep-03 Sep-04 Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10 1,258.30

Silver September 1, 2000 to September 8, 2010
24 20 16 12 8 4 0 Sep-00 Sep-01 Sep-02 Sep-03 Sep-04 Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10 19.85

Barrick Gold Corp. (NYSE: ABX) September 1, 2000 to September 8, 2010
55 50 45 40 35 30 25 20 15 10 Sep-00 Sep-01 Sep-02 Sep-03 Sep-04 Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10 44.39

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Newmont Mining Corp. (NYSE:NEM) September 1, 2000 to September 8, 2010
70 60 50 40 30 20 10 Sep-00 Sep-01 Sep-02 Sep-03 Sep-04 Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10 60.01

Goldcorp Inc. (NYSE:GG) September 1, 2000 to September 8, 2010
50 45 40 35 30 25 20 15 10 5 0 Sep-00 Sep-01 Sep-02 Sep-03 Sep-04 Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10 41.36

Silver Wheaton Corp. (NYSE:SLW) January 1, 2005 to September 8, 2010
25 20 15 10 5 0 Jan-05 Sep-05 May-06 Jan-07 Sep-07 May-08 Jan-09 Sep-09 May-10 23.47

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US CPI September 1, 2000 to Sept 1, 2010
220 210 217.60

Why did precious metals climb so high when inflation was increasing so modestly?

200 190 180 170 160 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10

Source: FRED® (Federal Reserve Economic Data); Federal Reserve Bank of St. Louis

An investor who was told a decade ago that cumulative US CPI for the next ten years would be 28% would not have predicted that gold’s price would more than quadruple, and be the best-performing major investment asset class in the entire world. The Seventies were, of course, even better for gold—its price soared from $36 in 1971 to $825 in 1980, before entering its two-decade Triple Waterfall Crash. As for silver, back then its price skyrocketed from $1.90 to $38, and then entered a crash that finally ended in 2001 at $4. Why did precious metals climb so high when inflation was increasing so modestly?

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And why are the precious metals outperforming most commodities and nearly all stock market indices now that the word deflation has entered common currency? The respected Bank Credit Analyst sneers at gold as an asset class, dismissing it as the pre-eminent example of the Greater Fool Theory: gold delivers no income, so one only buys it with the expectation of selling to an even greater fool. On that theory, gold’s recent rise to new heights makes at least a scintilla of sense, because interest rates in the US and Japan are in the Zero range. Holding gold no longer means forgoing meaningful short-term interest income. However, gold’s price trebled from 2003 to 2006, during which time an absent-minded Alan Greenspan finally got around to quintupling the fed funds rate from 1%, even though he ridiculed the idea that there could be a housing bubble, because he said no one could identify a bubble before it burst. (And for that kind of attention to duty he was dubbed “The Maestro” by Bob Woodward and was dubbed a knight by the Queen. History is more likely to record that, as a Fed Chairman, he made a good clarinetist—if not as good as Woody Allen.) The American dollar is, we are told today, worth 14% of its purchasing power in 1913, when the Fed was given custody of the greenback. We would bet that anyone who put aside a “Roosevelt for President on the Bullmoose Ticket in 1912” button when the Fed was being born did much better than somebody who put away the first greenback. ...a Fed Chairman, he made a good clarinetist...

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Explanations for Gold’s Recent Rise
1. Gold and the Dow Pierre Lassonde, formerly of Newmont and now Chairman of Franco Nevada, is one of those who believes there are long-wave cycles between the Dow-Jones Industrials and gold. Historically, at some point gold and the Dow trade at the same price. The last time that happened was in 1980, just as Paul Volcker was starting to twist the monetary vise that would crush inflation, sending the US back into recession. Lassonde and his intellectual brethren believe that the two asset classes will meet again within a few years: they just don’t know whether that will be at $6,000, $8,000, or $10,000. What kind of world would give us the Dow and gold at $6,000? The only thing one could say for certain that it would not re-elect a sitting President… or Prime Minister. 2. Deflation and the Decline and Fall of Banks and Sovereign Debts

...the sudden threat of a Greek debt default sent Poseidon-scale shock waves through the Mediterranean...

Gold has been trading inversely to stocks in general and bank stocks in particular. On days stocks climb, gold usually falls; conversely on days the stock market is taking gas, gold climbs. It was, for example, a winner when Greece made it to the front page for the first time since the Olympics (and one of the few times the world had any good reason to take note of it since Alexander the Great). Because Greek banks and a surprisingly large number of other European banks had invested heavily in Greek government bonds after the nation managed to lie its way into the Eurozone, the potential default of the government threatened the recovery of the entire Eurozone economy. Germany was dragged along in the bailout, while appalled Germans watched TV coverage of overpaid Greek civil servants rioting. (The vigorous activity displayed was uncharacteristic of modern Greek civil servants, where a Lotuseater lassitude tends to be the lifestyle.) Sovereign credits got a free pass in the Basel I rules (the virtuous, Volcker values, not the racy rules of Basel II for banks that wrote their own risk formulas and hid their most malodorous “investments” off balance sheet). Doubtless, Volcker felt he had to accommodate European sensibilities and didn’t want to be seen as the American imperialist in assigning different risk valuations to individual EU members. So the sudden threat of a Greek debt default sent Poseidon-scale shock waves through the Mediterranean, as other undercapitalized banks began to reflect on their coming descent into Hades if Italy, Spain and Portugal were to catch the Greek Reek.

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The European Central Bank responded to the new global concerns by setting up stress tests for Eurozone banks. Nearly all the banks passed, which suggested to some skeptics that the Mediterranean had become Lake Wobegon on majestic scale. (Recent examinations of some eurobanks’ balance sheets by some smart analysts confirm that cynicism.) Through all this shock, hand-wringing, political battling, and fear of future shock, gold’s price continued to rise. The European Central Bank-IMF rescue package was supposed to postpone Greek Tragedy and financial Medideaths for at least two years. However, Credit Default Spreads on government and bank debts in the region are once again climbing, and that has triggered a new all-time high for gold. The Spring crisis opened a long-covered lesion deep within the German psyche. For the first time since the Weimar Republic, individual Germans, in an outburst of atavism, rushed to banks to exchange euros for gold. Angela Merkel’s party suffered its worst-ever defeat in the North Rhine-Westphalia election because of rage that Germany was participating in the Greek bailout. To punish her center-right party, they voted Socialist and even Communist. (Solidarity for never?) The voters had been forced to surrender their precious Deutschemarks for euros which, they were told, were even better. Once they figured out that the euro was a pudding that could contain poisoned raisins, they rushed to protect themselves. A currency that is not specifically and irrevocably backed by any government, any tax system, or any army and navy depends entirely on citizens’ faith. Many Germans who, despite the winds of modernism, kept their faith in God, also kept their faith in the Deutschemark. Now, a large proportion of the population apparently believes deeply in neither. (The US manages these possibly overlapping or interconnected belief systems with panache: greenbacks include the motto “In God We Trust,” which may be construed as a form of assurance if foreign exchange markets or inflation raise Doubt among dollar-holders.) This Deutsche-angst, in which long-buried fears suddenly erupted across a broad swath of the population, was, we believe, an historic moment for gold. It could no longer be dismissed by sophisticated economists as merely the antiquated pre-Keynesian fixation of foreign exchange funds, or the delight of jewelers and people who might feel the need to leave their homeland under cover of night. It was suddenly the last remaining protection against cynical deals made by politicians and bureaucrats with each other in defiance of the wills of voters.

...European Central Bank-IMF rescue package was supposed to postpone Greek Tragedy and financial Medideaths for at least two years.

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As we have noted previously, when the member nations agreed on the creation of the euro, they set up a committee to approve the faces that would appear on the new currency. This was going to be the triumph of the European dream—currency celebrating the people that had made the West the world leader in arts and science and philosophy. After years of increasingly frustrated meetings, they abandoned the project: they couldn’t agree on even one great European whose visage wouldn’t be offensive to some group of Europeans. Consider: If the new united Europe can’t agree on even one of such eminences as Leonardo, Michelangelo, Verdi, Mozart, Bach, Beethoven, Titian, Cezanne, Montesquieu, Descartes, Erasmus, Rembrandt, Dante, Goethe, Curie, Pasteur, or Liebig, why should anyone trust its paper money depicting buildings and bridges? The euro’s loss is gold’s gain. 3. Inflation and Troubles for the Dollar and the Pound

The euro’s loss is gold’s gain.

From the time paper money came into broad circulation in the 18th Century, only two currencies have possessed global status—the pound and the dollar. (The euro was on its way to achieving that status until it slipped on Greece.) Both those currencies offered convertibility into specie—the pound into gold (until World War I) and the dollar into silver (until 1964). During each currency’s global dominance, it was backed by the world’s leading navy, a general commitment to free trade—and, until recently, a willingness to pursue and hang pirates. World War I ended the pound’s global dominance, although the dollar shared space with sterling for a few years before assuming dominance during the Depression. It is safe to say that no monetary theorist ever thought that the dollar could maintain its acceptability through another Depression, coming at a time when government debt exceeded 100% of GDP, or visualized a world in which derivatives on that debt and economy would multiply to $70 trillion. Or, for that matter, an industrialized world in which fertility and marital rates collapsed, and projected lifespans grew to nonagenarian levels while governments were on the hook for universal pensions and health care.

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Quite simply, unless America moves decisively toward budget balance, (which may require that the threat from Islamic terrorism shrinks to mere nuisance status), it is hard to see how the dollar can remain the global store of value. Gold’s core inverse factor is the dollar—although it has more recently been trading inversely to the euro. Those who sneer that gold has not outperformed Treasurys over the very long term ignore the fact that the basic financial projections for the US have not been this weak since the outbreak of the Civil War. Moreover, new gold mines were being discovered and developed across the globe for most of the past two centuries. No longer do new discoveries more than make up for declining production rates in existing mines. Indeed, most new deposits involve grades so low they would have been unthinkable even five years ago. As Barrick’s Aaron Regent remarks, we may not be in the era of peak oil, but we may well have entered the era of peak gold. Gold’s rather sudden emergence as the optimal hedge against recessiondriven deflation and derivatives-and-debt-driven inflation has given it new luster. It has mitigated risks and saved people’s lives from tyrants or invaders for millennia. It is now the last best hope against governments’ willingness to create debts to fight downturns—even at the cost of the money that will be printed later to service those debts. What worked in the stagflationary 1970s is now working to protect the wise against new kinds of government-spawned threats against the wealth remaining after the Lost Decade. Conclusion: There will not be enough gold to satisfy the needs of the newly needy.

There will not be enough gold to satisfy the needs of the newly needy.

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Conclusion
When a $1.5 billion offering of a single “A” three-year corporate bond with a 1% coupon is over-subscribed and routinely trades above-par in the aftermarket, any talk of near-term inflation must be coming from the underinformed or the perilously paranoid. That IBM offering came days after Johnson & Johnson sold $1.1 billion of bonds at the lowest interest rates in decades for ten and 30-year corporates— 2.95% for the tens and 4.5% for the thirties. Norfolk Southern, a BBB+ rated railroad, has joined the deflation-hedging party with a $250 million offering of 95-year bonds at 6%. So gold is not trading at $1250 because of rising fears of inflation. It is there because (1) it is very scarce and because investors are beginning to worry about a double-dip recession at a time the US government has lost political support for further bailouts. And (2) because so many investors are in a funk in which they see the longer-range American fundamentals deteriorating by the week. The US political class is being marked down as the recovery weakens. Perversely, the dollar has lately been strengthening, joining the yen in the losers’ club of weak economies with painfully strong currencies that make those flaccid economies even weaker. Japanese voters are conditioned to live in an economy that barely shows a pulse, run (if at all) by men too old to run. The only break in this pattern of gerontocratic drift was Koizumi, who briefly shook the nation out of its decline. But he had to step down after a near-record six years in office, and the succession of faceless failures resumed. The US is, for the first time, experiencing Japanese-style interest rates and could soon share Japan’s economic and political stasis. Even a few months ago, such an outcome would have seemed wildly improbable—a figment of someone’s perfervid imagination. We believe gold is a far better investment than a Ten-Year Treasury Note that yields roughly 2.57%. From 1980 to 2001, the bond was the better buy. Since then, gold has hugely outperformed the bond, which, in turn, has outperformed the stock market. Those performance results define The Lost Decade. On the other hand, a case can now be made that owning a long-duration Treasury is an alternative to holding gold as a Depression hedge.

...any talk of nearterm inflation must be coming from the under-informed or the perilously paranoid.

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If so, then the longer the better: a 30-year Treasury zero is a splendid Depression hedge. Why so long? When the Five-Year Treasury yields 1.4%, why reach out 25 more years for a measly 2.3% yield pickup? This is because the bonds are held strategically—as insurance policies against economic catastrophe, not as secure income-generating assets, or as security for loans. When the risk is Depression, the longer-dated the Treasury the better. When the risk is merely slowdown, followed by stasis, the longer-dated Treasury the better. When the risk is recovery, accompanied by inflation, the short-dated the Treasury the better. When the risk is bifurcated—Depression and/or Inflation—Gold is the all-in-one hedge. Gold is both a short-duration and long-duration asset. It is totally liquid, but it will survive forever, and its value will shift, depending on economic and geopolitical events. Bonds depend on their coupon rate and maturity for valuation, and on their issuer for quality. They are, therefore, short-duration assets compared with gold. The last time any government of a large bond-issuing nation proclaimed that it would endure even one thousand years (a mere afternoon compared with gold) was Hitler’s Third Reich, and its bonds were worthless within a few years. We are not predicting a Depression, of course, but we are predicting a faltering US economy that will deliver unsatisfactory results, at least for the near term, and that means problems for most US equity groups—and problems for companies exporting to the US from plants abroad.

When the risk is bifurcated— Depression and/or Inflation— Gold is the all-in-one hedge.

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Was G20 The Top For Canada?
Canadian Dollar vs. US Dollar January 1, 2000 to September 8, 2010

We have been unfailingly bullish on Canadian assets throughout this millennium.

1.10 1.05 1.00 0.95 0.90 0.85 0.80 0.75 0.70 0.65 0.60 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 0.96

Toronto Stock Exchange Composite Index compared to S&P 500 (currency adjusted) September 1, 2000 to September 8, 2010
40 30 20 10 0 -10 -20 -30 -40 -50 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 -23.96 2.07

TSE Composite Index

S&P 500

We have been unfailingly bullish on Canadian assets throughout this millennium. We have told Canadians to sell US stocks and bonds in favor of Canadian stocks and bonds, and have told foreigners—wherever resident—to choose Canadian stocks and bonds in preference to American securities.

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Canada has been the beneficiary of a continuing flow of favorable publicity for the past two years because of: • • • • • • • how well its financial institutions rode out the Crash; how well its central bank handled the economy; how well its federal government has performed compared with Washington; how well the currency has behaved; how well its stocks and bonds have performed; the Vancouver Olympics; the G8 and G20 meetings in Toronto. A campaign in Congress is being waged by enviro-extremists... to try to ban imports of “dirty oil” from the oil sands.

In recent weeks, however, there have been some unfavorable developments: • The loonie was .98 at the time of the G20, but it traded down to .945, before bouncing back to .964 after the Bank of Canada surprised many analysts with another quarter-point rate boost, to 1%. Canadian GDP, which had been growing impressively, has hit a rough patch recently, and the Bank of Canada used Bernanke’s “unusual uncertainty” label for the economy in its September 8th comments accompanying the rate announcement. A well-funded international campaign to demonize and vilify the Alberta Oil Sands operations has been gaining visibility and influence, and many retail stores in the USA have felt compelled to display noisome, misleading posters about the alleged environmental catastrophe on the prairie. A campaign in Congress is being waged by enviro-extremists such as Henry Waxman to try to ban imports of “dirty oil” from the oil sands. Enbridge, a major Canadian oil pipeline company, has for decades operated a line that carries Alberta crude oil to refineries in Ontario and Upper New York State. It sprang a leak in its line in Michigan which, it was feared,

• •

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would poison a river. The company responded quickly and efficiently, and Michigan politicians have praised its performance. However, Enbridge is one of two companies vying to build a pipeline to carry oil sands-originated crude to the West Coast for delivery to China. This concept has always been Alberta’s fallback to American threats to ban its oil. There is widespread opposition within British Columbia to these proposals, so the pipeline failure is serious—perhaps fatal—damage to Enbridge’s credibility—and is therefore bad news for all oil sands operators. • There is growing recognition by international economists that the worrisome US slowdown could quickly become seriously bad news for Canada. We hear increasing commentary (formally and informally) about the Canadian real estate bubble, along the lines of, “Didn’t Canadians learn anything from what happened in the US? Are they idiots?” There is more and more commentary about the rapid weakening of the finances of the government of Ontario, resulting from (1) an ambitious, expensive, though apparently helpful, emergency fiscal stimulus program, and (2) a bizarre electric generation construction program based on very optimistic costs for building wind farms, and wildly optimistic expectations for their effectiveness. We have been hearing dour warnings from Ontario friends for more than a year about the McGuinty government’s green obsessions. All agree that the wind programs will saddle taxpayers with huge debts and power users with big fee increases. This week, Margaret Wente, star columnist for The Globe & Mail, published a withering critique about the “wacky” wind programs. Premier McGuinty seems to have committed himself to Californicating Ontario—and Ontario is far more important to the Canadian economy than California is to the USA.

“Didn’t Canadians learn anything from what happened in the US? Are they idiots?”

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Our Updated Thoughts on Canada
We were pleased that the Bank of Canada raised its rate this week—against the recommendations of many prominent Canadian economists. To us, the biggest worry facing Canada is a burst real estate bubble. Because most Canadian mortgages are short-term or floating-rate, Governor Carney’s gutsy move should cool off the housing market without sending it into a US-style death spiral. We remain impressed with how well Prime Minister Harper manages a minority government in comparison with President Obama’s unsuccessful handling of a Congress with an overwhelming majority. In theory, a minority government is weak and indecisive, because it can fall at any moment, but Harper has kept this one going for four years, while accomplishing most of his legislative goals. He is routinely derided in the Canadian media, which are even more liberal than their US counterparts, and his occasional churlishness and routine remoteness mean that he arouses ardor scantily, compared to the tinselly magic of Nobelist Obama. We’ll take competence and remoteness in preference to enthusiasm and tinsel anytime—and particularly during a bad time for the economy. We do take the orchestrated campaign of the US Hard Left against the Alberta oil sands seriously. It has already affected cross-border trade, with various mini-boycotts against Alberta oil. Because the greens failed to get their cap-and-tax bill through Congress, and did not achieve a total ban on all offshore domestic drilling, they needed some campaign against a foreign “enemy” to whip up their troops and juice up their groups. They are having definite success in pressuring institutional investors to sell shares of oil sands producing companies. Some clients have told us they can’t qualify for funds from “environmentally sensitive” NGOs and pension funds if they own shares in “dirty oil companies who pollute air, earth and water.”

We’ll take competence and remoteness in preference to enthusiasm and tinsel anytime...

September 2010

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IBM@1 = Big Ben’s Big Blues
We continue to believe that clients should overweight the Canadian dollar, and that Canadian pension funds should hedge their exposure to the greenback, while recognizing that the greenback remains—if only by default—the global store of value. If, by some astonishing concatenation of events, the deal had been done back then, Canadians would have been selling at the bottom... We were most strenuous in our claims about the attractions of the loonie back when it was trading in the sixties relative to the greenback and various prominent Canadians, including some business organizations, were recommending that Canada beg to have the US absorb the loonie so that the Canadian economy would be “dollarized.” We thought that was a terrible deal for Canadians, and also believed there was no way the Federal Reserve could be reconstituted to make Canada a Fed District. If, by some astonishing concatenation of events, the deal had been done back then, Canadians would have been selling at the bottom—the lowest valuation for their currency in a century. We have, throughout our career, been basically inimical to selling assets at the bottom. That said, although a merger could theoretically be done today even-up, we’d still be opposed, but the reasons for that are more complicated now that the loonie is approaching parity. Summing up, Canada still looks less risky than the US; and Canada outside Ontario collectively looks far less risky than the US. And Canada still looks blander than the US. In a world where IBM can borrow at 1% for three years and gold trades at $1259 an ounce, bland ain’t bad.

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IBM@1 = Big Ben’s Big Blues INVESTMENT ENVIRONMENT
1. What Is Potash Corp. Worth? The Potash Corp. takeover bid is powerful proof—if it were needed—of our basic commodity stock investment thesis: own unhedged reserves in the ground in politically-secure regions, and don’t be distracted by near-term earnings fluctuations. What is Potash Corp. worth on a cash buyout? Most Street commentary is mildly or firmly against the bid, and is nearly united in saying BHP should either not raise its bid or raise it only modestly. Investors should be skeptical of those opinions, if only because, at $119 billion, BHP is, by far, the biggest-cap mining company in the world, and all those mining analysts who follow it closely have a built-in bias in favor of BHP management, and in favor of a management team that mines base metals around the world, compared with management of a company that produces a form of fertilizer mostly in Saskatchewan. BHP is truly formidable. It is one of the top producers of copper, iron ore and other metals, and is a sizable producer of oil and gas. Its balance sheet is pristine. So powerful is its diversified earnings base that, as it tells analysts, it can pay for Potash with “about two-and-a-half years’ cash flow.” And Potash Corp.’s market cap isn’t picayune: it’s $44.6 billion—which puts it beyond the reach of almost all other commodity-based potential bidders. Those Street analysts are delivering elegant EBITDA calculations to show that BHP should not raise its bid. On the slavish, short-term-earnings-driven valuation basis that is (sadly) utterly dominant on the Street, they could be right. However, most of BHP’s best revenue spinners will be exhausted before all those analysts die. But Potash Corp’s mine life will have shrunk only slightly by then: Potash Corp.’s reserve life index is measured in centuries, whereas all the other productive asset classes of BHP come from resources whose life index is measured—at the most—in decades. So who cares about a section of a giant ore body that won’t be produced until 2444?

Potash Corp.’s reserve life index is measured in centuries...

September 2010

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IBM@1 = Big Ben’s Big Blues
Until quite recently, major miners disdained potash, because it was a mere fertilizer, dependent on farm programs, weather, crop prices and other vagaries. It lacked the economic virility of copper, iron ore, metallurgical coal, or zinc, let alone oil. Real miners didn’t do fertilizer. ...half the Vermeer paintings on earth at a price it can easily afford. But when potash prices ran all the way from $150 a ton to nearly $1,000 a ton, the big mining companies were aghast. Here they had been overlooking a product that was mined, and this hayseed supplier that hadn’t even been asked to speak at mining conferences suddenly had a market cap that was bigger than any miner except BHP! So, when potash prices collapsed, dragging down POT’s price, it was almost inevitable that BHP wouldn’t let it get away again. BHP’s CEO, Marius Kloppers, was only in his job for a few weeks when he launched an audacious bid for Rio Tinto. That was scotched when Rio Tinto brought in China Aluminum (Chinalco), which scooped up enough stock to derail BHP. This time, he knows he must succeed. No other mining resource in the world can have the impact on BHP’s long-term future that would come from getting those multi-century Saskatchewan treasures from POT. If he wins, he’ll more than treble the blended duration of his entire reserve base of minerals. It is the mining equivalent of a great museum having one chance to acquire— legally—half the Vermeer paintings on earth at a price it can easily afford. That said, the outcome of this bid could, like the Inco and Falconbridge takeover battles, be decided by hedge funds and arbitrageurs whose time horizon isn’t centuries or decades: it’s days—or even hours. A Chinalco-style blockage could stymie Mr. Kloppers again, which would leave most Potash shares in public hands—at a temporarily reduced price. But that is purely speculation at this point. Investors should, we suggest, take the time to think carefully about the time horizons involved in settling the ultimate disposition of the longest-duration mineral resource in the world.

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THE COXE STRATEGY JOURNAL

2.

The US Politico-Economic Challenges

The world has been relying on the American economy, American generosity, American technology, and American willingness to expend blood and treasure in containing villainy for most of the past seven decades. And most of the time, the USA has delivered. And, yes, for most of the time it has received little thanks and, for all of that time it has been the primary hate object of the Global Left. (Since the Six-Day War, it’s had Israel as company.) The US remains the most formidable military power and is still the world’s largest economy and, in particular, the world’s largest importer of manufactured goods. But the US is now coming to resemble Captain Ahab, who moaned that he felt like Adam, weighed under by all the piled centuries since Paradise. Its financial industry, long an object of envy and hatred worldwide, has lived down to the worst accusations of its opponents; its total debt (personal, corporate, state and federal) has been rising faster than GDP for decades and the time for paying the Piper may be nearer than most Americans think; since 9/11, when it finally awakened to the reality that radical Islam sought its destruction, its economy has been subjected to growing costs—for military operations abroad and security at home: the time it takes for passengers to clear airport security against Islamic terrorists is a significant percentage of the time spent in airline travel; the real estate binge has wiped out the savings of tens of millions of its citizens, and leaves the entire financial system in seriously weakened condition. Yet, as a prominent American said, in another context, “The wells of regeneration are infinitely deep.” Bettors against America have usually lost. Restoration of political balance within Washington could be the first step on the road to recovery. As grim as the outlook may now appear, there are few nations whose situation has both less endogenous risk and greater upside. This is the traditional time of the year when markets express their deepest fears—and do so violently. Investors should have ample liquidity for the opportunities that arise when, through a collective failure of imagination, rational pessimism becomes despair. Despair, it will be recalled, is a sin.

“The wells of regeneration are infinitely deep.”

September 2010

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IBM@1 = Big Ben’s Big Blues RECOMMENDED ASSET ALLOCATION
Recommended Asset Allocation Capital Markets Investments US Pension Funds
US Equities Foreign Equities: European Equities Japanese and Korean Equities Canadian and Australian Equities Emerging Markets Commodities and Commodity Equities* Bonds: US Bonds Canadian Bonds International Bonds Long-Term Inflation Hedged Bonds Cash Allocations 17 2 0 7 11 12 17 8 6 10 10 Change unch unch –2 –2 –1 unch +5 unch unch unch unch

We have increased our durations as a hedge against a new economic slowdown.

Bond Durations
US Canada International Years 7.50 7.75 5.25 Change +1.25 +1.25 +0.25

Global Exposure to Commodity Equities
Change unch +3 –1 –2

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.

37% 27% 19% 17%

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September 2010

THE COXE STRATEGY JOURNAL

IBM@1 = Big Ben’s Big Blues RECOMMENDED ASSET ALLOCATION
Recommended Asset Allocation Capital Markets Investments Canadian Pension Funds
Allocations Equities: Canadian Equities US Equities European Equities Japanese, Korean & Australian Equities Emerging Markets Commodities and Commodity Equities* Bonds: Canadian Bonds - Index-Related - Long-term RRBs International Bonds Cash 18 7 3 2 10 12 Change –2 –1 unch unch –2 +2

22 10 6 10

+4 unch –1 unch

We have increased our durations as a hedge against a new economic slowdown. Canadian investors should hedge their exposure to the US Dollar.

Bond Durations
US (Hedged) Canada International Years 7.50 7.75 5.25 Change +1.25 +1.25 +0.25

Global Exposure to Commodity Equities
Change unch +3 –1 –2

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.

37% 27% 19% 17%

September 2010

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IBM@1 = Big Ben’s Big Blues RECOMMENDED ASSET ALLOCATION
Comments on Asset Allocation Changes The equity reductions reflect our growing concerns about the US economy, and how it will affect the Canadian economy. The lengthening of bond durations reflects two considerations: (1) pension funds’ needs for higher yields in a steep yield curve environment, and, more importantly, (2) hedging the total portfolio against downside economic risk. The raised allocation to commodity equities for Canadian accounts will increase the portfolio’s exposure to precious metals as a deflation hedge.

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September 2010

THE COXE STRATEGY JOURNAL

IBM@1 = Big Ben’s Big Blues INVESTMENT RECOMMENDATIONS
1. Investors should retain above-average liquidity levels. The US and European financial systems have solvency problems that have been papered-over. They could explode suddenly, creating severe liquidity problems. 2. Within equity portfolios overweight commodity stocks. As a group, they have significantly less endogenous risks than the broad stock market. 3. Within commodity equity portfolios, use the four-sector approach. Its biggest overweight should be precious metals, emphasizing gold. 4. The second-most attractive sector is agriculture. It is largely independent of the economic and financial risks that affect most equity groups, for which the overweight in precious metals is appropriate. The prices of corn, soybeans and wheat are the most important indicators of agricultural stock performance, and they are continuing strong in response to weather problems in Europe and Western Asia. 5. Crude oil’s day-to-day price changes are overwhelmingly driven by US equity performance. The tight correlation cannot last forever, but as long as the stock market continues to trade down, investors should underweight energy within commodity stock portfolios. 6. The outlook for natural gas remains dismal. Overweight oil stocks within energy portfolios. 7. Base metals are the group most closely correlated to global trade patterns and Chinese industrial activity. Their cyclicality means they remain the most vulnerable if investors conclude the US faces a double-dip recession. 8. Underweight financial stocks within US and European equity portfolios. Although big banks have improved their balance sheets, they remain burdened with the expensive evidence of past cupidity and stupidity. What took months to acquire will take years to divest or write off. If US house prices fall a further 10 - 20% as some experts insist, then the increase in putrescent assets on banks’ balance sheets will overwhelm the writedowns to date.

September 2010

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IBM@1 = Big Ben’s Big Blues
9. Remain overweight Canada within North American and global portfolios. The soft patch for the loonie and the Canadian economy should not become anything more serious. 10. In balanced portfolios, emphasize long-duration high-quality government bonds as the best asset class for a double dip. When—or if—the clouds start to roll by, reduce duration immediately.

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THE COXE STRATEGY JOURNAL
© Coxe Advisors LLP 2009. All rights reserved. Unauthorized reproduction, distribution, transmission or publication without the prior express written consent of Coxe Advisors LLP (“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 LLP
Distributed by BMO Capital Markets

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