Basic Points

Two Days After Hallowe’en

October 13, 2010

Published by Coxe Advisors LLP
Distributed by BMO Capital Markets

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Two Days After Hallowe’en

October 13, 2010
published by

Coxe Advisors LLP Chicago, IL

October 13, 2010

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

Don Coxe 312-461-5365 Angela Trudeau 604-929-8791

Two Days After Hallowe’en OVERVIEW
We are publishing earlier than previously planned, because of some important improvements to the backdrop for equity investing, particularly in emerging markets and commodity stocks. Their combined effect has been to improve the near-term outlook for most equities, including the S&P. None of these factors deal with the root problems bedeviling the US banking system and the US economy, but they certainly improve the investment background for risk assets—at least for the frequently problematic weeks around Hallowe’en. Hallowe’en has become the second-highest-ranked holiday for retail sales. Stores are awash in masks, costumes and candy. That it should be an occasion of such costly revelry would have shocked our ancestors. Since medieval times, Hallowe’en has been observed as the night before the day in which prayers for forgiveness for souls in Purgatory were offered. That meant their spirits were attuned to this world and could, perhaps, be accessed, thereby leading to tales of yawning graves and strolling spooks. We cite this lore because most of the industrial nations are suffering something approximating Economic Purgatory. This comes as punishment for their bankers’ sins of greed and mendacity, and their governments’ and consumers’ sins of gluttony—through excess spending and borrowing. Americans hold elections on the first Tuesday after Hallowe’en. The only ghosts that could be influencing voters in this election are those of the Founding Fathers, because, in significant degree, it is being fought over claims by various politicians and activists about what those eminences would counsel were they alive today. Although the economy is The Issue, the main division between the ruling Democrats and their Republican challengers is about the size of fiscal deficits and of the federal government. As long-term investors, we remain cautious, except for commodity-related and emerging markets stocks, but in a world where central banks are becoming more aggressive and governments are competing with each other to debase their currencies’ value, those longer-term doubts are of significantly less immediate concern. Finally, we join the rest of the world in rejoicing about the brilliantly-managed rescue of the heroic Chilean miners. As we went to press, a dozen were back on the surface. Hooray!

October 2010



0 2.. 2007 to October 12.5 3.80 So short a time so long ago.Two Days After Hallowe’en So short a time so long ago So long a time so short ago We have used those lines from “The Victorian House” by Canadian poet Philip Child as a title of Basic Points.600 1. 2010 1.300 1.500 1..200 1. including the core belief that equities will always outperform government bonds over any reasonable investment holding period.0 Oct-07 Feb-08 Jun-08 Oct-08 Feb-09 Jun-09 Oct-09 Feb-10 Jun-10 Oct-10 2.400 1. and we recall it now as a reminder that the past three years have been truly tumultuous.000 900 800 700 600 Oct-07 Feb-08 Jun-08 Oct-08 Feb-09 Jun-09 Oct-09 Feb-10 Jun-10 Oct-10 1.163.0 3.5 4. 2007 to October 12.0 4.100 1.39 October 2010 3 . US Treasury 10-Year Yield October 1. 2010 5.5 2. Long-held principles of investing have been seriously challenged. How many private portfolios and pension funds have been winners from what is now a three decade period in which the total return to date on continuously rolled 30-year Treasurys exceeds the returns from the S&P? S&P 500 October 1.

59 Three years…the usual term for consideration of performance of an investment manager for a pension fund. 1..the dollar’s new status as a carry-trade currency.300 1. The dollar double-topped in early 2002. before embarking on its most powerful bull market since the late stages of the stagflationary Triple Waterfall run-up. before entering a six-year bear market that ended with the Crash. before entering new decline. 4 October 2010 THE COXE STRATEGY JOURNAL . It triple-topped thereafter. 2007 to October 12.Two Days After Hallowe’en Gold October 1.. 2010 1.200 1.347. helped by the dollar’s new status as a carry-trade currency.90 . 2010 91 88 85 82 79 76 73 70 Oct-07 Feb-08 Jun-08 Oct-08 Feb-09 Jun-09 Oct-09 Feb-10 Jun-10 Oct-10 77.400 1..000 900 800 700 Oct-07 Feb-08 Jun-08 Oct-08 Feb-09 Jun-09 Oct-09 Feb-10 Jun-10 Oct-10 US Dollar Index (DXY) October 1. accompanied by a Flight from Fear into Treasurys.100 1. That time period began with the S&P struggling to a new all-time high before entering its worst plunge since the Depression.. when US short-term rates began plumbing Japanese depths. then plunged after Lehman’s implosion. 2007 to October 12. Gold rallied briefly amid the late stages of the commodity boom.

who. finding his analysis of Wall Street’s abuse of mathematics and statistics deliciously congenial. which meant the coming crash would be of epic proportions.000 practicing economists in the world in 2006 and perhaps only five saw the extent of the risks we were facing. says that there were probably 1. and we later queried him about it. Black Swans were. was the increasing reliance on mathematics.” The major reason. Cicero was later garroted by Mark Antony’s agents. so was it just a Black Swan event for Cicero or for Rome itself. The Black Swan. in financial forecasting and portfolio construction. author of the prescient assault on Wall Street’s operating principles. It was the famous scene in which Cicero was pillorying the rebellious upstart Catiline. Just prior to closing. but by the complex risk/return calculations devised by youthful mathematics and physics PhDs with no sense of history. he used a slide showing a scene in the Roman Senate. it was rumored. We had the good luck to speak prior to him at a conference in California in 2007 shortly after we’d read his book. because it signaled the end of the Roman Republic? “A Nobel in Economics seems to be no different than the Nobel in Literature: it’s fiction. rather than economic history. the unlikely “long-tail” events that spawners of mathematical formulas about rates of return deemed too remote to include in their risk calculations for portfolio construction. was secretly supported by Julius Caesar.Although the powerful relief rally in stocks that began in March 2009 revived hopes that the mighty Bear was re-entering long-term hibernation. He ridiculed the reasoning of the Value at Risk formulas which had led to Long Term Capital’s collapse. The Monster Mathematics That Spooked the World Nassim Taleb.” October 2010 5 . whose title. published in 2007. ten-year compounded equity returns still approximate current fed fund rates—a prolonged horror story that makes the goriest Hallowe’en shock movies look like mere children’s tales. that the financial system was no longer driven by accumulated wisdom. “A Nobel in Economics seems to be no different than the Nobel in Literature: it’s fiction. he believed. and was piling up trillions of dollars in exposure to grossly overvalued assets. he showed.000. We had known that particular painting from our high school Latin days. He used audience-friendly slides to illustrate his point. came from the Latin root of seniors and seniority to show how great. he noted. enduring systems had functioned—accumulated wisdom. and insisted the Street had learned nothing from that shock.

routinely ridiculed them in Basic Points by suggesting that. he said. As non-mathematicians. not the public. once Waddell’s “Sell at any Price” order went in. A “Let ‘em eat tape” attitude to the public should not be an accepted business model. driven by the ceaseless interaction of inherently dubious algorithms and robotics. Given Taleb’s record as a Tireisian teller of doom. as readers will recall. their data bases should include statistics on deaths from saber-toothed tiger attacks or from freezing during the last two Ice Ages to reflect properly the unforeseen disasters during the millennia that were supposedly covered in their formulas. on whose savings and support it ultimately depends. As recently as last June. If the containers break. we scorned the arrogance of the nouveaux-riches mathematicians.” and last month he warned.” “Let ‘em eat tape” 6 October 2010 THE COXE STRATEGY JOURNAL . “The crisis might not even have started yet. and. It recalls the 1953 Yves Montand classic Le Salaire de la Peur (“The Wages of Fear”) of desperate men driving trucks loaded with nitroglycerin on perilous mountain roads. other systems automatically sold or exited from the market. That the respected firm of Waddell & Reed triggered the May 5th “Flash Crash” argues that the entire system is inherently unstable. we were not happy to read that he’s equally gloomy now.Two Days After Hallowe’en His presentation confirmed our perception that those Wall Street formulas claiming that collateralized debt obligations could fail only once in hundreds-of-thousands-of-years were based on ignorance of history. or are even shaken too severely. what happens as he nears his destination. This is yet more evidence that the Street exists to serve its major players. “We have a lot more risks than we had in 2007. the driver will be blown to smithereens—which is. to command respect. Because of this interconnectedness of discrete systems with differing risk parameters. of course.

[Street] Humpty-Dumpty had a great fall.”) One by one. And all the King’s men Couldn’t put Humpty together again. All the King’s horses. at least to date. I’d leave out the horses.62 “If I had it to do all over again. (An old joke says that when the King was being interviewed later about the attempted rescue of Humpty-Dumpty. “If I had it to do all over again. proved disappointing. 2010 110 90 70 50 30 10 Oct-07 Feb-08 Jun-08 Oct-08 Feb-09 Jun-09 Oct-09 Feb-10 Jun-10 Oct-10 47. he replied. October 2010 7 . I’d leave out the horses. but how to save jobs and put the economy back on track.Has the Street Learned From Its Folly? KBW US Bank Stock Index (BKX) October 1. 2007 to October 7. Unfortunately. the results—in economic and political terms—have. It was an all-star group and it did its job: to reassure a frightened nation that it not only knew how to prevent a financial collapse.” More and more. the famous rescuers have faded away. The announcement that Larry Summers is returning to Harvard means that the only key Administration rescuer to remain is Tim Geithner—a Bush holdover. The Washington equivalent of the King’s horses and men was the White House’s economic rescue team. Humpty-Dumpty sat on a Wall. Wall Street’s collapse and Washington’s desperate rescue measures seem like a retelling of the Humpty-Dumpty nursery rhyme.

nothing succeeded success but excess. In this case. Britain and Switzerland were profoundly upset about having to strengthen their balance sheets to the levels that Paul Volcker and his colleagues imposed under Basel I. It turns out that banks in Germany. and now collectively asserts that it has been subjected to altogether too much regulation—particularly of its bonuses and its balance sheets. Then much of the global financial system rather suddenly found itself nearly buried alive under mountains of bad bets. For nearly a decade. Not that Wall Street is alone: we had hoped that the emergency global committee charged with rewriting the Basel Rules (Basel III) would set standards that would make a replay of 2008 extremely remote. 8 October 2010 THE COXE STRATEGY JOURNAL . Instead. That had never happened before. that new financial promiscuity delivered alluring rewards. Paul Volcker was never an insider. . Humpty-Dumpty’s shell has been glued back together and he now climbs back up the Wall. (despite billions in bailouts and government guarantees on its deposits). nothing succeeded success but excess. not one major global bank failed or needed rescue. That the reforms have been so modest.. although he was called back to help craft the financial regulatory reform.. as those sound rules were being obeyed. has to be a huge disappointment to some of the leaders in the discussions about new global regulations such as the Bank of Canada’s Mark Carney. Wall Street’s Best and Biggest have done an impressive job convincing voters—including many Tea Partiers—that. Led by Citibank and other practitioners of Enronesque off-balance-sheet accounting. its asymmetric bonus programs exemplify the great American way of life. those wise Volcker rules were largely jettisoned in favor of the see-no-evil practices of Basel II. It is said that nothing succeeds like success... The Street marshaled its maximum lobbying effort to dilute his program. and their impact so delayed. it became an exercise in postponing penitence. We heard him speak at a conference in Ottawa just as the economy was beginning to recover and he expressed confidence that the crisis had opened the door to acceptance of Canadian-style regulations that would prevent another disaster. seemingly as arrogant as ever. and tighter regulations on how it values its trillions in dubious assets would cripple the economy and send more jobs overseas. which is to continue for years. and by the crowd of enthusiasts for collateralized debt obligations. Thanks to the taxpayers and the Fed.Two Days After Hallowe’en Christina Romer and Peter Orszag departed weeks earlier. For a decade.

Backed by pusillanimous politicians. they threatened.. and OECD governments had almost simultaneously socialized the system’s risks while leaving the ownership within the private sector. bailed-out banks (what we have been calling the B5) won. GM-style. would be the price of ill-advised bureaucratic constraint. That seemed like modest pain for such a good result. if ever there were a time when bankers could be compelled to accept reasonable constraints on risk-taking.4% range. That optimism. bad. but would likely preclude the possibility of another financial crisis that would engulf nearly the whole OECD financial system. The bankers responded with a horror story that could be characterized as an endless financial Hallowe’en—the GDP damage would be as much as eight times greater than the experts predicted! Depression. .. the economy had barely survived.After all. Basel: The Shepherds Sleep With the Sheep Governor Carney and his reform-minded colleagues in other central banks were up against the united power of Wall Street. bonused.. was mostly misplaced. went the reasoning. this was it: Banks would concentrate on making economically-productive loans and strengthening their balance sheets and liquidity in a healing process that would take time.a horror story that could be characterized as an endless financial Hallowe’en. October 2010 9 . The Bank for International Settlements and the Financial Stability Board had produced a study showing that a one percent increase in the targeted ratio of tangible common equity to risk-weighted assets would lead to a maximum GDP decline of roughly one-fifth of one percent from “the baseline path” after 4-5 years. Even those epicene numbers overstated the health of numerous European banks stuffed with bonds from PIIGS. These organizations used their influence with their governments to castrate the proposals. Baa. Thus. millions of people had lost their jobs. Baa. and a collection of mismanaged European banks whose tangible capital ratios had fallen to the 2 .. The banks didn’t suffer the indignity of nationalization. sadly. the big.

For this reason. these are Augustinian promises—“Grant me Chastity. The program could be summed up as follows: Eurobanks: Borrow big! Load right up with bonds of PIIGS! The long deferral of the time when the worst banks have to meet the Tier One tangible equity tests has drawn extensive comment.The public at large has zero interest—in fact. But the wrangling that went on in the discussions killed any change at consensus. Basel III will continue the full exemption from allocating any of that precious pool of capital to holdings of sovereign debts from all EU members. liquid capital. banks will have up to nine years to reach the required risk-weighted 7% capital level (4. (otherwise known as Basel III). although a somewhat modified liquidity requirement will supposedly be in place…in five years. which had proved so unreliable when the crisis broke. Some critics argue that there will be at least one or two full-blown banking crises before the time when the banks have to meet these minimal solvency tests.5% tangible equity plus 2. Bonds of such putatively reliable issuers as Greece. but not yet. Germany’s. Portugal. in general.Two Days After Hallowe’en Under Basel Lite. Load right up with bonds of PIIGS! 10 October 2010 THE COXE STRATEGY JOURNAL . is an ongoing inducement for banks to finance the overextended and under-performing Eurozone members. One of the most-sought-after changes was to the banks’ minimum liquidity calculations. As Martin Wolf observed in his column in the Financial Times.5% as a buffer). the mouse that did not roar: This amount of equity is far below the levels markets would impose if investors did not continue to expect governments to bail out creditors in a crisis…. “Basel. O Lord. and that was left to future meetings. That means European banks can continue to use those ratings to puff up their Tier One equity. That their yields are far higher than. the subsidy it [the state] offers by providing free insurance must be offset by imposing higher capital requirements. As more than one observer has sneered. say.” Apart from allowing banks to keep operating even though so many of the largest are gigantic upside-down pyramids resting on a tiny apex of tangible.” Basel III rejects the wise US decision (in the Dodd-Frank reform bill) to reject the privileged status of those deflowered rating agencies in asset valuations. a negative interest—in subsidizing risk-taking by banks. Spain and Ireland will continue to be exempt from writedowns to reflect the plunges in their Collateralized Debt Swap prices.

He spoke recently about how far the Fed has gone to convince banks to make loans to small businesses.” .” Ben Bernanke is certainly displeased about this response. October 2010 11 . and that there would be no future bailouts. BMO meets the 2019 capital rules today on all three capital measures and on the leverage ratio. a very good position for the bank to be in. that led to a global financial collapse. BMO’s CEO. that their financial reports had to become reliable. Why? Because of. Example: Bill Downe. prove painless.Canada’s well-managed and well-regulated banks are sounding so relaxed about the rules as to be almost smug.we’re going to have to punish small businesses and consumers.. The banks were at bay as never before. They huff that being forced to use lower valuations for some of their [unmarketable] assets means that they will be forced to…are you ready for this?.” Summing up: Basel III puts off pain.. have been particularly hard hit by restrictive lending standards. with fingers crossed that serenity will rule the financial markets for many years to come. leaving funds for what really matter: securitization and bonuses.” The new credo: “If you won’t let us use our own valuations for stuff we can’t sell. that you didn’t want us to buy. “the combined effect of the risk-weighting rules and the higher capital as a ‘hockey stick’ that sharply penalize efforts to restart the securitization market. we’re going to have to punish small businesses and consumers. according to a banker interviewed by the Financial Times. Small businesses. Voters across the OECD had furiously demanded that the banks that collectively caused a crash and recession be reined in.. says that “Based on our estimates. make fewer loans to individuals and companies! They will cut back on their participation in the socially necessary activities that justify taxpayer bailouts. And yet “Bank loans outstanding have continued to decline. it is hoped. Clearly. What is the big banks’ response to getting off so lightly after being pilloried so publicly? Many of the most prominent Wall Street and European investment-oriented banks are actually complaining about having to accept even these watereddown rules changes. when imposing real reform will.. which depend importantly on bank credit.

Right? And they tell us they need freedom to grant big bonuses to their top management to stay competitive? Capitalism is a successful system when it rewards success and punishes failure. thereby further weakening the housing market whose problems are at the root of the worst downturn since the Depression. and the overhang grows daily. they seem destined to spend their lives. Result: the foreclosure process is frozen. As Paul Volcker complains. and now they display incompetence in managing foreclosures. and their stockholders’ money.Two Days After Hallowe’en The latest blemish to banks in the US comes from the apparent breakdown of their large-scale foreclosure program. the only socially useful innovation those banks have delivered in decades is the ATM. proving one of Milton Friedman’s most perceptive analyses: “The worst enemy of socialism is socialism. The socialists wearing bankers’ masks and costumes in a never-ending Hallowe’en celebration are winning. the worst enemy of capitalism is capitalists. Socialism tends to operate in the reverse. 12 October 2010 THE COXE STRATEGY JOURNAL . adding further downward pressure to house prices. either incompetent or dishonest or both. Collectively. and incompetence in valuing Collateralized Debt Obligations that included so many toxic loans.” The socialists wearing bankers’ masks and costumes in a never-ending Hallowe’en celebration are winning. So let’s see: many of the big banks displayed incompetence in making loans to borrowers who couldn’t service the debts. in many cases. They are admitting in court that the staff who were swearing out affidavits about the circumstances of thousands of loans were. and incompetence in valuing the prices of homes on which they were lending.

. it was reported that 279 US banks have gone bust since Lehman’s bankruptcy. the Basel Brandy & Cigars Club has improved liquidity conditions in the near-term. The robust rally rolls on. The family withdrew $200 million—tax free—from the bank before it imploded. when the rules were announced. (He wants to take his talent to the national level—and is in a virtual tie with a Republican who puffed up his military record for the Senate seat once held by Obama which was the bargaining chip in the dealmaking that led to the prosecution of Governor Rod Blagojevich. There is an upside to the ovine behavior of the Basel rulemakers. owned by the family of the State Treasurer. European and US stock markets soared. at least in the nearterm. Most of the regional banks fail because of real estate loans. sending previously bearish technicians into bullish mode: September proved to be one of the strongest months for the S&P in history. October 2010 13 . Last week.The Good News ’Mid the Bad Basel News There is an upside to the ovine behavior of the Basel rulemakers: by deferring the serious balance-sheet-building. you can’t make these things up. there are colorful lending stories. Sometimes. steamy portfolio of loans to high-profile members of the Mob. even as statistics on home foreclosures and regional bank failures show increases month-by-month.. with the Dow and S&P breaking through double-top technical resistance. like the Broadway Bank of Chicago. the collapse cost the taxpayers $250 million. and the regulators uncovered a large. Alexi Giannoulias. who campaigned for that office on the basis of his banking expertise as a senior officer of the bank. Indeed.) Basel III’s failure to impose meaningful controls on undercapitalized and over-ambitious banks should mean more liquidity in riskier sections of the capital markets—and that means higher stock prices. The rally gained strength when the Fed confirmed that it wasn’t going to be raising rates in the foreseeable future and was contemplating a resumption of its purchases of longer-dated Treasurys. No.

Basel III has been widely touted as a reason to buy stocks. 2009 to October 1.Two Days After Hallowe’en But the charts of the Relative Strength of the two key US bank stock groups show that the Basel news wasn’t enough to propel these underperforming stocks back into market leadership: Basel III has been widely touted as a reason to buy stocks.14 KBW US Regional Bank Index ETF (KRE) relative to S&P 500 October 1. and are impressed by any rally in which the banks significantly outperform. KBW US Bank Stock Index (BKX) relative to S&P 500 October 1. That raises questions for us about the durability of this rally. 14 October 2010 THE COXE STRATEGY JOURNAL . we are skeptical of the underpinnings of the stock market when the banks underperform. 2010 115 110 105 100 95 90 85 Oct-09 Dec-09 Feb-10 Apr-10 Jun-10 Aug-10 Oct-10 94.49 As clients know. 2009 to October 1. But the bank stocks are being pulled along by the rally. not leading it. 2010 125 120 115 110 105 100 95 90 Oct-09 Dec-09 Feb-10 Apr-10 Jun-10 Aug-10 Oct-10 100.

The doctor’s challenge was to choose the time when the injections would be reduced. and would usually demand that the doctors continue the injections. but unless the patients were taken off heroin promptly. . There is no historic precedent for such sustained stimulus.Financial Heroin for the massive injections of zero-interest-rate funds. no other pain-killer was as efficacious as heroin. which means no one can predict what longer-term damage it will inflict on the patient. It is now a year since he issued that warning and Ben Bernanke keeps pushing the time of heroin withdrawal further off into the distant mists of the future. and then eliminated. We used this analogy from the battlefield anesthesia practices of the Royal Canadian Army Medical Corps during World War II.Maintaining the Dosage of Financial Heroin Last December. October 2010 15 .. they would become addicts— unfit for either military or civilian life... We had used this metaphor on a panel presentation in Denver at which the principal speaker was David Dodge. we coined the term Financial Heroin for the massive injections of zero-interest-rate funds into the US economy. For seriously wounded soldiers. implying that nearly all of Obama’s first term would operate within a zero interest rate environment. The interest rate futures project no rate increase until 2012.. He concurred in its applicability to the international financial situation. and warned that central banks should not overstay their low or zero interest rate policies—the inflationary pressures once a recovery finally took hold would be too great. The wounded soldiers would still be in great pain. former Governor of the Bank of Canada.

Two Days After Hallowe’en What is dramatically different is what Bernanke has had to do with manipulating the Monetary Base to maintain the fed funds’ near-zero rate: US Monetary Base (Billions of Dollars.960 1.980 1. Since then. been dwindling.the patient (as measured by growth in loans and GDP) is dwindling even faster.940 1. 2010 2. but the patient (as measured by growth in loans and GDP) is dwindling even faster. So the heroin flow has.100 2.54 Source: Federal Reserve Economic Data.017.040 2. Economic Research Division. Louis (http://research.900 1.963. 16 October 2010 THE COXE STRATEGY JOURNAL US Monetary Base (Billions of Dollars. Federal Reserve Bank of St. the annualized rate of change was 48%.000 1. When we published last December.020 2. Louis (http://research.120 2.stlouisfed.500 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 2. in fact. Result: the Fed is discussing raising the dosage through QE2. Economic Research Division. 2008 to December 1. the Base’s annualized growth rate has been negative.67 .100 The patient’s vital sign (the fed funds rate) has held steady—but so has the Monetary Base. 2009 2. 2009 to September 1. Seasonally Adjusted) October 1.800 1.600 1.stlouisfed. Monthly.060 2. Monthly.080 2.000 1.700 1. Federal Reserve Bank of St.. Source: Federal Reserve Economic Data. Seasonally Adjusted) December 1.920 Oct-09 Dec-09 Feb-10 Apr-10 Jun-10 Aug-10 1.

275 1. October 2010 17 .50 As always.295 1. (As always. then the recovery is aging.290 1.294. which means the economy must also be decelerating. The tiny group of monetarists were murmuring that zero interest rates were damaging the economy. The annual Kansas City Fed-sponsored Jackson Hole get-together was a somber successor to the optimistic session of 2009. but had a particularly powerful impact on Gold: Gold September 20.285 1. 2010 to September 23.5% GDP growth that they claimed was proof of the success of Washington stimulus.300 1. As Bernanke ponders injecting QE2 into a banking system that finds reasons not to make economy-stimulating loans.) The September 21st announcement that the Fed was going to keep rates low for the foreseeable future and that it would be adding to its Treasury holdings sent stocks higher. Is it a vault? Yet. who a year ago were reveling in the 3. now that further Congressionally-spawned stimulus is off the table.One need not be a dogmatic monetarist to argue that credit demand has clearly been slowing. were now worried that the economically ignorant were taking charge—which meant recession was once again lurking out there past a Teton. the local insectae did not include any gold bugs.280 1. 2010 1.270 20-Sep 21-Sep 22-Sep 23-Sep 1. the local insectae did not include any gold bugs. the Fed is the only Big Picture game-player. he may be wondering what to call a bank that just takes what he creates and doesn’t lend it to create the economic multiplier effect that is a condition precedent to sustained growth. If interest rates and the Base decline together. The Keynesians. and its corpuscles are showing signs of anemia.

it drew the same response from the gold market: Gold September 26. In keeping with the Hallowe’en theme. of course. branded a witch by the church. because the trial to establish guilt meant being thrown into a pond: if you stayed up. when the Fed announced it was buying long-dated TIPS. but Bernanke and friends seem to have sprayed financial garlic.285 26-Sep 27-Sep 28-Sep 29-Sep 1. a week later. and persisting even as Christianity conquered Europe.) 18 October 2010 THE COXE STRATEGY JOURNAL .. It was based on a coven of 12 believers who danced around the 13th member—the god-on-earth.70 . you were a winner—of sorts—because you supposedly were headed to Heaven. If you drowned. that meant the water rejected you as evil. the Old Religion was widely practiced.. 2010 to September 29.320 1.315 1.290 1. For centuries before the dawn of Christianity. 2010 1. which proved to be bizarre modern superstitions in which reiterations of complex formulas replaced medieval incantations. we should explain the reason why thirteen is an unlucky number. which meant you were burned at the stake.Bernanke and friends seem to have sprayed financial garlic.310 1. unknown. The accuracy level of those tests is.Two Days After Hallowe’en Then.310.300 1. but was probably at least as reliable as Moody’s appraisal techniques for AAA-rated mortgaged-back CDOs. It was profoundly unlucky to be named a witch.305 1. (We had been suggesting that triskaidekaphobia [fear of the number 13] might keep gold below the $1300 level.295 1.

47%. The Ten-Year Treasury yield is 2. What is clear is that the longer the heroin flows. The banks invest those bargain-cost funds up the government yield curve or in other vehicles where returns are multiples of what they pay to the poor depositors. (Sophisticated private investors can invest in high-quality preferreds.875%. Ain’t we got funk! The rich are the managements of banks by taxpayer-funded bailouts or loans. In the meantime. to be used for stock buybacks and dividends.) Last month we commented on this redistribution of wealth from the small savers to the mighty. based on their lofty long-term rate of return assumptions: 7. The operating formula for a world of near-zero rates is: There’s nothing surer: The rich get richer And the poor get poorer. . In between time. junk bonds. Microsoft floated a huge issue at . and Emerging Market bonds. The Stanford scholars who claimed that the gigantic California state funds were underwater by hundreds of billions used the AA corporate rate for long-term returns.5 billion in three-year 1% bonds. whose deposits carry government guarantees (for which the banks pay nothing). corporate bonds. October 2010 19 .. the greater the damage to pension funds. The funds insisted they were solvent. The poor are those who save through bank deposits and CDs. the greater the damage to pension funds.the longer the heroin flows. Those surreal low rates may not be delivering much economic stimulus.98%. earning miserably low rates. They prop up undercapitalized and overlevered large financial institutions by robbing returns for savers. is 4. let alone prosper.As we wrote last month.. But most pension funds use projected return rates of 7-8% in their solvency calculations. Not to be outdone. heroin-driven near-zero interest rates are a basically unfair technique for pulling the economy out of its funk. puts pension funds into a painful position: no major asset class can be counted on to deliver returns anywhere near what the funds need to endure. but they’re certainly great news for the great. which is widely used for valuation of pension funds. That US stocks haven’t been earning observable returns for a decade. as evidenced by IBM’s oversubscribed issuance of $1. and the AA Ten-Year Corporate Bond yield.75%.

and the thrifty middle class. not a lender. involuntarily. Only a borrower. but they are keeping their counsel so as not to embarrass the Chairman and provoke painful wrangles with Congress.2%) up to the Two-Year Note (. but both Congress and subsequent Administrations regularly found its constraints awkward. to be replaced by a version that could be labeled “The Wisdom of Bolonius:” Only a borrower. has its dark side… The Incredible Shrinking Debt Duration The duration of the national debt has been declining for decades. the seemingly irresistible appeal of borrowing in T-Bills (. It was largely successful. Bernanke’s apparent willingness to use Quantitative Easing to keep rates low has only one Open Market Committee (FOMC) dissenter—Thomas Hoenig of the Kansas City Fed. The decline began accelerating after passage of the Gramm-Rudman-Hollings Balanced Budget and Emergency Deficit Control Act of 1985 (GRH). Polonius’s classic advice to his son Laertes is in peril of repeal. with occasional forays to Five-Years (1. Meanwhile. He is a wise. stubborn critic of Fed policy who is deeply disturbed by its unfairness to small savers and small banks. The longer the heroin flows. be. suppressing interest rates to levels never seen on a sustained basis in history. That Reagan-backed statute was designed to put a tight rein on Congress’s Propensity to Expend. in a similar position to the poor: they are forced to participate in the subsidization of the financial industry to pull the economy out of its funk. and an unstated alliance of Congressional committee chairmen and Treasury Secretaries found ways to reduce the stated annual deficits—that would. the more the damage to incomes of pension funds. be.26%).Two Days After Hallowe’en The funds are. not a lender. prove deleterious to the nation’s finances: 20 October 2010 THE COXE STRATEGY JOURNAL . It provided for automatic spending cuts (called “sequesters”) when the deficit broke through set deficit targets.42%). pensioners. We hear stories that several other members of the Board who are non-voting members of the FOMC are alarmed about the effect of near-zero rates and want to push the system toward normalcy. over the longer term.

or among the small number of members of the chattering class who looked for signs of fiscal folly.S.1. contribution rates had been set at levels to pay benefits. ever came out with a denunciation of this practice. Fund operations in the light of the Canadian experience. I was recommended (perhaps because I was working in New York at the time. I was shocked at the short average term of the portfolio. Later. plus a small convenience fund to cover a few months’ benefit payments.I was shocked at the short average term of the portfolio. designed to create a Trust Fund that would guarantee solvency far into the next century. . none of the nation’s high-profile fiscal watchdogs—inside Congress. This Fund would invest only in Treasurys. which was roughly nine years (as I recall). the Administration. This meant the Fund was not getting the benefit the Canadian plan was earning from its portfolio composed of long-term provincial bonds.. Chairman Moynihan called the Canada Pension Plan Administration to send an expert witness to analyze the S. On analyzing the actuarial reports and the investment program in detail. After citing page and verse from two actuarial reports on the Fund. after the Chairman consulted with aides. When this Fund’s operations were first reviewed by the US Senate Finance Committee’s subcommittee on Social Security in 1989. and. It was designed to match the average term of the national debt. he apologized and commended my testimony.. thereby costing nothing for expenses). I testified that the Trustees of the Fund were not acting in the best interest of Social Security contributors. One of Reagan’s most important reforms was creation of the Social Security Trust Fund as a long-term guarantor of the program. For the first four decades. Didn’t it save the taxpayers’ money? But at what longer-term cost? 2. he explained that committee members could hardly be expected to understand the complexities of pension funding. and were at the mercy of Congressional staff and experts from the Treasury. The Greenspan Commission came up with something approximating the Canada Pension Plan—much higher fixed contributions. in personal conversation. As far as we have been able to discern. A controversy ensued and I was attacked as having misrepresented the Fund’s portfolio. a sure way to reduce the annual fiscal deficit which was the key statistic for GRH was to issue an increasing percentage of new debt issues (new debt and rollovers) in shorter-term notes. Because the Treasury yield curve was upward-sloping most of the time. October 2010 21 .

repeal of the most contentious parts of Obamacare. The halcyon days for the Treasury will surely end once the economy recovers. of the Trust Fund has fallen to a mere 50 months. driving interest rates sharply higher—and reducing demand for new bonds as the size of maturing debt issues rises relentlessly. That means the Chancellor of the Exchequer has considerably more freedom in his debt management than does Timothy Geithner. the duration of the national debt and. one of the toughest jobs in Washington will be managing the Treasury’s debt offerings. (we assume). Canadian provinces’ bonds were 20 years. which has a current deficit problem worse than the US. competing with the waves of new debt for current deficits. That could come as early as next year if. In contrast. as we assume. The endless waves of trillions in maturing debt. This is dangerously short. 22 October 2010 THE COXE STRATEGY JOURNAL . could make each month Hallowe’en for the Treasury. Conclusion: The Treasury bull market will continue as long as the economy flirts with recession. which meant most Treasury auctions were hugely oversubscribed as eager investors—particularly the Japanese—fought with each other to lock in juicy rates.Two Days After Hallowe’en He felt he could not get a consensus to move the average term of the Trust Fund’s investments up to anything approaching what I recommended—15 years. which means Washington can raise all the money it needs at heroin-containing interest rates. (The US could have achieved a longer duration than Canada by investing heavily in the 30-year T-Bonds. The halcyon days for the Treasury will surely end once the economy recovers. because it routinely issues very long-term bonds—up to 50 years.. From our perspective. forcing refinancing at rapidly-rising rates.. the elections produce a Congress that ends the uncertainties clouding businesses’ willingness to invest and hire—including a stable tax regime. although borrowing short and cheap reduces the current fiscal deficit—a useful thing to do—it lays the foundation for a fiscal crisis when (if) the economy recovers and moves to something approaching a normal growth path. If so.) Since then. and a budget that aims toward moderation—not deficits forever. has a debt duration longer than ten years. The UK. the Reagan recovery came at a time when inflation and interest rates were falling rapidly.

who overwhelmingly reject his Congressional allies. It appears that voters are no longer willing to accept Obama’s explanation that the economy and the Afghan War are Bush’s responsibility. this Hallowe’en is precursor to a Democratic horror story of 1994 proportions. but they are usually re-elected on performance. shot more than a dozen holes-in-one during his first-ever round of golf. Bush 45. Americans rightly accepted those arguments for more than a year. health care. even though polls show that voters reject most of his program. environmental. solving the Palestinian problem and reassuring Iran that it didn’t need—and really shouldn’t get—get nuclear weapons. America was ready to consummate its love affair with a beautiful black man who was going to bridge the country’s basic racial divide. which means his party is in serious trouble in the midterm elections. Perhaps the only international figure who can claim to have beaten that record is North Korea’s Dear Leader. New faces can win on charm. and launch an era of progress on all major fronts—economic. Love can be blind. The President’s policies and performance are now rejected by a solid majority of independents. that will not mean voters have fallen in love with Republicans. and he remains well-liked. bring the nation together. If the latest Gallup polls on voters’ Congressional preferences prove accurate. but at some undefined point they began to expect that Obama would assume some of the blame. Kim Jong Il. Obama turned out to be just as charming in office as in the campaign. They will be fleeing from what scares them about Obama and Pelosi. but the latest result is Obama 48. New faces can win on charm. who.The Politics of Debt and Recession Two years ago. when Republicans won both Houses of Congress. October 2010 23 . For most of his Presidency it was Obama by a landslide. but they are usually re-elected on performance.) Mr. and international relations— including ending both wars. (The bedazzlement didn’t stop at the water’s edge: the Nobel Committee voted to grant him the prestigious Peace Prize after his first 11 days in office. and it seemed that only the right-wingers and Hilary Clinton backers asked how someone with no managerial background and minimal legislative experience could suddenly become the effective Leader of the World. One of the pollsters routinely asks voters which President they preferred—Bush or Obama. If so. we are assured.

it could elect the party it opposes most vehemently. they pulled the Democratic Party so far to the Left that voters elected Richard Nixon as President. but it will certainly have a huge impact on it. Santelli’s outburst was The New Shot Heard ‘Round the World—the World Was Waiting for the Uprise. and anger.. It may not outlast this midterm election. the founder of this group. The activists of that era failed to elect a President. 24 October 2010 THE COXE STRATEGY JOURNAL . Santelli’s outburst was The New Shot Heard ‘Round the World. therefore generalize—or demonize— about its policies. defined a Neo-Conservative as “A Jewish liberal mugged by reality. The Party was born when CNBC’s Rick Santelli blew up in a Howard Beale-style rant (“I’m mad as Hell and I’m not going to take it any more”). it may refashion the Republican Party in its own image. One cannot. local Tea Party groups were formed across the land.”) Most importantly. He had lost the Presidential election of 1960. “You won’t have Dick Nixon to kick around any more. Both established parties were stunned.” The Tea Party is a grassroots rebellion built on idealism. who defied the laws of political mortality by returning from the dead in 1968. and called for a Tea Party to take back the country. electable Republicans in favor of political newcomers given to extreme statements—most notably in the Nevada and Delaware races. he blew his top on TV. angrily telling the media. enthusiasm. Its supporters are unwilling to be mere foot soldiers for Country Club Republicans who are accustomed to doing deals with Big Government Democrats.. which means its beauty (or ugliness) is in the eye of the beholder and lacks the basic power of a precinct. With astonishing speed. They even spawned a new intellectual group—largely from the Jewish population which had been loyally Democratic since the Roosevelt era—the Neo-Conservatives. It could be a one-off wonder. (Irving Kristol. members and supporters. If the Republicans fail to win control of the Senate. The “Party” has no Constitution and no formal organization. when he then lost the California Gubernatorial election of 1962.Two Days After Hallowe’en Republicans running for office this year are the lucky beneficiaries of the sudden appearance of the Tea Party—the largest and most passionate political uprising since the anti-war movement swept across American politics from 1964 through the Seventies. or like the antiwar movement. and their furious public demonstrations alarmed moderates in both parties. and. the Tea Party will surely be blamed for having dumped experienced.

“We’ll know what’s in it when we pass it. (What happened to the Marxists? After the Fall of the Wall. more than his policies. and the ghosts of the Founding Fathers will be rejoicing. He claimed that its members were actually opposed to Obama’s color. they became an endangered species.” For that. The reality is that the Tea Party is no more built on bigotry and hate than the Anti-War movement was dominated by Marxists. believers in limited government and economic freedom should thank the Tea Party. mostly living off university endowments. There will be no new 2. ) The Tea Party has simply tapped into large-scale public resentment about the unsavory Congressional deals and buyouts (such as “The Second Louisiana Purchase. Anger is no substitute for reason and sound political and foreign policies.We are instinctively mistrustful of the politics of enthusiasm and anger. There may be as many bigots in the Tea Party as there were Marxists in the Anti-War movement. Jimmy Carter briefly emerged from well-deserved obscurity to become a big attraction on the liberally-oriented TV networks when he claimed that the Tea Party was strongly influenced by racism.” October 2010 25 . Princetonian George Will says there are now more Marxists at Harvard than in Eastern Europe.000-page law costing trillions of which the Speaker will say. “We’ll know what’s in it when we pass it. The Tea Party has stoked public alarm which will slow—but probably not reverse—the growth of Washington’s elephantiasis that threatens to hobble the nation for decades to come. but in both cases the extremists don’t define the causes.” and “The Cornhusker Kickback”) designed to achieve enactment of massive spending programs and major new intrusions into the economy. although we also mistrust professional politicians and their advisers and lobbyists as a class.

It’s a populist upsurge that could be very good news for the American economy. That alone is enough to make us more optimistic about the outlook for equities. sustained surge to 4% economic growth. At the very least. Some of the more thoughtful Congressional Republicans are willing to contemplate a national Value Added Tax (VAT). That certainly won’t happen.. against great odds. Although some Democrats claim that the Republicans will bankrupt the country because of their refusal to vote for any tax increase.Two Days After Hallowe’en We sense that investors now rushing back into stocks realize that the looming landmark power transformation in Washington won’t be won because of John Boehner or other well-established Republican officeholders. but the willingness to consider a VAT is. But it wasn’t Sam Adams and his partiers who wrote the Declaration of Independence and.. for Republicans. . and (2) the debt buildup from the various rescue attempts. Some taxes must increase—and increase significantly—barring a sudden. There are no Republican Presidential candidates among the so-called front runners who have. but they insist it can only be accepted in replacement of income taxes. displayed enough charm and gravitas to derail Obama in 2012.the change in power should ensure that the economically punitive tax increases. So this election could be the high-water mark for Republicans for many years—unless they surprise voters by displaying wisdom and political courage about the hard choices facing America as a result of (1) the recession. they will have to demonstrate real leadership..will not occur. not just naysaying and demands for tax cuts. the change in power should ensure that the economically punitive tax increases we discussed in last month’s issue will not occur. a heresy that needs to be revisited. 26 October 2010 THE COXE STRATEGY JOURNAL . to date. The deficits the nation will face for the loss of economic output during the recession. The Boston Tea Party was an act of civil disobedience that helped spark the most successful revolution the world had known. outlasted Britain in the war.. and the vast expansions in spending for so-called stimulus programs and for health care mean that if the Republicans are to capitalize on this opportunity. the real story is more complicated. and then managed to write a Constitution that amazed the world.

The Congressional Democrats have squandered the opportunity given to them by their election landslide and a deep recession. a firm manned by two Nobel economists using Value at Risk Algorithms. they seriously stained his winning image as a smart. In nine years the leadership—in terms of upward momentum—of the global economy shifted from the nations that had dominated it since the dawn of the Industrial Revolution to two of the world’s poorest nations as recently as 1975. and an economic collapse would be driven entirely by financial systems in the US and Europe. Nor were any Western leaders pondering the possibility that.. October 2010 27 . idealistic leader who disdained rotten politics. No financial leaders seemed perturbed that LTCM. at times. the First World was prospering from the tech boom. unseemly. global economic growth would be driven primarily by Asia. The Long-Term Capital Management (LTCM) crash was unnerving. which was sending Nasdaq to the moon. In nine years the leadership. As Obama and Pelosi were drawn into increasingly desperate and increasingly objectionable deals with Democratic holdouts. Instead of well-crafted programs designed with White House involvement and some bipartisan input. but it had frightened the Fed into massive reliquification. and its financial systems were still strong from the ongoing effects of Basel I. If the new Republican leaders in Congress don’t display more wisdom and greater problem-solving skills than the current crowd of losers.. would implode because of turmoil following an event as obscure as Russia’s default—and that Wall Street was busily gearing up to deploy those strategies on a scale that would threaten the foundations of the global economy. in the coming decade. what happened was. they will be abandoned by the Tea Partiers and the country—and Obama will win a second term by default. and sold with the President’s powerful merchandising. of the global economy shifted The Big Shift As the last millennium was drawing to a close.

We have consistently recommended that clients emphasize stocks of companies that produce what these new world champions need to buy—and sell the shares of companies which produce what Asia produces now—or soon will. the economic news has been mostly weak.) Since we last published. Empires can take a long time to disappear: it took four centuries for Rome to succumb to the barbarians after Caligula’s brief. movie and TV studios. The Crash devastated one of the last remaining components of Western productive superiority— its banking and finance systems. (Caligula remains well-known: when Neville Chamberlain passed over Churchill for a crucial Cabinet post. a Tory backbencher said it was the worst appointment since Caligula named his horse as Consul. The Crash devastated one of the last remaining components of Western productive superiority—its banking and finance systems. we recognize that we do our clients a disservice if we don’t keep an eye on the US stock market for those times when it will rally appreciably— within the context of a long bear market. we have tended to be less enthusiastic about the leading stocks in the leading stock markets—particularly the S&P—than most strategists. Given the suddenness and ferocity of the West’s fall from global leadership. Because we saw the erosion of economic power to be of such stupendous historical proportions. Worth pondering: If Mao Zedong and Pandit Nehru had been able to ensure that their successors for the next three decades would continue to enforce their pure socialist precepts—which were overwhelmingly admired by the intellectually fashionable in university campuses. 28 October 2010 THE COXE STRATEGY JOURNAL . However. and newspaper editorial rooms across the world—then the balance of global economic power today would look roughly the way it did in 1999. the only surprise about the performance of the S&P is that it almost managed to break even—in nominal terms—over the decade. Basic Points has chronicled this shift of power from the factories and financial giants of the West to the new Asian trendsetters.Two Days After Hallowe’en Within one decade the OECD economies were hit by two recessions (the second of which was worse than any since the Depression) and sustained relentless loss of manufacturing jobs to Asian economies which had been conspicuous foreign aid recipients for most of the postwar era. but the US stock market has been very strong. inglorious time on the throne signaled that the Empire had seen its best days.

the financial heroin and other stimulus programs in North America and Europe have combined with the big story of our time—the modernization and industrialization of Asia—to give equity investors reasons to buy stocks. Canadian growth has moderated in response to the American slowdown and a much-needed pause in the real estate boom. Singapore. The Eurozone’s overall growth rate has improved. led by Brazil. Latin America. Chinese growth remains powerful in comparison with almost any economic experience of the modern era except its own growth rate from 1992 through 2007. The renewed bear market in the dollar is itself a contributor to expansion of global liquidity. the important Asian economies—India. Decoupling may be a reality—not just an economist’s hypothesis. is performing well. Taiwan.43 Decoupling may be a reality—not just an economist’s hypothesis.We believe the three key factors in this happy disconnect have been the perceptions about (1) renewed liquidity growth from further Fed and ECB easing. and helps explain the stock market rally: US Dollar Index (DXY) January 1. but mostly because of powerful performance by the export industries of Germany. investors with an international perspective have shown signs of a willingness to consider the evidence that total global growth has become strong enough to maintain earnings momentum even if the US economy remains sluggish—or worse. 2010 90 88 86 84 82 80 78 76 Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 77. and Indonesia—remain robust. and (3) optimism about an economy-and-investor-friendly US midterm election. Moreover. October 2010 29 . 2010 to October 8. (2) easier-than-feared Basel III rules. In other words. Apart from Japan. Korea.

The Commodity Markets Respond to Increased Availability of Risk Money The industrial commodity markets have naturally responded to the greater availability of risk money: Zinc January 1.900 1.700 1.100 1. 2010 390 379.00 Copper January 1.500 2.300 2.69 30 October 2010 THE COXE STRATEGY JOURNAL . 2010 2. 2010 to October 1. 2010 to October 12.20 370 350 330 310 290 270 Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Crude Oil January 1.500 Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 2232.700 2. 2010 to October 12. 2010 88 85 82 79 76 73 70 67 Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 81.Two Days After Hallowe’en 2.

0 Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 5.9 10.6 4.4 5. 2010 5..7 11.4 3.71 Soybeans January 1.8 3.3 8. turning it into a roaring bull: Wheat January 1.5 10.00 Russia stopped the developing bear market in grain in its tracks.1 9..0 4. 2010 to October 1.The biggest commodity rallies. 2010 to October 1. Corn January 1. 2010 to October 1.2 3.8 5. 2010 11.9 Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 11. have been driven primarily by the lack of liquidity: drought in key grain-growing regions of Eastern Europe and Russia stopped the developing bear market in grain in its tracks.3 10. 2010 800 750 700 650 600 550 500 450 400 Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 713.75 October 2010 31 . however.7 9.

(We suspect that some of the arbitrageurs who leapt into the trading were frantically reading up on what potash was and why mere fertilizer could be so valuable. over subsequent weeks.2 3. including previously-contracted shipments.93 .8 3. Then the USDA announced that. global corn carryovers would decline. Last week’s announcement was a stunner.history’s two biggest up-limit days for corn.4 5. generating history’s two biggest up-limit days for corn at Chicago—and fury at the USDA from farmers who had sold their crops forward to speculators..4 3. of course.. Then the roles reversed: word that the wheat crops in Russia and Ukraine were being devastated by drought was confirmed with the market-shocking news that Putin was embargoing wheat exports. even with a record corn crop. or the grain embargoes from Russia and Ukraine. This came despite the third biggest year for global grain production in history. The United Nations Food and Agriculture Organization (FAO) this week proclaimed a new food crisis affecting thirty countries around the world. pulling the other grains in its wake.Two Days After Hallowe’en Corn’s decline was accelerating at midyear. discussed infrequently in the better Wall Street watering holes. Liebig’s Law of Minimums—the basis of the chemical fertilizer industry—has been. Wheat shot up. 2010 to October 12.0 4. amid evidence that this year’s crop would break all records.6 4. another grain-related bull story: BHP’s $130 per share bid for Potash Corporation instantly became the world’s biggest takeover battle. There is . we understand..) 32 October 2010 THE COXE STRATEGY JOURNAL .. the USDA continuously reduced its estimates of per-acre yields and the size of carryovers. Then. Corn Futures December 2012 contract January 1.0 Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 4. and it was pulling down soybeans and wheat along with it. the organization did not cite ethanol and biodiesel demands. 2010 5. Given the political sensitivities of key donors to the FAO.

2010 to October 12..Our sentiments about the uniqueness of Potash Corporation are well-known to our clients.52 October 2010 33 . 2010 44 40 36 32 28 24 20 Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 42. 2010 to October 12. The grains’ reversal from bearish to bullish triggered the one of the fastest and strongest rallies in agricultural stocks we can recall: Deere (DE) January 1. and great management. whose time horizon is the next lunch—not the availability of adequate lunches across the world in coming decades. 2010 75 70 65 60 55 50 45 Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 74.. We hope that the decision about its future ownership and management will be made primarily by long-term-oriented investors who understand the company’s important role in the global food situation—not arbitrageurs. CNH Global (CNH) January 1. It has the longest-duration assets of any commodity producer we follow.20 The grains’ reversal from bearish to bullish triggered the one of the fastest and strongest rallies in agricultural stocks.

318. 2010 to October 12.100 1.700 1.350 1. there are the monetary metals: Gold January 1. 2010 85 80 75 70 65 60 55 50 45 Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 84.400 Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 2.70 And.400 1.250 1.347. 2010 2.80 Silver January 1.150 2.000 Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 1. finally.000 1.550 1. 2010 to October 12.850 1.00 34 October 2010 THE COXE STRATEGY JOURNAL .Two Days After Hallowe’en Agrium (AGU) January 1.050 1.300 2.300 1.150 1.200 1. 2010 to October 12. 2010 1.

we actually said those accursed words—and within weeks of Hallowe’en. October 2010 35 . no double-digit inflation. a possible double-dip. This time. too. The dealer weighed them and paid him: they would be melted down within hours.” and currency warfare. then rising to higher peaks.) By that we mean that there’s more talk than action. there is no mania.. pausing. Having lived through the hyperkinetic precious metal markets of the Seventies. not runaway greed. “peak gold. deficits. The man in front of us had superb antique silver candlesticks. we can assure clients that This Time is Different. and then the Hunt Brothers went bust and the mania was over.Despite all the media hype about the roaring bull market in gold. derivatives. We also recall that the dealer was bankrupt within the week. PIIGS. (There. the precious metal markets have behaved in almost stately fashion—rising to new peaks. there is no mania. We recall the lineups of eager bullion buyers outside Canada’s premier gold market at the Bank of Nova Scotia in Toronto in the late Seventies. now there are friendly disagreements about Fed policy. We also recall standing in line for an hour to deliver our son’s piggybank full of true silver coins accumulated over the 13 years since his birth to a metal dealer and being paid more than two thousand dollars in cash. and this is a rally based on sound reasoning about government policies.. and all the TV advertisements about the fabulous returns from gold and silver. and no talk of Biblically-based rules of valuation. Then there was frenzy. This time.

56 0.55 0. both parties found time to act tough with the “currency manipulating” Chinese. And good’s bad today. 36 October 2010 THE COXE STRATEGY JOURNAL . Brazilian Real versus US Dollar January 1. Japan had angrily denounced China—for buying yen for its awe-inspiring Foreign Exchange Fund. as far as we know.57 0. A fortnight before.59 0.52 Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 0. most particularly against the Brazilian real. The yuan-yen war was on. the first time that the ordinary civilities of discussion between two nations whose trade with each other is one of the three largest cross-border relationships in the world was abandoned because of the insult of one buying the other’s currency as an investment.54 0.53 0. and Senator Schumer introduced similar legislation in the Senate. With an election looming. These two recent dust-ups come as the long argument between the US and China about the undervaluation of the yuan (or renminbi) was being moved to a potentially perilous battleground as the House passed a demand for renminbi revaluation.60 0. China and Japan have had their quarrels and their wars. The world has gone mad today. 2010 0.Two Days After Hallowe’en The Real Thing and the Global Currency Wars This topic came to the fore last month when Brazil publicly denounced governments abroad which were driving down the values of their currencies against each other but. 2010 to October 12. And black’s white today Cole Porter—Anything Goes Over the centuries. But this is.60 The yuan-yen war was on.58 0.61 0.

it is a force for inflation at home and abroad. 2010 90 88 86 84 82 80 78 76 Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 77. but then he had a really bad day when he bought back in and ended up losing 20. he had another good day not long after when he sold his interest in the South Sea Bubble for a 7.45 . If those who issue the stuff want it cheapened.why should anybody who has money to lose believe in the printed paper promises of politicians? When nearly all the governments of economies that matter in the world would like to see the exchange value of their currencies reduced. (That was on a good day for him. China must revalue its currency sharply higher..To the extent that China’s currency is undervalued. When he ran the Royal Mint. The yuan’s value against the dollar is up about 20% in the past three years.) October 2010 37 . China is being told it must drive up its currency value compared with the greenback—or face retribution. worth 21 shillings. he made the golden guinea. it’s not hard to see why shrewd investors would want to exchange paper currencies for gold. why should anybody who has money to lose believe in the printed paper promises of politicians? The pound was the store of value for two centuries because of one of Newton’s Lesser Laws. the standard of exchange. Currency traders understand that Washington is at the front of the parade of nations wanting to cheapen their currencies’ values: US Dollar Index (DXY) January 1.000 pounds—a fortune for that time.. 2010 to October 12.000 pound profit. in the minds of Congresspersons whose minds may not be massive. so. but China’s trade surplus with the US keeps increasing.

rather than paper money. For a long run.Two Days After Hallowe’en The idea of having no metal backing to a currency would have been dismissed as absurd as recently as the 19th Century. the idea of deliberately debasing it would have been dismissed as absurd and perilous until very. It’s back. but went out of fashion briefly. It’s back. very recently. When purely paper money became the medium of exchange. 38 October 2010 THE COXE STRATEGY JOURNAL . was around for a very long time. For a long run. The idea of holding gold or silver.

This appears to be one consequence of the increasing role of high-frequency traders in stock markets. For compliance reasons. . Therefore. They switch from the buy to the sell side. as we explain each time we give the lecture on “Investing in Commodity Stocks” at the CFA Institute’s Annual Equity Conference.. We respectfully disagree. But if all stocks are mere commodities to be bought and sold based on intraday sentiment changes. But we try to give clients the criteria to achieve superior results through recommendations on criteria for evaluating securities. We are disinclined to treat Basel III as the kind of good news that makes us want to make a major increase in equity exposure. Basic Points does not make stock-specific buy and sell recommendations. first and foremost. for a few bankers. their beta is the stock market. which means their stockholdings move with the synchronization of locust swarms. No such luck. just maybe. and. with a demonstrated risk of longer-term pain—for investors and the economy. is there much value in our work? We have long argued that commodity stocks are. a follower of Black-Scholes algorithms backed by enough computer power to manage Wal-Mart’s inventories who—too late— discovered a tiny glitch in his system.Two Days After Hallowe’en INVESTMENT ENVIRONMENT The Stock Market’s Changing Dynamics We recognize that the recent trend has been to macro-driven investing. We see large variations in endogenous value across and within the commodity sectors. stocks. sector weightings and weightings within commodity groups. October 2010 39 . When the “Flash Crash” occurred. That banks will be allowed to continue to put the entire system at risk delivers short-term gain—for bankers and investors. and away from stock-picking. and away from stock-picking..the recent trend has been to macro-driven investing. The correlations among equities have been extraordinarily high—even on an intraday basis. we expressed hope that the investigators would find some trader. due primarily to the Street’s reliance on short-term earnings forecasts—as if commodity stocks should be valued like any other stocks. But their alpha comes from the buildup of reserves and production of specific commodities (or of supplying technologies or inputs to commodity producers).

whose industrialization is expanding.Two Days After Hallowe’en We know what happens to the stock market when banks start to implode. In Illinois. We also know that governments. The other sector of the US financial system that concerns us is the municipal debt market. whose growth rate ex-Germany isn’t likely to exceed America’s: the PIIGS’ problems are probably as severe as those facing California. whose governments are—in comparison with the US or Greece 40 October 2010 THE COXE STRATEGY JOURNAL . The SEC is finally taking up the cudgels to compel states and municipalities to disclose their real liabilities under employee benefit plans.” As the spiritual says. regulators. As the spiritual says. excellent treatment from Washington’s stimulus program—which is about to enter the history books. The bailouts saved the system. things have gotten so bad that some prisons haven’t even be able buy toilet paper for inmates. Michigan. or benefits cuts for pensioners. as one might expect. but note that a great percentage of that offshore commitment is to Europe.” There will be a “next time. The Street loves to point out that the S&P is heavily weighted to companies operating internationally.” There will be a “next time. Most banks did not take advantage of the strong rally in financial stocks during the first four months of this to issue more equity. Since union agreements preclude pay cuts for current employees. but at the longer-run cost of preventing market clearance. We are told that 40% or so of single-family homes are worth less than their mortgages and other registered liens. Nearly half of the unemployed have been out of work for more than six months. legislatures and voters have battle fatigue from bank rescues and may lack the resources or will to save big institutions the next time they face collapse. which is a conspicuous financial offender. We are also told that the “real” unemployment rate is more than one-fifth of the workforce. and Illinois—to name some of the most egregious examples of mismanagement and underfunding. We prefer to concentrate on the equity group that is targeted to sales in countries whose middle class is growing. We take that point. and cut back on other expenses. so faster growth abroad will pay off for US stocks. Bernanke has said that “significant time” will be needed to restore the 8. state and local governments are going to have to fire people.5 million jobs lost in 2008-9. “This time water: the fire next time. “This time water: the fire next time. Reasonable conclusion: there won’t be a new housing boom for a very long time.” American banks still hold trillions in dubious or downright terrible assets for which there is no bid at the value the banks ascribe to them. And that deprivation comes despite Illinois receiving.

The CRB Futures Index is back to where it was in 2007. and whose banks are. The ineluctable arithmetic of protein conversion from grain to meat—seven for beef. That means investing in commodity-oriented stocks. and high politicization. We have watched them buy The Wrong Stuff. whose household debts relative to GDP are modest. the regulators should have been deeply skeptical of its promises and assurances. the obvious.. five for pork. three for chicken— means that the richer the Asian become. high-quality mines. and cannot be synthesized. tarred with Browne’s Brush.or Ireland or the UK. not their dotage. the risks can be serious. As advocates of commodity-stock investing. as BP demonstrated. whose pension programs are in their infancy. copper. The arithmetic is daunting: in the past decade. Whatever they produce is priced globally—primarily off demand from Asia. six for milk. After the Crash. Meanwhile. Summing up: what is in short supply. The S&P isn’t—and won’t be for a long time. have been in production for years and are near their peak or already in decline.. gasoline consumes one-third of US corn. oil or gold. or Portugal—well-financed. and is absolutely necessary for economic progress. and it is sad that the whole offshore industry could be—to use a term—tarred with Browne’s Brush. healthy. we have routinely encountered snobbish disdain from self-styled sophisticated investors.. despite annual gains in grain output. For most metals. in politically-secure regions with access to electricity and transportation. We may not have reached “peak oil” within the predictions of the late Matt Simmons.. we were told that “The Commodity Boom” was just the latest bust and there wouldn’t be another commodity rally for at least a decade. but we are forced into deeper and costlier drilling. We recommend The Right Stuff. (Given BP’s miserable safety record. Higher metal prices mean that low-grade deposits that were virtually worthless a decade ago are now attractive.) We have entered the second global food crisis in four years. but they require huge capex and they may involve excavation on a scale that local residents will reject. The great agribusiness companies are global treasures. and. the greater the demand for vegetable protein. Their core concept is scarcity: there is no Moore’s Law for the production and pricing of corn.the whole offshore industry could be. and biodiesel consumes important quantities of palm oil and soybean oil. by and large. is a great place for investment capital. hectares under cultivation have grown less than half as fast as demand for grain. October 2010 41 . .

50 7.25 Change unch unch unch Global Exposure to Commodity Equities Change –3 +1 unch +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.75 5. 34% 28% 19% 19% 42 October 2010 THE COXE STRATEGY JOURNAL .Two Days After Hallowe’en 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 18 2 0 7 13 13 17 8 6 10 6 Change +1 unch unch unch +2 +1 unch unch unch unch –4 Bond Durations US Canada International Years 7.

Korean & Australian Equities Emerging Markets Commodities and Commodity Equities* Bonds: Canadian Bonds . 34% 28% 19% 19% October 2010 43 .Long-term RRBs International Bonds Cash 18 8 3 2 12 13 Change unch +1 unch unch +2 +1 22 10 6 6 unch unch unch –4 Canadian investors should hedge their exposure to the US Dollar.75 5.25 Change unch unch unch Global Exposure to Commodity Equities Change –3 +1 unch +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.Two Days After Hallowe’en RECOMMENDED ASSET ALLOCATION Recommended Asset Allocation Capital Markets Investments Canadian Pension Funds Allocations Equities: Canadian Equities US Equities European Equities Japanese.Index-Related . Bond Durations US (Hedged) Canada International Years 7.50 7.

and it is unclear whether the political component of the rally will continue after Hallowe’en. the Administration.) 3. 44 October 2010 THE COXE STRATEGY JOURNAL . The next downleg of the dollar bear market has begun. 2. The market is already pricing this switch in. gridlock is usually good for the economy and the stock market. Canadian banks as a group are healthy huskies compared to the scrawny coyote image of the American banks.Two Days After Hallowe’en INVESTMENT RECOMMENDATIONS 1. When the Fed. Nimble short-term traders can make some good returns at times of rapid liquidity expansion. capitalist-oriented politicians will be salutary for US stocks and the economy. As a general rule. primarily because of the likelihood of rapid liquidity expansions within the OECD in the near-term. this downleg could be impressive. even though the fundamentals of the US economy remain unattractive for most equity groups. The transformation of the Chairmanships of important House of Representatives committees from business-bashers and take-no-prisonerGreens to moderate. the next phase of unlocking Canada’s oil (in shale) has just begun.5%-4% to deliver great returns from here. Canadian financial assets—apart from some life insurance companies—continue to look more attractive than US financial assets. and the reserves are enormous. Congress. The Canadian dollar’s attractions remain. In general. Expect few or no major new initiatives. The Bank of Canada has distanced itself from the Fed’s financial heroin policies. and most of the business community are cheering it on. That economic performance would be a welcome surprise—something akin to discovering that The Tooth Fairy lives. The S&P’s 17. 4. (There are studies that show that an astounding percentage of S&P gains come when Congress is not in session. This stock market rally has legs.8 multiple argues that next year’s US GDP growth would need to reach 3. from a balance sheet perspective.

If a Potash takeover deal is approved. Potash Corporation’s reserves compared to other companies’ are as Michael Jordan is to the average NBA player. The gold rally can cool out without being snuffed out. ensure that your portfolio maintains a strong weighting in the fertilizer group. Until the BKX and KRE show sustained strength relative to the S&P. We recommend you emphasize the companies that are strongest in potash and phosphorus production. Within the commodity stock group. Your gold holdings provide insurance that will be the more needed the higher stock prices rise. 7. October 2010 45 . continue to emphasize the Precious Metals and Agriculture stocks. above-benchmark durations remain attractive as long as the US economy struggles and the Fed is seen prone to Quantitative Easing. Within balanced portfolios. Within bond portfolios. Increase your exposure to the leading producers. Stripped of all the complexities. 6. But there are other well-endowed and well-managed fertilizer companies. 9. The election should destroy Henry Waxman’s ability to threaten the Alberta oil sands producers. underweight US equities. and not the nitrogenlevered producers—as long as the natural gas glut continues.5. 10.very long duration Treasurys and/or Canadas make sense as risk offsets to equity exposures. 8. four-digit gold is basically a bet against the governments and economies of the G-7.

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