2007 Basic Points APRIL

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Basic PointsBYE-BYE, BOND BULL

April 13, 2007

Produced by BMO Financial Group

Distributed by BMO Capital Markets



BYE-BYE, BOND BULL

Basic Points

An Investment Journal

Donald G. M. Coxe

Global Portfolio Strategist, BMO Financial Group

(312) 461-5365

e-mail: [email protected]

Research/Editing Angela Trudeaue-mail: [email protected]

Production/ Anna Goduco (print orders and mailing lists)Distribution e-mail: [email protected]



April

Overview

The Best of All Possible Bond Worlds was born in September 1981. It grew

and prospered, because of the mutually reinforcing effects from money

management by born-again monetarist central bankers, the growth of free

trade, the Triple Waterfall Collapse of commodities, productivity gains from

technology, and the end of the Cold War. For a quarter-century, infl ation and

interest rates were in secular decline from their stagfl ationary peaks.

Apart from a few bumps in the road, long zero-coupon bonds have been—by

far—the top-performing sector in the investment-grade fi xed income market.

As interest rates declined to levels that would have seemed Heaven-sent in

the Hellish Seventies, junk bonds became irresistible to the yield-starved.

We have been bond bulls for 26 years, except in 1993-94. We became even

more bullish in 1998, when we began arguing that defl ation, not infl ation,had become the primary challenge to the global price system.

We now believe that infl ation is returning, and the great bond bull will soon

be history. Supply Side Economics was a big part of the bond bull story in the

1980s. It is the core of today’s bear story.

This month, we look at the four great supply side challenges to the global

economy—energy, metals, grains, and workers—especially skilled workers.

The bond bull gamboled happily when all four were in sustained surplus

conditions. Three have already morphed from defl ationary oversupply to

infl ationary shortage; as for the fourth, unemployment statistics continue toset new lows, and worker shortages have begun to show up in many other

places than Fort McMurray, Alberta. The two-decade-long display of the

power of management at the expense of workers will soon be fading away.

Together, these supply side failures give an infl ation bias to the OECD

economies that will intensify in coming years. Only a recession will bring a

return of bond-friendly surpluses, and those will disappear once economic

growth returns.

Sustained global disinfl ation was the benign background that allowed—

indeed encouraged—the fi nancial market rescue operations familiarly

known as the Greenspan Put. The Bernanke Fed’s freedom of action will be

constrained by a new economic environmental challenge—Global Economic

Climate Change.

We are adjusting our Recommended Asset Allocation, deleting our exposure

to long-duration bonds.



April

Recommended Asset Allocation

Allocations Change

Domestic Equities 27 unch

Foreign Equities 29 unch

Domestic Bonds 12 unch

Long-Duration Bonds 0 -10

Foreign Bonds 15 unch

Cash 17 +10

Allocations Change

European Equities 6 unch

Japanese and Asian Equities 6 unch

Canadian & Australian Equities 6 unch

Emerging Markets 11 unch

Years Change

Global 4.25 unch

US 4.50 unch

Canada 4.75 unch

American Portfolios

U.S. Pension Fund

Bond Durations

Foreign Equity Allocations



Basic Points

April

BYE-BYE, BOND BULL

The Four Scarcity Stories of Our Time1. Energy

To the stunned statisticians at the International Energy Agency and most

analysts on Wall Street, the Asian Century’s fi rst creation of global scarcity—

energy—came out of nowhere. The IEA’s high-priced roster of tax-exempt

Parisian boulevardiers was shocked…shocked. Wasn’t China an oil exporter

when we last checked? How could a poor country like that be driving up oil

demand and prices for the whole world?

2. Metals

The next to be shocked were managements of major mining companies

who were happily shorting copper at 90 cents a pound, only to learn that

China had created its second global scarcity. Phelps Dodge, the industry’s

most adamant bear, was absorbed at a mere six times earnings by Freeport

McMoRan, the industry’s most adamant bull. Phelps management had

hedged itself into oblivion.

3. Grains and Oilseeds

The third Asian-spawned scarcity—feed grains and oilseeds—has just arrived.

To read the profusion of stories on Page One, this fi rst-ever cereal scarcity

without a major crop failure would seem to be purely an ethanol story

(which is itself another response to the oil scarcity story). However, that only

helps to explain the bull market in corn. The coming rises in prices for meat,

eggs, and dairy products will refl ect the overall supply/demand imbalance of

coarse grains and soybeans while the soaring middle class in China, India

and elsewhere in the Third World expands its diets (and midsections) with

non-vegetable proteins.

4. Workers

The fourth shortage story—which will be the most powerful contributor to

Asia’s rise to global economic dominance—is homebred in the OECD: themulti-decade collapse in reproduction. Before the industrial world began

outsourcing jobs to China, it had begun a process that would ultimately ensure

that outsourcing and soaring trade defi cits would not lead to widespread

unemployment. The worker never born is the worker never unemployed.

...the soaring

middle class in

China, India and

elsewhere in

the Third World

expands its diets

(and midsections)



April

GDP is simply output per worker multiplied by the number of workers.

Nations which don’t replace their workforce can maintain neither their

historic economic growth rate, nor their standing in global economic

rankings.

Scarcities create winners and losers.

The fi rst two shortages showered wealth on the top management of

commodity-producing companies and on investors in those companies—

particularly those obstinate souls who held on to their investments through

the numerous occasions during which the Street proclaimed “The End of the

Commodity Bull Market.”

The third scarcity has been benefi ting farmers, and the managements and

investors in the relative handful of companies involved in the grain sector.

The fourth scarcity has only begun to appear within the last year: The shortage

of workers, the most important scarcity of all, will inexorably benefi t workers

across the OECD, at the expense of managements and investors. As the

Boomers age and retire, they will not be fully replaced by new labor force

entrants. The billions of people that the neo-Malthusians warned would

produce global starvation and sustained unemployment were never born.

They will not be around to produce the wealth that ageing OECD economies

will need to fi nance social security and health insurance programs—nor to

care for the ageing Boomers and Gen-Xers.

Asia’s Thirst for Industrial Commodities

Today’s shortages of oil and metals were conceived and nurtured in the Triple

Waterfall collapse of those industries.

Crude Oil

July 1985 to April 2007

0

10

20

30

40

50

60

70

80

Jul-85 Jul-88 Jul-91 Jul-94 Jul-97 Jul-00 Jul-03 Jul-06

...the Street

proclaimed

“The End of the

Commodity Bull

Market.”



Basic Points

April

The Yom Kippur War and the Carter-assisted takeover of Iran by the mullahs

were the supply-side shocks that by 1980 had driven oil prices to seven times

their Sixties levels. Thereafter, oil was in global surplus because of all the oil

Big Oil had found and developed that the OPEC producers later grabbed.

Fresh from its success in looting, the cartel was able to relax in what seemed

to be perpetual control of petroleum supply and pricing. Houston’s boom

and bust from 1973 through 1988 was only the biggest and most-publicized

chapter in a grim story of economic contraction across the non-OPEC oil

world. Bankruptcies decimated the ranks of the drilling and oilwell service

companies, a melancholy pattern that reinforced the oil industry’s conviction

that OPEC’s hegemony would endure forever.

Within that cartel, a new kind of competition emerged—for shares in OPEC’s

quotas. As the “swing producer,” Saudi Arabia adjusted its production to

leave room for oil from the smaller member autocracies. That benign regime

soon found itself challenged by widespread cheating among its membership.

Given the ethical makeup of the club, that should have been no surprise.

Quotas were set in relation to each member’s statement of its proven reserves.

This honor system meant there was an incentive to overstate reserves. (That

would become Nigeria’s motivation to force Shell to overstate its Niger Delta

reserves.)

The other temptation toward what a critic might call “OPECcancy” was to

produce above quota and make private arrangements to sell the excess to

anyone (such as Marc Rich) who promised anonymity, could lease tankers

and fi nd customers eager to buy discounted oil.

By 1986, the Saudis, experiencing severe budget problems from their

exploding population and imploding economy, decided that swinging could

no longer be their thing. Sheik Yahmani, Saudi oil minister and grand vizier

of OPEC, opened the Saudi spigots wide—driving oil prices below $10 a

barrel.

The Saudis’ dramatic assertion of power battered an already depressed global

oil industry into submission. Its agonies were briefl y eased when the First Gulf War sent oil prices briefl y higher. Thereafter, the strong global economy

of the 1990s created a record international stock market boom at which Big

Oil was a mere bystander. Worldwide, drilling remained at depressed levels,

and few observers noticed the slow upward creep in global consumption—or

China’s switch from being an oil exporter to being an oil importer.

Fresh from its

success in looting,

the cartel was able

to relax ...



April

By the time experts such as Daniel Yergin had fi nally begun to notice how

Chinese demand was driving global oil prices skyward, the supply side

was already showing signs of serious ageing. Decades of OPEC’s practice

of draining oil revenues to fi nance corrupt governments and dysfunctional

economies had led to the inevitable problems of maintaining production.

These regimes were practicing their own version of The Goose that Laid the

Golden Egg : they didn’t behead the goose—they just starved it, giving most

of its food to family pets. The supermajor oilfi elds, such as Saudi Arabia’s

Ghawar and Mexico’s Cantarell, began to experience increasing diffi culties

in maintaining their output. There were no lusty new giants to pick up the

slack.

Those geologic-based problems for the government-owned oil giants were

unfolding while the private companies were struggling to maintain their

own output. Big Oil decided during the 1990s that its future lay with the

development of major fi elds in Russia, Venezuela, Nigeria and Angola.

Exxon spun off more than half its interest in Alberta’s Syncrude project to

the Canadian Oil Sands Trust, because Lee Raymond didn’t believe oil prices

would trade above $35 except during brief geopolitical crises, which meant

Syncrude would always be, at best, a marginal profi t generator. He needed to

maintain his company’s Reserve Life Index, and for that he required access

to the kind of huge prospects that were on attractive offer from three eager

promoters—Putin in Russia, Chavez in Venezuela, and Obasanjo in Nigeria.

He was even willing to bet heavily on deals with the long-time Communist

thug of Angola, Eduardo Dos Santos. Dos Santos came out on top in the

settlement with Jonas Savimbi that followed a four-decade-long civil war.

Savimbi, who had been backed by the US during the Reagan era, was

assassinated in 2002 by government troops, reportedly backed up by South

African mercenaries.

Mr. Raymond turned out to be absolutely right about the quality of oil reserves

available from those countries, and absolutely wrong about the political risk

to his stockholders from relying on his deals with them. His company has

already been seriously stiffed by Putin and Chavez, and Angola has joinedOPEC, and has recently announced it is dissatisfi ed with the terms of deals

made when the central government was distracted by its problems with “the

rebel Savimbi.” By the time Mr. Raymond retired, the world’s largest private

sector oil company was risking Paper Tiger status because of increasingly

questionable assumptions about its Reserve Life Index.

...their own version

of The Goose that

Laid the Golden Egg:

they didn’t behead

the goose—they

just starved it.



Basic Points

April

XOM should be greatly discounting the value of its giant reserves in Russia

and Venezuela, and should be assigning some risk factor to its reserves in

Nigeria and Angola. The other highly questionable aspect of Big Oil’s reserve

accounting that is very important to XOM is boe—converting natural gas

reserves to oil on its energy-equivalent basis. Exxon’s acquisition of Mobil

had given it ownership of that company’s giant LNG operations in Indonesia.

According to SEC rules, six units of LNG in a producing fi eld connected to

pipelines counted as a barrel of oil in a company’s RLI. That historic ratio

refl ected the relative energy content of six mcf of natural gas compared to

a barrel of oil, and the relative prices of those two fuels during the 1990s

tended to validate the accounting assumptions. However, LNG is the result of

a costly cryogenic process of cooling and compressing the gas and shipping

it in specially-built tankers. Gas to be converted into LNG is hardly worth asmuch as gas delivered to a pipeline. Only if oil prices soared far faster than

gas prices would Exxon-Mobil have real problems, but that seemed like pure

fantasy as long as OPEC controlled global oil prices.

XOM’s problems were broadly representative of Big Oil’s global challenges.

The industry had historically functioned in a bipolar world—OPEC and

the privately-owned oil producers. As the new decade dawned, the majors

and supermajors began to face competition for ownership of oil and gas

properties from a new crop of state-owned oil companies, including China’s

CNOOC and Sinopec, India’s national oil company, and the state-owned

companies in oil-rich states of the former Soviet Union.

The Miners Get a Major Shock

Copper

December 1988 to April 2007

50

100

150

200

250

300

350

400

Dec-88 Dec-91 Dec-94 Dec-97 Dec-00 Dec-03 Dec-06

...Big Oil’s global

challenges...

competition for

ownership of oil

and gas properties

from a new crop

of state-owned oil

companies...



April

The mining industry went through similar misery—and a similar un-

anticipated shock of prosperity.

Base metal producers had some moments of elation during their Triple

Waterfall Crash—notably the speculative copper squeeze of 1988—but the

industry was, apart from the global Left and the armaments makers, the

biggest loser from the Fall of the Wall on 11/9/89. That meant the Cold War

would soon end, thereby slashing global demand for military hardware. In

an eerie numerological coincidence, that outbreak of painful peace would

end on 9/11/01.

This decade has seen what consumers considered shocking increases in the

prices of minerals, and what Wall Street strategists considered even more

shocking increases in the prices of the shares of the mining companies.(Regrettably, Inco and Falconbridge are no longer held publicly; had they

not been acquired at bargain prices by acquisitors whose wisdom so vastly

exceeded the Street’s, Canadian base metal stocks’ performance would be

beyond Shock—and be within the realm of Awe.)

Gold’s performance was a useful benchmark of the global trend from

runaway infl ation to disinfl ation and even defl ation: apart from brief rallies,

its two-decade-long collapse fi nally bottomed in 2001—when defl ation was

the clear and present danger to many major economies. Its strong rally since

then was not a sign of the return of 1970s-style infl ation psychosis, but a

refl ection of soaring Indian and Chinese demand. Like the devastated oil and

base metal industries, gold’s long bear market had created conditions that

would prevent a characteristic response to soaring product prices.

A summary of what we have been saying since 2002, about the commodity

industries:

1. The hundreds of millions of new Asian residents of homes with indoor

plumbing, electricity and basic appliances, and the tens of millions of

new owners of cars have been the progenitors of the huge price increases

for energy and metals.

2. Unlike all the earlier commodity cycles, this soaring demand has produced

merely a series of baby-step supply side responses. For the fi rst time,

the historic pattern of major production increases that came on stream

when—or after—commodity prices peaked did not repeat itself.

3. In part this is due to the long-term pain to producers from the Triple

Waterfall: The greatest investment opportunities come from an asset class

where those who know it best, love it least, because they have been disappointed

most .

Regrettably, Inco

and Falconbridge

are no longer held

publicly; had they

not been acquired

at bargain prices...

Canadian base

metal stocks’

performance wouldbe beyond Shock—

and be within the

realm of Awe.



Basic Points

April

4. Big Oil has been the commodity world’s biggest loser from the widespread

operation of our Law of Political Risk for Third World Commodity

Producing Countries: The political risk for foreign investors increases as the

square of the price increase of the commodity . Russia, Venezuela, Ecuador

and Bolivia are the trend-setters. If the Reserve Life Index of Big Oil were

adjusted for the noxious political developments in those countries, it

would go down sharply—and few of those companies would qualify as

true Blue Chip investments on a longer-term basis.

The Bull Market in Grains: The Meat of the Story

The sudden bull market in feed grains and oilseeds, (which will inevitably

trigger food price infl ation) has, to date, produced more skeptics than

believers.

Soybeans

April 2004 to April 2007

400

500

600

700

800

900

1000

1100

Apr-04 Aug-04 Dec-04 Apr-05 Aug-05 Dec-05 Apr-06 Aug-06 Dec-06 Apr-07

Corn

April 2004 to April 2007

150

200

250

300

350

400

450

Apr-04 Aug-04 Dec-04 Apr-05 Aug-05 Dec-05 Apr-06 Aug-06 Dec-06 Apr-07

The political risk for

foreign investors

increases as the

square of the price

increase of the

commodity.



0 April

To the skeptics, who have dominated the media commentary, these outsized

gains come from “the ethanol craze.” They sarcastically argue that ethanol is

taken seriously primarily because the Iowa primary (the caucuses) must be

taken seriously by all presidential candidates.

Apart from this cynical (and possibly accurate) view of the motives of the

most prominent ethanol proponents, critics of corn-based ethanol as a

gasoline substitute note that it is protected by a 51-cent tariff against sugar-

based ethanol (from Brazil and the Caribbean). As for ethanol being a great

“green” fuel, the critics point out that the amount of gasoline needed by the

farmers to produce and deliver the corn, and to transport the ethanol to gas

stations, plus the amount of natural gas needed to make ammonia-based

fertilizer and operate the ethanol plants, makes the net energy from truly

renewable sources minimal.

Supporters point out that ethanol burns cleaner than regular gasoline or

MTBE, and that the risks to the US from dependence on the Gulf States and

Venezuela justify the extra costs. Chavez and Ahmadinejad are ethanol’s

biggest advertisements, and they manage to inject their spleen into global

headlines with suffi cient frequency to make ethanol look like a Heaven-sent

ingredient in national security strategy.

There is a precedent for building uneconomic energy facilities. Virtually

no American nuclear power plants would have been built if they had been

based on competitive economics—because in the Fifties and Sixties oil was

routinely trading at $3 to $4 a barrel. Eisenhower said the nation’s long-

range national security dictated a large-scale commitment to nuclear power,

and at that time the Sierra Club was no national force—so the nukes were

built.

In the past week, there have been signs of media rethinking of the grains story

as being much more than ethanol. Both The New York Times and The Wall

Street Journal published articles showing that Chinese meat consumption is a

crucial component in the pricing of corn and soybeans.

As we have been arguing rather strenuously this year, (including in interviewswith reporters of The Times and Journal) the impact of China and India on

coarse grain prices is a déjà vu story: we saw what they did to the prices

of oil, coal, steel and base metals. In its well-researched story on soybeans,

...the impact of

China and India on

coarse grain prices

is a déjà vu story.



Basic Points

April

The Times printed a chart showing China’s soybean imports soaring from 10

million to 33 million tons over the past six years. Not one of those beans is

being converted to biofuel.

Potash Corporation’s annual report notes, “China’s GDP grew more than 10%,

while India’s was up 8%...With higher incomes, the fi rst priority for many

people is more nutritious, protein-rich food. China’s meat consumption,

for example, has more than tripled in less than two decades. Producing

more animals takes a greater use of grain and feed supplements….A rising

global population with more money leads to spreading urbanization.

The agricultural land base per capita is less than half the 1950 level and is

expected to fall a further 13% by 2020 making higher crop yields a necessity.

Added to this, uncertainty over the world’s oil supply and desire for cleaner

fuels have resulted in a surge of demand for alternative energy sources such

as biofuels.”

The new boom in global grain prices is, in large measure, based on the rapid

growth of the Asian middle class. The people who went from bicycles to

motorcycles to cars, and from hovels to homes with indoor plumbing and

electricity, are graduating from a diet of rice, lentils and bread to the inclusion

of dairy products and meat. The growing prosperity of the US’s midsection is

coming from the growing midsections of the growing middle class in Asia.

This change in the diets of the new Asian middle class would have ultimately

had important implications for global food price infl ation. But when the

already short supplies of corn and soybeans were bid up by biofuel producers,

the two decades of benign food prices came to an end.

To date, North American prices for meat and dairy products have not

refl ected the huge price increases for corn and soybeans. Producers’ hedges

have cushioned the impact to date, but those are wearing off.

The third kind of commodity boom—feed grains and oilseeds—is different

from the others in one major respect: there are no super-giant grain fi elds,

and the only political challenges come from EU and environmental paranoia

about genetically-modifi ed seeds, and from other forms of protectionism.

Otherwise, this boom is like the others: there has been remarkably modest

supply side response to the surge in demand for feed grains and oilseeds.

There are no

super-giant

grain fi elds...



2 April

World Supply & Utilization of Major Crops, Livestock, & Products

[from USDA Economic Research Service: “Agricultural Outlook: Statistical Indicators”]

1997/98 1998/99 1999/00 2000/01 2001/02 2002/03 2003/04 2004/05 2005/06 F 2006/07 F

Mi ion units

WheatArea (hectares) 228.4 225.1 215.4 217.6 214.7 214.6 209.9 218.8 218.4 212.8Production (metric tons) 610.0 590.0 585.8 581.5 581.1 567.6 554.6 628.6 620.6 593.1Exports (metric tons) 104.5 102.0 112.7 104.1 110.8 110.1 104.5 113.1 113.6 110.7Consumption (metric tons) 577.3 579.0 585.0 583.9 585.0 603.8 588.5 610.0 624.4 619.3Ending stocks (metric tons) 197.1 208.1 208.9 206.5 202.7 166.6 132.7 151.2 147.5 121.2

Coarse grainsArea (hectares) 311.2 308.5 299.7 296.7 301.4 293.0 306.9 300.4 301.1 302.7Production (metric tons) 881.2 890.9 877.6 862.3 893.7 875.1 915.9 1,014.0 977.5 966.7Exports (metric tons) 85.8 96.7 104.8 104.4 102.7 104.6 103.0 102.0 109.1 107.9Consumption (metric tons) 867.2 869.2 882.4 884.4 906.6 902.3 945.9 975.9 989.1 1,014.5Endin stocks (metric tons) 215.8 237.4 232.2 210.1 197.1 169.9 139.9 178.0 166.4 118.6

OilseedsCrush (metric tons) 264.3 278.4 247.3 254.4 264.9 268.9 278.5 302.1 317.9 324.6Production (metric tons) 338.6 346.0 303.9 314.2 325.2 330.3 335.2 381.3 389.0 386.5Exports (metric tons) 62.1 63.5 59.9 66.9 62.7 70.0 67.1 74.6 77.5 82.2Ending stocks (metric tons) 30.2 32.9 35.1 38.9 41.2 47.5 43.9 56.3 60.8 58.2

1998 1999 2000 2001 2002 2003 2004 2005 2006 P 2007F

Beef and PorkProduction (metric tons) 128.2 131.4 132.1 133.2 139.3 140.6 144.1 148.6 153.3 158.1

Consumption (metric tons) 126.8 131.1 131.2 132.2 138.1 139.3 142.0 146.0 150.4 155.0Exports (metric tons) 8.2 9.2 8.9 8.9 10.2 10.6 11.4 12.3 12.2 12.8

Broilers and TurkeysProduction (metric tons) 49.5 52.3 55.3 57.1 59.2 59.2 60.8 63.9 64.9 66.0Consumption (metric tons) 48.8 51.6 54.1 55.5 57.6 57.7 58.9 62.1 63.6 64.5Exports (metric tons) 4.7 4.9 5.4 6.1 6.3 6.6 6.6 7.4 7.0 7.3

DairyMilk production (metric tons) 373.7 376.7 381.6 384.8 395.0 399.0 406.1 414.0 423.3 432.2

Source: USDA Economic Research Service, Agricultural Outlook: Statistical Indicators, March 2007: http://www.ers.usda.gov/Publications/ AgOutlook/AOTables/

Global acreage allocated to coarse grains, as the following data published by

the USDA Economic Research Service shows, has been virtually unchanged

in this decade.

Result: this crop year carryover will be the lowest (in relation to consumption)

on record. Huge price increases for grains have not produced meaningful

expansions in acreage. In the US, the conservation set-asides have remainedroughly intact, as farmers content themselves with Washington’s rental

payments for marginal lands that protect wildlife.



Basic Points

April

Abroad, Brazil has the potential to open up large tracts of well-watered land

for soybeans, but the fi elds are more than 600 miles from the sea, and the

only transportation is by truck over a narrow, potholed road. Most other

major grain producers are already using all the watered land available. Coarse

grains and oilseeds need far more water than wheat production requires, so

the potential for expanding output now that corn and beans are so expensive

is modest. Each week, as the cities of China and India expand, more farmland

disappears.

The USDA announcement, on March 30, of farmers’ planting intentions

was the most eagerly-awaited in history. Corn had become a Page One story,

as hedge funds crowded into corn futures and tales of Wall Street denizens

buying farmland were relayed on trading desks. (How many of these new

investors in agriculture, one wonders, can tell a heifer from a steer, or know

that the word “gilt” is a proper noun for a female pig, whereas “gilt” as

used on the Street is the slang contraction of “gilt-edged”—the term for UK

government bonds?)

Naturally, these late enthusiasts for the agricultural story drove spot corn

prices up too fast, and were in a panic to exit their positions when it was

announced that the acreage for corn would be the biggest since 1944. (Back

then, photographs of much of what is now Chicago, Greenwich, Boston and

Atlanta could have been used to depict the “amber waves of grain.”)

With corn down-limit after the report, some of Wall Street’s most prominent

soothsayers could barely contain their glee. They tut-tutted the “dangerous”

level of commodity speculation. (When the Street becomes pompously

puritanic about “speculation,” while a bull market is still rampant, it usually

means that those who have been making money by taking risks have been

earning outsized returns in products or sectors the Best Minds had not been

recommending.)

Stories exulting spot corn’s plunge from $4.25 to $3.75 led readers to believe

this noisy market effusion had only been a belch, not the proof of a sustained

change in the behavior of the system.

How many of these

new investors in

agriculture, one

wonders, can tell a

heifer from a steer



4 April

Corn Futures December 2008

Sept 2006 to April 2007

290

310

330

350

370

390

410

Sep-06 Oct-06 Nov-06 Dec-06 Jan-07 Feb-07 Mar-07 Apr-07

Corn

Sept 2006 to April 2007

200

250

300

350

400

450

Sep-06 Oct-06 Nov-06 Dec-06 Jan-07 Feb-07 Mar-07 Apr-07

True, there was no doubt that the ethanol story was generating speculation,

and that many of those players had been forced to leave the fi eld. However,

the value of the corn crop to be harvested in 2008 attracted rather less attention

from the speculators, and considerably less rage/shock/disappointment/

profi t-taking/panic after the USDA report was published.

In all past periods when corn and bean prices surged, the cause was a crop

failure that did not recur. Futures market prices for the following year’s cropsdid not share in the short-term bullishness. Big backwardation was the

pattern in the charts.

Not this time.

...the value of

the corn crop to

be harvested in

2008 attracted...

less rage/shock/

disappointment/

profi t-taking/

panic...



Basic Points

April

What is happening in the grains is more like what happened to oil prices:

coarse grain prices have gone up—and stayed there through another crop

year—without any actual or expected interruption of production and without

stimulating huge new global plantings.

The sharp rise in corn plantings that the USDA reported for this year comes

mostly at the expense of soybean planting, but also from cotton. In terms of

feeding the newly carnivorous tummies in China and India, the switch in

planting from soybeans to corn still means higher feeding costs for livestock

production, because soybean meal (48% protein) is the most effi cient way

to produce animal protein.

The Midwest, the pre-eminent global corn producer, has had 15 straight years

without a signifi cant crop failure—the longest on record.

What if the prairie skies are not cloudy all day this July?

What if food price infl ation becomes the highest in decades at a time when

oil prices continue to trade near $60?

Food Price Infl ation – Can Bondholders Stomach It?

Food price infl ation has already begun. As with some past infl ation shocks, it

could be kick-started into high gear by a spectacular piece of bad economic

luck. The painful food-price infl ation of the 1970s was kicked off by the

collapse of the anchovy harvest after the major El Niño of 1973. (Back then,

anchovies were the protein feed supplement of choice. Thereafter, soybean

meal replaced them as the staple.)

This time, it could be the shortage of bees.

Bees are nature’s gift to producers of a wide range of crops, particularly fruits.

For reasons experts have not yet been able to establish, the populations in

bee colonies across much of the US and Canada have been decimated since

last autumn. Apiarists call this a crisis. Already a Congressional committee

has met to consider the evidence and suggest some remedies. Even now,

nobody knows with any certainty what has caused the die-back and nobody knows what to do. It has already spread to nine countries in Europe.

This time, it could

be the shortage

of bees.



6 April

Honey Bee Colony Collapse Disorder

Map of Affected States, February 2007

Source: USDA Economic Research Service, Agricultural Outlook: Statistical Indicators, March 2007;and Mid-Atlantic Apiculture Research and Extension Consortium (MAAREC), February 2007,[http://maarec.cas.psu.edu/pressReleases/CCDMap07FebRev1-.jpg].

How can a previously-unknown pathogen suddenly appear and proceed to

slaughter bees on an unprecedented scale across much of North America and

Europe simultaneously?

Some environmentalists are using this phenomenon to rally new support

against “frankenfoods,”—genetically modifi ed seeds. The only evidence they

have is that no one has been able to identify the culprit. Ergo, something

they’ve always feared and despised must be to blame. Anyone who looks

at the map from the Congressional report showing the incidence of CCD

would see that the cornbelt—where GM seeds have taken over—still remains

nearly free of reported die-backs.

Nevertheless, investors should take note of the “frankenfood” smears,

because Monsanto, DuPont and Syngenta may well be judged guilty untilthey prove their innocence. ’Twas ever thus. When syphilis suddenly spread

across Europe in the late 1490s, the English immediately called it “The French

Disease,” and the French called it “The English Disease.” In reality, Spain was

to blame. It had been brought back from the New World by Columbus’s men

and by the troops accompanying the conquistadores—partial punishment for

the Europeans’ introduction of smallpox to the Americas.

Investors should

take note of the

“frankenfood”

smears.



Basic Points

April

A prominent American beekeeper, who was the fi rst to go public with a report

of die-back, suggests that widespread adoption of a new kind of pesticide—

neonicotinoids—could be the explanation.

Crops that collectively contribute approximately one-third of the American

diet, and almost $15 billion to the US economy, are at risk. A Research

Report to Congress on this previously-unknown conditions, tentatively titled

“Colony Collapse Disorder” notes: “Across the US 35% of all the bees are

gone. In some states 90%”.

In particular, alfalfa, which is the key component of hay, relies entirely on

insect pollinators. The dairy industry, already reeling from soaring corn and

soybean prices, could be truly at bay.

And if there ain’t hay in Wisconsin this summer, the milk and cheese

consumer’s cost ain’t hay.

If the bees don’t return with the fl owers of spring, food price infl ation this

year, which is already climbing quite strongly, will be at front-page scare

story levels before the full impact of $3.80 corn has reset the prices of meat,

cereals, eggs, and dairy products.

Infl ation Pressures: Bad-Luck Ben follow Auspicious Alan?

US Year-Over-Year CPI

January 1998 to April 2007

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07

Fed Governor William Poole, who hails from the St. Louis Fed, the keeper

of the purity of the monetarist fl ame, recently gave a speech in which he

restated the Fed’s responsibility as fi ghting infl ation—not trying to manage

the economy. Located not far from fi elds where corn and soybeans would

soon be planted, he was certainly aware that infl ationary pressures were

returning. He expressed himself as very worried about infl ation.

...if there ain’t

hay in Wisconsin

this summer, the

milk and cheese

consumer’s cost

ain’t hay.



8 April

Alan Greenspan luxuriated in baths of sweet-scented admiration. He was

even knighted. (Her Majesty, as we know from seeing The Queen, has her

off days.) He was certainly lucky. His predecessor, the saintly Paul Volcker,

was fi nally called in by Carter as the US was sinking into a stagfl ationary

swamp. He had to drive interest rates to seemingly intolerable levels to undo

the damage. Greenspan inherited a strong economy experiencing falling

infl ation and falling interest rates, which was on the cusp of the strongest

productivity gains in a generation.

These blessings gave him the fl exibility to dabble in another role—the

Manager of the US Economy—the Maestro, as he would be called in a best-

selling hagiography. He could respond to collapsing stock markets or a

weakening economy by slashing interest rates and printing money, without

worrying about the impact on infl ation.

Having helped to infl ate a commercial real estate bubble that then burst,

leading to a recession he didn’t recognize even when it was half-way

completed, he would move on to bigger game—presiding over the biggest

stock market bubble of all time. His sole act of restraint was to produce

a one-day stock market selloff when he publicly mused about “irrational

exuberance.” His fi nal injection of gas into the bubble came when he was

once again delivering the “Greenspan Put” to a tottering fi nancial market

after the collapse of Long-Term Capital Markets, which imploded due to a

heretofore unknown condition—a critical mass of Nobel economists.Nasdaq

September 1, 1998 to March 10, 2000

1000

1500

2000

2500

3000

3500

4000

4500

5000

5500

Sep-98 Nov-98 Jan-99 Mar-99 May-99 Jul-99 Sep-99 Nov-99 Jan-00 Mar-00

The recession which followed the Nasdaq collapse occurred at a time when

Greenspan had carte blanche to restimulate the economy, because, for the fi rst

time since the Depression, the pricing challenge to the US economy came

from defl ation.

Long-Term Capital

Markets, which

imploded due

to a heretofore

unknown

condition—

a critical mass of

Nobel economists.



Basic Points

April

Ben Bernanke has no such luck.

Greenspan’s Chairmanship was mostly characterized by surpluses and soft prices for commodities, and by labor surpluses and weak wage pressures

from workers; moreover, he could, with a fl ourish that made him seem to his

acolytes like a monetary Batman, rush to the rescue of a frightened Gotham

with the Greenspan Put without worrying over-much about a dollar collapse,

because of the reliable support from Beijing and Tokyo—the deep-pocketed

partners in “The Great Symbiosis”.

Mr. Bernanke, known for his beard, not his Batmobile, faces a far more

hostile economic and fi nancial environment. The global economic climate

is changing from strong to weak growth, and from weak to strong infl ation.

Gold

February 2006 to April 2007

500

550

600

650

700

750

Feb-06 Apr-06 Jun-06 Aug-06 Oct-06 Dec-06 Feb-07 Apr-07

US Dollar Index


80

82

84

86

88

90

92


Mr. Bernanke,

known for his beard,

not his Batmobile



0 April

Copper


200

250

300

350

400


iShares Emerging Markets (EEM)


80

85

90

95

100

105

110

115

120

125


Just prior to taking over as Chairman, he had cleverly arranged to have the

Bank of Japan intervene in soaring metal markets by commissioning, editing

and publishing, in his Journal of International Central Banking , a memo

prepared by BOJ economists showing how the BOJ’s zero interest rate policy

had unleashed a huge expansion of the euroyen market that let hedge funds

and investment banks borrow at less than 0.5% to play in a variety of risk

assets—notably gold, metals and Emerging Markets. When the BOJ at itsMarch meeting reversed that policy, draining 30 trillion yen (roughly $175

billion) from its Monetary Base in a mere 11 weeks, it unleashed panic among

the conspicuously rich in Greenwich and in London’s West End.

The BOJ...unleashed

panic among the

conspicuously rich

in Greenwich and in

London’s West End.



Basic Points

April

With gold and copper back up near their 2006 highs, is it time for another

BOJ bash on speculation?

The BOJ is not ready for an encore, given the ponderous, Kabuki-paced level

of activity in the Japanese economy. The Bank announced this week that it

was holding its rate at 0.5%. In his commentary on the meeting, Governor

Fukui said that the yen’s weakness was not due to a major resumption of

the carry trade. He was suitably opaque: “Currencies fl uctuate every day for

various reasons, but at the moment the movement is stable.”

A year ago, he was able to cite a strengthening Japanese economy when he

bailed out Bernanke. That return of robustness turned out to be yet another

false dawn over what was once called the Land of the Rising Sun.

In a very real sense, the infl ation signals from commodities are much

stronger now than then. Back then, grains were still, as they had always been,

objects of government solicitude—both in the US and EU—as unzippered-

wallet recipients of farm income supports. Now, the grains are threatening

to unleash the strongest food price infl ation in years. If gold goes through

$700 to stay this time, and if the dollar breaks 80 on the Dollar Index, then

discussions at the Fed will not focus on parsing the meaning of the most

recent Retail Sales and Non-Farm Payroll reports—or even about the plunge

in housing starts at the outer reaches of the nation’s cities on lands that could

be more wisely used for corn or soybeans.

The Bernanke nightmare scenario: subprime problems hobble the fi nancial

system, and the housing and auto sectors go into deep recession together,

dragging the economy down at a time CPI increases become the highest in

many years and the long end of the bond market fi nally responds the way

Greenspan predicted it would when he started tightening three years earlier.

The dollar breaks down, foreign central banks fi nd themselves unable to help

much, and the stock market plunges.

Most nightmares do not prefi gure actual disasters, except in plays and

novels.

Some do.

Most nightmares do

not prefi gure actual

disasters, except in

plays and novels.

Some do.



2 April

The Fourth Scarcity: People

Japan’s approach to reproduction (DON’T!) has become the role model for most of the OECD. At current European and Canadian fertility rates, each

ensuing generation’s workforce will be roughly half the size of its predecessor.

Japan is maintaining its lead in the tortoise-paced race to long-term extinction,

but it now has plenty of competition. Among the ways today’s Japan ensures

that the birth rate continues its asymptotic decline is by the decrease in the

supply of obstetricians to the zero level in smaller towns and cities.

In America, the Fourth Scarcity is the product of a notably successful campaign

in the Sixties and Seventies to change American reproductive habits based on

wildly inaccurate forecasting. Paul Ehrlich, author of the Sixties bestseller

The Population Bomb, predicted global disaster from overpopulation, andhis acolytes had enormous impact. The US fertility rate fell from 3.42 per

woman in the early 1960s to 1.8 by 1975.

That defi cit has, in the United States, been offset somewhat by the fl ood of

illegal immigrants and their offspring, and, (to a lesser degree) in Europe

by Muslim immigrants and their offspring However, the success of the neo-

Malthusians’ campaigns among the established US population is refl ected in

today’s overall shortage of US workers, with the unemployment rate holding

at 4.4% despite slowing economic growth.

Within the OECD, only in America are babies being produced at thereplacement rate—2.1 per female. According to the diehard environmentalists,

for whom babies are consumers of resources and emitters of CO2, this is just

another example of Americans’ scandalous disregard for the planet Earth.

(Latino mothers who are collectively responsible for America’s atypically

high rate of reproduction do not, it would appear, belong to Friends of the

Earth.)

But maintaining the fertility rate at the Zero Population Growth level doesn’t

provide enough new entrants into the labor force to offset the ageing of

the Baby Boomers, or to keep GDP growth rates above 3%. Last Friday, it

was reported that the US had added more jobs than economists expected,driving the unemployment rate down to just 4.4%. It was also reported that

Japan is

maintaining

its lead in the

tortoise-paced

race to long-term

extinction.



Basic Points

April

US employers have already used up the quota of highly-trained professional

immigrants on H-1B visas for this year (a pitifully low 165,000), and that they

would hire hundreds of thousands more if the government would let them

in. (Congressional policy, in a display of bipartisanship on the immigration

question, cannot agree on doing anything effective about keeping out millions

of mostly untrained immigrants who cross into this country illegally, but

will continue to ensure that the American executives, engineers, scientists,

nurses and doctors are protected against competition from potential

immigrant executives, engineers, scientists, nurses and doctors. As Microsoft,

IBM and other major companies have told Congressional committees, one

of the biggest stimuli to outsourcing is the shortage of qualifi ed workers in

America.)

Meanwhile, in Canada, which has very few Latino immigrants, the

unemployment rate is at a thirty-year low—along with the fertility rate; in

the EU, the unemployment rate is at a 14-year low, driven by above-trend

economic growth surging to an unsustainable 2%.

What if they had a recession and nobody turned up at the Unemployment

Offi ce?

No, we aren’t predicting the end of the economic cycle. We are predicting

that if a US house price collapse does indeed trigger a recession in North

America, unemployment, like politics, will be mostly local.

The drastic change in reproductive habits across the industrial world since

1970 has meant that today’s populations in those countries are roughly one-

third smaller than Sixties demographers predicted (adjusting for improved

mortality experience during that period).

One way of looking at this is to compare it to the Black Death, which wiped

out more than one-third of Europe’s population in four years. The hardest-

hit nation was Britain, where, experts now believe, an anthrax epidemic

among cattle and sheep increased human mortality above the rate seen on

the Continent. Medical practitioners of the time were obviously not skilled

enough to be able to isolate anthrax deaths from bubonic plague deaths.

What if they

had a recession

and nobody

turned up at the

Unemployment

Offi ce?



4 April

What happened in England after the plague subsided is well-recorded.

Feudalism, which was already decaying because of the growth of towns,

barely recovered. Many barons and other landlords were no longer able to

rely on their serfs to look after their estates, and had to recruit laborers in the

open market. It no longer became possible in most shires to enforce the laws

that tied serfs to their lords’ demesnes. Nor was the Church able to insist that

its lowliest parishioners had to abide by their oaths of loyalty to their lords.

One reason was that the mortality rate from the plague was frequently highest

among the clergy; priests and nuns who, obedient to their vows, continued to

attend the dying and deceased, were obviously at high risk of contracting the

disease; since so many clergy lived together in monasteries, the disease could

spread rapidly: many a monastery and nunnery was completely wiped out.

Why, asked the newly skeptical, did those who devoted their lives to serving God die at a higher rate than the rest of the populace in Christendom?

There is no spiritual component to this latest massive population loss.

That was Sudden Death: this is Slow Dearth. Because the economic impact

has developed slowly over the past two decades, during a time when the

impacts from technology and competition from low-wage nations were

leading to highly-publicized layoffs and plant closures at long-established

corporations, the declining rate of new entrants to the labor force attracted

little attention.

Ben Bernanke has mentioned wage infl ation pressures twice in the past month. That Average Hourly Earnings are now growing at the same rate as

when the Fed last tightened may be a coincidence. But back then, GDP and

overall employment were growing more briskly than now. The difference, we

believe, is that the pool of potential new workers ages 18-25 keeps getting

smaller. The Street’s assumption that a weak payroll number means the

economy is growing too slowly has been valid for most of the past fi fty years.

But when the supply of labor is no longer in surplus, a lack of jobs growth

could be due more to employers’ inability to fi nd the workers they want at

the rates they are willing to pay them, than because the economy’s gears are

stuck in neutral.There may be one last big rally in bonds if a recession arrives.

After that, it will be time for a Requiem for the Greatest of Them All.

That was Sudden

Death: this is

Slow Dearth.



Basic Points

April

US 10-Year Treasury Note Yield

May 1987 to April 2007

3

4

5

6

7

8

9

10

11

May-87 May-90 May-93 May-96 May-99 May-02 May-05

Government of Canada 10-Year Bond Yield

June 1989 to April 2007

3.5

4.5

5.5

6.5

7.5

8.5

9.5

10.5

11.5

12.5

Jun-89 Jun-91 Jun-93 Jun-95 Jun-97 Jun-99 Jun-01 Jun-03 Jun-05

Preparing a Goodbye to the Greatest of All Bond Bulls

This bond bull is a record-setter—in terms of its duration and the scale of thedrop in interest rates.

The remarkable global economic progress of the past 25 years has come largely

because Paul Volcker, Karl-Otto Pohl, Ronald Reagan and Margaret Thatcher

challenged and conquered the infl ation that had been gaining strength even

as industrial economies weakened over the previous three decades.

One by one, the non-monetary-policy factors promoting disinfl ation have

been crumbling. First and second to go were cheap energy and cheap metals.

Until recently, fi ve powerful factors that had helped hold down infl ation

were still at work—food prices, labor surpluses, a reasonably fi rm dollar,

disinfl ation driven by imports and outsourcing, and productivity gains.

One by one, the

non-monetary-

policy factors

promoting

disinfl ation have

been crumbling.



6 April

The last two factors are still disinfl ation-friendly: the US continues to import

disinfl ation. As for productivity, it no longer promotes cost controls as

powerfully as it did from 1994 through 2002, a process Alan Greenspan

correctly identifi ed.

A strong dollar is a powerful disinfl ationary force. The dollar is no longer

strong, but it hasn’t completely broken down.

US Dollar Index


80

82

84

86

88

90

92


As for labor costs, average hourly earnings in the US have been climbing at

more than 4%—their fastest clip since the peak of the last cycle. Anecdotally,we hear new stories each week of employers’ diffi culties in fi nding qualifi ed

help. The Challenger layoffs report last week not only did not project more

bad news for employees, but reduced the number of previously-announced

layoffs that would actually be implemented.

A recession might stop this rise in wage costs in its tracks, but the ensuing

recovery will, we believe, see an historic shift in the power balance between

employers and workers. The big, unseen Presence at all future bargaining

tables will be the Unborn. They will be casting their votes for the workers—

and against management.

The Year of the Death of the Bond: 007.

The Year

of the Death

of the Bond: 007.



Basic Points

April

INVESTMENT ENVIRONMENT

On CNBC last week, I followed two commentators who were agreeing that aweak Non-Farm Payroll number could make the Fed cut rates. I argued that

with a weak dollar, gold heading back to $700, food infl ation, commodity

infl ation and now wage infl ation, “those who keep looking for a Fed rate cut

are out to lunch….and lunch will cost a lot more.”

Everyone seems to agree that the main challenge to the US economy comes

from the end of the boom in house prices. Like so many American real estate

booms, its latter phases included excess supplies of credit and weakening

credit standards. Alan Greenspan kept the fed funds rate at a risible 1% for

too long, and a motley host of new-age mortgage originators and investors

found neat new ways to debauch longstanding credit guidelines and

constraints. It was as if those slick Silicon Valley denizens who pioneered

and proliferated the back-dated stock option programs were called in by the

new breed of mortgage originators. The tech sharks would do their best to

ensure that probity in mortgage appraisals would become as rare as probity

in tech companies’ fi nancial reports.

As discussed in last month’s issue (DON’T ASK; DON’T TELL: IT’S SUBPRIME

TIME!), the subprime mortgages with teaser rates, followed by resets to

market rates, have conspicuously high mortality rates.

Adjustable rate mortgages are priced off Libor, whereas conventional fi xed-rate mortgages are priced off the Ten-Year Note. Floating rate subprime

mortgages and so-called “Alt-As” and “Alt-Bs” are Libor-priced.

We get the feeling that much of the urgency out there for a Fed rate cut is that

it would cut Libor and that would help the mortgagors most at risk—those

facing resets.

Why shouldn’t the Fed ease their pain—and the pain being experienced by

fi nancial institutions who lent not wisely, but to the fi nancially unwell? The

pain is already over for 20 of the upstart mortgage lenders; they have gone

bankrupt or otherwise out of business. New Century Financial, the most conspicuous creator and packager of toxic waste, is the biggest bankrupt

to date, but more will join it in the mortuary. It now appears that nearly

40% of all mortgages issued last year in the US were subprime or the next

category up—Alt-As. Since the borrowers either had no proof of their ability

New Century

Financial, the most

conspicuous creator

and packager of

toxic waste, is the

biggest bankrupt

to date, but more

will join it in the

mortuary.



8 April

to service the debt (subprime) or inadequate proof (alt-As), the already-high

default rate on home mortgages would become grim were the US to fall

into recession. This week a major mortgage REIT revealed that it was taking

writedowns on some loan packages ranked as high as AA. It would appear

that confi ning the term “problem loans” to the categories that may appear, on

closer examination, to be designed primarily for the hapless homeless does

not address the full problem. It is as if there were a large cesspool upwind of

an upscale neighborhood: the odor would not be confi ned to the low-rent

district. Senator Dodd, Chairman of the Senate Banking Committee, pledges

aid (undescribed) to borrowers who are victims of “predatory” lenders. (The

Senator’s use of the term “Predatory” in this context is confusing. Does being

a predator involve shoveling out 100% or more of the purchase price of a

house to people whom any experienced, disciplined lender would rate aslikely deadbeats? Or does the predator prey on investors in the Collateralized

Debt Obligations who he thinks will soon be stuck with a portfolio full of

garbage?)

The Greenspan Put was a great gift for bad banks and hubristic hedge funds.

It was never designed for consumers who were in over their heads. To the

extent that Greenspan concerned himself with homebuyers, it was to give

advice that turned out disastrously. It was he—lest we forget—who, when

the fed funds rate was 1%—the equivalent of pricing a real diamond as if

it were a rhinestone—advised homebuyers and homeowners not to burden

themselves with fi xed-rate mortgages at the high interest rates that the

then-upward-sloping yield curve decreed. “Get the low-interest, adjustable-

rate mortgages and rely on us to keep out infl ation so those rates won’t go

up,” quoth the newly-knighted seer. Given his media reputation, perhaps

we should not be surprised that the number of subprime loans using resets

exploded after Greenspan gave his recommendation. Perhaps his parting gift

to his successor was a few million mortgage defaults based on his ability to

time the market.

Perhaps we are seeing something even bigger unfold: The Great Bond bull

was born, bred and fed during the era when leftist parties were being wipedout at the polls. Keynesianism and its American equivalents had reached

global dominance during the 1970s. (When Nixon unveiled wage and price

controls, he proclaimed, “We are all Keynesians now.”) Reagan and Thatcher

demolished the die-hard survivors of the discredited breed. Bill Clinton, was

able to get elected and re-elected at a time of disinfl ation and skepticism

about big government by espousing centrism and free trade. He might not

be able to even get the Democratic nomination with those policies today.

...the fed funds

rate was 1%—

the equivalent

of pricing a real

diamond as if it

were a rhinestone...



Basic Points

April

The conservatives have had their decades in power, and perhaps voters think

it is time to try protectionism, handouts, increased union power and weaker

defense policies again. History may judge President Bush as the man who

made voters believe they’d be better off doing what had kept infl ation and

the Cold War going.

As Marx observed, “History repeats itself: fi rst as tragedy, then as farce.”

Conclusion

The outlook for bonds had already become bleak before we heard about the

vanishing bees.

The possibility that the Bee Die-Back will be the once-in-a-century food

catastrophe that will be the fi nal ingredient in a Perfect Storm for the bond

market may still be remote, but we shall be hearing a great deal in the next

six weeks or so about Apis mellifera, the indispensable member of Order

Hymenoptera.

What is bad for bonds is also bad for Financial stocks.

BKX


15

35

55

75

95

115

135

May-92 May-94 May-96 May-98 May-00 May-02 May-04 May-06

Financial stocks soared skyward along with techs, lending legitimacy to

the Street’s collective replay of The Rake’s Progress on a bigger canvas. TheGreenspan Put and the roaring bond bull market saved them from serious

punishment during the stock shakeout attending the early years of Nasdaq’s

Triple Waterfall crash.

It is hard to construct a bullish scenario for US stocks against a bearish

scenario for Financials.

It is hard to

construct a bullish

scenario for US

stocks against a

bearish scenario

for Financials.



0 April

However, it is possible—indeed eminently reasonable—to remain bullish

about commodity stocks while going short bonds and the BKX.

The three commodity scarcity stories are long-term in nature, which means

commodity stock investors who can look through a downward correction of

the dollar and the overvalued bond market can expect continuation of strong

returns.

The labor shortage story is also long-term in nature. That it implies that

workers’ shares of the income pie should outpace gains for top managements

should not be construed as bad news. Plutocracy is not an attractive alternative

to democracy.

The new SEC rules are forcing companies to tell us about CEO’s compensation

packages, which—in some Black-Mass-style perversion of marriage vows—pay

these princes gigantically whether the stockholders be richer or poorer, and

the payments must continue—or even escalate—after the CEO has departed

the organization until death do them part and he goes to that Great Executive

Suite in the Sky. As the reports of billions in payments made without regard

to performance pour out, we realize anew that one of Milton Friedman’s

greatest insights was, “The principal problem with capitalism is capitalists; the

principal problem with socialism is socialism.”

The scale of CEO compensation packages, even after eliminating those highly-

publicized excesses for which the term “obscene” is inadequate, seems tobe based on a Lake Wobegon-style belief system of boards’ compensation

committees: all CEOs are better than average and ours is among the best of

that superbly-performing lot.

It looks as if the global winners in the next few years will be farmers

and workers. And maybe not CEOs, although they have those external

compensation advisors, who are paid handsomely to tell the Board

compensation committees how to “keep the company competitive.”

If the workers are fi nally going to receive greater percentage increases in

compensation than the average CEO whose company underperforms, that

might be a consummation devoutly to be wished.

Even though it would mean that the world has changed and the CPI will be

going up.

Painfully.

...CEO’s

compensation

packages, which—

in some Black

Mass perversion

of marriage

vows—pay these

princes gigantically

whether thestockholders be

richer or poorer...



Basic Points

April

INVESTMENT RECOMMENDATIONS

1. Reduce bond durations to below benchmarks, and in particular, reduceexposure to long duration bonds.

2. In balanced accounts, maintain exposure to long zero-coupon bonds as

hedges against commodity stock positions for as long as US recession risk

remains higher than normal.

3. Maintain market weight in Energy stocks, with emphasis on producing

companies in the Alberta Oil Sands. They will continue to have special

appeal for as long as Big Oil has big problems with its Reserve Life Indices.

Within the oil service sector, emphasize the Offshore Drillers.

4. Overweight exposure to gold, using mining stocks and/or the ETF. If the

US Dollar Index breaks 80, add to your gold positions promptly.

5. Remain overweight the producing base metal stocks with long-life secure

reserves. They remain the pre-eminent asset class for the next fi ve years.

6. Underweight Financial stocks. Within the group, emphasize the “dull”

banks who stick to their knitting, don’t take big derivative bets, and grow

their dividends faster than infl ation. Given the huge growth in personal

incomes of the Midwest farming community in this and coming years,

banks headquartered in farming communities will be prime takeover

candidates by big banks headquartered in the coastal regions where thenews will tend to be mostly bad.

7. Continue to build major overweight positions in the agricultural stocks.

This is, like the other commodity groups we have been recommending, a

long-cycle investment theme.

8. The Canadian dollar remains severely undervalued compared to the

greenback. American accounts should overweight Canadian assets (other

than exporting companies). In particular, American investors should

consider the wide range of Maple Bonds now available in what once was

the severely constricted Canadian bond market. Canadian accounts shouldunderweight US assets. There is no discernible reason for Canadian fi xed

income accounts to hold unhedged US dollar-denominated bonds.



2 April

9. Remain overweight Emerging Markets, concentrating on economies with

positive demography. Russia has the greatest diversity of mineral resources

of any major economy, but the worst demography of any major economy.

Caveat emptor .

10. Continue to underweight technology stocks. Within the biotech sector,

consider the GM seed companies as attractive alternatives to the

pharmaceutical companies.

11. Real-return government bonds, are about to become collectors’ items for

the wise. The total supply outstanding is modest, and will prove grossly

inadequate for the coming growth in demand—particularly from pension

funds.



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Documents

2007 Basic Points APRIL