BMO CM Basic Points Nov 2009

8/14/2019 BMO CM Basic Points Nov 2009

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Basic Points

The Power of Zero

November 12, 2009

Published by Coxe Advisors LLC

Distributed by BMO Capital Markets


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Don Coxe

THE COXE STRATEGY JOURNAL

The Power of Zero

November 12, 2009

published by

Coxe Advisors LLC

Chicago, IL


4/43


The Power of Zero

November 12, 2009

Author: Don Coxe [email protected]

Editor: Angela Trudeau [email protected]

Coxe Advisors LLC. www.CoxeAdvisors.com190 South LaSalle Street, 4th FloorChicago, Illinois USA 60603


5/431November

OVERVIEW

The Power of Zero

So what was all that Depression fuss about?

The US economy grew 3.5% in the Third Quarter, and all the major economic

numbers now being reported suggest this one will be even stronger. Stock

prices are soaring.

In case, youve forgotten:

Sixteen months ago we were heading into the Midnight Massacre, when

Messrs. Bernanke and Paulson launched the rescue of Fannie, Freddie and

Wall Street.

That swiftly evolved into the Age of Bailouts, with Congress enlisted in

emergency funding for Wall Streets biggest, boldest and brashest bankers

on a scale that made IMF rescues of entire nations look like chump change.

Only Lehman was allowed to experience the Schumpeteresque-slaughter

reserved for capitalist cupidity and stupidity. Operating with scripts and

strategies conceived on the fly, varying prescriptions of emergency assistance

were extended, under panic conditions, to Citigroup, Merrill Lynch, Morgan

Stanley, AIG and Goldman Sachs.

Since then, the Obama Administration and the Pelosi-led Congress have been

moving to take charge of some of the commanding heights and strategic

valleys of the US economy. Highlights: takeovers of General Motors andChrysler, a deficit of 12% of GDP, $790 billion in handouts and assistance

under the rubric of economic stimulus, a costly new national health care

system, and a vast array of tax and trade global warming programs whose

tentacles will reach into almost every sector of the economy.

To date, his rescue operations are succeeding. As Joe Biden put it, A year ago

we were talking about falling into Depression. Now were talking about the

shape of the recovery.

But deeply-wounded investors should be cautious about throwing caution

to the winds. Among the signs that the stimulus package didnt repair the

potholed yellow brick road to prosperity is the upside breakout in the Bad

News Asset: Gold.

This month, we begin our analysis by discussing the anniversaries of the

births of two new eras. First, the Age of Global Capitalism, which began 20

years ago with the Fall of the Wall. Second, the apparent ending of that era

a year ago with the return of Big Government as Economy Manager with the

election of Barack Obama. We werent sure then how he was going to deliver

Only Lehman was

allowed to experience

the Schumpeteresque-

slaughter reserved for

capitalist cupidity and

stupidity.


6/43

THE COXE STRATEGY JOURNAL2 November

everything his thrilled backers wanted, but we knew that he wanted to be a

transformative President and he cited Reagan as such a leadereven though

he said Reagan had the wrong views.

With that background, we search for an appropriate investment strategy for

tumultuous times. While the talk is of trillions in stimulus, foreclosures,

bailouts and deficits, we have decided to focus on a humble number

Zerowhich is roughly the rate on government short-term funds, high-grade

money market funds and inflation across the US, Canada, Japan, and most

of Europe.

We are leaving our cautious Asset Mix unchanged. Risk assetsother than

US real estate pricesare bubbling upward everywhere, but the big banks

balance sheets remain overloaded with the unmarketable unmentionables,and US regional banksthe backbone of the real economyare now being

engulfed by their exposure to commercial real estate and consumer loans as

unemployment continues to climb.

we have decided to

focus on a humble

numberZero...


7/433November

I. Capitalisms Triumph

Every week, someone publishes an analysis of the global economy by noting

that the triumph of free trade and free markets across most of the globe

began in the Reagan-Thatcher era. Now, they agree, its over. Each month,

Washingtons reach into the American economy expands rapidly, while the

economy expandsat bestgrudgingly.

It is certainly true that almost no one predicted the suddenness and scale

of US government intervention in the Wests flagship economy that had

been, until last year, a testimony to the wisdom of Milton Friedman and the

courage of Ronald Reagan. (The cheerful Reagan charmed voters by teasing his

opponents. He summed up Democratic economics as, If it moves, tax it; if it

keeps moving, regulate it; and if it stops moving, subsidize it. He summedup the goal of his policies toward the Soviets: We win; they lose.)

The political bipartisanship began with the Midnight Massacre of July 13,

2008 but lasted only until the grandiose goals of the new Administration

were revealed. The Pelosi-Obama stimulus package passed with no Republican

votes in the House, despite heavy lobbying from some segments of the

business community, notably General Electric, which became Obamas

most dedicated corporate cheerleaderitself and through MSNBCafter

receiving many billions in low-cost loans to its flagging finance subsidiary,

GE Capital.

The GM and Chrysler rescues were accomplished with minimal Republican

support. By then, the concern that the Administration was actually seeking

a major transformation of the structure of the US economy was developing

rapidly among conservatives and moderates. In addition, the pitchfork

politics in the House had terrified many business leaders that they and their

families could be the next victims of the fast-spreading rage against the

bailed-out rich.

Twenty-seven years ago, when the newborn Reagan and Thatcher Revolutions

seemed headed for death from double-digit interest rates, Chairman Volcker

declared victory over inflation and began expanding the money supply andcutting interest rates.

For those who didnt manage money during that recession, the fed fund rates

at the time that great easing began must seem surreal: 18%.

The Power of Zero

If it moves, tax it;

if it keeps moving,

regulate it; and if

it stops moving,

subsidize it.


8/434 November

The Power of Zero


Question: How did the economy survive with rates so high?

Answer: with great difficulty.Those rates were not only punitive for businesses and potential homebuyers,

but they meant that money market funds were well-nigh-irresistible

investmentshuge, risk-free returns with zero market volatility.

We can recall the challenges we faced in convincing pension fund clients

about our asset mix in late 1982: zero Cash, with the balance being roughly

equally divided between long-duration bonds (19 years) and equitieswith

minimal exposure to commodities. Why not, they asked, take those huge risk-

free upfront returns from Cash, rather than bet on a sustained, steep drop in

interest rates and inflation and a sharp, sustained economic recovery?

Because, we argued, inflation and long-term interest rates were already

falling sharply and would continue to do so, following commodity prices

down, lowering costs for businesses and consumers, particularly for energy.

Those three interlinked slides would virtually guarantee a strong economy

and strong stock prices for years to come. We insisted that short rates would

plummet.

That wasnt all that would fall from the Reagan and Thatcher revolutions

II. The Fall of the Wall

Those three interlinked declinesrates, inflation, and commodity

pricesand that one robust riseeconomic activity in the free market

economies across the West, led by the USAwere the underpinnings of

the Reagan-Thatcher accomplishments and the triumph of capitalism. Of

particular importance, the strength of the US, British and German economies

was matched by the robustness of their interlinked foreign policy in the face

of Communist threats to Western Europe. Thatcher and Reagan, with Helmut

Kohls support, installed Pershing nuclear missiles in Western Europe, despite

strong opposition from France, and widespread anti-war demonstrations

on Ivy League campuses and across Europe.

The free market teams stand against the faltering Bolsheviks, and their strong

economies at a time of economic stagnation in Russia and its occupied

territories in Western Europe, led to political unraveling in the Communist

world; the Wall fell and two years later the Communists were goneeven

from the Kremlin. (On his trip to England in 1979, Deng Xiaoping learned

why free economies were outperforming Russia and China, and he returned

to launch the Sino-Capitalist Revolution which keeps astonishing the world,

Why not, they asked,

take those huge

risk-free upfront

returns from Cash?


9/435November

even as faith in capitalism fades across much of the OECD. He had learned

why Hong Kong, Taiwan and South Korea could keep creating jobs and

wealth by rejecting socialismwhether on the Maoist, Bolshevik, or Indian

models.)

Putin calls the collapse of Bolshevism, The greatest geopolitical catastrophe

of the 20th Century. It was certainly bad news for him and his fellow KGB

officers, but they regrouped amid the chaotic Yeltsin era and eventually took

control of Russia. The KGB were the Jesuits of Russian Communism, and

they worked loyally to advance the Kremlins goals. But their relationship to

the Party waslike the Jesuits relation to the Vaticanat times problematic.

Example: Khrushchev once claimed that he had personally shot Beria, the KGB

leader, who wasnt deemed sufficiently submissive to the Central Committee,

(although the later version was that hed died before a firing squad). Like the

Jesuits, the KGB considered themselves the elites, and remained loyal to each

other. Now that they are the ruling class, they no longer have to answer to

bureaucrats and theorists.

It was also bad news for leftists across most of the Free World. They had

convinced themselves that, as the leader of Canadas New Democratic Party

put it after returning from a trip to Russia shortly before the Fall, I admire

their economics, but not their politics. It turned out that everywhere, like

Germany under National Socialism, Good Communists were as rare as

Good Nazis. Free markets and free economies worked: socialism didnt.There were no Nobel Peace Prizes for Reagan or Thatcher. Instead the prize

for the end of the Cold war went to

Mikhail Gorbachev.

(The Nobel Committees apparent love of losers is shown by its award of

the prize to the most conspicuous American foreign policy loserJimmy

Carterand rejection of the most conspicuous American foreign policy

winnerReagan. By coincidence, last week was also the anniversary of Carters

most memorable flopthe seizure of the American Embassy hostages by

Ayatollah Khomeinis radicals. They were imprisoned and abused for the 444

days it took to elect Reagan. Carter had withdrawn support for the Shah and

expressed Americas joy at the Khomeini revolution.)

Gorbachevs Nobel was the beginning of the rewriting of the history of Reagan

and Thatchers roles in Communisms fall. The culmination of this process

is arriving in the torrent of new books that airbrush out those doughty anti-

Communists from the portrayals of friendly people reaching out to hug each

other from both sides of the WallPyramus and Thisbe writ large.

The KGB were the

Jesuits of Russian

Communism...


10/436 November

The Power of Zero


In that sense, President Obama is riding the tide of historys restatement,

and vindicating the Nobel decision about who was the real peacemaker of

that era. Speaking to the cheering throng in Berlin this year, he said that

the world forced down the Berlin Wall. He didnt mention NATO, Reagan,

Thatcher, or Kohl. It was, in the sophistication of its vin blanc et brie analysis, a

causality claim comparable to the roosters renowned boast that his crowing

had brought the sun up. Which world did he have in mind? A coalition of

China, India, Russia, Vietnam, Burma, the United Nations and Iceland?

III. The Obama Triumph

A year ago, Grant Park in Chicago was the scene of the Democrats most

historic get-together since the partys Left spoiled then-Mayor Daleys party to

celebrate his partys national convention. Back then, there was an unseemly

riot, which helped elect Nixon. This time, there was pride, cheering, hugging

and wondrous exultation. We can attest that it was a great time to be a

Chicagoan, and a great time for America.

So how has the President anointed that night performed?

He remains the most charming and charismatic President of modern times,

and is still, quite probably, liked by more Americansand more people

abroadthan any American President. He and his radiant wife are, as The

New York Times notes, Americas greatest global brand.

But the reality of the Presidency is that handsome is as handsome does. His

approval ratings have descended from the Heavenly to the ordinary. All polls

disclose that while most Americans still like and admire him personally, they

disapprove of his policies.

Gallup published a poll on the First Anniversary of his election, comparing

what Americans thought of him then and now. Here are key findings:

Percent

Then Now

He will heal political divisions 54 28He will control ederal spending 52 31

He will improve the healthcare System 64 46

He will increase respect or America abroad 76 60

It was, in the

sophistication of

its vin blanc et brie

analysis, a causality

claim comparable

to the roosters

renowned boast

that his crowing had

brought the sun up.


11/437November

Other polls confirm that the basic political dynamic of America hasnt changed

much from its historical pattern: 40% of Americans still call themselves

conservatives, 20% liberals, and the rest style themselves as moderates.

Obama won by convincing an overwhelming majority of moderates that he

would rule from the center, andmost importantlyhe wasnt George Bush.

Despite a brilliant campaign, adoration from the media, a divided Republican

party, and a flagging economy, he was actually behind the Bush-baggaged

McCain in the polls until Lehman imploded, and suddenly it looked as if

the world could end. As Larry Summers would later joke, a new Messiah was

what was needed. (It hasnt come to an end, although a recentNew Yorker

cartoon shows a gentleman consoling a friend, saying, It isnt the End of the

World. Just around the corner, riding furiously toward them, are the Four

Horsemen of the Apocalypse.)

He won in a landslide, as the undecideds, en masse, became converts.

A year ago, Obama was impressing the nation (and, we admit, us) by unveiling

his economic policy team that included the magisterial Paul Volcker. Volcker

has been rarely seen since; three weeks ago, he corrected an interviewer

who said that the financial community felt that in recent months hed been

marginalized. Volcker said, I did not have influence to start with.

The rescue of the plummeting financial system was actually orchestrated by

Bush appointeesBen Bernanke and Hank Paulson, with the help of TimGeithner. Their policies have continuedfor good and illand Bernanke

and Geithner remain as partners.

The jury is still out on the Pelosi-Obama stimulus package, as it is on his

plans to run trillion-dollar deficits for a decadeand on Congresss national

health care billwhich remains in negotiation, despite its narrow victory in

the House.

Based on our recent trip to visit European clients, and numerous emails

from foreign clients across much of the world, many global investors are

alarmed about Obamas policies and are reducing their exposure to US assets

accordingly.

The dollars decline may be one symptom of these doubts about the actions

of Obama and the Democratic Congress.

...many global investors

are alarmed about

Obamas policies and

are reducing their

exposure to US assets

accordingly.


12/438 November

The Power of Zero


The US deficit/GDP ratio is above 12%at World War II levels, and is the

highest in the G-7, except for the UK. It is, for example, more than twice

Canadas. Few Americans would have expected that America would make

Italy look restrained and prudent in comparison. There is widespread

disappointment about how all that money has been spent, but as Keynes

observed, paying workers to dig ditches and then refill them is better than not

spending the money at all when consumer and business spending collapse

and Depression looms.

Last week, The Economist, which backed Obama enthusiastically during theelection campaign, published a full-page critique of his pro-union policies

titled Love of Labour. Contrasting his recovery policies with Reagans

response to the Air Traffic Controllers strike, it said, Mr. Obama is the most

pro-union president since Jimmy Carter, at least. It went on to describe the

implications of Obamas backing for the unions top prioritycard check

which would abolish secret ballots for union representation.

Abroad, his popularity remains high (except in Israel, where his approval

rating is a mere 4%), as evidenced by his Nobel Peace Prize. However, as his

attempt to replicate Tony Blairs success at charming the IOC into awarding

Chicago the Olympic Games demonstrated, he has been notably unsuccessfulin translating that popularity into significant diplomatic successes.

Perhaps the biggest difference between him and Reagan is in his views about

American history. He was raised in the post-Sixties era, when the Leftabroad

and within the USroutinely demonized America for its alleged racism and

imperialism.

US Dollar Index (DXY)

November 10, 2008 to November 10, 2009

74

76

78

80

82

84

86

88

90

Nov-08 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09

75.10

Few Americans would

have expected that

America would make

Italy look restrained

and prudent in

comparison.


13/43


14/4310 November

The Power of Zero


The Highs and Lows of Zero Rates

Zero is a seemingly-small number, but it is demonstrating its power to

change the world. We have seen many examples in individual countries of

The Power of One: this is that kind of power on global scale.

We are regularly told that we should expect a roaring recoveryReagan-style.

But if Reagan were alive, and Margaret Thatcher were in good health, they

would be astounded at how their two nations economies are struggling at a

time ofzero interest rateswhen they had to launch recoveries at a time of

record-high rates.

The US and British economies are performing at roughly the level they were

during the late stages of the 1981-82 recessionwhen corporations and

consumers borrowing costs were infinitely higher. That inflation could be

in the zero range would also astonish them, even though the biggest factor

in their first election victories was the runaway inflation of the Carter and

Callaghan erawhen malaise was the Presidential euphemism for the

spreading despair.

So why shouldnt the economic recovery be at least as strong as Reagansif

not even more robust?

Its because those Zero rates tell us that the financial systems problems that

triggered the economic collapse arent going away quicklyand could even

be getting worse.

Reagan and Thatcher didnt have to deal with serious demographic problems

that meant housing prices could notfor the first time since World War

IIleap in response to plunging interest rates. Reagan and Thatcher didnt

have to mortgage their nations futures to bail out bad banks, which, upon

being rescued, diverted the succor they were given to rebuild their devastated

capital to speculation and bonuses, thereby making their saviorspoliticians

and taxpayerslook like suckers.

Nor did they have to face the certainty that interest rates and inflation would

have to go up sometimeand that could be very inconvenient for both thepoliticians and the economic recovery.

Zero is a seemingly-

small number, but it

is demonstrating its

power to change the

world.


15/4311November

US interest rates and inflation could remain at current levels, were America to

mimic Japans experience from 1990 to Koizumis election. But those early

years of Japans Triple Waterfall Crash occurred at a time of rapid global

growth that meant Japans trade surpluses grew robustly, and the immense

levels of domestic savings were adequate to finance Tokyos endless fiscal

deficits. (Currently, Japanese investors are not quite able to absorb all the

debt coming from record deficits, but theyre certainly embarrassing their

American counterparts: theyre absorbing 94% of new government debt

offerings.) In contrast, Americas trade deficits are a permanent feature of

the US economy, and even the current uptick in US household savings is

no match for the fast-growing flow of new Treasurys, which means the US

becomes more dependent on foreign bond-buyers by the month.

The Administrations forecast through 2019 assumes that foreign creditors

appetites for Treasurys will grow at least as fast as the national debt. It predicts

sustained real GDP growth of 3% per year, with no recessions, no increases in

taxpayer cost for health care, anddespite sustained deficits and a doubling

of the national debt-to-GDP ratio (excluding Fannie and Freddie debt) from

41% to 82%long Treasury yields will not rise more than 1%. (We spoke

at a Canadian financial conference last month at which Niall Ferguson was

the star. He flashed that forecast up on the screen and said, Those arent real

forecasts: theyre Mickey Mouse numbers.)

Despite the current deficit of 12% of GDP, and despite increasing grumblingabout Washingtons willingness to incur huge deficits in bad times and good,

the foreign support of the dollar by buying Treasurys continues. There has

been one little-remarked change in the investment strategy of Americas

Sugar Daddy #1: in recent months, China has been rolling over its maturing

Treasury notes into T-Bills. It thereby chooses to forgo interest of 2%3.4%

in favor of near-Zero yields. What power, one wonders, does Beijing think,

comes from a Zero return in a weakening currency? And why is that putative

power growing so relentlessly?

Those arent real

forecasts: theyre

Mickey Mouse

numbers.


16/4312 November

The Power of Zero


A fast-growing Monetary Base at a time of Zero yields is the best a central

bank can do to prevent a Depression and get the economy moving again.

But it is based on redistributive justice: it takes wealth from savers and gives

it to the bad banks that caused the crisis. To add insult to that injury, many

of the most prominent of those bankers are paying themselves huge bonuses

for being so brilliant and creative as to take the free money and invest it

up the yield curveor across the wide range of risk assets, which are rising

robustly together. Goldman is the biggest winner from this wealth transfer:

even its mid-term debt only costs around 2%. Its CEO told the audience in a

London church that he does Gods work. This is the bank that, according

to reports about the tense bailout days, would have been dead within hours

had Paulson and Bernanke and friends not rescued AIG and Morgan Stanley.

Goldmans bonuses for this year will exceed the GDPs of 107 nations. Aintfree enterprise grand?

A Zero yield has been the Bank of Japans policy for most of the time since its

Triple Waterfall Crash commenced nearly 19 years ago. Our personal favorite

member of the BOJs Board then, was its only female, Eiko Shinozuka. She

consistently voted against near-Zero deposit rates. She claimed to represent

the generation that had pulled Japan out of its desperate condition after

World War II through its hard work and high savings rate. With state

pensions being so modest, and with the children of postwar generations

being less willing to perform the historic role of looking after their parents

and grandparents, people had to save for their old ageand nobody on

Planet Earth seemed to live as long as the Japanese. Amazingly, these people

did save remarkable amounts, and their favored deposit institution was the

Post Office, particularly after the banks began to implode. As interest rates

on deposits fell by more than 90%, her people were driven into penury to

prop up the bad bankers.

She reiterated those vigorous objections at almost every BOJ Board meeting,

and the male gerontocrats who made up the rest of the Board thanked her for

her contributionand continued to make the near-Zero-cost contributions

to the banks.Led by the Fed, central banks across the OECD have been Japonized.

They drive rates of bank deposits and money market funds toward Zero to

stimulate borrowing and enrich a flagging, flabby banking system.

...it is based on

redistributive justice:

it takes wealth from

savers and gives it to

the bad banks that

caused the crisis.


17/4313November

Not that the top dogs at the big, bad, bonused bailout banks (Hereinafter

called the B5) show penitence, gratitude or humility about this process: they

consider controls on their bloated incomes socialistic, and warn loudly

about the dire consequences for a free enterprise economy if Washington

and Whitehall suppress their astonishing bonuses.

Wherever his spirit rests, Benjamin Franklin must be livid. When the hard-

earned savings of ordinary people are looted to enrich greedy bankers, and

when they are told that this process is necessary to make America prosperous

again, no wonder so many citizens have displayed so much anger at Tea

Parties.

But the problems of the thrifty members of the lower- and middle-classes

who are losing so heavily from Zero yields may not continue endlessly in aJaponaise stasis. They could get worse: todays extreme monetary policies and

humongous deficits are laying and fertilizing the seeds of the next inflation,

which will be characterized, in the early stages, by sharp increases in the prices

of such necessities as food and fuels. Milton Friedman correctly predicted in

1973 that fast monetary expansion at near-Zero real yields would ultimately

trigger inflationand he was vindicated when US CPI reached double-digits

during the next recession.

We recently participated in a panel discussion organized by the Canadian

Consulate in Denver. The lead speaker was David Dodge, retired Governor of

the Bank of Canada. (Longtime readers will remember that we were calling

him North Americas Greatest Central Banker during the years when Alan

Greenspan was being accorded mythic powers.)

We were there to discuss when and how governments and central banks

should employ exit strategies from their current expansionary policies. With

one exception (a portfolio manager who insisted government deficits should

be expanded until unemployment reached zero), the panel agreed that the

level of current monetary expansion and deficits was unsustainable and

potentially dangerous.

Mr. Dodge was particularly eloquent on the high risks of maintaining currentmonetary and fiscal policies. He is really worried about the potential for

worrisome inflation and much higher interest rates that would choke off any

recovery.

...the big, bad,

bonused bailout

banks (Hereinafter

called the B5)...


18/4314 November

The Power of Zero


The first sign that the foreign central banks whove been trying to protect

their currencies from over-appreciation against the dollar may be reassessing

their forex strategies came with last weeks announcement by the Reserve

Bank of India that it was swapping a portion of its holdings into 200 tonnes

of gold the IMF is selling. That helped send gold to new highs.

MacroMavens, a routinely brilliant and thoughtful contrarian research

publication produced by our friend Stephanie Pomboy (who presciently

predicted the Crash with her in-depth studies of banks balance sheet

problems and the unfolding real estate collapse), issued the following chart

last month:

The chart displays the extent of the monetary masochism of the banks abroad

whose purchases keep yields across the curve on Treasurys, Fannie and

Freddie at unrealistically low yields. Zero T-Bills form the base of a debased

debt market.

As troubling as Zero is for savers, it also poses problems for portfolio

strategists.

Global Forex Reserves

Real vs. Nominal(adjusted for the dollar decline)

February 1, 2003 to October 23, 2009

Source: Stephanie Pomboy, MacroMavens, LLC.

0.8

1.1

1.4

1.7

2.0

2.3

2.6

2.9

3.2

Feb-03 Oct-03 Jun-04 Feb-05 Oct-05 Jun-06 Feb-07 Oct-07 Jun-08 Feb-09 Oct-09

Nominal Real

3.19

1.06

Zero T-Bills form the

base of a debased

debt market.


19/4315November

The Problem of Zero in Portfolio Construction

Although portfolio construction for pension and endowment funds has

become far more sophisticated and mathematical in recent years, its basic

process can be easily summarized.

In the classic capital asset pricing model for balanced portfolios, the investor

sets the projected long-term rate of return for the Risk-Free Asset (Cash)

and then assigns expected return rates based on volatility and endogenous

risk assumptions for the other asset classes that are under consideration

for inclusion in the Fund. The expected rates of return rise along with the

perceived risks in each asset class. An Efficient Frontier is then created that

mathematically balances risk and reward to achieve the minimum needed rate

of overall portfolio return. A pension fund meets its regulatory requirementsfor funding if the value of its current holdings, plus the compounded

projected returns of the asset classes meet its liabilities.

We have participated in many such portfolio designs over the decades, and

well recall how high rates of return on Cash bedeviled the process. When

the risk-free rate was as highor higherthan the historic long-term rate

of return on equities, it meant committees had to use the long-term rates on

Cash to build the model. That was accomplished by assuming a lower rate

going forward, because the duration of Cash is near-zero. Moreover, as of

August 1982, when the Reagan bull market began, the Constant Dollar Dow

Jones was at 1929 levels, indicating that the only real returns that had beenearned on equities in 53 years were dividends.

How does a portfolio optimizer deal with the Problem of Zero?

The obvious answer might be, Easily. It means all asset classes are hugely

attractive relative to Cash and no allowance for Cash will be made apart from

minimal liquidity concerns.

A more thoughtful answer should be, Zero Cash means big problems for

overall construction. Assuming that a Fund needs to earn a nominal 7%

overall, net of fees and costs, then the higher the Cash component, the higher

must be the rate of return assumptions for the other asset classes. Without

tinkering with those assumptions, then the higher the Cash component, the

higher the risk and volatility the portfolio must assume. Such asset classes as

Junk Bonds, Leveraged Loans, and small Emerging Markets might have to be

quite big commitments for the Fund to meet its objectives.

This is a challenging time to be designing pension fund portfoliosor asset

mixes for individual investors.

How does a portfolio

optimizer deal with the

Problem of Zero?


20/4316 November

The Power of Zero


According to BCA Research, US stocks have delivered an annual compounded

real rate of return ofnegative 4% for the past decade, while 10-year Treasurys

have given a positive annual real rate of 3.6%. (Embarrassingly, gold was

the top-performing asset class, delivering an annual real rate of return of

10.8% in that same time period. Commodities futures did 5.2%. How many

consultants or equity analysts during the perfervid period when tech stocks

were heading skyward told pension plans gold bullion would do three times

as well as US stocks for the next decade? Or, for that matter, how many

told their clients Emerging Markets shares would outperform the S&P by a

compounded real rate of 11.5%?)

Amid all the enthusiasm about soaring stocks and an economic recovery, it is

wise to retain ones perspective about what has happened to investors.

Last week, the Bank of America summed up the disappointments of our era

for institutional investors. It noted that there were 42 trading days left this

year, and the S&P would have to rise 42% to deliver a Zero rate of return for

the past decade.

By some calculations, on a compounded basis, long Treasurys have

outperformed the S&P since the beginning of the Reagan bull market. The

problem with those data is that they assume sustained reinvestment of

interest at the long end of the curve, but most bond managers would have

been below benchmark duration for extended periods, which meant their

cash income would have been reduced.

Apart from that nitpick, what that number shows is that capitalism has failed

its most basic testdelivering higher returns to investors than was paid on

risk-free government bonds. And this was the best of all times in the best of

all capitalist worlds: classic economic liberalism was becoming the fashion

everywhere outside North Korea, most of the Arab world, and Cuba. There

were more playing fields for multinationals than ever, corporate tax rates

were generally declining, there were no major wars, the supply of highly-

educated engineers, MBAs and CFAs was at record levels, and business was

more respected than it had been since the onset of the Depression.

...capitalism has

failed its most basic

testdelivering

higher returns to

investors than was

paid on risk-free

government bonds.


21/4317November

And yet a robot reinvesting 30-year Treasury coupons would have out-

performed the S&P Indexwhich itself outperformed most managed

accounts.

Constructing a pension fund portfolio and projecting its forward returns in the

Age of Zero could be termed a faith-based initiative.

One of the biggest cheerleaders for the 1990s US bull market was Jeremy

Siegel. The first edition of his best-sellingStocks for the Long Run came out in

1994. His data demonstrated the near-certainty of stocks as winners showing

inter alia For horizons of 20 years or more, bonds are riskier than stocks.

Then came Nasdaqs Triple Waterfall Crash and a recession, and his Absolute

Law had joined the phlogiston theory in historys trash heap.

After the 2008 Crash, we were hit with blizzards of advice about how wise it

was to hold Cash. Some money managers got heavily into Cash before the

Crash, and many other managers assured worried clients that they would

be holding higher levels of Cash until the next bull market was established

(whenever that happened).

The amount of Cash and Excess Bank Reserves in the US economy is at

all-time records, mostly because of Bernankes panicky doubling of the Feds

balance sheet. But this is a construct, not a solidly-based financial reality.

It recalls a well-known passage in the Bible:Consider the lilies of the field, how they grow. They toil not, neither do they

spin: And yet I say unto you, not even Solomon in all his glory was arrayed

like one of these.

Cash was splashed among the B5 to array their balance sheets, which were

looking Gandhian in their skinniness. But the B5 re-deposited a huge slug of

those funds with the Fed as excess reserves: why go through all the nuisance

involved in making loans to individual companies? They also bought up the

Treasury curve. These bankers toil not much, but they spin like mad: they

keep trying to convince us that they didnt cause the Crash, and they really

deserve their big bonuses.

These bankers toil

not much, but they

spin like mad...


22/4318 November

The Power of Zero


US Monetary Base (adjusted for Changes in Reserve Requirements)

January 1, 1970 to October 30, 2009

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

Note: Shaded areas indicate US recessions; seasonally adjusted


30 Year Mortgage Rates

April 1, 1971 to October 1, 2009

Fed Funds (Effective Federal Funds Rate)

January 1, 1970 to November 6, 2009



23/43


24/4320 November

The Power of Zero


Zero and Market Volatility

Why is it that all risky asset classes suddenly seem positively correlated to

each other?

The answer is that near-Zero borrowing costs at a time banking systems are

being flooded with fundsboth from government-insured deposits and

the buildup of liquidity from the Fedconstitute an historically-unique

inducement to the big banks and to their leading hedge fund clients to

borrow and speculate.

Last week, according to The Wall Street Journal, the World Bank expressed

alarm about asset price bubbles in equity markets across Asia, and in real

estate in China, Hong Kong, Singapore and Vietnam, and the IMF chimed

in with fears that surging Hong Kong asset prices are driven by a flood of

capital divorced from fundamental forces of supply and demand.

Hong Kong, of course, pegs its currency to the dollar, which means it

outsources its monetary policy to Ben Bernanke. The Zero rate automatically

means a weak dollarhere and in Hong Kong. To a somewhat lesser degree

it means a weak renminbi.

Central bankers have soothed us with assurances that rapid monetary growth

will not trigger inflation as long as economies remain weak. But they said that

in the 1970s, and commodity inflation proved them wrong.

The price of oil in recent months has traded almost in inverse lock-step with

the value of the dollar. This isnt the longer-term adjustment that characterized

the 1970sits occurring in real-time.

This daily activity mocks the reliance traders used to place on actual data

about oil supplies and demandsparticularly the weekly data about US

supplies of oil and refined products.

Many of the metalsnotably aluminumno longer trade primarily based

on LME inventory data. They dance to the global risk music of the markets.

Stocks trade together globally on a day-to-day basis. Yes, Emerging Marketscontinue to outperform the S&P, rising more than New York on bullish days,

and not falling as hard, on days risk is being unwound.

They dance to the

global risk music of

the markets.


25/4321November

The Barons of the B5 are reporting record trading profits, which means, as

Nouriel Roubini warns, thatsystemic risk is increasing, not decreasing. The locus

of this new risk has moved from toxic, untraded products whose values are

shielded against market pricing to marketable investments of nearly all

stripes.

That the Canadian dollar should rise and fall with metal and oil prices is not

surprising, but the euro also rises and falls, though not as much, as the loonie

on days of dollar weakness as dollars are borrowed and invested outside the

dollar zone in commodities and stocks across the world.

Problem: if the US economic recovery falters, a myriad of global risk assets

could be simultaneously subjected to the same kind of risk-unwinding

devastation as occurred after the Midnight Massacre and the collapse ofLehman, which were US-specific events. But this time, the Fed and most other

central banks would not be able to unleash needed liquidity by lowering rates.

The banking crisis was tied initially to subprime and other illiquid and

unmarketable assets. The Fed, the Bank of England and the European Central

Bank have taken trillions in overpriced toxic assets from the banking system,

directly, and through support of mortgage lenders such as Fannie and

Freddie, the Federal Home Loan Banks, and various European lenders. (The

Financial Times cites a Bank of England study that pegs total government and

central bank aid to private financial institutions at $14 trillion, which it calls

socialism for the rich.)

That unprecedented process was designed to prevent a Depression, revive the

banks, and free their capital for productive lending. However, the B5 banks

have used the funds to reload their trading desks, concentrating on market-

priced assets and derivatives tied to those assets.

As for the thousands of regional US banks on which an economic recovery

depends, they have not participated in the sudden explosion of trading

profits that have restored the B5 banks and their bloated bonuses. They have

to make their money the old-fashioned wayand thats tough these days.

...the thousands

of regional US

banks on which an

economic recovery

depends.....have to

make their money

the old-fashioned

wayand thats

tough these days.


26/4322 November

The Power of Zero


As clients are aware, we have long believed that the real US economy depends

far more on the health of Main Street banks than on the machinations of the

B5. And Main Street is hurting: more and more regional banks are folding,

and the FDIC Fund that insures bank deposits is the next government money

pool to face drainage. (The huge Federal Housing Act pool is also being

drained rapidly, but its lumped into overall Treasury statistics and can be

replenished without special legislation.)

CITs bankruptcy is a synecdoche for Main Street Americas problems. As the

largest factoring company, it has beenfor many decadesa reliable backstop

for small and medium-sized businesses across America. Companies assigned

their receivables to CIT, thereby allowing them to continue to sell their

output profitably, even to sophisticated giants such as Walmart and Amazon,

which are famously successful at boosting their cash flows by delaying their

payments to suppliers for months. Their local banks would assist in financing

inventories and making loans for capital investment secured by real estate

liens and owners personal guarantees. CIT is now operating in bankruptcy,

but it is hardly in shape to perform its historic functions as demand for

factoring rises in response to an economic recovery.

The Tea Party rages about the stimulus and bailout programs were signs thatMain Street was watching in horror the trillions going to Wall Street while

the lenders communities needed most were cutting back on lending, and

were buckling under the weight of their heavy exposure to local construction

loans backed by mortgages on properties whose values were plunging.

KBW Regional Bank Index ETF (KRE) relative to S&P 500


50

60

70

80

90

100

110

Nov-08 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09

57.34

...Main Street was

watching in horror

the trillions going to

Wall Street while the

lenders communities

needed most were

cutting back on

lending...


27/4323November

The spreading bankruptcies in shopping centers havent just devastated

major operators like the Bucksbaums. Many of the shops in those centers

are locally-owned, and as vacancies spread across the centers, the surviving

shops suffer sharp declines in walk-in businessand they default on their

bank loans.

The KRE has fallen to a new low on Relative Strength against the S&P at a

time of a booming stock market and record bonuses within the B5.

This is really bad news for small and medium-sized businesses, which are the

traditional engines of job creation. And the proprietors of those businesses

are, as industry surveys show, very worried about the effect of todays gigantic

deficits on tomorrows income tax rates.

The realization that the trillion-dollar deficits are destined to continue, even

when the economy gets back to sustained growth, frightens them. They hear

that they will be subject to much higher taxes on the rich, and hear that the

term rich means people who earn more than $500,000 a year. (According

to The Wall Street Journal, if the tax rate in 2007 were 100% on Americans

earning over $500,000 a year, that would have generated just over a trillion

in Treasury receipts.)

The 1990-page health care legislation not only has the millionaires taxes

on those earning above $500,000, but imposes high extra taxes on small

businesses which do not offer health care to their employees.

Doubtless, local bankers will be looking at the effects of these permanent tax

increases and mentally marking down their customers ability to service their

loans in future years.

There will not be the kind of sustained US economic recovery that will drive

a sustained US bull market until the shares of the Main Street (KRE) banks

begin to outperform both the B5 banks and the S&P.

The relatively obscure KRE is, we believe, the most reliable indicator of

whether the panoply of political programs is truly kick-starting a sustainable

US recoveryand whether the optimism of US equity investors is justified.

The...KRE is...

the most reliable

indicator of whether

the panoply of

political programs is

truly kick-starting

a sustainable

US recovery.


28/4324 November

The Power of Zero


No one can predict the limits on the capacity of the Fed and Congress to keep

finding new money to spend on rescues and stimulus. When the crisis was in

its early stages, Bernanke told Congress, Well do whatever is necessary (to

rescue the economy). Obama and Congressional leaders have made similar

pledges.

But there are limits on what even the Fed and Congress can do. At some point,

conditions have to return to normal and the regional banks have to take up

the slack. Thenand only thenwill investors be able to safely conclude

that the recovery has become the reality to be used in valuing all financial

assets. The life insurance industry wasnt built on issuing term policies to

cardiac cases in the Intensive Care Units.

We continue to recommend that clients take advantage of the stock markets

Zero-based budgeting of financial riskand scale back their exposure to

US economy-related shares. With the forward P/E on the S&P reaching 19,

it seems to be priced on the assumption that if Goldman is paying record

bonuses, the economys underpinnings are now strong enough to support

fast economic growth.

Can stock prices fall even as liquidity flows surge amid Zero rates and Zero

monetary restraint?

The Greenspan bubbles that collectively came to be known as the Greenspan

Put gave us Nasdaq at 5,000 and other enormities. Barring a multi-year

recovery that drives unemployment to relatively painless levels, this bubble

could make Greenspan look like a piker.

A tale from Main Street (or, more precisely, Chicago Avenue).

KBW Regional Bank Index ETF (KRE) relative to KBW US Bank Index (BKX)

June 22, 2006 to November 10, 2009

80

100

120

140

160

180

Jun-06 Oct-06 Feb-07 Jun-07 Oct-07 Feb-08 Jun-08 Oct-08 Feb-09 Jun-09 Oct-09

102.79

The life insurance

industry wasnt built

on issuing term

policies to cardiac

cases in the Intensive

Care Units.


29/4325November

Sunday in the Park With Feds

The Park National Bank has long been a fixture on Chicagos Gold Coast. We

walk by it nearly every business day. With a lovely building, a spacious parking

lot, and a location near Washington Square Park, it has always represented

prudence and prosperityjust what an upscale community expects from its

local bank.

Then, on Sunday November 1st, it was taken over by the Feds. It was well-

capitalized, and then it was toast.

Why?

It was owned by a failed bank holding company that had two bad banks

in Texas, three in California and one in Illinois. Among the now-necroticinvestments those banks made during the bubble years were the preferred

shares of Fannie and Freddie. As The Wall Street Journal reported, When

regulators shuttered the flailing [sic] banks after closing hoursthe FDIC

leaned on Citizens National Bank and Park National Bankto foot the bill.

The two banks were unable to pay the amounts assessed and were closed by

their chartering authorities, the agency said.

It is a measure of these frenetic times that Park Nationals demise came only

hours after Tim Geithnerat a ceremony in Chicagoawarded the bank

$50 million in tax credits to to help spur community-development projects

in low-income communities. (Geithner knew nothing of the closure. TheFDIC keeps bank closures secret until they actually happen. Its not the first

time Geithners been chatting with management of a bank about to vaporize,

but its probably the first time that he praised a bank for good management

and gave it a big gift for future programs after it had ceased to function.)

But the good news is that after some bank deaths, there is resurrection. US

Bancorp bought the collection of nine good and bad banks, the FDIC wrote

off $2.5 billion, and Park National has reopened as a branch of Minneapolis-

based US Bancorp.

What? We worry?

...its probably the first

time that [Geithner]

praised a bank for good

management and gave

it a big gift for future

programs after it had

ceased to function.


30/4326 November

The Power of Zero


Zero Rates and Gold

GoldNovember 1, 2000 to November 10, 2009

200

350

500

650

800

950

1,100

Nov-00 Nov-01 Nov-02 Nov-03 Nov-04 Nov-05 Nov-06 Nov-07 Nov-08 Nov-09

1,115.50

Fed Funds



For as long as there has been a free market in gold, the most-cited argument

against investing in bullion has been that its sterile: it pays no interest or

dividends, so why should anyone own it? Its not as if it were a painting byRembrandt or even Renoir that has unique scarcity value. Theres lots of gold,

theres lots of gold mines, and nearly all the gold thats ever been mined is

still above ground and is either in vaults or in jewelry.

...the most-cited

argument against

investing in bullion has

been that its sterile...


31/4327November

So why, at a time when consumer inflation seems little more threatening

than attacks from vampires, is gold leaping to new all-time highs even if

adjusted for compounded inflation back to the date of the release of the

classicDracula (1931).

Some possibilities:

1. Its a risk asset, so its benefiting from the rush to risk.

2. Borrowing at Zero to buy something with Zero yield is income-neutral.

3. Its the only asset that, based on history, outperforms underboth horror

storiesDepression and Hyperinflation.

4. Its upside breakout came at the time of Halloween.

5. India announced purchase of half the hoard on offer from the IMF, which

had been weighing on gold prices, and there are rumors that China will

take up the rest. This was the second surprising announcement from

India within a fortnight. The other was that the United Arab Emirates had

displaced such nations as the US, China and Germany as Indias biggest

trading partner in recent months. Apart from tea, and gold in the form

of baubles, bangles and beads, what big-ticket exports other than bullion

could India be sending to that collection of gold-loving states? Its no

longer exporting rice or sugar.

6. Statistics from across the world confirm that the economic recovery isgaining steam, so the specter of inflation is moving stealthily from deep

in the primeval forest toward the main path. Travelers beware.

7. Barrick CEOs statement in London about the continuous decline in new

gold mine output, suggesting, There is a strong case to be made that we

are already at peak gold. The golden rule of commodities has been that

the cure for high prices is high prices: when the price of stuff goes up, big

new production always follows, and the price goes down. Golds price

has more than quadrupled, but new-mine production keeps falling. With

central banks apparently switching from the sell to the buy side, this may

be a new world for the oldest store of value.

8. All of the above.

So why, at a time when

consumer inflation

seems little more

threatening than

attacks from vampires,

is gold leaping to new

all-time highs...


32/4328 November

The Power of Zero


Is gold overvalued? In terms of a reliable historic indicator, it may depend on

how you define a gentleman. The Economistonce sought to find a true value

of gold with a study showing that, for most of the time since the Middle

Ages, an ounce of gold would buy a gentlemans suit in London. That was

not the case on Jermyn Street from 1981 through 2007 even for the less-

prestigious tailors. With the recent decline in the pound, it is now applicable

to the shops located more than two blocks from St. Jamess Street. (It hasnt,

we believe, applied at Savile Row since King Edwards time.)

As gold and silver rise to higher peaks, we hear more and more stories that

serious investors are demanding bullionnot financial paper, whether in

futures or in the gold ETFs. (The GLD has been termed, The small investors

central bank.) Some prominent skeptics question whether the ETFs actually

own all the gold they claim, or whether they depend on counterparties to

make delivery. The core attraction of gold for those who fear an epochal

financial crisis is the absolute reliability of bullionthe only asset that is no

ones liability. These investors are now shying away from any investment that

relies on counterparties or on regulation by any financial authorities.

Roosevelt made ownership of gold illegal by Presidential order. Could such

intervention occur again? Impossible, say bankers.

A skeptic might well note that no one predicted the scale of intervention into

financial markets from governments and central banks that began with the

Midnight Massacre, so why should gold claims that need to be satisfied with

futures contracts or other counterparty arrangements be forever immune

from attack?

We do not share these morbid fears, but no longer characterize them as the

particular problems of the perpetually paranoid.

We do not share these

morbid fears, but no

longer characterize

them as the particular

problems of the

perpetually paranoid.


33/4329November

David Dodge began his speech in Denver by saying, This is a rebound, nota recovery. He considers it a snapback from an oversold position, fueled by

record amounts of monetary expansion, subsidies and deficits. He was not

very confident about the prospects of a sustained recovery, without some

setbacks.

We find ourselves bemused by the confidence displayed by forecasters who

(1) didnt predict the Crash, and (2) use charts and tables from past economic

recoveries in proof of their assertions that the best is yet to comeand

nothing really painful lies in between.

We freely admit we dont know whats going to happen to the US economy

over the next five years. But we do believe that Americans arent going to live

happily ever after if regional banks finances continue to weaken.

The challenges:

1. The root cause of the financial and economic collapsethe demographically-

driven plunge in real estate prices at a time of serious over-leverage in the

housing sectorremains a clear and present danger to banks and other

financial institutions.

2. All the US governments home mortgage lending institutions are

experiencing rising losses, despite the slight uptick in house prices. Thatbarely-observable bounce is due to most drastic price maintenance

program in historytaxpayer bailouts of lending institutions, the Feds

huge subsidy to mortgage rates through purchases of Fannie and Freddie

paper, and 10-year notes, and the First-Time Homebuyer Subsidy of $8,000.

It took all those trillions to get house prices to rise 4% from their panic

lows. Why should investors be confident the rally will continue? Steins

Law, which has never been repealed, may be ready to be proved anew:

If something cannot go on forever, it will stop.

3. Bernanke will have used up his entire declared quota of purchases of long

Treasurys and mortgage-backed paper within a few months. Then what?

4. Commercial real estate grows sicker each month, as office and condo

vacancy rates rise, and more and more regional banks go to the wall.

5. The biggest contributor to the 3.5% economic growth of the Third Quarter

came from the Cash for Clunkers program. That is gone.

The Power of Zero

INVESTMENT ENVIRONMENT

Steins Law, which has

never been repealed,

may be ready to be

proved anew...


34/4330 November

The Power of Zero


6. The only US auto company to report positive cash flow in the Third

QuarterFordstill struggles with a boom-year-negotiated UAW contract

that means its labor costs are much higher than the other members of

what used to be known as The Big Three. Since the UAW and Washington

effectively own those competitors to Ford, theres slim chance the union

will do anything to strengthen Ford: if Ford collapses, so much the better

for the union-owned Big Two. Chrysler has no hot new products in the

pipeline and an ambiguous management agreement with Fiat. GM is

adjusting to a shrunken product base and its finance subsidiary, GMAC,

has already received four emergency cash infusions from Washington since

the bankruptcy. Hyundai, no friend of the UAW, is the hottest company

in US sales. The current noise on Detroit assembly lines could turn out

to be a death rattle.

7. What may have been the most useful consumer economic stimulusthe

collapse in gasoline pricesis fast becoming a cherished memory. Gasoline

prices have already retraced roughly half their plunge. That most useful

of all tax cuts is being chipped away, as other taxes at federal, state and

local levels face inevitable increases.

8. Although overall consumer inflation remains near the Zero level, food

prices continue to rise relative to other costs, and natural gas prices are

no longer at remarkably cheap levels.

9. And it looks to be a cold winteratmospherically and otherwise.

So what should investors do?

Although commodity stocks underperformed the S&P from June through

September, they have resumed the outperformance they displayed for most of

this decade. Meanwhile, Chinas rush to lock up global supplies of industrial

commodities continues at breakneck speed. Niall Ferguson predicts that by

mid-2010, China will be a net seller of Treasurys because of its fast-growing

allocation to commodities. Nor is China alone: Indian companies are now

scouring the globe for commodity-producing assets, and Saudi Arabia is

buying grain land in many parts of the world.

As much as we are concerned by the insouciance of US equity investors,

we remain convinced that investment in commodity stocks has both lower

endogenous risk and higher long-term potential than US equities generally.

The current noise on

Detroit assembly lines

could turn out to be a

death rattle.


35/43


36/4332 November

The Power of Zero


Whenever there is a huge disparity between what nearly everybody who

matters believes and the actual conditions of the economy or the world,

investors who are prepared to bet that reality will eventually assert itself can

win big.

This could be one of the biggest such disjunctions in modern history. Yes, the

sun could suddenly go back to emitting sunspots at the rate of the previous

century. Yes, scientists still maintain that, despite eight centuries of evidence

of a correlation between sunspot activity and recorded temperatures on

Earth in the 80% range, there is no scientific proof that this is anything but

coincidence.

Damon Runyon observed, The race is not always to the swift, nor the battle

to the strong, but that is the way to bet.

In a chat with a knowledgeable investor last week, he commented on

Warren Buffetts willingness to pay so much for Burlington Northern. That

railroad, he observed, has two main businesses: transporting manufactured

goods from the West Coast to the East, and transporting steam coal from

the Rockies. Coal stocks are, perhaps, potentially the biggest losers from

the Administrations climate change legislation and regulations. If investors

began to conclude that the scientific community were going to reconsider

its view on global warming because of the plunge in solar activity, many

companies shares would benefit big, but probably none more than those of

the US coal companies.

...investors who are

prepared to bet that

reality will eventually

assert itself can win big.


37/4333November

The Power of Zero

RECOMMENDED ASSET ALLOCATION

Allocations Change

US Equities 17 unch

Foreign Equities

European Equities 5 unch

Japanese and Korean Equities 2 unch

Canadian and Australian Equities 11 unch

Emerging Markets 14 unch

Bonds

US Bonds 12 unch

Canadian Bonds 8 unch

International Bonds 11 unch

Long-Term Inflation Hedged Bonds 10 unch

Cash 10 unch

Years Change

US 5.25 unch

Canada 5.00 unch

International 4.50 unch

Recommended Asset Allocation(for U.S. Pension Funds)

Bond Durations

Change

Precious Metals 33% unch

Agriculture 33% unch

Energy 22% unch

Base Metals & Steel 12% unch

Global Exposure to Commodity Stocks

We recommend these sector weightings to all clients

for commodity exposurewhether in pure commoditystock portfolios or as the commodity component ofequity and balanced funds.


38/4334 November

The Power of Zero


INVESTMENT RECOMMENDATIONS

1. Remain underweighted in US equitiesas a percentage of total equitieswithin global portfolios, and as a percentage of assets in US balanced

portfolios. Underweight US bonds in global portfolios.

The Obama long-term financial projections for the US are high risk and

unsustainable. Forthcoming electionsor a currency crisiscould induce

some discipline, but within the OECD, the US should probably no longer

be accorded top ranking for bonds and stocks.

2. Within the US market, underweight US economy-related stocks and

overweight stocks tied to global economic activity.

Watch the performance of the KRE compared to both the BKX and S&P. Aslong as the KRE underperforms both of these indices, US-economy-related

stocks remain suspect.

3. Overweight Emerged Markets (such as China, Brazil, India, and Korea)

within global and international equity portfolios.

These markets should no longer be routinely discounted heavily for

political risk or accounting practices relative to the US. The credibility gap

has narrowed in the past year.

China continues to report robust economic activity and skeptics continue

to proclaimas they have for yearsthat its unsustainable. The time to

sell China, and, for that matter, base metal and energy stocks, is when the

last remaining Sino-skeptic has become unemployed.

4. Overweight the precious metal miners relative to bullion or the ETFs.

The time to overweight the ETF is when precious metal prices have entered

corrections.

The XAU and other gold stock indices have underperformed bullion for

the past two months because of a succession of bad news announcements

for such heavyweights as Barrick, Kinross and Agnico-Eagle. True, we cant

be sure there wont be more reports of disappointing execution among

the miners, but they have the reserves in the ground, and the best of them

have unhedged reserves in politically-secure areas of the world. Investors

who believe current prices could hold should do NAV calculations on the

miners based on current gold and silver prices, and they will see excellent

opportunities in the stocks.


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40/4336 November

The Power of Zero


8. Overweight Canada in both equity and fixed income portfolios, and remain

long the loon against the greenback.

In recent global rankings, Canada ranked #1 in the G-7 for its central bank,

its private banks, and its Minister of Finance (who is the longest-serving

in the G-7a remarkable feat for a minister in a minority government).

The principal knock on Canada is that it is dull. Dull has become the new

shiny.

9. In balanced portfolios with an equity bias, do not hold high Cash

exposures. Hold long-duration, high-quality bonds.

If this rebound becomes a sustained boom, you will loserather

modestlyon this exposure, but your equity holdings will appreciate

substantially, and you will be a net winner. If it becomes a bust, you will

win on the bonds, thereby reducing your overall portfolio loss. Long

bonds now reduce short-term cyclical risk. As of October, speculators

were hugely short 30-year and 10-year Treasurys and hugely long 2-year

Notesconsistent with a bullish call on stocks and the economy. If that

call swings to bearish, there will be a rush to the long end.


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BMO CM Basic Points Nov 2009