DC Basic Points Dec 2012

7/30/2019 DC Basic Points Dec 2012

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Basic Points

THE FINAL PROBLEM

December 21, 2012

Published by Coxe Advisors LLP

Distributed by BMO Capital Markets


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Don Coxe

THE COXE STRATEGY JOURNAL

THE FINAL PROBLEM

December 21, 2012

published by

Coxe Advisors LLP

Chicago, IL


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THE FINAL PROBLEMDecember 21, 2012

Coxe Advisors LLP.Author: Donald Coxe 312-461-5365

[email protected]

Editor: Angela Trudeau [email protected]

115 South LaSalle Street, 11th FloorChicago, IL USA 60603

Basic Points is published exclusively for BMO Financial Group and distributed by BMO Capital Markets Equity Research

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Desktop Publishing and Anna GoducoDistribution Coordinator [email protected]


5/561December 2012

OVERVIEW

THE FINAL PROBLEM

In this nal issue o Basic Points, we discuss what we consider The Final Problem or central banks,governments and investors in the industrial world.

Tragically, capitalism's greatest triumph and the powerul global economic expansion were interrupted by

capitalism's greatest inamy. The Crash was caused primarily by the major banks o Wall Street and Europe

that we have long labeled as the B5The Big, Bad, Bonused, Bail-out Banks. A recession spread rapidly

across the Industrial World, and panicky central banks and governments united to rescue collapsing banks,

at enormous taxpayer cost. Interest rates were slashed to near-zero during the crisis, when outright defation

loomed.

The ensuing recoveries have been so tepid that money continues to be astonishingly cheap or governments,

and corporationsand, bizarrely, or banks. What we have called The Financial Heroin continues to fowinto the veins o once-vibrant economies.

Meanwhile, the segments o the population still being punished or the bankers' sins are in the lower- and

middle-classes, who have long relied on saving through banks and short-term instruments.

In this nal issue, we cite Homer's description o a society in The Odysseyas we consider the question: When

will it be possible to phase out their emergency economic and social support programs?

We discuss the likelihood that the sustained dependence o governments on zero interest rates and more-

generous social benets creates a sel-sustaining system that pushes risk-taking and capitalism o to

increasingly distant horizons.

In the short term, i a scal deal in Washington survives the demands o extremists in Congress and the White

House, the US economy should continue with its modest growth. The towering decits will continue, but

the inevitable crisis will probably be pushed urther down the road. Canada, with the best-managed banks

and the soundest macro policies, will continue to grow moderately. In the eurozone, there are currently

no alarm bells to drown out the Christmas bells, but economies remain weak and the PIIGS remain crisis-

prone.

Our long-cycle view remains intact: Global economic leadership will continue to reside with the ormer

socialist Asian economies that most enthusiastically embraced capitalism to emerge rom poverty. We

call their astonishing perormance "The greatest eforescence o personal economic liberty in history."

Since these economies have ar higher commodity content than the rail, senescent Western economies,commodity prices should remain rm.

Best wishes or the holiday season and next year. For those who wish to keep inormed on our views, a new

product oering will come shortly to those who express interest to us via our website.

Many thanks or your sustained, enthusiastic support over this long timespan. You have been truly

wonderul!

Don Coxe


6/56

THE COXE STRATEGY JOURNAL2 December 2012


7/563December 2012

THE FINAL PROBLEM

President Reagan observed that nothing in Washington is so permanent as a

temporary government program. This time, the Crash-spawned record levels

o scal decits have endured three years into the recovery, as have the Fed's

zero interest rates.

Investors and businesses have become accustomed to zero and near-zero

rates on debt and economic growth.

What happens when (i?) central banks start raising rates and government

social spending is cut while unemploymentparticularly long-term

unemploymentremains high?

Should investors long or a reversion to normal scal and monetary policies,

or be terried o the likely consequences?

This discussion o The Final Problem is appropriate or the nal issue o

this publication's two decades o commentarya long liespan or a strategy

journal.

We began publishing just ater the collapse o Marxism's greatest triumph,

the Soviet Union. Thanks largely to President Reagan and Margaret Thatcher,

Stalin's empire joined the Bourbons and Ozymandias, shattering not with a

bang, but a whimper. The West had won.

The sudden death o Mother Russia was a horrendous shock to most

socialists. China, India and Indonesia drew the appropriate conclusions, andcommitted their economies to progress along capitalist lines.

That momentous global revolution meant thatBasic Points was blessed with

a near-perect background or its concepts at its birth and in its rst teen

years o distribution. As long as industrial nations' stock and bond markets

prospered amid economies progressing on mostly capitalist lines, and

the principal challenge to these economies was rom emerging economic

powerhouses embracing ruggedly capitalist themes to create competitiveness

and progress, our ree market-based recommendations drew a wide audience

o investors.

For the frst time in the modern era, massive monetary expansion and plunging

yields have ailed to ignite an economic recovery that would drive investors

rom bonds to stocks.

That is the root o the investment problem.

Should investors

long or a reversion

to normal scal and

monetary policies?


8/564 December 2012

THE FINAL PROBLEM


US Treasury Two-Year Note YieldDecember 19, 2007 to December 19, 2012

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

Dec-07 Aug-08 Apr-09 Dec-09 Aug-10 Apr-11 Dec-11 Aug-12

0.25

Basic Points and the Bond Bull

Basic Points was created in 1992 primarily as a bond-oriented strategy

publication that would also comment on important trends in equity

markets.

Most o us involved in its design assumed that the bond bull market born

in August 1981 would, like all its predecessors, soon succumb to the bond

bears born amid strong economic growth. Ater blowing out the candles on

its eleventh birthday, it would surely age rapidly and die.

We elt vindicated in that bond orecast when, a year later, bonds stopped

rallying and were hit hard, with the Treasury Ten-Year's yield climbing rom

5.2% to 8%.

Little did we know that the bond bull had barely reached puberty. He has

recently attained Methuselah status, celebrating his 31st birthday shortly

ater attaining a record 1.43% Ten-Year yield. Romping on sunlit uplands,

the bond bull has the last laughoutlivingBasic Points.

However, this boo bovine has long since outlived his welcome. In recent

years, his success has been achieved, not or his own value, but as the deault

asset among an unappealing range o choices.

Little did we know

that the bond bull had

barely reached puberty.


9/565December 2012

30-Year Treasury Bond Yield

December 19, 1982 to December 19, 2012

2

4

6

8

10

12

14

Dec-82 Dec-86 Dec-90 Dec-94 Dec-98 Dec-02 Dec-06 Dec-10

2.81

Three years ago, we coined the term "nancial heroin" or the zero and near-

zero yields central banks were providing. A nancial historian contemplating

that yield chart or the Treasury Two-Year Note can only marvel. How, based

on history, can there be a unctioning US economy? Five years ago that note

yielded 3%, modestly above the infation rate. Now it seems to have been

transmogried into a North American extension oJaponaiserie, yielding

a barely-perceptible 0.24%, as investors jettison concerns or a return on

money in avor o preoccupation with a return omoney.

But, as remarkable as those Two-Year yields may be, over the long term, the

bond bull has been most impressiveand rewardingor investors in long-

term Treasurys.

I capitalism were in a hospital and this chart were at the end o its bed,

visitors would be ordering fowers or the widow.

The long-term perormance o the Long Treasury documents a trend unique

in modern economic history:

Long-term, non-callable, high-quality bonds have, on a cumulative basis,

outperormed US stocks over 31 years.

Under ree-market economic theory, that is supposedly impossible.

The basic math o capitalismits Law o Gravitystates that Risk Assets,

such as stocks and real estate, must, over the long term, deliver higher returns

than risk-ree assets.

Long-term, non-callable,

high-quality bonds have,

on a cumulative basis,

outperormed US stocks

over 31 years.

Under ree-market

economic theory, that is

supposedly impossible.


10/566 December 2012

THE FINAL PROBLEM


This cumulative long-term underperormance o the risk assets, which have

historically been the incentives or capitalist managers and investors, arose

because o two gigantic busts coming within just eight years:

The rst blow to the Reagan-born Boom mentality o the late 20th Century

was the Triple Waterall Crash o Technology Stocks, starting just ater the

old Millennium died.

Then came the rantic, orce-ed housing booms in the US and most

European countries, which ended with the Momma Bear1 Bank Crash o

2007-9.

KBW US Bank Stock Index (BKX )

July 1, 2002 to December 19, 2012

20

30

40

50

60

70

80

90

100

110

120

Jul-02 Oct-03 Jan-05 Apr-06 Jul-07 Oct-08 Jan-10 Apr-11 Jul-12

48.56

Those disasters continue to infict pain on nancial markets, and, more

importantly, economies across the Industrial World.

Capitalism bleeds not rom its ailure but because o wounds inficted by a

tiny minority o greedy people masquerading as capitalists. They are the bad

priests in the secular church o capitalism.

Result: the S&P this year has been trading where it did thirteen years ago, and

bonds have been trading where they have neverbeore. The global economy

continues to grow, albeit modestly.

Thankully, capitalism isn't deadyet.

1 Teddy Bears, Baby Bears, Momma and Papa Bears are described in Chapter One: The Taxonomy o Bears;

The New Reality o Wall Street (2003, McGraw Hill)

They are the bad

priests in the secular

church o capitalism.


11/567December 2012

However, thirteen years o cumulative zero returns is enough to induce

nancial triskaidekaphobia.

Shell-shocked pension unds are feeing rom stocks to bonds; in response

to the zero capital appreciation on stocks and central bank promises o

sustained zero short-term rates, they are overweighting the asset class that

seems to keep on outperorming, even though current bond yields are o the

bottom o the charts.

The result is an historic rejection o the Capital Asset Pricing Model (CAPM)

with its Ecient Frontier or projecting asset returns according to risk. (For

readers unamiliar with this ormula, an oversimplied denition might be

helpul: the CAPM ranks asset classes according to risk and expected long-

term returns, with Treasurys and other AAA-rated government bonds beingthe risk-ree asset classes against which all others are measured. A pension

und decides what its long-term expected rate o return should be, and

constructs an asset mix composed o a wide range o asset classes, based on

their respective risks and historical rates o return.)

With current yields so low, this investor fight to bonds is the money under

the mattress approach to wealth-building.

According to The Financial Times, US public and many private pension unds

are still projecting that they will, or decades ahead, earn 7-8% long-term

returns, while European and Asian unds have been slashing their projectionsto 5%. The US practice makes as much sense as promising to pay aging,

expensive sports stars at their current rate or a urther 20 years. Not even the

Cubs would do that.

How can US pension plans get away with orecasting such optimistic expected

returns?

In part, the US projections could be rooted in a peculiarity o pension

unding rules under the Employee Retirement Income Security Act (ERISA)

and the pension und costing rules or calculating corporate prots as set out

in Financial Accounting Standard Board's pension protability rules under

FASB 87.

How can US pension

plans get away

with orecasting

such optimistic

expected returns?


12/568 December 2012

THE FINAL PROBLEM


We commented on this anomaly in 2003, when we discussed the report o

IBM's pension und, which was based on its own version o the CAPM.

IBM was projecting an 8% uture rate o return on its und's bonds, at a

time the Thirty-Year was yielding roughly 4.8%down rom 9.4% in 1990.

According to practices under ERISA, regulators can look at unds' previous

asset class returns as the basis or uture projections. The regulators accepted

IBM's contention that its long-term annual bond returns were ar above

8%, so there was apparently nothing wrong with projecting those splendid

returns orward. The IBM pension und return implicitly assumed a never-

ending bond bull; as a result o the rules o FASB 87, that projection produced

earnings-per-share gains that were most welcome when the company was

struggling in rebuilding mode.

The CAPM aces an existential challenge to its ormula o projected returns

above the Risk-Free Rate o Return on government bonds. Meanwhile,

the Basel rules or bank investing and accounting ace a dierent kind o

existential challenge. The increasingly perilous nances across most o

Europe have meant that the risk-ree rating applied to sovereign bonds has

become increasingly dubious.

Previously, the eurozone's proclaimed rule o admitting only nancially-

sound governments committed to modest decits had convinced bond

rating services and investors that all European sovereign bonds were risk-ree.

Result: portolios o banks and pension unds became heavily laden with

debt rom what came to be known as the PIIGS (and now, in the Orwellian

sanitized orm, as the GIIPS)Portugal, Ireland, Italy, Greece and Spain. At

an early stage in the Grand Illusion, Greek Ten-Year bonds briefy yielded

as ew as eleven bps above German Bundswhich were the unquestioned

standard o excellence.

In a Chicago speech last year, Axel Weber, ormer head o the Bundesbank,

cited this dependence on a fawed model as a major actor in the ongoing

eurozone crisis. "The banker who bought Greek bonds or eleven bps over

Bunds wasn't making an investment decision, but was buying o the model,

seeking a bonus or outperormance," he said, with an audible sneer.

...what came to be

known as the PIIGS

(and now, in the

Orwellian sanitized

orm, as the GIIPS)...


13/569December 2012

According to The Financial Times, "UK pension unds are holding more bonds

than equities or rst time since the so-called cult o equities in the 1950s.....

Alan Wilde, head o xed income and currency at Barings, added, 'The cult o

equity is dead or at least has been on lie support since 2002/3 ollowing the

dotcom crash and corporate problems in the US with the likes o Enron'.....

Pension unds have been slowly switching back to bonds in an attempt to

best the volatility o equity markets and receive a guaranteed income stream

to meet pension payments.....The Pensions Regulator.....said UK unds hold

43.2% in gilts [UK government bonds] and xed interest compared with

38.5% in equities."

The Long-Term Capital Market crisis o 1998 came rom reliance on a atally-

fawed modelthe Value at Risk model based on Black-Scholes. The Crash

o 2008 came rom reliance on yet another atally-fawed model: decades

o reliable returns on home mortgages and instruments tied to home

mortgages gave AAA ratings to home mortgage portolios. That blanket

approach stimulated a cancerous growth in complex instruments with heavy

weightings in dubious or outright raudulent mortgages.

Where there are losers, there must be winners.

There have been some notable beneciaries rom the lemming-like fow o

investment unds into bonds. Financially strong cash-generating companies

with records o modest or nonexistent dividends, such as IBM and Microsot,

have been borrowing big at rates o 1% or less to pay dividends, thereby

attracting equity investors committed to stocks yielding more than the

Financial Heroin ratezero, or near-zero. Historically, companies that

foated bonds to pay dividends were regarded with disdain. Now, they are

the new blue chips or conservative dividend unds.

Benjamin Graham would be aghast.

There have been some

notable beneciaries

rom the lemming-like

ow o investment

unds into bonds.


14/5610 December 2012

THE FINAL PROBLEM


Central Banks Fatten Up As Economies Slim Down

Those microscopic yields on debt o governments deemed sound were the

products o the 2008 crisis, as central bankers and governments rushed to

rescue banks and economies. The central bankers assured investors that

zero and near-zero rates were temporary emergency injections that would

not trigger stagfation, because economies were so weak. Once economies

rebounded, rates would return to normal. The surge in gold prices was, Street

economists assured us, based on fawed analysis o the supposed infation

risks rom what some o us considered the nancial elephantiasis suddenly

bloating central bank balance sheets.

US Monetary Base

January 1,1992 to December 19, 2012

0

500

1,000

1,500

2,000

2,500

Jan-92 Jul-94 Jan-97 Jul-99 Jan-02 Jul-04 Jan-07 Jul-09 Jan-12

2,651.80

Source: Federal Reserve Bank o St. Louis

Japan: Monetary Base


Source: Bank o Japan

300,000

400,000

500,000

600,000

700,000

800,000

900,000

1,000,000

1,100,000

1,200,000

1,300,000


1,244,449

The central bankers

assured investors that

zero and near-zero

rates were temporary

emergency injections...


15/5611December 2012

What we have ound most worrisome is the poor US economic perormance

since 2009 despite an all-out eort rom Washington to revive the sick

economy. The Obama Administration and the Fed have united to pull the

US out o recession by employing the techniques recommended by the two

best-known macro economists o the last centuryJohn Maynard Keynes

and Milton Friedman.

The Fed has ballooned its Monetary Base more dramatically than ever beore

(and is about to do much more) and has hugely lengthened the duration o

its assets; simultaneously the ederal government has been spending on a

scale not seen since World War II, boosting the National Debt by more than

40% in just our years.

Switzerland: Monetary Base


0

50

100

150

200

250

300

350


348.950

Source: Swiss National Bank

Source: European Central Bank

European Central Bank: Base Money (Monetary Base)

February 1,1999 to December 19, 2012

400,000

600,000

800,000

1,000,000

1,200,000

1,400,000

1,600,000

1,800,000

Feb-99 Feb-01 Feb-03 Feb-05 Feb-07 Feb-09 Feb-11

347,812.00

...the ederal

government has been

spending on a scale not

seen since World War II,

boosting the National

Debt by more than 40%

in just our years.


16/5612 December 2012

THE FINAL PROBLEM


Yet, despite all that Fed monetization and all that spending and all that new

debt, the US economy has barely avoided sliding back into the recessionary

bog. Unemployment rates remain high, but would be truly grim were it not

or the many millions who have given up looking or jobs and goneItalian

styleonto disability benets and ood stamps. Example: last month's

Nonarm Payroll report showed a slight decline in the unemployment rate,

largely because a urther 330,000 people dropped out o the workorce.

Where have all the workers gone?

The Presidentand most economistsassumed that all that scal and

monetary stimulus would kick-start a sustained recovery. Republicans have

wasted the nation's time in wailing o the waste in the $798 billion o

Obama-Pelosi stimulus spending. O course, much o the stimulus money

was wasted on cronyism, but Keynesian economics decrees that what counts

is spending the moneynot how eciently it is spent. Keynes said that even

paying men to dig ditches and ll them up was better than practicing tight-

sted monetary policies. The ditch-diggers would immediately spend their

paychecks, and the economy would rebound. In today's enlightened times,

men (and women) aren't paid to report or work to do something useless:

they're paid to stay home and watch TV. But they are still consumers.

Had Obama not turned on the spending re hoses ull blast, the economy

might well have slipped back into recession. Where the hoses were directed

is less important. Government is, by its nature and employment practices,ar less ecient than the private (non-big-banking) sector in allocating

resources, except or maintaining civil order and deending the nation against

enemies.

As or waste, the Bush Administration was no model o finty prociency. Its

"No Child Let Behind Act" ailedat large costto improve the tragically

low academic standards in so many o the major metropolitan school

districts. It also launched a war against Iraq at a time the nation was already

at war in Aghanistan based on dubious intelligence about Weapons o Mass

Destruction. (They weren't there, but the Pentagon is now alarmed that they

were trucked to Syria or saety prior to the invasion and are available to thedesperate Assad.)

The reason the economy is struggling to stay above water is not because o government

waste and corruption. Even Ben Bernanke suggested, hal-seriously, that scattering

money rom airplanes was better than doing nothing.

Republicans have

wasted the nation's

time in wailing o

the waste...



Thereore, what investorsand legislatorsshould ask is, "Why won't the

economy grow?"

Apart rom Paul Krugman and his allies on the Extreme Let, nobody believes

the nation can go nearly a hundred billion deeper in debt every month

orever. When will the economy be strong enough or a return to something

even vaguely approaching scal prudence?

We suggest two explanations: one rom a respected economist, and one o

our own.

1. Robert Gordon's Thesis

Proessor Robert Gordon o Northwestern University, a distinguished

economist with a global reputation, has recently advanced a provocative

thesis that is attracting considerable attention.2

In the early days o the Obama Administration he, like most academic

economists, was very optimistic that Obama's and Bernanke's policies would

pull the nation out o the recession and put it on a sustained path to strong

growth. He was condent enough to predict 4% GDP growth or late 2009

and thereater.

That never happened.

Why?

Dr. Gordon has pondered this question and come up with a worrisome

answer: we aren't getting the huge, sustained gains rom transormative and

disruptive new technologies that kick-started and sustained earlier recoveries

because o multiplier eects that stimulated job creation across broad sectors

o the economy.And we may not be seeing any more o them.

In his thesis, the rapid growth and ascent to world economic leadership o

the United States is due to three successive industrial revolutions:

No. 1 - steam and railroads rom 1750 to 1830;

No. 2 - electricity, internal combustion engine, running water, indoor

toilets, communications, entertainment, chemicals, petroleum, rom 1870

to 1900; and

No. 3 - computers, the web, mobile phones rom 1960 to present.

2 (See, or example, Martin Wol's admiring analysis o his work in The Financial Times: Is unlimited growth

a thing o the past? October 2, 2012)

...we aren't getting the

huge, sustained gains

rom transormative

and disruptive new

technologies that kick-

started and sustained

earlier recoveries...


18/5614 December 2012

THE FINAL PROBLEM


He notes that the Edison light bulb and the Bell telephone came out almost

simultaneously, and those inventions stimulated the birth and rapid growth

o the US electricity and telephone industries which became major drivers

o economic progress or decades, creating millions o jobs directly and

indirectly, while improving productivity on a sustained basis.

At about the same time, Benz was perecting the internal combustion engine;

within a ew decades came the Model T Fordpriced at $850 initially and

thanks to assembly-line production, just $300 by 1925. Nearly everyone

could aord a car, and that meant roads, gas stations, and repair shops had

to be built, year in, year out, and the oil and gas industry had to produce

more uel, year-in, year-out.

Eisenhower's peacetime victory o getting Congress to commit to theInterstate Highway System re-launched the altering economy in the 1950s.

Such a huge series o projects took a while to build momentum. Perhaps

more importantly, it took a ew years to generate the multiplier eects rom

interchanges and new supply chains. That growth had just begun to eed on

itsel as JFK won an election on the platorm o "Getting America moving

again."

Here are some other examples o key productivity and economically-

stimulative breakthroughs:

1. The Otis elevator (Technology's git to the Chicago Loop) was one othe important spinos ater electricity became available. It meant that

buildings where people worked (and later, lived) could be more than eight

stories high. The multiplier eects have continuedon and oor more

than a century. Skyscrapers changed city's skylines and created workspaces

within range o each other that led to sustained productivity gains.

2. Willis Carrier's invention o air conditioning had major implications or

skyscraper development. But its most crucial eect began in the 1920s,

as air conditioners spread into the backward and depressed American

South. The multiplier eects o this breakthrough have continued within

the USA, and across much o the tropical and sub-tropical world.

3. Air travel created millions o good jobs worldwide, spawned growth in

vacation communities and conventions, and eventually became the basis

...came the

Model T Ford

priced at $850

initially and thanks

to assembly-line

production,

just $300 by 1925.



o high-end global supply chains. It is, or example, estimated that there

is more than one job on the ground or every plane landing at Chicago's

O'Hare airport. However, Gordon notes, it has long since ceased to be

progressing in a transormative way. With the abandonment o the Super-

Sonic Transport service operated by British Airways and Air France, airlines

have actually increased signicantly the time it takes to fy the astest

civilian airplanes across the Atlantic in the most modern aircrat, a setback

he considers virtually unique in the history o industrial technology.

Then came the digital revolution, which in comparison to the two industrial

revolutions, has come and matured quickly. For three decades, computers,

the Internet and cellphones have promoted global growth in ways planned

and unplanned. He doesnt downplay the signicance o this revolution, but

is skeptical that it will be a big job-generator in the USA going orward.

Dr. Gordon hasn't seen many transormative breakthroughs on a net US

job-creating basis in recent years, and suspects they may not happenbecause

uture advances will ace the headwinds generated, in part, by that very success.

These include demography, education, inequality, globalization, energy and the

overhang o consumer and government debt.

The Internet is a classic capitalist creation which promotes creative destruction

across wide sectors o society, but, at least or the USA, he doubts that it

will be the basis o major net jobs gains in the oreseeable uture. Those

who lament the loss o brick-and-mortar bookstores and shops are probably

sentimentalists. However, it is unclear that Web distribution, which, in its

early stages was ueled by evasion o state and municipal sales taxes, is a

sustainable macro-model or job creation and GDP growth.

He believes that net global productivity growth will continue, but the

productivity growth o the US will abate while the rest o the world

advances.

Dr. Gordon is an enthusiast about inrastructure investmentroads and

bridgesbut doesn't see such projects as inherently transormative in a macro

sense. It costs a lot more to build a bridge today than in the Depressionandemploys ar ewer workers.

His thesis has evoked debate, but nobody has, to our knowledge, ridiculed

it or reuted it.

...uture advances will

ace the headwinds

generated, in part,

by that very success.


20/5616 December 2012

THE FINAL PROBLEM


AgricultureSustained Productivity Gainer

In a small group discussion o Gordon's thesis o the great economic

inventions, I suggested he include agriculture by adding Justus von Liebig's

discovery o the Law o Limits to Plant Growth, which triggered the

development o the ertilizer industry, thereby launching the expansion o

yields per hectare, and allowing the planet's population to multiply while

starvation rates ell. He ound that the three elements o plant growth were

potassium, nitrogen, and phosphorus. Each plant growing in each locale had

specic needs or each o the three chemicals, and spreading more o one or

two without the third would not deliver good returns. Chemical ertilizers

became huge contributors to global population growth.

Potash Corporation's charismatic Bill Doyle tells o an exchange he had at a

social event with a guest who asked him what he did. When he said he was

head o the world's biggest ertilizer company, the reply was, "Well, o course,

I believe we should only use natural ertilizers."

"An appealing idea, I'm sure," smiled Doyle, "but we'd have to close all the

national parks and orests."

"Why?"

"Because we'd need all that land to provide grassland or all the cattle we'd

need to produce the manure we'd need to produce the crops we need."

Pharmaceuticals as Transformative

What about pharmaceutical breakthroughs that lengthen lives and make

millions o people more productive? They are truly wondrous, but they

come at huge cost: Social Security, Medicare and pension plans are being

undermined and even bankrupted by keeping people alive longermuch

longer. (We discussed Peter Thiel, o PayPal ame, who is one o the

successul entrepreneurs who are committing themselves to unding research

into what they call immortalitylengthening lives by centuries. They talkcoolly o the prospects o achieving such longevity within decades. He is

not, we understand, behind the eerie project o keeping Ted Williams' brain

cryogenically or the day when technology will permit installing it in some

lucky athlete's craniumwho could be transormed into the next batter to

hit .400.)

...we'd need all that

land to provide

grassland or all the

cattle we'd need to

produce the manure

we'd need...



2. Our Thesis

We agree with Dr. Gordon's macro view, but suggest that there are special

actors hampering the economy this time. Collectively these problems orm

today's Final Problem.

We are o the view that two orces stand in the path o resuming rapid,

sustained economic growth in the USA and Europe. In essence, we believe

that by prolonging the administration o the cure or the Crash, the economic

impact might well prove to be almost as debilitating over the longer term

as the disease. We also wonder whether a series o interlocking and sel-

reinorcing actors guarantee that what we call "nancial heroin" must keep

fowing.As a result o the implosion o much o the private economy, and the explosion

o government programs and entitlements, the private sector may not be able

to produce enough real wealth to pay or the government and still nance its

own sustained growth. Under Obama, Washington's share o the economy

has soared to a postwar record o 24%, up sharply rom the mid-teens in the

Clinton and Bush eras. However the Fiscal Cli clash between the Far Let and

the Far Right is ultimately resolved, Obama is emerging the victor, leading a

united party, and the Republicans are deeply dividedso Washington's share

o GDP will continue to grow, and the economy will continue to struggle. Big

government is what 52% o the voters wanted and that's what they'll get.Elections matteras they should.

Meanwhile, as too many politicians and pundits are preoccupied with the

Fiscal Cli and in reghting the election, the continued fow o nancial

heroin may already be undermining the unctioning o the private economy.

Clients will recall that we coined that term three years ago when we were on a

panel in Denver with the eminent David Dodge, who had recently retired as

Governor o the Bank o Canada. He said in his speech that it was important

that central banks move interest rates back to normal levels as soon as

possible, primarilybut not entirelybecause o the risk o infation.

Obama is emerging

the victor, leading

a united party, and

the Republicans are

deeply divided...


22/5618 December 2012

THE FINAL PROBLEM


As he spoke, I thought o what my ather had told me o his experience in

the Italian Campaign in WWII. He perormed more battleeld anesthetics

than any other Canadian doctor, or which he was cited. He said that the

key skills needed were (1) identiying which wounded soldiers needed

heroinwhich was, by ar, both the riskiest and most potent anesthetic, and

(2) when it was necessary to withdraw it in avor o morphine. That switch

produced great pain or wounded soldiers accustomed to heroin, because

morphine wasn't as potent. But the soldiers had to be taken o heroin as

soon as possible because they would soon be addictsuseless as soldiers

and possibly destroyed as human beings.

I began my speech by suggesting that zero interest rates were nancial heroin.

Mr. Dodge commended me, saying this was a great analogy. In discussion later,

we agreed that ailure to exit rom zero rates would create huge problems.

As the years pass, and the heroin and handouts keep fowing, we increasingly

worry about the longer-term harm to the US economy rom zero interest

rates, the extensions o the duration o unemployment benets, and the

dramatic increases in the numbers o recipients o ood stamps and disability

benets. Could the cumulative eect o all that well-intended government

assistance mean that too much o the population might be morphing into a

new version o the lethargic Lotus-eaters Homer describes in The Odyssey?

Odysseus' ship was blown o course and landed on an island (supposedly

near present-day Libya) where the residents, who dined on the lotus fowers,

were peaceul, happy and sleepy. They willingly shared the fowers with crew

members:

Any crewman who ate the lotus, the honey-sweet ruit, lost all desire to send a

message back, much less return, their only wish to linger there with the Lotus-eaters,

grazing on lotus, all memory o the journey home dissolved orever. But I brought

them back. I orced them, hauled them under the rowing benches, lashed them

ast.3

This account o Odysseus's alarm at the eects on his battle-hardened crew

rom the opiate in the fowers, and his orcible roundup made us wonderwhether years o government support and poverty programs at a time that

manuacturing and heavy labor jobs have been disappearing might have a

similar eect on millions o Americansand on the seemingly dwindling

lan vital o the American economy.

3 The Odyssey/ Homer; translated by Robert Fagles, 1996

...their only wish to

linger there with the

Lotus-eaters, grazing

on lotus...



Millions o Americansparticularly menhave been dropping out o the

workorce and migrating to disability benets (and ood stamps, and other

benets) at participation rates approaching those or which Southern Italy

has been long renowned. They are replacing time in the workplace with the TV

and its hundreds o channels to dull their intellects and drive. As economists

note with increasing concern, the percentage o the Long-Term Unemployed

keeps growing even as overall unemployment numbers shrink modestly. This

is a slowly-unolding national tragedy, because the longer these people are

o work, the less likely are they to qualiy or the available jobsat least in

the eyes o potential employers who aren't eager to add employees anyway, in

ace o rising taxes, slow demand growth, and the onset o ObamaCare. The

result is that each deal between Obama and Congress includes a provision to

renew support or the long-term unemployed.

How do the zero interest rates gure into this large-scale lassitude?

(1) Banks and businesses are hoarding cash, even though it yields near-zero.

Why take needless risk? (There is already discussion about the possibility

o negative short-term unds.) As cash grows, the economy doesn't. The

Keynesian multiplierin the orm o rapid growth o M-1 and M-2hasn't

kicked in. Bernanke keeps increasing the supply o water but he can't make

the horses drink.

(2) The Fed's Operation Twist has so depressed long-term rates that a High-

Yield bond today yields what an AA corporate yielded even a ew years ago.

Biggest losers (apart rom pension unds) rom Ben's Lotusian ormulas

or bad banks: seniors saving through bank deposits and "sae" Treasurys.

Their incomes decline inexorably.

(3) More and more investors satisy themselves with the lotus-like dreamy risk

aversion o investment in bonds whose yields are as minimally nutritious

as fowers, shrinking rom the unpalatable stock market that has given a

zero return or approximately the time it took Odysseus to return rom

Troy to Ithaca.

(4) The longer the Lotusian heroin fows, the more dauntingand remotebecomes the possibility o central banks returning rates to normalcy.

Is the economy already too dulled and disappointed to withstand the

changes accompanying an economic recovery? The US decit is already

More and more investors

satisy themselves

with the lotus-like

dreamy risk aversion

o investment in bonds

whose yields are

as minimally nutritious

as owers...


24/5620 December 2012

THE FINAL PROBLEM


at Himalayan levels, although the cost oservicing the debt rises only

modestly in comparison, because, as outstanding bonds incurred in more

muscular times mature, they are rolled over into heroin-priced bonds

and bills. Mr. Obama brashly claims credit or the drop in interest costs

below orecasts as his big spending cut in his bargaining with Mr. Boehner.

What will happen when (i?) Treasury ten-year rates move back to their

average levels o the ve years beore the Crashroughly 4.25%? What

programs would have to be slashed or eliminated? What would happen

to rates on the $1 trillion in student loans, the increasingly osteoporotic

backbones o the over-priced and over-tenured university and college

system, that now exceed national credit card debt? What would happen to

the already-ragile stock market? Would the rail housing recovery survive

the onset o higher-rate mortgages? As or the government, a 2% rise inblended Treasury yields would add roughly $300 billion to annual debt

servicing costsroughly three months' current decits, and roughly hal

the presumably painul non-military spending cuts proposed in one o

the many proposed decit-reduction compromises that circulate in the

smog o Washington. How could Dr. Bernanke take his still-ragile patient

o the nancial heroin and infict such terrible pain?

The heroin analogy suggests serious problems preventing the economy rom

regaining its mojo through risk-taking.

One o capitalism's crucial attributes is its cold-eyed use o the pricemechanism to allocate resources and evaluate risk. When the economy is

vibrant, equity prices rise, the Keynesian animal spirits revive, and money

fows to increasingly-risky investments.

CBOE S&P 500 Volatility Index (VIX)

January 1, 2012 to December 21, 2012

12

14

16

18

20

22

24

26

28

Jan-12 Mar-12 May-12 Jul-12 Sep-12 Nov-12

17.11

How could

Dr. Bernanke take his

still-ragile patient of

the nancial heroin

and inict

such terrible pain?



But the sustained fow o nancial heroin may be diluting the eectiveness

o the capital pricing mechanisms. The VIX Index has this year treated

disappointing economic growth, ears o the scal cli, and intermittent

eurozone crises with a Lotusian "What Me Worry?" attitude. As more and

more Street commentators assure us, central bankers have, ater years o

struggling, accumulated the knowledge, connections, strategies and repower

to handle almost any crisis. So we don't need volatility protection anymore.

Relax and sni the fowers!

Capitalism only works well when its Risk/Reward principles are unctioning

eectivelyand there are both winners and losers. Its ailure came when the Big

Bad Bonused Bailout Bankers collectively agreed on risk and leverage strategies

that rewarded them on Croesus scale, with the risk being assumed rst by

their counterparties, then by their stockholders, then by their governments,

andultimatelythe global economybut not by the greedy, reckless risk-

creators. Yes, through pressuring the banks under the amendments to the

Community Reinvestment Act in 1997 to make loans to minority applicants

with 3% or less down, the government, and Fannie and Freddie, pushed

the industry toward what turned out to be the abyss. IBD (Investors Business

Daily) cites a recent study showing the leap o such high-risk loans rom less

than $300 billion in 1997 to $6.1 trillion in 2008. It quotes Jamie Gorelick,

(during her brie $120 million tour at Fannie Mae when it bulked up on

subprimes) telling a bankers' convention Fannie wanted more "CRA-riendly

loans."

The banks caved because (as we have learned rom discussions with bank

executives) i their CRA scores weren't high enough to satisy the government,

they'd be banned rom mergers and would ace a wide range o other

penalties, including constraints on bonuses. But "The Devil made me do

it" is a pathetic deense or a betrayal o capitalist principles that triggered a

global nancial collapse.

Investors collectively seem to believe that risk has been marginalized because

The System has learned how to prevent crashes, and thereore they need not

eel pain.

Is the pricing mechanism o capitalismpain vs. gainso anesthetized, and

has the economy been so weakened that it cannot withstand normal interest

rates?

Capitalism only

works well when its

Risk/Reward principles

are unctioning

efectively

and there are both

winners and losers.


26/5622 December 2012

THE FINAL PROBLEM


We can't resist summing up our concerns with a limerick:

Flower Power's Hour

Ben gives us the Land o the Lotus.

The Dems give us chances to vote us

More Washington gits,

With no need or thrit,

While we drink in the dream words rom POTUS.4

Fortunately, there are a ew strong Asian economies that still believe inand

practicesome o the core concepts o capitalism. Most o The West's

economies are being reduced to being handmaidens to big, nancially-stressed

governments and big, nancially-distressed banks. Economic growth under

Capitalism has never been driven by those institutions and bureaucracies. It

has been driven by inventions, ree trade, risk-taking, upward mobility and

creative destruction.

Until that muscular, risk-accepting society returns, the historic high returns

on the stock market will not. The only competitive and risky Lotus is a racing

car.

4 For those not steeped in Beltway acronyms, POTUS stands or President o the United States.

Most o The West's

economies are being

reduced to being

handmaidens to big,

nancially-stressed

governments and big,

nancially-distressed

banks.



The Arab Revolutions

We received criticism when we expressed doubts about the likelihood o

happy outcomes rom the dreamy demonstrators in Tahrir Square, and their

cell-phone-linked counterparts across most o the Arab world.

To us, this was a spontaneous and probably ragile outpouring that would

probably be taken over by illiberal men with tough agendas who had long

been awaiting the all o the old-line dictators with limited agendas. It is

what happened to the liberal Girondists in the French Revolution and the

liberal Mensheviks in the Russian Revolution.

The Egyptian Revolution is particularly tragic, because it evolved spontaneously

and was broadcast live globally on TV, and seemed to come to a bloodless,

successul conclusion because o the intervention o the American President,

who had long been identied with support or Aricans seeking reedom

rom oppression. Those o us who questioned the likelihood that the

secretive and determined Muslim Brotherhood had suddenly become a

liberal, tolerant, non-sectarian orce or democracy crossed our ngers. Its

Constitution commits it to Shariah and jihad, but this wouldn'twe were

toldaect the Brotherhood's behavior in government. Early reviews in the

mainstream media were breathlessly optimistic: the Brotherhood accepted

ull rights or women and Christians, would respect Egypt's treaty with Israel,

and welcomed Western tourists. Its leadership promised not to contest theparliamentary elections or the election or the Presidency.

Egyptians now know how those promises have worked out. They see how

courts have begun imposing lengthy jail sentences on Coptic Christians or

making remarks deemed insulting to Islam. They see how the army has, to

preserve some o its privileges and prots, become the protector o the new

regimeand not o the dissidents.

Nor is there much reason to be optimistic about Libya. The Benghazi deaths

o our brave Americans in a terrorist raid on the anniversary o 9/11 are

testimonials to the Administrations delusion that Al Qaeda had beenvanquishedand to the chaos that ollows the collapse o a dictatorship.

Egyptians now know

how those promises

have worked out.


28/5624 December 2012

THE FINAL PROBLEM


As this week's devastating report conrms, weeks o requests or increased

protection were denied by State. No one in the Administration thought that

9/11 might be an anniversary event or terrorists, because "The War on Terror"

is a term banned rom usage by anyone in authority. When the slaughters

occurred, they blamed it on a videoand jailed the creator.

To us, the worst outcome o the Libyan "liberation" or Aricans to date

has been the takeover o peaceul, historic Timbuktu by orces allied to Al

Qaeda in the Mahgreb who were battle-hardened and armed in the Libyan

campaign.

But even in our most pessimistic moments, we did not anticipate the horror

story that Syria has become. Aleppo is said to be the oldest continuously-

inhabited city in Asiaperhaps the world. Damascus has long beencharacterized by scholars as the birthplace o the Christian Church, because

o Paul's conversion. Throughout the sweep o history, those cities have never

experienced savagery on such a scale.

Amid the unraveling o authoritarian regimes across the Mideast, Israel, as

the lone democracy, is now more isolated than it has been since the Yom

Kippur War. Its Iron Domethe latest triumph o its amazing technology

industriesprotected it against the rockets Hamas had accumulated rom

Iran and other sources. However, Turkey is no longer a quiet ally, with

President Erdogan dismissing Israel as "a terrorist state." Next year, according

to almost all the experts, Iran will be testing its rst nuclear weapon.

Summing up, i you, like us, ound the news rom the Mediterranean

distressing this year, prepare or greater disappointments in 2013.

To us, the worst

outcome o the

Libyan "liberation"

or Aricans to date

has been the takeover

o peaceul, historic

Timbuktu...



The Commodity Outlook in Coming Years

The second commodity boom since Nixon closed the gold window was

interrupted by the Bank Crash.

That Crash let scars worldwide, but mostly in the industrial world, where

government debt suddenly exploded, and continues to grow aster than

GDPs.

Thanks to medical science and the pharmaceutical industry, Baby Boomers

will be living longer than they expected, and, thanks to the tech mania and

the Crash, with less money than they expected. Thanks to their collective

reproductive restraint, there will be ewer workers to pay or their Social

Security and ObamaCare.

Fortunately or them, there are several billion people in Asia who will

keep global GDP increasing even as Europe and the US will be collectively

engaged in Sisyphean struggles to grow economies ast enough to service

the government debts or which the Boomers and Gen-Xers can claim the

greatest credit.

The Emerging Economies which gave us The Greatest-Ever Commodity

Boom got a sharp shock rom Wall Street in 2008, and are now adjusting to

the reality that their basic economic and business models need redrating.

China and India, in particular, assumed that the capitalist economies wouldcontinue to prosper rom their reliance on the sound economic principles

which these new economic powerhouses had eagerly adopted.

Unortunately or the Asians, the West is, with a ew exceptions, no longer

driven primarily by capitalist risk-taking, and its new political leadership

is collectively dedicated to collectivist approaches to paying or welare

statism.

The economic fab and fatulence that now characterize the eurozone and

is gaining credence in the US, means Asian powerhouses won't have strong

export markets in the Old World.

So what does this mean or commodity prices?

The ashionable view on Wall Street these days is that, i there ever was a

"Commodity Supercycle," it's over. Strategists long adept at nding new

parades and leaping in ront o the marchers are telling us that commodities

are losersor even kaput.

...Baby Boomers will

be living longer than

they expected, and,

thanks to the tech

mania and the Crash,

with less money than

they expected.


30/5626 December 2012

THE FINAL PROBLEM


What is the evidence or this catastrophic commodity price collapse?

Compared with ve years ago, Brent Crude Oil is up 16%, Copper 14%, Iron

Ore 24%, Corn 64%, and Soybeans 30%, while Wheat is down 9%. As or

the precious metals, Gold is up 98% and Silver has doubled.

The one major commodity that makes the collapse case or these trend-

ollowers is Natural Gas, which has plunged 52%. That however, is the US

price, which is a victim o the shale miracle. Elsewhere in the world, natgas

sells or as much as three or our times the US priceand ar higher than

where US prices were ve years ago.

Yes, many commodity prices are below their peaks, but so is the S&P, which

doesn't prove that equities are dead. (We cannot resist noting that one o

the most determined proclaimers o the end o the commodity boom isCitigroup, whose stock price ve years ago [reverse split-adjusted] was $311,

and now trades or $37.25).

Since we have so oten made the case or well-chosen commodity stocks, and

since we could be deemed partis pris because we are established commodity

stock portolio managers, we'll just note that the economies growing ar

aster than any North American or European economies continue to be the

price-setters or commodities. The commodity stock investor is, in essence, relying

on that growth disparity to continue, whereas the commodity stock rejecter is saying

it will not. Those who ridicule commodity stock investing are tacitly saying

that the GDP o the OECD countries will, once again, outperorm the GDP

growth o China, India, Indonesia et al over the next ve years.

Apart rom momentum, what makes that implied orecast look absurd is

that the national debts and national cash fows o leading Asian nations look

blue chip compared to the US and the eurozone.

We can understand that the Obama backers on the Street have rose-colored

glasses about what he will achieve in his second term, and thereore reject

commodity stocks, but we do not share their belie in his nancial prudence.

He submitted no budgets in his rst two years in oce, then submitted one

that was voted down 79-0 in the Democratically-controlled Senate. His entirere-election campaign was based on endless insistence that "i the millionaires

and billionaires paid their are share," the rest o society wouldn't be acing

tax increases. Boehner tried to get the House to pass such a tax boost, but by

that time Obama had moved the goalposts: he wanted tax increases orall

the "rich"including those earning $250,000 a year.

We can understand

that the Obama

backers on the Street

have rose-colored

glasses about what

he will achieve in his

second term...



This could have been a teaching moment in the world's leading democracy.

As George Will pithily puts it, "Americans have become happily accustomed

to receiving $100 worth o government services and paying $60 or the

privilege." The truth is that nearly everybody is going to have to pay more

taxes.

What we nd most disturbing is that by denouncing the rich and, until last

week, making no other scal proposals, the President is demagoguing. His

argument is the equivalent o those yahoo Republican Tea Partiers who

demand that Washington eliminate its decits by cutting o oreign aid. He

has been unwilling to put real reorm o Social Security and Medicare on the

table, and he excluded tort reorm rom ObamaCarewhich would have

generated huge savings at the expense o a collectively dubious group o tort

lawyers, who are, coincidentally, big backers o the Democratic party.

The President has "bargained" by doing what he enjoys mostfying out in

his wondrousand extremely costlyplane to speak to adoring audiences.

He still wants to believe that he can singlehandedly solve all the nation's

problems by talking to riendly crowds or TV clips. His only announced

sizable budget cut in the Fiscal Cli negotiations is to slash $1 trillion rom

uture costs o ghting two wars. Conservatives compare this to cutting

spending by pledging not to build a ski resort on Mars.

Neither side in the current negotiations is addressing realistically the problems

o nancing unsustainable entitlements in a slow-growth economy.

So we retain our enthusiasm or commodities and commodity stocks.

We do, however, agree with the conclusions rom Leuthold's latest bulletin,

that commodity stocks tend to outperorm when the Producer Price Index

rises aster than the Consumer Price Index. That has been the case or most

o this century, but not recently. During the Stagfation era, that relationship

prevailed most o the time.

Which leads, naturally, to...

Conservatives

compare this to

cutting spending by

pledging not to build

a ski resort on Mars.


32/5628 December 2012

THE FINAL PROBLEM


The Special Case of Gold

How could we let the nal issue oBasic Points reach readers without updating

our views on the absolute necessity o maintaining portolio investment in

goldand primarily through gold mining stocks?

Some may sigh, "Can he possibly have anything new to say on this subject?

Haven't we heard it alland all too oten?"

Gold

October 1, 1992 to December 21, 2012

200

400

600

800

1,000

1,200

1,400

1,600

1,800

2,000


1,645.90

The agony or gold investors o Gold's Triple Waterall collapse nally ended

the week the War on Terror began.

The rst gold bull market began in August 1971, when Nixon closed the

Gold Window and ended in 1980, ollowed immediately by two decades o

Triple Waterall decline. Central bankers were heavy gold buyers as long as

the Gold Window was open, and in more measured activity thereater until,

by common agreement, gold prices rises needed to be discouraged because

they ostered an infation mania. The central bankers thereater became gold

sellers. When interest rates collapsed and concerns about the dollar began to

re-emerge during the Obama era, central bankers began creeping back into

bullion on little cat eet.

In part, their willingness to buy gold is because o past over-gorging on dollars.

When the bankers began to worry about their perilously high dollar exposure,

the Eurozone came to their rescue with a great new alternative in the orm o

the currency o the world's second-biggest and second-richest economic unit.

So the bankers eagerly plunged into euro-denominated paper.

When it became apparent that not only were many o the eurozone issuers

dubious credits, but just maybe the currency itsel was a post-modern

metaction that could easily go out o ashion, then the central bankers

began to go back to bullion.

...just maybe the

currency itsel was

a post-modern

metaction that

could easily go out

o ashion...



The astonishing recent increases in Chinese and Indian economic power and

personal wealth have naturally meant that interest in gold as an investment

among citizens in those countries has surged. As we wrote ater our rst trip

to India, poverty-stricken women working in the elds o Uttar Pradesh were

wearing gold armbands. When we asked our guide how such poor people

could aord gold, we were told it was their dowry. Under Indian law, at

marriage, title to the bride's property and possessions goes to her husband;

except her gold. She retains title to gold in her dowry. We asked whether such

displays o wealth in such poor communities would not put the women at

risk rom robbers, our guide was shocked, "No one would be so evil as to rob

a wie o her dowry!"

In China, the leading banks have, with government encouragement

and support, made bullion-buying (gold, silver and platinum) easy or

customerseven the poor. Result: Chinese have become the world's biggest

gold-buyers.

The richer Indian people become, and the richer Chinese people become,

and the more that central bankers have reason to worry about the politics

and profigacy o the eurozone and the US, the more those gold buyers will

infuence gold prices.

What has produced the big swings in gold prices in recent years has been

participation by major hedge unds in gold utures, Gold ETFs (and, to a

limited extent, in bullion).

Source: Meridian Macro Research LLC

Gold Commitment o Traders: Net Speculative Positions

(number o contracts)

December 19, 2012

0

50,000

100,000

150,000

200,000

250,000

300,000

Jan-04 Apr-05 Jul-06 Oct-07 Jan-09 Apr-10 Jul-11 Oct-12

163,699

As this chart shows, interest in gold rom commodity speculators has waned

latelyalong with the bullion price.

In China, the

leading banks have,

with government

encouragement

and support, made

bullion-buying

easy or customers

even the poor.


34/5630 December 2012

THE FINAL PROBLEM


We were surprised to learn that there is a Gold version o the VIX Index. In

recent months, it has behaved like the traditional VIXshowing little more

expectation o coming excitement than one would expect rom a community

o lotus-eaters:

CBOE Gold ETF VIX Index (GVZ)

October 1, 2011 to December 19, 2012

10

15

20

25

30

35

40

45

Oct-11 Dec-11 Feb-12 Apr-12 Jun-12 Aug-12 Oct-12 Dec-12

13.69

We remain o the view that gold's long-term outlook remains bright. It may

be the last asset let standing i governments run out o money to spend and

central banks run out o money that people believe in. But it doesn't require

Apocalypse to be a sound, long-term investment. We have even coined (we

say, blushingly) a mnemonic o why gold is a necessary investment based onour own initialsDGMC:

D or Demographic Decay

G or Government Policy Failures

M or Monetary policies that debase money

C or Crises arising rom any or all o the above

Why is Demographic Decay a reason or buying gold? Because it is at the core

o the scal challenges to the Welare State. As we have been saying since this

publication was born, birth dearths are temporary scal benets but long-

term scal disasters. In the near term, they increase emale participation in the

work orce, swelling GDP growth and tax receipts, and slowing the increases

in public educational costs. In the long term, they make infation-hedged

pension and medicare promises costly, then burdensome, and eventually

unaordable.

...showing little

more expectation o

coming excitement

than one would

expect rom a

community o

lotus-eaters...



We routinely cite Japan as the model or most Western economies in the era o

demographic decline and decay. A decade ago, we noted that Japan had more

morticians than obstetricians, as deaths overtook births. The latest statistic is

that sales o adult diapers there now exceed sales o babies' diapers. Canada

will be in that x within a ew decades, and only the Latinos are keeping the

US rom a similar prolealthough second-generation Latinos' birth rates

are plummeting.

Gold's intrinsic value rises inversely to the unding levels o government

social programs. In the US, Medicare aces nancial collapse within a decade

without major unding boosts; the Social Security Trust Fund is a victim

not only o longevity, (which most people know), but also o Washington's

continuous cuts in payroll taxes, and o the collapse in interest rates; the date

or the Fund 's extinction now approximates the expected liespan o a new

octogenarian.

Conclusion

Thesoi-disantsophisticates who sneer at commodities don't tell their clients

that gold bullion's perormance since Nixon closed the gold window is almost

exactly equal to the perormance o the S&P with dividends reinvested. That

was a our-decade period when monetary policies were mostly moderate

most o the time.

There has never been a three-year period since 1975 when monetary base

growth in the industrial world was remotely close to where it has been since

2008. That process is set to continue as ar as the eye can see. Moreover, the

growth in government debt and in the size o balance sheets o the major

banks that have already been bailed out once has no historic precedent.

Thereore, in our view, the likelihood that the S&P will perorm as well as

gold in the next three years is remote.

There has never been a

three-year period since

1975 when monetary

base growth in the

industrial world was

remotely close to where

it has been since 2008.


36/5632 December 2012

THE FINAL PROBLEM


Agricultural Commodities

Soybeans


3

6

9

12

15

18


14.09

Corn


1

2

3

4

5

6

7

8

9


6.97

Wheat


2

3

4

56

7

8

9

10

11


7.91



Thanks to the Great Midwest Drought o 2012, we now know that genetically-

modied seeds work splendidly to mitigate drought damage.

Corn prices shot up rom $5.55 a bushel in June to $8.39 in August amid talk

o a new Dust Bowl beore slumping to $7.12 in September as thousands

o armers reported unexpectedly high harvests. The FAO had scheduled a

crisis meeting in Rome and was ready to proclaim the third world ood crisis

until the USDA reported that it was going to be raising its per-acre returns

substantially.

Those happy returns were a source o pride or the big seed companies,

a source o joy or their investors, and a source o shock or the anti-GM

activists. The GM seeds ar outperormed the "natural" seeds.

Monsanto (MON)


65

70

75

80

85

90

95

Dec-11 Feb-12 Apr-12 Jun-12 Aug-12 Oct-12 Dec-12

91.68

Syngenta (SYT)


250

270

290

310

330

350

370

390

Dec-11 Feb-12 Apr-12 Jun-12 Aug-12 Oct-12 Dec-12

376.50

It has been our case since 2007 that investing in the leading and emerging

agricultural input companies with strong management, technology, vision

and distribution is to be participating in one o the most momentous aspects

o human progressprotably, and at low risk.

We stick by that orecast.

Those happy returns

were a source o

pride or the

big seed companies,

a source o joy or

their investors...


38/5634 December 2012

THE FINAL PROBLEM


Energy

Crude Oil (West Texas)


0

20

40

60

80

100

120

140


88.91

Crude Oil (Brent)


0

20

4060

80

100

120

140


110.10

Natgas


1

3

5

7

9

11

13

15


3.56



During the election campaign President Obama had some good things to

say about the nation's production o oil and gas, along with the ritualistic

bashing o oil and gas companies' tax breaks and "subsidies."

He has the great good ortune to be President at the time o one o US

history's greatest oil and gas discovery, and production boomsan economic

miracle the Let has refexively opposed. This despised sector created ar

more wealth and jobs than his Green Energy boondoggles. But i the Far

Let doesn't nd ways to block its progress, it will transormatively trigger a

vast expansion o US industry in Robert Gordon-style, as major plastics and

chemicals plants migrate to the US. This year, experts proclaimed that North

America is now on the cusp o becomingonce againenergy-independent

and a net exporter o oil and gas.

With all that oil in the shale and oil sands being developed, it is time or

oil enthusiasts to admit that we may not see $145or even $125or West

Texas Intermediate (WTI) or many years. We don't even know how long

WTI will deserve the name "benchmark," as a multiplicity o crude oil prices

complicates calculations o oil companies' protability.

That said, North American exploration and production companies with great

reserves and smarts can look at the rest o this decade with enthusiasm. The

new stars o the oil industrythe nimblest o the long-suering renersare

beneting enormously rom the new arbitrages and price spreads arising

rom those ast-changing patterns in production, distribution and exports oNorth American crude oil and products.

More challenging or investors in coming years will be the prot outlook

or costly deepwater ocean exploration as oil production ramps up onshore

rom Texas to Fort McMurray.

Nevertheless, the continuing crises in the Mideast will likely keep a premium

valuation or oil and gas properties in politically-secure countries.

Thirty-ve years ago, the Shah o Iran proclaimed "Oil and politics don't mix."

He was warning his ellow OPEC members that they had to get over their

resentments against Israel and its Western supporters and become partnersin global economic progress through reliableand reliably-pricedoil

production. Three years later, he was deposed in the revolution that brought

in the Ayatollah Khomeini, whom Jimmy Carter rapturously embraced as a

"saint."

The Shah was wrong, and he was soon dead wrong. Oil and politics mix

mightily when politics turn radical, as the Keystone dispute attests. We shall

soon know whether this President is oil-wise, or a more charming update o

Jimmy Carter.

The Shah was wrong,

and he was soon

dead wrong.


40/5636 December 2012

THE FINAL PROBLEM


Base Metals

Copper


0.00.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0


3.65

In all previous boom cycles or base metals, copper was "King Copper."

In this century, the oldest base metal o them allironhas been King.

Chinese steel production remains remarkably strong, although observers

keep predicting a severe sotening.

We continue to recommend underweighting in the base metals, but the

outlook or copper and iron ore prices is improving amid signs o renewedeconomic vitality. Major iron ore expansions have been put on hold, and

optimists think supply and demand are back in balance. Longer term, we

recommend maintaining exposure to companies with the best ore bodies

in the best countries. Political risk is becoming a more challenging problem

or investors as rich tax-exempt NGOs and other organizedand sometimes

disorganizedopposition threatens more and more projects, even in

countries with records o mostly honest and accommodative politics and

policies.

As a ormer colleague o ours used to say, "Capital is a coward." By that he

meant that wise investors naturally fee rom political and litigation risks.

We strongly recommend capital cowardice as a core investment policy to

clients.

We strongly

recommend capital

cowardice as a core

investment policy

to clients.



The Big Picture

1. China

The new leaders took over in China as the US was voting to keep the same

leaders in place. Each decade when a new Triple-P is announced (President,

Premier and Politburo) the wisdom o Deng Xiaoping is rearmed.

This changeover was more challenging than the previous switch, because o

the revelations o corruption and the Bo Xilai scandal, which embarrassed

the leadership on the ront pages o newspapers around the world. But

despite that unwonted tabloidism, the Old Order prevailed in the orm o

the New. Only the Papacy or the British Royal Family handle succession moresmoothly.

We know no more about the new Beijing duo than we have been reading

rom respected Western sources. We admire the prociency o the change-

over, and are relieved that the sordid and sensational aspects have been

suitably addressed.

What we know is that the astonishing growth o Deng's eradouble-digit

or three decadescontinues despite all those Wall Street "experts" who told

us that the supposed miracle is about to burst, kaleidoscope-style, due to

raudulent nancial statements and rampant corruption. They were telling

us rom 2006 onward o a coming collapse and it turned out they were right:

they just got the geography wrong. (O course, they never warned o Wall

Street's pending disaster.)

The Chinese and Indians watched capitalism's implosion with disbelieand

continued on with their progress.

So we are pleased that the predictors o Sinodoom 2012 are once again shown

to be hopelessly wrong.

We have been told annually that Chinese GDP is overstated. However, when

independent experts and the IMF add up external and internal data, the

results tend to conrm the Chinese claims as being o considerably greaterreliability than the nancial statements o many leading Western banks.

So, let us accept the skeptics' claim that China's growth may actually have

shrunken to merely 6%. That means it is growing only 2.5 times as ast as the

US, ve times as ast as the UK and seven times as ast as the eurozone.

We should collectively rejoice in China's success. China is ast on its way to

being the world GDP leader and the most reliable major economy. Already,

China's progress has hauled more than 900 million people out o poverty

The Chinese and

Indians watched

capitalism's implosion

with disbelie

and continued on

with their progress.


42/5638 December 2012

THE FINAL PROBLEM


and onto healthy diets in just two decadesthe most stupendous large-scale

improvement in human wellbeing in history. That is Momentum, with a

capital M.

Some day, Chinese growth will cease to be miraculous and will become

merely impressive.

Not soon, say we.

2. The Fed Sets a New Benchmark

Last week's Fed announcement reiterated that the Board sees little chance o

abandoning its zero rate policy in the next three years. In a surprising policy

change, it proposes to target monetary growth to a fawed statisticthe

unemployment rate.

The Fed has been targeting infation since Volcker's era. What is a relatively

recent phenomenon is that it has been targeting "desirable" infation

2%31 bps above the yield on the Ten-Year Note. That has changed: the Fed

now thinks 2.5% infation would be just ne. We have long believed that central

bankers who want to create higher rates o ination get their wishes ulflled. Japan

is the sole exception, but Japanese demography has long been uniquein

human history. It will be a ew decades beore European and North American

population shrinkage reaches Japanese levelsand a ew centuries beore

Japan ceases to exist.

3. European Woes

There is no end to the eurozone rescue dramas, but in recent weeks three new

distractions have emerged or Euroelites:

CatalonianpressurestoexitfromSpainhaveintensied;

BritishpatiencewiththeEUisbeingexhausted,andDavidCameronfacesa

party revolt that may orce him to hold a reerendum on exiting the EU;

Ritorna,Silvio!Wewere,perhaps,prematurewhenwewroteLa Commedia

e Finita! Mario Monti (briefy known as Super Mario) is stepping down as

Premier and the rash Berlusconi is running againrom two potentially

devastating court convictions and toward another premiership, which

would grant him immunityagain. Marx observed that history repeats

itsel, rst as tragedy, then as arce. The mercurial Berlusconi may be about

to reverse the Marxian order o destiny.

We have long believed

that central bankers

who want to create

higher rates o

ination get their

wishes ulflled.



The Final Problem

Four years and counting...

When will Washington summon the courage to slow the fow o Lotusian-

liquidity and tell people and marginal businesses and banks that the time to

revert to normalcy has nally come?

The longer the exit is delayed, the costlier it will be or governments, the

unemployed, and the underemployed. Telling addicts they have to start the

path to cold turkeyhoodand meaning ittakes political courage.

But, as my ather noted about the vehement reactions rom wounded soldiers

when their heroin was withdrawn, addiction is easy, but withdrawal is hard.

How can the White House, Congress and the Fed slow the fow o Lotusian-

liquidity when more people and marginal businesses are getting hooked

every week?

By targeting the unemployment rate, and eschewing the economic indicators

that central banks have learned over the decades, the Fed has apparently put

itsel on autopilot. The longer the nation accepts this radical change in the

monetary rules, the more obsolete will Fed meetings become. This makes

sense or Bernanke and his colleagues: they won't be demonized or yanking

away the punch bowl: they will be letting the economy decree that zero is no

longer the right price or money.

When the unemployment rate alls below 7% at a time o better economic

growth, a new generation o bond vigilantes will emerge, and yield curves

will begin to steepen. The Fed can step up its money printing, but the market

will soon take charge. Assuming, (as seems reasonable) that this occurs at a

time that Washington is bracing or another debt ceiling "crisis," Risk will

return to nancial markets.

Conclusion

Our assumption: there will be more interim deals and debt ceiling dramas,

b

Documents

DC Basic Points Dec 2012