Don Coxe Basic Points Sep 2011

Basic PointsThe Deficient Frontier

September 16, 2011

Published by Coxe Advisors LLP

Distributed by BMO Capital Markets

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Don CoxeTHE COXE STRATEGY JOURNAL

The Deficient Frontier

September 16, 2011

published by

Coxe Advisors LLPChicago, IL

THE COXE STRATEGY JOURNALThe Deficient FrontierSeptember 16, 2011

Coxe Advisors LLP.Author: Donald Coxe 312-461-5365 [email protected]

Editor: Angela Trudeau 604-929-8791 [email protected] South LaSalle Street, 4th Floor Chicago, Illinois USA 60603

Basic Points is published exclusively for BMO Financial Group and distributed by BMO Capital Markets Equity Research for clients of BMO Capital Markets, BMO Nesbitt Burns, BMO Harris Private Banking and Harris Private Bank.

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1September 2011

OVERVIEW


Since mid-May, we have been growing increasingly bearish about the stock markets and the economies of Europe and, to a somewhat lesser extent, the USA.

In our Conference Call on August 12, we moved Recommended Equity exposure to the bottom of our 40 - 60 pension fund range.

Our core concern has been the breakdown of public finances, particularly in the eurozone, which is undermining the traditional Capital Asset Pricing Model. European banks are collectively heavily over-levered, and any "haircuts" to the valuations of eurosovereign bonds could be devastating to the financial system. In a momentous paradox, the epicenters of European risk today are not toxic mortgage securities or junk bonds, but the debts of overindebted and underachieving eurozone nations. The financial crises in the eurozone are rooted in the breakdown of the Risk-Free Rate of Return on government bonds, which exposes many European banks—particularly the major French banks—to towering levels of risk, thereby rendering Basel III valuations near-useless.

The Atlantic has not proved to be a secure moat for financial models in the United States: Collateral Debt Swap pricing for Treasurys now costs slightly more than the pricing of prime corporate debts, and major American banks and money market funds have huge exposures to struggling European banks.

The once-impregnable Efficient Frontier is becoming the Deficient Frontier, pushing pension fund risk/return projections into no-man's-land.

There would never be a good time for an implosion of the risk models that have served banks, pension funds, and other financial institutions so well for so long. But a time when economic weakness is intensifying and spreading across the OECD is a uniquely grim time for an existential challenge to risk management systems.

It is fair to say that investors in eurozone banks—and institutions lending to them—are assuming unknowable levels of risk. Whatever those risks are today, they can only worsen if, as seems probable, a recession engulfs Europe.

This month we suggest a new approach to portfolio design in our pension fund models at a time of near-record-low short-term interest rates and very low confidence that the bullish consensus of summer will survive the chills of autumn. We suggest a strategy of scaling back beta exposure in favor of very high quality dividends.

We are retaining our very cautious portfolio recommendations issued last month.

THE COXE STRATEGY JOURNAL2 September 2011

3September 2011


German DAX IndexSeptember 14, 2010 to September 14, 2011

5,000

5,500

6,000

6,500

7,000

7,500

8,000

Sep-10 Nov-10 Jan-11 Mar-11 May-11 Jul-11 Sep-11

5,508.24

French CAC 40 IndexSeptember 14, 2010 to September 14, 2011

2,750

2,950

3,150

3,350

3,550

3,750

3,950

4,150

4,350


3,045.62

Italy FTSE MIB IndexSeptember 14, 2010 to September 14, 2011

13,000

15,000

17,000

19,000

21,000

23,000

25,000


14,642.72

I. European Banks' Risk-Free Exposures Become Disease Carriers

4 September 2011


THE COXE STRATEGY JOURNAL

Spain IBEX 35 IndexSeptember 14, 2010 to September 14, 2011

7,500

8,000

8,500

9,000

9,500

10,000

10,500

11,000

11,500


8,337.90

The financial crisis and crash of 2008 were rooted in American "risk-free" assets—AAA-rated collateralized mortgage securities. It turned out they should have been rated TTT—for toxicity.

There is, (we were to learn to our horror in 2008) a literary model for the creation of these financial horrors—Mary Shelley's classic Frankenstein. They were confected by amoral geniuses and immoral associates through the blending of small quantities of healthy financial tissues with large dollops of polluted financial tissues to deliver a falsely reassuring appearance, fooling the rating agencies into characterizing them as financial super-entities endowed with the AAA ratings that had previously been largely the preserve of well-run governments fully backed by the taxation systems of strong economies.

Under the Basel rules, banks which bought these supposedly superb agglomerations, did not have to allocate any of their regrettably scarce capital to support them on their balance sheets.

A typical bank bulking up on these attractively-yielding wonders was, unknowingly, in the position of a US army regiment in Europe during World War I, filling its barracks with recruits off the latest troop ship who were carrying the flu virus.

The Crash of 2008 that nearly disemboweled many major US banks was spawned in the toxic relationship between Wall Street's factories and the more demagogic elements of Congress, eager to use Fannie, Freddie and rules against bank "discrimination" to force-feed mortgage lending to— or even above—real home values to borrowers who had little or no evidence of their ability to service such debts. The Ninja Mortgage—no income, no job, and no assets—was the crowning achievement of that process. Barney Frank's name is on the legislation passed to prevent future bailouts—

There is, (we were to learn to our horror in 2008) a literary model for the creation of these financial horrors— Mary Shelley's classic Frankenstein.

5September 2011

a wondrously hilarious restatement of financial and economic history. That one of Congress's biggest boosters of bad lending practices should be co-author of laws allegedly designed to prevent repeats of such disasters is a delicious self-parody of Congressional misbehavior.

The Made-In-The-USA mortgage catastrophe should have merely flattened financial institutions here. Astonishingly, many major and mid-sized European banks loaded up on these Financial Frankenstein Monsters. Why, we wondered, would banks and pension funds abroad buy these Frankensteinian blends of Wall Street and Washington greed, and disastrous design? That their face value ran into the trillions was rooted in blind faith in AAA mortgage product ratings, without considering that collapsing middle class fertility rates precluded a new housing boom: the naught decade middle class generation was roughly 60% the size of its predecessor, so house prices in aggregate could hardly be expected to go up the way they had when fertility had been strong—as it had been since Plymouth Rock.

Sadly, the bursting of the US real estate bubble inflicted huge damage on the psyches and balance sheets of leading European financial institutions whose managements had believed, (as a German banker recently told Michael Lewis), that the US was a rules-based society. Result: many leading European banks—including even some top Swiss banks—had to be bailed out by their governments.

"Never again!" was the motto of regulators, risk managers and investors. "From here on, we're going to invest our capital in good, safe government bonds issued by members of the eurozone!"

That some members of the eurozone had histories of revolutions, civil wars and/or defaults within living memory was dismissed as irrelevant. In an efflorescence of enthusiasm about the wondrous new currency that would supplant the dollar as the global #1 currency, European banks loaded up on all the risk-free eurobonds they could buy: in particular, they loved to buy bonds from Portugal, Ireland, Italy, Greece and Spain—five countries eager to borrow big at rates ranging to 16 basis points above the rate available on good-as-gold German Bunds.

None of the European banks who bought truckloads of these bonds seemed the least concerned that these countries had never previously been able to borrow at such modest premiums to Bunds. The bankers were as gobsmacked by Jacques Delors' effulgent vision of a eurozone that would outperform the USA and ratify the European social contract, as were his fellow elitists who worked with him on the master plan that led to the Maastricht Treaty and the euro.

"From here on, we're going to invest our

capital in good, safe government bonds

issued by members of the eurozone!"

6 September 2011



As bad luck would have it, a wag in Goldman noted that those five big borrowers and spenders with suspect track records could be collectively nicknamed PIIGS.

The five PIIGS were happily feeding at the eurobond trough when the Irish crisis of 2008-9 forced the Emerald Isle into bailout mode.

That shock made some eurobankers begin to think the unthinkable—What about Greece, Portugal, Spain and Italy?

And then the first existential crisis burst on the scene.

KBW European Large-Cap Bank Index (KEBI)January 1, 2008 to September 14, 2011

0

10

20

30

40

50

60

70

Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11

19.42

KBW European Mid & Small-Cap Bank Index (KMBI)January 1, 2008 to September 14, 2011

0

10

20

30

40

50

60

70

Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11

14.99

The five PIIGS were happily feeding at the eurobond trough...

7September 2011

The European banking system has been lurching from crisis to crisis for more than a year. Greece, which led the way to the creation of European civilization, is leading the way to European disintegration. As this is written, short-term Greek government debt is yielding 85%, but the European Central Bank (ECB) is holding down rates on longer-term benchmark Greek debts to teens by large-scale buying.

The ECB has had to become the buyer of first and last resort for other PIIGS offerings, and investors are already looking ahead to Italy's need to roll over €400 billion in bonds over the next two years—apart from funding its operating deficits.

Jean-Claude Trichet of the ECB is obviously looking over his shoulder at the plight of the big French banks. On Monday, Societe Generale shares fell to a 20-year low, accompanied by double-digit declines for BNP Paribas and Credit Agricole. (Since June, those banks' shares are down, on average, more than 50%.)

We have considerable sympathy for the overworked Trichet, who has performed heroically, as the debt of one PIIG after another begins to emit noxious odors. He even had the courage to respond to rising food and fuel inflation by raising the eurozone interest rate in the midst of the latest financial crisis. He has visibly aged, and will be replaced the day after Hallowe-en—by a respected Italian, Mario Draghi.

Although Greece’s unions and leftist radicals still manage to capture headlines and strangle the nation's economy, the real challenges to the survival of the euro—and much of the European banking system—come from Italy and, to a lesser extent, Spain. (Ireland and Portugal are broke, but mostly polite, and don't grab global headlines by trashing cars and buildings or publicly ravaging what is left of their economies.)

Greece, which led the way to the

creation of European civilization, is leading

the way to European disintegration.

8 September 2011



Forza Italia!

At the moment, it is possible that Italy will be nearing mendicant status within months after Mr. Draghi takes office: Italy's notably uncivil servants took to the streets last week to protest Premier Berlusconi's first real attempt to impose something approaching austerity on Italy's finances.

We are not among those Puritans—including the editors of The Economist—who have been demanding that Silvio Berlusconi step down. As we wrote when his plight first moved to Page One, with all his faults, Berlusconi has provided more stability for the fissiparous and barely-governable Italy than almost any of his predecessors.

Italy was put together by Garibaldi, Cavour and King Vittorio Emmanuele in the Risorgimento out of a large collection of states, city-states and Papal States 150 years ago. Much of what is important in the history of the Middle Ages, the Renaissance and the Enlightenment was achieved despite seemingly endless wars and coups. (Ironically, apart from Puccini, Lampedusa, Eco and some great film-makers, the quality of the cultural output since Italy became a united country isn't at the level of the Renaissance or Enlightenment eras, when internecine warfare was a persistent pastime.)

The greatest of modern Italian novels, The Leopard, which covers the period of unification, includes a memorable quotation from one of the young liberals who had fought in the revolution: "Everything must change so that everything can stay the same."

That pretty much sums up modern Italian history. The North provides the economic dynamism, and Rome the government, while most of southern Italy and Sicily is ruled—if at all—by the Mafia and/or the Church.

Mussolini tried to give this nation a sense of destiny through fascism—an attempt to revive the glory of Rome through semiotics and slogans—and ill-starred African invasions. But he could not disguise the essential evil and outright absurdity of fascism. He had to be propped up by Hitler, destroying the last vestige of his claim to be the New Roman, and met justice at the end of a rope.

Few of his successors have had much success in imposing a national consciousness and an effective government on Italy. Governments tended to stay in power only long enough for the leaders to pay off their supporters and were then succeeded by others with different labels and similar cynicism.

...with all his faults, Berlusconi has provided more stability for the fissiparous and barely-governable Italy than almost any of his predecessors...

9September 2011

Berlusconi, a TV magnate, had surprising success in raising the national consciousness, using the soccer slogan Forza Italia! as his party designation. Italy may well have been governed better during his tenure than at almost any time since Constantine moved the capital of the Empire to Constantinople in 330.

But not by much.

Taxes still aren't collected reliably. The far-Left unions continue to block industrial progress and the far-Left civil service unions continue to impede attempts to open up the economy and operate public systems honestly. Those rioters you see on TV are collectively well-paid: according to Bridgewater, Italian unit labor costs since the euro appeared are up more than those in any other large European economy—40%.

Despite his obvious faults, we are inclined to view Berlusconi as a raffish rogue, with a deep appreciation of the Italian love of the bella figura—the striking face, image, gestures and self-assurance. In the midst of the crisis this summer, responding to a prosecution about his involvement with an under-aged woman, he appeared in Sicily and told a crowd, "The latest poll asked 1,000 Italian women, 'Would you like to sleep with Berlusconi?' One-third said 'Yes' and two-thirds said 'What? Again?' "

The sands in Berlusconi's hourglass are finally running out; he will probably not survive this latest crisis.

Nor, we suspect—sadly—will Italy or, ultimately, the euro.

Italy is too big to fail and too big to bail....

And too inefficient, indebted and corrupt to succeed.

This just in: the Dow is rallying strongly this afternoon because of word out of Italy of a potential new one-off wealth tax of €400 billion that would make Italian bonds look magnifico—and do wonders for the beaten-down share prices of those big French banks which collectively have made the biggest French commitment to Italy since Napoleon—stuffing their coffers with €400 billion in Italian bonds.

To us, the chances of passing—and enforcing—such a tax are equivalent to the chances of making Italian the sole acceptable language at meetings of all eurozone agencies—and the European parliament.

But we had a smile as we were reading the breathless stories, seeing the fine hand of the irrepressible Berlusconi at work.

He'll be missed.

Italy may well have been governed better

during his tenure than at almost any time since Constantine moved the capital of the Empire to Constantinople in 330.

10 September 2011



The Rescuers

The European Financial Stability Fund (EFSF) has been working with the International Monetary Fund (IMF) and the European Central Bank to prevent defaults or other crises that could put the eurozone at risk.

More or less by organizational default, Germany's Angela Merkel has been forced into the role of unhappy savior of the euro.

New eurozone bailout agencies have been springing up, causing some challenges for the acronymically challenged.

Last week, the eurobailout era was given a crucial reprieve, when Germany’s Constitutional Court upheld Germany's backing for the EFSF's projected payments to Greece. Although leading analysts assured the markets that the court would back Angela Merkel's tottering regime's participation in the eurozone rescues, the announcement triggered a huge stock market rally across Europe, and a 275 point leap on the Dow.

Tellingly, at New York, the BKX (the index for the B5—the Big, Bad, Bonused, Bailout banks and some others) had one of its best days in a year, leaping 5.9%—and gold gapped down $40 after the announcement and closed down $55.70.

We cite those massive market responses to what was supposedly a foregone court decision in support of our longstanding argument that eurozone sovereign debt problems are the biggest problem facing OECD financial markets.

But the Court didn't endorse new blank checks and Brussels bailouts: it insisted that the Bundestag must ratify each new deal—including the pending Greek bailout. The first Greek bailout triggered the resignation from the ECB board of Axel Weber, former Bundesbank CEO. The prospect of a second was, it would seem, the reason his successor, Jurgen Stark, resigned suddenly—citing "personal reasons."

In theory, despite those high-profile resignations and polls showing widespread voter resistance to further bailouts, the Court's stipulation of Bundesbank assent should not be a problem: the leftist opposition to Merkel's center-right coalition is, of course, enthusiastic about shoveling out sky's-the-limit aid to governments that are either socialist, spendthrift, or both.

...eurozone sovereign debt problems are the biggest problem facing OECD financial markets.

11September 2011

But Merkel's own coalition is unraveling, as it loses one regional election after another. In the most recent vote, in her homeland of Mecklenburg-Western Pomerania, her party's vote plunged and the Free Democrat Party, the conservative conscience of her coalition, was annihilated.

Merkel's Christian Democratic Union and Christian Social Union supporters are fed up after more than a half-century of picking up the biggest share of the tab for Brussels' vast spending programs—and two years of bailouts for profligate PIIGS—with no end in sight. Middle-class Germans note—bitterly—that the rest of Europe didn't chip in for the €100 billion costs of rescuing East Germany after the Fall of the Wall.

Some analysts report that, despite defections from her own parties, Merkel's Greek bailout bill should pass the Bundestag because of support from the Opposition. But that would be a terrible humiliation for the Chancellor and would probably be the beginning of the end of her government.

It might also signal an important shift in European politics: after years of center-right rule in most of Europe, the Left could be on the verge of a major comeback, as voters worry about their politically-promised perks and pensions. In France, even Dominique Strauss-Kahn's implosion has done little to raise Premier Sarkozy's pitiful poll standing—with an election looming next year. The Strauss-Kahnless Socialists are strongly favored.

Markets rallied strongly Wednesday on the report that EU Commission President Manuel Barroso will be presenting optional routes for creating and issuing eurozone bonds. (Mr. Barroso, a former President of Portugal, is now Eurocrat-in-Charge atop the vast EU bureaucracy.)

Eurozone bonds—the unholy grail of europhiles—would be backed by the full faith and credit of all members. This "Solidarity forever" instrument would mean that all members would be, in theory, equal as guarantors, but investors would pay on the basis of Bund yields. Angela Merkel swiftly ruled out such asymmetric involvement, knowing of its huge unpopularity at home. But the eurocrats will try to keep the pressure on—thereby protecting their own privileges and pensions. Deutschland über alles has been cleansed and sanitized to read Deutschland pays for alles.

How bad is the situation now? The Wall Street Journal quotes an unnamed executive for Bank Paribas, "We can no longer borrow dollars... Since we don't have access to dollars, we're creating a market in euros...we hope it will work, otherwise the downward spiral will be hell....and no one will lend to us anymore."

Deutschland uber alles has been cleansed

and sanitized to read Deutschland

pays for alles.

12 September 2011



The Journal cites BIS statistics showing that the three biggest French banks held "nearly $57 billion in Greek sovereign and private debt vs. $34 billion held by the largest German banks. French banks held more than €140 billion in total Spanish debt and almost €400 billion in Italian debt as of December."

The Journal continues..."Now that the situation is bordering on catastrophe, analysts are suggesting that the government is set to start nationalizing French banks."

The situation will get worse: it's baked into the socialist principles underlying the EU's social contract. As noted Fabian Socialist George Bernard Shaw long ago observed, "He who promises to rob Peter to pay Paul can count on Paul's vote."

Peter and friends have long been generating the wealth that Brussels has been dispensing.

Now that monstrous new demands are being made monthly on Peter and friends, Paul and friends are getting anxious—and feel a strong need to take political power to ensure the handouts and bailouts not only continue—but grow—even as the European economy contracts. That's just sensible socialism.

As everywhere else, there are more Pauls than Peters in the eurozone. In Greece, the Pauls so far outnumber the Peters that the nation needs to raise €140 billion in loans within weeks.

(That internal divide between Peters and Pauls might even become a potent political force in the USA: latest statistics show that nearly half of Americans pay no income tax and roughly 70% receive more from Washington in Social Security, Medicaid, Medicare, food stamps and other goodies than they pay in taxes. As the President explains his policies, "We're all in this together and it's time that the rich paid their fair share." When will the upper 30% of the population begin arguing that in Europe and Canada, Value-Added Taxes—paid by all consumers—finance a big chunk of the costs for health care and other universal benefits. The US has no VAT.)

As noted Fabian Socialist George Bernard Shaw long ago observed, "He who promises to rob Peter to pay Paul can count on Paul's vote."

13September 2011

II. The Third Neo-Stagflationary Recession?A decade ago, the US was entering a recession. Three years ago, the US, and most of the OECD were entering a recession. Many observers—including us—think that the US and OECD are on the cusp of another recession.

There is a precedent.

The last time three recessions occurred in one decade was during the stagflationary Seventies, with recessions in 1970, 1974, and 1980—which was briefly interrupted to be swiftly followed by an even deeper recession that lasted into 1983. The last of those recessions began with oil and gold prices at all-time highs, and inflation at a near-record high, triggering the third bear market. At the bottom of that brutal bear market (August 1982), the constant-dollar Dow-Jones Industrials traded at October 1929 levels. In real terms, a long-term investor had barely broken even on a 53-year hold—apart from dividends.

How does recent experience mimic that melancholy past?

As this journal was going to press, we note that today's major US economic reports included the second straight month for deeply-negative Philadelphia Fed and Empire State Indices, an unexpected increase in weekly jobless claims, a year-over-year rise in CPI to 3.8%, which was 2% ex-food and energy, and a decline in workers' real earnings of .8%—against expectations of -.1%.

Not a good day.

As for other signs in recent months:

• Goldpricesreachedall-timehighs;

• Oilpricestouchedall-timehighsjustbeforetherecessionof2008began,and rallied again this year—although not to previous peaks;

• Pricesofmostothercommodities—includingtheThree"BigCs"—cotton,corn and copper— touched record highs;

• Economicgrowthratescomingoutoftherecessionhavebeenmodest;GDP growth in the US and Europe in the past 11 months has been barely perceptible—driving unemployment rates higher at a time of painful fiscal deficits;

• Voters' faith in their governments' abilities to manage economies haseroded sharply, and few political leaders (apart from Canada's Stephen Harper) have reason to feel politically secure.

At the bottom of that brutal bear market

(August 1982), the constant-dollar

Dow-Jones Industrials traded at

October 1929 levels.

14 September 2011



The biggest difference between the Seventies and now is that interest rates and inflation rates today are at levels that Seventies governments and investors would have considered Heaven-sent.

So why refer to stagflation?

Because producers of foods, fuels, and metals have been among the biggest winners (other than the trial lawyers) in this decade—after two decades of misery.

Contrast the performance in this decade of what was—albeit briefly—the most-valuable stock in 1999 with that of the world's biggest oil company, the world's biggest mining company, and the world's the world's biggest fertilizer company:

Exxon Mobil (XOM) January 1, 2000 to September 14, 2011

25

35

45

55

65

75

85

95

105

Jan-00 Apr-01 Jul-02 Oct-03 Jan-05 Apr-06 Jul-07 Oct-08 Jan-10 Apr-11

74.01

Cisco Systems (CSCO)January 1, 2000 to September 14, 2011

0

10

20

30

40

50

60

70

80


16.67

...interest rates and inflation rates today are at levels that Seventies governments and investors would have considered Heaven-sent.

15September 2011

Yes, Apple (AAPL) and Google (GOOG) have been spectacular performers, but Nasdaq is back to where it was a dozen years ago. Without those two sensations, its performance in recent years would have been dull. Technology became an even bigger part of the global economy in this decade than its most enthusiastic boosters in the 1990s would have predicted. However, ease of entry, ease of technology theft, and relentless competition have meant that most tech products have proved to be commodities that generate lower profits than those received by producers of industrial commodities or precious metals. Dull stuff is outperforming brilliantly-engineered wonder products.

Potash Corporation (POT)January 1, 2000 to September 14, 2011

0

10

20

30

40

50

60

70

80


57.14

BHP Billiton (BHP)January 1, 2000 to September 14, 2011

0

20

40

60

80

100

120


78.78

Dull stuff is outperforming

brilliantly-engineered wonder products.

16 September 2011



An OECD economic cycle in which prices of foods, fuels and precious metals rise far more strongly than prices of manufactured goods—or workers' wages—is inherently stagflationary. A greater and greater share of total consumer spending goes to the commodity producers who own the farmland, the mines or the oil wells. The industrial and service-based economies find they cannot deliver the kind of strong, sustained, low-inflation economic growth that was the pattern for most of the postwar era.

During the Seventies Stagflation Era, OECD demand drove food, fuel and metals prices at inflationary rates.

This time, consumers in the OECD are paying uncomfortably high prices for food, fuel and industrial metals because of soaring demand from the new economic powerhouses of the Third World. Inflation is being imported—not caused—by the US and Europe. Apart from the wages and benefits costs for some powerful public employee groups, workers are unable to improve their incomes more rapidly than their costs for foods and fuels.

This is a paradox:

• LedbytheGreenspanandBernankeFeds,OECDcentralbankshaveprintedmoney at astonishingly high rates;

• LedbyObamaandmanyleadersintheeurozone,OECDnationshavecollectively been running deficits that make the profligate Western governments of the Seventies look positively Puritanical.

Yet overall nominal CPI rates have, (until recent months) remained benign, giving central bankers justification for aggressive monetary expansions. Right-wing activists may fulminate that money-printing and deficits have produced terrible inflation, but—commodities apart—the evidence is hardly persuasive. Bernanke and Obama are challenging conventional economics—and winning.

At least for now.

Bernanke and Obama are challenging conventional economics— and winning.

At least for now.

17September 2011

What? We Worry?

With major stock markets across the world in bearish mode, and a new global banking crisis looming, the S&P is not in deeply bearish mode and few economists are predicting a recession.

S&P 500 September 14, 2010 to September 14, 2011

1,100

1,150

1,200

1,250

1,300

1,350

1,400


1,209.11

US Dollar Index (DXY) January 1, 2010 to September 14, 2011

70

72

74

76

78

80

82

84

86

88

90

Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10 Jan-11 Mar-11 May-11 Jul-11 Sep-11

76.35

Naturally, we are being asked daily about our dour outlook for US stocks and the US economy. Are we overdoing it? Eurosclerosis, many of our critics feel, is not necessarily a transmissible disease.

We hear several reasons for this calm reaction to bad news. The dollar has stopped plunging and, mostly because of the 58% weighting of the euro in the DXY, has been strengthening recently:

Eurosclerosis, many of our critics feel,

is not necessarily a transmissible disease.

18 September 2011



1. Treasurys have been in a runaway bull market as global investors rush to what looks—at the very least—like the best of a bad lot of government bonds.

Among major benchmark government bonds, only Bunds (–0.24), Japan (–0.98), Sweden (–0.23) and Switzerland (–1.10) yield less than Treasurys. So much for the scare talk that the world would stop financing runaway US deficits.

10-Year US Treasury YieldJanuary 1, 2011 to September 14, 2011

1.5

2.0

2.5

3.0

3.5

4.0

Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11

2.07

2. American energy costs are the lowest in the industrial world, with Natgas at $4, and West Texas at $89—compared with the new global benchmark—Brent—$109.

3. America's domestic political fissures are wide and widening, and Obama's political approval ratings have been weak and falling, but (as noted above), incumbency is no political advantage almost anywhere these days. Obama still has unique charm, and, as he showed last week, when he reaches back to the platform dynamism that mesmerized not just the US, but much of the world—including the Nobel committee, he is formidable. His approval ratings are falling, but which other OECD leader has such magnetism? And which of the Republican candidates has the right ingredients to knock him off his pedestal?

4. The huge US commitments to Iraq and Afghanistan are trending down and will shrink to mere nuisance range within a year.

5. The rest of the world doesn't have companies such as Apple. The US still leads the world in innovation.

So much for the scare talk that the world would stop financing runaway US deficits.

19September 2011

6. US companies' profits have remained strong even as the economy weakens—and they hold record levels of cash.

7. Smart young people from all over the world still rush to attend American universities.

8. Thanks to Dodd-Frank, the problems of the US financial system are being addressed, and an economic slowdown—or even a mild recession—will not produce a systemic financial crisis à la 2008.

9. Just about the only economists and pundits who are bears on stocks and predict a US economic downturn have been doom-and-gloomers for years. Why believe them now?

10. The run-up in gold is merely a bubble blown up by over aged cranks and is of no economically-predictive value.

11. Finally, (and most often cited), the multiple on the S&P is at bargain levels; only a financial recession could make buying US stocks now a bad idea. It’s always darkest just before the dawn.

We find the first eight arguments persuasive—in varying degrees. We strongly disagree with #10; as for #9, we have deep respect for at least two prominent bears—David Rosenberg, of Gluskin Sheff + Associates, and Stephanie Pomboy of MacroMavens who have been consistently and cogently challenging #11.

The Big Banking Problem for Bullishness

We became increasingly nervous that those smart seers were bang-on about the fundamental US economic weakness as the news from big banks became more worrisome, but we didn’t join their bearish camp until May. We held out hope as long as we thought the rot, misrepresentation, mismanagement and delusions in the financial systems of Europe and the US would not necessarily drag down the so-called "real economy."

We long ago lost our confidence in the oft-trumpeted restraint, shrewdness, and honest financial reporting of many of the major banking institutions that are crucial for the US economy—all of whom are bigger than Lehman. But as long as there was even a fair chance that these drags on the economy would be skated onside by total economic and financial strength abroad, we were prepared to keep our high recommended equity weightings.

We long ago lost our confidence in the

oft-trumpeted restraint, shrewdness, and honest

financial reporting of many of the major

banking institutions...

20 September 2011



From decades of experience—some of it painful—we have learned that unsolved banking problems can trump pure economic performance in terms of stock market returns. Bad business managers usually wound only their investors and creditors; bad bankers, when acting in concert with each other—and with bad politicians—destroy entire economies.

Although the US banks are in better shape than their European counterparts because they aren't stuffed to their aortas with toxic risk-free bonds, they don't engender confidence.

JPMorgan Chase (JPM)January 1, 2007 to September 14, 2011

15

20

25

30

35

40

45

50

55

Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11

33.81

Bank of America (BAC)January 1, 2007 to September 14, 2011

0

10

20

30

40

50

60


7.33

...bad bankers, when acting in concert with each other—and with bad politicians—destroy entire economies.

21September 2011

Each of those three giants was bailed out—or substantially helped—by the taxpayers. The rage that would find its expression in the Tea Party came—in considerable measure—from those bailouts.

How have the big bailout banks behaved since then?

Is the Tea Party merely a collection of ignoramuses who don't understand high finance?

JPMorgan has been much in the news this year, partly because CEO Jamie Dimon says he's sick and tired of being criticized by politicians. He also says that Basel III's rules are "anti-American" and it might be wise for the US to pull out of Basel. (Do Wall Street CEOs have fat wallets and thin skins? Lloyd Blankfein responded to criticisms by saying he was doing God's work.)

Citigroup (C)January 1, 2007 to September 14, 2011

0

100

200

300

400

500

600


28.59

KBW US Bank Index (BKX)January 1, 2007 to September 14, 2011

0

20

40

60

80

100

120

140


38.85

Do Wall Street CEOs have fat wallets and

thin skins?

Lloyd Blankfein responded to criticisms by saying he was doing

God's work.

22 September 2011



We wonder what Ben Bernanke would say about Dimon's contribution to the economic recovery if he were free to comment.

Bernanke has been pumping astounding quantities of reserves into the banks to stimulate the moribund economy. Mr. Dimon helps himself to gobs of that stimulus money and the returns on the almost-free FDIC-guaranteed deposits to buy back his stock—$4.3 billion worth this year. (Not quite true: that's what he spent—as of now, those shares are worth about $3.6 billion. He was buying big when the stock was in the high forties. It's called "generating shareholder value" by returning money to the stockholders. Dimon's investment expertise could, perhaps, be questioned, but there are lots of finance professors who'd say he's doing the right thing. Those smart stockholders who looked at the economy and rushed to take Bernanke's money as packaged by Dimon should be thanking Bernanke for improving their standard of living. Meanwhile, Ron Paul, the Tea Party and Rick Perry are calling for Bernanke's hide because they think he's too cozy with Wall Street. )

Bank of America's Brian Moynihan responded to Obama's call for business to hire more workers by announcing plans to fire about 30,000 workers. Of course, he's trying to deal with the disaster arising from his predecessor Ken Lewis's decisions to buy Merrill Lynch and Countrywide Financial. Those acquisitions were made in the depths of the worst financial crisis since the Depression—when BAC stock was selling for more than twice today's price. The greatest retail bank in the USA decided to become the biggest bank in the USA by buying its way into Wall Street.

(Full disclosure: we had strongly and repeatedly endorsed CEO Ken Lewis's performance at BAC for the years leading up to 2006. In response to a question from us about the scale of their Eurodollar liabilities at a meeting in our office in 2002, Mr. Lewis, grinned at his CEO and said, " We're proud to answer that question—and you're the first person who's ever asked us: the answer is zero! And we're probably the only large institution in the world that can make that statement." We were impressed, and strongly recommended BAC stock for four years—arguing that such Bagehotian prudence warranted at least 2 points on the bank's P/E. Four years later, as we examined his reports, we began to worry that he might be straying from the straight and narrow path. After repeated phone calls, we learned that BAC had abandoned this exemplary caution, and stopped recommending the stock, partly because we thought he should have told investors of his decision to join a club that included so many dubious members.

Mr. Dimon helps himself to gobs of that stimulus money and the returns on the almost-free FDIC guaranteed deposits to buy back his stock—$4.3 billion worth this year.

23September 2011

Citigroup stock is having a somewhat better year than it has had in its recent past: it’s only down from $49 to $27. (As clients are aware, we consider Citi a multi-strategy hedge fund masquerading as a bank and benefiting from cheap deposits through that role-playing, managed by a former hedge fund manager who got the largest signing bonus of our time, shortly before presiding over a 95% drop in its stock price.) That $49 valuation came when its management finally figured out a way to get the stock price up—through a mammoth reverse split. (Our chart adjusts for this: the stock never traded at $500: even Apple never got that high—Steve Jobs' technique for taking AAPL from $9 to $390 differs somewhat from Wall Street's shareholder value concepts.)

Why do we devote such analysis to these three mega-banks? They’ve certainly had better years than most of their European counterparts.

But the melancholy reality is that Obama and Bernanke—and US equity investors—need these banks to be big parts of the solution to the problem of microscopic economic growth.

We know they all have huge exposures to European banks. Based on their demonstrated expertise in building shareholder value, we would not be surprised to find out that one or more of them is deeply worried about some of his bank's euro-exposure.

The Old World may be about to come to redress some imbalances in the New.

Returning to our list, as we discuss in the next section, we believe that argument #11 (about a gold bubble) will prove to be 100% wrong. Gold is telling the political and financial elites what they don't want to hear. It is a big bet that the risk-free asset class—and the banks who bet on it—will prove to be a delusion almost as grotesque as the risk-free mortgage products that caused the crash.

As for the last argument, if the big name Street economists who say the economic pause is past are right, then

But we cannot help recalling the story of the eternal Wall Street optimist who fell off the top of the Empire State Building. As he was passing the 65th floor he was heard to shout, "So far, so good!"

But a possible politico-economic sea change of opinion might give investors confidence that high gold prices are here to stay.

What if Obama and his counterparts in Europe decide to do a Roosevelt?

...we consider Citi a multi-strategy hedge

fund masquerading as a bank and benefiting from

cheap deposits through that role-playing,

managed by a former hedge fund manager who

got the largest signing bonus of our time...

24 September 2011



III. Governments, Central Banks, and Gold

Perhaps the most enduring paradox in all finance is the way major governments and central banks treat their gold holdings: they ignore them.

When nearly all OECD economies are running huge deficits at a time of near-zero interest rates, and nearly all governments are looking for ways to raise revenues without imposing economy-unfriendly taxes, why don't the big holders revalue their gold to, say, $2,200 an ounce and declare themselves willing sellers at that price—in bars or in bonds backed by gold—and willing buyers at, say, $2,000?

Roosevelt revalued gold from $20.67 an ounce to $35 and declared that the US was a buyer and seller at that price. He also made it illegal for US citizens to own gold.

By the end of the Depression, most of the world's visible gold reserves were in Fort Knox.

...why don't the big holders revalue their gold to, say, $2,200 an ounce and declare themselves willing sellers at that price?

Gold Holdings of Selected Central Banks and the IMF

TonnesUnited States 8,133.5IMF 2,814.0BIS 119.0ECB 502.1

EUROPE Germany 3,401.0Italy 2,451.8France 2,435.4Switzerland 1,040.1Netherlands 612.5Portugal 382.5United Kingdom 310.3Spain 281.6Austria 280.0Belgium 227.5Sweden 125.7Turkey 116.1Greece 111.5Poland 102.9

Source: World Gold Council, World Official Gold HoldingsInternational Financial Statistics, September 2011

25September 2011

Apart from all the jobs created in Nevada and other gold-mining states, this attempt to introduce controlled inflation at a time of surging deflation was at least mildly salutary. Having most of the world's gold also proved extremely useful in helping to finance the recoveries in war-torn Western Europe.

Gold's roaring run to $1800 must be a huge embarrassment to the central bankers. Why should investors be rushing out of government bonds into bullion? Don't they believe us when we tell them that printing all this money isn't going to debauch the currency?

The best way to take gold out of its newfound role as moral arbiter of governments' fiscal and monetary policies may be to cap it.

Yes, captious critics would say that this is the equivalent of buying a bathroom scale whose highest reading is three pounds above the buyer's current weight.

But desperate times call for desperate measures.

The gold bugs have long proclaimed their own version of the Golden Rule: “He who has the gold makes the rules."

By that standard, Barack Obama could become the leader of the world overnight.

Proclaiming a cap on gold and making all the gold in Western central banks' vaults available for sale—or as backing for convertible bonds—would be a blow to speculators.

Ironically, it would be good news for most gold mining stocks.

And wonderful news for gold mine prospects that are barely more than a hole in the ground.

Why?

Back in the 1930s, gold mining stocks were stock market darlings. Who else could sell everything they produced to the government at a guaranteed price? Roosevelt was a hero to miners, prospectors and stock pushers.

It was the golden age for penny gold stocks. Anyone could take a flutter on them. There were no lotteries, and the only legal gambling was church basement bingo games. Anybody with a dream and a drill hole was able to peddle his shares, and securities regulation ranged from lax to nonexistent.

The best way to take gold out of its newfound

role as moral arbiter of governments' fiscal and

monetary policies may be to cap it.

26 September 2011



A story about an unexpected side effect of all the prospecting in that speculative era.

Management of Gunnar Gold, one of the numerous speculative stocks of the early 1940s, thought it had a promising gold deposit in the Yukon. There was some funny impurity in the ore, but it didn't seem to worry management. Suddenly, the Canadian government nationalized the company—paying the stock market price, which was less than $2 a share. Only after the war was over did the surprised shareholders learn that Gunnar's ore was radioactive. The uranium it contained went to a hush-hush US government operation in Los Alamos and some of it ended up in the bomb bay of Enola Gay to be dropped on Japan.

Without the guaranteed price for gold, that mine might never have been discovered.

We believe a new era in which gold was back into the very centre of central banks' operations would be a great time for gold prospecting and gold mine development.

As for the strong, well-financed producing gold mines with huge, politically-secure reserves—the Goldcorps, Barricks, Newmonts and their brethren—they would no longer be white chips: they'd be blue chips, paying secure dividends which, at a time of low-low interest rates, would be prized.

The upward revaluation would permit some of the better-endowed PIIGS to issue gold-backed bonds at minuscule interest rates. As for the US, which has more gold than anybody else, and doesn't seem to have the faintest idea why it has it—or what to do with it—Obama could apply net sales proceeds directly to the deficits.

The cap on gold would take a major bearish investment medium out of the stock market—gold bullion. For months, on the days stocks have gone down, gold has gone up.

If gold were capped and governments combined their willingness to sell gold with a ban on naked short-selling of bank shares, and on naked Collateralized Debt Swaps, governments and banks might get a breathing spell.

Why ban naked Collateralized Debt Swaps?

Because they violate the centuries-old rule for insurance products—an insurable interest. When life insurance was first created in England, companies let anyone buy a life insurance policy on anyone else. Then they

We believe a new era in which gold was back into the very centre of central banks' operations would be a great time for gold prospecting and gold mine development.

27September 2011

found that those lives insured by people who weren’t personally related to the life insured tended to die violently. So the concept of insurable interest developed—just as the fire insurers had never let people buy insurance on dwellings in which they had no ownership interest.

AIG would never have gone down (at a cost to taxpayers of more than $100 billion), if it hadn't violated its insurance principles by going gung-ho into Collateralized Debt Swaps.

As the eminent Paul Volcker has said so often, why should economies and taxpayers be at risk for banks that get deeply into newfangled financial products? Western economies grew satisfactorily in the decades before all these monstrosities were developed, and the bank failures that happened were easily managed.

Today's announcement that UBS has apparently blown $2 billion in its trading operations is a perfect case in point: UBS had to be bailed out by Swiss taxpayers because it was levered more than 40 to one and had monstrous holdings of putrescent US mortgage paper. A great bank that had survived for more than a century as a pillar of Swiss prudence and rectitude had tried to become Goldman Swiss—and it lacked both the smarts and the capital for that remake. Less than three years later, it's due to report a quarterly loss it blames on a rogue trader. Axel Weber of Bundesbank fame is due to take charge next year of this organization whose financial structure in recent years seems to have been modeled on Swiss cheese.

As the chart shows, he's needed now.

UBS January 1, 2007 to September 14, 2011

0

10

20

30

40

50

60

70


11.41

UBS had to be bailed out by Swiss taxpayers because it was levered

more than 40 to one and had monstrous

holdings of putrescent US mortgage paper.

28 September 2011



Why do we devote so much space to making political proposals?

Because we are deeply worried that another financial crisis is coming, at a time when governments' bailut budgets are seriously constrained.

President Obama's long-awaited speech about his great plans for creating jobs was greeted with reactions ranging from boredom to disdain. It was a highly-energized and well-delivered rouser. However, all he could do is promote a new batch of "shovel-ready" projects and jobs for teachers that would be financed by higher taxes on the rich. He is seen as someone who spent $800 billion on stimulus that didn't work, and he's now largely devoid of both ideas and money.

Obama and his European counterparts look at the performance of shares of the big banks and must feel that, (as we put it in Basic Points), Naught's Had, All's Spent.

The government-owned gold that could provide such support to the leaders in the US and Europe is a nuisance to them, because its strong performance in the marketplace is a daily reminder of the futility of their seemingly endless crisis meetings and new acronymic rescue mechanisms backed by..........what?

Bernanke has expressed a yearning for some inflation (but not in foods or fuels) to help the hapless housing market.

Obama has failed to put the economy on a growth path. Most of his Republican opponents are as doctrinaire as he—while mouthing different dated dogmas of equivalent futility.

As Reagan put it, when the nation faced similar crisis, "If not us, who? And if not now, when?" (He also summed up the Democrats' economic program pithily, "If it moves, tax it; if it still moves, regulate it; if it fails, subsidize it." That perfectly distills today's Demodogmatism. But the Republicans' dogmatic refusal to permit any tax increases—even on the carried interest of hedge fund managers who create few jobs—is equally unhelpful.

If there were ever a time to start accessing the gold Roosevelt bought at $35—and reducing endogenous risk in the global banking system—this is it.

"If it moves, tax it; if it still moves, regulate it; if it fails, subsidize it."

http://research-ca.bmocapitalmarkets.com/documents/9C08752C-87B2-4352-AC39-DC4ACB8C1958.PDF

29September 2011

Gold-backed bonds and gold for sale at $2,200 to all bidders would, of course, be selling off "the family silver." But desperate times call for desperate solutions. The biggest and most obvious asset Obama has is the one asset that he supposedly can't touch.

Why not?

Long-duration Gold-backed Treasurys paying, say, .5% interest would be one way of selling off much of the Treasury's hoard without swamping the cash gold market.

Those with long memories will recall when Jacques Rueff, DeGaulle's gold guru, convinced France to issue some gold-backed bonds as proof that the nation didn't face serious inflation risk. Then came stagflation and the runaway gold market and those gold-backed bonds became fabulous investments.

Most central bankers know that embarrassing story, which may preclude their willingness to make any recommendations now. To be remembered as the guy who sold gold at $2,000 in a long-term bond and gold went to $5,000 would be ghastly.

But the reason why Rueff lost so big was that Nixon closed the gold window in 1971 and then oil prices quadrupled and stagflation—which had never existed before—took charge. Under this tentative scenario, the US would transfer all bullion needed to back the bonds, and Congress would pass legislation guaranteeing those gold bond conversions until the bonds matured.

Finally, the wise, witty folk at the Leuthold Group have published the Chart of the Year showing the cumulative total return on gold vs. the cumulative total return on the S&P since Nixon closed the gold window, repealing the cap on gold imposed by Bretton Woods.

Remarkably, gold's bull market in this millennium has meant that its annualized return has caught up with the S&P—9.9% vs. the S&P's 9.8%. If you'd put a bar of gold in a vault and left it there for 40 years, you'd have slightly outperformed most equity investors. The S&P has been long proclaimed as proof of the triumph of American capitalism with its business schools, management training, and superb collection of so many of the world's greatest companies. Buy and hold the S&P and you're going to be rewarded by the very best wealth-generators. Buy and hold gold and you're as outdated as believers in the phlogiston theory.

The biggest and most obvious asset Obama

has is the one asset that he supposedly

can't touch.

Why not?

30 September 2011



This statistic could be used by Obama to argue that now is a good time to lock in the gold bull market by monetizing the nation's holdings through various strategies and vehicles forty years after Nixon uncapped gold and 78 years after Roosevelt boosted it 70%.

The same strategy would apply to some of the more desperate European nations. They have gold; they need to sell bonds and the market doesn't want them; their deficits are scary and they're all supposed to retrench simultaneously. Issuing long-term bonds with a fixed call on gold would make their bonds marketable.

Most of the gold sitting in vaults in the US and Europe was accumulated at significant cost to the taxpayers of the time. It is performing no usual function at a time when it seems as if all governments—notably Switzerland—want the value of their currencies to decline. The reason nations wanted and needed gold was to back their currencies.

Pawn shops and jewellery stores report high levels of gold cashouts from middle class people who are having trouble getting by. The point of gold is that for all of history, it has been the one certain thing that can be used to buy goods and services or discharge debts.

Why don't the governments bring out their gold and use it to back their bonds?

Obama should, in our view, try to find one non-Keynesian economist who understands gold to advise him. We’re sure he could get an old-fashioned scholar from the University of Chicago to help him out if he made a few calls.

Why don't the governments bring out their gold and use it to back their bonds?

31September 2011

Francly, Ma Chère, I Do Give a Damn

In our September 16, 2011 Client Conference Call, we discussed the momentous implications of Swiss Central Bank Governor Hildebrand's decision to peg the Swiss franc to the euro.

Swiss Franc vs. US DollarJanuary 1, 2010 to September 14, 2011

0.8

0.9

1.0

1.1

1.2

1.3

1.4

1.5

Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10 Jan-11 Mar-11 May-11 Jul-11 Sep-11

1.15

The franc tracked gold for much of this year, as investors with a sense of history bought the one currency that was a reliable store of value.

The franc had that stature during the stagflation era.

There were two prime reasons:

1. Switzerland prized its status as an island of financial stability in an inflationary world, and gold was a major component of its foreign exchange reserves.

2. Swiss banks were growing their managed assets rapidly, partly due to the allure of secrecy and tax dodging, but also because the rich wanted to own franc-denominated assets at a time the banks had a firm rule that 10% of each account had to be held in gold. As wealth denominated in other currencies was converted into francs, the upward pressure on the franc became enormous.

Francly, Ma Chère, I Do Give a Damn

32 September 2011



By the late Seventies, the soaring franc was threatening Swiss industries—particularly watch manufacturing.

So Bern imposed special taxes on capital inflows, and pegged the franc to the Deutschemark. Once the gold bull market turned into a crash, the Reagan recovery began, and the dollar entered a roaring bull market, the pressure came off the franc.

This time is different.

Not only has the franc risen by nearly a third against the euro from early 2009 to last week, but Swiss residents have been switching their routine shopping needs to France, Germany or Italy, creating a crisis for Swiss retailers. This despite cutting Swiss rates to zero and massive forex intervention that has quintupled Swiss central bank holdings of euros, dollars, pounds and other currencies—including the Canadian dollar. Instead of the franc being a haven (which could be deemed earthly Heaven), the declared national policy now is to tie the currency and the economy to the euro.

This is amazing. The currency that has long been synonymous with prudence and safety is adopting as its sole objective the fate of the only currency that lacks the backing of any government, tax system, army or navy—a mere meta-currency. It could be deemed the singular case of a crowd rushing from the safety of a dock onto a sinking ship. Or, possibly, leaving Haven for Hell.

Speculators may still choose to use this period of euro-parity to sell euro-assets and buy Swiss assets—notably real estate—on the assumption that the endogenous risk in the euro is so great that it will eventually implode, forcing the Swiss to abandon their self-imposed peg.

What particularly interests us is that this Swiss decision to replace the nation's traditional protective systems from walls to Swiss cheese should mean massive new inflows into gold.

Rhett Butler delivered his classic dismissal to Scarlett before walking out.

Mr. Hildebrand is walking out on Swiss traditions that have been part of the national character for centuries.

It could be deemed the singular case of a crowd rushing from the safety of a dock onto a sinking ship. Or, possibly, leaving Haven for Hell.

33September 2011

IV. A Model for a Post-CAPM World

1. Bullet-proof Dividend Payers

With the CAPM's elegant formulas and rules under daily challenge, and with high-grade bond yields so far below traditional funding assumptions, we believe institutions and high net worth investors should reconsider the rules used in portfolio construction.

We suggest that

1. The portfolio's beta-rated Equities exposure—including stocks and commodities—should be reduced to 35% in favor of income components for as long as the threats of financial crisis and recession remain highly visible. If we learned anything from the horrors of 2008, it is that life-threatening diseases within banking systems can overwhelm economies and equity markets.

2. The Income sector—traditionally composed solely of debt instruments—should be reconstituted to include 10% in bullet-proof high dividend reliability stocks. Companies selected must have great dividend and dividend growth records—and must not be big allocators of cash in stock buybacks.

The justifications used for such programs are inherently contradictory: they are said to be returning money to stockholders, but they actually give funds only to those who want to sell their shares. If the companies also have generous stock option schemes for top executives, the programs could easily be construed as being, at least in effect if not in design, cover-ups about the real cost of such dilution, and as extra enrichment to the insiders by financing the purchase of their low-cost shares at higher prices. Dividends go only to those who choose to remain as partners in the enterprise. Stock buybacks go only to those who want out—in whole or in part—or those who are selling the stock short. It is unclear why those groups of investors should be the objects of corporate solicitude or corporate cash.

We recommend that investors using this approach to portfolio construction assign the dividend stocks into a sector designated for five-year returns—à la private equity agreements. The portfolio should be measured against the yield for five-years Treasurys or five-year Canadas or Bunds. To illustrate: today's 5-year Treasurys yield .94%. Assume the dividend portfolio yields 2.75% initially and increases at an thereafter at an expected average growth rate of 5%. (This would be a big part of the investment thesis: don't just buy

The justifications used for such programs

are inherently contradictory: they are

said to be returning money to stockholders,

but they actually give funds only to those who want to sell their shares.

34 September 2011



high-yielding stocks, but buy those with acceptable yields and a corporate policy of increasing payouts.) All income above .94% would be credited to the book cost of the shares. At the end of five years the total return would be calculated—Market Value, less Adjusted Book Cost.

Those managing such portfolios would contact company managements about their dividend policies—not about earnings and capex forecasts. We would expect that if this approach became popular, companies would change their payout policies to qualify for inclusion in dividend portfolios.

The portfolio manager would ignore Street Buy, Sell or Hold recommen-dations, which are overwhelmingly beta-based. Beta analyses would be crucial in the Equity portfolios.

But it has a lot of history behind it. Until the growth stock era of the 1960s, most pension funds and insurance companies invested in stocks for their dividends. (We well remember when we joined Mutual Life of Canada in 1970 that its largest stockholding was IBM. When we queried this, we were told that the company began buying IBM for its dividends during the Depression and kept reinvesting them for years. Then, when the holding became large and worrisome, they would sell off chunks, but the darned stock kept roaring back and kept boosting its dividends. We finally convinced management to sell one-third of the position when we argued that IBM could lose the Telex anti-trust lawsuit. We wrote a mock trial judgment based on the General Motors-DuPont Supreme Court decision. Fortunately for our investment career, that's the way the case went at trial a few weeks later. The NYSE had to open late the next day because of the torrents of selling and it took more than a decade for IBM stock to recover its former glory.)

In fact, until very recently (as British actuaries measure these things), large British pension funds valued their stockholdings primarily on the basis of the reliability and potential growth of their dividends—not on increases in earnings or the P/E ratios. We recalled this last year after the BC Macondo disaster, when there was so much discussion about whether BP would pay its dividend—which was crucial for a huge amount of British pension fund assets.

It is fair to say that dividends were—overwhelmingly—the most important component of equity valuations by major institutions for more than a century after the advent of joint stock companies.

...dividends were—overwhelmingly— the most important component of equity valuations by major institutions for more than a century after the advent of joint stock companies.

35September 2011

Bernie Cornfeld and his like peddled the growth stock concept to retail and institutional investors at a time when dividends were heavily taxed and capital gains were taxed at lower levels.

But the importance of dividends even in the "modern era" was confirmed in a Financial Times survey of long-term equity returns with reinvestment of dividends by industry classification published a few years ago. The winner—by a wide margin—was the big petroleum companies, which routinely distributed generous dividends. Reinvesting those payouts was, over the long term, a superb investment strategy. (It has doubtless dwindled in these days of consultants and investment specialists; an equity specialist rarely gets control of the dividends from the funds under management, so reinvestment is almost an abstract concept.)

In a recent meeting with a board of directors, we illustrated the concept of low endogenous risk with bullet-proof dividend payers by asking rhetorically, "Can anyone in this room imagine a world of the near future where Bristol Myers won't be able to pay a dividend? By that test, isn’t Bristol Myers a safer income investment by far than, say, an Italian government bond?"

We strongly recommend that institutional and retail investors break the shackles of labeling and look at security of income—whether in dividends or interest. In a zero interest rate environment, there is a long list of great companies with a long record of dividend payments on schedule—and of sustained growth in those payouts.

We also recommend that companies' managements consider the changed situation for dividend-payers in a zero interest rate world and decide to eliminate stock buybacks against promises to boost dividends year-in, year out—on a five-year time horizon basis. Companies that took that public pledge would, we believe, be then eligible for enrolment in the bullet-proof dividend category, making them eligible to be held within the income section of both pension fund and high net worth portfolios.

The new value of dividends is one logical outcome of the etiolation or outright collapse of the Capital Asset Pricing Model.

That the Efficient Frontier has become the Deficient Frontier is, to date, understood by surprisingly few investors and commentators. As more come to understand the great void in their analytical processes, we suspect that even more financial turmoil will develop.

That the Efficient Frontier has become the

Deficient Frontier is, to date, understood

by surprisingly few investors and

commentators.

36 September 2011



2. Gold vs. Gold Mining Stocks

Our respect—indeed enthusiasm—for gold is well-known to all our clients over the past decade.

Of late, gold and gold stocks have been huge outperformers, as an equity bear market seems to be taking shape, with stock markets fibrillating at times and talk of recessions becomes a component of daily commentaries—even from economists who continue to issue moderately bullish economic forecasts.

Those Big Price Swings in Gold

Like other market participants, we have found gold's recent intra-day and intra-week price swings more than mildly disconcerting.

Gold September 8, 2001 to September 17, 2011

0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

2,000

Sep-01 Dec-02 Mar-04 Jun-05 Sep-06 Dec-07 Mar-09 Jun-10 Sep-11

1,779.90

Gold June 1, 2011 to September 17, 2011

1,400

1,500

1,600

1,700

1,800

1,900

2,000

1-Jun 14-Jun 27-Jun 10-Jul 23-Jul 5-Aug 18-Aug 31-Aug 13-Sep

1,779.90

Of late, gold and gold stocks have been huge outperformers, as an equity bear market seems to be taking shape, with stock markets fibrillating at times...

37September 2011

Gold mining shares have, in general, dramatically underperformed bullion, and that has led to more questions than any other from clients this summer. A recent, superbly-researched, study of gold mining companies from BMO's mining team documents how cheap most mines are compared with bullion. Any investor with even a modest interest in precious metals investing should read this report thoroughly.

As we have observed in recent Conference Calls, the great gold mines are the cheapest relative to bullion that we have seen in our lifetime. (They tended to be expensive relative to bullion for most of the 21 years of gold's Triple Waterfall collapse that began in 1980. Barrick, in particular, achieved the remarkable feat of selling its annual output well above average bullion prices, thanks to Peter Munk's spectacularly successful hedging program.)

In recent years, when most of the mines modestly underperformed the gold ETF (GLD), we commented that we had counseled some members of the World Gold Council not to create that ETF.

They rightly pointed out that it would create new, sustained demand for gold, by providing investors with a convenient vehicle that didn't involve storing bullion in basements or bank vaults. Moreover, the liquidity provided by an actively-traded stock exchange vehicle meant that they could trade gold cheaply.

They made what certainly appeared to be the right call. We were, it would seem, wrong.

But it may now be of some interest to investors to consider the objections we raised.

We argued:

1. An ETF is an exchange-traded stock, which means that gold takes on beta risk: in times of sharp stock sell offs, margin clerks can swiftly sell the GLD to raise needed cash. that is in fact what happened during the darkest days of 2008—and what happens on many triple digit down days for the Dow these days.

2. Gold's uniqueness as the prehistoric and historic store of value could be polluted—or even lost—when it became just another stock exchange vehicle.

3. The GLD would eventually compete with the stocks for investor favor. Why buy gold mines with all their operational risks when one can buy the pure play that has, at least in theory, only commodity price risk?

Gold mining shares have, in general,

dramatically underperformed

bullion, and that has led to more questions

than any other from clients this summer.

38 September 2011



That warning has seemingly been vindicated each time some company reports even mildly disappointing earnings due to rising costs for energy, taxes, or labor. Capex costs have routinely exceeded projections—notably for the giant tires needed for mega mining projects, which at times became unavailable at almost any price. Holders of the ETF just kept getting richer while holders of the gold mining company's shares watched enviously.

The success of the GLD has, of course spawned new ETFs, each of which not only competes with GLD but with gold mines.

Result: considerable frustration in recent years among gold mine managers that investors seem no longer interested in assigning value to their "unhedged reserves in the ground in politically-secure areas of the world"—the metric we repeated endlessly during the 1970s, to which we returned in 2003 and thereafter as we announced a new commodity bull market that would outstrip all predecessors—with gold a near-certain winner.

We have stuck to our guns, telling clients they should be valuing developing gold companies by that metric—and keeping it for comparing producers with each other. To us, the most alluring aspect of the great gold companies was the leverage in their reserves and resources as gold prices kept climbing.

As investors know, mining companies report three kinds of reserves—proven, probable, and resources. Proven are those being mined and adjoining existing ore bodies, and established by close drilling. Probable are those, usually lower grade, that need to be drilled out more rigorously. Resources are those indicated from geology and some drilling, and quite often with significantly lower gold content per ton than existing producing mines.

To us, the great allure of the great gold companies that investors usually get—seemingly—for free, are the resources. With gold at $500 an ounce, those resources would be rather like the leprechaun's pot of gold at the end of a rainbow—a dream. As gold prices kept marching higher, more resources became probable preserves, and more of the probable reserves became proven reserves—after more drilling and development. Once gold soared into triple digits, the mining companies could look at their resources as great assets ripe for the picking.

With gold climbing past $1400 an ounce, the in-ground reserves and resources in politically-secure properties owned by the great gold companies should have entered investors' calculations of value.

That hasn't happened.

Yet.

To us, the great allure of the great gold companies that investors usually get— seemingly—for free, are the resources.

39September 2011

One reason may be that mining investors are suffering from a form of sticker shock: gold has gone so far, so fast, that many investors deem it overdue for a huge correction. The Street has of late been teeming with economists and strategists who speak derisively of a bubble in gold. Most of this pack of economists and strategists was—at best—tepid about gold and gold mining stocks as bullion rallied from $300 to $1200, and almost never recommended significant weighting in gold or gold mines. They stuck to recommending conventional financial assets. "Put your money into bank stocks, not into holes in the ground" was the wisdom dispensed.

Most of them had been trained in elite universities by Keynesian economists and finance professors who dismissed gold as something between a barbarous relic and a bore.

There is a certain self-serving logic in this view: gold is, in the physics of modern finance, anti-matter. It is a basic bet that intrinsic value will be a better store of value than a dollar, euro, pound, Swiss franc or yen—those printed paper promises of politicians.

(When Nasdaq was in the late stages of its Moon Shot, the Street teemed with economists and strategists who said tech stocks were headed for Saturn. The worst year of our professional career was 1999, when we expressed utter disbelief at tech stock valuations—before Nasdaq doubled again—to 5200. Nasdaq as the millennium dawned wasn't just a bubble—it was the largest-scale collective idiocy in the history of financial markets. Unfortunately, it wiped out much—maybe most—of the collective savings of the Baby Boomer generation; with retirement looming, too many members of that generation tried to recoup by buying heavily-mortgaged homes—because, unlike stocks, home prices could never collapse. What they believed was that they were responding to learning acquired late in life. The word for that is opsimathy. Sadly, they had just found one last great way to let Wall Street loot their savings. The word for that is suckers. Had they bought gold with what they had left, they'd have recouped their tech losses. But almost no one of Street significance suggested that.)

We believe good gold mining stocks with production and reserves in politically-secure areas will outperform bullion over the next year or more. It may take time before investors are prepared to value reserves at $1800 an ounce, but the disparity will narrow. Gold's 25% leap this summer has actually widened the valuation gap.

Maybe gold investors aren't too greedy—just too cautious.

When Nasdaq was in the late stages of its Moon

Shot, the Street teemed with economists and strategists who said

tech stocks were headed for Saturn.

40 September 2011



KBW US Bank Index (BKX) relative to S&P 500September 14, 2010 to September 14, 2011

70

75

80

85

90

95

100

105


76.00

KBW US Regional Bank Index (KRX) relative to S&P 500September 14, 2010 to September 14, 2011

80

85

90

95

100

105

110


88.25

How Long Can US (and Canadian) Stocks Remain Uncoupled From the Global Equity Bear Market?

The plunge in European financial stocks in recent weeks has been truly brutal. Of late, the underperformance of US bank stocks risks turning into a rout:

THE INVESTMENT ENVIRONMENT

41September 2011

The TED Spread and the European IOS spread have also been flashing warning signs that the rate of deterioration is accelerating.

What has doubtless helped US stocks has been the spectacular performance of Treasurys:

What makes this rally particularly impressive is that its momentum increased after the S&P downgrade. It almost seemed to be the equivalent of a Hollywood clunker that its backers feared would fail—until the censors announced that movie houses would have to display stern warnings about the levels of nudity and violence that would be disturbing for many viewers.

That long Treasury zeros have performed like gold is a paradox—and a warning.

Investors are clearly concerned that the levels of endogenous risk in most financial markets are rising even as economic growth rates fall almost everywhere.

The wild swings on Wall Street also raise warning alarms for the S&P, which has been so strong relative to European and Asian exchanges. The robo-traders may be profiting in unseemly fashion, but small investors—and serious investors—should be concerned that volatility is so intense for so long.

10-Year US Treasury YieldsSeptember 14, 2010 to September 14, 2011

1.5

2.0

2.5

3.0

3.5

4.0


2.08

That long Treasury zeros have performed like gold is a paradox—

and a warning.

42 September 2011



The Arab Spring and Its Fall

What started in Tunisia with a starving street vendor swiftly became the geopolitical story of the year. The revolution in Egypt was the best-covered on TV of any in history, drawing most of us into this emerging vision of the birth of a new, liberal society in one of the oldest civilizations on earth.

We have commented in Basic Points and the Conference Calls that, as much as we wanted to believe that all these dreamy young people embracing each other and freedom, the record of such rebellions is filled with more stories of those that became new—and more vicious—tyrannies than of those that lived up to the revolutionaries' progressivism and desire for personal freedom.

Right from the beginning, investors wondered what the fall of Mideast tyrants might do to the price of oil.

When the demonstrations spread from Egypt and Tunisia to Libya and Bahrain, we got a glimpse of what these revolutions could cost the rest of the world—in terms of high oil prices and slower economic growth.

Brent CrudeJanuary 1, 2011 to September 16, 2011

90

95

100

105

110

115

120

125

130

Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11

112.34

Although the revolts spread to another oil-producing nation—Syria—oil prices have been in a step decline since the April panic.

However, production of Libya's light oil is still seriously constrained and no one knows when normalcy will return. Syrian oil production has also been cut back.

...the record of such rebellions is filled with more stories of those that became new—and more vicious—tyrannies than of those that lived up to the revolutionaries' progressivism...

43September 2011

Tentative conclusion: The governments of Bahrain and Saudi Arabia will not fall, and eventually Libyan and Syrian oil will be flowing out under new management. This is not the kind of oil shock that, of itself, will trigger a recession as did the Arab oil boycott after the Yom Kippur War.

At this point, the most disappointing news comes from Egypt, where the Army and the Islamic Brotherhood seem to be the power centers of whatever new government will take over. Those lovely liberals with the big dreams will have even less power in the future than they had under Mubarak.

The biggest loser from the Arab Spring—apart from the fallen dictators—is Israel. When the demonstrators in Tahrir Square were dominating global TV and the Obama Administration was busying itself in pressuring Hosni Mubarak to shape up or ship out, Benjamin Netanyahu registered strong public concern. The peace treaty with Egypt has been the core of Israeli security since it was negotiated—and both sides have benefited hugely from it.

As Hosni Mubarak was carried to trials in a cage, Islamist elements in Egypt came into the open, demanding that its peace treaty with Israel be revised or—better—ended. When the Cairo mob swarmed to the Israeli embassy and began chipping at the protective wall with tools, the police and Army stood watching. Then with the wall down, the mob poured into the embassy, reaching the top floor—in a seeming replay of the Tehran takeover of the US embassy that would expose the wimpiness of Jimmy Carter and begin 444 days of capture of American personnel.

Finally, the Army came in. But one of the most sacred of all laws of diplomacy—the sanctity of embassy property—had been violated while the army and police stood by.

It now appears that the Obama Administration was caught flat-footed by the Arab Spring, and ended up influencing revolutionary events strongly only in Egypt—assisting in the political decapitation of Mubarak—the least brutal of the dictators and the best friend of America and Israel. It chose to ignore the Syrian revolt for months, claiming that Assad was "a reformer." When the Libyan rebellion could no longer be ignored, the Administration agreed to a half-hearted anti-Gaddafi policy of "leading from behind" that seemed to please almost no one—(but ended up well).

The biggest loser from the Arab Spring—

apart from the fallen dictators—is Israel.

44 September 2011



As Netanyahu feared, Mubarak's fall has been terrible news for Israel—and for American influence in Egypt. Once again, the most perilous strategy for a leader in a troubled Third World country is to be a friend of America. That's the way it was before Reagan, and later, Bush, made it clear that America stood by its friends—even when it was inconvenient.

It gets worse.

The Islamic Brotherhood's influence within the government of another nation whose peace treaty with Israel has been crucial—Turkey—implies that the Islamic world revolts are reinforcing anti-Israel sentiment across the Mideast—leading to sustained existential threats to Israel. Not only is Turkey planning to back a Gaza-bound fleet with its own navy, but it is publicly disputing Israel's claim to offshore oil and gas—which was expected to be a powerful contributor to Israel's economic security for decades to come. Amid this rush to take advantage of Israel's emerging isolation, the United Nations has agreed to take up a proposal to recognize the Palestinian states as a legitimate nation—with borders to be defined by international agreement.

Polls in Egypt and other Arab states show overwhelming anti-Israeli sentiment (except among the beleaguered Coptic Christians).

Even Jordan, Israel's other friendly neighbor, has been experiencing ferment and the King is under pressure to scale back the nation's relations with Israel.

In this month in 1973, Egypt and Syria, with help from a few other Arab states, were mobilizing to launch the invasion of Israel on Yom Kippur.

It is probably fair to say that Israel's security is now imperiled the most it has been since its seemingly overmatched forces defeated the invaders—and the UN Security Council stepped in to save Egypt from Israeli occupation.

Now the UN is stepping in to tell Israel it must recognize a government sworn to eradicate it.

We do not argue that Israel's newly-energized enemies will go to war, but they can undermine Israeli security in so many ways.

Could the Obama Administration have influenced events in a direction more favorable to the existential interests of the only democracy in the region?

We'll never know.

It was never really tried.

Once again, the most perilous strategy for a leader in a troubled Third World country is to be a friend of America.

45September 2011

Allocations ChangeUS Equities 14 –2

Foreign Equities: European Equities 0 –2 Japanese and Korean Equities 2 –2 Canadian and Australian Equities 4 –1 Emerging Markets 5 –5

Commodities and Commodity Equities* 5 –6

Gold & Gold Stocks 5 +5

Income Generating Assets Dividend Stocks 10 +10 Bonds: US Bonds 20 +4 Canadian Bonds 8 +1 International Bonds 4 +1 Inflation Hedged Bonds 12 –2

Cash 11 unch

Recommended Asset Allocation Capital Markets Investments

US Pension Funds

Years ChangeUS 7.00 +3.00Canada 7.00 +2.75International 5.00 +1.20Inflation Hedged Bonds 9.00 +3.50

Bond Durations

ChangeAgriculture 32% –1Precious Metals 37% +9Energy 19% –5Base Metals & Steel 12% –3

Global Exposure to Commodity Equities

We recommend these sector weightings to all clients for commodity exposure—whether in pure commodity stock portfolios or as the commodity component of equity and balanced funds.

RECOMMENDED ASSET ALLOCATION


46 September 2011



RECOMMENDED ASSET ALLOCATION

Allocations Change

Equities: Canadian Equities 14 –2 US Equities 4 –1 European Equities 0 –2 Japanese, Korean & Australian Equities 2 –4 Emerging Markets 5 –3

Commodities and Commodity Equities 5 –7

Gold & Gold Stocks 5 +5

Income Generating Assets Dividend Stocks 10 +10 Bonds: Canadian Market-Related 32 +9 Canadian Real-Return Bonds 12 –2 International Bonds 3 unchCash 8 –3

Recommended Asset Allocation Capital Markets Investments Canadian Pension Funds

Global Exposure to Commodity Equities

ChangeAgriculture 32% –1Precious Metals 37% +9Energy 19% –5Base Metals & Steel 12% –3

We recommend these sector weightings to all clients for commodity exposure—whether in pure commodity stock portfolios or as the commodity component of equity and balanced funds.

Years ChangeUS (Hedged) 7.00 +3.10Canada: – Market Index-Related 7.00 +3.00 – Real-Return Bonds 9.00 +3.50International 5.00 +1.00

Bond Durations

Canadian investors should hedge their exposure to the US Dollar.

47September 2011

INVESTMENT RECOMMENDATIONS

1. If possible within your investment guidelines, avoid European bank stocks.

Deutsche Bank's Josef Ackermann says that the situation for European banks resembles 2008. Such candor is commendable. The collapse of the risk-free sovereign rate of return for so many members of the eurozone means that total portfolio risks are high—and rising.

2. Avoid investing in US banks that have dubious balance sheets, that give top executives big stock option deals, and that squander Bernanke-supplied funds in stock buybacks.

American bank stocks' performance has been deteriorating and now the tort lawyers have been freed to sue big banks—possibly for treble damages. This class of raptors has historically been the second biggest contributor to Democratic candidates, next only to trade unions.

3. We recommend that investors hold their current positions in Canadian oil sands stocks, but exercise caution about new commitments.

Perhaps the most important economic policy decision Obama will make this year is to decide on the Keystone XL Pipeline to carry Alberta oil sands oil to Oklahoma and Texas. Will he stand up to the enviro-fanatics? He has been disappointing them lately, and this might be the Big One he can give them. That perhaps 100,000 good-paying jobs are at stake might be enough to make him give the green light. Astonishingly, the world's second or third largest oil reserves, within the boundaries of America's neighbor and long-time ally, are now the subjects—temporarily, perhaps—of great political risk.

4. Maintain heavy weighting in precious metals, emphasizing gold stocks.

They have been good to you for ten years, and they should continue to be so.

5. Maintain heavy weighting in agricultural stocks.

They have (to us, at least) surprisingly high betas, but the endogenous risk in their earnings is well below that of most cyclical stocks—commodity and otherwise.


48 September 2011



6. Retain strong exposure to US oil producers operating on land.

The spread between West Texas and Brent oil remains at levels that must be infuriating to European governments. So does the spread between US natural gas and European prices. Energy is, at the moment, the most conspicuous competitive advantage the US possesses. Paradoxically, it is the sector the Left reviles the most.

7. Prices of copper and iron ore remain at levels that appear to rule out any global economic slowdown. Strikes and floods have sustained base metal prices—but only demand can keep them at these levels. We don't see that rescue on the horizon. Underweight base metals.

8. Bond investors should be sure that they are earning yields commensurate with the risks they are almost forced to assume at a time of surreal interest rates.

It is almost an Alice-in-Wonderland world when some prominent members of the asset class delivering the worst investment shocks—government bonds—can get away with paying record low rates to investors. Why subsidize poor economic management by lending governments money at risible interest rates? Better to rely on income from great corporations through dividends.

9. The Canadian dollar is suddenly looking weak.

Canadian economic performance is stuttering because of the slowdown in exports to the USA. Otherwise, Canada should remain, in our view, a haven country for investors.

Canadian banks remain vastly more attractive than their American or European brethren—even if that might not be saying very much.

Canadian government bonds are higher quality than Treasurys—and they offer slightly higher yields.

US corporate bonds look attractive relative to Treasurys—and a handful actually have higher ratings.

10. Bullet-proof dividend paying stocks with a record of sustained payout growth should be the core investment asset class for income-oriented investors, as long as central banks continue to suppress interest rates, and as long as the Deficient Frontier exists.

Earnings growth forecasts are worth less in a mini-stagflationary world. Take the money now, and quarterly thereafter, and don't fret unduly about the relative price performance of your stockholdings.

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Economy & Finance

Don Coxe Basic Points Sep 2011