bmo cm basic points nov 2009
TRANSCRIPT
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Basic Points
The Power of Zero
November 12, 2009
Published by Coxe Advisors LLC
Distributed by BMO Capital Markets
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Fannie Mae FNM 1
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Goldman Sachs GS
General Motors GM
General Electric GE
Bank of America BAC 1
CIT Group CIT
Walmart WMT
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Don Coxe
THE COXE STRATEGY JOURNAL
The Power of Zero
November 12, 2009
published by
Coxe Advisors LLC
Chicago, IL
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THE COXE STRATEGY JOURNAL
The Power of Zero
November 12, 2009
Author: Don Coxe [email protected]
Editor: Angela Trudeau [email protected]
Coxe Advisors LLC. www.CoxeAdvisors.com190 South LaSalle Street, 4th FloorChicago, Illinois USA 60603
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OVERVIEW
The Power of Zero
So what was all that Depression fuss about?
The US economy grew 3.5% in the Third Quarter, and all the major economic
numbers now being reported suggest this one will be even stronger. Stock
prices are soaring.
In case, youve forgotten:
Sixteen months ago we were heading into the Midnight Massacre, when
Messrs. Bernanke and Paulson launched the rescue of Fannie, Freddie and
Wall Street.
That swiftly evolved into the Age of Bailouts, with Congress enlisted in
emergency funding for Wall Streets biggest, boldest and brashest bankers
on a scale that made IMF rescues of entire nations look like chump change.
Only Lehman was allowed to experience the Schumpeteresque-slaughter
reserved for capitalist cupidity and stupidity. Operating with scripts and
strategies conceived on the fly, varying prescriptions of emergency assistance
were extended, under panic conditions, to Citigroup, Merrill Lynch, Morgan
Stanley, AIG and Goldman Sachs.
Since then, the Obama Administration and the Pelosi-led Congress have been
moving to take charge of some of the commanding heights and strategic
valleys of the US economy. Highlights: takeovers of General Motors andChrysler, a deficit of 12% of GDP, $790 billion in handouts and assistance
under the rubric of economic stimulus, a costly new national health care
system, and a vast array of tax and trade global warming programs whose
tentacles will reach into almost every sector of the economy.
To date, his rescue operations are succeeding. As Joe Biden put it, A year ago
we were talking about falling into Depression. Now were talking about the
shape of the recovery.
But deeply-wounded investors should be cautious about throwing caution
to the winds. Among the signs that the stimulus package didnt repair the
potholed yellow brick road to prosperity is the upside breakout in the Bad
News Asset: Gold.
This month, we begin our analysis by discussing the anniversaries of the
births of two new eras. First, the Age of Global Capitalism, which began 20
years ago with the Fall of the Wall. Second, the apparent ending of that era
a year ago with the return of Big Government as Economy Manager with the
election of Barack Obama. We werent sure then how he was going to deliver
Only Lehman was
allowed to experience
the Schumpeteresque-
slaughter reserved for
capitalist cupidity and
stupidity.
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THE COXE STRATEGY JOURNAL2 November
everything his thrilled backers wanted, but we knew that he wanted to be a
transformative President and he cited Reagan as such a leadereven though
he said Reagan had the wrong views.
With that background, we search for an appropriate investment strategy for
tumultuous times. While the talk is of trillions in stimulus, foreclosures,
bailouts and deficits, we have decided to focus on a humble number
Zerowhich is roughly the rate on government short-term funds, high-grade
money market funds and inflation across the US, Canada, Japan, and most
of Europe.
We are leaving our cautious Asset Mix unchanged. Risk assetsother than
US real estate pricesare bubbling upward everywhere, but the big banks
balance sheets remain overloaded with the unmarketable unmentionables,and US regional banksthe backbone of the real economyare now being
engulfed by their exposure to commercial real estate and consumer loans as
unemployment continues to climb.
we have decided to
focus on a humble
numberZero...
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I. Capitalisms Triumph
Every week, someone publishes an analysis of the global economy by noting
that the triumph of free trade and free markets across most of the globe
began in the Reagan-Thatcher era. Now, they agree, its over. Each month,
Washingtons reach into the American economy expands rapidly, while the
economy expandsat bestgrudgingly.
It is certainly true that almost no one predicted the suddenness and scale
of US government intervention in the Wests flagship economy that had
been, until last year, a testimony to the wisdom of Milton Friedman and the
courage of Ronald Reagan. (The cheerful Reagan charmed voters by teasing his
opponents. He summed up Democratic economics as, If it moves, tax it; if it
keeps moving, regulate it; and if it stops moving, subsidize it. He summedup the goal of his policies toward the Soviets: We win; they lose.)
The political bipartisanship began with the Midnight Massacre of July 13,
2008 but lasted only until the grandiose goals of the new Administration
were revealed. The Pelosi-Obama stimulus package passed with no Republican
votes in the House, despite heavy lobbying from some segments of the
business community, notably General Electric, which became Obamas
most dedicated corporate cheerleaderitself and through MSNBCafter
receiving many billions in low-cost loans to its flagging finance subsidiary,
GE Capital.
The GM and Chrysler rescues were accomplished with minimal Republican
support. By then, the concern that the Administration was actually seeking
a major transformation of the structure of the US economy was developing
rapidly among conservatives and moderates. In addition, the pitchfork
politics in the House had terrified many business leaders that they and their
families could be the next victims of the fast-spreading rage against the
bailed-out rich.
Twenty-seven years ago, when the newborn Reagan and Thatcher Revolutions
seemed headed for death from double-digit interest rates, Chairman Volcker
declared victory over inflation and began expanding the money supply andcutting interest rates.
For those who didnt manage money during that recession, the fed fund rates
at the time that great easing began must seem surreal: 18%.
The Power of Zero
If it moves, tax it;
if it keeps moving,
regulate it; and if
it stops moving,
subsidize it.
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The Power of Zero
THE COXE STRATEGY JOURNAL
Question: How did the economy survive with rates so high?
Answer: with great difficulty.Those rates were not only punitive for businesses and potential homebuyers,
but they meant that money market funds were well-nigh-irresistible
investmentshuge, risk-free returns with zero market volatility.
We can recall the challenges we faced in convincing pension fund clients
about our asset mix in late 1982: zero Cash, with the balance being roughly
equally divided between long-duration bonds (19 years) and equitieswith
minimal exposure to commodities. Why not, they asked, take those huge risk-
free upfront returns from Cash, rather than bet on a sustained, steep drop in
interest rates and inflation and a sharp, sustained economic recovery?
Because, we argued, inflation and long-term interest rates were already
falling sharply and would continue to do so, following commodity prices
down, lowering costs for businesses and consumers, particularly for energy.
Those three interlinked slides would virtually guarantee a strong economy
and strong stock prices for years to come. We insisted that short rates would
plummet.
That wasnt all that would fall from the Reagan and Thatcher revolutions
II. The Fall of the Wall
Those three interlinked declinesrates, inflation, and commodity
pricesand that one robust riseeconomic activity in the free market
economies across the West, led by the USAwere the underpinnings of
the Reagan-Thatcher accomplishments and the triumph of capitalism. Of
particular importance, the strength of the US, British and German economies
was matched by the robustness of their interlinked foreign policy in the face
of Communist threats to Western Europe. Thatcher and Reagan, with Helmut
Kohls support, installed Pershing nuclear missiles in Western Europe, despite
strong opposition from France, and widespread anti-war demonstrations
on Ivy League campuses and across Europe.
The free market teams stand against the faltering Bolsheviks, and their strong
economies at a time of economic stagnation in Russia and its occupied
territories in Western Europe, led to political unraveling in the Communist
world; the Wall fell and two years later the Communists were goneeven
from the Kremlin. (On his trip to England in 1979, Deng Xiaoping learned
why free economies were outperforming Russia and China, and he returned
to launch the Sino-Capitalist Revolution which keeps astonishing the world,
Why not, they asked,
take those huge
risk-free upfront
returns from Cash?
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even as faith in capitalism fades across much of the OECD. He had learned
why Hong Kong, Taiwan and South Korea could keep creating jobs and
wealth by rejecting socialismwhether on the Maoist, Bolshevik, or Indian
models.)
Putin calls the collapse of Bolshevism, The greatest geopolitical catastrophe
of the 20th Century. It was certainly bad news for him and his fellow KGB
officers, but they regrouped amid the chaotic Yeltsin era and eventually took
control of Russia. The KGB were the Jesuits of Russian Communism, and
they worked loyally to advance the Kremlins goals. But their relationship to
the Party waslike the Jesuits relation to the Vaticanat times problematic.
Example: Khrushchev once claimed that he had personally shot Beria, the KGB
leader, who wasnt deemed sufficiently submissive to the Central Committee,
(although the later version was that hed died before a firing squad). Like the
Jesuits, the KGB considered themselves the elites, and remained loyal to each
other. Now that they are the ruling class, they no longer have to answer to
bureaucrats and theorists.
It was also bad news for leftists across most of the Free World. They had
convinced themselves that, as the leader of Canadas New Democratic Party
put it after returning from a trip to Russia shortly before the Fall, I admire
their economics, but not their politics. It turned out that everywhere, like
Germany under National Socialism, Good Communists were as rare as
Good Nazis. Free markets and free economies worked: socialism didnt.There were no Nobel Peace Prizes for Reagan or Thatcher. Instead the prize
for the end of the Cold war went to
Mikhail Gorbachev.
(The Nobel Committees apparent love of losers is shown by its award of
the prize to the most conspicuous American foreign policy loserJimmy
Carterand rejection of the most conspicuous American foreign policy
winnerReagan. By coincidence, last week was also the anniversary of Carters
most memorable flopthe seizure of the American Embassy hostages by
Ayatollah Khomeinis radicals. They were imprisoned and abused for the 444
days it took to elect Reagan. Carter had withdrawn support for the Shah and
expressed Americas joy at the Khomeini revolution.)
Gorbachevs Nobel was the beginning of the rewriting of the history of Reagan
and Thatchers roles in Communisms fall. The culmination of this process
is arriving in the torrent of new books that airbrush out those doughty anti-
Communists from the portrayals of friendly people reaching out to hug each
other from both sides of the WallPyramus and Thisbe writ large.
The KGB were the
Jesuits of Russian
Communism...
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The Power of Zero
THE COXE STRATEGY JOURNAL
In that sense, President Obama is riding the tide of historys restatement,
and vindicating the Nobel decision about who was the real peacemaker of
that era. Speaking to the cheering throng in Berlin this year, he said that
the world forced down the Berlin Wall. He didnt mention NATO, Reagan,
Thatcher, or Kohl. It was, in the sophistication of its vin blanc et brie analysis, a
causality claim comparable to the roosters renowned boast that his crowing
had brought the sun up. Which world did he have in mind? A coalition of
China, India, Russia, Vietnam, Burma, the United Nations and Iceland?
III. The Obama Triumph
A year ago, Grant Park in Chicago was the scene of the Democrats most
historic get-together since the partys Left spoiled then-Mayor Daleys party to
celebrate his partys national convention. Back then, there was an unseemly
riot, which helped elect Nixon. This time, there was pride, cheering, hugging
and wondrous exultation. We can attest that it was a great time to be a
Chicagoan, and a great time for America.
So how has the President anointed that night performed?
He remains the most charming and charismatic President of modern times,
and is still, quite probably, liked by more Americansand more people
abroadthan any American President. He and his radiant wife are, as The
New York Times notes, Americas greatest global brand.
But the reality of the Presidency is that handsome is as handsome does. His
approval ratings have descended from the Heavenly to the ordinary. All polls
disclose that while most Americans still like and admire him personally, they
disapprove of his policies.
Gallup published a poll on the First Anniversary of his election, comparing
what Americans thought of him then and now. Here are key findings:
Percent
Then Now
He will heal political divisions 54 28He will control ederal spending 52 31
He will improve the healthcare System 64 46
He will increase respect or America abroad 76 60
It was, in the
sophistication of
its vin blanc et brie
analysis, a causality
claim comparable
to the roosters
renowned boast
that his crowing had
brought the sun up.
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Other polls confirm that the basic political dynamic of America hasnt changed
much from its historical pattern: 40% of Americans still call themselves
conservatives, 20% liberals, and the rest style themselves as moderates.
Obama won by convincing an overwhelming majority of moderates that he
would rule from the center, andmost importantlyhe wasnt George Bush.
Despite a brilliant campaign, adoration from the media, a divided Republican
party, and a flagging economy, he was actually behind the Bush-baggaged
McCain in the polls until Lehman imploded, and suddenly it looked as if
the world could end. As Larry Summers would later joke, a new Messiah was
what was needed. (It hasnt come to an end, although a recentNew Yorker
cartoon shows a gentleman consoling a friend, saying, It isnt the End of the
World. Just around the corner, riding furiously toward them, are the Four
Horsemen of the Apocalypse.)
He won in a landslide, as the undecideds, en masse, became converts.
A year ago, Obama was impressing the nation (and, we admit, us) by unveiling
his economic policy team that included the magisterial Paul Volcker. Volcker
has been rarely seen since; three weeks ago, he corrected an interviewer
who said that the financial community felt that in recent months hed been
marginalized. Volcker said, I did not have influence to start with.
The rescue of the plummeting financial system was actually orchestrated by
Bush appointeesBen Bernanke and Hank Paulson, with the help of TimGeithner. Their policies have continuedfor good and illand Bernanke
and Geithner remain as partners.
The jury is still out on the Pelosi-Obama stimulus package, as it is on his
plans to run trillion-dollar deficits for a decadeand on Congresss national
health care billwhich remains in negotiation, despite its narrow victory in
the House.
Based on our recent trip to visit European clients, and numerous emails
from foreign clients across much of the world, many global investors are
alarmed about Obamas policies and are reducing their exposure to US assets
accordingly.
The dollars decline may be one symptom of these doubts about the actions
of Obama and the Democratic Congress.
...many global investors
are alarmed about
Obamas policies and
are reducing their
exposure to US assets
accordingly.
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The Power of Zero
THE COXE STRATEGY JOURNAL
The US deficit/GDP ratio is above 12%at World War II levels, and is the
highest in the G-7, except for the UK. It is, for example, more than twice
Canadas. Few Americans would have expected that America would make
Italy look restrained and prudent in comparison. There is widespread
disappointment about how all that money has been spent, but as Keynes
observed, paying workers to dig ditches and then refill them is better than not
spending the money at all when consumer and business spending collapse
and Depression looms.
Last week, The Economist, which backed Obama enthusiastically during theelection campaign, published a full-page critique of his pro-union policies
titled Love of Labour. Contrasting his recovery policies with Reagans
response to the Air Traffic Controllers strike, it said, Mr. Obama is the most
pro-union president since Jimmy Carter, at least. It went on to describe the
implications of Obamas backing for the unions top prioritycard check
which would abolish secret ballots for union representation.
Abroad, his popularity remains high (except in Israel, where his approval
rating is a mere 4%), as evidenced by his Nobel Peace Prize. However, as his
attempt to replicate Tony Blairs success at charming the IOC into awarding
Chicago the Olympic Games demonstrated, he has been notably unsuccessfulin translating that popularity into significant diplomatic successes.
Perhaps the biggest difference between him and Reagan is in his views about
American history. He was raised in the post-Sixties era, when the Leftabroad
and within the USroutinely demonized America for its alleged racism and
imperialism.
US Dollar Index (DXY)
November 10, 2008 to November 10, 2009
74
76
78
80
82
84
86
88
90
Nov-08 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09
75.10
Few Americans would
have expected that
America would make
Italy look restrained
and prudent in
comparison.
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The Power of Zero
THE COXE STRATEGY JOURNAL
The Highs and Lows of Zero Rates
Zero is a seemingly-small number, but it is demonstrating its power to
change the world. We have seen many examples in individual countries of
The Power of One: this is that kind of power on global scale.
We are regularly told that we should expect a roaring recoveryReagan-style.
But if Reagan were alive, and Margaret Thatcher were in good health, they
would be astounded at how their two nations economies are struggling at a
time ofzero interest rateswhen they had to launch recoveries at a time of
record-high rates.
The US and British economies are performing at roughly the level they were
during the late stages of the 1981-82 recessionwhen corporations and
consumers borrowing costs were infinitely higher. That inflation could be
in the zero range would also astonish them, even though the biggest factor
in their first election victories was the runaway inflation of the Carter and
Callaghan erawhen malaise was the Presidential euphemism for the
spreading despair.
So why shouldnt the economic recovery be at least as strong as Reagansif
not even more robust?
Its because those Zero rates tell us that the financial systems problems that
triggered the economic collapse arent going away quicklyand could even
be getting worse.
Reagan and Thatcher didnt have to deal with serious demographic problems
that meant housing prices could notfor the first time since World War
IIleap in response to plunging interest rates. Reagan and Thatcher didnt
have to mortgage their nations futures to bail out bad banks, which, upon
being rescued, diverted the succor they were given to rebuild their devastated
capital to speculation and bonuses, thereby making their saviorspoliticians
and taxpayerslook like suckers.
Nor did they have to face the certainty that interest rates and inflation would
have to go up sometimeand that could be very inconvenient for both thepoliticians and the economic recovery.
Zero is a seemingly-
small number, but it
is demonstrating its
power to change the
world.
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US interest rates and inflation could remain at current levels, were America to
mimic Japans experience from 1990 to Koizumis election. But those early
years of Japans Triple Waterfall Crash occurred at a time of rapid global
growth that meant Japans trade surpluses grew robustly, and the immense
levels of domestic savings were adequate to finance Tokyos endless fiscal
deficits. (Currently, Japanese investors are not quite able to absorb all the
debt coming from record deficits, but theyre certainly embarrassing their
American counterparts: theyre absorbing 94% of new government debt
offerings.) In contrast, Americas trade deficits are a permanent feature of
the US economy, and even the current uptick in US household savings is
no match for the fast-growing flow of new Treasurys, which means the US
becomes more dependent on foreign bond-buyers by the month.
The Administrations forecast through 2019 assumes that foreign creditors
appetites for Treasurys will grow at least as fast as the national debt. It predicts
sustained real GDP growth of 3% per year, with no recessions, no increases in
taxpayer cost for health care, anddespite sustained deficits and a doubling
of the national debt-to-GDP ratio (excluding Fannie and Freddie debt) from
41% to 82%long Treasury yields will not rise more than 1%. (We spoke
at a Canadian financial conference last month at which Niall Ferguson was
the star. He flashed that forecast up on the screen and said, Those arent real
forecasts: theyre Mickey Mouse numbers.)
Despite the current deficit of 12% of GDP, and despite increasing grumblingabout Washingtons willingness to incur huge deficits in bad times and good,
the foreign support of the dollar by buying Treasurys continues. There has
been one little-remarked change in the investment strategy of Americas
Sugar Daddy #1: in recent months, China has been rolling over its maturing
Treasury notes into T-Bills. It thereby chooses to forgo interest of 2%3.4%
in favor of near-Zero yields. What power, one wonders, does Beijing think,
comes from a Zero return in a weakening currency? And why is that putative
power growing so relentlessly?
Those arent real
forecasts: theyre
Mickey Mouse
numbers.
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The Power of Zero
THE COXE STRATEGY JOURNAL
A fast-growing Monetary Base at a time of Zero yields is the best a central
bank can do to prevent a Depression and get the economy moving again.
But it is based on redistributive justice: it takes wealth from savers and gives
it to the bad banks that caused the crisis. To add insult to that injury, many
of the most prominent of those bankers are paying themselves huge bonuses
for being so brilliant and creative as to take the free money and invest it
up the yield curveor across the wide range of risk assets, which are rising
robustly together. Goldman is the biggest winner from this wealth transfer:
even its mid-term debt only costs around 2%. Its CEO told the audience in a
London church that he does Gods work. This is the bank that, according
to reports about the tense bailout days, would have been dead within hours
had Paulson and Bernanke and friends not rescued AIG and Morgan Stanley.
Goldmans bonuses for this year will exceed the GDPs of 107 nations. Aintfree enterprise grand?
A Zero yield has been the Bank of Japans policy for most of the time since its
Triple Waterfall Crash commenced nearly 19 years ago. Our personal favorite
member of the BOJs Board then, was its only female, Eiko Shinozuka. She
consistently voted against near-Zero deposit rates. She claimed to represent
the generation that had pulled Japan out of its desperate condition after
World War II through its hard work and high savings rate. With state
pensions being so modest, and with the children of postwar generations
being less willing to perform the historic role of looking after their parents
and grandparents, people had to save for their old ageand nobody on
Planet Earth seemed to live as long as the Japanese. Amazingly, these people
did save remarkable amounts, and their favored deposit institution was the
Post Office, particularly after the banks began to implode. As interest rates
on deposits fell by more than 90%, her people were driven into penury to
prop up the bad bankers.
She reiterated those vigorous objections at almost every BOJ Board meeting,
and the male gerontocrats who made up the rest of the Board thanked her for
her contributionand continued to make the near-Zero-cost contributions
to the banks.Led by the Fed, central banks across the OECD have been Japonized.
They drive rates of bank deposits and money market funds toward Zero to
stimulate borrowing and enrich a flagging, flabby banking system.
...it is based on
redistributive justice:
it takes wealth from
savers and gives it to
the bad banks that
caused the crisis.
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Not that the top dogs at the big, bad, bonused bailout banks (Hereinafter
called the B5) show penitence, gratitude or humility about this process: they
consider controls on their bloated incomes socialistic, and warn loudly
about the dire consequences for a free enterprise economy if Washington
and Whitehall suppress their astonishing bonuses.
Wherever his spirit rests, Benjamin Franklin must be livid. When the hard-
earned savings of ordinary people are looted to enrich greedy bankers, and
when they are told that this process is necessary to make America prosperous
again, no wonder so many citizens have displayed so much anger at Tea
Parties.
But the problems of the thrifty members of the lower- and middle-classes
who are losing so heavily from Zero yields may not continue endlessly in aJaponaise stasis. They could get worse: todays extreme monetary policies and
humongous deficits are laying and fertilizing the seeds of the next inflation,
which will be characterized, in the early stages, by sharp increases in the prices
of such necessities as food and fuels. Milton Friedman correctly predicted in
1973 that fast monetary expansion at near-Zero real yields would ultimately
trigger inflationand he was vindicated when US CPI reached double-digits
during the next recession.
We recently participated in a panel discussion organized by the Canadian
Consulate in Denver. The lead speaker was David Dodge, retired Governor of
the Bank of Canada. (Longtime readers will remember that we were calling
him North Americas Greatest Central Banker during the years when Alan
Greenspan was being accorded mythic powers.)
We were there to discuss when and how governments and central banks
should employ exit strategies from their current expansionary policies. With
one exception (a portfolio manager who insisted government deficits should
be expanded until unemployment reached zero), the panel agreed that the
level of current monetary expansion and deficits was unsustainable and
potentially dangerous.
Mr. Dodge was particularly eloquent on the high risks of maintaining currentmonetary and fiscal policies. He is really worried about the potential for
worrisome inflation and much higher interest rates that would choke off any
recovery.
...the big, bad,
bonused bailout
banks (Hereinafter
called the B5)...
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THE COXE STRATEGY JOURNAL
The first sign that the foreign central banks whove been trying to protect
their currencies from over-appreciation against the dollar may be reassessing
their forex strategies came with last weeks announcement by the Reserve
Bank of India that it was swapping a portion of its holdings into 200 tonnes
of gold the IMF is selling. That helped send gold to new highs.
MacroMavens, a routinely brilliant and thoughtful contrarian research
publication produced by our friend Stephanie Pomboy (who presciently
predicted the Crash with her in-depth studies of banks balance sheet
problems and the unfolding real estate collapse), issued the following chart
last month:
The chart displays the extent of the monetary masochism of the banks abroad
whose purchases keep yields across the curve on Treasurys, Fannie and
Freddie at unrealistically low yields. Zero T-Bills form the base of a debased
debt market.
As troubling as Zero is for savers, it also poses problems for portfolio
strategists.
Global Forex Reserves
Real vs. Nominal(adjusted for the dollar decline)
February 1, 2003 to October 23, 2009
Source: Stephanie Pomboy, MacroMavens, LLC.
0.8
1.1
1.4
1.7
2.0
2.3
2.6
2.9
3.2
Feb-03 Oct-03 Jun-04 Feb-05 Oct-05 Jun-06 Feb-07 Oct-07 Jun-08 Feb-09 Oct-09
Nominal Real
3.19
1.06
Zero T-Bills form the
base of a debased
debt market.
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8/14/2019 BMO CM Basic Points Nov 2009
19/4315November
The Problem of Zero in Portfolio Construction
Although portfolio construction for pension and endowment funds has
become far more sophisticated and mathematical in recent years, its basic
process can be easily summarized.
In the classic capital asset pricing model for balanced portfolios, the investor
sets the projected long-term rate of return for the Risk-Free Asset (Cash)
and then assigns expected return rates based on volatility and endogenous
risk assumptions for the other asset classes that are under consideration
for inclusion in the Fund. The expected rates of return rise along with the
perceived risks in each asset class. An Efficient Frontier is then created that
mathematically balances risk and reward to achieve the minimum needed rate
of overall portfolio return. A pension fund meets its regulatory requirementsfor funding if the value of its current holdings, plus the compounded
projected returns of the asset classes meet its liabilities.
We have participated in many such portfolio designs over the decades, and
well recall how high rates of return on Cash bedeviled the process. When
the risk-free rate was as highor higherthan the historic long-term rate
of return on equities, it meant committees had to use the long-term rates on
Cash to build the model. That was accomplished by assuming a lower rate
going forward, because the duration of Cash is near-zero. Moreover, as of
August 1982, when the Reagan bull market began, the Constant Dollar Dow
Jones was at 1929 levels, indicating that the only real returns that had beenearned on equities in 53 years were dividends.
How does a portfolio optimizer deal with the Problem of Zero?
The obvious answer might be, Easily. It means all asset classes are hugely
attractive relative to Cash and no allowance for Cash will be made apart from
minimal liquidity concerns.
A more thoughtful answer should be, Zero Cash means big problems for
overall construction. Assuming that a Fund needs to earn a nominal 7%
overall, net of fees and costs, then the higher the Cash component, the higher
must be the rate of return assumptions for the other asset classes. Without
tinkering with those assumptions, then the higher the Cash component, the
higher the risk and volatility the portfolio must assume. Such asset classes as
Junk Bonds, Leveraged Loans, and small Emerging Markets might have to be
quite big commitments for the Fund to meet its objectives.
This is a challenging time to be designing pension fund portfoliosor asset
mixes for individual investors.
How does a portfolio
optimizer deal with the
Problem of Zero?
-
8/14/2019 BMO CM Basic Points Nov 2009
20/4316 November
The Power of Zero
THE COXE STRATEGY JOURNAL
According to BCA Research, US stocks have delivered an annual compounded
real rate of return ofnegative 4% for the past decade, while 10-year Treasurys
have given a positive annual real rate of 3.6%. (Embarrassingly, gold was
the top-performing asset class, delivering an annual real rate of return of
10.8% in that same time period. Commodities futures did 5.2%. How many
consultants or equity analysts during the perfervid period when tech stocks
were heading skyward told pension plans gold bullion would do three times
as well as US stocks for the next decade? Or, for that matter, how many
told their clients Emerging Markets shares would outperform the S&P by a
compounded real rate of 11.5%?)
Amid all the enthusiasm about soaring stocks and an economic recovery, it is
wise to retain ones perspective about what has happened to investors.
Last week, the Bank of America summed up the disappointments of our era
for institutional investors. It noted that there were 42 trading days left this
year, and the S&P would have to rise 42% to deliver a Zero rate of return for
the past decade.
By some calculations, on a compounded basis, long Treasurys have
outperformed the S&P since the beginning of the Reagan bull market. The
problem with those data is that they assume sustained reinvestment of
interest at the long end of the curve, but most bond managers would have
been below benchmark duration for extended periods, which meant their
cash income would have been reduced.
Apart from that nitpick, what that number shows is that capitalism has failed
its most basic testdelivering higher returns to investors than was paid on
risk-free government bonds. And this was the best of all times in the best of
all capitalist worlds: classic economic liberalism was becoming the fashion
everywhere outside North Korea, most of the Arab world, and Cuba. There
were more playing fields for multinationals than ever, corporate tax rates
were generally declining, there were no major wars, the supply of highly-
educated engineers, MBAs and CFAs was at record levels, and business was
more respected than it had been since the onset of the Depression.
...capitalism has
failed its most basic
testdelivering
higher returns to
investors than was
paid on risk-free
government bonds.
-
8/14/2019 BMO CM Basic Points Nov 2009
21/4317November
And yet a robot reinvesting 30-year Treasury coupons would have out-
performed the S&P Indexwhich itself outperformed most managed
accounts.
Constructing a pension fund portfolio and projecting its forward returns in the
Age of Zero could be termed a faith-based initiative.
One of the biggest cheerleaders for the 1990s US bull market was Jeremy
Siegel. The first edition of his best-sellingStocks for the Long Run came out in
1994. His data demonstrated the near-certainty of stocks as winners showing
inter alia For horizons of 20 years or more, bonds are riskier than stocks.
Then came Nasdaqs Triple Waterfall Crash and a recession, and his Absolute
Law had joined the phlogiston theory in historys trash heap.
After the 2008 Crash, we were hit with blizzards of advice about how wise it
was to hold Cash. Some money managers got heavily into Cash before the
Crash, and many other managers assured worried clients that they would
be holding higher levels of Cash until the next bull market was established
(whenever that happened).
The amount of Cash and Excess Bank Reserves in the US economy is at
all-time records, mostly because of Bernankes panicky doubling of the Feds
balance sheet. But this is a construct, not a solidly-based financial reality.
It recalls a well-known passage in the Bible:Consider the lilies of the field, how they grow. They toil not, neither do they
spin: And yet I say unto you, not even Solomon in all his glory was arrayed
like one of these.
Cash was splashed among the B5 to array their balance sheets, which were
looking Gandhian in their skinniness. But the B5 re-deposited a huge slug of
those funds with the Fed as excess reserves: why go through all the nuisance
involved in making loans to individual companies? They also bought up the
Treasury curve. These bankers toil not much, but they spin like mad: they
keep trying to convince us that they didnt cause the Crash, and they really
deserve their big bonuses.
These bankers toil
not much, but they
spin like mad...
-
8/14/2019 BMO CM Basic Points Nov 2009
22/4318 November
The Power of Zero
THE COXE STRATEGY JOURNAL
US Monetary Base (adjusted for Changes in Reserve Requirements)
January 1, 1970 to October 30, 2009
Source: St Louis Federal Reserve, database: FRED (Federal Reserve Economic Data)
Note: Shaded areas indicate US recessions; seasonally adjusted
Source: St Louis Federal Reserve, database: FRED (Federal Reserve Economic Data)
30 Year Mortgage Rates
April 1, 1971 to October 1, 2009
Fed Funds (Effective Federal Funds Rate)
January 1, 1970 to November 6, 2009
Source: St Louis Federal Reserve, database: FRED (Federal Reserve Economic Data)
-
8/14/2019 BMO CM Basic Points Nov 2009
23/43
-
8/14/2019 BMO CM Basic Points Nov 2009
24/4320 November
The Power of Zero
THE COXE STRATEGY JOURNAL
Zero and Market Volatility
Why is it that all risky asset classes suddenly seem positively correlated to
each other?
The answer is that near-Zero borrowing costs at a time banking systems are
being flooded with fundsboth from government-insured deposits and
the buildup of liquidity from the Fedconstitute an historically-unique
inducement to the big banks and to their leading hedge fund clients to
borrow and speculate.
Last week, according to The Wall Street Journal, the World Bank expressed
alarm about asset price bubbles in equity markets across Asia, and in real
estate in China, Hong Kong, Singapore and Vietnam, and the IMF chimed
in with fears that surging Hong Kong asset prices are driven by a flood of
capital divorced from fundamental forces of supply and demand.
Hong Kong, of course, pegs its currency to the dollar, which means it
outsources its monetary policy to Ben Bernanke. The Zero rate automatically
means a weak dollarhere and in Hong Kong. To a somewhat lesser degree
it means a weak renminbi.
Central bankers have soothed us with assurances that rapid monetary growth
will not trigger inflation as long as economies remain weak. But they said that
in the 1970s, and commodity inflation proved them wrong.
The price of oil in recent months has traded almost in inverse lock-step with
the value of the dollar. This isnt the longer-term adjustment that characterized
the 1970sits occurring in real-time.
This daily activity mocks the reliance traders used to place on actual data
about oil supplies and demandsparticularly the weekly data about US
supplies of oil and refined products.
Many of the metalsnotably aluminumno longer trade primarily based
on LME inventory data. They dance to the global risk music of the markets.
Stocks trade together globally on a day-to-day basis. Yes, Emerging Marketscontinue to outperform the S&P, rising more than New York on bullish days,
and not falling as hard, on days risk is being unwound.
They dance to the
global risk music of
the markets.
-
8/14/2019 BMO CM Basic Points Nov 2009
25/4321November
The Barons of the B5 are reporting record trading profits, which means, as
Nouriel Roubini warns, thatsystemic risk is increasing, not decreasing. The locus
of this new risk has moved from toxic, untraded products whose values are
shielded against market pricing to marketable investments of nearly all
stripes.
That the Canadian dollar should rise and fall with metal and oil prices is not
surprising, but the euro also rises and falls, though not as much, as the loonie
on days of dollar weakness as dollars are borrowed and invested outside the
dollar zone in commodities and stocks across the world.
Problem: if the US economic recovery falters, a myriad of global risk assets
could be simultaneously subjected to the same kind of risk-unwinding
devastation as occurred after the Midnight Massacre and the collapse ofLehman, which were US-specific events. But this time, the Fed and most other
central banks would not be able to unleash needed liquidity by lowering rates.
The banking crisis was tied initially to subprime and other illiquid and
unmarketable assets. The Fed, the Bank of England and the European Central
Bank have taken trillions in overpriced toxic assets from the banking system,
directly, and through support of mortgage lenders such as Fannie and
Freddie, the Federal Home Loan Banks, and various European lenders. (The
Financial Times cites a Bank of England study that pegs total government and
central bank aid to private financial institutions at $14 trillion, which it calls
socialism for the rich.)
That unprecedented process was designed to prevent a Depression, revive the
banks, and free their capital for productive lending. However, the B5 banks
have used the funds to reload their trading desks, concentrating on market-
priced assets and derivatives tied to those assets.
As for the thousands of regional US banks on which an economic recovery
depends, they have not participated in the sudden explosion of trading
profits that have restored the B5 banks and their bloated bonuses. They have
to make their money the old-fashioned wayand thats tough these days.
...the thousands
of regional US
banks on which an
economic recovery
depends.....have to
make their money
the old-fashioned
wayand thats
tough these days.
-
8/14/2019 BMO CM Basic Points Nov 2009
26/4322 November
The Power of Zero
THE COXE STRATEGY JOURNAL
As clients are aware, we have long believed that the real US economy depends
far more on the health of Main Street banks than on the machinations of the
B5. And Main Street is hurting: more and more regional banks are folding,
and the FDIC Fund that insures bank deposits is the next government money
pool to face drainage. (The huge Federal Housing Act pool is also being
drained rapidly, but its lumped into overall Treasury statistics and can be
replenished without special legislation.)
CITs bankruptcy is a synecdoche for Main Street Americas problems. As the
largest factoring company, it has beenfor many decadesa reliable backstop
for small and medium-sized businesses across America. Companies assigned
their receivables to CIT, thereby allowing them to continue to sell their
output profitably, even to sophisticated giants such as Walmart and Amazon,
which are famously successful at boosting their cash flows by delaying their
payments to suppliers for months. Their local banks would assist in financing
inventories and making loans for capital investment secured by real estate
liens and owners personal guarantees. CIT is now operating in bankruptcy,
but it is hardly in shape to perform its historic functions as demand for
factoring rises in response to an economic recovery.
The Tea Party rages about the stimulus and bailout programs were signs thatMain Street was watching in horror the trillions going to Wall Street while
the lenders communities needed most were cutting back on lending, and
were buckling under the weight of their heavy exposure to local construction
loans backed by mortgages on properties whose values were plunging.
KBW Regional Bank Index ETF (KRE) relative to S&P 500
November 10, 2008 to November 10, 2009
50
60
70
80
90
100
110
Nov-08 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09
57.34
...Main Street was
watching in horror
the trillions going to
Wall Street while the
lenders communities
needed most were
cutting back on
lending...
-
8/14/2019 BMO CM Basic Points Nov 2009
27/4323November
The spreading bankruptcies in shopping centers havent just devastated
major operators like the Bucksbaums. Many of the shops in those centers
are locally-owned, and as vacancies spread across the centers, the surviving
shops suffer sharp declines in walk-in businessand they default on their
bank loans.
The KRE has fallen to a new low on Relative Strength against the S&P at a
time of a booming stock market and record bonuses within the B5.
This is really bad news for small and medium-sized businesses, which are the
traditional engines of job creation. And the proprietors of those businesses
are, as industry surveys show, very worried about the effect of todays gigantic
deficits on tomorrows income tax rates.
The realization that the trillion-dollar deficits are destined to continue, even
when the economy gets back to sustained growth, frightens them. They hear
that they will be subject to much higher taxes on the rich, and hear that the
term rich means people who earn more than $500,000 a year. (According
to The Wall Street Journal, if the tax rate in 2007 were 100% on Americans
earning over $500,000 a year, that would have generated just over a trillion
in Treasury receipts.)
The 1990-page health care legislation not only has the millionaires taxes
on those earning above $500,000, but imposes high extra taxes on small
businesses which do not offer health care to their employees.
Doubtless, local bankers will be looking at the effects of these permanent tax
increases and mentally marking down their customers ability to service their
loans in future years.
There will not be the kind of sustained US economic recovery that will drive
a sustained US bull market until the shares of the Main Street (KRE) banks
begin to outperform both the B5 banks and the S&P.
The relatively obscure KRE is, we believe, the most reliable indicator of
whether the panoply of political programs is truly kick-starting a sustainable
US recoveryand whether the optimism of US equity investors is justified.
The...KRE is...
the most reliable
indicator of whether
the panoply of
political programs is
truly kick-starting
a sustainable
US recovery.
-
8/14/2019 BMO CM Basic Points Nov 2009
28/4324 November
The Power of Zero
THE COXE STRATEGY JOURNAL
No one can predict the limits on the capacity of the Fed and Congress to keep
finding new money to spend on rescues and stimulus. When the crisis was in
its early stages, Bernanke told Congress, Well do whatever is necessary (to
rescue the economy). Obama and Congressional leaders have made similar
pledges.
But there are limits on what even the Fed and Congress can do. At some point,
conditions have to return to normal and the regional banks have to take up
the slack. Thenand only thenwill investors be able to safely conclude
that the recovery has become the reality to be used in valuing all financial
assets. The life insurance industry wasnt built on issuing term policies to
cardiac cases in the Intensive Care Units.
We continue to recommend that clients take advantage of the stock markets
Zero-based budgeting of financial riskand scale back their exposure to
US economy-related shares. With the forward P/E on the S&P reaching 19,
it seems to be priced on the assumption that if Goldman is paying record
bonuses, the economys underpinnings are now strong enough to support
fast economic growth.
Can stock prices fall even as liquidity flows surge amid Zero rates and Zero
monetary restraint?
The Greenspan bubbles that collectively came to be known as the Greenspan
Put gave us Nasdaq at 5,000 and other enormities. Barring a multi-year
recovery that drives unemployment to relatively painless levels, this bubble
could make Greenspan look like a piker.
A tale from Main Street (or, more precisely, Chicago Avenue).
KBW Regional Bank Index ETF (KRE) relative to KBW US Bank Index (BKX)
June 22, 2006 to November 10, 2009
80
100
120
140
160
180
Jun-06 Oct-06 Feb-07 Jun-07 Oct-07 Feb-08 Jun-08 Oct-08 Feb-09 Jun-09 Oct-09
102.79
The life insurance
industry wasnt built
on issuing term
policies to cardiac
cases in the Intensive
Care Units.
-
8/14/2019 BMO CM Basic Points Nov 2009
29/4325November
Sunday in the Park With Feds
The Park National Bank has long been a fixture on Chicagos Gold Coast. We
walk by it nearly every business day. With a lovely building, a spacious parking
lot, and a location near Washington Square Park, it has always represented
prudence and prosperityjust what an upscale community expects from its
local bank.
Then, on Sunday November 1st, it was taken over by the Feds. It was well-
capitalized, and then it was toast.
Why?
It was owned by a failed bank holding company that had two bad banks
in Texas, three in California and one in Illinois. Among the now-necroticinvestments those banks made during the bubble years were the preferred
shares of Fannie and Freddie. As The Wall Street Journal reported, When
regulators shuttered the flailing [sic] banks after closing hoursthe FDIC
leaned on Citizens National Bank and Park National Bankto foot the bill.
The two banks were unable to pay the amounts assessed and were closed by
their chartering authorities, the agency said.
It is a measure of these frenetic times that Park Nationals demise came only
hours after Tim Geithnerat a ceremony in Chicagoawarded the bank
$50 million in tax credits to to help spur community-development projects
in low-income communities. (Geithner knew nothing of the closure. TheFDIC keeps bank closures secret until they actually happen. Its not the first
time Geithners been chatting with management of a bank about to vaporize,
but its probably the first time that he praised a bank for good management
and gave it a big gift for future programs after it had ceased to function.)
But the good news is that after some bank deaths, there is resurrection. US
Bancorp bought the collection of nine good and bad banks, the FDIC wrote
off $2.5 billion, and Park National has reopened as a branch of Minneapolis-
based US Bancorp.
What? We worry?
...its probably the first
time that [Geithner]
praised a bank for good
management and gave
it a big gift for future
programs after it had
ceased to function.
-
8/14/2019 BMO CM Basic Points Nov 2009
30/4326 November
The Power of Zero
THE COXE STRATEGY JOURNAL
Zero Rates and Gold
GoldNovember 1, 2000 to November 10, 2009
200
350
500
650
800
950
1,100
Nov-00 Nov-01 Nov-02 Nov-03 Nov-04 Nov-05 Nov-06 Nov-07 Nov-08 Nov-09
1,115.50
Fed Funds
November 1, 2000 to November 10, 2009
Source: St Louis Federal Reserve, database: FRED (Federal Reserve Economic Data)
For as long as there has been a free market in gold, the most-cited argument
against investing in bullion has been that its sterile: it pays no interest or
dividends, so why should anyone own it? Its not as if it were a painting byRembrandt or even Renoir that has unique scarcity value. Theres lots of gold,
theres lots of gold mines, and nearly all the gold thats ever been mined is
still above ground and is either in vaults or in jewelry.
...the most-cited
argument against
investing in bullion has
been that its sterile...
-
8/14/2019 BMO CM Basic Points Nov 2009
31/4327November
So why, at a time when consumer inflation seems little more threatening
than attacks from vampires, is gold leaping to new all-time highs even if
adjusted for compounded inflation back to the date of the release of the
classicDracula (1931).
Some possibilities:
1. Its a risk asset, so its benefiting from the rush to risk.
2. Borrowing at Zero to buy something with Zero yield is income-neutral.
3. Its the only asset that, based on history, outperforms underboth horror
storiesDepression and Hyperinflation.
4. Its upside breakout came at the time of Halloween.
5. India announced purchase of half the hoard on offer from the IMF, which
had been weighing on gold prices, and there are rumors that China will
take up the rest. This was the second surprising announcement from
India within a fortnight. The other was that the United Arab Emirates had
displaced such nations as the US, China and Germany as Indias biggest
trading partner in recent months. Apart from tea, and gold in the form
of baubles, bangles and beads, what big-ticket exports other than bullion
could India be sending to that collection of gold-loving states? Its no
longer exporting rice or sugar.
6. Statistics from across the world confirm that the economic recovery isgaining steam, so the specter of inflation is moving stealthily from deep
in the primeval forest toward the main path. Travelers beware.
7. Barrick CEOs statement in London about the continuous decline in new
gold mine output, suggesting, There is a strong case to be made that we
are already at peak gold. The golden rule of commodities has been that
the cure for high prices is high prices: when the price of stuff goes up, big
new production always follows, and the price goes down. Golds price
has more than quadrupled, but new-mine production keeps falling. With
central banks apparently switching from the sell to the buy side, this may
be a new world for the oldest store of value.
8. All of the above.
So why, at a time when
consumer inflation
seems little more
threatening than
attacks from vampires,
is gold leaping to new
all-time highs...
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8/14/2019 BMO CM Basic Points Nov 2009
32/4328 November
The Power of Zero
THE COXE STRATEGY JOURNAL
Is gold overvalued? In terms of a reliable historic indicator, it may depend on
how you define a gentleman. The Economistonce sought to find a true value
of gold with a study showing that, for most of the time since the Middle
Ages, an ounce of gold would buy a gentlemans suit in London. That was
not the case on Jermyn Street from 1981 through 2007 even for the less-
prestigious tailors. With the recent decline in the pound, it is now applicable
to the shops located more than two blocks from St. Jamess Street. (It hasnt,
we believe, applied at Savile Row since King Edwards time.)
As gold and silver rise to higher peaks, we hear more and more stories that
serious investors are demanding bullionnot financial paper, whether in
futures or in the gold ETFs. (The GLD has been termed, The small investors
central bank.) Some prominent skeptics question whether the ETFs actually
own all the gold they claim, or whether they depend on counterparties to
make delivery. The core attraction of gold for those who fear an epochal
financial crisis is the absolute reliability of bullionthe only asset that is no
ones liability. These investors are now shying away from any investment that
relies on counterparties or on regulation by any financial authorities.
Roosevelt made ownership of gold illegal by Presidential order. Could such
intervention occur again? Impossible, say bankers.
A skeptic might well note that no one predicted the scale of intervention into
financial markets from governments and central banks that began with the
Midnight Massacre, so why should gold claims that need to be satisfied with
futures contracts or other counterparty arrangements be forever immune
from attack?
We do not share these morbid fears, but no longer characterize them as the
particular problems of the perpetually paranoid.
We do not share these
morbid fears, but no
longer characterize
them as the particular
problems of the
perpetually paranoid.
-
8/14/2019 BMO CM Basic Points Nov 2009
33/4329November
David Dodge began his speech in Denver by saying, This is a rebound, nota recovery. He considers it a snapback from an oversold position, fueled by
record amounts of monetary expansion, subsidies and deficits. He was not
very confident about the prospects of a sustained recovery, without some
setbacks.
We find ourselves bemused by the confidence displayed by forecasters who
(1) didnt predict the Crash, and (2) use charts and tables from past economic
recoveries in proof of their assertions that the best is yet to comeand
nothing really painful lies in between.
We freely admit we dont know whats going to happen to the US economy
over the next five years. But we do believe that Americans arent going to live
happily ever after if regional banks finances continue to weaken.
The challenges:
1. The root cause of the financial and economic collapsethe demographically-
driven plunge in real estate prices at a time of serious over-leverage in the
housing sectorremains a clear and present danger to banks and other
financial institutions.
2. All the US governments home mortgage lending institutions are
experiencing rising losses, despite the slight uptick in house prices. Thatbarely-observable bounce is due to most drastic price maintenance
program in historytaxpayer bailouts of lending institutions, the Feds
huge subsidy to mortgage rates through purchases of Fannie and Freddie
paper, and 10-year notes, and the First-Time Homebuyer Subsidy of $8,000.
It took all those trillions to get house prices to rise 4% from their panic
lows. Why should investors be confident the rally will continue? Steins
Law, which has never been repealed, may be ready to be proved anew:
If something cannot go on forever, it will stop.
3. Bernanke will have used up his entire declared quota of purchases of long
Treasurys and mortgage-backed paper within a few months. Then what?
4. Commercial real estate grows sicker each month, as office and condo
vacancy rates rise, and more and more regional banks go to the wall.
5. The biggest contributor to the 3.5% economic growth of the Third Quarter
came from the Cash for Clunkers program. That is gone.
The Power of Zero
INVESTMENT ENVIRONMENT
Steins Law, which has
never been repealed,
may be ready to be
proved anew...
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8/14/2019 BMO CM Basic Points Nov 2009
34/4330 November
The Power of Zero
THE COXE STRATEGY JOURNAL
6. The only US auto company to report positive cash flow in the Third
QuarterFordstill struggles with a boom-year-negotiated UAW contract
that means its labor costs are much higher than the other members of
what used to be known as The Big Three. Since the UAW and Washington
effectively own those competitors to Ford, theres slim chance the union
will do anything to strengthen Ford: if Ford collapses, so much the better
for the union-owned Big Two. Chrysler has no hot new products in the
pipeline and an ambiguous management agreement with Fiat. GM is
adjusting to a shrunken product base and its finance subsidiary, GMAC,
has already received four emergency cash infusions from Washington since
the bankruptcy. Hyundai, no friend of the UAW, is the hottest company
in US sales. The current noise on Detroit assembly lines could turn out
to be a death rattle.
7. What may have been the most useful consumer economic stimulusthe
collapse in gasoline pricesis fast becoming a cherished memory. Gasoline
prices have already retraced roughly half their plunge. That most useful
of all tax cuts is being chipped away, as other taxes at federal, state and
local levels face inevitable increases.
8. Although overall consumer inflation remains near the Zero level, food
prices continue to rise relative to other costs, and natural gas prices are
no longer at remarkably cheap levels.
9. And it looks to be a cold winteratmospherically and otherwise.
So what should investors do?
Although commodity stocks underperformed the S&P from June through
September, they have resumed the outperformance they displayed for most of
this decade. Meanwhile, Chinas rush to lock up global supplies of industrial
commodities continues at breakneck speed. Niall Ferguson predicts that by
mid-2010, China will be a net seller of Treasurys because of its fast-growing
allocation to commodities. Nor is China alone: Indian companies are now
scouring the globe for commodity-producing assets, and Saudi Arabia is
buying grain land in many parts of the world.
As much as we are concerned by the insouciance of US equity investors,
we remain convinced that investment in commodity stocks has both lower
endogenous risk and higher long-term potential than US equities generally.
The current noise on
Detroit assembly lines
could turn out to be a
death rattle.
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8/14/2019 BMO CM Basic Points Nov 2009
35/43
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36/4332 November
The Power of Zero
THE COXE STRATEGY JOURNAL
Whenever there is a huge disparity between what nearly everybody who
matters believes and the actual conditions of the economy or the world,
investors who are prepared to bet that reality will eventually assert itself can
win big.
This could be one of the biggest such disjunctions in modern history. Yes, the
sun could suddenly go back to emitting sunspots at the rate of the previous
century. Yes, scientists still maintain that, despite eight centuries of evidence
of a correlation between sunspot activity and recorded temperatures on
Earth in the 80% range, there is no scientific proof that this is anything but
coincidence.
Damon Runyon observed, The race is not always to the swift, nor the battle
to the strong, but that is the way to bet.
In a chat with a knowledgeable investor last week, he commented on
Warren Buffetts willingness to pay so much for Burlington Northern. That
railroad, he observed, has two main businesses: transporting manufactured
goods from the West Coast to the East, and transporting steam coal from
the Rockies. Coal stocks are, perhaps, potentially the biggest losers from
the Administrations climate change legislation and regulations. If investors
began to conclude that the scientific community were going to reconsider
its view on global warming because of the plunge in solar activity, many
companies shares would benefit big, but probably none more than those of
the US coal companies.
...investors who are
prepared to bet that
reality will eventually
assert itself can win big.
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RECOMMENDED ASSET ALLOCATION
Allocations Change
US Equities 17 unch
Foreign Equities
European Equities 5 unch
Japanese and Korean Equities 2 unch
Canadian and Australian Equities 11 unch
Emerging Markets 14 unch
Bonds
US Bonds 12 unch
Canadian Bonds 8 unch
International Bonds 11 unch
Long-Term Inflation Hedged Bonds 10 unch
Cash 10 unch
Years Change
US 5.25 unch
Canada 5.00 unch
International 4.50 unch
Recommended Asset Allocation(for U.S. Pension Funds)
Bond Durations
Change
Precious Metals 33% unch
Agriculture 33% unch
Energy 22% unch
Base Metals & Steel 12% unch
Global Exposure to Commodity Stocks
We recommend these sector weightings to all clients
for commodity exposurewhether in pure commoditystock portfolios or as the commodity component ofequity and balanced funds.
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THE COXE STRATEGY JOURNAL
INVESTMENT RECOMMENDATIONS
1. Remain underweighted in US equitiesas a percentage of total equitieswithin global portfolios, and as a percentage of assets in US balanced
portfolios. Underweight US bonds in global portfolios.
The Obama long-term financial projections for the US are high risk and
unsustainable. Forthcoming electionsor a currency crisiscould induce
some discipline, but within the OECD, the US should probably no longer
be accorded top ranking for bonds and stocks.
2. Within the US market, underweight US economy-related stocks and
overweight stocks tied to global economic activity.
Watch the performance of the KRE compared to both the BKX and S&P. Aslong as the KRE underperforms both of these indices, US-economy-related
stocks remain suspect.
3. Overweight Emerged Markets (such as China, Brazil, India, and Korea)
within global and international equity portfolios.
These markets should no longer be routinely discounted heavily for
political risk or accounting practices relative to the US. The credibility gap
has narrowed in the past year.
China continues to report robust economic activity and skeptics continue
to proclaimas they have for yearsthat its unsustainable. The time to
sell China, and, for that matter, base metal and energy stocks, is when the
last remaining Sino-skeptic has become unemployed.
4. Overweight the precious metal miners relative to bullion or the ETFs.
The time to overweight the ETF is when precious metal prices have entered
corrections.
The XAU and other gold stock indices have underperformed bullion for
the past two months because of a succession of bad news announcements
for such heavyweights as Barrick, Kinross and Agnico-Eagle. True, we cant
be sure there wont be more reports of disappointing execution among
the miners, but they have the reserves in the ground, and the best of them
have unhedged reserves in politically-secure areas of the world. Investors
who believe current prices could hold should do NAV calculations on the
miners based on current gold and silver prices, and they will see excellent
opportunities in the stocks.
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THE COXE STRATEGY JOURNAL
8. Overweight Canada in both equity and fixed income portfolios, and remain
long the loon against the greenback.
In recent global rankings, Canada ranked #1 in the G-7 for its central bank,
its private banks, and its Minister of Finance (who is the longest-serving
in the G-7a remarkable feat for a minister in a minority government).
The principal knock on Canada is that it is dull. Dull has become the new
shiny.
9. In balanced portfolios with an equity bias, do not hold high Cash
exposures. Hold long-duration, high-quality bonds.
If this rebound becomes a sustained boom, you will loserather
modestlyon this exposure, but your equity holdings will appreciate
substantially, and you will be a net winner. If it becomes a bust, you will
win on the bonds, thereby reducing your overall portfolio loss. Long
bonds now reduce short-term cyclical risk. As of October, speculators
were hugely short 30-year and 10-year Treasurys and hugely long 2-year
Notesconsistent with a bullish call on stocks and the economy. If that
call swings to bearish, there will be a rush to the long end.
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THE COXE STRATEGY JOURNAL
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Published by Coxe Advisors LLC