September 9, 2010
September 9, 2010
published by
Coxe Advisors LLP
Chicago, IL
THE COXE STRATEGY JOURNAL
IBM@1 = Big Ben’s Big Blues
September 9, 2010
Since then, the number we’ve been using for our analysis has been Zero. This
time it’s One: the 1% coupon on Big Blue’s recent $1.5 billion three-year
bond issue, which came—oversubscribed—at par. IBM was AAA back when
its System 360 dominated the industry, but today it doesn’t even make its
own PCs and it is a mere Single A.
The coupon on that bond tolls trouble for “Big Ben” Bernanke and most
investors—particularly pension funds. (IBM’s bond yield is slightly less than
half its stock’s.) The only major economy of the past century that experienced
bond yields in that range has been Japan, a demographic disaster whose
future is modeled on the passenger pigeon.
So now clients, like Scrooge, get a second chance. This time, the reasons
for caution are even stronger, so we are reducing recommended exposures
to non-commodity stocks accordingly. As for bonds, many institutional
bond managers find the Depression-level yields available in quality bonds
insulting. What is left for their investors after management fees? However, for
balanced funds and individual investors, long-duration government bonds offer
portfolio insurance against renewed economic weakness.
Our next issue will come in October, a month known for Halloween and
other kinds of scary events.
September 2010 1
2 September 2010 THE COXE STRATEGY JOURNAL
IBM@1 = Big Ben’s Big Blues
2.4
Sep-09 Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sep-10
1.6
1.4
1.2
1.0
0.8 0.79
0.6
Sep-09 Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sep-10
The optimism of late winter began to melt with the arrival of Spring. By June,
instead of green shoots busting out all over, the jobless claims had begun
a renewed climb, and the historically-reliable Journal of Commerce-ECRI
Industrial Price Index had peaked and rolled over.
September 2010 3
IBM@1 = Big Ben’s Big Blues
70%
...revelations of 60%
10% 9.83%
0%
Aug-09 Oct-09 Dec-09 Feb-10 Apr-10 Jun-10 Aug-10
* The IPI growth rate compares latest week's index with the IPI average over the past year.
Source:
By late summer, some tech giants which had reported blowout Q2 earnings
began issuing warnings that Q3 would be painful. State and local governments
stopped stimulus-driven hiring and began firing. Christina Romer, the cheerful
cheerleader of stimulus packages, suddenly departed from the Obama team.
Larry Summers, who had proclaimed the economy was “approaching escape
speed” was no longer a fixture on Sunday morning talk shows. The President’s
approval rating slid to lows that panicked Congressional Democrats into
putting his global warming legislation into the deep freeze.
30
28
26
24
22 22.11
20
18
Sep-09 Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sep-10
September 2010 5
IBM@1 = Big Ben’s Big Blues
This means the full burden of turning around the sinking economy falls on
the Fed. An angry electorate has rejected the crisis cooperation between the
Fed and the Administration that began in the waning months of the Bush era
and continued through the first half of this year. (That rage is, of course, more
emotional than rational: had the TARP program not been implemented,
many of the biggest banks would have failed, with horrendous economic
consequences. Indeed, a large proportion of the loans made under crisis
conditions have already been repaid.)
September 2010 7
IBM@1 = Big Ben’s Big Blues
Billions of dollars
2300
2200
2100
2000
1900
1800
1700
1600
Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep
2009 2010
To the average of Compounded annual rates of change, average of two maintenance periods ending:
two maintenance
08/26/09 11/18/09 01/27/10 02/24/10 03/24/10 04/21/10 06/02/10 06/30/10
periods ending:
01/27/10 44.8
Source: Federal Reserve Economic Data; Federal Reserve Bank of St. Louis
Source: Federal Reserve System Monthly Report on Credit and Liquidity Programs and the Balance Sheet; August 2010, Board
of Governors of the Federal Reserve System
Ned Davis notes that the May 6th “flash crash” has been a big contributor to
this asset shift: “In the 11 straight weeks leading up to the ‘flash crash’ the
public poured a strong $26.6 billion into equity mutual funds, but in the 16
straight weeks since the ‘flash crash’ they have sold in each and every week,
pulling out $55.9 billion net.”
The “flash crash” is yet more evidence that Wall Street doesn’t get it. Having
most of the responsibility for the 2008 crash that sent millions of people into
unemployment and triggered the worst downturn since the Depression, the
Street continues to whine that it needs room for its “innovations,” and insists
that its big bonuses are the American Way to Prosperity. We heartily concur
with Paul Volcker’s analysis that the only socially useful innovation the
banking industry has produced in recent decades is the ATM. Stock trading in
billionths of seconds by robots to capture minute price differences is a waste
of engineering talent and a mortal threat to the financial system when robots
run amok. We hope that the bosses at Accenture, who advise many leading
financial organizations, were suitably horrified about the value of the new
trading platforms when their stock briefly traded at 14 cents per share during
the “flash crash.” Perhaps we need a new law that says that if there’s another
such financial obscenity, all those trading shops will be shut down for good
and their owners will have to sell the assets of their businesses for 14 cents to
the Social Security Trust Fund.
September 2010 9
IBM@1 = Big Ben’s Big Blues
Dr. Bernanke and friends have ample justification for resorting to what is
already labeled QE2—the second round of Quantitative Easing of Treasury
Rates. Round One began in early 2009 and ended last March, with the Fed
buying $1.4 trillion in government and agency bonds.
...near-Zero interest
What is chilling is the evidence that record-low mortgage rates driven by the
rates that have been
plunge in Ten-Year Note yields have not arrested the decline in house prices
punishing savers since
or the increase in foreclosures.
January 2009...
In other words, the near-Zero interest rates that have been punishing
savers since January 2009 have benefited bankers and corporations—
such as IBM—but have not restored respectability and salability to housing.
The longer this Japonisation of the debt markets continues, the greater the
debilitation of the pension systems—public and private—across North
America. [Our June 2005 issue was titled Japonaiserie. We said, “The Nikkei's
runup and plunge were one-half of a foolish twosome. The other half was
a real estate bubble and collapse. Could the real estate bubble which has
spread across Western economies be a delayed mimicking of the other half
of the ghastly Japanese experience?]
What was billed as a benign bailout and benefit program is, in reality, a
gigantic transfer of wealth from the unsophisticated thrifty (who save through
government-guaranteed bank deposits) to the greedy group of gamblers
and fools who—in large measure—created the crisis: Wall Street’s trading
platforms. (It has also been good to IBM and other corporate bond issuers,
and to well-managed banks that are doing their part to make credit available
to responsible borrowers, but that cross-subsidy is socially justifiable because
it does in fact lead to higher levels of economic activity. The rain falleth on
the just and the unjust alike.)
It is clear that the Fed and the Treasury will continue to pour money into
the twin sinkholes that polluted the housing landscape—Fannie Mae and
Freddie Mac (F&F). Now that they—and the Federal Housing Authority—are
financing or guaranteeing roughly 90% of residential mortgages, there is
no possibility that Washington will either stop the process or go after such
political eminences as Franklin Raines and Jamie Gorelick who received
more than $200 million for mismanaging Fannie during the years when its
books were cooked and it was expanding its market share by increasing the
risk component of its portfolio.
September 2010 11
IBM@1 = Big Ben’s Big Blues
In one respect, Bernanke & Co. are making things better for us all: in a process
unique within the Washington power structure, they are slowing down the
growth in the national debt while the other power centers are rapidly raising
it. As The Wall Street Journal reports, by driving down Treasury yields, they
Maybe the Fed will reduced the government’s interest costs by 22% in 2009—while the debt
become the nation’s outstanding was rising 30%. An optimist would say that less pain from a
biggest used car dealer. record debt gain is financial prestidigitation on epic scale; a pessimist would
say that the Bank of Japan did precisely that for a decade, and Japan still
ended up with the worst debt/GDP ratio in the industrial world.
The housing optimists cite affordability as the reason for believing house
prices should be stabilizing—or even rising. They cite the Q2 uptick in the
July Case-Shiller Index as a hopeful straw in the wind; we believe it reflected
the fast-forward effect of the temporary tax credit on house purchases, which
has since expired.
Since mortgage rates are priced off the Ten-Year Note, Bernanke & Co. could,
at least in theory, make house-buying irresistibly painless by driving the
Ten-Year yield below 2%.
We believe that this is a very likely Fed response. It has the advantage that if
house prices really rallied, the federal subsidy in underpriced debt would be
gradually reduced as homeowners moved or died.
Already, economists are discussing which Fed innovations lie ahead if the
economy etiolates further. Among the suggestions for neat new ways to debase
the Monetary Base: buying up large parcels of credit card and automobile
debt. (Who knows? Maybe the Fed will become the nation’s biggest used car
dealer. “Buy from Big Ben, Who’s Got the Biggest Deals!”)
The Democrats controlled Congress during the late years of Bush’s term, and We suspect that future
resisted all Administration attempts to rein in F&F and reduce Washington’s historians will largely
wide-ranging inducements to banks and mortgage brokers to make loans absolve him—
to impecunious borrowers. Presidents love to brag that they create jobs and will also largely
and prosperity, but Congress writes the laws and spends the money. The absolve Bush.
congressional barons, jealous of their prerogatives, served Obama poorly
by passing thousands of pages of ill-designed laws that undermined the
effectiveness of his recovery programs.
His failure came from his analysis of previous Presidents’ problems when
Congresses rebelled against detailed legislation prepared in the White House,
insisting that lawmaking was not an Administration prerogative. His strategy
was to promote a concept heavily in speeches across the land, relying on his
personal magnetism, while outsourcing the actual drafting to the Democratic
Congress.
September 2010 13
IBM@1 = Big Ben’s Big Blues
The result, as even prominent Obama backer Martin Wolf of the Financial
Times admits, was deeply disappointing.
Sadly, Mr. Obama realized his error too late: last week he announced a $50
billion stimulus package that could be modeled on the successful $500
billion program China launched to prevent a recession there: his program
would help to rebuild the nation’s decaying interstate highway and railway
The final 2,000 page bill was probably only read in full by lobbyists and
committee staff members. Obama himself never claimed to have read
anything more than summaries. He was even vague about what the bill had
to contain if he were to support it. Despite more than 60 public speeches on
the absolute necessity of passing the bill, he never really explained what it
contained or why this particular monstrosity was the best the nation could
get.
September 2010 15
IBM@1 = Big Ben’s Big Blues
The Health Care bill may be the best thing for the plaintiffs’ bar since
cigarettes—and much bigger than BP’s Macondo disaster. This bar bonanza
guarantees that all talk of controlling health care costs in the future is just
that—talk.
The Health Care bill
From our personal knowledge and research, we can attest that the single
may be the best thing
biggest cost advantage the Canadian health care system has over its American
for the plaintiffs’ bar
counterpart is legal costs—direct and indirect. Example: a Canadian
since cigarettes...
neurologist’s annual malpractice insurance costs, we are told, roughly $3,500.
In the US, it routinely runs to $200,000. No wonder American doctors order
far more and far costlier tests for their patients: missing even one test can
mean a $25 million trial judgment. That doesn’t happen in Canada because
trials are generally held before judges—not juries, which are subject to
lawyers’ manipulation about the scientific issues in the case; moreover in
Canada “pain and suffering” damages are controlled, and contingency fees
are virtually banned. (John Edwards is blamed by the American Society of
Obstetricians and Gynecologists for single-handedly changing the odds in
cases of babies born with cerebral problems: he never lost a jury trial and is
credited with more than doubling obstetricians’ insurance costs.)
The other fallout from the health care bill is that health insurers have been
boosting their rates by 40% or more. They justify these horrendous increases
by claiming that they are going to have to take any applicant regardless of
existing health conditions—and they know from (Republican) Mitt Romney’s
Massachusetts plan that many people wait until they actually need medical
care before signing up. They also don’t believe that doctors in hospitals
will agree to permanent 25% pay cuts for Medicare recipients. The insurers
are being attacked by Bill O’Reilly on Fox News, with the kind of outraged
venom for which he is renowned (and feared). Using statistics on the bonuses
being paid to CEOs, he shouts that their pay is “obscene,” and demands a
Congressional investigation.
September 2010 17
IBM@1 = Big Ben’s Big Blues
What if the world has changed, and US equity performance in the next
economic cycle doesn’t replicate the performance of the cycles in the late
20th Century when the US was the dominant global economy?
We believe that the same equity group which outperformed during the last
economic recovery and has been outperforming since the S&P peaked in
Spring—commodity stocks—will outperform during the next cycle. If so,
this is bad news for the US economy and US stocks, because the US economy
and the S&P are underweight commodity companies compared to consumer,
financial and technology companies.
THEN NOW
IBM 113 124.00
General Electric 52 14.70
AT&T 48 27.00
Johnson & Johnson 46 58.00
Procter & Gamble 54 59.00
Merck 64 35.00
Coca-Cola 58 56.00
Boeing 44 62.50
Microsoft 58 24.00
Intel 41 18.20
Bank of America 25 12.40
THEN NOW
Exxon Mobil 41.75 59.30
Conoco 30.60 53.00
Anadarko 17.00 47.64
BHP Billiton 9.90 66.75
Freeport McMoRan 9.87 71.32
Potash Corp. 8.26 147.00
Monsanto 12.00 53.00
Deere 16.75 63.70
Barrick Gold 15.37 46.47
Newmont 19.56 61.49
Nor did we include Apple and Google. True: Apple outperformed all but one
of our commodity stocks, and Google wasn’t public in 2000. But Apple had
gone nowhere from 1988 until mid-1999 and wasn’t considered as even a
red chip—let alone a blue chip—and its stock price plummeted along with
the other techs from 2000 through 2003. What happened thereafter is truly
September 2010 19
IBM@1 = Big Ben’s Big Blues
magical and we admit you never heard about it from us. Apple’s allure is of
Edenic proportions: Steve Jobs is to Apple what its copper, iron ore and oil
reserves are to BHP.
Not only was this true during their first bull run—from 2002 through
mid-2008, but it has been true since the S&P peaked in April.
Why?
Because, although those traditional blue chips are great global enterprises,
their performance is heavily influenced by US economic and financial
conditions. As the shrewd (and deliciously irreverent) Stephanie Pomboy of
MacroMavens demonstrates, total US corporate profit growth over the long
term is remarkably correlated to the value of US residential real estate, which
means to us that the commodity stocks’ outperformance of the S&P should
be even greater in future years than in the past decade.
Twin Bubbles...
Corporate Profits vs. Residential Real Estate
($ Billions)
1965 – 2010
25,000 2,000
1,639.30
20,000 1,600
16,507.20
15,000 1,200
10,000 800
5,000 400
0 0
1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Residential Real Estate Corporate Profits
As stocks, the commodity companies’ collective beta is the stock market, so ...their alpha comes
they are blown and buffeted by broad stock market trends, particularly in from the price of the
New York and London. commodities on which
their earnings are
But their alpha comes from the price of the commodities on which their earnings
dependent...
are dependent—and most commodity prices are now heavily influenced by
demand from China. In a deflationary and increasingly regulated US and
European environment, traditional companies have less pricing power than
commodity companies, whose pricing springs from scarcity.
THEN NOW
Copper 0.91 3.49
Crude Oil 33.38 74.50
Natural Gas 4.83 3.85
Potash 130.00 350.00
Corn 1.94 4.65
Wheat 2.67 7.24
Gold 280.00 1,259.00
Silver 5.04 20.10
The effect of the gigantic US shale gas discoveries on the dismal relative
performance of natural gas to other commodities is clear, and explains why
we have not been recommending natural gas-levered stocks within the Energy
group for more than a year. Note the continuing absurdity of the accounting
convention in which six mcf of gas are always considered equivalent to a
barrel of crude oil, based on their respective heating effectiveness: back
in 2000, they were close: $28.98 worth of gas was considered, for valuing
reserves, to be worth $33.38. Today $23.10 in gas comes out as being worth
$74.50 for accounting purposes. Oil and gas companies which use this
blended boe calculation without breaking out the oil and gas values should
be downgraded by investors: it’s the oil patch’s version of the distortions in
Wall Street balance sheets that laid the foundations for the Crash.
September 2010 21
IBM@1 = Big Ben’s Big Blues
This was the decade This was the decade in which both of the Boomers’ two defining retirement
in which both of the investing programs blew up.
Boomers’ two defining
First was the Triple Waterfall collapse of tech stocks.
retirement investing
programs blew up. Nasdaq Composite Index
January 1, 1990 to September 8, 2010
5,000
4,000
3,000
2,000 2,225.44
1,000
0
Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10
As coincidence would have it, Nasdaq’s sustained rally from its October 1998
low after the collapse of Long-Term Capital to its peak at 5048 on March 25,
2000, started as a Boomer voyage of discovery with the index at 1492 just
two days from Columbus Day, the anniversary of the discovery of the New
World.
At its peak, Nasdaq was trading at more than 300 times actual forward
earnings (adjusted for stock option costs), and new tech billionaires were
being spawned each week. It was the most disgraceful extravaganza in the
history of finance.
As Silicon Valley was licking its wounds and counting its fallen, in the other
center of financial excess, things were just beginning to heat up for an even
bigger disaster.
With the PhDs in science no longer flocking to the West Coast in search
of instant riches, the greediest bosses in the financial industry sensed that
their time had arrived. The Wall Street banks had been learning how to
develop risk control models from the Black-Scholes formulas that brought
And so the Boomers believed that they could make up what they’d lost on
sure-thing tech darlings that were now, in many cases, as extinct as dinosaurs,
by buying the absolutely surest of sure things: houses. They levered up to buy
more home than they needed, and then levered up to buy other residences
to flip. Condoflip.com became a hot website. At the peak, in a showing of
houses in a new suburb of Seattle, every house went in minutes and the
average buyer was snapping up four homes—fully financed by mortgages.
The seemingly impossible was happening: while the stench of dead techs was
still in the air, a worse collective delusion than Nasdaq had appeared—on a
scale that Silicon Valley could never have conceived in its most phantasmagoric
dreams…
When the tech mania was exposed, people lost their savings, pajamahadeen
traders had to find real jobs, and pension funds lost their surpluses.
But when Wall Street’s scam was exposed in all its rotting trillions, giant
corporations went bust across the world, everyone’s home—from Greece to
San Francisco—was worth less, and, by 2008, more than a quarter of all
homes in the US, UK, Ireland, and Spain were worth less than the mortgage
and associated loans on them, and governments and central banks across the
industrial world had entered sustained crisis mode.
September 2010 23
IBM@1 = Big Ben’s Big Blues
...George Steinbrenner The tax debate in Washington has been full of sound and fury but has signified
was shrewd to the last: nothing. Republicans keep demanding further tax cuts—Reagan-style—and
he died this year. Democrats keep demanding higher taxes “for the rich” (a somewhat
evanescent label that can apply to those earning more than $50,000 a year,
but most certainly to anyone earning $200,000 a year.)
Democrats think “higher taxes for the rich” is a political winner, because
nearly half the population pays no income tax. Democrats’ economic policies
remain unchanged from those summed up by Reagan: “If it moves, tax it; if
it’s still moving, regulate it; if it fails, subsidize it.”
What is coming down the tracks unless Congress acts fast is a monstrous
tax increase on New Year’s Eve, as the Bush tax cuts expire. According to the
Chamber of Commerce, “Marginal tax rates will increase for every taxpayer.
Capital gains tax rates will climb 33%. Dividend rates for stockholders
will jump as much as 164%. The child tax credit will be cut in half and the
marriage penalty will return.”
But what really frosts the C of C is the big income tax boost on upper income
taxpayers, a large number of whom run small and medium-sized businesses.
(Oh, and the federal death tax rate goes from zero to roughly 50%. As many
wiseacres observed, Yankees owner George Steinbrenner was shrewd to the
last: he died this year.)
The federal government’s share of GDP spending has climbed from 20% to
25% in the past three years, and that has to be financed somehow. Why not
just return to the tax rates of the prosperous Clinton era?
That argument would make some sense if the economy were growing at 4%
or more. But one has to be either a tenured academic or a real despiser of
business people (or both) to believe that a big tax increase coming at the
time of a big increase in health care costs while the nation hovers on the edge
of a really deep recession is brilliant policy.
Our take is that the voters will send a message that they are too frightened
...national sales tax...
of economic collapse to impose a big tax increase now. In our view, the
has as much
Republicans have been too disorganized and incoherent to deserve a lusty
political appeal as a
mandate, but their commitment to maintaining the Bush rates will make
ruthlessly-enforced
them—if but briefly—the more sensible of the parties in the eyes of the 51%
50 mph speed limit.
or so of the population who actually pay income tax.
We expect that Congress will postpone the impact of the tax changes for
another two years—as recommended by Obama’s recently-retired Budget
Director. That could come this Fall, or early in the next Congress.
If not, then we think the markets will swiftly begin to price in a double dip.
September 2010 25
IBM@1 = Big Ben’s Big Blues
Gold
September 1, 2000 to September 8, 2010
1,258.30
1,200
1,000
800
600
400
200
Sep-00 Sep-01 Sep-02 Sep-03 Sep-04 Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10
Silver
September 1, 2000 to September 8, 2010
24
20 19.85
16
12
0
Sep-00 Sep-01 Sep-02 Sep-03 Sep-04 Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10
40
35
30
25
20
15
10
Sep-00 Sep-01 Sep-02 Sep-03 Sep-04 Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10
60 60.01
50
40
30
20
10
Sep-00 Sep-01 Sep-02 Sep-03 Sep-04 Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10
20
15
10
0
Jan-05 Sep-05 May-06 Jan-07 Sep-07 May-08 Jan-09 Sep-09 May-10
September 2010 27
IBM@1 = Big Ben’s Big Blues
US CPI
September 1, 2000 to Sept 1, 2010
220
217.60
210
Why did precious
metals climb so 200
170
160
Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10
Source: FRED® (Federal Reserve Economic Data); Federal Reserve Bank of St. Louis
An investor who was told a decade ago that cumulative US CPI for the next
ten years would be 28% would not have predicted that gold’s price would
more than quadruple, and be the best-performing major investment asset
class in the entire world.
The Seventies were, of course, even better for gold—its price soared from
$36 in 1971 to $825 in 1980, before entering its two-decade Triple Waterfall
Crash. As for silver, back then its price skyrocketed from $1.90 to $38, and
then entered a crash that finally ended in 2001 at $4.
Why did precious metals climb so high when inflation was increasing so
modestly?
The respected Bank Credit Analyst sneers at gold as an asset class, dismissing
...a Fed Chairman,
it as the pre-eminent example of the Greater Fool Theory: gold delivers no
he made a good
income, so one only buys it with the expectation of selling to an even greater
clarinetist...
fool.
On that theory, gold’s recent rise to new heights makes at least a scintilla
of sense, because interest rates in the US and Japan are in the Zero range.
Holding gold no longer means forgoing meaningful short-term interest
income.
However, gold’s price trebled from 2003 to 2006, during which time an
absent-minded Alan Greenspan finally got around to quintupling the fed
funds rate from 1%, even though he ridiculed the idea that there could be
a housing bubble, because he said no one could identify a bubble before it
burst. (And for that kind of attention to duty he was dubbed “The Maestro”
by Bob Woodward and was dubbed a knight by the Queen. History is more
likely to record that, as a Fed Chairman, he made a good clarinetist—if not
as good as Woody Allen.)
The American dollar is, we are told today, worth 14% of its purchasing power
in 1913, when the Fed was given custody of the greenback. We would bet that
anyone who put aside a “Roosevelt for President on the Bullmoose Ticket in
1912” button when the Fed was being born did much better than somebody
who put away the first greenback.
September 2010 29
IBM@1 = Big Ben’s Big Blues
What kind of world would give us the Dow and gold at $6,000? The only
thing one could say for certain that it would not re-elect a sitting President…
or Prime Minister.
2. Deflation and the Decline and Fall of Banks and Sovereign Debts
Gold has been trading inversely to stocks in general and bank stocks in
particular. On days stocks climb, gold usually falls; conversely on days the
stock market is taking gas, gold climbs. It was, for example, a winner when
Greece made it to the front page for the first time since the Olympics (and
one of the few times the world had any good reason to take note of it since
Alexander the Great). Because Greek banks and a surprisingly large number of
other European banks had invested heavily in Greek government bonds after
the nation managed to lie its way into the Eurozone, the potential default
of the government threatened the recovery of the entire Eurozone economy.
Germany was dragged along in the bailout, while appalled Germans watched
TV coverage of overpaid Greek civil servants rioting. (The vigorous activity
displayed was uncharacteristic of modern Greek civil servants, where a Lotus-
eater lassitude tends to be the lifestyle.)
Sovereign credits got a free pass in the Basel I rules (the virtuous, Volcker
values, not the racy rules of Basel II for banks that wrote their own risk
formulas and hid their most malodorous “investments” off balance sheet).
Doubtless, Volcker felt he had to accommodate European sensibilities and
didn’t want to be seen as the American imperialist in assigning different
risk valuations to individual EU members. So the sudden threat of a Greek
debt default sent Poseidon-scale shock waves through the Mediterranean,
as other undercapitalized banks began to reflect on their coming descent
into Hades if Italy, Spain and Portugal were to catch the Greek Reek.
The Spring crisis opened a long-covered lesion deep within the German
psyche. For the first time since the Weimar Republic, individual Germans, in
an outburst of atavism, rushed to banks to exchange euros for gold. Angela
Merkel’s party suffered its worst-ever defeat in the North Rhine-Westphalia
election because of rage that Germany was participating in the Greek bailout.
To punish her center-right party, they voted Socialist and even Communist.
(Solidarity for never?) The voters had been forced to surrender their precious
Deutschemarks for euros which, they were told, were even better. Once
they figured out that the euro was a pudding that could contain poisoned
raisins, they rushed to protect themselves. A currency that is not specifically
and irrevocably backed by any government, any tax system, or any army
and navy depends entirely on citizens’ faith. Many Germans who, despite
the winds of modernism, kept their faith in God, also kept their faith in
the Deutschemark. Now, a large proportion of the population apparently
believes deeply in neither. (The US manages these possibly overlapping or
interconnected belief systems with panache: greenbacks include the motto
“In God We Trust,” which may be construed as a form of assurance if foreign
exchange markets or inflation raise Doubt among dollar-holders.)
September 2010 31
IBM@1 = Big Ben’s Big Blues
From the time paper money came into broad circulation in the 18th Century,
only two currencies have possessed global status—the pound and the dollar.
(The euro was on its way to achieving that status until it slipped on Greece.)
World War I ended the pound’s global dominance, although the dollar
shared space with sterling for a few years before assuming dominance during
the Depression.
It is safe to say that no monetary theorist ever thought that the dollar could
maintain its acceptability through another Depression, coming at a time
when government debt exceeded 100% of GDP, or visualized a world in
which derivatives on that debt and economy would multiply to $70 trillion.
Or, for that matter, an industrialized world in which fertility and marital
rates collapsed, and projected lifespans grew to nonagenarian levels while
governments were on the hook for universal pensions and health care.
As Barrick’s Aaron Regent remarks, we may not be in the era of peak oil, but
we may well have entered the era of peak gold.
Conclusion: There will not be enough gold to satisfy the needs of the newly
needy.
September 2010 33
IBM@1 = Big Ben’s Big Blues
Conclusion
When a $1.5 billion offering of a single “A” three-year corporate bond with
a 1% coupon is over-subscribed and routinely trades above-par in the after-
market, any talk of near-term inflation must be coming from the under-
...any talk of near-
informed or the perilously paranoid.
term inflation must
be coming from the That IBM offering came days after Johnson & Johnson sold $1.1 billion of
under-informed or the bonds at the lowest interest rates in decades for ten and 30-year corporates—
perilously paranoid. 2.95% for the tens and 4.5% for the thirties. Norfolk Southern, a BBB+ rated
railroad, has joined the deflation-hedging party with a $250 million offering
of 95-year bonds at 6%.
The US is, for the first time, experiencing Japanese-style interest rates and
could soon share Japan’s economic and political stasis. Even a few months
ago, such an outcome would have seemed wildly improbable—a figment of
someone’s perfervid imagination.
We believe gold is a far better investment than a Ten-Year Treasury Note that
yields roughly 2.57%. From 1980 to 2001, the bond was the better buy. Since
then, gold has hugely outperformed the bond, which, in turn, has outperformed the
stock market. Those performance results define The Lost Decade.
On the other hand, a case can now be made that owning a long-duration
Treasury is an alternative to holding gold as a Depression hedge.
Why so long? When the Five-Year Treasury yields 1.4%, why reach out 25
more years for a measly 2.3% yield pickup?
When the risk
This is because the bonds are held strategically—as insurance policies against is bifurcated—
economic catastrophe, not as secure income-generating assets, or as security Depression
for loans. and/or Inflation—
Gold is the
When the risk is Depression, the longer-dated the Treasury the better.
all-in-one hedge.
When the risk is merely slowdown, followed by stasis, the longer-dated
Treasury the better.
Bonds depend on their coupon rate and maturity for valuation, and on their
issuer for quality. They are, therefore, short-duration assets compared with
gold. The last time any government of a large bond-issuing nation proclaimed
that it would endure even one thousand years (a mere afternoon compared
with gold) was Hitler’s Third Reich, and its bonds were worthless within a
few years.
September 2010 35
IBM@1 = Big Ben’s Big Blues
• how well its central bank handled the economy; A campaign in Congress
is being waged by
• how well its federal government has performed compared with
enviro-extremists...
Washington;
to try to ban imports
• how well the currency has behaved; of “dirty oil” from
the oil sands.
• how well its stocks and bonds have performed;
• The loonie was .98 at the time of the G20, but it traded down to .945,
before bouncing back to .964 after the Bank of Canada surprised many
analysts with another quarter-point rate boost, to 1%.
• Canadian GDP, which had been growing impressively, has hit a rough patch
recently, and the Bank of Canada used Bernanke’s “unusual uncertainty”
label for the economy in its September 8th comments accompanying the
rate announcement.
• Enbridge, a major Canadian oil pipeline company, has for decades operated
a line that carries Alberta crude oil to refineries in Ontario and Upper New
York State. It sprang a leak in its line in Michigan which, it was feared,
September 2010 37
IBM@1 = Big Ben’s Big Blues
would poison a river. The company responded quickly and efficiently, and
Michigan politicians have praised its performance. However, Enbridge is
one of two companies vying to build a pipeline to carry oil sands-originated
crude to the West Coast for delivery to China. This concept has always been
“Didn’t Canadians Alberta’s fallback to American threats to ban its oil. There is widespread
learn anything from opposition within British Columbia to these proposals, so the pipeline
what happened in the failure is serious—perhaps fatal—damage to Enbridge’s credibility—and
US? Are they idiots?” is therefore bad news for all oil sands operators.
• There is more and more commentary about the rapid weakening of the
finances of the government of Ontario, resulting from (1) an ambitious,
expensive, though apparently helpful, emergency fiscal stimulus program,
and (2) a bizarre electric generation construction program based on very
optimistic costs for building wind farms, and wildly optimistic expectations
for their effectiveness. We have been hearing dour warnings from Ontario
friends for more than a year about the McGuinty government’s green
obsessions. All agree that the wind programs will saddle taxpayers with
huge debts and power users with big fee increases. This week, Margaret
Wente, star columnist for The Globe & Mail, published a withering critique
about the “wacky” wind programs. Premier McGuinty seems to have
committed himself to Californicating Ontario—and Ontario is far more
important to the Canadian economy than California is to the USA.
We do take the orchestrated campaign of the US Hard Left against the Alberta
oil sands seriously. It has already affected cross-border trade, with various
mini-boycotts against Alberta oil. Because the greens failed to get their
cap-and-tax bill through Congress, and did not achieve a total ban on all
offshore domestic drilling, they needed some campaign against a foreign
“enemy” to whip up their troops and juice up their groups. They are having
definite success in pressuring institutional investors to sell shares of oil sands
producing companies. Some clients have told us they can’t qualify for funds
from “environmentally sensitive” NGOs and pension funds if they own
shares in “dirty oil companies who pollute air, earth and water.”
September 2010 39
IBM@1 = Big Ben’s Big Blues
We continue to believe that clients should overweight the Canadian dollar, and
that Canadian pension funds should hedge their exposure to the greenback,
while recognizing that the greenback remains—if only by default—the global
store of value.
If, by some astonishing
We were most strenuous in our claims about the attractions of the loonie
concatenation of events,
back when it was trading in the sixties relative to the greenback and various
the deal had been done
prominent Canadians, including some business organizations, were
back then, Canadians
recommending that Canada beg to have the US absorb the loonie so that the
would have been selling
Canadian economy would be “dollarized.” We thought that was a terrible
at the bottom...
deal for Canadians, and also believed there was no way the Federal Reserve
could be reconstituted to make Canada a Fed District. If, by some astonishing
concatenation of events, the deal had been done back then, Canadians would
have been selling at the bottom—the lowest valuation for their currency in
a century. We have, throughout our career, been basically inimical to selling
assets at the bottom. That said, although a merger could theoretically be
done today even-up, we’d still be opposed, but the reasons for that are more
complicated now that the loonie is approaching parity.
Summing up, Canada still looks less risky than the US; and Canada outside
Ontario collectively looks far less risky than the US.
In a world where IBM can borrow at 1% for three years and gold trades at
$1259 an ounce, bland ain’t bad.
The Potash Corp. takeover bid is powerful proof—if it were needed—of our
basic commodity stock investment thesis: own unhedged reserves in the Potash Corp.’s
ground in politically-secure regions, and don’t be distracted by near-term reserve life index
earnings fluctuations. is measured in
What is Potash Corp. worth on a cash buyout? centuries...
Most Street commentary is mildly or firmly against the bid, and is nearly united
in saying BHP should either not raise its bid or raise it only modestly.
It is one of the top producers of copper, iron ore and other metals, and is a
sizable producer of oil and gas. Its balance sheet is pristine. So powerful is its
diversified earnings base that, as it tells analysts, it can pay for Potash with
“about two-and-a-half years’ cash flow.” And Potash Corp.’s market cap isn’t
picayune: it’s $44.6 billion—which puts it beyond the reach of almost all
other commodity-based potential bidders.
Those Street analysts are delivering elegant EBITDA calculations to show that
BHP should not raise its bid.
However, most of BHP’s best revenue spinners will be exhausted before all
those analysts die. But Potash Corp’s mine life will have shrunk only slightly
by then: Potash Corp.’s reserve life index is measured in centuries, whereas
all the other productive asset classes of BHP come from resources whose life
index is measured—at the most—in decades.
So who cares about a section of a giant ore body that won’t be produced
until 2444?
September 2010 41
IBM@1 = Big Ben’s Big Blues
Until quite recently, major miners disdained potash, because it was a mere
fertilizer, dependent on farm programs, weather, crop prices and other
vagaries. It lacked the economic virility of copper, iron ore, metallurgical
coal, or zinc, let alone oil. Real miners didn’t do fertilizer.
...half the Vermeer
But when potash prices ran all the way from $150 a ton to nearly $1,000 a
paintings on earth
ton, the big mining companies were aghast. Here they had been overlooking
at a price it can
a product that was mined, and this hayseed supplier that hadn’t even been
easily afford.
asked to speak at mining conferences suddenly had a market cap that was
bigger than any miner except BHP!
So, when potash prices collapsed, dragging down POT’s price, it was almost
inevitable that BHP wouldn’t let it get away again.
BHP’s CEO, Marius Kloppers, was only in his job for a few weeks when he
launched an audacious bid for Rio Tinto. That was scotched when Rio Tinto
brought in China Aluminum (Chinalco), which scooped up enough stock
to derail BHP.
This time, he knows he must succeed. No other mining resource in the world
can have the impact on BHP’s long-term future that would come from getting
those multi-century Saskatchewan treasures from POT. If he wins, he’ll more
than treble the blended duration of his entire reserve base of minerals.
That said, the outcome of this bid could, like the Inco and Falconbridge
takeover battles, be decided by hedge funds and arbitrageurs whose time
horizon isn’t centuries or decades: it’s days—or even hours.
Investors should, we suggest, take the time to think carefully about the time
horizons involved in settling the ultimate disposition of the longest-duration
mineral resource in the world.
The world has been relying on the American economy, American generosity,
American technology, and American willingness to expend blood and
treasure in containing villainy for most of the past seven decades.
“The wells of
And most of the time, the USA has delivered. regeneration are
infinitely deep.”
And, yes, for most of the time it has received little thanks and, for all of
that time it has been the primary hate object of the Global Left. (Since the
Six-Day War, it’s had Israel as company.)
The US remains the most formidable military power and is still the
world’s largest economy and, in particular, the world’s largest importer of
manufactured goods.
But the US is now coming to resemble Captain Ahab, who moaned that he
felt like Adam, weighed under by all the piled centuries since Paradise. Its
financial industry, long an object of envy and hatred worldwide, has lived
down to the worst accusations of its opponents; its total debt (personal,
corporate, state and federal) has been rising faster than GDP for decades
and the time for paying the Piper may be nearer than most Americans think;
since 9/11, when it finally awakened to the reality that radical Islam sought its
destruction, its economy has been subjected to growing costs—for military
operations abroad and security at home: the time it takes for passengers to
clear airport security against Islamic terrorists is a significant percentage of
the time spent in airline travel; the real estate binge has wiped out the savings
of tens of millions of its citizens, and leaves the entire financial system in
seriously weakened condition.
As grim as the outlook may now appear, there are few nations whose situation
has both less endogenous risk and greater upside.
This is the traditional time of the year when markets express their deepest
fears—and do so violently.
Investors should have ample liquidity for the opportunities that arise when,
through a collective failure of imagination, rational pessimism becomes
despair.
September 2010 43
IBM@1 = Big Ben’s Big Blues
RECOMMENDED ASSET ALLOCATION
Recommended Asset Allocation
Capital Markets Investments
US Pension Funds
Allocations Change
US Equities 17 unch
Foreign Equities:
European Equities 2 unch
Japanese and Korean Equities 0 –2
Canadian and Australian Equities 7 –2
Emerging Markets 11 –1
Commodities and Commodity Equities* 12 unch
Bonds:
US Bonds 17 +5
Canadian Bonds 8 unch
International Bonds 6 unch
Long-Term Inflation Hedged Bonds 10 unch
Cash 10 unch
Change
Precious Metals 37% unch
Agriculture 27% +3
Energy 19% –1
Base Metals & Steel 17% –2
Bond Durations
Years Change
US (Hedged) 7.50 +1.25
Canada 7.75 +1.25
International 5.25 +0.25
Change
Precious Metals 37% unch
Agriculture 27% +3
Energy 19% –1
Base Metals & Steel 17% –2
September 2010 45
IBM@1 = Big Ben’s Big Blues
RECOMMENDED ASSET ALLOCATION
Comments on Asset Allocation Changes
The equity reductions reflect our growing concerns about the US economy,
and how it will affect the Canadian economy.
The US and European financial systems have solvency problems that have
been papered-over. They could explode suddenly, creating severe liquidity
problems.
It is largely independent of the economic and financial risks that affect most
equity groups, for which the overweight in precious metals is appropriate.
The prices of corn, soybeans and wheat are the most important indicators
of agricultural stock performance, and they are continuing strong in
response to weather problems in Europe and Western Asia.
6. The outlook for natural gas remains dismal. Overweight oil stocks within
energy portfolios.
7. Base metals are the group most closely correlated to global trade patterns
and Chinese industrial activity. Their cyclicality means they remain
the most vulnerable if investors conclude the US faces a double-dip
recession.
Although big banks have improved their balance sheets, they remain
burdened with the expensive evidence of past cupidity and stupidity. What
took months to acquire will take years to divest or write off.
If US house prices fall a further 10 - 20% as some experts insist, then the
increase in putrescent assets on banks’ balance sheets will overwhelm the
writedowns to date.
September 2010 47
IBM@1 = Big Ben’s Big Blues
The soft patch for the loonie and the Canadian economy should not
become anything more serious.
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