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Basic Points

IBM@1 = Big Ben’s Big Blues

September 9, 2010

Published by Coxe Advisors LLP

Distributed by BMO Capital Markets

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BMO Capital Markets Disclosures

Company Name Stock Ticker Disclosures Company Name Stock Ticker Disclosures
Accenture ACN General Electric GE 1, 3, 4
Apple AAPL 2 Goldcorp GG 1, 3, 4
AT&T T Google GOOG 2
Bank of America BAC Intel INTC 2
Barrack Gold ABX 1 International Business Machines IBM
BHP Billiton BHP Johnson & Johnson JNJ
Boeing BA Merck MRK
Citigroup C 3, 4 Microsoft MSFT 2
Coca-Cola KO Monsanto MON
ConocoPhillips COP Nasdaq NDAQ 2
Deere DE Newmont Mining NEM 3, 4
Enbridge ENB 1, 3, 4 Norfolk Southern NSC
Exxon Mobil XOM Procter & Gamble PG
Fannie Mae FNM Potash POT 1, 3, 4
Freddie Mac FRE Rio Tinto RTP
Freeport McMoRan FCX Silver Wheaton SLW 3, 4
(1) BMO Capital Markets or its affiliates owns 1% or more of any class of common equity securities of the company
(2) BMO Capital Markets makes a market in the security
(3) BMO Capital Markets or its affiliates managed or co-managed a public offering of securities of the company in the past twelve months
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(5) BMO Capital Markets or its affiliates expects to receive or intends to seek compensation for investment banking services from the company
in the next three months
(6) BMO Capital Markets has an actual, material conflict of interest with the company
Don Coxe

IBM@1 = Big Ben’s Big Blues

September 9, 2010

published by
Coxe Advisors LLP
Chicago, IL
IBM@1 = Big Ben’s Big Blues
September 9, 2010

Author: Don Coxe 312-461-5365
Editor: Angela Trudeau 604-929-8791
Coxe Advisors LLP.
190 South LaSalle Street, 4th Floor
Chicago, Illinois USA 60603
IBM@1 = Big Ben’s Big Blues
We return to the blues theme we used a year ago (Dem Blues).

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.

Last September, we expressed concern at the stock market’s ebullient

conviction that the recovery was a sure thing. We recommended that clients
reduce equity exposures in favor of bonds. The recommendation was
ill-timed: The S&P was 1016 on publication date, and it continued on its
merry way for seven more months, peaking at 1215. Then the economy slid
back into first gear, interest rates plummeted, and gold soared.

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
IBM@1 = Big Ben’s Big Blues

US Ten-year Treasury Yield

September 8, 2009 to September 8, 2010
4.0 Has the US economy
3.8 fallen into Jackson Hole?
2.6 2.65

Sep-09 Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sep-10

US Three-year Treasury Yield

September 8, 2009 to September 8, 2010





0.8 0.79

Sep-09 Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sep-10

Has the US economy fallen into Jackson Hole?

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

Journal of Commerce JoC-ECRI Industrial Price Index Growth Rate *

August 1, 2009 to August 31, 2010


...revelations of 60%

fraud, foul play and 50%

foolishness sent yields 40%

on Greek bonds to 30%
Olympian heights... 20%

10% 9.83%
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.

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.

At first, the blame was on a sovereign debt crisis originating in Greece.

Unfolding revelations of fraud, foul play and foolishness sent yields on
Greek bonds to Olympian heights, where they joined the Collateralized
Debt Swap yields on Greek banks. With the banking Mediterror spreading to
Italy, Spain and Portugal, the European Central Bank and the governments of
the Eurozone raced to issue a rescue package. As skepticism about sovereign
debts began to spread across the world at a time of a slowing US economy,
financial stocks slumped, setting off stock market plunges worldwide.


KBW US Bank Index (BKX)
September 8, 2009 to September 8, 2010
...a profusion of
52 hastily-fashioned
50 Obamacronymic
48 support programs.
46 45.84
Sep-09 Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sep-10

KBW US Regional Bank Index ETF (KRE)

September 8, 2009 to September 8, 2010





22 22.11


Sep-09 Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sep-10

The epicenter of the 2008 crash—US mortgage Collateralized Debt

Obligations—moved back to Page One, despite a profusion of hastily-
fashioned Obamacronymic support programs. Some of those programs were
designed to save mortgagors from lenders; some were designed to induce
lenders to make loans to borrowers who had neither jobs nor downpayments;
all the programs created jobs for bureaucrats in banks, social agencies, and

September 2010 5
IBM@1 = Big Ben’s Big Blues

Meanwhile, on Main Street, a fast-rising rebellion against fast-rising

government debts changed the political calculus. The Tea Party, a spontaneous
uprising triggered by a TV rant from CNBC’s Rick Santelli, rather suddenly
made political incumbency a political liability. The days when a Congressman
...6% of voters also or Senator could brag about all the goodies he or she had delivered, turned into
believe Elvis lives... nightmares for big names with big spending credentials. Because Democrats
controlled nearly every power center in Washington except the Supreme Court,
they were the primary victims of the new financial Puritanism—sometimes
even in their own primaries. However, the Tea Partiers were also angry at
establishment Republicans: In Florida, the formerly popular Governor Crist
fell to a rising Latino star in the Senate primary, and veteran Republican
politician Bill McCollum was beaten by an upstart health care executive in
the gubernatorial primary. Even John McCain got a serious scare running for
re-election in Arizona against a novice.

Result: There will be no more multi-billion-dollar stimulus packages this

year. The latest poll shows that only 6% of voters believe the Obama-Pelosi
package actually reduced unemployment. (A wag at the Cato Institute noted
that 6% of voters also believe Elvis lives, and he knows Elvis’s step-brother,
who assures him Elvis is dead.)

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.)

Nevertheless, with public fear of runaway deficits now the transcendent

political reality, the Administration and Congress cannot launch big new
rescue programs.

It’s up to Ben now.


Fed Up?
That the Fed Funds rate has stayed near Zero for so long—and that bond
yields have fallen so far and so fast—is not due to massive new monetary
stimulus. The Monetary Base is roughly where it was in December—when
the Fed Funds rate....
the S&P was slightly higher than today, and the yield on the 10-Year Treasury
is not due to massive
Note was 3.8%, compared to today’s 2.6%. The financial markets—not the
new monetary stimulus.
Fed—have been driving down yields since the stock market peaked. (Year-to-
date, investors have poured $190.7 billion into bond funds and withdrawn
$7 billion from equity funds.)

US Federal Funds Rate

September 8, 2008 to September 8, 2010
0.2 0.18
Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10
Source: Federal Reserve Economic Data; Federal Reserve Bank of St. Louis

September 2010 7
IBM@1 = Big Ben’s Big Blues

US Adjusted Monetary Base

updated September 2, 2010
j y
Averages of Daily Figures, Seasonally Adjusted

Billions of dollars







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

02/24/10 54.0 24.3

03/24/10 43.8 16.2 40.9

04/21/10 31.6 5.4 10.5 -21.1

06/02/10 24.8 2.4 4.1 -15.5 -18.3

06/30/10 20.9 0.5 1.0 -14.8 -16.5 -9.4

07/28/10 19.0 0.4 0.7 -12.4 -13.2 -7.0 -6.5

08/25/10 17.7 0.7 1.1 -10.1 -10.4 -4.7 -3.2 1.5

Source: Federal Reserve Economic Data; Federal Reserve Bank of St. Louis


Credit and Liquidity Programs and the Federal Reserve’s Balance Sheet
(Data are shown through July 28, 2010)
Securities Held Outright Selected Liabilities of the Federal Reserve

...the banking industry

has produced in recent
decades is the ATM.

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.)


The reason we dwell on this collateral damage is that almost no one (except
Tom Hoenig of the Kansas City Fed and James Bullard of the St. Louis Fed)
is calling for the Fed to restore anything approaching normal interest rates to
protect the incomes of those at the bookends of the fixed income market—
small savers and pension funds. These hard-hit savers who have been the ...end the charade
backbone of the debt markets for decades are being systematically sacrificed that the taxpayers’
to benefit homeowners who sought to enrich themselves by buying more exposure to F&F debt
house than they needed and the brain-dead lenders who eagerly lent them through Treasury
more money than they could afford. guarantees is an
Can the Fed make QE2 or some other combination of inventions or
stratagems work well enough to avert a renewed housing collapse and a
renewed recession? Or is the .95% yield on the IBM bonds a sign that the real
economy is flirting with Depression—as our friend David Rosenberg argues
so consistently and cogently?

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.

Republicans, who never fought hard enough to rein in the Democratic-led

Congress as F&F were running wild, have finally made one useful
recommendation: end the charade that the taxpayers’ exposure to F&F debt
through Treasury guarantees is an off-the-balance-sheet item excluded from
calculations of the National Debt. This adoption of Enron or Citigroup
financial reporting may fool some unsophisticated Tea Partiers, but it won’t
fool serious investors—at home or abroad.

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!”)


Should Obama Be Blamed for the Weakening Economy?
We suspect that future historians will largely absolve him—and will also
largely absolve Bush.

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.

Because of the crisis, he came in as a key player, prior to inauguration, exuding

coolness and competence, as Wall Street’s biggest names were falling on their
own swords. He cooperated effectively with the Bush crisis managers, making
the transition almost seamlessly smooth. He chose intelligent, experienced
advisors for his economy team, reassuring the nation and foreign investors
that the nation wasn’t in the hands of dreamy amateurs.

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

He never claimed to be an expert on the economy, and he had the sense to

appoint Paul Volcker and Larry Summers, both of whom are brilliant and
experienced, to roles in the new Administration. His reappointment of Tim
Geithner was also logical, because he had been one of Hank Paulson’s top
crisis managers, and was as close to indefatigable as any public servant can
be. (His tax dodging only showed up after he’d been named, and with the
entire economy on the edge of collapse, this was no time for penny-pinching
morality. Geithner was a holdover from the Bush Administration who
knew where the problems were, including the bodies already buried.) The
appointment of Christina Romer was also commendable: she had friends
on both sides of the aisle, great experience, and radiated optimism amid the

September 2010 13
IBM@1 = Big Ben’s Big Blues

Unfortunately, putting Volcker and Romer in roughly the same general

area of responsibility as Summers was like putting two fine trout into a
pool inhabited by a barracuda. Mr. Summers had never been renowned for
respecting dissenting opinions. Unlike Obama, who, as a former law journal
... putting Volcker and editor, enjoys the cut and thrust of arguments, Summers is a team player of
Romer in roughly the the Putin School of Management.
same general area
In retrospect, the President showed the proper blend of decisiveness,
of responsibility as
patience, and public optimism needed during the darkest hours of the crisis.
Summers was like
His stimulus package might even have had observably acceptable results if he
putting two fine trout
and his staff had drafted it.. Unfortunately, he outsourced it to Nancy Pelosi
into a pool inhabited
and the House Committee Chairmen, and, as veteran pols, they weren’t
by a barracuda.
about to let a good $900 billion go to waste. They did what Congresspersons
know best: they looked after those who’d elected them. Unfortunately—for
him and the nation—that led to bills that run into thousands of pages, with
trillions in bills to be paid by future taxpayers, drawn with the eager help of
lobbyists for key Democratic constituencies who could barely believe their

The result, as even prominent Obama backer Martin Wolf of the Financial
Times admits, was deeply disappointing.

Surprisingly, Larry Summers was largely taken in by those Congressional

pros: he repeatedly spoke glowingly of the tremendous “multiplier” effects
that would come from funding “shovel-ready” projects, such as much-needed
roads and bridges. True, the nation didn’t get new bridges to nowhere, as
the Republicans had delivered to Alaska when Ted Stevens was in control
of Senate appropriations: there weren’t many bridge or road projects of
any kind: as of last count, a mere $27 billion of 2008 spending went on
federal road and bridge projects. The rest was, by and large, lovingly spent
on Democratic constituencies and priorities from long-moldering wish-lists.
The Keynesian Multiplier Effect from economically-enhancing projects that
was supposed to trigger sustained growth wasn’t really given a fair chance to
prove its relevance for the nation’s economic crisis.

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


systems. By cutting down on traffic jams and speeding up delivery of
commodities and manufactured goods, his program would deliver jobs now
and greater economic growth later. We are told there is joy in Heaven when
a sinner repents, but we fear that this program will founder amid the tumult
of elections. We are told there is joy
in Heaven when
The same Congressional Committee mauling befell Obama’s #1 legislative
a sinner repents,
priority—a national health care reform bill. There was bipartisan agreement
but we fear that this
that the existing system was deeply flawed; there was widespread support for
program will founder...
making insurance available to the uninsured; there was little—if any—love
for the health insurers.

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

Result: legislation that has a dramatically negative impact on the willingness

of small and medium-sized businesses to hire employees. The very sectors
of the economy whose risk-taking juices should be flowing most vigorously
are paying down debts and accumulating cash, fearful of soaring health care
costs and punitive provisions for non-compliance.

Republicans were initially too frightened of the Obama groundswell to fight

the bill, and participated in some early discussions about the makeup of the
legislation. Even midway through the long struggle, leading Republicans said
they’d be prepared to support it if it included reasonable provisions about
tort law reform. Obama expressed willingness to meet them halfway on this

But then the second-most-important Democratic financing constituency

(next only to unions) got deeply involved with its Congressional allies. The
trial lawyers not only insisted there be no constraints on their ability to sue
(such as the upper limits on damages in some state programs), but that the
bill include hundreds of mandated behaviors and systems that could be
enforced by plaintiffs’ lawyers in court.

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
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.

The President’s falling approval rating is widely trumpeted by Republicans

as evidence that his “extremism” is rejected by the voters. The gobsmacked
enthusiasm he evoked in the campaign has naturally given way to the
recognition that he is a young politician with no business or managerial
experience—but most voters still like him personally and wish him well.


Just as Reagan came into office after a dreadful decade for the American
economy and American stocks, so Obama arrived as a disappointing decade
for America was turning into a disaster.

Republicans don’t like to admit that Reagan’s popularity at this stage

[Voters] elect liberals
of his Presidency was no higher than Obama’s. Both Presidents were
and boot them out
suffering through grueling recessions that were not of their making, and the
when they do exactly
unemployment rates at this point were almost identical.
what they promised...
George Jonas of the National Post argues that voters elect conservatives to office
to manage effectively, and boot them out when they prove to be ineffective
managers or scandal-prone. Conversely they elect liberals and boot them out
when they do exactly what they promised—to expand the government’s role
in the economy and their lives past society’s collective level of comfort.

Obama, a certified liberal, managed to get Congress to pass transformative

health care and financial regulation, and, had the recession not proved so
painful, his global warming and union card check laws would also have been
enacted. No one should say he has betrayed his election promises. However,
polls show that a decisive percentage of voters feel he pushed too far, too fast,
and is “too liberal” in a nation that is historically center-right.

If the Republicans win one or both houses of Congress in November, Obama

will no longer have to bear the blame alone if the economy does not come
roaring back. Clinton’s career was probably saved by the moderation forced
on him by the Republican landslide of 1994. A seemingly-moderate Obama
would be a formidable challenge for any of the Republicans currently
considering a Presidential challenge.

September 2010 17
IBM@1 = Big Ben’s Big Blues

The Lost Decade?

Although investors are well aware that the S&P is down nearly one-third in
the past decade, and that long-term interest rates are down by roughly 50%,
few seem to understand how the world has changed. Strategists routinely
...the same equity group
discuss S&P targets for the time just beyond the horizon when the US gets
which outperformed
back to a normal growth track.
during the last
economic recovery... S&P 500
will outperform during September 8, 2000 to September 8, 2010
the next cycle. 1,600
1,100 1,098.00
Sep-00 Sep-01 Sep-02 Sep-03 Sep-04 Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10

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.


We have compiled a list of ten great US blue chips that together exemplified
America’s competitive might as the millennium dawned. This is unscientific
and is meant only to show how shares of some of the strongest and best-
known exemplars of American capitalism have performed during the ten-year
bear market for the S&P.

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

By way of comparison, here is a list of some of the greatest commodity-

producing companies in the world—same time period:

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

(We have not included dividends, which in some cases—such as Exxon—are


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.

From a capital preservation and capital growth perspective, the stock

Steve Jobs is to Apple
performance of the commodity greats vs. the non-commodity greats is
what its copper, iron ore
impressive. But was that due to a brief commodity bubble that has no longer-
and oil reserves are to
term investment significance?
We believe that comparing the highest-quality commodity stocks to a group
of the highest-quality industrial blue chips during “The Lost Decade” makes
a crucial point: in this long-term equity bear market, commodity stocks have
been far better investments than traditional equities.

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.


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

20,000 1,600

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

Source: BEA, Fed, flow of funds, Stephanie Pomboy (MacroMavens, LLC)


The performance of commodity “blue chips” is driven by:

1. global equity performance

2. global commodity performance

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
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.

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.

By comparing the great commodity companies to the great US-based

global companies, the investor can identify which nation’s economic
performance is most important for stock price performance. For the American
non-commodity blue chips, it’s the USA; for the commodity companies—
including the oil majors—it’s China, together with the other major Asian
emerging and emergent economies.

September 2010 21
IBM@1 = Big Ben’s Big Blues

The Deflationary Decade, You Say?

The Lost Decade has tragic longer-term consequences for Baby Boomers as a
population cohort and for pension funds.

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




2,000 2,225.44


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

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.

Sadly, it would hold that title for just three years.

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


down Long-Term Capital, and how to get around the constraints of
Paul Volcker’s Basel Rules by using the Enron accounting model for off-balance-
sheet assets of lower quality to drive actual leverage half-way to the moon.
What was needed to make these formulas work was to create complex new
products faster than Silicon Valley had ever developed them, and peddle ...while the stench of
them to banks and hedge funds. dead techs was still
in the air, a worse
Main Street banks were good for the basic tranches, because they could get
collective delusion than
guarantees from Fannie and Freddie, but whizbang mortgage originators
Nasdaq had appeared...
like Countrywide and New Century Financial who asked few questions
and got even fewer honest answers from prospective homebuyers supplied
the erotic exotica of the upper tranches. The homebuyers understood the
nudges and winks: home prices could only go up, so everybody involved in
these [slightly] irregular transactions was going to win big. Fannie Mae and
Freddie Mac were always there to help through purchases of subprimes, and
Barney Frank and Chris Dodd, chairmen of the important Congressional
committees, made sure that any objections raised by those damn Bushies
were brushed aside.

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. 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

…with unimaginably worse consequences.

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

When Will the Lost Decade End?

Just over the horizon looms what Obama hopes is the Promised Land, but
what many prominent economists think is a new disaster.

...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.


The one tax that would make economic sense would be a national sales tax,
but that has as much political appeal as a ruthlessly-enforced 50 mph speed

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
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 and Silver in the Lost Decade

September 1, 2000 to September 8, 2010





Sep-00 Sep-01 Sep-02 Sep-03 Sep-04 Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10

September 1, 2000 to September 8, 2010

20 19.85



Sep-00 Sep-01 Sep-02 Sep-03 Sep-04 Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10

Barrick Gold Corp. (NYSE: ABX)

September 1, 2000 to September 8, 2010
45 44.39

Sep-00 Sep-01 Sep-02 Sep-03 Sep-04 Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10


Newmont Mining Corp. (NYSE:NEM)
September 1, 2000 to September 8, 2010

60 60.01





Sep-00 Sep-01 Sep-02 Sep-03 Sep-04 Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10

Goldcorp Inc. (NYSE:GG)

September 1, 2000 to September 8, 2010
Sep-00 Sep-01 Sep-02 Sep-03 Sep-04 Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10

Silver Wheaton Corp. (NYSE:SLW)

January 1, 2005 to September 8, 2010




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

September 1, 2000 to Sept 1, 2010
Why did precious
metals climb so 200

high when inflation 190

was increasing so
modestly? 180


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


And why are the precious metals outperforming most commodities and
nearly all stock market indices now that the word deflation has entered
common currency?

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

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

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

Explanations for Gold’s Recent Rise

1. Gold and the Dow

Pierre Lassonde, formerly of Newmont and now Chairman of Franco

...the sudden threat of Nevada, is one of those who believes there are long-wave cycles between
a Greek debt default the Dow-Jones Industrials and gold. Historically, at some point gold and
sent Poseidon-scale the Dow trade at the same price. The last time that happened was in 1980,
shock waves through just as Paul Volcker was starting to twist the monetary vise that would crush
the Mediterranean... inflation, sending the US back into recession. Lassonde and his intellectual
brethren believe that the two asset classes will meet again within a few years:
they just don’t know whether that will be at $6,000, $8,000, or $10,000.

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 European Central Bank responded to the new global concerns by setting
up stress tests for Eurozone banks. Nearly all the banks passed, which
suggested to some skeptics that the Mediterranean had become Lake Wobegon
on majestic scale. (Recent examinations of some eurobanks’ balance sheets
by some smart analysts confirm that cynicism.) ...European Central
Bank-IMF rescue package
Through all this shock, hand-wringing, political battling, and fear of future
was supposed to
shock, gold’s price continued to rise.
postpone Greek Tragedy
The European Central Bank-IMF rescue package was supposed to postpone and financial Medideaths
Greek Tragedy and financial Medideaths for at least two years. However, for at least two years.
Credit Default Spreads on government and bank debts in the region are once
again climbing, and that has triggered a new all-time high for gold.

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.)

This Deutsche-angst, in which long-buried fears suddenly erupted across a

broad swath of the population, was, we believe, an historic moment for gold.
It could no longer be dismissed by sophisticated economists as merely the
antiquated pre-Keynesian fixation of foreign exchange funds, or the delight
of jewelers and people who might feel the need to leave their homeland
under cover of night. It was suddenly the last remaining protection against
cynical deals made by politicians and bureaucrats with each other in defiance
of the wills of voters.

September 2010 31
IBM@1 = Big Ben’s Big Blues

As we have noted previously, when the member nations agreed on the

creation of the euro, they set up a committee to approve the faces that
would appear on the new currency. This was going to be the triumph of
the European dream—currency celebrating the people that had made the
The euro’s loss is West the world leader in arts and science and philosophy. After years of
gold’s gain. increasingly frustrated meetings, they abandoned the project: they couldn’t
agree on even one great European whose visage wouldn’t be offensive to
some group of Europeans. Consider: If the new united Europe can’t agree on
even one of such eminences as Leonardo, Michelangelo, Verdi, Mozart, Bach,
Beethoven, Titian, Cezanne, Montesquieu, Descartes, Erasmus, Rembrandt,
Dante, Goethe, Curie, Pasteur, or Liebig, why should anyone trust its paper
money depicting buildings and bridges?

The euro’s loss is gold’s gain.

3. Inflation and Troubles for the Dollar and the Pound

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.)

Both those currencies offered convertibility into specie—the pound into

gold (until World War I) and the dollar into silver (until 1964). During each
currency’s global dominance, it was backed by the world’s leading navy,
a general commitment to free trade—and, until recently, a willingness to
pursue and hang pirates.

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.


Quite simply, unless America moves decisively toward budget balance, (which
may require that the threat from Islamic terrorism shrinks to mere nuisance
status), it is hard to see how the dollar can remain the global store of value.
Gold’s core inverse factor is the dollar—although it has more recently been
trading inversely to the euro. There will not be
enough gold to
Those who sneer that gold has not outperformed Treasurys over the very long
satisfy the needs of
term ignore the fact that the basic financial projections for the US have not
the newly needy.
been this weak since the outbreak of the Civil War. Moreover, new gold mines
were being discovered and developed across the globe for most of the past
two centuries. No longer do new discoveries more than make up for declining
production rates in existing mines. Indeed, most new deposits involve grades
so low they would have been unthinkable even five years ago.

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.

Gold’s rather sudden emergence as the optimal hedge against recession-

driven deflation and derivatives-and-debt-driven inflation has given it new
luster. It has mitigated risks and saved people’s lives from tyrants or invaders
for millennia. It is now the last best hope against governments’ willingness
to create debts to fight downturns—even at the cost of the money that will
be printed later to service those debts.

What worked in the stagflationary 1970s is now working to protect the

wise against new kinds of government-spawned threats against the wealth
remaining after the Lost Decade.

Conclusion: There will not be enough gold to satisfy the needs of the newly

September 2010 33
IBM@1 = Big Ben’s Big Blues

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%.

So gold is not trading at $1250 because of rising fears of inflation. It is there

because (1) it is very scarce and because investors are beginning to worry
about a double-dip recession at a time the US government has lost political
support for further bailouts. And (2) because so many investors are in a funk
in which they see the longer-range American fundamentals deteriorating by
the week.

The US political class is being marked down as the recovery weakens.

Perversely, the dollar has lately been strengthening, joining the yen in the
losers’ club of weak economies with painfully strong currencies that make
those flaccid economies even weaker.

Japanese voters are conditioned to live in an economy that barely shows a

pulse, run (if at all) by men too old to run. The only break in this pattern
of gerontocratic drift was Koizumi, who briefly shook the nation out of its
decline. But he had to step down after a near-record six years in office, and
the succession of faceless failures resumed.

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.


If so, then the longer the better: a 30-year Treasury zero is a splendid
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.

When the risk is recovery, accompanied by inflation, the short-dated the

Treasury the better.

When the risk is bifurcated—Depression and/or Inflation—Gold is the

all-in-one hedge.

Gold is both a short-duration and long-duration asset. It is totally liquid, but

it will survive forever, and its value will shift, depending on economic and
geopolitical events.

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.

We are not predicting a Depression, of course, but we are predicting a faltering

US economy that will deliver unsatisfactory results, at least for the near term,
and that means problems for most US equity groups—and problems for
companies exporting to the US from plants abroad.

September 2010 35
IBM@1 = Big Ben’s Big Blues

Was G20 The Top For Canada?

Canadian Dollar vs. US Dollar

January 1, 2000 to September 8, 2010
We have been unfailingly 1.10

bullish on Canadian 1.05

assets throughout this 0.96
Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10

Toronto Stock Exchange Composite Index compared to S&P 500

(currency adjusted)
September 1, 2000 to September 8, 2010
Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10

TSE Composite Index S&P 500

We have been unfailingly bullish on Canadian assets throughout this

millennium. We have told Canadians to sell US stocks and bonds in favor of
Canadian stocks and bonds, and have told foreigners—wherever resident—to
choose Canadian stocks and bonds in preference to American securities.


Canada has been the beneficiary of a continuing flow of favorable publicity
for the past two years because of:

• how well its financial institutions rode out the Crash;

• 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
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 Vancouver Olympics;

• the G8 and G20 meetings in Toronto.

In recent weeks, however, there have been some unfavorable developments:

• 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.

• A well-funded international campaign to demonize and vilify the Alberta

Oil Sands operations has been gaining visibility and influence, and many
retail stores in the USA have felt compelled to display noisome, misleading
posters about the alleged environmental catastrophe on the prairie.

• A campaign in Congress is being waged by enviro-extremists such as Henry

Waxman to try to ban imports of “dirty oil” from the oil sands.

• 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 growing recognition by international economists that the

worrisome US slowdown could quickly become seriously bad news for

• We hear increasing commentary (formally and informally) about the

Canadian real estate bubble, along the lines of, “Didn’t Canadians learn
anything from what happened in the US? Are they idiots?”

• 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.


Our Updated Thoughts on Canada
We were pleased that the Bank of Canada raised its rate this week—against
the recommendations of many prominent Canadian economists. To us,
the biggest worry facing Canada is a burst real estate bubble. Because most
We’ll take
Canadian mortgages are short-term or floating-rate, Governor Carney’s gutsy
competence and
move should cool off the housing market without sending it into a US-style
remoteness in
death spiral.
preference to
We remain impressed with how well Prime Minister Harper manages a enthusiasm and
minority government in comparison with President Obama’s unsuccessful tinsel anytime...
handling of a Congress with an overwhelming majority. In theory, a minority
government is weak and indecisive, because it can fall at any moment, but
Harper has kept this one going for four years, while accomplishing most of
his legislative goals. He is routinely derided in the Canadian media, which are
even more liberal than their US counterparts, and his occasional churlishness
and routine remoteness mean that he arouses ardor scantily, compared to the
tinselly magic of Nobelist Obama. We’ll take competence and remoteness in
preference to enthusiasm and tinsel anytime—and particularly during a bad
time for the economy.

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.

And Canada still looks blander 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.


IBM@1 = Big Ben’s Big Blues
1. What Is Potash Corp. Worth?

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.

Investors should be skeptical of those opinions, if only because, at $119

billion, BHP is, by far, the biggest-cap mining company in the world, and
all those mining analysts who follow it closely have a built-in bias in favor
of BHP management, and in favor of a management team that mines base
metals around the world, compared with management of a company that
produces a form of fertilizer mostly in Saskatchewan.

BHP is truly formidable.

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.

On the slavish, short-term-earnings-driven valuation basis that is (sadly)

utterly dominant on the Street, they could be right.

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.

It is the mining equivalent of a great museum having one chance to acquire—

legally—half the Vermeer paintings on earth at a price it can easily afford.

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.

A Chinalco-style blockage could stymie Mr. Kloppers again, which would

leave most Potash shares in public hands—at a temporarily reduced price.
But that is purely speculation at this point.

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.


2. The US Politico-Economic Challenges

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.

Yet, as a prominent American said, in another context, “The wells of

regeneration are infinitely deep.” Bettors against America have usually lost.
Restoration of political balance within Washington could be the first step on
the road to recovery.

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, it will be recalled, is a sin.

September 2010 43
IBM@1 = Big Ben’s Big Blues
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
US Bonds 17 +5
Canadian Bonds 8 unch
International Bonds 6 unch
Long-Term Inflation Hedged Bonds 10 unch
Cash 10 unch

We have increased our durations as a hedge against a new economic

Bond Durations
Years Change
US 7.50 +1.25
Canada 7.75 +1.25
International 5.25 +0.25

Global Exposure to Commodity Equities

Precious Metals 37% unch
Agriculture 27% +3
Energy 19% –1
Base Metals & Steel 17% –2

We recommend these sector weightings to all clients

for commodity exposure—whether in pure commodity
stock portfolios or as the commodity component of
equity and balanced funds.


IBM@1 = Big Ben’s Big Blues
Recommended Asset Allocation
Capital Markets Investments
Canadian Pension Funds
Allocations Change
Canadian Equities 18 –2
US Equities 7 –1
European Equities 3 unch
Japanese, Korean & Australian Equities 2 unch
Emerging Markets 10 –2
Commodities and Commodity Equities* 12 +2
Canadian Bonds
- Index-Related 22 +4
- Long-term RRBs 10 unch
International Bonds 6 –1
Cash 10 unch

We have increased our durations as a hedge against a new economic

Canadian investors should hedge their exposure to the US Dollar.

Bond Durations
Years Change
US (Hedged) 7.50 +1.25
Canada 7.75 +1.25
International 5.25 +0.25

Global Exposure to Commodity Equities

Precious Metals 37% unch
Agriculture 27% +3
Energy 19% –1
Base Metals & Steel 17% –2

We recommend these sector weightings to all clients

for commodity exposure—whether in pure commodity
stock portfolios or as the commodity component of
equity and balanced funds.

September 2010 45
IBM@1 = Big Ben’s Big Blues
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 lengthening of bond durations reflects two considerations: (1) pension

funds’ needs for higher yields in a steep yield curve environment, and, more
importantly, (2) hedging the total portfolio against downside economic

The raised allocation to commodity equities for Canadian accounts will

increase the portfolio’s exposure to precious metals as a deflation hedge.


IBM@1 = Big Ben’s Big Blues

1. Investors should retain above-average liquidity levels.

The US and European financial systems have solvency problems that have
been papered-over. They could explode suddenly, creating severe liquidity

2. Within equity portfolios overweight commodity stocks. As a group, they

have significantly less endogenous risks than the broad stock market.

3. Within commodity equity portfolios, use the four-sector approach. Its

biggest overweight should be precious metals, emphasizing gold.

4. The second-most attractive sector is agriculture.

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.

5. Crude oil’s day-to-day price changes are overwhelmingly driven by US

equity performance. The tight correlation cannot last forever, but as long
as the stock market continues to trade down, investors should underweight
energy within commodity stock portfolios.

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

8. Underweight financial stocks within US and European equity


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

9. Remain overweight Canada within North American and global


The soft patch for the loonie and the Canadian economy should not
become anything more serious.

10. In balanced portfolios, emphasize long-duration high-quality government

bonds as the best asset class for a double dip. When—or if—the clouds
start to roll by, reduce duration immediately.


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