B M O

C A P I TA L

M A R K E TS

R E S E A R C H

Basic Points
2007 ALMANAC 2008 OUTLOOK

Donald G. M. Coxe
Global Portfolio Strategist, BMO Financial Group (312) 461-5365 e-mail: don.coxe@bmo.com

Research/Editing: Publishing: Production:

Angela Trudeau e-mail: angela.trudeau@shaw.ca Monica Shin e-mail: monica.shin@bmo.com Anna Goduco e-mail: basic.points@bmo.com

Basic Points

Table of Contents

Foreword ..................................................................................................................................... 512 We Said It: 2007 in Review Outlook 2008 The Age of Complacency ....................................................................................................... January Milton Friedman: RIP Baubles, Bangles & Needs .................................................................................................... February DONT ASK; DONT TELL: ITS SUBPRIME TIME! ................................................................ March BYE-BYE, BOND BULL................................................................................................................April When The Financial Killings Will Have To Stop ........................................................................May Babel in Bond-Land .................................................................................................................... June Amazing Graces; Debt Demons .................................................................................................. July Two Part Issue:......................................................................................................................... August I. A Guide To Commodity Stock Investing II. Fall Came Early Jurassic Park Avenue.......................................................................................................... September The Ghosts of Octobers Past................................................................................................. October Commodities After the End of Disinflation .................................................................... November Double, Double, Greed and Trouble, CDOs and Housing Bubble ..........................................December Appendix I: Index The Big Themes of 2007 ...............................................................................................1 II: Investment Recommendations of 2007 ................................................................................13 III: Asset Allocation Changes in 2007 ........................................................................................14

Overview
Once again we reprintword for worda year of Basic Points. We remain gratified by the size of the readership for this hefty reprise, and grateful for the strong support we receive from a growing base of clients. It takes a determined and loyal reader to plow through twelve issues of a financial journal. As always, this almanac serves as a reminder of what markets were doingmonth-to-monthand how we interpreted those events and mood swings. As such, it is probably best consumed in intervalsrather than straight through. What was the market doing last May? And what did these guys think about it at the time? Did they have any idea how big the subprime mess was going to be? We have tried to stick to our shtick: We try to help long-term investors those with time horizons of five years or moremeet their goals. Trading accounts may glean useful ideas from some of our commentary, but we dont profess to have the right instincts or approachesor frequency of distributionfor short-term flips. The exception to this approach is our 35 years of experience with major stock market sell-offs. We have developed a set of indicators that have shown powerful predictive value during the major downdrafts since 1972. We therefore keep an iceberg watch, even though we plan to be cruising for years. Our thematic investing helps us to blend these ways of watching the horizons. We believe the great commodity bull market will remain intact for another decade, which means commodity stocks will outperform broad market indices almost every year. We watch the performance of Nasdaq and the bank stocks as contrary indicators. Our years of experience with Triple Waterfalls tell us that when the crashing asset class begins to outperform the broad stock market indices, that is a warning sign that the rally will fail. Example: The golds outperformed the stock market in 1987, even though gold was in the early stages of a 21-year collapse. That was a sign that the stock market rally had reached thin ice. When the US Dollar Index and the TED Spread then began to flash red alerts, we were able to warn clients that something wicked was this way coming.

Foreword

We have been doing this for decades, which means we have developed a relationship with many clients that has a warmth unusual by Street standards. We keep the conversations alive through two media: Basic Points is our flagship vehicle. Between publications, we stay in touch with our weekly interactive conference calls, which serve as updates on our major themes and provide commentaries on market fads and flaps.

We Said It: 2007 in Review

(a) Complacency Turns to Consternation
In January, we characterized the markets behavior since 2003 as The Age of Complacency. We had for months been expressing skepticism about the sustained yield compression, but our recommendations to invest in quality had proved misguided, Junk bonds have been coursing through the financial system like microbes and rats in sewer systems via the new breeds of collateralized debts and derivatives that make risk disappear almost magically. We remain skeptical that packaging can permanently upgrade what it wraps, but we admit that the financial systems magicians have been putting on a great show. By March, (DONT ASK; DONT TELL; ITS SUBPRIME TIME!) we had begun to realize that this great show was built on misrepresentations going all the way back to mortgage originations, which meant it was not just a problem for Wall Street. In May, (When The Financial Killings Have To Stop), we raised the question that the sustained global liquidity gush arising from the Beijing-Tokyo accord of October 1998 (that we have long called The Great Symbiosis), which had driven Treasury yields to unreasonably low levels, might soon haltwhich would send shock waves across global debt markets. By June, (Babel in Bond-Land) we lookedwith fearat the astounding growth of bond derivatives, comparing their hubris and vulnerability to the Tower of Babel story in Genesis. Each decade seems to produce its own form of collective financial hubris that leads to a meltdown....In this decade it is collateralized debt products that seek to make Risk disappear from cash markets into a tower inhabited by investment banks and hedge funds in which the shared language is algorithms. Like all past Babels, this one will, at some point, self-destruct.

Foreword

In the midst of the August global crisis, we were forced to update our analysis as an appendage to our primary themethe outlook for the commodity stocks. We noted how the subprime crisis had spread across the world, and began pondering how this gross capitalist abuse would damage both the economyand capitalism itself. We reached for a new metaphor for the debt meltdown in September, using Jurassic Parkwhere dinosaurs were created in labs by scientifically brilliant, but greedy and reckless, men. Those dinosaurs very nearly took over their environment. Similarly, the brilliance of the mathematical, software and marketing prowess of the debt investment banking divisions of organizations located on or near (Jurassic) Park Avenue was on a scale that would challenge the US economy and stock markets, and caused financial distress and crises across the world. We issued a plea to Wall Street to punish those who had hurt millions of homeowners and put the global financial system at risk. With financial crises occurring weekly, we chose Octobera disasterprone monthto recall financial crises we had lived through in our professional career (The Ghosts of Octobers Past). From those experiences we drew some lessons for the mortgage/CDO debacle. In December, we resorted to a new metaphorMacbeths witchesto explain how financial concoctions devised in secret could temptand corruptprominent men and inflict widespread pain and devastation (Double, Double, Greed and Trouble, CDOs and Housing Bubble). Why did we keep resorting to mythic or fictional themes to explain how top names on Wall Street were pummeling homeowners and investors on astounding scale? We are frequently most comfortable when we think by analogy. A decades experience with a quantitative investment management firm taught us that disciplined processes can indeed reduce investment losses from human errors and frailties. Organizations that learn the processes but never learn the disciplines are menaces to their clientsand ultimately to the capitalist system.

Foreword

(b) Inflation and the Commodity Bull Market: A Partnership for Our Time?
We were among the first to announce the birth of the Great Commodity Bull Marketand among the few who stuck with it and even added a new asset classagricultural stocksto the bullish story. So we updated our views on commodities and commodity stocks monthly, despite being forced to take notice of the unfolding disasters among investment banks and mortgage lenders. In February (Baubles, Bangles and Needs), we returned to our experience in India to revise our views on the attractiveness of gold and gold stocks. Noting that India had become the greatest gold-consuming nation, and that gold bangles were the dowry of choice among so many rural brides, we argued that one way investors could participate in Indias entry into the role of major global economies was through the oldest of readilytradable asset classes. In April (BYE-BYE BOND BULL), we finally caved in to our growing concerns that the major underpinnings of the Volcker-Reagan-Thatcher disinflation revolution were eroding seriously. The two decades of falling inflation and falling interest rates, which had spawned the greatest bond bull market of all time, had been built on stringent monetary policies, backed by excess supplies of food, fuels, metals and manpower. Three of those overhangs had turned to scarcity, and across the OECD, labor force growth was finally succumbing to the three-decade-long birth dearth. We developed those arguments in May (When The Financial Killings Will Have To Stop) as part of our review of the problematic underpinnings of the Treasury market because of the Clinton-Bush policies of shrinking the duration of the national debt and grossly abusing the Social Security Trust Fundpolicies that, if performed in a private sector fund, would almost certainly lead to lawsuits and/or prosecutions. In July (Amazing Graces, Debt Demons), we reiterated our strongly bullish call on the commodity stocksparticularly the agriculturalsdespite the rapidly-unfolding financial crisis. In essence, we argued that unless you were so scared as to be entirely in cash, you should get increasingly overweight the commodities.

Foreword

In August, we finally unveiled a weighting approach to long-term commodity investing. Clients had increasingly been asking us to be more specific about which groups looked best. We argued that precious metals would not be the best performers over the long term, but pressed for a 20% weighting now because the precious metals are overdue for a big rally. In November (Commodities After the End of Disinflation), we put the commodity and inflation stories together. Some clients expressed amusement at what they suggested was a cheeky title. We made the case that commodity stocks would outperform for the next five yearsas they had since the bull markets birth in 2002but that much of their superior performance would come from a fundamental repricing of their earnings: The mining and oil stocks that paced the market had experienced P/E declines in absolute and relative terms, because the investment consensus remained convinced that this commodity bull marketlike all its predecessorswould eventually collapse and real companies (such as tech stocks) would start to outperform. Our investment respect for basic materials and skepticism for technology is unchanged. Commodities Triple Waterfall Crash ended in 2001. Technologys Crash should last for at least another decade. Yes, there will be spectacular winnersRIM, Google, Apple come to mindbut the fast-eroding barriers to entry for most tech products make the famously-porous Texas barriers to illegal immigration look like the Great Wall of China in comparison. To be a great mining or oil company you need great, long-lived orebodies or oilwells in politically-secure regionsand smarts. To be a great tech company you only need smarts. Smarts are more widely distributed than politicallysecure minerals. (Come to think of it, on Wall Streetor maybe even Bay Streetsmarts can get you into trouble: Bland, bureaucratic banking where CEOs are long on prudence and tradition, and short on incentive compensation, is betterfor the stockholders and for the economy. Too many bankers who are highly paid seem to feel the need to do some really neat things to justify their outsized emoluments. Really neat may come to mean really disastrousfor stockholders and the economy, but never for the top execs. Heads they win; tails, everybody else loses. This is the updatingusing executive compensation consultantsof the outdated principles of Adam Smith.)

Foreword

Outlook 2008
The Chinese Calendar made a breathtakingly accurate call for 2007: It was The Year of the Pig. The roaring global economy was derailed by the collective greed and slime dumped on its tracks by the head hogs at some of Wall Streets biggest names. Indeed, there have been only two previously porcine orgies in Wall Streets perfumed history that plumbed such depths1929 and 1998-2000. Impressive also, is the Calendars call for this year: The Year of the Rat. The Rat is respected in Buddhist tradition as a canny creature. We are modernizing that interpretation, and basing our financial forecast on the Rat in its historic role in the West, as a prime carrier of Black Death (even though a few modern scholars dispute that allegation). Wall Streets Rats are indeed canny: They commissioned the creation and release of thousands of ingeniously designed financial plague vectors known as Collateralized Debt Obligationsand spread them across the world in far less time than it took for Bubonic Plague to follow the Silk Road to Europe. The Rats of 1344-50 didnt know they were spreading Plague, so they cant be villains. The Rats of 2005-7 had to know they were spreading financial disease: The models that issued the spurious default forecasts were based on subprime and Alt-A foreclosure loss rates during the years when house prices were rising almost as fast as the prices of the Shills and Mountebanks previous darlingstech stocks from 1997 through 2000. We shall be hearing a great deal about Rats as the year unfolds. Since few of the felonious rich have been subjected to any punishmentand many have been showered with going-away presents that would make an Alex Rodriguez or David Beckham envious, it is fitting that this should be a great year for Rats. The losers from the predations of the Big Rats include: Shareholders in banks and mortgage lenders that either originated the poisonous products or became beslimed; Shareholders in Index Funds, because banks and mortgage originators were worth roughly one-fifth of the S&P 500;

10 Foreword

 Investors in short-term enhanced cash or money market funds that bought beslimed products or invested in bank-sponsored SIVs that bought beslimed products. Almost anyone holding US dollar assets, or engaged in trade with US buyers: As revelations of large-scale defaults, foreclosures, foolishness and fraud became daily fare, the dollarthe symbol of US financial strength and reliabilityslid against nearly all currencies, even the Iraqi dinar. Homeowners by the millions who took on more debt than they could afford because of teaser deals, including low or zero interest rates, interest-only, and negative amortization come-ons: They will lose their homes and, perhaps, repent their greed and gullibility. Those who promoted and packaged those deals will, it can be safely predicted, repent neither their own greed or their organized institutional preying on the greed and gullibility of little people who, when their paychecks are issued, find that income taxes at full rates have been deducted. Suckers pay full taxes. The US economy: Scale of damage to be quantified this year. Ben Bernanke and his Fed colleagues: They wanted to defend the dollar and fight inflation; they have to bail out the rich and the vile to prevent an economic implosion. To date, their special injections have failed to stem the decline in the Monetary Base, so they have not been inflationary. Jean-Claude Trichet & his ECB colleagues, David Dodge and his B. of C. colleagues, and Mervyn King and his B. of E. colleagues: They all wanted to fight inflation, but have to bail out those who have been conspicuously misbehaving to save the innocent. The global economy: As the Bank of Canada summed it up, the subprime crisis has unleashed repricing of risk, a process that proceeds erratically, and is interrupted when central banks make massive injections into debt markets. A few major banks have managed, by their recklessness and amorality, to have forced far greater anti-panic injections by central banks than al Qaeda has achieved. Whatever growth was expected for 2008 and 2009 by the seers has been scaled back considerably. The extreme bears predict a US recession that will prick the Chinese bubble and spread economic chaos across Asia. Foreword 11

As will be clear from our review of what we wrote last year, it took several months before we understood the dimensions of the deceptions Wall Street had injected into the global financial system. When a municipal water system is injected with toxic materials, the results may not show up for days, and can range from outright death to mild nausea. Bear Stearns, Merrill Lynch and their brethren will not know the full outcome of their sale of toxic waste as AAA products for at least another year. We expect that the current bear market in financial stocks will become a broad-based bear, implying a correction of 10%-20% before bottoming out. We expect the financials and golds to give us the All Clear signal for the US stock market, when they switch roleswith gold stocks moving sideways or correcting down from what will be new alltime highs, and financials delivering at least six weeks of outperformance of the S&P on relative strength. An optimistic interpretation of what lies ahead is that the appalling blunders or deceptions of leading bankers and hedge funds and Private Equity funds will lead to a necessary cleansing of the global financial system. For years, we were told that one of the biggest reasons for maintaining a small weighting in Emerging Markets was the cronyism, poor accounting, and even criminality (by our standards) of Third World financial institutions. Better to keep your money with those sound, prudent Wall Streetand City and Swissinvestment banks. Well, so much for that modern version of The White Mans Burden. Bankers who blow billions with product lines that barely existed in earlier cycles, or who create off-balance entities to get around the Basel Accord, or who enter into dubious dealings with Prime Broker hedge funds to mask overvaluations of non-market instruments, have done more damage to American homeowners and the global financial systemand slashed more value from bank stock pricesthan all the Third World financial scandals in decades. Maybe well hear no more self-serving piffle about modern computer-based risk management techniques that warrant higher stock market valuation of bank earningsand other justifications for outsized exec stock option and bonus programs.

12 Foreword

If we actually get virtue in banking, and protecting and serving stockholders and clients actually come before pampering CEOsbefore and after disastersthen maybe a modest US recession will be worth the pain. Assuming the US downturn is not deep enough to derail the Asian Miracle, then US and global stock pricesand interest ratesshould be higher by yearend than today. Getting from here to there will have to include some serious pain for those investors who display their vestigial faith in the leadership of the global banking system by hanging on to stocks of major investment banks that have announced huge lossesbut only for stockholders.

Foreword

13

Basic Points
The Age of Complacency

January 12, 2007

Produced by BMO Financial Group Distributed by BMO Capital Markets

Basic Points
An Investment Journal
Donald G. M. Coxe
Global Portfolio Strategist, BMO Financial Group (312) 461-5365 e-mail: don.coxe@bmo.com

Research/Editing Production/ Distribution

Angela Trudeau e-mail: angela.trudeau@shaw.ca Anna Goduco (print orders and mailing lists) e-mail: basicpoints@bmo.com

The Age of Complacency

Overview
The 1990s were the Age of Mania. After 9/11 came the Age of Fear. We have entered the Age of Complacency. This Age will age faster than its predecessors. Last year was rewarding for almost all asset classes except oil, gas, and shortonly hedge funds. Large-cap stocks were up; small-cap stocks were up; Emerging Markets Stocks were up; Bonds were up, and, as in the Biblical forecast, they that were last [in quality] were first. The greenback was down, but not much, and its descent was so restrained and graceful that it became a net supplier to global liquiditywhich needed reinforcement as much as New Orleans needed the last inch of rain from Katrina. Liquidity was so robust that it continued to slosh happily through financial markets despite tightening by the Fed, the ECB, the Bank of Japan, the Bank of Canada, the Bank of China, and the Reserve Bank of Indiato mention only a few of the cautious curtailers of credit. Inverted yield curves, those historic harbingers of horror, demonstrated no greater ability to frighten financial markets than Halloween masks. Looking forward, we think that 2007 could be the first year in which investors are forced to plug workforce demography into their projections. The births that didnt occur in the industrial world from 1970 to the late 1980s are the great gaps in todays and tomorrows workforces. Good result: near-record low unemployment across the non-Japanese G-7. Bad result: coming pressure on corporate profit margins from a worker shortage and slower growth in the population of consumersand homebuyers. Until now, demography has mostly been discussed in terms of the aging of societies. We think the important story could prove to be the hundred million or so potential workers and consumers who were never born. Yield spreads continue to shrink, suggesting that bond buyers are becoming what might be called nanophiliacsinvestors addicted to microscopic income premiums. Junk bonds have been coursing through the financial system like microbes and rats in sewer systems via the new breeds of collateralized debts and derivatives that make risk disappear almost magically. We remain skeptical that packaging can permanently upgrade what it wraps, but we admit that the financial systems magicians have been putting on a great show. The new year begins with mostly good news, and we hope that will continue: To all our clients, a happy and prosperous New Year.

January

Recommended Asset Allocation

American Portfolios

U.S. Pension Fund

Domestic Equities Foreign Equities Domestic Bonds Long-Duration Bonds Foreign and Foreign-Pay-Bonds Cash Allocations 24 26 15 15 15 5 Change unch unch unch unch unch unch

Foreign Equity Allocations

European Equities Japanese and Asian Equities Canadian & Australian Equities Emerging Markets Allocations 6 6 6 8 Change unch unch unch unch

Bond Durations
Global US Canada Years 4.50 5.25 5.50 Change unch unch unch

January

Basic Points
The Age of Complacency
The Year Fear Fell From Favor
No doubt about it: 2006 was a very good year for the markets. No doubt about it: 2006 was a very good year for the global economy. Despite a slowing US economy amid sustained warnings of a housing-led recession, despite strong oil prices and soaring precious metals prices, and despite tightening by all major central banks, financial markets performed splendidly.
S&P 500 January 2006 January 2007
1,450 1,400 1,350 1,300 1,250 1,200 1,150 1,100 Jan-06 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07

It...was a very good year...

Russell 2000 January 2006 January 2007

900 800 700 600 500 400 300 Jan-06 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07

January

EAFE iShares January 2006 January 2007

80

75

70

65

60

55 Jan-06 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07

US Dollar Index January 2006 January 2007

92

90

88

86

84

82 Jan-06 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07

Yield Spread between US Triple A Bonds and Single B Bonds January 2006 January 2007
-2.0 -2.2 -2.4 -2.6 -2.8 -3.0 -3.2 Jan-06 Mar-06 May-06 Jul-06 Sep-06 Nov-06

Source: Lehman Brothers Inc.

January

Basic Points
Yield Spread between Emerging Markets Bond Index and US Treasurys January 2006 January 2007
2.1 2.0 1.9 1.8 1.7 1.6 1.5 1.4 1.3 1.2 Jan-06 Mar-06 May-06 Jul-06 Sep-06 Nov-06

The shaken sheiks switched their plutocratic cash flows to other markets...

Source: Lehman Brothers Inc.

Most impressively, this bullish gamboling across a financial world that seemed composed almost entirely of sunlit uplands was not so frantic as to signal the return of manic conditions. Price-earnings ratios rose, but the only big bubbles appeared in the Arabian Gulf markets. When those bubbles suddenly burst, there were warnings of doom from those accustomed to warning of doom, that these mini-markets were the canaries in the global financial coal mines. Instead, they proved to be the bearers of good tidings of great joyand great investment flowsto global bond and stock markets. The shaken sheiks switched their plutocratic cash flows to other marketsparticularly the Eurozone, other Asian markets, and private equity funds. This was the year in which private equity funds and hedge funds (including Goldman Sachs and their brethren) moved from mere prominence to seeming dominance in the US and some other global markets. Then, in May, the Carry Trades gloriously profitable access to Amazonian floods of near-zerocost financing from the Bank of Japan suddenly went down the drain with the 30 trillion yen drained by the BOJ from the euroyen market. Result: there were miscarriages in commodities, US long bonds, and Emerging Markets bonds and shares, and, for a few anxious weeks, it looked as if the magic money machines would implode. Not to worry: In July, the BOJ announced it was comfortable with the size of its downsized (but still hefty) Monetary Base, and the big players were able to resume, albeit more cautiously, their euroyen borrowing. They had also been diversifying into funding in other Eurocurrencies. Markets stabilized, and most equity asset classes entered a new bull phase. The Fed went on hold, after a pattern of tightening at each meeting, and some other major

January

central banks were either in pause mode, or were tightening with less fervor. The Bank of China and the Reserve Bank of India moved to the head of the somewhat diminished Global Restraint Class. (The oldest established of them all would rejoin that Class on January 11th.) ...crude oil markets...got spooked in early summer by the Katrina ReDux Klan...
Goldman Sachs May 2006 January 2007
210 200 190 180 170 160 150 140 130 May-06 Jun-06 Jul-06 Aug-06 Sep-06 Oct-06 Nov-06 Dec-06 Jan-07

It helped greatly that crude oil markets, which got spooked in early summer by the Katrina ReDux Klan, (a noisy group of amateur Apocalypse Now! weather forecasters), came to realize that a one-half degree rise in global temperatures didnt, by itself, guarantee an immediate reprise of The Big One. Instead, one of the most benign hurricane seasons of recent times blessed the Gulf of Mexico, Oils Dwarf Gulf. Oil prices stopped climbing, and began a deep descent. (The news about the recovery from Katrinas devastation in New Orleans and Mississippi remains sad; the shortage of workers is seriously hampering reconstruction. More on that theme on p. 20.) Oils plunge was greased by falling fears of an Iranian-sparked war in Oils Giant Gulf. Mahmoud Ahmadinejad relaxed his warnings of an attack on the West, relying on his great good friends and great good trading partners on the UN Security Council to ensure that the worst he and his friends need fear was a limp-wristed slap, not amputation. He was ecstatic with the way things turned out for his troops of Hezbollah in Lebanon, as the cease-fire sent the Israelis out and left the Iranian-backed armies intact. It took these worthies only a few weeks to take to the streets and launch a campaign to bring down the Cedar Revolution governmentone of the few democratically-elected governments in the Arab world.

January

Basic Points
Crude Oil March 2006 January 2007
80

75

70

65

Present fears are less than horrible imaginings.

60

55 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07

So, 2006 could be summed up in the words of Lady Macbeth: Present fears are less than horrible imaginings. Amid hand-wringing about houses, and cursing about yield curves, the US economy performed better than the doomsayers warned, but slightly worse than most economists and investors expected. However, the global economy continued on an even keel. Result: stock markets abroad outperformed the US, most investors were contented, and some were ebullient. Not bad for the world five years after the recession caused by techs collapse and 9/11.

The What, Me Worry? World of Finance

VIX Index January 1987 January 2007
50 45 40 35 30 25 20 15 10 5 Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06

January

When the VIX (the index that measures the ratios of puts to calls in options trading), and other risk spreads and indicators collectively display an insouciance that borders on insolence, either something bigand goodis happening or the possibility of something bigand badis being ignored. ...the spectacular Fall of the Great Wall of Worry about Chinese Banks... The VIX reached an all-time low in late December. Apart from a spike at the time of the outbreak of war in Lebanon (coinciding with oils leap to $79), the VIX has been declining from the low twenties to the teens over the past three years, resembling the chart of an aging processmonth-by-month descent, interrupted spasmodically with energy bursts, followed by even deeper senescence. By the VIX test, the world has achieved financial and economic peace in our time. That assessment is significant, because the VIX has long been a useful and reliable measure of the presence of Fear on Wall Street. Its remarkably benign readings have led some observers to question whether it is still relevant. Could it be that the enormous growth of Private Equity has corrupted the VIX? A shrewd client raised this suggestion in one of our recent Conference Calls. He was prescient: The Wall Street Journal shortly thereafter published an article that suggested that the scale of private equity buyouts, plus the scale of rumors of potential private equity buyouts, could be reducing investors need for put options. The reason the VIX has been such a useful indicator for so long is that rising put activity has historically been a sign of coming market corrections. As investors sense rising levels of risk, they buy insurance through puts. However, if investors dont think they need insurance, the business of writing puts languishes. There is logic in this analysis. The principle of insurance is that insurers appraise risk levels in setting premiums. Insuring expensive mansions on barrier islands off Florida has become almost prohibitively expensive because of the frequency of killer storms. Insuring against frost damage, on the other hand, is cheap. If investors think that a takeover bid will quickly ensue if a stock falls a few points, then they may feel they dont need to protect their positions with puts. However, the VIX is not alone in its Rubaiyat-like peace. The TED Spread, credit spreads, and the spectacular Fall of the Great Wall of Worry about Chinese Banks confirm the tranquility of the financial world. It is less than two years since some of Wall Streets best-known Sinologists warned of a coming

January

Basic Points
collapse of the big Chinese banks. Instead, what came was a world-record IPO. So much for the argument that Chinese banks were in worse shape than the Japanese zombie banks of the early 1990s. No wonder the VIX closed the year at a mere 11, down from a high of 23.50, when it was responding to the pain from the BOJs liquidity drain. In our Conference Call of December 21st, we commented, Perhaps what we have most to fear is the absence of fear itself. We were thus pleased to read Larry Summers essay in the Financial Times of December 27th, which concluded with the words, At least as far as the markets are concerned, perhaps the main thing we have to fear is lack of fear itself. Dr. Summers is one of the brightest and most accomplished men of our time. His fatal flawa famously low threshold of tolerance for foolishnessshould have disqualified him as a candidate for the presidency of Harvard. In this article, he addresses one of the most-adduced reasons for financial complacencythe markets ability to handle financial risk through increased securitization and syndication observing, It is natural that associated risk premiums have also declined. After surveying the arguments for greater stability, he notes, It is fair to point out to those who take comfort from the markets comfort that they hardly ever predict serious disruption and historically the moments of greatest complacency have been the moments of greatest danger. Woody Brock argues persuasively that the US stock market has, for too long, been priced based on its continuing belief in the stock market risks inherent in a very wide standard deviation for the US economy. That deviation has not existed since the onset of the Reagan-Volcker era. After the tumultuous 1970s, annual swings within the US economyin terms of GDP and inflationhave narrowed in each decade. We agree with his suggestion that, because of reduced macro-volatility, priceearnings ratios deserve to be somewhat above long-term levels, and longterm bond yields should remain lower during periods of Fed tightening than in the Bad Old Days (when the Bad Old Ideas of Keynes, Samuelson et al. ruled.) However, the rally since late-July that has taken the S&P from 1230 to 1426 has been a straight trip, with few stops even for bathroom breaks. Meanwhile, US GDP growth has begun to shrink like an economic version of Alice after downing a big swig from the Drink Me bottle. That economic shrinkage has been a growth elixir for bond buyers. ...the rally since late-July...has been a straight trip, with few stops even for bathroom breaks.

January

US 10-Year Treasury Yield July 2006 January 2007

5.4 5.2

The stock market wasnt as nave as the Pfizer board...

5.0 4.8 4.6 4.4 4.2 Jul-06 Aug-06 Sep-06 Oct-06 Nov-06 Dec-06 Jan-07

TLT (The ETF for Long Treasury Bonds) July 2006 January 2007
94 92 90 88 86 84 82 Jan-06 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07

In other words, the US stock market rally has been driven, in good measure, by the fall in long yields and by the growth of the new consensus that the Fed will just have to start easing soon. True, stock valuations show that investors are no longer gripped by the kind of lunacy that drove the Nasdaq to 5000. Neither do they any longer seem to share the faith in huge future profit growth that inspired such CEO horror stories as Pfizers Hank McKinnells pay package. (McKinnell was paid as if he would deliver fabulous results to investors with patented cures for cancer and heart disease. The stock market wasnt as nave as the Pfizer board: PFEs stock performed as if all the companys products were going generic at once.

10

January

Basic Points
His most noteworthy accomplishment was to get the Business Roundtable that had chosen him as its Chairman and spokesman (!)to retain Pfizers own compensation consultants to publish a study that claimed American CEOs were underpaid. This Roundtable document was, perhaps, the second cheekiest claim of our time, exceeded only by North Koreas insistence that Kim Jong Il once shot a round of golf that included several holes in one.)

Another Year for the Fearless?

a) Slowdown Finally Hits Industrial Metals
Since last July, we have been arguing that a US-led global economic slowdown would lead to the Second Phase of the Great Metals Bull Market of this Decadethe slow Second Movement in a Miner Key of the three-part Sonata that would accompany a decline in base metal prices. We recommended that clients hang on to their mining stocks because it was unclear how far they could decline, and because we expected further takeovers, but they should hedge their risks in the base metal stocks by purchasing long zero coupon bonds.
Copper January 2006 January 2007
425 400 375 350 325 300 275 250 225 200 Jan-06 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07

...the Second Phase of the Great Metals Bull Market of this Decadethe slow Second Movement in a Miner Key

January

11

Zinc January 2006 January 2007

4,700 4,200

At times last year... inventories of the three key base metals were measured in days.

3,700 3,200 2,700 2,200 1,700 Jan-06 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07

Nickel January 2006 January 2007

40,000 35,000 30,000 25,000 20,000 15,000 10,000 Jan-06 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07

It took a while, but eventually the metals inventories began to respond to the sustained contractions in global liquidityand all the publicity about the bursting of the US housing bubble. At times last year, Exchange-disclosed inventories of the three key base metals were measured in days. Each time these numbers were published, the many bears on the base metals would growl that certain unnamed market players were misrepresenting the true situation by manipulating the LME and Comex inventories. Tales of huge hidden inventories in China and Europe were told. King Copper is the kingpin of the industrial metals, and its action is always a potent influence on what happens to the prices of the others. Naturally, it became the focal point of market reactions to soaring metal prices when it broke out on the upside above $2.00 and kept running. As copper was moving smartly higher, one of the Internets most-followed weekly investment advisory services published two Sell recommendations by the man it claimed to be the worlds foremost expert on copper. He claimed

12

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Basic Points
that the Chinese were in the process of springing a giant trap on copper speculators. They had hidden their inventories and disguised their short positions, and they were about to flood the market with metal and would collapse copper prices back into the high pennies. The only trap was for those who followed these shrill forecasts. One reason given for the Sell stories from those who might personally be heavily short was that the operating capacity of the worlds known operating mines was, at all times, marginally greater than global demand. Moreover, copper had been the object of massive price manipulation at times in the past, so it was always possible that a new scam had occurred. We have always tended to use the Occams Razor principle (The simplest answer is the best) in situations where people are alleging dubious, dastardly dealings to explain something that is more likely to be occurring because of obvious conditions. That inventories were slim was due primarily to demand matching supplystated supply. But the mining industry routinely experiences glitches, cave-ins, strikes and shutdowns, let alone riots, revolutions, and wars. Freeports massive Grasberg copper-gold mine has been particularly prone to cave-ins due to water and pitwall problems. Also, from time to time, the local natives get restless, particularly when they are told by activists that the mine is polluting their environment. Since 2001, actual supplies of new-mined metal have been unable to keep up with strong demandparticularly from China. Scrap has made up the difference, but scrap supplies are not as reliable and predictable as supplies of virgin metal. (So much of the scrap that has been sent to smelters in recent years has come from looting and pillaging that the industry is facing growing demand to start scrutinizing offerings from dubious sources. How worried it may actually be about the complaints isnt clear. The spokesman for the Canadian Association of Recycling Industries responded to critics by admitting, If you show up with a whole roof from a church, somebody should be asking questions. We say Amen to that.) Once exchange-traded inventories of copper (and the other metals) began to be measured in weeks, not days, traders rushed to unload as if it had been announced that a technological breakthrough meant that all base metals would be replaced with plastics. If you show up with a whole roof from a church, somebody should be asking questions. We say Amen to that.

January

1

...since King Leopold and all the Belgians fledas if pursued by King Kongin 1960.

Dennis Gartman, who is as smart (and readable) as they come, has said that he doesnt expect to see $4 copper again in his lifetime. Wed be prepared to bet him on that grandiloquent assertion. True, $4 was not a demand-driven price, but the result of a brilliantly executed short squeeze at a time demand had been running ahead of supply for two years. Shrewd players salivated at the declining inventories, knowing that some major miners, (notably Phelps Dodge) who could, in theory, afford to hedge more heavily if prices spiked, were already disastrously short. Such low-risk opportunities for short squeezes dont come oftenand their unwinding after the speculators have made a bundle doesnt mean the long-term bullish case is now dead. We disagreed strongly with those who said $2 copper was an insane price that would trigger gigantic new production that would hammer prices. There are few copper deposits of meaningful size in politically secure areas of the world that could be brought on stream in the next few years, and it takes so many years and so much money that they will not come into production unless copper prices stay highin historic terms. Even in famously insecure regions, where litigation risk is minimal, bringing on new copper mines is no cinch. Katanga province of the Congo, long known as the greatest undeveloped copper region in the world, has been hot lately, with three big deposits under development. The Congo recently held an election, and some of our clients have been telling us that we should therefore abandon our negative attitude toward making serious investments in that tragic land where civil war has been the norm, not the exception, since King Leopold and all the Belgians fledas if pursued by King Kongin 1960. The good news is that things are calming down in the jungle. The bad news for Phelps Dodge and the other mine developers is that things are calming downwhich means various local strongmen, the World Bank, and a mushroom crop of other deal-breaking moralists, now claim that the deals the miners made with the fragile government are opaque. (Opaque is an international bureaucratic term for an agreement that was probably based on corruption, and should be a no-go unless that deal is rewritten to the satisfaction of a dozen big-name NGOs, the World Bank, and the UN Secretary-General.) Thats the way great non-opaque deals like the Iraq Oil for Food Program earn the international Good Housekeeping Seal of Approval (and earn so much for the selfless internationalists involved).

1

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Basic Points
Although coppers rise and fall have attracted the most attention, nickel and zinc have also had huge moves followed by merely modest corrections, without attracting coppers attention or allegations of Chinese booby traps. Nickel supplies are extremely short at a time of a renewed surge in stainless steel production, and zinc benefited from Beijings announcements that it was no longer promoting expanded zinc production because of soaring energy costs and increased concerns about air and water pollution. Conclusion: When $4 copper was in the headlines, oil was also strong, and gold was $700, the scare talk was of a return to 1970s-style stagflation. The Wall Street Journal was calling on the Fed to begin raising rates 50bp at each meeting to stop inflation mania in its tracks. Those commodities soared, more or less, together, and they have fallen, more or less, together. When global economic growth once again turns upward, the base metals will lead the commodity recovery, because their supply/demand profile is clearer than that of oil, and they arent burdened with the mystique of gold.

...the base metals... arent burdened with the mystique of gold.

b) Mainly Because of the Heat

The plunge in oil and natural gas prices is mainly because of the heat. The post-solstice weeks, ordinarily the time when thermometers plunge, have instead been the time for near-equinox temperatures in most of North America and Western Europe. It is as if the atmospheric environment were VIXed benign and beautiful. (Except for residents of the Pacific Northwest.) Whats bad for the XOI is certainly good for the rest of the stock marketand for consumers. A Bit of History:
Soybeans January 1972 January 1975
1300 1200 1100 1000 900 800 700 600 500 400 300 Jan-72 Jul-72 Jan-73 Jul-73 Jan-74 Jul-74 Jan-75 Jul-75

January

15

Corn January 1972 January 1975

400 350

It is as if the atmospheric environment were VIXedbenign and beautiful.

300 250 200 150 100 Jan-72 Jul-72 Jan-73 Jul-73 Jan-74 Jul-74 Jan-75 Jul-75

Wheat January 1972 January 1975

700 600 500 400 300 200 100 Jan-72 Jul-72 Jan-73 Jul-73 Jan-74 Jul-74 Jan-75 Jul-75

Gold January 1970 January 1975

200 175 150 125 100 75 50 25 Jan-70 Jul-70 Jan-71 Jul-71 Jan-72 Jul-72 Jan-73 Jul-73 Jan-74 Jul-74 Jan-75 Jul-75

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Basic Points
The unwonted warmth is generally taken as proof positive that global warming is accelerating. For example, political polls in Eastern Canada show a sharp leap in support for Green policies, particularly Kyoto-style controls on carbon dioxide. Even Exxon Mobil is, somewhat belatedly, professing greentinted views. Here in Chicago, where the weathermen report we have been enjoying a winter that is almost as warm as some of those in the Gay Nineties, there seems to be near-unanimity that the good news for home heating bills will continue because global warming has become the homeowners best friend. Heat in another locationthe Humboldt Current that flows from Antarctica to Mexicohas rather different implications for consumers and financial markets. The charts show what happened to grain prices in the 1970s when a major El Nio decimated Perus anchovy harvest at a time of low grain carryovers. (Anchovies were the globally important near-pure-protein animal feed supplement of the day.) Well, another El Nio is unfolding. The surface seawater in the Humboldt Current is heating up. El Nios are natural phenomena that have no relationship to the global warming/cooling cycles. After the major 1972 Nio devastated global grain markets, the Ford Administration began installing temperature sensors off the Pacific Coast of Latin America, a policy continued by the Carter Administration. As Carters Secretary of Agriculture disclosed to a special meeting of the Toronto Society of Financial Analysts three decades ago, this program was implemented to give the US Administration advance warning of likely crop failures in Australia, Russia and other grain-producing regions that could result from future El Nios. (During the runup to the 1972 election, the Nixon Administration, in a policy designed to attract farm-state votes and Soviet support for ending the Vietnam War, announced a program to sell US wheat to the USSR at $1.65 a bushel, financed by a seven-year loan to the Kremlin at a rate below Treasury yields. What it didnt know was that Russia and Ukraine were suffering disastrous crop failures. The Kremlin bought the

...global warming has become the homeowners best friend.

January

17

...the most expensive US aid program to the Russians since Lend-Lease.

entire US wheat crop that year, and, in a deliciously capitalist in-your-face response to Nixon and his machinations, resold much of it at three times the price it was charged. It was, we learned later, the most expensive US aid program to the Russians since Lend-Lease. The dramatic leap in grain prices was as great a contributor to short-term global CPI increases as OPECs quadrupling of oil prices. However, the Arabs unfairly got all the blame. See comment in our tribute to Milton Friedman on p.32.) A Modest El Nio? Once again, the global wheat carryover is lowthe lowest in a decade. Anchovies arent so important today, because Brazils huge soybean production in vast areas that were virgin Rain Forest in 1972 has changed the animal feed business. Tough on toucans. Good for the World Wildlife Fund, though. It was casting around for a cute endangered species to supplement its wildly successful panda fundraising, and preserving some of the toucans fast-shrinking habitat got the nod.
Wheat January 2006 January 2007
550 500 450 400 350 300 Jan-06 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07

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Basic Points
Soybeans January 2006 January 2007
725 700 675 650 625 600 575 550 525 Jan-06 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07

A moderate El Nio that would boost grain prices is pure lagniappe.

Corn January 2006 January 2007

400

350

300

250

200 Jan-06 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07

In our October issue, (Earth, Air, Fire, Waterand Globalism), we added agribusiness companies to our list of appropriate long-term commodity stock investments. Naturally, we hadnt known there would be a new El Nio then. Our case was based on the long-term shift in supply and demand. A moderate El Nio that would boost grain prices is pure lagniappe. It is too early to predict the power or duration of this Nio. Nor can anyone predict with certainty how the weather will affect crops in the Midwest and other breadbasket regions. But investors should consider the possibility that OPEC will be successful in protecting the $50 range on oil, and that the global economy will continue to slow, but prices of grains and meats climb sharply because of crop failures. That would not be a salubrious environment for non-agribusiness equities.

January

19

c) Will The Crucial Shortage Be Workers, Not Money or Stuff?

Last Friday, financial markets were roiled by a surprisingly strong US NonFarm Payroll report. Based on the ADP report issued three days earlier, economists had been looking for a break-even jobs report. Instead, the Labor Department not only reported a robust gain of 167,000 jobs, but upward revisions of the previous two months numbers. Even worse, (from a bond standpoint), workers pay rose at its fastest rate in six years. (We have not heard comment from the important expertsLou Dobbs, Pat Buchanan and their political friends, who have enjoyed such success by proclaiming that Bushs immigration policies send American jobs abroad, keeping American workers incomes unfairly low.) We have tended to cite the net jobs gain in the Non-Farm Payroll report as the basis of an investment decision in this journal only slightly more frequently than we have cited the insights of Scarlett Johannson or Paris Hilton. The much-watched Payroll Report is a Page One story whose numbers are subject to so many revisions that we long ago decided to leave it to the economists to parse. However, we also read that the rate of US unemployment remained at 4.5%, and that unemployment in the Eurozone is at a fourteen-year low, and unemployment in Canada is at a thirty-year low. The Eurozone statistic was particularly arresting: at yearend 1992, Germany was in the historic construction and reconstruction boom that followed reunification. As the formerly flinty West Germans poured billions and billions of Deutschemarks into the vast slum project that had been the Socialist Workers Paradise, jobs were creatednot only in Germany but across Europe. It was the first true boom in what is now known as the Eurozone since the 1960s, and may be the last it will experience for a very long time. That 1992 boom drove unemployment rates to new lows. This time, GDP growth across the Eurozone is in the 1.75% range, which is about the same as Canadas 4th-quarter rate (according to BMO Capital Markets Economics), and the USs 4th-quarter annualized rate. Is an insipid 2% the new solution to the G-7s unemployment challenge? The UKs current growth rate is slightly higher than the rest of the G-7, (according to the IMF), and unemployment there is in the 5% range.

We have tended to cite the net jobs gain in the NonFarm Payroll report ...only slightly more frequently than we have cited the insights of Scarlett Johannson or Paris Hilton.

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Basic Points
So, the non-Japan G-7 collectively has GDP growth of roughly 2% and unemployment at its lowest percentage since Valry Giscard dEstaing and Helmut Schmidt first called Gerald Ford about arranging a Western Economic Summit in 1975which became the G-7. Why is this significant? Because GDP growth has been modest, yet the Holy Grail of economic policyfull employment at low inflationis apparently within reach. Not sos youd know, to hear all the grumbling across the Eurozone and US about the export of jobs, and the need to stimulate the economy to create jobs. French voters repudiated the EU Constitution that had been drafted by DEstaing and endorsed by all French political parties except Le Pens Poujadistes. Polls disclosed that the principal reason given by voters for this act of lse majest toward the French ruling class was lack of job opportunities at a time of sluggish economic growth. How has sustained slow growth managed to produce that consummation devoutly wished by nearly all politicians, investors and, for that matter, economists? We think clients should consider the following possibility: This, it appears, is the first economic cycle in which the collapsed birth rates of earlier cycles become a defining characteristic of the economies of the industrial world..Japonaiserie, if you will. Japans economy has been unable to break out of its slow, stately Kabuki downward staircase performance, despite (1) record fiscal deficits, (2) zero or near-zero interest rates, (3) a machinery manufacturing boom arising from the nations status as #1 Supplier of Foreign Direct Investment to China, (4) the advantages flowing from being the headquarters for such global industrial phenoms as Toyota, Honda, and Sony, and (5) the productivity gains produced by a successfully technological society with a great record for educating its young at a globally competitive level. Why? Because its fertility rate became its infertility rate two decades before that change occurred in the rest of the worldand kept right on plunging. Result: the Japanese workforce declines during each economic cycle. ...the Holy Grail of economic policy full employment at low inflation is apparently within reach.

January

21

GDP is simply output per worker multiplied by the number of workers. If the workforce-age population doesnt increaseas it did in all earlier economic cyclesthen the only way real GDP can grow at what is called the trend growth rate is for productivity gains to increase at a rate that delivers productivity dividends and offsets the demographic stasis. Japan has proved itself incapable of growing at the rate that shocked the Wests sense of superiority. Yes, we know that, after years of fear about Japans growing competitiveness, it became fashionable to deride the Japanese experience with decline as irrelevant for the rest of the industrial world. The Wests comfort with It cant happen here came from powerful productivity gains since the early 1990s. But above-trend productivity gains cannotas Japan provedoffset plunging birth rates forever. Furthermore, we should not blindly assume we can count on above-trend productivity gains forever. Indeed, recent productivity statistics suggest that the peak gains are behind us. The Japonisation of European fertility rates began in the early 1970s, and the US fertility rate entered permanent decline (at a much slower rate than Europe) at about the same time. The US birth and fertility rates have remained near replacement levels, mostly because of Hispanic immigrationlegal and illegal. (Once again, Lou Dobbs, Pat Buchanan and their anti-immigration allies have both the wrong diagnosis about the condition of the US economy, and the wrong remedies.) But even in the US, the workforce-age population can no longer grow at anything remotely resembling the rate of postwar economic cycles. Yesterdays empty cradles are todays empty chairs in unemployment offices. This looks to be the first economic cycle of what will prove to be the unique characteristics of 21st Century Economic Cycles. We believe that production and economic growth in each ensuing cycle will be increasingly driven by labor-force-age demography, but politics will continue to be driven by the costs of maintaining yesterdays labor force. If we have reached full employment without vigorous economic growth and without painful inflation, then this isnt a Goldilocks Economyit may better be termed a Babyblocked Economy, as economic growth stays constrained by slow workforce growth. As we know from the complaints from politicians and unions, total job growth in the US and Europe during this economic recovery has been tepid

Yesterdays empty cradles are todays empty chairs in unemployment offices.

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Basic Points
compared to earlier cycles. Had the demographic profiles within the advanced industrial world resembled those of earlier eras, unemployment would have remained at the politically painful levels that would have forced central banks to favor monetary expansion, not contraction. Instead, the bankers have had the luxury of tightening for two years, confounding those skeptics who looked at soaring commodity prices as proof of a return to stagflation. (Barrons witty curmudgeon, Alan Abelson, continues to insist that we are living in stagflation that will lead to recession, but he sounds more and more like those Administration spokespersons who have for three years insisted the US was winning big in Iraq and Afghanistan.) Stagflation was the economic condition that changed the Western world. Double-digit inflation at a time of high and rising unemployment created deep social divisions and transformed politics. In Europe and North America, leftist governments fell, replaced by avowed conservatives: Reagan replaced Carter, Thatcher bested Callaghan, and Kohl defeated Schmidt. Thatchers win in 1979 came in a campaign based on TV ads showing long lines of unemployed at time of an endless succession of public sector strikes in support of wage demands far above those of the private sector. The winning slogan: Labour isnt working. The exception was France, where the continuing political power of the Moscow-oriented Communist Party under Marchais prevented the democratic Left from uniting to displace the Gaullists until Mitterand was able to forge a centreleft coalition that won in 1981 and retained power until the Chirac era began in 1995.) The problem with a strongly optimistic view of full employment without inflation as the perfect backdrop for stocks is that a major propellant of the bull market has been the extraordinary performance of corporate profitability. In all past cycles, once the recovery was well-established, labors share of corporate revenues increased, and profit margins eventually narrowed. This time, profit margins continued to widen, as the global wage arbitrage out of China and India combined with above-trend productivity gains to put management and stockholders into the sweet spot and kept them there. (As we now know, the sweetest spot from this windfall at labors expense has been in the CEOs chair: suddenly, every chief exec was ranked as a genius to be treasured, the way the Aga Khan used to be able to crawl into a seat on a scale, to have his weight matched in gold and jewels.) However, if North America is at nearly full employment, then the power balance is about to shift: the workers share of the pie will have to increase. No longer will new CEOs and division managers be able to crystallize their

...the global wage arbitrage out of China and India... put management and stockholders into the sweet spot...

January

2

Private Equity is now the fons et origo of most of the growth in debt that barely passes the smell test.

stock options and bonuses simply by firing workers and basking in investor applause, confident that those unneeded peons can be replaced later out of a plenteous pool of the unemployed, should growth require rehires. Already there are anecdotal reports that a new trend is emerging: many companies will be trying to protect their existing workforces even during periods of slowing sales growth, fearing that they will not be able to find capable staff when the next upturn comes. We think a strong case can be made for the argument that the profit gains since 9/11 were extraordinary, and that there will not just be reversion to the mean: in the next decade, the pressure on margins from foreign competition, coming from Asia at a time of mass retirements here, will mean that workers with good work ethics will becomedare we say it?scarce commodities. Remember when the only scarce human commodities to be found and retained at almost any cost were CEOs like Hank McKinnell and Bob Nardelli, and workers were mere costs which those geniuses were so wonderful at cutting? That, we believe, will prove to be yesterdays story.

d) The Bond Market: Junkyard Dogs Become Pampered Poodles

Another unsettling statistic published last week came in a Wall Street Journal article on the effect of private equity on the corporate bond market: 71% of the outstanding debt of S&P-rated US industrial corporations is now classed as junk, including seventy members of the S&P 500. One-quarter of debt outstanding is Double-B, 42% is Single-B, and 4% is CCC to D rated. Time was that Junk was the term for overindebted companies that could only break even or earn a modest profit when the economy was strong and the competition wasnt fierce. Each recession produced new tenants of the junkyard. Michael Milken changed all that. He gave the world the term High Yield and gave KKR et al. the takeover financing to become big enough to be feared as barbarians. Private Equity is now the fons et origo of most of the growth in debt that barely passes the smell test. Thats how Neiman-Marcus and Four Seasons Hotels find themselves included in a category in which the majority of companies are as out of place in polite company as Cracker-Jack with prosciutto con melone.

2

January

Basic Points
Although this year is Double O Seven, it is unlikely to be known as the Year of the Bond. That title goes to last year, which, according to The Financial Times, saw global debt capital offerings of $6,380 bn., twice the level five years ago and eight times the level of equity issuance, according to Dealogic. That global markets were able to absorb $120 billion in debt offerings in an average week meant that new products had to be devised to meet the new needs of new times. Last year, the Collateralized Debt Obligation came into its own. This vehicle for throwing together a wide range of debt products at a time of vertiginous growth rates for Credit Derivatives meant that banks, pension funds and mutual funds could buy a few issues and get wide diversification. Safety in numbers is a useful principle, particularly when loading up on substandard debt at a barely observable yield premium to quality merchandise. There are only six Triple A industrial companies left. In our childhood, we remember reading in New York Stock Exchange promotional material about The Bluest of the Blue,(less reverently known as Vestal Virgins)great companies that had zero funded debt. IBM, Coca-Cola and other giants were proud to be in that elite group, which, for investors who had survived the Depression, was the only kind of non-utility stock it was safe to own. Then Franco Modigliani began winning fame and friends on the Street with elegantly-reasoned research about the mismanagement of corporate balance sheets. (Those 1960 effusions won him the Nobel Prize in Economics in 1985, by which time there were fewer virginal balance sheets on the Big Board than there were unclad virgins entertaining visitors in Vegas.) Prof. Modigliani looked at how companies financed themselves and demonstrated that debt-aversion was a costly form of virtue. Not only were bonds a low-cost financing alternative to equity, debt interest was tax-deductible. He was, of course, correct. The Depression mentality had lasted too long. It was time for well-managed companies to strap on debt and trade on the equity. Wall Street profited hugely from this restatement of corporate morality, as the corporate bond market, which had been, in financial terms, the size of Herald Square, began the growth that would take it to Central Park size. If pure, pristine balance sheets were the markets outdated fixation on virtue four decades ago, then, by Modigliani standards, sophisticated behavior reigns.

Safety in numbers is a useful principle, particularly when loading up on substandard debt at a barely observable yield premium to quality merchandise.

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25

We understand the contentions that: 1. funded debt on corporate balance sheets at a time of historically-low yields makes sense; ...once the defaults begin, those odorfree products of investment banker sweat are going to start to smell. 2. funded debt on corporate balance sheets at a time of record-low premiums over Treasurys makes that sensible idea near-irresistible; 3. the markets appetite for high-yield debt is almost insatiable: give em what they like and how they like it; 4. private equitys gargantuan swallows for stocks are largely debt-financed, so the stock market benefits greatly from the net subtraction of equity from the market. Even when companies are not taken private, the threat of takeovers has weakened balance sheets by inducing managements to borrow heavily to buy back stock. The problem with these self-reinforcing arguments for growing debt and subtracting equity from the economic system is that it is the perfect fair-weather strategy. It is, therefore, the least appropriate foul-weather strategy. The VIX Index and TED Spread have been trading in fair-weather territory. The NYSE has gone through a record 914 trading sessions without a 2% correction. Gold is being devalued, while junk debt is the object of lust. It will not last forever. We wonder when the trillions of dollars face value invested in these sophisticated products that appear to reduce default risk to near-zero levels by throwing so many unrelated and apparently uncorrelated assets together into some post-modern primordial stew will become the next financial disaster. Risk cannot be eliminated: it can, through ingenuity, be disguised, muted, masked and modified. But once the defaults begin, those odor-free products of investment banker sweat are going to start to smell.

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Basic Points
e) The War on Terror
The expression War on Terror has gone out of fashion, along with expectations that military victories in Afghanistan and Iraq would end the War in those nations. The Bush-Blair grand design to bring democracy to the Muslim Mideast is in ruins. The two leaders who launched that War have joined Saddam on the losing side. They wont be hanged, but they are the recipients of the democratic equivalent. George Bush, Americas least-loved leader since Carter, presided over the destructionnot of jihadism, but of the Rove Plan for Republican Hegemony. Tony Blair, Americas favorite Brit, and Labours winningest leader, has been forced into a humiliating promise to hand over the reins to his impatient successor, Gordon Brown. Donald Rumsfeld was fired before all the votes had been counted in the Democrats amBush. It turned out that his success in devising and executing a strategy for winning two wars fast, with minimal loss of life (on all sides) was good as far as it wentbut, like Bush the Firsts attack on Iraq, it didnt go far enough. As he exited the stage, Al Qaeda and the Taliban were back big time in Afghanistan, and Iraq was a battleground between Al Qaeda-leaning Sunnis, and Iranian-backed Shias. Hezbollah and Syria were once again threatening to terminate democracy in Lebanon, Egypts brief experiment in wide-open elections is now mere memory, and the gulf sheikdoms are back to business as usual. To the chagrin of the Pope, a huge Saudi-financed mosque is being erected in Rome, but construction of any Christian edifice or conversion of any Muslim to Christianity remain beheadable offences in Saudi Arabia. Toleration of Islam and protection of Muslim rights of worship and proselytizing isjustlydemanded by Muslims across Christendombut that fairness is seen by Wahhabis and many other Islamic fundamentalists as yet another sign of Western weakness.

Donald Rumsfeld was fired before all the votes had been counted in the Democrats amBush.

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Oddly enough, most Iraqis are getting on with their lives today.

What the US and its few allies now face is that having superior armies and technology can win fighting wars, but cannot, in itself, win durable peace. If we have learned anything from the progressand the lack thereofin the war with Radical Islam to date, it is that what the spooks call HUMINT (human, on-the-ground, intelligence) is the condition precedent to success. More soldiers and more high-tech weaponry cannot be decisive. In other words, the West could be facing the problem British governments had with the IRA for decades: putting more soldiers into Northern Ireland didnt stop IRA bombings, murders, and mutilations. It was only when a few top IRA officials decided to defect, and when dozens of Belfast Catholic women whose men had been mutilated or killed by IRA thugs began to approach police with information that the tide turned. President Bush is now promoting a temporary increase of troops in Iraq to clean up Baghdad and a few other hot spots. He declined that option in the past when politicians ranging from Nancy Pelosi and Harry Reid to John McCain endorsed it. Perhaps it will work. But more soldiers may not change the locals perceptions that their only real security lies with their tribe or sect, not with the Americans or with the Iraqi police. Saddams Sunni rule kept the Shias cowed by slaughters and torture. However, most people were able to get on with their lives by avoiding activities that would arouse the suspicions of Baathist enforcers. Oddly enough, most Iraqis are getting on with their lives today. Outside the killing zones in Baghdad, the economy has been functioning quite wella sort of Arab version of 1970s Ireland. The Iraqi currency has been strengthening, and independent polls show that Iraqis have greater confidence in the future than they had in the recent past. An optimist could argue that ifor whenthe Iraqi army begins to do a better job protecting the oilfields, Iraq could actually begin to show progress that might convince citizens to cooperate with the authorities. In the meantime, investors should make some allowance for the possibility that most of the news from that troubled area of the world will remain disheartening.

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Basic Points
THE INVESTMENT ENVIRONMENT
Writing in Barrons, Michael Santoli puts it beautifully: Wisdom resides near the border of patience and stubbornness. Yet when it comes to investing, the market alone determines where that frontier lies. These are trying times for those ____ few (To the reader: fill in the blank space with either wise or stubborn) who believe that the quality commodity-producing stocks represent the clearest investment value case for the opening decades of this Millennium. Nevertheless, commodity-price-friendly shortages are, in considerable measure, the fruits of fast liquidity growth. Liquidity growth is a cyclical phenomenon. We have long believed that when sustained contractions in the all-time record growth of real, effective global liquidity finally came, they would signal the coming of the end of the first phase of The Great Commodity Bull Market. The contractions began nearly two years ago, and, after an almost precisely pachydermal gestation period, twins arriveda new kind of global economy, and a new kind of stock market performance. The major economic data turned from consistently strong to mixed; commodities such as natural gas, oil, and copper that had been scarcity stories swung into oversupply, and their prices plunged; technology stocks finally began to perform as Wall Street had for five years been predicting (and praying for in secular orisons): outperforming basic materials stocks. The most important commodity sectorenergybecame enervated, and mines lost their mettle. In comparison to gold, almost all other asset classes glittered. The exception to this dispirited performance has been the asset class whose value is not set by reserves under the ground, but what is produced above itgrains. Perhaps the most arresting commodity statistic of 2006 was that crude oil on the Nymex, whose price action was so frequently reported on Page One, rose exactly a penny last year. Given the amount of investor thought time devoted to oil prices, that performance gave new meaning to the expression, A penny for your thoughts. (Moreover, the yearend pennythe payoff in this performance measurement calculationwasnt worth as much as the May penny, because of the plunge in copper and zinc prices.) ...after an almost precisely pachydermal gestation period, twins arrived...

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29

The global gush of liquidity has slowed to a more stately pace, and... threatens to slow to a trickle.

At about the time the Fed went on hold, the authorities in China and India ratcheted up their tightening processesthrough higher interest rates, greater controls on credit for consumers and real estate, and in banks required reserve ratios. The global gush of liquidity has slowed to a more stately pace, and, with the tightening announced since yearend, threatens to slow to a trickle. Last weeks US economic news was probably the strongest in many weeks. (We say probably, because the one kind of torrent that never dries up is the economic data flow, and there are nearly always varying hues within the gush.) Last summer, the emerging consensus was that the US faced a full-blown housing crisis. Leading the baying pack was Paul Krugman, who, before he began to devote his efforts to writing newspaper columns demonizing Republicans and promoting left-wing Democrats, was tabbed by The Economist as the economist under forty most likely to win a Nobel Prize. Meanwhile, at about that time, the homebuilder stocks stopped falling and quietly began to outperform both the housing market and the stock market. Do the stocks tell us that the housing market is already close to a bottom? It makes sense that copper prices would plummet at a time of shrinking liquidity growth and predictions of a global economic slowdown in 2007. That oil prices have slid during the same time period also makes sense. Not only will slowing economic growth hurt oil prices, but since mid-December there has been strong evidence in the US to support the global warming experts; heating oil accounts for 6% of US petroleum demand, and with Chicago and New York experiencing March temperatures in January, heating oil consumption has been falling almost as fast as did cranberry consumption just before Thanksgiving in 1959 when prominent scientists produced evidence they caused cancer, forcing the Secretary of Health to warn Americans to alter their Thanksgiving dinner menus.

0

January

Basic Points
What makes less sense is that, when the Non-Farm Payroll number shocked the markets with its strength, and bonds fell, and both Nasdaq and the US Dollar Index leapt, copper continued to plunge, and oil barely stabilized. We expect that we shall soon hear that some commodity funds had been forced to slash exposure, and they sold whatever they owned. We also expect to hear that some recent large-scale investors in commodity funds are throwing in the towel. Bondsthe longer the betteroutperformed commodity indices in the last half of 2006, and they will continue to deliver acceptable performance until there is inescapable evidence that the US economy is once again on a roll. Financial markets have long since stopped worrying about Afghanistan and Iraq, but they have shown they can respond swiftly to major Mideast outbreaks of violencesuch as in Lebanonor perceptions of a huge geopolitical shiftsuch as when Ahmadinejad was fulminating about starting a war if his nuke program were stopped. We think global investors have come to assume that the US will continue to huff and puff about the dangers of an Iranian nuke, but will also continue to work through the United Nations. That was the policy the enlightened governments of Europe followed when Italy invaded Ethiopiathey left it to the League of Nations. History suggests that Iran will experience some inconvenience, but will continue merrily away building centrifuges, enriching its uranium, and impoverishing most its people. In other words, nothing much for investors to be concerned about. ...global investors have come to assume that the US will continue to huff and puff about the dangers of an Iranian nuke...

January

1

Milton Friedman RIP

The deathat 94of the greatest free-market economist since Adam Smith is an occasion to recall how much the world has benefited from his life and work. Many of those who worried about the Free Worlds steady decline into statism in the 1960s were inclined to blame Keynes, whose doctrines were used and abusedto justify almost any governmental intrusion into the market economy. By 1971, Richard Nixon could proclaim, We are all Keynesians now, as he closed the gold window, making the greenback pure fiat money, and announced wage and price controls to stop inflation. Pierre Trudeau, another economic activist, put the same straitjacket on the Canadian economy. Many European nations also experimented with the process. Yet inflation kept climbingreaching double-digit levels. When the controls were imposed, they were justified on the grounds that consumers were being gouged by rapacious businessmen and greedy unions. When they didnt work, a new villain had to be found by all those leftist and left-leaning governments. And so it came to pass that the OPEC nations were demonized, but the obloquy focused overwhelmingly on Arabs. In our lifetime, the only greater collective calumny from governments and media on foreign nations was against Germany and Japan during World War II. The avowedly liberal media and politicians were just as vicious as the conservative papers and politicians. Among the leaders in this long campaign was Herblock of the Washington Post, whose cartoons of fat, loathsome Arabs chuckling at soaring gas prices and long gas lines were reprinted across the land. The one voice that denounced this long libel was an American economist who happened to be JewishMilton Friedman. He told people not to blame the Arabs for inflation, because it was caused by central bankers monetary policies. Inflation is always and everywhere a monetary phenomenon.

2

January

Basic Points

He won the Nobel Prize in 1976, and by 1984 he had won his battle with Keynes, Samuelson and the liberal economists. Stagflation (a word coined by Brian Reading of The Economist) supposedly could not occur under Keynesstyle policies. The Phillips Curve, an article of faith among the post-Keynesians, decreed that inflation was correlated to the unemployment rate: rising unemployment would therefore mean falling inflation, whereas the reverse occurred during the 1970s. When Paul Volcker took over the Fed and Margaret Thatcher installed an acolyte at the Bank of England, Friedmans monetary theories were put to the test. Inflation collapsed, along with any remaining credibility for the old economics. True, pure Friedmanism has never been applied anywhere, but his emphasis on free trade, free markets and monetary discipline has permeated all economic success stories of the past quarter-century. Example: Chiles Pinochet used some elements of Friedmans market and monetary policies to give his nation the first sustained non-inflationary economic growth in Latin American history, and most other Latin nations were forced to emulate those wise policies. (Friedman declined to work with Pinochet because he was a dictator.) Brazil, for example, continues to experience record-low inflation and interest rates under the supposedly socialist rule of Lula. Two centuries after Adam Smith, the world, in one of its times of greatest need, was blessed with the work and wisdom of Smiths greatest disciple. For that, we should all be thankful.

January



INVESTMENT RECOMMENDATIONS
1. Continue to maintain an overweighted position in oil stocks with long reserve life indices in politically secure regions, particularly in the Alberta oil sands. The share price of a company with more than fifty years reserves will continue to fluctuate in response to oil price changes, and oil prices will remain weak until there is clear evidence of a return to fast global growth, but there are so few such companies that they deserve a huge scarcity premium. 2. Continue to maintain an overweighted exposure to mining stocks with long reserve life indices in politically secure regions. Base metals have no OPEC to stop their downward corrections, but great orebodies are still rare, and the mining majors are richer than ever before. Takeovers will continue, so stocks of strong companies will not fall as far as metal prices. Whenever the global recovery resumes, base metals should be the top-performing commodity asset class. 3. Continue to maintain an overweighted position in gold, whether through the mines or the ETF. The serial debauching of corporate bonds, and the dissemination of junk derivatives through the financial system mean that, if a true global slowdown comes, systemic risk will return. Golds true value these days is not as an inflation hedge, but as a protection against serious problems for the dollar and/or the financial system. 4. Build an overweight position in agribusiness stocks. If the El Nio turns out to be stronger than currently forecast, be aggressive in your purchases. 5. Build an overweight position in Emerging Markets stocks. The world of tomorrow will become increasingly dependent on the increasingly scarce resources that EMs have in abundancecommodities and workers. 6. Maintain a longer-than-benchmark bond duration in balanced portfolios. Buy long zeros as hedges against portfolio exposure to falling industrial commodity prices. 7. The Canadian dollar is the most undervalued of the leading currencies. Canadian-based investors should ensure they hedge their exposure to US dollar-based investments. American clients should diversify their bond exposure by reducing Treasury holdings in favor of Canadas. All other investors should be building increased exposure to high-quality Canadian assets.



January

Basic Points
8. If Nasdaq continues to outperform the S&P in coming weeks, expect a stock market correction. This is a record run for US stocks without a 10% pullback. Nothing is forever, particularly a Nasdaq-led rally. 9. This is the Year of the Cicada in the Upper Midwest, when billions of homopterous insects will suddenly emerge from the ground and chirp. This phenomenon occurs every 17 years. The last two happy times for cicadas were not happy times for investors.

January

5

Basic Points
Baubles, Bangles & Needs

February 20, 2007

Produced by BMO Financial Group Distributed by BMO Capital Markets

Basic Points
An Investment Journal
Donald G. M. Coxe
Global Portfolio Strategist, BMO Financial Group (312) 461-5365 e-mail: don.coxe@bmo.com

Research/Editing Production/ Distribution

Angela Trudeau e-mail: angela.trudeau@shaw.ca Anna Goduco (print orders and mailing lists) e-mail: basicpoints@bmo.com

Baubles, Bangles & Needs

Overview
This month, we are making three significant changes to our strategy recommendations. First, we have changed our view on gold. Until now, we have recommended holding an overweight position in gold (through mining shares and the ETF) to reduce endogenous riskstrictly a foul-weather friend. After our trip to India, we began to consider golds attractions for investors as a fair-weather friend. Secondly, we now recommend a strong overweighting in agriculturally-related stocks. We first recommended the agriculture stocks in October. We believe that the investment opportunities in stocks tied to production of grains, oilseeds and meats could be somewhat reminiscent of what we saw three years ago in the oil and gas stocks. Ethanol is an environmentally dubious idea whose time has come, because it offers the chance of controlling petroleum prices, and, therefore, of controlling the cash flows to the promoters of Islamic terrorism. If all the corn and soybean fuel projects under discussion were to come on stream, they could put a cap on oil prices, which would be good news for the global economyand great news for mining companies. The basic supply/demand balance for coarse grains and oilseeds globally would probably be transformed. Prices of grains and oilseeds will continue to experience upward pressure, and problems for the livestock industries and food price inflation have only begun. Thirdly, we are reducing our bond exposure, both in duration and in percentage allocation. Despite our five-year-long enthusiasm for hard assets, we continued to recommend exposure to long-duration bonds. Changing that long-held viewpoint requires an explanation in some detail. In January, we began consideration of the impact of demographic changes on investment strategies. This month we carry that process forward, looking at future changes in long-term attractiveness of some major asset classes. These changes in viewpoint trigger significant changes to our Recommended Asset Mix. We recommend that clients use the increased exposure to equitiesUS and foreignto build positions in agricultural, gold, base metal, and energy stocks. Commodity stocks remain our favorite equity asset class.

February

Recommended Asset Allocation

American Portfolios

U.S. Pension Fund

Domestic Equities Foreign Equities Domestic Bonds Long-Duration Bonds Foreign Bonds Cash Allocations 27 29 12 10 15 7 Change +3 +3 -3 -5 unch +2

Foreign Equity Allocations

European Equities Japanese and Asian Equities Canadian & Australian Equities Emerging Markets Allocations 6 6 6 11 Change unch unch unch +3

Bond Durations
Global US Canada Years 4.25 4.50 4.75 Change -.25 -.75 -.75

February

Basic Points
Baubles, Bangles & Needs
We began rethinking our long-held views on gold during our visit to India. Driving through the rural villages of South Rajasthan, one of the economically poorest areas in North India, we were struck by seeing so many impoverished women wearing gold bangles. We knew that gold was an historic dowry component in regions where only a small percentage of the population owned land, but the surprise was such widespread wearing of wealth; in villages and in cities we saw women wearing gold jewelry. We were thinking about the meaning of all that jewelry when we began writing this essay, while listening to music of Borodins beautiful Second String Quartetlater adapted as the 1953 hit Kismetthereby our title. Given that India has the highest inflation rate (6%+) of any of the large economies, gold is a logical investment. But golds role in the intellectual and cultural history of India is a far more significant inducement to buy bangles than the current CPI growth rate. India is the biggest gold-consuming nation in the world, and its consumption has risen so strongly that it more than matches central bank gold sales. As more and more Indians become even modestly wealthy, more and more of their saved rupees go to gold. Even without the mystique of three millennia of history in which gold was synonymous with wealth, power and personal security, gold is now looking attractive to the rising Indian middle class as a market investment, compared with other readily-available investment alternatives. The banking system outside large urban centers is dominated by great numbers of small, local deposit institutions, of widely varying financial stability. That kind of diversity and financial archaism does not encourage the newly wealthy to invest their life savings in bank deposits at near-zero or even negative real interest rates. The Indian stock market has become one of the wonders of the financial world, but it is still an Emerging Market, and its success is a very recent phenomenon. The components of the Indian economy represented in that rather narrow index are collectively overheating, as has been widely observed in recent months. Indias classic problems havent gone awaythe seemingly impenetrable bureaucracy of the License Raj, the

Even without the mystique... gold is now looking attractive...

February

...gold is the readily available, and easily understood option for a sizable chunk of the new middle classs discretionary resources.

infrastructure problems bedeviling a fast-growing economy that moves on outdated or even primitive roads. Then there is the corruption and influence-peddling within the decision-making structure of a federalist state that has historically protected outmoded vested interests in a fashion that would evoke envy from Jacques Chirac, but scorn from any official of the WTO. Real estate is, as always, the most obvious investment asset class, but, apart from home ownership, it is a market that requires patience and capital. In that somewhat colorful and chaotic array of investment options, risks and rewards, gold is the readily available, and easily understood option for a sizable chunk of the new middle classs discretionary resources. Even for wealthier investors, gold has attractions at a time of very low real interest rates on bonds and short-term deposits offered by major issuers and institutions. Gold is big in India, but it has always had allure elsewhere in Asia. Indeed, the Chinese have long accorded it a special place in their historical musings about the nature of things. As we wrote last year, Zarathustras Four ElementsEarth, Air, Fire and Waterwere brought to India by Persians. From there, the concept was taken to China by Buddhist priests. (Buddha was an Indian, and his revelations came to him at a spot just outside Varanasi, Hinduisms holiest place.) The Hindus added a fifth elementSkybeing the forces in the heavens. The Chinese rejected that addition, substituting gold as the Fifth Element. Despite that status, gold has not been for todays Chinese the kind of investment treasure it has been for Indians. Perhaps the availability of a wider range of local investment alternatives generated by Chinas awe-inspiring growth has made gold seem less interestingor less necessary. We have long cited central banks eagerness to sell their gold as a reason for rejecting gold bugs insistence that gold is the safest investment medium and the only real money. Since most of the central banks who hold most of the bullion have been trying for decades to downsize or (as in Canadas case) to get out entirely, why assume that all other assets should be denominated in gold, or that gold prices must go up? The World Gold Council, working through the IMF and other international agencies, managed to get an agreement constraining central bank gold salesto save the African gold industry from collapse.

February

Basic Points
Why should anyone have an intellectual and emotional attachment to something whose price might still be $250 an ounce if all those sellers werent sticking to a deal they made, under pressure from Bono and the banking boys, to join a gigantic global price-fixing agreement which could have been derived from such spurious deals as the EUs Common Agricultural Policy? We have reconsidered our view that gold had too many of the attributes of an overpriced, sickly hothouse plant that could not endure the chill winds of free markets. It is finding enough real buyers to give it credibility, and the companies who made fortunes in the last decade betting against it through hedging now must face the reality that they overstayed their bets. Our revised thinking on gold assumes that the central bankers will continue to sell their permitted quantities each year, and the entire overhang will be out of the way within a few years. Long before then, gold will be in its own long-term bull market based on real market forces, and will not be a commodity propped up by governmentslike American or Canadian milk or almost anything produced by French farmers.
Gold January 972 to February 2007
900 750 600 450 300 150 0 Jan-72 Jan-75 Jan-78 Jan-81 Jan-84 Jan-87 Jan-90 Jan-93 Jan-96 Jan-99 Jan-02 Jan-05

gold...will not be a commodity propped up by governments like American or Canadian milk or almost anything produced by French farmers.

February

Philadelphia Gold Stock Index December 98 to February 2007

180 160 140 120 100 80 60 40 20 0 Dec-83 Dec-85 Dec-87 Dec-89 Dec-91 Dec-93 Dec-95 Dec-97 Dec-99 Dec-01 Dec-03 Dec-05

Golds big problem has not been those big holdings by big central banks who wanted to get out in a big way...

US CPI January 972 to February 2007

225 205 185 165 145 125 105 85 65 45 25 Jan-72 Jan-75 Jan-78 Jan-81 Jan-84 Jan-87 Jan-90 Jan-93 Jan-96 Jan-99 Jan-02 Jan-05

Golds big problem has not been those big holdings by big central banks who wanted to get out in a big way: it was that inflation had not been a big problem for years. How much should investors pay for a hedge against a dwindling nuisance? For two decades, most investors willingness to pay up for inflation protection gradually faded away, as they put their money into more productive investments. Milton Friedmans breakthrough insight that sound central bank policies and freer trade would end the inflation that had haunted the Free World since the 1950s eventually attracted enough support in high places to prove that it worked.

February

Basic Points
Volcker, Reagan, Thatcher and the Bundesbanks Karl-Otto Pohl were the leaders in the successful war on inflation. Thanks to them, the mania that had driven Gold to $825 and Silver to $50 was crushed, the first crash in what would become the Triple Waterfall collapse of commodities. In the killing fields, the corpse of chrysophilia would eventually be foundwith gold at $250 and silver at $4. By then, the specter haunting global price systems had become deflation. Japan was the first major economy to suffer outright deflation, but by 2000, a collection of global deflationary forces was driving world inflation down to levels that sent long-term interest rates to such minimal levels that numerous private pension plans were facing funding crises. The hoary maxim, Be careful what you wish for was proved anew, as pension plans, which had for decades despaired of their ability to earn enough to offset inflation, now found their tech investments devastated, while the fastest-growing category on their balance sheets had become their discounted liabilities. Irony of ironies: from 1981 through 2001, gold was just about the worstperforming asset class, and long zero-coupon Treasurysthe asset most despised and ridiculed by gold bugswere just about the best-performing asset class. Even when gold finally rallied from its tarnished state in the Slough of Despond, it faced a new humiliation: it underperformed the asset its supporters had been sneering at for millenniathe base metals. The Age of Reverse Alchemy had arrived: step right up and get rich by letting us convert your lousy gold into lovely base metals!
Gold January 200 to December 200
550 500 450 400 350 300 250 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05

The Age of Reverse Alchemy had arrived...

February

Copper January 200 to December 200

250

200

150

100

50 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05

Nickel January 200 to December 200

18,500 16,500 14,500 12,500 10,500 8,500 6,500 4,500 2,500 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05

Zinc January 200 to December 200

2,000 1,800 1,600 1,400 1,200 1,000 800 600 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05

February

Basic Points
Investors who dumped their Barrick, Gold Fields or Newmont and put the proceeds into such base metal producers as Inco, Falconbridge, BHP Billiton, Phelps Dodge or Teck Cominco were the new Alchemists.
Barrick Gold Corp. (ABX) January 2002 to December 200
37 33 29 25 21 17 13 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06

Newmont Mining Company (NEM) January 2002 to December 200

65 55 45 35 25 15 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06

Gold Fields Limited (GFI) January 2002 to December 200

30 25 20 15 10 5 0 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06

February

Inco Ltd. (N) January 2002 to December 200

90 80 70 60 50 40 30 20 10 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06

Falconbridge (FAL) January 2002 to December 200

55 45 35 25 15 5 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06

Phelps Dodge Corporation (PD) January 2002 to December 200

120 100 80 60 40 20 0 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06

0

February

Basic Points
Teck Cominco Limited (TCK.B: TSX) January 2002 to December 200
95 85 75 65 55 45 35 25 15 5 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06

To the true gold bug, all governmentcreated inflation statistics are lies. Really Big Lies.

But in recent months the ground has begun to shift. Gold began to outperform the base metals, even though global inflation and interest rates were still declining. In the background was a renewed debate about inflation and gold. 1. Golds sharp rise has revived the gold bugs. Members of this mutant species, whose recorded sightings had shrunk to tiger levels, are once again gamboling enthusiastically. One of them was recently quoted in Barrons as predicting that coffee would sell at one million dollars a cup within his lifetimeand he is no beardless youth. (Yes, the cost of a cup of coffee has gone from its Depression level of a dime to $2.00, if Starbucks price is taken as the global standard, but one should be hesitant about using that statistic to justify a forecast that Weimar inflation rates are about to engulf the world.) To these hardy cynics, all paper currencies have ultimately proved worthless, so its only a matter of [relatively short] time before the dollar joins the tsarist rouble and the Zimbabwe dollar as proof of the universal frailty, venality and mendacity of governments. Strange that these self-proclaimed realists arent making these same predictions about the Swiss franc, the renminbi, or, for that matter, even the once-despised rupee. To the true gold bug, all government-created inflation statistics are lies. Really Big Lies. How, they ask, can anyone talk of 3% inflation when one looks at the real world: the soaring costs of tuition at prep schools and elite universities, and the nonstop increases in prices for Park Avenue residences, great wines,

February



and paintings by deceased artists? That the costs of cars and computers are hedonically adjusted to reflect greater value is, to these skeptics, more proof that the Bureau of Labor Statistics suppresses the real cost of living to make the government look good. Those countless thousands of BLS employees must be...the closest approximation of collective devotion unto death seen since those storied 00 Spartans at Thermopylae. We are asked to believe that those thousands of Bureau of Labor Statistics employees who visit Wal-Mart, Target, Macys, Home Depot, Ace Hardware, and the nations supermarkets each week to check the prices of thousands of items are co-conspirators in a plot to cover up George Bushs debauching of the dollar. Moreover, these data-collectors are the same people, or the successors to the same people, who performed the same mountebankery for Clinton, with the same precision. Amazingly, not one of them, after retiring or being fired, ever went public with the biggest fraud story of all time. Those countless thousands of BLS employees must be, according to this viewpoint, the closest approximation of collective devotion unto death seen since those storied 300 Spartans at Thermopylae. 2. Inflation believers who arent gold bugs say, Well, yes, we understand that the central bankers are dedicated to fighting inflation, but isnt it a fact that prices keep going up? As the wags say, the only money that goes as far today as it did twenty years ago is the quarter that rolls under the bed. And $60 oil and $17 nickel and $10,000 Barbra Streisand tickets show that the brief period of price stability that came after the Tech Crash is long gone. 3. The fundamental weakness of the dollar is another component of predictions of rising inflation. The dollars powerful bull market from 1995 to 2002 was a major contributor to the drop in inflation rates, particularlythough by no means exclusivelyin the US. Since then, the dollars value has been sustained by the willingness of Asian central banks to fund the US trade deficit, which is approaching the levels of the GDP of all but the richest nations. This gigantic vendor financing program obviously cannot last forever. When the financial music stops, the dollar will collapse and inflation will soar out of control. We agree that what we call The Great Symbiosis cannot be a permanent arrangement. But we do not agree with the contention that a 20% drop in the greenbacks value would mean 20% inflation. Many overseas suppliers would doubtless eat much of the dollars depreciation, in order to protect their share of the US market.

2

February

Basic Points
Currency is not the whole story: the Swiss franc has been strong against the dollar in recent years. But, as any visitor to Geneva or Zurich can attest, Swiss prices for a wide range of products and services are far higher than American prices. Or consider the pound: the pound lacks the prestige of the Swiss franc, but it has been very strong against the greenback. Yet London is, according to those who calculate these things, a far costlier city for residents and businesspeople than New Yorklet alone Chicago.

Why Inflation Could Accelerate to Moderate from Low

David Hackett Fischers The Great Wave records the history of European inflation since medieval times. He shows that when food and fuel prices rose sharply together, inflation always occurred. What is interesting is that if only one of those commodity groups experienced rising prices, inflation quite frequently did not occur. What of Friedmans contention that only the printing of money causes inflation? He was more careful than that. He said, Money matters most, and Always and at all times, inflation is a monetary phenomenon. Inflation naturally occurs when fuel and/or food prices spikeeven during the long centuries of the gold standardbut those sudden boosts did not form a sustained pattern of price increases without excess monetary creation. (Pre-paper money, the debasement occurred in the coinage itself.) What is clear is that some of the important economic contributors to disinflation that assisted central banks restrictive policies in bringing inflation down and keeping it down have changed since 2001-2003when talk of deflation was heard far beyond Tokyo.

...when food and fuel prices rose sharply together, inflation always occurred.

Why Hasnt the Commodity Boom Raised Inflation Rates Sharply?

Had investors known in 2001 that oil was headed for $70, copper for $3, and corn for $4, they might naturally have assumed that this decade would have been a replay of the 1970s. That didnt happen, mostly because central bankers didnt print money to offset the commodity price increases. But there were other important factors at work.

February



Businesses in the major economies have managed to absorb a doubling of oil pricesand even greater rises in base metal pricesbecause of global competitive forces, productivity gains, the wage arbitrage out of Asia, low interest rates, and low food prices, (which helped to prevent worker unrest at a time of wage restraint). Golds new luster does not come because the inflation beast has arisen from its crypt. Looking forward, there is little risk of high percentage increases in energy and metals prices from current levels. That so many central banks chose to use Core Inflation as the major guide to setting economic policy and that no inflation mania developed meant that economies did not experience a true oil shock despite a runup in oil prices from $25 to $75: real money growth continued adequate but never frenetic, while consumers never came to assume that inflation was headed for double-digit levels. As we have noted many times before, central bankers must fight a two-front war against inflation: the first is to suppress price increases across the broad swath of economies by controlling money growth; the second is to prevent the mental metastasization of the inflation virus among consumers, governments, unions, and businesses. If those major sectors come to believe inflation is headed out of control, only draconic central bank tightening ( la Volcker and Thatcher) will arrest the spread of the disease through the economy. Golds new luster does not come because the inflation beast has arisen from its crypt. Gold is attracting buyers who look at the hundreds of trillions of dollars worth of derivatives that have been spawned in this decade, and wonder whether these will always continue to be useful droids, or whether they will become runaway robots. (In particular, the astounding growth of Credit Default Swaps raises worries for the system. When, as is now often the case, the face value of the default swaps on debt of a corporation can be many times greater than the companys debts, changes in the companys capital structure can set off shock waves. That investment banks have no trouble finding hedge funds willing to participate in creating debt out of thin air suggests there could be something perilous in the air.) But gold is also winning because there are so many more people willing to buy jewelryand so many of that group like the idea of buying 22 carat gold jewelry because it is a neat way to invest. Yes, there are still people who pay fortunes for towels held by Marilyn Monroe, or for autographs of John Lennon. But gold jewelry collectors shopping in Abu Dhabi or Dubai just want the real thingand they want it now.



February

Basic Points
Meanwhile, another commodity bull market has come out of nowhere, (or more accurately, out of the ground), and it raises questions about the continuance of disinflation: the grains and beans are on a tear, and a Big New Idea is the reason for these big gains. Could food price inflation come back? And if it does, what will that mean for the anodyne idea that inflation is yesterdays story? What has been unfolding in Mexico gives pause. Falling inflation, falling interest rates, soaring returns from oil, and huge cash inflows from Mexican workers in the US helped Mexico to achieve balancedif subdued economic growth. Unfortunately, the Vicente Fox government lacked the will to use the breathing space to enact and implement much-needed economic reforms. Since then, global interest rates have been rising, whilst output from Cantarell, Mexicos major oilfield (and once the third largest in the world) has been collapsingdown a half-million barrels/day last year alone. Pemex, the state-owned oil company, has long been forced to cede most of the net revenues from its production to the federal treasury: its profits have accounted for roughly one-third of government revenues. The potential demise of Cantarell would be a national disaster. The new Calderon government, which won election over a fireeating Chavista by the kind of nail-biting margin Bush achieved in Florida, is unable to help Pemex, partly because the Mexican constitution treats foreign participation in its oilfields with the kind of xenophobia American admirers of Lou Dobbs feel for undocumented Mexican immigrants. In the midst of this fast-developing crisis, corn prices have skyrocketed, sending tortilla prices up 35%. Food riots have broken out. The tortilla is to Mexico City what bread was to Rome, and every emperor (except Caligula) knew that if bread became too expensive for the urban mob, he was in troubleand might not be able to count on the loyalty of the Praetorian Guard. What is happening to the price of Mexicos staple food is part of a much bigger global grain price runup. Grain and oilseed prices would have been firm anyway, because world stocks have been falling for years, and demand from livestock producers has been rising. The tortilla is to Mexico City what bread was to Rome...

February



For five years, we have been counseling clients to buy the mining and oil stocks because of rising demand from the new Third World middle class, particularly in China and India. All those new cars, apartment buildings and air conditioners were swallowing the worlds production of oil and base metals. ...they learnedto their horrorthat the new middle class were of carnivorous disposition. And so it has been with feed grains and oilseeds. When people get richer, those who are not committed vegetarians are no longer content with a diet of bread, rice and vegetables. They want meat. Just as the worldly-wise of the world thought cheap oil would last forever, and were shockedshocked!at $50 oil, these same wise people assumed that the only problems with grains would be about having to pay farmers too much to grow them, and then finding some place to get rid of their output. Then they learnedto their horrorthat the new middle class were of carnivorous disposition. Why werent they content to have a loaf of bread and a jug of wine in the wildernesslike the enlightened Omar? (Come to think of it, where did the wilderness go?) And, just as the planners were trying to figure out how to feed all the needed ducks, chickens, pigs and cattle, some other planners came up with an idea to solve another set of problems by generating demand for coarse grains and oilseedsas fuels. The strain on grain supplies shows plainly in the charts:

Wheat January 2002 to February 2007

550 500 450 400 350 300 250 200 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07



February

Basic Points
Corn January 2002 to February 2007
450 400 350 300 250 200 150 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07

Soybeans January 2002 to February 2007

1100 1000 900 800 700 600 500 400 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07

Soybean Meal January 2002 to February 2007

350 300 250 200 150 100 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07

February

7

Hamiltons Law: Where you stand depends on where you sit.

1. Global wheat prices are up sharply, mostly because of a severe drought in Australia, and yet another setback to wheat production from the former USSR. India, the worlds second-largest wheat producer, this week announced a ban on wheat exports. (It was not long ago that one of the hardest-fought issues in trying to reach new international trade deals was the widespread subsidization of wheat exports.) 2. Ethanol is now becoming the fuel of choice for (a) global warming enthusiasts; (b) those articulate students of Mideast affairs, like Thomas Friedman of The New York Times, who argue that high oil prices finance Saudi export of jihadism through madrassas and Islamic charities across the world; (c) grain farmers, particularly in Ohio, Illinois, Iowa, Minnesota, Wisconsin, Nebraska, Missouri, Oklahoma and Kentucky, who havent luxuriated in such lush returns from their fields since the 1970s, and (d) voters in the above states, for whom ethanol has become a secular religion. Ethanol demand has already transformed corn markets from glut to scarcity, and threatens to transform the pricing structure for grains and oilseeds. Of particular importance are the voters in the Iowa Caucuses, the first test for presidential candidates next year. As a result of changes unfolding in the dating of other primaries, Iowa could have even greater leverage than ever: it and New Hampshire could be the only races before Super-Duper Tuesday in February, where more than one-third of all electoral votes would be up for grabs. In effect, the mini-campaigns in the two small, snowy states could provide the momentum for a candidate to go into the nationwide primary with the momentum and the money to blow away hisor hercompetition. Iowa is a typical US state only if one believes that tractors, fertilizer, hockey and ethanol are everyday preoccupations of voters in such states as New York, California, Florida, Michigan and Arizona. Given Iowas potentially decisive political prominence, is it any surprise that two senators known for their skepticism on ethanolClinton and McCain have rather suddenly discovered it to be a national treasure? Their past opposition came from practicing Hamiltons Law: Where you stand depends on where you sit. Their constituents have been forced to pay higher prices for gasoline to subsidize ethanol production and distribution. That tradeoff doesnt sell well in Tucson or Westchester.

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Basic Points
Now, however, these Presidential candidates can justify their switches on national security grounds, since both have good records in that area of public policy. The worst of the violence in Iraq comes from radical Sunnis al Qaeda and otherswho get most of their funding from jihadist Wahhabites in Saudi Arabia, and from radical Shias, who get funding from the Shias who rule Iran. The most obvious way to slash cash flows to killers of American troops is to slash oil prices. (Yes, yes, we know that the nation could save on oil and save the earth from overheating by abolishing SUVs and imposing punitive gasoline taxes. We also know that many of the organizations and groups most vociferously advocating such constraints on the middle and lower classes are heavily backed by rich people who fly in private jet planes, which areby farthe most egregious contributors to high oil prices and global warming per person served. We suggest that the debates on these crucial policy issues will become more rational once voters reject any recommendations on energy conservation or global warming from any corporation, politician or NGO that uses private jets.) The McCain and Clinton conversions from stouthearted skepticism to passionate public protestations of belief are grim news for Mexicos President Calderon. Because Mexico is a member of NAFTA, US corn prices indirectly contribute to the escalation of the prices of tortillas for Mexicans. (Not as much as Mexican gringo-bashers love to allege, but theres no doubt that when a quarter of the US corn crop goes into producing fuel, not feed, corn and soybean prices are going higher. The Mexican governments long history of manipulating tortilla prices, while tolerating a system in which a handful of private companies produce all the tortillas and corn flour, may have to reconsider its ways now that global corn prices look to stay painfully high.) Ethanol is stimulating the building of new production facilities across the Midwest at the speed that high oil prices are stimulating the building of nuclear plants in Iran. Bad politics happen anywhere. When prices of corn and soybeans soar, it is a tough time for livestock producers. Hog farmers in China may have a special problem: This is The Year of the Pig in China, which is considered such an auspicious year to be born that China expects a baby boom. Chinese parents will be cutting back on the use of fetal identity systems to detect, and, in millions of cases, abort, unwanted girls in a One Child Policy regime. With China having such a huge surplus of young males compared to the female population, the authorities are hinting that this would be a good year for a baby boomlet that includes girls.

The most obvious way to slash cash flows to killers of American troops is to slash oil prices.

February

9

Not that the Chinese government has forgotten its foreign policy goals amidst all this excitement. According to reports, Beijing has instructed television stations not to show too many images of pigs, because such displays could offend Muslims. ...it isnt the Year of the Pig in the US. Nor is it the Year of the Steer: Meanwhile, South Koreans arent worrying about giving porcine offense, and are swamping maternity wards with reservations because many fortune-tellers there claim this The Year of the Golden Pig, which comes every 600 years: to be born this year means truly wondrous prospects. But it isnt the Year of the Pig in the US. Nor is it the Year of the Steer:
Feeder Cattle February 200 to February 2007
125

115

105

95

85 Jan-06 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07

Lean Hogs February 200 to February 2007

80 75 70 65 60 55 50 Jan-06 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07

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Basic Points
When it becomes very costly to feed cattle in the final weeks prior to slaughter, feedlot operators reduce their bid prices for feeder cattle. Ranchers must then decide whether to sell at painfully low prices, or keep their steers longer. Result: Live Cattle prices stay higher.
Live Cattle February 200 to February 2007
100

...prices of hamburger will be moving toward todays steak prices.

90

80

70 Jan-06 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07

But that retention policy cannot last. Soon those range-fed cattle will be heading for the last roundup. That means meat prices will remain weak for at least six more months. Then, we can expect that prices of hamburger will be moving toward todays steak prices. According to the US Dept. of Agriculture, ending world stocks of coarse grains fell from 197 million tons in 2002 to the current level of 167 million tons, and an expected level of just 121.6 million tons by this crop yearend. Total world acreage for production of all grains is flat since 2002. With increasing urbanization and industrialization, land is being withdrawn from production in the major crop-producing countries, but denuding of forests and land reclamations have kept total acreage in balance. The sudden enthusiasm for biofuels threatens to create grain and oilseed shortages worldwideand to lengthen the list of endangered species as natural habitats are converted to fuel production.

February

2

...meat and aquaculture-fed fish are about to become hostages to grain demand from cars and trucks.

A large, and rapidly growing proportion of corn now goes to ethanola gasoline substitute or extenderwhile a small, but growing, proportion of soybeans is going to biodiesel fuel. In the US the number of diesel automobiles is small, but the number of diesel trucks is large. In Europe, diesel cars are widespread. Although the focus and hype on ethanol has meant that corn prices have risen most sharply, global soybean prices will probably track corn more closely, in the future, if only because so little corn will be available for animal feeds. Prices of meat and aquaculture-fed fish are about to become hostages to grain demand from cars and trucks. Ultimately meat and fish prices will have to go up. For investors, this means that companies which can produce genetically-modified seeds to produce grains and beans from marginal lands, or seeds with built-in resistance to pests and weeds, are now core investment concepts in a commodityoriented portfolio, as are shares of companies who supply equipment and fertilizers to farmers.

The Cradle Will Rock

The phenomenon of record low percentage levels of unemployment across most of the industrial world at a time of historically-modest economic growth is proof positive that the birth dearth of the 1970s and 1980s has begun to reshape industrial economies. As we wrote last month, the basic numbers are simple: GDP growth is growth in output per worker multiplied by the number of workers. More workers mean more nominal GDP. More productivity means more GDP per worker. Together, these twin forces produce the most important of all economic datagrowth in real GDP. This is not a new challenge for Western Europe: Germany and Holland led postwar Europe in producing growth at a rate that used up the supply of available home-grown workers. Result: these countries, followed by France, then Italy and then Scandinavia, began importing workersfrom the south side of the Mediterranean and the Bosporus. The strategy was to bring in millions of neighbors who wanted to escape from the poverty in Turkey, Algeria, Morocco and Egypt. Meanwhile, Britain, which had a relatively open-door policy toward Commonwealth immigration, attracted millions from Africa, India, Pakistan and Bangladesh.

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Basic Points
Germany was more cautious than some of its neighbors: it labeled the Turks and other exotics as Gastarbeitersguest workers, who could stay for a few years, then go home. They could not qualify for German citizenship except after many yearsand then rarely. The system worked very well, and those hard-working young Turks made up the gaps in the workforce from the number of Germans who were killed in the war. Frances imports were heavily from its former colony, Algeria, and they helped keep GDP growth strong. (By surrendering quickly, France didnt lose as many young men fighting in WWII as Germany or Britain, the US or Canada.) The immigrants to the Continentmostly Muslimhelped keep GDP growth strong until the late 1990s. By then, rising levels of unemployment among Muslim residents was increasing welfare and health care budgets faster than GDP. Why did unemployment rise disproportionately among Muslims? There are many answers. First, was that European economic growth rates slowed, but implementation of technology meant that productivity improved; Result: fewer workers needed. Another is the seniority rules enforced by powerful unions fell most heavily on the youngwhere the Muslim population percentage is highest. Another is that young Turks and Arabs have been victims of workplace discrimination. It is a melancholy fact of human history that whenever the number of jobs no longer matches the number of available workers, foreignerseven if they are native-bornwill become objects of discrimination, resentment and blame. Another reason is that too many youthful Arabs chose to drop out of schools and live on welfare, or to switch to Islamic schools where the instruction was religiously focusednot joboriented. Since 9/11, of course, an increasingly disaffected minority among the tens of millions of Muslim immigrants living in Europe has created other kinds of problems. With jihadism now the fashion among some highly visible young Muslim males, almost nobody suggests any more that Europe should deal with its birth dearth problems by importing tens of millions more young Muslims. Sadly, the rage of a minority within a minority hurts the majority of the minority that wants to build better lives by participating in the opportunities of advanced, open, free market economies. Although racism is never justifiable, its roots are recognizable when the established population comes to feel threatened by the public misbehavior of a few.

Sadly, the rage of a minority within a minority hurts the majority of the minority...

February

2

With a fertility rate among non-Muslim European women in the 1.1 range, that decision to discontinue large-scale immigration from the Muslim world means that each ensuing European generation will be roughly half the size of the current generation. If we depend entirely on birth rate, we are going to turn into Europe What does that imply for GDP rates? It means those economies cannot be as large in the future as they are today. As Alan Greenspan told attendees at a dinner hosted by Republican Senator Bob Bennett, the demographic outlook for major economies abroad is frightening, notably for Japan, Germany, Russia, and even China (31% of whose population will be over age 60 by mid-century). Senator Bennett is using those data to remind fellow Senators to use caution about changing immigration laws. If we depend entirely on birth rate, we are going to turn into Europe, he observes. What does the coming scarcity of working-age people imply for real estate values? The great attraction of real estate as a long-term investment has always been, as Will Rogers put it, Buy land. They arent making any more of it. He didnt have to add, And theyll keep on making more babies, because that was always the way it had been. Apart from wars, plagues, and famines, urban populations kept rising from generation to generation. Areas where old industries were the economic backbone, and new industries did not come in to take their place, lost populationas was the case for Lancashire in England, and Detroit after the race riotsbut overall urban populations continued to increase. Sao Paulo and Rio de Janeiro, for example, now hold nearly half Brazils population, while population growth across much of that giant countrys area has been modest or stagnant. But when each succeeding generationroughly 35 yearsis half its predecessor, why should real estate values rise? If there are half as many shoppers, why should shopping centers keeplet alone increasetheir value? If there are half as many workers, why should office buildings keeplet alone increasetheir value? And if there are half as many people, why should houses or apartments keeplet alone increasetheir value? Sam Zell, one of Chicagos shrewdest investors, has just had a $900 million payday, selling Equity Office Properties. Pension funds have been huge buyers of office buildings, because they need long-duration assets whose value rises faster than inflation. But what if the statistics on the inevitability of long-term profits turns out to be wrong because there arent enough people

2

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Basic Points
around? Based on population statistics since 1971, a 100-year reversion on a lease executed today (what we call a ground rent) would expire at a time when the population of workers in the 18-50 age range would be two-thirds less than today. That couldnt happen to Chicago or Los Angeles, as long as Latino immigration continues to make up for the fall in the domestic birth rate, but it could happen to many major cities elsewhere. These comments do not, of course, apply to leases on office buildings in Delhi or Mumbaior even to Shanghai, where the national demographics are nowhere near as favorable as Indias: the continued inward migration from rural areas will sustain growth in the major cities. But European cities cannot expect to gain population increases from inward migration at a time the overall birth rate is far below replacement level. If Europeans were wild animals, they would soon qualify for the endangered species list. Mark Steyn makes this point cogently in his new book, America Alone. We found the book useful because it looks at Europes statistics in a longer-term perspective. We had been looking at the questions from the standpoint of GDP growth, but his work argues (with the lively polemicism that is his trademark) Europe has entered a population death spiral. Because of the grandiose generosity of European retirement and welfare provisions, (including, in some countries, pensionable retirement ages for public servants in their 40s and 50s), what was once called the population pyramid comes to resemble a triangle perched on its apex. We are not convinced that the Europe (and, for that matter, Canada) of the somewhat distant future will be depopulated. But we are convinced that investors should be building demographic calculations into their longer-term calculations. The US, largely because of those controversial undocumented Latinos, has the best population profile of the industrial nations. Already, 50% of the new Americanseither by birth or by immigrationare Latinos. Within a few years that number will be 75%. Europe cannot emulate that rate of almost accidental Americanism with a flood of young Muslims. The overwhelming majority of Latinos want to become part of the American Way of Life. They dont seek to import the legal or political systems of the countries they have left. They do not yearn to be ruled by a theocracy based in a foreign culture, no do they riot when a film or newspaper distributes anti-Catholic material. They accept democracy, and they accept the reality that so many of the freedoms of which Americans are so proud spring from the nations deeply-rooted Protestant Christian traditions.

If Europeans were wild animals, they would soon qualify for the endangered species list.

February

2

Happily, those observations also apply to the overwhelming majority of American Muslims, most of whom have been living and working in this country for generations. The American melting pot approach to absorbing aliens still works: this country has experienced no riots, and only a smattering of homebrew terrorist threats. The Street equivalent of succumbing to a mirage is th quartile performance, followed by a pink slip.

A Change of Opinion on Bonds

We are making a substantial reduction in bond duration. Our reasoning is as follows: 1. It is far easierand far less riskyfor pension funds to make a major shift in bond exposure than in their equity portfolios. Making largescale equity shifts can be problematic and is rarely appropriate for major institutions. However, even the biggest pension funds can change bond durations quickly and at modest cost, either through outright switches or through use of derivatives. Furthermore, they can always reverse the tradethe bonds sold will still be there, or bonds of similar quality and liquidity will always be available. Conversely, if one slashes ones exposure, say, to mining stocks, there is near-zero guarantee they, or similar quality stocks, will be available when the mining cycle seems more propitious. So investors should always be far more willing to consider major portfolio shifts in bonds than in stocks. 2. We have been fans of long-term bonds and zeros because (1) they offer the best capital gains potential once the Fed (and/or other major central banks) resume lowering rates, and (2) they are the best hedges against deflation. A buyer of long-term zero coupon Japanese Government Bonds (JGBs) in 1990 who held on as deflation gradually tightened its grip on Japan had far better returns during the rest of the decade than a holder of Microsoft or Dell. 3. Once the yield curve inverts, a holder of long bonds has to pay a carrying cost for keeping them, rather than switching into shorter-term, higheryieldingand less riskybonds. That those conditions (what Alan Greenspan ridiculed as a desire to lose money) have persisted so long during this cycle is because the market sees an era of rate cutting lying just beyond the horizon. Seeing something that is just beyond the horizon can be a money-making experience on the Street, but can be an invitation to death in the desert. The Street equivalent of succumbing to a mirage is 4th quartile performance, followed by a pink slip.

2

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Basic Points
4. Because we have for eight years believed that the primary challenge to the price system came from deflation, we have generally favored long bonds. Although we do not see a return to central-bank-spawned inflation, we note that two contributors to falling inflation since the late 1990s oversupply of labor and oversupply of commoditieshave been deleted from the disinflation and deflation rosters. With near-record-low rates of unemployment, wage rates have finally begun to growat a time corporate profit growth is slowing. 5. Not only do long bonds now yield less than short-term bonds, they deliver historically low real yields. That condition of sustained low returns at higher than normal risk is driven, in part, by fear. The longest-running Page One Economic Scare Story of our time is the tale of the coming housing collapse. The Rule of Page Sixteen says one should not be investing on the basis of those Page One horror stories. The recent recovery in homebuilding stocks suggests that the worst of the downturn is behind us. Who will be delighted with long-term bonds yielding less than 5% if it turns out that fears of a housing crisis were overblown? (And who, by the way, is holding all that sub-prime mortgage paper?) 6. Another argument for holding long bonds, even though they deliver low real rates of return, is that US and European economic growth rates are finally slowing down, following two years of central bank monetary restraint. This is just the time for maximum capital gains by holding long bonds and zeros. But what if the slowdown is just a pause that clears the decks for even faster growth, as happened a decade ago? Once investors began to sense such a pattern, they would run, not walk, to unload. With the US Leading Indicators declining below the zero growth line, and US Q4 GDP growth about to be retroactively written down, the slowdown that bondholders have been waiting for looks to be unfolding. So why cut back on exposure now? Answer: liquidity levels remain high, whereas during previous Fed tightenings, liquidity droughts emerged. Furthermore global growth remains strong, so the bet on sharply lower rates soon is no sure thing. 7. Long bonds have gained support during this decade from global changes in pension fund valuations. In the past, actuaries and regulators did not fret about pension funds bond durations, because their large holdings of equities meant their long-duration liabilities were covered by highperforming long-duration stocks. The Triple Waterfall Tech Stock collapse

...what if the slowdown is just a pause?

February

27

The bond crop never fails

exposed the risks in extremely long-duration stocks (those with high p/e ratios and low or zero dividends). Pension funds thereupon rushed to acquire long-term noncallable government bonds, which were then as rare as tech companies who accurately reported the costs of their stock option programs. Governments have naturally been responding to this actuarially-driven longing for long bonds, and the shortage could soon go away. The bond crop never fails is one of the oldest maxims in the government bond market. It became obsolete in, say, 1999. It will soon be back to thrill you again. 8. We have particularly stressed the attractiveness of long zeros as hedges against downside risks in commodity stocks. We said we did not expect a recession, but the sustained contraction of central-bank-spawned liquidity meant that, unless we had truly entered a Brave New World, there would be a global slowing which would hurt prices of industrial commodities. We have seen sharp selloffs in prices of oil, gas, and most of the base metals. Lately, we have been seeing rallies. Maybe the worst is already over, in which case investors can take off some of their hedges. (Nickel is the notable exception to this pattern. Alas, the two pure-play nickel stocks we discussed for years in this journal were yanked away by shrewd acquisitors, while most Street analysts continued to predict nickel prices falling to the $5 range.) Meanwhile, one pattern we have been writing about for three years continues: big mining companies continue to be on the prowl to buy smaller mining companies. 9. Most global stock indices are trading at, or near, all-time highs. This week all three Dow Jones indices touched records, and the Nikkei reached a six-year high. Barring a sudden financial crash caused by metastasizing derivative disease, it is hard to maintain the view that one should keep remain overweighted in an asset class that looks best when all else looks worst. Stock markets are, of course, imperfect forecasters, but they have a better record of predicting the economic future than the economic consensuswhich has never predicted a recession. (Who dares to call economics The Dismal Science after so many decades of sustained optimism?) If stock prices dismiss the probability of the onset of an economic environment that would make long bonds irresistible, then investors should certainly consider reducing both their exposure and their durations.

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Basic Points
10. Why did we not make this recommendation last November when the Ten-Year Treasury yielded 4.44%, instead of waiting it to correct to 4.69%? Because oil was leading industrial commodity prices down, and, despite our pious protestations of immunity toward Page One stories, we were finally getting worried that systemic risk from bad housing-related debt could hurt the US economy. We were comfortable keeping our hedges in place. That was the wrong call. 11. What happens if industrial commodity prices plunge anew and it begins to look as if the housing bubble has truly burst? Then we can extend bond durations again, with the damage being greater to what remains of our reputation than to our portfolios.

Who dares to call economics The Dismal Science after so many decades of sustained optimism?

February

29

INVESTMENT ENVIRONMENT
The continued runup in grain prices is great news for the US federal government, because it will automatically slash its farm subsidies, which will allow it to be even more sanctimonious in its wrangling with the EU over the Doha trade round. It is also great news in the grain belt, which begins just beyond the horizon we see at sunset from our 27th floor condo on Lakeshore Driveand it aint a mirage. But the impacts on farming are uneven: it takes 10-11 bushels of feed to ready a barrow or gilt for market, and the $0.68 a pound price paid for a hog on the Chicago Merc is down 6 cents from the time when corn was $2.00 a bushel. Major producers, such as Smithfield, have hedged heavily against higher grain prices, but those hedges expire this year. If prices for bacon and pork do not move significantly higher, the factory farms will cut production. Until recently, the only pork whose cost was rising sharply and steadily was of the Congressional variety. Ifand that is a big ifthe new rules against Earmarking constrain the Congressional tax hogs, that burden on taxpayers will not worsen. But the cost of the more traditional forms of pork may be about to rise in time to make the barbecue season a costly experience. The short product life cycle means the poultry industry is already feeling virtually the full impact of $4 corn. Cattle ranchers have had the option of delaying delivery to market, but the recent snapback in feeder cattle prices should shift inventories in coming weeks to the feedlotsand consumers. Once these varying short-term adjustments are complete, consumers will be paying higher prices for meat and eggs. Doubtless the dairy cartels and supply-management structures will soon ensure that prices for milk and other dairy products rise to offset soaring feed costs. Meanwhile, oil prices are back up above $58, and copper refuses to stay below $2.50. As this is written, there is talk of a BHP or Rio Tinto bid for Alcoa, or maybe Alcan. In discussing those rumors with a caller, we pointed out that the major mining companies are gushing cash at spectacular rates, and there are few targets for mine development. The key constraintslitigation and political risksdraw more boardroom scrutiny than ever.

Until recently, the only pork whose cost was rising sharply and steadily was of the Congressional variety.

0

February

Basic Points
This week, Chavista Evo Morales of Bolivia nationalized the tin smelter owned by Glencore, which was for years (and still could be, for all we know) a Marc Rich vehicle. Morales (when has any Latin politician had a surname that was less descriptive?) says he has no intention of paying any compensation for the property. Glencore has announced it will sue to recover the fair market value of the smelter. We certainly wish them luck, but wonder how an international tribunal would assess the real value of a smelter in a state whose leader proclaims old-style socialist principles. Maybe Morales can defend himself by saying the fair market value is zero, because what sane investor would want to own a property in Marxist Bolivia? The Patinos once owned the Bolivian tin industry, but they had to flee from earlier looters, and may have been the models for Francisco dAnconia in Atlas Shrugged. Given Morales propensity for making outrageously inflammatory utterances, we wouldnt be surprised if he chose to delight his followers by offering coca for tin. It was the coca farmers who were decisive in electing Morales, and they always face distribution problems for their output. Glencores founder, Marc Rich, had decades of experience in unloading contraband around the world on a tax-free basis. Everybody wins, si? What may be unfolding is a new and unsettling commodity pricing environment for consumers: high energy prices + high metals prices + high grain prices + high meat prices. What makes this cycle unique is that the high energy prices for the first time ever are driving up grain prices, which will surely lead to higher meat prices. Until now, energy costs were, for most pig and broiler chicken producers, the second largest input costbut far below the cost of feed. Now, there is a positive upward correlation between energy and feed costs. Colonel Harlan Sanders would have had trouble maintaining his cheery smile when confronted with that story. The ethanol story was for years mostly the story of ADMs mostly successful attempts to upgrade corn into higher returns through politics. What changed it to a market-shaking success was 9/11 and the growing realization that high oil prices were indirectly funding al Qaeda and other Wahhabite terrorist operations worldwide. As Saudi oil revenues climbed far above the regimes ability to deploy them at home or in the Gulf, more and more funds, (analysts insist), were disseminated abroad through the Department of Islamic Affairs, which is dominated by Wahhabites.

Everybody wins, si?

February



When Bush dramatically announced...that America had to break its addiction to oil, it was a shock to Texas...

A retired Indian foreign affairs officer told me how it has worked. Saudi representatives abroad visit a mosque whose membership is mostly poor and mostly unpolitical. The representatives volunteer to provide six months residential training for a local cleric or would-be cleric, along with funding for expanding the mosque. They also offer further training programs in subsequent years. After a few years, the preaching in the mosque may no longer deal purely with pieties, but becomes heavy on jihadism, and denunciation of Jews and Americans. This pattern has been repeated around the world. And, he smiled, all along the Saudis keep assuring the Americans they are their most loyal Mideast allies! Tony Blair has begun trying to deport radical imams who preach violence and hate, but courts are leery of becoming involved in what the defendants say are purely religious issues. For two years, Americas most influential foreign affairs columnist, Thomas Friedman of The New York Times, who strongly backed Bush on Iraq, has been demanding that Washington cap oil prices through strict fuel consumption regulations and mandatory use of biofuels. For Friedman, Saudi Arabias most important export is not oil: it is jihadism, allied with violent anti-Semitism. George Bush took a long time coming to grips with this problem. One the first imams he recruited for public prayers after 9/11 was later convicted of crimes involving money-laundering for terrorist groups abroad. The Bush family has been famously pro-Saudi for decadesand, it is rumored, very profitably so. When Bush dramatically announced in the 2005 State of the Union address that America had to break its addiction to oil, it was a shock to Texas, and an occasion for rejoicing in Illinois and Iowaand among many surprised liberals, who were delighted that Bush was finally agreeing with them. This year, he raised the ante, insisting that the US produce at least 35 billion gallons of renewable fuels a year within ten yearsroughly 10% of expected gasoline consumption. Bills in Congress would mandate production of 60 billion gallons by 2030. Meanwhile, over in the EU, rising interest in biofuels has nothing to do with the War on Terror (as befits a grouping who are collectively doing their best to have nothing to do with the War on Terror). Brussels has decreed that 5.75% of Eurodiesel fuel must be crop-generated by 2010. (Only in Brussels

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Basic Points
would they come up with a percentage for fuel content of 5.75%: not 5% not 6%, but 5.75%). Lord Browne of BP (Surprise!) insists his company will do all it can to support these initiatives. He may be a bit too busy defending himself before Congressional committees and American courts to tour any corn fields or break ground for any ethanol plants, but we feel sure he will do his best to continue promoting BP as the greenest of the oil companies. The survivors of all those American workers who lost their lives working under wretched conditions in his Texas refinery can console themselves that their boss was a great environmentalist who meant well. We have not changed our view that ethanol is of dubious economic and environmental merit. It is corrosive for politics, automobiles, and pipelines. If only for the problems of transporting it across mountain ranges, it would not become an overnight sensation in a free market environment. However, autarky may be justifiable in the War on Terror. If oil prices can be held below $75 over the longer term through use of biofuels, then the growth in terrorisms cash flows will be moderated. That is a worthy objective, even if it means we pay a lot more for hamburgers, sausage, and fried chickenlet alone steak. When faddish enthusiasms suddenly engulf the political arena, little time is spent addressing what Donald Rumsfeld called the known unknowns and the unknown unknowns. (He certainly did not spend enough time on them before it was too late.) Global warming is being blamed as the likely progenitor of everything from Katrina to the record cold we have been experiencing in Chicago. Without getting into that debate, we suggest a rather more obvious outcome of sustained warming: longer growing seasons in the temperate zoneswhere most of the worlds grain is produced. Three decades ago, the US Secretary of Agriculture told a dinner of the Toronto Society of Financial Analysts that the scientific community was in agreement that the period of global cooling we had been experiencing threatened a new Ice Age. The first signs were a reduction in the growing season. There had been some painful experiences with late plantings and early frosts in the Upper Midwest and the Canadian West, and these were the precursors of disasters to come. We needed, he said, to develop new hybrid grains and oilseeds that could survive shortened growing seasons. We did.

...ethanol... is corrosive for politics, automobiles, and pipelines.

February



Or, more accurately, Monsanto and Pioneer did. (Pioneer was later acquired by DuPont.) According to the climate studies, the world is 0.7 degrees warmer now than a century ago. It is sharply warmer than it was in 1992, because the worlds temperature fell by more than a full degree after the eruption of Mt. Pinatubo in July 1991, which filled the global atmosphere with volcanic ash and hydrosulfurous acid particles, creating a global mirror, reflecting sunlight back into space. If the rise in earths temperatures since then continues to progress, then North American and British, Scandinavian, Ukrainian and Russian farmers can look forward to record-long growing seasons and record grain production, assuming that they control the likely increase in pests who survive the mild winters. Whether longer seasons will offset the drawdown of corn and other grains for biofuels is, of course, a known unknown. Indeed, without global warming, it is hard to see how the world will produce enough coarse grains and oilseeds and sugar and grass to meet what we are being told of the coming demands for sustainable, atmospheric-friendly, fuels. (Corn used for ethanol is not completely subtracted from the animal feed market. The residue of the milling processdistillers graincan be used for cattle feed, the way the moonshiners fed their cows in the good old days. That byproduct isnt considered good pig meal, so if corn prices stay at these remarkable levels, hog producers will be worse off than beef producers.) This new demand for coarse grains couldnt come at a worse time from Chinas standpoint: China consumes roughly twelve times Indias level of feed grains, because of the scale of its livestock industry and the wealth of its population. According to the USDA, Chinese demand for meat, dairy and fish products grows at about the same rate as incomes. The Chinese have been busy making up to such toxic regimes as Iran and Zimbabwe to get access to needed oil and metals. If corn and soybeans are to be the new commodity stars, then perhaps China could do the world a favor by helping regimes such as Mugabes produce grain.

If the rise in earths temperatures since then continues to progress...farmers can look forward to record-long growing seasons and record grain production,



February

Basic Points
There would have been a serious shortage of global feed grains and oilseeds within a few years in any case, because Indias incomes are rising at a rate that means they can no longer rely on grass and scraps for their livestock. Now, thanks to what may well turn out to be biofuelishness, feed grains look to be in short supplyand very expensivefor years to come. Rex Tillerson, CEO of the Exxon, the company we are supposed to hate, (as opposed to BP, the company which, despite its occasional sins, we are supposed to love), told a conference this week that he was no expert on moonshine. (Ethanol is the scientific term for what hillbillies called corn likker. It must have a special additive to prevent its use forrecreational purposes.) Mr. Tillerson dismissed the idea that ethanol and other plant-derived fuels were threats to the petroleum industry. Despite Mr. Tillersons insouciance, we think it likely that this most unlikely coalition of farmers, liberals, greens, and patriots will ensure that biofuels become, at the very least, a costly fad, and more likely a mania. They will surely become the automobile form of the school milk program, so that car owners will have to use them. One result: talk of $100 oil in the near future should be sequestered into those chat rooms where enthusiasts discuss the likelihood of Cub World Series victories and people report flying saucer sightings. If the US taxpayers could put men on the moon, they can turn green enthusiasms into long green for producers of feed grains, oilseeds, and other sugar-containing plants. The space program was a money maker for some companies and individuals. So will green fuels: There will be splendor in the grass. ...biofuelishness

February



INVESTMENT RECOMMMENDATIONS
1. Reduce bond exposureboth in percentage of portfolio and in duration. 2. Upgrade the quality of your bonds, because at some stage in this tightening process, some asset class will crash, and spreads will widen. 3. Continue to build exposure to Emerging Markets equities, but at a restrained pace. Some markets, such as China and India, are frothy, and Russia is becoming a projection of Putins attempt to resurrect Russian global power. The rewards still outweigh the risks. 4. Remain overweight the commodity-producing stocks. 5. Build gold stock exposure, emphasizing companies which do not hedge their gold output. 6. We recommend only a modest overweighting in energy, but continue to argue that the producing Alberta Oil Sands companies should be major components of that energy portfolio. Shell is being forced to pay up to acquire the shares in Shell Canada it does not own. Biofuels are likely, at least for the next few years, to constrain oil price increases, so that should slow down development of the oil sandswhich would be great news for todays producers, because they would no longer be hit by soaring costs because of bidding wars for men and materials caused by new entrants to the sands. 7. The biofuels craze should encourage investors who were building exposure to the agricultural stocks to accelerate their investment programs, with emphasis on companies directly involved in US and Canadian production of coarse grains and oilseeds. Investors should think of the companies tied to grains as being more than farm stocksthey are also becoming significant parts of the global gasoline and diesel fuel industries.



February

Basic Points
8. We do not know whether a major mining company will bid for Alcan or Alcoa. We do think the aluminum stocks are good value in any event. 9. High-quality publicly-traded base metal companies are an endangered species. Buy them while they are still cheap and still available, using the Basic Points criterion: long-life reserves in the ground in politically secure regions of the world. Fast growth in global supplies of biofuels should make energy users feel far more confident about security of supply at moderate pricesand that would mean global economic growth would be faster than otherwisetriggering higher metal prices. 10. Nasdaq and the Dow have delivered virtually identical total returns (exdividends) over the past five years. That suggests either that Techs have done somewhat better than they deserve or the rest of the market has done somewhat worse than it deserves. Either way, underweight Technology. 11. In case you have forgotten, avian flu is still spreading among global bird populations, particularly among farm-raised fowl, and among cats of many species. It hasntyetmutated to acquire human-to-human transmission. In one sense, it is getting stronger: the human mortality rate from the disease, which was less than 50% when we first wrote about it in August 2005, is now 61%. If the mortality rate were a stock, youd buy it. To put that rate into perspective, the death rate from the worst modern pandemicthe Spanish Flu of 1918was 2% in the US, and closer to 5% in India. More than fifty million people died.

February

7

Basic Points
DONT ASK; DONT TELL: ITS SUBPRIME TIME!

March 21, 2007

Produced by BMO Financial Group Distributed by BMO Capital Markets

Basic Points
An Investment Journal
Donald G. M. Coxe
Global Portfolio Strategist, BMO Financial Group (312) 461-5365 e-mail: don.coxe@bmo.com

Research/Editing Production/ Distribution

Angela Trudeau e-mail: angela.trudeau@shaw.ca Anna Goduco (print orders and mailing lists) e-mail: basicpoints@bmo.com

DONT ASK; DONT TELL: ITS SUBPRIME TIME!

Overview
Its the debt market, not the stock market. Each expansionary credit cycle spawns and bloats its own excesses. The stimulus to create new forms of speculation comes from the pledges of battered investors that they will not make the same mistake the next time. The Street responds to this shift in investment dietary desires with Ingeniously Modied (IM) fare that meets the needs of the new breeds of risk gluttons. The man-made monstrosity of the 1990s was Nasdaq, whose rise and fall magnied the rewards and the ensuing collapse in the equity market. That ethical and nancial catastrophe has left its mark: despite a sustained explosion of global liquidity, the stock market has been quite well-behaved. In particular US large-cap stocks, the asset class epicenter of 1990s seismic shocks, have been stable: their p/e is now barely half that of their small-cap brethren. The real nancial excesses are now centered in the nether regions of the bond market. Everyone knew about the remarkable expansionand the even more remarkable performanceof junk bonds, most of which were born during this cycle. However, most investors had only a hazy awareness that the most speculative sector of the residential mortgage marketsubprime loanswas also experiencing suspiciously rapid growth, in new loans, share of housing marketand, naturally, in delinquencies. All stories of large-scale nancial malfeasance end badly for investorsbut not usually for the big Wall Street rms who prospered so mightily from peddling the products whose risks were so misunderstood by their clients. After the long liquidity boom, the bond swamp is now being drained. As the waters recede, the nostril-assaulting residue is what bond players call toxic waste. This month we discuss the challenges facing the bond market. It has managed to defy the central bankers by delivering lower long-term rates while the bankers were delivering much higher short-term rates. One of its propsthe absence of food price inationis eroding rapidly. Anotherthe assumption that inverted yield curves must lead to such slow economic growth that the central bankers will capitulateis also being challenged. The stock market made a half-hearted attempt at correction. Unless there are revelations of major systemic risks arising from the imploding junk mortgage market, this pullback will not prove painful or prolonged. Its subprimes timein both the housing and stock markets.

March

Recommended Asset Allocation

American Portfolios

U.S. Pension Fund

Allocations 27 29 12 10 15 7 Change unch unch unch unch unch unch

Domestic Equities Foreign Equities Domestic Bonds Long-Duration Bonds Foreign Bonds Cash

Foreign Equity Allocations

Allocations 6 6 6 11 Change unch unch unch unch

European Equities Japanese and Asian Equities Canadian & Australian Equities Emerging Markets

Bond Durations
Years 4.25 4.50 4.75 Change unch unch unch

Global US Canada

March

Basic Points
DONT ASK; DONT TELL: ITS SUBPRIME TIME!
This issue was drafted just before and on the ides of March. In line with Teireisian tradition, let us observe that the truly grim augury for the debt markets comes not from the corporate debt sector, but from the mortgagebacked sector. For nearly two years, we have been hearing jeremiads about the excesses in the housing market. House prices were soaring nearly everywhere. Those levitating home prices meant that owners could let their homes be ATMs. This was a relatively new process. The drawdown opportunities created by house-price-ination have long been used for remodeling and upgrading homes, and they constituted no problem for the overall economy. They nanced repairs and capital investment on the worlds biggest asset class. However, in this cycle, a new pattern emergedthe house as credit cardthe cash generator to nance expenditures on absolutely anything. Depending on whom you believe, home equity drawdowns through conventional mortgages, and second or third mortgages (called Home Equity Loans) have nanced one-third or more of total GDP growth. And then, house prices stopped going up. And then, house prices started going down. One of the measures the really rich used for themselves, (back when $25 million was really, really rich), was indebtedness: You are only worth as much as you owe was the kind of self-assured dry wit they would deliver over dry martinis in drawing-room comedies such as Philip Barrys. The democratization of that elitist self-aggrandizement is one of the dubious achievement of this era. Own your share of the American Dream was the line used by home builders, condomaniacs in apartment buildings, and marketers of the stylish new mortgage products to people who couldnt qualify for the traditional, old-fashioned kind. The oft-told story (on Page One) of the Great American Housing Bubble the story of foolish people paying too much for houses because they were convinced the prices had to keep soaringhas taken a new plot twist: the most egregious folly was not the over-optimism of home buyers, but the greed, venality, stupidity and sleaze of home lenders. Home prices, ...the most egregious folly was not the overoptimism of home buyers, but the greed, venality, stupidity and sleaze of home lenders.

March

...the bartenders got drunker than the patrons.

particularly in coastal cities with large populations of investment professionals became overvalued, but a few years cooling would have corrected this exuberance without major systemic damage. With unemployment at a mere 4.5%, the overall housing market should have enough breathing room to nd its bearings. Besides, the bubble is a coastal phenomenon. Between the Rockies and the Appalachians, house price rises have been mostly muted. What makes this bacchanalia different from its predecessors is that the bartenders got drunker than the patrons. The Fed, in McChesney Martins classic formulation, is supposed to take away the punch bowl when the party gets rowdy. The way one knows that it is time to say, Time, ladies and gentlemen, is from the decibel level and the percentage of lewd comments, and those measuring techniques have always focused on the customersnot on those pouring the punch. Alan Greenspan, who is hard of hearing, had trouble performing that central bankerly function of revelry appraisal. Result: he could talk about irrational exuberance, but he never knew it when he saw it and he never heard it. Indeed, he denied that a bubble could be identied until after it burst, and insisted that central bankers should not take on the task of ghting asset ination. Leave markets to settle excesses by themselves. I think that I may never see Irrational exuberncy. But should I see emergent bubbles, Id not actthat might cause troubles. Greenspan was doubtless right about letting the high-prole house speculators bid against each other. The most visible excesses have been concentrated among the McMansion buyers spending some of their prots from Wall Street or from backdated stock optionsand they can take care of themselves. They have done such a conspicuously fabulous job of that up to now, and they are unlikely to have lost either the enthusiasm or the touch. However, far away from Hollywood, Park Avenue, Greenwich, and other dens of the luxuriously indebted, another, sadder kind of excess was occurring. People who should have continued to rent were seduced into buying homes they could not afford. Once upon a time, homebuyers had to qualify for a GSE-insured mortgage by completing a detailed questionnaire and supplying extensive documentation on their earnings, taxes, and liabilities.

March

Basic Points
Then that lovably louche, laid-back Clinton formula was adopted by a newlyoffensive groupthe fast-growing army of mortgage originators: dont ask; dont tell. Our admittedly unscientic analysis of TV ads, (based on those shown when we watchthe baseball playoffs and the NFL), had alerted us in 2005 to a new kind of mortgage offeringthe 60 second mortgage approval via phone or online. We wondered what kinds of investors would nance such loans. The stories being published about the operations of New Century Financial answer that question and reveal a whole new subculture of nancial folly. For students of Street absurdities there were echoes of Jack Grubman and WorldCom. New Century insiders had dumped huge quantities of stock before it began to sink. Then an analyst with a Street rm recommended the stock days before it fell by 95% and was delisted. He was, in the tried-andtrue formula for such stories, unavailable for comment, although the press commentary made it very clear that his rm had underwritten many billions of dollars worth (if that noun actually applies to such porous paper) of subprime loan product excreted by New Century. What we know of the animal spirits in the Street bond cages is that there were many bulls (who underwrote the bonds), a few weasels, and no junkyard dogs. Perhaps we should have been reexively suspicious of any mortgage lender that was growing fast by issuing newfangled products and calling itself New Century. Dr. Johnson once received an unsolicited manuscript from a young writer, who asked him for his opinion. The Doctor replied, This manuscript is both good and original. Unfortunately, that which is good is not original, and that which is original is not good. In the case of New Century, what was original about its operations was not good, but it did lead to originations. What made it possible to nd buyers for the huge volume of loans it was creating that couldnt pass the Smell Test, let alone a credit check, was Wall Streets development of Collateralized Debt Obligations. By adding New Centurys interest-only and exible payment loans made to people who had no proof of creditworthiness to packages containing Triple A loans, the Street was able to sell products that included something for every kind of risk-taker. ...the fast-growing army of mortgage originators: dont ask; dont tell.

March

Wall Street is the global leader in nancial cosmetology, the art of putting lipstick on pigs...

In reecting on stock market reaction to the revelations about the subprime asco, we admit to being somewhat surprised that the Street was so surprised about the scale of trashiness in these mortgage junk bonds that had been gussied up by the cynical sharpies to appear respectable. Wall Street is the global leader in nancial cosmetology, the art of putting lipstick on pigs and then nding buyers eager for the extra yield, most of whom probably assumed they would pass it along to greater fools before the stench from the sties reached intolerable levels. Since these were the same rms who had peddled worthless tech stocks using the same techniques, why would investors assume that it would be different this time? According to The Wall Street Journal, 2.5% of New Centurys mortgages went into default without making a single payment. To paraphrase Lady Bracknell (The Importance of Being Earnest): to lose a loan after a year may be regarded as a misfortune, but to lose it in a month looks like carelessness.
Total U.S. Residential Mortgages in Foreclosure (NSA; %, end of quarter)
1.6 1.5 1.4 1.3 1.2 1.1 1.0 0.9 0.8 1986 1989 1992 1995 1998 2001 2004

Source: Mortgage Bankers Association / Haver Analytics / BMO Capital Markets Economics

The foreclosure rate on subprimes is now 4.5%, whereas on prime loans it is one-ninth of that. Subprimes share of mortgage loans serviced and their default rate are both at the 13% levela coincidence that would excite bearish triskaidekaphobes. Total foreclosures have already reached levels previously seen only in or after recessions. Since the subprimes gained their big market share during the late stages of the housing bubble, we must assume that the peak of the foreclosure rate will not be seen until late this year or in 2008. In other words, like the tech crash, the story will get worse before it gets better. Should the US fall into recession, then the main support for housing priced by greed, not needfull employmentwill evaporate.

March

Basic Points
Fannie Mae and Freddie Mac had also leapt into bed with subprime lenders, and their names on loan packages were, to the unwary, Good Housekeeping seals of approval. Since neither of those Washington-spawned mortgage mutants has been able to le valid nancial statements for years, it seems only fair that they should be willing to lend billions to people who are also unable or unwilling to le accurate nancial information. These factors suggest default rates have nowhere to go but up, and valuations of those Collateralized Debt Obligations that include substantial supplies of nonperforming loans have nowhere to go but down: 1. The last time a sector of home loans went bad amid bankruptcies, weeping and wailing was in 1999 when manufactured homes collectively collapsed as if blown down by a Big Bad Wolf. Lenders thereupon swore off the prefabs and went into the business of manufacturing loan products instead. We are entering the rst true stress test of this new product line. Why should investors be surprised that the products are failing that test? 2. Amid the low-quality loans, which formed more than 20% of mortgage lending in 2005-6, are those designed for borrowers who would not have received credit had traditional disciplines not been abandoned when lenders became orgiasts. Among these inducements and pain-killers were teaser interest rates, interest-only loans, no payments at all for a year, and forty- and fty-year mortgages. Sadly, a disproportionate share of the people who succumbed to the sales pitches from the sleazy lenders were African-Americans and recent immigrants. The Chicago Tribune recently printed a map of the city showing the number of foreclosures in each of the citys many communities. The minority-heavy areas of the South Side and the immigrant-heavy areas of the West Side have the overwhelming percentage of defaults. The newspaper included some stories of people who are being evicted. The tales they tell of not understanding such complexities as what mortgage resets would mean if interest rates rose are credible tales of personal tragedies. Although Basic Points has managed to restrain its enthusiasm for tort lawyer suits against businesses, this might well be a nationwide problem that would justify lawsuits based on misrepresentation and/or breaches of implied duciary duty. The most agrant of these noxious lending operators portrayed themselves as friends of borrowers by dismissing the importance of creditworthiness documentation. (We dont need all the red tape the banks use, they said. What they meant was, We dont ask, because we know you wont be able to tell us the criteria that would qualify you for a regular, insured, low-interest mortgage. Just sign here.)

[Fannie Mae and Freddie Mac]...only fair that they should be willing to lend billions to people who are also unable or unwilling to le accurate nancial information.

March

...that modern classic Nothing Down for the 2000s...

3. When the Federal Reserve and other regulators nally got around to recommending some tightening of home mortgage lending rules, the spokesman for the Mortgage Bankers Association explained why his group was opposed. These rules will prevent some people from getting mortgages. He knew exactly what terminology to use because Congress has long promoted easy lending practices. When Congressman St. Germain (D., R.I.) basically threw out the constraints on Savings & Loan Association investing in 1982, he was treated as a hero. Among those who applauded him was one Alan Greenspan, who was at the time a consultant to some members of the Savings & Loan industry. As the head of the Federal Savings & Loan Insurance Corporation told us in a visit to his ofce in 1984, The industry is bankrupt because of the St. Germain reforms. I tell them this in Congress in executive session every time I go to the Hill but they refuse to reinstate any of the former rules. The only question is when the S&Ls go bust. It took longer than FSLICs boss expectedanother ve years. Before then, Fed Chairman Alan Greenspan did publicly express some concern about the lending practices of some major S&Ls. The real-estate-led recession of 1991(whose existence Greenspan denied at the time), was rooted in the collapse of the S&Ls. But even the worst of those S&Ls took longer than sixty seconds to make a loan. Perhaps the most informative material on the problems of the mortgage industry we have read since subprimes became the prime time story was a full-page ad in The Chicago Tribune, with the headline Eighth Grader turns $2,200 into $35,000 and the picture of the smart young lad, whose name is J.J. Bright. Anyone can do it, the boy says. All one needs to do is to attend a workshop Creating Wealth With Real Estate by the author of that modern classic Nothing Down for the 2000s, penned by the smiling gentleman who can help you get rich, Mr. Robert G. Allen. Theres a special bonus: The Foreclosure Phenomenon: Finding Hidden Prots in Your Neighborhood. By the way, Master Brights parents have also taken the workshop, and they attest that their net worth has just gone beyond $1 million and theyre targeting $2 million next year.

March

Basic Points
Thats what America needs: a little old-fashioned optimism, a lot of help from good people such as New Century Financial, and therell be no more of this gloomy talk about a crisis in subprime mortgages. (Master Bright, we are informed, put down $2,200 of his own money, bought a spec house for $138,000, and resold it for that $35,000 prot. He currently holds 11 acres in North Carolina bought for no money down, and estimates it has doubled in value.) What? Me worry? Prime Time ends at 11 p.m. weeknights. Subprime Time (in Page One terms) will probably end some time before we turn back the clocks to Standard Time.

Another kind of alchemy has been at work in the scrap section of the corporate bond market.

Where are the [Bond] Junkyard Dogs?

Badder than old King Kong And meaner than a junkyard dog. The global supply of junkyard dogs has been stretched by huge demand in this cycle, because scrap metal has become the stuff of kings ransoms. Scrap dealers, long dismissed by the glitterati as sweaty toilers in the soft underbelly of the economy, are now becoming recognized as alchemists who turn scrap base metal into gold. Another kind of alchemy has been at work in the scrap section of the corporate bond market: junk bonds have been the stars, delivering returns far above high-grades. These are not true transmutations: they will prove to be reversible chemical reactions. Only the unwary will confuse junkas in metalwith junkas in bonds. Junk metal is an absolutely necessary ingredient in economic progress and is seriously supply-constrained. Junk bonds are an aspect of market evolution, and their supply is limited only by the risk tolerances of the investment community. That is a commodity which has been climbing toward innity in recent yearsa condition that will not survive the next credit crisis or recession, whichever comes rst.

March

a) Corporate Junkyards
The corporate junk bond market has been around since Michael Milkens era, but it really took off in this cycle through the exponential growth of private equity. As more and more publicly-traded companies went private, the supply of junk bonds exploded. In a typical privatization, the outstanding debt of the acquired company, which was usually investment grade, instantly became junk. That overnight transformation occurred because the buyer issued a ton of new debt to nance the purchase, so the once-healthy balance sheet became tuberculous. The remarkable growth of private equity has had even wider effects: many a corporate balance sheet has been impaired without an actual buyout. The companies most coveted by the new lions of Wall Street have tended to be steady, unspectacular growers who have fed happily for decades in capitalisms grasslands without attracting predators. Managements had learned over the years the value of strong balance sheets, knowing that major shifts in the economy or in their competitive position were part of the corporate life cycle. After watching so many of their kind get devoured by the fast-swelling ranks of private equity, many of the survivors have deliberately weakened their balance sheets through stock buybacks, special dividends, and/or acquisitions. Across corporate America, the new strategy is to avoid the appearance of being too healthy and muscular. Such old-fashioned companies cannot help emitting the pheromones that arouse predators lusts. Collectively, the various breeds and herds of these ne beasts are shrinking. They were once as populous as wildebeests. Were current rates of self-imposed high levels of indebtedness and private equity acquisitions to continue unabated, they might become almost as rare as unicorns. Junkyard dogs are menacing beasts who make sure the junk doesnt disappear. In this cycle, the junk keeps disappearing from dealers shelves, as bond investors reach for yield in a sustained climate of low interest rates. There is a plenitude of junkyard hogs and a shortage of junkyard dogs to restrain those porcine appetites. The four-letter word for many bond mutual fund managers isnt riskits redemptions. A high-grade bond fund offers a running yield of barely 5% at a time that all stock markets are giving positive returnsnotably foreign markets and, most notably, Emerging Markets. Within the bond funds, Emerging Markets and High Yield funds have hugely outperformed Investment Grade funds.

Across corporate America, the new strategy is to avoid the appearance of being too healthy and muscular.

10

March

Basic Points
As long as the junkyard hogs vastly outnumber the junkyard dogs, Private Equity rms will continue to ourish. Last week, it was revealed that Blackstone, one of the most eminent of the Private Equity rms, may be going public. Its leader, Stephen Schwarzman, who has long derided public markets for forcing managers to concentrate on short-term decisions, has reconsidered his views. Among the reasons he is said to be pondering a Damascene conversion to the merits of markets is that the single transaction of letting the public in on, say, 20% of his rm would double his current $10 billion net worth. It would also give him an even greater hoard to slake his acquisitory appetite. There might be another reason for his rethinking. Senator Schumer has come out against tort lawsuits against companies based on enforcing SEC rules. This has been the vehicle for much of the vexatious litigation that not only cost companies billions, while delivering pittances to stockholders, but has become, along with Sarbanes-Oxley, a major reason why it is becoming increasingly difcult to recruit successful businesspeople as directors of public companies. Academics and other harmless emblems of integrity crave the income from directors fees and from serving on all the process and compliance board committees that businesspeople loathe. HPs problems came from the war between the compliance committee people such as Ms. Dunn and the technology committee people who actually dealt with the problems of running a highly-competitive business. As the CEO of a major company recently told us, Im having trouble keeping the businessmen on my board, because class action suits always get aimed at those with personal wealth not the academics. Our Directors and Ofcers Insurance only goes so far, and those tort lawyers love to claim billions. That Senator Schumer is publicly questioning the value to the public of these tort lawsuits deserves to be a Page One story, because, like all leading Democrats, he gets major nancial support from the tort bar. If Sarbanes-Oxley gets some useful modications, and if the SEC were to assert its jurisdiction over the kinds of cases taken by the tort bar, then the major drivers toward going private in this cycle would vanish. We ask our clients to sympathize with Mr. Schwarzman as he wrestles with the temptation of a quick $10 billion, and ponders the possibility that reform of securities laws would take away his biggest edge over public listing. However, we do not suggest that they plan to back up that humanitarian instinct by pledging to unzip their wallets when his next billion-dollar junk bond offering appears. That offering will include no guarantee from Blackstone, let alone its principals.

As long as the junkyard hogs vastly outnumber the junkyard dogs, Private Equity rms will continue to ourish.

March

11

Caveat emptor is still cited from time to time, although not as often as some of us might wish. Regrettably, cave canem hasnt been heard around bond junkyards in years. It shows spunk to buy junk, and the Real Men who buy those bonds for their xed-income portfolios can sneer and kick sand in the faces of the 98-pound weaklings who buy high-grades. The rating agencies summaries of the nations balance sheets grow more doleful year by year. Blue chip bond ratings have become rarities. More and more of the nations total output comes from companies with debt burdens that would have frightened investors in past cycles. Typical of these laments is S&Ps recently-published review: For 25 years, Standard & Poors Ratings Services has documented the decline in credit quality at U.S. corporations. Companies ability to repay lenders has weakened as corporate managers have focused increasingly on pleasing their shareholders rather than the investors who buy their debt. In documenting the decline, the writers note, Out went the cachet that came with a pristine balance sheet. In came the swarm of Killer Bs, those speculative-grade companies that now represent about 40% of all corporate debt ratings, up from only 7% in 1980. And, let us note, 1980 was A Very Bad Year, which came after A Very Bad Decade. We are old enough to remember when the worlds best-selling business book was Le De Americain (The American Challenge) by Jean-Jacques Servan-Schreiber, which was one long, loud alarum warning Europe that most of its major companies would be either swallowed up or overwhelmed by the nancial strength of American corporations.

Regrettably, cave canem hasnt been heard around bond junkyards in years.

b) Public Junkyards
The collective degradation of the American corporate balance sheet could be viewed as the business communitys participation inand validation ofThe American Way of Debt: Washington and most state governments are also systematically undermining their nancial strength, although they have chosen to disguise the degradation by using Enron-style, off-balancesheet vehicles, where the present value of liabilities is disclosedif at allin other reports. At the national level it is Social Security, Medicare and pensions and health care for employees, including soldiers. At the state level it is Medicaid and pensions and health care for employees. Fortunately, there

12

March

Basic Points
is some hope that the states and municipalities will not be able to continue this scam much longer: new accounting rules are forcing them to spell out their pension and health care liabilities. As the radical concept of fair disclosure spreads, the deteriorating national nancial picture will be apparent to all who take the time to read it. The tax-exempt bond market is the only segment of Americas public capital markets that is overwhelmingly nanced by domestic investors. Given Americas negative household savings rate, a trade decit of 6.5% of GDP and Washingtons nancial problems, foreign portfolio investorsand, under the operations of The Great Symbiosis, foreign countries exchange reservesshoulder a big share of nancing Americas luxuriant lifestyle. That the muni market should be an oasis of health and stability is because of a splendidly convenient Constitutional principle: Congress, the Courts have maintained, cannot tax the states. Therefore, state and local bonds are free of federal income tax. Additionally, the states exempt from state income tax the interest on local bonds paid to state residents. New York City bonds are Triple Tax Free to Gotham residents, meaning that they also exempt from New York Citys income tax. Until Mr. Giulianis mayoralty, even that total immunity was insufcient inducement to get investors to buy NYC bonds without paying interest rates that were as high, compared with other tax-free bonds, as the Manhattan skyline compared to, say, Topekas. This litany of nancial woes does not, in itself, provide justication for predicting a collapse in the American high-yield bond market, or for fearing that deterioration in the junk markets will unleash the equity bear. We think that the US nancial system will muddle through this latest excess, particularly if interest rates declineas the fed funds futures predict. Indeed, if the mortgage-backed sectors problems were to trigger a serious selloff in stocks, the Fed could be forced into easing, even though that would probably trigger another dollar devaluation. As in all stock market selloffs, long Treasurys have been the haven for those retreating from the stench of rotting mortgagesthe smell-shocked investors. If, as we believe, this turns out to be a mere correction, then investors will reconsider the wisdom of staying in that haven. Barring a major selloff triggered by strong evidence of the onset of recession, the outlook for long-term interest rates will soon not be bond and mortgagefriendly.

As in all stock market selloffs, long Treasurys have been the haven for those retreating from the stench of rotting mortgagesthe smell-shocked investors.

March

13

The problem is not with the stars who run the Fed, but in the foods we feed ourselves. For most of the past quarter-century, food prices have been benign. Most importantly, they have not contributed to inationary pressures since oil took off from $21 a barrel. That has already begun to change. The February PPI showed foods up 1.9% up 6.8% on a yearly basis. The tide has turnedbefore US grain farmers could turn a furrow.

The tide has turnedbefore US grain farmers could turn a furrow.

Bond Bane From The Plains

Corn March 2006 to March 2007
450 400 350 300 250 200 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07 Mar-07

Soybeans March 2006 to March 2007

800 750 700 650 600 550 500 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07 Mar-07

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Basic Points
Soybean Meal March 2006 to March 2007
240 230 220 210 200 190 180 170 160 150 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07 Mar-07

Beats me all to heck, Howll I ever tend the farm?

The Hog Farmers Lament I love you, A bushel and a peck, A bushel and a peck, And it beats me all to heck. Beats me all to heck, Howll I ever tend the farm? A bushel and a peck of corn cost the hog producer $3.10 at this time last year; it now costs $5.30. But the pig farmer isnt getting a cost pass-through:
Lean Hogs March 2006 to March 2007
80 75 70 65 60 55 50 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07 Mar-07

At least, not yet.

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The beef complex is, (dare we say it?), a bit more complex:
Feeder Cattle March 2006 to March 2007

Outlook: consumers could get burned at the steak this summer.

120

110

100

90 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07 Mar-07

Live Cattle March 2006 to March 2007

100

90

80

70 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07 Mar-07

Feeder cattle are those in the feedlots, getting plumped up and marbled for slaughter on a heavy diet of corn and soybean meal. When costs of feeds leapt, the feedlot operators played hardball, cutting their bids for steers. Ranchers, a notably tough breed, hung back, keeping their steers on the land or in barns awaiting the inevitable price rise. Outlook: consumers could get burned at the steak this summer. (The Good Folks at the Golden Arches arent waiting: the cost of a burger at our neighborhood McDonalds is up 8% since the last issue of Basic Points.)

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Basic Points
So why arent hog futures up sharply? It seems that a power play is under way. Smitheld and other huge factory operators saw this coming, and bought hedges on their corn and soybeans. They may take this opportunity to increase their market share of the American pork industry at the expense of hog farmers on family farmsa dwindling breedand smaller hog factory operations, including undercapitalized cooperatives. Out there, somewhere, everywhere, is the real heavyweight. Wal-Mart is the price-setter for supermarkets. Depending on the companys hedge positions, and how much market share it wants to gain, Wal-Mart could phase in the price increases, month by month, over this summer and fall. Amid rising screams from livestock and dairy farmers, the US Secretary of Agriculture is bland and anodyne about the prospects. He says corn prices will average just $3.50 this year, and says the next couple of years should be good for grain producers. As for consumer food price ination, he sees just 2% or 3% this year. In other words, despite a powerful rise in feed costs, the consumer will see food costs rising at the same rate as price increases in the broad economy. However, those comforting comments came after his department issued its authoritative data on global supplies of coarse grains and oilseeds. Here are excerpts:
World Supply & Utilization of Coarse Grains
2002/03 2003/04 2004/05 2005/06 F 2006/07 F

...this years carryover could be the lowest in relation to consumption in decades.

Million units
Area (hectares) Production (metric tons) Consumption (metric tons) Carryover (metric tons) 293.0 875.1 902.3 169.9 306.9 915.9 945.9 139.9 300.4 1,014.1 975.9 178.0 301.3 977.6 989.2 166.4 303.5 967.2 1,014.4 119.3

Source: USDA Agricultural Outlook, February 2007

These gures show that this years carryover could be the lowestin relation to consumptionin decades. The consumption estimates do not, we believe, reect the full impact of ethanol for corn, or diesel biofuel for soybeans.

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We are in Stage Two of the upgrading of consumption patterns of the fastgrowing middle class in the Third World, particularly China and India. The feed grains have begun to reect that revolution, the way oil and base metals did in 2002-2004. ...corn-based ethanol (once affectionately known as moonshine or mountain dew) is a very costly way to produce gasoline. Stage One, which has been mentioned in almost every issue of Basic Points for six years, is moving into dwellings with indoor plumbing, electricity and basic appliances, and then buying motorcycles and/or carsand in rural areas, tractors. Stage Two is switching from a vegetable-based diet to a diversied diet that includes regular consumption of meat (and seafood). Poultry is the rst step. Then come lamb, beef and pork. The spread of Avian Flu across Asia has meant the culling of tens of millions of chickens, ducks and geese. Then came the reports of u deaths from eating tainted poultry, which doubtless accelerated the move into the red meats. Fowl are efcient protein converters. A bushel of corn produces 19.6 pounds of retail chicken, but just 13 pounds of pork, and a mere 5.6 pounds of beef. As the global population of carnivores increases, the pressure on supplies of feed grains intensies. It now seems that the appetites of Asias new middle class would have been able to create feed-grain shortages even if nothing else had changed. But if most of those scheduled 90 new US ethanol reners come on stream, then there will be a real squeeze on global corn supplies, even though US farmers are, (according to a source cited by our friend Dennis Gartman), planning to plant 87.8 million acres of corn this year, up from 78.3 million in 2006. The ethanol and biofuel craze means that global demand for renewable fuels changes the supply/demand situation dramatically. Yes, when corn is processed, only the starch is removed, which is then converted to fructose, and the rest of the grain is available as livestock feed. It is a useful, food supplement for cattle, (not as nutritious as raw corn), but is not recommended for hogs. As we wrote last month, corn-based ethanol (once affectionately known as moonshine or mountain dew) is a very costly way to produce gasoline. Rening ethanol from cane sugar is at least ve times more efcient. (Thats why rum was always cheaper to distill than bourbon. Knowing that fact, the tourist can respond knowledgeably to the wording on the popular Caribbean T-shirt which says, Rum is the Answer: What is the Question?)

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Basic Points
When President Bush met with Brazils President Lula and talked about the need to expand ethanol production, his praise for free markets rang hollow because Congress regards the 54 cent ethanol tariff as non-negotiable. (No candidate of either party could expect to campaign in the Iowa Caucuses or the primaries in Illinois, Minnesota, Kentucky, Nebraska and Kansas if he/she advocates a free market in ethanol.) The EU is mandating a minimum of 5.75% of diesel-fueled cars based on biofuels, (soybean oil, canola or palm oil) by 2011. Last week, Angela Merkel announced agreement on a mandate that 20% of all fuels be renewable by 2020. Each time some critic of Vladimir Putin dies suddenly, and each time Venezuelas Chavez and Irans Ahmadinejad embrace each other and vow solidarity against the United States, and each time a Saudi-nanced imam in a mosque somewhere demands jihad against Israel and the wicked West, the strategic value of renewable fuels looks better. There was brief optimism that major portions of the US farmland conservation set-asides would be returned to corn production this year, but most farmers are content to collect rents from the USDA and keep the land as habitat for waterfowl and other game. (The NRA and other hunting lobbies are joined with the Audubon Society and the Sierra Club in urging continuation of those preserves.) Here is a statistic to give believers in sustained low ination nightmares: the global supply of feed grains is at near-record lows relative to likely consumption this year and next, despite 16 straight years of favorable growing conditions in the Midwestthe worlds leading producing region. This is an historic winning streak. Despite all the talk in High Places about turmoil in world weather caused by global warming, it has been benign whereand whenit counts. (And global warming is spreading fast: astronomers at the St. Petersburg Institute in Russia report melting icecaps on Mars.) Last year, we experienced a mild El Nio, which ended suddenly. For a while, climatologists thought that a La Nia had arrived, but theyve backtracked on that assertion: NOAA says while there could be a weak La Nia this summer, they now expect a continuation of the record-breaking good weather in the US midsection.

...global warming is spreading fast: astronomers at the St. Petersburg Institute in Russia report melting icecaps on Mars.

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This has...been nine years longer than the fat kine years on which Josephs famously successful storage scheme was based.

This has, by the way, been nine years longer than the fat kine years on which Josephs famously successful storage scheme was based. At Passover, which comes in three weeks, millions of the faithful will be recalling those events, and what would happen to the children of Israel whose ancestors had come to Egypt for grain during the Seven Lean Years. We believe there has been a change in the fundamentals of global grain and oilseed markets. If oil prices stay in the $60 range, ethanol and biofuel production will keep climbing worldwide, pressuring feed grain supplies. Already there are calls from American dairy and hog producers for the government to do something to lower prices of corn and beans. Bond buyers may consider the wisdom of making contributions to those farm lobbies. Almost unnoticed amid the publicity about $4 corn and ethanol is the longterm decline in US wheat production, as farmers shift toward the more-profitable feed grainsmostly produced with genetically modied seeds. The US National Association of Wheat Growers is upset about that, and is working to enlist the support of Australia and Canada, the other two major wheat exporters, to promote the development of biotech wheat. There is some urgency that wheat not go the way of barley and oats and become a minor crop, says the Associations Chief Executive. (Because wheat is a food grain, GM seeds are more controversial than animal feed seeds. Result: no marketdriven enthusiasm for GM wheat seed development.) The wheat farmers have a point: other wheat-growing regions of the world have greater rainfall than, say, the Dakotas or Nebraska, and can be expected to switch to feed grains if the current biofuel boom continues. That could mean painfully higher food prices for the poor in Third World nations. China and even Canada have been using some wheat in animal feeds, thereby reducing supplies for human consumption. (Joining the bread-line is a poor trade-off: wheat has 14% protein content, whereas soybean meal has 48%.) As grain supplies shrink and prices rise worldwide, political turmoil is inevitable. The ruling party in India has suffered losses in local elections because of food-price ination and the government has embargoed wheat exports. What happens to grain production in Africa in coming years will not only be important in global grain pricing, but crucial to breaking the seemingly endless poverty across much of that continent. Africa can probably only expand food output signicantly, by planting GM grains that protect against pests.

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Basic Points
The EU has prevented African nations from using GM seeds because they are Frankenfoods, but that latte liberal protectionism may have to be dropped if total global supplies of grain become inadequate and Africa has a chance to escape from poverty by feeding its own people and selling its surpluses abroad. And the EU has given a sign that it may be ready to reconsider its prejudices. The Page Sixteen story of the month is a brief press release from the EUs agricultural division, which manages the 47% of the EU budget that nances farmers and bureaucrats. In response to demands that the EU do something about rising coarse grains prices, Brussels said that market forces would be allowed to operate to handle the EUs grain supplies. The Eurocracy is advocating market-based economics for grains? Why didnt this apostasy make front pages across the world? It has taken them ve decades to begin rethinking their views on the evils of free markets. But lets not be unduly critical: it took the Church three centuries to admit that, on reection, Galileos views on heliocentrism were correct. We think that $4 corn and $4.70 wheat at a time of good crops across most of the world are signs of a shift in market power away from consumers to farmers, and, within the agricultural sector, away from livestock operators to cash crop operators. We also think that one of the major underpinnings of the long bond bull market that began in 1981 is about to give way. As Chairman Bernanke has rightly observed, the Fed must watch consumers expectations for ination closely. Using the implied ination rate from the pricing of the TIPS (the ination-protected Treasury bonds) is a useful measure of the markets ination expectations, but consumer forecasts can be more self-fullling. If Smitheld, ConAgra, Cargill, Tyson, Wal-Mart and McDonalds raise their meat prices month-after-month, and the big dairy operations get price increases at a similar pace, then consumers will be getting sticker shock weekly at the checkout counters. They will not be willing to accept Fed statements that ination remains within acceptable ranges.

The Eurocracy is advocating market-based economics for grains?

March

21

Why not offer a Vegan CPI and a Carnivore CPI...?

The best outcome would be a one-off leap in meat and dairy prices that reects producers feed costs, followed by sustained price stability. But that is too much to hope for. The risk is a change in ination psychology coming from table talkweek after week. The global economy dodged the oil price bullet because other consumer costs did not follow oil. Perhaps Speaker Pelosi could help with a creative response. Coming from San Francisco, she could suggest a third price indexing system to join the widely reported nominal and core CPI. Why not offer a Vegan CPI and a Carnivore CPI to isolate the meat, milk and cheese ination, and to encourage people to adopt healthy lifestyles? The USDA could supply the projections to back such a Pelosi proposal. Their long-range forecast predicts a rise in Chinese meat consumption that could be partially offset by a 5-10% drop in the US. (That drop, long forecast by nutritionists, comes when Americans nally give up on the Atkins Diet.) Conclusion: As long as the long Treasury market functions primarily as an escape hatch for frightened equity investors, interest rates will stay at levels that are mortgagor-friendly. Ironically, when (if?) investors conclude that the risks of a housing-collapse-induced recession are yesterdays worry, then the bond market is going to face quite different problems.

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Basic Points
INVESTMENT ENVIRONMENT
The subprime mortgage crisis made it to the front page of last weeks Sunday New York Times, in another ne piece of reporting by Gretchen Morgensen. In many ways, this has the hallmarks of a full-blown nancial crisis: The stock market has been tumbling, with nancial stocks prominent in the pummeling: Fannie and Freddie are involved, as are most of the major Wall Street investment banks; the Fed and other major central banks have been in tightening mode for more than a year, the economy is in slowing mode, the Current Account decit is at record levels, news from the Iraq War remains grim, Washingtons leadership inspires scant condence. We have not changed our investment stanceyet. The weakness in equities still looks like a correction. Here are some reasons: 1. We have been waiting for a correction for nearly a year, and all corrections come against some backdrop of developments that scare the markets. Even when nearly all investors agree that a correction would be healthy, many or most of them become anxious when it arrives, because the cause is some disconcertingly bad news. 2. When we published The Age of Complacency (Basic Points, January) we expressed the view that it was the absence of fear that was so worrisome. That suggested to us that the recognition of risk could lead to over-reaction. Back then, all the talk of the housing bubble was what its pricking would mean for retail sales and the economy. What is scaring the stock market now is the prospect of systemic risk arising from stupid, sleazy lending practices. So Fear has been stalking stocksat last. We consider that encouraging news. Being so out of practice with Fear, it is likely that many equity investors have overreacted. 3. That the asset class at risk is mortgages owed by people who obviously should never have been lent the money in the first place is mildly reassuring: assuming that not all the people involved in originating and nancing these loans are shysters and/or fools, then the ultimate scale of this problem should be manageable. It comes at a time of full employment and low inflation, and soft, but not disastrous, real estate prices. So Fear has been stalking stocks at last.

March

23

True disasters would come when idiotic loans, fraudulent loans, marginal loans, and reasonable loans go into arrears together because of the simultaneous impact of soaring unemployment and collapsing real estate prices at a time when rising ination ties the Feds hands. Now, when butteries ap their wings in Greenwich and Wall Street, stocks fall from Paris to Hong Kong. 4. Gold prices have been falling. In three decades of nancial crises, gold has been a splendidly-performing asset class when the system itself was at bay. That gold fell more than the Dow during Subprime Time observances is a very reassuring sign. 5. Despite the central bank tightening, global liquidity still looks robust. In previous aps involving US credit conditions, US domestic liquidity levels were dictated by Fed-induced drought conditions. This time, US debt and equity markets are beneting from international pooling of liquidities from Eurocurrencies and overstuffed central banks. That equity markets experienced global stormingsimultaneous selloffs across the globewas a sign of the reach of US hedge funds and trading departments of US investment banks. Now, when butteries ap their wings in Greenwich and Wall Street, stocks fall from Paris to Hong Kong. (That is the downside of hegemony. Jacques Chirac would grumble, but understand.) 6. The modest underperformance of nancial stocks this month is reason to believe that the selloff will be contained. When nancial stocks barely underperformed during the sudden late-February selloffs, we advised clients that this rst stage of the long-awaited corrections would not last long. If nancials should begin to sharply underperform the Dow, then we would be forced to revise our thinking. In all major US stock selloffs since 1971, nancial stocks signicantly underperformed in the weeks leading up to the plunge, and were among the worst performers on the day or days of the collapse. 7. The US Dollar Index remains above its November lows, and the euro, the paper of the second-largest Eurocurrency zone, is below its November highs. Most of the action remains in the yen, which reects the push/pull of the Carry Trade and The Great Symbiosis. All major nancial crises of the past 35 years except the Bahtulism & Ringittworm Crisis in the Asian Emerging Markets have included a run on the dollar.

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Basic Points
8. The VIX rose during the worst of the carnage, but remains within a midteens comfort zone. 9. Long-term interest rates remain at remarkably low levels, both for Treasurys and higher-risk products, which means renancings and bailouts can be achieved at acceptable cost. In most previous crises, either the yield curve was steep and spreads over Treasurys were wide, or the curve was inverted at a high level and spreads were wide. Although the spreads above Treasurys have widened somewhat, they remain so tight that investors should be willing and able to absorb new offerings. 10. The apparent Dow Theory Buy signal we got when the Industrials and Transports simultaneously broke into new high ground was a head fake. However, they would have to fall signicantly to give a Dow Sell signal. Nevertheless, all major indices gapped down, and there is much technical work to do before strategists can safely proclaim the return of the bull. 11. When the stock market sells off in response to a fast-unfolding nancial problem that most investors had not known about previously, there is an immediate bull market for bearish predictors who assert atly that much worse is yet to come. One reason the Nasdaq crash was so catastrophic was that most investors believed they understood what made techs tick, and it was only when they found out that most of what they believed to be true had been peddled by Shills & Mountebanks that the real horror arrived. The percentage of those now selling stocks and commodities who gave no thought to subprimes before but now believestronglythat the subprime market is a Hellhole that will swallow the nancial system is at a new high. A little learning is a dangerous thing. 12. The food price ination we have been anticipating has already begun at the wholesale level. Last week, the US reported that crude foodstuffs and feedstuffs prices were up 18.8% over a year earlier. Some food prices increases have already reached the consumer, as US food CPI was up 0.7% in January and 0.8% in February. The impact of $4 corn and $7.50 soybeans should reach the supermarkets by summertime. In the meantime, long bond prices climb on days the stock market falls, thereby providing an economic cushion. This stock market correction will be in the past before talk of serious ination hits the Street.

...all major indices gapped down, and there is much technical work to do before strategists can safely proclaim the return of the bull.

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The good news is that volatility is back. The bad news is that volatility is back.

13. This stock market selloff is making a mild contribution toward slowing the rate of growth of food-price ination. As liquidation spreads across asset classes, commodities join stocks in diving, and the grains become part of the big crash to raise big cash. Corn is down 9% from its peak, and soybeans are down 5%. They have underperformed the Dow. Last Wednesday, when the grains were getting hit hardest, ISI published a detailed report on Chinas food price ination, which included such data as corn inventories being down by two-thirds since 2000, and wheat and rice being down by roughly half. To us, this tended to conrm our argument that the grains story is a form of replay of the metals storyfour years later. Naturally, the panicky stock market didnt pause to reect. 14. The good news is that volatility is back. The bad news is that volatility is back. On March 14th, the Dow was down as much as 150 points, but then rallied strongly to close up 57 on the day. That kind of intraday swing is not likely to be the sign of a bottom. It is more characteristic of bearish markets. (There have been, we recall, more big one-day reversal rallies in bear markets than in bull markets. Moral: dont sell into a falling market. Wait for the snapback.)

Politics
Of vastly greater long-term importance than subprime mortgages is the change in Americas political dynamics. The Bush era is coming to an end, and a new political structure will replace it. The Democrats seized majorities in both houses of Congress, and they are favored in polls by most voters as the likely winners of the White House next year. George Bushs misguided invasion of Iraq based on faulty intelligence, his stubborn support of Donald Rumsfeld, and his simplistic strategies for the War on Terror have destroyed the Republicans chances to achieve Karl Roves dream of sustained national dominance. Although that vision may seem silly today, it was taken seriously by numerous pundits and scholars after the 2004 elections. At that point, the Republicans not only held the White House and Congress, but they were the dominant party at the statehouse level. The Republicans are now, of course, in disarray, and it is as fashionable to write them off as it was to write off the Democrats in 2004.

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Basic Points
David Broder of The Washington Post, who has never been conspicuously solicitous of Republicans feelings of inadequacy, now joins those who advise us to reject the belief that the Democrats have 2008and beyondlocked up. In truth, next years elections are wide-open. No contender has a lock on the presidential nomination of either party, and voters express willingness to choose at least one RepublicanRudy Giulianiover any Democrat. (Yes, polls at this early date are of little value, except to show that the electorates utter rejection of George Bush doesnt guarantee a Democratic win next year.) No permanent majority is possible, given the parties nationwide nearparity. How quickly people forget the Republicans national landslide in 1994, when, under Newt Gingrichs leadership, they not only pulled off one of the greatest gains in House membership in history, but won almost everything down to dogcatcher. After that debacle, Bill Clinton seemed doomed to nish his term as a lame duck. Instead, Bob Dole, who was going to be the next President, would ultimately be forced to content himself with the consolation prize as Pzers star Viagra salesman, while the victor would demonstrate conclusively that he didnt need pills. The drastic change in the structure of the party primaries next year means that after Super-Duper Tuesday, we could know the winners from both parties. There are good and bad possibilities in this scenario. Without exhausting the range of outcomes, we note that once the Republicans have nominated their challenger, George Bushs already-weakened control shrinks notably. The President would no longer be the sole spokesperson of the Republican Party. That alone will change the dynamics. For investors, the importance of this speculation is that the entire national debate could become less poisonous. Whatever his faults, Mr. Bush has lost control of the national agenda and is deeply resented within his own party as the man who blew the Republicans historic lead over the Democrats by starting an unnecessary war he wouldnt nish. If investors at home and abroad sense a new, more realistic leadership in Washington, and a greater sense of national unity, that will be benecial for US capital markets. And it could happen in eleven months. In truth, next years elections are wide-open. No contender has a lock on the presidential nomination of either party.

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INVESTMENT RECOMMENDATIONS
1. Use panic selling periods to build exposure to the equities you will want to own for the long term. 2. Remain overweight the high-quality base metal stocks. They will continue to be volatile, but they still have the greatest intrinsic value of any asset class for the world that will be transxed by the next phase of the economic revolutions in China, India, andthe latest hot spotVietnam. 3. Remain overweight the producing oil sands stocks. They are unique assets and are uniquely valuable to Big Oil as it contemplates its dwindling reserves and mounting political risks. 4. Remain overweight gold and gold stocks. They have not proved to be foul-weather friends, as we had long believed. They should be good fairweather friends. 5. Long bonds will remain useful hedges as long as the current discontent continues. But you should be looking to reduce your exposure, because food-price ination will be in evidence by barbecue season, and it is unlikely to be offset by plunging oil prices. 6. The great dividend-paying stocks are comforting investments in troublous times. They will also look good when the skies clear. 7. The Canadian stock market remains more attractive than its American counterpart, and the Canadian bond market is far more attractive than its junk-heavy American counterpart. Even the bumper crop of Maple Bonds has not meant that the average quality of Canadian-denominated corporates has taken on an air of junkiness. 8. Use periods of turmoil and despair to build exposure to Emerging Markets, the equity asset class that has the best demographic characteristics. In the OECD, only one nationthe UShas a favorable outlook for maintaining its workforce in coming decades. 9. For the faint of heart, or those who cannot afford short-term volatility, use deep out-of-the money puts as insurance until it becomes clear whether the current unease is merely a correctionor something much worse. Optimists can hope that this winter of our discontent will be made glorious summer by a revival in the US housing market, but buying insurance on that outcome could be worth the cost.

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Basic Points
BYE-BYE, BOND BULL

April 13, 2007

Produced by BMO Financial Group Distributed by BMO Capital Markets

Basic Points
An Investment Journal
Donald G. M. Coxe
Global Portfolio Strategist, BMO Financial Group (312) 461-5365 e-mail: don.coxe@bmo.com

Research/Editing Production/ Distribution

Angela Trudeau e-mail: angela.trudeau@shaw.ca Anna Goduco (print orders and mailing lists) e-mail: basicpoints@bmo.com

BYE-BYE, BOND BULL

Overview
The Best of All Possible Bond Worlds was born in September 1981. It grew and prospered, because of the mutually reinforcing effects from money management by born-again monetarist central bankers, the growth of free trade, the Triple Waterfall Collapse of commodities, productivity gains from technology, and the end of the Cold War. For a quarter-century, ination and interest rates were in secular decline from their stagationary peaks. Apart from a few bumps in the road, long zero-coupon bonds have beenby farthe top-performing sector in the investment-grade xed income market. As interest rates declined to levels that would have seemed Heaven-sent in the Hellish Seventies, junk bonds became irresistible to the yield-starved. We have been bond bulls for 26 years, except in 1993-94. We became even more bullish in 1998, when we began arguing that deation, not ination, had become the primary challenge to the global price system. We now believe that ination is returning, and the great bond bull will soon be history. Supply Side Economics was a big part of the bond bull story in the 1980s. It is the core of todays bear story. This month, we look at the four great supply side challenges to the global economyenergy, metals, grains, and workersespecially skilled workers. The bond bull gamboled happily when all four were in sustained surplus conditions. Three have already morphed from deationary oversupply to inationary shortage; as for the fourth, unemployment statistics continue to set new lows, and worker shortages have begun to show up in many other places than Fort McMurray, Alberta. The two-decade-long display of the power of management at the expense of workers will soon be fading away. Together, these supply side failures give an ination bias to the OECD economies that will intensify in coming years. Only a recession will bring a return of bond-friendly surpluses, and those will disappear once economic growth returns. Sustained global disination was the benign background that allowed indeed encouragedthe nancial market rescue operations familiarly known as the Greenspan Put. The Bernanke Feds freedom of action will be constrained by a new economic environmental challengeGlobal Economic Climate Change. We are adjusting our Recommended Asset Allocation, deleting our exposure to long-duration bonds.

April

Recommended Asset Allocation

American Portfolios

U.S. Pension Fund

Allocations 27 29 12 0 15 17 Change unch unch unch -10 unch +10

Domestic Equities Foreign Equities Domestic Bonds Long-Duration Bonds Foreign Bonds Cash

Foreign Equity Allocations

Allocations 6 6 6 11 Change unch unch unch unch

European Equities Japanese and Asian Equities Canadian & Australian Equities Emerging Markets

Bond Durations
Years 4.25 4.50 4.75 Change unch unch unch

Global US Canada

April

Basic Points
BYE-BYE, BOND BULL
The Four Scarcity Stories of Our Time
1. Energy To the stunned statisticians at the International Energy Agency and most analysts on Wall Street, the Asian Centurys rst creation of global scarcity energycame out of nowhere. The IEAs high-priced roster of tax-exempt Parisian boulevardiers was shockedshocked. Wasnt China an oil exporter when we last checked? How could a poor country like that be driving up oil demand and prices for the whole world? 2. Metals The next to be shocked were managements of major mining companies who were happily shorting copper at 90 cents a pound, only to learn that China had created its second global scarcity. Phelps Dodge, the industrys most adamant bear, was absorbed at a mere six times earnings by Freeport McMoRan, the industrys most adamant bull. Phelps management had hedged itself into oblivion. 3. Grains and Oilseeds The third Asian-spawned scarcityfeed grains and oilseedshas just arrived. To read the profusion of stories on Page One, this rst-ever cereal scarcity without a major crop failure would seem to be purely an ethanol story (which is itself another response to the oil scarcity story). However, that only helps to explain the bull market in corn. The coming rises in prices for meat, eggs, and dairy products will reect the overall supply/demand imbalance of coarse grains and soybeans while the soaring middle class in China, India and elsewhere in the Third World expands its diets (and midsections) with non-vegetable proteins. 4. Workers

...the soaring middle class in China, India and elsewhere in the Third World expands its diets (and midsections)

The fourth shortage storywhich will be the most powerful contributor to Asias rise to global economic dominanceis homebred in the OECD: the multi-decade collapse in reproduction. Before the industrial world began outsourcing jobs to China, it had begun a process that would ultimately ensure that outsourcing and soaring trade decits would not lead to widespread unemployment. The worker never born is the worker never unemployed.

April

GDP is simply output per worker multiplied by the number of workers. Nations which dont replace their workforce can maintain neither their historic economic growth rate, nor their standing in global economic rankings. ...the Street proclaimed The End of the Commodity Bull Market. Scarcities create winners and losers. The rst two shortages showered wealth on the top management of commodity-producing companies and on investors in those companies particularly those obstinate souls who held on to their investments through the numerous occasions during which the Street proclaimed The End of the Commodity Bull Market. The third scarcity has been beneting farmers, and the managements and investors in the relative handful of companies involved in the grain sector. The fourth scarcity has only begun to appear within the last year: The shortage of workers, the most important scarcity of all, will inexorably benet workers across the OECD, at the expense of managements and investors. As the Boomers age and retire, they will not be fully replaced by new labor force entrants. The billions of people that the neo-Malthusians warned would produce global starvation and sustained unemployment were never born. They will not be around to produce the wealth that ageing OECD economies will need to nance social security and health insurance programsnor to care for the ageing Boomers and Gen-Xers.

Asias Thirst for Industrial Commodities

Todays shortages of oil and metals were conceived and nurtured in the Triple Waterfall collapse of those industries.
Crude Oil July 1985 to April 2007
80 70 60 50 40 30 20 10 0 Jul-85 Jul-88 Jul-91 Jul-94 Jul-97 Jul-00 Jul-03 Jul-06

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Basic Points
The Yom Kippur War and the Carter-assisted takeover of Iran by the mullahs were the supply-side shocks that by 1980 had driven oil prices to seven times their Sixties levels. Thereafter, oil was in global surplus because of all the oil Big Oil had found and developed that the OPEC producers later grabbed. Fresh from its success in looting, the cartel was able to relax in what seemed to be perpetual control of petroleum supply and pricing. Houstons boom and bust from 1973 through 1988 was only the biggest and most-publicized chapter in a grim story of economic contraction across the non-OPEC oil world. Bankruptcies decimated the ranks of the drilling and oilwell service companies, a melancholy pattern that reinforced the oil industrys conviction that OPECs hegemony would endure forever. Within that cartel, a new kind of competition emergedfor shares in OPECs quotas. As the swing producer, Saudi Arabia adjusted its production to leave room for oil from the smaller member autocracies. That benign regime soon found itself challenged by widespread cheating among its membership. Given the ethical makeup of the club, that should have been no surprise. Quotas were set in relation to each members statement of its proven reserves. This honor system meant there was an incentive to overstate reserves. (That would become Nigerias motivation to force Shell to overstate its Niger Delta reserves.) The other temptation toward what a critic might call OPECcancy was to produce above quota and make private arrangements to sell the excess to anyone (such as Marc Rich) who promised anonymity, could lease tankers and nd customers eager to buy discounted oil. By 1986, the Saudis, experiencing severe budget problems from their exploding population and imploding economy, decided that swinging could no longer be their thing. Sheik Yahmani, Saudi oil minister and grand vizier of OPEC, opened the Saudi spigots widedriving oil prices below $10 a barrel. The Saudis dramatic assertion of power battered an already depressed global oil industry into submission. Its agonies were briey eased when the First Gulf War sent oil prices briey higher. Thereafter, the strong global economy of the 1990s created a record international stock market boom at which Big Oil was a mere bystander. Worldwide, drilling remained at depressed levels, and few observers noticed the slow upward creep in global consumptionor Chinas switch from being an oil exporter to being an oil importer.

Fresh from its success in looting, the cartel was able to relax ...

April

...their own version of The Goose that Laid the Golden Egg: they didnt behead the goosethey just starved it.

By the time experts such as Daniel Yergin had nally begun to notice how Chinese demand was driving global oil prices skyward, the supply side was already showing signs of serious ageing. Decades of OPECs practice of draining oil revenues to nance corrupt governments and dysfunctional economies had led to the inevitable problems of maintaining production. These regimes were practicing their own version of The Goose that Laid the Golden Egg: they didnt behead the goosethey just starved it, giving most of its food to family pets. The supermajor oilelds, such as Saudi Arabias Ghawar and Mexicos Cantarell, began to experience increasing difculties in maintaining their output. There were no lusty new giants to pick up the slack. Those geologic-based problems for the government-owned oil giants were unfolding while the private companies were struggling to maintain their own output. Big Oil decided during the 1990s that its future lay with the development of major elds in Russia, Venezuela, Nigeria and Angola. Exxon spun off more than half its interest in Albertas Syncrude project to the Canadian Oil Sands Trust, because Lee Raymond didnt believe oil prices would trade above $35 except during brief geopolitical crises, which meant Syncrude would always be, at best, a marginal prot generator. He needed to maintain his companys Reserve Life Index, and for that he required access to the kind of huge prospects that were on attractive offer from three eager promotersPutin in Russia, Chavez in Venezuela, and Obasanjo in Nigeria. He was even willing to bet heavily on deals with the long-time Communist thug of Angola, Eduardo Dos Santos. Dos Santos came out on top in the settlement with Jonas Savimbi that followed a four-decade-long civil war. Savimbi, who had been backed by the US during the Reagan era, was assassinated in 2002 by government troops, reportedly backed up by South African mercenaries. Mr. Raymond turned out to be absolutely right about the quality of oil reserves available from those countries, and absolutely wrong about the political risk to his stockholders from relying on his deals with them. His company has already been seriously stiffed by Putin and Chavez, and Angola has joined OPEC, and has recently announced it is dissatised with the terms of deals made when the central government was distracted by its problems with the rebel Savimbi. By the time Mr. Raymond retired, the worlds largest private sector oil company was risking Paper Tiger status because of increasingly questionable assumptions about its Reserve Life Index.

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Basic Points
XOM should be greatly discounting the value of its giant reserves in Russia and Venezuela, and should be assigning some risk factor to its reserves in Nigeria and Angola. The other highly questionable aspect of Big Oils reserve accounting that is very important to XOM is boeconverting natural gas reserves to oil on its energy-equivalent basis. Exxons acquisition of Mobil had given it ownership of that companys giant LNG operations in Indonesia. According to SEC rules, six units of LNG in a producing eld connected to pipelines counted as a barrel of oil in a companys RLI. That historic ratio reected the relative energy content of six mcf of natural gas compared to a barrel of oil, and the relative prices of those two fuels during the 1990s tended to validate the accounting assumptions. However, LNG is the result of a costly cryogenic process of cooling and compressing the gas and shipping it in specially-built tankers. Gas to be converted into LNG is hardly worth as much as gas delivered to a pipeline. Only if oil prices soared far faster than gas prices would Exxon-Mobil have real problems, but that seemed like pure fantasy as long as OPEC controlled global oil prices. XOMs problems were broadly representative of Big Oils global challenges. The industry had historically functioned in a bipolar worldOPEC and the privately-owned oil producers. As the new decade dawned, the majors and supermajors began to face competition for ownership of oil and gas properties from a new crop of state-owned oil companies, including Chinas CNOOC and Sinopec, Indias national oil company, and the state-owned companies in oil-rich states of the former Soviet Union.

...Big Oils global challenges... competition for ownership of oil and gas properties from a new crop of state-owned oil companies...

The Miners Get a Major Shock

Copper December 1988 to April 2007
400 350 300 250 200 150 100 50 Dec-88 Dec-91 Dec-94 Dec-97 Dec-00 Dec-03 Dec-06

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The mining industry went through similar miseryand a similar unanticipated shock of prosperity. Base metal producers had some moments of elation during their Triple Waterfall Crashnotably the speculative copper squeeze of 1988but the industry was, apart from the global Left and the armaments makers, the biggest loser from the Fall of the Wall on 11/9/89. That meant the Cold War would soon end, thereby slashing global demand for military hardware. In an eerie numerological coincidence, that outbreak of painful peace would end on 9/11/01. This decade has seen what consumers considered shocking increases in the prices of minerals, and what Wall Street strategists considered even more shocking increases in the prices of the shares of the mining companies. (Regrettably, Inco and Falconbridge are no longer held publicly; had they not been acquired at bargain prices by acquisitors whose wisdom so vastly exceeded the Streets, Canadian base metal stocks performance would be beyond Shockand be within the realm of Awe.) Golds performance was a useful benchmark of the global trend from runaway ination to disination and even deation: apart from brief rallies, its two-decade-long collapse nally bottomed in 2001when deation was the clear and present danger to many major economies. Its strong rally since then was not a sign of the return of 1970s-style ination psychosis, but a reection of soaring Indian and Chinese demand. Like the devastated oil and base metal industries, golds long bear market had created conditions that would prevent a characteristic response to soaring product prices. A summary of what we have been saying since 2002, about the commodity industries: 1. The hundreds of millions of new Asian residents of homes with indoor plumbing, electricity and basic appliances, and the tens of millions of new owners of cars have been the progenitors of the huge price increases for energy and metals. 2. Unlike all the earlier commodity cycles, this soaring demand has produced merely a series of baby-step supply side responses. For the rst time, the historic pattern of major production increases that came on stream whenor aftercommodity prices peaked did not repeat itself. 3. In part this is due to the long-term pain to producers from the Triple Waterfall: The greatest investment opportunities come from an asset class where those who know it best, love it least, because they have been disappointed most.
8 April

Regrettably, Inco and Falconbridge are no longer held publicly; had they not been acquired at bargain prices... Canadian base metal stocks performance would be beyond Shock and be within the realm of Awe.

Basic Points
4. Big Oil has been the commodity worlds biggest loser from the widespread operation of our Law of Political Risk for Third World Commodity Producing Countries: The political risk for foreign investors increases as the square of the price increase of the commodity. Russia, Venezuela, Ecuador and Bolivia are the trend-setters. If the Reserve Life Index of Big Oil were adjusted for the noxious political developments in those countries, it would go down sharplyand few of those companies would qualify as true Blue Chip investments on a longer-term basis.

The Bull Market in Grains: The Meat of the Story

The sudden bull market in feed grains and oilseeds, (which will inevitably trigger food price ination) has, to date, produced more skeptics than believers.
Corn April 2004 to April 2007
450 400 350 300 250 200 150 Apr-04 Aug-04 Dec-04 Apr-05 Aug-05 Dec-05 Apr-06 Aug-06 Dec-06 Apr-07

The political risk for foreign investors increases as the square of the price increase of the commodity.

Soybeans April 2004 to April 2007

1100 1000 900 800 700 600 500 400 Apr-04 Aug-04 Dec-04 Apr-05 Aug-05 Dec-05 Apr-06 Aug-06 Dec-06 Apr-07

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To the skeptics, who have dominated the media commentary, these outsized gains come from the ethanol craze. They sarcastically argue that ethanol is taken seriously primarily because the Iowa primary (the caucuses) must be taken seriously by all presidential candidates. ...the impact of China and India on coarse grain prices is a dj vu story. Apart from this cynical (and possibly accurate) view of the motives of the most prominent ethanol proponents, critics of corn-based ethanol as a gasoline substitute note that it is protected by a 51-cent tariff against sugarbased ethanol (from Brazil and the Caribbean). As for ethanol being a great green fuel, the critics point out that the amount of gasoline needed by the farmers to produce and deliver the corn, and to transport the ethanol to gas stations, plus the amount of natural gas needed to make ammonia-based fertilizer and operate the ethanol plants, makes the net energy from truly renewable sources minimal. Supporters point out that ethanol burns cleaner than regular gasoline or MTBE, and that the risks to the US from dependence on the Gulf States and Venezuela justify the extra costs. Chavez and Ahmadinejad are ethanols biggest advertisements, and they manage to inject their spleen into global headlines with sufcient frequency to make ethanol look like a Heaven-sent ingredient in national security strategy. There is a precedent for building uneconomic energy facilities. Virtually no American nuclear power plants would have been built if they had been based on competitive economicsbecause in the Fifties and Sixties oil was routinely trading at $3 to $4 a barrel. Eisenhower said the nations longrange national security dictated a large-scale commitment to nuclear power, and at that time the Sierra Club was no national forceso the nukes were built. In the past week, there have been signs of media rethinking of the grains story as being much more than ethanol. Both The New York Times and The Wall Street Journal published articles showing that Chinese meat consumption is a crucial component in the pricing of corn and soybeans. As we have been arguing rather strenuously this year, (including in interviews with reporters of The Times and Journal) the impact of China and India on coarse grain prices is a dj vu story: we saw what they did to the prices of oil, coal, steel and base metals. In its well-researched story on soybeans,

10

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Basic Points
The Times printed a chart showing Chinas soybean imports soaring from 10 million to 33 million tons over the past six years. Not one of those beans is being converted to biofuel. Potash Corporations annual report notes, Chinas GDP grew more than 10%, while Indias was up 8%...With higher incomes, the rst priority for many people is more nutritious, protein-rich food. Chinas meat consumption, for example, has more than tripled in less than two decades. Producing more animals takes a greater use of grain and feed supplements.A rising global population with more money leads to spreading urbanization. The agricultural land base per capita is less than half the 1950 level and is expected to fall a further 13% by 2020 making higher crop yields a necessity. Added to this, uncertainty over the worlds oil supply and desire for cleaner fuels have resulted in a surge of demand for alternative energy sources such as biofuels. The new boom in global grain prices is, in large measure, based on the rapid growth of the Asian middle class. The people who went from bicycles to motorcycles to cars, and from hovels to homes with indoor plumbing and electricity, are graduating from a diet of rice, lentils and bread to the inclusion of dairy products and meat. The growing prosperity of the USs midsection is coming from the growing midsections of the growing middle class in Asia. This change in the diets of the new Asian middle class would have ultimately had important implications for global food price ination. But when the already short supplies of corn and soybeans were bid up by biofuel producers, the two decades of benign food prices came to an end. To date, North American prices for meat and dairy products have not reected the huge price increases for corn and soybeans. Producers hedges have cushioned the impact to date, but those are wearing off. The third kind of commodity boomfeed grains and oilseedsis different from the others in one major respect: there are no super-giant grain elds, and the only political challenges come from EU and environmental paranoia about genetically-modied seeds, and from other forms of protectionism. Otherwise, this boom is like the others: there has been remarkably modest supply side response to the surge in demand for feed grains and oilseeds. There are no super-giant grain elds...

April

11

Global acreage allocated to coarse grains, as the following data published by the USDA Economic Research Service shows, has been virtually unchanged in this decade.
World Supply & Utilization of Major Crops, Livestock, & Products [from USDA Economic Research Service: Agricultural Outlook: Statistical Indicators]
1997/98 Wheat Area (hectares) Production (metric tons) Exports (metric tons) Consumption (metric tons) Ending stocks (metric tons) Coarse grains Area (hectares) Production (metric tons) Exports (metric tons) Consumption (metric tons) Ending stocks (metric tons) Oilseeds Crush (metric tons) Production (metric tons) Exports (metric tons) Ending stocks (metric tons) 1998/99 1999/00 2000/01 2001/02 2002/03 2003/04 2004/05 2005/06 F 2006/07 F

Million units
228.4 610.0 104.5 577.3 197.1 311.2 881.2 85.8 867.2 215.8 264.3 338.6 62.1 30.2 1998 225.1 590.0 102.0 579.0 208.1 308.5 890.9 96.7 869.2 237.4 278.4 346.0 63.5 32.9 1999 131.4 131.1 9.2 52.3 51.6 4.9 376.7 215.4 585.8 112.7 585.0 208.9 299.7 877.6 104.8 882.4 232.2 247.3 303.9 59.9 35.1 2000 132.1 131.2 8.9 55.3 54.1 5.4 381.6 217.6 581.5 104.1 583.9 206.5 296.7 862.3 104.4 884.4 210.1 254.4 314.2 66.9 38.9 2001 133.2 132.2 8.9 57.1 55.5 6.1 384.8 214.7 581.1 110.8 585.0 202.7 301.4 893.7 102.7 906.6 197.1 264.9 325.2 62.7 41.2 2002 139.3 138.1 10.2 59.2 57.6 6.3 395.0 214.6 567.6 110.1 603.8 166.6 293.0 875.1 104.6 902.3 169.9 268.9 330.3 70.0 47.5 2003 140.6 139.3 10.6 59.2 57.7 6.6 399.0 209.9 554.6 104.5 588.5 132.7 306.9 915.9 103.0 945.9 139.9 278.5 335.2 67.1 43.9 2004 144.1 142.0 11.4 60.8 58.9 6.6 406.1 218.8 628.6 113.1 610.0 151.2 300.4 1,014.0 102.0 975.9 178.0 302.1 381.3 74.6 56.3 2005 148.6 146.0 12.3 63.9 62.1 7.4 414.0 218.4 620.6 113.6 624.4 147.5 301.1 977.5 109.1 989.1 166.4 317.9 389.0 77.5 60.8 2006 P 153.3 150.4 12.2 64.9 63.6 7.0 423.3 212.8 593.1 110.7 619.3 121.2 302.7 966.7 107.9 1,014.5 118.6 324.6 386.5 82.2 58.2 2007F 158.1 155.0 12.8 66.0 64.5 7.3 432.2

Beef and Pork Production (metric tons) Consumption (metric tons) Exports (metric tons) Broilers and Turkeys Production (metric tons) Consumption (metric tons) Exports (metric tons) Dairy Milk production (metric tons)

128.2 126.8 8.2 49.5 48.8 4.7 373.7

Source: USDA Economic Research Service, Agricultural Outlook: Statistical Indicators, March 2007: http://www.ers.usda.gov/Publications/ AgOutlook/AOTables/

Result: this crop year carryover will be the lowest (in relation to consumption) on record. Huge price increases for grains have not produced meaningful expansions in acreage. In the US, the conservation set-asides have remained roughly intact, as farmers content themselves with Washingtons rental payments for marginal lands that protect wildlife.

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Basic Points
Abroad, Brazil has the potential to open up large tracts of well-watered land for soybeans, but the elds are more than 600 miles from the sea, and the only transportation is by truck over a narrow, potholed road. Most other major grain producers are already using all the watered land available. Coarse grains and oilseeds need far more water than wheat production requires, so the potential for expanding output now that corn and beans are so expensive is modest. Each week, as the cities of China and India expand, more farmland disappears. The USDA announcement, on March 30, of farmers planting intentions was the most eagerly-awaited in history. Corn had become a Page One story, as hedge funds crowded into corn futures and tales of Wall Street denizens buying farmland were relayed on trading desks. (How many of these new investors in agriculture, one wonders, can tell a heifer from a steer, or know that the word gilt is a proper noun for a female pig, whereas gilt as used on the Street is the slang contraction of gilt-edgedthe term for UK government bonds?) Naturally, these late enthusiasts for the agricultural story drove spot corn prices up too fast, and were in a panic to exit their positions when it was announced that the acreage for corn would be the biggest since 1944. (Back then, photographs of much of what is now Chicago, Greenwich, Boston and Atlanta could have been used to depict the amber waves of grain.) With corn down-limit after the report, some of Wall Streets most prominent soothsayers could barely contain their glee. They tut-tutted the dangerous level of commodity speculation. (When the Street becomes pompously puritanic about speculation, while a bull market is still rampant, it usually means that those who have been making money by taking risks have been earning outsized returns in products or sectors the Best Minds had not been recommending.) Stories exulting spot corns plunge from $4.25 to $3.75 led readers to believe this noisy market effusion had only been a belch, not the proof of a sustained change in the behavior of the system.

How many of these new investors in agriculture, one wonders, can tell a heifer from a steer

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13

...the value of the corn crop to be harvested in 2008 attracted... less rage/shock/ disappointment/ prot-taking/ panic...

True, there was no doubt that the ethanol story was generating speculation, and that many of those players had been forced to leave the eld. However, the value of the corn crop to be harvested in 2008 attracted rather less attention from the speculators, and considerably less rage/shock/disappointment/ prot-taking/panic after the USDA report was published.
Corn Sept 2006 to April 2007
450 400 350 300 250 200 Sep-06 Oct-06 Nov-06 Dec-06 Jan-07 Feb-07 Mar-07 Apr-07

Corn Futures December 2008 Sept 2006 to April 2007

410 390 370 350 330 310 290 Sep-06 Oct-06 Nov-06 Dec-06 Jan-07 Feb-07 Mar-07 Apr-07

In all past periods when corn and bean prices surged, the cause was a crop failure that did not recur. Futures market prices for the following years crops did not share in the short-term bullishness. Big backwardation was the pattern in the charts. Not this time.

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Basic Points
What is happening in the grains is more like what happened to oil prices: coarse grain prices have gone upand stayed there through another crop yearwithout any actual or expected interruption of production and without stimulating huge new global plantings. The sharp rise in corn plantings that the USDA reported for this year comes mostly at the expense of soybean planting, but also from cotton. In terms of feeding the newly carnivorous tummies in China and India, the switch in planting from soybeans to corn still means higher feeding costs for livestock production, because soybean meal (48% protein) is the most efcient way to produce animal protein. The Midwest, the pre-eminent global corn producer, has had 15 straight years without a signicant crop failurethe longest on record. What if the prairie skies are not cloudy all day this July? What if food price ination becomes the highest in decades at a time when oil prices continue to trade near $60? This time, it could be the shortage of bees.

Food Price Ination Can Bondholders Stomach It?

Food price ination has already begun. As with some past ination shocks, it could be kick-started into high gear by a spectacular piece of bad economic luck. The painful food-price ination of the 1970s was kicked off by the collapse of the anchovy harvest after the major El Nio of 1973. (Back then, anchovies were the protein feed supplement of choice. Thereafter, soybean meal replaced them as the staple.) This time, it could be the shortage of bees. Bees are natures gift to producers of a wide range of crops, particularly fruits. For reasons experts have not yet been able to establish, the populations in bee colonies across much of the US and Canada have been decimated since last autumn. Apiarists call this a crisis. Already a Congressional committee has met to consider the evidence and suggest some remedies. Even now, nobody knows with any certainty what has caused the die-back and nobody knows what to do. It has already spread to nine countries in Europe.

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15

Honey Bee Colony Collapse Disorder Map of Affected States, February 2007

Investors should take note of the frankenfood smears.

Source: USDA Economic Research Service, Agricultural Outlook: Statistical Indicators, March 2007; and Mid-Atlantic Apiculture Research and Extension Consortium (MAAREC), February 2007, [http://maarec.cas.psu.edu/pressReleases/CCDMap07FebRev1-.jpg].

How can a previously-unknown pathogen suddenly appear and proceed to slaughter bees on an unprecedented scale across much of North America and Europe simultaneously? Some environmentalists are using this phenomenon to rally new support against frankenfoods,genetically modied seeds. The only evidence they have is that no one has been able to identify the culprit. Ergo, something theyve always feared and despised must be to blame. Anyone who looks at the map from the Congressional report showing the incidence of CCD would see that the cornbeltwhere GM seeds have taken overstill remains nearly free of reported die-backs. Nevertheless, investors should take note of the frankenfood smears, because Monsanto, DuPont and Syngenta may well be judged guilty until they prove their innocence. Twas ever thus. When syphilis suddenly spread across Europe in the late 1490s, the English immediately called it The French Disease, and the French called it The English Disease. In reality, Spain was to blame. It had been brought back from the New World by Columbuss men and by the troops accompanying the conquistadorespartial punishment for the Europeans introduction of smallpox to the Americas.

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Basic Points
A prominent American beekeeper, who was the rst to go public with a report of die-back, suggests that widespread adoption of a new kind of pesticide neonicotinoidscould be the explanation. Crops that collectively contribute approximately one-third of the American diet, and almost $15 billion to the US economy, are at risk. A Research Report to Congress on this previously-unknown conditions, tentatively titled Colony Collapse Disorder notes: Across the US 35% of all the bees are gone. In some states 90%. In particular, alfalfa, which is the key component of hay, relies entirely on insect pollinators. The dairy industry, already reeling from soaring corn and soybean prices, could be truly at bay. And if there aint hay in Wisconsin this summer, the milk and cheese consumers cost aint hay. If the bees dont return with the owers of spring, food price ination this year, which is already climbing quite strongly, will be at front-page scare story levels before the full impact of $3.80 corn has reset the prices of meat, cereals, eggs, and dairy products. ...if there aint hay in Wisconsin this summer, the milk and cheese consumers cost aint hay.

Ination Pressures: Bad-Luck Ben follow Auspicious Alan?

US Year-Over-Year CPI January 1998 to April 2007
5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07

Fed Governor William Poole, who hails from the St. Louis Fed, the keeper of the purity of the monetarist ame, recently gave a speech in which he restated the Feds responsibility as ghting inationnot trying to manage the economy. Located not far from elds where corn and soybeans would soon be planted, he was certainly aware that inationary pressures were returning. He expressed himself as very worried about ination.

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Long-Term Capital Markets, which imploded due to a heretofore unknown condition a critical mass of Nobel economists.

Alan Greenspan luxuriated in baths of sweet-scented admiration. He was even knighted. (Her Majesty, as we know from seeing The Queen, has her off days.) He was certainly lucky. His predecessor, the saintly Paul Volcker, was nally called in by Carter as the US was sinking into a stagationary swamp. He had to drive interest rates to seemingly intolerable levels to undo the damage. Greenspan inherited a strong economy experiencing falling ination and falling interest rates, which was on the cusp of the strongest productivity gains in a generation. These blessings gave him the exibility to dabble in another rolethe Manager of the US Economythe Maestro, as he would be called in a bestselling hagiography. He could respond to collapsing stock markets or a weakening economy by slashing interest rates and printing money, without worrying about the impact on ination. Having helped to inate a commercial real estate bubble that then burst, leading to a recession he didnt recognize even when it was half-way completed, he would move on to bigger gamepresiding over the biggest stock market bubble of all time. His sole act of restraint was to produce a one-day stock market selloff when he publicly mused about irrational exuberance. His nal injection of gas into the bubble came when he was once again delivering the Greenspan Put to a tottering nancial market after the collapse of Long-Term Capital Markets, which imploded due to a heretofore unknown conditiona critical mass of Nobel economists.
Nasdaq September 1, 1998 to March 10, 2000
5500 5000 4500 4000 3500 3000 2500 2000 1500 1000 Sep-98 Nov-98 Jan-99 Mar-99 May-99 Jul-99 Sep-99 Nov-99 Jan-00 Mar-00

The recession which followed the Nasdaq collapse occurred at a time when Greenspan had carte blanche to restimulate the economy, because, for the rst time since the Depression, the pricing challenge to the US economy came from deation.

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Basic Points
Ben Bernanke has no such luck. Greenspans Chairmanship was mostly characterized by surpluses and soft prices for commodities, and by labor surpluses and weak wage pressures from workers; moreover, he could, with a ourish that made him seem to his acolytes like a monetary Batman, rush to the rescue of a frightened Gotham with the Greenspan Put without worrying over-much about a dollar collapse, because of the reliable support from Beijing and Tokyothe deep-pocketed partners in The Great Symbiosis. Mr. Bernanke, known for his beard, not his Batmobile, faces a far more hostile economic and nancial environment. The global economic climate is changing from strong to weak growth, and from weak to strong ination.
US Dollar Index February 2006 to April 2007
92 90 88 86 84 82 80 Feb-06 Apr-06 Jun-06 Aug-06 Oct-06 Dec-06 Feb-07 Apr-07

Mr. Bernanke, known for his beard, not his Batmobile

Gold February 2006 to April 2007

750 700 650 600 550 500 Feb-06 Apr-06 Jun-06 Aug-06 Oct-06 Dec-06 Feb-07 Apr-07

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Copper February 2006 to April 2007

400

The BOJ...unleashed panic among the conspicuously rich in Greenwich and in Londons West End.

350

300

250

200 Feb-06 Apr-06 Jun-06 Aug-06 Oct-06 Dec-06 Feb-07 Apr-07

iShares Emerging Markets (EEM) February 2006 to April 2007

125 120 115 110 105 100 95 90 85 80 Feb-06 Apr-06 Jun-06 Aug-06 Oct-06 Dec-06 Feb-07 Apr-07

Just prior to taking over as Chairman, he had cleverly arranged to have the Bank of Japan intervene in soaring metal markets by commissioning, editing and publishing, in his Journal of International Central Banking, a memo prepared by BOJ economists showing how the BOJs zero interest rate policy had unleashed a huge expansion of the euroyen market that let hedge funds and investment banks borrow at less than 0.5% to play in a variety of risk assetsnotably gold, metals and Emerging Markets. When the BOJ at its March meeting reversed that policy, draining 30 trillion yen (roughly $175 billion) from its Monetary Base in a mere 11 weeks, it unleashed panic among the conspicuously rich in Greenwich and in Londons West End.

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Basic Points
With gold and copper back up near their 2006 highs, is it time for another BOJ bash on speculation? The BOJ is not ready for an encore, given the ponderous, Kabuki-paced level of activity in the Japanese economy. The Bank announced this week that it was holding its rate at 0.5%. In his commentary on the meeting, Governor Fukui said that the yens weakness was not due to a major resumption of the carry trade. He was suitably opaque: Currencies uctuate every day for various reasons, but at the moment the movement is stable. A year ago, he was able to cite a strengthening Japanese economy when he bailed out Bernanke. That return of robustness turned out to be yet another false dawn over what was once called the Land of the Rising Sun. In a very real sense, the ination signals from commodities are much stronger now than then. Back then, grains were still, as they had always been, objects of government solicitudeboth in the US and EUas unzipperedwallet recipients of farm income supports. Now, the grains are threatening to unleash the strongest food price ination in years. If gold goes through $700 to stay this time, and if the dollar breaks 80 on the Dollar Index, then discussions at the Fed will not focus on parsing the meaning of the most recent Retail Sales and Non-Farm Payroll reportsor even about the plunge in housing starts at the outer reaches of the nations cities on lands that could be more wisely used for corn or soybeans. The Bernanke nightmare scenario: subprime problems hobble the nancial system, and the housing and auto sectors go into deep recession together, dragging the economy down at a time CPI increases become the highest in many years and the long end of the bond market nally responds the way Greenspan predicted it would when he started tightening three years earlier. The dollar breaks down, foreign central banks nd themselves unable to help much, and the stock market plunges. Most nightmares do not pregure actual disasters, except in plays and novels. Some do.

Most nightmares do not pregure actual disasters, except in plays and novels. Some do.

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The Fourth Scarcity: People

Japans approach to reproduction (DONT!) has become the role model for most of the OECD. At current European and Canadian fertility rates, each ensuing generations workforce will be roughly half the size of its predecessor. Japan is maintaining its lead in the tortoise-paced race to long-term extinction, but it now has plenty of competition. Among the ways todays Japan ensures that the birth rate continues its asymptotic decline is by the decrease in the supply of obstetricians to the zero level in smaller towns and cities. In America, the Fourth Scarcity is the product of a notably successful campaign in the Sixties and Seventies to change American reproductive habits based on wildly inaccurate forecasting. Paul Ehrlich, author of the Sixties bestseller The Population Bomb, predicted global disaster from overpopulation, and his acolytes had enormous impact. The US fertility rate fell from 3.42 per woman in the early 1960s to 1.8 by 1975. That decit has, in the United States, been offset somewhat by the ood of illegal immigrants and their offspring, and, (to a lesser degree) in Europe by Muslim immigrants and their offspring However, the success of the neoMalthusians campaigns among the established US population is reected in todays overall shortage of US workers, with the unemployment rate holding at 4.4% despite slowing economic growth. Within the OECD, only in America are babies being produced at the replacement rate2.1 per female. According to the diehard environmentalists, for whom babies are consumers of resources and emitters of CO2, this is just another example of Americans scandalous disregard for the planet Earth. (Latino mothers who are collectively responsible for Americas atypically high rate of reproduction do not, it would appear, belong to Friends of the Earth.) But maintaining the fertility rate at the Zero Population Growth level doesnt provide enough new entrants into the labor force to offset the ageing of the Baby Boomers, or to keep GDP growth rates above 3%. Last Friday, it was reported that the US had added more jobs than economists expected, driving the unemployment rate down to just 4.4%. It was also reported that

Japan is maintaining its lead in the tortoise-paced race to long-term extinction.

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Basic Points
US employers have already used up the quota of highly-trained professional immigrants on H-1B visas for this year (a pitifully low 165,000), and that they would hire hundreds of thousands more if the government would let them in. (Congressional policy, in a display of bipartisanship on the immigration question, cannot agree on doing anything effective about keeping out millions of mostly untrained immigrants who cross into this country illegally, but will continue to ensure that the American executives, engineers, scientists, nurses and doctors are protected against competition from potential immigrant executives, engineers, scientists, nurses and doctors. As Microsoft, IBM and other major companies have told Congressional committees, one of the biggest stimuli to outsourcing is the shortage of qualied workers in America.) Meanwhile, in Canada, which has very few Latino immigrants, the unemployment rate is at a thirty-year lowalong with the fertility rate; in the EU, the unemployment rate is at a 14-year low, driven by above-trend economic growth surging to an unsustainable 2%. What if they had a recession and nobody turned up at the Unemployment Ofce? No, we arent predicting the end of the economic cycle. We are predicting that if a US house price collapse does indeed trigger a recession in North America, unemployment, like politics, will be mostly local. The drastic change in reproductive habits across the industrial world since 1970 has meant that todays populations in those countries are roughly onethird smaller than Sixties demographers predicted (adjusting for improved mortality experience during that period). One way of looking at this is to compare it to the Black Death, which wiped out more than one-third of Europes population in four years. The hardesthit nation was Britain, where, experts now believe, an anthrax epidemic among cattle and sheep increased human mortality above the rate seen on the Continent. Medical practitioners of the time were obviously not skilled enough to be able to isolate anthrax deaths from bubonic plague deaths.

What if they had a recession and nobody turned up at the Unemployment Ofce?

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23

That was Sudden Death: this is Slow Dearth.

What happened in England after the plague subsided is well-recorded. Feudalism, which was already decaying because of the growth of towns, barely recovered. Many barons and other landlords were no longer able to rely on their serfs to look after their estates, and had to recruit laborers in the open market. It no longer became possible in most shires to enforce the laws that tied serfs to their lords demesnes. Nor was the Church able to insist that its lowliest parishioners had to abide by their oaths of loyalty to their lords. One reason was that the mortality rate from the plague was frequently highest among the clergy; priests and nuns who, obedient to their vows, continued to attend the dying and deceased, were obviously at high risk of contracting the disease; since so many clergy lived together in monasteries, the disease could spread rapidly: many a monastery and nunnery was completely wiped out. Why, asked the newly skeptical, did those who devoted their lives to serving God die at a higher rate than the rest of the populace in Christendom? There is no spiritual component to this latest massive population loss. That was Sudden Death: this is Slow Dearth. Because the economic impact has developed slowly over the past two decades, during a time when the impacts from technology and competition from low-wage nations were leading to highly-publicized layoffs and plant closures at long-established corporations, the declining rate of new entrants to the labor force attracted little attention. Ben Bernanke has mentioned wage ination pressures twice in the past month. That Average Hourly Earnings are now growing at the same rate as when the Fed last tightened may be a coincidence. But back then, GDP and overall employment were growing more briskly than now. The difference, we believe, is that the pool of potential new workers ages 18-25 keeps getting smaller. The Streets assumption that a weak payroll number means the economy is growing too slowly has been valid for most of the past fty years. But when the supply of labor is no longer in surplus, a lack of jobs growth could be due more to employers inability to nd the workers they want at the rates they are willing to pay them, than because the economys gears are stuck in neutral. There may be one last big rally in bonds if a recession arrives. After that, it will be time for a Requiem for the Greatest of Them All.

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Basic Points
Preparing a Goodbye to the Greatest of All Bond Bulls
This bond bull is a record-setterin terms of its duration and the scale of the drop in interest rates.
US 10-Year Treasury Note Yield May 1987 to April 2007
11 10 9 8 7 6 5 4 3 May-87 May-90 May-93 May-96 May-99 May-02 May-05

One by one, the non-monetarypolicy factors promoting disination have been crumbling.

Government of Canada 10-Year Bond Yield June 1989 to April 2007

12.5 11.5 10.5 9.5 8.5 7.5 6.5 5.5 4.5 3.5 Jun-89 Jun-91 Jun-93 Jun-95 Jun-97 Jun-99 Jun-01 Jun-03 Jun-05

The remarkable global economic progress of the past 25 years has come largely because Paul Volcker, Karl-Otto Pohl, Ronald Reagan and Margaret Thatcher challenged and conquered the ination that had been gaining strength even as industrial economies weakened over the previous three decades. One by one, the non-monetary-policy factors promoting disination have been crumbling. First and second to go were cheap energy and cheap metals. Until recently, ve powerful factors that had helped hold down ination were still at workfood prices, labor surpluses, a reasonably rm dollar, disination driven by imports and outsourcing, and productivity gains.

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25

The last two factors are still disination-friendly: the US continues to import disination. As for productivity, it no longer promotes cost controls as powerfully as it did from 1994 through 2002, a process Alan Greenspan correctly identied. The Year of the Death of the Bond: 007. A strong dollar is a powerful disinationary force. The dollar is no longer strong, but it hasnt completely broken down.
US Dollar Index January 1990 to April 2007
92 90 88 86 84 82 80 Feb-06 Apr-06 Jun-06 Aug-06 Oct-06 Dec-06 Feb-07 Apr-07

As for labor costs, average hourly earnings in the US have been climbing at more than 4%their fastest clip since the peak of the last cycle. Anecdotally, we hear new stories each week of employers difculties in nding qualied help. The Challenger layoffs report last week not only did not project more bad news for employees, but reduced the number of previously-announced layoffs that would actually be implemented. A recession might stop this rise in wage costs in its tracks, but the ensuing recovery will, we believe, see an historic shift in the power balance between employers and workers. The big, unseen Presence at all future bargaining tables will be the Unborn. They will be casting their votes for the workers and against management. The Year of the Death of the Bond: 007.

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Basic Points
INVESTMENT ENVIRONMENT
On CNBC last week, I followed two commentators who were agreeing that a weak Non-Farm Payroll number could make the Fed cut rates. I argued that with a weak dollar, gold heading back to $700, food ination, commodity ination and now wage ination, those who keep looking for a Fed rate cut are out to lunch.and lunch will cost a lot more. Everyone seems to agree that the main challenge to the US economy comes from the end of the boom in house prices. Like so many American real estate booms, its latter phases included excess supplies of credit and weakening credit standards. Alan Greenspan kept the fed funds rate at a risible 1% for too long, and a motley host of new-age mortgage originators and investors found neat new ways to debauch longstanding credit guidelines and constraints. It was as if those slick Silicon Valley denizens who pioneered and proliferated the back-dated stock option programs were called in by the new breed of mortgage originators. The tech sharks would do their best to ensure that probity in mortgage appraisals would become as rare as probity in tech companies nancial reports. As discussed in last months issue (DONT ASK; DONT TELL: ITS SUBPRIME TIME!), the subprime mortgages with teaser rates, followed by resets to market rates, have conspicuously high mortality rates. Adjustable rate mortgages are priced off Libor, whereas conventional xedrate mortgages are priced off the Ten-Year Note. Floating rate subprime mortgages and so-called Alt-As and Alt-Bs are Libor-priced. We get the feeling that much of the urgency out there for a Fed rate cut is that it would cut Libor and that would help the mortgagors most at riskthose facing resets. Why shouldnt the Fed ease their painand the pain being experienced by nancial institutions who lent not wisely, but to the nancially unwell? The pain is already over for 20 of the upstart mortgage lenders; they have gone bankrupt or otherwise out of business. New Century Financial, the most conspicuous creator and packager of toxic waste, is the biggest bankrupt to date, but more will join it in the mortuary. It now appears that nearly 40% of all mortgages issued last year in the US were subprime or the next category upAlt-As. Since the borrowers either had no proof of their ability New Century Financial, the most conspicuous creator and packager of toxic waste, is the biggest bankrupt to date, but more will join it in the mortuary.

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...the fed funds rate was 1% the equivalent of pricing a real diamond as if it were a rhinestone...

to service the debt (subprime) or inadequate proof (alt-As), the already-high default rate on home mortgages would become grim were the US to fall into recession. This week a major mortgage REIT revealed that it was taking writedowns on some loan packages ranked as high as AA. It would appear that conning the term problem loans to the categories that may appear, on closer examination, to be designed primarily for the hapless homeless does not address the full problem. It is as if there were a large cesspool upwind of an upscale neighborhood: the odor would not be conned to the low-rent district. Senator Dodd, Chairman of the Senate Banking Committee, pledges aid (undescribed) to borrowers who are victims of predatory lenders. (The Senators use of the term Predatory in this context is confusing. Does being a predator involve shoveling out 100% or more of the purchase price of a house to people whom any experienced, disciplined lender would rate as likely deadbeats? Or does the predator prey on investors in the Collateralized Debt Obligations who he thinks will soon be stuck with a portfolio full of garbage?) The Greenspan Put was a great gift for bad banks and hubristic hedge funds. It was never designed for consumers who were in over their heads. To the extent that Greenspan concerned himself with homebuyers, it was to give advice that turned out disastrously. It was helest we forgetwho, when the fed funds rate was 1%the equivalent of pricing a real diamond as if it were a rhinestoneadvised homebuyers and homeowners not to burden themselves with xed-rate mortgages at the high interest rates that the then-upward-sloping yield curve decreed. Get the low-interest, adjustablerate mortgages and rely on us to keep out ination so those rates wont go up, quoth the newly-knighted seer. Given his media reputation, perhaps we should not be surprised that the number of subprime loans using resets exploded after Greenspan gave his recommendation. Perhaps his parting gift to his successor was a few million mortgage defaults based on his ability to time the market. Perhaps we are seeing something even bigger unfold: The Great Bond bull was born, bred and fed during the era when leftist parties were being wiped out at the polls. Keynesianism and its American equivalents had reached global dominance during the 1970s. (When Nixon unveiled wage and price controls, he proclaimed, We are all Keynesians now.) Reagan and Thatcher demolished the die-hard survivors of the discredited breed. Bill Clinton, was able to get elected and re-elected at a time of disination and skepticism about big government by espousing centrism and free trade. He might not be able to even get the Democratic nomination with those policies today.

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Basic Points
The conservatives have had their decades in power, and perhaps voters think it is time to try protectionism, handouts, increased union power and weaker defense policies again. History may judge President Bush as the man who made voters believe theyd be better off doing what had kept ination and the Cold War going. As Marx observed, History repeats itself: rst as tragedy, then as farce.

Conclusion
The outlook for bonds had already become bleak before we heard about the vanishing bees. The possibility that the Bee Die-Back will be the once-in-a-century food catastrophe that will be the nal ingredient in a Perfect Storm for the bond market may still be remote, but we shall be hearing a great deal in the next six weeks or so about Apis mellifera, the indispensable member of Order Hymenoptera. What is bad for bonds is also bad for Financial stocks.
BKX January 1992 to April 2007
135 115 95 75 55 35 15 May-92 May-94 May-96 May-98 May-00 May-02 May-04 May-06

It is hard to construct a bullish scenario for US stocks against a bearish scenario for Financials.

Financial stocks soared skyward along with techs, lending legitimacy to the Streets collective replay of The Rakes Progress on a bigger canvas. The Greenspan Put and the roaring bond bull market saved them from serious punishment during the stock shakeout attending the early years of Nasdaqs Triple Waterfall crash. It is hard to construct a bullish scenario for US stocks against a bearish scenario for Financials.

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However, it is possibleindeed eminently reasonableto remain bullish about commodity stocks while going short bonds and the BKX. The three commodity scarcity stories are long-term in nature, which means commodity stock investors who can look through a downward correction of the dollar and the overvalued bond market can expect continuation of strong returns. The labor shortage story is also long-term in nature. That it implies that workers shares of the income pie should outpace gains for top managements should not be construed as bad news. Plutocracy is not an attractive alternative to democracy. The new SEC rules are forcing companies to tell us about CEOs compensation packages, whichin some Black-Mass-style perversion of marriage vowspay these princes gigantically whether the stockholders be richer or poorer, and the payments must continueor even escalateafter the CEO has departed the organization until death do them part and he goes to that Great Executive Suite in the Sky. As the reports of billions in payments made without regard to performance pour out, we realize anew that one of Milton Friedmans greatest insights was, The principal problem with capitalism is capitalists; the principal problem with socialism is socialism. The scale of CEO compensation packages, even after eliminating those highlypublicized excesses for which the term obscene is inadequate, seems to be based on a Lake Wobegon-style belief system of boards compensation committees: all CEOs are better than average and ours is among the best of that superbly-performing lot. It looks as if the global winners in the next few years will be farmers and workers. And maybe not CEOs, although they have those external compensation advisors, who are paid handsomely to tell the Board compensation committees how to keep the company competitive. If the workers are nally going to receive greater percentage increases in compensation than the average CEO whose company underperforms, that might be a consummation devoutly to be wished. Even though it would mean that the world has changed and the CPI will be going up. Painfully.

...CEOs compensation packages, which in some Black Mass perversion of marriage vowspay these princes gigantically whether the stockholders be richer or poorer...

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Basic Points
INVESTMENT RECOMMENDATIONS
1. Reduce bond durations to below benchmarks, and in particular, reduce exposure to long duration bonds. 2. In balanced accounts, maintain exposure to long zero-coupon bonds as hedges against commodity stock positions for as long as US recession risk remains higher than normal. 3. Maintain market weight in Energy stocks, with emphasis on producing companies in the Alberta Oil Sands. They will continue to have special appeal for as long as Big Oil has big problems with its Reserve Life Indices. Within the oil service sector, emphasize the Offshore Drillers. 4. Overweight exposure to gold, using mining stocks and/or the ETF. If the US Dollar Index breaks 80, add to your gold positions promptly. 5. Remain overweight the producing base metal stocks with long-life secure reserves. They remain the pre-eminent asset class for the next ve years. 6. Underweight Financial stocks. Within the group, emphasize the dull banks who stick to their knitting, dont take big derivative bets, and grow their dividends faster than ination. Given the huge growth in personal incomes of the Midwest farming community in this and coming years, banks headquartered in farming communities will be prime takeover candidates by big banks headquartered in the coastal regions where the news will tend to be mostly bad. 7. Continue to build major overweight positions in the agricultural stocks. This is, like the other commodity groups we have been recommending, a long-cycle investment theme. 8. The Canadian dollar remains severely undervalued compared to the greenback. American accounts should overweight Canadian assets (other than exporting companies). In particular, American investors should consider the wide range of Maple Bonds now available in what once was the severely constricted Canadian bond market. Canadian accounts should underweight US assets. There is no discernible reason for Canadian xed income accounts to hold unhedged US dollar-denominated bonds.

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9. Remain overweight Emerging Markets, concentrating on economies with positive demography. Russia has the greatest diversity of mineral resources of any major economy, but the worst demography of any major economy. Caveat emptor. 10. Continue to underweight technology stocks. Within the biotech sector, consider the GM seed companies as attractive alternatives to the pharmaceutical companies. 11. Real-return government bonds, are about to become collectors items for the wise. The total supply outstanding is modest, and will prove grossly inadequate for the coming growth in demandparticularly from pension funds.

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Basic Points
When The Financial Killings Will Have To Stop

May 17, 2007

Produced by BMO Financial Group Distributed by BMO Capital Markets

Basic Points
An Investment Journal
Donald G. M. Coxe
Global Portfolio Strategist, BMO Financial Group (312) 461-5365 e-mail: don.coxe@bmo.com

Research/Editing Production/ Distribution

Angela Trudeau e-mail: angela.trudeau@shaw.ca Anna Goduco (print orders and mailing lists) e-mail: basicpoints@bmo.com

When The Financial Killings Will Have To Stop

Overview
The over-arching phenomenon of this equity bull market has been the record kill rate scored by those masters of leverageproprietors of activist hedge funds and private equity rms. The scale of their spoils has had enormous impact on the pricing of US stock marketsparticularly the S&P Mid-Caps. This decades new larger-than-life heroes have suddenly attained wealth equivalent to the so-called robber barons who built vast corporations and catapulted America into world industrial and economic leadership. Todays super-rich are the winners from the asset ination spawned and nurtured by a decade of record growth in liquidity. Money has not only been absurdly plentiful but absurdly cheap. The exponential growth in derivatives has magnied the opportunities for the new cool engineersthe nancial engineers, who have taken over from the software engineers as the Street and media darlings. We do not associate ourselves with those who would seek to demonize private equity rms, (locusts is one of the polite terms), over-regulate them, or even overtax them. In particular, we respect the contribution made to the markets and the economy from those, like Canadas Onex, who buy to build, rather than those whose round trips are measured in months. The winning practitioners of the new nance are notable for their shrewdness, guts, and understanding of this eras unique credit dynamics. We are grateful they have left our kinds of stocks alone. Had they chosen to take out the mines and oils with their seemingly unlimited access to cheap money, we would have had little to write about and few opportunities to boost our clients wealth. The buyouts of the companies we favored have come from their own industries, meaning that the market capitalization of commodity stocks keeps growing. We like it that way. Last month we reversed our multi-decade endorsement of long-term bonds, arguing that ination is about to return. Once central bankers and investors understand that dollar-denominated corporate bondsnot stockshave become the largest-scale speculation of our time, credit spreads will widen, and bond vigilantes, a species thought to be extinct, will, like cicadas, reappear in vast numbers. The onset of price declines for the American individuals inationary asset of choicehomesis the rst indicator that credit promiscuity is a social disease that can produce painful consequences. As CPI begins to climb, led by food and fuels, then junk bonds and Panglossian CDOs will decouple from traditional xed-income assets, whose yields will rise more gently, as investors rush to upgrade their portfolios.

May

May

Overview
This generations nouveaux riches will retain their instant billions. Only their lenders and their recent investorsparticularly those who buy their suddenly-available stockare likely to experience pain as disciplineone of capitalisms core attributesreturns from its long vacation. Because of numerous questions from clients about our views on takeovers of Canadian companies, we are also discussing another trend in nancial killings based on cheap moneythe takeovers of major Canadian resource companies with irreplaceable assets in the ground. Buying stocks can help to make nancial markets and the economy work more efciently. Buying the worlds most valuable nickel and oil sands deposits in the ground raises rather different questions. We are leaving our Recommended Asset Mix unchanged.

May

Recommended Asset Allocation

American Portfolios

U.S. Pension Fund

Allocations 27 29 12 0 15 17 Change unch unch unch unch unch unch

Domestic Equities Foreign Equities Domestic Bonds Long-Duration Bonds Foreign Bonds Cash

Foreign Equity Allocations

Allocations 6 6 6 11 Change unch unch unch unch

European Equities Japanese and Asian Equities Canadian & Australian Equities Emerging Markets

Bond Durations
Years 4.25 4.50 4.75 Change unch unch unch

Global US Canada

May

Basic Points
When The Financial Killings Will Have To Stop
Our title is inspired by Constantine Fitzgibbons Orwellian 1978 novel about a Communist takeover of Britain, When the Kissing Had to Stop. Our thesis is that sustained buying of Treasurys by investors who are not motivated primarily by prot maximization has prolonged and distorted the bond bull market: By overpricing Treasurys, these big buyers have suppressed market responses to rising short rates, rising economic activity, rising commodity prices, soaring credit demand and a bearish dollar. Fixed income investors have been forced to reach for yield, thereby making the worst credits the best-performing bonds. The Biblical forecast They that are last shall be rst was a prediction of the winners and losers from the Apocalypse, and is not an investment policy guide for prudent investors. From the bottom of the equity bear market on August 12, 1982, to the bull market peak in 2000, long Treasurysparticularly zero-coupon bondsdelivered fabulous performance, outperforming all asset classes on a cumulative basis until the nal stage of Nasdaqs rush to its Triple Waterfall peak. Remarkably, they have continued to perform well, even though their great performance during the 80s and 90s was due in part to their inverse correlation to commodities, which were in their Triple Waterfall collapse. Although energy and metals commodities and stocks have been the star performers of this decade, long bonds solidly outperformed the S&P 500 until mid-2005. They have continued to be useful in balanced portfolios, climbing sharply during stock market selloffs. We believe they are now the appropriate asset class only for the grisly-minded bears who believe the US economy faces a deep recession induced by a housing collapse. (There are lots of them: a recent poll disclosed that a majority of Americans believe the nation is already in recession, although most respondents said their own economic situations were good. Chalk that national economic schizophrenia up to the Democrats successful campaigning against the failings of the Bush regime. That pervasive bearishness probably explains why the majority of retail investors have not participated in the current equity runup.) long Treasurys... are now the appropriate asset class only for the grisly-minded bears...

May

The Three Big Buyers of Overpriced Treasurys

1. The Treasury Bond Market and the Trust Fund
The truth is that the federal government has been in decit every year for decades. The rstand most obviousof these bond buyers of rst and last resort has been the Social Security Trust Fund. Its purchases of non-market Treasurys are structured to keep the Funds duration tied close to the duration of the national debtnow roughly six years. Since the late 1980s, the duration of the national debt has been in long-term decline. Even the soaring decits of the early years of the Bush era did not interrupt this trend. Although the Bush Administration nally reopened the 30-year Treasury bond, it has continued what we believed was a deeply misguided policy of the Clinton Administrationreducing debt duration. This was always a risky policy, even when Washington was reporting scal surpluses. Those surpluses were both illusory and delusory: they were illusory, because the Treasury reports the net inow into the Social Security Trust Fund as income, lumping in the forced savings from the Federal Insurance Contributions Act (FICA) contributions to the Trust Fund with overall tax revenues; they were delusory, because the Trust Fund was known at all times to be headed for deep decits once the Boomers began to retire. That reality, which is discussed in each years actuarial valuation of the System, meant that the scal pressures in ensuing decades must grow remorselessly unless future governments impose punitive taxes and spending cuts to levels that will cripple economic growth. By 2017, FICA taxes and investment interest will no longer exceed benets, and all the sub-accounts of Social Security will be in decit. By 2041, the (imaginary) national piggy bank will be empty. The truth is that the federal government has been in decit every year for decades. Decits were reduced somewhat during the Clinton era, but the published numbers that bragged of surpluses were phony because they continued the practice of sloshing FICA contributions in with ordinary tax revenues. (The current Page 16 story on the federal decit is that it has been running at the second-lowest in relation to GDP of the G-7: below 2%. Only Canada, which has been cashing surpluses for years, has a better record than Bush. Moreover, Canada has never included Canada Pension Plan contributions as tax revenues, so its surpluses on Washington GAAP accounting (Grabbing Astronomic Allocations of Pension Contributions as Tax Revenues) would be

May

Basic Points
so high as to suggest the Canadian government could make a takeover bid for Alaska without incurring a decit. The Page One stories continue to give us analyses from supposedly unbiased observers that prove that Bush is an unconscionable spendthrift. The investment policies of the Trust Fund and the misrepresentation of Washingtons scal situation have been big concerns of mine since I was asked to analyze the Trust Funds operations. I ask readers indulgence as I recount my confrontation with the Social Security Administration and Washington politics. As I have previously written (Basic Points, February 2005), I was called, at the suggestion of the Canada Pension Plan Administration, to testify before the US Senate Finance Committee in 1988 about the operation of the Social Security Trust Fund. I presented detailed evidence to show that the Trust Fund was being seriously mismanaged. It was using taxpayers contributions to buy equally laddered bonds of maturities of one to fteen years, so that the average term of each purchase was eight years and the average term (not duration) of the Fund was less than seven years. The interest rate set for all bonds purchased is the average yield on all outstanding US securities not due or callable until 4 years or more from the date the rate is determined. Given the continued decline in the duration of the national debt, and the upward-sloping yield curves that prevailed for most of the time, this has meant the Fund has never been investing more than a tiny percentage of its assets in the bonds whose durationand interest ratebore some relationship to the long-term liabilities of the Social Security System. That meant the Treasury was paying far less on its borrowings than it would if the Fund were honestly invested. It also meant that the Fund was missing out on the greatest bond bull market of all time: each quarter it was forced to roll over high-yielding bonds at par into lower-yielding instruments. Trustees of any private pension plan investing that way would have been subject to litigation by plan participants and prosecutioncivil and criminalunder ERISA rules and the common law duties of trustees not to act in their own interest, but in the interests of the beneciaries of the trust. The Trust Fund was the bipartisan baby born after the Dole-Moynihan amendments were enacted. It was supposed to be modeled on the Canada Pension Plan Trust Fundwhich, at the time of my testimony, held highyielding twenty-year provincial government bonds, the best-performing major asset class in Canada during the 1980s. (Later, when Canadian equity markets began to recover from their decades of global underperformance, and bond yields fell to unattractive levels, the CPP was given the authority Trustees of any private pension plan investing that way would have been subject to litigation...

May

The CPP Investment Board is now a model for social security systems...

to become a major, globally respected, investor in nancial markets, including fully marketable bonds of all classes, stocksdomestic and foreignprivate equity, real estate, and direct investments. The CPP Investment Board, staffed by a growing band of professionals, is now a model for social security systems, and, backed by realistic actuarial forecasting, is the reason why the Plan is one of the soundest pension programs in the world.) I had been asked to testify because, in 1973, I had been co-author of a report from the CPP Advisory Committee to the federal government that changed the CPP Funds policy of setting the interest rates on its holdings in provincial bonds. The Fund had been setting its borrowing rates based on the yield on a Depression-era 3% perpetual bond; after our report, it changed to charging borrowers what the market was paying during the inationary 1970s. The resulting huge increase in investment income put the CPP on a sound footing. I had also been co-author of the Report of the Royal Commission on the Status of Pensions of Ontario, which recommended that the major government plansincluding government employees plans and the Ontario Teachers Fundbe invested in open market investments, rather than being mere book entries in government accounts. My testimony about the mismanagement of the Trust Fund was bitterly challenged by a representative of the Social Security Administration, and I was asked to stand down. I thereupon walked up and handed the Chairman, Senator Moynihan, four years of actuarial reports on the Fund with the key numbers highlighted to show just how much money was being lost. The Chairman was surprised, turned to his legislative assistant, and asked him to leave the room to check up on the material in the documents; he requested that I wait while other witnesses were heard. Later, Senator Moynihan called me back to the stand, apologized on behalf of the Committee for the way I had been treated, endorsed my powerful recommendations, and expressed the hope that the Committee would call on Congress to amend the Funds investing procedures. When the meeting adjourned, he came down to chat with me. What chance, he asked, Do we politicians have to handle this kind of technical material? This afternoon, well be attending meetings of the Labor Committee and then answering phone calls from voters about all kinds of problems. We have to rely on the ofcials. When they deliberately mislead us, were in no position to challenge them. Why is it that, in Canada, experts like you pitch in to try to make social programs work, whereas in this country they seem to take the attitude that all government programs are bound to be screwed up? I had no real answer to that lament.

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Basic Points
The Senators gloomy appraisal was accurate. Despite this indictment from the Committee, nothing was done to rectify the investment policies and procedures. The x was in. The Gramm-Rudman budgeting rules were in force at the time, constraining Congresss ability to increase spending without boosting taxes, and the huge prots of the Trust Fund were oh-so-useful in making Congress and the Administrations nancial performance look acceptable to even the most cynical critics. After Gramm-Rudmans tourniquet on the appropriations process expired, the habits of bad investing and bad reporting were so well-established and so useful to ensuing Congresses and Administrations that they had become as difcult to amend as the Constitution. Those illusory and delusory surpluses continue to shrink. By 2013 they will become so small that they will no longer be meaningful in Treasury calculations of budget decits. The major prop to the Treasury market that those net contributions have provided will be gone. Real buyers will have to emerge to pick up the slack. The three-decade-long bipartisan picking of workers pockets to invest in lower-yielding Treasurys will no longer be one of the three hidden subsidies that have kept Treasury rates lower than market conditionsand a negative national savings ratewould dictate. Long before then, interest rates will have begun to rise in response to rising ination, and the investment policy that was so inappropriate for the disination era will nally begin to look smart. The Treasury will have lost its chance to lock in low long-term borrowing. Not that the Fund will benet much from those rising rates: it will be melting faster than any of those glaciers one reads about these days. The dissimulation and abuse of trust by successive Congresses and Administrations has been a bipartisan affair. Even the brilliant Robert Rubin engaged in the Treasury equivalent of Nasdaq nancial reporting. Each month, like his predecessors in ofce, he personally signed the documents authorizing purchase of mid-term Treasurys in an upward-sloping Treasury curve for a fund whose liabilities had a multi-decade duration. The 1990s were the years in which Washington could have simultaneously strengthened the nancial position of the Social Security Trust Fund and the borrowing position of future Administrations by holding the term of the marketable bond component of the national debt steady and by selling its longest-term new issues to the Fund at realistic interest rates. Had Social Security switched to 30-year bonds in 1989, the Fund would not be facing a negative cash-ow position during the next decade. That the Fund was only

The x was in.

May

earning 4.6% from 2000 to 2005 on a hoard accumulated over two decades shows the cumulative folly of a policy based on an unrealistically short duration that focused on mid-term Treasurys. The Social Security Trust Fund .... [and] two Asian foreign exchange funds.... Washington big spenders big friends. The Social Security Trust Fund wasnt the only large-scale buyer whose purchases depressed rates on short and mid-term Treasurys: We now turn our attention to two Asian foreign exchange funds which went from relative obscurity to global giantism by loading up on Treasurys and, more recently, mortgage-backs. They bought more than $1.4 trillionmostly with their share of the proceeds of export sales of manufactured goods to US consumers. They became the global nancial Odd Couple in October 1998and, like the Social Security Trust Fund, the Washington big spenders big friends.

2. Partners in The Great Symbiosis

Renminbi January 2002 to May 2007
8.3 8.2 8.1 8.0 7.9 7.8 7.7 7.6 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07

Yen January 2002 to May 2007

140 135 130 125 120 115 110 105 100 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07

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Basic Points
What we have since 2004 called The Great Symbiosis is, of course, the understanding reached between the two dominant economies of Asia at the end of the Asian currency crises of 1997-98. When Russia and Long-Term Capital defaulted, the Fed, the Peoples Bank of China and the Bank of Japan collectively reated the global nancial system. This was the rst time China had been part of a major global rescue operation. As the price of canceling a threatened devaluation of the renminbi that would have sent the global system into renewed crisis, China insisted on a line in the sand of 122 for the yen, forcing Japan to revalue upward from 142. The rest, as they say, is history: an astounding growth in what we have called Real, Effective Financial Liquidity. Money owed across currencies and borders in unprecedented volumes with unprecedented freedom. The global free trade in goods and services that sparked the anti-globalism riots has been a small fraction of the seemingly frictionless ow of liquidity across banking systems, economies, currencies, and trading screens. Asias high savings rates supplied the funding to offset Americas negative savings rates. The housing bubbles in Spain, London, and America were, in signicant part, inated by Beijing and Tokyo. So were the private equity takeover booms in North America and Europe. It is possible that the Symbiotic pair will become the basis of something much bigger in coming yearsan Asian monetary agreement that would include Singapore, Hong Kong and South Korea. Assuming that the Symbiosis remains intact, with China letting the renminbi rise gradually against the dollar, the yen must eventually move upward. It is currently depressed by the Carry Tradeinvestors who short the yen to buy deposits in dollars, euros, pounds, Swiss francs, Australian dollars, and some exotic currencies. Given the near-zero ination in Japan, and the slowing of Japans economic output that is not tied to Direct Investment and trade with China, it is not clear the BOJ can carry out another surprise attack on Carry Trade speculators by draining the euroyen market, like the one a year ago that was apparently orchestrated with the help of Ben Bernanke. This year, for the rst time since the spawning of the Symbiosis, Chinas forex reserves have been booming at a time both the dollar and yen have been weak, while the renminbi keeps climbing to record highs. This suggests that China is responding to American pressure to revalue its currency upward, which could mean the great Asian safety net under the dollar is slowly unraveling. If Senator Schumer and Speaker Pelosi get their way, China

...the great Asian safety net under the dollar is slowly unraveling.

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11

[Chinas] bloated forex reserves which make Fort Knox look like a good-sized bank in Topeka...

would be forced to drive the renminbi far higher against the greenbackfast. That could only be achieved by dumping a huge portion of its Treasury hoard, which would drive US interest rates to Emerging Markets levels, making the current state of the housing market look like a runaway boom. Secretary Paulson is trying to avert a Democrat-led assault on China. Homeowners and investors can only wish him well. After years of greenback etiolation, years of global central bank support operations, and years of rising gold prices, it is now becoming almost chic to speak of the coming shortage of dollars. Some prominent analysts point to the years of growing dollar bearishness based on the current account decits; they argue that those decits arent really important. They also cite the huge dollar short positions in the published statistics for the currency futures markets. Finally, they point out that everybody has been a dollar bear forever and yet the dollar has only declined modestly. So the contrarian bet is the winning trade. Yes, its chic to be contrarian. But, regardless of how much company joins us in the uncool camp, we remain of the view that the only way to resolve the global dollar imbalance without a deep US recession is for a sustainedbut non-violentdevaluation. The Symbiosis partners stand to lose a bundle if the dollar were to break 79 on the Dollar Index and go into a major bear plunge. But their losses on foreign trade would surely be far greater than their losses in their unnecessarily large forex accounts. There is no question of them unloading their hoardsunless forced by Congress. However, China has of late been musing about using its bloated forex reserveswhich make Fort Knox look like a good-sized bank in Topekafor something more than a subsidy to Washington. Beijing has announced it plans to manage its trillion-plus in reserves actively; it has installed investment managers and has responded to American politicians threat of trade sanctions if it doesnt stop its currency manipulation (readdollar life support system) by promising that it will seek to achieve acceptable returns. How can it switch from passive to active management without roiling global bond and currency markets? One option being explored is funding regional lending corporations that in turn fund small and mid-size businesses in the hinterlands. This sector of the market has been happy feeding grounds for loan sharks. Using foreign exchange reserves to help nance domestic businesses might well turn out to be an even worse investment than

12

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Basic Points
dollar-denominated bonds at subsidized interest rates, but the Chinese have so much more in their vaults than they need that they can afford to move some of it into the coffers of obscure people running obscure companies in obscure communities.

3. Oil Exporters
It is dj vu for the rulers of Saudi Arabia, the Emirates, Kuwait and other merrie men of OPEC. The last time oil prices rose far beyond forecasts, they were forced to face the problems of those who are rather suddenly rich beyond their wildest dream. After blowing money on baubles, bangles, buildings, bribes and weaponry, they deposited most of what was left in Eurodollar accounts with big global banks. This outsourcing of the stress of investing worked the way outsourcing should: the banks were stuck with the problem of investing a cash ow that looked to be limitless. A new idea emerged to meet the new needs of those new times: shovel out those petrodollars from rich Third World countries to poor Third World countries. Why let the IMF and the World Bank monopolize those markets? Walter Wriston of First National City Bank, who had years of experience making loans to companies that then went bankrupt, proclaimed, No nation has ever gone bankrupt. He and the other globe-trotting bankers then proceeded to spendand losemoney on heroic scale. The new breed of bankers was innovative. One of their breakthroughs that never made it into B-School textbooks was The Secretary Loan. Offerings of participations in syndicate loans to Third World and Second World governments were made to correspondent banks via teletype. The Secretary Loan was the upper limit on a participation that could be made by the secretary in a bank ofce when the lending ofcer was out for one of the three-martini lunches that helped dene the era when twas very bliss to be alive and recycling petrodollars. Wristons Law, as it turned out, was not destined to join Moores Law in the Business Hall of Fame, although it led to more activity and more headlines. There was almost no dictatorship or hellhole in the world that failed to qualify for Wristonlargesse. There were few dictatorships and hellholes in the world who did not fail to repay those loans. Among the more notable was North Korea, the object of the generosity of a global syndicate led by a prominent Canadian bank. That loan was particularly memorable, because

After blowing money on baubles, bangles, buildings, bribes and weaponry, they deposited most of what was left in Eurodollar accounts with big global banks.

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Canadian taxpayers shared... thereby helping to nance the North Korean nuclear weapons program.

so much of the proceeds was spent in full-page advertisements in the business sections of Canadian newspapers. These were long, tedious discussions of extremely arcane items of Marxist theory addressed to various Communist notables in other parts of the globe. The money not spent in what appears to have been a sort of missionary activity to revive the Canadian Left went for weaponry and, as we would later learn, for the rst stages of the development of nuclear bombs. The loans, of course, were never serviced, and were written off, which meant that Canadian taxpayers shared in the loss, thereby helping to nance the North Korean nuclear weapons program. Since Canada even refuses to participate in the US anti-missile shield because of its hostility to anything that smacks of nuclear arms, this has been the nations only venture in nuke-building. The banking blunders of that era hobbled the global banking system for most of the 1980s, and underlaid the nancial crises of 1984 and 1987. This time, the oil-rich are savvy and educated. The new breed of Arab investor is not content to hold Eurodollar deposits. He wants marketable securities for his nations foreign exchange account, and for the accounts of the great state-owned nancial institutions that are so prominent in nancing the construction booms where the sand meets the Gulf. For a while, this meant investing much of the excess cash ow in Treasurys. All the Big Oil CEOs were adamant that $45 oil wouldnt last, so choosing the obvious, most liquid investments made sense. Then a New York judge agreed to the ling of a class action suit against Saudi Arabia for 9/11 because 15 of the hijackers were Saudis. That meant that, at least in theory, successful plaintiffs could sequester any Saudi assets in the US. Since the Fed had routinely held Treasurys for the account of foreign central banks, that could mean that even those trust assets could be tied up in litigation. No surprise that the oil states began to buy their Treasurys through London bond desks, where anonymity was easily achievable. For a while, a good portion of the excess oil returns was reinvested back into the Gulf states, as the booms in Dubai and Abu Dhabi caught the worlds attention. The Saudi stock market was briey the best-performing in the worldjust before it became the worst-performing.

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Basic Points
The Financial Times recently published an interesting analysis of the impact of excess oil and gas prots by Clarium, a noted California hedge fund (and valued client). In brief, they argue that $60 oil has been the progenitor of a huge global savings programa regressive trillion dollar-a-year tax increase on middle-class consumers. The money goes to London or Switzerland and gets levered up and then invested in nancial markets. So rising oil prices do not mean rising interest ratesthey mean downward pressure on interest rates. This counterintuitive theory helps to explain todays paradox of 1970s-style oil prices and 1990s-style interest rates on long-term bonds and mortgages. The idea of forced savings as a means of holding down nominal and real interest rates has historical basis. During World War II, Americans and Canadians saved near-record percentages of GDP. Price controls masked ination tendencies, interest rates were held down, and soldiers sent their paychecks to their wives and families to be saved for buying houses and cars after the war. Savings bonds and war bonds were sold heavily, using patriotism and support of the troops as powerful marketing messages. When the boys came home and those savings were unleashed, ination took off, despite government attempts to continue controls. The Clarium argument helps to explain the coexistence of inverted yield curves and robust liquidity. They believe curves will become even more inverted as central banks try to prevent asset ination from spreading into economic inationwhereas we believe that ination-driven increases in short rates will break the back of the inverted curve, sending long rates skyward. What percentage of the excess oil wealth is being invested in dollar-denominated securities? It was nearly 100% back in the 1970s and after the First Gulf War. Based on public statements by Arab leaders, the US response to 9/11, and the Iraq War, have forced Gulf states to rethink their dollar-friendliness. The creation of the euro means there is another giant liquidity pool available to them, and OPEC has far more merchandise trade with Europe than with the US. Russia has also become an important factor in global capital markets, investing its net proceeds from oil and gas. Putin has made it clear he isnt interested in subsidizing America, and the dollar exposure of Russias reserves has been shrinking.

...$60 oil has been the progenitor of a huge global savings program a regressive trillion dollar-a-year tax increase on middle-class consumers.

May

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The Dollar Index suggests that the oil and gas exporters are devoting less and less of their excess prots to US assets since Bush launched the War on Terror and began to challenge Putins attempts to revive the Russian empire. The incredible shrinking US yield spread table will enter history. There will be weeping, wailing, gnashing of teeth and the era of ever-increasing private equity takeovers will end.
US Dollar Index January 1995 to May 2007
125 120 115 110 105 100 95 90 85 80 Jan-95 Jul-96 Jan-98 Jul-99 Jan-01 Jul-02 Jan-04 Jul-05 Jan-07

Conclusion
Treasurys became overvalued, in signicant part, because of steady investment ows from yield-insensitive investorsforced and otherwise. The Trust Funds net purchases of Treasurys continue to shrink and dollar-propping purchases from The Great Symbiosis may become more problematic. Such help as they receive from the vast OPEC and Russian oil and gas prots probably come because of nancial market currency-related arbitrage operations, not from direct purchases. (Russia and the Arab states may buy European bonds, but investment banks and hedge funds swap or switch a large measure of of the proceeds into higher-yielding Treasurys or other dollar-denominated instruments.) It will not be long before long-dated Treasurys will have to nd buyers based on their intrinsic investment merits. Whennot ifthe Dollar Index breaks 79, that will be a very tough sell. Once the US yield curve moves toward normalcy in response to rising US ination, the US bond market will move from placidity to turmoil. Credit spreads will widen as investors reassess liquidity risks; then it will not be long before some of the big private equity deals go sour, which will hit the junk bond market hard. The incredible shrinking US yield spread table will enter history. There will be weeping, wailing, gnashing of teethand the era of ever-increasing private equity takeovers will end.

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Basic Points
The Killings in Takeovers of Canadian Resources
We have been asked by several Canadian clients for clarication about our strong opposition to some of the takeovers of Canadian resource companies. This is our detailed response. (The opinions contained herein are those of Donald Coxe and do not necessarily represent the opinions of BMO Capital Markets.) The material is primarily for Canadian clients, but others who were forced to tender their Inco or Falconbridge shares, or who fear being forced to sell their oil sands holdings, should nd the analysis of interest. We opposed the takeovers of Inco and Falconbridge, and have for two years expressed strong concern that Big Oils Reserve Life Index problems would lead to takeovers of publicly-traded oil sands companies at unrealistically low pricesbecause they tend to trade in line with spot oil prices. Last September, we gave a speech to the 30th Annual Meeting of the Canadian Council of Chief Executives (whose membership includes the CEOs of Canadas biggest companies) in which we ridiculed the prices at which Inco and Falconbridge were sold and warned that takeovers of oil sands companies would probably be next. (We had a polite exchange of views with the Brazilian Ambassador about his governments holding in CVRD during the question period. He complained that I had characterized it as a government-controlled company whereas they had oated it publicly and only maintained a minority position. I replied that I was not criticizing Brazil, and certainly not CVRDs management, which is clearly rst class. Suppose some other major company looked at the new CVRD, and said, Theres a well-managed company that is the worlds #2 iron ore company, and that virtually stole the worlds #2 nickel company in a takeover, so I should acquire it. They couldnt: Your government holds the golden shares that preclude a takeover. There was no reciprocity in that deal.) We have received criticism from some clients for taking these stands. Youre a believer in free markets, and were a strong opponent of Trudeaus Foreign Investment Review Agencys policies. Why not let the market price those assets? Are we being hypocritical? Fair question.

golden shares ... preclude a takeover. There was no reciprocity in that deal.

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Here is why we were so vigorous in opposing the Inco and Falconbridge deals: 1. Inco and Falconbridge were sold, respectively, to a Brazilian-governmentcontrolled company and a company that had strong historical connections to Marc Richat less than six times earnings. (Mr. Rich, once Americas best-known alleged lawbreaker on the lam, was accused of dodging both US income taxes and US embargoes against trading with the USSR during the Cold War, and with Saddam Hussein thereafter. He was pardoned by Bill Clintonafter a $450,000 donation to the Clinton library by his exwife made, coincidentally, within days of Clintons exit from the White House. He has redeemed himself by passing management of his companies to successors, and with large-scale philanthropy in Israel. Nevertheless, his ideas about free markets and the duties of a citizen would not pass muster with the prim, proper and punctilious Adam Smith, who considered himself a professor of moral philosophynot an economistand who found time for research and writing because of his stipend as a collector of customs revenues.) As we said at the time, because Those who know it best, love it least, the consensus about metal prices for valuing the stocks was roughly $4 for nickel and $1.50 for copper. This was, to us, like valuing Manhattan apartments today based on their prices during the 1991 recession. 2. A year before the takeover bids from CVRD and Xstrata, Inco and Falconbridge (which had just merged with another Canadian giant, Noranda) had entered into a merger agreement that would have created a global powerhouse that could have fended off the likes of Xstrata. (This was precisely the strategy we recommended in Hard Rock Rocks, Basic Points, August, 2005.) The merger was approved by the requisite Canadian authorities and had the support of the companies unions. Anti-trust authorities in Brussels and Washington took more than eight months to analyze the deals. During that time, nickel and copper prices soared, as did the prots and stock prices of CVRD and Xstrata. Due to the unconscionable pettifogging and delaying tactics of bureaucrats in the EU and Washington, the merger of two companies whose operations were overwhelmingly within Canada was tied up, allowing foreign bidders to leap in with bids for each of the partners, killing the deal and sending control abroad at pathetically low prices. There have been widespread rumors that lobbyists in Brussels encouraged the Eurocrats to do what their class does best: stall. They did: they nally gave approval just in time for Xstratas lock-in deal with Brascan to expire. Xstrata had bought 19.9% of Falconbridge on August 15, 2005, at the then-market price. It was committed to pay Brascan whatever it paid above that price

...most Wall Street analysts failed investors by insisting that they should value those stocks based on $4 nickel and $1 copper.

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Basic Points
if it later bid for the rest of Falconbridge within the time of the lock-in. Soaring prices for nickel, copper and mining stocks meant that Brascan was in for a big payday. It never came. A major Canadian company, that had held Noranda shares for roughly two decades prior to the merger with Falconbridge, was another victim of the dark side of globalization: the EUs sympathy for European champions. The Free Market was put on hold until the European-based bidder was freed of its duty to pay the previous owner what it paid to everybody else. Should admirers of The Invisible Hand be putting their hands together to applaud the marriage of mumbling bureaucrats and slick takeover artists? 3. As the Pope observed recently, Faith must be tempered with Reason. Faith in Free Markets does not imply a blind devotion to the instant operation of a particular kind of instrument of open markets. When that instrument is deployed by a government-controlled company or by one that has issues about its control and no history whatever of participation in the Canadian economy, a reasonable, even Friedmanesque, analyst of markets would not succumb to dogmatism about unfettered markets from supporters of one of the bidders. As Scott Hand, CEO of Inco, told us after the battle was over, Once we were in play, arbitrageurs and hedge funds controlled nearly half our stock. They couldnt have cared less about our longer-term plans for shareholder value from our merger with Falco. We have learned how some activist hedge funds engaged in takeover battles have been able to acquire voting rights to large quantities of shares they never owned. Is the Free Market a system for creating wealth and jobs over the long term, or must it be permanently at risk to a few well-funded players lust for instant gratication? 4. Yes, BMOs investment banking division eventually backed Teck Comincos bid for Inco when stock market price action made it apparent that the endless Brussels Pout was killing the proposed merger with Falconbridge. But BMOs support of Teck Cominco was not the foundation of our opposition to those lowball bids from offshore bidders. We personally had no desire to be forced to pay capital gains taxes on a divestiture of our long-held Inco shares. With Falconbridge also on the way out, it meant we could not take the money we had after taxes and reinvest in comparable companies with comparable reserves in a politically-secure region. We would have been content to roll our Inco stock fully into Teck Cominco on a tax-free basis, but the hot money based in such conspicuous strongholds of mining excellence and high taxation as the Cayman Islands, Virgin Islands, and Channel Islands was demanding all-cash. What particularly bothered us was that what should have been an open-market contest was

...hot money based in such conspicuous strongholds of mining excellence and high taxation as the Cayman Islands

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Where else outside Venezuela can one nd 75 years of oil reserves?

being decided, in effect, by foreign bureaucracies who shouldnt have been parties. Only by the kind of intellectual contortions found among vexatious lawyers and over-reaching politicians and bureaucrats could there be justication for blocking this merger of two major Canadian companies with operations primarily in the same townSudbury. They had a record of a century of history in Canada, and were owners of an overwhelming percentage of Canadas total supply of irreplaceable nickel/copper assets. Could Canada expect to block mergers of ethanol producers within Brazil because they might drive up prices of some Canadian food products? Or would the EU let Canada block proposed mergers between German and Swiss machinery manufacturers because they just might raise machinery costs for Canadian manufacturers? As listeners to our Conference Calls are fully aware, we argued during the long struggles for Inco and Falconbridge that Canadian institutions should resist tendering their shares because there was no chance they could take the proceeds of those sales and buy comparable assets elsewhere. Apart from the former Soviet Gulag mines of Norilsk, or the Cuban nickel mines owned and developed by Freeport that were stolen by Castro (and then leased to a Canadian company), there are almost no nickel mines in the world that can be mentioned in the same breath with Sudbury or Voiseys Bay. Our long-standing focus on reserves in the ground colors how we view the prospect of takeover bids for the remaining publicly-traded producers in the Alberta oil sands. Where else outside Venezuela can one nd 75 years of oil reserves? And if you are offered a tempting price for Suncor or Canadian Oil Sands, where do you plan to reinvest those proceeds, assuming that you like the long-term outlook for oil? Virtually all publicly-traded oil and gas companies have reserve lives of less than 16 years, and most are in single digits if you apply political risk factors to the percentage of a companys production or reserves located in such notably investor-friendly democracies as Russia, Venezuela, Nigeria, Angola, or Venezuela. We take no overall stand on principle against takeovers of Canadian companies who do not have long-life mining or oil reserves, no matter how large those companies may be. For example, we have lost no sleep over the prospect of a takeover of BCE, which is a transactionalnot a resourcecompany. Indeed, the long-suffering stockholders of that company may have a claimon the grounds of compassionto be taken out of their misery.

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Basic Points
Nor do we oppose foreign takeovers of Canadian companies in principle. We focus on the question of ownership of reserves in the ground. If even such a marvelous Canadian tech success as Research In Motion were taken over by a foreign rm, we wouldnt emit a peep of protest. Nearly all tech companies have histories of acquisitions and deals, and the takeover and merger process in that dynamic industry is an expression of its own rootlessness and rapid growth. But for companies whose principal assets are non-renewable resources in Canada, we wonder why the self-styled small c conservatives who hymn the sanctity of free markets arent interested in the Constitutional implications of leaving any possible deal analysis to Investment Canada in Ottawa. At the moment, Ottawa seems beset by a fear of upsetting acolytes at the shrine of unfettered markets, who are apparently presumed to make up the overwhelming percentage of the population of Brussels, Brasilia, Berne, and Washington. Here is why we think shareholders of Inco and Falconbridge who, like us, didnt want to sell their shares, and Canadian taxpayers who beneted from owning dividend-paying shares qualifying for the dividend tax credit were not accorded the full protection the Canadian Constitution allots: Section 92(A) of Canadas Constitution Act of 1867 states: (1) In each province, the legislature may exclusively make laws in relation to: (a) (b) exploration for non-renewable natural resources in the province; development, conservation and management of non-renewable natural resources and forestry resources in the province, including laws in relation to the rate of primary production therefrom; and development, conservation and management of sites and facilities in the province for the generation and production of electrical energy.

Why was such a big percentage of the True Norths Strong legacy sold so Freely?

(c)

Why didnt the managements of Inco and Falconbridge suggest that the provincial governments should have been asked for their consent, before ownership of two of the three most valuable hard-rock assets in the Canadian Shield went abroad? Why was such a big percentage of the True Norths Strong legacy sold so Freely? The long-standing Canadian joke is that what most divides Canadians on almost any question is, Is this a federal or provincial responsibility?

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...any future bids for oil sands companies should be reviewed primarily by the Alberta government...

When the British Parliament took up (in 1867) the question of passing a Constitution for its frozen colonies in what it called British North America (at an evening session after debating the problem of stray dogs in London, which occasioned far more interest from the Honourable Members), the important attractions for the Mother Country were the new nations sheries, minerals, forests, and beaver pelts. London believed that the American Civil War had been fought largely over the division of economy-related powers between Washington and the states, so the British government, after consulting with Canadas Sir John A. Macdonald, was at pains to write rules that would let the widely-dispersed colonies economies grow. That meant giving control over natural resources to the provinces. If there had been a battle for control of the Sudbury copper operations a century ago, (nickel was then considered a nuisanceknown as Old Nicks Metalin the copper ore), the Ontario government would have been the primary adjudicator. In other words, we are talking of concepts that have been at the core of Canadas historyhowever inconvenient that history may be for residents of the village of Zug, Switzerland, which includes, inter alia, the management of Xstrata and Glencore, and Marc Rich. We have reproduced the relevant section of the Canadian Constitution in full, because it suggests to us that the bids for ownership of the unique and irreplaceable mineral reserves owned by Inco and Falconbridge should have been considered by both the bureaucracies and the requisite standing committees of the legislatures of Ontario, Manitoba, Newfoundland and Labrador for Inco, and Ontario and Quebec for Falconbridge. It also means to us that any future bids for oil sands companies should be reviewed primarily by the Alberta government, although Ottawa could also participate because the transaction would involve foreign trade. (In retrospect, it would have been amusing to have watched the managements of Phelps Dodge and CVRD dueling with Newfoundlands feisty premier, Danny Williams. If that had happened, Inco might still be a public company, its stock would have more than doubled, and they would still be arguing.) Would letting bureaucrats and MPPs stick their noses into the terms of a takeover not mean annoying delays? You betcha. Although perhaps not as long as it took Brussels and Washington to approve takeovers of companies whose total assets in the US and EU might be barely enough to purchase a few pricey pensions for Eurocrats, but whose assets within Canadian provinces would be worth todaybased on what has happened to prices of base metal and base metal stocks since last Septemberat least $90 billion.

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Basic Points
We told the CEOs at the Canadian Council of Chief Executives that they should consider advising the managers of their own companies pension funds that they would not be held accountable in performance measurement evaluations if they rejected foreign takeover bids for oil sands companies. We suggested that the large public plans, such as the CPP, Ontario Teachers and the Caisse should take their oil sands holdings out of their Marketable Canadian Equities accounts and put them into their private equity holdings, along with toll highways, infrastructure, water utilities and other long-term investments that are valued on a long-term rate of return basis, not according to stock market prices that are set primarily on the basis of spot prices for crude oil. With reserve lives for companies such as Suncor and Canadian Oil Sands running toward the end of this century or beyond, it makes little sense for major institutions with long-duration liabilities to be valuing those assets according to the stock markets current pas de deux with Fear or Greed. What does this imply for Alcoas takeover bid for Alcanwherein our rm is an advisor to the bidder? Since the bauxite and alumina come from far outside Canada, there is no issue of reserves in Canadian ground. The Quebec government, which has always been conscious of its Constitutional rights, had already built in the kinds of guarantees it wanted long before there was talk of any takeover. To us, it means that if Quebec and Ottawa sign off, then stockholders should be free to decide whether ownership of this great Canadian company goes south. As historians would point out, Alcan was a pre-Depression spinoff from Alcoa to comply with Canadian and US anti-trust concerns, so its not quite like Inco and Falconbridgetrue home brews. Putting it back together again might seem odd, but it has taken a lot more time than it took to start putting AT&T back together after the biggest anti-trust divestiture of all time.

New mining deposits are formed every billion years or so.

Conclusion
New companies are formed every day or so. New oil sands deposits are formed every hundred million years or so. New mining deposits are formed every billion years or so. Free markets in stocks are obviously desirable, but the history of stock markets is that the bigger they get, the more they get regulated.

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23

They both saw this as a question of sale of control of Canadian companies, not Canadian mineral deposits.

The rights to nd, claim and develop Canadian mineral deposits have been provincially regulated for 139 years; in addition, securities regulation is also a matter of provincial responsibility. Why then, is control on foreign acquisition of companies owning Canadian mineral resources a federal preserve even when it doesnt seem interested? Americans, it would seem, are much happier checking on the wording of their Constitution than are Canadians on theirs. Neither the Liberals under Paul Martin nor the Conservatives under Stephen Harper chose to intervene during Inco and Falconbridges long agonies. They both saw this as a question of sale of control of Canadian companies, not Canadian mineral deposits. If Ottawa had any clear Constitutional role, it should have been to demand that the EU and Washington either grant speedy review of what was really an internal Canadian affair (once Falconbridge sold off its Norwegian renery), or to indemnify Inco and Falconbridge against any claims against them by the EU or Washington if they had proceeded with their merger. Canada could have asserted that the egregious exterritorial interventions by those governments had the effect of protecting the market power of Putins national championNorilsk, so if they really cared about free markets they should be applauding the Inco-Falco merger. The Alberta oil sands are worth immeasurably more than all the nickel and copper in Sudbury, Raglan, Timmins, and Voiseys Bay. How will the Canadian business community and Canadian legislatures respond when Big Oil, facing big problems with its rapidly-shrinking Reserve Life Indices and rapidly-increasing political risks abroad, decides on taking a quick x in friendly little Alberta? Expect lots of talk about the sanctity of free markets. And, just maybe, some talk about the Canadian Constitution, future generations, and whether loss of control of the last mega-mineral assets is worth taking some time to consider. Last observation: Suppose some Gulf State investment funds decide to diversify away from low-yielding bonds and get together to buyat twice the quoted pricesa million acres of wheat and canola acreage in Saskatchewan and Manitoba, thereby giving (as churlish opponents might say) new meaning to the term Arable Land. Would Ottawa treat this as the free market in operation? Would those purists who ridicule anyone who has questioned the big mining takeovers treat this as the free market in operation?

24

May

Basic Points
As You Were Asking
Last months Basic Points drew a large response. Our decision to eliminate long-duration bonds from our Recommended Asset Mix evoked surprise. That was, of course, our intention: we deliberately went to zero to ensure that clients got the message that a bond bear market was coming: we just didnt know when. In meetings since then with clients in Toronto and Los Angeles, we encountered much curiosity and some strong opposition. Here are some of the questions and objections we have been hearing: 1. How can you switch from being a super-bull on bonds to being a super-bear in a month? Once we concluded that food price ination was inevitable, we found our visceral bond bullishness was no longer tenable. David Hackett Fischers The Great Wave, a work of archaeo-economics, traces consumer prices in Europe and, more recently, America, back to Renaissance times. He shows that if food and fuel prices change direction together on a sustained basis, ination or deation ensue. If one or the other moves alone, there may or may not be a sustained change in overall prices. Failure of the anchovy harvest off Peru in 1973, which triggered runaway grain prices, was an even greater contributor to global ination than the Yom Kippur War. We already have rising grain and meat prices. This years global carryover of feed grains in relation to consumption is the lowest on record, due primarily to rising meat consumption in China and India; the ethanol boom, which is being given exaggerated credit for high corn prices, merely exacerbates an already tight supply situation. Already, food prices have begun to rise, although meat prices still do not reect feed costs. The PPI for unprocessed foods is up more than 25% on the year. For the rst four months of this year, US food and fuel prices have also soared at an annualized rate of 25%. Even worse news may be on the way: we may have a plunge in production of many food crops because of the Colony Collapse Disorder that has been killing honey bees on unprecedented scalethe kind of extraordinary bad luck that 34 years ago wiped out the anchovies. Add ination of foods to ination of fuels and metals, and then add the fastdeveloping scarcity of skilled labor, and the main vectors of the 25 years of disination are either going or gone. Either central bankers will hang tough, which will be bond-bearish, or they will succumb to political pressure to ease upwhich would be even more bond-bearish.

...the main vectors of the 25 years of disination are either going or gone.

May

25

2. Why wont the Fed cut rates, given the weakening US economy? Mr. Bernanke has been spelling it out: he sees his job as primarily ghting ination, not stimulating the economy. With a Current Account decit of 7% of GDP, and the dollar in a sustained sinking spell, he needs to reassure foreign holders of US debt that he is not planning to debauch the currency to try to put the small remaining percentage of unemployed workers into jobs. If he cuts rates now, he would increase the ination pressures from the trade account. That is a recipe for a full-blown currency crisis. We doubt that the economic weakness is driven merely by the inverted yield curve: shortage of economically useful workers could be an even bigger constraint. GDP is output per worker, multiplied by the number of workers. Therefore, if the pool of available workers is shallow and small, economic growth will be constrained. Credit is still quite freely available. The erosion of the homes status as ATM is a highly-publicized concern, but unemployment remains at extremely low levels that have historically signaled a strongor even inationaryeconomy. At 4.5%, the US may be at full employment: 2.5% is frictional and the other 2% mostly fail the Woody Allen test80% of success is just showing up. Many members of that 2% contributed to the economy by their ability to access subprime loans, even though they were classed as Ninjasno income, no jobs and no assets. Now that New Century Financial and many of the other new-wave money gushers have gone bust, such people cannot get loans, so house prices continue to weaken. Regardless of pressure from Congress, the Fed is unlikely to revive the practice of large-scale lending to deadbeats. The Governor of the Bank of Canada has taken the novel step of slashing his forecast for future Canadian economic growth because of the coming shrinkage in the Canadian labor force due to the thirty-ve-year-long birth dearth. Already, the Canadian economy is becoming constrained by labor shortages. What began in the oil sands has spread across most of the land. Five provinces have established overseas immigration bureaus to attract workers and speed paperwork. The searches include Europe, South America and Asia particularly China and India. Meanwhile, at home, other Canadian skilled workers are being courted by Australian mining companies and Saudi Aramco. Watson Wyatt has a painful 20-20 vision for Canada: if economic growth averages 3% and productivity grows at 1.75%, Canada could face a shortage of 1.2 million workers by 2020.

Ninjasno income, no jobs and no assets.

26

May

Basic Points
In the US, the problem identied years ago by Tom Friedman of The New York Times is hitting homethe failure of public education to graduate enough trained workers. That shortage was masked during the 1990s by outsourcing and by productivity gains, but it is showing up now. The fall in productivity growth is doubly inationary: it means that the economy cannot grow as rapidly as heretofore without forcing prices higher, and it means that the marginal worker is like the marginal, somewhat antiquated machine that is the last to be put into service. Employers who hire now have trouble nding workers as skilled and as willing to work as those on staff. If they hire out of desperation, their costs will climb. The bond market blandly assumes that the Fed blandly assumes that ination is almost solely a demand-side phenomenon. Therefore, if the economy slows because of falling consumer spending, ination must fall. We believe that rising input costs will mean that the next wave of ination will be a supply-side phenomenon, just as the Reagan-Thatcher disination was primarily a supply-side process. Soaring feed grain prices have already begun to force producers of meat, eggs, dairy products and processed foods to raise their prices. As the CEO of Smitheld Foods said, in talking about the leap in corn prices, and promising his company wouldnt eat those increased costs, The meat industry hasnt got a price increase in 30 years. 3. Isnt the impact of the Birth Dearth a very long-range problem, and not a reason for taking investment action now? It has been seen as a very long-range problem for a very long time. However, for most of the OECD countries, the future is now. The US has managed to keep its fertility rate at the replacement level of 2.1 because of the sustained inux of Latinos. As long as Congress and the Administration cannot agree on what to do about illegal immigration, this fertility bonus will continue to be an American competitive advantage. Reproduction across the rest of the industrial world has been so far below replacement levels for so long that economic growth potential is permanently constrained. For a growing number of nations, the number of new entrants to the labor force no longer exceeds the number leaving the labor force through retirement or death. The fastest-growing age cohort across the OECD is now the over-85s. This is the age group that needs the maximum supply of personal assistance and health servicesthe kinds of jobs that ...the marginal worker is like the marginal, somewhat antiquated machine that is the last to be put into service.

May

27

Its payback time.

cannot be offshored. Who will be available to meet those needs? Whatever the psychic satisfactions from eldercare for some, pushing wheelchairs and assisting in personal hygiene are not widely considered cool careers. The population prole today is almost exactly reversed from the 1960s, which means the supply/demand ratio for personal service jobs can only worsen. That deteriorating demography will hold down demand-driven ination, but will mean rising cost pressures. The balance of power between management and labor, which has been in managements favor since Reagan red the air trafc controllers and Thatcher let the coal miners rot on strike is shifting back. Labor costs are roughly two-thirds of production costs. Workers are going to be scarcer, older, and more determined to get their share of a pie that they believe has been going mostly to fat cats. Its payback time. 4. You arent suggesting stagation, but you believe that ination will be severe enough to force major changes in the capital markets. Explain. Steins Law will eventually assert itself in the pricing of debt market risk. The continued narrowing of yield spreads cannot go on forever: it will soon stop and will reverse, in response tosome nancial perturbation, rising ination, a breakdown in the dollar, a recessionor all of the above. When spreads begin to widen and defaults begin to appear among those trillions in LBO bonds, the process will become self-reinforcing. Yes, we are talking of a longer-term process. Since 1981, the process of disination has been nearly continuous. It has been such a reliable process for so long that investors and businesspeople take it for granted. Virtually no North American management team has experience in managing in a sustained inationary environment. Every business school graduate of the past twenty-ve years learned, as an article of secular faith, the absolute necessity of just-in-time inventories. The great advantage of this new religion was that it became universally proved during a two-decade-long commodity bear market. The reward for virtuous management practices through lean inventories at a time of falling raw materials prices was that the companies best at running lean were the meanest competitors.

28

May

Basic Points
This article of faith has not been revisited during a time when commodity prices from oil to copper to aluminum to steel to corn to wheat to resins are in major bull markets. The most protable companies during the inationary 1970s had huge inventory protsbecause of carrying high inventories. But this commodity bull market has shown more staying power than the markets of the 1970s. Where are the companies who are winning from this boom by challenging Holy Writ? Keynes famously answered a criticism that he had changed his views by saying, The facts have changed. When facts change, how do you respond, sir? Where are the daring companies who change their strategies on the basis that commodity deation is yesterdays story? The US Inventory to Sales ratio keeps falling to new record lows, even with economic growth the slowest since the last recession. What we do see are companies which have been losing big by betting big against existing levels of commodity prices by selling forward as if the world of the 1980s were about to return. We see no companies who are chortling because they increased their inventoriesand thereby their prot margins. Nor, as supply squeezes spread from oil to nickel to scrap metal to manganese to platinum, do we see any companies chortling because they were able to keep their factories operating at out while some competitors were forced to cut production rates temporarily or pay ridiculous prices for immediate delivery of some necessary input. The heroes of the 1980s and 1990s in corporate America, such as Jack Welch, were famous for their ability to control costs, particularly inventory and personnel costs. Six Sigma and other such systems were recipes for virtually nonstop success during an era characterized by falling raw material prices, falling interest rates, soaring stock prices, and weak union power. Fire the bottom 10% every year! There are thousands more out there eager to work for you. One of Welchs rst major decisions was to sell off his commodity businesses. As he wrote in his biography, it was a great sale. His successor, Jeff Immelt, who struggles to maintain the GE mystique, could certainly use those unfashionable operations today. We expect that long-term interest rates will rise by at least 200 basis points by the end of this decade, in response to rising ination and continued central bank tightness. We expect that long-term interest rates will rise by at least 200 basis points by the end of this decade, in response to rising ination and continued central bank tightness.

May

29

That will mean the p/e ratio on the S&P will start to shrink, and will change the relative attractiveness of stock groups within the market. Historically, nancial stocks have been underperformers during a period of rising ination and rising interest rates. When ination re-enters the system, earnings of nancial companies tend to spread widely, depending on their funding and loan quality. Banks with booming prots from LBO and other junk lending will be absorbed by those who stuck with prudenceeven when it had become seriously unfashionable. Similarly, a return to inationary conditions will have a major impact on investment returns. There are almost no investment management organizations with experience in managing investment portfolios in an inationary environment. Summing up: if our views about rising ination, rising interest rates and rising commodities are accurate, the winning companies, the winning management teams and the winning investment strategies will be based on strategies that had been nearly totally discredited in every business school by 1989. That means the risksand the rewardsgoing forward will be much biggerfor those whose management policies arent caught in time warps.

...the risks and the rewards going forward will be much bigger for those whose management policies arent caught in time warps.

30

May

Basic Points
INVESTMENT RECOMMENDATIONS
1. Remain substantially overweight the base metal stocks. As we have been saying for four years, these are core investments and will continue to outperform almost all other stock market sectors. 2. Retain a strong position in the Alberta oil sands producing companies. They are unique assets, now that Hugo Chavez has, in effect, taken development of the only other major oil sands properties off the table for private sector companies. 3. Remain overweight the gold mining stocks and the gold ETF. When gold breaks through $700 the next time, it will be ready to challenge its alltime high. There are, unhappily, few senior producers who continue to grow low-cost unhedged reserves in politically secure regions. 4. Reduce exposure to banking and nancial stocks. Their main attraction now is dividend growth. Concentrate on the well-managed companies with a record of at least a decade of growing dividends faster than ination, with payout ratios of 50% or less. 5. Continue to build exposure to agribusiness. The leading stocks have run up so rapidly that many investors have become discouraged. The earnings outlook is more than strong enough to warrant stock purchases at these levels. There had never been two great grain price years in a row. Until now. The gains in wealth from feed grain production have only begun. The high returns farmers can earn on investment in high-priced inputsequipment, fertilizer, and seedshave also only begun. Stock and bond markets still ignore the potential for serious food-price ination because of bee Colony Collapse Disorder, which remains a Page 16 story. 6. Reduce bond exposure all three ways: portfolio weighting, duration and risk. When the Dollar Index breaks 79, accelerate your reduction in US Dollar exposure. 7. Continue to build exposure to Emerging Markets. They have two kinds of scarce commodities: workers and tradable commodities.

May

31

Basic Points
Babel in Bond-Land

June 15, 2007

Produced by BMO Financial Group Distributed by BMO Capital Markets

Basic Points
An Investment Journal
Donald G. M. Coxe
Global Portfolio Strategist, BMO Financial Group (312) 461-5365 e-mail: don.coxe@bmo.com

Research/Editing Production/ Distribution

Angela Trudeau e-mail: angela.trudeau@shaw.ca Anna Goduco (print orders and mailing lists) e-mail: basicpoints@bmo.com

Babel in Bond-Land

Overview
Two months ago, we reluctantly abandoned our quarter-century conviction that long bonds were a core investment that would continue to outperform short bonds and cashas they had for all rolling ve-year periods since Reagans election. We announced that a long-term bear market in bonds was coming. At the time we wrote, the overwhelming investment consensus was that the Feds next change in policy would be to cut rates. Disagreements were limited to how many cuts loomed within the next year. Our argument that the Fed was more likely to boost rates than cut them was greeted with widespread surprise. This month we update our analysis, reecting clients questions and suggestions. We remain of the view that our target for the next two years is, at minimum, a 200 bp increase in long Treasury yields, accompanied by a return toward normalcy in yield spreadsand in the supply of liquidity. As our model for analysis of the structural weaknesses in the US debt market, we have chosen the Tower of Babel. Each decade seems to produce its own form of collective nancial hubris that leads to a meltdown. In the 70s it was Third World bank loans; in the 80s it was portfolio insurance; in the 90s it was Collateralized Mortgage Obligations and Long-Term Capital Management. In this decade it is collateralized debt products that seek to make Risk disappear from cash markets into a tower inhabited by investment banks and hedge funds in which the shared language is algorithms. Like all past Babels, this one will, at some point, self-destruct. We are leaving our cautious Recommended Asset Mix unchanged.

June

Recommended Asset Allocation

American Portfolios

U.S. Pension Fund

Allocations 27 29 12 0 15 17 Change unch unch unch unch unch unch

Domestic Equities Foreign Equities Domestic Bonds Long-Duration Bonds Foreign Bonds Cash

Foreign Equity Allocations

Allocations 6 6 6 11 Change unch unch unch unch

European Equities Japanese and Asian Equities Canadian & Australian Equities Emerging Markets

Bond Durations
Years 4.25 4.50 4.75 Change unch unch unch

Global US Canada

June

Basic Points
Babel in Bond-Land
This story from Genesis has never failed to captivate students of human nature. In recent years, it has been the basis of a splendid novel by A.S. Byatt, and an Academy Award-winning lm directed by Alejandro Inarritu. Although hubris is at the core of the story, what distinguishes it from the Greek tradition is that the sinful action motivated by pride is a collective attempt to challenge Heaven through the use of technology, not an individual affront to the gods rooted in human fate. On the plain of Shinar, (todays Iraqi province of Kurdistan), fourth generation descendents of Noah became consumed with pride in their mastery of a new technology. They convinced themselves that bricks and mortarthe Big New Idea of the post-diluvian agecould be used to build us a city and a tower, whose top may reach unto Heaven, and let us make a name, lest we be scattered abroad upon the face of the whole earth. God considered this challenge, noting that Behold, the people is one, and they all have one languageand now nothing shall be restrained from them, which they have imagined to do. His response: Go to, let us go down, and there confound their language, that they may not understand one anothers speech. Thus were born the multitudinous languages of the world. (There are still some diehards who yearn for Esperantothat once-fashionable idea of returning to the linguistic unity of the pre-Babel world. Shaw was its most noted enthusiast, and his Estate still gets revenues to fund research toward a global language from the royalties on My Fair Lady.) The rise and fall of Babel is a useful model for appraising the characteristic nancial hubris of our timethe conception, birth, growth and metastasizing of complex over-the-counter risk-management instruments. Until recently, the pricing of corporate debt risk had been achieved through the dual systems of bank lending practices and open-market trading in bonds, short-term paper, and, more recently, futures. Since 1970, systemic risk within the nancial system had been priced primarily through the Eurodollar market, which was the rst global liquidity pool not directly related to a specic central banks open-market activities.

bricks and mortar the Big New Idea of the post-diluvian age...

June

...more and more products whose pricing became more and more opaque.

The spread between the rate on the front-month Eurodollar future and the front-month T-Bill future (the TED Spread) became the thermometer of the health of the global banking system. From 1976 through 1998, it never failed to climb sharply before a nancial crisis. It is, therefore an ominous sign that it has been climbing sharply in the past weekto its highest levels in years. To date, no other important risk indicators conrm its warning, but clients should be watching it. It has moved from 63 to 92; should it break through par, we would expect signs of stress for some major nancial institutions. What distinguishes this TED Bear is the collapse in T-Bill yields: three-month bills now offer a miserly 4.64%, a remarkable 61 bp under the fed funds rate. As long-Treasury yields skyrocketed, T-Bill rates fell, indicating a massive duration shift among largepresumably foreignholders. Because LIBOR rates did not climb, as they usually do during a TED crisis, this apparent TED perturbation, which is unaccompanied by a rise in gold and/or a fall in the dollar, may justify the tentative appraisal that Its different this time. The rst large-scale use of new kinds of instruments designed to ofoad risk was the so-called portfolio insurance of the 1980s. Over-condence in the efcacy of these products was that eras dening hubriswhich was punished in the Crash of 1987. Moores Law was the technological foundation of the hubristic evolution of the 1990s. As chips became progressively more powerful, and as algorithms became more sophisticated, and as more and more mathematics wizards migrated from universities and research institutes to Wall Street, investment banks began designing more and more products whose pricing became more and more opaque. Sell-side computers talked to buy-side computers, and their shared language fed the growing condence that risk could be protably managed outside the well-watched public markets. This was the growth of privately-nanced and priced markets at a time private equity was also growing rapidly. Occasional ameouts involving the new structures of that time, Structured Productssuch as the implosion of David Askins rm were barely noticed, as condence in geeks, nerds and PhDs continued to grow. (David, who is a personal friend, was one of the geniuses who built Drexel and the mortgage-backed bond market; that a hedge fund investing in mortgage products built by someone so brilliant, experienced, and honest could vaporize within hours was an early-warning sign of the limits of risk-ofoading into an ether produced by the output from investment bank computers.)

June

Basic Points
Then came Long-Term Capital Management. As we have remarked, that meltdown occurred due to a heretofore-unknown conditiona critical mass of Nobel economists. Unlike previous implosions, this collapse had momentous consequences for the nancial markets and the US economy. Rushing to save such prominent members of the Nobelity from the embarrassment of bankruptcy and huge lawsuits, Alan Greenspan helped orchestrate a Fed bailout that averted bankruptcy. To ensure the success of his rescue mission, he ooded the system with torrents of liquidity at a time when Nasdaq had already begun to levitate out of the Layer of Wild Enthusiasm into the Anoxic Idiocy Belt beyond. Those boomers who put Cisco into their 401(k)s when it was the worlds biggest market cap company have Sir Alan to thank. (He has doubtless been seriously thanked by his fellow famed economists.) This decade has seen a new kind of hubristhe transfer of nancial risk from publicly-traded bonds and loans to privately produced and priced instruments. Risk has been excreted from junk into Towers in the Sky through Credit Default Swaps, Collateralized Debt Obligations, and other nancial androids that multiply at unimaginable speed. Nor has their reproduction rate been constrained by anything so trivial as the volume of products they purport to insure: the face value of the derivatives that seem to absorb the risk (and necrotic odors) in corporate credits ranges, we are told, to somewhere between ten and twenty times the face value of the underlying junk. These spawn of the intermarriage of math wizards and computers oat up and mingle with each other somewhere in the Van Allen Belt above the two GreenwichesLondon and Connecticut. Alchemy this majestic is beyond the dreams of Medieval and Renaissance wizards. As for the scale of these acts of creation, they make Sarumans spawning of thousands of orcs look like mere childs play. The result of this removal of risk from cash markets is that, in this decade, the higher the quality of debt instruments, the worse has been their comparative rate of return to investors. Bad is Good; Terrible is Better. It is as if Zimbabwes dollar had become a store of value more esteemed than the greenback. (Perhaps that comparison helps to explain why the UN, in its latestand historically consistentdisplay of wisdom, has anointed Zimbabwe as the head of the Committee on Sustainable Development. We were impressed that the UN stood so rmly by its principles in that decision, and assume Mugabe got the nod over Castro because of questions about the Stalinistas health.)

It is as if Zimbabwes dollar had become a store of value more esteemed than the greenback.

June

...we hope that when one or more of this years crop of baby Babelists screams in death agonies, they will not be rescued la LTCM.

In the Wall Street replay of Babel, the best brains in London and New York unite to build sky-high towers whose value is set not by open markets, but by investment bankers and hedge funds, using their own electronic linguistics. Designing, creating and marketing new instruments, and tranches is a highmargin business for Bear Stearns and other Keepers of the Arcana. The hedge funds who buy these electronic creatures participate in a cost relationship in which the pricing is handled between famously good friends. The SEC has, of course, no authority to participate in those transactions and valuations. It consoles itself by multiplying the rules, regulations and procedures imposed on old-fashioned mutual fund managers, thereby driving up the cost of compliance so high that many medium-sized organizations are being forced into mergers. A huge rm that commits large-scale violations of the rules simply writes two checksone to the SEC and the other to its software suppliersand gets back to marketing its funds. While this micro-analysis of funds invested in publicly-traded securities marked-to-market under rigorous systems occupies the SEC, the multi-trillion-dollar swapping of swaps and other privately-valued instruments proceeds unfettered and unfazed. We are certainly not arguing that the hedge funds need to be tightly regulated. But we hope that when one or more of this years crop of baby Babelists screams in death agonies, they will not be rescued la LTCM. The Greenspan Put should have departed the Fed along with its eponym. Castles in the air exist, by their nature, in the eyes of beholders. The foundations of investment aero-edices are in the valuations of the tens of trillions worth of neo-assets. Moodys and the other rating services rate the Collateralized Debt Obligations and other exotica that are held by banks, mutual funds and other traditional institutions. These vehicles abound in the courtyards around the Tower. Their valuations depend on assumptions based on market performance over a few months or years. Long-Term Capital, we recall, had what John Meriwether and his Nobel partners claimed was the worlds greatest nancial data bank, containing minute-by-minute trading information on a world of asset classes. When it imploded, they defended themselves by saying that the Russian default was a high deviation event outside their historical data base. Their data, we would later learn, extended all the way back..to 1991.

June

Basic Points
The Nobelity saw no reason for including the unpleasantness of October 1987 in their merry machines. (Mr. Meriwether, the beneciary of the bailout, has been named, we are informed by the wise and witty Stephanie Pomboy, Man of the Year by an organization of hedge funds. Words ail us.) Long-Term Capital fell, in part, because it made a big bad bet on Russia. These days, those who make big bad bets on Russia may nd, to their surprise, that their lifespan no longer correlates to the actuarial tables. This latest attempt at Babelism will, like its predecessors, fail. The new nancial system that measures itself in the trillions of dollars disdains price discovery in major public markets, justifying its clandestine procedures and outsized prots by the genius of its participants and the power of its computing systems. The systemic risk that brought down Long-Term Capital Markets is now extravasated through the investment banks which daily spawn new risk-swallowing Pac-men. When will this new Babel totter? Already, the Bank Stock Index (BKX) is in a sustained Relative Strength bear market against the S&P:
Relative Strength of the Bank Index (BKX) versus the S&P 500 June 2006 to June 2007
-0.10 -0.15 -0.20 -0.25 -0.30 -0.35 -0.40 Jun-06 Aug-06 Oct-06 Dec-06 Feb-07 Apr-07 Jun-07

systemic risk... is now extravasated through the investment banks which daily spawn new risk-swallowing Pac-men.

June

Moreover, the bond bull market that began shortly after Reagans inauguration appears to have broken down decisively. When the yield on the Ten-Year Treasury broke through 5.1%, it broke the long downtrend line dating back to the Reagan era. this liquidity... seems to come not from central banks, but from nowhere. It will return there someday.
10-Year Treasury Bond Yield June 2006 to June 2007
5.3 5.1 4.9 4.7 4.5 4.3 Jun-06 Aug-06 Oct-06 Dec-06 Feb-07 Apr-07 Jun-07

Everyone believes we are awash in liquidity. But what does that term really mean? What has been growing at astounding rates is what we call Real, Effective Global Liquidity. This is frictionless money that ows effortlessly from highsavings areas to low-savings areas, across national and currency boundaries. This is money on screensnot in pockets. It is the product of the interaction of the creation of the euro as a currency pool the size of the Eurodollar pool, the bourgeoning foreign exchange reserves of Asia and OPEC, the rapid growth of what are called Sovereign Wealth Fundsgovernment-owned or managed funds that are not held within foreign exchange reserves, and the boundless growth of currency and interest-rate derivatives that absorb risk from cash markets. Yes, we are awash in liquidity. But, to the extent this liquidity is articially manufactured, it seems to come not from central banks, but from nowhere. It will return there someday. Here is now dawning another new day Into eternity this new day was born, Into eternity at night twill return. What may help speed its return is the onset of food-price ination.

June

Basic Points
So, Whats This Got To Do With the Price of Eggs?
Corn June 2004 to June 2007
450 400 350 300 250 200 150 Jun-04 Oct-04 Feb-05 Jun-05 Oct-05 Feb-06 Jun-06 Oct-06 Feb-07 Jun-07

Soybeans June 2004 to June 2007

1000 900 800 700 600 500 400 Jun-04 Oct-04 Feb-05 Jun-05 Oct-05 Feb-06 Jun-06 Oct-06 Feb-07 Jun-07

Wheat June 2004 to June 2007

600 550 500 450 400 350 300 250 Jun-04 Oct-04 Feb-05 Jun-05 Oct-05 Feb-06 Jun-06 Oct-06 Feb-07 Jun-07

June

the May PPI was issued... Raw foodstuffs were up 31.2%.

Egg prices in April were up 18% year-over-year. But they were a comparative bargain, as the total raw foodstuff PPI was up 26%. Fully processed food, however, which is what gets measured in CPI, (but is banned from the Core Index), was up merely 8%. Those numbers did not get chewed on by the Street. Indeed, some of the nations best-known economists stated that the April ination numbers were so benign that the Fed would be easing sooner, rather than later. As this was being written, the May PPI was issued. It was up 4.1% year-overyear, but, subtracting food and energy, it was up a barely-visible 1.6%. Consumer foods were up slightly more than in April at 8.5%. Raw foodstuffs were up 31.2%. Those of us with long memories recall that in the 1970s, it was raw foodstuffs that were the rst PPI component to soar at high double-digit rates, well before the CPI reached double-digits. April was the month that corn prices were the subjects of cover stories in two unlikely journalsFortune and Foreign Affairs. That corns price is as high as an elephants eye should not, in itself, attract lengthy coverage in the journals of record for boom and bust, and war and peace. The core theme of both articles was the threat of global food ination caused by American policies on ethanol. The only reason corn prices are high, say these Manhattan agriculturists, is the heavily-politicized program of promoting ethanol as a gasoline additive to reduce the nations dependency on oil. The Fortune and Foreign Affairs attacks on ethanol are part of the backlash against Washingtons focus on corn-based fuel. The winners from the ethanoboom have included, of course, Archer Daniels Midland, which pioneered both ethanol and the practice of politicizing it, and more than 70 locallyowned corn reneries. Already, roughly 20% of the nations corn output goes into gas tanks rather than into bovine, ovine, or porcine stomachs. The losers from this green energy enthusiasm have begun to protest. The losers arent just big businesses which rely on cheap grains. They include family farms, dairies, ranchers, and consumers. The American chicken industry, which is faced with huge cost increases, is heavily concentrated. However, although giants such as Smitheld dominate the pork industry, many family farms continue to market hogs. Many more produce milk. Corn at $4 a bushel is a challenge to a large swath of US agricultural operations. But what makes that challenge truly terrifying for many small-scale hog or milk producers is that corn in the next four years is priced well above $4. Worse: if all the ethanol reneries that are talked about actually get built, ethanol production in 2009 could be ten billion gallons, slightly more than double 2006 production.

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Basic Points
Back-to-back high grain prices have never occurred before: throughout history, when grain prices soared, it was a one-off event caused by bad weather in major growing regions. Now, the futures markets price in expensive corn, oats, soybeans and sorghum, while assuming that the weather will remain benign and the demand will continue to exceed supply. Result: a fast-spreading campaign to propagate the story that family farms, ranches dairies and consumers are being hurt by Washingtons ethanolprotecting tariffs and subsidy policies, which are leading to diversion of too much of the nations corn away from animal feed to biofuel. Nor is the opposition conned to the USA. For the rst time, there is now a global corn arbitrage out of Chicago. Indias National Egg Council is demanding that Delhi protect it from abuse of futures that has raised the costs of egg production by 70%. The Egg Council, which produces most of the nations eggs, has long bought corn from farmers by offering them such quantity of rupees as its bureaucrats and economists thought t. The Council was the dominant purchaser. Now, broadband has brought the Internet to farming villages and towns, and the Chicago Board of Trade website tells farmers what their crops are worth. Result: globalizationinduced ination that originates two blocks from where this piece is written. But ethanol is not the biggest story in grains. It is merely another example of well-intended government intervention based on outdated data. At the time ADM and the congressional delegations from Iowa, Illinois, Minnesota, Ohio and Missouri were urging that New York Times Thomas Friedmans demands that the nation nd substitutes for Arab and Iranian oil be met, nobody bothered to check the USDAs data on global feed grain consumption. What happened with meat, eggs and milk was what had happened with oil the assumption that those billions of people in China and India dont really matter much to us, except in terms of giving us cheap goods and services. That they could be raising our cost of living by driving up the cost of what we eat, and how we heatthats a bizarre idea. The tax-exempt boulevardiers of the International Energy Agency kept ignoring Chinas surging oil demands because China wasnt a member of the OECD, which meant consumers were shocked by $50 oil, and assumed there had to be a conspiracy. Naturally, nobody in power learned anything from that experience in bureaucratic obfuscation.

...globalizationinduced ination that originates two blocks from where this piece is written.

June

11

Here are extracts from the USDAs report on global production of grains and meats. If you look at the annual increases in meat and dairy production worldwide, you will see that they are growing more rapidly than oil: What BHPs Chip Goodyear calls the supercycle for energy and metals has been joined by a supercycle in grains.
Global Supply and Utilization of Grains April 2007
2000/01 2001/02 2002/03 2003/04 2004/05 2005/06 F 2006/07 F Wheat Production (metric tons) Consumption (metric tons) Ending stocks (metric tons) Coarse grains Production (metric tons) Consumption (metric tons) Ending stocks (metric tons) Oilseeds Production (metric tons) Ending stocks (metric tons)

Million units
581.5 583.9 206.5 862.3 884.4 210.1 314.0 39.5 2001 581.1 585.0 202.7 893.7 906.6 197.1 324.9 41.7 2002 139.3 59.2 395.0 567.6 603.8 166.6 875.1 902.3 169.9 330.0 48.1 2003 140.6 59.2 399.0 554.6 588.5 132.7 915.9 945.9 139.9 334.9 44.3 2004 144.1 60.8 406.1 628.6 610.0 151.2 1,014.0 975.9 178.0 381.2 56.8 2005 148.6 63.9 414.0 620.6 624.4 147.5 977.5 989.1 166.4 390.3 63.3 2006 P 153.3 64.9 423.3 593.1 619.3 121.2 966.7 1,014.5 118.6 402.9 67.4 2007F 158.1 66.0 432.2

Beef and Pork Production (metric tons) Broilers and Turkeys Production (metric tons) Dairy Milk production (metric tons)

133.2 57.1 384.8

Source: USDA Economic Research Service, Agricultural Outlook: Statistical Indicators, April 2007: http://www.ers.usda. gov/Publications/AgOutlook/AOTables/

Those numbers document the next phase of the bourgeoisation of China and India. Demographers estimate that about 40 million people-per-year enter the middle class in those countriesmeaning that they move into dwellings with indoor plumbing, electricity, and basic appliances, with expectations of owning cars. That powerful trend, as we have been writing since 2002, is the cause of $65 oil, $3.00 copper, and $18 nickel. What BHPs Chip Goodyear calls the supercycle for energy and metals has been joined by a supercycle in grains. The slow growth in demand in the OECD for oil and metals could have been easily accommodated at rockbottom Triple Waterfall Crash prices. Most Street economists, strategists and commodity analysts continued to project oil and metal demand the way they always hadbased on OECD statistics. As late as 2004, in the midst of a massive commodity boom, Sell recommendations came on base metal stocks whenever the Non-Farm Payroll number came in below forecasts. Some of the Streets big names tried to justify their hopelessly inaccurate forecasts by

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Basic Points
alleging conspiracies, and secret commodity reserves. Then they began to argue that Chinas economy was on the edge of a major slowdown or an outright crashwhich would send oil, copper and nickel back to their comfort zones ($30, $.85, and $3.50, respectively.) So we werent surprised when the same savants (1) failed to predict soaring grain prices, and then, (2) blamed them on ethanol. There probably arent enough hectares under cultivation in the world to supply the corn, soybeans, barley, sorghum, alfalfa, and oats needed for the livestock that will be needed to satisfy current Asian dietary demandseven without ethanol, and other grain and soybean-based biofuels. The next time you hear some economist or analyst blaming food ination on ethanol, ask him or her why the world now has the all-time low carryover of feed grains, soybeans and wheat in relation to consumption. Ethanol accounts for less than 10% of global corn production and isnt a factor in consumption of the other grainsor soybeans. We are denitely not fans of ethanol, because the assumptions underlying its efcacy arguments are, like so much of the analysis from leading global warmists, dubious. We certainly do not recommend the shares of ethanol producers. Ethanol, buoyed up by subsidies, and protected by tariffs, was a very protable product when corn was $2.50 or less and natural gas was $7 or less, and oil was over $65. An ethanol renerys costs are, basically, corn and natural gas. Everything else is trivial compared to those items. Ethanols crack spread means producers are, in effect, long gasoline and short corn and natural gas. Unlike some Canadian economists, we have never believed oil was likely to go to $100 in this decadeapart from a geopolitical event that closed the Strait of Hormuz or shut down Saudi production. On the other hand, disappointing weather in the US Midwest is a predictable event. Or, it should be. we werent surprised when the same savants (1) failed to predict soaring grain prices, and then, (2) blamed them on ethanol.

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Global Feed Need: Stormy Weather in the Midwest

One could assume, based on historical data, that there would be damaging weather in the corn belt at least once every decade, with a full-blown drought every 19 years. Other weather problems that have led to major yield reductions have included late frosts in Spring, lack of rainfall during pollination in July, floods, and early frosts in autumn. But the last time there was a crop failure or even a significant yield reduction in the nations midsection, George H.W. Bush was President and Bill Clinton was still known as Governor Clinton. As things stand now, there is a high probability that there will be a second Clinton Presidency before there will be a Midwest crop failure. We have been surprised to learn how many clients are surprised when we tell them of the fifteen-year winning streak. Global warmists have convinced an amazing number of people that the weather has gone amok. Any time there is a flood or hurricane or drought, some experts emerge to warn us that this disaster could have been predicted. We are to blame, because of the way we pump CO2 into the air. There will be a corn crop failure one of these years. Speculators have bet on a drought many more times than one has occurred. Current record prices for grains reflect the latest of these weather bets. Maybe theyll be right this time; maybe not. But someday a drought will come. And with it, disaster. We now know that when a major Midwest crop failure occurs, it will be the global food equivalent of an Al Qaeda bomb strike that shuts down Saudi Arabian oil production for months. The force of those shock waves would trigger food riots across the world and topple some precarious Third World governments. It will send food inflation to peaks not seen since 1974. In this years US growing season, the annual worry about a return of drought has been joined by wondering whether honeybee Colony Collapse Disorder (CCD) will seriously undermine production of fruits and vegetables. We have commented previously that alfalfa is the crop whose failure due to reduced bee pollination would have the greatest impact on food prices. Alfalfa is 100% insect-pollinated60% honeybee pollinated. It is also the

...when a major Midwest crop failure occurs, it will be the global food equivalent of an Al Qaeda bomb strike that shuts down Saudi Arabian oil production...

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Basic Points
backbone of pastures and hayelds across the land. In particular, it is crucial for dairy farmers. Without alfalfa, feeding the Holsteins and Guernseys corn and soybean meal would be ruinously expensive for most family farms. We are grateful for the correspondence we have received from several US and Canadian readers with agricultural backgrounds. They disagree with the USDA report on the importance of bees in pasturage and hay. They have pointed out that the honey bees importance in alfalfa pollination is a regional matter. Another bee species, the alfalfa leafcutter bee, is the prime pollinator in northern areas. Also, there are two markets for alfalfafor feed, as pasturage and hayand for seeds. Our readers points out that alfalfa is a perennial. Some also believe that if the seed crop fails, farmers can buy seed overseas. (CCD has been reported in nine countries there.) Both the CCD Report to Congress and USDA Impact of Pollinator report combined values for direct pollination of crops, such as almonds, apples or alfalfa seed, with those indirectly affected such as alfalfa for hay (needing seed for replanting). Particularly for alfalfa, crop impacts will be spread out across several years. The experts agree a signicant loss of honeybees will affect crop production levels and pollination costs, but predicting the scope of impacts, particularly economic impacts, is a source of considerable disagreement. We are pleased that alfalfa crops may not be at risk. While the cause of CCD remains a mystery and bee disappearance continues, this remains a known unknown for crop production in the US. We have, however, received conrmation from other readers that our bee fears are not misplaced. Some have suggested that the (mostly) American practice of transporting bees to many locations during the year may have overstressed the bees and made them prone to some autoimmune disease. Declining bee populations in the past 20 years, and monoculture farming have made this practice a necessity. Only 5% of American honey bees are kept in one location to produce honey: the other 95% are taken around the nation by lone beekeepers, who (presumably) drive in trucks with hives, a rie and a guitar in the back, and listen to country music. This rugged individualism helps explain why beekeepers never became entitled to a slick Washington lobby, or to a large, solicitous group of bureaucrats whose job was to ensure that they always got their share of the appropriations. Beekeepers are themselves endangered by CCD; Many beekeeping operations of the type who provide crop pollination services to farmers will be hard-pressed to ...lone beekeepers, who (presumably) drive in trucks with hives, a rie and a guitar in the back, and listen to country music.

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As wheat, corn and other grains soar to new highs...bond prices worldwide sink.

recover nancially from this malady, the latest of many expensive blows to their livestock in the past decade. This industry like so many is experiencing a demographic challengethe average age of beekeepers is approaching 55. Facing an unknown peril and years of expensive hive rebuilding costs, the concern is that many beekeepers may simply decide, like the bees, to leave the hives behind and move on, or retire. The new food ination is, to us, simply the next chapter in a story we have been telling each month for six years. The soaring New Asian Middle Classs appetite for oil gave the world $65 oil. Its appetite for electricity, indoor plumbing and air conditioners gave the world $3 copper. Its appetite for meat and dairy products has given us $4 corn and $8.30 soybeans. The ethanol campaign is part of an attempt to use biofuelscorn, soybeans, sugar, animal fats, wood chips, etc.to prevent oil prices from reaching $100. The articulate Thomas Friedman and his supporters have a strong case: sitting back and doing nothing about our dependence on oil virtually guarantees endless growth in cash ows for supporters of Islamic terror operations. President Ahmadinejad has proclaimed that his country is producing nuclear ssion and the clock has begun ticking on the destruction of Israel. Paying a little more for meat and milk to ensure that the clock ticks much longer than he expects is an attractive strategy. When the ethanol boom was starting to build momentum, everyone assumed corn would stay cheap and plenteous foreverjust as everybody who mattered gured oil and metal prices would stay low forever. To date, the marginal demand for corn for fuel has produced far greater grain price boosts than it has moderated demand for petroleum. This is another example of The Law of Unintended Effect. Not all their assumptions have been proved wrong: they assumed that Midwest growing weather would always be good. As wheat, corn and other grains soar to new highs, and 70% increases in pork prices drive Chinese CPI to 3.4%well above the upper limit of ination Beijing nds tolerablebond prices worldwide sink. The worst is yet to come.

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Basic Points
The Big Bad Bond Bear
We are on record as predicting that long US Treasury yields will reach at least 6.75% within two years. That surge in yields will not be enough to keep the greenback from falling to new lowsor to keep gold from reaching new highs. Last month, we suggested that four surpluses had undergirded the twentyve-year-long bond bull marketenergy, metals, food, and labor. The rst two surpluses had vanished by 2003. The food surplus vanished late last year. The labor surplus is already gone in many parts of the world. We believe that workers have entered a long-term period of growth in incomes and power after history-making union defeats at the hands of Thatcher and Reagan launched two decades of declining relative incomes and power. Last week, the Labor Departments announcement that Q1 unit labor costs had risen three times as fast as previously estimated was the big contributor to a 129 point Dow droop. Despite the major gains in oil and gas prices, energy has not created big ination pressuresas measured by CPI. Neither have the huge runups in base metal prices. In part, energys muted impact was due to the Katrina squeeze on natural gas, followed by a collapse, at a time oil prices were trading mostly in the $60 range. If natural gas prices should break out toward $10 this winter, the CPI will almost certainly reect energy ination. The best hope for food price ination is that it manages to stay in the high single-digit range. A big assist comes from the plunge in sugar prices: sugar is a food-price heavyweight because of its ubiquity in processed foods and beverages. With corn no longer in surplus, sugar might be able to regain at least some of the market share it lost to corn fructoseand thereby restrain some of the inationary impact of the boom in feed grains. Should sugar prices remain at these levels, the pressure on the US to admit Brazilian and Caribbean sugar-based ethanol will become so intense that even Senators

The best hope for food price in ation is that it manages to stay in the high single-digit range.

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The food price ination we shall soon be experiencing is unlike any predecessor, because it comes without a crop failure.

Grassley and Obama may not be able to hold back the tide. To date, the power of a Dominican Republic-based family has been able to keep US sugar prices far above global prices, thereby costing many thousands of jobs in the confectionery industry. We have been told by a person who attended one of the familys glittering social extravaganzas that the clans leader was one of only ve or six people who were privileged to reach President Clinton by phone almost without regard to his activity at the time. (Incidentally, Canada has been a big beneciary of this protectionism of a vested interest that benets a wealthy family and, incidentally, devastates the Everglades by draining the Parks water to produce sugar that could be purchased far cheaper abroad. Candy factories that had been prominent features of the economy in Chicago and Michigan for decades have been shuttered, because Canadian candy makers buy their sugar in the global free market, and then ship candy to US consumers. Even Chicagos powerful mayor Richard Daley wasnt able to break the sugar interests control of the leaders in the Democratic Party. Within the Republican Party, Bob Dole remains the spokesman for the Kansas sugar beet producers, but he needs the Florida Cubans to hold the party together in its sugar programs.) The food price ination we shall soon be experiencing is unlike any predecessor, because it comes without a crop failure. Therefore, once it arrives, it will not disappear as a result of a barn-bursting crop. At some point, it might even put pressure on the Core ination number. The sudden selloff in bonds has produced a ood of Street analysis. On at least one point the bulls are in agreement: bond yields are unaffected by any risk from food-price ination. In assessing that torrent of research, we see that the economists still talk about ination risk and Fed policy in terms of Corenot Nominalination. The Fed, we are told, continues to watch the Core Personal Consumption Expenditure reading as its guide. The bulls case was presented elegantly in the Lex column of the Financial Times on June 12th. The relationship between food prices and ination has been weakening for decades. In the late 1940s food accounted for 43% of the US consumer price index. By 1975, when food and oil shocks had pushed ination into double digits, it was down to a quarter and its weight in the basket is just 14 % now. The article concludes with a ne touch of sarcasm, Pricier cucumbers are unlikely to herald the return of stagation just yet.

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Basic Points
We have devoted so much of ourand our readerstime on foods for three reasons: 1. Falling or stable food prices were a pillar of the decades of disination that gave us the roaring bull markets of our time. The fall of even a small pillar in the Parthenon was always noticed with alarm. 2. Food and energy are commodities people buy every week, and their perceptions about ination are likely to change from benign to concerned when their basic essentials no longer behave benignly. We believe labor is going to have more power in the years and decades to come,(because of scarcity), so workers perceptions of economic reality may become, perhaps, more important than the views of those who delete food and fuels from their computations as sheer noise. 3. The downside of globalization is that we have global pricing of energy and basic food products, which means soaring demand abroad injects food and energy ination into the serene world of the OECD upper middle class. It also means that wage rates abroad must rise: Meat is 7% of Chinese CPI and pork is up 71%. That global wage arbitrage out of China that infuriates Lou Dobbs and delights bond buyers may not be as powerful in the future as it has been in the recent past. We believe overall labor costs will soon start to rise at rates that will register in both Core and Nominal CPI, but employers will doubtless absorb some of those cost increases before raising prices of their goods and services. Each day we read stories about labor shortages. Chicago Fed Governor Mike Moskow conrmed anecdotal evidence we had heard that many employers in this region are hoarding workers, fearing that if they lay them off, they may not be able to rehire them.

The bond bear has nally emerged from his den, drawn by the need for food.

Conclusion
The bond bear has nally emerged from his den, drawn by the need for food. He will become an increasing threat to the unwary.

June

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INVESTMENT ENVIRONMENT
The dening excesses of this era have permeated and polluted corporate and home mortgage debt. One of the laments in hedge fund circles has been the disappearance of volatility. The VIX Index, which measures the activity in put options in the Chicago Board Options Exchange, is a widely-accepted measure of equity volatility. Its placidity in recent years reects the lack of runaway Fear or Greed since Nasdaqs correction became Nasdaqs collapse.
VIX Index January 1990 to June 2007
50 45 40 35 30 25 20 15 10 5 0 Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06

Whenever the entire global nancial system reaches a point of inection after a lengthy continuum, it experiences a surge in volatility. Suddenly, the fundamental price relationships that had long existed between bonds and stocks, and between sectors in the stock market, are called into question, then abandoned, and, after a period of turmoil, a new equilibrium emerges. When Nasdaq peaked, plunged and went pfftt, the relative values of all other nancial assets changed. Although few noticed it, the new stock market leadership would be commoditiesthe group that had experienced the years of ecstasy and the decades of agony thereafter during the rst Triple Waterfall. The coming point of inection will not be equity-centered. The dening excesses of this era have permeated and polluted corporate and home mortgage debt. Therefore, the killing elds will be populated with xed income instruments. The tens of trillions of derivatives that have been absorbing the risks in the real nancial markets will surely undergo a population plunge that may recall the last years of the passenger pigeons and buffalosor perhaps, todays honey bees.

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Basic Points
This coming mass root canal without benet of anaesthetic will occur because ination re-emerged from its crypt. All relative pricings of assets are inationdependent. The greatest tribute to Thatcher and Reagans success in defeating the ination dragons comes monthly with the surveys of consumer expectations. They predicted double-digit ination in the Jimmy Carter era and were correctin both their forecasts about ination and their purging of the President who had ddled and lamented the national malaise while ination burned. In recent years consumers have been predicting 3% or less. The disappearance of the four kinds of excess inventories that suppressed ination for so long means that we are at risk of a true ination shock. First was energy, then metals, then food, and now workers. Meanwhile, the corporate sector worldwide still practices just-in-time inventory management. It is still chic to run lean inventories of raw materialsand staff. When there are no price-stabilizing inventories except the Strategic Petroleum Reserves, then food, fuel and metal prices are in continuous risk of supply side shocks. A few offshore oil workers are kidnapped by MEND, a drought occurs in Ukraine, Peruvian copper miners go on strikenone of these events would have had great pricing impact during the 1980s and 1990s, because there were such large supply overhangs. We agree that sustained ination cannot occur without excess monetary growth. Otherwise, sudden price shocks simply redistribute shares of GDP and prots without creating a new, consistent, high level of overall pricing. Although central bankers in the disination era practiced the faith in monetarism with the zeal of Spanish bishops during the Inquisition practicing their faith, they have in recent years become morehow shall we say? latitudinarian. The Fed no longer hymns the sanctity of monetarism. As for its putative devotion to the principles of Reagan, Volcker and Friedman, since Christmas it has been behaving more like the reformed Scrooge than his earlier version: M-2 has been growing at 7.4% and MZM 10%. The Private Equity rms could well be gloating, God bless us every one!

This coming mass root canal without benet of anaesthetic...

June

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Is the ECB politicized, or is it simply reveling in Pohl-axing?

As a condition of agreeing to the creation of the European Central Bank, the Bundesbank insisted that this replacement bank be assigned a benchmark monetary growth target4.5%. Karl Otto Pohl must be cursing himself for his naivete: the ECB has been above that target every month for six years, and recently it has been missing the mark (not, alas, the Deutschemark, any more) so egregiously that one can only assume the target has come to resemble the Holy Grail or the Ark of the Covenant: a sublime symbol of sacred belief that may not really exist: Euromoney is now growing at 10.4%, a mere 131% above the Bundesbank-imposed maximum growth rate. Is the ECB politicized, or is it simply reveling in Pohl-axing? Although global ination remains restrained, money supply growth keeps climbing in such newly-important nations as China and India, with recent expansion in the 20% range in both those economies. To date, global excess monetary growth, levered up through the Babel towers, has mostly been absorbed in asset ination. That energy and food prices have risen so smartly might give bondholders pause, but luckily all that money and all that leverage have gone into inating the prices goods that arent included in the Core ination indices. This new global ination is a copy of the globalization-induced ination the OECD has experienced from oil and metals: if it were not for the new middle class in China and India, oil would still be at $30 or so a barrel, copper would still be at $0.75 or so and nickel would still be at $4 or so. The wage arbitrage from China and India has held down OECD ination in nished goods and some services, whereas the commodity arbitrage has given us ination in just about everything that we buy that isnt measured in Core Ination. If nominal ination creeps into the Core and that form of ination increases by 1.5 %, then mid- and long-term interest rates would have to rise by at least that amount. In the case of Treasurys, we think yields will rise more than the CPI, because (1) Treasury yields have been so suppressed for so long (as discussed in last months issue), and (2) the dollar will be so weak that investors will demand a currency risk premium. As Treasury yields rise and the dollar falls, Risk will re-enter the nancial system, and the castles in the air will begin to crumble. Once that process begins to build momentum, it will not take long for the ingenious support systems of this latest Babel to commence eroding.

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Basic Points
Yield spreads, which have been compressed far past the point of absurdity, will return to normalcy. Among the victims will be holders of the vast debt issued by private equity rms to nance their acquisitions. As their appetites grew, and as the balance sheets of their subsidiaries weakened, the rms respondedby convincing the Street to reduce or virtually eliminate the restrictions in covenants on their debts! Thus were born the cov-lite loans, this eras version of the Third World loans that made so many global banks look at once piteous and ridiculous in the 1980s. These symptoms of money mania will be a system stress point that will give way. As those corporate debts begin to weaken and rot, substantial numbers of structured products that managed to package this eras new kinds of mortgagessubprimes, AltAs, and AltBswill already be getting marked down. The collapses and foreclosures that have already begun eroding the perceived quality of these Babel babies will mean widespread misery among the poor who thought they nally had their share of the American dream. Their misery will be unlikely to wound the Wall Street organizations that created and coined those temptations to personal disaster for the poor and uninformed. As for the cov-lite loans, their collapses could, perhaps, reduce the scale of some future birthday parties among the private equity super-rich. Fortunately, most of the world doesnt have cov-lite loans, subprime loans, altAs, or other such soft and hard nancial pornography. The global economy will not go into a tailspin. The really strong growth will continue to be in South and East Asia, which means commodity demand will remain high. Man doth not live by bad bonds alonebut by bread, meat, milk, oil, gas, coal, copper and aluminum. The kinds of stocks we have been recommending for so long will become even more relatively attractive as more and more corporate structured debt begins to emit odorsand stops remitting interest payments. The mining, oil and food production stocks we espouse areand will remainformidable cash generators. They still trade at a discount to the S&P. We think theyll be at even yield within three yearsbecause investors will pay more for their earnings, and because the S&Ps multiple will shrink by two points or so to reect higher ination and the unattractiveness of the dollar.

Fortunately, most of the world doesnt have cov-lite loans... or other such soft and hard nancial pornography.

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INVESTMENT RECOMMENDATIONS
1. Reduce overall portfolio exposure to bonds. The recent selloff has inicted serious technical damage on most global bond markets and is a sign of how powerful this bear could be. Within the bond portfolio, move to higher quality and shorter duration issues. Long term and low quality were the winning strategies of this decade. They have become the losing strategies. 2. Continue to build commodity stock exposure within equity portfolios. 3. The most attractive stock group now is companies which benet from food price inationsuch as meat packers and supermarketsand those who help farmers to boost outputs, including the feed and seed companies, and the farm machinery manufacturers. The least attractive in the food sector is the ethanol producers. Being permanently short corn is being under permanent stress. 4. Remain overweight the base metal producers. 5. Remain overweight the oil sands producers, and market weight the other oil producers. Remain overweight the reners and the offshore oil drillers. 6. Begin to build exposure to North American natural gas producers. We have not recommended exposure to gas stocks since Katrina, but now believe that gas could outperform oil next year. 7. Remain overweight gold and gold mining shares. Gold bugs sang so long that ination had come back that many investors nally got tired of waiting for their claims to come true. But it also took a long time for the cicadas to return; they are back. So is food ination. 8. The Canadian railways are beneciaries of rising demand for commodities, including potash, grains and coal. That leverage to the commodity story means they could well be better values than their highly-publicized US counterparts. 9. The stock market keeps postponing the inevitable correction. When it nally does come, it could be ugly, because it will be accompanied by signs of rising ination. Financial stocks are traditionally the most vulnerable to a correction caused by rising ination and rising interest rates.

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Basic Points
Amazing Graces; Debt Demons

July 10, 2007

Produced by BMO Financial Group Distributed by BMO Capital Markets

Basic Points
An Investment Journal
Donald G. M. Coxe
Global Portfolio Strategist, BMO Financial Group (312) 461-5365 e-mail: don.coxe@bmo.com

Research/Editing Production/ Distribution

Angela Trudeau e-mail: angela.trudeau@shaw.ca Anna Goduco (print orders and mailing lists) e-mail: basicpoints@bmo.com

Amazing Graces; Debt Demons

Overview
The performance of the bookends of the US nancial market is key to the global economy. At one end are the shares of companies producing the commodities whose performance is driven primarily by the surging growth of the new middle classes in the Third World, notably China and India. The appetites of these new bourgeoisie made the oil, base metal and agricultural stocks the brightest stars in the stock market galaxy. At the other endin full retreatare this eras dening debt instruments Collateralized Debt Obligations (CDOs) with their heavy inclusion of subprime mortgages, and the unsecured loans and debentures nancing the seemingly inexhaustible appetites of the new class of business baronsthe private equity giants, and the towering structures of credit derivatives tied to cash instruments. Historically, when food, fuel and metal stocks are soaring, excess global liquidity generates ination. Historically, when lower-quality debt is plummeting, global liquidity is contracting, thereby signaling deationand a stock market correction led by the Financials. This is todays version of the classic Wall Street clash between the Bull and the Bearwhich has historically been waged on the oor of the stock exchange. As if scripted, this time, it is subprime-strewn hedge funds operated by the investment bank with Bear in its name that focus investor attention on the excesses of the CDOs. In April, we changed our call on the outlook for inationfor the rst time since 1994. That meant a reversal of our view on the bond market, which ended our long-standing love affair with long bonds. This month, we look at the meaning of the performance of commodities and complex debt instrumentsthose two inversely correlated asset classes. We are leaving our Recommended Asset Mix unchanged.

July

Recommended Asset Allocation

American Portfolios

U.S. Pension Fund

Allocations 27 29 12 0 15 17 Change unch unch unch unch unch unch

Domestic Equities Foreign Equities Domestic Bonds Long-Duration Bonds Foreign Bonds Cash

Foreign Equity Allocations

Allocations 6 6 6 11 Change unch unch unch unch

European Equities Japanese and Asian Equities Canadian & Australian Equities Emerging Markets

Bond Durations
Years 4.25 4.50 4.75 Change unch unch unch

Global US Canada

July

Basic Points
Amazing Graces; Debt Demons
Volcker, Reagan and Thatcher proved that ination couldand wouldbe tamed. It ceased to be a crucial concern, distraction or nuisance to the key economic playersconsumers, businesspeople and investors. In epidemiological terms, by the mid-1990s it had become a marginal threat to the OECD economies: greater, of course, than smallpox, but probably less than polio. It took a long time before all three groups of ination-watchers became truly complacent, but by the millenniums end, few investors were spending much time scrutinizing economic reports on the wonders of the Incredible Shrinking Core Ination. Ination was of use mainly in predicting when the next Fed or ECB rate cut was coming. In April, we became full-blown bond bears and unreserved advocates of gold. The global fundamentals for ination had deteriorated. Consumers had been the rst group to stop worrying about ination, followed by businesspeople. Equity investors were soon joined by bond investors, who became born-again believers in inations demise. That secular religious conversion was tested in this decade when every central bank began raising rates with the fervor of the frightened. Bond investors chose to treat the quintupling of the fed funds rate as good news, and kept buying long-term bonds. Their faith was the driving force in the creation of an inverted yield curve. That they reacted so uncharacteristically to the Feds sustained tightening was, to Chairman Greenspan, a conundrum. He even mused aloud that bond investors must want to lose money. In terms of advice to the public, his own record during that period could be called a conundrum. After having warned bond investors that he meant business and that long rates were headed higher, he counseled homeowners to choose the bargains available in oating-rate mortgages and rely on the Fed to keep out ination. As the US home mortgage market continues its agonizing slide into crisis, the hardest-hit homeowners are those who took his advice and got teaser rate mortgages. All of them are suffering as they face the skyhigh rates demanded on resets, and many are being foreclosed.

...bond investors... became born-again believers in inations demise.

July

... rarely in the history of nancial markets have so many investors made so much money in so few stocks on such a sustained basis.

Prior to joining the Fed, Mr. Greenspan was a highly regarded economics consultant. Some of his former clients have told us that he was well-regarded for his ability to assemble disparate data coherently and present it impressively. He was known for having an amazing command of economic data. However, they said that, as a forecaster, his record was, at best, mediocre. Now that business organizations seeking his advice are paying him far higher fees, they should hope he will prove to be an opsimathsomeone who acquires learning late in life. As for the oating rate mortgagors facing foreclosure, they will get no second chance.

The Big Question

In recent weeks, we have visited institutional clients in Los Angeles, New York, and Greenwich. The issues concerning them at most meetings could be phrased thus: Will the interlocked US housing and mortgage crises amid rising bond yields due to food and fuel ination, have enough impact on the global economy to change our call that the commodity stocks should be the cornerstones of investment strategy? No. From 2001 to mid-2006, we had the freedom to urge heavy investment in commodity stocks without worrying about ination that would drive bond yields to painful levels, or a US housing-induced recession. It was a gratifying experience: rarely in the history of nancial markets have so many investors made so much money in so few stocks on such a sustained basis. As long as food prices remained non-inationary, and bond investors remained willing to buy long bonds even when their yields were below the fed funds rate, it looked as if the commodity bull markets would remain intact. Then another commodity class joined the bull run: foodstuffs. What convinced us this was the next great commodity investment opportunity was what we learned in India in November. That trip came on a leave of absence. The itinerary, driven by the desire to walk in the footsteps of my father and grandfather, turned out to be a classic Page Sixteen experience. I did not spend time on the Page One storyMumbai, Bangelore, et al. Instead, I toured rural Rajasthan and Uttar Pradesh, and

July

Basic Points
saw how two forces of globalizationthe introduction of world pricing of agricultural products with the advent of broadband in villages, and the introduction of modern farming techniques to the rural areaswere transforming the regions where 71% of the Indian population lives. What we saw in India was the fast-developing shortage of adequately-watered agricultural land and the fast-developing growth in use of modern agricultural inputs. We also saw the increasing consumption of animal protein in peoples diets. The image of Indians as scrawny vegetarians living lives of Gandhian asceticism remained in the founders portraits on all rupee notes, but was no longer a portrait of the bourgeoning middle and upper classes. Not for nothing was the countrys best-known capitalist, a scion of the Mittal family, named Lakshmi: Lakshmi is the goddess of wealth. The celebrations of the nations great holidayDiwaliwere those of a self-condent consumer society that had escaped from the rice and lentil era. India had joined China in the same historic force: the emergence of hundreds of millions of middle class consumers. What became inescapable as we traversed Northern India was the recognition that protein was joining energy and base metals in the global scarcity sweepstakes. Meat and dairy products were no longer restricted to a small minority in India (and China)and the global energy shortage had nally triggered US and European enthusiasm for biofuels. We had never included the grains in our investor market basket because they are renewable resources and were the commodity class whose large-scale hedging operations had created an opportunity to attract external speculative capitalwhich was the foundation of the Chicago Board of Trade and foreign grain exchanges. Our mantra, repeated seriatim in this publication and our Conference Calls, was Invest in unhedged reserves in the ground in politically secure areas of the world. However, there is barely enough arable land in the world to supply the feed grains, oilseeds, and wheat needed now, let alone for the hundreds of millions more consumers in China and India that will be competing for daily supplies of vegetable and animal protein in the next decade. It was clear that global food price ination was inevitable.

...protein was joining energy and base metals in the global scarcity sweepstakes.

July

Beauty in investment termslies in the eyes of the holder...

Since the Middle Ages, when food and fuel prices changed direction together, overall ination responded in spades. This was true when charcoal was the most important publicly-traded energy source, but remained true when petroleum took charge. (When only one of those basic components changed direction, overall price levels did not necessarily experience a sustained directional change.) These observations come from several books on economic history, but particularly from David Hackett Fischers The Great Wave. Last weeks FAO report on the outlook for soaring global food ination over the next decade merely served to conrm what we had already learned. We added one asset class to our commodity stock recommendationsagriculturalsand deleted one asset classlong bondsfrom our xed income recommendations. Three months ago, we changed our call on bonds and gold: we had been bullish on bonds in this publication for all but a few months since its inception, and had been neutral on gold, considering it useful portfolio insurance against a market plunge driven by runaway risk in the nancial system. After visiting India, we saw that gold was a consumer good that beneted from rising incomes there. To our surprise, India had become the worlds biggest gold-consuming nation. Indian brides who lacked land ownership wore their wedding dowries on their arms, and Indias gold purchases had grown to the level that they absorbed all central bank sales. So gold was yet another commodity whose pricingat the marginwas beneting from demand from the new middle class in Asia. But even with that change in our rating on gold, we did not take the next step of recommending an overweighting in gold and gold shares as ination hedges until April.

The Graces: And Now There Were Three

In aesthetic terms, we spent ve years praising two Graces. The India trip convinced us to complete the classic trio by adding foodstuffs. The Three Graces were daughters of ZeusEuphrosyne, Aglaea and Thalia, who represented Beauty, Mirth, and Good Cheer. We think these pleasant attributes are relevant in the stock selection process. Beautyin investment termslies in the eyes of the holder, and holders of the stocks in those charts could easily, were they modern Catullans, write odes to their beauty. Mirth lies in the number of times Oracles, having probed the entrails, proclaimed in the agora that the commodity bull market was over. Good Cheer has come so many times to those who added to their stock positions after the Oracles uttered their prophecies of impending doom, sending their acolytes rushing to the exits.
6 July

Basic Points
BHP Billiton (BHP: NYSE) January 2003 to July 2007
70 60 50 40 30 20 10 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

Rio Tinto (RTP: NYSE) January 2003 to July 2007

350 300 250 200 150 100 50 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

CVRD (RIO: NYSE) January 2003 to July 2007

50 45 40 35 30 25 20 15 10 5 0 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

July

Suncor (SU: NYSE) January 2003 to July 2007

100 90 80 70 60 50 40 30 20 10 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

Canadian Oil Sands Trust (COS.UN: TSX) January 2003 to July 2007
40 35 30 25 20 15 10 5 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

XTO Energy (XTO: NYSE) January 2003 to July 2007

65 55 45 35 25 15 5 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

July

Basic Points
Potash Corp. of Saskatchewan (POT: NYSE) January 2003 to July 2007
90 80 70 60 50 40 30 20 10 0 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

Mosaic (MOS: NYSE) October 2004 to July 2007

45 40 35 30 25 20 15 10 Oct-04 Mar-05 Aug-05 Jan-06 Jun-06 Nov-06 Apr-07

Monsanto (MON: NYSE) January 2003 to July 2007

80 70 60 50 40 30 20 10 0 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

July

Deere (DE: NYSE) January 2003 to July 2007

130 120 110 100 90 80 70 60 50 40 30 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

...once the grains joined oil in contangothe Three Graces were leading a dance that could well reach Bolero! frenzy.

Although the Three Graces have for millennia been portrayed dancing together in the nude, their stock market imitatorsoils, mines and grains have only occasionally been up and dancing at the same time. The oils were rst, then base metals joined in; the grains were nowhere to be seen until they had a great year in 2004, but then went into seclusion for two years. When they returned to the theatron, they took center stage. That the modern Graces frequently traded places as stars was advantageous to both investors and Oracles. Investors could prot splendidly from a Dionysiac phase for one commodity group, while making judicious forays into a group that was in the backgroundor even off stage. Oracles could burnish their tarnished reputations by pointing to a groups pullbackat least on relative strengtheven though another was soaring. But billions beneted from the fact that the grains did not enter a new longterm bull market contemporaneously with oil, copper, iron ore and nickel. Bad enough that electricity and fuel and metal costs were climbing dramatically, but for most people what really mattered was food costs. Food is what everyone buys at least weekly, which means it is the most forceful creator of inationary expectations. It is psychologically more important than oil because gasoline prices have such widely-varying sales taxesand because not everyone drives a car. Soaring food prices can arouse urban mobs and bring down governments. Once the grains joined the commodity bull marketand once the grains joined oil in contangothe Three Graces were leading a dance that could well reach Bolero! frenzy. (Example: spot corn trades at $3.48; December 08 corn is $3.95, and December 09 corn trades at $4.02.)

10

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Basic Points
Debt Demons
At the other bookend of the markets in this era were two new kinds of computerspawned debt instrumentsCollateralized Debt Obligations (CDOs), and the derivatives that drained risk from cash markets, transmuting them into a Babeltype tower of hubris that oated above the cash markets. (We discussed this process in last months Basic Points, Babel in Bond-Land.) They have been accompanied by an explosive growth in corporate debt used mostly to nance takeovers of publicly-traded companies, but also to nance the Vanity Fair lifestyles of the ostentatiously public superstars of private equity. Had Nero or Louis XVI lived to be sixty they would certainly have staged birthday parties on a scale beyond Stephen Schwarzmans fest, but this Lucullan Boomer has set the modern standard for sexagenarian celebration. As applied to complex computer-generated instruments , the term demon is used in a new book by Richard Bookstaber, cited in James Grants authoritative Interest Rate Observer (June 15). The word comes, like the Graces, from Greek mythology. According to the OED, a demon (daemon) was a being of a nature between gods and men, an inferior divinity, spirit, genius (including the souls or ghosts of deceased persons). Socrates claimed to be guided by an inward Oracle which his hemlock-proffering accusers claimed was a personal demon. Over the ensuing millennia, the meaning gradually evolved. The OED notes that in general, current usage it means an evil spirit. It is used in a more complex sense in the remarkable trio of fantasy novels published by Philip Pullman. Long-Term Capital Managements implosion is a salutary reminder, not only of the limitations of genius, but also of the hubristic faith in the ability to replace uncertainty about the investment future with certitude based on historical records. As such, the Nobelitys vast database was the digital equivalent of the souls or ghosts of deceased persons, who have, since time immemorial, been consulted by the living as guides to future events. Financial and economic models should be deemed instructive and suggestive, not conclusive. The fact that PhDs in physics and mathematics construct such models may lead the unwary to believe that the models predictive power has the force of science, not mere probability. Such certitude is based in hubris; since Homers time, people have learned that the punishment for hubris can be terrible. (Our former colleague, Justin Mamis, put it succinctly: The market will eventually do whatever is needed to infuriate the greatest number of participants.)

...the Nobelitys vast database was the digital equivalent of the souls or ghosts of deceased persons ...

July

11

...the subprime problem...was a bad news/good news story that justied new highs for the Dow and S&P.

What brought the mortgage bond bear from his cave was the large-scale failure of two models used by many investment banks and hedge funds: the rst predicted the range of probable defaults on subprime loans, and the second predicted the valuation, under a presumed range of conditions, of CDOs that included subprime and lower-quality loans, and high-grade loans. When two rather modestly-sized Bear Stearns hedge funds focused on CDOs got into rather immodestly-sized trouble, equity investors who had been growing complacent about the subprime debacle took notice. The Streets comfortable consensus had been that the subprime problem would continue to bedevil the housing market, and would slow economic growth, enabling the Fed to ease, and was not a source of systemic risk. In other words, this was a bad news/good news story that justied new highs for the Dow and S&P. The TED Spread was saying otherwise. It spiked as fears developed that the Bears problems might trigger systemic risk, but retreated when the hedge fund settlement terms were announced. It remains elevated, but not at crisis levels.
TED Spread July 2005 to July 2007
0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 Jul-05 Nov-05 Mar-06 Jul-06 Nov-06 Mar-07

[Note to readers: this chart is prepared by Mark Steele, Quantitative/ Technical Analyst for BMO Capital Markets. As we have explained on numerous occasions, the old-fashioned TED Spread that served us for three decades is no more: the Merc stopped issuing a Ninety-Day T-Bill Futures Contract which, when run with the Ninety-Day Eurodollar Futures Contract, gave the Spread. This is a spot Spread, which is useful for directionality, but its precise readings do not correlate perfectly with the historic spread.]

12

July

Basic Points
Bear Stearns stock has been underperforming Financials generallywhich have been in a bear market on Relative Strength.
Bear Stearns (BSC: NYSE} January 2007 to July 2007
175 170 165 160 155 150 145 140 135 Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07 Jul-07

What would happen when somebody actually tried to peddle this gallimaufry of goods for the gullible?

Two Bear-sponsored hedge funds were involved: the High-Grade Structured Credit Strategies Fund that was focused on supposedly higher-quality packages of CDOs, and the High-Grade Structured Credit Leverage Fund that included heavy weightings of subprimesand heavy leverage. All CDOs involve complex layering of loans of varying credit quality. The most respectable of these elegantly crafted amalgams are given AAA ratings by the bond rating services, despite the inclusion of product so strongly scented that the Street calls it toxic waste. Leverage, the testosterone of the hedge fund Bull, smote the Bear. During the long bull market for bonds and stocks, outperformance of most hedge funds compared with First Quartile long-only investors came mostly from leverage. Get it mostly right, and then magnify the impact of your genius by leveraging to the hilt. The problems arise when something not anticipated within the supposedly bulletproof structure occurs. Macbeth, it will be recalled, took on Macduff in a duel to the death, taunting him with the promise given by the witches that no man of woman born could defeat him. Macduff shouted back that he had been from his mothers womb untimely rippedand Macbeth, realized too late, the aw in his hubristic battle plan. When the Bearbabies began to bleed, and investors rushed to redeem their holdings, the bank began to scramble. Merrill Lynch, one of the outside lenders, announced it was going to liquidate its positions, and the fund managers were faced with a ghastly prospect: the valuations used for the funds were based on models, not transactions. What would happen when somebody actually tried to peddle this gallimaufry of goods for the gullible? Not only would Merrill then come to the Bear for the difference, but
July 13

...a conuence of market conditions offered aggressive acquirers success on majestic scale... Result: Mutual Bliss.

all the other holders would nd that the actual market value of their funds was well below what the bland Bearpersons had claimed, which would lead to unpleasant demands and vengeful litigation. The well-known investment dilemma, Well that certainly looks OK, but just whom do you expect to sell it to? was debated in the days of increasingly acrimonious meetings between the fund managers, investors and creditors. Result: the Bear pledged up to $3.5 billion to avoid immediate distress sales. There is little reason to believe that the Bear products were of especially dubious quality compared to hundreds of billions of dollars worth of other CDOs and other exotica that still reside in investment-grade portfolios around the world. Stories that subprime packages for immediate sale have gone at 40% haircuts began to circulate. The Bond Babel Tower has begun to sway. Meanwhile, another class of investors in low-class debt is showing signs of creeping caution. The private equity (PE) boom in this decade has been the other conspicuous credit consumer. The PE people discovered soon after stock markets stabilized in 2002 that a conuence of market conditions offered aggressive acquirers success on majestic scale: 1. Treasury yields were remarkably low, which meant that 2. Bond managers, including pension and mutual funds, worried that their asset class was offering such pitiful returns that investors might take their money out of dull bonds, but meanwhile 3. Junk bond defaults had been shrinking steadily, and 4. Since the decade began, bond performance had become quality-inverse: starting with the lowest grade of junk, returns climbed from bottom to top, with Treasurys being the most insipid performers of all. They that are last had become rst. Besides 5. These big PE rms had compiled very low default records over the last 15 years, and they kept coming to a highly-liquid market with new debt offerings in record-breaking volumes. The best-performing bond investors were proting from LBO paper, as the conviction grew that KKR et al. wouldnt let their companies go bust. So there was no longer any need for covenants that would constrain these fabulous performers from continuing to reward both themselves and their loyal lenders. Result: Mutual Bliss.

14

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Basic Points
The sky became the limit for the amount of money investors were willing to give PE investors in subordinated paper and collateralized bank loans, so there was no apparent limit on the market capitalization of mid-cap companies waiting to be removed from the nuisances of Sarbanes-Oxley, and the constraints on management vision from quarterly earnings reporting. The most obvious effect of the torrent of privatizations was on the S&P 400. Mid-Cap Mutual Funds were the prime beneciaries of the buyout binge, as stocks in their portfolios were acquired at large markups. Meanwhile, LargeCap Funds performance languished. The pre-eminent industrial Big-Cap GEwas a pre-eminent disappointment, as was the pre-eminent Big-Cap bankCitigroup.
General Electric (GE: NYSE) January 2001 to July 2007
55 50 45 40 35 30 25 20 Jan-01 Sep-01 May-02 Jan-03 Sep-03 May-04 Jan-05 Sep-05 May-06 Jan-07

The sky became the limit...

Citigroup (C: NYSE) January 2001 to July 2007

60 55 50 45 40 35 30 25 20 Jan-01 Sep-01 May-02 Jan-03 Sep-03 May-04 Jan-05 Sep-05 May-06 Jan-07

July

15

To the operations managers seeking to maintain... capital spending: jam tomorrow maybe but no jam today.

As the decade wore on, and as the supply of underleveraged small and midcap success stories with strong managements and good cash ow growth began to dwindle, the p/es on small and mid-cap companies relative to largecaps reached near-record proportions. Strategist after strategist pointed out that disparity, and the short interest on the Russell 2000 soared. Moreover, the mid-caps as a group were gradually developing what might be called Inverse Survivorship Bias. Hedge funds collective investment performance has long been tainted by Survivorship Bias, because the investment returns delivered by underachievers who left the business dont get included in industry return statistics. Collectively, the mid-caps who remain public (apart from the commodity producers) probably have lesser investment merit than those acquired by the PE companies, who can be presumed to be great stock selectors. Meanwhile, another trend was emerging. US business capital spending was not sharing in the otherwise strong economic recovery. As each new year dawned, forecasters assured us that the long overdue recovery in capex is coming this year. Various reasons for the failure of the dog to bark were adduced, such as Chinese competition, and disappointment with George Bush. Nobody pointed out the obvious. Companies with strong balance sheets and established managements are absorbed by PE giants who are trying to monitor fast-growing portfolios of stocks in many industries with operations in most of the world. Their new owners views of those companies are subject to switches in time horizons for exits as equity markets change. The acquired companies once had modest debtloads which were incurred primarily for capital spending. Now they have debtloads many times their cash ow nancing payouts to the ownerswith nothing to show for those payouts but the debts. Instead of managing for growth, the companies have to be managed for servicing the debts. The capex budgets are the most obvious candidate for cuts: maintenance yes, growth maybe. To the operations managers seeking to maintain the companies historic growth in capital spending: jam tomorrowmaybebut no jam today. Day after day after day Remember that the best of the small and mid-size non-nancial American companies have been responsible for a disproportionate share of American economic growth. That means they have probably been responsible for a disproportionate share of American productivity gains. Result: It is hard to imagine that American productivity growth in the future will be as strong as in the relatively recent past. The days when brilliant managers such Henry Kravis, Stephen Schwarzman, Pete Peterson and

16

July

Basic Points
their top-ight brethren could be deeply involved in improving the operating capabilities of their stable of companies are history. Now they are out fund-raisingor even going publicand are engaged in bidding wars with other PEs for publicly-traded companies. Time was that the PEs planned on holding their investments for many years. Although most of their takeovers still start out that way, all it takes is a bull market to push the owners to the exits. Now, the actual term of a typical round trip is somewhere between a one-night stand and the run of a Broadway musical that manages to break even. Time was that their stables were compact and the range of industries they followed was relatively constrained. Now they acquire companies at breathtaking speed and have even been buying chip companies. Among the rst such acquisitions was Freescale. Which leads to a story. I was ying out of OHare last December; United Airlines announced a gate change which necessitated a lengthy walk to another concourse. A young man had been seated nearby and we walked briskly together. I introduced myself, including my corporate identication, and he reciprocated. He was with Freescale, the semi-conductor company whose acquisition by a PE rm had been announced only days previously. I said, casually, You must have been pleased with the price you got for your stock. He answered enthusiastically, Surprised! We were shocked! We know this is a business that if you get two good years, youve got a down year coming. Good call. In April, Freescale reported Q1 sales down 12%. In May it was announced: Texas semiconductor manufacturer Freescale is cutting jobs across the company as part of a strategy to reduce costs during a sluggish year. In May, S&P published a melancholy review of the nancial status of corporate America. M&A has contributed to the deterioration in credit quality, they report. The median issuer rating is currently BBB- compared with BBB+ at the end of 1996. Non-nancial corporation rating totals now, as compared to 1996:
Risk Category AAA A BBB B CCC and under 1996 24 406 480 408 22 Now 7 278 548 887 63

Now, the actual term of a typical [PE] round trip is somewhere between a one-night stand and the run of a Broadway musical...

July

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this takeover era... has manic qualities that recall two earlier eras.

A decade that ended with American stocks at dramatically higher prices, less than one year of recession, and the lowest average interest rates in four decades produced this sustained degradation in the balance sheets of corporate America. For years, the Business Round Table and other big business organizations have routinely lambasted Washington for the increase in the US national debt, warning that such debt buildup imperiled the outlook for future generations. Why beholdest thou the mote that is in thy brothers eye, but considerest not the beam in thine own eye? (Matthew 7:3) Although this takeover era is unique because of the huge role played by private equity, it has manic qualities that recall two earlier eras. The LBO boom of the 1980s was pioneered by Michael Milken through his brilliantly successful Drexel, Burnham, which virtually created junk bonds as a signicant investment vehicle. He was charged by Rudy Giuliani (the headline-seeking Eliot Spitzer of his time) with 98 counts of racketeering and fraud, and pleaded guilty to six felonies. He served only 22 months of a ten-year jail sentence and re-emerged, still a billionaire, as a philanthropist. We know few people who think he was treated fairly, and many who hold him in high regard. The only offences to which he pleaded guilty that might have been worthy of prosecutorial zeal arose from his dealings with Ivan Boeskyinsider trading and tax fraud. Drexels collapse cast a pall over junk bonds for years. We also remember, because we came into the business just as it was ending, the conglomerate boom of the 1960s, which was a big enough story to knock Vietnam off the front page from time to time. The glamour stocks then were Gulf+Western Industries, Beatrice Foods and their brethren. They discovered a sure-re formula for gaming the Street. If they could get a higherthan-market p/e through creative accounting and open, active courtship of the Street, they could grow their earnings endlessly by buying up low p/e companies with low price-to-book ratios, using either stock, or cash or both. The key was synergy. Before Moores Law became a stock market concept, 2+2+5 was the formula for great stock performance. Jimmy Ling built LingTemco-Vought into a major corporation, starting with aerospace and moving on to control of a few dozen companies in a bewildering array of industries, including meatpacking, sporting goods, and drugs. (Does this, by any chance, sound familiar?) He and the others justied their nancial engineering by arguing that the diverse companies basically ran their own affairs.

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Basic Points
Central ofce managed a few functions, including accounting, investor relations, legal, and capital budgeting. The conglomerators were beginning to challenge the entire structure of American industry before they overreached, some of their most misleading accounting was exposed, and they crashed. What triggered Lings fall (if we recollect correctly) was the purchase of Jones & Laughlin Steel, which was dirt cheap on a price-to-book basis but was in reality a pathetic, decrepit case of Rust Belt senility mixed with elephantiasis. Although KKR, Carlyle, Blackstone, Onex, Edgestone and other well-established PE success stories will doubtless prosper and survive the end of the latest conglomeration mania, too many PE rms have been spawned in this cycle, and serious attrition is inevitable. It has long been understood that whenever the growth in the population of lions and cheetahs outruns the growth in the population of wildebeeste and zebras, the feline population falls.

...whenever the growth in the population of lions and cheetahs outruns the growth in the population of wildebeeste and zebras, the feline population falls.

InationIf You Dare Call It ThatReturns

All three key industrial commodity asset classes are now in inationary mode. (Precious metals are, as noted earlier, ordinarily classied separately as stores of value.) This was not the case between 1981 and 2006. Oil prices mostly languished, but shot up when there was large-scale shooting and bombing in the Gulf; base metal prices mostly languished, but shot up during booming economic times if prolonged strikes occurred or, on occasion, when somebody tried to corner a metal market. Grain prices mostly languished, but shot up when shoots of grain werent shooting up because of droughts or oods. The only enduring effect of those brief boomlets was to conrm commodities bad reputations with central bankers and economists. Better to ignore such temporary annoyances entirely than include them in the published ination numbers that form central bankers scorecards, and the comparisons between predicted and actual ination numbers that form economists scorecards. As everyone except gold bugs knew, each temporary unpleasantnesses would always be succeeded by prolonged periods of commodity price weakness. But what is now occurring is different.

July

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Bond investors serenity has been interrupted:

US 10-Year Treasury Note Yield January 2007 to July 2007

The last time prices of all three commodity groups were rising far faster than overall ination levels was during the most recent Dark Ages, otherwise known as the Seventies.

5.3 5.1 4.9 4.7 4.5 4.3 Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07 Jul-07

The last time prices of all three commodity groups were rising far faster than overall ination levels was during the most recent Dark Ages, otherwise known as the Seventies. (Not only were they Dark because of stagationary recessions, wildly erratic markets, and a growing pessimism that democracies could survive the Communist challenge, they were also a periodlike the early Middle Agesof global cooling, which caused a wide range of agricultural disasters. In 1978, the US Secretary of Agriculture said that a panel of leading scientists had conrmed that crop failures caused by late spring and early autumn frosts could be a major global problem because the evidence suggested the world was entering a new Ice Age.) The mere suggestion that anything even faintly resembling Seventies-style food and fuel ination could be on the horizon is dangerous heresy in some quarters. Thus, when, after so many years, we switched from the disination camp to the ination camp based on the threat of commodity-driven ination, we drew some ak. Some critics argued that our concerns with food ination were overblown. Foods and fuels arent included in the Core CPI or in the Feds favorite ination indicator, Core Personal Consumption Expenditures. Foods and fuels are too volatile to inuence either central bank policies or investorsas shown by the failure of ination-hedged bonds (known as TIPs or RRBs) to outperform nominal government bonds. Besides, food is just 14% of US CPI and it would take unbelievable rates of food ination to offset the deationary impact on Imputed Rent from plunging house prices. Those are certainly soundif somewhat technicalarguments.

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Basic Points
Having noted the experts point that food/fuel ination is not worth discussion in informed circles, we merely note en passant that US Raw Food PPI in May was up 31.2% year-over-year, and oil is staying stubbornly above $70. We came into this business in 1972, and recall that it was Raw Food ination that kicked off the runaway ination of that era. Perhaps its different this time. There is, however, at least one other shard of evidence that money could be losing its value: Barbra Streisand priced her European tour tickets north of $1,000. Core ination was, (as we recall), the great gift to economics and public policy of Arthur Burns, a Nixon appointee who served as Fed Chairman from 1970 to 1978. The Nixon era was certainly no high point in American public life, but it is particularly memorable for its ination. Nixon closed the gold window in 1971 and proclaimed, We are all Keynesians now. What ensued was, naturally, ination at rates that would have appalled Keynes. (Nixon was followed by the accidental President, the likable, inept Gerald Ford, and then by a President whose performance in so many areasincluding inationmade his predecessors look at times like reincarnations of Washington and Madison.) The Economist recently weighed into this debate about Nominal vs. Core ination, and that wise and witty journal took the view that central bankers risk losing their public credibility if they take refuge in a price mechanism that ignores such highly visible day-to-day expenditures. Well buy that. Bernanke and his brethren surely understand that if the populace at large assumesin its ignorancethat ination is coming back, then people will alter their behavior in ways deleterious to sound economic growth. Hoarding will replace just-in-time inventories; public sector unions will go back to issuing high wage demands and restoration of socially acceptable working conditions, aka featherbedding. Ination is two parts statistics of past price increases and one part fears about future price increases. Fears can be irrational, of course, but if twice-weekly visits to food stores in the family car keep costing more than they did the week before, it could be tough for central bankers to turn off that long-unused fear mechanism. In other words, ination could be too important to be left to the economists.

...ination could be too important to be left to the economists.

July

21

Treasurys as Havens
Since the yield on the 10-year startled statisticians by breaking a two-decadelong descent line, Treasury yields have retreated by a quarter-point. Stock markets worldwide, which still behave as if they will use almost any excuse to climb higher, responded to this rally in their characteristic fashion. A man predisposed to drinking might, upon hearing that a buddy he was planning to go out drinking with has been hospitalized, immediately pour himself a stiff drink and toast his friends health; if he shortly thereafter learned that his friend had died, he would surely pour himself another in memory of his friend. We note this behavior because our switch from bond bullishness to bond bearishness was not just a prediction that long Treasury yields were heading toward 7%: we also predicted a return toward normalcy in yield spreads. In other words, what we described as the true mania of this decade was in the bondnot the stockmarkets. The collapse of risk spreads in the cash debt markets has been the dening folly of this decade. (Elegant computerdesigned derivatives have become a virtual catch-all for risk in most publiclytraded debt markets; we are old-fashioned enough to believe that risk can be masked, reassigned or cosmetically-coated, but not eliminated.) All manias are rooted in the collective abandonment of rational risk appraisal. In the 1970s, investorsand big oil companiesbought base metal companies and properties at outlandish multiples as ination hedges. They were then shocked to nd that the double-digit yields produced by ination also produced recessions, which meant demand for metals other than precious metals slumped. Then came the disinationary 1980s, by which time the collapse in birth rates in the OECD was beginning to show up in a slow down in growth in metal demand. The oil companies exited from the mining business after embarrassing writedowns on memorable scale. In the 1980s, Japanese bank stocks kept soaring, even though the banks were effectively making no money on their corporate lending and their book of bad loans was rising sharply. The argument was that their vast holdings of stocks and real estate made them high-value ways to participate in the endless

Elegant computer-designed derivatives have become a virtual catch-all for risk...

22

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Basic Points
Japanese boom. Then the endless boom ended. Then stock prices began to implode and, despite desperate attempts at price maintenance, real estate prices followed. The big Japanese banks, which in 1989 were all included in the list of the worlds 20 biggest banks, moved to the list of the worlds fastest-depreciating bank stocks. In the 1990s, the tech mania drove Nasdaqs multiple into triple digits. During this equivalent of the Pamplona Bull Run, no prominent Wall Street seer reminded clients that Nasdaqs multiple at the beginning of the Reagan bull market was close to the Dows. When fears of Y2K forced computer users worldwide into a panic of capital spending to avert millennial disaster, almost no prominent technology analysts warned that once this force-fed boom was over, there would likely be a major contraction in capex. At yearend 1999, percentage earnings growth in the future for Nasdaqs darlings was almost universally predicted to be faster than in the past. The greatest collective madness in the history of markets obliterated collective memory about earnings multiples and cyclicality. Although history, thankfully, has few precedents for that mania, seeing Ratatouille recalled for us a childhood favorite, The Pied Piper of Hamelin. The only rat to survive the mass drowning in the River Weser recounts the effects of the Pipers music: At the rst shrill notes of the pipe, I heard a sound as of scraping tripe, And putting apples, wondrous ripe, Into a cider-presses gripe. And it seemed as if a voice Sweeter far than by harp or psaltery Is breathed) called out, Oh rats, rejoice! The world is grown to one vast drysaltery! Investors have done nothing in this decade as stupid as they did in the last decade. Indeed, a strong argument can be made for the proposition that retail investors have collectively displayed admirable prudence. The manias have been concentrated in one classinstitutional bond investors.

Then the endless boom ended.

July

23

When the Babel in Bond-Land implodes, there will be screams of rage that the computer models used to price the Russian doll CDOs were built on the garbage-in, garbage-out principle and that the rating agencies had once again failed investors. the Russian doll CDOs were built on the garbage-in, garbage-out principle... The model-builders will lie low for a while, but they will be back, and will once again be showered with money. We recall an old Peter Arno New Yorker cartoon that shows a crashed airplane, with its pilot parachuting to safety. As the crowd rushes to the crash scene, a man walks away, rubbing his hands in glee, saying, Well, back to the old drawing board! There has been an outbreak of good newsof a sortfor beleaguered holders of long Treasurys: the growing fear about the growing collapses in subprime loans has been sending some frightened bond investors scuttling back into their haven investmentgood old-fashioned Treasurys. Those days in which the fear of debt implosion exceeds the fear of ination have been good days for T-Bonds. There will, however, be many days in which the market fears both the non-repayment on subprime-backed bonds, and repayment in depreciated money on Treasurys. Those days only Cash wins. Long Treasurys have become the least unpalatable of a newly-unpalatable asset class.

24

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Basic Points
INVESTMENT ENVIRONMENT
If you are a highly motivated seller of a home in most parts of the US, or if you are a real estate broker, or if you are a homebuilder, or if you are a portfolio manager who is pondering the values assigned to endishly complex instruments whose value was assigned by their creators, you are doubtless concerned about both the US economy and the US stock market. Indeed, if you are any of the above, you may have joined the tide of investors switching out of US equity funds in favor of markets abroad. Yet US stocks trade near all-time highs. On the other hand, if you are a typical West European who, according to polls, thinks the US is more dangerous to world peace than Russia, China or even Iran, you are no longer surprised to hear of any enormity in that inhumane neo-liberal economy, and snicker when told of a potentially cataclysmic subprime meltdown. What do you expect from a country that thinks government is the problemnot business? Yet US stocks trade near all-time highs. The US economy is no longer the pace-setter for the global economy. That title is either unclaimed or has moved to China. For the rst time since the golden age of the Raj, India may be, at the margin, a greater contributor to global growth than the US. Embarrassingly, even the Eurozone, long associated with stagnation and constipation, is now displaying stronger growth than the US. Yet US stocks trade near all-time highs. It seems as if most of the worlds professionally furrowed brows got that way because of concerns about the US housing market and the perceived excesses in the US bond market and banking system related to professional equity and hedge funds. Yet US stocks trade near all-time highs. US credit spreads, which had declined to the barely visible level, are now widening, and risk measurements such as the TED Spread are ashing amber after long years of green in which Wall Street was amassing record levels of green. Yet US stocks trade near all-time highs. This could be termed a conundrum. ...risk measurements such as the TED Spread are ashing amber...

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25

Grain Strains
Meanwhile, US consumers face big increases in their food costs. Whether such costs are worthy of measurement may be debatable, but if the average Americanwho is, of course overindebtedwill soon be spending an extra 10% or so on food, it surely means he or she will have less money to spend on discretionary purchases. Consumers across most of the economic world will be spending signicantly more on food this year and next. Even though corn prices have pulled back sharply from their highs, soybeans, other coarse grains, and wheat remain at lofty levels. The worlds carryover of grains and oilseeds at the end of the crop year in September will probably be the lowest (in relation to consumption) on record. Even if there were no new biofuel plants built anywhere, the supply/ demand situation next year could be much worse. On all previous occasions when global supplies were this tight, the cause was crop failure. That is why the current boom in feed grains and oilseeds is unique: production has been strong and US coarse grain and oilseed plantings (on a combined basis) are at multi-decade records. Wheat trades at $6 a bushel primarily because of droughts in the former Soviet Union, and Australia, and excess rains in Texas, Kansas, and Oklahoma. These challenges to food price stability are occurring at a time of high oil pricesand a new record for sustained good weather across most of the Midwest, which styles itself as the Saudi Arabia of corn, producing 41% of the worlds supply. What would happen to food ination if normal weather cyclicality reasserted itself? Dont ask. There is a somewhat tenuous connection between the worlds problems with oil prices and availability, and the worlds problems with grain price and availability. OPEC has lately been complaining that the industrial world is spending too much money on trying to grow renewable sources of alternatives to oil, instead of on reneries which could absorb the kind of sour heavy crude that some OPEC producers might be able to produce if markets were available. Most OPEC members cant produce up to their current quotas, because they routinely useand abusethe gigantic prots from current production on dysfunctional political and economic structures, rather than in reinvestment in their oil and gas elds. This could be classed as a chicken and egg problem.

What would happen to food ination if normal weather cyclicality reasserted itself?

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Basic Points
When the Egg Council of India protested to Prime Minster Singh that the costs of producing an Indian egg were up 70% in the past year because of abuse of futures, it signaled that, for the rst time, there was a true global market in cornand corn prices were up faster than prices for the alternative protein feed, soybeans, because roughly 10% of the worlds corn is being allocated to ethanol. As we have previously noted, the distribution of Board of Trade pricing data across rural India through the expansion of broadband capability has meant that farmers are no longer willing to accept the Egg Councils agents offers for corn. This is globalized ination originating two blocks from where this is written. So the price and availability of corn is another chicken and egg problem. Humans and animals burn the carbon in their foods to provide energy and rebuild tissues. They burn the carbon in oil, gas, corn, soybeans, wheat, and wood chips to produce heat and energy. One problem with using ethanol as a gasoline alternative is that its formula C2OHmeans that it has a free hydroxyl, which is corrosive. Result: ethanol cannot be shipped over pipelineseven well-maintained pipelines operated by somebody other than BP. There is a new unity in carbon-based economics. The same rapidly-growing middle classes in Asia are driving up prices of hydrocarbons and coal, and the prices of feed grains. Diverting the supply of a meaningful percentage of plant proteins into biofuels automatically guarantees a sustained shortage of plant proteins for animal feeds. If the new middle class in China and India had contented itself with buying homes with indoor plumbing and basic appliances, and then cars, then the world would just be short of oil, gas and base metals. But the new Asian bourgeoisie wants meat and dairy products, and there arent enough hectares under cultivation worldwide at todays yields to feed the worlds supply of hogs, calves, steers and sheep, plus the fast-growing herds of dairy cattlewith enough high protein feed left over for ethanol and other biofuels. Needed: a substantial increase in average yields. The US has been doing just thatits average corn production per acre has risen by two bushels a year over the past 26 years. Good weather has helped, along with improvements in farm machinery and in fertilizer usage, but the major contributor has been

...the new Asian bourgeoisie wants meat and dairy products...

July

27

The third Grace has just moved to center stage.

genetically modied seedsparticularly from Monsanto. (Many climatologists also attribute the sustained gains to rises in global CO2, which, of course contributes to faster growth in plants and thereby to the lowering of food costs across the globe. We wonder whether this benecent effect of CO2 is widely discussed these days. Presumably the Chinese leadership thinks about it every time a new coal-burning power plant goes on streamwhich is to say, every week.) Although corn prices have pulled back, the agricultural stocks are continuing to outperform the stock market. Does this indicate that investors should cash their prots? No. The price gains in ag-stocks to date are just the rst phase of a decade-long process. Last weeks FAO and OECD report on the food outlook predicted a decade of higher food prices. The CEO of Nestle predicts signicant and long-lasting food-price ination. That means farmers almost everywhere will have the market incentives to invest. Some day, the Midwests run of good luck will end. This year, the corn belt was spared the oods of the lower Mississippi Valley and the droughts of the Southeast. Some day, the odds will trigger a crop failure and then a global food crisis will loom. If the global economy continues to roll, despite the problems in the US debt and housing markets, then the mining and oil stocks will continue to outperformas they have for more than six years. The agricultural stocks have only begun the process of convincing investors that they are entitled to higher multiples because their customers no longer just have an occasional great year. The third Grace has just moved to center stage. (Authors Note: One of the members of our long-standing committee of voluntary advisors is Thalia Kingsford, a VP and Investment Advisor from Calgarynamed after the Grace.)

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Basic Points
INVESTMENT RECOMMENDATIONS
1. The Three Graces remain the guides to equity investing. Portfolios heavily overweighted toward production of oil, gas, metals and proteins will remain primarily levered to globalnot USeconomic growth, which will remain the winning orientation. 2. The next four months are, on average, the least attractive of the year for equity investors. We have been expecting a broad stock market correction for nearly a year. Perhaps seasonality will bring it quickly. We do not recommend committing meaningful net new cash to either equities or bonds until the markets show real signs of Fear. 3. The dollar continues to hover just above its breakdown point of 79 on the DX Index. Its support is the yen. That means that if the LDP suffers heavy losses this month in the elections for the Upper House of the Diet and the party forces out Premier Abe, the dollar could rally out of its danger zone. Conversely, if the LDP does better than polls suggest, that could be bad news for the buckand good news for gold. 4. This is the key month for corn pollination in the Midwest. Real drought conditions would reduce yields sufciently to get corn back to its highs and send beans into the teens. Those are short-term factors that will mean volatility for ag-stocks. Wonderful weather could send corn prices back toward $3.00. That would give investors another chance at building strong exposure to the leading farm-related stocks. 5. Every bond rally should be an opportunity for duration reductionand improvement of quality. 6. The pullback in corn and the weakness in natural gas have taken pressure off the ethanol stocks. They are attractive only as trading vehicles. Long term, they seem doomed to be on the wrong side of the history. Other biofuels will eventually marginalize or displace ethanol. 7. Continue to underweight Financial stocksat least until stock markets undergo a sharp correction. Banks tend to be the places where yesterdays biggest and baddest enthusiasms come to restand decay.

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Basic Points
Two Part Issue:
I A Guide To Commodity Stock Investing II Fall Came Early

August 8, 2007

Produced by BMO Financial Group Distributed by BMO Capital Markets

Basic Points
An Investment Journal
Donald G. M. Coxe
Global Portfolio Strategist, BMO Financial Group (312) 461-5365 e-mail: don.coxe@bmo.com

Research/Editing Production/ Distribution

Angela Trudeau e-mail: angela.trudeau@shaw.ca Anna Goduco (print orders and mailing lists) e-mail: basicpoints@bmo.com

Two Part Issue:

I A Guide To Commodity Stock Investing II Fall Came Early

Overview
Blame it on the Bear. We had not considered producing an issue whose girth could preclude readers from including it in their vacation plans, because it would command picnic basket space needed for loaves of bread and jugs of wine and, perhaps, poetry books. We had planned that this months issue would be devoted solely to publishing a user-friendly Recommended Commodity Stock Sector Weighting. We have always said we use ve-year time horizons in our strategy, and the rst phase of the commodity bull market passed its rst birthday last winter. It was, therefore, time to outline a strategy for the next ve years of the supercycle. But the stock market pullback that had, for us, become as overdue as Godot, nally came, and commodities are once again merely a Page Sixteen story. We could hardly publish a commentary that ignored a nancial market setback of signicant proportions, so this is a two-part issue, with the Page One story covered in Section II. We are leaving our cautious Recommended Asset Allocation unchanged. If we are correct in our view that the current panic in collateralized debt instruments is a welcome sign of creeping sanity in the bond market, then an important buying opportunity for stocks could come soon.

August

Recommended Asset Allocation

American Portfolios
U.S. Pension Fund
Allocations 27 29 12 0 15 17 Change unch unch unch unch unch unch

Domestic Equities Foreign Equities Domestic Bonds Long-Duration Bonds Foreign Bonds Cash

Foreign Equity Allocations

Allocations 6 6 6 11 Change unch unch unch unch

European Equities Japanese and Asian Equities Canadian & Australian Equities Emerging Markets

Bond Durations
Years 4.25 4.50 4.75 Change unch unch unch

Global US Canada

Commodity Stock Portfolio Sector Weightings

Energy Agriculture Base Metals & Steel Precious Metals 33 25 22 20

August

Basic Points
SECTION I: A Guide To Commodity Stock Investing
It has been more than ve years since we started recommending that clients position themselves for what would be the biggest commodity bull market in history. As the story unfolded, we outlined a few basic principles: The greatest investment opportunities come from an asset class where those who know it best, love it least, because they have been disappointed most. Invest in companies with long-life unhedged reserves in the ground in politically secure areas of the world. Contrary to the history of past commodity cycles, which were short-lived, this would last well into the next decade, because of what we called: the greatest simultaneous eforescence of human economic liberty in history as hundreds of millions of Chinese and Indians joined the middle class; that status would come from moving into dwellings with indoor plumbing, electricity and basic appliances, with a substantial percentage of these people owning cars. We used, as the basis of comparison, what occurred after World War II, when approximately 80 million people in North America, Europe and Japan attained middle class status between 1946 and 1960. The mining and oil booms of the mid-Fifties were driven by these peoples demands for houses, cars, and electricity. This time, roughly 40 million people per year in China and India attain middle class status. This commodity boom would not be choked off because of the traditionally over-enthusiastic Supply Side response. Among the mining and oil companies, the survivors in company managements were in sustained survivor mode, and were so traumatized by the Triple Waterfall Commodity Crash (19802001) that they were more inclined to hedge their production forward to lock in what they thought were unsustainably high prices, than to open new mines or oilelds. Their pessimism and caution were reected among the majority of commodity analysts left on Wall Street. In 1982, there were more oil analysts than technology analysts on the Street. By 2002, despite the Tech Crash, there were far more semiconductor analysts on the Street than commodity stock analysts. Most of the commodity analysts who had survived the two decades of decline, disappointment and despair kept the greatest simultaneous eforescence of human economic liberty in history

August

their jobs by calling clients to get them to sell their stocks during those brief windows of opportunity when commodity prices spiked. They were close to the shell-shocked survivors in company managements, and shared their pessimismwhich would slowly improve to caution, but would take a long time to attain optimism. ...the Street, which was so lightly staffed with commodity believers, moved swiftly into Denial Mode. As The Great Commodity Boom began to unfold, the Street, which was so lightly staffed with commodity believers, moved swiftly into Denial Mode. When oil rst broke out above $35 in January 03, the Street screamed Sell!. And it was so: crude promptly slid back to $25. And the Street looked on the price collapse, and it was pleased. Then came a virtually uninterrupted run to $50, followed by a pullback to $42, then an uninterrupted run to $60. At each pause along the way, the Street proclaimed the coming demise of the commodity boom. The pattern was replicated among the base metals: powerful rallies, then sharp pullbacks, which would produce widespread Street claims that the bull market was over. The Street continued to predict 85 cent copper as prices sprinted past $2.50 on their way to a spike to $4. When prices plunged to $2.60, the consensus future value for copper became $1.25, a gure which has largely survived in Street valuations even as copper trades at $3.50. Meanwhile, the big mining companies devoted most of their (to them) astonishing increases in cash ows to buying other companies and their own stock, not to opening new mines. As the commodity boom unfolded, clients often asked why we never recommended the grains and foods. We always responded that our whole strategy was based on unhedged reserves in the ground that had been there for at least 60 million years andin the case of Canadian nickel mines1.6 billion years: supplies were nite. Grains and foods were renewables, and their prices were driven by the interactions of government programs and weather, not permanent scarcities. End of discussion. We recommended gold shares only for a minority exposure, because we remained rmly convinced that the primary challenge to the global price system came from deation not ination. Gold would be an outperformer if (when) a nancial crisis la 1987 or 1998 unfoldednot because of a return of serious ination. Oil had gone from $20 to $60 and ination hadnt upticked, so why should anyone pay for a hedge against a return of the beast that Volcker, Reagan and Thatcher had apparently slain?

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Basic Points
One of our enduring themes was The Rule of Page Sixteen: Never invest on the basis of a story on Page One: that is the Efcient Market. Invest on the basis of a story on Page Sixteen that is on its way to Page One. Commodities from time to time had brief ings on Page One, but even in the stock market sections of publications such as The Wall Street Journal, on days commodity stocks soared to new highs, most of the commentary would be about other winnersparticularly tech stocks. If oil prices were leaping, this would be covered as bad news, and various sages would analyze the effect of higher gasoline prices on consumer spending. We had a disarmingly simple strategy: stay invested in mines and oils for the long term. On the eight or nine occasions in which commodities sold off sharply, and prominent pundits proclaimed The End of the Commodity Bull Market, we stubbornly insisted that clients invest even more in the stocks, but refrained from suggesting relative weightings. Then came Katrina. Oil spiked past $70 and natural gas to $15. Suddenly, energy stocks had become a sustained Page One Story. Various Street economists who had (how shall we say this) modest records as commodity analysts began to proclaim the inevitability of $100 oil. We even saw some oil sands stock recommendations based on $200 oil. For the rst time, we made a Switch recommendation: we suggested scaling back exposure to oil stocks and redeploying the funds into base metals. We have continued to de-emphasize the oils in favor of the metals ever since then. By late last year, we had conned our Overweight recommendations in oils to the Oil Sands stocks, which we have for ve years stressed as the preeminent commodity asset groupbecause of having more than 75 years in recoverable oil resources, compared to an industry Reserve Life Index in the low teens. We also braced ourselves for what we thought was the inevitable response of Big Oil to its declining Reserve Life Indices: the oil sands companies, with their reserves that would last into the next century, continued to trade at multiples approximating those of traditional E&P stocks. As Big Oil watched its gigantic reserves in Russia and Venezuela being nationalized, and contemplated the increasing political risks to their production in countries such as Nigeria and Angola, it was inevitable that they would look to Alberta.
August 5

We had a disarmingly simple strategy: stay invested in mines and oils for the long term.

We began to reconsider our zero exposure to agriculture as we were researching India in preparation for our leave of absence visit there last November. What we learned traipsing around rural Rajasthan and Uttar Pradesh convinced us that we had to abandon our previous dogmatism. What we learned traipsing around rural Rajasthan and Uttar Pradesh...
Global Supply and Utilization of Grains June 2007
2000/01 2001/02 2002/03 2003/04 2004/05 2005/06 2006/07 2007/08 Wheat Production (metric tons) Consumption (metric tons) Ending stocks (metric tons) Coarse grains Production (metric tons) Consumption (metric tons) Ending stocks (metric tons) Oilseeds Production (metric tons) Ending stocks (metric tons)

Million units
581.5 584.2 205.8 862.5 884.1 210.5 313.9 39.4 2000 581.1 585.2 201.8 893.9 906.8 197.6 324.9 41.8 2001 134.6 57.2 391.4 567.6 603.7 165.7 875.3 902.9 170.0 330.2 48.2 2002 139.3 59.2 402.3 554.6 588.3 131.9 916.6 946.3 140.3 335.2 44.4 2003 140.6 59.2 406.4 629.1 609.8 151.2 1,016.9 979.3 177.9 381.1 56.8 2004 144.1 60.8 412.3 622.3 624.5 149.0 978.6 993.1 163.4 390.5 64.4 2005 148.6 64.0 418.2 594.1 621.1 122.0 976.0 1,014.1 125.4 404.3 71.3 2006 152.9 65.2 425.1 610.2 620.1 112.0 1,056.4 1,060.2 121.5 399.0 60.8 2007 156.7 65.8 434.0

Beef and Pork Production (metric tons) Broilers and Turkeys Production (metric tons) Dairy Milk production (metric tons)

132.1 55.3 386.8

Source: USDA Economic Research Service, Agricultural Outlook: Statistical Indicators, June 2007: http://www.ers.usda. gov/Publications/AgOutlook/AOTables/

As the USDA statistics prove, there is a severe shortage of feed-grain-producing land worldwide, and barely enough land for wheat. Once we understood that the new middle class of China and India, who had given the world cheap labor, and expensive oil, coal, iron ore, copper, nickel and lead, were now upgrading their diets to include meat and dairy products, we saw that a sustained worldwide grain shortage was inevitableregardless of governments and regardless of weather conditions. On our return, we began recommending agricultural stocks with the kind of enthusiasm we had previously reserved for oil sands and base metal stocks. We also upgraded gold, because we saw that Indian brides were absorbing all central bank gold sales. Then, in April, partly because of our view on the splendid outlook for agstocks, we changed our two-decade-long view of disination and resulting low interest rates. We thereupon recommended that clients buy gold and gold stocks as ination hedges. Food ination was about to join fuel ination. Historically, whenever those two staples moved up or down together on a sustained basis, overall ination moved in the same direction.

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Basic Points
It is now time to put these disparate views together into a coherent commodity investment strategy.

A Strategy for Commodity Stock Portfolios

Commodities are where you nd them. So are commodity stocks. Successful commodity stock investing means investing in companies that may be headquartered in the US, Canada, Australia, Britain, France, Brazil, Italy, South Africa, Norway or Chinato name only some of the nations with established, publicly-traded, commodity producers. Investors benchmarked to major stock indices such as the S&P have only modest exposure to commoditieswhich means the Energy stocks dominate their commodity weighting. There is now only one Base Metal company in the S&P 500 and 400 combined, so US clients who are restricted to American stocks tell us not to waste our time and theirs talking about the great opportunities in metals. Even our Canadian clients have had to rethink their commodity exposure since Inco and Falconbridge were deleted from the TSXwith Alcan next. A Recommended Investment Weighting Structure for Global Commodity Stock Portfolios:
Commodity Stock Portfolio Sector Weightings
Energy Agriculture Base Metals & Steel Precious Metals 33 25 22 20

There is now only one Base Metal company in the S&P 500 and 400 combined...

This is our Opening Weighting, which will be updated in future issues of this publication, and in our Conference Calls. Energy will include oil, gas, coal, pipelines, and uranium. It will not include electricity generating companies, except such companies as TransCanada and Cameco, which have exposure to nuclear plants, or the aluminum companies, which have extensive exposure to electrical production. Ethanol and biofuels companies will be included within the Ag sector. Agriculture will include the fertilizer, farm equipment, grain handling, biofuels, seed, dairy, and commodity foods companies. Water will be included in this grouping, although we have not, to date, conducted enough research to make any recommendations at this time. Over the longer term,

August

large-scale irrigation and perhaps desalination will be needed to produce enough grain to meet the relentless growth in demand from the livestock, dairy and biofuels industries. Base Metals and Steels will include not only the pure play companies, but the multinational mining companies that may also produce oil, gas, uranium, precious metals, rare earths, and fertilizers. Precious Metals will be mostly the gold miners, but will include producers of platinum and palladium. To help clients understand where we are in this commodity supercycle, we have decided to include in this issue of our journal the charts of major companies within each category, whose performance illustrates what clients have earned by sticking with the stocks as we urgedthrough the many times when wiser heads were counseling clients to cash their prots and buy higher quality stocksnotably tech stocks. We include the stock charts to remind investors just how massive and broadbased this rally has been to date, not to suggest that all clients should own all these stocks now. They are strong companies investors should consider as benchmarks for their commodity portfolios. In some cases, the stock prices fully reect their companys prospects. Clients should be guided by our analysts up to date recommendations about any of the securities listed. As clients realize, our compliance rules discourage us from making specic Buy and Sell recommendations on individual stocks: that responsibility lies with BMOs analysts and client representatives. Many thousands of investors of widely differing circumstances, and with widely differing investment objectives, listen to our Conference Calls and read Basic Points. Moreover, we do not qualify as experts in any of these industries. In general, these are the shares of the Blue or Red Chip companies that are heavyweights in global stock market indices, potential core positions for long-term investors, and whose performance is representative of the returns investors have earned to date. Their price performance in this decade is the history of a momentous change in the global economy. As readers look at these charts, they will see that the stock groups did not always move up and down together, even though talk of the commodity boom suggested that they were heavily correlated. Energy moved rst, then base metals and golds, and nally agriculture.

Their price performance in this decade is the history of a momentous change in the global economy.

August

Basic Points
1. Energy 33%
Exxon Mobil (XOM NYSE) January 2002 to August 2007
105 95 85 75 65 55 45 35 25 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

Conoco Phillips (COP NYSE) January 2002 to August 2007

100 90 80 70 60 50 40 30 20 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

Valero (VLO NYSE) January 2002 to August 2007

90 80 70 60 50 40 30 20 10 0 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

XTO (XTO NYSE) January 2002 to August 2007

65 55 45 35 25 15 5 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

Suncor (SU NYSE) January 2002 to August 2007

110 100 90 80 70 60 50 40 30 20 10 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

Cdn Oil Sands Trust (COS.UN TSX) January 2002 to August 2007
40 35 30 25 20 15 10 5 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

Husky (HSE TSX) January 2002 to August 2007

50 45 40 35 30 25 20 15 10 5 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

EnCana (ECA NYSE) January 2002 to August 2007

70 60 50 40 30 20 10 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

August

Petrobras (PZE NYSE) January 2002 to August 2007

18 16 14 12 10 8 6 4 2 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

Smith International (SII NYSE) January 2002 to August 2007

70 60 50 40 30 20 10 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

Cdn Natural Resources (CNQ NYSE) January 2002 to August 2007

80 70 60 50 40 30 20 10 0 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

Fording Canadian Coal (FDG NYSE) March 2003 to August 2007

50 45 40 35 30 25 20 15 10 5 0 Mar-03 Sep-03 Mar-04 Sep-04 Mar-05 Sep-05 Mar-06 Sep-06 Mar-07

Schlumberger (SLB NYSE) January 2002 to August 2007

100 90 80 70 60 50 40 30 20 10 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

Peabody (BTU NYSE) January 2002 to July 2006

80 70 60 50 40 30 20 10 0 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06

Global Santa Fe (GSF NYSE) January 2002 to August 2007

75 65 55 45 35 25 15 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

Cameco (CCJ NYSE) January 2002 to August 2007

60 50 40 30 20 10 0 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

10

August

Basic Points
Clearly, this diverse collection of companies tied to energy is the cornerstone of a commodity portfolio. Within the sector, we note that the producing oil sands companies continue to be our #1-ranked group, based on our rock-bottom metric: unhedged reserves in the ground in a politically secure area. Last weeks announcement of the takeover of Western Oil Sands by Marathon is a sign of bids to come. Alberta is experiencing fearsome ination, (fearsome to residents whose incomes arent tied to oil or the stock market, and to the Bank of Canada), but as the political situation for foreignbased oil companies continues to deteriorate in Russia, Nigeria, Angola, and Venezuela, and as global Reserve Life Indices continue to erode, these stocks look better and better. XTO has frequently been BMO Capital Markets analyst Ray Deacons favorite large-cap US E&P companyand he has been absolutely right in his calls. Petrobras has become a global heavyweight. Schlumberger, Global Santa Fe (which is merging with Tidewater) and Smith International are great companies whose products and services are needed by all organizationsgovernmental or privatelooking for oil in difcult terrain or deep at sea.

...the cornerstone of a commodity portfolio.

August

11

2. Agriculture 25%
Deere (DE NYSE) January 2002 to August 2007
150 130 110 90 70 50 30 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

Agrium (AGU NYSE) January 2002 to August 2007

50 45 40 35 30 25 20 15 10 5 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

CNH Global (CNH NYSE) January 2002 to August 2007

60 50 40 30 20 10 0 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

Monsanto (MON NYSE) January 2002 to August 2007

80 70 60 50 40 30 20 10 0 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

Trimble (TRMB NYSE) January 2002 to August 2007

40 35 30 25 20 15 10 5 0 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

DuPont (DD NYSE) January 2002 to August 2007

55

50

45

40

35 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

12

August

Basic Points
Potash (POT NYSE) January 2002 to August 2007
90 80 70 60 50 40 30 20 10 0 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

Syngenta (SYT NYSE) January 2002 to August 2007

45 40 35 30 25 20 15 10 5 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

Smitheld (SFD NYSE) January 2002 to August 2007

34 31 28 25 22 19 16 13 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

Andersons (ANDE NYSE) January 2002 to August 2007

70 60 50 40 30 20 10 0 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

Tyson (TSN NYSE) January 2002 to August 2007

25 23 21 19 17 15 13 11 9 7 5 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

Bunge (BG NYSE) January 2002 to August 2007

100 90 80 70 60 50 40 30 20 10 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

Saskatchewan Wheat Pool (SWP TSX) January 2002 to August 2007

40 35 30 25 20 15 10 5 0 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

August

13

What is now known as agation will be an investment theme for many years. As is usual in dealing with major commodity moves, we nd ourselves in dissent with the Page One commentaries from prominent journalists and economists who lack agricultural backgrounds but have strong political views. (This writer was General Counsel to the Canadian Federation of Agriculture and General Manager of the Ontario Federation of Agriculture prior to entering the investment world, but has never plowed a eld. This doesnt constitute expertise, but it is at least nodding familiarity. It is why the weeks in rural India had such impact.) Both Foreign Affairs and Fortune published cover stories on the corn boom in April. They were little more than assaults on the ethanol industry. Unwary readers would conclude that the only reason corn prices had soared was because of the ethanol boom. Not once did those writers comment on the big storythe new Asian middle class that was adding meat and dairy products to its diets. Not once did those writers note that prices for sorghum, barley and wheatwhich arent driven by ethanolwere also booming. The Manhattan-based grain experts, who might have difculty distinguishing a heifer from a steer, had obviously never looked at the USDA data on global croplands for feed grains, and on soaring demand for meat and dairy products. Perhaps the authors were doctrinaire vegans. Reading these screeds, we recalled reading comments years ago from prominent latte liberals such as Shirley Maclaine, who condently predicted that the Chinese would not make our disastrous mistake with automobiles, because they loved their bicycles too much. We had also seen predictions that Indians would never become carnivores, because they had a spiritual attitude to animals. We are, we admit, somewhat embarrassed to publish the charts of the leading agricultural stocks, because nobody relying on our work would have owned any of them prior to last October. Some of our leading institutional clients were already there before we changed our views, and had earned great prots before we realized that fertilizer, farm equipment and seeds were the next great commodity story.

Perhaps the authors were doctrinaire vegans.

14

August

Basic Points
In looking at the stocks available in this sector, clients should consider the fertilizer, farm machinery and seed companies as the ag equivalents of oil service companies: they are the companies who will supply the products and technology farmers must have to increase grain yields. The major meat and poultry organizations are commodity companies who deliver the equivalent of gasoline and rened products to the marketplace. The dairy companies are mostly commodity companies, but they also manufacture and market packaged products to consumers. We do not include the packaged food companiessuch as Nestle, Kraft, Kellogg or Hersheyin our list, because they must buy the raw materials from the farmers, grain handlers and distributors, and their earnings outlook is negatively correlated to price increases for raw foods. Supermarkets are great beneciaries from food ination, but we have not included them in our stock lists because the Wal-Mart market share struggle complicates our analysis of these stocks. Our food analysts can pick out which companies will get full-cost-passthrough. In brief, soaring Third World demand for meat and dairy products would have guaranteed a rm pricing environment for producers of feed grains and other products based on supplies of corn, sorghum, oats, soybeans, and barley. Despite what is now 16 straight years of benign weather conditions in the US Midwestself-styled Saudi Arabia of corngrain prices are high. Ethanol and other biofuels will be increasingly important in grain pricing, but the big story is in the bellies of people who previously couldnt afford meat and dairy products. The nations whose middle classes have given the world $75 oil and $3.50 copper are nowand for years to comegiving it expensive grains.

...the big story is in the bellies of people who previously couldnt afford meat and dairy products.

August

15

3. Base Metals & Steel 22%

BHP Billiton (BHP NYSE) January 2002 to August 2007
80 70 60 50 40 30 20 10 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07
20 10 0 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 50 40 30

Teck Cominco (TCK NYSE) January 2002 to August 2007

Rio Tinto (RTP NYSE) January 2002 to August 2007

350 300 250 200 150 100 50 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

Cleveland Cliffs (CLF NYSE) January 2002 to August 2007

100 90 80 70 60 50 40 30 20 10 0 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

Anglo-American (AAUK NYSE) January 2002 to August 2007

40 35 30 25 20 15 10 5 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

Freeport McMoRan (FCX NYSE) January 2002 to August 2007

120 100 80 60 40 20 0 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

CVRD (RIO NYSE) March 2002 to August 2007

50 40 30 20 10 0 Mar-02 Sep-02 Mar-03 Sep-03 Mar-04 Sep-04 Mar-05 Sep-05 Mar-06 Sep-06 Mar-07

Alcan (AL NYSE) January 2002 to August 2007

110 100 90 80 70 60 50 40 30 20 Jan-02 Sep-02 May-03 Jan-04 Sep-04 May-05 Jan-06 Sep-06 May-07

16

August

Basic Points
Alcoa (AA NYSE) January 2002 to August 2007
50 45 40 35 30 25 20 15 Jan-02 Sep-02 May-03 Jan-04 Sep-04 May-05 Jan-06 Sep-06 May-07

Nucor (NUE NYSE) January 2002 to August 2007

80 70 60 50 40 30 20 10 0 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

US Steel (X NYSE) January 2002 to August 2007

140 120 100 80 60 40 20 0 Jan-02 Sep-02 May-03 Jan-04 Sep-04 May-05 Jan-06 Sep-06 May-07

In looking at this list, we thought of occasions when we have experienced disappointments visiting art museums because favored paintings were on loan to other galleries. When one knows a gallery has two Vermeers and begins a tour by locating the Dutch room and nds two blank spaces, then even the four Rembrandts arent satisfactory compensation. The difference, of course, is that Inco and Falconbridge, which, with BHP had been our personal most-favored stocks, are gone forever. (We consoled ourselves with the Inco takeover by redeploying most of the proceeds into CVRD, with the rest going into FNX and Lion Ore, so we havent suffered nancially. We did not switch our winning on Falconbridge into Xstrata because of the ambiguities in that companys control, but Freeport McMoRan turned out to be great consolation.) Nevertheless, we rather wish that our forecast in August 2005 (Basic Points: Hard Rock Rocks)that the only way the midsize miners could avoid takeovers by the giants was to mergehad, like some other shots in the dark, proved erroneous. Inco and Falconbridge did, in fact, pursue that strategy, but Brussels bureaucrats, with (we are told) diverse forms of encouragement from their great good friends in Switzerland, stalled long enough so that

Brussels bureaucrats, with...diverse forms of encouragement from their great good friends...

August

17

Xstratas lock-in period on paying up for Brascans holdings of Falconbridge expired, and the marriage was cancelled on the church steps. Phelps Dodge was another favorite, based on its gigantic reserves in the ground in Arizona. Management of that venerable organization was a perfect example of our characterization of the typical survivors of the Triple Waterfall era. With their understandable emotional response to the two decades of decline, disappointment and despair, management hedged so much of their future production at around a dollar a pound that their mark-to-market losses triggered a bid from a well-heeled organization that would put the stockholders out of their misery. Freeport, a believer in copper, complied. We were delighted to be relieved so protably of our Phelps shares, but recognized that this meant that one-half of the S&Ps exposure in base metals would disappear. That 22% weighting might be a real problem for many institutional investorsbecause of the paucity of investment-quality stocks traded in Toronto, New York and London. The inclusion of Steel within this group doesnt automatically mean such portfolio managers will have a wide range of alternatives, because the global steel industry has been consolidating almost as rapidly as the mining business. Our inclusion of Anglo-American in this category means investors might have a heavyweight alternative to BHP, Rio Tinto and CVRD. It has always been known as a major precious metals producer, still holds 42% of AngloGold Ashanti, and remains the worlds largest platinum miner, along with its 45% interest in fabled De Beers. However, new CEO Cynthia Carroll, whom we met at our Resources conference in Florida while she was still running Alcans Primary Metals division, apparently wants to diversify out of South Africa and precious metals into other mining areas of the world and into base metals. In the last three months, Anglo has taken big positions in Brazilian iron ore (MMX Minerals) and Alaskan copper (Northern Dynasty). Teck Cominco is the last big-cap Canadian base metal miner, (Cameco is included among Energy stocks in our formula), and it has a virtually unparalleled record for delivering shareholder value over the long term. (It has also become a player in the oil sands.)

Teck Cominco ...has a virtually unparalleled record for delivering shareholder value over the long term.

18

August

Basic Points
4. Precious Metals & Gems 20%
Barrick (ABX NYSE) January 2002 to August 2007
37 32 27 22 17 12 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

Agnico Eagle (AEM NYSE) January 2002 to August 2007

50 45 40 35 30 25 20 15 10 5 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

Goldelds (GFI NYSE) January 2002 to August 2007

30 25 20 15 10 5 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

Kinross (KGC NYSE) January 2002 to August 2007

16 14 12 10 8 6 4 2 0 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

Goldcorp (GG NYSE) January 2002 to August 2007

45 40 35 30 25 20 15 10 5 0 Jan-02 Sep-02 May-03 Jan-04 Sep-04 May-05 Jan-06 Sep-06 May-07

Aber (ABZ TSX) January 2002 to August 2007

55 50 45 40 35 30 25 20 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

Newmont (NEM NYSE) January 2002 to August 2007

65 60 55 50 45 40 35 30 25 20 15 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

August

19

In addition to these large-cap companies, investors have a world of choice in gold miners. In particular, there is a host of junior companies drilling for gold all over the world. According to Major Drilling, (which is itself an investment that mining enthusiasts would nd interesting), drilling for gold and silver is by far the biggest hard rock exploration activity. ...the only ination worth measuring is Corewhich excludes foods and fuels. We had been neutral on the gold stocks until April, but then recommended an overweight position. We found two reasons for investors to build gold exposure: gold has always been a useful haven when crises hit the nancial system, and the onset of food and fuel ination would attract investors to the classic ination hedge. To date, the gold shares have been indifferent investments. They rose sharply when it looked as if the US dollar were going to break down, but then plunged when the dollar held at its all-important support level80 on the US Dollar index (DXY)
US Dollar Index (DXY) January 2001 to August 2007
120 110 100 90 80 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07

Since we exited from the disination camp, our predictions of rising food and fuel ination have been at least partially vindicated, but the Street continues to accept the regnant view among economists and the Fed: the only ination worth measuring is Corewhich excludes foods and fuels. Result: gold draws yawns. There is another reason why investors have failed to drive gold shares even back to the peaks they reached in 2006: the major miners (no, that is not an oxymoron) are having trouble replacing their production, their costs are rising faster than the gold price, and many of the most interesting exploration targets are in such daunting countries as Russia and Zimbabwe.

20

August

Basic Points
We continue to be surprised when we hear from gold bugs that we should be willing to recommend companies exploring for gold in politically unstable areasespecially in Russia and in South American banana republics. To be a gold bug is to believe that all governments, always and at all times, cheat people out of wealth with a range of nefarious activities, including currency debasement, decits, taxes, and runaway ination. Having such a cynical attitude toward, for example, the US government and the currency it issues, it beats us why they should believe that they will be allowed to get rich from mines in countries that have histories of expropriations, assassinations, revolutions, and/or hyperination. Yet we are told of cant-miss gold companies with fabulous orebodies in such choice places as Venezuela or Bolivia. The gold ETF (GLD)which is one-tenth of an ounce of gold held in trust is a reasonable alternative to gold mining stocks for investors who wish to get the pure ination hedge, free of political, exploration, and cost ination risk. We admit to being surprised and dismayed that gold and gold stocks failed to shine amid the increasingly grim news of the home mortgage crisis, and the piteous performance of investment banking stocks. This should be a time when investors would rush to the classic haven. It is doubtful that even the most paranoid gold bugs foresaw a mortgage mess on this scale. Why not a new Age of Gold? It is a sound contrarian investment principle that any stock that gets great news day after day and goes nowhere should be sold forthwith. (Conversely, stocks that get bad news day after day and dont decline should be bought.) On that basis, this should be a time to sell the golds, not buy more. Had we not already switched into the ination camp, we would surely be pointing to this lackluster performance as further proof why no one should hold much exposure to gold. Nevertheless, we recommend increased gold exposure, because we believe that it is only a matter of time before the greenback breaks 79, thereby taking out the 1992 low and proclaiming a major dollar bear market. Each time it has looked as if this would happen, gold has moved toward $700, and each time the dollar held, gold has retreated. We think that an upside breakout will occur with the DXY below 79 (80 has been the support in recent years), and then gold will quite probably go to a new alltime highaccompanied by the highest rates of global food ination since the days when gold last traded above $700.

To be a gold bug is to believe that all governments, always and at all times, cheat people out of wealth with a range of nefarious activities...

August

21

Sector Weightings
Why these initial weightings? We expect that Fuels and Foods will ordinarily have a combined weighting in the 60% range, and metals the rest. Here is our rationale: Food demand is even less cyclical than oil demand: eating is not optional. 1. Energy 33% Globally, the market cap of energy stocks is several times greater than the combined capitalizations of all other commodity stocks. Therefore, investors have enormous choice in this group. A diversied large-size energy portfolio might have at least two oil sands producers, a pipeline, one or more integrated oil companies with good dividends, perhaps some exposure to Canadian royalty trusts, some leading E&P companies, some oil service exposure, some drillers (deep sea preferred), one or two coal stocks and one or two uranium stocks, and, perhaps some small-cap alternative energy companies. In other words, an investor needs room to get diversication within the energy group. Over the long term, oil prices should stay ahead of ination, which means long unhedged reserves in the ground remain the core investment conceptyear in, year out. 2. Agriculture 25% Agricultural investing faces the opposite challenge: total global market cap is so modest. Furthermore, what is on offer is mostly the equivalent of oil service and drilling stocks without any chance of owning the reserveswhich is what the oil world will be like in a few decades when OPEC and other sovereign oil companies and sovereign wealth funds own nearly all the major oil deposits that arent in the Canadian oil sandsor in countries that have been undergoing sustained civil wars. However, a portfolio oriented toward global food production is a core concept. It reduces portfolio cyclicality, because it is only marginally correlated to global economic performance. Food demand is even less cyclical than oil demand: eating is not optional. Base metals will continue to be correlated to Asian economic growth. Precious metals will be driven by other factors. The impact of weather extremes on an agricultural portfolio is somewhat unpredictable. If (when?) the Midwest experiences a severe drought in June and July, driving corn to $11 a bushel, that may or may not be a bullish development for ag stocks globally. The drought in Europe this year has

22

August

Basic Points
been worth roughly $2 a bushel to wheat, which means wheat producers elsewhere will have more money to invest in their farms. We see prices of raw foods rising much faster than global ination for years, until crop yields in Asia, Africa and Latin America begin to approach North American and European yields. Unlike the long-term outlook for oil, gas and base metals, where scarcities can only get worse in each new economic cycle, the world already has the know-how to produce more than enough grains and meat and dairy products. It has happened before and will happen again. Dr. Norman Borlaug, father of the Green Revolution, showed India how to increase its grain output sevenfold, thereby saving hundreds of millions of lives. He achieved similar results, where local governments allowed, in Africa. (He was also single-handedly responsible for demolishing the Malthusian forecasts of famous liberal forecasters of the 1960s, who predicted that billions of people would starve to death.) He was nally grantedby President Busha Congressional Medal this year for his work: he may have saved more lives than any other human being. Because he has been so right for so long, many global Greens continue to nd him both a threat to the environment and a reminder that some of their favorite faith-based programs such as banning insecticides and pesticideshave tended to promote human misery and death. What is needed now:

Dr. Norman Borlaug... may have saved more lives than any other human being.

large-scale sustained investment by farmers in inputs, including farm machinery and GM seeds; increased research into GM seeds to ght the non-political pests of Africa; education of farmersand governmentsin the Third World; extensive irrigation and/or desalination; large-scale investment in rail and shipping infrastructure to get food to markets. Example: The collapse of the Mississippi bridge last week boosted grain prices because of the blockage of the river: most grain goes by barge. That bridge had been there for four decades and, like the TransAlaska pipeline, it hadnt been properly maintained. And this wasnt Zimbabwe or Rajasthan.

August

23

3. Base Metals and Steel 22% We are still of the view that investors will make more money in mining stocks over the next ve years than in non-oil-sands E&P stocks. The weighting reects the paucity of investment-quality mining stocks on offer. We are looking at the Steels as offering useful diversication. 4. Precious Metals 20% We plan to reduce this weighting toward 10% over the next year or so, but believe the precious metals are overdue for a big rally. Over the long term, base metals should continue to outperform precious metals.

...investors will make more money in mining stocks over the next ve years than in non-oil-sands energy stocks.

Conclusion
This is our rst attempt at creating a commodity strategy model. We look forward to receiving suggestions from clients about how we can make it more user-friendly in the years ahead. If clients are supportive, we shall make it dynamic, not static, changing groups relative weights opportunisticallywithout reducing overall commitment to commodities.

24

August

Basic Points
SECTION II: Fall Came Early
In mid-July, investors who had been following the old trading rule, Sell in May and go away were doubtless ruing their reliance on such hoary wisdom. Financial markets were continuing their comfortable climb, shrugging off stories of the unfolding mess in US subprime mortgages, and the buildup of junk loans in the banking system as Private Equity (PE) rms continued their near-manic acquisition pace. Then the bull market ended not with a whimper, but a bang.
Dow-Jones Industrials August 2006 to August 2007
14,500 14,000 13,500 13,000 12,500 12,000 11,500 11,000 Aug-06 Oct-06 Dec-06 Feb-07 Apr-07 Jun-07 Aug-07

S&P 500 August 2006 to August 2007

1,600 1,550 1,500 1,450 1,400 1,350 1,300 1,250 Aug-06 Oct-06 Dec-06 Feb-07 Apr-07 Jun-07 Aug-07

August

25

German Dax August 2006 to August 2007

5,500 5,300 5,100 4,900 4,700 4,500 4,300 4,100 3,900 3,700 3,500 Aug-06 Oct-06 Dec-06 Feb-07 Apr-07 Jun-07 Aug-07

Main Streets acute anoxia spread quickly to Wall Street.

US Bank Stock Index (BKX) August 2006 to August 2007

125 120 115 110 105 100 Aug-06 Oct-06 Dec-06 Feb-07 Apr-07 Jun-07 Aug-07

Perhaps it was a coincidence, but the SECs decision to repeal the uptick rule on stock short sales became effective last month, and almost immediately selling short became a wondrously protable pastime. Fear emerged immediately after the Dow had managed to climb to a new peak, closing at an even 14,000. A triple-zero record close looked suspiciously like a nal manufactured gasp from the bulls. Suddenly, the stock market gazed down from this Neverest Peak and realized its oxygen supply was inadequate for such a rareed altitude. Collateralized mortgage investors were learning that the subprime mortgage collapse was not an isolated event; the contagion was spreading into prime home mortgages and home equity loans. Main Streets acute anoxia spread quickly to Wall Street. Contemporaneously, the parade of Private Equity buyouts stopped in its tracks in response to alarms from the computerstructured Babel Towers. These elegant edices were stuffed to the heavens

26

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Basic Points
with collateralized debentures and bank loans that were rotting rapidly from the toxic interaction of minimal covenants and minimal interest rates. (The Payment-in-Kind subordinated paper that allowed substitution of paper for interest payments was already beginning to look like it would become the unkindest cuts of all.) Thanks to this overdue onset of common sense among institutional bond investors, there has been a sudden dearth of buyers for the hundreds of billions in par value of collateralized loans for the Private Equity deals already promisedlet alone for any new mega-deals. The bridge loans to provide low-rate short-term nancing for mega-buyouts have become The Bridges to Nowhere. Share prices of investment banks, the cathedrals of the new Gilded Age, began to crumble in response to an outbreak of nancial agnosticism. Publishers have presumably begun preparing for release of the long-awaited sequel to the best-selling account of the previous high-water market for Private Equity, Barbarians at the Gates. Rumored title: Barbarians and Their Bargain Rates. Nor did diversication by geography or sector provide a haven against the waves of selling. Stock markets in countries whose nancial systems dont offer collateralized mortgages or other computer games for high-IQ risk-takers suffered along with Wall Street. A stock market correction is that relative raritya shock that nearly everyone claims to wish and expect, but whose arrival produces widespread dismay and distress. The noisy minority rejoicing amid the gloom cites its years of bearishness, and proclaims, with the re and fury of Old Testament Prophets, that this is mere foretaste of the punishment to come. The early stage of a sell-off is almost always called a correction. Seven years ago, the rst slump in tech stocks was so labeled, and each succeeding drop elicited even stronger calls from Shills & Mountebanks for investors to buy the dip. That had been a sure-re strategy for years. Then it turned out that the tech stock dip was a dip in the sense that the Grand Canyon was a gully. It also turned out that the believers had exhausted their savings, whereas insiders were far from exhausting their supply of stock for sale from exercise of options. Indeed, due to what turned out for Silicon Valley glitterati to be one of the greatest intellectual breakthroughs since the semiconductor backdated optionsthe supply of stock was almost innite. ...collateralized mortgages or other computer games for high-IQ risk-takers...

August

27

Todays excesses have only tangential connection to stock options. The biggest winners were the proprietors of such y-by-night mortgage bucket shops as New Century Financial, who grew rich from options gained from the prots of housingalbeit brieythe poor. The subprime problem... has spread like polluted water spilled on glass.

High-Risk Mortgage Debt

Bear Stearns (BSC NYSE) August 2006 to August 2007
180 170 160 150 140 130 120 110 100 Aug-06 Oct-06 Dec-06 Feb-07 Apr-07 Jun-07 Aug-07

We have written about the housing debacle in previous issues, so we shall only observe here that what most of us had thought last year was just a worry about what would happen when the housing bubble deated, turned out to be much more. Like most investors, we were surprised to learn this year (1) that loans made to people who couldnt have come close to qualifying for mortgages in any earlier cycle were more than 20% of all new loans, and (2) thanks to what we might call mortgage lendings entry into the prestidigital age, these loans could be packaged into bond products that had higher credit ratings than 99% of US corporations. The subprime problem, concentrated in loans made since 2005, has spread like polluted water spilled on glass. Daily, we read new evidence that mountains of mortgage debt had been built through the interaction of sleazy mortgage lenders using sleazy home valuation practices and sleazy documentation practices. The necrosis, which began with the so-called Ninja subprimes (No Income, No Jobs, No Assets) is working its way through Alt-As to prime home equity and other highly-rated housing debts. What helped send stocks to their worst sell-off in years was the report from Countrywide Financial of major writedowns in prime home equity loans.

28

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Basic Points
Countrywide Financial (CFC NYSE) August 2006 to August 2007
50 45 40 35 30 25 Aug-06 Oct-06 Dec-06 Feb-07 Apr-07 Jun-07 Aug-07

Countrywide Financial was the best-performing stock in the S&P 500 for two decades. More than 95% of its outstanding shares have been held by institutions. It is now clear that Countrywides supposedly bullet-proof balance sheet has been rusting through from the slime in home nancing, so we have only begun to see the extent of the disaster. More and more, this looks like the collapse of the S&Ls in the 1980s after Congress simultaneously legislated an increase in their Federal Deposit Insurance limits and a gutting of restrictions on their investment practices. (In the light of the grim news about Countrywides nances, the companys recent conversion from national bank to federal thrift raises disturbing questions about the real reasons for the charter change. CFC will no longer be supervised by the Fed and the Ofce of Comptroller of the Currency, but by the Ofce of Thrift Supervision. Although its previous regulators obviously dozed at crucial times, they have a far better record for minding the store than their successors. Finally, as Financial Week reports, the CEO earned $380 million from recent stock sales conducted whilst the company was in big buyback mode.) This is already being termed The Bear Market because of leadership from the only investment rm to have that ursine metaphor in its name. In the light of The Wall Street Journals detailed account of the events of the past weekend, it might also be labeled, A Bridge [Tourney] Too Far. The Bears two top ofcers are bridge champions, and their famously fraternal relationship dates back to 1987, when James Cayne, the current CEO, called the rms expert on mortgage-backed securities, and asked, Are you the Warren Spector that was the king of bridge? They stayed close in many respects

Countrywides supposedly bullet-proof balance sheet has been rusting through from the slime in home nancing,

August

29

notably their compensation: last year Cayne took home $33.85 million while Spector drew $32.1 mil. In July, as Bears stock was plummeting and credit spreads were widening worldwide because of CDO problems, both men spent a week at a Nashville bridge championship tournament. Mr Spector won. Days later, Cayne red his able brother in arms. Cayne red his able brother in arms.
American Home Mortgage (AHM NYSE) August 2006 to August 2007
40 35 30 25 20 15 10 5 0 Aug-06 Oct-06 Dec-06 Feb-07 Apr-07 Jun-07 Aug-07

When we rst learned that American Home Mortgageone of the biggest of the new-style mortgage originatorshad ceased trading, we wondered whether this might prove to be a signicant problem for the stock market, because one of the requisites for a Big One is that some analyst has just recommended the stock before it vaporizes. That had, in fact, happened: an analyst issued a Buy days before the collapse. When they reopened the stock the following afternoon (July 31), it proved to have enough impact to turn a big Up day for the market into another big Down day. The stock trading at 22 cents Monday traded at $34 in February. It has declared bankruptcy and is preparing to join New Century in the mortuarywhich desperately needs a new wing to accommodate the inow of colorful corpses.

30

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Basic Points
High Risk Corporate Debt
1. Investment Banks
JP Morgan (JPM NYSE) August 2006 to August 2007
54 52 50 48 46 44 42 Aug-06 Oct-06 Dec-06 Feb-07 Apr-07 Jun-07 Aug-07

Goldman Sachs (GS NYSE) August 2006 to August 2007

245 225 205 185 165 145 125 Aug-06 Oct-06 Dec-06 Feb-07 Apr-07 Jun-07 Aug-07

Merrill Lynch (MER NYSE) August 2006 to August 2007

100 95 90 85 80 75 70 65 Aug-06 Oct-06 Dec-06 Feb-07 Apr-07 Jun-07 Aug-07

August

31

Before they ask us to pay the bill, and while we still have the chance...

The leading banks are on the hook for approximately $290 billion in cheap nancing to the big Private Equity rms on already-announced deals, (to which stock prices had already responded). A major player, Citigroups Chuck Prince, said, in what may become the most-quoted corporate strategy concept of our time, As long as the music is playing, youve got to get up and dance. Were still dancing. His explanation for betting his stockholders billions recalled for us the words of an Irving Berlin classic: There may be trouble ahead But while theres music and moonlight and love and romance Lets face the music and dance Before the ddlers have ed Before they ask us to pay the bill, and while we still have the chance, Lets face the music and dance
Citigroup (C NYSE) January 2000 to August 2007
60 55 50 45 40 35 30 25 20 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07

John Reed, who built Citibank into a global consumer banking powerhouse, had a different view of enhancing shareholder value. He took over the top job shortly before the commercial real estate debacle in the late 1980s. After struggling with the mountains of bad loans, he remarked, If it were up to me, I would never make another corporate loan. Despite his prodigious accomplishments in consumer banking, he was squeezed out by Sanford Weill, (of Jack Grubman private school fame), who wanted to be the biggest man in Wall Street investment banking. Mr. Prince continues in Weills tradition. It may not be long before another Princehis largest stockholder, Prince Al-Waleedloses his patience.

32

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Basic Points
2. Private Equity Firms
Stephen Schwarzman has become the poster boy for this markets peak and plunge. His decision to take Blackstone public shocked many market observers. Hadnt he and his Private Equity (PE) brethren claimed for years that a major reason why they could run so many companies so much better than those organizations had done on their own was that they were free of the stock markets quarter-by-quarter short-termism, and they didnt have to suffer the slings, arrows and indignities of Sarbanes Oxley? So why was he selling now? His prospectus drew attention to another advantage he had: PE companies (and hedge funds) only pay 15% income tax on their carry, whereas the rest of the investor population pays 35%. The justication adduced for this huge tax break is that PE people work so hard. They also, we were told, benet the economy. (Presumably the thousands of people they re at the companies they take over to cover some of the cost of the dividends paid to the new owners are mere featherbedders, so national productivity statistics should improve. The money they save on taxes does create some new jobs for investment bankers, art auctioneers, pilots of private jets, crew for their yachts, Washington lobbyists, wine importers and professional party-givers. Senator Edwards, who has added to his already-great wealth by becoming a courtier at Fortress, (another PE and hedge fund), beneted by rubbing shoulders with Masters of the Universe, learning the value to a mega-investors self-image of $400 haircuts.) Senators Carl Levin and Chuck Grassley didnt seem too sympathetic to the plaints of an overworked billionaire whose 60th birthday party cost a reputed $7 million. They have introduced legislation to make the super-rich pay taxes at the level of ordinary folk like Senators. (Nobody seems to ask how it is that tax havens such as the Caymans, the British Virgin Islands (BVI), and Curacao have recently been booming as if they were located in the Arabian Gulf. A recent study of the Treasury bond market claimed that the Caribbean isles were collectively one of the three biggest Treasury buyers in the world. We have been renting cottages in the BVI for many years, during which time the islands styled themselves as Natures Little Secrets. No more. Islanders say the building boom, which has reached Vero Beach proportions, is due to the gigantic wealth generated by the zero tax status for hedge funds and partnerships headquartered there. We were told that the rich Americans and Brits who have spawned this boom are only taxable on prots they actually distribute back home. As long as those rewards for hard work in New York,

The justication adduced for this huge tax break is that PE people work so hard.

August

33

Greenwich and London stay in the sunshine, they remain tax-free. Some of the names mentioned to us as having Caribbean tax haven status are prominent funders of blogs and politicians who demand that Bushs tax cuts for the rich be repealed.) It is a good thing for Mr. Schwarzmans term life insurance rates that he didnt also cut the Kremlin in on the deal. After attracting a torrent of publicity, Mr. Schwarzman took a chunk of his company public at $31 a share. We commented on the merits of this offering just prior to IPO date, predicting that the only winners from that deal would be the vendors and their bankers. In the event, Blackstone sank like any other stone.
Blackstone (BX NYSE) June 2007 to August 2007
36 34 32 30 28 26 24 21-Jun 25-Jun 29-Jun 3-Jul 7-Jul 11-Jul 15-Jul 19-Jul 23-Jul 27-Jul 31-Jul 4-Aug

Mr. Schwarzman has proved anew the principle generally ascribed to P.T. Barnum: Theres a sucker born every minute. (Barnum may not have said it, but he did say, Every crowd has a silver lining.) The Chinese Foreign Exchange Fund was along for a $3 billion ride on Blackstones IPO, and its managers are getting surprising abuse in Chinese blogs for switching Treasurys into this dubious stock. It is a good thing for Mr. Schwarzmans term life insurance rates that he didnt also cut the Kremlin in on the deal.

34

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Basic Points
Ill-Bred Spreads
Since we became full-blown bond bears in April, we have argued that we anticipated two kinds of bond bear markets: a rise of perhaps 200 bp in long Treasury yields, as the Treasury curve reverts to normalcy, ceasing to display Illinois topography and moving to Colorado-style, and a return to normal yield spreads. The real mania in this decade has not been among starry-eyed retail equity investors: the new maniacs are the institutional brainiacs in credit derivatives. The spread between CCC junk and Treasurys had narrowed since 2001 by 750 bp when we argued that this rush to legitimize trash was the corporate credit version of Nasdaq at 5000. Amid the credit mania that swept Wall Street and hedge funds, nearly everyone forgot that there were real people, real communities and real corporations at the base of all these computer-designed superstructures. Since May, yields for junk corporate paper, such as Collateralized subordinate bank loans, have widened out by more than 150 bp. But theres nearly a third of a trillion more to come from existing deals, let alone such deals as the Private Equity giants may yet place. As investors perceive growing risk in the nancial system, all credit spreads widen. The chart shows the effect on spreads for investment-grade corporate bonds in the index:
710 Year Corporate OAS Spreads January 1999 to August 2007
300 250 200 150 100 50 0 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07

the new maniacs are the institutional brainiacs in credit derivatives.

Press reports this week say that the secondary market for investment-grade corporate bonds has dried up, with dealers unwilling to make bids, even for what wasmere weeks agohigh-quality liquid paper. When the river dries up, the just and the unjust alike go thirsty.

August

35

The Sophisticated Debauchery of American Balance Sheets

The core strategy of todays typical PE takeover is to buy a well-managed company with a good balance sheet, then lever it up with debt at six to nine times cash ow, which is used to pay for the company and to pay a huge dividend to the PE rm for having made the deal. The deal is nanced almost entirely with other peoples money, which is the genius of nancial engineering. The acquired company is supposed to become even more successful than it was when it was nancially strong, because those brilliant nancial engineers at PE headquarters will make it more efcient. In other words, modern nancial alchemy justies the issuance of all that debtnot a penny of which goes into the companys treasury. (If the acquired company had more than a few pennies in its treasury at acquisition date, they would also have been sucked away, to become part of some PE persons lifestyle enhancement.) Pardon us if we suggest that such a strategy may work on a small scale, but not on a grand scale. The inevitable result will be weakened competitive performanceand defaults. In the great horse race of capitalism, the steeds weighed down by saddlebags stuffed with owners bars of bullion cannot keep up with lesser nags who carry only the jockeys. Immanuel Kant argued that the way to test the validity of an ethical principle was universality: if everybody did it, would it work? By that test, the strategy of PEs buying up companies and burdening them with debt to pay off stockholders and buyers alike is clearly ruinous. Debt should be primarily represented by the depreciated value of the capital goods that are the backbone of the business. Grand Galas at the Museum of Modern Art presided over by the glamorous spouse of a PEs head honcho nanced by draining liquidity from companies treasuries will be scant help as the acquired companies compete against strongly-nanced American competitorslet alone against China. But isnt this balance sheet debauchery justied according to Merton Miller and Franco Modiglianis Nobel prize-winning thesis that it shouldnt matter if corporate balance sheets had substantial debt?

In the great horse race of capitalism, the steeds weighed down by saddlebags stuffed with... bullion cannot keep up with lesser nags...

36

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Basic Points
Not really. Their work really addressed the misplaced dogmatism in the nancial fashions of another era, when being free of funded debt was the Holy Grail of business virtue. In the Fifties, the leading NYSE companies, such as IBM and Coca-Cola, were called the bluest of the blue chips because they had no bonds outstanding. This was at a time when the memories of the Depression were still so strong that investment ofcers at major trust companies insisted that stocks should have higher dividend yields than were available from bond yieldsto compensate for stocks inherent riskiness. The acquisitors of the 1960sthe conglomeratorssaw that the benign bond markets of the time meant that cheap funded debt was a much cheaper source of imbedded capital than common stocks, so they used debtplus some stockto buy companies. However, the overall capital structures of the corporations were still conservative: there was no way the debt markets would have absorbed debenture issues totaling six to nine times corporate cash ows. We therefore regard the closing of the Streets Discount Window to PE as unalloyed good news for the American economy. The possibility that future corporate debt offerings will be mostly applied to capital investments, rather than in payouts to the super-rich, is a reason to feel better about the US stock markets longer-range attractions. Once again, let us note that this censure is not directed against those PE rms, such as Onex and EdgeStone, that build value through long-term ownership of acquired companiesnot from one-night-stand-style nancial engineering.

...the closing of the Streets Discount Window to PE... unalloyed good news for the American economy.

August

37

INVESTMENT ENVIRONMENT
This stock market pullback is cathartic: the housing market was being polluted with sleazy marketing, appraisal, lending and packaging practices, and the corporate debt market was being polluted with a ood of securities remarkable for their absence of traditional covenants and the scantiness of their interest rates. An analysis of the perverse incentives in the current system appeared last week in the Financial Times by Sean Egan, co-founder of the Alliance for Mortgage Securitization Reform and a managing director of the Egan-Jones group. Under the Basel II accords, $100 of AAA securitized assets requires a bank to hold 56 cents of of equity to back the debt. However, if the bank or fund holds $100 of BBB assets, it has to hold $4.80 of equitya far more onerous proposition. As we noted last month, the rating agencies earn their money by issuing ratings on these debt products that are priced according to models, not markets, which means the raters are tempted to gain market share by over-rating such arcane products. Censorious raters dont get the fees. Bond managers stuck with virtually unmarketable paper rated AAA by Moodysfor which it was handsomely paidmay wonder whether the incentive system for bond rating has quietly become skewed. The unstated motto of the geniuses in the investment banks who designed and priced these mathematically complicated products for which open market pricing was not available was a variant of the Hallmark slogan: When you care enough to enrich the very few. Capitalisms greatest enemy has never been socialism: It has always been the privileged few who abuse free, open markets while mouthing the pieties of Adam Smith. The markets are nally wising up. None too soon. Assuming that the writedowns to the investment banks are in the $100-150 billion range, this will prove to be a painfulbut mostly manageableogging on Wall Street. Much of the poisonous paper was distributed to institutions abroad, and, as the bailout of IKB, a small Dusseldorf bank which gorged on subprimes demonstrates, the costs are extravasated globally, which means they should be absorbed without creating serious systemic risk.

When you care enough to enrich the very few.

38

August

Basic Points
In the wake of that German bailout, there have been dour German references to the collapse of Austrias Kredit Anstallt in 1931, which proved to be a major factor in deepening the Depression and setting the stage for Hitler. Please spare us an outbreak of Teutonic angst: IKB is hardly a reprise of Anstallt. Anstallt, which was stuffed with bad paper, failed, and many of its counterparties were driven into bankruptcy. This time, there is more than enough global liquidityand there is more than enough global nancial architectureto handle such small-scale events. The real pain will be felt among the mortgagors, who succumbed to slick marketing that they were getting their share of the American Dream painlessly. The percentage of American households owning their homes increased from the 65% range to 69% in recent years, which was cited by Fannie Mae et al as proof that the American Way of Debt worked to everyones benet. Retired General Ralph Peters recently published a thoughtful essay about coming back to his hometown and seeing the profusion of foreclosure signs. He talked to some shattered people for whom the Dream had become a Nightmare. They all described how they had not understood complexities such as resets, escrows for taxes and insurance, and other aspects of their dealswhich had become ordeals. He expressed rage at the shysters who had met their quotas and earned their bonuses by exploiting their clients. The traditional relationship between homeowners and local banks based on insured mortgages that were collateralizedif at allthrough Fan and Fred is no longer the model. Wall Street bought the mortgages from slimy mortgage brokers who were lightly regulated by state agencies with small staffs and minimal regulatory requirements or procedures. The shyster companies may go bankrupt, but many of their ofcers will walk away with big winnings from sale of optioned stock during the Manic Years. This fundamentally awed process was bound to end in big losses for investment banks and hedge fundsand serious pain for the mortgagors. Thousands of homeowners facing foreclosure discover that they are in a Kafkaesque castle of corridors where neither they nor their lawyers can locate the ultimate owners of their loan. Behind the seemingly endless array of doors, machines are talking to each other, but no human being comes out to help.

...homeowners facing foreclosure discover that they are in a Kafkaesque castle of corridors...

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39

Some pundits have characterized the housing and mortgage markets as the new American Wild West. In this Wild West, homeowners lose everything, and the Bad Guys get away to enjoy the fruits of their chicanery, while lying low until the heats off, and they can embark on their next scam. In the old Wild West, the cattle rustlers and peddlers of phony title deeds were imprisoned, shot or hanged. Those were the good old days.

Those were the good old days.

Bee Update
The threat to major food crops from Colony Collapse Disorder has not, to date, materialized. This doesnt mean there never was a major problem. In recent weeks, detailed reports from the USDA, and such disparate sources as Reuters, the New York Times and The New Yorker suggest that the colony collapses are either (1) manageable through use of recognized, readily-available special treatments, or (2) the bee equivalent of the catastrophic immunity impairment that characterizes AIDS, for which a cure could prove both costly and elusive. This has not proved to be this food cycles equivalent of the sudden anchovy wipeout due to a massive El Nio. We shall watch for reports of outbreaks from the Southern Hemisphere in coming weeks, and from Northern Hemisphere hives in late autumn. What has changed is that governments and scientists are taking this very seriously and are working together to prevent an even worse outbreak during the Northern Hemispheres next years growing season. That is reassuring.

40

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Basic Points
INVESTMENT RECOMMENDATIONS
1. This sell-off is not concluded. No oneabsolutely no oneknows what those vast quantities of collateralized debt valued by models are actually worthparticularly in distress sales. There is currently far more leverage among investment banks and bond-oriented hedge funds than there is understanding of the dimensions of the problems. The problems for housing and banking will be over when the reverse becomes true. 2. In the meantime, remain greatly underweight Financial stocks, particularly US and British investment banks. The winner of the ABN Amro/LaSalle auction, which was priced at a time the banking stocks were only mildly underperforming the stock market, will come to see its victory as no Dutch treat? 3. Remain substantially overweight commodities within equity portfolios. The mining and oil stocks have sharply underperformed the commodities, which is a major contrast with the many previous End of the Commodity Bull Market sell-offs. 4. Within that sector, you may wish to move toward the relative weightings we recommend for starters. In particular, note the solid outperformance of leading fertilizer and farm equipment stocks during the panics. 5. The bond bear market is gaining strength, although investors in Treasurys might not notice it. In bull markets, speculative and low quality assets tend to outperform highest quality assets. In bear markets, the reverse is true. The current ight to quality is a symptom of bearishness, not a sign that long Treasurys have once again become a great asset class. 6. The Japanese election result conrms that Shinzo Abe is to Junichiro Koizumi what Dan Quayle was to Jack Kennedy. Japanese savers, including the archetypal Mrs. Watanabes are sending yen abroad at record rates. Reduce exposure to Japanese stocks. 7. Emerging Markets shares have been hammered along with other risky asset classes amid the subprime and Private Equity debt debacles. This is not a repeat of 1997-98, when the typical EM had an overvalued currency and inadequate foreign exchange reserves. Today the reverse is the more characteristic situation. EM shares should be on your Buy list when the current sell-off shows signs of exhausting itself.

August

41

8. If gold rushes past $700 amid falling stock markets and a breakdown in the dollar, the stock market sell-off will accelerate, perhaps producing a selling climax. To be a true bear market, it should decline by at least 20%. That is still an unlikely outcomeand will not occur if gold continues to drift. 9. If gold and precious metals enter a roaring bull market, then there would probably be widespreadbut shortliveddevastation in financial markets. 10. As a general rule, equity bull markets are driven by news from the earnings statements, whereas equity bear markets are driven by news from the balance sheets. 11. September and October are usually the worst months for hurricanes and the stock market. Global warmists have been predicting a terrible year for hurricanes. Longstanding bears predict a stock market disaster. Maybe there will be another Katrina at a time the Babel Tower is clearly crumbling, in which case the stock market sell-off could be of major proportions. We doubt it.

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Basic Points
Jurassic Park Avenue

September 5, 2007

Produced by BMO Financial Group Distributed by BMO Capital Markets

Basic Points
An Investment Journal
Donald G. M. Coxe
Global Portfolio Strategist, BMO Financial Group (312) 461-5365 e-mail: don.coxe@bmo.com

Research/Editing Production/ Distribution

Angela Trudeau e-mail: angela.trudeau@shaw.ca Anna Goduco (print orders and mailing lists) e-mail: basicpoints@bmo.com

Jurassic Park Avenue

Overview

All financial crises are alike, in that they all come from a sudden shrinkage of liquidity, which is caused by the explosive interaction of cupidity and stupidity. At that point Fear, which had been an unprofitable and unfashionable constraint, takes charge. Yet all financial crises are unique, because economies, technology and financial markets evolve rather rapidly, so each decades follies and flaps have some special characteristics. We are instructed that Virtue is its own reward. That is scant consolation, in the early years of each new boom, for prudent investors with vivid recollections of the markets punishment for those whose lack of virtue had been most conspicuous. The boom is defined and driven by new groups of risk-takers who throw caution to the wind, borrowing big at the small costs available early in the new cycle, and then winning big. Their prosperity and arrogance grow even faster than their leverage and their assets under management. More and more of the conservatively cautious, under pressure from disgusted clients, are forced to concede that its different this time, and place their bets. What is different this time is that the assets whose overvaluation triggers this crisis arent overvalued stocks or other tradable instruments; they are the potentially perilous products of brilliant engineersthe high finance equivalent of the runaway raptors of Jurassic Park. This month we try to catch this markets falling knife long enough to describe it and predict its ultimate destination. We are leaving our cautious Recommended Asset Mix unchanged. We also take this opportunity to wish Mr. Bernanke well and continue to encourage him to resist the pressure to send his very best imitation of the Greenspan Put to the very rich debt denizens of Jurassic Park Avenue. This financial crisis was created by people who are fabulously wealthy compared to average Americans. Theynot poor homeownerswould be the biggest winners if the Fed slashes rates. Malefactors should be punishednot rewarded.
September 

Recommended Asset Allocation

Recommended Asset Allocation (for U.S. Pension Funds)
US Equities Foreign Equities European Equities Japanese and Korean Equities Canadian and Australian Equities Emerging Markets Bonds US Bonds Canadian Bonds International Bonds Cash Allocations 27 7 5 6 11 12 4 11 17 Change unch +1 -1 unch unch unch unch unch unch

Bond Durations
US Canada International Years 4.50 4.75 4.25 Change unch unch unch

Global Exposure to Commodity Stocks

Energy Agriculture Base Metals & Steel Precious Metals
We recommend these sector weightings to all clients for commodity exposurewhether in pure commodity stock portfolios or as the commodity component of equity and balanced funds.

33 25 22 20

September

Basic Points
Jurassic Park Avenue
S&P 500 September 200 to September 2007
1,500 1,300 1,100 900 700 Sep-01 May-02 Jan-03 Sep-03 May-04 Jan-05 Sep-05 May-06 Jan-07

Relative Strength of the BKX vs. S&P 500 September 2006 to September 2007
20 15 10 5 0 -5 -10 Aug-06 Oct-06 Dec-06 Feb-07 Apr-07 Jun-07 Aug-07

BKX

S&P 500

Shanghai Stock Index September 2006 to September 2007

5,500

4,500

3,500

2,500

1,500 Sep-06 Nov-06 Jan-07 Mar-07 May-07 Jul-07 Sep-07

September

Bombay Sensex September 2006 to September 2007

16,000 15,000

After a century to get over its resentment toward the very rich, America is experiencing its second Gilded Age...

14,000 13,000 12,000 11,000 Sep-06 Nov-06 Jan-07 Mar-07 May-07 Jul-07 Sep-07 B

1. The Second Gilded Age

After a century to get over its resentment toward the very rich, America is experiencing its second Gilded Age, and once again Park Avenue is its premier address. The first was the era of the Rockefellers, Carnegies, Fricks, Vanderbilts and their ilk. They turned post-Civil War America into the mightiest industrial nation on earth, and their prodigious philanthropy continues to enrich Americaand the world. The Robber Barons remain objects of disdain for the intellectual elites, even among those who fawn on todays super-rich. In part, this contempt comes because those eminent American Victorians were proudly pious men who believed in the Protestant Ethic. John D. Rockefeller described great wealth as A gift from Heaven signifying, This is my beloved son, in whom I am well pleased. Andrew Carnegie, who began his career as an impoverished bobbin-winder, gave away $380 million, (leaving less than $2 million to his heirs), mostly to libraries across North America and Scotland, arguing that the working man could benefit from libraries only by putting in the kind of time and effort that would please God. Social scientists such as R.H. Tawney and Max Weber argued that industrialization and economic progressfirst in Britain, then Americawere due, in great measure, to the widespread acceptance of the Protestant Ethic in those nations. The mainstream Protestant churches where the industrialists and financiers of the 18th and 19th centuries worshipped have, in recent decades, become increasingly modernized and marginalized, and would no more spout the primitive piety of the Protestant Ethic than they would denounce the United Nations.

September

Basic Points
None of those barons ever wereor ever expected to bebailed out by Washington when they got overextended. The ethics of the time were that capitalism was a system that relied on rewards and discipline so it would have been immoral to use public resources to rescue them from their own mistakes. That belief system has been expressed in our time as Capitalism without punishment is like religion without Hell. It is different this time. The American billionaires of the Second Gilded Age who have created the current liquidity crisis come from investment banking, hedge funds, and Private Equity. They do not cite Divine Right as justification for their wealth, or for their insistence that they be permitted to continue paying income tax on such profits as they pay themselves from their tax havens in the Caribbean at just 15%rather than the 35% that others pay. Many of them atone for this apparent lack of concern for the federal deficit by financing blogs and political candidates who demand that the 35% rate of tax on everyone else be increasedwhile the 15% rate is left alone. That approach to dealing with the deficit is gaining ground. Leading Democratic Presidential candidates and Congresspersons are supporting the 15% rate for hedge funds and Private Equity partners, while Bush and his core backers remain opposed to all tax hikes. The articulate spokesman for the American poor, John Edwards, who calls for major tax increases on the rich, has not made the hedge fund tax rate a target of his righteous wrath. It may be captious to note that a part of his large fortune is invested in Fortress, the hedge fund that pays him a consulting fee. Among its operations, the fund is a large subprime mortgage investor. The Robber Barons would be appalled that many of todays super-rich, who created this crisis, are ganging up on the Fed to demand a series of rate cutsto help poor homeowners. According to published income statistics, the average employeeincluding the janitorof investment banking and hedge fund firms in New York and Greenwich, earns far more in a month than most Americans earn in a year. If the Fed capitulates, those rich will get a whole lot richer, but the poor will not. James Grant calls this proposal socialism for the rich. This is the first time in our experience that the stock market has been subjected to wave upon wave of fear, trembling and selling, entirely because of conditions originating outside the stock market itself.

Capitalism without punishment is like religion without Hell.

September

Those diehards who keep insisting that stock prices have been too high for too long... are not so much citing history as rewriting it.

We entered this business just in time for the disastrous stock markets of 1973-74, witnessed the Continental Illinois panic of 1984 which nearly provoked a worldwide collapse, were on Wall Street twenty years ago as conditions were deteriorating in preparation for the Crash of 1987, and suffered through the real estate-driven bear market of the early 1990s, the LTCM panic of 1998, and the Triple Waterfall Crash of technology that began in 2000. In each of those cases, except the Continental Illinois collapse, equities were substantially overvalued going into the bear market. In all other plunges, the stock market had substantial endogenous risk, although the selloff was usually led by a few highly vulnerable sectorsincluding the banks. This time, the NYSE financials, which provided a disproportionate share of total earnings growth, are once again leading the retreat. The difference is that the overall market is trading roughly at its average p/e of recent decades. In relation to ten-year Treasurys, the US market is a bargain. Moreover, one can make a strong case for the proposition that stocks should trade at higher multiples than was the case in past cycles. Our lifetime has seen victories over National Socialism in Germany, Bolshevik Socialism in the USSR, and over Old Left socialism in North America, Europe and most of the world. Those triumphs for liberal concepts over Socialist dogma gave the world global free trade, deregulation, and, momentously, the adoption of capitalist incentives and deregulation in China, India and in many other previously Socialist Third World nationsand in lower taxes almost everywhere. (e.g., top income tax rates in the US and UK were over 75% until the Thatcher-Reagan era.) Stocks should trade at higher multiples when companies have bigger and better playing fieldsat home and abroadto demonstrate their competitiveness, and when dividends and capital gains are not taxed at punitive rates. Those diehards who keep insisting that stock prices have been too high for too long, and who use long-term average valuations that include the Depression, World War II, the high tax and high tariff years from 1946-1983, and the high inflation years of the Seventiesare not so much citing history as rewriting it. When we published God Bless America, two weeks after 9/11, we argued that the new War on Terror would mean that a Cold War-style p/e factor was once again appropriate. We now see that, although Islamic radicalism and jihadism in the age of nuclear proliferation are, like Nazism and Communism, mortal challenges to Western-style freedoms, these forces have not yet attained such horrific power that p/es should revert to Cold War levels. Given the EUs and Russias eagerness to sell advanced technology and weaponry to Iran on credit, Ahmadinejad will get the Bomb, but he is unlikely to share it

September

Basic Points
with Osama, let alone Chavez. The genie is out of the bottle in the region of the world where bottled genies were invented. However, this genie wont go back in the bottle after granting three wishes. We can expect more of what we have hadbombings and beheadings or threats of bombings and beheadings in New York, London, Paris, Madrid, Bali, Mumbai, Toronto, Karachi, Baghdad, Israel, Gaza, Egypt, and everywhere else where a few fanatics use Western technology to attack the West. But the world has learned to live with this latest evidence that savagery is a component of human DNA that needs to be suppressednot stimulatedwhether in Communist cells, Hitler youth rallies, or jihadist madrassas. (Personal note: the writer was having dinner with friends in Guelph, Ontario on August 22nd, when we heard a loud bang. We all thought of a bomb, but in Guelph? We ran out to the street. Yes, a letter bomb had exploded a block away, but it had been safely detonated by the bomb squad. The bomb, police said, was powerful enough to have blown the recipients head off. There had been press reports of two other letter bombs in the Toronto area, one of which had injured its recipient. Eight days later, Toronto police nabbed an Adel Arnaout, a landed immigrant from Lebanon working as a security guard. Police found three other bombs in his rented car and detonated them, after driving in convoy, and under cover from helicopters, from the north of the city to the lake shore, shutting down parkways and bridges. Mr. Arnaout has been charged with three counts of attempted murder and one of inflicting serious injury. Although the letter bombs had been a big story in Ontario, the arrest of the bomber, the shutdown of traffic in East Metro, and the detonation of three bombs was not carried by the politically-correct The Globe & Mail on its front page. The big story the Globe featured was the announcement that Al Gore was coming to Victoria, B.C. to have high tea and discuss the real threat to the worldglobal warming.) The technology that has sent stock markets into tailspins created debt products for some of the leading investment banks, hedge funds and a few Private Equity firms. Some of them reside on Park Avenue, but what they share is a secular faith in the glories of new financial structures that are born and bred electronicallyand priced according to models, not markets. Their spawn have multiplied like the Jurassic velociraptors, and their rapacity devours resources needed for the health of free financial markets. The revulsion against Enron and some of the more egregious tech frauds of the 1990s triggered (1) Congressional passage of Sarbanes-Oxley, a panic-driven approach to financial regulation that assumed that mostif not allCEOs and CFOs were greedy Gullivers who had to be restrained by Lilliputian ropes, and (2) a major expansion of class action tort litigaSeptember 7

Sarbanes-Oxley... a panic-driven approach to financial regulation that assumed that mostif not all CEOs and CFOs were greedy Gullivers who had to be restrained by Lilliputian ropes...

tion in which named plaintiffs were given shares of stock and substantial bribes by rich tort lawyers who sued virtually any company whose stock price slumped; in most cases, the companies paid the lawyers their danegeld, and stockholders got the equivalent of Cracker Jack prizes. The Great New Thing in this decade has been the Jurassic Park Avenue creation of fiendishly complex fixed income creatures... According to the Newtonian physics of markets, these actions spawned two reactions: 1. Private Equity, which had been a relative bit player in public markets, grew beyond all imagination, fueled by absurdly large quantities of absurdly cheap money. Their mushroom growth helped to reprice US mid-cap (and, later, large-cap) stocks, and to flood US banks and debt markets with junk paper. Driving this astonishing expansion was a superbly seductive argument in favor of privatization: you escape the mind-numbing pettifoggery of Sarbox, and the chicanery of tort lawyers by going private. 2. Once IPO prospectuses reached telephone book size to cover all the potential issues that could trigger a Sarbox-based class action suit, the case for designing, developing and marketing highly-sophisticated debt investments sold only to institutions became almost irresistible. Spend your money on mathematical geniuses, not on lawyers.

2. Mad Scientists of Jurassic Park Avenue?

Drexel Burnham pioneered the mortgage-backed bond-equivalent instruments that became the backbone of investment-grade institutional bond portfolios. Then came Collateralized Mortgage Obligations that linked multitudes of conventional mortgages and other high-quality residential debts together. As these instruments proliferated, they continued to trade activelyand remained publicly priced. The Great New Thing in this decade has been the Jurassic Park Avenue creation of fiendishly complex fixed income creatures called Collateralized Debt Obligations that combined investment-grade conventional mortgages with jumbo mortgages, Home Equity loans, piggyback mortgages, Alt-A mortgages and Subprime Mortgages, including low-end Subprimes, the socalled Ninja mortgagesNo Income, No Job, No Assets, otherwise known as Toxic Waste and even other CDOs. What made these synthetic products so successful was that their complex computer-created formulas were designed with the assistance and advice of Moodys, S&P, and/or Fitch. The independent rating services advised on the apportioning of ingredients of diverse quality that would, through electronic alchemy, become the inves-

September

Basic Points
tors Gold StandardAAA paper. There were almost no corporations left anywhere which had Triple A ratings, so the Joyously Jurassic creatures eventually made up a major component of the total supply of the most desirable debt instruments. They were never designed for public trading. Like Michael Crichtons velociraptors, they were kept caged and fed with just the right kind of valuations to avoid disaster. The geniuses behind this development are PhDs in mathematics and/or physics. They have created hundreds of billions of dollars worth of financial creatures with electronic DNA who exist within databases. One could call their doctorate-holding parents Procreators of Hidden Debts. Each of these newly-spawned triumphs of tendentious mathematics was valued according to the experience of mortgage defaults and foreclosures since the products first became major components of the housing market. In other words, soaring house prices were built into the valuation formulas. The housing bubble moved from the real estate ads into software, wherein it was accorded immortality. In this Brave New World, homeowners who couldnt make their mortgage payments wouldnt be foreclosed; they would just keep refinancing their mortgage, credit card and home equity debts by paying their friendly mortgage brokers higher and higher fees for putting their loans into newly-spawned CDOsat 100% or so of their homes endlessly rising values. The process recalls that other triumph of mathematical geniusesthe LongTerm Capital Management data basethat only went back five years, and had no provisions for a Russian default. When a Goldman fund stuffed with toxic software spawn faced disembowelment and had to be bailed out, the CEO described market conditions as 25th standard deviation events occurring every day. Upon inquiring how often a 25th standard deviation event is likely to occur, we were informed it is expected once every 100,000 years. We are familiar with Harold Wilsons oft-quoted maxim that, in politics, a fortnight is an eternity, but we had not realized that billions upon billions of dollars were being bet on the assumption that the expected risk of mortgage default was calculated to include, for averaging purposes, the time shortly after our African ancestors had learned to walk erectly. Perhaps the Street will consider including anthropologists and professors of pre-history along with the mathematicians in their modeling teams, now that it seems that Really Big Wheels rely so heavily in their investing on what happened in the years before the invention of the Wheel.

The geniuses behind this development are PhDs in mathematics and/or physics... Procreators of Hidden Debts.

September

Bear Stearns revelations stopped the bull market at an even ,000 for the Dow. What has ensued can be justly termed the Bear market.

For a few years, these splendidly arcane software-spawned products prospered and proliferated, sucking up many hundreds of billions of dollars, euros, yen and Swiss francs. Then, investors discovered that the pricing models for US residential mortgages were based, in large measure, on the assumption of an endlessly rising tide that would lift all debtsand, it now appears, on Alan Greenspans assurance that interest rates wouldnt rise. As word began to spread that the payment, repayment and collateral assumptions behind not only the subprimes but several layers above them within these elegant structures were fatally flawed, financial markets worldwide began to totter. The sequence was as follows: 1. Home prices stopped climbing and began to show signs of weakness. Homeowners in default could no longer continue their pattern of refinancingand getting even more cash for boats, cars, and vacations. Credit card debt began climbing nationally even faster than house prices once had. 2. Foreclosure rates skyrocketed: as of July, they were up 93% over 2006. 3. Worried holders of the software-spawned structures tried to sell them to the Street, only to learn that their effective value was, in morbid Street lingo OfferedWithout. 4. Bear Stearns, a Park Avenue star, found that two of its heavily-promoted hedge funds were collapsing. One was partially bailed out; investors in the other were told they could expect little, if any, return on their investment. The fallout from Bear Stearns revelations stopped the bull market at an even 14,000 for the Dow. What has ensued can be justly termed the Bear market. 5. Subprime shock migrated from Wall Street to Main Street and across the world. Two small German state banks and a small Dutch bank had to be bailed out because of losses on US CDOs. China reported large exposure. Even Singapore reported losses. (We assume none of the geniuses will plan a vacation there; undesirables are unwelcome and flogging is prescribed for a wide range of lesser offences than bilking billions from global investors, including the careless disposal of chewing gum.) 6. Major investment banks share prices plunged.

0

September

Basic Points
Bear Stearns (BSC NYSE) September 2006 to September 2007
180 170 160 150 140 130 120 110 100 Sep-06 Nov-06 Jan-07 Mar-07 May-07 Jul-07

Lehman Brothers (LEH NYSE) September 2006 to September 2007

90

80

70

60

50 Sep-06 Nov-06 Jan-07 Mar-07 May-07 Jul-07

Goldman Sachs (GS NYSE) September 2006 to September 2007

245 225 205 185 165 145 Sep-06 Nov-06 Jan-07 Mar-07 May-07 Jul-07

September



Merrill Lynch (MER NYSE) September 2006 to September 2007

100 95 90

In a bear market, financial stocks trade on their balance sheets.

85 80 75 70 65 Sep-06 Nov-06 Jan-07 Mar-07 May-07 Jul-07

The unvarying rule about financial-led bear markets: In a bull market, financial stocks trade on their earnings. In a bear market, financial stocks trade on their balance sheets. What makes this crisis unique, and what makes predicting its progress so difficult, is that no oneabsolutely no oneknows what all the Jurassic Park Avenue products on the balance sheets of hedge funds, investment banks, and bond mutual funds are actually worth. The irrepressible Warren Buffett commented that he would love to be weighed according to a model, but he has to use a scale. The entire history of bank regulation since Paul Volcker first convened a Basel committee to create rules and regulations for valuing global institutions has been based on market values and risk-adjusted market values. We now know that many major banks chose to escape the strictures of those rules by loading up on mortgage products that had never ever been valued in the markets. All those hymns to the virtue of transparency and harmony in financial reporting were sung by people who turned out to be elegant, sophisticated shills who employed brilliant, sophisticated mountebanks.

3. LBO Debt
While the stock market attempted to come to terms with the idea that even Goldman Sachs couldnt seem to manage risk any more (as evidenced by the hideous performance of its flagship hedge funds and the scary performance of its stock), another Street-spawned debt problem took investors attention.

2

September

Basic Points
The big banks had been falling all over themselves trying to outbid each other to finance Private Equity takeovers of public companies. As one PE titan admitted recently, when the Street was so eager to shower him with low-interest, covenant-free debt at the level of nine to twelve times the earnings of a company his firm considered buying, how could he say No? (We could paraphrase his behavior as The debt made me do it.) Who would be willing to take such smelly paper off the hands of the investment banks? Answer: until recently, thousands of institutional investors across the globe were eager to help the Street keep the PE party going. Then, four developments ended the grand PE party: 1. Credit spreads began to widen from absurdly cheap to merely cheap. 2. Recognition dawned that an additional $300 billion of dubious-quality paper was on its way once major PE deals closed. This paper would be used to finance the entire cost of buying yet more companies at big premiums to their previous market price, plus paying a huge dividend to the buyers (for all their hard work in making the bids). The acquired companies credit ratings would go from good quality to odoriferous junk in the time it would take a witch to deliver a curse. 3. Stephen Schwarzman threw a multi-million-dollar 60th birthday party for himself that drew precisely the opposite kind of response he had expected. What was meant to be a tribute to the new master of the universe was widely seen as crass, not class. Would you want him as the boss of an acquired company that had long prided itself on its traditions of decorum and excellence? Is Caligula your idea of a really neat emperor, even if you reside far from Rome in Transalpine Gaul? 4. Mr. Schwarzman, who had long cited freedom from quarterly earnings short-termism and Sarbox as reasons why PE firms could outperform their competitors even when their balance sheets were heavily burdened with debt, successfully floated an offering of stock in Blackstone at $31. Intraday, the stock touched $38 before pulling back. (Whoever paid $38 may become the Wall Street equivalent of Steve Bartman, famed as the archetype of Chicago futility, because his interference with a Cub outfielder cost the team a trip to the World Series.) The proceeds of the offering briefly boosted Mr. Schwarzmans stated wealth in the Billionaire Bragging stakes.

Is Caligula your idea of a really neat emperor...

September



Blackstone (BX NYSE) July 2007 to September 2007

36 34 32

Mr. Schwarzmans... timing for selling the public a share in his company was magnificent.

30 28 26 24 22 20 21-Jun 28-Jun 5-Jul 12-Jul 19-Jul 26-Jul 2-Aug 9-Aug 16-Aug 23-Aug 30-Aug

SubPrimal Screams
Whatever doubts anyone might have had about Mr. Schwarzmans wisdom in buying companies, his timing for selling the public a share in his company was magnificent. The stock market peaked and plunged almost immediately thereafter, as fears of a housing collapse that would trigger a recession roiled the markets. His rival, Henry Kravis, who had also rather suddenly discovered that privacy wasnt such a wonderful thing after all, was too late with his me-too attempt to take KKR public. (It didnt help that his publicly-traded affiliate, which invested in mortgage paper, cratered, due to inability to roll over short-term debts.)
KKR Financial (KFN NYSE) September 2006 to September 2007
30 28 26 24 22 20 18 16 14 12 10 Sep-06 Nov-06 Jan-07 Mar-07 May-07 Jul-07



September

Basic Points
Leading the market down was Countrywide Financial, the nations largest mortgage issuer, and long the superstar S&P financial stock.
Countrywide Financial (CFC NYSE) September 2006 to September 2007
50 45 40 35 30 25 20 15 Sep-06 Nov-06 Jan-07 Mar-07 May-07 Jul-07

Mr. Bernanke, mimicking Deng Xiao Ping, said, in effect, To borrow is beautiful!

Its now-famous chairman, Angelo Mazilo, had, coincidentally, been selling his stock almost as heavily as CFC was selling mortgages before the storm broke. Thanks to his prudent divestiture of the overwhelming proportion of his shares, Mr. Mazilo can take a somewhat relaxed attitude toward the housing market and CFCs share of the national economy. Nevertheless, he joined the more-famous Jim Cramer in a plea to the Fed to save the economy from recession. Mr. Cramers primal (or subprimal) screams that the Fed act NOW became a hit on YouTube. The Fed did actbut it wasnt what the mortgage issuers and Jurassic geniuses expected. Nor did it end the market selloff. This was Ben Bernankes first test of coolness under fire. And he passed it. His response was creative. He called a teleconference meeting of the Federal Reserve Boardnot the Open Market Committeeand cut the Discount Rate a half-point. He also widened the range of acceptable repo securities from merely Treasurys, and later expanded the time for loan repayment. He also redefined the bankerly virility test: in the past, any banker who rushed to the Discount Window was deemed to be in desperate shape. Mr. Bernanke, mimicking Deng Xiao Ping, said, in effect, To borrow is beautiful! The fast-evolving Bernanke strategy, as confirmed in his Jackson Hole speech last week, reflects the fast-evolving liquidity drought, which is centered in the disappearing market for short-term commercial paperparticularly AssetBacked Commercial Paper (ABCP).

September

5

...the prospects of rate boosts in September are somewhat more remote than a Nobel Peace Prize for George Bush.

ABCP had become a multi-trillion-dollar asset class in North America and Europe that operated as a parallel universe to the global banking system, which has been operating under Bank for International Settlements regulatory architecture based on the Basel Accords. ABCP has been the mechanism for spectacular growth in financing consumer loan products through packaging in vehicles that convert risky loans such as autos, home equity and low-quality mortgages into AAA products through self-replenishing pools. It is experiencing its worst-ever crisis. Countrywide Financial was among the first big issuers to find it could not roll over its maturing paper. The contagion spread across the US, into Canada and then into Europe. Hundreds of billions worth of commercial paper has evaporated. The banking system might ordinarily step into the breach, snapping up the offerings of AAA paper, and keeping the short-term markets liquid. However, many major US and European banks are overstuffed with junk paper from LBOs, and are collectively on the hook for $300 billion more. In the past, issuers could rely on an uncritical mass of institutional investors desperate for debt products that paid a few basis points above bank paper. However, the new Black Hole of Calculating Institutional Investors has discovered the splendors of T-Bills with the fervor of former atheists who have just received nocturnal visits from angels. The major asset class with the widest swing in yields for the past six weeks has been T-Bills. Yields have ranged from less than 2% to 4.8%without any change in the fed funds rate. The liquidity drought has forced major central banks to inject hundreds of billions worth of funds into local markets. These massive injections frequently lead to temporary de facto cuts in the official central bank lending rates. Because central banks have eased credit in three waysin acceptable loan duration, in quality of assets accepted on repos and even in terms of the range of financial institutions eligible for aidmonetary bases are growing dramatically without any changes in official rates. Bernankes formula has been adopted by the European Central Bank, and local Landesbanks in Germany, choked with US Jurassic creations, are getting emergency aid from commercial banks and the ECB. Only the Bank of England has remained aloof from this rush to reliquify. The central banks now frantically shoveling out loans on a widening range of acceptable security had previously been monetarily hawks. The Bank of Canada and the ECB had been readying their market participants for rate boosts in September. Now, the prospects of rate boosts in September are somewhat more remote than a Nobel Peace Prize for George Bush.

6

September

Basic Points
Special Note to Wiccans and Triskaidekaphobes In Canada, a newly-public Asset-Back issuer named Coventree kicked off a crisis by announcing it could not roll over its maturing paper. The entire Asset-Backed Commercial Paper market collapsed. An astonishingly long list of public companies revealed that they had substantial exposure to Coventree paper. As of writing, there is talk of litigation against Canadian banks for failing to come to the aid of the ABCP issuers. National Bank has bailed out a company it sponsored, but the outlook for many of the other companies is murky. The effect on consumer credit in Canada has been sufficiently severe that the Bank of Canada is said to be scaling back its forecasts for economic growth and inflation. Thats a big deal for such a small company. But its name suggests it had a special destiny.
Coventree (COF TSX) November 2006 to September 2007
18 16 14 12 10 8 6 4 2 0 Nov-06 Dec-06 Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07 Jul-07 Aug-07

Coventree... its name suggests it had a special destiny.

The company went public in November. Since the name Coventry had been used by many other companies, the promoters came up with this special spelling. They obviously werent students of history. A coven tree was usually a willow or rowan. Historically, under the Old Religion, which was active across Europe even before Stonehenge was built, twelve members of a coven would dance in a circle around the thirteenth member. The Church made sustained efforts over the centuries to wipe out paganism (as it chose to call it) and coven members were called witches. Any evidence in ones home or farm of symbols involving the number 13 was sufficient to lead to prosecution and likely death by drowning or burning at the stake. That is why 13 became an unlucky number: triskaidekaphobia (fear of #13) was a survival strategy.

September

7

Where did all the liquidity go? Did it evaporate due to global warming?

Coventree, like many other issuers of ABCP, seems to have increased its investment risks as rapidly as the supply of its paper outstanding. Ultimately, it could not find buyers for its paper. Corporations who borrow short, lend long, and take risks that are not fully disclosed to the market cannot expect to live long once central banks have become serious about tightening. As Fate had decreed, on August 13th Coventree was unable to place new asset backed commercial paper to fund the repayment of previously issued ABCP that had matured. Its fall from financial grace has cast a freezing spell on the Canadian financial system, which may or may not be relieved by the Bank of Canadas first caress. But going broke is a lesser punishment than being burnt at the stake. In the spirit of political correctness, (because Wiccans are, in fact, protected under Canadian law, and even the Army must make provision for their right to rites), Wiccans, please take note of this sad storybut dont take any notes issued by Coventree.

Where Are the Flows of Yesteryear?

It seems so long ago that everyone who mattered (and, we confess, us), said the world was awash in liquidity. When he was still a relatively obscure Fed member, Ben Bernanke coined one of the most-quoted aperus of our time the global saving glut. (It is usually misquoted as savings.) Where did all the liquidity go? Did it evaporate due to global warming? Liquidity is partly quantifiable, partly transactional, and partly psychological. The most usual measure is total dollar-adjusted global liquidity, which adds US monetary aggregates to their equivalents in the major industrial nations, adjusted for their currencies values. As investors learned to their despair in 1987, that number was a snare and delusion. When a crisis developed in the Eurodollar market and investors began fleeing from the dollar and from dollar-based securities, the resulting dollar drought produced a global financial crisis. Paul Volcker set in motion the procedures to rectify this problem, putting large financial institutions with Eurodollar assets and liabilities onto a common financial footing for reporting and regulatory purposes, which meant liquidity could flow more freely across institutional and geographic boundaries. Relaxation of foreign exchange controls, improved technology, and development of the Internet greatly facilitated this process. The emerging markets remained largely outside, until the restructuring of the global finan September

Basic Points
cial system in 1998 when China entered the system as a full-scale participant, setting the renminbis trading range against the yen and the dollar. In this decade, most of the leading Third World economies switched from their history of having high levels of external dollar-denominated debt and inadequate forex reserves, to having modest levels of dollar-denominated debt and robust forex reserveswhich were overwhelmingly invested in dollars. To these growing dollar hoards were added a new breed of investorsovereign wealth funds. They were repositories of excess export revenues, usually from commodities, and were also overwhelmingly invested in dollars. Here are some of the major influences on the supply and use of global liquidity in this decade: 1. China, which has the worlds fast-growing economy, has a savings rate of 40%. 2. The US savings rate fell from small to tiny to minuscule to negativeyet interest rates fell and credit spreads contracted to barely-perceptible levels. 3. To finance its Current Account deficit, the US has been drawing down more than 75% of global cross-border savings. There may not be a global saving glut, but there most assuredly has been a global saving glutton. 4. Until it finally took off, China had the worst-performing stock market of any economy in the world. That meant that most of Chinas prodigious savings had to be exported or the nations interest rate structure would have been under sustained downward pressure, which would have triggered inflation. Now that Chinas stock market is worth more than Japans, it will be an increasing source of pressure on available savingsleaving fewer savings available for markets abroad. 5. Japans Triple Waterfall Crash appeared to end after Koizumi won the firstever election in which the people voted on a real program of reform, rather than on a succession of wrinkled gerontocrats from the mislabeled Liberal Democratic Party. However, Japans interest rates remained the worlds lowest, and the development of the euroyen market meant that the yen became the borrowing currency of choice for hedge funds and investment banks trading departments. The bottom end of the yens trading range against the dollar (110-122) was set by Beijing nearly nine years ago with the advent of what we have called The Great Symbiosis. The yens fluctuations within that band have had enormous impact on the value of high-interest-rate currencies, US fixed income products, commodities, stocks and derivatives.

Japans...first ever election in which the people voted on a real program of reform, rather than on a succession of wrinkled gerontocrats...

September



6. The advent of the euro and the abolition of the predecessor currencies greatly expanded global liquidity, because the value of liquid financial assets in the Eurozone approximated the value of dollar-based liquid assets. 7. All previous crises and crashes since 1973 had the Eurodollar market as their epicenter, because Eurodollars were the only large pool of interbank activity that were not directly under the sway of a central bank. Therefore, with the growing importance and flexibility of the euroyen and euro pools, what we have called real, effective global liquidity expanded faster than the growth rates of monetary aggregates and global forex reserves. The financial world became less crisis-prone. 8. Flaps occurred occasionally in global markets in recent years when the Bank of Japan contracted the euroyen pool. The most dramatic was AprilMay 2006, when the BOJ drained 30 trillion yen from its monetary base in an operation that, inter alia, stopped gold from breaking through $700 and copper from breaking through $4. As we described those events, (see Basic Points, May and June 2006), they came after publication of a paper by BOJ economists that had been edited, with recommendations, by Ben Bernanke just before he became Fed Chairman. That paper showed how euroyen rates fostered speculation in currencies, commodities and other assets. Gold wasnt soaring this year, the euroyen pool was liquid, and, by mid-July, everything seemed right with the world. The Dow and S&P went to alltime highs. 9. The new global financial importance of the euroyen and euro pools have been repeatedly documented by Dennis Gartman, whose daily letter is a must-read. He continually updates the chart that compares the performance of the yen to the euro to the performance of the S&P.
Euro/Yen versus S&P 500 November 2006 to September 2007
114 112 110 108 106 104 102 100 98 Nov-06 Dec-06 Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07 Jul-07 Aug-07

...with the growing importance and flexibility of the euroyen and euro pools...The financial world became less crisis-prone.

Euro/Yen

S&P 500

20

September

Basic Points
10. Since 2004, we had, from time-to-time, seen reports about sustained large-scale German investment in US mortgage products. We wondered why anyone who didnt need to own US mortgage products would want to own paper issued by Fannie or Freddiebecause both have practiced phony accounting at levels that make Enron look as restrained and reliable as Berkshire Hathawaylet alone in Jurassic-style computer-modeled products. Then we remembered a bit of Brit wit we heard in London long ago: When the Americans are buying, sell them what they want; when the Germans are buying, sell everything. Once again, as we read reports of previously-obscure German banks going down because of Jurassic products, we conclude that late-to-the-party Germans helped make a market top.

...when the Germans are buying, sell everything.

The Banks and the Drought in the Asset-Backed Commercial Paper Market
The unwillingness of investors to take further dollops of vastly overpriced and undercovenanted LBO debt from PE takeovers has strained the capacity of banks to step up and back the Asset-Backed Commercial Paper market. The banks problems are compounded by evidence that subprime slime is working up through other grades of mortgage products. In particular, unfolding stories that dubious or outright fraudulent overvaluations had become the norm for some mortgage issuers argues for bleak times ahead for holders of non-market-priced productsincluding many investment banks and the hedge funds they sponsor. But it will get worse. The stock markets tumble came amid widespread publicity that hundreds of billions worth of subprime and other adjustable rate mortgages will be resetting to sharply higher interest rates over the next 18 months. With default rates already at the levels last seen during the depths of the 1991 real estate recession, how will homeowners handle big increases in their monthly payments? It is likely going to get much worse for the real value of Jurassic Park Avenue products. How important are they to the balance sheets of the major investment banks? Do they put their Tier One exposures at risk? Residential mortgages have been given generous capital allocation rules under the Basel Accords, given their history of tiny loss ratios. But comparing the riskiness of conventional

September

2

mortgages allotted to 70% of actual home value, granted to people with excellent credit records, to the kind of toxic waste pumped into the new-age products is like comparing the risks from confronting a charge by an Italian cavalry unit to those from an attack by a Panzer division. The supply of fools eventually runs out, and the system seizes up. Like most investors, we have had to learn a new vocabulary for understanding the risks to the banking system. We had, perhaps naively, assumed that Basel I and II had purified the big bankswhose bad behavior had put the global financial system at risk on numerous occasions. Now we learn that some of them might bear more than casual resemblance to the Enron model of using Special Purpose Entities to keep risks off the balance sheets and inflate returns on equity. We knew they had conduits, which, as we understood, were bank-sponsored vehicles for handling various kinds of consumer loans and credits. The banks have been standing behind those vehicles. The banks have also had various kinds of relationships to various kinds of new credit issuers financed in the ABCP market. Coventree is one such firm, which grew spectacularly until its business model imploded. As all investors in commercial paper know, the only way a credit issuer can afford to pay a higher than T-Bill rate is to take credit and/or duration risks with its loans. So we have little sympathy for those companies who took Coventree paper to pick up a few basis points over bank paper. They knewor ought to have knownthere was a higher level of risk. That a number of junior Canadian mining companies invested major portions of the capital they had raised to build new mines in Coventree paper must have prompted many stockholders to want to drop their treasurers down mine shafts. Investing in Northern Moose Pasture Mines is a big enough risk in itself without its treasurer reaching for a few basis points in yield from a company that hadnt been around any longer than Northern Moose. Writing in the Financial Times, the urbane Martin Wolf observes that this decades enthusiasm for expanding the issuance of short-term paper far beyond the banking system was based on the argument that sophisticated investors could make their own appraisals of risk, and thereby increase their investment returns. He says that what really happened was that the decision on credit quality was extended to those who were unable to make sound appraisals. The supply of fools eventually runs out, and the system seizes up.

22

September

Basic Points
The situation is different with bank entities weve been hearing about lately Structured Investment Vehicles (SIVs) and their riskier relatives, SIV-Lites. SIVs can buy a range of debt products, whereas SIV-Lites (according to the Financial Times) buy only mortgage-backed bonds and CDOs. In Jurassic terms, these are theoretically benign animalsnot raptors or T-Rexes. The banks analyze each asset that goes into the SIVs, and buy them only if they meet the banks tests for assets they are willing to put on their balance sheets. The SIVs issue Asset-Backed Commercial Paper to finance their acquisitions, and investors happily buy it because its bank-backed. The problem is that an increasing percentage of AAA-rated CDOs held by SIVs have, in effect, been re-rated to AAAwful. The banks loaded their SIVs with such products, because their durations were either unpredictable or likely to be longer than the banks felt comfortable holding in their Baselregulated accounts. The banks knew they had duration risk, but they are now horrified to find out that they have really serious credit risk as well. That has been the problem for those small German banks which suddenly became world-famous. The Financial Times estimates that there are roughly $400 billion in SIV assets that have fundamental duration mismatches and unknownbut scary credit risks. Late last week, Barclays discovered the problems of trying to hold liquidity within leaky SIVs. It borrowed 1.6 billion pounds from the Bank of Englands emergency Discount Window, and pumped 1.6 billion dollars into a SIV Lite whose commercial paper the markets would no longer accept, because of the SIVs huge exposure to US CDOs. It also indicated it would be looking at funding other SIVs. It was revealed that Barclays had, in a creative dash of Anglo-Saxon finance, designed a SIV for Sachsen LB, the German bank whose failure has forced the resignation of the finance minister of Saxony. Barclays stock has been so badly hammered that its offer for ABN Amro now looks like the high water mark of mergermania. What is clear is that these chaotic debt markets are challenging for even the best-managed banks. State Streets investment group has one of the best reputations in the industry. Its Limited Duration Bond Fund, an institutional vehicle, lost 37% of its value during the first three weeks of August and is down 42% in the past year, according to a report in The Globe & Mail. That kind of hit suggests that the managers have recently applied some stern valuation criteria to exotic items in their portfolio, and concluded that their previous valuationsmodel-basedwere no longer appropriate. Remember: State Street has been a top tier fixed income manager for a very long time.
September 2

SIV-Lites buy only mortgage-backed bonds and CDOs. In Jurassic terms, these are theoretically benign animals not raptors or T-Rexes.

...major banks are facing monstrous liquidity strains because their SIVs are too heavily committed to AAAwful Jurassic CDOs.

You can bet the bank regulators in Basel are taking note of the risks to bank balance sheets. A skeptic might wonder whether some banks took on such huge risks in off-balance-sheet entities to defeat the whole purpose of the Basel rules. Paul Volcker and his successors wanted to ensure that there wouldnt be future financial crises because of banks that had (1) borrowed short and lent long in illiquid investments, or (2) borrowed short and lent badly in terms of credit risks, or (3) both of the above. Many big and previously reputable banks have, we now know, been practicing Strategy (3) on a grand scale. We have had far too much experience with crises caused by bank misbehavior to be comfortable as we ponder the implications of these revelations of foolishness and mountebankery in the banks. Although Stephen Schwarzmans birthday bash attracted widespread snickers, the Deutschebank celebration for 500 of its more successful investment bankers in Barcelona drew less commentsneering or otherwise. The bank paid the Rolling Stones a reported $5.4 million for entertaining the assembled rainmakers$10,800 per productive head. Depending how serious the global financial crisis become, the event may become more famous in the future than it was at the time: the date was July 12th. If the Bank sold stock market futuresor calls on its own stockat the time it was delivering Mick Jagger his check, it could easily have recouped the costs of the bankers bacchanal. It is one thing if the losers from Jurassic CDOs are levered hedge funds, and the population of instant billionaires is thereby reduced. Weand the global financial systemcan surely live with that. But major banks are facing monstrous liquidity strains because their SIVs are too heavily committed to AAAwful Jurassic CDOs. The surge in Libor and Euribor interbank rates, which has driven the TED Spread and its euro and sterling equivalents to panic zone levels, is due, we are told, to banks unwillingness to lend to each other because they need to hoard liquidity to back their own suspect SIVs. In other words, the basic purpose of the Basel rules for banks has been undermined.

2

September

Basic Points
Too many banks created too many SIVs because they wanted to lever up their earnings without putting the assets and liabilities on their balance sheets. Now they have to hang on to such truly liquid assets as they can, in order to respond to the markets decision that its no longer eager to live with SIVs. The financial world was a far safer place when the bankers abided by both the letter and the spirit of Paul Volckers great reforms. We can only hope that investors in non-financial stocks will not share in the punishment that will probably be meted out to the banks that let their legal departments find exquisitely sophisticated ways to get around the constraints of the Basel rules. A Modest Proposal: We earn our living by analysing markets. We are, therefore, at something of a loss to handicap this market activity because it is rooted in an unknowably large population of investment creatures that are not markedexcept in supremely tolerant computer programsto market. We have been surprised by the suddenness and scale of the drought in the commercial paper markets of North America and Europe. We have been pleased that central banks have managed to offset much of the systemic impact of this drought by astonishingly huge cash infusions. But this process in which man-made monsters drain liquidity from the debt markets we can follow is fatiguing and frustrating. We have publicly recommended that Wall Street deal with this overpopulation by controlling the work of the PhDs who spawn these systemic polluters. What is needed is to control the capacity of the Procreators of Hidden Debts. What is needed is the financial equivalent of vasectomies for the Jurassic Park systems. As long as CDOs and other exotica were a small part of financial markets, there was justification for the Streets enthusiasm in hiring mathematicians who would otherwise be performing socially useful work. But the population explosion of Jurassic creatures can only be halted through a cessation of new creation of Jurassic products or with a crash and a recession. How can major investment banks who owe their wealth and power to open, transparent financial markets justify creating so many creatures which would perish in the cold light of market pricing like vampires forced into sunlight? What is needed is the financial equivalent of vasectomies for the Jurassic Park systems.

September

25

Surely the people involved in creating and trading the market-based and priced structured equity and commodity products must resent the bad name the reckless debt product creators are giving to all structures. When will credit agencies stop applying AAA labels to products containing toxic waste and Alt-As? Would a soup company be allowed to sell soups with 2% sewage content? When will bond investors take the pledge against buying any more of these financially lethal creatures?

Would a soup company be allowed to sell soups with 2% sewage content?

Is There Still Mold on Gold?

Gold Futures September 2006 to September 2007
740 720 700 680 660 640 620 600 580 Sep-06 Nov-06 Jan-07 Mar-07 May-07 Jul-07 Sep-07

Ten-Year US Treasury Notes Yield September 2006 to September 2007

5.3 5.1 4.9 4.7 4.5 4.3 Sep-06 Nov-06 Jan-07 Mar-07 May-07 Jul-07 Sep-07

26

September

Basic Points
In April, we told you, in effect, to lighten up on bonds and increase exposure to gold. We argued that food inflation was about to join energy inflation, and that wage inflation was next. We also argued that the huge subsidy to US debt markets from foreign investors was unlikely to last. That meant that credit spreads would revert to normal, and that the yield curve would also go back to normal. At that point we shared the general bullishness about the economic outlook. We took the view that the housing bubble had been on Page One for nearly a year, and no train wreck predicted that far in advance ever does much damage. We had in March published, DONT ASK! DONT TELL! ITS SUBPRIME TIME!, but, after reading what we could find and talking to a few experienced bond investors, we underestimated the scale of penetration of the institutional bond market by unacceptably risky product. We also failed to anticipate the last-minute flood of LBOs that would swamp the banking system with unmarketable products. We had been expecting a stock market correction, but thought it would be a relatively painless affair. We never anticipated the freeze-up of the commercial paper marketshere and abroad. That freeze-up is the equivalent of severe central bank tightening on consumer credit. Coming at a time when millions of recent mortgagors no longer had equity in their homes as the basis for refinancings or home equity loans, it meant that the risk level in the economy had suddenly spiked. It also meant that investors would run to government bonds. As risks suddenly became repriced, the effect on bond markets was dramatic. Result: Treasury yields are back to where they were when we published on April 13th. For a while, we looked good with our bond call. It turned out we were just luckyand the financial system was about to enter a string of collective bad luck, arising from years of poor management of risks by major investment banks, hedge funds, and Private Equity firms.

We never anticipated the freeze-up of the commercial paper markets...

September

27

Had we known back then that the global financial system would be put at risk by software-spawned debt creatures, we would have predicted a record price for gold. For weeks, we have been wondering why investors have not rushed into gold. Instead, T-Bills have been exciting and gold has been boring. Veteran gold bugs, who have long argued that the global financial system is a house of cards, must be deeply conflicted in recent weeks: their predictions of doom are being fulfilled, but almost nobody is seeking solace in gold.
Gold April 2007 to September 2007
700

Gold did act as a sort of Store of Value...by doing nothing in particular...

675

650

625 Apr-07 May-07 Jun-07 Jul-07 Aug-07 Sep-07

The stories of financial institutional misbehavior tend to justify the allegations of the most seriously paranoid people who are not forcibly confined in institutions for the insane. This should be a Golden Age for Gold Bugs. Gold did act as a sort of Store of Value during the summer stock and bond selloffs, by doing nothing in particular, recalling a song from Iolanthe about the phlegmatic behavior of another venerable institution during a period of crises: When Wellington thrashed Bonaparte In good King Georges time, The House of Lords Throughout the war Did nothing in particular, And did it rather well.

2

September

Basic Points
What will it take to make gold break out of its torpor? Most likely, it will take a breakdown of the dollar, which keeps tantalizing market watchers by threatening to break through 80 on the DXY.
US Dollar Index (DXY) January 2006 to September 2007
91

Alfred North Whitehead wrote, The laws of physics are the laws of Fate.

87

83

79 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07

Will it happen? Yes, we still believe so. Gold looks to us to be the greatest bargain it has been in many a year.

The Intersection of Jurassic Park Avenue and Main Street

In Jurassic Park, brilliant scientists labored long and hard to achieve amazing breakthroughs, and were shocked when their lab-spawned creatures began to run wild. Their pride in their acts of creation blinded them to the risks they created. They even struggled to prevent anyone from killing off their creations until, too late, their creations turned on them. Alfred North Whitehead wrote, The laws of physics are the laws of Fate. He argued that those who want to understand the future of humanity should read Sophocles, Aeschylus, and Euripides. In their tragedies, humans are unable to escape their Fates, and the punishment for their hubris is terrible. Already, the markets response to its shock that AAA can mean AAAwful has been sudden droughts in the commercial paper markets of the US, Canada and Europe.

September

2

Autumn is nearly here, a time when stocks often take their cues from leaves.

The crunch on the creation and distribution of US consumer credit paper from the Jurassic depredation is as if the Fed had delivered a surgical strike against American consumers. Their indefatigability and optimism were the conditions precedent to the global economic recovery after the pain and suffering from the idiocy of the Tech Triple Waterfall and the horror of 9/11. Writing in the Telegraph, Niall Ferguson reminds us how long it took for the US to recover from the Vietnam defeat and from the capital market chaos of the inflationary 1970s. He suggests that Iraq and the housing/mortgage debacle could be replays of those sad times. We respect him greatly, but we think he is too pessimistic. Nevertheless, we recognize that whatever the odds against a US recession were three months ago, they have lessened now. A fed funds cut now would unleash more speculation by the gang that gave us this mess, without necessarily stimulating greater economic activity. It would likely lead to a dollar collapse, rather than a continuation of the benign devaluation process that has already helped the US trade balance. We believe the global economy can survive a mild US recession, and still believe that equities tied to strong growth in demand from Third World consumersfood, fuels and metalsare core investments, regardless of the near-term prospects for the American economy. With the recent recovery, the stock market has largely recovered from its July swoon and August angst. We do not believe the adjustment to a sharply reduced placement for the US within the global economy is priced into US stocks, particularly US financial shares. Those risks could get priced soon: Autumn is nearly here, a time when stocks often take their cues from leaves.

0

September

Basic Points
INVESTMENT RECOMMENDATIONS
1. Remain underweight US and global Financial stocks, particularly Wall Street investment banks. They are the carriers of the contagion. Canadian bank stocks will suffer less than others, because Canadas big banks have such a protected competitive environment at home. Historically, the patient investor has never lost money owning one of the Big Five Canadian bank stocksthis should continue to be true as long as they stick to their knitting. 2. Remain overweight commodity stocks, using the suggested sectoral weights shown in our Recommended Asset Mix. (The weightings are for whatever commodity stock exposure you carry, whether a small fraction of a large equity portfolio, a pure commodity portfolio, or within the equity portion of a balanced fund.) The commodity bull market lives. 3. Maintain bond durations below benchmarks. If Bernanke is forced to ease, that will be bond-bullish briefly at best. With unemployment so low, and the dollar so weak, a cut in the fed funds rate will be seen as an inflationary capitulation by the worlds biggest debtor. 4. US investors should use Canada bonds as partial substitutes for Treasurys. Canada has been running fiscal and trade surpluses for more than a decade, and its currency is fundamentally strong. Canadians should not invest in US bondsunless fully hedged. 5. Food inflation is becoming a worldwide problem. There are no cheap answers to rising prices for grains, meats, and dairy products. There are no cheap agricultural stocksbased on historic p/e ratiosbut this is the first cycle in modern history when food shortages are due to prosperity in the Third World, particularly China, and not to crop failures. The bull market in ag shares is still in its early phase. 6. The proliferation of ETFs gives investors new low-cost means of managing equity portfolio risks. Consider, in particular, the shares that allow investors to be short Financial stocks. By owning these shares, you reduce your portfolios endogenous risk.

September



7. We have not changed our view that this equity selloff need not be the beginning of a major bear market. All major central banks have been tightening for years, so a correction was overdue. If the manmade systemic risks prove not to be of monstrous proportions, some reliquification should be sufficient to prevent a major bear market. Problem: no one has any real idea of the extent of the problem caused by CDOs, SIVs, and other triumphs of modern technology. Nevertheless, the world beyond Jurassic Park Avenue looks healthy. 8. As BMO Capital Markets rails analyst Randy Cousins argues, the railroad stocks are great long-term investments that have corrected rather severely. They have superb franchises, and excellent management.

2

September

Basic Points
The Ghosts of Octobers Past

October 11, 2007

Produced by BMO Financial Group Distributed by BMO Capital Markets

Basic Points
An Investment Journal
Donald G. M. Coxe
Global Portfolio Strategist, BMO Financial Group (312) 461-5365 e-mail: don.coxe@bmo.com

Research/Editing Production/ Distribution

Angela Trudeau e-mail: angela.trudeau@shaw.ca Anna Goduco (print orders and mailing lists) e-mail: basicpoints@bmo.com

The Ghosts of Octobers Past

Overview
October, a month of lengthening nights, is a time for ghostsin baseball, Halloween rites, and in the stock market. Ghosts, as Scrooge learned, can be useful. The huge volatility in financial markets in recent months has triggered a great increase in client inquiries about how these panics compare with past crises that we have lived through. We are therefore invoking some ghostsin the form of texts we wrote during October crises past. We are not summoning the ghosts of October 1929: Halloween is yet a while off, and our purpose is not to terrify. We are evoking only those spirits we have known personally1987, 1998 and 2004. This summoning up remembrance of crises past is not because we are warning of another crash. Those markets helped shape the economic and financial world of our time. The recent fashion for recalling the horrors of World War II does not derive from a belief that we shall ever go to war with Germany or Japan again, but to help us understand history since the War. We remain cautious about most equity sectors in the US market. The stock markets recovery from its panic lows to a new high has been impressive, but we doubt that the problems of subprimes and opaque debt instruments have been resolved. That major bank stocks have soared in response to multibillion-dollar writedowns reflects the durability of the single cockroach theory of corporate finance: if you discover and kill one cockroach, the kitchen is now totally hygienic. We are not so credulous. Even Canada, whose financial system has been a model of probity compared to the USas reflected in the relative performance of the currenciesfaces serious commercial paper problems. A US housing-led recession is not a remote possibility. Prominent economists we read assign the odds in the 20% to 50% range. The hundreds and hundreds of billions-worth of American consumer spending financed by mortgage drawdowns that kept factories (and roulette wheels) humming are yesterdays stories. What remain are the debts. For many of the most-stressed homeowners, the interest rates on their mortgages are scheduled to climb sharply, at a time of rising prices for foods, fuels, andadding injury to insultrising realty taxes based on bubble-peak valuations.

October

October

Overview
However, the global economy is being reliquified because the US appears to have launched into yet another Plaza-style currency devaluation. Central bankers abroad dare not raise their rates with the Fed in easing mode, and their currencies values will continue to rise. That process has the potential to unleash a new round of commodity inflation, led by gold, base metals, foodstuffs, and, to a lesser extent, energy. It also means the US yield curve will continue to steepen, which will ultimately be a boon to the banksmany of which need all the help they can get. We have therefore changed our Recommended Asset Mix for US pension funds, taking 5% out of bonds and putting it into equities. The commodity producers are the clearest winners from this US bailout of venal financial groups whose schemes for enrichment were based on deluding the most vulnerable group of American homeowners. Nevertheless, there will be inflationary impact of (1) higher commodity prices and (2) protecting mismanaged and dishonest financial organizations which should have suffered real pain. This program could fail. We are therefore maintaining our high cash position. Deliberately debasing ones currency is dangerous. However, the plunge in Congressional support for freer trade is dictating a strategy of making the US more competitive by weakening the greenback. We discuss the background to that strategy in detail in this issue. We also include a critical analysis of the proposed drastic changes to Albertas oil and gas royalties. For clients in Canada and Europe, we recommend a similar switch from bonds to commodity equities. Foreign investors should review their countries export industries competitiveness under a sharply devalued dollar.

October

Recommended Asset Allocation

Recommended Asset Allocation (for U.S. Pension Funds)
US Equities Foreign Equities European Equities Japanese and Korean Equities Canadian and Australian Equities Emerging Markets Bonds US Bonds Canadian Bonds International Bonds Cash Allocations 30 7 5 8 11 7 4 11 17 Change +3 unch unch +2 unch -5 unch unch unch

Bond Durations
US Canada International Years 4.50 4.75 4.25 Change unch unch unch

Global Exposure to Commodity Stocks

Energy Agriculture Base Metals & Steel Precious Metals
We recommend these sector weightings to all clients for commodity exposurewhether in pure commodity stock portfolios or as the commodity component of equity and balanced funds.

33 25 22 20

October

Basic Points
The Ghosts of Octobers Past
October 1987: Black Monday

Clients frequently ask what it was like to have been a strategist on Wall Street during the Crash, and suggest we reprint what we published during that crisis. Given the market volatility since July, this seemed like the perfect time to deliver a condensation of those tumultuous times, as covered in the Wertheim Schroder Portfolio Strategy Letter. I had joined Wertheim Schroder, a respected Research house, on April Fools Day that year, and began publishing a weekly commentary shortly thereafter.
Dow Jones Industrials July 1987 to December 1990
3,000 2,800 2,600 2,400 2,200 2,000 1,800 1,600 Jun-87 Dec-87 Jun-88 Dec-88 Jun-89 Dec-89 Jun-90 Dec-90

...the TED Spread... measured both liquidity and risk within the dollar zone of the global financial system.

In re-reading what we published that year, the consistent theme from Day One was our equity bullishness based on the powerful correlation between the Reagan-Volcker bond bull market and the performance of the stock market. The TED Spread, a classic tool for bond traders, was the key indicator we used for these twin bull markets, which were built on disinflation, a strong dollar, falling perceptions of risks from both inflation and banking collapses, and a sustained US economic recovery, after a decade of false starts and ruinous inflation. The reason the TED Spread was indispensable during the 1980s was that it measured both liquidity and risk within the dollar zone of the global financial system. Banks were still rebuilding their balance sheets after years of dissipating their resources in unrecoverable Third World loans. During the 1970s, OPEC found itself awash in a rising tide of dollars. How could

October

The TED, in effect, measured the negative impact of bankerly incompetence.

these mostly primitive economies invest them? Major global banks, which had access and prestige across the Arab world, offered to recycle OPEC nations (and nationals) deposits into loans to Third World countries, many of which were oil-poor and were suffering from trying to pay the bills for oil imports. Recycling, we soon learned, was a euphemism for spraying greenbacks across the globe to scores of states and mini-states, most of whom suffered misrule under governments ranging from the benignly bad to the brutally bad, to the utterly ghastly. The bankers competed with each other to shovel out petrodollar deposits in Eurodollar loans to an array of improbable, objectionable, and utterly ridiculous borrowers because of their reliance on Walter Wristons famed epiphany that no country ever goes bankrupt. Those loans started to go bad in the early 1980s, shortly after the Commodities Triple Waterfall began in 1981. (One of the justifications with which Seventies bankers propped up each other at three-martini lunches was that these Third World countries produced commodities, and commodity prices would keep rising.) The real killer was oil: crude oil prices began their long decline in 1980 from $40 a barrel to $10. This meant that the petrodollar flow into Eurodollar deposits shrank, stopped, and then reversed as OPEC countries had to withdraw funds to cover their expenditures on baubles, bangles, bribes, and arms. Meanwhile, as prices of all commodities declined, those Third World borrowers collectively morphed from being desiderata to disasters. That would be the pattern for tech stocks 20 years later. Therefore, our bullishness during the Eighties about the basics of the ReaganThatcher economic outlook had to be tempered by the fear of new signs of distemper in the banking system, where yesterdays bad ideas had silted up. Our overall equity strategy was based on the belief that most of the people who ran the companies we were recommending were pretty smart, but most of the bankers were foolsand their folly was the major risk to our bullish forecasts. The TED, in effect, measured the negative impact of bankerly incompetence. When stupidity reached critical mass, a crisis ensued, blasting stock markets and forcing central banks into easing, which revived investors fears that inflation would return. Because of our conviction about the positive correlation between bonds and stocks, we took the view that cash was a basically unattractive asset for pension funds, and recommended zero exposure.

October

Basic Points
In the Wertheim Schroder Portfolio Strategy Letter dated October 12th, (which went to press on Friday the 9th), we showed the following chart on the cover to display the superb correlation between the T-Bonds and the TED spread:
T-Bond Futures vs. TED Spread (Inverted) January 198 to December 198

Note: The solid line is the T-Bond Futures; the dotted line is the TED Spread.

Inside, we included the chart for that year:

T-Bond Futures vs. TED Spread (Inverted) January 1987 to October 1987

October

We announced: We have decided to make our third asset shift since this service began. We, are, for the first time, raising cash within the equity component of the fund, making the cash 10% of the overall fund... In support of that, we included the following chart:
Dow Jones Industrials vs. TED Spread (Inverted) January 1987 to October 1987

...with the Dow down 22.%... Wall Streets worst panic since 1929.

But we found it hard to abandon our basic optimism about the ReaganVolcker-Thatcher recovery, with the TED still far off its spike-high earlier in the year. We ended with: The world looks riskier. But it isnt coming to an end. It would actually look that way just ten days later, with the Dow down 22.6% and trading reports running hours late in what was labeled Wall Streets worst panic since 1929.

October

Basic Points
Our October 19, 1987 issue, (that went to press on Friday, the 16th) was published the day of the Crash. Its cover chart was T-Bonds and Gold, showing that gold was suddenly sharply outperforming and had moved to a new recovery high.
T-Bond Futures vs. Gold January 198 to October 1987

It was the financial equivalent of those dance-hall fires in which hundreds die because the exits were either inadequate or locked.

Note: Line A is the T-Bond Futures; line B is Gold.

We began our discussion: We are forced to reduce equity exposure again. The result of the liquidity problems for the American market of the Feds determined tightening of the system in response to the panic on the dollar is a heightened level of risk Last week, under near-panic conditions, T-Bill rates soared 50 points in two days, and the TED Spread went past 150 The Fed is currently being forced into a high-risk policy by the pressure on the dollar. If the Fed were to continue tightening for more than another few weeks, a recession would be inevitable. In our Conference Call on the 16th, we told clients we were doubling recommended cash in Mondays edition and warned that if the TED were to go to 200 or more, a major market selloff was coming. In discussions with clients and in our morning Research meeting, we strongly recommended that investors buy deeply out-of-the money Putswhich many did.

October

The TED opened at 215 on Monday (up roughly 50 points from late Fridays reading) and held that level amid record frenzy in the Chicago Eurodollar Futures pit. By the time the Stock Exchange opened, the rout was on. Continental Illinois... one of the nations largestvaporized in hours... What happened thereafter made history. Why did the TED leap? Because a crisis occurred in the Eurodollar market, as holders rushed to exit from positions in the dollar. Part of the problem was that there were no comparably-sized europools in other currencies to absorb a record exit rate. It was the financial equivalent of those dance-hall fires in which hundreds die because the exits were either inadequate or locked. There were rumors of a banking crisis, bank stocks had been sharply underperforming, and golds leap signified a belief that inflation was coming backa threat to all paper currencies. The dollars crisis helped trigger a panic about the survivability of US financial institutions, setting off the collapses in the share prices of banks, brokers, and S&Ls. (Reason: memories of the shocking collapse three years earlier of Continental Illinois. All too many US institutionsparticularly commercial bankshad been growing their balance sheets the quick waythrough attracting wholesale Eurodollar deposits, (which did not require the banks to deposit part of the funds with the Fed), rather than the painstaking Bank of America wayby home-growing retail checking accounts and CDs. The Continental (whose buildingor tombis across the road from where this text is written) grew through Eurodollar deposits, which were heavily used, Seventies-style, to make bad loans to badly-run oil companies. Once the banks and institutions who held those Eurodollar CDs concluded the Continental was no safer than a life insurance policy on Humpty-Dumpty, the bankone of the nations largestvaporized in hours, triggering what Paul Volcker would privately call the worst financial crisis since 1929.) The Big Fear on Black Monday was that some big US banks and investment banks were about to join the Continental in the Eurodollar graveyard. The Feds rescue team leapt in, reliquifying, and ensuring that the financial system would stand behind the investment banks and brokers caught in the no-mans land between clients sale orders and cash receipts from the buying brokers. Bear Stearns, it was widely rumored, faced bankruptcy because of counterparty risks. Although stocks rallied, times remained tense. We left a shaken Wall Street for a long-scheduled trip to see clients in Tokyo, and sat out the rest of the crisis a world away. (Our Japanese clients turned out to be just as shaken as were the Americans.)

10

October

Basic Points
October 1998: The Long-Term Capital Management Crisis and the birth of The Great Symbiosis
Greenwich cowboys and crybaby Nobel economists...

On October 6, 1998, Basic Points appeared, entitled Bailem all, The long, and the short Of great gall (The title came from the classic WWII song of the British Army officers stationed in India, Bless em all, The long and the short and the tall. The soldiers were bemoaning their distance from the warYoull get no promotion this side of the ocean.) This was, we must now confess, an essay published less in profundity than in pique. We were greatly upset about the Feds decision to bail out a conspicuously undeserving group of Greenwich cowboys and crybaby Nobel economists, who had been slathering money and praise on each other at the hilariously mislabeled Long-Term Capital Management. As we wrote: That decision [the Feds bailout] came at a time when the Japanese authorities were grappling with the problems that would attend the collapse of Long-Term Credit Bank (LTCB) which had been one of the backbones of the nations dazzling recovery from military conquest. For two years, the Japanese had been told, first privately, then very publicly, and very often, that the keys to a return to economic growth were to (1) abandon crony capitalism, and (2) let bad banks like LTCB fail. The model, as Alan Greenspan, Secretary Rubin, Wall Street chieftains, and other luminaries preached, was the American approach to the S&L crisis. The Fed has tried to soothe criticsincluding the saintly Paul Volckerby arguing that the LTCM bailout was justified because the financial markets are in such fragile shape that the collapse of an unregulated hedge fund would mean fire sale prices. Asian deflation management techniques have come to Wall Street We went on, (raging with righteous wrath) to make what turned out to be the worst forecast of our career: The bailout wont end the bear market. Six great problems stand in the way of the next bull market and the foulweather friends of Meriwether have only prolonged the agony.
October 11

...a massive reflation that transmogrified Nasdaq from being merely an overenthusiastic fad into the most absurd and insane stock market of all time.

What actually happened was that Greenspan & Co., supported by what we only much laterwould identify as the vast resources of The Great Symbiosis, took their guidance from the old British saying, In for a penny, in for a pound. Having saved the arrogant elites and their investment banks from the pain and ignominy of public revelation and bankruptcy, they proceeded to launch a massive reflation that transmogrified Nasdaq from being merely an overenthusiastic fad into the most absurd and insane stock market of all time. By year-end 1998, after fed funds rates had fallen 75 bps, US Money of Zero Maturity (MZM) was growing at the surreal annual rate of 14%. The fast-swelling forex reserves of Beijing and Tokyo underwrote this horrendous reflation, by supporting the dollar, and by holding market interest rates down. What the Greenspan Fed did was inflate a bigger bubble than the Japanese authorities had created a decade earlier. Everybody who mattered in Washingtonin the Treasury Department, the SEC and the Fedunderstood the terrible consequences of the actions and inactions of the Bank of Japan and the Ministry of Finance, but then chose to adopt them as the model for The New Economy. (President Clinton, who had barely escaped impeachment over an internal problem, was not inclined to oppose excess.) The year 1999 would turn out, for us, to be a prolonged period of pain, disillusionment, and embarrassment. In the December 14th issue of Basic Points, we wrote: The first full-blown mania in this long bull market has appeared. The Internet stocks had been merely a raffish sideshow when the market was moving majestically to 9300. Then in the markets rocket run back to the heavens, the Internet stocks became The Big Story. Unlike past penny stock extravaganzas, these companies attain multi-billion-dollar capitalizations within days of their birth, long before they achieve earnings. (The only recorded faster growth to full stature was Athenas: she sprang full-formed from Zeuss brow after Hephaestus delivered the perfect headache remedy; he cured Zeuss splitting headache by cleaving his forehead with an axe. Nasdaq was just 2000 when we penned that prophecy. Our headache didnt get better for 16 months.

12

October

Basic Points
October 200: Dollar Devaluation: The American Strategy To Win The Real World Series
The overvalued dollarpropped up by The Great Symbiosis was hollowing out much of US manufacturing.

Published on the eve of the federal elections, we argued that the US trade deficit had reached levels that were debilitating the US economy and bedeviling the political process. The overvalued dollarpropped up by The Great Symbiosis was hollowing out much of US manufacturing. From our location in the Midwest, we saw this challenge as too serious to be overlooked any longer. Long-established companies were shuttering plants, and clients were telling us that university students were despairing about having a future with US industrial companies. The election campaign was bringing demands for protectionism. We identified two unique burdens on US manufacturers that overwhelmed their efforts to achieve competitiveness: health care costs that had to be priced directly into goods, rather than absorbed through government programs that were either covered through general taxation (as in Japan and Canada), or the VAT, which was not applied to export goods, (as in Europe). We cited the BMW made in Munich, and sold into the US free of the 24% VAT a domestic buyer would pay for the same automobileor for an American import into Europe. a unique tort systemthe worst environment for litigation in the world. The contingent fee systema made-in-America monstrosityburdened the business community. According to the National Association of Manufacturers, the runaway tort system added 3.2% to unit labor costs. A Tillinghast Towers Perrin studyassesses the national costs of the tort system in 2002 at $233 billion2.23% of GDP, a de facto tax of $809 on every American in the form of higher prices for goods and services. (The unquantifiable costs of closed playgrounds, emergency wards, and of neurologists and obstetricians who have quit their practices arent included.)

We concluded that the only way to transfer those costs to foreign competitors was to devalue the dollar, stating: The dollar must be devaluedby at least 25%...Well suggest as a target the highest rate against foreign currencies the US has experienced in the postwar era. So that implies something north of 1.50 for the euro, par for the Canadian dollar, and 83 for the yen. As for yuan 20%-25% should help [The rates back then were roughly 78 cents for the Canadian dollar, $1.25 for the Euro, and 1.2 for the yen.] Thus endeth the testimony from Ghosts of Octobers Past.
October 1

Reflecting on the Ghosts Testimony 1. Ted Spread Crises

The Basel Accord has imposed prudence on those tempted to imprudence... Why has the TED in recent weeks sometimes behaved as if this could become a reprise of 1987 or 1998?
S&P 00 vs. TED Spread (Inverted) January 2007 to October 2007
300 TED Spread 250 S&P 500 Index (Inverted Scale) 1400 S&P 500 Index (Inverted Scale) 1350

200 TED Spread (bps) 1450 150 1500 100 1550

50

1600

Jan 07 Feb 07 Mar 07 Apr 07 May 07 Jun 07 Jul 07 Aug 07 Sep 07 Oct 07 Nov 07 Dec 07 Jan 08

(provided by Mark Steele, Technical Analyst, BMO Capital Markets)

If the two big risks the TED measures come from (1) collective idiocy in the financial system, and (2) a run on the Eurodollar market, then the TED shouldnt be so elevated today. (1) Banks are collectively a lot smarter and safer than they were during the Seventies and Eighties. The three-martini lunch lenders to the Third World are long gone. The Basel Accord has imposed prudence on those tempted to imprudence, and transparency to those who craved mystery. (2) As we noted earlier, the euroyen, euro-euro, euro-Swiss franc and eurosterling pools are collectively far wider and deeper than the Eurodollar pool. Exiting from the dollar is now a keystroke activity, not a terrified dash into an overcrowded stairway. The TED should therefore, in theory, like the Dow Industrials, be displaying a What, Me Worry? attitude.

1

October

Basic Points
For roughly a quarter-century, the TED Spread was a widely-watched indicator. It was measured by the yield differential between the front-month T-Bill and Eurodollar contracts on the Chicago Mercantile Exchange. Then, (to our dismay), when interest rates got down to very low levels and market volatility followed suit, the Merc discontinued offering the T-Bill contract, citing inadequate demand. What we have as substitute is the next-best thing to the classic TEDthe cash TED Spreadwhich measures the spot yield differential between the bills and Euros:
TED Spread January 2007 to October 2007
2.5 2.0 1.5 1.0 0.5 0.0 Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07

The Eagle has become the Rodney Dangerfield of the global financial aviary.

(provided by Mark Steele, Technical Analyst, BMO Capital Markets)

What would the ghosts of 1987 find to savor in our world? The TED is volatile and trades in a far higher range than it had during what we have called The Age of Complacency (20032006). The dollar, despite a few days rally, is trading near an alltime low against major currencies. (We also remark that, apart from Zimbabwe and a few such hellholes which are admired only at the UN, the dollar is also weak against most Third World currencies. The Eagle has become the Rodney Dangerfield of the global financial aviary.) Gold is trading at its highest levels since it retreated from its Triple Waterfall peak in 1980. Bank stocksparticularly major investment bankswere sharply underperforming until their recent rallies.

October

1

US Dollar Index (DXY) January 2007 to October 2007

86 85 84 83 82 81 80 79 78 77 Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07

Gold January 2007 to October 2007

750 720 690 660 630 600 Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07

Bank Index (BKX) January 2007 to October 2007

120

115

110

105

100 Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07

1

October

Basic Points
One difference with 1987 is Fed policy. The 1987 Fed had begun renewed tightening in August immediately upon the appointment of Alan Greenspan as successor to the irreplaceable Volcker. Two tightenings occurred before the Crash, and long yields had risen accordingly. This time, the Fed has cut rates by a dramatic 50 bps, yet ten- and thirty-year Treasury yields have climbed modestly, and commodity prices have climbed, led by gold. Conclusion: Until the TED gets back to double-digit levels and stays there, investors should not conclude that the All Clear horn has sounded. Even the Bank of Canada, which eschews bailouts, was forced to pump liquidity into the system for five straight days last week because of the lack of thawing in the nations great glacierthe Asset-Backed Commercial Paper (ABCP) market. Paraphrasing Marcellus, who had seen the ghost of Hamlets father, Something is rotten in the state of the markets. All financial crises end in reliquification. But a reliquification does not, in itself, restore calm to global financial markets. The dollars external value must be stabilized, allowing a sustained retreat of the TED Spread. We are a long way from that safe harbor. ...investors should not conclude that the All Clear horn has sounded.

2. The Uniqueness of the Crisis of 1998

Until it reached its October climax, the world financial crisis of 1998 looked as if it would endlike all major perturbations in the previous 20 years with a dollar devaluation. As stock markets stumbled, the DXY fell from roughly par to the 92 range during the late summer. Then, when the yens value swung in hours from 142 to 115, the greenback rallied powerfully. For the first time, a global crisis was focused on the yuan/ yen values. That crisis was resolved in what we would later call The Great Symbiosis. China had originally threatened to devalue the yuan unless Japan abandoned its policy of stealth yen devaluation which had taken the yen from 105 to 145. They drew the line in the sand at 122, and this has tended to act as the bottom of the yens trading range for most of the time since then. The two nations pledged to maintain their currencies relationships to each other, primarily by pegging their relationships to the dollar. In pursuance of that policy, they have bought more than $1.3 trillion in Treasurys and Agencies. We discussed this in the February 2004 issue, The Great Symbiosis.

October

17

As we noted (in awe) in the October 2004 issue: In just one week before we published that issue, Japan bought more than $60 billion in Treasurys as the yen was threatening to rise against the greenback. The yens current weakness at a time of controlled, gradual strengthening of the yuan and strength of all other tradable currencies suggests China is no longer focused on the yuan/yen relationship, meaning that what we call The Great Symbiosis which has been called The Third Bretton Woods by Wall Streeters who discovered this system more recently, is fading into history. Other than the greenback, the yen has beenby farthe weakest of the major currencies. OPEC members speak more and more of pricing their output in euros, which makes sense given the heavy trade between the Arab oil states and Iran with Europe. That is doubtless, quietly, affecting the willingness of the sovereign wealth funds in the region to hold Treasurys. If The Great Symbiosis is no longer operative, and the oil state forex reserves and sovereign wealth funds are reallocating their cash flows away from the greenback, then the global safety net under the dollar is termiteridden and will not offer reliable support whennot ifthe next run on the dollar comes.

...the global safety net under the dollar is termite-ridden...

3. Weak Dollars/ Strong Commodities

Dollar weakness, if it comes on slowly, and proceeds smoothly, can be good for US stocks, because in that circumstance liquidity tends to be generous, and foreign earnings of US companies rise when converted into greenbacks. The US trade deficit shrinks, and US capex is modestly stimulated. Foreign companies whose stockholders equity in dollar terms rises, are emboldened to buy US companies. (Just last week, for example, TD Bank made a major US acquisition, and its CEO admitted that the Canadian loonies parity made the deal more attractive.) Dollar weakness can be bad news for US stocks and bonds, because countries whose currencies are weak are inflation-prone. Once foreign dollar-holders sense that the dollar weakness is serious, they may exit with indecorous speed, and that means major financial crises. But it can be very good news for commodities as an asset class, and precious metals in particular.

18

October

Basic Points
That commodities tend to rise in price during periods of dollar weakness is well understood. Causation, coincidence, or both? After Nixon closed the gold window in 1971, the dollar fell against most currencies, and central banks, freed of the discipline of gold, printed money with reckless abandon, sending inflation rates to postwar records. Commodities, whose supplies are, in most cases, subject to production constraints, were a natural hedge against runaway printing presses and many commodities became grossly overvalued (in relation to their economic usefulness). The commodity Triple Waterfall runup from 1971 to 1981 was the result. Ned Davis recently published a table showing that, in every year of this decade starting in 2002 (except 2005), the dollar weakened, and in each of those years the CRB rose. However, his table shows that the CRBs best year was 2002, when it soared 23%, but the DX only fell by 1.8%. It is, however, a real stretch to ascribe the roaring bull markets in metals and oil of this decade to that slight fall in greenback value. Incidentally, 2002 was a terrible year for most stocks, but commodity stocks, the group that would be the defining stock sector for this decade, had a wondrous year. Meanwhile, tech stocks were completing Stage Two of their Triple Waterfall collapse. The powerful performance of mining and oil stocks compared with the pitiful performance of Wall Streets darlings evoked ridicule from many of the Streets Best Minds. Why should deep cyclicals be outperforming growth cyclicals? Sell those Sunset Stocks while you can! Although the dollars weakness didnt cause the commodity bull market, it contributed to it. A weak dollar has long been associated with rapid expansion in global liquidity, which is strongly beneficial for commodities. In previous cycles, the weak dollar was a powerful stimulus to Third World growth, because most of the Emerging Markets external debt was dollar-denominated, and foreign exchange reserves were skimpy. In this cycle, for the first time, Emerging Markets currency reserves have gone from strength to strength, and the weak dollar meant that many of these countries struggled to hold down their currencies values. It is different this time.

Sell those Sunset Stocks while you can!

October

19

4. How Significant Is This Decades Commodity Rally?

CRB Futures January 1971 to December 1981
325 275 225 175 125 75 Jan-71 Jul-72 Jan-74 Jul-75 Jan-77 Jul-78 Jan-80 Jul-81

CRB Futures January 1981 to December 2001

315 295 275 255 235 215 195 175 Jan-81 Jul-83 Jan-86 Jul-88 Jan-91 Jul-93 Jan-96 Jul-98 Jan-01

CRB Futures January 2002 to October 2007

375 355 335 315 295 275 255 235 215 195 175 Jan-02 Sep-02 May-03 Jan-04 Sep-04 May-05 Jan-06 Sep-06 May-07

20

October

Basic Points
This decade has seen the broadest, most sustained commodity rally of modern times. Looking back to when we entered this business in 1972, commodities entered a Triple Waterfall rally, then a two-decade-long collapse, and then entered what we believe will prove to be the longest and strongest commodity rally of all time. The CRBs Triple Waterfall rally from 1971 to 1980 was bigger than its move in this decade, but it was in sideways mode for five years from mid-1973, before the inflation mania took hold. In the late phases of this surge, speculators were buying commodities and commodity futures primarily as hedges against inflation, not because of belief in sustained improvement in the supply/demand balance. This was driven by a runaway CPI, which reached an annualized year-overyear rate of 14% in early 1980. Silvers price, in the Hunt brothers squeeze, soared from $5 to $50, helping to form the top of the Waterfall. The CRB has never displayed mania symptoms in this decade, but it has moved higher each year from 9/11, peaking a year ago at 360, falling to as low as 300 this year, then rallying to its current level of 328. Those people who say, This is just a replay of the Seventies betray their ignoranceor their biasor both. For most people, commodity price rises have been pains in their pocketbook, not stimuli to investment, speculation, or hoarding. Noteworthy example: the public has not rushed into precious metals in this cycle. There have been no lineups to buy gold at the Bank of Nova Scotia at King & Bay Streets in Toronto. (The only lineup to get into a bank weve seen this year was the picture of panicky depositors at Northern Rock, the British mortgage bank. Northern Rock seems, like Long-Term Capital Management, to have been misnamed, rather as if a certain prominent starlet named Spears had a given name like Prudence.) What is most noteworthy about this most noteworthy of all commodity bull markets is that nearly all commodity futures curves have stayed in backwardation: you can buy commodities in the future more cheaplyusually far, far more cheaplythan you can buy them today. Wall Streets seers reflect the consensus: commodity price rises are due to short-term squeezes; vast new production will come on stream; then prices will collapse; always have; always will.

...you can buy commodities in the future more cheaply usually far, far more cheaplythan you can buy them today.

October

21

Like Draculate denizens, these software spawn would perish in sunlight.

What is also very noteworthy is that, unlike all past commodity bull markets, the p/e ratios on the great commodity producers shares have not widened in relative or absolute terms. The p/e ratios on tech stocks have outperformed the p/e ratios on the shares of companies whose earning performance is gigantically better than those of the tech companies. There may be an underlying logic there, but we do not recommend that clients devote much time to searching for it.

5.

There Were Few Hedge Funds In Those Past Crises: Its Different This Time

This is the first financial crisis in which large numbers of hedge funds are involved. The hedge fund population is up by 900% or more since the LTCM crisis, and those using leverage to invest in AAAwful subprime mortgages have been the unwilling stars of this X-Rated show. LTCM was about hubris in the form of Nobel Laureates involvement in designing data systems that would supposedly reflect all financial market conditions of any consequence. In 1997, Robert Merton and Myron Scholes won the Nobel for their option pricing theories. A year later, LTCM, relying heavily on their names to attract capital, and their theories to construct trading models, went broke. Do not send to find for whom Nobels toll: they toll for thee. This crisis comes from the hubris in Jurassic Park Avenue, where PhDs have designed and built mortgage products that contain liberal quantities of toxic waste, yet receive AAA ratings from complaisant rating services. These products were not just manufactured in back rooms, but they were designed never to see the light of day on trading floors. Like Draculate denizens, these software spawn would perish in sunlight. The game was to include a helping of excellent mortgages in an algorithmically-created recipe that included some good mortgages, many iffy mortgages, and a generous serving of outright slime: mix well, and thenhey presto!you have generated a product valued at far more than the sum of its parts. It was as if a pet food company used arcane formulas to mix inspected beef and fish of varying grades with a 10% helping of assorted roadkilldeer, dogs, cats, frogs, toads, snakes, raccoons, etc., scraped off highways, for which grateful authorities gave them tax credits for their environmental excellence. Such a formula might produce a product that could undersell Purina. For a while.

22

October

Basic Points
In the case of the Collateralized Debt Obligation (CDO) packagers, those money-mad scientists never had any intention of retaining their exotic excrescences: relying on a postmodern Greater Fool theory, they sold them off to others, who moved them, as rapidly as possible, to some ultimate buyers who were too greedy, incautious and/or ignorant to read the fine print on the package. LTCMs successors found riches where conventional investors had seen risk and poverty in subprime mortgages, including Jurassic Park Avenues defining breakthough, NINJA mortgages: (Loans for 100% or so of a house purchase price to borrowers having No Income, No Jobs or Assets). How, you ask, could any algorithm, even from the slimiest of Jurassic Park elites, make this decades equivalent of the 1980s bank loans to North Korea and Zimbabwe look good? Answer: use the years of the housing bubble as the basis for calculating losses from mortgage defaults and foreclosures. Those statistics proved that losses from foreclosures were negligible during the years housing prices were going straight up. (This could, possibly, be the approach Floridas Republican governor is using to price the costs to taxpayers of his hurricane insurance programstatistics on hurricane damage incurred from December to June.) When the housing bubble was nearing its climax, Bear Stearns, Merrill Lynch and their brethren publicly announced huge commitments to subprime and bragged that such commitments generated huge profits to stockholders (and, coincidentally, huge bonuses for investment bankers and CEOs). The casual investors might have assumed that large-scale magic morphing of DDDreadful Subprimes into hundreds of billions worth of AAA-rated CDOs would attract a question or two from somebodyanybodyin the SEC, the Fed, the Comptroller of the Currency, or from some functionary in any of the many state regulatory agencies that issued mortgage licenses to firms such as New Century Financial and to a vast number of newly-minted mortgage brokers. However, those agencies policies, if their bosses bestirred themselves from sleep long enough to formulate policies, were, Dont ask. And the disclosure policies of all the participants in the chainfrom lowly mortgage brokers to Jurassic Park Avenue multi-millionaireswere, Dont tell.

...magic morphing of DDDreadful Subprimes into hundreds of billions worth of AAA-rated CDOs...

October

2

a 2th standard deviation event. ... events that occur only once in 100,000 years, which meant back to the Paleolithic era.

Some of todays breed of database builders apparently learned from LTCMs blunder in using such a short period of history for their calculations of standard deviation spreads. When a Goldman fund blew up, the CEO called this a 25th standard deviation event. As we noted last month, this term describes events that occur only once in 100,000 years, which meant back to the Paleolithic era. As historians, we are profoundly impressed by those who are respectful of history. We are slack-jawed in admiration of those who seek to use the lessons of 100,000 years of experience. Wishing to be helpful to these suffering scholars, we offered the suggestion that, to improve their models effectiveness, they might include professors of prehistory and anthropologists in their crew, since most of the behavior their risk analysis programs were assessing took place long before the invention of the wheel. Pause, for a moment, to consider the relationship between the timespan covered in the database of the modelsfive years or lessand the timespan used to average out results used in the explanation of financial loss100,000 years. This vast disparity could, perhaps, have been devised from the ratio of the average income of the mortgagors to those of Wall Streets model-builders, marketers, and mouthpieces. This years crisis resembles those of 1987 and 1998 in that computer-driven behavior models have figured prominently. The difference is that the modeling this time was based on the probable behavior of the poor, (of which the Street may be presumed to know little), whereas in those previous crises, it was the probable behavior of the rich (of which the Street may be presumed to have known rather more). The 1987 Crash was accelerated by the misbehavior of models used to construct what was arrogantly termed portfolio insurance. The 1998 crisis was caused by the misbehavior of those very factors the Nobelity had thought worth observing. In each case, what would have been a brief and well-contained market adjustment became a crisis because of the Streets quasi-religious belief in the predictions of models.

2

October

Basic Points
But the fact that all such experiments have failed disastrously has not dimmed Wall Streets faith that some new crop of greedy geeks will find the magic formula for never-ending accumulation of risk-adjusted riches. One definition of insanity is repeating the same failed experiment over and over, expecting that the next time one will get a favorable outcome. But the Jurassic Park Avenue glitterati are not madmen. There is a precedent for this process that is not grounded in insanity. European monarchs hired the medieval equivalents of the Wall Street algorithm experts as alchemists, to turn base metals into gold. Historians report that when those alchemists failed, their royal clients would jail and flog them; if the alchemists were lucky, they wouldnt suffer the fate of others, who had been thrown from the battlements or boiled in oil. (This latter punishment was rarely inflicted, we understand, during times of high oil prices.) We live, alas, in a civilized age. Neither outright crime nor loathsome slime draws the kind of punishment that would give pause to greedy modern miscreants. Our modern monarchs just (1) scream to the Fed for a bailout, which is duly awarded, and (2) use some portion of the proceeds to hire other alchemists, and to search (futilely) for other sure-fire formulae. Our failed alchemists dont even have to justify their behavior to Congress. The medieval mountebanks merely cheated a few monarchs and barons. Todays snake oil peddlers bring down financial markets and drive hundreds of thousands of people from their homes. Reflecting on the differences in punishment of malfeasance, a reasonable person might well conclude that the medieval approach has much to commend it. (Perhaps, given concerns about global climate change, we can substitute some other punishment for boiling in oil. Nevertheless, capital punishment is surely appropriate for those who have punished the capital of innocent millions. In the tradition of the object all sublime of the Mikado, Let the punishment fit the crime.) Todays snake oil peddlers bring down financial markets and drive hundreds of thousands of people from their homes.

October

2

THE INVESTMENT ENVIRONMENT

1. The Commodity Bull Market Continues
The volatility of recent months certainly recalls some of those Octobers past.
Dow Jones Industrials May 2007 to October 2007
14,100 13,900 13,700 13,500 13,300 13,100 12,900 12,700 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07

Mortgage Finance Index (MFX) May 2007 to October 2007

105 100 95 90 85 80 75 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07

2

October

Basic Points
US Dollar Index (DXY) May 2007 to October 2007
84 83 82 81 80 79 78 77 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07

Gold May 2007 to October 2007

740 720 700 680 660 640 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07

Crude Oil May 2007 to October 2007

85 80 75 70 65 60 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07

October

27

CRB Futures May 2007 to October 2007

335

...the prices of [commodity stocks] such as oil, copper, iron ore, steel, and fertilizersare, in effect, set by the new middle class of the Third World, particularly in China and India.

325 315 305 295 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07

We have been taking the view that the most bearish forecasts for the US financial system and economy will not come true, and have been holding equity exposures steady. We are gratified that our insistence that commodity stocks would outperform during the financial crisis has been vindicated to date. Various other strategists looked at the behavior of commodity stocks during previous crises and recommended that investors unload them. The thesis is that investors should rush from cyclicals to consumer non-discretionary stockssell autos and Wal-Mart and buy Big Pharma. Why have the commodity stocks held up amid all the chatter about a coming US inflation? Because the prices of what they producesuch as oil, copper, iron ore, steel, and fertilizersare, in effect, set by the new middle class of the Third World, particularly in China and India.

28

October

Basic Points
Examples of the ability of the pre-eminent companies to weather storms:
BHP Billiton (BHP TSX) January 2007 to October 2007
85 80 75 70 65 60 55 50 45 40 35 Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07

Freeport McMoRan (FCX NYSE) January 2007 to October 2007

120 110 100 90 80 70 60 50 40 Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07

CVRD (RIO NYSE) January 2007 to October 2007

40 35 30 25 20 15 10 Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07

October

29

XTO Energy (XTO NYSE) January 2007 to October 2007

63 58 53 48 43 Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07

Conoco Phillips (COP NYSE) January 2007 to October 2007

95 90 85 80 75 70 65 60 Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07

Potash Corp. of Saskatchewan (POT NYSE) January 2007 to October 2007

120 110 100 90 80 70 60 50 40 Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07

0

October

Basic Points
Deere (DE NYSE) January 2007 to October 2007
150 140 130 120 110 100 90 Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07

Alberta... the best place for oil investment among... four countries... the others being Venezuela, Russia, and Kazakhstan.

Monsanto (MON NYSE) January 2007 to October 2007

90 85 80 75 70 65 60 55 50 45 Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07

2. The Alberta Oil Sands Royalty Folly

We had not planned to include a discussion of the Alberta royalties debate in this issue, but, on reading the report of the Panel, we thought we could not remain silent. We have been among the most conspicuous supporters of the oil sands stocks in the financial community and our clients have invested heavily based, in part, on our insistence that Alberta is not a politically risky region. After reading the report, we believe that, if it were implemented, Alberta would still be considered the best place for oil investment among the four countries with highly prospective oil resources, the others being Venezuela, Russia, and Kazakhstan.

October

1

Longtime readers will already have noticed a conspicuous omission in the family of winning commodity stocks: we didnt include Suncor and Canadian Oil Sands Trust in our charts of recent blue chip commodity winners. ...we are as convinced as ever about the investment merits of the producing oil sands companies. The Alberta oil sands stocks that we have been recommending nearly every month for five years have underperformed in recent weeks, because of the announcement of recommendations to the provincial government that it impose potentially painful royalties on the oil industry. We were in Alberta when the proposals were announced. Our visit to the province included a helicopter tour of the oil sands. We read everything we could find on the proposals, and talked to many prominent Albertans including some who back the royalty and tax increasesand we are as convinced as ever about the investment merits of the producing oil sands companies. (Although the Panel astonishingly proposes to repudiate royalty legislation under which Suncor and Syncrude were developed, this would be pure Marxism, and would trigger court actions based on the ancient English concept of estoppel. Those which are nearing production or, in our colleague Randy Ollenbergers memorable locution, are slide show oil sands producers are likely to be in a markedly different risk profile. They will be subject to whatever the maximum royalty might become, and their capital costs per barrel will dwarf those of Syncrude and Suncor, because of the serious inflation in Albertawhich is, of course, the result of the nonstop building boom caused by the oil sands.) The truth is that nobody in the 1990s predicted $80 oil when the royalty rates were set, or that an unprecedented rush by new players into the sands would unleash serious inflation on all Alberta residents. We talked to Albertans sympathetic to the Committees proposals, and they based their concurrence on the costs being imposed on themand on charities and hospitalsfrom the wage-price spiral caused by cost-plus push in Fort McMurray. Few in this decade predicted the most important impact of $50 oil: it triggered the repudiation of royalty and tax arrangements with Big Oil in Russia, Venezuela and other oil-rich countries. We thereupon formulated what we call The Law of Political Risk for Foreign Companies in Third World Commodity-Producing Countries: the political risk increases as the square of the commodity price increase.

2

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Basic Points
Something else that few predicted when Putin, Chavez et al. were tearing up deals with Big Oil under which those companies had committed hundreds of billions of dollars in investment in new oil and gas production: there would be a record-breaking rush into the Alberta oil sands. The current reality is that the Alberta oil sands are now unique: the only other such deposit in the world is in the Orinoco Basin in Venezuela. That means those deposits are effectively off-limits to privately-owned oil companies in general, and Big Oil in particular. OPEC has long declared most of its resources off-limit for private oil companies. Big Oils Reserve Life Indices are shrinking. The companies are responding by investing their cash flows in their own shares$170 billion last year (according to the John S. Herold organization). Big Oils business model risks becoming the Cheshire cat of Alice in Wonderland. There are precious few countries with preciously large oil and gas reserves for the industry to reinvest its strong cash flows. A higher royalty for the oil sands, and a slowing in the rate of new permits reflects (1) higher oil prices than the industry ever expected: Big Oil has been adamant that oil prices would fall back to $35, and (2) higher inflation for the Alberta economy than anyone ever predicted. We would not ordinarily take sides in a decision that must be made by the people of Alberta, but under the guise of a fair share the province could inflict serious pain on investors no matter where they resideand on Canadas image worldwide. The Alberta government should be extremely suspicious about a proposal from a Panel whose leading consultant is deeply tied into the tax regime of Alaska. In an interview with Diane Francis of the National Post, he talked of making Albertas oil tax take competitive with Alaskas. Alaska? Youve got to be kidding! Alaska has never had a diversified economy, and its residents are famed as being grotesquely over-pampered by governmentsstate and federal alike with Bridges to Nowhere and other such impedimenta of the handout state. That largesse has kept back development of a diversified economy, and too much of the population lives on handouts or is on government payrolls. Alberta is a diversified, vibrant, complex economy. It should stay that way. Big Oils business model risks becoming the Cheshire cat of Alice in Wonderland.

October



The Panel takes a strong stand on principles that lie somewhere between those of the Mafia and those of Marxists...

Our predisposition to treat the Panels recommendations with respect was sorely strained from the moment we read the covering letter to the Alberta minister of finance. We have personally had extensive experience with government-appointed policy committees, and we were surprised at the inflammatory language used to introduce the report. This sounded more like a Left Coast tirade against a government alleged to be in bed with a greedy oil industry than a reasoned study of taxation alternatives. It went on to suggest that because bitumenwhich is what the oil sands producedoesnt have a free, open market, that means Albertans are probably being robbed. (That upgraders cost billions and are subject to the risk of Crack Spread volatility doesnt, in this Panels view, mean that the industry isnt being dishonest about its profitability.) However, the industry neednt feel that its the only villain in this tax-boost screed. The Alberta Department of Energy, and indeed the entire Alberta government, has failed in its duty to be trustee of the provinces resources. After a series of denunciations of the government, and after demanding full disclosure, the Panel asserts, Stated politely, this standard of disclosure is not presently [sic] being met. The Panel takes a strong stand on principles that lie somewhere between those of the Mafia and those of Marxists about pledges, promises and deals made in good faith by the government and the industry on which hundreds of billions of dollars of investment have been committed by private investors: While it may not be best practice for a government to change the rules after projects have begun, it is definitely not best practice for the Government of Alberta to accept something less than fair share. What is a fair share? That, of course, is whatever this Panel, headed up by a former forestry executive, (an industry noted for its lack of profitability compared to the oil industry) thinks. The Panel is very insistent in its rejection of the old-fashioned idea that pledges and guarantees from the government should be honored. The Panel begins its report by wallowing in self-congratulation, referring to its work as visionary actions we take now on behalf of our grandchildren and yet-tobe born great grandchildren, but it fiercely opposes grandfathering. The Panel recommends against grandfathering: all recommended provisions should apply equally to all participants, and at the same time. (The legislated royalty rules for Suncor and Syncrude that kept those companies from



October

Basic Points
collapsing during the years of low oil prices and high technological difficulties must now be scrapped. Once upon a time in Alberta, a mans handshake was his bond. Now, its Vladimir Putin who is apparently the model. He knows how to deal with Big Oil. He knows how to revoke a promise to Big Oil and get away with it.) The most reassuring statement we found in the report was the Panels observation about comparative governmental takes of heavy oil: This is the best comparison to Albertas oil sands, and the bitumen in Venezuela would be a very good comparison except for the differences in political systems and philosophy between the two. We were relieved that the Panel, upon reflection, decided not to use Hugo Chavez as a model of resource policy management. We noted, however, that the Panel only recognized a difference about political systems and philosophy. In view of the venom in the rest of this report, that could be taken to mean that hes less of a villain than the Government of Alberta or the Canadian oil industry. We are of the view that the Panels report is of a quality that the Province could hardly adopt. It betrays itself by its prose style: it is not written with the restraint, literacy and open-mindedness that bespeaks the careful, unbiased judgment of the wise. If this is a document offered as the basis of government policy, it deserves a C for literary style and a D for the quality of its reasoning and recommendations. We still see Alberta as the place that the oil industry will have to go to replace its dwindling reserves. When almost everybody who mattered was wrong about (1) global oil demand; (2) global oil production to meet that demand, meaning that (3) oil prices went far higher than predicted, unleashing (4) large-scale looting by the rulers of the nations with the largest apparently available oil reservesother than Canada, then, 1. theres room for new royalty arrangements in the oil sands, without killing the goose that lays the golden eggs, and 2. investors should look on the producing oil sands companies as uniquely attractive investments.

We were relieved that the Panel, upon reflection, decided not to use Hugo Chavez as a model of resource policy management.

October



Investors should assume that typical Prairie Common Sense will assert itself...

As bad as the report is for the oil sands companies, the segment of the industry that could be hurt the most is the natural gas-levered companies. As Jim Buckee of Talisman observed, (in a letter to Premier Stelmach), companies are struggling to replace production by drilling deeper at far greater costs. The assumptions about gas-well profitability used by the committee bear little relationship to current reality: costs are far higher than they were during the years the Panel used for its calculations, and natural gas prices are far weaker than most industry figures expected. Our conclusion: the Panels report is a document about which Albertans and all Canadiansshould be embarrassed, not enraged. Investors should assume that typical Prairie Common Sense will assert itself, and this report will be praised, studied, and then used as the basis for legislation that will dismay and disappoint the Panel members. Advice to future commissions: dont hire a consultant from Alaska.

. Gold: Foul-Weather Friend

Golds breakout has meant that the gold mining stocks finally joined their commodity brethren.
Barrick (ABX NYSE) January 2007 to October 2007
43 41 39 37 35 33 31 29 27 Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07



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Goldcorp (GG NYSE) January 2007 to October 2007
32 30 28 26 24 22 20 Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07

Kinross (KGC NYSE) January 2007 to October 2007

16 15 14 13 12 11 10 Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07

Newmont (NEM NYSE) January 2007 to October 2007

48 46 44 42 40 38 Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07

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7

As we had long predicted, once the DXY fell to a new low, gold would break out above $700. It continues to trade inversely to the dollar. If our forecasts for further dollar depreciationand of the thrust of Fed policyprove accurate, then goldand gold shares, should go to new all-time highs. ...replacing...production through new mines in politically reliable nations has become a real challenge. The gold stocks have had trouble outperforming the bullion. The major reason, of course, is that some of the companiesnotably Newmontare having to admit that replacing their production through new mines in politically reliable nations has become a real challenge. Another constraint: gold is not far off its all-time high in dollars, but hasnt been a big winner for companies and investors whose assets are denominated in other currencies.
Gold (Euros) January 200 to October 2007
600 550 500 450 400 350 300 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

Gold (Canadian Dollars) January 200 to October 2007

800 750 700 650 600 550 500 450 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

8

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Basic Points
Gold (British Pounds) January 200 to October 2007
400 380 360 340 320 300 280 260 240 220 200 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

At some point, inflation will once again become a serious fear.

Gold (Swiss Francs) January 200 to October 2007

900 850 800 750 700 650 600 550 500 450 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

Gold will not truly be in record terrain until it sets records in all major currencies. That day will come. At some point, inflation will once again become a serious fear. At that point, gold will solidly outperform all paper currencies.

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. Commodities vs. Commodity Stocks

We believe, as a general principle, that investors should own both commodity-producing companies shares, and commoditieseither actually or through commodity futures contracts or options. The gold mining shares are a special example of this situationwhere a gold ETF is readily available to investors as an alternative to assuming the business and political risks inherent in owning the gold mining companies. As shrewd an investor as Dennis Gartman says flatly that he refuses to play gold through mining companies shares, because of stock-specific business risks and political risks. But we believe the principle of reducing portfolio risk while acquiring greater exposure to the commodity bull market is applicable more broadly. It is hard for investors to acquire a diversified portfolio of quality agricultural stocks, but in theory at least, easy to own grains, oilseeds, meat and milk through futures contracts. A commodity portfolio gives instant diversification across commodity classes, thereby reducing portfolios endogenous risks. Owning futures in copper, aluminum, lead and zinc is a good way to expand exposure to the metals without having to invest in some highly speculative stocks. We have been moved to study this question because of the growing scale of pension fund investment in commoditiesdirectly and through derivatives based on subcomponents of such indices such as the Goldman Sachs Index. Some of the major US university endowments whose performance has impressed investors have large commitments to commodities. (They doubtless also have sizable exposure to commodity stocks through their equity portfolios, but they do not break such exposure out.) Institutional investors using commodity indices for exposure have outperformed stock market indices handily, according to some studies we have seen. Why? Because commodity prices have gone up sharply, while commodity futures curves have overwhelmingly stayed in backwardation. That means an investor buying into an index and rolling it monthly is quite consistently buying cheap and selling dearand with relatively low volatility.

...investors should own both commodity-producing companies shares, and commodities...

0

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Basic Points
How cheaply does a long-term investor buy commodities? Consider these charts:
Oil Futures Curve January 2008 to January 201
79 78 77 76 75 74 73 72 71 Jan-08 Sep-08 May-09 Jan-10 Sep-10 May-11 Jan-12 Sep-12

Copper Futures Curve January 2008 to January 201

8,500 8,000 7,500 7,000 6,500 6,000 5,500 5,000 Jan-08 Sep-08 May-09 Jan-10 Sep-10 May-11 Jan-12 Sep-12

Zinc Futures Curve November 2007 to December 2010

3,000 2,950 2,900 2,850 2,800 2,750 2,700 2,650 Oct-07 Feb-08 Jun-08 Oct-08 Feb-09 Jun-09 Oct-09

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1

Why are futures prices so far below spot prices? 1. The greatest investment opportunities come from asset classes where those who know it best love it least, because they have been disappointed most. It is still true that many commodity producers believe Wall Streets prognostications that commodity prices must collapse. So they give Wall Street the commissions to sell forward. 2. Cheap financing: a new mine or oil field that will be producing in, say, four years involves huge capital investment. Companies whose balance sheets are already fully committed can raise funds interest free by selling forward. 3. Risk reduction: a company that knows it will have a major mine or oilfield on stream in three years may not wish to assume the full price risk. It can hedge someor allof the early expected production and take those contracts to the bank as security for capital financing. 4. Corporate focus: a gold mining company that acquires another gold mine with substantial copper or zinc production may decide to hedge its base metal exposure and lock in the contribution to per-ounce gold production cash costs.

The greatest investment opportunities come from asset classes where those who know it best love it least, because they have been disappointed most.

The Feds New Policyand the Debate

It would appear that nearly everybody now believes that, because of the housing and subprime messes, the Fed was (1) right to cut rates on September 18th, and (2) should retain an easing posture, thereby preventing a financial crisis and recession. There are two viewpoints on how that policy should be constructed and how it should proceed. 1. Martin Feldstein: Plaza Redux

What the Fed seems to have embarked on is a reliquification of the system as part of the policy Martin Feldstein recommended at its Jackson Hole meetingmaking the dollar competitive. The dollars decline to date has done little to stanch the trade deficit. The Fed should therefore ease aggressively to prevent further hollowing out of the nations industrial baseand to head off a recession.

2

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Basic Points
The Clinton policy was the Rubin policy: keep the dollar strong. But the trade deficit doubled as a percentage of GDP. The Bush Administration has had a more nuanced policy: talk at all times of keeping the dollar strong, but do nothing about its valuation, other than publicly urging China and Japan to increase their currencies values. When Henry Paulson was in Canada recently, he reiterated the Administrations policya sound dollar, which is a dollar priced fairly in the currency markets. This is, in effect, a restatement of the underlying thinking behind the Reagan policy James Baker virtually forced on the G-7 at the Plaza on September 21, 1985, which led to a dollar devaluation against all major currencies. The dollar has declined against all currencies except the yen since January 2002. The unexpected scale of the Fed easing on September 18th has accelerated this process and says, in effect, We cant continue to have a trade deficit of 78% of GDP. We are lectured at all international meetings that we have to reduce this imbalance by cutting our fiscal deficits and otherwise tightening our belts. We have slashed our fiscal deficit by more than 50%in absolute terms and in relation to GDPdespite absorbing more than 75% of the cost of fighting the War on Terror against foes that threaten all of you. Our fiscal deficit is now lowerin GDP termsthan any other G-8 members except Canada and Germany. Our aim is to get the trade deficit down to its historic level23% of GDP. Domestic financial system excesses have forced us to move more quickly with devaluationwith a concomitant risk of inflation. We shall have to take that risk. We trust we have your support. 2. Bail Aggressively To Save The Overextended Rich

The foregoing summary of what may now be Fed strategypromote economic growth and head off a recession by making the currency competitivewas not suggested as a basis for policy in what has become the most-quoted criticism of the Fed within the financial community. Bill Gross, whom we have long admired as the most respected person in bond management, disappointed us with his recently-published indictment of Bernanke & Co.. It is a must-read for anyone who wants to understand the challenges facing the Fedand the financial markets. (It is interesting that this no-holds-barred attack on the current Fed comes from someone who has one Alan Greenspan on his payroll.)

October



Mr. Gross basically endorses Jim Cramers infamous meltdown on TV in which he ranted and screamed that the Fed knew nothing about what was really going on. ...this global liquidity crisis originated in the misbehavior of immoral and unconscionable people... Mr. Gross calls for further Fed rate cuts, because he doubts that even now the Fed understands how serious are the housing crisis and subprime problems. As a liberal, (like so many other billionaires), he rails against Republican orthodoxy that prevents the Fed from reliquifying. We are aware that blogs financed by rich liberals blame Republicans for, among other sins, 9/11, the Iraq War, all the problems of New Orleans, deficits, a climate of fear in Hollywood that has destroyed free speech, spying on citizens, a love of torture, the inadequacy of public schools, and global warming. We had not realized that an unwillingness to bail out rich speculators who created this financial crisis because of their own greedy stupidity was another peculiarly Republican fault. We beg to differ. We agree with James Grant, who calls bailouts Socialism for the rich. There is no doubt that the 50 bps reduction to date has vastly benefited a collection of hedge fund managers and investment bankers whose collective wealth was already in the hundreds of billions of dollars. However, we were surprised that The Warren Buffett of Bonds should resort to sneering that anyone who wasnt eager to protect overleveraged billionaires from their own folly must be a slave to Republican orthodoxy. The subprime and private equity excesses which created this global liquidity crisis originated in the misbehavior of immoral and unconscionable people, many of whom happened to be very, very richand were determined to regain whatever wealth market forces had drained from them when their overleveraging, reliance on models rather than markets, misrepresentations andin some casesfraud were revealed. They screamed for Fed reliquification to protect poor homeowners. They would have the world believe that their demands come from their deep spiritual concern for the poor.



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Basic Points
That claim is mendacity on majestic scale. We recall the mythical defendant who murdered both his parents and then pled for sympathy from the jury because he was an orphan. Remember one of Milton Friedmans most famous observations: the greatest enemy of capitalism is capitalists, while the greatest enemy of socialism is socialism. Until now, we had assumed that such wisdom was bipartisan. We are now, in effect, being told by a prominent Democrat that such insights have been re-classified as Republican orthodoxy. Unfortunately, by attempting to politicize the debate on Fed policy, the renowned Mr. Gross may have made it harder for the Fed to do the right thing. 3. The Right Thing ...the renowned Mr. Gross may have made it harder for the Fed to do the right thing.

We admit that we had hoped the Fed would hang tough. We thought that the moral hazard problems created by the Greenspan Feds excessively loose monetary policies should be punished through market discipline. Failing such flogging, we assumed that these rogues and mountebanks would go on to even greater assaults on surviving islands of decency in the financial system. We have also, as readers know, feared a return of inflation. As we have noted many times before, when food and fuel prices raise together, inflation has always become a problem. Perhaps we are overstating that risk because of our bullishness on commodities. We hope Mr. Bernanke will now rediscover his former restraint. But, because of the powerful pressures on the Fed to continue easing, we have changed our Recommended Asset Mix. If Bernanke heroically resists all these pressures, then the asset shift will have been in error. We continue to wish him welland to believe he is an upgrade on his predecessor.

October



INVESTMENT RECOMMENDATIONS
1. Reduce bond exposure and increase exposure to commodity stocks. If the Fed is truly in a weak position because of the subprime mess and the financial and political of Jurassic Park Avenue, then the dollar is going to go down fasterand commodity prices will rise faster. 2. Collateralized Debt Swaps, junk bonds and other tradable debt instruments have responded powerfully to massive central bank reliquification. Fixed income investors should not assume that the rush to narrower yield spreads will continue asymptotically. Jurassic Park Avenue may be able to make slime smell like Chanel for a while, but Truth eventually wins out. 3. Despite central bank lending on unprecedented scale, borrowing rates in major markets remain mostly above central bank targets, indicating continued banking system stress. All major central banks were unanimous four months ago that inflation was a clear and present danger, and their next move would be to raise rates. The freezeups in ABCP, SIVs, and SIV-lites, and the stock and bond market panics, have forced central banks to do what theyd eschewed. Unless they were all wet before they rained liquidity on financial markets, the inflation risk has increased substantially. Reduce bond durations and increase commodity exposures, particularly gold. 4. The Canadian dollar finally reached parity with the greenback. Most Canadians seem to regard this as the peak. We believe the peak is out there above the cloudsat least $1.10and have therefore changed our long-standing target of parity. The US dollar devaluation must go much further to bring the US trade deficit down below 5%. Canada runs an endless trade surplus with the US. We look for at least $1.50 on the euro and par on the yen. 5. Agriculturals remain our favorite commodity stock sector for new money commitments. The fertilizer, farm equipment and seed companies remain excellent value for long-term investors.



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Basic Points
6. The Alberta oil sands producers may struggle in stock markets for a while, but their resource lives extend into the late years of this century. They are core investments. Investors should bet that the Alberta government will not be swayed into folly by a poorly-reasoned set of recommendations. Royalty increases will come, but not enough to destroy the industry. Edmonton has not, we believe, become Moscow. 7. Nasdaq has been performing strongly. We remain convinced that tech stocks are in the long third wave of their Triple Waterfall collapse. The small minority of Tech companies that will beat the odds will have unbreakable patents, unshakable brand names, and unique pricing powerlike Google, RIM and Apple. Most of the rest are mere commodity producersof the commodity class whose prices will fall whilst other commodity prices rise. Investors should be very selective, and should also ensure that they know their companies p/e ratios based on reported earnings after pricing in stock option costs. They will have to dig to get those numbers. Most of The Street has, like modern Bourbons, learned nothing from the fallout from its fraud and foolishness during the tech mania and forgotten nothing about the eagerness of investors to believe that airbrushed earnings are the basis of great opportunities. The Street may well be re-confirmed in the thrust of its view that theres a sucker born every minute, but the collapse in OECD birth rates will mean a progressive reduction in the actual rate of growth of new suckers, which will prevent Nasdaqs p/e from re-reaching the stratosphere.

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Basic Points
Commodities After the End of Disinflation

November 8, 2007

Produced by BMO Financial Group Distributed by BMO Capital Markets

Basic Points
An Investment Journal
Donald G. M. Coxe
Global Portfolio Strategist, BMO Financial Group (312) 461-5365 e-mail: don.coxe@bmo.com

Research/Editing Production/ Distribution

Angela Trudeau e-mail: angela.trudeau@shaw.ca Anna Goduco (print orders and mailing lists) e-mail: basic.points@bmo.com

Commodities After the End of Disinflation

Overview
We announced the birth of the great commodity bull market, which would last at least five years in February 2002. This new calfs arrival was virtually unnoticed on Wall Street. As it grew into a frisky bullock and then a rampaging bull, we argued it would prove to be the greatest commodity bull of all time. That bold claim drew scant support among research departments on the Street. The life of this bull, strategists argued, would be like those of recent decadesbrutish and short. Each time the bull got too frisky and was corralled, experts said they had been right all alongthe bull was dying. We stubbornly insisted those setbacks were really buying opportunities, not signs the bull was about to be converted to steerdomor steaks. This month, we make our forecast for the next five years. During that time, we foresee just one major setback for commoditiesa US recession, which may or may not trigger a global recession. This could come as early as next year, thereby ensuring Hillary Clintons return to the White House in an enhanced role. If the recession does not come in 2008, it should arrive with the onset of the next decade, as has been the pattern since 1960. Our conviction that investors should continue to emphasize commodities remains. Over the next five years, commodity stocks outperformance of most major stock indices will be, we believe, at least as great as in the past five. However, the next five years will not be mere replays of their predecessors. The onset of what should prove to be the most painful global inflation in three decades will mean greater economic and stock market volatility and wider price swings. The dollar bear market will be more brutal than we have been saying for the past three years, because currency bears now feed on Wall Streets fast-spreading necrosis. We are leaving our Recommended Asset Mix unchanged. With deep regret, we are forced to remove Alberta from the shrinking list of politically-secure regions of the world for the oil industry, taking its rating from AAA to A. Venezuela it isnt, but it isnt Kansas either. Once a political region has violated its vows, those who believe it can be trusted not to break its new pledges are betting their companies futures on a dubious concept: retroactive political virginity.

November

Recommended Asset Allocation

Recommended Asset Allocation (for U.S. Pension Funds)
US Equities Foreign Equities European Equities Japanese and Korean Equities Canadian and Australian Equities Emerging Markets Bonds US Bonds Canadian Bonds International Bonds Cash Allocations 30 7 5 8 11 7 4 11 17 Change unch unch unch unch unch unch unch unch unch

Bond Durations
US Canada International Years 4.50 4.75 4.25 Change unch unch unch

Global Exposure to Commodity Stocks

Energy Agriculture Base Metals & Steel Precious Metals
We recommend these sector weightings to all clients for commodity exposurewhether in pure commodity stock portfolios or as the commodity component of equity and balanced funds.

33 25 22 20

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Basic Points
Commodities After the End of Disinflation
How Sweet It Is!
We begin with a brief retrospective:
CRB Futures February 2002 to November 2007
375 355 335 315 295 275 255 235 215 195 175 Feb-02 Oct-02 Jun-03 Feb-04 Oct-04 Jun-05 Feb-06 Oct-06 Jun-07

Crude Oil February 2002 to November 2007

100 90 80 70 60 50 40 30 20 10 Feb-02 Oct-02 Jun-03 Feb-04 Oct-04 Jun-05 Feb-06 Oct-06 Jun-07

November

Copper February 2002 to November 2007

450 400 350 300 250 200 150 100 50 Feb-02 Oct-02 Jun-03 Feb-04 Oct-04 Jun-05 Feb-06 Oct-06 Jun-07

Nickel February 2002 to November 2007

60,000 50,000 40,000 30,000 20,000 10,000 0 Feb-02 Oct-02 Jun-03 Feb-04 Oct-04 Jun-05 Feb-06 Oct-06 Jun-07

Gold February 2002 to November 2007

740 680 620 560 500 440 380 320 260 Feb-02 Oct-02 Jun-03 Feb-04 Oct-04 Jun-05 Feb-06 Oct-06 Jun-07

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Basic Points
The idea for this opening picture book comes from a recommendation we once heard from Tom Wolfe. Mr. Wolfe was the speaker at a National Review anniversary dinner after the Fall of the Wall had proclaimed victory in the Cold War. He began by reminding us of the election victories by Reagan and Thatcher that had made this historic event possible. He noted that liberals were telling us not to gloat. He then shouted, I say, lets gloat! The comparison comes because commodity stock enthusiasts remain in a minority. Techs Triple Waterfall Crash and a roaring commodity boom havent convinced most growth-oriented investors that commodity stocks are better investments than techs. (Canada and Australia are exceptions to this generalizationfor obvious reasons. We increased our recommended weighting in the stocks of those countries for US Pension Funds in last months Basic Pointsa signal to investors elsewhere to put new money into the resource stocks.) The major oil stocks have always had significant institutional followings. They are heavyweights in the S&P, and have great dividend records, and everyone knowsor think they knowthe oil story. Rising oil prices were, until subprime emerged from the slime, the most reliable bad news story for the media when the other stories looked good. Owning Exxon Mobil was a low-risk way to be able to report some good news for investors during those years when seemingly everyone was fretting that $35, or $50, or $60, or $70 oil was going to hurt the economy, thereby holding back the performance of tech stocks. That rather limited interest in the investment merits of oil stocks has not extended to mining stocks. In part, this lack of interest in what has been the best-performing asset class in this decade reflects the makeup of the US stock market. There is only one general mining stock in the S&PFreeport McMoRan, which, until it acquired Phelps Dodge, was considered too risky by most institutions because its only mine was in Indonesia. (Freeport was actually included in some US-based Emerging Markets funds.) There is only one gold mining stock in the S&PNewmontwhich has had problems in replacing its production from reserves in politically-secure regions. Even in Canada, there is a dearth of large-cap base metal stocks since Inco and Falconbridge were taken out by foreign companies. Canadas

I say, lets gloat!

November

control...migrated from genuine investors to global hedge funds and arbitrageurs...

long-standing propensity for importing the worstrather than the best aspects of American fads and fashions spilt over into investors appraisal of the nations great mining companies. In Loonie Land, enthusiasm for mining stocks was, to put it politely, restrained. As the Inco and Falconbridge stock prices soared amid takeover frenzy, Canadians sold large portions of their holdings into the stock marketat the urging of the majority of base metals analysts. Result: the control of both companies migrated from genuine investors to global hedge funds and arbitrageurs, who were delighted to cash large short-term profits by delivering Inco and Falconbridge to CVRD and Xstrata at roughly three times their next years earnings. The companies tried to defend themselves by discussing their long-term plans for cost reductions in Sudbury, and their gorgeous earnings outlooks in coming years. It was as successful as campaigns to convince teenagers that sexual abstinence is really cool. Consider the modest expectations of commodity stock investors in the light of those two transactions. Two of the worlds three largest nickel/copper producers, which had been publicly held since Edwardian times, were bought by, respectively, (1) a newly-minted company headquartered in Marc Richs Swiss village, managed by men who had helped Marc get even richer while ranked as Americas most notorious at-large felon, and (2) a spin-off from a Brazilian-government-owned iron ore producer. If the convictions in the investment community about the real underlying strength of the great commodity bull market had risen even remotely as high as the prices of base metals and the companies earnings, Inco and Falconbridge would still be independent companies. Freeports buyout of Phelps Dodge is another illustration of the conspicuous lack of conspicuous enthusiasm among investors in mining companies. Most studies of the histories of mergers show that investment bankers, stockholders in the acquired companies, and the CEOs of the acquiring companies are the winners in most takeovers. Few mergers deliver the earnings gains to the acquirers that investment bankers had outlined. Many prove to be outright disasterssuch as the acquisitions of base metal giants Anaconda and Amax by oil companies during the Seventies run-up to the Triple Waterfall Crash of base metals. To those who have learned from bitter experience, CEOs enthusiasm for acquisitions is most closely correlated to the incentive arrangements in their contracts: bigger companies automatically pay bigger compensationand bigger golden parachutes.

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Basic Points
Given this sorry record of acquisitions, consider the stock price performance of CVRD, Xstrata, and Freeport-McMoRan:
CVRD (RIO NYSE) January 200 to November 2007
40 35 30 25 20 15 10 5 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

Xstrata (XTA.L LSE) January 200 to November 2007

4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

Freeport-McMoRan (FCX NYSE) January 200 to November 2007

130 120 110 100 90 80 70 60 50 40 30 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

November

Inflation is about to become a challenge for both central bankers and serious investors.

In each case, the mega-acquisition at a record price for the bought company was a huge win for the stockholders of the acquisitor. There is no buyers remorse among the major miners. We have also detected no sellers remorse among the Street experts who urged owners to tender their shares at risible prices. [These comments remain valid in the light of BHPs bid for Rio Tinto, which is discussed on page 29.] What is also conspicuous by its absence is anything resembling the upward revisions in price-earnings ratios that have historically attended groups whose earnings have vastly outpaced the rest of the market. In reality, major mining and oil companies have struggled to keep their P/Es from shrinking. Despite allocating enormous sums into stock buybacks ($170 billion in the case of the oils alone), managements have watched their absolute and relative P/Es languish. Nasdaqs P/E was 13 at the beginning of its Triple Waterfall runup. At its peak, Nasdaq was trading at a triple-digit multiple. According to analysts who adjusted reported earnings for costs of stock options, the Indexs P/E was 350 at its peak in March 2000. Most of the money that most investors made in tech stocks came from P/E multiple revisions, not in earnings growth adjusted for the real cost of stock options. In sharp contrast, none of the money investors have made in mining and oil stocks has come from P/E revisions. Moreover, real stock option costs for the established resource companies tend to be trivial compared to tech companies and Wall Street banks. At a time of almost unprecedented stress for the dollar and for US financial stocks, another big problem is about to emerge: Inflation is about to become a challenge for both central bankers and serious investors.

Inflation: Not Quite Extinct After All

How did the world escape a return of inflation when oil ran from $22 to $62 amid strong economic growth almost everywhere? Were central bankers magicians? During the late years of the Triple Waterfall Commodities Crash, most of the tiny band of remaining True Gold Believers were reduced to claiming that published inflation numbers were fraudulent. Then, as the economy

November

Basic Points
boomed and commodity prices took off, they became more insistent that inflation was returning and even the governments numbers would soon show it. In particular, they cited the housing bubble as proof of bureaucratic fraudulence, because the housing component of CPI was not rising as sharply as house prices. Well, whatever the truth back then, even gold bugs can stop worrying about runaway US house price inflation now. (In fact, the American housing/ mortgage crisis has become a major challenge to the global financial system, and the best friend gold lovers have had for three decades.) Todays dissenters on the accuracy of US inflation data are sophisticated globe-trotters who look at such indicators as Sotheby art auction prices, Park Avenue apartments, and hotel rooms in London and Dubai, and argue that official inflation rates are so understated as to be absurd. Until April, we believed that the US inflation numbers compiled by the Bureau of Labor Statistics (BLS) have understated US CPI somewhat, due to their emphasis on tech durable goods that are hedonically deflationary because of great capacity upgrades at reduced prices. Nevertheless, we considered the BLS numbers as directionally accurate. We have disagreed with those who smirk that the agency should engage in full disclosure by dropping the L from its organizations acronym. We did, however, maintain that the policy of the Fed and of many other central banks to rely on Core Inflation (the CPI for economists who neither eat nor heat) was a potentially unwise attempt to inject academic economics into a statistic that really matters to the average voter. We stuck to our view that disinflation was the primary challenge to the global price system until we had digested what we learned in India. When we advised clients that the biggest commodity stock story of 2007 would be the agricultural group, (farm equipment, fertilizers, and seeds), we were making a bet that food inflation was coming back. Big time. So, in April, we drastically revised our bond outlook, predicting a new bond bear market. We eliminated one of our favorite asset classesvery long-term bondsfrom our Recommended Asset Mix. We know from the work of David Hackett Fischer, and from our own background in economic history, that when food and fuel prices rise together, overall inflation soon increases sharply.

...the biggest commodity stock story of 2007 would be the agricultural group...

November

We do not believe that it is different this time, even though food is only 14% of the US CPI. We believe that: Ben Bernanke and his bankerly brethren...cant let the economy slide into a potentially deep recession in order to punish a few billionaires. 1. Globalization provides the transmission mechanisms to pass along changing trends in Third World inflation pressures. The ability of China and India to continue to export deflation is being weakened by the high percentage of foods in their CPIs. Wage rates have begun to climb in those countries and we have begun to hear stories about operations being moved from China to Vietnam or Cambodia, and from India to other countrieseven back to the US. 2. Without sustained, excessive monetary expansion, inflation will not ratify major commodity price boosts. The shares of the income pie will simply be redistributed in favor of commodity producers at the expense of other sectors in the economy. Proof of that postulate came with the most famous of all commodity price shocks... We recall the widespread resentment of Arabs that became popular when CPIs exploded: that inflation was blamed on the trebling of oil prices after the Yom Kippur War. (In retrospect, no libel against Arabs before or since can compare with that one. We recall the cartoons of the ultra-liberal Herblock in the Washington Post, which routinely featured grossly obese Arabs in full robes laughing at Americans stuck in gas lineups, or at Americans reeling in horror at the price of gas.) One lonely economist, Milton Friedman, blasted the media and the economics establishment for their propagation of this libel. The blame, he insisted, fell on central bankers for printing money in the completely misguided view that this monetization would offset the impact of high oil prices. That generation of central bankers helped give liberalstatist policies a bad name, thereby paving the way for election victories by Thatcher and Reagan. As they retired from the fray, they were replaced across most of the OECD by bankers who had learned the horrors of excess monetary expansion. They held power for two decades. They are all now retired, or deceased. Their successors have experienced only mild inflation. That means they are susceptible to the pressure from financial elites in New York, Greenwich and London to save the economy from the effects of their greed and folly. Ben Bernanke and his bankerly brethren understand the problem of moral hazard, but they also know that they cant let the economy slide into a potentially deep recession in order to punish a few billionaires.

0

November

Basic Points
Until now, they seemed to be free to fight the Street-induced recession by reliquifying, because inflation remained more theoretical than real. This is about to become an inflation reality show. Food inflation is more visible and more injurious than energy inflation. Outside the US and some OPEC nations, most of the cost to a consumer of gasoline or diesel comes in the form of taxes; a doubling in oil prices doesnt mean a doubling in a motorists cost. In many Third World countries, (notably China and India), governments subsidize fuel costs heavily. Foods are rarely taxed as much as other consumer goods, so leaps in food prices go right to the consumer. Moreover, consumers shop each week, and most watch changes in prices. After failure of the wheat and anchovy harvests in 1972-73, the relentless week-by-week rise in food inflation had a far greater impact on consumers psyches than rising oil prices. (Last gasp of the Old Left: The Federal Reserve Bulletin of 1978 explained the succession of inflation shocks: Most prominent among these inflationary forces were a drop in the exchange rate of the dollar, a considerable increase in labor costs, and severe weather. Nary a word about all those extra billions of greenbacks they printed that just might have contributed to the dollars drop or to labor cost increases.) ...a new secular religion: just-in-time inventory controls.

Nobody (Who Matters) Knows the Troubles Weve Seen

It is not just todays crop of central bankers who werent around when food price inflation and energy inflation and monetary inflation destabilized economies and unleashed double-digit CPIs. Almost nobody who is managing serious bond money was a portfolio manager during the 1970s. Almost no CEO of a Fortune 500 company was above the middle management level during the 1970s. One of the most important attitudinal shifts since those troubled times came with the arrival of a new secular religion: just-in-time inventory controls. As recently as 1979, 35% of Exxons reported profits came from inventory gains. The company held crude oil in vast storage operations, including tankers off Norway. Price controls made it difficult or impossible to profit at the pump from rising oil prices, so hoarding was the sure-fire route to greater profits. (The CFA program for years thereafter laid heavy emphasis on distinguishing LIFO from FIFO so that students could strip out inventory gains from company reports.)

November



Almost everyone who has graduated from a business school since 1982 absolutely knows that great managers restrict themselves to just-in-time inventories. When a wolf has not been seen in a valley for decades, the shepherds no longer lie awake at night... This secular religion had unimpeachable evidence to back up its claim for management virtue: it really worked. Raw materials prices fell during the first two decades in which just-in-time was an article of faith. By the onset of the millennium, this had long since ceased to be merely an automatic component of modern management and had become a form of financial fanaticism. The inventory-to-sales ratio has been falling in nearly every quarterincluding Q1 this year, when economic growth came in well below forecasts. Company after company reported how well it was managing inventoryand many complained about profit strains caused by the rising costs of raw materials. Nowhere did we see something like: We are proud to report that through buying hedges and adding to inventories we controlled our raw material costs and have gained a profit advantage over our competitors. This pervasive belief system that decrees the overarching need to maintain minimal inventories of raw and semi-processed goods regardless of the pricing environment, and also to maintain minimal staffingregardless of the present and future unemployment ratesmakes the global economy inflationprone for the first time since the early 1980s. When a wolf has not been seen in a valley for decades, the shepherds no longer lie awake at night listening for a baying sound or the scream of a terrified sheep. Eventually, as the older shepherds die off, they are replaced by young people who cannot identify a wolf track or a wolf call. If, then, the wolves return, they will have splendid pickings before the shepherds realize the peril to their flocks.

2

November

Basic Points
What Will Feed the Next Inflation? Food.
Here are three numbers worth remembering: 1. 26.3% 2. 16.9% 3. 6.7% Those are year-to-date percentage price increases of components of the US September PPI report. The first is Crude Foods The second is Intermediate Foods and Feeds The third is Finished Consumer Foods We recall how the great inflation of the 1970s got under way: double-digit percentage increases in crude foods were the first sign that something brand new and big was happening. There had been no war and no Arab boycott, yet food prices were skyrocketing. 1. The Great Grain Robbery The Nixon Administration let a junior official in the Dept. of Agriculture have control over export sales of wheat to Russia at a subsidized interest rate. By the time they caught up to what he was happily doing, he had sold the entire US wheat crop at $1.65 a bushel. As a result of crop failures in Russia, there was, in reality, a big global wheat shortage that the Administration hadnt noticed. Wheat leapt to $5 a bushel. 2. Where, Oh Where, Have Our Little Fish Gone? Anchovies were the worlds leading high-protein animal feed supplement. Thanks to the giant El Nio of 1973, almost no anchovies could be found in the waters of the Humboldt Current off Peru. Tough on the fishermen, but disastrous for world food prices. 3. Other 1970s Crop Failures Because of late spring and early fall freezes across much of the Northern Hemisphere at various times during the 1970s, grain harvests were all too frequently far below targets. A committee of scientists assembled by Jimmy Carter proclaimed the likely onset of a new Ice Age. The Secretary of Agriculture stated as a national priority the need to develop genetically modified seeds to cope with shorter growing seasons. A committee of scientists assembled by Jimmy Carter proclaimed the likely onset of a new Ice Age.

November



4. The Return of Autarky As food prices climbed, more and more governments across the world began to adopt a Bismarck strategyautarkywhich later was a key component of Hitlers strategy for waging warprotecting their consumers from food shortages. Governments began refusing to renew grain sales agreements, and there were more and more new hoarding programs on a scale that would have impressed Joseph. Collectively, these global glitches led to higher food prices during the 1970s, which reinforced the emerging commodities Triple Waterfall mania, and exacerbated the subsequent collapses during the 1980s.

Governments began refusing to renew grain sales agreements, and there were more and more new hoarding programs on a scale that would have impressed Joseph.

Upon What Meat Doth the Rich Asian Feed?

Corn January 200 to November 2007
450 400 350 300 250 200 150 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

Soybeans January 200 to November 2007

11 10 9 8 7 6 5 4 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07



November

Basic Points
Wheat January 200 to November 2007
1000 900 800 700 600 500 400 300 200 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

The strategy to compete with the US in the Chinese grain market: Dont Ask: Just Sell.

Live Cattle January 200 to November 2007

105 100 95 90 85 80 75 70 65 60 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

1. Chinese Grain Demands After the grain shortages of the 1970s came the surpluses of the 1980s. China was a frequent buyer of grains at subsidized pricesmostly wheatfrom Western nations. The populace lived mostly on bread, rice, and beans. When population growth exceeded food production, or when famines struck, China sought deals abroad. As global grain surpluses built up, Western nations began to compete with each other to feed China. Not all the competition was on price: Canada and many European countries changed their foreign policy toward China away from Cold War conformity to ardent friendship. There was neer a mention of the Chinese regimes record. The strategy to compete with the US in the Chinese grain market: Dont Ask: Just Sell.

November



...a campaign to get the world off oil ...

Nowadays, the bourgeoning Chinese middle and upper classes demand for meat and dairy products means that growth in Chinas consumption of feed grains is much faster than its famously growing demand for oil and metals. This years doubling of world wheat prices is only marginally driven by this protein boom: it was caused, like all grain booms in previous history, by crop failures. The severe Australian drought had a global impact far beyond that nations share of world wheat production, because grain carryoverslike inventories of other grains and most other commoditieshad shrunk to such pitifully low levels. (The USDA estimates that world wheat production for this crop year is 600.5 million tons, down 5.8 million tons from 2006. The biggest production decline comes from Australiadown 7.5 million. It is a measure of how slender is the global grain surplus that a 1% production drop doubles the price.) 2. Third World Countries: First World Appetites Chinas sustained double-digit economic growth during and after the reign of Deng Xiaoping would have eventually put strong pressure on global feed grain prices. However, the rising fortunes of people in other Emerging Marketsparticularly Latin America, East Asia and Indiahas meant that people are able to buy more food, and they consume more meat, eggs and dairy products. Result: global carryovers of all grainsfeed grains, wheat, and ricehave dropped steadily in the past 10 years. As of year-end 2006, they were the lowestin relation to global consumptionon record. 3. New Problems Breed New Causes and New Cures Meanwhile, in the most enlightened circles in the West, a campaign to get the world off oil began. A coalition of global warmists, greens, farm lobbyists and Archer Daniels Midland got governments to pass legislation forcing the oil companies to use more ethanol (US) and/or biodiesel (EU) in its formulations. This campaign was already gaining strength when oil prices climbed above $35 a barrel at a time of growing American fury because of continued publicity that fifteen of the nineteen 9/11 terrorists were Saudis. The farm lobbyists and green enthusiasts thereupon acquired a new set of alliesAmerican conservatives, including President Bush. Thomas Friedman, the renowned New York Times foreign affairs columnist, spoke for both groups in this unlikely new coalition: he had backed the Iraq war (until it began to go badly), and he, unlike another prominent Democrat, is a reasonable and credible writer about global warming. Result: the US and Europe have legislated an unachievable gain in production of ethanol and biofuels. (In the US, gasoline blenders must use 4.7 billion gallons of ethanol this year and 7.5 billion gallons in 2012.)



November

Basic Points
Naturally, no one in this collection of enthusiasts bothered to check USDA statistics about the shrinkage of global acreage devoted to grain production, or the soaring demand for feed grains from China and India. The lobbyists included numerous rural cooperatives operating under-funded ethanol refineries, creating a bumper crop of tale-spinners who argued that corn would stay below $2.50 a bushel forever, making all those ethanol plants big money-spinners. There was at least as much energy expended by this mixture of wildly varying schools of enthusiasts and slick promoters as was coming from the ethanol plants. Then, corn prices leapt to as high as $4 a bushel and soybeans climbedslowly and steadilypast $10. Suddenly, the stock price charts for ethanol producers other than ADM began to resemble those of dot-coms in 2001. Demands to lift the tariffs against low-cost Brazilian and Caribbean sugarcane ethanol began to circulate in Congress among those who were running neither for President, nor for office in the corn belt. Nobody ever mentioned that grain prices were at sky-high levels despite the longest weather winning streak on record for Midwest corn. On the plains, where the skies are not (we are informed) cloudy all day, farmers have enjoyed 17 straight years of adequatebut rarely excessive rainfall. US corn production this year was an astounding 13.1 billion bushelsyet corn prices remain very highas do the futures prices for next years crop. That back-to-back bull market for feed grains after bumper crops has not occurred since World War II. When corn prices leap, they attract attention from people whose knowledge of combines has historically been confined to antitrust issues. In April, both Fortune and Foreign Affairs ran cover stories on corn, warning of global food problems from runaway corn prices. To the Manhattan experts, its all about ethanolan idea born of bad politics. Not once did the writers note the USDA statistics showing that carryover stocks of sorghum, soybeans and barley were also very lowbecause of rising Asian demand for meat and dairy products. The ethanol craze could not have come at a worse time. There would have been tight supplies of grains and oilseeds anyway, but turning 25% of the (near-record) US corn crop into ethanol was the most misconceived alcohol policy since Prohibition. Prohibition, it will be recalled, was also based on good intentions.

When corn prices leap, they attract attention from people whose knowledge of combines has historically been confined to antitrust issues.

November

7

An Economy Without Safeguards and Shock Absorbers

Although Alan Greenspan and other central bankers are given credit for the quarter-century of disinflation that began with the elections of Thatcher and Reagan, they got more than a little help from the sustained oversupply of major economic inputs. For decades, the global economy benefited from excesses: there was too much food, too much oil, gas and coal, too much steel, copper, aluminum and nickel, and there were too many people looking for jobs. The Triple Waterfall Crashes of commodities eventually wiped out the oversupply of food, fuels, and metals. The collapse in the birth rate after 1970 eventually wiped out the oversupply of workers across most of the OECD. The supply of new entrants to the labor force is now barely above the number of workers retiring or dying. Labor shortages have only begun to show up. They will be intensifying for at least the next two decades. The growth surprise of the next decade will be membership in unions. The period of disinflation/deflation was characterized by a secular improvement in corporate profitability, particularly in the US. The key cost inputslabor, raw materials and taxeshad levitated during the 1970s. Thatcher (the coal miners) and Reagan (the air traffic controllers) capitalized on voter resentment against rising union demands at a time of falling inflation to set in motion the reversal of decades of growth of union power. Mergers, free trade, the secular decline of heavily-unionized old-line US, British and European industries and the rapid growth of industries whose employees were disinterested in unions with their slavish support of Democrats in the US and socialists in Europe meant that, by 2000, the public sector unions dominated the union movement. Thanks to the seemingly unmitigated excesses of big businesses at a time workers wages and job security have been weakening, the stage is set for a union renaissance after the current US slowdown ends. When Wall Streets biggest names blow billions and savage their stock prices, and then leave with going-away presents that approximate three years earnings for Alex Rodriguez or David Beckham, it is difficult to maintain the justification that capitalism is a system based on risks and rewards: the workers assume the risks, and the bosses get the rewards, no matter how badly they screw up and no matter whether they spend as much time playing golf and bridge (or even smoking pot) as they do attending meetings to deal with the crises they created.

Wall Streets biggest names blow billions and savage their stock prices, and then leave with going-away presents...

8

November

Basic Points
How the Return of Inflation Will Benefit Commodity Stocks
After the US emerged from the tech crash recession and the shock of 9/11, global economic growth was strong, sustained, and disinflationary. That benign, beautiful boom is no longer in robust bloom: The subprime/CDO products spawned on what we have been calling Jurassic Park Avenue unleashed the financial equivalents of velociraptors that are chewing on major financial institutions and disemboweling some lesser banks and hedge funds outright. The Asset-Backed Commercial Paper market has undergone a Financial Climatic CrisisGlobal Freezing. Because too many new and old billionaires were overextended when the Jurassic Park crisis hit Wall Street, the Fed was forced into dramatic easingfirst through a succession of huge repo injections, and then through a cumulative 75 bp cut in both the fed funds and discount rates. Those moves exceeded market expectations, and there was joy in Wall Street, Greenwich, and in the tax havens where so many hedge funds and SIVs are registered. (Those who demanded the most from the Fed pay the least in taxes15% on that portion of their earnings that has not been moved to tax havens such as the Virgin or Cayman Islands, Curaao, or the Channel Islands. To be fair, some of them do good with their moneythey repatriate some of their untaxed earnings, pay 15% tax on them, and generously donate to worthy tax-exempts such as MoveOn.Org, which demonize Bush and General Petraeus and demand big tax increases on those who are so unsophisticated as to earn their money where the IRS can find it.) The billionaire-friendly monetary expansion, which was replicated by central banks abroad, came only weeks after all major central banks had been telling financial markets that their next move would be toward further tightening. Those who demanded the most from the Fed pay the least in taxes...

When the supply of new money explodes, while the supply of new foodstuffs, oil, metals and workers remains stable or actually shrinks, the world becomes inflation-prone after 25 years of being disinflation-prone. This is a momentous secular change.

November



Dollar Devaluation
US Dollar Index (DXY) January 80 to November 2007
170 160 150 140 130 120 110 100 90 80 70 Jan-80 Jan-83 Jan-86 Jan-89 Jan-92 Jan-95 Jan-98 Jan-01 Jan-04 Jan-07

We are in the third dollar devaluation since August 1971, when Nixon closed the gold window. The second was the Plaza Agreement of September 21, 1985. The Plaza Accordand the later Louvre agreementgave gold investors their last chance to (1) make profits on trading gold, and (2) to get out for good.
Gold January 7 to January 2002
900 800 700 600 500 400 300 200 100 0 Jan-71 Jan-74 Jan-77 Jan-80 Jan-83 Jan-86 Jan-89 Jan-92 Jan-95 Jan-98 Jan-01

20

November

Basic Points
Golds sharp runup from September 1985 through the Crash of 1987 did not revive inflation from its crypt. The metal was in the Third Stage of a Triple Waterfall Crashalong with other commodities. This was merely a bear market rally. The stars were aligned for disinflation. The dollar eventually stabilized, and then entered a powerful new bull market during the tech mania. As the dollar strengthened during the late 1990s, global deflationary threats emerged. By 2001, Alan Greenspan was talking of deflation risk. We recalled the ghastly years of the 1970s last week when we saw that the International Monetary Fund had issued an optimistic economic forecast, noting that global economic growth this year was the strongest since the early 1970s. This is an important announcement. We sat near an IMF economist at an Ottawa dinner for CEOs last year, and he was wowing the assembled bosses by telling them of his organizations vast analytical skills. The principal reason he cited for IMF forecasting excellencewhich these companies should all be using in their own planningwas that they had 3,000 economists on staff. Three thousand economists! That is a majesticnay, awe-inspiringstatistic. That could be more than the number of laborers employed at any one time in the building of The Great Pyramid. Why was the IMFs recent announcement of global GDP growth so important? Because the IMF didnt see the terrible global recession of 1973-75 coming or the stagflationary years that followed. Admittedly, the IMF didnt have 3,000 economists on staff when it failed to predict most of the major economic events of the 1970s, 1980s, and 1990s. Example of IMF perspicacity: Like the rest of the economics establishment, it warned Margaret Thatcher that freeing the pound from exchange controls would lead to a currency collapse and economic crisis, and it warned Reagan that tax cuts would trigger an inflation-driven downturn.

The principal reason... for IMF forecasting excellence...was that they had ,000 economists on staff.

November

2

...the greatest concentration of financial guts, guile and glory was located in Manhattan.

That an organization which supports so many economists in a wholesome, tax-free environment thinks we are about to go back to the 1970s is certainly a source of concern. What if the current eventsdollar devaluation, rapid money supply growth, soaring systemic risk in the banking system, and sharply rising prices for foods, fuels and metalsnotably goldproduce similar results now to those of 35 years ago? Golds recent rally is the real deal. The dollar keeps falling, and central bankers who had been readying themselves to head off food and fuel inflation are hamstrung by the risk of a global recession because of damage caused to the financial system by escapees from the computer systems and software shops on Jurassic Park Avenue. We believe that the acceleration in the dollars plunge in recent weeks is directly correlated to the revelations about the Streets balance sheet problemsand about the behavior of Wall Street titans during the crisis. Sir Francis Drake refused to cease his game of bowls when a messenger announced the Armada had been sightedhe knew they were far enough off that he could finish his game before finishing them off. In contrast, James Cayne of Bear Stearns kept right on participating in bridge tournaments, as did his #2, who was directly responsible for the failing hedge funds. He finally did fire him, but only after his subordinate defeated him in another tournament. Stanley ONeal of Merrill played many a round of great golf while his firm was imploding. He was given a wonderful farewell, which will allow him to buy a golf course if he chooses to devote himself fulltime to a career for which he may have better qualifications than running an investment bank that specializes in subprime loans. Why are such petty details important in the currency markets? Because, according to Bank of England Governor Mervyn King, Wall Street distributed $400 billion or so in CDOs and subprimes across the globe. The major US firms had a special cachetas the worlds slickest and smartest. Other onceproud American industriessuch as autos and steelhad long succumbed to foreign competition. But the greatest concentration of financial guts, guile and glory was located in Manhattan. The world eagerly lined up to buy these newfangled products produced by super-geniuses. High interest rates and a Triple-A rating! And dont ask anyone to explain how they do it. That would just show your ignorance.

22

November

Basic Points
It now appears that foreigners willingness to swallow slime priced as prime was a major underpinning of the dollar, and kept it from breaking down even as the trade deficit stayed at towering heights. Once the world learned that these titans were short both on explanations and ethics, it stopped buying. We have previously characterized the US trade with Germany as, We buy BMWs and Mercedes, and we pay for them with subprime-based CDOs. When that game was up, it was downhill all the way for the dollarand for the stock prices of the Wall Street firms that had created and distributed the perfumed products. Result: The chart of the dollar bears more than a casual resemblance to the charts of leading investment banks. Next result: Not all the money that moves out of the dollar can move into euros, pounds and Swiss francs. Of late, a disproportionate amount has moved into the Canadian dollara North American Free Trade Area currency that hasSurprise!great fundamentals, including fiscal and current account surpluses and a commodity tinge to its trade balance. The loonie has become a neat way to stay in that zone without being in an over-owned currency that has fiscal and current account deficits. As of writing, the US dollar is weak against just about everything except another dollarZimbabwes. History says that when the greenback is in that kind of trouble, inflation isnt far behind. ...the US dollar is weak against just about everything except another dollarZimbabwes.

November

2

Why Inflationand the Fear of Inflation Will Improve Performance of Commodity Stocks
...mining and oil companies relative performance has not kept up with their relative earnings growth... The question we are asked most by clients: when will this commodity boom end? To us, the most suggestive aspect of stock market performance during this commodity boom has been the failure of leading mining and oil stocks to improve their absolute and relative P/Es. The pattern for outperforming stock market sectors has historically been that they start from a discount to the market multiple and move to a market multiple or a slight premium. By then, investors have reappraised the prospects for the sector, more analyst coverage has developed, and the ignorance or misunderstanding that held the group at a discount has vanished. Occasionally, a sector goes all the way from a discount to a huge premium. This happens when institutional investors have to own the leading stocks in the sectorparticularly at quarter-ends when mutual funds report their shareholdings. To date, the mining and oil companies relative performance has not kept up with their relative earnings growth because: 1. The greatest investment opportunities come from an asset class where those who know it best, love it least, because they have been disappointed most. Although most of the battle-scarred managers and analysts who still had jobs at the bottom of the commodity Triple Waterfall Crash have departed, their successors have generally been reluctant to proclaim a new era. They remember how grim things were quite recently. 2. Invest in commodity companies not primarily on the basis of their current earnings, but on the basis of unhedged reserves in the ground in politically-secure areas of the world. The major mining and oil companies are collectively having difficulty in replacing their productionlet alone in replacing it from politically-secure areas of the world. Capital costs and operating costs have soared almost as rapidly as commodity prices. As for political risk, our third maxim, The Law of Political Risk in Third World Commodity-Producing Countries: The political risk increases as the square of the commodity price increase. That has meant that the huge reserves Western oil companies held in Russia, Kazakhstan, Nigeria, Venezuela and Angola need to be discountedor written off entirely. Even Alberta has changed its spots. (See discussion on page 27).

2

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Basic Points
3. This commodity boom will be driven by the new middle class in China and India. These are people who, for the first time, move into dwellings with indoor plumbing, electricity and basic appliances, and many of whom will buy cars. The Street took several years to latch onto this story, but it has fattened on it since then, particularly in promoting sales of Emerging Market mutual and hedge funds. Problem for many institutional investors: everybody knows the story now. Whats new? 4. What we now hear regularly from clients who have followed our work is that they dont see any catalysts out there to improve companies earnings or the stock markets appraisal of those earnings. These arent growth stories, because the companies have such trouble replacing their output with ore bodies and oil wells that are anywhere near as profitable as what theyre producing from now is the routine observation. 5. Finally, the objection to commodity stocks from some major institutions has been that commodities were historically inflation hedgesand it has been decades since there was serious inflation. Why buy hedges you dont need? We agreed with that reasoning for the first five years of the commodity bull market. We said investors should buy them because of their intrinsic merits as the best-performing asset class. When we changed our view on inflation in April, that meant we added a new reason for buying commodity stocks: investors were going to need inflation hedges, which meant the P/E ratios on the commodity stocks were about to climb. The year-over-year sector returns within the S&P (as reported in The New York Times): Energy Materials Information Technology +34% +29% +25.7%

...it has been decades since there was serious inflation. Why buy hedges you dont need?

And, oh, yes, lest you thought we forgot: Financials 10.7%

Within the Materials group, the star performers were Monsanto (+118.2%) and Freeport McMoRan (+85.1%). Stocks such as BHP Billiton, CVRD, Barrick Gold, Suncor, Kinross, and Potash are not, of course, in the S&P, which was up just 10.2%.

November

2

The commodity supercycle will continue, pausing only for a US recession.

We believe that food and fuel inflation, combined with the dollars devaluation, will mean that the US in particular, and the global GDP in general, will experience far greater inflation and far greater volatility over the next five years than has occurred during the years since the end of the last recession. We also believe that investors will respond to the outbreak of inflation by including commodity stocks in investment portfolios as inflation hedges. Thereafter, the stocks will trade not just on earnings, but on their ability to reduce endogenous portfolio risk. When will this new double-barreled commodity stock boom that is just beginning, end? Perhaps when gold peaks outa long time from nowand when major commodity stocks are selling at twice the markets multiple. At that point, we would have to warn investors that nothing is foreverand they should emotionally and intellectually prepare to separate themselves from some of the most rewarding financial friends theyve ever known. The commodity supercycle will continue, pausing only for a US recession. That downturn will be mild, because (1) growth outside the OECD will remain stronger than within the industrial world, and (2) unemployment will not reach serious levels because of lack of labor force growth. One big caveat: The housing bubbles in other parts of the world, including Britain, Ireland and Spain, and parts of Canada, are far more extreme than the US has experienced. If it should turn out that there have been comparable breakdowns in appraisal and lending practices in those countries, then they could experience house price collapses even greater than the US has just begun to suffer. Inflation is caused by excess monetary creation by central bankers. Asset inflation is caused because private sector bankers, awash in cash, rush to lend in asset-based loans. Nasdaqs Gadarene rush was fueled by margin debt. Housing bubbles are fueled by bankers willingness to keep goosing their lending based on three mutually-reinforcing trends: (1) soaring appraisals for home values, (2) soaring percentages of acceptable mortgage and home equity debt per dwelling, and (3) a democratization of credit appraisals: almost anyone who wasnt actually in jail, (including illegal immigrants), became eligible for 90100% financing. The same house appraised at

2

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Basic Points
$200,000 in 1998 on which a banker would lend no more than $150,000 to an employed person with a fine credit record, could boast a mortgage and piggyback totaling $450,000 in 2005 based on an appraised value of $450,000, even if the borrower had a putrid credit recordif anyone actually checked. (We wrote about that process in the March Basic Points: DONT ASK; DONT TELL: ITS SUBPRIME TIME!)

Alberta Betrays Its Past, Its Pioneers, and Its Producers

From time to time, we make bad calls, and we have to apologize to clients. Our biggest recent blunder was our recommendations on oil sands investments in the light of the recommendations of the Alberta Royalty Review Panel. As we said last month, and as we reiterated in our Conference Calls, and in all direct communications with clients, we considered the report such a poorlywritten, poorly-reasoned, mean-spirited betrayal of the traditions of a great province that we assumed it would be treated as an embarrassment. It failed to achieve even mediocrity, so it could be safely ignored. Coincidentally, it was while we were reading about the fiftieth anniversary of the publication of Ayn Rands most influential book, Atlas Shrugged, that Premier Stelmach stunned us by endorsing both the tone of the Panels collectivist rant and most of its recommendations. Most importantly, he broke a promise he had made publicly not to accept its recommendation to break promises made to Suncor and Syncrude, the pioneers of the oil sands development. The premier may not have read Atlas Shrugged. Had he read Rand, he would have known that what he was endorsing she called looting, and the members of the Panel (other than the woman with a background in the oil industry who disavowed the Report) are looters. He specifically endorsed the Panels astonishing recommendation to break with the Alberta tradition that a mans word is his bond. He endorsed the Panels insistence to end the Grandfathering of the operations built by pioneers who took the risks, raised the capital, struggled for decades and finally prosperedeven though the rights of Suncor and Syncrude are guaranteed in an act of the Alberta legislature. Looters respect neither traditions nor laws.

Our biggest recent blunder was our recommendations on oil sands investments...

November

27

Premier Stelmachs party, (which still calls itself Conservative), is currently embarked on a public relations campaign to reassure shocked investors that Alberta remains a great place for investors. Part of their pitch is that royalty and tax structures will be reviewed every five years. ... looters love to say theyre acting for the people. Step right up ladies and gentlemen. Plunk down your billions to invest. Take your risk. Well come back every five years to see how youre doing. If youre doing better than wed expected, well, of course, well take more of your production and give it to the people. Rand noted that looters love to say theyre acting for the people. They dont point out that a dollar grabbed from a producer spends a night out on the town in Edmonton, so that whats left for the people may not be enough to do all the wonderful things taxpayers have been toldat election timesto expect. Investors in companies other than Suncor and Canadian Oil Sands may be relieved that the premier has diluted the most punitive proposals of the Panel, and shows some understanding of the plight of the natural gas producers. Chavez he isnt, (despite some perfervid Albertans claims to the contrary). But hes no Reagan or Thatcher, either. (Hes not even a Harper, who ended a dubious system under which non-taxable trusts could grow rapidly by buying assets from producing oil companies at higher prices than they were worth to the taxable producers. Having restored a semblance of tax fairnessand headed off a plan to privatize BCEhe then delivered the biggest overall tax reduction to Canadians in decades, including a huge cut in corporate taxes, thereby making oil and gas assets much more valuable, and making all Alberta taxpayers better off.) Because our core investing concept is ranking companies on the basis of unhedged reserves in the ground in politically-secure regions, and because we have been beating the drums on behalf of the Alberta oil sands companies for five years, we must face the unpleasant truth: the oil sands have been unchanged for millions of years, but Alberta has changed dramatically in just one year (since the departure of Premier Klein). On balance, well give the premier the benefit of the doubt, and leave Alberta as a semi-safe place for investors: instead of a Triple A rating, it gets a single A. On that same scale, Newfoundland and Labrador earns an A+. The stock markets have, to date, seemed to accept the new taxes and new statism in Alberta. Thats mostly because oil is up roughly $20 a barrel and

28

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Basic Points
federal taxes are scheduled to fall. We note that some Albertans who back the Panel cite the markets stoicism as evidence that the proposals are gaining widespread acceptance. An interpretation that looks at stock prices and not a leap of oil prices to a new record to prove the wisdom of the new taxes doesnt even deserve a rebuttal. ...oil sands have been unchanged for millions of years, but Alberta has changed dramatically in just one year (since the departure of Premier Klein).

BHPs Mega-Bid for Rio Tinto

This proposed merger would create the one resource giant that most global investors would want to own. These companies have long been rivals, as we can attest from remarkspublic and privatewe heard from company executives at the Society of Economic Geologists conference. They are partners in operating the worlds biggest copper mineChiles Escondida. Rio became a target after completing its cash offer for Alcan. We shall leave it to our expert mining analysts to analyze the details of the bid and what it would mean to shareholders of these blue chips. To us, it confirms our view that, in a world where most of the major undeveloped orebodies are either in high-risk countriessuch as the Congoor off limits to major Western companiesas in Russiamining companies can buy secure assets most cheaply by buying each other. Moreover, it demonstrates that the costs of opening mines almost anywhere have climbed so high that the metals prices shown in forward futures curves remain absurdly low. The assumption implicit in Street metals forecasts, that the world will soon be flooded with cheap new metal, remains as absurd as it has been since the commodity bull market became a reality. As we observe elsewhere in this publication, someday, that will not be the case. Someday, stock markets will value mining companies reasonably, based on realistic futures prices. This mega-bid is most assuredly not the sign of manic market conditions, or overdeveloped corporate egos. Those driving forces in typical mergers outside the resource industries do not apply. BHPs bold bid demonstrates that our valuation metricunhedged reserves in the ground in politicallysecure regionsis being validated by one of the worlds smartest and most successful minersa company run for the benefit of stockholders, not the compensation schemes for top management.

November

2

INVESTMENT ENVIRONMENT
...with the US apparently willing to devalue the greenback, the dollar entered its worst bear market in decades... The low-volatility continuum in the capital markets since the commodity bull was born in 2002 ended this summer. Here is a capsule review of the events that made life exciting for investors and central bankers. 1. Oil prices soared more than 50%. Although professional pooh-poohers blame the price rise on speculation, the published inventories of crude oil, heating oil and gasoline remain stubbornly low. If this winter should prove chilly, then natural gas, the only fuel in sustained oversupply, could also become costly. We told investors to exit natural gas producers at the time of Katrina, and have not suggested re-entry until recently. 2. The subprime and CDO blowups were shown to have spewed financial pollution across the world, forcing central bankers into sustained bucketbrigade liquidity rescue operations. 3. By September, it became apparent foreign financial institutions willingness to buy vast quantities of vastly-overrated US debt instruments had been a major prop to the dollar. With that prop removed, and with the US apparently willing to devalue the greenback, the dollar entered its worst bear market in decades, with no bottom in sight. 4. Gold prices jumped 25%, with no signs of retail investor speculation. Serious investors had begun making serious changes in their forecasts for the dollar and inflation. 5. The Canadian dollar was the most spectacular winner from the greenbacks plunge. Although the same skeptics who had ridiculed the loonies leap past $.80 as being merely a commodity play, bayed aloud that its pricing was ridiculous, what was happening was that the currency had quietly morphed into a financialnot an economiccurrencylike the Swiss franc in the 1970s. The loonie was backed by a nation with the best fiscal position in the G-7, and a well-regulated, well-protected, oligopolistic

0

November

Basic Points
banking system whose underpinningscompared to its southern neighborslooked more appealing each week as big US banks weakened. The Asset-Backed Commercial Paper flap was bad news for some upstart issuers and some investors, but apparently not for the big banks. 6. Various indicators of financial risk in the US and Europe, including the TED Spread, Libor borrowing compared to the fed funds rate, and the ABXwhich measures risk in mortgage-backed securities, remain at elevated levels despite massive central bank reliquification. 7. Iran moved to the top of the Mideast risk list, without Afghanistan and Iraq becoming peaceful. 8. Many prominent seers, including Alan Greenspan, took to speaking almost casually about the likelihood of a US recession, with the risk of such a downturn being in the 2550% range. 9. Food price riots and protests were happening somewhere in the world every week. 10. The troubles of Citigroup and Merrill served as reminders that in bull markets, banks trade off their income statements, but in bear markets, they trade off their balance sheets. Those banks whose financial statements are dollar-denominated are at increasing disadvantage compared to competitors abroad: a weak currency means money is leaving a country: a strong currency means it is coming in. Money enters and exits through banks. In the banking business, it is far better to receive than to give. 11. Virtually all commodity futures charts remained in backwardation, signaling that investors and consumers doubt that current high commodity prices can endure. As inflation fears rise, many of those curves will eventually switch into contango. Then the fun for commodity stock investorsand the fear for inflation fighting central bankerswill really begin. In the banking business, it is far better to receive than to give.

November



INVESTMENT RECOMMENDATIONS
1. Remain overweight commodity stocks within equity portfolios. 2. Use our recommended weightings to allocate investments across the sectorsenergy, agriculture, precious metals and base metals. The major international oil companies are not the bestor even second-bestway to invest in oil and gas. They face becoming yesterdays story, because they are not replacing their production from politically-secure regions and they are competing with the state-owned and controlled companies worldwide. Those who still believe Big Oil controls world oil and gasoline prices can be included with those who claim to have seen flying saucers. 3. Gold (the ETF) and precious metals shares should be your primary emphasis on new money investments in commodity stocks. Golds price is ultimately headed for quadruple-digits in dollar terms. Remember the rule: buy stocks on the basis of unhedged reserves in the ground in politicallysecure areas of the world. Use any earnings-related pullbacks in shares of companies meeting that criterion to increase your exposure. 4. Review your investments in Alberta in the light of the change in the political climate there. Institutions considering investing in Calgary office towers should reconsider their plans. Downtown Calgary, with its open pits, looks to be in a building boom that will end badly. It is a high-cost city, and it is no longer located in a politically-pristine province. Saskatchewan could be a reasonable alternative. The NDP government there has a reputation for sound, sensible government and for keeping its word. Two of Canadas greatest companiesCameco and Potashare headquartered there. And the oil sands extend into Saskatchewan. Newfoundland and Labrador has moved ahead of Alberta for mining and oil investing security. 5. The current stock market rally is skating on thin ice: apart from the splendid performance of commodity stocks, the market lacks credible leadership. Nasdaq, carried by the Four HorsemenRIMM, GOOG, AAPL and MSFThas been outperforming the Dow; banks and other financials have been underperforming for months, and the Transports have failed to confirm the Dows new highs.

2

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Basic Points
6. The dollars decline has been quickening lately. In particular, the Canadian dollar has been on a tear. It is showing signs of becoming primarily a financialnot an economiccurrency. That could prove problematic for many Canadian industrial, retail and forest companies. We had for three years predicted parity for loonie, and raised that forecast to $1.10 last month. Those Midwest industrial companies that, by ingenuity, persistence, and heavy investment in technology somehow managed to survive the years of an overvalued greenback, have become very attractive investments. Their leading Quebec and Ontario competitors are about to face tougher competitive times. Canadian companies should consider using their new wealth to buy US competitors. 7. The problems of the financial system havent vanished because of two rate cuts. An aged, emphysematous hiker accustomed to smoking two packs of cigarettes a day may start breathing more easily after descending from an ill-considered trip up a mountain, but that doesnt mean hes a candidate for a $1 million term life insurance policy without a medical. Those big bank SIVs are leaking badly, and Asset-Backed Commercial Paper still suffers from a rare condition of the financial climate: Global Freezing. Remain greatly underweight the banks and mortgage lenders. 8. Agricultural stocks have been the brightest stock market stars this year. They are no longer cheap. But what they do is absolutely necessary for the global economy to generate sufficient growth in agricultural output to avert 1970s-style food inflation. They are core investments under any stock market conditions. 9. Oil nearing $100 and the subprime crisis are obvious constraints on economic growth. Commodity stock investors should review their base metal exposurethe most cyclical commodity group.

November



Basic Points
Double, Double, Greed and Trouble, CDOs and Housing Bubble

December 19, 2007

Produced by BMO Financial Group Distributed by BMO Capital Markets

Basic Points
An Investment Journal
Donald G. M. Coxe
Global Portfolio Strategist, BMO Financial Group (312) 461-5365 e-mail: don.coxe@bmo.com

Research/Editing Production/ Distribution

Angela Trudeau e-mail: angela.trudeau@shaw.ca Anna Goduco (print orders and mailing lists) e-mail: basic.points@bmo.com

Double, Double, Greed and Trouble, CDOs and Housing Bubble

Overview
The witches on the blasted heath in Macbeth used a complex formula of ingredientsmany toxicfor their bubbling cauldron. The resultant product was used in their forecasting of outcomes of the contests among the Scottish elites. Their predictions were cloaked in mystic terms, devilishly designed to mislead the user by appealing to his greed and ambition. Their successors, Wall Streets designers, creators and marketers of subprime-based Collateralized Debt Obligations (CDOs), mixed a variety of ingredientsmany toxicinto their housing bubble products. Their computer-based formulas were modern witches brews of complexity designed to seduce greedy users into believing that they would profit heavily from modern alchemyAAA products formed from alloys containing a range of AA, A, BBB and toxic waste products. While Milton Friedman yet lived, many of Wall Streets biggest names were earning big bonuses peddling products based on defiance of one of his most-uttered principles, There is no such thing as a free lunch. Those who relied on witches brews in medieval times were hideously punished. Macbeth, relying on the witches prophecies, killed the king and others, and took the thronewith fatal results for himself and his Queen. It is different this time: the mixers and marketers of the new brews have been vastly enriched, and remain so. The punishment that fits the crimes falls instead on (1) investorsfinancial institutions and others who bought the funds flecked with the toxic materials; (2) shareholders of the poisonpeddling Wall Street banks; (3) millions of homeowners; and (4) the global economy. At a time central banks should be tightening policies to fight sharply rising inflation, they are forced into reflationary bailouts. This month, we consider the prospects and make some changes to our Recommended Asset Mix for US Pension Funds. We have added a new asset classlong-term inflation-hedged sovereign bonds denominated in major foreign currencies. They have attractions as hedges against recession and stagflation. Despite the bad news about the consequences of bad behavior, tis the season to be jolly: we extend our best wishes to clients and friends for their holidays Christmas, or Yule, and/or New Years.

December

Recommended Asset Allocation

Recommended Asset Allocation (for U.S. Pension Funds)
US Equities Foreign Equities European Equities Japanese and Korean Equities Canadian and Australian Equities Emerging Markets Bonds US Bonds Canadian Bonds International Bonds Long-Term Inflation Hedged Bonds Cash Allocations 26 7 5 8 11 7 4 11 10 11 Change -4 unch unch unch unch unch unch unch +10 -6

Bond Durations
US Canada International Years 4.50 4.75 4.25 Change unch unch unch

Global Exposure to Commodity Stocks

Energy Agriculture Base Metals & Steel Precious Metals
We recommend these sector weightings to all clients for commodity exposurewhether in pure commodity stock portfolios or as the commodity component of equity and balanced funds.

33 25 22 20

December

Basic Points
Double, Double, Greed and Trouble, CDOs and Housing Bubble
In its cover story on the huge CDO and losses at top Wall Street banks, Fortune asked, What Were They Smoking? How could they keep on leveraging up their firms balance sheets to acquire high-risk housing bets long after the bubble had burst? How did home mortgage debt, a low-risk, low-volatility asset class beloved by conservative investors, become this decades equivalent of the technology mania and crash that had destroyed the savings of millions and discredited so many investment banks? Arthur Levitt, former SEC Chairman, describes this ghastly sequence of events as the deification of debt.
Citigroup December 2006 to December 2007
60 55 50 45 40 35 30 25 Dec-06 Feb-07 Apr-07 Jun-07 Aug-07 Oct-07

What Were They Smoking?

Bear Stearns December 2006 to December 2007

180 170 160 150 140 130 120 110 100 90 Dec-06 Feb-07 Apr-07 Jun-07 Aug-07 Oct-07 Dec-07

December

Merrill Lynch December 2006 to December 2007

100 95 90 85 80 75 70 65 60 55 50 Dec-06 Feb-07 Apr-07 Jun-07 Aug-07 Oct-07 Dec-07

There have always been small-scale venues for subprime borrowers; for instance, pawn shops and payday lenders...

Countrywide Financial December 2006 to December 2007

50 45 40 35 30 25 20 15 10 5 Dec-06 Feb-07 Apr-07 Jun-07 Aug-07 Oct-07 Dec-07

What happened was the Streets sudden lust for seemingly endless quantities of new mortgagorsthose who had been largely excluded from earlier housing booms through their failure to meet minimal credit standards. The Boston Fed, in its landmark analysis Subprime Outcomes: Risky Mortgages, Homeownership Experiences, and Foreclosures, published December 3, 2007, notes: There have always been small-scale venues for subprime borrowers; for instance, pawn shops and payday lenders have both existed for a long time. However, until recently, subprime borrowers were unable to systematically obtain large-scale loans such as mortgages. With reformed lending laws and increasingly sophisticated financial markets and instruments, a new mortgage lending channel emerged that serviced subprime borrowers in particular.

December

Basic Points
How generous and progressive of Wall Street to remove the stigmas and limitations of pawningby fawning on the millions who would love to own a home, they just couldnt afford to buy one. The Wall Street Witches Brews were composed of attractive debt instruments mixed in with varying dosesto users tasteof modern equivalents of Macbeths Witches recipe. Those three crones danced around a cauldron that included such choice ingredients as eye of newt and toe of frog and finger of birth-strangled babe. The arcane formulae cooked up by Wall Streets most bewitching PhDs turned out to be just as efficacious. After years of perfecting the design of such profitable investment products, Wall Street was, by late 2006, indulging in giant orgies of debt issuancethe modern equivalents of Witches Sabbats. The world was, (we were told almost daily), awash in liquidity. There was no doubt Wall Streets loan originators were drunk, and not just on subprime-based CDOs. CLOsCollateralized Loan Obligationswere also booming, based on astonishing growth in Leveraged Buyouts, (and, to us, the equally-astonishing willingness of investors and speculators to buy the decreasingly-restrictive paper used in those acquisitions.) Charles Prince, then the CEO of Citigroup, and cynosure of CNBC, summed up the grand strategy of the serial celebrators: As long as the music is playing, youve got to get up and dance. Were dancing. We wrote, at the time he uttered those dreamy words (midsummer, as one might expect), that the Princely poesy recalled for us the words of an Irving Berlin classic: There may be trouble ahead, But while theres music, and love and romance Lets face the music and dance. Before the fiddlers have fled, Before they ask us to pay the bill, And while we still Have the chance. Lets face the music and dance. ...eye of newt and toe of frog and finger of birth-strangled babe. The arcane formulae cooked up by Wall Streets most bewitching PhDs turned out to be just as efficacious.

December

Then the music stopped. Panicky subprime and CLO buyers pulled the plugs on the amplifiers.

Wall Streets high steppers were dancing not only to Subprime Time, but also to the High-Yield Reel: Private Equity (PE) firms were swallowing up publiclytraded companies on gargantuan scale. Those acquisitions were largely financed by bank loans, which were later repackaged into Collateralized Loan Obligations (CLOs), and peddled to hedge funds and other investors (aka speculators). How came this sudden, spectacular prominence of Private Equity, an industry that had been (since the bad old days of Barbarians at the Gate) a discreet, plush-carpet industry which went on public display only at events like museum fundraisers or celebrity golf tournaments? How had Blackstones Stephen Schwarzman suddenly joined Dennis Kozlowski and Nero on the short list of historys most spectacular birthday party-givers? Then the music stopped. Panicky subprime and CLO buyers pulled the plugs on the amplifiers.
Bank Stock Index (BKX) vs. Mortgage Finance Index (MFX) January 2007 to December 2007
10% 0% -10% -20% -30% -40% -50% -60% Jan-07 Mar-07 May-07 Jul-07 Sep-07 Nov-07

Bank Stock Index (BKX)

Mortgage Finance Index (MFX)

Such sudden falls from grace have occurred throughout history. Doubtless some formed the basis of fairy tales about witches turning Princes into toads. As global freezing hit the banking system, it became apparent that investment bankers eager to get advisory fees on PE buyouts had put their firms on the hook for hundreds of billions of dollars of suddenly-unmarketable LBO loans financing the takeovers. Slumping stock markets were pressuring stock prices generally but many of the LBOables share prices were hard-hitdown far below agreed-on buyout prices.

December

Basic Points
As talk of a potential recession became clamorous, investors in bank shares began to rush to the exits, worrying about what those LBO loans were really worth. Many of them were to deeply cyclical companies, (unlike the steady cash-flow growers that had been the PE industrys classic investments) and were also structured according to the new fashion crazecov-lites. Cov-lites are not a new form of background lighting. In fact, they were created deep in the bowels of the banking system. They allow borrowers to escape mostor allof those boring outdated constraints on corporate performance, including maintenance of acceptable levels of cash flows and restrictions on other borrowing. In other words, cov-lites are instant junk that give heavily indebted companies the power to continue to diminish shareholders equity and dispose of capital assets without recognizing anything so vulgar and 20th Century as lenders liens and constraints. Moreover, those newly-created debts that turn the A-rated into X-rated didnt go to create income-producing assets: they went to pay off the former stockholders and to swell the pools of lightlytaxed money in which the PE giants bathe so luxuriantly. That the banks who had invented and created these new kinds of risks suddenly found them difficultor impossibleto unload was a welcome sign of creeping sanity among institutional debt investors. Not only had the music stopped: with the plug pulled, the air in the dance hall became heavy with the stench of rapidly-rotting garbage, and the exit doors were proving pathetically inadequate to absorb the panicky mobs of fleeing fools.

Cov-lites are not a new form of background lighting.

To Ben and Other Central Bankers: Save The Nouveaux Riches Who Caused the Crisis! Save the World!
Although in March we published a scathing essay on subprime-based CDOs (DONT ASK; DONT TELL: ITS SUBPRIME TIME!), we must now bare our souls and admit to pathetic naivet: until July, we more or less accepted the Streets assurances that the total tainted volume of CDOs was manageable in the context of a growing US economy within a strongly-growing global economy.

December

We told ourselves that the view of Wall Street as a den of slick thieves...was populist paranoia.

We didnt want to believe that the Street would willingly inflict damage on homeowners and the economy on a scale that would be life-threatening to the global economy. We told ourselves that the view of Wall Street as a den of slick thieves, which has been around since Andrew Jacksons days, was populist paranoia. We maintained hope that the damage could be contained Until the leaps in the TED spread and gold told us that this was now a global crisis:
TED Spread December 2006 to December 2007
2.4 2.0 1.6 1.2 0.8 0.4 0.0 Dec-06 Feb-07 Apr-07 Jun-07 Aug-07 Oct-07 Dec-07

Gold December 2006 to December 2007

840 780 720 660 600 540 Dec-06 Feb-07 Apr-07 Jun-07 Aug-07 Oct-07 Dec-07

December

Basic Points
All past TED spread crises were concentrated in one, or a few, suddenly impecunious banks or funds, such as Continental Illinois (1984) or the 1987 Crash (Bear Stearns and a few other major brokers), or the Long Term Capital Management crisis (1998). The bailouts came, and the crises went. This time, the crisis just keeps going onand onand on. The TED has been trading at or near its 1987 Crash level of 215 for weeks, and yet most stock markets are trading quite near their all-time highs. Historically, the TED has operated like a thermometer of the health of the global financial system: when it soars to a life-threatening height, the systems Intensive Care Units take over, applying ice and administering antibiotics for a few days, then sending the patients home. This record-length stay in the ICUs should have hammered stock markets almost everywhere. To recall: On August 9th, the European Central Bank launched the lifeboats, stuffing the euro-equivalent of $131 billion into European banks. The Fed came next. The Bank of England sat this one out until it, too, was forced to reliquify. A leading British mortgage bank, Northern Rock, dissolved as if drenched in sulfuric acid. When the Bank was forced into the reflationary injections it had previously eschewed, Governor Mervyn King revealed the extent of the US malefactors damage on global banking systems: $400 billion of odoriferous US CDOs and subprimes had been sold to investors outside the US. (Were he Churchillian, he might have summed up the problems he confronted, Never in the course of human history has so much garbage been sold by so few to so many. ) Meanwhile, usually-virtuous and straitlaced Canada was experiencing a mini-financial crisis because the market for Asset-Backed Commercial Paper had suddenly frozen. Huge blocks of subprime paper had worked their way through the polluted sludge at the bottom of Lake Erie like so many lampreys and zebra mussels. Although each week has brought new stories of scandalous behavior among the Streets elites, to us one of the most painful tales came in a front page New York Times story about Narvik. Never in the course of human history has so much garbage been sold by so few to so many.

December

Narvik? Narvik, a fjord port of 18,000 residents, is 100 miles above the Arctic Circle. It is one of four small Norwegian towns that went broke because of investing their municipal funds in absolutely safe American CDOs. Their AAAcquisitions are said to be worth just 55% of face value. That story resonated with us, because it is the second time Narvik has been on the front page of the world press. The last time was 67 years ago. During the phony war after Hitlers conquest of Poland, the effete Chamberlain government did little to stop Germany from building up its already potent weaponry, still secretly hoping that Hitler would come to reason. German factories were operating flat out, and, although Britain was finally starting to rearm itself, the gap between the two powers was still widening. Chamberlain finally decided, under pressure from Churchill, to blockade Narvik, the German-occupied site where the crucial iron ore from neutral Sweden was being loaded into German merchant ships. The Germans inflicted a humiliating defeat on the British. That military disaster proved to be the event that saved Britain and the West from German National Socialism. Finally, the Tory rebels were able to rouse the House of Commons into a vote of non-confidence in Chamberlain, and install Churchill as Prime Minister. If Chamberlain had lasted even a few more months, Hitler might have won the war. So Narvik, the Arctic site of a British military disaster of historic importance, is now just another dot on the map showing where the CDO disaster has struck. Then, it was Nazis; now it is Wall Street investment bankers, who sold the Norwegians these polluted products according to their restated code of capitalism: When you care enough about enriching yourself to send the very worst. Citigroup und Merrill ber alles! It was bad enough that Merrill Lynch, the firm most associated with the great historic cause of bringing equity investments to Main Street, should have been a large-scale creator and distributor of subprimes that became the curses of Main Street. However, to us, one of the most discouraging features of this slowly-unfolding disaster was the revelation that some major banks had adopted what looks suspiciously like an Enron-style approach to balance sheet management undisclosed special purpose off-balance sheet structures. Enron officials were prosecuted because their Special Purpose Entities (SPEs) were crafted to mislead investors about the real strength of the company and to shovel profits to insiders. The SPEs ended up SPEaring their makers.

Enron officials were prosecuted because their Special Purpose Entities (SPEs) were crafted to mislead investors... The SPEs ended up SPEaring their makers.

10

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Basic Points
Maybe we are wrong about this, but it appears that some of the big banks structures, called Special Investment Vehicles (SIVs), were designed to get around the inconvenient rules of the Basel Accords capital constraints on banks exposure to higher risk and illiquid investments. Few investors including usknew of these subterfuges. We looked at the banks healthy Tier One Capital ratios and thought that it would take a financial earthquake measuring 8 or more on the Richter Scale to shake those mountains of monetary morality. The Basel Accords were Paul Volckers second-greatest achievementnext to smashing inflation. The Accords gave us a collapse-free decade among large global banks, after years of bank failures and bailouts. For bank officers to violate the spiritif not the letterof the Accords to achieve higher returns on equity is, (in our possibly Puritanical view), a reason for reappraisal of bank shares. Perhaps such a revaluation would force investors and analysts to downgrade the shares of those that evaded the inconvenient cookie-cutter Basel rules with corner-cutting schemes. The Accords were meant to prevent crises. Yes, the rules certainly restrained banks returns on equity, but the rules were accepted by global banks and had they all strictly adhered to them, the current crisis would either never have occurred, or would be manageable without driving the TED spread into crisis territory and keeping it there despite frantic efforts by central banks to restore calm. In what old-fashioned value investors might consider an ironic triumph for full disclosure and fair play, the SIVs did what they should have been expected to doleakand the share prices of the furtively levered banks sank. What do those leaking SIVs hold? According to the Financial Times, as of October they collectively held: Residential Mortgage-Backed Securities (RMBS) Asset-Backed Securities (ABCP) Collateralized Debt Obligations (CDO) Financial debt Collateralized Loan Obligations (CLO) Commercial Mortgage-Backed Securities (CMBS) 28.5 17.0 10.6 29.8 6.3 7.7 % % % % % %

...an Orwellian financial condition negative amortization.

Included in the RMBS are an undisclosed percentage of subprimes and Option Adjustable-Rate Mortgages (option ARMs). These mortgages have low teaser rates, and borrowers can defer payments on them, producing an Orwellian financial conditionnegative amortization. From 2009 through 2011, some $229 billion of such beauties get reset to market rates of interest and repayment.

December

11

CDOs...the Park Avenue version of the classic American frontier practice of mountebanks selling miraculous snake oil to illiterate sodbusters.

(By the way, since SIVs suddenly became famous, another financial asset class has joined subprimes and CLOs in the financial emergency wards: commercial mortgages are being downgraded by the week. There is already talk that commercial mortgage-backed securities (CMBS) will prove to be as perilous an investment group as commercial mortgages were after the collapse of the S&Ls at the end of the 1980s. As the sad antiwar folksong goes, When will they ever learn?) CDOs and SIV paper were not just sold to a wide array of institutional clients, (what could be termed the consenting adults defense to a charge of unseemly behavior) including major banks and hedge funds, but also to Florida schools and UK high street (local) banksand to those tiny Norwegian communities and some equally tiny towns in rural Australia. The justification the Streets finest had used for marketing such dubious instruments that were never cleared with Securities regulators was that they were created by experts and sold to those who were sophisticated enough to do their own appraisals. What actually happened was that hundreds of billions of dollars worth in market value of overrated opaque debt was foisted on those who lacked the expertise to evaluate what they were buying. The marketing of CDOs was the Park Avenue version of the classic American frontier practice of mountebanks selling miraculous snake oil to illiterate sodbusters. Where were the ratings agencies in this sordid story? They were happily cashing checks for assigning AAA ratings by the thousand to the best structures Wall Streets systems could spawn. They were, sadly, little more than rubber stamps. The CDOs were so brilliantly designed that they could fool all but the most sophisticatedand most of them were on the payroll of the big banks and hedge funds. How good are the holdings the banks stuffed into their SIVs? The Financial Times observes, SIV capital notes, [the equity on SIVs balance sheets supporting those porous structures] which usually make up 510% of each vehicles funding, have on average lost almost 50% of their value in the past couple of months, according to the rating agencies. The SIVs sold their shortterm paper to unsuspecting investors based on the prestige and reputations of their parent banks, and on the equity base which was supposedly the equivalent of Tier One equity under the Basel rules.

12

December

Basic Points
If the SIVs were hedge funds, they might have lost most of their clients. Vikram Pandit, Citigroups new CEO, has been a star hedge fund manager, but his fund, according to the always-reliable Dennis Gartman, has seriously under-performed almost any other hedge fund. Sounds like he should be really comfortable with the assets in Citi itself and in its leaking SIVs. He doesnt have to worry about hedge fund cashout times any more. All he has to do is talk to a few more SWFs (Sovereign Wealth Funds). Prince Al-Waleed bin Talal owns slightly under 5% of Citi, and ADIA (Abu Dhabi Investment Authority) bought 4.9% and some other unnamed Mideast funds chipped in more in a rescue package of convertible securities yielding 11%. The importance of 4.9%? If it were 5%, the Fed would have to give its approval. Senator Schumer, whose righteous rage led to the blocking of Dubais investment in US ports, has been as silent as the tomb about what skeptics might see as the beginning of a creeping takeover of what once was one of the most illustrious of American financial institutions. There is a precedent. When Citi was facing disaster in 1990 because of commercial real estate problems arising from the S&L collapses, Prince Al-Waleed stepped in with the required funding in a convertible note that eventually paid off handsomely. There was a kicker: the US sale of advanced fighter jets to Saudi Arabia had been held up in Congress by concerns for Israeli security, and the Prince said he was strongly desirous that the US show its good will to his country by ratifying those contracts. The Bush Administration threw its full weight behind the deal, Israel made it clear it was not opposed, and the New York congressional delegation dropped its opposition. Those fighters ended up being used against Saddam in the first Gulf War, Citibank stock became one of the stars of the 1990 bull marketand everybody lived happily ever after. CDOs, and SIVs and Big Citi So high on subprime A grouping sublime And with other bad debts in the kitty.

Vikram Pandit... should be really comfortable with the assets in Citi itself and in its leaking SIVs.

December

13

Three Strikes and Youre Out?

We now know that the creation and marketing of hundreds of billions of dollars worth of CDOswhat could be called Barry Bondsjuiced-up debt that produced a record rate of home runs for investment bankers earningswas a Hall of Wall Street Fame that would become a Hall of Shame. It started out quietly enough, as a rising foreclosure rate among loans issued to people who would never have been considered for mortgage financing in any earlier era. Then, after the July collapses of Bear Stearns and Goldman Sachs flagship hedge funds, it became a full-blown crisis. Despite weekly rescue operations from central banks, and weekly assurances that the worst of the housing problems are now behind us, the financial system remains under acute strain. Last week, the Fed, the ECB, the Bank of England, the Bank of Canada and the Swiss National Bank announced a huge international rescue operationthe biggest emergency reliquification since the 9/11 financial rescues. Whod have thought that the big banks could have created a financial crisis bigger than Osama pulled off? From the headlines, the casual reader would conclude it is all about subprime mortgages and the pricking of the US housing bubble. It is more than that, as we have seen. It is systemic. The classic combination of bankerly cupidity and bankerly stupidity has entered, pace Churchill, its Finest Hour. In deference to the brilliant mathematics used to construct the predicted returns for off-market models, we propose the following formula for valuing financial stocks: BC2 x BS2 = BCEOP + BB (Bankerly Cupidity squared, times Bankerly Stupidity squared makes Big CEO Payouts and Big Bailouts.) 1. The subprime mortgages are inflicting damage on the entire US housing market because of their enwrapment in CDOs that include better-quality products. If a totally natural manufacturer of designer water includes a large dollop of sewer water plus a few dashes of swamp water and the rest is pure Evian, the end product will be damaging not only to the consumer, but to the bottled water industry. Wall Streets missteps accelerated the plunge in US housing prices and imperiled the entire US economy.

The classic combination of bankerly cupidity and bankerly stupidity has entered, pace Churchill, its Finest Hour.

14

December

Basic Points
2. The PE-induced Collateralized Loan buildup, amid rapidly-decaying covenant protections, has left some Street banks impaled on the projections of their own greed. They have either dumped the CLOs, and taken writedowns, or they are stuck with retaining them in full view on their pockmarked balance sheets. 3. The transmogrification of all those AAA loans into AAAwful loans has been painful for the reputation of the rating agencies, but it has been catastrophic for the monolinesthe bond insurers, such as AMBAC. These guarantee organizations are useful components of the credit markets, particularly for US municipal bonds. If they collapse, the slowly progressive freezing of US domestic credit marketssuch as what besets many US state and municipal pooled money market fundscould usher in a new Ice Age. Warburgs investment of $1 billion in MBIA is an encouraging developmentif it proves adequate to the rescue challenge. The dramatic charge of the global central bank cavalry last week has not driven bank borrowing rates down to central bank target levels, or lowered the TED spread, but it shows that central bank fear and creativity can be powerful goads to achieving rescue for iced-in market players. The Feds legal constraints on acceptable security for loans at the fed funds rate have forced Ben Bernanke and his colleagues to devise new strategies. This novel program, which involves a large-scale auction in which beleaguered banks can borrow using lesser-quality securities than Treasurys or Fannie and Freddie paper, shows that help can find its way around legalisms. The ECB has broad discretion in accepting securities for its loans. It ordinarily has confined its lending to euro advances, but it has had to wade in with special provisions for Libor-based loans because so many Eurozone banks have so much exposure to bad US paper. Partially offsetting Canadas balance of trade surplus with the US has been the seepage of subprime and other dubious US debt paper into Canadian Asset-Backed Paper Markets. Canada sends oil, wheat and cars to the US and absorbs highly-perfumed paper in return. Bank of Canada Governor David Dodge, usually given to cool, unemotional appraisals, was bluntly angry about the damage inflicted on Canadian financial markets, which was interfering with his monetary policymaking. We have a collective interest in the whole thing not going into a shambles, he said. Because theyre levered, the amount of global assets that would be affected if all this went down would be eight or ten times the nominal value of the notes, so youre starting to get into the $200 billion, quarter-trillion dollars worth, he warned.

The PE-induced Collateralized Loan buildup...has left some Street banks impaled on the projections of their own greed.

December

15

Wall Streets witches should be proud of having such impact. It can console them, as they face up to the challenge to find the next way to mulct billions from suckers. ...the challenge to find the next way to mulct billions from suckers. The end to this program of delivering huge growth in wealth to some of the Streets most famed geniuses is not because of a sudden seizure of conscience in high places, but because of a sudden seizure in asset-backed paper markers. Foreign buyers of Wall Streets worst products have sworn theyll not be bagged again by paying up for AAAwful securities. These products were never designed to be priced according to the market, but according to the models. The models were based on the foreclosure losses experienced when lending practices were characterized by some caution and restraint, and house prices were soaring. Back then, default rates were low, and foreclosure recoveries were generally satisfactory. However, many of the most perfumed CDOs now populating the financial world were conceived and born during the period of largely unrestrained lending practices and peaking house prices. The rest were conceived and born during the period of utterly unrestrained lending practices and falling house prices. That the Street continued to rely on those outdated models in late 2006 and even through the first half of 2007, when subprime CDO creation and marketing climbed sharply, is disconcerting for those seeking proof of intelligent life on the Streetbut even more disconcerting for those seeking evidence of ethical life therein. The New Century Financials and their ilk diversified their marketing to include overlevered mortgage refinancersusing teaser rates to entice those who couldnt meet their payments on their mortgages that were a notch or two above subprime to lever up ever more. The Shills & Mountebanks, grossly enriched by their successful peddling of tech trash, went into hiding when Nasdaqs plunge exceeded 50%. They re-emerged to promote the housing boom that would restore Baby Boomers wealth in time for their retirement. Prof. Shiller conducted a survey of homebuyers that showed that a large percentage were bidding up house prices and borrowing to the hilt precisely because of how much they had lost on tech stocks. This was a sure-fire way to recoup, becausethey were assuredhouse prices nationally had never gone down. Moreover, Alan Greenspan, mediaanointed as the maestro, publicly urged homeowners to choose AdjustableRate Mortgages, relying on the Fed to keep interest rates down by its antiinflationary policies. (Four months later, he started raising rates rapidly.)

16

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Basic Points
We write this after hearing of Conrad Blacks sentencing6.5 years in jail for pocketing payments of $12 million that should have gone to Hollinger stockholders. Yes, he was doubtless guilty. Maybe he deserved such strong punishment. If so, what can we say of those who concocted, promoted and sold those hundreds of billions of subprime-based products in CDOs priced according to obviously spurious models? Any reader of USA Today, let alone The Wall Street Journal, had known since June 2006 that there was a housing bubble that was near bursting. One expert after another was warning of a serious housing slump. It is, we believe, inconceivable that all those programmers, mortgage bankers, investment bankers and CEOs with extensive experience in housing-related credit products would have assumed that house prices would continue to rise by at least 5% a yearthereby allowing for relatively painless refinancings and/or foreclosures. Their judgment seems to have been impaired by their own bonus programs and by their conviction that they could unload the vastly overpriced paper onto greater fools. Like the people of Narvik. Angelo Mozilo, of Countrywide Financial, last year received a $10 million bonus for agreeing to stay on as CEO. He thereupon launched a huge buyback of his companys stock at a time he was unloading nearly all of his own shares and announced that the company was going to grow its subprime business by hiring people who had lost their jobs due to bankruptcies in other mortgage originating companies. Was he ensuring high prices for the stock he was dumping or was he just carried away by his enthusiasm for the mortgage market? He recently published an article in the financial press, recounting interviews with mortgage applicants in 2006. He expressed horror that they were so utterly convinced that house prices could only go up. Why did he later drain the companys treasury at the same time he was putting more than $250 million into his own pockets through stock option exerciseat prices more than double todays levels? Are we to believe that all those rich experts really believed there was no housing bubble and that the models AAA valuations were valid? Are we to believe that all those rich experts really believed there was no housing bubble and that the models AAA valuations were valid?

December

17

Fannie and Freddie... these long-time Democrat pets are nearly flat on their backs...

If we were jurors and those men were charged with some civilor criminal offence which had led, inter alia, to the hammering of their own stock prices and to triggering a serious economic slowdown or recession, we might find it hard to accept defense evidence that they all really believed those mortgages would be rock-solid investments. One last question: According to some recent estimates, US companies completed a further $170 billion in stock buybacks during the Third Quarter. One wondersparticularly in the case of financial corporationshow many of those purchases were influenced by CEOs stock option sales? One also wonders how many of those companies treasurers are now delirious with joy and bursting with pride about the money drained from their balance sheets.

Will There Be a Recession?

The S&L scandals led to the brief recession of 1990 that the Bush family still believes was decisive in defeating Bushs re-election bid. This real estate debacle is far greater, and is having enormous impact on the US economy(and, incidentally, on the Republicans already-bleak political prospects), and on financial markets around the world: Headline hits: UBS, the huge Swiss bank which derives 40% of its income from wealth management, while stating the ultimate value of our subprime holdings which remains unknowable, has written down $10 billion in US CDO losses and has raised $11.5 billion from Singapores sovereign wealth fund and an undisclosed Mideast investor in convertible securities that will lead in two years to as much as a 12.4% equity stake. Merrill Lynch has already written down $7.9 billion, but it still holds $20.9 billion in CDOs and subprimes. Morgan Stanley has already written down $3.7 billion, but it still has $6 billion in subprimes and CDOs. Washington Mutual, Fannie Mae and Freddie Mac have reported billions in losses and have announced major refinancings to rebuild shattered balance sheets. (When the crisis broke, prominent Congressional Democrats such as Barney Frank demanded that the Administration authorize Fannie and Freddie to rescue the mortgage market through large-scale purchase of riskier loans. Now that these long-time Democrat pets are nearly flat on their backs, Congresspersons are advancing other varieties of rescue schemes.)
18 December

Basic Points
Fannie Mae December 2005 to December 2007
75 70 65 60 55 50 45 40 35 30 25 Dec-05 Apr-06 Aug-06 Dec-06 Apr-07 Aug-07 Dec-07

California, here the foreclosures come...

Freddie Mac December 2005 to December 2007

80 70 60 50 40 30 20 Dec-05 Apr-06 Aug-06 Dec-06 Apr-07 Aug-07 Dec-07

We noted earlier the Boston Feds superb report on subprimes. Among its many statistics: Historically, 20% of homes purchased with subprime mortgages end in foreclosure; in 2006-07, this rose to 30%. During a 20% drop in housing prices, subprime borrowers are fourteen times more likely to default than borrowers in rising markets. In 2006 and 2007, subprime borrowers accounted for 58% of all foreclosures. California, here the foreclosures come: in 2005, 25% of all new California mortgage loans were subprime. As real estate values plummet, the Fools Golden State is facing a fiscal crisis. Californias constitution forbids the state from deficit budgeting, and Gov. Schwarzenegger warns of a deficit of more than $10 billion.

December

19

Deflation or Inflation?
In recent weeks, we have been taking heat from some economistsand one or two clientsabout our contention that inflation threats are increasing. A quadrupling of wheat prices in 1973...had a far greater impact on global inflation than real estate price runups in New York, London, and Los Angeles. The argument we hear most often is that falling real estate and stock prices are deflationary: recall how Japan entered outright deflation when prices of stocks and real estate collapsed. Our arguments: 1. During Nasdaqs Triple Waterfall runupidiocy on a scale that makes the housing bubble look like pure Puritanisminflation barely worked its way into the real economy. Its impact was mostly confined to the prices of high-end real estate in Silicon Valley and New York, and the cost of yachts, and of tables in the toniest restaurants. 2. Alan Greenspan was (for once), right, when he said that there was no evidence that asset inflation necessarily triggered economic inflation. (This, he felt, was a satisfactory answer to accusations that his own mega-reflation after Long-Term Capital fell was a major reason why Nasdaq had gone to the moon.) 3. Real estate inflation can ultimately work its way into the economic statistics by forcing increases in business costs, rents, and employee compensation. But the linkages have proved erratic, not linear. A quadrupling of wheat prices in 1973 after the Russian wheat and anchovy harvests simultaneously failed had a far greater impact on global inflation than real estate price runups in New York, London and Los Angeles. 4. Real estate prices respond, like commodities, to supply and demand shifts, but real estate prices are much more sensitive to interest rates and credit availability than are commodities. 5. Over the long term, real estate prices will tend to outperform inflation, whereas commodity prices have failed, over the long term, to keep up with inflation. (Example: grain prices now, although at historic highs, are far below 1973 levels when adjusted for intervening inflation.) When commodity prices soar, they have quick impact on producer and consumer prices. The relatively slow upward creep of rents has less impact on yearover-year inflation data. 6. To the extent that plunging asset prices force central banks into inflationary monetary policies, then they are actually inflationarynot deflationary.

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Basic Points
That was what caused the stagflation of the 1970s. It is, we believe, the risk today. As of June, all five major OECD central banks had proclaimed that their next policy move would be toward tightening. All have been forced into force-feeding the financial markets and bailing out the super-rich who caused the crisis at a time of rising food and fuel prices. 7. Some economists justify their insistence on core inflation, rather than CPI, arguing that The Fed cant pump out more oil and produce more wheat. That debating point misses the point. Friedmans opposition in 1974 to central banks policies was that by printing money to try to offset the impact of soaring food and fuel inflation, they prevented consumers from cutting back on discretionary expenditures at a time of sharply rising costs for basics. Inflation comes when food and fuel prices, and excess monetary creation supplies funds for consumers to continue their spending on optional items, whose prices thereupon rise. The way to halt inflation is to let primary producers grabperhaps temporarilya bigger share of the total pie at the expense of other sectors of the economy. 8. If all the rescue packages work, asset prices will not reach clearing levels, and will remain overhangs on economic growth. In particular, urban real estate prices will not fall to levels that will stimulate capital investment in or near cities. If workers cannot afford housing, either the businesses that need them will locate in lower-cost municipalities, or will give up on the US entirely and move to Asia. Beginning with the minutes of its October 3031, 2007, meeting, the Fed added nominal CPI to its list of macroeconomic indicators that together reflect our dual mandate of promoting price stability and maximum sustainable employment. Ben Bernanke told the Cato Institute, Ultimately, households care about the overall or headline rate of inflation; therefore the FOMC should refer to an overall inflation rate when evaluating whether the Committee has met its mandated objectives over the long run. With US CPI now at 4.3%, Treasury yields are negative out to ten years. Either CPI collapses, or yields climb sharplyor stagflation takes charge. Mainstream economists either thought that CPI could never reach these levels, or dismissed CPI as an outdated measurement. They continue to assume that the Fed will slash rates, because whatever inflation risk exists would vanish if a recession ensued. The economic consensus was hopelessly wrong when stagflation arrived in the 1970s, and was hopelessly wrong when Volcker, Reagan and Thatcher were smashing it 25 years ago. We believe stagflation is returning.

Ben Bernanke told the Cato Institute, Ultimately, households care about the overall or headline rate of inflation..."

December

21

Long Bonds: Why Now?

In April, we eliminated one of our favorite asset classes from our Recommended Asset Mix for US Pension Fundslong-term bonds. We also recommended that clients scale back exposure to all riskier credits. We predicted a move back to a normal upward-sloping yield curve and a return to normal yield spreads. Having maintained long bonds as a recommended asset class for years, we deleted them because we concluded that the next few years would see the onset of a significant bear market in bonds. Heres how the US 10-year bond has behaved this year:
US 10-Year Treasury Notes Yield January 2007 to December 2007
5.5 5.3 5.1 4.9 4.7 4.5 4.3 4.1 3.9 3.7 3.5 Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07 Nov-07 Dec-07

Our timing about divesting long government bonds was, we now know, terrible.

We had been bond bulls for all but a few months since 1981, so this was a major policy change. Our timing about divesting long government bonds was, we now know, terrible. We assumed the global economic recovery would continue apace, and the underlying inflationary pressures from foods, fuels, industrial raw materials, and labor shortages would gradually assert themselves. We try to set investment policy based on longer-term risk/reward assumptions, not on current Page One stories or economic consensus assumptions on inflation. Long yields did rise slightly after our asset mix shift, but once the financial crisis began to engulf the financial markets and central banks were forced to abandon their policies of restraint, Treasurys soared.

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December

Basic Points
It is trite to say that asset prices are driven by the intersection of Fear and Greed. What has actually happened is that two kinds of Fear have driven the government bond markets1) Bond Investors Fears: fear of credit defaults on lower-quality instruments, and 2) Asset Allocators Fears: fear of recession has driven asset allocations away from equities and cash into long governments. We now know that we underestimated the scale of fraud and foolishness within the credit markets. We had, in June, (Babel in Bond-Land) expressed the view that credit derivatives would be a collapsing asset class, and their fall would raise interest rates on longer-term bonds. We saw that the Achilles heel of the debt markets was the multi-trillion-dollar derivatives market, which was so heavily based on the relationship between leverage and liquidity. Leverage kept multiplying as liquidity kept expanding. As we had suggested, once the liquidity flow into dollar-based debt products reversed (in response to global investors shock at how Wall Street had betrayed them), many key derivatives were devastated, as shown in the spectacular drops in such specialized indices as the ABX. We did predict a coming equity correction led by financials, but within the context of continued strong economic growth that would force both inflation rates and interest rates higherat the expense of equity prices. In retrospect, we should have been completely cynical about Wall Streets selfserving claims that the Streets intentions were innocent and that the total losses would be temporarily painful, but not on an economy-disruptive scale. (We note, parenthetically, that Goldmans forecasters were not alarmist, at a time their internal traders were taking bets against subprimes and CDOs that would lead to one of the greatest investment wins of all time.) We had dug enough into the subprimes to know that there would be big losses there, and to be convinced of the scabrous behavior of their creators. We had no idea of the sheer scale. We thought this would be, in terms of deaths in nature, the equivalent of routine fish diebacks, which leave numerous dead fish littering the beach. This has turned out to be the equivalent of those alewives catastrophes, where beaches in Lake Ontario were buried under billions of dead, stinking small fish, and the cleanup costs were enormous.

...the sheer scale [of subprime losses]... has turned out to be the equivalent of those alewives catastrophes, where beaches in Lake Ontario were buried under billions of dead, stinking small fish...

December

23

Deflation will be a disease suffered mostly by those who own more real estate than they need or can afford, and among owners of Wall Street banks shares.

We are now reintroducing long bonds as an asset class, but are recommending inflation-hedged bonds issued by sovereign credits in strong currencies such as loonies, euros, and pounds. Although inflation-protected Treasurys (called TIPs) are a safer alternative than buying 10-year bonds with a real rate of return of .5%, they are denominated in the currency that has the most to lose from a Bernanke bailout of the big banks and assorted hedge funds. Those bailouts abroad are also inflationary, but the likely increase in value of the currencies compared to the dollar should, for dollar-based investment funds, offset much of the inflation pain. Deflation will be a disease suffered mostly by those who own more real estate than they need or can afford, and among owners of Wall Street banks shares.

The Three Faces of Gold

Gold January 1980 to December 2007
800 700 600 500 400 300 200 Jan-80 Jan-83 Jan-86 Jan-89 Jan-92 Jan-95 Jan-98 Jan-01 Jan-04 Jan-07

US Dollar Index January 1980 to December 2007

170 160 150 140 130 120 110 100 90 80 70 Jan-80 Jan-83 Jan-86 Jan-89 Jan-92 Jan-95 Jan-98 Jan-01 Jan-04 Jan-07

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December

Basic Points
What does the runup in gold prices tell us? We believe gold price movements are driven by three forces. Sometimes they overlap, which makes interpretation more difficult. Beware of those who assert flatly that any move in gold is due to just one cause. 1. Gold price movements have historically been driven primarily by inflation fears. The Bank of Canada released an interesting study in April (Gold Prices and Inflation) that showed that gold has been a good predictor of inflation rates in countries whose currencies are pegged to the US dollar. During the 1970s, gold prices soared from $35 an ounce to as much as $850. During that time, US inflation climbed from 4% to 13%. In other words, gold prices rose far faster than inflation. Gold had been pegged at $35 since Depression times, but when the Nixon Administration took off the cap and legalized American gold ownership, gold did not immediately leap, partly because wage and price controls briefly suppressed measured inflation rates in the US and some other industrialized nations. We now know that the late stages of golds runup were the third stage of a Triple Waterfall mania, which also carried silver prices up as much as 24 times. Like the next two maniasJapan and Nasdaqthe third stage of the price increases was not predictive or rational, but was driven purely by emotions. Golds basic role as an inflation hedge is not based on emotions, except among some gold bugs, who kept telling us during golds Triple Waterfall Crash that it was the only reliable store of value. Stores of value dont behave like Nasdaq. Gold mania, or chrysophilia, actually bears more than a passing resemblance to bubonic plague, which devastated Asia and Europe in the 14th Century. It broke out again many times, but has not been an important killer for at least a century. Improved municipal sanitation practices and antibiotics seem to have eradicated it. Not quite: it remains endemic among some small burrowing animals in the Southwest desert regions of the US. So it has been with gold mania. It still survives in some dark, remote regions.

Gold mania, or chrysophilia, actually bears more than a passing resemblance to bubonic plague...

December

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2. Since 1982, golds primary role has been its inverse correlation to the dollar. The 45% runup in bullion prices from late 1986 through the stock market crash of 1987 was because of the dollar devaluation in the Plaza Accord (September 21, 1985), and the abject failure of the successor agreement, the Louvre Accord, in 1987, to stabilize the greenback. That 45% rally was gold investors last chance to get as much as $500 for their holdings: the next thirteen years took gold all the way down to a pathetic $250, thanks to the dollars roaring bull market, which began in 1996. 3. During the 1987 rally, gold took on a new lusteras a hedge against financial collapse. It has performed that rule in all later crises. The slide in the dollar explained only part of golds powerful bounce: the rest came from fears about systemic crises in the global financial system. When the TED spread started to break out of its long torpor in the Spring of 1987, golds strength increased, and it joined the TED spreadas both soared, leading up to the Crash. That action displayed golds third characteristic: Gold is the only financial asset that is nobodys liability. That makes it a pure store of value when financial panics are disemboweling risky paper assetsstocks and commercial paper alike. That is why we became seriously worried about the financial markets in early August. Not only had the TED spread leapt to crisis level, but gold was soaring even though measured inflation remained modest across the OECD. Yes, the dollar was going to a new low, but was only down 7% from its levels in the Spring when the TED spread was showing no signs of impending panic. Golds gain far outpaced what could have been expected from its inverse relationship to the value of the dollar.

Gold is the only financial asset that is nobodys liability.

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December

Basic Points
That is how gold is now behaving on most trading days. When financial stocks participate in a broad stock market rally, gold tends to weaken. When bad banks are behaving really badly, and stocks fall, gold usually breaks out on the upside. Gold is, therefore one of the four most useful tools for assessing systemic risk in these troubled times. The others are the TED spread, the Bank Stock Index, and the Dollar Index. When they break down together, stocks and corporate credits plunge together. On December 12th, the day one of the great global financial rescue operations in history was announced, stocks soared. First to roll over were the Financials. As they gave up gains, and began to slide back toward the pit from which they had emerged, the rest of the stock market gave up its gains, entering negative territory before rallying modestly in the final hour of trading. The financial stocks did not participate in that late recovery. Throughout the day, the TED spread stayed stubbornly at 213. It had been below 50 as recently as July. It was 215 the day of the 1987 Crash. And, oh yes, gold managed to hang on to part of its gain. On December 12th... First to roll over were the Financials... the TED spread stayed stubbornly at 213.

December

27

INVESTMENT ENVIRONMENT
...equity markets continue to behave as if they are driven overwhelmingly by Greed, while debt markets are driven overwhelmingly by Fear. Discussing strategies for long-term investing with the TED above 200 is like holding a conference at a Darfur refugee camp on the dangers of high-fat and salt diets. Yet, as the year winds down, we find a continuation of the central paradox of 2007: equity markets continue to behave as if they are driven overwhelmingly by Greed, while debt markets are driven overwhelmingly by Fear. Major equity indices have held up remarkably well, despite daily torrents of bad financial news and talk of impending recession. Because of the heavy (but fast-fading) weight of Financials in the S&P, stock investors principal worries are about bank problems that could trigger a recessionbut they seem to assume that the Fed will manage both problems satisfactorily. Debt managers principal worries are mostly about return of principal (and the return of the Fed to operating by an established set of inflation-fighting principles.) The Wall Street stock peddlers who dismiss the possibility of a US recession in the face of two massive hits to the slender savings of Americans (Nasdaq and the housing bubble) tend to fall back on the inevitability argument: Wall Street is littered with the bones of forecasters who said the American consumer was tapped out. That observation is trueas far as it goes. What may not go as far is the American ability to make up for exiguousor non-existentsavings with heavyor unlimitedborrowing. The three-bedroom ATM which financed, (according to some estimates) as much as 40% of consumer spending growth in this decade is closed because of simultaneous infestations from rats, termites, and bedbugs that migrated from Manhattan. If the American personal savings rate were to rise to within sniffing range of savings rates across the rest of the OECD, the US would fall into a sharp recession. The baby-boomer Presidents booms [Clinton and Bush] were both dependent on a sustained national repudiation of thrift. The last thing the teetering American economy needs now is a return to Ben Franklinstyle virtue. Fortunately, no candidate for the Presidency is recommending anything as perilous as that. What would have seemed economically impossible outside a Depression arrived in this decade: the already-low American savings rate fell to zero then kept falling.

28

December

Basic Points
It is, we suggest, a time for investors to make what has been that most dangerous of all betsto bet against the continued ability of the American consumer to go deeper into debt to sustain his/her consumption. The effects of manic, unrestrained consumption that the CDOs financed bears an eerie similarity to the effects of another kind of consumption that beset 19th Century heroines in novels, plays, and operas. They did, we recall, keep dancing until their music stopped. It could be argued, as do the Administrations spokespersons, that focusing on housing and debt problems misses the reality of a strong economy. Third quarter GDP was the strongest in a year, the unemployment rate remains so low as to pose a Phillips-Curve-style inflationary threat, interest rates are so low as to make borrowing relatively painless for homeowners, businesses and municipalities, the non-oil trade deficit is shrinking in response to the deflowered dollar, and inflation remains benignfor now. Yet polls show that most Americans are frightened about the economic outlook and a large percentage believes that the nation is already in recession. Bill Clinton wonwith 43% of the voteson the slogan, Its the economy, stupid! Which Republican politician will have the courage to say, Its the stupid bankers, not the economy! On a trip to Riyadh a few years ago, we were informed that, on Saturday afternoons, they regularly held beheadings in a civic square. It was said to reduce the crime rate. Each system has its own incentivesand rewards and punishments. Our system certainly lacks incentives to reduce the financial crime rate. (Note: We are not recommending beheading bad bankers.) The major problem of our economic system could be the incentive structure in our banking and investment sectors. The Invisible Hand that, in more ethical times, guided most bankers most of the time toward prudence and the financial system to providing strong underpinnings for the economy, now operates asymmetrically: bankers get huge incentives to take huge risks with the stockholders money, secure in the knowledge that theyll be hugely rewarded even if they blow billions in bad bets. Heads, they win; tails, shareholders and the economy lose. The Invisible Hand that, in more ethical times, guided most bankers most of the time toward prudence... now operates asymmetrically.

December

29

Putin...There is no such thing as an ex-KGB Agent.

And they call that capitalism! When the Fed bails out the offending banks (and hedge funds) it is really a form of crony capitalismwhat James Grant calls socialism for the rich. Angelo Mozilo, arguably the most successful seller of stock this year, when asked about Countrywides gigantic third quarter losses, shrugged, Capitalism isnt perfect. Such bluntness calls to mind the eponymous creator of an alternative economic system: Putinism might well be a franker, more straightforward system of cosseting and protecting the extremely wealthy. We cherish Mr. Putin only for his public utterances. Our favorite to date: when asked at a press conference why he was surrounding himself with so many ex-KGB Agents, he said, There is no such thing as an ex-KGB Agent. Bravo, Putin! Faced with what looks more and more like the serial debauching of some major Wall Street banks, investors should restrict their financial stock exposure to banks and non-bank financials that operate prudentlywith reward systems that do not overpay top management when fast liquidity growth swells corporate earnings, and that punish bungling bosses who blow billions, and that have both minimal stock option plans and minimal stock buyback programs. (As a general rule, dividends are preferable to buybacks, and buybacks frequently tend to be most prominent where the stock option program is most excessive.) Because of the sadly limited number of such virtuous US banking institutions, this principle automatically implies underweighting financial stocks. Because the dollar and most Wall Street investment banks are locked together in a downward spiral, US investors should be diversifying their investments toward opportunities abroad. During earlier banking crises, Emerging Markets stocks and bonds tanked, as investors fled from risky investments. It is certainly different this time. Indias Indexthe Sensexhit an alltime high last week as major North American financial stocks were diving. Although the criticism one hears from global investors about India is that there is so much corruption in that economy, widespread Indian baksheesh doesnt seem to be of the Western kind that disembowels big financial institutions. It is a melancholy commentary on the creators of CDOs that Emerging Economies financial institutions seem models of probity compared to some of Wall Streets biggest names.

30

December

Basic Points
We frequently receive calls from clients who point out that this financial crisis has been on Page One for months, the bank stocks have been hammered, hedge funds are short those names, and almost nobody loves them. When we moved from being mildly bearish to extremely bearish about the banks early this year, it was a contrarian position. It has worked out well. So, they ask, isnt it time for us to reverse our bearishness now that its the consensus view? Consider that question in the context of football betting. Although such gambling is illegal in most states, bettors function in open markets with myriads of up-to-date information supplied by competing media organizationsand the bookies vigorish is fully disclosed. There are no real insiders, and Wall Street denizens have no advantage over Joe Sixpack. Moreover, unlike many stock option programs, no one gets to bet once the game is under waylet alone actually decided. It is the consensus view among Las Vegas oddsmakers that the New England Patriots are heavy favorites and the Miami Dolphins are deep underdogs. To bet on a team that has won all its games and against a team that has lost nearly all its games is going with the crowd. Its also the way to bet. The fallout from Wall Streets misdeeds is forcing central bankers to deliver daily intravenous infusions. It may also be in the process of handing over control of major investment banks to Sovereign Wealth Funds in countries who love to share in Western wealth, but do not share most Western values. (But, then, it is fair to ask, do some of Wall Streets biggest names really share Western values?) The good news for stockholders in these banks is that roughly $40 from each barrel of oil sold from Abu Dhabi, Qatar, Oman and Saudi Arabia is said to be going into Sovereign Wealth Funds. That is a lot of big-bank-buying power. The investor in Wall Street banks may eventually be able to sell out profitably to investors whose wealth comes from supplyingat a high profit marginthe fuels America needs. That is worth pondering the next time you read about the banks corporate jets: they may be doing their bit to raise the bid price for their companies shares.

To bet on a team that has won all its games and against a team that has lost all its games is going with the crowd. Its also the way to bet.

December

31

INVESTMENT RECOMMENDATIONS
1. Remain heavily underweight banks, particularly investment banks that have displayed monumental stupidity. Do not assume that a change at the top will automatically convert them into temples of wisdom, (unless it is accompanied by demands for the departing to repay bonuses based on bets that turned out disastrously). Better to assume that, like subprime-based CDOs, there are layers of rot that can make the entire product dangerous to your financial health. 2. Remain overweight Emerging Markets, emphasizing those that are oil, gas, and/or food exporters. 3. Soaring food costs threaten stability for some Third World economies. We have been ardently endorsing India since we returned from our leave of absence a year ago. We are now more cautious, because a weak monsoon could be politically and economically destabilizing at a time of $4 corn and $10 wheat. 4. Remain heavily overweight goldboth stocks and the ETF. Gold is almost as good a protection against banking problems as SKFthe UltraShort Financials ETFa security which may not be a suitable investment in some portfolios. 5. We continue to believe that the Agricultural stocks are the pre-eminent investment class of our time. Farm incomes are rising rapidly, and, in the US, farms and farm land are the real estate assets that are rising in value and are virtually immune to foreclosures. That means the leading Ag companies have great pricing power and minimal credit problems. We now hear suggestions that because food inflation has finally made it to the cover of The Economist, it is time to start moving toward the exits. Not so: We think that fine cover story could be the atonementAt Last!for the magazines famous 1999 cover: $5 Oil.

32

December

Basic Points
6. Remain overweight oil and gas producers, including the Alberta oil sands producing companies. As disappointed as we are with the new royalty schemes in that province, Alberta certainly remains more attractive than Nigeria or Angolaand much more attractive than Russia, Kazakhstan, or Venezuela. 7. We think it is time to begin accumulating the refiners that are equipped to handle heavy high-sulfur crude. The collapse of the crack spread has savaged refiners earnings, but that will eventually rebound. The Saudis have virtually turned out the Light, and less and less of the oil that the Gulf states will be lifting will be of the most desirable grades. 8. Retain the base metals stocks that have long-life unhedged reserves in secure areas. Even if there is a global recession caused by global collapses of subprime paper and LBO loans, it will not be deep enough to drive base metal prices back to 2004 levelsbut would be worrisome enough to push further mine development even farther into the future. 9. When borrowing, borrow where possible in dollars. When investing, invest where possible in other currencies. 10. Stagflation is a bad backdrop for bondsand for non-commodity stocks. The central bankers could have headed it off had Wall Street behaved with a modicum of morality, but the Fed and its brethren are forced into sustained reflation because of the global solvency crisis. Corporate earnings for most sectors will not meet current optimistic Street forecasts, and rising inflation will reduce the markets P/E.

December

33

Appendix I: Index The Big Themes of 2007

Agribusiness 15-19, 29, 34 1, 15-22, 30, 33-36 14-21, 26 1-2, 9-17, 21, 30-32 25, 27, 31 9-18, 23-24 1, 4-6, 9-10, 19-20, 26-29 August 4, 6-8, 12-15, 22-23, 41 September 30-31 October 28, 30-31, 40, 46 November 9, 13-19, 25, 32-33 December 20, 32 October 3, 31-36, 47 November 1, 27-29, 32 December 33 February March April June July August November 1, 18, 21-22, 31-37 18-20 3, 10-11, 14 10-11, 13, 16-17 5, 26-27, 29 14-15 16-17 January February March April May June July

Alberta Royalty Decision

Alternative Energy

Appendix

Bonds

1, 5, 9-11, 20, 31, 34 1, 7, 26-29, 36 1, 10, 13, 21-22, 25, 28 April 1, 21, 24-26, 28-32 May 1, 5-10, 14-16, 25-27, 31 June 1-4, 8, 17-19, 22, 24 July 1-4, 6, 14, 20, 22, 24, 29 August 33-35, 41 September 16, 26-28, 31 October 3-5, 7, 9, 15, 17, 45-46 November 9, 11 December 1, 22-24, 33 May 3, 17-24 November 5-6 January April August November December 10, 23-24 30 30 6, 18, 22, 29 1, 14, 17-18, 29-30, 32 8, 13, 15, 30 4, 16, 19-20, 34 18, 28 3, 5, 7-8, 11, 13, 15 10-12 11-13, 16, 22 5, 16, 25, 27 3, 6, 14-15 19, 31 18, 28, 43 10, 17, 25

January February March

Canadian Resource Takeovers

CEO Compensation

China

January February March April May June July August September October November

Appendix

Colony Collapse Disorder

April May June August January February April May June July August September October

15-17, 29 25, 31 14-16 40

The Commodity Bull Market

11-15, 29 5, 13-15, 30-31 1-15, 30 29 12-13, 20 1, 4, 6, 20 1-6, 8, 24 31 19-22, 26-31, 36, 40, 42 November 1-33 (entire issue) 6, 13-14 30-31, 37 5-7, 9-10 17-21, 23 5, 11, 20-21 31-36, 38, 40 1, 5, 24, 27-29, 32 3-24

Commodity Risk

January February April May August October November August January March April May June July

Commodity Stock Investment Guide Corporate Debt

1, 5-6, 8, 24-26 1-3, 9-13 28 1, 5, 11, 16, 19 1-7, 20-21, 23 1, 12, 14-19, 22-23, 25, 28 August 25-27, 31-38, 41 September 1, 4-5, 7-16, 19, 21, 23-28 October 3, 10, 12, 22-25, 44, 46 November 19, 23 December 1-18, 24, 30-32
Appendix 3

Demography

January February April May June July October November January February March April May August September October November December January February March May June July September January April May June July August

1, 20-24 1, 22-25 1-2, 22-24, 26, 30 25-29 17, 19 22 47 12, 18-19, 26 1, 34 3, 36 28 20, 32 31 41 19 19 16 30, 32 20 22-23, 25, 32-33 21, 24 15 8, 22 25 20

Emerging Markets

Eurozone

Financials

1 27, 29, 31 30, 31 7, 24 1, 12-15, 25, 29 21, 27-32, 38, 41-42 September 3, 6, 12, 21-25, 31 October 1, 5-6, 10, 14-16, 26, 28, 46 November 8, 22, 31-33 December 6-7, 23, 27-28, 30-31

Appendix

Food Price Ination

January February March

19 15, 19-21, 30, 33-34 1, 14-17, 20-22, 25-26 April 11, 15, 21, 27 May 25, 27, 31 June 8, 10-11, 13-18, 23-24 July 5, 10, 20-21, 26-28 August 6, 14-15, 21, 23 September 27, 31 October 1 November 9, 11, 13-17, 31 December 21, 32 11 12 6 3, 13 18

Free Trade and Protectionism

April May September October November January

Global Liquidity

1-12, 15, 19-23, 29-30 February 4-7, 12-14, 27 March 1, 24 April 5, 19-21 May 1,10-15, 25 June 1, 5, 8, 20-21, 23 July 1-4, 29 August 3-4, 6, 8, 22, 25-26, 35, 38-39 September 1-6, 8, 10, 15-25, 27-30, 32 October 1-6, 13-14, 17-19, 44, 46 November 1, 8-12, 16, 18-19, 21-23, 26, 30 December 1, 7-9, 14-15, 18, 20-23, 27, 31, 33

Appendix

Gold and Precious Metals Stocks

January February March April May June July August

15-16, 26, 29, 34 1-7, 9, 11, 14, 36 24, 28 8, 19, 21, 27, 31 31 4, 24 3, 6, 19 4, 6, 8, 18-22, 24, 42 September 20, 26, 28-29 October 9-10, 15-16, 18-19, 21, 27, 36-40, 46 November 4-5, 8-9, 20-21, 25-26, 30, 32 December 8, 24-27, 32 30 3-4, 16, 35 18, 28 7-8, 11, 13, 15 11-12, 16, 22 4-6, 25, 27 3, 6, 14-15 28 9-10, 17, 25 30, 32

India

January February March April June July August October November December

Appendix

Industrial Metals Stocks

3, 11-14, 29-31, 34 1, 7-11, 13-14, 16, 28-31, 36-37 March 28 April 1-4, 7-8, 20-21, 31 May 17-25, 29, 31 June 12-13, 16, 17, 21-24 July 1, 5, 7, 10, 19, 22, 27-29 August 4-5, 8, 16-18, 22-24, 41 September 30 October 19, 28-29, 40 November 4-8, 16, 18-19, 24-25, 29, 32-33 December 33 January February 15, 23 3, 6-7, 11-15, 26-27, 31 March 22, 24-25 April 1, 8, 15, 17-19, 21, 25-27, 30 May 1, 9, 15-16, 25-30 June 17-19, 21-24 July 1-4, 6, 10, 19-21, 24 August 4, 6, 11, 20-23 September 27 October 1-6, 10, 18-19, 21, 32-33, 39, 43, 45 November 1, 8-19, 21-23, 25-26, 30-31 December 1, 20-26, 28-29, 33

January February

Ination/Deation/Stagation

Appendix

Investment in a Triple Waterfall World

February April May August October November December January February March April June September November January February April May July August September October December

27-28 8 5, 18 3-4, 18 6, 19, 21, 47 5, 8, 14, 18, 21, 24 25 6, 27-28, 31 1, 19, 23, 32 19 6-7 16 6-7 31 5, 21-22 7 20-22 10-11 22-23, 29 41 19 10-11, 18, 43 20, 25

Islam and Geopolitics

Japan

Appendix

Oil and Gas Stocks

3, 7, 15, 17, 19, 29-31, 34 February 1, 13-16, 19, 26-31, 35-36 March 14, 20 April 1-7, 9, 31 May 13-15, 20, 25, 29 June 17, 21-24 July 1, 5, 8, 10, 19, 22, 26-29 August 4-5, 7-11, 22-23, 41 September 30 October 19, 27-28, 30, 36 November 3, 5, 10, 16, 18-19, 24-25, 30, 32-33 December 33 January February March April May June July August October November December May 6, 34 36 28 1, 31 20, 22-24, 31 24 8 5, 7, 11, 22 31-36, 47 27-29, 32-33 33 6-10

January

Oil Sands Stocks

Pensions and US Social Security

Appendix

Risk and Market Volatility

January February March May June July August September October November December January April May August November May June August September October December

1, 5, 7-9, 13, 26, 35 27-29 1, 9-10, 23, 25-26 3, 5 4-7, 20, 22 11-12, 24-25, 29 1, 25-29, 38, 41-42 1, 5-6, 24, 30 1, 5-10, 14-15, 17 1, 30-31 8-10, 15, 23, 26-28 17 32 15-16 20-21 29 12, 14, 16, 24 8 34 19-20 12, 18 13, 18, 31

Russia

Sovereign Wealth Funds

State-owned Enterprise

April 7 November 6

10

Appendix

US Dollar

1, 3, 5, 7, 9-10, 15, 20, 22, 30-31 February 11-13, 29 March 1, 4, 8, 13, 23-24 April 1, 18-21, 23-28, 30-31 May 5-6, 10-12, 15-16, 26, 28-31 June 1, 4, 10, 17-18, 21-23 July 3, 12, 21, 25 August 20-21, 37, 39 September 1, 10, 15-16, 18-20, 29-31 October 1-5, 9-19, 25, 27-28, 38, 42-46 November 1, 8-11, 18-23, 26, 30-31, 33 December 1, 7, 9, 13-16, 18, 20-26, 28-31, 33 January February March April May June July August September October November December 27-28 19, 30 19, 23, 26-27 10, 28-29 5, 7 10-11, 18 16, 21 33 5 44 19 13, 18, 28-29

January

US Politics

Appendix

11

Wall Streets Disastrous Derivatives

1, 3, 7, 9, 12, 25-26, 30 February 28-29 March 1-8, 23-25 April 18, 21, 27-28 May 1, 26 June 1-7, 20, 22-23 July 1-4, 11-14, 22, 24-25, 28 August 1, 25-30, 35, 38-42 September 1, 7-10, 12-18, 21-30, 32 October 1-3, 22-25, 44, 46 November 19, 22-23, 26-27, 30-31, 33 December 1-19, 23, 29-30, 32 January February March May October 27-28 31-33 23, 26 16 43

January

War on Terror

12

Appendix

II: Investment Recommendations of 2007

Issue January February March April May June July August September October November December Page 34 36 28 31 31 24 29 41 31 46 32 32

Appendix

13

III: Asset Allocation Changes in 2007

Issue February April August September October December Page 2 2 2 2 4 2

14

Appendix

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