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Financial Heroin
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Don Coxe
THE COXE STRATEGY JOURNAL
Financial Heroin
published by
Coxe Advisors LLC
Chicago, IL
THE COXE STRATEGY JOURNAL
Financial Heroin
We do not hold it against those crisis managers in the US and Europe who were so kind
to the insiders in giant banks who faced impalement on swords forged of their own greed
and stupidity. We do, however, hold it against those Congressional Republicans who
voted against the legislation to rein in bonuses for them, because without Washington’s
rescues at taxpayer expense, these big blunderers wouldn’t have had the chance to prove
that, in a Zero Interest Rate Environment, they are geniuses who deserve huge pay
packets.
Last month we discussed The Power of Zero, which we suggested was the most important
number in the financial universe. We end this year by considering the dilemma Ben
and friends face in timing the decision to move rates away from the Zero level—which
added so many zeroes to the incomes of levered investors—and has reduced, albeit less
dramatically, the number of zeroes in the unemployment statistics.
This month, we devote some commentary to the investment merits of Canada, whose
politics and governance are becoming, on a comparative basis, even less interesting than
America’s as the relative performance of the Canadian financial system keeps improving.
America’s approach to the politics of finance is more fun to watch: it has Barack Obama,
Nancy Pelosi, Barney Frank and the Big Bad Bonused Bailout Banks. Canada has Stephen
Harper—who might manage, on a good day, to display 5% of Obama’s charisma—and
a collection of sound, unspectacular, profitable, well-managed banks, (including BMO,
which sends this journal to you).
As we write, the climate debate has become centered in Hans Christian Andersen’s fairy-
tale city of Copenhagen, which is hosting 20,000 guests, 140 private planes and 1,200
limos—the trappings of the heroic attempt to save the planet. This historic venture is
enriching so many of those who have the vision to do the Right Thing about the Wrong
Things—such as oil sands, offshore drilling, cars and coal. We now know so much more
about the lengths to which visionaries will go to save the planet, their positions and
their paychecks after the publication of thousands of their emails to each other, many of
which suggest that Hans Christian Andersen is reborn and lives in East Anglia. We also
know more about the radical global warmists from their rioting at the Conference.
The holidays should be much happier for investors this year than last. We wish our
clients and friends a Merry Christmas, Happy Chanukah, and a Happy and Prosperous
New Year, and send Tiny Tim’s blessing:
December 1
S&P 500
January 1, 2008 to December 15, 2009
1,500
1,400
1,300
1,200
1,100 1,106.50
1,000
900
800
700
600
Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09
2,100
1,900
1,700
1,590.55
1,500
1,300
1,100
900
Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09
The topic for the speaking panel was “The Challenge Of Reducing Fiscal And
Monetary Stimulus”.
I was due up next, and was pondering my remarks as Mr. Dodge proceeded.
As he outlined the challenge, I suddenly thought of one of my father’s tales
of his wartime experience.
December 3
Financial Heroin
The problem for the doctor came when the patient had begun to recover
from surgery, and was receiving heroin. How quickly could the dosage be
reduced and when would it be terminated? Although few soldiers were freed
of heroin without experiencing pain and distress, it was necessary to take the
drug away as rapidly as possible. Otherwise they would become addicts and
their lives would be ruined—for soldiering and everything else….
Mr. Dodge looked surprised, then nodded his head, and was kind enough
to comment later that this was an excellent analogy for the central bankers’
current dilemma.
How much heroin has been pumped into Uncle Sam’s veins in recent
months?
Source: St Louis Federal Reserve, database: FRED® (Federal Reserve Economic Data)
US M-2
January 1, 1970 to November 30, 2009
Source: St Louis Federal Reserve, database: FRED® (Federal Reserve Economic Data)
December 5
Financial Heroin
As Ben Bernanke promised Congress in the dark days after Lehman, “We will
do whatever is necessary.”
A year ago, we thought that recovery for the financial system and the
economy would be characterized by massive, sustained deleveraging. The
Crash had starkly shown the devastation that runaway deleveraging at a time
of shrinking liquidity could inflict on financial assets and the economy.
The fragility of the financial system in 2007–8 came, in large measure, from
the migration of a model of financing from the so-called shadow banking
system into the daylight version. The new stars of the Street were overlevered
hedge funds and private equity firms. They drove the bull markets in complex
new mortgage products, flawed-model derivatives—and in compensation
for the brashest bettors. So profitable were they, that they were able to hire
elite investment bankers and traders from the Big Banks—and to supply the
justification that the big bonuses paid by the big banks were necessary to
keep their biggest producers.
In retrospect, Wall Street should have tried to follow the advice of the Tenth
Commandment, rather than of Long-Term Capital Management and Enron.
Thou shalt not covet thy client’s house, nor his lifestyle, nor his male
employees, nor his female employees, nor his bullish bets, nor his asinine
bids at contemporary art auctions, nor anything that is thy client’s.
The refashioning of Wall Street (and the City of London and many of Europe’s
biggest banks) to the designs of the most spectacular financial collapses of
the late 1990s was, we thought, such ghastly gluttonous groupthink that we,
like many other critics, assumed that their subsequent near-death experiences
would induce some remorse among the remorseless, and some penitence
among the publicly unrepentant. Although it would, perhaps, be too much
to expect a commitment to civic virtue and financial conservatism, we had
thought that the financial nudity seen in mid-2008, which had to be covered
by the costly TARP, would no longer be a threat to the health of the economy;
the Rube Goldberg financial engineering of such monstrosities as Citigroup
would be unwound as the Fed sustained the markets’ ability to absorb the
effluent.
The first sign that the Street was not going to tiptoe toward creeping decency
was its successful partnership with some of the Congresspersons who had
gone to bat against Bush when he and Greenspan tried to rein in Fannie
and Freddie against the Financial Accounting Standards Board’s attempt to
promulgate a new rule that would force the banks to mark to market their
holdings of dubious and downright toxic assets. The bankers were left to
value their capital based on their own internal models—whose Panglossian
optimism had drawn their organizations to the edge of collapse.
December 7
Financial Heroin
Freed of the constraints which a free market based on full and fair disclosure
would have imposed, these captains of free enterprise then rushed for the
trillions in free BenBucks and levered up anew, this time buying (mostly)
respectable stuff—such as Treasurys and tradable corporate bonds. The cash
...providing little the Fed created to save them from the consequences of their own folly sits
more stimulus to as T-Bills or fed funds on their balance sheets, providing little more stimulus
the real economy to the real economy than sending out daily re-broadcasts of Jimmy Carter
than sending out speeches on economic malaise.
daily re-broadcasts
They sit on their piles of rotting subprime paper, loath to sell even portions
of Jimmy Carter
of them at prices that would (1) trigger huge immediate losses, and, (2)
speeches on
prove that their remaining holdings were grossly overvalued. They appear to
economic malaise.
be modeling themselves on how John Law managed the later stages of the
Mississippi Bubble: the key to keeping the game going after the real asset
base had collapsed was price maintenance of the securities. Once Law was
unable to prop up the prices and keep large sellers from unloading, the whole
scheme imploded. In this case, the Street has a seemingly neutered FASB and
powerful Congressional committee chairmen to keep the bubbles afloat.
That’s what has been happening to the biggest beneficiaries of the taxpayer-
financed bailouts.
No wonder that the latest polls show that “Tea party politicians” rank just
behind Democrats in popularity, and well ahead of Republicans.
No wonder that for the past three months, the IBD/TIPP polls of consumer
sentiment have shown rising economic pessimism, even as the Dow was
surging skyward.
Because, once you leave Wall Street and Washington’s Lobbyists’ Row on K
Street, there’s a whole lot of hurtin’ goin’ on…
KBW US Regional Bank Index ETF (KRE) vs. KBW Bank Index (BKX)
January 1, 2009 to December 15, 2009
120
110
100
96.07
90
80
70 72.97
60
50
40
Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09
KBW US Regional Bank Index ETF (KRE) KBW Bank Index (BKX)
110
100
90
80
70 72.97
60
50
40
Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09
December 9
Financial Heroin
This cool analysis from a baron about the fate of peasant bankers recalls
The bank has died:
Gray’s Elegy Written in a Country Churchyard. It could be updated as follows:
it was too small for TARP.
Elegy for a Deceased Village Bank
These banks made loans to people they knew for properties in communities
they knew. The losses are cyclically-driven: at the end of every real estate
boom, lots of regional banks fail due to construction financing for projects
that turned out to be uneconomic at the prices prevailing in the early years of
the next cycle. Those bank losses can be called the cost of the American way
of banking—many, many banks, including many small regional banks.
Main Street bankers watch in awe and envy as the Big Bad Bonused Bailout
Banks (whom we have relabeled as B5) repay TARP loans out of their huge
profits on the reinvestment of Zero-cost deposits. The rush to repay those
emergency infusions does not reflect over-capitalization among the B5 or
an eagerness to repay to the taxpayers the largesse they received when they
were collectively in extremis: they continue to assert they cannot resume
traditional lending to businesses and consumers, while levering up to buy
Treasurys and risk assets. The repayment urge is driven by a powerful financial
hormone—the lust to free the big banks from Washington’s constraints on
executive pay and bonuses. The new mottos are “It would be a shame to
waste a good crisis-induced subsidy,” and “Nothing that’s bold’s eschewed
again.”
Few Main Street banks qualify for TARP or other relief. In this age of financial
elephantiasis, they are Too Small to Bail.
They do benefit directly from the increased ability of their customers to service
loans as interest rates remain at low levels. They also benefit indirectly from
the economic activity of the broad-based stimulus programs in the form of
fiscal deficits, bailouts, and handouts, and, of course, from the government
guarantee on their customers’ deposits, and Bernanke’s healing yield curve.
But that takes time, and many of these banks are Too Weak to Wait.
The front wheels are the real economy: Big Business and Small
Business.
The rear wheels are the financing mechanisms: Big Banks and Small
Banks.
We believe the underperformance of the Small Banks compared with the Big
Banks, the stock market and the corporate bond market, at a time of modest
economic growth, is reviving the kind of endogenous risk in the financial markets
that shrank so rapidly from October 2008 through March of this year.
December 11
Financial Heroin
We also believe these dichotomies will increase the pressure on the Fed and
some other OECD central banks to keep pumping out the financial heroin—
thereby increasing the likelihood of widespread addiction and dependency.
Already the Pelosi Congress is considering legislation that would (1) subject
Fed monetary policies to review by the Congressional Budget Office, and (2)
strip the Fed of its supervisory authority over financial institutions, handing
that power to a new agency created by Congress—presumably in the image of
its Creator. The same politicians who applauded so vigorously as Fannie and
Freddie debased the lending requirements for mortgages and expanded their
balance sheets so recklessly, now seek to apply that expertise to supervision
of the entire banking system.
Last week, Volcker, the man who has done more than anyone in modern
history to design and deliver sound regulation to international banking,
told a London audience what he thought was good and what was bad about
today’s banks.
Volcker said the “single most important contribution” they’ve made in the
last 25 years was introducing ATMs. ATMs meet, he said, the test of being
“useful.” Apart from that, he had nothing good to say about commercial
banks that behaved as investment banks. He agreed with the head of Britain’s
Financial Service Authority that such banks are “socially useless.” He said
derivatives, such as credit swaps and collateralized debt obligations, had taken
the economy “right to the brink of disaster.” He noted that the economy had
grown faster during the 1960s when such instruments didn’t exist.
As the 1970s demonstrated, the longer central banks wait to scale back on
above-trend money growth, the worse the ensuing inflation—even when the
economy slides back into recession.
It would seem that the appropriate year-end advice for levered bettors on US
stocks and corporate bonds is, “Enjoy yourself, it’s later than you think.”
December 13
Financial Heroin
It was the collapse of the financial system that gave us the crash in stocks and
...nobody does this
commodities and a deep recession. So any discussion of the Environment
much-needed probing
must include consideration of Systemic Risks.
of the system’s belly
and bowels better One reason why that financial collapse caught so many investors unaware
than our friend is that there have been so few accomplished analysts of the diseases and
Stephanie Pomboy malignancies affecting the digestive tracts and arteries of the financial system.
David Rosenberg, Nassim Taleb and Nouriel Roubini are probably the most
noted practitioners of what might be called Financial Gastroenterology. In
our view, nobody does this much-needed probing of the system’s belly and
bowels better than our friend Stephanie Pomboy of MacroMavens. She has
graciously consented to let us use material from one of her latest publications,
The Incomparable Ben Bernanke:
She points out that credit issuance over the past 12 months is at an all-time
record and notes,
“They just want the replacement bubble they (or rather their
constituents) bought and paid for! I mean, Greenspan never had
these problems. He made replacing one bubble with another look
...as those financial
easy.”
gastroenterologists
After digesting (if that is the correct term) her analysis, we began to chew on continue to warn us,
the question of what all that paper issuance and all those reported profits there’s worse than gas
had done for the Big Banks: pains ahead for the
financial system.
KBW Bank Index (BKX) relative to S&P 500
June 1, 2009 to December 15, 2009
120
115
110
105
100
98.87
95
Jun-09 Jul-09 Aug-09 Sep-09 Oct-09 Nov-09 Dec-09
2. As If There’s No Tomorrow
If, as we assert, stocks and corporate bonds are overvalued because of Zero-
Based Investing, then when will this high-risk extra leverage be unwound?
And what will be the effect on asset prices when Bernanke and Trichet start
raising rates?
December 15
Financial Heroin
The selloff in stocks and bonds after the announcement of the nonfarm
payrolls suggests that what the markets most fear is not negative or even zero
economic growth, but fast economic growth.
In other words, the big bettors are betting the big Bernanke bets will not win
Bernanke, Obama & Co.
big.
could soon be of
the same view as After previous deep recessions, the snapbacks were dramatic, as inventory
the despairing liquidation turned to inventory accumulation, and layoffs turned to
Lady Macbeth: callbacks. Despite all those trillions spent and all that monetary stimulus, the
“Nought’s had; US economy has moved only from the critical care ward to the ambulatory
all’s spent.” convalescent wing.
With winter coming on, Bernanke, Obama & Co. could soon be of the same
view as the despairing Lady Macbeth: “Nought’s had; all’s spent.”
So, after all this chatter, you may be impatient to be told how to invest,
knowing that Bernanke and Co. are going to keep the heroin flowing as long
as they can.
In one respect, the Street consensus is where it was during the late stages of
the past two bubbles—technology and housing: lip service to the idea that
asset prices could be a tad aggressive, and a correction would be healthy, but
NOT advising significant reduction in equity exposure and switching to the
asset class that wins in stock selloffs—long bonds.
Nevertheless, we are not scornful of the Street for this unwillingness to outline
an exit strategy for investors before Bernanke & Co. move to their exit strategy
and begin the painful process of withdrawing the financial heroin.
Why?
Because the sheer scale of deficits and monetary stimulus is so far beyond
what was ever experienced that one finds it somewhat problematic to warn
clients that a deep double-dip recession that would look like a Depression is
around the corner.
And, because once the recovery really gets underway, equity prices could
remain quite strong for a while even in face of rising rates.
December 17
Financial Heroin
So what would the impact have been if the BLS had announced that US
employment had risen by 790,000 jobs?
In brief:
1. The TSX Index is more attractive than the S&P because more than half its
weight is in sound banks, and oil, gas, and mining stocks.
3. Canada has the largest reserves of fresh water in the hemisphere, excellent
ports on both seacoasts, the largest oil reserves outside Saudi Arabia, and
a somewhat better K-12 public education system than the US.
250
219.10
200
150
100
50
0
Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09
500
479.22
400
300
200
100
0
Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09
1.0
0.94
0.9
0.8
0.7
0.6
Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09
December 19
Financial Heroin
They pointed out that “Outperforming the Toronto or New York Exchange
means nothing to us if the Canadian or US dollar’s decline against the franc
wipes out the apparent gain. Besides, wealthy clients usually have strong view
about currency risk and would take business away from their managers if
they lost money on currency—the one area in which many clients considered
themselves better experts than the fund managers.”
When we tried arguing that a weak currency could mean lower profits for
Canadian companies, they dismissed that argument out of hand: “We’ll
happily pay a higher P/E for companies operating in a strong currency, even
if it constrains their earnings growth, because those earnings are real.”
Canada’s trade with China is booming, and major new port facilities are
under construction in British Columbia to facilitate further expansion.
The sectors of the Canadian economy that are particularly hard hit by the
strong loonie are autos, steel, and tourism—but these industries have a trivial
weighting in the TSX. Most of Canada’s manufacturing base is foreign-owned,
so investors who buy the TSX aren’t exposed to the currency problems that
hurt the Canadian subsidiaries of such global giants as P&G, Colgate, or
Nestlé.
We believe the differences between Canada and the US go all the way back
to their national origins.
The US is the inheritor of a revolution against British rule. At that time, Britain
also ruled the colonies that make up today’s Ontario, Quebec and Atlantic
Canada. The American revolutionaries sought to “liberate” the colonials in
December 21
Financial Heroin
present-day Quebec, who had only fallen under British rule in 1759 at the
Battle of the Plains of Abraham. France was on the side of the rebels, so it
seemed logical that the French settlers would have welcomed American rule.
They didn’t, for a variety of reasons, and the former British North American
“Peace, order and colonies evolved into two quite different nations over the next century. Canada
good government.” was put together from the colonies which, in general, had experienced little
contact or interest in each other. However, the astonishing scale of American
land armies during the American Civil War convinced Canadian politicians
and the British Foreign Office that it was time to create a semi-independent
nation that could stand on its own feet—with help from Queen Victoria and
her army and navy.
In that statute, Canada was dedicated to delivering “Peace, order and good
government.” That remains in the nation’s Constitution.
December 23
Financial Heroin
Because they were required to stick fairly closely to the leverage rules of
Basel I that big American and European banks were violating, and because
of their sustained profitability from their oligopoly on their home turf, the
big Canadian banks came through the US financial crisis of 2007-8 in good
There is no Canadian shape. The most amusing of the ironies was that by late 2008, all members
political counterpart to of the Big Five of Canadian banking had higher stock market capitalizations
Barney Frank, Maxine than Citigroup—which—they had told Ottawa a decade earlier—would put
Waters or Chris Dodd... them out of business.
It also helps that the Ottawa regulators in the Bank of Canada and agencies
within the Department of Finance are more professional than those in the
Treasury Department or other US agencies.
Why?
Because under the US spoils system, each new regime appoints not only the
top layers in the various departments and agencies, but some of the important
layers underneath. Those departing political appointees from the previous
Administration then take lucrative jobs within the financial community, or
as lobbyists.
That’s one big reason why financial regulation works so well in Canada compared
to the US. There is no Canadian political counterpart to Barney Frank, Maxine
Waters or Chris Dodd, who can get high-level appointments to entities such as
Fannie Mae, who override decision-making within those operations in favor of
their own political interests, and who block regulators—even at Alan Greenspan’s
exalted level—from intervening to prevent financial disaster.
We certainly don’t argue that all Canadian politicians are saintly and sound.
But a sustained history of protecting the civil service from unseemly political
partisan interference means regulation has a good chance of succeeding in
With the exception of Pierre Trudeau, Canada’s political leaders have lacked
the glamour, panache and punch of America’s more colorful politicians.
Some years ago, Washington’s National Press Club ran a contest for a
newspaper headline that would attract the least readership. The hands-down
winner: “Interesting new policy proposals from Canada.”
Last October, Ben Bernanke and Hank Paulson might well have wished that
Canadian dullness and caution had permeated Wall Street.
December 25
Financial Heroin
This unanimity among scientists became the basis for imposing controls
on carbon across economies, which is the purpose of the Copenhagen
conference. If economic growth suffers, that is the cost of saving the planet.
Besides, we’ll eventually develop new technologies that will stimulate good
growth—not the polluting kind.
But then the anonymous hackers released the thousands of e-mails from the
epicenter of Global Warmism—the Hadley Research Unit at the University
of East Anglia.
This is the center that produced the data that produced the UN document that
produced the “consensus” that produced the Nobel Prize for Al Gore and friends.
And, we learned, it is the center that not only managed to “lose” all the
data showing that the world had been getting warmer, but that it replaced
the actual data with computer-created models. And it never told anybody
outside its own in-group. Perhaps only the Flat Earth Society, it appears,
has a smaller historically-documented data base. (As we now know, leading
global warmists refer to their opponents as “Flat Earthers.”)
Those who questioned whether the Hadley Unit was straying from pure
science into political advocacy were demonized as tools of reactionary forces.
(As recently as last week, the usually reasonable Tom Friedman of The New
York Times insisted that the Hadley scientists reacted so strongly because they
were beset by lies financed by Big Oil. So A Really Big Lie That Gets A Nobel
is justified if it’s responding to lies from small climate groups almost nobody
(except Hadley researchers) has heard of that might be funded by Big Oil.
“It is beyond dispute that the Met Office Hadley Centre occupies
a position at the pinnacle of world science and in translating that
science into policy advice to governments.”
Whenever we hear from the global warmists, what they say is “Beyond
dispute”, it’s just as if the Pope or a Cardinal were speaking Ex Cathedra: the
matter is settled.
This month’s posting of thousands of Hadley emails on the web is, depending
on your viewpoint, a criminal violation of privacy (Senator Barbara Boxer),
nothing much at all (The New York Times), not even worth mentioning (The
Economist), the greatest challenge to science’s legitimacy of our time (Bret
Stephens, Wall Street Journal) or proof that global warming is a fraud (too
many to cite).
December 27
Financial Heroin
Even some global warmists admit dismay about the e-mail discussions of
ways to suppress opposition and to “juice up” data. That these scientists
would resort to such anti-scientific behavior belies the claim of the warmists:
“Maybe Newton was
it’s settled.
an ass, but the theory
of gravity still works.” Furthermore, their schemes to suppress publication of research challenging
their own work challenge the most sacred of all scientific principles—the free
and open search for truth.
Note the implicit assumption: a theory that has been challenged by thousands
of scholars, and is at risk because of recent evidence of cooling temperatures,
is as valid as Newtonian physics. Has the scientist found evidence of apple
trees shedding fruit that thereupon flew upward and disappeared in the
clouds?
Many commentators have noted the eerie similarity between these scientists’
eagerness to censor and suppress dissent and the Catholic Church’s treatment
of Galileo—the classic case of science vs. religion. There is no doubt that
leading global warmists behave as if they were priests of a secular religion.
They proclaim their eagerness to take over the organization of a vast section
of the world’s economy—the modern version of Plato’s vision of a command-
and-control society ruled by an oligarchy of the Enlightened.
We disagree strongly, however, with those who claim that these revelations prove
that global warming is a fraud.
That the Catholic Church and Spanish Inquisition were wrong in burning at
the stake the dissenters of their day does not prove that God does not exist.
Carbon offsets are sold on a similar principle, although with rewards that are
measured purely in earthly terms.
The modern sales pitch amounts to: “Pay Blood & Gore, then sin some
more”.
The Colorado scientist who wrote to his East Anglia allies in anguish about
the remarkably huge and remarkably early snowfall that canceled a World
Series game, admitted that “We can’t explain the cooling that’s going on. It’s
a travesty.” (As all baseball fans know, that occurred on October 10th.)
Why did the scientists give up on the evidence from tree rings and switch
to models? Were they ahead of their time immersing themselves in the
modeling craze of the 1990s—with Long Term Capital Management merely
following in their (non-carbonic) footprints?
Why did they have to concede, under pressure, to a Canadian critic that the
three hottest days in the past century weren’t in the 1990s, as they originally
claimed, but in the 1930s?
December 29
Financial Heroin
When Al Gore was asked to comment on the emails, he said he hadn’t read all
of them, but they were “as Shakespeare said, full of sound and fury signifying
nothing.” Besides, he asserted, they were all at least ten years old and are of no
relevance for today’s debate.
All the emails were date-stamped and some were as recent as this November.
How could Mr. Gore be so sure they were all at least ten years old?
1. Gore’s quotation comes from the last and most famous of Macbeth’s
soliloquies. It is spoken as Macbeth is girding himself for the final battle
with Macduff. He expresses his final despair about Life, but Gore only
quotes the second half of that sentence:
Yet, the emails are entirely composed by the scientists on whose analyses
and forecasts Gore and the UN have relied.
2. Macbeth had murdered Macduff’s wife and children and was confident
that he could kill Macduff in any battle because the Three Witches had told
him he would not fall until “Birnam Wood shall come to Dunsinane”.
4. Finally, Mr. Gore’s selective quotation impales him: the words come from a
hero-villain who drew excessive conclusions about his own invulnerability
from a forecast made by the leading seers of his time.
Although Mr. Gore may be running out of credible scientific support for
his misplaced dogmatism, he can still fall back on his one real scientific
achievement—inventing the Internet—and on the billions he and his
partner in the firm of Gore & Blood are investing in green projects and in
the creation and trading of carbon offsets.
December 31
Financial Heroin
The EPA says that, according to a Supreme Court decision, it has the sole right
to decide what is a pollutant and how to control it. (The Supreme Court said
that, under existing legislation originally enacted under President Nixon, the
EPA has the authority to define and regulate airborne pollutants.)
So the EPA now certifies that CO2 which is absolutely necessary for plant life
and occurs naturally in the air we breathe, is in the same category as such
man-made pollutants as sulphur dioxide (that causes acid rain, asthma, and
lung cancer), hydrogen sulphide (which, when leaked even briefly, has killed
people), and methyl isocyanate gas—which, when leaked at Bhopal, killed
and sickened thousands of people. That means the EPA has the right and duty
to approve all construction designs for large multi-family buildings, engines
and emission devices for cars and trucks, and all factories and electrical
generating plants that are found to emit more than 250 tons of CO2 per
year, and all dairy operations. (Bovine flatulence is such a potent source of
greenhouse gas that Sir Paul McCartney has called on all citizens to observe
a meatless Monday to help save the planet.)
It is fair to say that, unless a future Congress amends the law, the EPA will be
the most powerful bureaucracy any democracy has ever spawned anywhere
since the collapse of Communism.
It took a while for Zero borrowing rates to take effect, with the S&P and other
...gold’s performance
major equity indices slumping in winter, bottoming in Spring and soaring
could be the clearest,
thereafter. Helping to pull them skyward was a splendid year for corporate
purest example of
and other risk bonds.
Zero-Based Investing.
The Zero rates’ economic stimulus is hard to measure, but their impact on
tradable risk assets is as obvious as the Washington Monument.
No discussion about what the future holds for investors would be complete
without consideration of gold’s powerful performance in recent weeks. So
we shall begin our discussion of the Environment with the classic monetary
metal.
Gold
As the only major financial asset that never pays interest or dividends, gold’s
performance could be the clearest, purest example of Zero-Based Investing:
Gold
January 1, 2009 to December 15, 2009
1,250
1,200
1,150
1126.00
1,100
1,050
1,000
950
900
850
800
Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09
With a 25% rise this year, Gold has beaten the S&P roughly 7%. As measured
by the XAU, gold mining stocks’ total return is 35%.
But gold’s investment return was exceeded by the amount of publicity and
debate it generated. Its late-year blow-off past $1200 briefly made it a Page
One story—thereby automatically guaranteeing a sharp correction.
December 33
Financial Heroin
Sophisticated Explanations
• gold is the only asset that is nobody’s liability and is therefore a haven
in an increasingly uncertain world;
• capitulation by hedged gold miners, notably Barrick;
• India’s purchase of 203 tonnes from the IMF, removing the overhang in
bullion markets;
• China’s announcement that its gold holdings are higher than were
previously revealed;
• “Peak gold” discussions, as investors ponder the failure of gold mines to
maintain—let alone increase—their production despite record bullion
prices. The classic expression for getting rich quick is to find a gold
mine—but it takes time, experience and capital to bring on a mine.
Reported gold companies’ reserves haven’t been rising, but soaring gold
prices will change that: millions of tons of low-grade “resources” that
haven’t been booked as ore reserves will be reclassified if gold prices
remain near or above current levels;
• recognition of the longer-term implications of central banks’ astounding
levels of creation of fiat money at a time they are collectively becoming
net buyers of gold—after decades of sustained selling;
• respect for gold’s future because prices have managed the remarkable
feat of setting new records at a time jewelry demand—traditionally the
main support for gold—is slumping sharply;
• portfolio diversification by sophisticated investors who seek a haven at
a time of zero returns on Cash—with no indications that central banks
are about to abandon their Zero policies.
“My one-year target for gold is 1345—the onset of the Black Death.
“Apart from that, I really can’t say how high gold could ultimately go,
although longer-term it should reach 1485, when Richard III fell in
the Battle of Bosworth, launching the Tudor monarchy, and giving us
the enduring quote, “My Kingdom for a horse!”
Next day, Goldman issued its authoritative target price for next year: 1350.
We were called for comment, and graciously accepted that prediction because
it was the end of the Black Death.
The point of these musings is that no one really has any idea of the longer-
term price of gold that can be justified by sober analysis.
All that we can sensibly say is that gold’s price entered a 20-year Triple
Waterfall collapse in 1980, falling from $825 to $250, and has risen every
year in this decade. If it can maintain its strength at a time jewelry demand
is shrinking, then investors and speculators are in charge; their motivations
include momentum and malaise: Gold looks good because it keeps going
up, and they’re scared about what the Fed and Obama and other central
banks and governments are doing, and have no great confidence that there
will be a sustained, noninflationary economic recovery, so gold is a good
place to hide.
December 35
Financial Heroin
Gold has been the best-performing major commodity since the financial
crisis began:
120
100
80
Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09
We see no big reason why that outperformance should be over. After its
breathless run to $1220, it’s entitled to correct back toward $1,000—or even
a bit below that chiliastic level—without ending its bull market.
Finally, gold may even be decoupling from the dollar. The sheer scale of
foreign exchange reserves in China, Hong Kong, India and other countries
whose currencies are pegged, directly or otherwise, to the dollar may be
opening a whole new demand for gold. Just to maintain even tiny percentage
exposure to gold in forex reserves means these nations must remain on the
buy side. The euro was once seen as a worthwhile alternative to the dollar
in Asian forex accounts, but the unfolding problems of its Eastern European
and Mediterranean members are exposing the euro’s internal contradictions
as a viable alternative to the dollar.
In a world in which nearly all paper money has problems, and in which the
sheer supply of paper money is expanding far faster than global GDP, gold
has its best claim as a constituent of foreign exchange reserves since Bretton
Woods booted it out sixty-five years ago.
That the CRB has delivered virtually identical year-over-year returns to the
S&P is obviously of concern to us, since we have been warning of a coming
S&P correction since late summer.
Of the commodities we follow, crude oil, copper, gold and silver have
outperformed the S&P, the grains have roughly broken even, and natural gas,
of course, has sharply underperformed. In other words, this isn’t a replay of
the 1970s—yet. Nevertheless, we are concerned that in recent weeks, the total
Speculative Open Interest in US commodities has moved into overbought
range. Zero is having its effect.
As for the relative performance of the commodity stocks to the S&P, the base
metals have hugely outperformed, most of the oils and agriculturals have
outperformed modestly, (although there have been a few significant losers),
and the gold miners have collectively marginally outperformed.
December 37
Financial Heroin
3. Wherever they are headquartered and wherever they distribute, the price
of whatever they sell is influenced or controlled by demand from China,
India, Taiwan, Korea and Indonesia—and these economies and their
populations will continue to gain in wealth and in share of global GDP
at the expense of the economies and residents of the US and Europe.
4. Real assets that are really needed for people and economies to survive are
really comforting to own at times of extreme financial uncertainty.
Bond Durations
Years Change
US 5.25 unch
Canada 5.00 unch
International 4.50 unch
Change
Precious Metals 33% unch
Agriculture 33% unch
Energy 22% unch
Base Metals & Steel 12% unch
December 39
Financial Heroin
INVESTMENT RECOMMENDATIONS
1. Remain underweighted in US equities—as a percentage of equities within
global portfolios, and as a percentage of assets in US balanced portfolios.
Underweight US bonds in global portfolios.
The long-term financial projections for the US are scary, even if one accepts
the Obama assumptions: ten years of large deficits, no recessions, strong,
sustained economic growth, and a mere 1% increase in Treasury yields.
Those numbers make no allowance for the costs of health care, which
will be huge. Debilitating tax increases are inevitable, even if the global
warming “cap and tax” legislation does not pass.
Gold and other precious metals appear to have entered a period of above-
average volatility, but the unprecedented creation of paper money and
national debts means ownership of the metals and producers will tend
to reduce endogenous risk in most portfolios. The stocks will tend to
outperform bullion on the upside; the bullion will outperform on the
downside.
Oil and natural gas are both in oversupply at the moment. The difference is
that crude oil prices remain strong despite oversupply, as oil companies and
speculators hoard oil in anticipation of stronger demand next year—and
in fear of a new Mideast war. Shale gas may be too readily available to
be good short-term news for either the profits or stock prices of oil and
gas producers—but Exxon’s move on XTO shows what having huge shale
reserves can do for takeover values in politically-secure terrain.
8. Base metal stock prices are somewhat riskier than those of other commodity
groups, but are worth holding.
Cash isn’t a true risk reducer, because it delivers no yield and cannot rise
if there’s a new panic. If you must own something that pays you nothing,
buy gold. In contrast, long-duration bonds are the best hedge against a
renewed economic downturn.
10. Canada offers better government, better governance, a better currency, and
a better stock market than the USA. Buy Canadian.
The flip side to this is a wise balance sheet policy for Canadian companies.
Borrowing in American dollars makes sense for Canadian exporters and
resource companies—and for some other Canadian industries. Take
advantage of (1) Bernanke’s heroin injections into US debt markets, and
(2) Canada’s new financial prestige to reduce your endogenous currency
risk by bulking up your borrowing in greenbacks.
December 41
THE COXE STRATEGY JOURNAL
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