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Basic Points

Financial Heroin

December 16, 2009

Published by Coxe Advisors LLC

Distributed by BMO Capital Markets

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Don Coxe

Financial Heroin

December 16, 2009

published by
Coxe Advisors LLC
Chicago, IL
Financial Heroin

November 12, 2009

Author: Don Coxe 312-461-5365

Editor: Angela Trudeau 604-929-8791

Coxe Advisors LLC.

190 South LaSalle Street, 4th Floor
Chicago, Illinois USA 60603
Financial Heroin
During this season of giving thanks, we invite you to join us in thanking Ben Bernanke,
Claude Trichet and Mark Carney. They have done good things for the economy this
year—and much better things for the prices of the risk-based assets held in so many

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

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:

“God bless us every one.”

December 1
S&P 500
January 1, 2008 to December 15, 2009


1,100 1,106.50


Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09

Toronto Stock Exchange Composite (TSX)

January 1, 2008 to December 15, 2009
Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09

MSCI Global Ex-US

January 1, 2008 to December 15, 2009






Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09


Financial Heroin

Our title came to us during a speech by a justly respected former central


In October, we were on the panel at a conference organized by Canada’s

Consul-General in Denver. The star speaker was David Dodge, who was, until
“North America’s wisest
2007, Governor of the Bank of Canada. (Long-time followers of our work
central banker’’
may recall how often I cited him as “North America’s wisest central banker,’’
which was a seriously-meant comparison with the much-worshipped Alan
Greenspan, who had been knighted by the Queen and was for so long credited
with mystical powers that he might even have been beatified by the Vatican
had he chosen to renounce his dalliance with the Atheistic Objectivism of
Ayn Rand.)

The topic for the speaking panel was “The Challenge Of Reducing Fiscal And
Monetary Stimulus”.

Freed of the speaking constrictions of governorship, but governed by his

polite unwillingness to embarrass a successor or provoke furious debate in
Parliament, Mr. Dodge spoke of how serious the financial crisis had been,
assigning the blame largely to overlevered investment banks, and then
addressed the risks for the global economy from the central banks’ policy
of keeping liquidity so high and rates so low for so long. He argued that
the central banks should begin to tighten policy even while unemployment
remained uncomfortably high and economic growth was relatively subdued,
warning that the alternative was being forced into imposing painful monetary
tightness and high interest rates that would choke off an economic recovery.
Although he was restrained in his rhetoric, he let the audience know that
the risks of a grim outcome from the current record levels of monetary ease
could become very high within the near future.

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

I began my remarks by telling the audience that my father was a doctor in

the Canadian Army in WWII, and served in the Italian campaign. He became
greatly respected for his anaesthesia and pain management under battlefield
surgery and rehabilitation conditions. (He was cited after war’s end for
“Zero interest rates perhaps having performed more anaesthetics under such conditions than
are Financial Heroin.” any other Canadian doctor.)

In discussing his experiences, he told me that he swiftly learned that the

best—and frequently the only—reliable drug for the critically wounded
was heroin. Soldiers who writhed in agony under other medications almost
always responded to heroin.

The problem wasn’t deciding whether to administer it: if morphine didn’t

work fast, you didn’t waste time, you injected 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….

I paused at that point, and then said,

“Zero interest rates are Financial Heroin.”

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


US Monetary Base (adjusted for Changes in Reserve Requirements)
January 1, 1970 to November 30, 2009

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)

Fed Funds (Effective Federal Funds Rate)

January 1, 1970 to November 25, 2009

Note: Shaded areas indicate US recessions

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.”

That’s the way army doctors treated wounded soldiers—Canadians and

Germans alike—in the field dressing stations.
Thou shalt not covet
thy client’s house... Like all analogies, this one has a limitation: the army only injected heroin into
the veins of seriously wounded soldiers. Bernanke and friends are injecting
it into the entire economy; one small component of it—highly-levered
banks and speculators on the front lines of finance—is not only absorbing
a disproportionate share of the supply, but has recently been displaying the
kind of ecstasy associated with overdosing on powerful drugs.

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.

Perhaps, if some professor at Wharton or Harvard had updated the

commandment, it might have prevented a financial collapse and a deep

We suggest the following restatement:

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 big banks refashioned their balance sheets to mimic their hottest clients,
using the window of opportunity provided by the abandonment of the rules
in the Basel Accord I that had given the financial world its longest period since
the 1960s without the collapse of a large bank. Although only Paul Volcker
(who had led the committee that created Basel I) expressed alarm about In terms of balance
over-leverage and over-reliance on models, the regulators let the big banks sheet caution and
bet big. In terms of balance sheet caution and coverage, Basel II was to Basel coverage, Basel II was
I what a bikini was to a burkha. Not only was the leverage allowed to soar to to Basel I what a bikini
Babel and Dubai tower heights, but the risk models were based on the same was to a burkha.
Black-Scholes models that felled Long-Term Capital Management—and the
balance sheet design was based on Enron’s innovation—off-balance-sheet
special purpose borrowing.

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

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…


The Pain is Mainly on Main Street
As the “Too Big To Fail” banks rejoice in their financial heroin injections,
there are few signs of euphoria on Main Street. Indeed, the bankers on Main
Street collectively remind us of those impressionist portraits of lonely, angst-
On Main Street, the
ridden absinthe drinkers.
small, low-flying banks
These charts of the relative performance of small regional banks to the big of the genus parva banca
national banks and the S&P show that, in banking terms, as the rich get have begun to succumb
richer, the poor get poorer. The population of big banks is now holding to a collective die-off.
steady, after the liquidation of Bear Stearns and Lehman, and the hastily-
arranged Morganatic Marriage of Merrill Lynch to Bank of America. On Main
Street, the small, low-flying banks of the genus parva banca have begun to
succumb to a collective die-off.

KBW US Regional Bank Index ETF (KRE) vs. KBW Bank Index (BKX)
January 1, 2009 to December 15, 2009



70 72.97



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

KBW US Regional Bank Index ETF (KRE) KBW Bank Index (BKX)

KBW US Regional Bank Index ETF (KRE) vs. S&P 500

January 1, 2009 to December 15, 2009
120 122.49

70 72.97
Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09

KBW US Regional Bank Index ETF (KRE) S&P 500

December 9
Financial Heroin

According to James Grant, JP Morgan’s Jamie Dimon has predicted that,

because of commercial real estate losses, “several hundred additional smaller
regional banks go—not make it.”

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

For it, no more the blazing lights will burn,

No business small attempt to show the sharps
That would a loan on inventories earn.
The bank has died: it was too small for TARP.

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

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 regional bankers, and many of their customers, worry about the longer-
term impact of that other form of stimulus which comes from governments—
deficits, bailouts, and handouts. These massive overruns collectively acquire
an earthly version of eternal life in the form of their permanent place in the
fastest growing component of the economy—the national, state and local That gentle rainfall is
debts. Since Obama is budgeting a decade of endless debt increases to build unduly concentrated
the kind of Green, sharing economy he wants, the regional bankers and on bankers, investors
small businesspeople see the inevitability of higher taxes, reduced economic and speculators.
growth, and higher inflation.

The central bankers (and governments) are, effectively, in the situation of

those oft-cited mythical droppers of dollars from helicopters. To paraphrase

The quality of stim’lus is not strained,

It droppeth as the gentle rain from Heaven
Upon the place beneath:
It is twice blessed;
It blesseth him that gives and him that takes:
‘Tis mightiest in the mightiest.

That gentle rainfall is unduly concentrated on bankers, investors and

speculators. The blessing is supposed to accrue to the politicians and central
bankers who are dropping the trillions into the economy, but that part of the
political calculus does not seem to be working out well for Pelosi, Geithner,
or even Bernanke.

Think of the US economy as a four-wheel-drive vehicle:

The front wheels are the real economy: Big Business and Small

The rear wheels are the financing mechanisms: Big Banks and Small

If the left rear wheel is in splendid condition and is maintained at optimal

pressure, while the right rear wheel has mechanical problems and is under-
pressurized, the vehicle will not perform satisfactorily, and will be accident-

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.

The screams of a recovering soldier whose heroin is withdrawn may be

Volcker said the
nothing compared to the screams from Congress and the Left if the Fed
“single most important
decides it must begin reducing its injections.
contribution” they’ve
made in the last 25 If Ben the Heroin Hero stops the infusions in time, he will deserve to be
years was introducing mentioned in the same breath as Paul Volcker—a real hero….
Because he will have done the brave thing—at the risk of the loss of his job
and of the Fed’s independence.

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.

One shocked member of his financial audience challenged his dismissal of

modern finance, and the magisterial Volcker huffed, “You can innovate as
much as you like, but do it within a structure that doesn’t put the whole
economy at risk.” He reiterated his support of Soros’ view that “proprietary
trading should be pushed out of investment banks to hedge funds where it


Volcker is right. The collateralized debt obligations, collateralized mortgage-
back securities, and other computer-spawned complexities and playthings
were not the solutions to basic needs in the economy, but to unslaked
greeds on Wall Street. Without them, banks would have had no choice but
to continue to devote their capital and talents to meeting real needs from Without them...
businesses and consumers, and there would have been no crisis, no crash, there would have
and no recession. been no crisis,
no crash, and no
Bernanke would doubtless concur, although he doesn’t dare say so in public.
He is engaged in a multi-trillion-dollar rescue operation to save the global
economy from collapsing under the weight of toxic derivatives and bad
trading bets.

When will he take the risk of stemming the heroin flow?

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

Before the Heroin Dripping Stops

1. Systemic Risks

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:

Total Credit Issuance

January 1, 2002 to December 15, 2009
$ Billion
2002 2003 2004 2005 2006 2007 2008 2009 2010
Source: Stephanie Pomboy, MacroMavens, LLC.

She points out that credit issuance over the past 12 months is at an all-time
record and notes,

“Ben has restored the nation to its primary occupation—the

manufacture of paper stuff….Fully 90% of the $109 billion increase in
corporate profits in the 3rd Quarter came from the financial sector.”


In defending him against his harsh Congressional critics, she observes,

“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 those financial
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





Jun-09 Jul-09 Aug-09 Sep-09 Oct-09 Nov-09 Dec-09

Their insipid stock-price performance despite huge profits based on Bernanke-

bubbles raises serious questions about their eagerness to repay TARP loans
out of their fed-subsidized profits. It would appear that the biggest bankers
in the biggest banks are continuing to manage their organizations as if they
were private companies owned by a few insiders and traders.

If so, then, as those financial gastroenterologists continue to warn us, there’s

worse than gas pains ahead for the financial system.

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?

Be careful what you wish for.

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.
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.”

3. Investing Under Bubble Conditions

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.


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.


In brief, as long as you don’t try to delude yourself that you’re a value investor
when you’re buying the typical non-commodity and cyclical components of
the S&P or the Russell 2000, you can console yourself in the knowledge that
this particular bubble may not be ready to burst for some months. can console
However, the amount of Bernanke pumping needed to keep it afloat is
yourself in the
increasing, which suggests even he can’t keep this bubble alive much longer
knowledge that this
if the real economy fails to take wing. Despite a huge upside breakout of the
particular bubble may
Monetary Base in the past two months, the S&P has moved up just a tad.
not be ready to burst
Even that move is suspect, because it has been accompanied by a plunge in
for some months.
short sales of non-financial stocks, and lackluster volumes.

Fortunately for investors, if you’re interested in investing in North America,

you have a real alternative: the worse the US may look to global investors, the
better its biggest trading partner appears...

December 17
Financial Heroin

Canada, the North Star in NAFTA

Amid the excitement in financial markets when the BLS announced that
November’s job losses were far less than in earlier months, restated October’s
number downward, and cut the unemployment rate from 10.3% to an even
Canada had
10%, seemingly few investors noted the announcement from Ottawa:
gained 79,000 jobs
in November. Canada had gained 79,000 jobs in November.

The usual back-of-envelope conversion factor for Canada to US statistics is

ten, to reflect roughly the sizes of the two economies.

So what would the impact have been if the BLS had announced that US
employment had risen by 790,000 jobs?

We ask this rhetorical question to make a serious point: you do have a

North American Free Trade Area alternative to investing in US stocks and
bonds—and its attractions are increasing almost as rapidly as the federal
government’s share of the American economy.

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.

2. The Canadian economy is currently more attractive than the US economy

because of (1) its sound banking and financial system, (2) its commodity
orientation, (3) its public debt/GDP ratio is lower than the US, (4) its
current fiscal deficit/GDP ratio, which is far lower than the US, and (5)
because the politicians in Ottawa who share the Pelosi-Frank-Emmanuel-
Obama ambitions to play an ever-increasing role in the direction of the
economy are in the Opposition—not in control.

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.

4. Canada’s national retirement program, the Canada Pension Plan, is not,

like Social Security, backed by book entries in the national debt, but by
a professionally-managed fund that invests globally, virtually free of
political influence. It is—by far—the best-funded social pension system in
the G-7 and, is somewhat comparable to Chile’s and Norway’s. It covers
all Canadians except residents of Quebec, who have a parallel benefit
structure, but a somewhat lower level of funding.


Toronto Stock Exchange (TSX) (currency adjusted) relative to S&P 500
January 1, 2001 to December 15, 2009





Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09

S&P/TSX Capped Financials Index (TTFS) (currency adjusted) relative to

KBW Bank Index (BKX)
January 1, 2001 to December 15, 2009





Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09

Canadian dollar (CAD versus USD)

January 1, 2001 to December 15, 2009




Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09

December 19
Financial Heroin

The Strong Loonie: A Problem for Investors?

For most foreign investors, “Buying Canada” has meant investing in Canadian
banks (and some leading non-bank financials, such as Manulife, Sun Life,
Great-West Life and Power Corporation), and buying commodity stocks.
“There are three
considerations in In part, the attraction in the later years of this decade, has been the strong
global equity investing: Canadian dollar—the loonie.
the first is currency,
We learned about that aspect of global investing from Swiss clients during
the second is currency...”
the 1980s. They told us how crucial currency was in buying equities. Their
light-hearted rule of thumb was, “There are three considerations in global
equity investing: the first is currency, the second is currency, the third is, what
makes this an attractive company?”

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.”

That explains why strong Canadian resource companies whose output is

US-dollar-denominated are highly respected globally—even though most of
their costs are incurred in a strengthening Canadian dollar.

Moreover, Canadian mining and oil companies are, in effect a play on

booming Asian economies such as China, India and Korea even if most of
their sales are to the US—because the price of their output is, in effect, set
by Asian demand. An Alberta oil sands producer ships no oil to Asia, but
the US dollar price is set—at the margin—by Asian demand. Besides, many
major Canadian resource companies operate globally, earning profits in
many currencies.

Canada’s trade with China is booming, and major new port facilities are
under construction in British Columbia to facilitate further expansion.


Canada has had its own relationship with China that predates Nixon’s
“opening” of the Middle Kingdom. China recognized “Red China” long before
the US, and Canadian missionaries—particularly medical missionaries—were
highly esteemed in China. Dr. Norman Bethune, a Canadian Communist,
provided notable service as a battlefield physician to Mao Zedong’s army in Why haven’t some
1938-9. He was so admired that Mao published an extremely laudatory essay Canadian banks shared
after his death, and erected a statue in his honor. Canada was also a major the fate of Citibank or
supplier of wheat to China at a time the US was embargoing its exports. In a Bank of America—
nation in which resentments for past perceived slights are long remembered, if not Lehman?
Canada has few blemishes.

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

Those Strong Canadian Financial Stocks

Most Canadians—let alone most Americans and Europeans—are unaware that
Canada has been starring in some G-7 rankings published by international

#1 ranked central bank

#1 ranked banking system
#1 ranked Minister of Finance

These rankings suggest that the Canadian financial system is exemplary—at

least by G-7 standards and in comparison with the US—which is, for most
foreign investors, the only really crucial comparison.

Why is the Canadian financial system so strong and well-managed? Why

haven’t some Canadian banks shared the fate of Citibank or Bank of
America—if not Lehman?

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.

Canada was constituted under a statute passed by the British Parliament

called the British North America Act, in 1867. (It is said that on the day
the Canadian Constitution was passed in Westminster, there was a higher
attendance level and greater interest shown by the Parliamentarians in a
dog-tax law that was next on the agenda.)

In that statute, Canada was dedicated to delivering “Peace, order and good
government.” That remains in the nation’s Constitution.

That pragmatic and administratively-oriented credo contrasts sharply with

the words that 91 years earlier announced the birth of the USA, which was
dedicated to protecting the basic human rights of “Life, liberty and the pursuit
of happiness.” The writer of that ringing document, Thomas Jefferson, would
have roared with laughter at Canada’s quiet objectives—and would then
have denounced them. Jefferson believed that every nation—including the
USA—needed revolutions from time to time to prevent national governments
from gaining too much power over their citizens. “That government is best
which governs least” was his firm view.

Canada has never been ruled by governments which espoused Jeffersonian

minimalism. Occasional threats of invasion and annexation from American
advocates of Manifest Destiny, the challenge of uniting the nation from sea
to sea, the enthusiasm of Canadians of British descent for fighting abroad
in Britain’s wars—from South Africa to the Somme, the exceptionalism and
later the threats of separatism from Quebec, the lack of industrial giants like
Rockefeller or Carnegie, and the harsher climate have all combined to make
Canadians more deeply dependent on their governments—provincial and
federal—than the typical American.


The result of such divergence was that Americans embraced capitalism with
more fervor and success than Canadians, and America was more clearly the
land of opportunity for ambitious young people who wanted to be richer
than their ancestors.
Canada didn’t lose
Canada’s financial system has always reflected this sense of insecurity that
banks during the
has underpinned the national commitment to protect the economy from the
Depression, whereas
financial collapse of banks. Result: Canadian banks have always been far less
thousands of American
numerous and far more tightly regulated than US banks.
banks collapsed.
However, the system has worked to Canadians’ benefit. Canada didn’t lose
banks during the Depression, whereas thousands of American banks collapsed.

There have been some restructurings of failed financial institutions in

Canada in recent decades, but the big five—and more recently, six—national
banks have been towers of financial strength compared to the average big US

Although Canadian bankers naturally like to pat themselves on their backs

for this success, much of the credit should really go to the Bank of Canada
and the nation’s tradition of highly-experienced, nonpolitical regulators in

When Citigroup was formed in 1998 as a $250 billion colossus, Canadian

banks rushed to Ottawa and demanded the right to merge. “How can we
compete against such a giant?” they wailed.

Forgotten amid the denunciations of “Ottawa bureaucrats” and “petty

politicians” by some bankers were how well they had been protected against
competition since Confederation. Canadian banking may be the longest-
lived, most stable, and most profitable oligopoly in the history of finance.
Foreign banks for decades couldn’t take Canadian deposits and their right
to maintain office space was controlled. When negotiations on NAFTA were
proceeding, Canada continued its ban on American banks’ ownership of
more than a small minority interest in Canadian institutions. Meanwhile,
other negotiators outmaneuvered American objections to Canadian banks’
outright acquisition of American banks. Those “bureaucrats and politicians”
bankers sometimes deride ensured that Canadian banks’ highly-profitable
dominance of the Canadian financial system would continue.

As Canadian bankers lobbied in Ottawa, talk of merger approval dwindled

and died. Since there were only five big banks with operations across Canada
and abroad, this would have meant shrinking the number of Canadian banks
to two or three. There was near-zero public enthusiasm for that proposal,
and there was widespread alarm among small businesspeople.

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.

From our perspective, Canadian bankers have displayed political tone-

deafness on occasion, but they are collectively wiser and are better risk
managers than their American or British counterparts.

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.


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.

The Canadian civil service has a tradition of professionalism and careerism.

Only the very top layer of the key departments includes outright political
appointees, and most of them have blue-ribbon backgrounds that justify
their appointment. Nothing like the Congressional log-rolling and hectoring
that poisons the process in Washington occurs in Ottawa—with the rarest
of exceptions. A Deputy Minister of Finance in Ottawa is customarily a true
professional who has served political masters from both major parties and
given them his or her best advice and information.

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


Canada—whereas it has, sadly, little chance in the US. Bizarrely, the pending
legislation in Congress on financial regulation would greatly expand this
day-to-day interference and influence peddling and make an ineffective
regulatory environment even worse.
That sucking sound is
The reality is that when you buy a Canadian bank stock, you are buying a
Canadian money and
participation in a good economy that works under traditions of regulation
financial products
that have evolved over 140 years. You are also buying the Canadian dollar.
being drawn into
When working on Toronto’s top trading desk in the 1980s, we learned that the US market.
some Japanese and European investors would send us overnight orders to
buy or sell large blocks of the bank stocks as a group depending primarily on
their short-term view for the Canadian dollar.

Peace, order and good government: dull?

But that gap between glamour in Washington and cautious professionalism

in Ottawa has existed for most of the time since Canadian Confederation.

With the exception of Pierre Trudeau, Canada’s political leaders have lacked
the glamour, panache and punch of America’s more colorful politicians.

But banking and financial regulation shouldn’t be heavily involved with

glamour, panache, and eagerness to assume large, heavily-levered risks for
large personal reward. When their bets went sour, the taxpayers were on
the hook for trillions. And, within less than a year, the bettors were back,
announcing record profits, and protesting that any constraints on their
compensation were un-American.

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.

Finally, we offer a NAFTA Note: the combination of a strong loonie and

strong Canadian financial stocks means than Canadian banks and non-bank
financials have splendid opportunities to increase their market share in the
US at a time US financial stocks are in their weakest position relative to
Canadian companies since the Depression.

If nature abhors a vacuum, the holes in US financial companies’ balance

sheets offer opportunities to financially muscular Canadian competitors.
That sucking sound is Canadian money and financial products being drawn
into the US market.

December 25
Financial Heroin

The Changed Climate for the Climate Change Chattering Class

Since we last published, Global Warming has been on the front page nearly
every day. While it is imprinted within our genes that we must resist the urge
to devote extensive discussion to what you read and hear about most, this
This is the center that
has been one of our major themes for three years, so we cannot resist talking
produced the data
about the latest developments.
that produced the UN
document that produced Besides, so much of it is so delicious!
the “consensus” that
produced the Nobel Prize Those Three Thousand E-Mails
for Al Gore and friends. The most-publicized scientific consensus of our time is that there is no
possible debate about global warming: it is settled science. The final nail
in the coffins of the few fools left out there who continued to question
the data and computer models showing that the world would soon be
irremediably hot was the awarding of the Nobel Prize to Al Gore and the
UN’s Intergovernmental Committee on Climate Change.

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.


The reality is that the Hadley Unit has been mixing science and politics since
its birth in 1990—it’s just changed sides. It was actually founded by none
other than Margaret Thatcher. As Lawrence Solomon explains in the Financial
Post, she was trying to promote the building of nuclear power plants, and
among her opponents, of course, were the coal miners. She had majored The enthusiasts
in chemistry at Oxford and retained her interest in science. She arranged to correctly saw that this
set up and fund this research centre to collect global data which would, she could be the lever
hoped, eventually convince everybody except the coal miners that nuclear to deliver to the
power—the only greenhouse-gas-free system—was the only sensible electric Enlightened the
power program. control of “capitalist”
economies whose voters
It may be the worst decision she ever made.
obstinately refused to
Her hopes of disinterested science that would lead all but the insane to adopt elect socialists or
nuclear power were dashed. As with so many foundations and universities, even leftists.
the dominance of the Left in academia meant that this centre became the
leading advocate of the global Left’s leading cause after the Fall of the Wall—
global warming. The enthusiasts correctly saw that this could be the lever to
deliver to the Enlightened the control of “capitalist” economies whose voters
obstinately refused to elect socialists or even leftists. (Of course, not all the
scientists and enthusiasts who wrote the emails have such extreme goals,
but the temptation of huge grants and real political power was too much for

As recently as 2007, a government-commissioned review of Hadley’s

effectiveness stated:

“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

But this dispute about scientific misbehavior isn’t going away.

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.

One of the scientists who participated extensively in various schemes to

prevent scientists who questioned their data and conclusions from getting
published or getting jobs, defended himself in a newspaper interview by
saying, “All that the emails show is that some scientists behaved badly. Maybe
Newton was an ass, but the theory of gravity still works.”

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

This scientist must be particularly close to Supreme Warm-monger Al Gore,

because in his debate with Sarah Palin, Mr. Gore sneered, “It’s like Gravity.
It’s There.”

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.


That Al Gore (of the potent partnership of Gore & Blood) has become
astonishingly wealthy by managing “Green” investments that rely heavily on
government subsidies and lucrative carbon offset deals does not prove that
global warming is fraudulent. He is simply the modern version of the Vatican
shill Tetzel, who came through Wittenberg in 1517, raising money for St. The modern sales
Peter’s Basilica through sale of indulgences. Indulgences were ways of buying pitch amounts to:
your own way out of thousands of years in Purgatory or freeing a deceased “Pay Blood & Gore,
family member. He had a line that Gore might envy: then sin some more”.

As soon as the gold in the casket rings

The rescued soul to Heaven springs.

His fundraising was for a great cause—paying Michelangelo to complete the

Sistine Chapel. We all owe a debt to Friar Tetzel.

But his somewhat dubious marketing techniques had disastrous results

for the Church he served. He so enraged a young, idealistic priest named
Martin Luther that he launched the Reformation, shattering the unity of

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

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.)

That’s really where the debate should stand.

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

What about the seeming correlation between the virtual disappearance of

sunspots and the recent cooling? Four centuries of documentation show (as
NASA concedes) a correlation of more than 80% between sunspot activity
and temperatures on Earth. Why should they assume that the powerful
...what the world sunspot activity of the past two centuries would continue indefinitely? Why
needs is to apply the do they reject evidence that the world was warmer a thousand years ago than
Atkins Diet to the air: now?
low carbs in what we eat
It remains, of course, possible that global warming exists and that CO2—with
and what we breathe.
some help from methane—is the prime cause. In essence they are telling us
that what the world needs is to apply the Atkins Diet to the air: low carbs in
what we eat and what we breathe.

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?

Some tongue-in-cheek observations about his rebuttal:

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:

“Tis a tale told by an idiot

Full of sound and fury, signifying nothing.”

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”.

The Witches, the best-regarded forecasters of their time, dabbled in weather


“When shall we three meet again?

In thunder, lightning, or in rain.”


The staff at East Anglia could, perhaps, be considered their successors, and
their resort to “tricks” to cover up data that challenged their conclusions
about future climate conditions argue that, like the witches, they are
creative in creating their forecasts.
Mr. Gore may be
3. Macbeth, who has seen what looked like Birnam Wood moving toward
running out of credible
Dunsinane (because Macduff told his soldiers to cut tree branches to cover
scientific support for his
themselves), for the first time wonders whether his own data base had
misplaced dogmatism,
been misconstrued. He sighs,
he can still fall back on
“Out, out, brief candle his one real scientific
Life’s but a walking shadow.” achievement—
inventing the Internet...
The only scientifically-cited alternative to the claim that man-made heat is
warming the world excessively is the fact that we have experienced—until
2007—two centuries of strong sunspot activity. Sunspots, which are energy
bursts from the sun’s core which move to its surface, appear as shadows
on the sun. They could be characterized as “walking shadows.”

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 Environmental Protection Administration Takes Charge

As warmists were jetting to Copenhagen, the US EPA announced that it had
made the finding that CO2 is a pollutant dangerous to human health. That
means the EPA has the power and responsibility to regulate all CO2 emissions
Bovine flatulence is
across the US economy, and in any products entering the US.
such a potent source
of greenhouse gas that Until this announcement, the warmists were relying mainly on getting
Sir Paul McCartney has passage through Congress of Obama-backed legislation that would include
called on all citizens both capping greenhouse gas output and providing trading mechanisms for
to observe a meatless emitters. That legislation was in trouble because of its huge impact on the US
Monday... economy. It was heavily supported by such major Obama financial backers
as General Electric that seek to profit big time from producing green energy
products, but was opposed by such major employers as the truckers, chemical
producers, coal producers, and oil producers and refiners.

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.

As shocked business groups are already complaining, this open-ended,

unrestrained power to a bureaucracy is yet another huge constraint on capital
investment at a time US capex is flagging. We can safely predict that many
more factories will be opened in China, which is among the conspicuous
winners in Copenhagen.


Financial Heroin
A year of bull markets in bonds and stocks is a welcome successor to last
year’s disasters.

It took a while for Zero borrowing rates to take effect, with the S&P and other’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

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:

January 1, 2009 to December 15, 2009
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

The media were filled with authoritative explanations:

Hyperventilating Commentators’ Explanations:

• the collapse of the dollar;

The classic expression • the repudiation of Obamanomics;
for getting rich quick is • a warning of a coming financial collapse, leading to Depression;
to find a gold mine— • a signal of the runaway inflation to come;
but it takes time, • China has only begun to convert its dollar holdings into bullion: the
experience and capital best is yet to come;
to bring on a mine. • a short squeeze on gold ETFs which are misrepresenting how much
bullion they hold: beware of counterparty risk: buy bullion, not
• a coming Armageddon in the Mideast.

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.

Clients can undoubtedly add other justifications and explanations to their



We were in Toronto the week gold prices were setting records daily, and
were asked—on TV—to explain the dramatic run-up. Various prominent
commentators were falling all over themselves to issue ever-higher targets for
bullion prices.
“My one-year target
We admitted that we couldn’t explain the sudden rush and the dramatic daily
for gold is 1345—
leaps. When asked for our price target, we suggested….
the onset of the
“As an historian, I seek some historic data to assist our predicting. Black Death.”
When gold broke through $1,000, we began considering appropriate
targets. As every English schoolboy knows, 1066 was the Norman
Conquest—the first gold target. The next important date was Magna
Carta—1215—and gold has now managed to attain that level. The
next big date is the Provisions of Oxford 1258 [when Simon de
Montfort forced important constitutional changes on Henry III].

“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!”

The interviewers laughed, and changed the topic.

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:

Gold relative to CRB Futures has its best January 1, 2007 to December 15, 2009
claim as a constituent 220
of foreign exchange 200
reserves since Bretton
180 178.70
Woods booted it out
sixty-five years ago.



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.


Commodities and Commodity Stocks

Reuter-Jeffries CRB Futures Index

December 15, 2008 to December 15, 2009
290 ...we learned to our
280 sorrow that commodities
and commodity stocks
are among the bloodiest
240 victims when the margin
230 clerks take charge.
Dec-08 Feb-09 Apr-09 Jun-09 Aug-09 Oct-09 Dec-09

Are commodities in bubble conditions?

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.

We believe there is little evidence of a large new commodity bubble. That

said, we learned to our sorrow that commodities and commodity stocks are
among the bloodiest victims when the margin clerks take charge.

December 37
Financial Heroin

However, the basic reasons for overweighting commodity stocks remain


1. They are proxies for unhedged reserves of necessary raw materials in

politically-secure locations. As such, they benefit over the longer term
Real assets that are
from the trend to global shrinkage of both reserves and politically secure
really needed for
locations. The takeout of XTO by Exxon illustrates this point. XTO was
people and economies
the only US oil and gas producer in the Coxe Commodity Strategy Fund,
to survive are really
because we liked its reserves and its land positions. It wasn’t as popular
comforting to own
with the Street, which is always more interested in near-term earnings
at times of extreme
than long-term value.
financial uncertainty.
2. Commodity stocks are, collectively, proxies for participating in the growing
wealth of the growing Third World middle class—the most important
demographic of our time.

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.


Financial Heroin
Recommended Asset Allocation
(for U.S. Pension Funds)
Allocations Change
US Equities 17 unch
Foreign Equities
European Equities 5 unch
Japanese and Korean Equities 2 unch
Canadian and Australian Equities 11 unch
Emerging Markets 14 unch
US Bonds 12 unch
Canadian Bonds 8 unch
International Bonds 11 unch
Long-Term Inflation Hedged Bonds 10 unch
Cash 10 unch

Bond Durations
Years Change
US 5.25 unch
Canada 5.00 unch
International 4.50 unch

Global Exposure to Commodity Stocks

Precious Metals 33% unch
Agriculture 33% unch
Energy 22% unch
Base Metals & Steel 12% unch

We recommend these sector weightings to all clients

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

December 39
Financial Heroin
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.

2. Within US equity portfolios, underweight US economy-related stocks and

overweight stocks tied to foreign economies.

US stocks outperformed after Obama’s election, but that created what

could be called erogenous risk for investors. As long as the KRE continues
to underperform both the BKX and S&P, risks of a double-dip economy

3. Overweight Emerged Markets (such as China, Hong Kong, Brazil, India

and Korea) within global and international equity portfolios.

These markets should no longer be discounted heavily because of assumed

gaps between their accounting and American practices. The credibility gap
has been narrowed significantly. The FASB’s capitulation to Congressional
pressure on big banks’ balance sheets is a sign that Volcker-style virtue is

4. Remain overweight commodity stocks within balanced accounts and

equity-only accounts.

Strong commodity-oriented companies are tied to global growth trends,

led by the Asian powerhouses, which means they have less endogenous
risk than companies tied to the US and Europe.

5. Emphasize gold stocks in commodity stock accounts.

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


6. Continue to overweight the agriculture stocks.

The best-performing commodity group in the past three months has

been the agricultural stocks, led by the machinery and fertilizer stocks.
Street analysts turned negative on these groups during the summer, when
it looked as if US crop production would reach painful levels. Then the
weather intervened. We remain of the view that the best of the agriculture
stocks are among the best-quality core positions among all equities.

7. Maintain exposure to the energy stocks, but continue to emphasize oil

producers and to de-emphasize natural gas producers.

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.

The producers are dependent on China’s willingness to continue to buy

more metal than it needs for current consumption.

9. Within balanced portfolios, emphasize long-duration, high-quality

bonds at the expense of Cash. Canadian bonds should be used by foreign
investors, where possible, as alternatives to Treasurys and US corporates.

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
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