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Basic Points

The Power of Zero

November 12, 2009

Published by Coxe Advisors LLC

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THE COXE STRATEGY JOURNAL

The Power of Zero

November 12, 2009

published by
Coxe Advisors LLC
Chicago, IL
THE COXE STRATEGY JOURNAL
The Power of Zero

November 12, 2009

Author: Don Coxe 312-461-5365


DC@CoxeAdvisors.com

Editor: Angela Trudeau 604-929-8791


AT@CoxeAdvisors.com

Coxe Advisors LLC. www.CoxeAdvisors.com


190 South LaSalle Street, 4th Floor
Chicago, Illinois USA 60603
The Power of Zero
OVERVIEW

So what was all that Depression fuss about?

The US economy grew 3.5% in the Third Quarter, and all the major economic
numbers now being reported suggest this one will be even stronger. Stock Only Lehman was
prices are soaring. allowed to experience
the Schumpeteresque-
In case, you’ve forgotten:
slaughter reserved for
Sixteen months ago we were heading into the Midnight Massacre, when capitalist cupidity and
Messrs. Bernanke and Paulson launched the rescue of Fannie, Freddie and stupidity.
Wall Street.

That swiftly evolved into the Age of Bailouts, with Congress enlisted in
emergency funding for Wall Street’s biggest, boldest and brashest bankers
on a scale that made IMF rescues of entire nations look like chump change.
Only Lehman was allowed to experience the Schumpeteresque-slaughter
reserved for capitalist cupidity and stupidity. Operating with scripts and
strategies conceived on the fly, varying prescriptions of emergency assistance
were extended, under panic conditions, to Citigroup, Merrill Lynch, Morgan
Stanley, AIG and Goldman Sachs.

Since then, the Obama Administration and the Pelosi-led Congress have been
moving to take charge of some of the commanding heights and strategic
valleys of the US economy. Highlights: takeovers of General Motors and
Chrysler, a deficit of 12% of GDP, $790 billion in handouts and assistance
under the rubric of economic stimulus, a costly new national health care
system, and a vast array of tax and trade global warming programs whose
tentacles will reach into almost every sector of the economy.

To date, his rescue operations are succeeding. As Joe Biden put it, “A year ago
we were talking about falling into Depression. Now we’re talking about the
shape of the recovery.”

But deeply-wounded investors should be cautious about throwing caution


to the winds. Among the signs that the stimulus package didn’t repair the
potholed yellow brick road to prosperity is the upside breakout in the Bad
News Asset: Gold.

This month, we begin our analysis by discussing the anniversaries of the


births of two new eras. First, the Age of Global Capitalism, which began 20
years ago with the Fall of the Wall. Second, the apparent ending of that era
a year ago with the return of Big Government as Economy Manager with the
election of Barack Obama. We weren’t sure then how he was going to deliver

November 1
everything his thrilled backers wanted, but we knew that he wanted to be a
transformative President and he cited Reagan as such a leader—even though
he said Reagan had the wrong views.

With that background, we search for an appropriate investment strategy for


we have decided to
tumultuous times. While the talk is of trillions in stimulus, foreclosures,
focus on a humble
bailouts and deficits, we have decided to focus on a humble number—
number—Zero...
Zero—which is roughly the rate on government short-term funds, high-grade
money market funds and inflation across the US, Canada, Japan, and most
of Europe.

We are leaving our cautious Asset Mix unchanged. Risk assets—other than
US real estate prices—are bubbling upward everywhere, but the big banks’
balance sheets remain overloaded with the unmarketable unmentionables,
and US regional banks—the backbone of the real economy—are now being
engulfed by their exposure to commercial real estate and consumer loans as
unemployment continues to climb.

2 November THE COXE STRATEGY JOURNAL


The Power of Zero

I. Capitalism’s Triumph
Every week, someone publishes an analysis of the global economy by noting
that the triumph of free trade and free markets across most of the globe
began in the Reagan-Thatcher era. Now, they agree, it’s over. Each month,
“If it moves, tax it;
Washington’s reach into the American economy expands rapidly, while the
if it keeps moving,
economy expands—at best—grudgingly.
regulate it; and if
It is certainly true that almost no one predicted the suddenness and scale it stops moving,
of US government intervention in the West’s flagship economy that had subsidize it.”
been, until last year, a testimony to the wisdom of Milton Friedman and the
courage of Ronald Reagan. (The cheerful Reagan charmed voters by teasing his
opponents. He summed up Democratic economics as, “If it moves, tax it; if it
keeps moving, regulate it; and if it stops moving, subsidize it.” He summed
up the goal of his policies toward the Soviets: “We win; they lose.”)

The political bipartisanship began with the Midnight Massacre of July 13,
2008 but lasted only until the grandiose goals of the new Administration
were revealed. The Pelosi-Obama stimulus package passed with no Republican
votes in the House, despite heavy lobbying from some segments of the
business community, notably General Electric, which became Obama’s
most dedicated corporate cheerleader—itself and through MSNBC—after
receiving many billions in low-cost loans to its flagging finance subsidiary,
GE Capital.

The GM and Chrysler rescues were accomplished with minimal Republican


support. By then, the concern that the Administration was actually seeking
a major transformation of the structure of the US economy was developing
rapidly among conservatives and moderates. In addition, the pitchfork
politics in the House had terrified many business leaders that they and their
families could be the next victims of the fast-spreading rage against the
bailed-out rich.

Twenty-seven years ago, when the newborn Reagan and Thatcher Revolutions
seemed headed for death from double-digit interest rates, Chairman Volcker
declared victory over inflation and began expanding the money supply and
cutting interest rates.

For those who didn’t manage money during that recession, the fed fund rates
at the time that great easing began must seem surreal: 18%.

November 3
The Power of Zero

Question: How did the economy survive with rates so high?

Answer: with great difficulty.

Those rates were not only punitive for businesses and potential homebuyers,
Why not, they asked, but they meant that money market funds were well-nigh-irresistible
take those huge investments—huge, risk-free returns with zero market volatility.
risk-free upfront
We can recall the challenges we faced in convincing pension fund clients
returns from Cash?
about our asset mix in late 1982: zero Cash, with the balance being roughly
equally divided between long-duration bonds (19 years) and equities—with
minimal exposure to commodities. Why not, they asked, take those huge risk-
free upfront returns from Cash, rather than bet on a sustained, steep drop in
interest rates and inflation and a sharp, sustained economic recovery?

Because, we argued, inflation and long-term interest rates were already


falling sharply and would continue to do so, following commodity prices
down, lowering costs for businesses and consumers, particularly for energy.
Those three interlinked slides would virtually guarantee a strong economy
and strong stock prices for years to come. We insisted that short rates would
plummet.

That wasn’t all that would fall from the Reagan and Thatcher revolutions…

II. The Fall of the Wall


Those three interlinked declines—rates, inflation, and commodity
prices—and that one robust rise—economic activity in the free market
economies across the West, led by the USA—were the underpinnings of
the Reagan-Thatcher accomplishments and the “triumph” of capitalism. Of
particular importance, the strength of the US, British and German economies
was matched by the robustness of their interlinked foreign policy in the face
of Communist threats to Western Europe. Thatcher and Reagan, with Helmut
Kohl’s support, installed Pershing nuclear missiles in Western Europe, despite
strong opposition from France, and widespread “anti-war” demonstrations
on Ivy League campuses and across Europe.

The free market team’s stand against the faltering Bolsheviks, and their strong
economies at a time of economic stagnation in Russia and its occupied
territories in Western Europe, led to political unraveling in the Communist
world; the Wall fell and two years later the Communists were gone—even
from the Kremlin. (On his trip to England in 1979, Deng Xiaoping learned
why free economies were outperforming Russia and China, and he returned
to launch the Sino-Capitalist Revolution which keeps astonishing the world,

4 November THE COXE STRATEGY JOURNAL


even as faith in capitalism fades across much of the OECD. He had learned
why Hong Kong, Taiwan and South Korea could keep creating jobs and
wealth by rejecting socialism—whether on the Maoist, Bolshevik, or Indian
models.)
The KGB were the
Putin calls the collapse of Bolshevism, “The greatest geopolitical catastrophe
Jesuits of Russian
of the 20th Century.” It was certainly bad news for him and his fellow KGB
Communism...
officers, but they regrouped amid the chaotic Yeltsin era and eventually took
control of Russia. The KGB were the Jesuits of Russian Communism, and
they worked loyally to advance the Kremlin’s goals. But their relationship to
the Party was—like the Jesuits’ relation to the Vatican—at times problematic.
Example: Khrushchev once claimed that he had personally shot Beria, the KGB
leader, who wasn’t deemed sufficiently submissive to the Central Committee,
(although the later version was that he’d died before a firing squad). Like the
Jesuits, the KGB considered themselves the elites, and remained loyal to each
other. Now that they are the ruling class, they no longer have to answer to
bureaucrats and theorists.

It was also bad news for leftists across most of the Free World. They had
convinced themselves that, as the leader of Canada’s New Democratic Party
put it after returning from a trip to Russia shortly before the Fall, “I admire
their economics, but not their politics.” It turned out that everywhere, like
Germany under National Socialism, “Good Communists” were as rare as
“Good Nazis.” Free markets and free economies worked: socialism didn’t.
There were no Nobel Peace Prizes for Reagan or Thatcher. Instead the prize
for the end of the Cold war went to …

Mikhail Gorbachev.

(The Nobel Committee’s apparent love of losers is shown by its award of


the prize to the most conspicuous American foreign policy loser—Jimmy
Carter—and rejection of the most conspicuous American foreign policy
winner—Reagan. By coincidence, last week was also the anniversary of Carter’s
most memorable flop—the seizure of the American Embassy hostages by
Ayatollah Khomeini’s radicals. They were imprisoned and abused for the 444
days it took to elect Reagan. Carter had withdrawn support for the Shah and
expressed America’s joy at the Khomeini revolution.)

Gorbachev’s Nobel was the beginning of the rewriting of the history of Reagan
and Thatcher’s roles in Communism’s fall. The culmination of this process
is arriving in the torrent of new books that airbrush out those doughty anti-
Communists from the portrayals of friendly people reaching out to hug each
other from both sides of the Wall—Pyramus and Thisbe writ large.

November 5
The Power of Zero

In that sense, President Obama is riding the tide of history’s restatement,


and vindicating the Nobel decision about who was the real peacemaker of
that era. Speaking to the cheering throng in Berlin this year, he said that
“the world” forced down the Berlin Wall. He didn’t mention NATO, Reagan,
It was, in the Thatcher, or Kohl. It was, in the sophistication of its vin blanc et brie analysis, a
sophistication of causality claim comparable to the rooster’s renowned boast that his crowing
its vin blanc et brie had brought the sun up. Which “world” did he have in mind? A coalition of
analysis, a causality China, India, Russia, Vietnam, Burma, the United Nations and Iceland?
claim comparable
to the rooster’s III. The Obama Triumph
renowned boast A year ago, Grant Park in Chicago was the scene of the Democrats’ most
that his crowing had historic get-together since the party’s Left spoiled then-Mayor Daley’s party to
brought the sun up. celebrate his party’s national convention. Back then, there was an unseemly
riot, which helped elect Nixon. This time, there was pride, cheering, hugging
and wondrous exultation. We can attest that it was a great time to be a
Chicagoan, and a great time for America.

So how has the President anointed that night performed?

He remains the most charming and charismatic President of modern times,


and is still, quite probably, liked by more Americans—and more people
abroad—than any American President. He and his radiant wife are, as The
New York Times notes, America’s greatest global brand.

But the reality of the Presidency is that handsome is as handsome does. His
approval ratings have descended from the Heavenly to the ordinary. All polls
disclose that while most Americans still like and admire him personally, they
disapprove of his policies.

Gallup published a poll on the First Anniversary of his election, comparing


what Americans thought of him then and now. Here are key findings:

Percent
Then Now

He will heal political divisions 54 28


He will control federal spending 52 31
He will improve the healthcare System 64 46
He will increase respect for America abroad 76 60

6 November THE COXE STRATEGY JOURNAL


Other polls confirm that the basic political dynamic of America hasn’t changed
much from its historical pattern: 40% of Americans still call themselves
conservatives, 20% liberals, and the rest style themselves as moderates.
Obama won by convincing an overwhelming majority of moderates that he
would rule from the center, and—most importantly—he wasn’t George Bush. ...many global investors
are alarmed about
Despite a brilliant campaign, adoration from the media, a divided Republican
Obama’s policies and
party, and a flagging economy, he was actually behind the Bush-baggaged
are reducing their
McCain in the polls until Lehman imploded, and suddenly it looked as if
exposure to US assets
the world could end. As Larry Summers would later joke, a new Messiah was
accordingly.
what was needed. (It hasn’t come to an end, although a recent New Yorker
cartoon shows a gentleman consoling a friend, saying, “It isn’t the End of the
World.” Just around the corner, riding furiously toward them, are the Four
Horsemen of the Apocalypse.)

He won in a landslide, as the undecideds, en masse, became converts.

A year ago, Obama was impressing the nation (and, we admit, us) by unveiling
his economic policy team that included the magisterial Paul Volcker. Volcker
has been rarely seen since; three weeks ago, he corrected an interviewer
who said that the financial community felt that in recent months he’d been
marginalized. Volcker said, “I did not have influence to start with.”

The rescue of the plummeting financial system was actually orchestrated by


Bush appointees—Ben Bernanke and Hank Paulson, with the help of Tim
Geithner. Their policies have continued—for good and ill—and Bernanke
and Geithner remain as partners.

The jury is still out on the Pelosi-Obama stimulus package, as it is on his


plans to run trillion-dollar deficits for a decade—and on Congress’s national
health care bill—which remains in negotiation, despite its narrow victory in
the House.

Based on our recent trip to visit European clients, and numerous emails
from foreign clients across much of the world, many global investors are
alarmed about Obama’s policies and are reducing their exposure to US assets
accordingly.

The dollar’s decline may be one symptom of these doubts about the actions
of Obama and the Democratic Congress.

November 7
The Power of Zero

US Dollar Index (DXY)


November 10, 2008 to November 10, 2009
90

88

Few Americans would 86


have expected that 84
America would make 82
Italy look restrained 80
and prudent in 78
comparison. 76
75.10
74
Nov-08 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09

The US deficit/GDP ratio is above 12%—at World War II levels, and is the
highest in the G-7, except for the UK. It is, for example, more than twice
Canada’s. Few Americans would have expected that America would make
Italy look restrained and prudent in comparison. There is widespread
disappointment about how all that money has been spent, but as Keynes
observed, paying workers to dig ditches and then refill them is better than not
spending the money at all when consumer and business spending collapse
and Depression looms.

Last week, The Economist, which backed Obama enthusiastically during the
election campaign, published a full-page critique of his pro-union policies
titled “Love of Labour.” Contrasting his recovery policies with Reagan’s
response to the Air Traffic Controllers’ strike, it said, “Mr. Obama is the most
pro-union president since Jimmy Carter, at least.” It went on to describe the
implications of Obama’s backing for the unions’ top priority—card check—
which would abolish secret ballots for union representation.

Abroad, his popularity remains high (except in Israel, where his approval
rating is a mere 4%), as evidenced by his Nobel Peace Prize. However, as his
attempt to replicate Tony Blair’s success at charming the IOC into awarding
Chicago the Olympic Games demonstrated, he has been notably unsuccessful
in translating that popularity into significant diplomatic successes.

Perhaps the biggest difference between him and Reagan is in his views about
American history. He was raised in the post-Sixties era, when the Left—abroad
and within the US—routinely demonized America for its alleged racism and
imperialism.

8 November THE COXE STRATEGY JOURNAL


His own beliefs, as expressed in his speeches worldwide, certainly don’t
condemn America with the fervor of the hard Left, but show little of the
powerful pride in America’s history that animated Reagan. Obama has told
countries around the world about all the ways that America has misbehaved
or disappointed them—and has apologized….most recently to the Iranian His own beliefs...
mullahs for Eisenhower’s role in dumping Mossadegh in 1953. For his public show little of the
apologies he has generally been greeted with applause—but he has captured powerful pride in
almost no new support for his foreign policy initiatives. America’s history
The exception to his Administration’s pattern of passivity and apologetic that animated
coaxing came with the return of Hillary Clinton to prominence, in Pakistan, Reagan.
after months of seeming ineffectiveness by Obama’s appointee, Richard
Holbrooke. On her recent trip there, she displayed coolness, gutsiness and
a sensitivity toward Pakistan’s great internal challenges that did America
proud.

On balance, a year after he won the Presidency, and while he still enjoys
widespread good will, Obama has only begun to prove his effectiveness (1)
in managing the US economy without damaging the nation’s longer-term
financial position, and (2) in protecting America’s interests abroad.

Last week’s three off-year elections certainly do not prove that voters have
suddenly forgiven Bush and are ready to reinstate Republicans. Obama was
not on the ballots, unemployment was still climbing even after the economists
said the recession had ended, and the Democrats’ deficits had scared a
majority of independents into switching their preference to the Republicans.
The next elections are a year away, by which time the economy should be
stronger, the rage over the 1990-page health care bill might have dissipated,
and the Republicans will still lack a Newt Gingrich-style leader to put together
the various resentments and enthusiasms into a winning coalition. It took
rare talent for the current leadership to lose the 23rd Congressional District
in New York the Republicans had held for 72 years.

Obama may fear serious voter backlash about the scale and wisdom of the
new programs being legislated, but at least for now, he doesn’t need to fear
the Republicans. The Republican Party is leaderless, and frequently clueless,
so Obama doesn’t need to be a Roosevelt or Reagan to stay on top.

November 9
The Power of Zero

The Highs and Lows of Zero Rates


Zero is a seemingly-small number, but it is demonstrating its power to
change the world. We have seen many examples in individual countries of
The Power of One: this is that kind of power on global scale.
Zero is a seemingly-
small number, but it We are regularly told that we should expect a roaring recovery—Reagan-style.
is demonstrating its But if Reagan were alive, and Margaret Thatcher were in good health, they
power to change the would be astounded at how their two nations’ economies are struggling at a
world. time of zero interest rates—when they had to launch recoveries at a time of
record-high rates.

The US and British economies are performing at roughly the level they were
during the late stages of the 1981-82 recession—when corporations’ and
consumers borrowing costs’ were infinitely higher. That inflation could be
in the zero range would also astonish them, even though the biggest factor
in their first election victories was the runaway inflation of the Carter and
Callaghan era—when “malaise” was the Presidential euphemism for the
spreading despair.

So why shouldn’t the economic recovery be at least as strong as Reagan’s—if


not even more robust?

It’s because those Zero rates tell us that the financial system’s problems that
triggered the economic collapse aren’t going away quickly—and could even
be getting worse.

Reagan and Thatcher didn’t have to deal with serious demographic problems
that meant housing prices could not—for the first time since World War
II—leap in response to plunging interest rates. Reagan and Thatcher didn’t
have to mortgage their nations’ futures to bail out bad banks, which, upon
being rescued, diverted the succor they were given to rebuild their devastated
capital to speculation and bonuses, thereby making their saviors—politicians
and taxpayers—look like suckers.

Nor did they have to face the certainty that interest rates and inflation would
have to go up sometime—and that could be very inconvenient for both the
politicians and the economic recovery.

10 November THE COXE STRATEGY JOURNAL


US interest rates and inflation could remain at current levels, were America to
mimic Japan’s experience from 1990 to Koizumi’s election. But those early
years of Japan’s Triple Waterfall Crash occurred at a time of rapid global
growth that meant Japan’s trade surpluses grew robustly, and the immense
levels of domestic savings were adequate to finance Tokyo’s endless fiscal “Those aren’t real
deficits. (Currently, Japanese investors are not quite able to absorb all the forecasts: they’re
debt coming from record deficits, but they’re certainly embarrassing their Mickey Mouse
American counterparts: they’re absorbing 94% of new government debt numbers.”
offerings.) In contrast, America’s trade deficits are a permanent feature of
the US economy, and even the current uptick in US household savings is
no match for the fast-growing flow of new Treasurys, which means the US
becomes more dependent on foreign bond-buyers by the month.

The Administration’s forecast through 2019 assumes that foreign creditors’


appetites for Treasurys will grow at least as fast as the national debt. It predicts
sustained real GDP growth of 3% per year, with no recessions, no increases in
taxpayer cost for health care, and—despite sustained deficits and a doubling
of the national debt-to-GDP ratio (excluding Fannie and Freddie debt) from
41% to 82%—long Treasury yields will not rise more than 1%. (We spoke
at a Canadian financial conference last month at which Niall Ferguson was
the star. He flashed that forecast up on the screen and said, “Those aren’t real
forecasts: they’re Mickey Mouse numbers.”)

Despite the current deficit of 12% of GDP, and despite increasing grumbling
about Washington’s willingness to incur huge deficits in bad times and good,
the foreign support of the dollar by buying Treasurys continues. There has
been one little-remarked change in the investment strategy of America’s
Sugar Daddy #1: in recent months, China has been rolling over its maturing
Treasury notes into T-Bills. It thereby chooses to forgo interest of 2%–3.4%
in favor of near-Zero yields. What power, one wonders, does Beijing think,
comes from a Zero return in a weakening currency? And why is that putative
power growing so relentlessly?

November 11
The Power of Zero

A fast-growing Monetary Base at a time of Zero yields is the best a central


bank can do to prevent a Depression and get the economy moving again.
But it is based on redistributive justice: it takes wealth from savers and gives
it to the bad banks that caused the crisis. To add insult to that injury, many
...it is based on of the most prominent of those bankers are paying themselves huge bonuses
redistributive justice: for being so brilliant and creative as to take the free money and invest it
it takes wealth from up the yield curve—or across the wide range of risk assets, which are rising
savers and gives it to robustly together. Goldman is the biggest winner from this wealth transfer:
the bad banks that even its mid-term debt only costs around 2%. Its CEO told the audience in a
caused the crisis. London church that he does “God’s work.” This is the bank that, according
to reports about the tense bailout days, would have been dead within hours
had Paulson and Bernanke and friends not rescued AIG and Morgan Stanley.
Goldman’s bonuses for this year will exceed the GDPs of 107 nations. Ain’t
free enterprise grand?

A Zero yield has been the Bank of Japan’s policy for most of the time since its
Triple Waterfall Crash commenced nearly 19 years ago. Our personal favorite
member of the BOJ’s Board then, was its only female, Eiko Shinozuka. She
consistently voted against near-Zero deposit rates. She claimed to represent
the generation that had pulled Japan out of its desperate condition after
World War II through its hard work and high savings rate. With state
pensions being so modest, and with the children of postwar generations
being less willing to perform the historic role of looking after their parents
and grandparents, people had to save for their old age—and nobody on
Planet Earth seemed to live as long as the Japanese. Amazingly, these people
did save remarkable amounts, and their favored deposit institution was the
Post Office, particularly after the banks began to implode. As interest rates
on deposits fell by more than 90%, “her people” were driven into penury to
prop up the bad bankers.

She reiterated those vigorous objections at almost every BOJ Board meeting,
and the male gerontocrats who made up the rest of the Board thanked her for
her contribution—and continued to make the near-Zero-cost contributions
to the banks.

Led by the Fed, central banks across the OECD have been Japonized.

They drive rates of bank deposits and money market funds toward Zero to
stimulate borrowing and enrich a flagging, flabby banking system.

12 November THE COXE STRATEGY JOURNAL


Not that the top dogs at the big, bad, bonused bailout banks (Hereinafter
called the B5) show penitence, gratitude or humility about this process: they
consider controls on their bloated incomes “socialistic,” and warn loudly
about the dire consequences for a free enterprise economy if Washington
and Whitehall suppress their astonishing bonuses. ...the big, bad,
bonused bailout
Wherever his spirit rests, Benjamin Franklin must be livid. When the hard-
banks (Hereinafter
earned savings of ordinary people are looted to enrich greedy bankers, and
called the B5)...
when they are told that this process is necessary to make America prosperous
again, no wonder so many citizens have displayed so much anger at “Tea
Parties.”

But the problems of the thrifty members of the lower- and middle-classes
who are losing so heavily from Zero yields may not continue endlessly in a
Japonaise stasis. They could get worse: today’s extreme monetary policies and
humongous deficits are laying and fertilizing the seeds of the next inflation,
which will be characterized, in the early stages, by sharp increases in the prices
of such necessities as food and fuels. Milton Friedman correctly predicted in
1973 that fast monetary expansion at near-Zero real yields would ultimately
trigger inflation—and he was vindicated when US CPI reached double-digits
during the next recession.

We recently participated in a panel discussion organized by the Canadian


Consulate in Denver. The lead speaker was David Dodge, retired Governor of
the Bank of Canada. (Longtime readers will remember that we were calling
him “North America’s Greatest Central Banker” during the years when Alan
Greenspan was being accorded mythic powers.)

We were there to discuss when and how governments and central banks
should employ exit strategies from their current expansionary policies. With
one exception (a portfolio manager who insisted government deficits should
be expanded until unemployment reached zero), the panel agreed that the
level of current monetary expansion and deficits was unsustainable and
potentially dangerous.

Mr. Dodge was particularly eloquent on the high risks of maintaining current
monetary and fiscal policies. He is really worried about the potential for
worrisome inflation and much higher interest rates that would choke off any
recovery.

November 13
The Power of Zero

The first sign that the foreign central banks who’ve been trying to protect
their currencies from over-appreciation against the dollar may be reassessing
their forex strategies came with last week’s announcement by the Reserve
Bank of India that it was swapping a portion of its holdings into 200 tonnes
Zero T-Bills form the of gold the IMF is selling. That helped send gold to new highs.
base of a debased
MacroMavens, a routinely brilliant and thoughtful contrarian research
debt market.
publication produced by our friend Stephanie Pomboy (who presciently
predicted the Crash with her in-depth studies of banks’ balance sheet
problems and the unfolding real estate collapse), issued the following chart
last month:

Global Forex Reserves


Real vs. Nominal
(adjusted for the dollar decline)
February 1, 2003 to October 23, 2009
3.2

2.9 3.19

2.6

2.3

2.0

1.7

1.4
1.06
1.1

0.8
Feb-03 Oct-03 Jun-04 Feb-05 Oct-05 Jun-06 Feb-07 Oct-07 Jun-08 Feb-09 Oct-09

Nominal Real

Source: Stephanie Pomboy, MacroMavens, LLC.

The chart displays the extent of the monetary masochism of the banks abroad
whose purchases keep yields across the curve on Treasurys, Fannie and
Freddie at unrealistically low yields. Zero T-Bills form the base of a debased
debt market.

As troubling as Zero is for savers, it also poses problems for portfolio


strategists….

14 November THE COXE STRATEGY JOURNAL


The Problem of Zero in Portfolio Construction
Although portfolio construction for pension and endowment funds has
become far more sophisticated and mathematical in recent years, its basic
process can be easily summarized.
How does a portfolio
In the classic capital asset pricing model for balanced portfolios, the investor optimizer deal with the
sets the projected long-term rate of return for the “Risk-Free Asset” (Cash) Problem of Zero?
and then assigns expected return rates based on volatility and endogenous
risk assumptions for the other asset classes that are under consideration
for inclusion in the Fund. The expected rates of return rise along with the
perceived risks in each asset class. An Efficient Frontier is then created that
mathematically balances risk and reward to achieve the minimum needed rate
of overall portfolio return. A pension fund meets its regulatory requirements
for funding if the value of its current holdings, plus the compounded
projected returns of the asset classes meet its liabilities.

We have participated in many such portfolio designs over the decades, and
well recall how high rates of return on Cash bedeviled the process. When
the risk-free rate was as high—or higher—than the historic long-term rate
of return on equities, it meant committees had to use the long-term rates on
Cash to build the model. That was accomplished by assuming a lower rate
going forward, because the duration of Cash is near-zero. Moreover, as of
August 1982, when the Reagan bull market began, the Constant Dollar Dow
Jones was at 1929 levels, indicating that the only real returns that had been
earned on equities in 53 years were dividends.

How does a portfolio optimizer deal with the Problem of Zero?

The obvious answer might be, “Easily. It means all asset classes are hugely
attractive relative to Cash and no allowance for Cash will be made apart from
minimal liquidity concerns.”

A more thoughtful answer should be, “Zero Cash means big problems for
overall construction. Assuming that a Fund needs to earn a nominal 7%
overall, net of fees and costs, then the higher the Cash component, the higher
must be the rate of return assumptions for the other asset classes. Without
tinkering with those assumptions, then the higher the Cash component, the
higher the risk and volatility the portfolio must assume. Such asset classes as
Junk Bonds, Leveraged Loans, and small Emerging Markets might have to be
quite big commitments for the Fund to meet its objectives.”

This is a challenging time to be designing pension fund portfolios—or asset


mixes for individual investors.

November 15
The Power of Zero

According to BCA Research, US stocks have delivered an annual compounded


real rate of return of negative 4% for the past decade, while 10-year Treasurys
have given a positive annual real rate of 3.6%. (Embarrassingly, gold was
the top-performing asset class, delivering an annual real rate of return of
...capitalism has 10.8% in that same time period. Commodities futures did 5.2%. How many
failed its most basic consultants or equity analysts during the perfervid period when tech stocks
test—delivering were heading skyward told pension plans gold bullion would do three times
higher returns to as well as US stocks for the next decade? Or, for that matter, how many
investors than was told their clients Emerging Markets shares would outperform the S&P by a
paid on risk-free compounded real rate of 11.5%?)
government bonds.
Amid all the enthusiasm about soaring stocks and an economic recovery, it is
wise to retain one’s perspective about what has happened to investors.

Last week, the Bank of America summed up the disappointments of our era
for institutional investors. It noted that there were 42 trading days left this
year, and the S&P would have to rise 42% to deliver a Zero rate of return for
the past decade.

By some calculations, on a compounded basis, long Treasurys have


outperformed the S&P since the beginning of the Reagan bull market. The
problem with those data is that they assume sustained reinvestment of
interest at the long end of the curve, but most bond managers would have
been below benchmark duration for extended periods, which meant their
cash income would have been reduced.

Apart from that nitpick, what that number shows is that capitalism has failed
its most basic test—delivering higher returns to investors than was paid on
risk-free government bonds. And this was the best of all times in the best of
all capitalist worlds: classic economic liberalism was becoming the fashion
everywhere outside North Korea, most of the Arab world, and Cuba. There
were more playing fields for multinationals than ever, corporate tax rates
were generally declining, there were no major wars, the supply of highly-
educated engineers, MBAs and CFAs was at record levels, and business was
more respected than it had been since the onset of the Depression.

16 November THE COXE STRATEGY JOURNAL


And yet a robot reinvesting 30-year Treasury coupons would have out-
performed the S&P Index—which itself outperformed most managed
accounts.

Constructing a pension fund portfolio and projecting its forward returns in the
These bankers toil
Age of Zero could be termed “a faith-based initiative.”
not much, but they
One of the biggest cheerleaders for the 1990s US bull market was Jeremy spin like mad...
Siegel. The first edition of his best-selling Stocks for the Long Run came out in
1994. His data demonstrated the near-certainty of stocks as winners showing
inter alia “For horizons of 20 years or more, bonds are riskier than stocks.”

Then came Nasdaq’s Triple Waterfall Crash and a recession, and his “Absolute
Law” had joined the phlogiston theory in history’s trash heap.

After the 2008 Crash, we were hit with blizzards of advice about how wise it
was to hold Cash. Some money managers got heavily into Cash before the
Crash, and many other managers assured worried clients that they would
be holding higher levels of Cash until the next bull market was established
(whenever that happened).

The amount of Cash and Excess Bank Reserves in the US economy is at


all-time records, mostly because of Bernanke’s panicky doubling of the Fed’s
balance sheet. But this is a construct, not a solidly-based financial reality.

It recalls a well-known passage in the Bible:

Consider the lilies of the field, how they grow. They toil not, neither do they
spin: And yet I say unto you, not even Solomon in all his glory was arrayed
like one of these.

Cash was splashed among the B5 to array their balance sheets, which were
looking Gandhian in their skinniness. But the B5 re-deposited a huge slug of
those funds with the Fed as excess reserves: why go through all the nuisance
involved in making loans to individual companies? They also bought up the
Treasury curve. These bankers toil not much, but they spin like mad: they
keep trying to convince us that they didn’t cause the Crash, and they really
deserve their big bonuses.

November 17
The Power of Zero

US Monetary Base (adjusted for Changes in Reserve Requirements)


January 1, 1970 to October 30, 2009

Source: St Louis Federal Reserve, database: FRED® (Federal Reserve Economic Data)

Fed Funds (Effective Federal Funds Rate)


January 1, 1970 to November 6, 2009

Source: St Louis Federal Reserve, database: FRED® (Federal Reserve Economic Data)

30 Year Mortgage Rates


April 1, 1971 to October 1, 2009

Note: Shaded areas indicate US recessions; seasonally adjusted


Source: St Louis Federal Reserve, database: FRED® (Federal Reserve Economic Data)

18 November THE COXE STRATEGY JOURNAL


Wall Street keeps reassuring us that it will eventually earn satisfactory returns
on its trillions in complex mortgage-backed derivatives.

But the courts could pose a problem for the holders of these dubious
products.
As millions of the
Wall Street packaged vast numbers of mortgages of quality ranging from mortgages in those
hopeless to malodorous to acceptable to high quality. Because of their putrescent packages
variety—regional and otherwise—the Street arranged to create a servicing went into arrears...
agency that would handle the payments and enforce the covenants.

As millions of the mortgages in those putrescent packages went into arrears,


they were foreclosed. In two recent court decisions, the mortgagors have been
able to defeat or delay foreclosure by arguing that the agent could not prove it
had a direct financial interest and could not produce the real owner(s). These
decisions—which could put a large percentage of US home mortgage debt at
risk from something other than mortgagor default—are under appeal. Those
courts agreed with mortgagors’ assertion that they have a common-law right
to negotiate with their mortgagee about altering the terms of the loan prior to
completion of foreclosure. Produce, the judges, demanded, the mortgagees.
It certainly makes sense to us that a person’s home is his castle, and it can
only be put at risk in a transaction made between consenting adults.

So tens-of-trillions in face value of mortgages in arrears held by those who


didn’t know to whom they were lending—or whether the borrower even had
a job or was in jail—might not, according to this theory, be legally foreclosed
because the mortgagor and mortgagee never knew each other.

All those math and physics PhDs who built the products, and the bankers
who distributed them, never thought about a principle in mortgages that
dates back to the 14th century and the emergence of Courts of Equity. (That’s
where the word “equity” comes from.)

Equity was based on the Chancellor’s religious-based concern for welfare


of people of the middle- and lower-classes who suffered under the rigors of
Common Law.

If more US courts decide that those ancient protections for homeowners


need to be protected against derivatives, the results for the B5, Fannie and
Freddie would be very…..interesting.

November 19
The Power of Zero

Zero and Market Volatility


Why is it that all risky asset classes suddenly seem positively correlated to
each other?

They dance to the The answer is that near-Zero borrowing costs at a time banking systems are
global risk music of being flooded with funds—both from government-insured deposits and
the markets. the buildup of liquidity from the Fed—constitute an historically-unique
inducement to the big banks and to their leading hedge fund clients to
borrow and speculate.

Last week, according to The Wall Street Journal, the World Bank expressed
alarm about “asset price bubbles in equity markets across Asia, and in real
estate in China, Hong Kong, Singapore and Vietnam,” and the IMF chimed
in with fears “that surging Hong Kong asset prices are driven by a flood of
capital ‘divorced from fundamental forces of supply and demand.’’’

Hong Kong, of course, pegs its currency to the dollar, which means it
outsources its monetary policy to Ben Bernanke. The Zero rate automatically
means a weak dollar—here and in Hong Kong. To a somewhat lesser degree
it means a weak renminbi.

Central bankers have soothed us with assurances that rapid monetary growth
will not trigger inflation as long as economies remain weak. But they said that
in the 1970s, and commodity inflation proved them wrong.

The price of oil in recent months has traded almost in inverse lock-step with
the value of the dollar. This isn’t the longer-term adjustment that characterized
the 1970s—it’s occurring in real-time.

This daily activity mocks the reliance traders used to place on actual data
about oil supplies and demands—particularly the weekly data about US
supplies of oil and refined products.

Many of the metals—notably aluminum—no longer trade primarily based


on LME inventory data. They dance to the global risk music of the markets.

Stocks trade together globally on a day-to-day basis. Yes, Emerging Markets


continue to outperform the S&P, rising more than New York on bullish days,
and not falling as hard, on days risk is being unwound.

20 November THE COXE STRATEGY JOURNAL


The Barons of the B5 are reporting record trading profits, which means, as
Nouriel Roubini warns, that systemic risk is increasing, not decreasing. The locus
of this new risk has moved from toxic, untraded products whose values are
shielded against market pricing to marketable investments of nearly all
stripes. ...the thousands
of regional US
That the Canadian dollar should rise and fall with metal and oil prices is not
banks on which an
surprising, but the euro also rises and falls, though not as much, as the loonie
economic recovery
on days of dollar weakness as dollars are borrowed and invested outside the
depends.....have to
dollar zone in commodities and stocks across the world.
make their money
Problem: if the US economic recovery falters, a myriad of global risk assets the old-fashioned
could be simultaneously subjected to the same kind of risk-unwinding way—and that’s
devastation as occurred after the Midnight Massacre and the collapse of tough these days.
Lehman, which were US-specific events. But this time, the Fed and most other
central banks would not be able to unleash needed liquidity by lowering rates.

The banking crisis was tied initially to subprime and other illiquid and
unmarketable assets. The Fed, the Bank of England and the European Central
Bank have taken trillions in overpriced toxic assets from the banking system,
directly, and through support of mortgage lenders such as Fannie and
Freddie, the Federal Home Loan Banks, and various European lenders. (The
Financial Times cites a Bank of England study that pegs total government and
central bank aid to private financial institutions at $14 trillion, which it calls
“socialism for the rich.”)

That unprecedented process was designed to prevent a Depression, revive the


banks, and free their capital for productive lending. However, the B5 banks
have used the funds to reload their trading desks, concentrating on market-
priced assets and derivatives tied to those assets.

As for the thousands of regional US banks on which an economic recovery


depends, they have not participated in the sudden explosion of trading
profits that have restored the B5 banks and their bloated bonuses. They have
to make their money the old-fashioned way—and that’s tough these days.

November 21
The Power of Zero

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


November 10, 2008 to November 10, 2009
110

100
...Main Street was
90
watching in horror
the trillions going to 80
Wall Street while the
70
lenders communities
needed most were 60
57.34
cutting back on
50
lending... Nov-08 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09

As clients are aware, we have long believed that the real US economy depends
far more on the health of Main Street banks than on the machinations of the
B5. And Main Street is hurting: more and more regional banks are folding,
and the FDIC Fund that insures bank deposits is the next government money
pool to face drainage. (The huge Federal Housing Act pool is also being
drained rapidly, but it’s lumped into overall Treasury statistics and can be
replenished without special legislation.)

CIT’s bankruptcy is a synecdoche for Main Street America’s problems. As the


largest factoring company, it has been—for many decades—a reliable backstop
for small and medium-sized businesses across America. Companies assigned
their receivables to CIT, thereby allowing them to continue to sell their
output profitably, even to sophisticated giants such as Walmart and Amazon,
which are famously successful at boosting their cash flows by delaying their
payments to suppliers for months. Their local banks would assist in financing
inventories and making loans for capital investment secured by real estate
liens and owners’ personal guarantees. CIT is now operating in bankruptcy,
but it is hardly in shape to perform its historic functions as demand for
factoring rises in response to an economic recovery.

The “Tea Party” rages about the stimulus and bailout programs were signs that
Main Street was watching in horror the trillions going to Wall Street while
the lenders communities needed most were cutting back on lending, and
were buckling under the weight of their heavy exposure to local construction
loans backed by mortgages on properties whose values were plunging.

22 November THE COXE STRATEGY JOURNAL


The spreading bankruptcies in shopping centers haven’t just devastated
major operators like the Bucksbaums. Many of the shops in those centers
are locally-owned, and as vacancies spread across the centers, the surviving
shops suffer sharp declines in walk-in business—and they default on their
bank loans. The...KRE is...
the most reliable
The KRE has fallen to a new low on Relative Strength against the S&P at a
indicator of whether
time of a booming stock market and record bonuses within the B5.
the panoply of
This is really bad news for small and medium-sized businesses, which are the political programs is
traditional engines of job creation. And the proprietors of those businesses truly kick-starting
are, as industry surveys show, very worried about the effect of today’s gigantic a sustainable
deficits on tomorrow’s income tax rates. US recovery.

The realization that the trillion-dollar deficits are destined to continue, even
when the economy gets back to sustained growth, frightens them. They hear
that they will be subject to much higher taxes on “the rich,” and hear that the
term “rich” means people who earn more than $500,000 a year. (According
to The Wall Street Journal, if the tax rate in 2007 were 100% on Americans
earning over $500,000 a year, that would have generated just over a trillion
in Treasury receipts.)

The 1990-page health care legislation not only has the “millionaire’s taxes”
on those earning above $500,000, but imposes high extra taxes on small
businesses which do not offer health care to their employees.

Doubtless, local bankers will be looking at the effects of these permanent tax
increases and mentally marking down their customers’ ability to service their
loans in future years.

There will not be the kind of sustained US economic recovery that will drive
a sustained US bull market until the shares of the Main Street (KRE) banks
begin to outperform both the B5 banks and the S&P.

The relatively obscure KRE is, we believe, the most reliable indicator of
whether the panoply of political programs is truly kick-starting a sustainable
US recovery—and whether the optimism of US equity investors is justified.

November 23
The Power of Zero

KBW Regional Bank Index ETF (KRE) relative to KBW US Bank Index (BKX)
June 22, 2006 to November 10, 2009

180

The life insurance 160


industry wasn’t built
140
on issuing term
policies to cardiac 120
cases in the Intensive
100 102.79
Care Units.
80
Jun-06 Oct-06 Feb-07 Jun-07 Oct-07 Feb-08 Jun-08 Oct-08 Feb-09 Jun-09 Oct-09

No one can predict the limits on the capacity of the Fed and Congress to keep
finding new money to spend on rescues and stimulus. When the crisis was in
its early stages, Bernanke told Congress, “We’ll do whatever is necessary” (to
rescue the economy). Obama and Congressional leaders have made similar
pledges.

But there are limits on what even the Fed and Congress can do. At some point,
conditions have to return to normal and the regional banks have to take up
the slack. Then—and only then—will investors be able to safely conclude
that the recovery has become the reality to be used in valuing all financial
assets. The life insurance industry wasn’t built on issuing term policies to
cardiac cases in the Intensive Care Units.

We continue to recommend that clients take advantage of the stock market’s


Zero-based budgeting of financial risk—and scale back their exposure to
US economy-related shares. With the forward P/E on the S&P reaching 19,
it seems to be priced on the assumption that if Goldman is paying record
bonuses, the economy’s underpinnings are now strong enough to support
fast economic growth.

Can stock prices fall even as liquidity flows surge amid Zero rates and Zero
monetary restraint?

The Greenspan bubbles that collectively came to be known as the Greenspan


Put gave us Nasdaq at 5,000 and other enormities. Barring a multi-year
recovery that drives unemployment to relatively painless levels, this bubble
could make Greenspan look like a piker.

A tale from Main Street (or, more precisely, Chicago Avenue)….

24 November THE COXE STRATEGY JOURNAL


Sunday in the Park With Feds
The Park National Bank has long been a fixture on Chicago’s Gold Coast. We
walk by it nearly every business day. With a lovely building, a spacious parking
lot, and a location near Washington Square Park, it has always represented
...it’s probably the first
prudence and prosperity—just what an upscale community expects from its
time that [Geithner]
local bank.
praised a bank for good
Then, on Sunday November 1st, it was taken over by the Feds. It was well- management and gave
capitalized, and then it was toast. it a big gift for future
programs after it had
Why?
ceased to function.
It was owned by a failed bank holding company that had two bad banks
in Texas, three in California and one in Illinois. Among the now-necrotic
investments those banks made during the bubble years were the preferred
shares of Fannie and Freddie. As The Wall Street Journal reported, “When
regulators shuttered the flailing [sic] banks after closing hours…the FDIC
leaned on Citizens National Bank and Park National Bank…to foot the bill.
‘The two banks were unable to pay the amounts assessed and were closed by
their chartering authorities,’ the agency said.”

It is a measure of these frenetic times that Park National’s demise came only
hours after Tim Geithner—at a ceremony in Chicago—awarded the bank
$50 million in tax credits to “to help spur community-development projects
in low-income communities.” (Geithner knew nothing of the closure. The
FDIC keeps bank closures secret until they actually happen. It’s not the first
time Geithner’s been chatting with management of a bank about to vaporize,
but it’s probably the first time that he praised a bank for good management
and gave it a big gift for future programs after it had ceased to function.)

But the good news is that after some bank deaths, there is resurrection. US
Bancorp bought the collection of nine good and bad banks, the FDIC wrote
off $2.5 billion, and Park National has reopened as a branch of Minneapolis-
based US Bancorp.

What? We worry?

November 25
The Power of Zero

Zero Rates and Gold


Gold
November 1, 2000 to November 10, 2009

...the most-cited 1,100 1,115.50


argument against
950
investing in bullion has
been that it’s sterile... 800

650

500

350

200
Nov-00 Nov-01 Nov-02 Nov-03 Nov-04 Nov-05 Nov-06 Nov-07 Nov-08 Nov-09

Fed Funds
November 1, 2000 to November 10, 2009

Source: St Louis Federal Reserve, database: FRED® (Federal Reserve Economic Data)

For as long as there has been a free market in gold, the most-cited argument
against investing in bullion has been that it’s sterile: it pays no interest or
dividends, so why should anyone own it? It’s not as if it were a painting by
Rembrandt or even Renoir that has unique scarcity value. There’s lots of gold,
there’s lots of gold mines, and nearly all the gold that’s ever been mined is
still above ground and is either in vaults or in jewelry.

26 November THE COXE STRATEGY JOURNAL


So why, at a time when consumer inflation seems little more threatening
than attacks from vampires, is gold leaping to new all-time highs even if
adjusted for compounded inflation back to the date of the release of the
classic Dracula (1931).
So why, at a time when
Some possibilities:
consumer inflation
1. It’s a risk asset, so it’s benefiting from the rush to risk. seems little more
threatening than
2. Borrowing at Zero to buy something with Zero yield is income-neutral.
attacks from vampires,
3. It’s the only asset that, based on history, outperforms under both horror is gold leaping to new
stories—Depression and Hyperinflation. all-time highs...

4. Its upside breakout came at the time of Halloween.

5. India announced purchase of half the hoard on offer from the IMF, which
had been weighing on gold prices, and there are rumors that China will
take up the rest. This was the second surprising announcement from
India within a fortnight. The other was that the United Arab Emirates had
displaced such nations as the US, China and Germany as India’s biggest
trading partner in recent months. Apart from tea, and gold in the form
of baubles, bangles and beads, what big-ticket exports other than bullion
could India be sending to that collection of gold-loving states? It’s no
longer exporting rice or sugar.

6. Statistics from across the world confirm that the economic recovery is
gaining steam, so the specter of inflation is moving stealthily from deep
in the primeval forest toward the main path. Travelers beware.

7. Barrick CEO’s statement in London about the continuous decline in new


gold mine output, suggesting, “There is a strong case to be made that we
are already at ‘peak gold’.’’ The golden rule of commodities has been that
the cure for high prices is high prices: when the price of stuff goes up, big
new production always follows, and the price goes down. Gold’s price
has more than quadrupled, but new-mine production keeps falling. With
central banks apparently switching from the sell to the buy side, this may
be a new world for the oldest store of value.

8. All of the above.

November 27
The Power of Zero

Is gold overvalued? In terms of a reliable historic indicator, it may depend on


how you define a gentleman. The Economist once sought to find a true value
of gold with a study showing that, for most of the time since the Middle
Ages, an ounce of gold would buy a gentleman’s suit in London. That was
We do not share these not the case on Jermyn Street from 1981 through 2007 even for the less-
morbid fears, but no prestigious tailors. With the recent decline in the pound, it is now applicable
longer characterize to the shops located more than two blocks from St. James’s Street. (It hasn’t,
them as the particular we believe, applied at Savile Row since King Edward’s time.)
problems of the
As gold and silver rise to higher peaks, we hear more and more stories that
perpetually paranoid.
serious investors are demanding bullion—not financial paper, whether in
futures or in the gold ETFs. (The GLD has been termed, “The small investor’s
central bank.”) Some prominent skeptics question whether the ETFs actually
own all the gold they claim, or whether they depend on counterparties to
make delivery. The core attraction of gold for those who fear an epochal
financial crisis is the absolute reliability of bullion—the only asset that is no
one’s liability. These investors are now shying away from any investment that
relies on counterparties or on regulation by any financial authorities.

Roosevelt made ownership of gold illegal by Presidential order. Could such


intervention occur again? Impossible, say bankers.

A skeptic might well note that no one predicted the scale of intervention into
financial markets from governments and central banks that began with the
Midnight Massacre, so why should gold claims that need to be satisfied with
futures contracts or other counterparty arrangements be forever immune
from attack?

We do not share these morbid fears, but no longer characterize them as the
particular problems of the perpetually paranoid.

28 November THE COXE STRATEGY JOURNAL


The Power of Zero
INVESTMENT ENVIRONMENT

David Dodge began his speech in Denver by saying, “This is a rebound, not
a recovery.” He considers it a snapback from an oversold position, fueled by
record amounts of monetary expansion, subsidies and deficits. He was not
“Stein’s Law”, which has
very confident about the prospects of a sustained recovery, without some
never been repealed,
setbacks.
may be ready to be
We find ourselves bemused by the confidence displayed by forecasters who proved anew...
(1) didn’t predict the Crash, and (2) use charts and tables from past economic
recoveries in proof of their assertions that the best is yet to come—and
nothing really painful lies in between.

We freely admit we don’t know what’s going to happen to the US economy


over the next five years. But we do believe that Americans aren’t going to live
happily ever after if regional banks’ finances continue to weaken.

The challenges:

1. The root cause of the financial and economic collapse—the demographically-


driven plunge in real estate prices at a time of serious over-leverage in the
housing sector—remains a clear and present danger to banks and other
financial institutions.

2. All the US government’s home mortgage lending institutions are


experiencing rising losses, despite the slight uptick in house prices. That
barely-observable bounce is due to most drastic price maintenance
program in history—taxpayer bailouts of lending institutions, the Fed’s
huge subsidy to mortgage rates through purchases of Fannie and Freddie
paper, and 10-year notes, and the First-Time Homebuyer Subsidy of $8,000.
It took all those trillions to get house prices to rise 4% from their panic
lows. Why should investors be confident the rally will continue? “Stein’s
Law”, which has never been repealed, may be ready to be proved anew:
“If something cannot go on forever, it will stop.”

3. Bernanke will have used up his entire declared quota of purchases of long
Treasurys and mortgage-backed paper within a few months. Then what?

4. Commercial real estate grows sicker each month, as office and condo
vacancy rates rise, and more and more regional banks go to the wall.

5. The biggest contributor to the 3.5% economic growth of the Third Quarter
came from the Cash for Clunkers program. That is gone.

November 29
The Power of Zero

6. The only US auto company to report positive cash flow in the Third
Quarter—Ford—still struggles with a boom-year-negotiated UAW contract
that means its labor costs are much higher than the other members of
what used to be known as The Big Three. Since the UAW and Washington
The current noise on effectively own those competitors to Ford, there’s slim chance the union
Detroit assembly lines will do anything to strengthen Ford: if Ford collapses, so much the better
could turn out to be a for the union-owned Big Two. Chrysler has no hot new products in the
death rattle. pipeline and an ambiguous management agreement with Fiat. GM is
adjusting to a shrunken product base and its finance subsidiary, GMAC,
has already received four emergency cash infusions from Washington since
the bankruptcy. Hyundai, no friend of the UAW, is the hottest company
in US sales. The current noise on Detroit assembly lines could turn out
to be a death rattle.

7. What may have been the most useful consumer economic stimulus—the
collapse in gasoline prices—is fast becoming a cherished memory. Gasoline
prices have already retraced roughly half their plunge. That most useful
of all “tax cuts” is being chipped away, as other taxes at federal, state and
local levels face inevitable increases.

8. Although overall consumer inflation remains near the Zero level, food
prices continue to rise relative to other costs, and natural gas prices are
no longer at remarkably cheap levels.

9. And it looks to be a cold winter—atmospherically and otherwise.

So what should investors do?

Although commodity stocks underperformed the S&P from June through


September, they have resumed the outperformance they displayed for most of
this decade. Meanwhile, China’s rush to lock up global supplies of industrial
commodities continues at breakneck speed. Niall Ferguson predicts that by
mid-2010, China will be a net seller of Treasurys because of its fast-growing
allocation to commodities. Nor is China alone: Indian companies are now
scouring the globe for commodity-producing assets, and Saudi Arabia is
buying grain land in many parts of the world.

As much as we are concerned by the insouciance of US equity investors,


we remain convinced that investment in commodity stocks has both lower
endogenous risk and higher long-term potential than US equities generally.

30 November THE COXE STRATEGY JOURNAL


As we learned from the aftermath of the Midnight Massacre, commodity
stocks can be savaged at least as ruthlessly as other stocks when the margin
clerks take charge. However, owning the shares of the companies which own
the resources that China, India, Korea and other major new economic powers
need most is, surely, the soundest of long-term-oriented equity strategies. The Copenhagen
Kaffeeklatsch looms:
Meanwhile, astronomers who have for years assumed that solar activity
it seeks to bind the
would remain at such levels that the world would have to cut back sharply on
industrial world into
its CO2 and methane emissions to prevent disastrous global warming have
promising a scaled-
begun to ponder the dramatic evidence that the sun has become virtually
down Bonnie and Clyde
silent.
leap into a government
Even David Hathaway, NASA solar physicist and sunspot expert, admits controlled economy...
that he and many of his colleagues are now discussing the possibility (still
unlikely) that the collapse in sunspots and solar winds could mean that Planet
Earth faces something like the Maunder Minimum (1645-1760). According
to NASA’s own statistics, the world was really cold for that period—known as
the Little Ice Age. In the new “SuperFreakonomics,” the authors remind us
that 30 years ago, many of the leading experts were warning the world faced
a new Ice Age, and were advocating radical policies to warm Earth up.

The Copenhagen Kaffeeklatsch looms: it seeks to bind the industrial world


into promising a scaled-down Bonnie and Clyde leap into a government-
controlled economy in which the overarching priority is cutting down on
greenhouse gases. There will be sustained constraints on economic activity
to produce tiny reductions in global temperatures decades in the future.
The evidence that the trend to warming has ceased in the past decade—and
is actually reversing—is rejected. It is as if a patient were told his leg had
to be amputated because of a risk of infection, even though the patient’s
temperature had fallen from its peak and his other bodily signs were tending
toward normal. Al Gore, who admitted to Congress that his net worth had
risen from $1 million to $100 million through his varying involvements in
green investments, warns in his latest screed that new evidence shows that
the warming is actually worse than previously estimated. He reiterates his
claim that hurricane activity continues to increase dramatically, although, as
George Will writes, this year the East Coast’s hurricane experience was half
the average of the last fifty years.

November 31
The Power of Zero

Whenever there is a huge disparity between what nearly everybody who


matters believes and the actual conditions of the economy or the world,
investors who are prepared to bet that reality will eventually assert itself can
win big.
...investors who are
This could be one of the biggest such disjunctions in modern history. Yes, the
prepared to bet that
sun could suddenly go back to emitting sunspots at the rate of the previous
reality will eventually
century. Yes, scientists still maintain that, despite eight centuries of evidence
assert itself can win big.
of a correlation between sunspot activity and recorded temperatures on
Earth in the 80% range, there is no scientific proof that this is anything but
coincidence.

Damon Runyon observed, “The race is not always to the swift, nor the battle
to the strong, but that is the way to bet.”

In a chat with a knowledgeable investor last week, he commented on


Warren Buffett’s willingness to pay so much for Burlington Northern. That
railroad, he observed, has two main businesses: transporting manufactured
goods from the West Coast to the East, and transporting steam coal from
the Rockies. Coal stocks are, perhaps, potentially the biggest losers from
the Administration’s climate change legislation and regulations. If investors
began to conclude that the scientific community were going to reconsider
its view on global warming because of the plunge in solar activity, many
companies’ shares would benefit big, but probably none more than those of
the US coal companies.

32 November THE COXE STRATEGY JOURNAL


The Power of Zero
RECOMMENDED ASSET ALLOCATION

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
Bonds
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

Change
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.

November 33
The Power of Zero
INVESTMENT RECOMMENDATIONS

1. Remain underweighted in US equities—as a percentage of total equities


within global portfolios, and as a percentage of assets in US balanced
portfolios. Underweight US bonds in global portfolios.

The Obama long-term financial projections for the US are high risk and
unsustainable. Forthcoming elections—or a currency crisis—could induce
some discipline, but within the OECD, the US should probably no longer
be accorded top ranking for bonds and stocks.

2. Within the US market, underweight US economy-related stocks and


overweight stocks tied to global economic activity.

Watch the performance of the KRE compared to both the BKX and S&P. As
long as the KRE underperforms both of these indices, US-economy-related
stocks remain suspect.

3. Overweight Emerged Markets (such as China, Brazil, India, and Korea)


within global and international equity portfolios.

These markets should no longer be routinely discounted heavily for


political risk or accounting practices relative to the US. The credibility gap
has narrowed in the past year.

China continues to report robust economic activity and skeptics continue


to proclaim—as they have for years—that it’s unsustainable. The time to
sell China, and, for that matter, base metal and energy stocks, is when the
last remaining Sino-skeptic has become unemployed.

4. Overweight the precious metal miners relative to bullion or the ETFs.

The time to overweight the ETF is when precious metal prices have entered
corrections.

The XAU and other gold stock indices have underperformed bullion for
the past two months because of a succession of bad news announcements
for such heavyweights as Barrick, Kinross and Agnico-Eagle. True, we can’t
be sure there won’t be more reports of disappointing execution among
the miners, but they have the reserves in the ground, and the best of them
have “unhedged reserves in politically-secure areas of the world”. Investors
who believe current prices could hold should do NAV calculations on the
miners based on current gold and silver prices, and they will see excellent
opportunities in the stocks.

34 November THE COXE STRATEGY JOURNAL


5. Overweight the leading agricultural stocks. The farm equipment, seed and
fertilizer stocks are core investments for the next cycle.

With one of the coldest and wettest Octobers on record, Midwest farmers’
crops at October-end were overdrenched, overdue and overrun with blights
and moulds. Recent warmer and dryer weather has improved yields, and
the heaters are working overtime to dry out what has been harvested—and
corn and soybean prices have pulled back slightly from their recent highs.
Global carryovers will not increase this year, which means world food
“surpluses” remain precarious—as evidenced by the sharp run-up in
rice.

6. The base metals stocks have been the global commodity stars. The best
stock market values now could be in the small-caps that are long on ore
and short—or nil—in earnings.

In retrospect, we should have recommended overweighting in this sector,


but we were spooked by the collapse of the Baltic Dry Index and its
subsequent failure to rally—and the relatively high levels of inventory on
the LME. It appears that China has used some of its surplus dollars to get
China overstocked on metals.

7. Overweight Canadian oil sands stocks within equity portfolios.

The Canadian oil sands stocks continue to suffer bad press among the
defenders of the planet about alleged environmental misdeeds and risks.
Each dead duck listed in shocked reports sent across the world has been
worth millions in reduced market cap for the companies. (The actual
total number killed in this supposed replay of the Exxon Valdes is what a
few hunting parties would collectively bag on a good weekend.) A major
Canadian institution recently joined this parade of the super-chic by
publishing a supposedly unbiased study on oilsands emissions that was
prepared by two of that nation’s pre-eminent greenhouse gasbags. The
institution could have achieved the same results by retaining Gore—but
Gore costs more. Treat those fashionable emissions with caution—and
treat your portfolio to oil sands stocks.

November 35
The Power of Zero

8. Overweight Canada in both equity and fixed income portfolios, and remain
long the loon against the greenback.

In recent global rankings, Canada ranked #1 in the G-7 for its central bank,
its private banks, and its Minister of Finance (who is the longest-serving
in the G-7—a remarkable feat for a minister in a minority government).
The principal knock on Canada is that it is dull. Dull has become the new
shiny.

9. In balanced portfolios with an equity bias, do not hold high Cash


exposures. Hold long-duration, high-quality bonds.

If this rebound becomes a sustained boom, you will lose—rather


modestly—on this exposure, but your equity holdings will appreciate
substantially, and you will be a net winner. If it becomes a bust, you will
win on the bonds, thereby reducing your overall portfolio loss. Long
bonds now reduce short-term cyclical risk. As of October, speculators
were hugely short 30-year and 10-year Treasurys and hugely long 2-year
Notes—consistent with a bullish call on stocks and the economy. If that
call swings to bearish, there will be a rush to the long end.

36 November THE COXE STRATEGY JOURNAL


THE COXE STRATEGY JOURNAL
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herein are provided as of the date hereof and are subject to change without notice. From time to time, Coxe publications
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