Don Coxe Basic Points Sep 2011


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Don Coxe Basic Points Sep 2011

  1. 1. Basic PointsThe Deficient FrontierSeptember 16, 2011Published by Coxe Advisors LLPDistributed by BMO Capital Markets
  2. 2. Disclosure StatementThis third party publication is not prepared by BMO Capital Markets Corp., BMO Nesbitt Burns Inc., BMO Nesbitt Burns Ltee/Ltd and BMO Capital Markets Limited. The information, opinions, estimates, projections and other materials contained hereinare provided as of the date hereof and are subject to change without notice. Neither Bank of Montreal (“BMO”) nor its affiliateshave independently verified or make any representation or warranty, express or implied, in respect thereof, take no responsibilityfor any errors and omissions which may be contained herein or accept any liability whatsoever for any loss arising from any useof or reliance on the information, opinions, estimates, projections and other materials contained herein whether relied upon bythe recipient or user or any other third party (including, without limitation, any customer of the recipient or user). Informationmay be available to BMO and/or its affiliates that is not reflected herein. The information, opinions, estimates, projections andother materials contained herein are not to be construed as an offer to sell, a solicitation for or an offer to buy, any products orservices referenced herein (including, without limitation, any commodities, securities or other financial instruments), nor shallsuch information, opinions, estimates, projections and other materials be considered as investment advice or as a recommendationto enter into any transaction. BMO Capital Markets is a trade name used by the BMO investment banking group, which includesBank of Montreal globally; BMO Nesbitt Burns Inc. and BMO Nesbitt Burns Ltée/Ltd. (members CIPF) in Canada; BMO CapitalMarkets Corp. (member SIPC) and Harris N.A. in the U.S.; and BMO Capital Markets Limited in the U.K.Unauthorized reproduction, distribution, transmission or publication without the prior written consent of BMO Capital Marketsis strictly prohibited.TO U.K. RESIDENTS: In the UK this document is distributed by BMO Capital Markets Limited which is authorised and regulatedby the Financial Services Authority. The contents hereof are intended solely for the use of, and may only be issued or passed on to,(I) persons who have professional experience in matters relating to investments falling within Article 19(5) of the Financial Servicesand Markets Act 2000 (Financial Promotion) Order 2005 (the “Order”) or (II) high net worth entities falling within Article 49(2)(a) to (d) of the Order (all such persons together referred to as “relevant persons”). The contents hereof are not intended for the useof and may not be issued or passed on to, retail clients.™ - “BMO (M-bar roundel symbol) Capital Markets” is a trade-mark of Bank of Montreal, used under licence.© Copyright Bank of Montreal 2009“BMO Capital Markets” is the trade used by the investment banking groups of BMO Nesbitt Burns Inc, BMO Nesbitt Burns Ltee/Ltd,BMO Capital Markets Corp., BMO Capital Markets Limited, BMO Nesbitt Burns Securities Limited and the Bank of Montreal.” BMO Capital Markets Disclosures Company Name Stock Ticker Disclosures Company Name Stock Ticker DisclosuresAmerican International Group AIG General Motors GMApple AAPL 2 Goldcorp GG 1, 4Bank of America BAC Goldman Sachs GS 3, 4Barrick Gold ABX 1, 3, 4 Google GOOG 2BHP Billiton BHP International Business Machines IBMBNP Paribas BNP.PA JPMorgan Chase JPM 1Bristol-Myers Squibb BMY Nasdaq NDAQCisco Systems CSCO 2 Newmont Mining NEM 4Citigroup C 1 NYSE Euronext NYXCredit Agricole ACA.PA Potash POT 1, 3, 4DuPont DD Societe Generale GLE.PAExxon Mobil XOM UBS UBS(1) BMO Capital Markets or its affiliates owns 1% or more of any class of common equity securities of the company.(2) BMO Capital Markets makes a market in the security.(3) BMO Capital Markets or its affiliates managed or co-managed a public offering of securities of the company in the past twelve months.(4) BMO Capital Markets or its affiliates received compensation for investment banking services from the company in the past twelve months.(5) BMO Capital Markets or its affiliates expects to receive or intends to seek compensation for investment banking services from the companyin the next three months.(6) BMO Capital Markets has an actual, material conflict of interest with the company.
  3. 3. Don CoxeTHE COXE STRATEGY JOURNALThe Deficient FrontierSeptember 16, 2011published byCoxe Advisors LLPChicago, IL
  4. 4. THE COXE STRATEGY JOURNALThe Deficient FrontierSeptember 16, 2011Coxe Advisors LLP.Author: Donald Coxe 312-461-5365 dc@coxeadvisors.comEditor: Angela Trudeau 604-929-8791 at@coxeadvisors.com190 South LaSalle Street, 4th FloorChicago, Illinois USA 60603Basic Points is published exclusively for BMO Financial Group and distributed by BMO Capital Markets Equity Researchfor clients of BMO Capital Markets, BMO Nesbitt Burns, BMO Harris Private Banking and Harris Private Bank.BMO Capital Markets Equity ResearchManager, Publishing: Monica Shin monica.shin@bmo.comDesktop Publishing and Anna GoducoDistribution Coordinator
  5. 5. The Deficient FrontierOVERVIEWSince mid-May, we have been growing increasingly bearish about the stockmarkets and the economies of Europe and, to a somewhat lesser extent, theUSA.In our Conference Call on August 12, we moved Recommended Equity exposureto the bottom of our 40 - 60 pension fund range.Our core concern has been the breakdown of public finances, particularly in theeurozone, which is undermining the traditional Capital Asset Pricing Model.European banks are collectively heavily over-levered, and any "haircuts" tothe valuations of eurosovereign bonds could be devastating to the financialsystem. In a momentous paradox, the epicenters of European risk today arenot toxic mortgage securities or junk bonds, but the debts of overindebtedand underachieving eurozone nations. The financial crises in the eurozone arerooted in the breakdown of the Risk-Free Rate of Return on government bonds,which exposes many European banks—particularly the major French banks—totowering levels of risk, thereby rendering Basel III valuations near-useless.The Atlantic has not proved to be a secure moat for financial models in theUnited States: Collateral Debt Swap pricing for Treasurys now costs slightly morethan the pricing of prime corporate debts, and major American banks and moneymarket funds have huge exposures to struggling European banks.The once-impregnable Efficient Frontier is becoming the Deficient Frontier,pushing pension fund risk/return projections into no-mans-land.There would never be a good time for an implosion of the risk models that haveserved banks, pension funds, and other financial institutions so well for so long.But a time when economic weakness is intensifying and spreading across theOECD is a uniquely grim time for an existential challenge to risk managementsystems.It is fair to say that investors in eurozone banks—and institutions lending tothem—are assuming unknowable levels of risk. Whatever those risks are today,they can only worsen if, as seems probable, a recession engulfs Europe.This month we suggest a new approach to portfolio design in our pensionfund models at a time of near-record-low short-term interest rates and verylow confidence that the bullish consensus of summer will survive the chills ofautumn. We suggest a strategy of scaling back beta exposure in favor of very highquality dividends.We are retaining our very cautious portfolio recommendations issued lastmonth. September 2011 1
  6. 6. 2 September 2011 THE COXE STRATEGY JOURNAL
  7. 7. The Deficient FrontierI. European Banks Risk-Free Exposures Become Disease CarriersGerman DAX IndexSeptember 14, 2010 to September 14, 20118,0007,5007,0006,5006,0005,500 5,508.245,000 Sep-10 Nov-10 Jan-11 Mar-11 May-11 Jul-11 Sep-11French CAC 40 IndexSeptember 14, 2010 to September 14, 20114,3504,1503,9503,7503,5503,3503,150 3,045.622,9502,750 Sep-10 Nov-10 Jan-11 Mar-11 May-11 Jul-11 Sep-11Italy FTSE MIB IndexSeptember 14, 2010 to September 14, 201125,00023,00021,00019,00017,00015,000 14,642.7213,000 Sep-10 Nov-10 Jan-11 Mar-11 May-11 Jul-11 Sep-11 September 2011 3
  8. 8. The Deficient Frontier Spain IBEX 35 Index September 14, 2010 to September 14, 2011 11,500 11,000There is, (we were to 10,500learn to our horror 10,000in 2008) a literary 9,500model for the creation 9,000of these financial 8,500horrors— 8,337.90 8,000Mary Shelleys classic 7,500Frankenstein. Sep-10 Nov-10 Jan-11 Mar-11 May-11 Jul-11 Sep-11 The financial crisis and crash of 2008 were rooted in American "risk-free" assets—AAA-rated collateralized mortgage securities. It turned out they should have been rated TTT—for toxicity. There is, (we were to learn to our horror in 2008) a literary model for the creation of these financial horrors—Mary Shelleys classic Frankenstein. They were confected by amoral geniuses and immoral associates through the blending of small quantities of healthy financial tissues with large dollops of polluted financial tissues to deliver a falsely reassuring appearance, fooling the rating agencies into characterizing them as financial super-entities endowed with the AAA ratings that had previously been largely the preserve of well-run governments fully backed by the taxation systems of strong economies. Under the Basel rules, banks which bought these supposedly superb agglomerations, did not have to allocate any of their regrettably scarce capital to support them on their balance sheets. A typical bank bulking up on these attractively-yielding wonders was, unknowingly, in the position of a US army regiment in Europe during World War I, filling its barracks with recruits off the latest troop ship who were carrying the flu virus. The Crash of 2008 that nearly disemboweled many major US banks was spawned in the toxic relationship between Wall Streets factories and the more demagogic elements of Congress, eager to use Fannie, Freddie and rules against bank "discrimination" to force-feed mortgage lending to— or even above—real home values to borrowers who had little or no evidence of their ability to service such debts. The Ninja Mortgage—no income, no job, and no assets—was the crowning achievement of that process. Barney Franks name is on the legislation passed to prevent future bailouts—4 September 2011 THE COXE STRATEGY JOURNAL
  9. 9. a wondrously hilarious restatement of financial and economic history.That one of Congresss biggest boosters of bad lending practices should beco-author of laws allegedly designed to prevent repeats of such disasters is adelicious self-parody of Congressional misbehavior. "From here on, wereThe Made-In-The-USA mortgage catastrophe should have merely flattened going to invest ourfinancial institutions here. Astonishingly, many major and mid-sized capital in good, safeEuropean banks loaded up on these Financial Frankenstein Monsters. government bondsWhy, we wondered, would banks and pension funds abroad buy these issued by members ofFrankensteinian blends of Wall Street and Washington greed, and disastrous the eurozone!"design? That their face value ran into the trillions was rooted in blind faith inAAA mortgage product ratings, without considering that collapsing middleclass fertility rates precluded a new housing boom: the naught decade middleclass generation was roughly 60% the size of its predecessor, so house pricesin aggregate could hardly be expected to go up the way they had when fertilityhad been strong—as it had been since Plymouth Rock.Sadly, the bursting of the US real estate bubble inflicted huge damage on thepsyches and balance sheets of leading European financial institutions whosemanagements had believed, (as a German banker recently told MichaelLewis), that the US was a rules-based society. Result: many leading Europeanbanks—including even some top Swiss banks—had to be bailed out by theirgovernments."Never again!" was the motto of regulators, risk managers and investors."From here on, were going to invest our capital in good, safe governmentbonds issued by members of the eurozone!"That some members of the eurozone had histories of revolutions, civil warsand/or defaults within living memory was dismissed as irrelevant. In anefflorescence of enthusiasm about the wondrous new currency that wouldsupplant the dollar as the global #1 currency, European banks loaded up onall the risk-free eurobonds they could buy: in particular, they loved to buybonds from Portugal, Ireland, Italy, Greece and Spain—five countries eagerto borrow big at rates ranging to 16 basis points above the rate available ongood-as-gold German Bunds.None of the European banks who bought truckloads of these bonds seemedthe least concerned that these countries had never previously been able toborrow at such modest premiums to Bunds. The bankers were as gobsmackedby Jacques Delors effulgent vision of a eurozone that would outperform theUSA and ratify the European social contract, as were his fellow elitists whoworked with him on the master plan that led to the Maastricht Treaty andthe euro. September 2011 5
  10. 10. The Deficient Frontier As bad luck would have it, a wag in Goldman noted that those five big borrowers and spenders with suspect track records could be collectively nicknamed PIIGS. The five PIIGS were happily feeding at the eurobond trough when the IrishThe five PIIGS were crisis of 2008-9 forced the Emerald Isle into bailout mode.happily feedingat the eurobond That shock made some eurobankers begin to think the unthinkable—Whattrough... about Greece, Portugal, Spain and Italy? And then the first existential crisis burst on the scene. KBW European Large-Cap Bank Index (KEBI) January 1, 2008 to September 14, 2011 70 60 50 40 30 20 19.42 10 0 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 KBW European Mid & Small-Cap Bank Index (KMBI) January 1, 2008 to September 14, 2011 70 60 50 40 30 20 14.99 10 0 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-116 September 2011 THE COXE STRATEGY JOURNAL
  11. 11. The European banking system has been lurching from crisis to crisis formore than a year. Greece, which led the way to the creation of Europeancivilization, is leading the way to European disintegration. As this is written,short-term Greek government debt is yielding 85%, but the European CentralBank (ECB) is holding down rates on longer-term benchmark Greek debts to Greece, which ledteens by large-scale buying. the way to the creation of EuropeanThe ECB has had to become the buyer of first and last resort for other PIIGS civilization, is leadingofferings, and investors are already looking ahead to Italys need to roll the way to Europeanover €400 billion in bonds over the next two years—apart from funding its disintegration.operating deficits.Jean-Claude Trichet of the ECB is obviously looking over his shoulder at theplight of the big French banks. On Monday, Societe Generale shares fell toa 20-year low, accompanied by double-digit declines for BNP Paribas andCredit Agricole. (Since June, those banks shares are down, on average, more than50%.)We have considerable sympathy for the overworked Trichet, who hasperformed heroically, as the debt of one PIIG after another begins to emitnoxious odors. He even had the courage to respond to rising food and fuelinflation by raising the eurozone interest rate in the midst of the latest financialcrisis. He has visibly aged, and will be replaced the day after Hallowe-en—bya respected Italian, Mario Draghi.Although Greece’s unions and leftist radicals still manage to capture headlinesand strangle the nations economy, the real challenges to the survival of theeuro—and much of the European banking system—come from Italy and,to a lesser extent, Spain. (Ireland and Portugal are broke, but mostly polite,and dont grab global headlines by trashing cars and buildings or publiclyravaging what is left of their economies.) September 2011 7
  12. 12. The Deficient Frontier Forza Italia! At the moment, it is possible that Italy will be nearing mendicant status within months after Mr. Draghi takes office: Italys notably uncivil servants...with all his faults, took to the streets last week to protest Premier Berlusconis first real attemptBerlusconi has to impose something approaching austerity on Italys finances.provided more stability We are not among those Puritans—including the editors of The Economist—whofor the fissiparous and have been demanding that Silvio Berlusconi step down. As we wrote whenbarely-governable Italy his plight first moved to Page One, with all his faults, Berlusconi has providedthan almost any of his more stability for the fissiparous and barely-governable Italy than almost anypredecessors... of his predecessors. Italy was put together by Garibaldi, Cavour and King Vittorio Emmanuele in the Risorgimento out of a large collection of states, city-states and Papal States 150 years ago. Much of what is important in the history of the Middle Ages, the Renaissance and the Enlightenment was achieved despite seemingly endless wars and coups. (Ironically, apart from Puccini, Lampedusa, Eco and some great film-makers, the quality of the cultural output since Italy became a united country isnt at the level of the Renaissance or Enlightenment eras, when internecine warfare was a persistent pastime.) The greatest of modern Italian novels, The Leopard, which covers the period of unification, includes a memorable quotation from one of the young liberals who had fought in the revolution: "Everything must change so that everything can stay the same." That pretty much sums up modern Italian history. The North provides the economic dynamism, and Rome the government, while most of southern Italy and Sicily is ruled—if at all—by the Mafia and/or the Church. Mussolini tried to give this nation a sense of destiny through fascism—an attempt to revive the glory of Rome through semiotics and slogans—and ill-starred African invasions. But he could not disguise the essential evil and outright absurdity of fascism. He had to be propped up by Hitler, destroying the last vestige of his claim to be the New Roman, and met justice at the end of a rope. Few of his successors have had much success in imposing a national consciousness and an effective government on Italy. Governments tended to stay in power only long enough for the leaders to pay off their supporters and were then succeeded by others with different labels and similar cynicism.8 September 2011 THE COXE STRATEGY JOURNAL
  13. 13. Berlusconi, a TV magnate, had surprising success in raising the nationalconsciousness, using the soccer slogan Forza Italia! as his party designation.Italy may well have been governed better during his tenure than at almost anytime since Constantine moved the capital of the Empire to Constantinoplein 330. Italy may well have been governed betterBut not by much. during his tenure thanTaxes still arent collected reliably. The far-Left unions continue to block at almost any time sinceindustrial progress and the far-Left civil service unions continue to impede Constantine moved theattempts to open up the economy and operate public systems honestly. Those capital of the Empire torioters you see on TV are collectively well-paid: according to Bridgewater, Constantinople in 330.Italian unit labor costs since the euro appeared are up more than those inany other large European economy—40%.Despite his obvious faults, we are inclined to view Berlusconi as a raffishrogue, with a deep appreciation of the Italian love of the bella figura—thestriking face, image, gestures and self-assurance. In the midst of the crisis thissummer, responding to a prosecution about his involvement with an under-aged woman, he appeared in Sicily and told a crowd, "The latest poll asked1,000 Italian women, Would you like to sleep with Berlusconi? One-thirdsaid Yes and two-thirds said What? Again? "The sands in Berlusconis hourglass are finally running out; he will probablynot survive this latest crisis.Nor, we suspect—sadly—will Italy or, ultimately, the euro.Italy is too big to fail and too big to bail....And too inefficient, indebted and corrupt to succeed.This just in: the Dow is rallying strongly this afternoon because of word out ofItaly of a potential new one-off wealth tax of €400 billion that would make Italianbonds look magnifico—and do wonders for the beaten-down share prices of those bigFrench banks which collectively have made the biggest French commitment to Italysince Napoleon—stuffing their coffers with €400 billion in Italian bonds.To us, the chances of passing—and enforcing—such a tax are equivalent tothe chances of making Italian the sole acceptable language at meetings of alleurozone agencies—and the European parliament.But we had a smile as we were reading the breathless stories, seeing the finehand of the irrepressible Berlusconi at work.Hell be missed. September 2011 9
  14. 14. The Deficient Frontier The Rescuers The European Financial Stability Fund (EFSF) has been working with the International Monetary Fund (IMF) and the European Central Bank to...eurozone sovereign prevent defaults or other crises that could put the eurozone at risk.debt problems are the More or less by organizational default, Germanys Angela Merkel has beenbiggest problem facing forced into the role of unhappy savior of the euro.OECD financial markets. New eurozone bailout agencies have been springing up, causing some challenges for the acronymically challenged. Last week, the eurobailout era was given a crucial reprieve, when Germany’s Constitutional Court upheld Germanys backing for the EFSFs projected payments to Greece. Although leading analysts assured the markets that the court would back Angela Merkels tottering regimes participation in the eurozone rescues, the announcement triggered a huge stock market rally across Europe, and a 275 point leap on the Dow. Tellingly, at New York, the BKX (the index for the B5—the Big, Bad, Bonused, Bailout banks and some others) had one of its best days in a year, leaping 5.9%—and gold gapped down $40 after the announcement and closed down $55.70. We cite those massive market responses to what was supposedly a foregone court decision in support of our longstanding argument that eurozone sovereign debt problems are the biggest problem facing OECD financial markets. But the Court didnt endorse new blank checks and Brussels bailouts: it insisted that the Bundestag must ratify each new deal—including the pending Greek bailout. The first Greek bailout triggered the resignation from the ECB board of Axel Weber, former Bundesbank CEO. The prospect of a second was, it would seem, the reason his successor, Jurgen Stark, resigned suddenly—citing "personal reasons." In theory, despite those high-profile resignations and polls showing widespread voter resistance to further bailouts, the Courts stipulation of Bundesbank assent should not be a problem: the leftist opposition to Merkels center-right coalition is, of course, enthusiastic about shoveling out skys-the-limit aid to governments that are either socialist, spendthrift, or both.10 September 2011 THE COXE STRATEGY JOURNAL
  15. 15. But Merkels own coalition is unraveling, as it loses one regional electionafter another. In the most recent vote, in her homeland of Mecklenburg-Western Pomerania, her partys vote plunged and the Free Democrat Party,the conservative conscience of her coalition, was annihilated. Deutschland über allesMerkels Christian Democratic Union and Christian Social Union supporters has been cleansedare fed up after more than a half-century of picking up the biggest share and sanitized toof the tab for Brussels vast spending programs—and two years of bailouts read Deutschlandfor profligate PIIGS—with no end in sight. Middle-class Germans note— pays for alles.bitterly—that the rest of Europe didnt chip in for the €100 billion costs ofrescuing East Germany after the Fall of the Wall.Some analysts report that, despite defections from her own parties, MerkelsGreek bailout bill should pass the Bundestag because of support from theOpposition. But that would be a terrible humiliation for the Chancellor andwould probably be the beginning of the end of her government.It might also signal an important shift in European politics: after yearsof center-right rule in most of Europe, the Left could be on the verge of amajor comeback, as voters worry about their politically-promised perksand pensions. In France, even Dominique Strauss-Kahns implosion hasdone little to raise Premier Sarkozys pitiful poll standing—with an electionlooming next year. The Strauss-Kahnless Socialists are strongly favored.Markets rallied strongly Wednesday on the report that EU CommissionPresident Manuel Barroso will be presenting optional routes for creating andissuing eurozone bonds. (Mr. Barroso, a former President of Portugal, is nowEurocrat-in-Charge atop the vast EU bureaucracy.)Eurozone bonds—the unholy grail of europhiles—would be backed by thefull faith and credit of all members. This "Solidarity forever" instrumentwould mean that all members would be, in theory, equal as guarantors,but investors would pay on the basis of Bund yields. Angela Merkel swiftlyruled out such asymmetric involvement, knowing of its huge unpopularity athome. But the eurocrats will try to keep the pressure on—thereby protectingtheir own privileges and pensions. Deutschland über alles has been cleansedand sanitized to read Deutschland pays for alles.How bad is the situation now? The Wall Street Journal quotes an unnamedexecutive for Bank Paribas, "We can no longer borrow dollars... Since wedont have access to dollars, were creating a market in euros...we hope it willwork, otherwise the downward spiral will be hell....and no one will lend tous anymore." September 2011 11
  16. 16. The Deficient Frontier The Journal cites BIS statistics showing that the three biggest French banks held "nearly $57 billion in Greek sovereign and private debt vs. $34 billion held by the largest German banks. French banks held more than €140 billion in total Spanish debt and almost €400 billion in Italian debt as of December."As noted Fabian Socialist The Journal continues..."Now that the situation is bordering on catastrophe,George Bernard Shaw analysts are suggesting that the government is set to start nationalizing Frenchlong ago observed, banks.""He who promises to robPeter to pay Paul can The situation will get worse: its baked into the socialist principles underlyingcount on Pauls vote." the EUs social contract. As noted Fabian Socialist George Bernard Shaw long ago observed, "He who promises to rob Peter to pay Paul can count on Pauls vote." Peter and friends have long been generating the wealth that Brussels has been dispensing. Now that monstrous new demands are being made monthly on Peter and friends, Paul and friends are getting anxious—and feel a strong need to take political power to ensure the handouts and bailouts not only continue—but grow—even as the European economy contracts. Thats just sensible socialism. As everywhere else, there are more Pauls than Peters in the eurozone. In Greece, the Pauls so far outnumber the Peters that the nation needs to raise €140 billion in loans within weeks. (That internal divide between Peters and Pauls might even become a potent political force in the USA: latest statistics show that nearly half of Americans pay no income tax and roughly 70% receive more from Washington in Social Security, Medicaid, Medicare, food stamps and other goodies than they pay in taxes. As the President explains his policies, "Were all in this together and its time that the rich paid their fair share." When will the upper 30% of the population begin arguing that in Europe and Canada, Value-Added Taxes— paid by all consumers—finance a big chunk of the costs for health care and other universal benefits. The US has no VAT.)12 September 2011 THE COXE STRATEGY JOURNAL
  17. 17. II. The Third Neo-Stagflationary Recession?A decade ago, the US was entering a recession. Three years ago, the US, andmost of the OECD were entering a recession. Many observers—includingus—think that the US and OECD are on the cusp of another recession. At the bottom of thatThere is a precedent. brutal bear market (August 1982),The last time three recessions occurred in one decade was during the the constant-dollarstagflationary Seventies, with recessions in 1970, 1974, and 1980—which Dow-Jones Industrialswas briefly interrupted to be swiftly followed by an even deeper recession traded atthat lasted into 1983. The last of those recessions began with oil and gold October 1929 levels.prices at all-time highs, and inflation at a near-record high, triggering thethird bear market. At the bottom of that brutal bear market (August 1982),the constant-dollar Dow-Jones Industrials traded at October 1929 levels. Inreal terms, a long-term investor had barely broken even on a 53-year hold—apart from dividends.How does recent experience mimic that melancholy past?As this journal was going to press, we note that todays major US economicreports included the second straight month for deeply-negative PhiladelphiaFed and Empire State Indices, an unexpected increase in weekly jobless claims,a year-over-year rise in CPI to 3.8%, which was 2% ex-food and energy, and adecline in workers real earnings of .8%—against expectations of -.1%.Not a good day.As for other signs in recent months:• Gold prices reached all-time highs;• Oil prices touched all-time highs just before the recession of 2008 began, and rallied again this year—although not to previous peaks;• Prices of most other commodities—including the Three "Big Cs"—cotton, corn and copper— touched record highs;• Economic growth rates coming out of the recession have been modest; GDP growth in the US and Europe in the past 11 months has been barely perceptible—driving unemployment rates higher at a time of painful fiscal deficits;• Voters faith in their governments abilities to manage economies has eroded sharply, and few political leaders (apart from Canadas Stephen Harper) have reason to feel politically secure. September 2011 13
  18. 18. The Deficient Frontier The biggest difference between the Seventies and now is that interest rates and inflation rates today are at levels that Seventies governments and investors would have considered Heaven-sent. So why refer to stagflation?...interest rates andinflation rates today Because producers of foods, fuels, and metals have been among the biggestare at levels that winners (other than the trial lawyers) in this decade—after two decades ofSeventies governments misery.and investors would Contrast the performance in this decade of what was—albeit briefly—thehave considered most-valuable stock in 1999 with that of the worlds biggest oil company,Heaven-sent. the worlds biggest mining company, and the worlds the worlds biggest fertilizer company: Cisco Systems (CSCO) January 1, 2000 to September 14, 2011 80 70 60 50 40 30 20 16.67 10 0 Jan-00 Apr-01 Jul-02 Oct-03 Jan-05 Apr-06 Jul-07 Oct-08 Jan-10 Apr-11 Exxon Mobil (XOM) January 1, 2000 to September 14, 2011 105 95 85 75 74.01 65 55 45 35 25 Jan-00 Apr-01 Jul-02 Oct-03 Jan-05 Apr-06 Jul-07 Oct-08 Jan-10 Apr-1114 September 2011 THE COXE STRATEGY JOURNAL
  19. 19. BHP Billiton (BHP)January 1, 2000 to September 14, 2011120100 Dull stuff is 80 78.78 outperforming 60 brilliantly-engineered wonder products. 40 20 0 Jan-00 Apr-01 Jul-02 Oct-03 Jan-05 Apr-06 Jul-07 Oct-08 Jan-10 Apr-11Potash Corporation (POT)January 1, 2000 to September 14, 2011807060 57.145040302010 0 Jan-00 Apr-01 Jul-02 Oct-03 Jan-05 Apr-06 Jul-07 Oct-08 Jan-10 Apr-11Yes, Apple (AAPL) and Google (GOOG) have been spectacular performers,but Nasdaq is back to where it was a dozen years ago. Without those twosensations, its performance in recent years would have been dull. Technologybecame an even bigger part of the global economy in this decade than itsmost enthusiastic boosters in the 1990s would have predicted. However,ease of entry, ease of technology theft, and relentless competition havemeant that most tech products have proved to be commodities that generatelower profits than those received by producers of industrial commodities orprecious metals. Dull stuff is outperforming brilliantly-engineered wonderproducts. September 2011 15
  20. 20. The Deficient Frontier An OECD economic cycle in which prices of foods, fuels and precious metals rise far more strongly than prices of manufactured goods—or workers wages—is inherently stagflationary. A greater and greater share of total consumer spending goes to the commodity producers who own the farmland,Bernanke and Obama the mines or the oil wells. The industrial and service-based economies findare challenging they cannot deliver the kind of strong, sustained, low-inflation economicconventional growth that was the pattern for most of the postwar era.economics— During the Seventies Stagflation Era, OECD demand drove food, fuel andand winning. metals prices at inflationary rates.At least for now. This time, consumers in the OECD are paying uncomfortably high prices for food, fuel and industrial metals because of soaring demand from the new economic powerhouses of the Third World. Inflation is being imported—not caused—by the US and Europe. Apart from the wages and benefits costs for some powerful public employee groups, workers are unable to improve their incomes more rapidly than their costs for foods and fuels. This is a paradox: • Led by the Greenspan and Bernanke Feds, OECD central banks have printed money at astonishingly high rates; • Led by Obama and many leaders in the eurozone, OECD nations have collectively been running deficits that make the profligate Western governments of the Seventies look positively Puritanical. Yet overall nominal CPI rates have, (until recent months) remained benign, giving central bankers justification for aggressive monetary expansions. Right-wing activists may fulminate that money-printing and deficits have produced terrible inflation, but—commodities apart—the evidence is hardly persuasive. Bernanke and Obama are challenging conventional economics—and winning. At least for now.16 September 2011 THE COXE STRATEGY JOURNAL
  21. 21. What? We Worry?With major stock markets across the world in bearish mode, and a newglobal banking crisis looming, the S&P is not in deeply bearish mode andfew economists are predicting a recession. Eurosclerosis, many of our critics feel,S&P 500 is not necessarily aSeptember 14, 2010 to September 14, 2011 transmissible disease.1,4001,3501,3001,250 1,209.111,2001,1501,100 Sep-10 Nov-10 Jan-11 Mar-11 May-11 Jul-11 Sep-11Naturally, we are being asked daily about our dour outlook for US stocks andthe US economy. Are we overdoing it? Eurosclerosis, many of our critics feel,is not necessarily a transmissible disease.We hear several reasons for this calm reaction to bad news. The dollar hasstopped plunging and, mostly because of the 58% weighting of the euro inthe DXY, has been strengthening recently:US Dollar Index (DXY)January 1, 2010 to September 14, 20119088868482807876 76.35747270 Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10 Jan-11 Mar-11 May-11 Jul-11 Sep-11 September 2011 17
  22. 22. The Deficient Frontier 1. Treasurys have been in a runaway bull market as global investors rush to what looks—at the very least—like the best of a bad lot of government bonds. Among major benchmark government bonds, only Bunds (–0.24), JapanSo much for the scare (–0.98), Sweden (–0.23) and Switzerland (–1.10) yield less than that the world So much for the scare talk that the world would stop financing runawaywould stop financing US deficits.runaway US deficits. 10-Year US Treasury Yield January 1, 2011 to September 14, 2011 4.0 3.5 3.0 2.5 2.07 2.0 1.5 Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11 2. American energy costs are the lowest in the industrial world, with Natgas at $4, and West Texas at $89—compared with the new global benchmark—Brent—$109. 3. Americas domestic political fissures are wide and widening, and Obamas political approval ratings have been weak and falling, but (as noted above), incumbency is no political advantage almost anywhere these days. Obama still has unique charm, and, as he showed last week, when he reaches back to the platform dynamism that mesmerized not just the US, but much of the world—including the Nobel committee, he is formidable. His approval ratings are falling, but which other OECD leader has such magnetism? And which of the Republican candidates has the right ingredients to knock him off his pedestal? 4. The huge US commitments to Iraq and Afghanistan are trending down and will shrink to mere nuisance range within a year. 5. The rest of the world doesnt have companies such as Apple. The US still leads the world in innovation.18 September 2011 THE COXE STRATEGY JOURNAL
  23. 23. 6. US companies profits have remained strong even as the economy weakens—and they hold record levels of cash.7. Smart young people from all over the world still rush to attend American universities. We long ago lost our8. Thanks to Dodd-Frank, the problems of the US financial system are being confidence in the addressed, and an economic slowdown—or even a mild recession—will oft-trumpeted restraint, not produce a systemic financial crisis à la 2008. shrewdness, and honest financial reporting9. Just about the only economists and pundits who are bears on stocks and of many of the major predict a US economic downturn have been doom-and-gloomers for years. banking institutions... Why believe them now?10. The run-up in gold is merely a bubble blown up by over aged cranks and is of no economically-predictive value.11. Finally, (and most often cited), the multiple on the S&P is at bargain levels; only a financial recession could make buying US stocks now a bad idea. It’s always darkest just before the dawn.We find the first eight arguments persuasive—in varying degrees. We stronglydisagree with #10; as for #9, we have deep respect for at least two prominentbears—David Rosenberg, of Gluskin Sheff + Associates, and Stephanie Pomboyof MacroMavens who have been consistently and cogently challenging #11.The Big Banking Problem for BullishnessWe became increasingly nervous that those smart seers were bang-on aboutthe fundamental US economic weakness as the news from big banks becamemore worrisome, but we didn’t join their bearish camp until May. We heldout hope as long as we thought the rot, misrepresentation, mismanagementand delusions in the financial systems of Europe and the US would notnecessarily drag down the so-called "real economy."We long ago lost our confidence in the oft-trumpeted restraint, shrewdness,and honest financial reporting of many of the major banking institutionsthat are crucial for the US economy—all of whom are bigger than Lehman.But as long as there was even a fair chance that these drags on the economywould be skated onside by total economic and financial strength abroad, wewere prepared to keep our high recommended equity weightings. September 2011 19
  24. 24. The Deficient Frontier From decades of experience—some of it painful—we have learned that unsolved banking problems can trump pure economic performance in terms of stock market returns. Bad business managers usually wound only their investors and creditors; bad bankers, when acting in concert with each...bad bankers, when other—and with bad politicians—destroy entire economies.acting in concert with Although the US banks are in better shape than their European counterpartseach other—and because they arent stuffed to their aortas with toxic risk-free bonds, theywith bad politicians— dont engender confidence.destroy entireeconomies. JPMorgan Chase (JPM) January 1, 2007 to September 14, 2011 55 50 45 40 35 33.81 30 25 20 15 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Bank of America (BAC) January 1, 2007 to September 14, 2011 60 50 40 30 20 10 7.33 0 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-1120 September 2011 THE COXE STRATEGY JOURNAL
  25. 25. Citigroup (C)January 1, 2007 to September 14, 2011600500 Do Wall Street CEOs400 have fat wallets and300 thin skins?200 Lloyd Blankfein responded to criticisms100 by saying he was doing 28.59 0 Gods work. Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11KBW US Bank Index (BKX)January 1, 2007 to September 14, 2011140120100 80 60 40 38.85 20 0 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11Each of those three giants was bailed out—or substantially helped—by thetaxpayers. The rage that would find its expression in the Tea Party came—inconsiderable measure—from those bailouts.How have the big bailout banks behaved since then?Is the Tea Party merely a collection of ignoramuses who dont understandhigh finance?JPMorgan has been much in the news this year, partly because CEO JamieDimon says hes sick and tired of being criticized by politicians. He also saysthat Basel IIIs rules are "anti-American" and it might be wise for the US topull out of Basel. (Do Wall Street CEOs have fat wallets and thin skins? LloydBlankfein responded to criticisms by saying he was doing Gods work.) September 2011 21
  26. 26. The Deficient Frontier We wonder what Ben Bernanke would say about Dimons contribution to the economic recovery if he were free to comment. Bernanke has been pumping astounding quantities of reserves into the banks to stimulate the moribund economy. Mr. Dimon helps himself to gobs ofMr. Dimon helps that stimulus money and the returns on the almost-free FDIC-guaranteedhimself to gobs of deposits to buy back his stock—$4.3 billion worth this year. (Not quitethat stimulus money true: thats what he spent—as of now, those shares are worth about $3.6and the returns on billion. He was buying big when the stock was in the high forties. Its calledthe almost-free FDIC "generating shareholder value" by returning money to the stockholders.guaranteed deposits Dimons investment expertise could, perhaps, be questioned, but there areto buy back his stock— lots of finance professors whod say hes doing the right thing. Those smart$4.3 billion worth stockholders who looked at the economy and rushed to take Bernankesthis year. money as packaged by Dimon should be thanking Bernanke for improving their standard of living. Meanwhile, Ron Paul, the Tea Party and Rick Perry are calling for Bernankes hide because they think hes too cozy with Wall Street. ) Bank of Americas Brian Moynihan responded to Obamas call for business to hire more workers by announcing plans to fire about 30,000 workers. Of course, hes trying to deal with the disaster arising from his predecessor Ken Lewiss decisions to buy Merrill Lynch and Countrywide Financial. Those acquisitions were made in the depths of the worst financial crisis since the Depression—when BAC stock was selling for more than twice todays price. The greatest retail bank in the USA decided to become the biggest bank in the USA by buying its way into Wall Street. (Full disclosure: we had strongly and repeatedly endorsed CEO Ken Lewiss performance at BAC for the years leading up to 2006. In response to a question from us about the scale of their Eurodollar liabilities at a meeting in our office in 2002, Mr. Lewis, grinned at his CEO and said, " Were proud to answer that question—and youre the first person whos ever asked us: the answer is zero! And were probably the only large institution in the world that can make that statement." We were impressed, and strongly recommended BAC stock for four years—arguing that such Bagehotian prudence warranted at least 2 points on the banks P/E. Four years later, as we examined his reports, we began to worry that he might be straying from the straight and narrow path. After repeated phone calls, we learned that BAC had abandoned this exemplary caution, and stopped recommending the stock, partly because we thought he should have told investors of his decision to join a club that included so many dubious members.22 September 2011 THE COXE STRATEGY JOURNAL
  27. 27. Citigroup stock is having a somewhat better year than it has had in its recentpast: it’s only down from $49 to $27. (As clients are aware, we consider Citia multi-strategy hedge fund masquerading as a bank and benefiting fromcheap deposits through that role-playing, managed by a former hedge fundmanager who got the largest signing bonus of our time, shortly before ...we consider Citipresiding over a 95% drop in its stock price.) That $49 valuation came when a multi-strategy hedgeits management finally figured out a way to get the stock price up—through fund masquerading as aa mammoth reverse split. (Our chart adjusts for this: the stock never traded bank and benefiting fromat $500: even Apple never got that high—Steve Jobs technique for taking cheap deposits throughAAPL from $9 to $390 differs somewhat from Wall Streets shareholder value that role-playing,concepts.) managed by a former hedge fund manager whoWhy do we devote such analysis to these three mega-banks? They’ve certainly got the largest signinghad better years than most of their European counterparts. bonus of our time...But the melancholy reality is that Obama and Bernanke—and US equityinvestors—need these banks to be big parts of the solution to the problem ofmicroscopic economic growth.We know they all have huge exposures to European banks. Based on theirdemonstrated expertise in building shareholder value, we would not besurprised to find out that one or more of them is deeply worried about someof his banks euro-exposure.The Old World may be about to come to redress some imbalances in theNew.Returning to our list, as we discuss in the next section, we believe thatargument #11 (about a gold bubble) will prove to be 100% wrong. Gold istelling the political and financial elites what they dont want to hear. It is abig bet that the risk-free asset class—and the banks who bet on it—will proveto be a delusion almost as grotesque as the risk-free mortgage products thatcaused the crash.As for the last argument, if the big name Street economists who say theeconomic pause is past are right, thenBut we cannot help recalling the story of the eternal Wall Street optimist whofell off the top of the Empire State Building. As he was passing the 65th floorhe was heard to shout, "So far, so good!"But a possible politico-economic sea change of opinion might give investorsconfidence that high gold prices are here to stay.What if Obama and his counterparts in Europe decide to do a Roosevelt? September 2011 23
  28. 28. The Deficient Frontier III. Governments, Central Banks, and Gold Gold Holdings of Selected Central Banks and the IMF...why dont the big Tonnes United States 8,133.5holders revalue their IMF 2,814.0gold to, say, $2,200 BIS 119.0an ounce and declare ECB 502.1themselves willing EUROPEsellers at that price? Germany 3,401.0 Italy 2,451.8 France 2,435.4 Switzerland 1,040.1 Netherlands 612.5 Portugal 382.5 United Kingdom 310.3 Spain 281.6 Austria 280.0 Belgium 227.5 Sweden 125.7 Turkey 116.1 Greece 111.5 Poland 102.9 Source: World Gold Council, World Official Gold Holdings International Financial Statistics, September 2011 Perhaps the most enduring paradox in all finance is the way major governments and central banks treat their gold holdings: they ignore them. When nearly all OECD economies are running huge deficits at a time of near- zero interest rates, and nearly all governments are looking for ways to raise revenues without imposing economy-unfriendly taxes, why dont the big holders revalue their gold to, say, $2,200 an ounce and declare themselves willing sellers at that price—in bars or in bonds backed by gold—and willing buyers at, say, $2,000? Roosevelt revalued gold from $20.67 an ounce to $35 and declared that the US was a buyer and seller at that price. He also made it illegal for US citizens to own gold. By the end of the Depression, most of the worlds visible gold reserves were in Fort Knox.24 September 2011 THE COXE STRATEGY JOURNAL
  29. 29. Apart from all the jobs created in Nevada and other gold-mining states, thisattempt to introduce controlled inflation at a time of surging deflation was atleast mildly salutary. Having most of the worlds gold also proved extremelyuseful in helping to finance the recoveries in war-torn Western Europe. The best way to takeGolds roaring run to $1800 must be a huge embarrassment to the central gold out of its newfoundbankers. Why should investors be rushing out of government bonds into role as moral arbiter ofbullion? Dont they believe us when we tell them that printing all this money governments fiscal andisnt going to debauch the currency? monetary policiesThe best way to take gold out of its newfound role as moral arbiter of may be to cap it.governments fiscal and monetary policies may be to cap it.Yes, captious critics would say that this is the equivalent of buying abathroom scale whose highest reading is three pounds above the buyerscurrent weight.But desperate times call for desperate measures.The gold bugs have long proclaimed their own version of the Golden Rule:“He who has the gold makes the rules."By that standard, Barack Obama could become the leader of the worldovernight.Proclaiming a cap on gold and making all the gold in Western central banksvaults available for sale—or as backing for convertible bonds—would be a blowto speculators.Ironically, it would be good news for most gold mining stocks.And wonderful news for gold mine prospects that are barely more than ahole in the ground.Why?Back in the 1930s, gold mining stocks were stock market darlings. Who elsecould sell everything they produced to the government at a guaranteed price?Roosevelt was a hero to miners, prospectors and stock pushers.It was the golden age for penny gold stocks. Anyone could take a flutteron them. There were no lotteries, and the only legal gambling was churchbasement bingo games. Anybody with a dream and a drill hole was able topeddle his shares, and securities regulation ranged from lax to nonexistent. September 2011 25
  30. 30. The Deficient Frontier A story about an unexpected side effect of all the prospecting in that speculative era. Management of Gunnar Gold, one of the numerous speculative stocks of the early 1940s, thought it had a promising gold deposit in the Yukon. There wasWe believe a new era some funny impurity in the ore, but it didnt seem to worry which gold was Suddenly, the Canadian government nationalized the company—paying theback into the very stock market price, which was less than $2 a share. Only after the war wascentre of central banks over did the surprised shareholders learn that Gunnars ore was radioactive.operations would be The uranium it contained went to a hush-hush US government operation ina great time for gold Los Alamos and some of it ended up in the bomb bay of Enola Gay to beprospecting and gold dropped on Japan.mine development. Without the guaranteed price for gold, that mine might never have been discovered. We believe a new era in which gold was back into the very centre of central banks operations would be a great time for gold prospecting and gold mine development. As for the strong, well-financed producing gold mines with huge, politically- secure reserves—the Goldcorps, Barricks, Newmonts and their brethren— they would no longer be white chips: theyd be blue chips, paying secure dividends which, at a time of low-low interest rates, would be prized. The upward revaluation would permit some of the better-endowed PIIGS to issue gold-backed bonds at minuscule interest rates. As for the US, which has more gold than anybody else, and doesnt seem to have the faintest idea why it has it—or what to do with it—Obama could apply net sales proceeds directly to the deficits. The cap on gold would take a major bearish investment medium out of the stock market—gold bullion. For months, on the days stocks have gone down, gold has gone up. If gold were capped and governments combined their willingness to sell gold with a ban on naked short-selling of bank shares, and on naked Collateralized Debt Swaps, governments and banks might get a breathing spell. Why ban naked Collateralized Debt Swaps? Because they violate the centuries-old rule for insurance products—an insurable interest. When life insurance was first created in England, companies let anyone buy a life insurance policy on anyone else. Then they26 September 2011 THE COXE STRATEGY JOURNAL
  31. 31. found that those lives insured by people who weren’t personally related tothe life insured tended to die violently. So the concept of insurable interestdeveloped—just as the fire insurers had never let people buy insurance ondwellings in which they had no ownership interest. UBS had to be bailedAIG would never have gone down (at a cost to taxpayers of more than $100 out by Swiss taxpayersbillion), if it hadnt violated its insurance principles by going gung-ho into because it was leveredCollateralized Debt Swaps. more than 40 to oneAs the eminent Paul Volcker has said so often, why should economies and and had monstroustaxpayers be at risk for banks that get deeply into newfangled financial holdings of putrescentproducts? Western economies grew satisfactorily in the decades before all US mortgage paper.these monstrosities were developed, and the bank failures that happenedwere easily managed.Todays announcement that UBS has apparently blown $2 billion in itstrading operations is a perfect case in point: UBS had to be bailed out by Swisstaxpayers because it was levered more than 40 to one and had monstrousholdings of putrescent US mortgage paper. A great bank that had survivedfor more than a century as a pillar of Swiss prudence and rectitude had triedto become Goldman Swiss—and it lacked both the smarts and the capitalfor that remake. Less than three years later, its due to report a quarterly lossit blames on a rogue trader. Axel Weber of Bundesbank fame is due to takecharge next year of this organization whose financial structure in recent yearsseems to have been modeled on Swiss cheese.As the chart shows, hes needed now.UBSJanuary 1, 2007 to September 14, 2011706050403020 11.4110 0 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 September 2011 27
  32. 32. The Deficient Frontier Why do we devote so much space to making political proposals? Because we are deeply worried that another financial crisis is coming, at a time when governments bailut budgets are seriously constrained."If it moves, tax it; if it President Obamas long-awaited speech about his great plans for creatingstill moves, regulate it; jobs was greeted with reactions ranging from boredom to disdain. It wasif it fails, subsidize it." a highly-energized and well-delivered rouser. However, all he could do is promote a new batch of "shovel-ready" projects and jobs for teachers that would be financed by higher taxes on the rich. He is seen as someone who spent $800 billion on stimulus that didnt work, and hes now largely devoid of both ideas and money. Obama and his European counterparts look at the performance of shares of the big banks and must feel that, (as we put it in Basic Points), Naughts Had, Alls Spent. The government-owned gold that could provide such support to the leaders in the US and Europe is a nuisance to them, because its strong performance in the marketplace is a daily reminder of the futility of their seemingly endless crisis meetings and new acronymic rescue mechanisms backed by.......... what? Bernanke has expressed a yearning for some inflation (but not in foods or fuels) to help the hapless housing market. Obama has failed to put the economy on a growth path. Most of his Republican opponents are as doctrinaire as he—while mouthing different dated dogmas of equivalent futility. As Reagan put it, when the nation faced similar crisis, "If not us, who? And if not now, when?" (He also summed up the Democrats economic program pithily, "If it moves, tax it; if it still moves, regulate it; if it fails, subsidize it." That perfectly distills todays Demodogmatism. But the Republicans dogmatic refusal to permit any tax increases—even on the carried interest of hedge fund managers who create few jobs—is equally unhelpful. If there were ever a time to start accessing the gold Roosevelt bought at $35—and reducing endogenous risk in the global banking system—this is it.28 September 2011 THE COXE STRATEGY JOURNAL
  33. 33. Gold-backed bonds and gold for sale at $2,200 to all bidders would, ofcourse, be selling off "the family silver." But desperate times call for desperatesolutions. The biggest and most obvious asset Obama has is the one assetthat he supposedly cant touch. The biggest and mostWhy not? obvious asset ObamaLong-duration Gold-backed Treasurys paying, say, .5% interest would be one has is the one assetway of selling off much of the Treasurys hoard without swamping the cash that he supposedlygold market. cant touch.Those with long memories will recall when Jacques Rueff, DeGaulles gold Why not?guru, convinced France to issue some gold-backed bonds as proof that thenation didnt face serious inflation risk. Then came stagflation and the runawaygold market and those gold-backed bonds became fabulous investments.Most central bankers know that embarrassing story, which may precludetheir willingness to make any recommendations now. To be rememberedas the guy who sold gold at $2,000 in a long-term bond and gold went to$5,000 would be ghastly.But the reason why Rueff lost so big was that Nixon closed the gold windowin 1971 and then oil prices quadrupled and stagflation—which had neverexisted before—took charge. Under this tentative scenario, the US wouldtransfer all bullion needed to back the bonds, and Congress would passlegislation guaranteeing those gold bond conversions until the bondsmatured.Finally, the wise, witty folk at the Leuthold Group have published the Chartof the Year showing the cumulative total return on gold vs. the cumulativetotal return on the S&P since Nixon closed the gold window, repealing thecap on gold imposed by Bretton Woods.Remarkably, golds bull market in this millennium has meant that itsannualized return has caught up with the S&P—9.9% vs. the S&Ps 9.8%.If youd put a bar of gold in a vault and left it there for 40 years, youdhave slightly outperformed most equity investors. The S&P has been longproclaimed as proof of the triumph of American capitalism with its businessschools, management training, and superb collection of so many of theworlds greatest companies. Buy and hold the S&P and youre going to berewarded by the very best wealth-generators. Buy and hold gold and youreas outdated as believers in the phlogiston theory. September 2011 29
  34. 34. The Deficient Frontier This statistic could be used by Obama to argue that now is a good time to lock in the gold bull market by monetizing the nations holdings through various strategies and vehicles forty years after Nixon uncapped gold and 78 years after Roosevelt boosted it 70%.Why dont the The same strategy would apply to some of the more desperate Europeangovernments bring out nations. They have gold; they need to sell bonds and the market doesnttheir gold and use it to want them; their deficits are scary and theyre all supposed to retrenchback their bonds? simultaneously. Issuing long-term bonds with a fixed call on gold would make their bonds marketable. Most of the gold sitting in vaults in the US and Europe was accumulated at significant cost to the taxpayers of the time. It is performing no usual function at a time when it seems as if all governments—notably Switzerland—want the value of their currencies to decline. The reason nations wanted and needed gold was to back their currencies. Pawn shops and jewellery stores report high levels of gold cashouts from middle class people who are having trouble getting by. The point of gold is that for all of history, it has been the one certain thing that can be used to buy goods and services or discharge debts. Why dont the governments bring out their gold and use it to back their bonds? Obama should, in our view, try to find one non-Keynesian economist who understands gold to advise him. We’re sure he could get an old-fashioned scholar from the University of Chicago to help him out if he made a few calls.30 September 2011 THE COXE STRATEGY JOURNAL
  35. 35. Francly, Ma Chère, I Do Give a DamnIn our September 16, 2011 Client Conference Call, we discussed themomentous implications of Swiss Central Bank Governor Hildebrandsdecision to peg the Swiss franc to the euro. Francly, Ma Chère, I Do Give a DamnSwiss Franc vs. US DollarJanuary 1, 2010 to September 14, 20111. Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10 Jan-11 Mar-11 May-11 Jul-11 Sep-11The franc tracked gold for much of this year, as investors with a sense ofhistory bought the one currency that was a reliable store of value.The franc had that stature during the stagflation era.There were two prime reasons:1. Switzerland prized its status as an island of financial stability in an inflationary world, and gold was a major component of its foreign exchange reserves.2. Swiss banks were growing their managed assets rapidly, partly due to the allure of secrecy and tax dodging, but also because the rich wanted to own franc-denominated assets at a time the banks had a firm rule that 10% of each account had to be held in gold. As wealth denominated in other currencies was converted into francs, the upward pressure on the franc became enormous. September 2011 31
  36. 36. The Deficient Frontier By the late Seventies, the soaring franc was threatening Swiss industries— particularly watch manufacturing. So Bern imposed special taxes on capital inflows, and pegged the franc to the Deutschemark. Once the gold bull market turned into a crash, the ReaganIt could be deemed the recovery began, and the dollar entered a roaring bull market, the pressuresingular case of a crowd came off the franc.rushing from the safetyof a dock onto a sinking This time is different.ship. Or, possibly, Not only has the franc risen by nearly a third against the euro from early 2009leaving Haven for Hell. to last week, but Swiss residents have been switching their routine shopping needs to France, Germany or Italy, creating a crisis for Swiss retailers. This despite cutting Swiss rates to zero and massive forex intervention that has quintupled Swiss central bank holdings of euros, dollars, pounds and other currencies—including the Canadian dollar. Instead of the franc being a haven (which could be deemed earthly Heaven), the declared national policy now is to tie the currency and the economy to the euro. This is amazing. The currency that has long been synonymous with prudence and safety is adopting as its sole objective the fate of the only currency that lacks the backing of any government, tax system, army or navy—a mere meta- currency. It could be deemed the singular case of a crowd rushing from the safety of a dock onto a sinking ship. Or, possibly, leaving Haven for Hell. Speculators may still choose to use this period of euro-parity to sell euro- assets and buy Swiss assets—notably real estate—on the assumption that the endogenous risk in the euro is so great that it will eventually implode, forcing the Swiss to abandon their self-imposed peg. What particularly interests us is that this Swiss decision to replace the nations traditional protective systems from walls to Swiss cheese should mean massive new inflows into gold. Rhett Butler delivered his classic dismissal to Scarlett before walking out. Mr. Hildebrand is walking out on Swiss traditions that have been part of the national character for centuries.32 September 2011 THE COXE STRATEGY JOURNAL
  37. 37. IV. A Model for a Post-CAPM World1. Bullet-proof Dividend PayersWith the CAPMs elegant formulas and rules under daily challenge, and with The justifications usedhigh-grade bond yields so far below traditional funding assumptions, we for such programsbelieve institutions and high net worth investors should reconsider the rules are inherentlyused in portfolio construction. contradictory: they are said to be returningWe suggest that money to stockholders,1. The portfolios beta-rated Equities exposure—including stocks and but they actually give commodities—should be reduced to 35% in favor of income components funds only to those who for as long as the threats of financial crisis and recession remain highly want to sell their shares. visible. If we learned anything from the horrors of 2008, it is that life- threatening diseases within banking systems can overwhelm economies and equity markets.2. The Income sector—traditionally composed solely of debt instruments— should be reconstituted to include 10% in bullet-proof high dividend reliability stocks. Companies selected must have great dividend and dividend growth records—and must not be big allocators of cash in stock buybacks.The justifications used for such programs are inherently contradictory: theyare said to be returning money to stockholders, but they actually give fundsonly to those who want to sell their shares. If the companies also havegenerous stock option schemes for top executives, the programs could easilybe construed as being, at least in effect if not in design, cover-ups aboutthe real cost of such dilution, and as extra enrichment to the insiders byfinancing the purchase of their low-cost shares at higher prices. Dividendsgo only to those who choose to remain as partners in the enterprise. Stockbuybacks go only to those who want out—in whole or in part—or those whoare selling the stock short. It is unclear why those groups of investors shouldbe the objects of corporate solicitude or corporate cash.We recommend that investors using this approach to portfolio constructionassign the dividend stocks into a sector designated for five-year returns—àla private equity agreements. The portfolio should be measured against theyield for five-years Treasurys or five-year Canadas or Bunds. To illustrate:todays 5-year Treasurys yield .94%. Assume the dividend portfolio yields2.75% initially and increases at an thereafter at an expected average growthrate of 5%. (This would be a big part of the investment thesis: dont just buy September 2011 33
  38. 38. The Deficient Frontier high-yielding stocks, but buy those with acceptable yields and a corporate policy of increasing payouts.) All income above .94% would be credited to the book cost of the shares. At the end of five years the total return would be calculated—Market Value, less Adjusted Book Cost....dividends were— Those managing such portfolios would contact company managementsoverwhelmingly— about their dividend policies—not about earnings and capex forecasts. Wethe most important would expect that if this approach became popular, companies would changecomponent of equity their payout policies to qualify for inclusion in dividend portfolios.valuations by majorinstitutions for more The portfolio manager would ignore Street Buy, Sell or Hold recommen-than a century after the dations, which are overwhelmingly beta-based. Beta analyses would beadvent of joint stock crucial in the Equity portfolios.companies. But it has a lot of history behind it. Until the growth stock era of the 1960s, most pension funds and insurance companies invested in stocks for their dividends. (We well remember when we joined Mutual Life of Canada in 1970 that its largest stockholding was IBM. When we queried this, we were told that the company began buying IBM for its dividends during the Depression and kept reinvesting them for years. Then, when the holding became large and worrisome, they would sell off chunks, but the darned stock kept roaring back and kept boosting its dividends. We finally convinced management to sell one-third of the position when we argued that IBM could lose the Telex anti-trust lawsuit. We wrote a mock trial judgment based on the General Motors-DuPont Supreme Court decision. Fortunately for our investment career, thats the way the case went at trial a few weeks later. The NYSE had to open late the next day because of the torrents of selling and it took more than a decade for IBM stock to recover its former glory.) In fact, until very recently (as British actuaries measure these things), large British pension funds valued their stockholdings primarily on the basis of the reliability and potential growth of their dividends—not on increases in earnings or the P/E ratios. We recalled this last year after the BC Macondo disaster, when there was so much discussion about whether BP would pay its dividend—which was crucial for a huge amount of British pension fund assets. It is fair to say that dividends were—overwhelmingly—the most important component of equity valuations by major institutions for more than a century after the advent of joint stock companies.34 September 2011 THE COXE STRATEGY JOURNAL