Don Coxe Basic Points Nov. 2011


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It's The Banks, Stupid!

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Don Coxe Basic Points Nov. 2011

  1. 1. Basic PointsIts the Economy Banks, Stupid!November 18, 2011Published by Coxe Advisors LLPDistributed by BMO Capital Markets
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  3. 3. Don CoxeTHE COXE STRATEGY JOURNALIts the Economy Banks, Stupid!November 18, 2011published byCoxe Advisors LLPChicago, IL
  4. 4. THE COXE STRATEGY JOURNALIts the Economy Banks, Stupid!November 18, 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. Its the Economy Banks, Stupid!OVERVIEWToo many equity investors are getting sick of the stock market. Glowingcorporate earnings dont seem to matter anymore, and the market is subjectto absurdly wide price swings. Many American equity investors who arepulling money out of their mutual funds are telling advisors they think thestock market must be rigged.The seemingly endless pattern of risk-on risk-off days in European and NorthAmerican stocks which scares investors originates from the Wagnerian-scaledrama of the existential crisis of the euro, and the problems of Europeanand, to a somewhat lesser extent, American banks.These dramas play out against the backdrop of growing fears of a new globalrecession, which could, some analysts fear, be at least as challenging as itspredecessor, because governments have exhausted their bailout funds.We are not convinced that a North American recession is inevitable and, inany case, we doubt that its severity would approach 2008 levels. Zero interestrates and record deficits should be good cushions.This month we explain why investors should indeed be worried about thosebadly-managed Wall Street and European banks in the light of the collapseof their asset pricing models.But we suggest that those endless crises in the eurozone could very likelytrigger a policy response that would dramatically improve the outlook forEuropean banks—and stocks generally.We also consider the implications of the politicization of the Keystoneapplication in a broader context of debates on US energy policies. The Canadiangovernment and much of the Canadian oil industry were surprisingly naiveabout Keystones chances, actually believing that environmental issues werethe only barriers to an Obama OK.We are leaving our Asset Mix recommendations unchanged. November 2011 1
  6. 6. 2 November 2011 THE COXE STRATEGY JOURNAL
  7. 7. Its the Economy Banks, Stupid!The wise Northrop Frye once told students of a trans-continental trip he hadtaken in the observation car of a train. He noted that passengers could chooseseats that faced forward or backward. This was a option not available to thepioneers who came by foot, horseback or canoe. They had to look ahead. ...the men who runHe said that those train passengers who looked backwards were reflecting big US and Europeanon where they had been, and that this was, on balance, a better strategy banks are collectivelythan looking ahead, because one could gradually build ones understanding the most publiclyabout the land—and the nation—without trying to peer ahead to what controversial segmentwould come next. of Big Business...We are going to follow Fryes precept by beginning with two pages of chartsabout where we have been. We want clients to reflect on how ghastly theperformance of the [non-Canadian] bank stocks has been.While musing on these horror stories of failures and bailouts, clients shouldalso be reflecting on the fact that the men who run big US and European banksare collectively the most publicly controversial segment of Big Business inclaiming that they deserve to be paid more than they earn. Really? Were theyfootball or baseball coaches with such disastrous records, theyd have beenridiculed and fired. Bizarrely, they have managed to elicit support from manynaive conservatives who drink the Kool-Aid that Wall Street is composed ofcapitalist giants beset by leftist political Lilliputians. Even in the midst of theworst crash since 1929, they insisted that their bonuses had to be paid orthey might decamp to....No one seemed to ask where they could go with their blown-up risk models.Zimbabwe? November 2011 3
  8. 8. Its the Economy Banks, Stupid!Citigroup (C) Bank of America (BA)January 1, 1986 to November 17, 2011 January 1, 1985 to November 17, 2011600 60500 50400 40300 30200 20100 10 6.83 31.59 0 0 Jan-86 Jan-89 Jan-92 Jan-95 Jan-98 Jan-01 Jan-04 Jan-07 Jan-10 Jan-85 Jan-88 Jan-91 Jan-94 Jan-97 Jan-00 Jan-03 Jan-06 Jan-09Goldman Sachs (GS) Banco Santander (SAN)May 1, 1999 to November 17, 2011 January 1, 1985 to November 17, 2011250 16225 14200 12175 10150 8125 6 6.18100 4 92.35 75 2 50 0 May-99 Nov-00 May-02 Nov-03 May-05 Nov-06 May-08 Nov-09 May-11 Jan-85 Jan-88 Jan-91 Jan-94 Jan-97 Jan-00 Jan-03 Jan-06 Jan-09Deutsche Bank (DB) UBS (UBS)January 1, 1985 to November 17, 2011 January 1, 1985 to November 17, 2011120 80 70100 60 80 50 60 40 30 40 30.35 20 20 10 11.21 0 0 Jan-85 Jan-88 Jan-91 Jan-94 Jan-97 Jan-00 Jan-03 Jan-06 Jan-09 Jan-85 Jan-88 Jan-91 Jan-94 Jan-97 Jan-00 Jan-03 Jan-06 Jan-09Societe Generale (GLE) Credit Suisse (CS)January 1, 1987 to November 17, 2011 January 1, 1985 to November 17, 2011160 100140 80120100 60 80 60 40 40 25.60 20 20 21.10 0 0 Jan-87 Jan-90 Jan-93 Jan-96 Jan-99 Jan-02 Jan-05 Jan-08 Jan-11 Jan-85 Jan-88 Jan-91 Jan-94 Jan-97 Jan-00 Jan-03 Jan-06 Jan-094 November 2011 THE COXE STRATEGY JOURNAL
  9. 9. It looks as if the Big Banks could be in a Triple Waterfall collapse formationthat would force further assistance.We are frequently asked when the next Triple Waterfall would arrive. Asdiscussed in our book1, financial markets of the last three decades of the ...the herd ofpast millennium were driven by three Triple Waterfall rises and crashes— Too Big to Fail bankscommodities in the 70s, Japan in the 80s, and technology in 90s. should have beenEach of these convulsions sucked in vast amounts of capital on the way up and culled...became a source of funds for the next mania on the way down. The housingbubble which inflated the Big Bank Bubble sucked in far more capital thanits predecessors, because a 60% rise in house prices at a time of shrinking orvanishing down payments imposed monstrous demands on debt markets.The Greenspan Put obliged, as did so many central banks abroad.We have no doubt that, had governments not intervened during the 2008 crashwith gigantic bailouts, unbelievably cheap money, and extremely generousguarantees on deposits, the past decade would have been defined by a crashof 1929 proportions in which many American and European banks wouldhave been wiped out. That would have been a rather sudden Triple Waterfall,but the collateral damage from letting so many wretchedly-managed banksfail simultaneously would have been catastrophic.Nevertheless, the herd of Too Big to Fail banks should have been culled,thereby freeing up liquidity and capital for well-managed organizations. Wehave long wondered why Lehman was the last to go. Reading Ron Suskindsperceptive account of the Obama Administration (The Confidence Men), wewere interested to learn that President Obama issued orders to let Citigroup gobust. This was, to us, a remarkably wise decision, and our respect for Obamarose on reading it. Regrettably, Obama didnt follow up to ensure compliance.Mr. Geithner somehow never got around to implementing those orders, andCiti has lived on, a sickly multi-strategy hedge fund masquerading as a bank.Was it saved because Robert Rubin had been collecting fees totaling morethan $100 million for dispensing strategic advice—including increasing thebanks leverage during the later stages of the bubble?1 The New Reality of Wall Street, 2003, McGraw Hill. November 2011 5
  10. 10. Its the Economy Banks, Stupid! KBW US Bank Stock Index (BKX) October 1, 1992 to November 17, 2011 140 120The big bankers of 100Wall Street and Europeare, it would seem, 80modern Bourbons, 60who have forgotten 40 37.30nothing [about their 20boom-built bonuses]and learned nothing 0[about the perils of Sep-92 Oct-94 Nov-96 Dec-98 Jan-01 Feb-03 Mar-05 Apr-07 May-09 Jun-11physics-based riskmodels and excessleverage]. This chart of the history of the BKX shows Leg One taking the Big Banks up roughly 200% to the Long-Term Capital crisis, which produced a swift 45% crash; this was halted by the Greenspan Put, which continued to pump in liquidity, taking them back to their peaks in a long sideways move, followed by a retrenchment. Then came the second Greenspan Put taking them to a new peak during the real estate bubble which took them to a peak that was 300% above the 1995 lows. The entire rallying process consumed 12 years—two to three years longer than the rallies of the previous Triple Waterfalls. An optimist would argue that the 2008-09 crash ended the banks equivalent of a Triple Waterfall crash, which means they had been sufficiently punished for their sins against capitalism and, thus cleansed, were ready to resume their industrys historic role in economic expansion: less leverage, more lending, reduced risks, and more contribution to economic progress. Sadly, this never happened. The big bankers of Wall Street and Europe are, it would seem, modern Bourbons, who have forgotten nothing [about their boom-built bonuses] and learned nothing [about the perils of physics-based risk models and excess leverage].6 November 2011 THE COXE STRATEGY JOURNAL
  11. 11. Like the Bourbons, they lost their heads, if only metaphorically. In the earliercase, there was never a question of showering more wealth on King Louis andMarie Antoinette in hope that they would clean up their acts and strengthenthe French economy. However one might disparage the Jacobins, they werentnaïve. Like the Bourbons, they lost their heads...What about those earlier Triple Waterfalls?Commodities remain in a long-term bull market that shows scant signs ofthe excesses of the 1970s. Even gold, which is frequently cited as being inbubble mode, is merely catching up to long-term monetary expansion. (Itsprice multiplied 22 times in the Seventies mania.)Gold ($/oz) vs. Currency in Circulation* ($billion)January 1, 1998 to November 17, 20111,900 1,100 1,0501,700 1,000 Last 1,052.151,500 1 Wk chng +6.79 9501,300 900 8501,100 800 900 750 700 700 650 500 Last 1,721.00 600 1 Wk chng –67.68 550 300 500 100 450 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Gold ($/oz) Currency in Circulation ($billions)*source: Federal ReserveChart courtesy of Meridian Macro Research (, to our disappointment, remains in its Triple Waterfall mode 21 yearsafter the crash began. As the Olympus scandal now reveals, investors arenot convinced that Japanese businesses have been able to shrug off eitherthe corruption of the yakuza (the Japanese mafia) or the nations disastrousdemography. November 2011 7
  12. 12. Its the Economy Banks, Stupid! As an industry, Technology has survived Nasdaq’s Triple Waterfall collapse, and has remained an engine of global growth, although investors who held onto such 1990s darlings as Cisco may not be consoled. Google wasnt public at the peak and Apple was not the company in 2000 that it would become"In the 1880s, total UK with the 2nd Jobs assets were equalto 5% of GDP. At the Cisco (CSCO)bubble peak they were January 1, 1991 to November 17, 2011500%..." 80 70 60 50 40 30 20 18.53 10 0 Nov-91 Nov-93 Nov-95 Nov-97 Nov-99 Nov-01 Nov-03 Nov-05 Nov-07 Nov-09 Nov-11 The perceptive Tony Jackson wrote in The Financial Times (Nov. 6, 2011) about a speech delivered by Andrew Haldane of the Bank of England, "that most of the harmful developments in finance in the last century came from the banks ‘desire to break their balance sheet chains’." "In the 1880s, total UK bank assets were equal to 5% of GDP. At the bubble peak they were 500%. As to consolidation, the assets of the UKs three biggest banks at the start of the 20th Century were 7% of GDP. By the end of it they were 75% and by 2007— astonishingly—200%. Leverage climbed from 3 - 4 times in the 19th Century to 30 times in the bubble. And return on equity— unsurprisingly—went from modest single figures to 30% at the peak." We all know what happened next.8 November 2011 THE COXE STRATEGY JOURNAL
  13. 13. Have the Big, Bad, Bonused Bailout Banks (hereinafter called B5) learnedfrom their near-death experience?Apparently not.The bonus fixation that has driven the desire for excess leverage is part of the case of UBS,Wall Streets self-spawned DNA. After the crash, not only did Merrill Lynch bonuses were paidpay their fallen "stars" based on phantom earnings that ignored losses on from a pool that hadsubprimes, but in the case of UBS, bonuses were paid from a pool that had been totally drained bybeen totally drained by rogue trader fraud. rogue trader fraud.Bonus promises for bankers are, it would appear, like excessive pensionpromises for unionized government employees created by deals for unionsupport for politicians in elections: they must be honored even when theyare funded from over-greedy investment projections, and by imploded capitalasset risk models.Not all big banks are run to enrich insiders with returns from perilously highleverage and dubious investments: the index of Canadian bank stocks revealsan industry that has continued its long tradition of behaving itself, therebydramatically outperforming its counterparts in the US and Europe:S&P/TSX Canadian Bank Stocks vs. KBW US Bank Index (BKX)June 1, 2002 to November 17, 2011250200 175.73150100 50 -45.48 0 May-02 Jul-03 Sep-04 Nov-05 Jan-07 Mar-08 May-09 Jul-10 Sep-11 S&P/TSX Canadian Bank Stocks KBW US Bank Index (BKX)Source: S&P/TSX Bank Stocks; GICS, Industry Group November 2011 9
  14. 14. Its the Economy Banks, Stupid! No Canadian bank went bust in the Depression, so it was no surprise that all the Canadian banks came through the worst banking crash since the Thirties in solid condition. Credit good management, constrained leverage, and supervision by the Bank of Canada under its great governors in the past...the occupiers of decade—David Dodge and Mark Carney. That Mr. Carney was recently chosenZuccotti Park...tap to lead the global Financial Standards Board (replacing Mario Draghi whointo rage that the moved to the European Central Bank) should be reassuring to investors—banks who were the and a spit in the eye for JPMorgan Chases CEO, Jamie Dimon, who hadbiggest private sector assailed him in Washington weeks before. Mr. Dimon is one of those bigcauses of the crash bankers whose public displays of arrogance helped spawn the Occupy Walland recession show Street demonstrations. Although the occupiers of Zuccotti Park are leaderless,little remorse and undisciplined and largely incoherent in their demands, they tap into ragelittle willingness to that the banks who were the biggest private sector causes of the crash andaccept constraints on recession show little remorse and little willingness to accept constraints ontheir leverage and their leverage and proprietary trading. (One TV clip showed some signs theyproprietary trading. were holding, including one that impressed us: "Bring Back Glass-Steagall.") The demonstrators should also, of course, be targeting Barney Frank and his politically-correct Fannie Mae allies, who probably deserve as much of the blame as the banks for the housing collapse, but that is a complicated story to explain, and the mainstream media have certainly not chosen to cite the catastrophic misdeeds of politicians they favor.10 November 2011 THE COXE STRATEGY JOURNAL
  15. 15. The Eurozone Crisis—and the BanksSince May, we have been warning that the Basel banking version of theCapital Asset Pricing Model was obsolete and misleading—and could triggera new collapse. ...the G-20 Meeting—The Dexia collapse is a form of financial sick joke: a major financial institution held on the site of thethat passed the European Banking Authoritys supposedly-demanding stress famed Film Festival,test with flying colors in July thereupon vaporized within weeks. Imagine (but might have beensomeone dying of cancer who had taken out a $10 million term life insurance better held in a morgue)policy at a reduced premium for exceptional health two months earlier. Wouldthe insurer and its reinsurer continue to retain the examining doctor?The proximate cause of the Dexia demise was the worsening of the Greekcrisis at a time the prices for outstanding debt of other PIIGS—most notablyItaly—were weakening. As this is written, despite at least €70 billion of ECBpurchases, the benchmark ten-year Italian government bond yields 7.04%—ascary 5.25% more than German bunds, and 3.38% more than French bonds—whose yield spread above bunds has been also been widening recently. (Byway of comparison, Treasurys yield 2% and Canadas yield 2.13%.)Italys outstanding debt—120% of GDP—is the worlds third-largest, andit must roll over more than €200 billion next year—let alone finance itsgrowing fiscal deficit. Spanish yields have also been climbing sharply and arenow 6.29%. The market is convinced that Italian yields are unsustainable,and is getting rapidly becoming panicky about Spains.At the G-20 Meeting—held on the site of the famed Film Festival, (but mighthave been better held in a morgue), Silvio Berlusconi was in fine form forthe role of Harlequin in a Commedia Dell Arte farce. He airily dismissed talksof an Italian debt crisis, saying he had turned down an IMF loan, as beingunnecessary. He said the plunging price of Italian bonds was "Yesterdaysstory, the restaurants are full, it is difficult to reserve a seat on a plane...I cantsee another figure on the Italian scene capable of representing Italy on theinternational stage." November 2011 11
  16. 16. Its the Economy Banks, Stupid! Despite that (probably accurate) self-assessment, he lost his parliamentary majority in a vote on Nov. 8th, and got the hook from Stage Left. He is replaced by Mario Monti, a non-elected technocrat, with a glowing resume who began his political career as a Communist. He announced a Cabinet composed external other technocrats—no elected politicians. (Plato would have approved of anconclave could all-guardian government with no voter input.) A bank portfolio managerhumiliate Greece as prepared to take a big bet on Italian bonds based on the belief that thedramatically as its Italian parliament and population will submit to Montis medicines forown bureaucrats, more than a few months probably shouldnt even be managing his or herunion leaders and own money—let alone anyone rich Meanwhile, where the eurocrisis began, another leader has fallen. Georgehave... Papandreou is gone. Nothing became Papandreou in his premiership as the leaving of it: he tried to give the voters a chance to ratify the Draconic terms of the nation’s bailout. We were sorry the EU banned that resort to democracy. The terms of the rescue package have been denounced as "humiliating" for Greece, but no external conclave could humiliate Greece as dramatically as its own bureaucrats, union leaders and tax-dodging rich have during the many months that little Greece has been making big waves in global markets. What really upset Sarkozy, Merkel, et al. was the idea of putting terms of a eurodeal to the voters. The euro was a confection of the elites and they have been congratulating each other for years on its wondrous qualities. It was only put to the electorate of a few members—not including the Germans—and barely survived. The members of the eurozone ruling class tend to be more comfortable with each other—despite personal rivalries—than with their voters. They graduate from the best universities and are virtually unanimous that the route to repealing Europes bloody past is with supranational institutions that, through one-time constitution-style agreements, are placed permanently above and beyond the direct control of voters. Prior to the "make or break" euro meetings of October 25th, one of the officials justified the bailout plan by expostulating, "We cannot make war on the nation of Plato."12 November 2011 THE COXE STRATEGY JOURNAL
  17. 17. Plato, it will be recalled, abandoned Athens for Sicily, where he tried to makethe regime of a local dictator the demonstration of his views on Guardians andthe Cave. The project failed dismally, and Greece only got good governmentbriefly during the reign of Alexander the Great—a Macedonian. It has hadlittle—if any—experience with wise government since 323 B.C. A proposed Greece only got good€120 billion bailout 2,334 years later that is justified on the basis of helping government brieflyPlatos heirs could only be conceived by an eurocrat who would never think during the reign ofof putting the proposal to a vote of his own nationals. Alexander the Great— a Macedonian.But the fact that this emotional resort to Platonic philosophy was adducedin the midst of a modern crisis set us to thinking about the importance ofphilosophy in the Continental leaders learning.They have all studied the same philosophers, albeit with natural nationalpredispositions to their own great minds. Descartes cool, geometric logicwas at the root of French socialist Jacques Delors design of the euro: aperfectly-designed currency with no provision for exits, like the successionof perfectly-drafted French constitutions, which in practice have only beenamended by the Paris mob. Rousseaus concept of the supremacy of theGeneral Will untrammeled by popular elections on fixed schedules thereforehas enormous appeal for the new European aristocracy.The classic liberalism of the Scottish and English philosophers andeconomists—Berkeley, Hume, Smith, Locke, Ricardo and Mill—has had onlymodest influence with the Continental elites, where the French philosophes—such as Voltaire, Rousseau, and Condorcet, and more recently, Durkheim,and the German schools of Leibniz, Kant, Schopenhauer and Hegel arestudied intensively.Angela Merkel emerged from that dramatic eurocrisis meeting of Oct. 26 asthe leader of the eurozone, outlasting all the male elitists in a marathon thatextended to 3 a.m. Her triumph triggered a gigantic global stock market rally,driven (as we learned later), mostly by short-covering.We wondered whether her own philosophic training was crucial. Raised in themost Marxist of the Eastern European Soviet dictatorships, she would havebeen taught Hegels "great waltz" dialectic, which had been incorporatedby Marx and Lenin into Communist dogma. If so, she might have takenthe euro regime and rules as the Thesis, the Greek rebellion against it as theAntithesis, and sought to achieve a Synthesis with the 50% haircut on thevalue of Greeces outstanding bonds as the price of a new, durable euro. November 2011 13
  18. 18. Its the Economy Banks, Stupid! Crucial to this synthesis was—and is—a rule that a Hegelian might admire: a decree that slashing the value of Greeces bonds shall not be deemed a "credit event" that would automatically trigger the many billions in credit default swaps (CDS). Since these instruments were never part of the designIf a 50% slash in of the euro or euro bond markets, they must not be allowed to dictate theprincipal value is not a terms of any new event—what is? This bold concept has doubtless been a shock to holders of CDS—Greek and otherwise. If a 50% slash in principal value is not a credit event—what is? This ruling creates big winners and big losers. That apparently leaves it to investors to try to find out which banks were big writers of Greek CDS and which banks were big buyers. KBW European Large-Cap Banking Index (KEBI) January 1, 2005 to November 17, 2011 90 80 70 60 50 40 30 20 18.46 10 Jan-05 Nov-05 Sep-06 Jul-07 May-08 Mar-09 Jan-10 Nov-10 Sep-11 The KEBI chart of the large European banks shows that they broke through their 200-day moving average on the downside for good in January 2008 and have failed to rally back close to it since the crash. They are down 76% from their 2007 highs, outdistancing the BKX, which is down by two-thirds. Some investors tell us that the US banks are considerably stronger than their European counterparts. Based on the record of Dexia and earlier collapses of European banks within weeks of passing stress tests, that argument has appeal.14 November 2011 THE COXE STRATEGY JOURNAL
  19. 19. European banks collectively have four times the assets of their Americancounterparts—but, malheureusement, do not have four times their tangiblenet equity. That huge trans-Atlantic asset variation comes from the differencein savings habits of the two continents. American savings rates were near-zero in the years pre-crash, while Europeans have had relatively stronger Wall Street, where thesavings rates. Also, Europeans are far more inclined to save through banks physics PhDs (turnedthan Americans. That helps to explain why Europe—notably Germany—is financial alchemists)so overbanked compared to the US. converted leadpipe losers into gold.That disparity worked out disastrously for European banks during theforce-fed US housing bubble. The past decade was the first time the Americaneconomy experienced the full effect of collapse in US fertility rates. As fertilityrates fell from approximately 2 babies per female during the Seventies andEighties to 1.4 or less, the result was that the number of first-time jobholdersand homebuyers was drastically reduced during the "noughts." Europeexperienced the same demographic collapse, but its governments did not,like Washington, introduce stringent rules for banks that forced banks tomake loans to minorities somewhat commensurate with the volume ofloans they were making to whites. Barney Frank was the leader in Congressin demanding strict enforcement of these rules.Regional banks which plunged into the origination of dubious loans foundthat Wall Street and Washington were eager to take them off the banks hands.Through complex derivatives, the Street achieved the miracle of AAA ratingseven when significant portions of the loans in the product were to borrowerswho—if they actually existed and were not in jail, (requirements which werenot always enforced during the manic years)—were unlikely to be able toservice the debts when the music stopped, as the dancing man, Citigroup’sChuck Prince, so memorably framed it. Angelo Mozilo of CountrywideFinancial, and a long list of brand-new upstart lenders eagerly arranged thedeals and sent them to Wall Street, where the physics PhDs (turned financialalchemists) converted leadpipe losers into gold.To an astounding degree, they peddled them to European banks. When thehousing bubble burst, the fallout was a TransAtlantic disaster. November 2011 15
  20. 20. Its the Economy Banks, Stupid! As Michael Lewis records in Vanity Fair, German bankers bought the CDOs because they were AAA-rated, and "we thought America was a rules-based society." (Germany is, of course, the quintessential rules-based society.) Wall Street was, in a way, a rules-based society. As Nassim Taleb explained...the term "legacy (when we shared a platform in 2007), the Street was relying on terriblyassets" to describe unrealistic risk models, managed by arrogant fools who knew physics androtting remnants of the mathematics but almost nothing about finance. This would lead, he said, topast binge based on a crash that might recall 1929. He was exulting because a journal devoted toinvestment models... statistics (The American Statistician, August 2007) had just devoted an entireis of a piece with such issue to attacking him and defending the models.Victorian euphemisms The Basel version of the Capital Asset Pricing Model decreed that AAA-ratedas "nightsoil" for the mortgage derivatives required no allocations of the [scarce] capital ofcontents of bedpans. European banks. Result: before the eurobanks began to lose on sovereign PIIGS debt, they were already ailing from the effects of overexposure to putrid products backed by American real estate. According to The Wall Street Journal, "Sixteen top European banks are holding a total of about €386 billion ($532 billion) of potentially suspect credit market and real estate assets.....more than the €339 billion of Greek, Irish, Italian, Portuguese and Spanish government debt that those same banks were holding at the end of last year....European banks, on average, have roughly halved their stockpiles of legacy assets since 2007...meanwhile the top three US banks, Bank of America, Citigroup and JPMorgan Chase have slashed such assets by well over 80% over a similar period." We had not previously heard the term "legacy assets" to describe rotting remnants of the past binge based on investment models. It is of a piece with such Victorian euphemisms as "nightsoil" for the contents of bedpans. The Victorians lacked complex mathematical models, and they made no bets on bedpans. Todays badly-performing banks lack bedpans, but theyre swimming in perfumed portfolios excreted by mathematical models. This is called progress.16 November 2011 THE COXE STRATEGY JOURNAL
  21. 21. One possible benefit of the "legacies" of the misplaced enthusiasms ofEuropean banks for American subprime paper could be that the EuropeanCentral Bank—now under the leadership of Mario Draghi—will be swiftto continue cutting the competitively skyhigh rates imposed by previousmanagement under Jean-Claude Trichet. [M. Trichet] was an inflation-fighting centralM. Trichet may have been the worlds most obdurate inflation fighter. The banker who put hisECB, unlike the Fed and many other central banks—has only one mandate— American counterpartsfighting inflation. With rising commodity prices driving up costs of food to shame.and fuels, M. Trichet drove ECB rates to levels infinitely higher than BenBernankes zero-level prices. (Dr. Bernanke is seemingly pleased to be givinghis money away free: he is promising to continue this largesse at least until2014. That will mean six years of free money. Who can tell the long-termeffect of consuming financial heroin on such a scale?)M. Trichet actually raised his rate twice this year at a time eurozone economieswere visibly sagging. He pronounced that his record as an inflation fighterwas better than the Bundesbanks. He proudly characterized his performanceas "Impeccable! Impeccable!"We agree. He was an inflation-fighting central banker who put his Americancounterparts to shame. The euros rise in value on his watch accurately reflectshis impeccable inflation credentials. He managed to make a global store ofvalue out of a dubious theory.His enthusiastic self-appraisal was his swan song, as M. Draghi was alreadyin the waiting room. He dropped the Trichet rate 25 bp his first day on thejob.As grim as the outlook for peripheral bonds may be, contagion is spreadingacross eurozone non-German bonds since the decision to reject the payoutsunder Greek CDS was announced. According to Gillian Tett of the FinancialTimes, American banks may have issued a half-trillion dollars’ worth of suchpaper. What investors in eurobonds now face is the prospect of problemsacross the zone. As more and more economies face recession, this process iselevating their debt costs.When will the Germans face the fact that they can’t remain obdurate whenall their supposedly strong partners are facing financing problems? November 2011 17
  22. 22. Its the Economy Banks, Stupid! American Banks With the exception of Wall Street, American banks seem to have made some financial progress since 2008.So why do bank stocks Their stock prices have underperformed the S&P but have recently beenlook bleak? outperforming the big banks represented in the BKX. The S&P—which includes bank stocks—is up roughly 25% in that time. KBW US Bank Index (BKX) vs. KBW US Regional Banking Index ETF (KRE) January 1, 2011 to November 17, 2011 10 0 -10 -13.14 -20 -30 -28.59 -40 Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11 Oct-11 Nov-11 KBW US Regional Banking Index ETF (KRE) KBW US Bank Index (BKX) So why do bank stocks look bleak? The answer, of course, is that they couldnt lay off all their suspect real estate loan exposure on Wall Street, Fannie Mae, Freddie Mac, or the Federal Home Loan Bank, (although the taxpayers are down $170 billion and counting on Fan and Fred). It will be recalled that when the Bush Administration finally became concerned about F&F in 2007, and tried to rein them in, Barney Frank led a successful Congressional campaign to protect them from interference by the Fed or the Comptroller. Collectively, the regional banks had large exposure to Fannie and Freddie preferred shares. They loved those tax-exempt dividends. Until there were no dividends...although Fannie and Freddie continue to pay their bosses big bonuses. Depending on the location of the regional banks, their biggest problem is commercial real estate. They may not have any complex real estate derivatives on their books, but they are saddled with piles of debt on vacant stores and shuttered warehouses, and large exposure to municipal bonds of varying quality.18 November 2011 THE COXE STRATEGY JOURNAL
  23. 23. That is one reason why we have been so concerned about the sickly KRE.With the Wall Street banks, we know that most of their problems come fromderivatives they cant sell and egos they can’t control. Result: so much of WallStreet debt trades at a discount, and their shares sell at discounts to net assetvalue. With the Wall Street banks, we knowAn unwary investor who saw that a banks shares and debts were selling at a that most of theirsizable discount to stated net asset value might assume that the banks bosses problems come fromwouldnt be getting bonuses. derivatives they cantIn capitalist theory, executive pay is for value-creating performance of a kind sell and egos theythat drives share prices to large premiums over book value—and makes their can’t control.outstanding debts rise in value at a time of zero interest rates from GentleBen Bernanke.The bosses of those B5 banks, who are long on greed and short on shame,dodge capitalist principles they find inconvenient for setting their owncompensation. They assume that, when their debts trade at discounts, thatreduces their debts and therefore generates earnings, which beget bonuses.Nearly one-half of some of the big banks recently-reported earnings came fromthe declining market value of their debt. Not the repayment of debt, mindyou—merely the bid price of their paper.The regional banks bosses dont get those Wall Street benefits, because solittle of their debt trades actively. Their bosses are old-fashioned enough tobelieve that theyd like to see their debt trade at a premium to par value.The problem is that until more of those vacant shopping centers and homesfind lessees or buyers, the regionals will be struggling. The regionals arealso worried about their exposure to debt from subprime state and localgovernments—like Illinois, California and Harrisburg.One bright spot for some local banks: among the best-run of the regionalsare banks that have maintained high exposure to Treasurys. Since Treasuryshave been a superb investment this year, some of these banks must havebenefited greatly—providing that they didnt confine themselves to the frontend of the curve.Well stick to our long-stated view that the KRE will give the signal that theeconomy is really on its way back when it solidly outperforms both the S&P andthe BKX at a time of rallying equity prices.At the moment, the KRE is treading water—and winter is coming. November 2011 19
  24. 24. Its the Economy Banks, Stupid! What Happens to Investment Risk Perceptions With Italy Joining Greece in the Calculations? We believe investors should make the following assumptions:Somehow, this muststop. 1. The fight to keep Greece within the eurozone has been so intense because the prospect of a sudden Grecian exit would unleash chaos across the zone.Stein’s Law says thatit will. Greek individuals and companies would rush to withdraw funds from Greek banks, and bank lending would come to a standstill. (Already, there is evidence that some Greeks are frightened: bank deposits are down roughly 25% since December 2009.) Outside Greece, banks and companies having Greek counterparties would be frantically trying to rearrange agreements, and Greece would fall into a Depression. The prospect of such an implosion spreading to Italy would be an existential challenge to the eurozone. Italian bond yields—already at levels unsustainable over the longer term—would skyrocket, and banks inside and outside the zone would default. 2. Although Berlusconi is no longer Premier, his party has the most seats in Parliament. Investors should not assume that a new coalition after a future election would have the kind of stability that occurs in Northern Europe after a government loses an election. 3. Spanish bond yields will probably continue to climb after this months election, putting that nation into deeper recession. 4. Investors assume that Ireland and Portugal have been stabilized, but when banks across Europe are pulling in lines of credit in response to a collapse in Greece and a potential collapse in Italy, all lesser-grade credits will suffer. Since Greece first went on investors radar there have been dozens of days in which global stocks have plunged because of a threatened Greek default, followed by brief rallies because of a new rescue package, followed by more riots and yet another bailout proposal, followed by another selloff because of a crisis in another country. It is unacceptable that global stock markets are being held hostage to the follies and fake financials of a few underachieving, overindebted economies in a zone with an overvalued currency and over-stringent monetary policies. Somehow, this must stop. Stein’s Law says that it will.20 November 2011 THE COXE STRATEGY JOURNAL
  25. 25. The Implications for GoldTo date, the major asset class which has benefited most from the PIIGSdramas is gold.When the possibility of a Greek default first came under serious discussion in This is beginning toMay 2010, gold was trading in the $1100 range, and the S&P was in the 1166 look like Gold Bugrange. Ten-Year Treasury yields were roughly 3.8%. Remarkably, the euro was Nirvana...roughly 1.35 in dollar terms—where it is today. The KEBI Index was roughly35: it is now 19.5.We have been arguing for more than a year that the existential challenge tothe euro from the plight of the PIIGS is the primary driver of gold prices.Europeans who find that their bank deposits, paychecks, life insurance andpensions are all euro-denominated have been buying some protection inthe form of gold. Other investors, contemplating the possible implosion ofthe currency of the worlds second-largest trading zone have been makingsimilar moves. The growing problems in the zone have been shrinkingglobal economic activity and central banks other than the ECB are—as ofnow—virtually unanimous in lowering rates to minuscule levels to avertrecessions...and to depreciate their currencies.For the first time since the abandonment of the gold standard, central banksare overwhelmingly dedicated to weakening the exchange rates of theircurrencies. When faith in the “printed paper promises of politicians" flags,gold offers an incorruptible store of value. This is beginning to look like GoldBug Nirvana—where panicky people protect their wealth by selling paper tobuy gold. (Maybe the bankers are ahead of the pack: central banks bought148 tonnes of gold in the third quarter.)Ben Bernanke has said zero interest rates will remain until at least 2014.That means the financial heroin will continue to flow, which meanscontinuation—and exacerbation—of negative real interest rates as far asmost eyes can see.What the US and Europe seem to be experiencing is a modified stagflation,in which food and fuel prices stay stubbornly high, and interest rates remainat losing levels for investors.Gold is the only historic medium of exchange whose value has been risingfor nearly 11 straight years.The forces driving it upward are accelerating.Conclusion: Once gold breaks through its August peak of 1920, it will challengethe magic millennium level of 2000—and will eventually pierce it. November 2011 21
  26. 26. Its the Economy Banks, Stupid! US Energy Policies: Political Risk for Oil Investing Rises 1. The Politics of Keystone XL[President Obama] is For coolly-calculated political reasons, President Obama has kicked theback to doing what Keystone XL oil can down the road.he enjoys most and We had thought that would be his likeliest response, and raised the politicaldoes better than risk issue in Basic Points and our Conference Calls—(albeit merely as aanyone—campaigning. significant possibility investors should consider). He cited environmental concerns about aquifers, but those were never the gut issue on Keystone, and were already being fully addressed by TransCanada (TRP) in response to a long list of State Department requirements. Even the Nebraska Governor who led the opposition agreed that some relatively modest tweaks would meet his state’s concerns, and joined all the state governors on the pipeline route in praising the opportunities, jobs and progress the line would deliver. TransCanada swiftly agreed to those changes—but Obama held firm. He is back to doing what he enjoys most and does better than anyone—campaigning. The pipeline was a big, obvious victim of calculations in Presidential politics made by the most muscular environmental NGOs and the White House. The wealthiest NGOs had made it their signature issue. They were candid that they needed “a big win” to revive their coalitions and supporters, such as Hollywoods leading experts on environmental science issues, who flew to Washington to protect the environment by spending a night in jail protesting "dirty oil." From the NGOs standpoint, after polls showed that only a small minority of the population believed in man-made global warming as a relevant political issue, something big and preferably foreign was needed. Although most of the actual debate and analysis on the issue—and the State Departments exhaustive review—were about the pipeline itself, the NGOs made it clear they want to kill Keystone to stop the oil sands operations. Theyve been horrified about the Canadian publicity that the oil sands are "the new Saudi Arabia." This is their chance to ensure that theres no North American Saudi Arabia.22 November 2011 THE COXE STRATEGY JOURNAL
  27. 27. Weeks ago, we watched an interview on public televisions "News Hour,"featuring some celebrity (whose name escapes us) who had demonstrated inWashington and had spent a night in jail. He never mentioned the Nebraskanenvironmental questions. He said that blocking the pipeline was the only wayto stop oil sands expansion and perhaps even force shutdowns. When told Truth is the first victimthat the Alberta government said that Canada could just divert the output in such scorched-earthto the Pacific Coast to ship to China, he said that their information was that campaigns waged byindigenous people would kill any such proposal. (We are inclined to agree wealthy enthusiasts whowith him in that appraisal.) travel in jet planes and automobiles to killThe opposition to Alberta went global when the European Union issued a oil exploration.policy statement that European refiners were not to use fuel from "dirty oilproduction"—which is a term used by the Banana (Build Absolutely NothingAnywhere Near Anything) school of enviro-enthusiasm.Mr. Obama is not such an extremist—at least not outside North America. Onhis trip to Brazil he renewed US financial support for that nations ambitiousprogram of developing offshore oil, at a time exploration in the Gulf ofMexico was largely shut down. (The US, through government-guaranteedloans, is participating in a big way in developing those fields.)Until recently, the main NGO fund-raising campaigns focused on blockingoil projects in Alaska, and drilling on any US coast. The litmus test for fightinga vile energy project is that it has the potential for raising many millions ofdollars for tax-exempt organizations with strong records in using litigationto tie up energy (and mining) developments. The Alberta oil sands becametheir Hate #1 because they not only produce oil, but, until recently, mostof it came from mining. (Steam-Assisted Gravity Drilling, which leaves afootprint smaller than a football field, is a more recent development, butit gets lumped in with the open pits that supposedly despoil boreal forestsand kill birds. That a typical wind farm kills many more birds and bats ina year than all the oil sands projects have accomplished throughout theirhistory is, of course, irrelevant. Truth is the first victim in such scorched-earth campaigns waged by wealthy enthusiasts who travel in jet planes andautomobiles to kill oil exploration.)When TransCanada agreed to all the State Department requirements forpermitting, its management thought their long approval campaign wasover. The State Department had the authority to draft the rules, with EPAassistance, and that was that. November 2011 23
  28. 28. Its the Economy Banks, Stupid! But, very late in the game, well after the time Canadian authorities and the US oil industry were convinced Keystone was a "Go," Obama announced he was intervening and would make the final decision. By postponing the decision until after the elections, he has virtually guaranteed his campaignAmerican drivers will huge support from the major left-wing and environmental funding sources,be paying more for because they now know that if he loses next year, the decision on Keystonetheir gasoline... will be made by a Republican—and Republicans are overwhelmingly in favor. Speaker John Boehner spoke last week of its many thousands of high-pay immediate "shovel-ready" construction and maintenance jobs that wont cost US taxpayers a dime. (Obama spent hundreds of billions allegedly for "shovel-ready" jobs, but it turned out only a minuscule amount went for such jobs. Most went for unionized bureaucrats and teachers employed by state and local governments. As Rick Perry scoffed, "My dog has created more shovel-ready jobs than Obama." He may have been on target, but, as has been his experience in his ill-starred campaign, he didnt score any points, because the quip wasnt original.) One Canadian company—Enbridge—seems to have made the correct calculations about Obamas plans. Within days after the Obama rejection, it, with backing from the Caisse de Depot, it bought a pipeline from ConocoPhillips and plans to switch the direction of its flow northward from the Gulf to Cushing. That means the huge discount on WTI to Brent must narrow—and it did narrow on Wednesday. American drivers will be paying more for their gasoline, but that doesnt offend the NGOs, who want high gas prices to supply a pricing umbrella for their various green strategies. As of now, Obama stands likely to win re-election. He says hes raising a billion dollars in campaign funds and no one seems to doubt hell do it, even though his campaign oratory is loaded with attacks on "the rich," and his overwhelming support in mainstream media means he doesnt really need that kind of money. The Republicans will not be running an opponent with his Teleprompter talents, charisma, or charm—or heartwarming personal biography… And he will not be facing a Reagan.24 November 2011 THE COXE STRATEGY JOURNAL
  29. 29. It looks as if the oil industry is making its plans on the assumption thatKeystone will not proceed. Big Obama backer Warren Buffetts railroad standsto win big, because the huge growth in Dakotas oil production will have togo by train if Keystone isnt approved. Keystone is in mortalThe odds, as of now, are that Keystone is in mortal peril. The death certificate peril. The deathis due November 2012. certificate is dueIt takes a re-elected Democrat to sign it. November 2012. It takes a re-elected2. Shale Gas and Oil Democrat to sign it.The other relatively new campaign against production of fossil fuels is theopposition to shale gas and oil produced through fracking.To date, this has been a regional struggle. Most states are thrilled with themoney pouring into local economies—not to mention the soaring royaltypayments. To date, hundreds of thousands of high-paying jobs have beencreated. Example: the Dakotas economies are booming as never before, andmost residents cannot believe their good fortune. As Dennis Gartman reports,North Dakota now produces more oil than an OPEC member, Ecuador—andproduction is headed much higher—if environmentalists dont stop it.In communities with colleges, and other centers of employment for leftistenthusiasts—such as upstate New York—opposition to fracking has beenfierce—and successful. The opponents allege pollution of aquifers and citenumerous examples of headaches ascribed to air pollution.Until very recently, the prevailing viewpoint of big-picture thinkers withoutties to litigating NGOs or oil and gas companies was that the US benefitshugely from the cheapest natural gas in the industrial world, and theprospect of cheap gas prices for perhaps a century is one reason to be bullishon America. November 2011 25
  30. 30. Its the Economy Banks, Stupid! The environmentalists who oppose all fossil fuels (as opposed to people who oppose polluting coal plants) were becoming desperate. Then a potentially seismic shift in public opinion suddenly emerged: some recent small earthquakes in the Midwest just may have been caused quakes fracking. At least one seismologist has publicly argued that earthquakes inin low-or-no-risk low-risk earthquake areas were probably caused by fracking.zones are a newconcept. These are early days for this brand-new debate, but investors should not dismiss the possibility that gas producers could be faced with gigantic liability lawsuits brought by deep-pocketed NGOs should a quake cause meaningful damage. Seismology is still evolving. Scientists have learned to develop probability forecasts for big quakes in earthquake-prone zones such as the San Andreas Fault. But man-made quakes in low-or-no-risk zones are a new concept. Lawsuits alleging them would probably, until now, be considered as fanciful as alleging that tribal gods had been angered. (We recall—with awe—how leading liberals renowned for killing conventional energy projects elsewhere and supporting Green projects across the nation managed to kill a wind farm off Cape Cod by having a section of the ocean declared as religiously sacred for aborigines. This land is their land—even when under the sea.) One hopeful sign: the influential Natural Resources Defense Council asserts that fracking has, in fact, caused two small quakes. However, it goes on to outline safety procedures—such as avoiding fracking along major fault zones—that should minimize fracquake risks. In other words, the industry should be able to progress as long as it follows stringent rules. So—just maybe—the shale gas industry can confine most of its worrying to gas prices.26 November 2011 THE COXE STRATEGY JOURNAL
  31. 31. Its the Economy Banks, Stupid!THE INVESTMENT ENVIRONMENT1. How the Capital Markets Could Eventually Reach A Happy Ending ...Greece has goneEuro vs. US Dollar from being renownedJanuary 1, 1999 to November 17, 2011 for its ruins to being1.7 renowned for the1.6 ruin it inflicts on1.5 the eurozones1.4 economy... 1.351. Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11How much longer must global investors start their days by checking whethertheir stock markets will be up or down based on the latest news in Greeceand/or Italy?Would anyone have predicted 15 months ago that Greek politics, promisesand riots would have more sustained impact on stock prices in North Americathan US GDP changes, US payroll employment data and changes in earningsforecasts? Greece hasnt been truly important since the death of Alexanderthe Great, (although its revolt against Turkish rule did lead to Lord Byronsdeath from fever).In the past year, Greece has gone from being renowned for its ruins to beingrenowned for the ruin it inflicts on the eurozones economy and on shareprices of European—and even some major American—bank stocks.Greek disease spread swiftly across the Aegean, and Italy now reels, withfallout as far as Spain. If Italy fails, then there is no hope of saving the euroor averting a deep recession. Thanks to the Basel capital asset pricing rules,banks across Europe not only have Greek exposure but big bets on Italy.(According to Reuters, as of June, French banks held $416.4 billion worth ofItalian bonds.) November 2011 27
  32. 32. Its the Economy Banks, Stupid! When the euro was forged, the Bundesbank did its best to ensure that, even if governments broke the rules, monetary policies would be noninflationary. Jean-Claude Trichet has consciously imitated Karl-Otto Pöhl, Axel Weber, and other revered Bundesbankers....during a full year in Meanwhile, across the rest of the world, as we have discussed, central bankerswhich most of the news and their governments are doing their best to drive down the value of theirfrom the eurozone has currencies. When the Swiss National Bank was transformed from being abeen of crises... model of prudence to looking like a Weimar banker in drag, it was clear thatthe Euros exchange global inflation threats would rise—eventually.rate against the dollaris unchanged. But the European Central Bank stuck to its Bundesbanque idée fixe of fighting inflation through a strong currency that has, by dint of sound monetary policies, inherited the global respect long accorded to the Deutschemark. Result: during a full year in which most of the news from the eurozone has been of crises, interrupted by crisis meetings, followed by new crises, and new crisis meetings, the Euros exchange rate against the dollar is unchanged. This is probably the most arresting economic statistic of the year. But the euro formidable in a world where nearly every other central bank and government craves weakness for its currency has long since become a major source of weakness for eurozone economies: The strong Northern economies find their global competitiveness challenged by the strength of their currencies. The weak southern economies wasted the major benefits to them of the euro—low interest rates and seemingly unquenchable demand for their bonds. They became uncompetitive with Northern economies—notably Germany, which had sacrificed for 15 years to rebuild East Germany; during that long period, German unions accepted pay increases that were laughably low compared to wage gains for workers and civil servants in the South (and Ireland) , and to tight deficit controls that were brutally restrictive compared to the loose fiscal policies practiced by most of the PIIGS. The peripherals ignored their declining competitiveness in markets outside the eurozone as the euro gained strength in a currency world of weaklings. They were thus hit with a double whammy: they lost competitiveness almost everywhere, and now slide into recessions that inflate their deficits at a time the adamant euroelites demand they cut their deficits—or else. Their economies contract because of the sickening declines in their competitiveness, and the contractionary policies hammering their feeble societies.28 November 2011 THE COXE STRATEGY JOURNAL
  33. 33. The Bundesbank mentality served the Northern economies well for thedecades in which most global economies were usually concerned that theircurrencies were strong—or at least stable.But this new era when strong currencies are despised by their own central Its time for thebanks is unforgiving for the only large economy that practices the old-time eurozone to startcurrency religion. pumping out itsThis weeks disorderly eurobond markets have triggered an open flap between own brand ofthe two Euroguardian nations about the ECBs responsibility for stabilizing Bernanke prices. Each time Italian and Spanish bond yields soar, the ECB stepsin, but only to prevent chaos. France argues that the ECB should do far morethan Germany says is legal under EU rules.The Germans and Jean-Claude Trichet have been pleased that the anti-inflationary policies of the ECB have worked for 11 years, delivering lowerinflation and a far higher market price for the currency than the dollar.But inflation isnt the issue now.Its survival.Therefore:The euro must be devalued. The target should be its value as of its inception foraccounting on 1/1/99—$1.16—although the ECB should allow for downsizeovershoot.The process of devaluing it will involve massive liquidity expansion withinthe eurozone, thereby reliquifying the parched banking system and restoringlending activity across the eurozone.Its time for the eurozone to start pumping out its own brand of Bernankeheroin—until the euro reaches a globally competitive range and the Europeanbanks have rebuilt themselves to at least the minimal-to-modest strength oftheir American counterpartsWhen eurobanks no longer have to pay infinitely higher rates on short-termdeposits than American banks, they will be better able to handle the problemsof (1) putrefying American CDOs purchased when the euro was trading farabove par on the dollar, and (2) depreciating PIIGS bonds lending their ownpeculiar odors to their balance sheets. November 2011 29
  34. 34. Its the Economy Banks, Stupid! But how can such reliquification and monetary depreciation be sold to the Germans? They know of two disastrous policy regimes—hyperinflation and Hitler. They believe that one begot the other. Never again! Sarkozy talks of a new Franco-German domain within the eurozone, andJames Carville, Finland now argues that the six members with AAA ratings should have awhere art thou now? greater measure of control: (Slovakia shouldnt have a veto.) The Germans still act publicly as if there can be no retreat from the sound money policies that have prevailed under Duisenberg and Trichet. But Angela Merkel is a realist and she is the new uncrowned queen Angela of the eurozone. She can expect powerful support from German manufacturers who fear losing their competitiveness in peripheral economies that abandon the euro—and are losing competitiveness globally because of the levitating euro. As one German auto manufacturing CEO told a friend of ours, " If the euro comes apart in a crash, then wed be left with a mark whose value was up 40% over the peripherals and we couldnt sell in the South or in most of the world!" She can also point out that inflation in major non-euro economies with weak currencies is roughly at—or even less than—eurozone levels. Theres room for currency depreciation and bank reliquification. She has shown herself open to discussions of a new core decisionmaking structure for the euro. With French yields soaring far above bunds, the partnership that is crucial for euro-survival risks destruction by the new bond vigilantes. (James Carville, where art thou now?) We suspect that what could bring Merkel and the German political leaders to accept (temporary) Bernankization of the ECB is the rapid deterioration of finances for the European banking system. This is, in reality, the core issue that is destabilizing global capital markets. If the European Central Bank, backed by the full eurozone membership, reflated money supplies and drove short-term rates to America levels, there would be strong rallies among the beaten-down bank stocks, giving them the opportunity to raise new infusions of equity—a process of financial strengthening that would feed on itself as global investors stopped worrying about an epidemic of Dexia-itis and looked at the rising values of banks net equity.30 November 2011 THE COXE STRATEGY JOURNAL
  35. 35. It is not too Panglossian to expect that the financial crisis of the eurozonewould gradually migrate from Page One of newspapers within Europe—andacross the world.If—or when—that happened, share prices of major US banks would also Monetary virtue worksstop falling and start rising. well in theory, but howIf—or when—that happened, a new global equity bull market would be does it work in practiceborn. when nobody seems to prize it anymore?But even before that overall rally was returning smiles to Wall Street and theworld, that other bull market that never really went away would be excitinginvestors...2. Gold Moves From the Sidelines to Center StageAs the only medium of exchange that cannot be synthesized or devaluedby high-speed central bank printing presses, gold wins from eurodespair oreurodevaluation.If the ECB—the last holdout against financial heroin—joins the lotus-eatingmajority of central bankers, gold would enter a spectacular bull market onceit became apparent that the euroelites had decided to save their banks andtheir economies by rejoining the world. Monetary virtue works well in theory,but how does it work in practice when nobody seems to prize it anymore?We have been advocating the reintroduction of gold into the world monetarysystem by using it to back long-duration bonds of profligate nations suchas Italy and the USA. That still could happen, but weve had no takers.Keynesian orthodoxy lives among intellectual elites, even as they lose faithin the Old-Time Religion.But the failure to rebrand gold as the backing for long-duration inflation-hedged bonds doesnt mean gold has no future.If investors in other assets sense that the last holdout against monetary excesshas decided that virtue is punishing all members of its currency zone, theywill rush into gold as the last refuge in a universe of Paper Moonshine. November 2011 31
  36. 36. Its the Economy Banks, Stupid! For those who wish to protect their wealth against monetary excesses on a global scale, there are several options: Gold Bullion or ETFs Gold Royalty and Streaming companies Large-Cap Gold Miners Medium- and Small-Cap Gold Miners, and Exploration Companies Gold Bullion or ETFs We believe gold bullion—in specie or ETF—should be a cornerstone of almost any long-term portfolio. It meets the KISS principle of simplicity, and is devoid of the execution and other risks that beset the mining stocks. It provides liquidity, security and a foundation for performance, based on current and near-term prices for the metal. We disagree with those who say you can’t trust the ETFs because governments could block access to the bullion. The major bullion ETFs track spot gold prices. Dennis Gartman is the most articulate exponent of the view that investors should only buy the GLD or other bullion equivalents—not gold miners. He notes that the profitability of mining gold has failed to keep pace with the rise in bullion, and the mines have great political risks. Rather than avoiding all miners, we recommend that investors seek the opportunities offered by mining companies with the right characteristics: great assets, good management, operating in politically-secure areas of the world. Gold bullion, and the royalty and streaming companies, perform well when investors are filled with fear, and seek the safety of "the asset that is nobody’s liability." The ETF has been the sweet spot in this years strong gold rally.32 November 2011 THE COXE STRATEGY JOURNAL
  37. 37. Gold Royalty and Streaming CompaniesThese companies have unique business models that allow them to minimizerisk and maximize upside reward from rising metal prices: Because their earnings come from dozens of mines, they provide a miners (and diversified portfolio of known revenue streams. royalty companies) provide a levered play They have fixed costs—they dont have to provide more money as capital on gold price increases. costs for opening and extending mines increase. Despite having huge and growing revenues, they have staff counts and overheads that are normally found only in companies too small to apply for stock exchange listings. The auto dealer from whom we purchased our family car has roughly as many employees as one of these companies.They are core investments for almost any investor who wants to participatein the future of gold.Large-Cap Gold MinersAll long-term gold investors should have some exposure to the major miningcompanies.Our core investment thesis is: “invest in companies with unhedged reserves in theground in politically-secure areas of the world”.Furthermore, gold miners (and royalty companies) provide a levered play ongold price increases.The relative value of unhedged reserves compared with the investment valueof holding spot gold is changing as strong gold prices improve both theprofitability of existing production and the volume of economic reserves.As the price of gold goes up, not only does the value of currently recordedreserves rise with it, but the total reserves economic for mining increase.Investors in well-managed large-cap gold mines have been greatlydisappointed at their stocks recent price performance.Why? Because the investor consensus on gold, which shifts from fear ofinflation to fear of a deflationary crash, is in one of its confused periods. Thatmeans speculative enthusiasm for the miners and exploration companies isat a relatively low ebb. November 2011 33
  38. 38. Its the Economy Banks, Stupid! The North American and Australian-based majors are all serious companies, with strong management teams, and most boast splendid properties and long-life reserves in politically-secure regions. (We note, however, that, while gold reserves are increasing, so are political risks. Investors must be wary...while gold reserves about deterioration in some formerly favorable nations.)are increasing, so We believe investors have soured on the large caps stocks unduly and expectare political risks. them to benefit when gold shows signs of a new upside breakout.Investors mustbe wary aboutdeterioration in some Medium- and Small-Cap Gold Miners, and Exploration Companiesformerly favorable When gold was surging toward $1,900 the bullion and the explorationnations. companies were outperforming the established miners—the bookends of enthusiasm. When retail investors regain the confidence to take bets on the exploration companies ability to find orebodies that are strong candidates for acquisition by the major miners, this group can deliver sensational returns. We strongly recommend exposure to those smaller companies that have proven management teams, proven reserves in politically-secure areas of the world, and properties with potential for major additions to reserves within the next four years. We are old enough to remember the days of $35 gold when mines were unprofitable unless the ore grade was near one ounce per ton. These days, even mines with grades near one gram per ton can be very profitable—if the resources are large enough, the local communities and governments are greatly supportive, and the management is adept, realistic, long-term- oriented—and gutsy. Silver and Other Precious Metals We have always recommended some exposure to silver. We believe silver will be pulled skyward with gold, but do not recommend that investors maintain large silver or platinum exposure at the expense of gold. Gold is the clear-cut choice—and the metal that offers the greatest chance for reintegration into global monetary programs.34 November 2011 THE COXE STRATEGY JOURNAL