Don-Coxe-Basic-Points-Two-Days-After-Hallowe’en-101310

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Basic PointsTwo Days After Halloween

October 13, 2010

Published by Coxe Advisors LLP

Distributed by BMO Capital Markets


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(1) BMO Capital Markets or its ailiates owns 1% or more o any class o common equity securities o the company

(2) BMO Capital Markets makes a market in the security

(3) BMO Capital Markets or its ailiates managed or co-managed a public oering o securities o the company in the past twelve months

(4) BMO Capital Markets or its ailiates received compensation or investment banking services rom the company in the past twelve months

(5) BMO Capital Markets or its ailiates expects to receive or intends to seek compensation or investment banking services rom the company

in the next three months(6) BMO Capital Markets has an actual, material confict o interest with the company

BMO Capital Markets Disclosures

Company Name Stock Ticker Disclosures Company Name Stock Ticker Disclosures

Agrium AGU Deere DE

Bank of Montreal BMO 1, 3, 4, 6 General Motors GM

Bank of Nova Scotia BNS.TO 1, 3, 4 International Business Machines IBM

BHP Billiton BHP Microsoft MSFT 2

British Petroleum BP Nasdaq NDAQ 2

Citigroup C 3, 4 Potash POT 1

CNH Global CNH

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This 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 use

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Don Coxe

THE COXE STRATEGY JOURNAL

Two Days After Halloween

October 13, 2010

published by

Coxe Advisors LLP

Chicago, IL


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October 13, 2010

Author: Don Coxe [email protected]

Editor: Angela Trudeau 604-929-8791

[email protected] Advisors LLP. www.CoxeAdvisors.com190 South LaSalle Street, 4th Floor

Chicago, Illinois USA 60603


5/511October 2010

OVERVIEW


We are publishing earlier than previously planned, because of some important

improvements to the backdrop for equity investing, particularly in emerging

markets and commodity stocks.

Their combined effect has been to improve the near-term outlook for most

equities, including the S&P. None of these factors deal with the root problems

bedeviling the US banking system and the US economy, but they certainly

improve the investment background for risk assetsat least for the frequently

problematic weeks around Halloween.

Halloween has become the second-highest-ranked holiday for retail sales.

Stores are awash in masks, costumes and candy. That it should be an occasion

of such costly revelry would have shocked our ancestors. Since medievaltimes, Halloween has been observed as the night before the day in which

prayers for forgiveness for souls in Purgatory were offered. That meant their

spirits were attuned to this world and could, perhaps, be accessed, thereby

leading to tales of yawning graves and strolling spooks.

We cite this lore because most of the industrial nations are suffering

something approximating Economic Purgatory. This comes as punishment

for their bankers sins of greed and mendacity, and their governments and

consumers sins of gluttonythrough excess spending and borrowing.

Americans hold elections on the first Tuesday after Halloween. The onlyghosts that could be influencing voters in this election are those of the

Founding Fathers, because, in significant degree, it is being fought over

claims by various politicians and activists about what those eminences would

counsel were they alive today. Although the economy is The Issue, the main

division between the ruling Democrats and their Republican challengers is

about the size of fiscal deficits and of the federal government.

As long-term investors, we remain cautious, except for commodity-related and

emerging markets stocks, but in a world where central banks are becoming

more aggressive and governments are competing with each other to debase

their currencies value, those longer-term doubts are of significantly less

immediate concern.

Finally, we join the rest of the world in rejoicing about the brilliantly-managed

rescue of the heroic Chilean miners. As we went to press, a dozen were back

on the surface. Hooray!


6/51

THE COXE STRATEGY JOURNAL2 October 2010


7/513October 2010


So short a time so long ago

So long a time so short ago

We have used those lines from The Victorian House by Canadian poet

Philip Child as a title of Basic Points, and we recall it now as a reminder

that the past three years have been truly tumultuous. Long-held principles

of investing have been seriously challenged, including the core belief that

equities will always outperform government bonds over any reasonable

investment holding period. How many private portfolios and pension funds

have been winners from what is now a three decade period in which the total

return to date on continuously rolled 30-year Treasurys exceeds the returns

from the S&P?

S&P 500

October 1, 2007 to October 12, 2010

600

700

800

900

1,000

1,100

1,200

1,300

1,400

1,500

1,600

Oct-07 Feb-08 Jun-08 Oct-08 Feb-09 Jun-09 Oct-09 Feb-10 Jun-10 Oct-10

1,163.80

US Treasury 10-Year Yield


2.0

2.5

3.0

3.5

4.0

4.5

5.0

Oct-07 Fe b-08 Jun-08 Oct-08 Feb-09 Jun-09 Oct-09 Feb-10 Jun-10 Oct -10

2.39

So short a time

so long ago...


8/514 October 2010



Three yearsthe usual term for consideration of performance of an investment

manager for a pension fund. That time period began with the S&P struggling

to a new all-time high before entering its worst plunge since the Depression,

accompanied by a Flight from Fear into Treasurys. Gold rallied briefly

amid the late stages of the commodity boom, then plunged after Lehmans

implosion, before embarking on its most powerful bull market since the late

stages of the stagflationary Triple Waterfall run-up.

The dollar double-topped in early 2002, before entering a six-year bear

market that ended with the Crash. It triple-topped thereafter, before entering

new decline, helped by the dollars new status as a carry-trade currency, when

US short-term rates began plumbing Japanese depths.

US Dollar Index (DXY)


70

73

76

79

82

85

88

91


77.59

Gold


700

800

900

1,000

1,100

1,200

1,300

1,400


1,347.90

...the dollars new

status as a carry-trade

currency...


9/515October 2010

Although the powerful relief rally in stocks that began in March 2009 revived

hopes that the mighty Bear was re-entering long-term hibernation, ten-year

compounded equity returns still approximate current fed fund ratesa

prolonged horror story that makes the goriest Halloween shock movies look

like mere childrens tales.

The Monster Mathematics That Spooked the World

Nassim Taleb, author of the prescient assault on Wall Streets operating

principles, The Black Swan, published in 2007, says that there were probably

1,000,000 practicing economists in the world in 2006 and perhaps only five

saw the extent of the risks we were facing. A Nobel in Economics seems to be

no different than the Nobel in Literature: its fiction. The major reason, hebelieved, was the increasing reliance on mathematics, rather than economic

history, in financial forecasting and portfolio construction. Black Swans were,

he showed, the unlikely long-tail events that spawners of mathematical

formulas about rates of return deemed too remote to include in their risk

calculations for portfolio construction.

We had the good luck to speak prior to him at a conference in California in

2007 shortly after wed read his book, finding his analysis of Wall Streets

abuse of mathematics and statistics deliciously congenial. He ridiculed the

reasoning of the Value at Risk formulas which had led to Long Term Capitals

collapse, and insisted the Street had learned nothing from that shock, and

was piling up trillions of dollars in exposure to grossly overvalued assets,

which meant the coming crash would be of epic proportions. He used

audience-friendly slides to illustrate his point, that the financial system was

no longer driven by accumulated wisdom, but by the complex risk/return

calculations devised by youthful mathematics and physics PhDs with no

sense of history.

Just prior to closing, he used a slide showing a scene in the Roman Senate,

whose title, he noted, came from the Latin root of seniors and seniority to

show how great, enduring systems had functionedaccumulated wisdom.We had known that particular painting from our high school Latin days, and

we later queried him about it. It was the famous scene in which Cicero was

pillorying the rebellious upstart Catiline, who, it was rumored, was secretly

supported by Julius Caesar. Cicero was later garroted by Mark Antonys

agents, so was it just a Black Swan event for Cicero or for Rome itself, because

it signaled the end of the Roman Republic?

A Nobel in Economics

seems to be no

different than the

Nobel in Literature:

its fiction.


10/516 October 2010



His presentation confirmed our perception that those Wall Street formulas

claiming that collateralized debt obligations could fail only once in

hundreds-of-thousands-of-years were based on ignorance of history. As

non-mathematicians, we scorned the arrogance of the nouveaux-riches

mathematicians, and, as readers will recall, routinely ridiculed them in Basic

Points by suggesting that, to command respect, their data bases should include

statistics on deaths from saber-toothed tiger attacks or from freezing during

the last two Ice Ages to reflect properly the unforeseen disasters during the

millennia that were supposedly covered in their formulas.

That the respected firm of Waddell & Reed triggered the May 5 th Flash Crash

argues that the entire system is inherently unstable, driven by the ceaseless

interaction of inherently dubious algorithms and robotics. It recalls the 1953

Yves Montand classicLe Salaire de la Peur(The Wages of Fear) of desperate

men driving trucks loaded with nitroglycerin on perilous mountain roads.

If the containers break, or are even shaken too severely, the driver will be

blown to smithereenswhich is, of course, what happens as he nears his

destination. Because of this interconnectedness of discrete systems with

differing risk parameters, once Waddells Sell at any Price order went in,

other systems automatically sold or exited from the market. This is yet more

evidence that the Street exists to serve its major players, not the public, on

whose savings and support it ultimately depends. A Let em eat tape attitude

to the public should not be an accepted business model.

Given Talebs record as a Tireisian teller of doom, we were not happy to read

that hes equally gloomy now. As recently as last June, he said, The crisis

might not even have started yet, and last month he warned, We have a lot

more risks than we had in 2007.

Let em eat tape


11/517October 2010

Has the Street Learned From Its Folly?

KBW US Bank Stock Index (BKX)


10

30

50

70

90

110


47.62

More and more, Wall Streets collapse and Washingtons desperate rescue

measures seem like a retelling of the Humpty-Dumpty nursery rhyme.

Humpty-Dumpty sat on a Wall, [Street]

Humpty-Dumpty had a great fall.

All the Kings horses,

And all the Kings men

Couldnt put Humpty together again.

The Washington equivalent of the Kings horses and men was the White

Houses economic rescue team. It was an all-star group and it did its job:

to reassure a frightened nation that it not only knew how to prevent a

financial collapse, but how to save jobs and put the economy back on track.

Unfortunately, the resultsin economic and political termshave, at least

to date, proved disappointing.

(An old joke says that when the King was being interviewed later about the

attempted rescue of Humpty-Dumpty, he replied, If I had it to do all over

again, Id leave out the horses.)One by one, the famous rescuers have faded away.

The announcement that Larry Summers is returning to Harvard means that

the only key Administration rescuer to remain is Tim Geithnera Bush

holdover.

If I had it to do all

over again, Id leave

out the horses.


12/518 October 2010



Christina Romer and Peter Orszag departed weeks earlier. Paul Volcker was

never an insider, although he was called back to help craft the financial

regulatory reform. The Street marshaled its maximum lobbying effort to

dilute his program, and now collectively asserts that it has been subjected to

altogether too much regulationparticularly of its bonuses and its balance

sheets. Thanks to the taxpayers and the Fed, Humpty-Dumptys shell has

been glued back together and he now climbs back up the Wall, seemingly as

arrogant as ever.

Wall Streets Best and Biggest have done an impressive job convincing

votersincluding many Tea Partiersthat, (despite billions in bailouts and

government guarantees on its deposits), its asymmetric bonus programs

exemplify the great American way of life, and tighter regulations on how it

values its trillions in dubious assets would cripple the economy and send

more jobs overseas.

Not that Wall Street is alone: we had hoped that the emergency global

committee charged with rewriting the Basel Rules (Basel III) would set

standards that would make a replay of 2008 extremely remote. Instead,

it became an exercise in postponing penitence. It turns out that banks in

Germany, Britain and Switzerland were profoundly upset about having

to strengthen their balance sheets to the levels that Paul Volcker and his

colleagues imposed under Basel I. For a decade, as those sound rules were

being obeyed, not one major global bank failed or needed rescue. That hadnever happened before.

It is said that nothing succeeds like success. In this case, nothing succeeded

success but excess, which is to continue for years.

Led by Citibank and other practitioners of Enronesque off-balance-sheet

accounting, and by the crowd of enthusiasts for collateralized debt obligations,

those wise Volcker rules were largely jettisoned in favor of the see-no-evil

practices of Basel II. For nearly a decade, that new financial promiscuity

delivered alluring rewards. Then much of the global financial system rather

suddenly found itself nearly buried alive under mountains of bad bets.

That the reforms have been so modest, and their impact so delayed, has to

be a huge disappointment to some of the leaders in the discussions about

new global regulations such as the Bank of Canadas Mark Carney. We heard

him speak at a conference in Ottawa just as the economy was beginning

to recover and he expressed confidence that the crisis had opened the door

to acceptance of Canadian-style regulations that would prevent another

disaster.

...nothing succeeded

success but excess...


13/519October 2010

After all, the economy had barely survived, millions of people had lost

their jobs, and OECD governments had almost simultaneously socialized

the systems risks while leaving the ownership within the private sector. The

banks didnt suffer the indignity of nationalization, GM-style.

Thus, went the reasoning, if ever there were a time when bankers could

be compelled to accept reasonable constraints on risk-taking, this was it:

Banks would concentrate on making economically-productive loans and

strengthening their balance sheets and liquidity in a healing process that

would take time, but would likely preclude the possibility of another financial

crisis that would engulf nearly the whole OECD financial system.

That optimism, sadly, was mostly misplaced.

Baa, Baa, Basel: The Shepherds Sleep With the Sheep

Governor Carney and his reform-minded colleagues in other central

banks were up against the united power of Wall Street, and a collection of

mismanaged European banks whose tangible capital ratios had fallen to the

2 - 4% range. Even those epicene numbers overstated the health of numerous

European banks stuffed with bonds from PIIGS.

These organizations used their influence with their governments to castrate

the proposals.

The Bank for International Settlements and the Financial Stability Board had

produced a study showing that a one percent increase in the targeted ratio of

tangible common equity to risk-weighted assets would lead to a maximum

GDP decline of roughly one-fifth of one percent from the baseline path

after 4-5 years. That seemed like modest pain for such a good result.

The bankers responded with a horror story that could be characterized as an

endless financial Halloweenthe GDP damage would be as much as eight

times greater than the experts predicted! Depression, they threatened, would

be the price of ill-advised bureaucratic constraint.

Backed by pusillanimous politicians, the big, bad, bonused, bailed-out banks

(what we have been calling the B5) won.

...a horror story

that could be

characterized as an

endless financial

Halloween...


14/5110 October 2010



Under Basel Lite, (otherwise known as Basel III), banks will have up to nine

years to reach the required risk-weighted 7% capital level (4.5% tangible

equity plus 2.5% as a buffer). As Martin Wolf observed in his column in the

Financial Times, Basel, the mouse that did not roar: This amount of equity

is far below the levels markets would impose if investors did not continue

to expect governments to bail out creditors in a crisis.The public at large

has zero interestin fact, a negative interestin subsidizing risk-taking by

banks, in general. For this reason, the subsidy it [the state] offers by providing

free insurance must be offset by imposing higher capital requirements.

Apart from allowing banks to keep operating even though so many of the

largest are gigantic upside-down pyramids resting on a tiny apex of tangible,

liquid capital, Basel III will continue the full exemption from allocating

any of that precious pool of capital to holdings of sovereign debts from all

EU members. Bonds of such putatively reliable issuers as Greece, Portugal,

Spain and Ireland will continue to be exempt from writedowns to reflect the

plunges in their Collateralized Debt Swap prices. That their yields are far

higher than, say, Germanys, is an ongoing inducement for banks to finance

the overextended and under-performing Eurozone members. The program

could be summed up as follows:

Eurobanks: Borrow big!

Load right up with bonds of PIIGS!

The long deferral of the time when the worst banks have to meet the Tier One

tangible equity tests has drawn extensive comment. Some critics argue that

there will be at least one or two full-blown banking crises before the time

when the banks have to meet these minimal solvency tests. As more than one

observer has sneered, these are Augustinian promisesGrant me Chastity,

O Lord, but not yet.

Basel III rejects the wise US decision (in the Dodd-Frank reform bill) to reject

the privileged status of those deflowered rating agencies in asset valuations.

That means European banks can continue to use those ratings to puff up

their Tier One equity.

One of the most-sought-after changes was to the banks minimum liquidity

calculations, which had proved so unreliable when the crisis broke. But the

wrangling that went on in the discussions killed any change at consensus,

and that was left to future meetings, although a somewhat modified liquidity

requirement will supposedly be in placein five years.

Load right up with

bonds of PIIGS!


15/5111October 2010

Canadas well-managed and well-regulated banks are sounding so relaxed

about the rules as to be almost smug. Example: Bill Downe, BMOs CEO,

says that Based on our estimates, BMO meets the 2019 capital rules today

on all three capital measures and on the leverage ratio. Clearly, a very good

position for the bank to be in.

Summing up: Basel III puts off pain, with fingers crossed that serenity will

rule the financial markets for many years to come, when imposing real reform

will, it is hoped, prove painless.

Voters across the OECD had furiously demanded that the banks that

collectively caused a crash and recession be reined in, that their financial

reports had to become reliable, and that there would be no future bailouts.

The banks were at bay as never before.

What is the big banks response to getting off so lightly after being pilloried

so publicly?

Many of the most prominent Wall Street and European investment-oriented

banks are actually complaining about having to accept even these watered-

down rules changes. They huff that being forced to use lower valuations for

some of their [unmarketable] assets means that they will be forced toare

you ready for this?... make fewer loans to individuals and companies! They

will cut back on their participation in the socially necessary activities that

justify taxpayer bailouts, leaving funds for what really matter: securitizationand bonuses.

Why? Because of, according to a banker interviewed by the Financial Times,

the combined effect of the risk-weighting rules and the higher capital as

a hockey stick that sharply penalize efforts to restart the securitization

market.

The new credo: If you wont let us use our own valuations for stuff we cant

sell, that you didnt want us to buy, that led to a global financial collapse,

were going to have to punish small businesses and consumers.

Ben Bernanke is certainly displeased about this response. He spoke recentlyabout how far the Fed has gone to convince banks to make loans to small

businesses. And yet Bank loans outstanding have continued to decline. Small

businesses, which depend importantly on bank credit, have been particularly

hard hit by restrictive lending standards.

...were going to

have to punish

small businesses

and consumers.


16/5112 October 2010



The latest blemish to banks in the US comes from the apparent breakdown

of their large-scale foreclosure program. They are admitting in court that the

staff who were swearing out affidavits about the circumstances of thousands

of loans were, in many cases, either incompetent or dishonest or both. Result:

the foreclosure process is frozen, and the overhang grows daily, adding further

downward pressure to house prices.

So lets see: many of the big banks displayed incompetence in making loans

to borrowers who couldnt service the debts, and incompetence in valuing the

prices of homes on which they were lending, and incompetence in valuing

Collateralized Debt Obligations that included so many toxic loans, and

now they display incompetence in managing foreclosures, thereby further

weakening the housing market whose problems are at the root of the worst

downturn since the Depression. Right? And they tell us they need freedom to

grant big bonuses to their top management to stay competitive?

Capitalism is a successful system when it rewards success and punishes failure.

Socialism tends to operate in the reverse. The socialists wearing bankers

masks and costumes in a never-ending Halloween celebration are winning.

As Paul Volcker complains, the only socially useful innovation those banks

have delivered in decades is the ATM. Collectively, they seem destined to spend

their lives, and their stockholders money, proving one of Milton Friedmans

most perceptive analyses: The worst enemy of socialism is socialism; the

worst enemy of capitalism is capitalists.

The socialists wearing

bankers masks

and costumes in

a never-ending

Halloween celebration

are winning.


17/5113October 2010

The Good News Mid the Bad Basel News

There is an upside to the ovine behavior of the Basel rulemakers: by deferringthe serious balance-sheet-building, the Basel Brandy & Cigars Club has

improved liquidity conditions in the near-term. Indeed, when the rules were

announced, European and US stock markets soared, with the Dow and S&P

breaking through double-top technical resistance, sending previously bearish

technicians into bullish mode: September proved to be one of the strongest

months for the S&P in history.

The rally gained strength when the Fed confirmed that it wasnt going to be

raising rates in the foreseeable future and was contemplating a resumption

of its purchases of longer-dated Treasurys.

The robust rally rolls on, even as statistics on home foreclosures and regional

bank failures show increases month-by-month. Last week, it was reported

that 279 US banks have gone bust since Lehmans bankruptcy. Most of the

regional banks fail because of real estate loans. Sometimes, there are colorful

lending stories, like the Broadway Bank of Chicago, owned by the family

of the State Treasurer, Alexi Giannoulias, who campaigned for that office

on the basis of his banking expertise as a senior officer of the bank. The

family withdrew $200 milliontax freefrom the bank before it imploded;

the collapse cost the taxpayers $250 million, and the regulators uncovered

a large, steamy portfolio of loans to high-profile members of the Mob. (He

wants to take his talent to the national leveland is in a virtual tie with a

Republican who puffed up his military record for the Senate seat once held

by Obama which was the bargaining chip in the dealmaking that led to the

prosecution of Governor Rod Blagojevich. No, you cant make these things

up.)

Basel IIIs failure to impose meaningful controls on undercapitalized and

over-ambitious banks should mean more liquidity in riskier sections of the

capital marketsand that means higher stock prices, at least in the near-

term.

There is an upside to the

ovine behavior of the

Basel rulemakers...


18/5114 October 2010



But the charts of the Relative Strength of the two key US bank stock groups

show that the Basel news wasnt enough to propel these underperforming

stocks back into market leadership:

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


90

95

100

105

110

115

120

125

Oct-09 Dec-09 Feb-10 Apr-10 Jun-10 Aug-10 Oct-10

100.49

KBW US Bank Stock Index (BKX) relative to S&P 500


85

90

95

100

105

110

115

Oct-09 Dec-09 Feb-10 Apr-10 Jun-10 Aug-10 Oct-10

94.14

As clients know, we are skeptical of the underpinnings of the stock market

when the banks underperform, and are impressed by any rally in which thebanks significantly outperform.

Basel III has been widely touted as a reason to buy stocks. But the bank

stocks are being pulled along by the rally, not leading it. That raises questions

for us about the durability of this rally.

Basel III has been

widely touted as a

reason to buy stocks.


19/5115October 2010

Maintaining the Dosage of Financial Heroin

Last December, we coined the term Financial Heroin for the massive injectionsof zero-interest-rate funds into the US economy.

We used this analogy from the battlefield anesthesia practices of the Royal

Canadian Army Medical Corps during World War II. For seriously wounded

soldiers, no other pain-killer was as efficacious as heroin. The doctors

challenge was to choose the time when the injections would be reduced,

and then eliminated. The wounded soldiers would still be in great pain, and

would usually demand that the doctors continue the injections, but unless

the patients were taken off heroin promptly, they would become addicts

unfit for either military or civilian life.

We had used this metaphor on a panel presentation in Denver at which the

principal speaker was David Dodge, former Governor of the Bank of Canada.

He concurred in its applicability to the international financial situation, and

warned that central banks should not overstay their low or zero interest rate

policiesthe inflationary pressures once a recovery finally took hold would

be too great.

It is now a year since he issued that warning and Ben Bernanke keeps pushing

the time of heroin withdrawal further off into the distant mists of the future.

The interest rate futures project no rate increase until 2012, implying that

nearly all of Obamas first term would operate within a zero interest rateenvironment. There is no historic precedent for such sustained stimulus,

which means no one can predict what longer-term damage it will inflict on

the patient.

...Financial Heroin for

the massive injections

of zero-interest-rate

funds...


20/5116 October 2010



What is dramatically different is what Bernanke has had to do with

manipulating the Monetary Base to maintain the fed funds near-zero rate:

US Monetary Base

(Billions of Dollars, Monthly, Seasonally Adjusted)

December 1, 2008 to December 1, 2009

1,500

1,600

1,700

1,800

1,900

2,000

2,100

Dec-08 Mar-09 Jun-09 Sep-09 Dec-09

2,017.67

Source: Federal Reserve Economic Data, Economic Research Divis ion, Federal Reserve Bank of St. Louis

(http://research.stlouisfed.org/fred2)

US Monetary Base

(Billions of Dollars, Monthly, Seasonally Adjusted)

October 1, 2009 to September 1, 2010

Source: Federal Reserve Economic Data, Economic Research Divis ion, Federal Reserve Bank of St. Louis

(http://research.stlouisfed.org/fred2)

1,920

1,940

1,960

1,980

2,000

2,020

2,040

2,060

2,080

2,100

2,120

Oct-09 Dec-09 Feb-10 Apr-10 Jun-10 Aug-10

1,963.54

The patients vital sign (the fed funds rate) has held steadybut so has the

Monetary Base. When we published last December, the annualized rate of

change was 48%. Since then, the Bases annualized growth rate has been

negative. So the heroin flow has, in fact, been dwindling, but the patient (as

measured by growth in loans and GDP) is dwindling even faster. Result: the

Fed is discussing raising the dosage through QE2.

...the patient

(as measured by

growth in loans and

GDP) is dwindling

even faster.


21/5117October 2010

One need not be a dogmatic monetarist to argue that credit demand has

clearly been slowing, which means the economy must also be decelerating.

If interest rates and the Base decline together, then the recovery is aging, and

its corpuscles are showing signs of anemia.

As Bernanke ponders injecting QE2 into a banking system that finds reasons

not to make economy-stimulating loans, he may be wondering what to

call a bank that just takes what he creates and doesnt lend it to create the

economic multiplier effect that is a condition precedent to sustained growth.

Is it a vault?

Yet, now that further Congressionally-spawned stimulus is off the table, the

Fed is the only Big Picture game-player.

The annual Kansas City Fed-sponsored Jackson Hole get-together was a

somber successor to the optimistic session of 2009. The Keynesians, who a

year ago were reveling in the 3.5% GDP growth that they claimed was proof of

the success of Washington stimulus, were now worried that the economically

ignorant were taking chargewhich meant recession was once again lurking

out there past a Teton. The tiny group of monetarists were murmuring that

zero interest rates were damaging the economy. (As always, the local insectae

did not include any gold bugs.)

The September 21st announcement that the Fed was going to keep rates low

for the foreseeable future and that it would be adding to its Treasury holdingssent stocks higher, but had a particularly powerful impact on Gold:

Gold

September 20, 2010 to September 23, 2010

1,270

1,275

1,280

1,285

1,290

1,295

1,300

20-Sep 21-Sep 22-Sep 23-Sep

1,294.50

As always, the local

insectae did not include

any gold bugs.


22/5118 October 2010



Then, a week later, when the Fed announced it was buying long-dated TIPS,

it drew the same response from the gold market:

Gold

September 26, 2010 to September 29, 2010

1,285

1,290

1,295

1,300

1,305

1,310

1,315

1,320

26-Sep 27-Sep 28-Sep 29-Sep

1,310.70

(We had been suggesting that triskaidekaphobia [fear of the number 13]

might keep gold below the $1300 level, but Bernanke and friends seem to

have sprayed financial garlic. In keeping with the Halloween theme, we

should explain the reason why thirteen is an unlucky number. For centuries

before the dawn of Christianity, and persisting even as Christianity conquered

Europe, the Old Religion was widely practiced. It was based on a coven of 12

believers who danced around the 13th memberthe god-on-earth, branded a

witch by the church. It was profoundly unlucky to be named a witch, because

the trial to establish guilt meant being thrown into a pond: if you stayed

up, that meant the water rejected you as evil, which meant you were burned

at the stake. If you drowned, you were a winnerof sortsbecause you

supposedly were headed to Heaven. The accuracy level of those tests is, of

course, unknown, but was probably at least as reliable as Moodys appraisal

techniques for AAA-rated mortgaged-back CDOs, which proved to be bizarre

modern superstitions in which reiterations of complex formulas replaced

medieval incantations.)

...Bernanke and friends

seem to have sprayed

financial garlic.


23/5119October 2010

As we wrote last month, heroin-driven near-zero interest rates are a basically

unfair technique for pulling the economy out of its funk. They prop up

undercapitalized and overlevered large financial institutions by robbing

returns for savers. The operating formula for a world of near-zero rates is:

Theres nothing surer:

The rich get richer

And the poor get poorer.

In the meantime,

In between time,

Aint we got funk!

The rich are the managements of banks by taxpayer-funded bailouts or

loans, whose deposits carry government guarantees (for which the bankspay nothing). The poor are those who save through bank deposits and CDs,

earning miserably low rates. The banks invest those bargain-cost funds up

the government yield curve or in other vehicles where returns are multiples

of what they pay to the poor depositors. (Sophisticated private investors can

invest in high-quality preferreds, corporate bonds, junk bonds, and Emerging

Market bonds.)

Last month we commented on this redistribution of wealth from the small

savers to the mighty, as evidenced by IBMs oversubscribed issuance of $1.5

billion in three-year 1% bonds. Not to be outdone, Microsoft floated a

huge issue at .875%, to be used for stock buybacks and dividends. Those

surreal low rates may not be delivering much economic stimulus, but theyre

certainly great news for the great.

What is clear is that the longer the heroin flows, the greater the damage to

pension funds. The Ten-Year Treasury yield is 2.47%, and the AA Ten-Year

Corporate Bond yield, which is widely used for valuation of pension funds,

is 4.98%.

But most pension funds use projected return rates of 7-8% in their solvency

calculations. The Stanford scholars who claimed that the gigantic California

state funds were underwater by hundreds of billions used the AA corporaterate for long-term returns. The funds insisted they were solvent, based on

their lofty long-term rate of return assumptions: 7.75%. That US stocks

havent been earning observable returns for a decade, puts pension funds

into a painful position: no major asset class can be counted on to deliver

returns anywhere near what the funds need to endure, let alone prosper.

...the longer the heroin

flows, the greater the

damage to pension funds.


24/5120 October 2010



The funds are, involuntarily, in a similar position to the poor: they are

forced to participate in the subsidization of the financial industry to pull the

economy out of its funk.

The longer the heroin flows, suppressing interest rates to levels never seen

on a sustained basis in history, the more the damage to incomes of pension

funds, pensioners, and the thrifty middle class.

Poloniuss classic advice to his son Laertes is in peril of repeal, to be replaced

by a version that could be labeled The Wisdom of Bolonius:

Only a borrower, not a lender, be.

Bernankes apparent willingness to use Quantitative Easing to keep rates low

has only one Open Market Committee (FOMC) dissenterThomas Hoenigof the Kansas City Fed. He is a wise, stubborn critic of Fed policy who is deeply

disturbed by its unfairness to small savers and small banks. We hear stories

that several other members of the Board who are non-voting members of

the FOMC are alarmed about the effect of near-zero rates and want to push

the system toward normalcy, but they are keeping their counsel so as not to

embarrass the Chairman and provoke painful wrangles with Congress.

Meanwhile, the seemingly irresistible appeal of borrowing in T-Bills (.2%) up

to the Two-Year Note (.42%), with occasional forays to Five-Years (1.26%),

has its dark side

The Incredible Shrinking Debt Duration

The duration of the national debt has been declining for decades. The decline

began accelerating after passage of the Gramm-Rudman-Hollings Balanced

Budget and Emergency Deficit Control Act of 1985 (GRH).

That Reagan-backed statute was designed to put a tight rein on Congresss

Propensity to Expend. It provided for automatic spending cuts (called

sequesters) when the deficit broke through set deficit targets.

It was largely successful, but both Congress and subsequent Administrationsregularly found its constraints awkward, and an unstated alliance of

Congressional committee chairmen and Treasury Secretaries found ways to

reduce the stated annual deficitsthat would, over the longer term, prove

deleterious to the nations finances:

Only a borrower,

not a lender, be.


25/5121October 2010

1. Because the Treasury yield curve was upward-sloping most of the time,

a sure way to reduce the annual fiscal deficit which was the key statistic

for GRH was to issue an increasing percentage of new debt issues (new

debt and rollovers) in shorter-term notes. As far as we have been able

to discern, none of the nations high-profile fiscal watchdogsinside

Congress, the Administration, or among the small number of members

of the chattering class who looked for signs of fiscal folly, ever came out

with a denunciation of this practice. Didnt it save the taxpayers money?

But at what longer-term cost?

2. One of Reagans most important reforms was creation of the Social

Security Trust Fund as a long-term guarantor of the program. For the first

four decades, contribution rates had been set at levels to pay benefits,

plus a small convenience fund to cover a few months benefit payments.

The Greenspan Commission came up with something approximating the

Canada Pension Planmuch higher fixed contributions, designed to create

a Trust Fund that would guarantee solvency far into the next century. This

Fund would invest only in Treasurys.

When this Funds operations were first reviewed by the US Senate Finance

Committees subcommittee on Social Security in 1989, Chairman Moynihan

called the Canada Pension Plan Administration to send an expert witness to

analyze the S.S. Fund operations in the light of the Canadian experience. I

was recommended (perhaps because I was working in New York at the time,thereby costing nothing for expenses).

On analyzing the actuarial reports and the investment program in detail, I

was shocked at the short average term of the portfolio. It was designed to

match the average term of the national debt, which was roughly nine years

(as I recall). This meant the Fund was not getting the benefit the Canadian

plan was earning from its portfolio composed of long-term provincial bonds.

I testified that the Trustees of the Fund were not acting in the best interest of

Social Security contributors.

A controversy ensued and I was attacked as having misrepresented the Funds

portfolio. After citing page and verse from two actuarial reports on the Fund,

and, after the Chairman consulted with aides, he apologized and commended

my testimony. Later, in personal conversation, he explained that committee

members could hardly be expected to understand the complexities of pension

funding, and were at the mercy of Congressional staff and experts from the

Treasury.

...I was shocked at

the short average

term of the portfolio.


26/5122 October 2010



He felt he could not get a consensus to move the average term of the Trust

Funds investments up to anything approaching what I recommended15

years. (The US could have achieved a longer duration than Canada by

investing heavily in the 30-year T-Bonds; Canadian provinces bonds were

20 years.)

Since then, the duration of the national debt and, (we assume), of the Trust

Fund has fallen to a mere 50 months. This is dangerously short. The UK,

which has a current deficit problem worse than the US, has a debt duration

longer than ten years, because it routinely issues very long-term bondsup

to 50 years. That means the Chancellor of the Exchequer has considerably

more freedom in his debt management than does Timothy Geithner.

From our perspective, although borrowing short and cheap reduces thecurrent fiscal deficita useful thing to doit lays the foundation for a fiscal

crisis when (if) the economy recovers and moves to something approaching a

normal growth path. The endless waves of trillions in maturing debt, forcing

refinancing at rapidly-rising rates, competing with the waves of new debt

for current deficits, could make each month Halloween for the Treasury.

In contrast, the Reagan recovery came at a time when inflation and interest

rates were falling rapidly, which meant most Treasury auctions were hugely

oversubscribed as eager investorsparticularly the Japanesefought with

each other to lock in juicy rates.

Conclusion: The Treasury bull market will continue as long as the economy

flirts with recession, which means Washington can raise all the money it

needs at heroin-containing interest rates. The halcyon days for the Treasury

will surely end once the economy recovers, driving interest rates sharply

higherand reducing demand for new bonds as the size of maturing debt

issues rises relentlessly. That could come as early as next year if, as we assume,

the elections produce a Congress that ends the uncertainties clouding

businesses willingness to invest and hireincluding a stable tax regime,

repeal of the most contentious parts of Obamacare, and a budget that aims

toward moderationnot deficits forever.

If so, one of the toughest jobs in Washington will be managing the Treasurys

debt offerings.

The halcyon days

for the Treasury will

surely end once the

economy recovers...


27/5123October 2010

The Politics of Debt and Recession

Two years ago, America was ready to consummate its love affair witha beautiful black man who was going to bridge the countrys basic racial

divide, bring the nation together, and launch an era of progress on all major

frontseconomic, environmental, health care, and international relations

including ending both wars, solving the Palestinian problem and reassuring

Iran that it didnt needand really shouldnt getget nuclear weapons.

Love can be blind, and it seemed that only the right-wingers and Hilary

Clinton backers asked how someone with no managerial background and

minimal legislative experience could suddenly become the effective Leader

of the World. (The bedazzlement didnt stop at the waters edge: the Nobel

Committee voted to grant him the prestigious Peace Prize after his first 11days in office. Perhaps the only international figure who can claim to have

beaten that record is North Koreas Dear Leader, Kim Jong Il, who, we are

assured, shot more than a dozen holes-in-one during his first-ever round of

golf.)

Mr. Obama turned out to be just as charming in office as in the campaign,

and he remains well-liked, even though polls show that voters reject most of

his program. One of the pollsters routinely asks voters which President they

preferredBush or Obama. For most of his Presidency it was Obama by a

landslide, but the latest result is Obama 48, Bush 45. It appears that voters

are no longer willing to accept Obamas explanation that the economy and

the Afghan War are Bushs responsibility. Americans rightly accepted those

arguments for more than a year, but at some undefined point they began to

expect that Obama would assume some of the blame.

New faces can win on charm, but they are usually re-elected on performance.

The Presidents policies and performance are now rejected by a solid majority

of independents, who overwhelmingly reject his Congressional allies, which

means his party is in serious trouble in the midterm elections. If the latest

Gallup polls on voters Congressional preferences prove accurate, this

Halloween is precursor to a Democratic horror story of 1994 proportions,when Republicans won both Houses of Congress.

If so, that will not mean voters have fallen in love with Republicans. They

will be fleeing from what scares them about Obama and Pelosi.

New faces can win on

charm, but they are

usually re-elected on

performance.


28/5124 October 2010



Republicans running for office this year are the lucky beneficiaries of the

sudden appearance of the Tea Partythe largest and most passionate

political uprising since the anti-war movement swept across American politics

from 1964 through the Seventies. The activists of that era failed to elect a

President, and their furious public demonstrations alarmed moderates in

both parties. They even spawned a new intellectual grouplargely from the

Jewish population which had been loyally Democratic since the Roosevelt

erathe Neo-Conservatives. (Irving Kristol, the founder of this group,

defined a Neo-Conservative as A Jewish liberal mugged by reality.) Most

importantly, they pulled the Democratic Party so far to the Left that voters

elected Richard Nixon as President, who defied the laws of political mortality

by returning from the dead in 1968. He had lost the Presidential election of

1960, and, when he then lost the California Gubernatorial election of 1962,he blew his top on TV, angrily telling the media, You wont have Dick Nixon

to kick around any more.

The Tea Party is a grassroots rebellion built on idealism, enthusiasm, and

anger. The Party was born when CNBCs Rick Santelli blew up in a Howard

Beale-style rant (Im mad as Hell and Im not going to take it any more),

and called for a Tea Party to take back the country. With astonishing speed,

local Tea Party groups were formed across the land. Both established parties

were stunned.

Santellis outburst was The New Shot Heard Round the Worldthe WorldWas Waiting for the Uprise.

The Party has no Constitution and no formal organization, which means

its beauty (or ugliness) is in the eye of the beholder and lacks the basic

power of a precinct. One cannot, therefore generalizeor demonize

about its policies, members and supporters. It could be a one-off wonder,

it may refashion the Republican Party in its own image, or like the antiwar

movement, it could elect the party it opposes most vehemently.

It may not outlast this midterm election, but it will certainly have a huge

impact on it. Its supporters are unwilling to be mere foot soldiers for Country

Club Republicans who are accustomed to doing deals with Big Government

Democrats. If the Republicans fail to win control of the Senate, the Tea Party

will surely be blamed for having dumped experienced, electable Republicans

in favor of political newcomers given to extreme statementsmost notably

in the Nevada and Delaware races.

Santellis outburst was

The New Shot Heard

Round the World...


29/5125October 2010

We are instinctively mistrustful of the politics of enthusiasm and anger,

although we also mistrust professional politicians and their advisers and

lobbyists as a class. Anger is no substitute for reason and sound political and

foreign policies.

Jimmy Carter briefly emerged from well-deserved obscurity to become a big

attraction on the liberally-oriented TV networks when he claimed that the

Tea Party was strongly influenced by racism. He claimed that its members

were actually opposed to Obamas color, more than his policies. The reality

is that the Tea Party is no more built on bigotry and hate than the Anti-War

movement was dominated by Marxists. There may be as many bigots in the

Tea Party as there were Marxists in the Anti-War movement, but in both cases

the extremists dont define the causes. (What happened to the Marxists? After

the Fall of the Wall, they became an endangered species, mostly living off

university endowments. Princetonian George Will says there are now more

Marxists at Harvard than in Eastern Europe. )

The Tea Party has simply tapped into large-scale public resentment about the

unsavory Congressional deals and buyouts (such as The Second Louisiana

Purchase, and The Cornhusker Kickback) designed to achieve enactment

of massive spending programs and major new intrusions into the economy.

The Tea Party has stoked public alarm which will slowbut probably not

reversethe growth of Washingtons elephantiasis that threatens to hobble

the nation for decades to come. There will be no new 2,000-page law costing

trillions of which the Speaker will say, Well know whats in it when we pass

it.

For that, believers in limited government and economic freedom should thank

the Tea Party, and the ghosts of the Founding Fathers will be rejoicing.

Well know whats in it

when we pass it.


30/5126 October 2010



We sense that investors now rushing back into stocks realize that the looming

landmark power transformation in Washington wont be won because of

John Boehner or other well-established Republican officeholders. Its a

populist upsurge that could be very good news for the American economy.

At the very least, the change in power should ensure that the economically

punitive tax increases we discussed in last months issue will not occur. That

alone is enough to make us more optimistic about the outlook for equities.

Although some Democrats claim that the Republicans will bankrupt the

country because of their refusal to vote foranytax increase, the real story is

more complicated. Some of the more thoughtful Congressional Republicans

are willing to contemplate a national Value Added Tax (VAT), but they insist

it can only be accepted in replacement of income taxes. That certainly wont

happen, but the willingness to consider a VAT is, for Republicans, a heresy

that needs to be revisited.

The deficits the nation will face for the loss of economic output during

the recession, and the vast expansions in spending for so-called stimulus

programs and for health care mean that if the Republicans are to capitalize

on this opportunity, they will have to demonstrate real leadership, not just

naysaying and demands for tax cuts. Some taxes mustincreaseand increase

significantlybarring a sudden, sustained surge to 4% economic growth.

There are no Republican Presidential candidates among the so-called front

runners who have, to date, displayed enough charm and gravitas to derailObama in 2012. So this election could be the high-water mark for Republicans

for many yearsunless they surprise voters by displaying wisdom and

political courage about the hard choices facing America as a result of (1) the

recession, and (2) the debt buildup from the various rescue attempts.

The Boston Tea Party was an act of civil disobedience that helped spark the

most successful revolution the world had known. But it wasnt Sam Adams

and his partiers who wrote the Declaration of Independence and, against great

odds, outlasted Britain in the war, and then managed to write a Constitution

that amazed the world.

...the change in power

should ensure that the

economically punitive

tax increases...will not

occur.


31/5127October 2010

The Congressional Democrats have squandered the opportunity given to

them by their election landslide and a deep recession. Instead of well-crafted

programs designed with White House involvement and some bipartisan

input, and sold with the Presidents powerful merchandising, what happened

was, at times, unseemly. As Obama and Pelosi were drawn into increasingly

desperate and increasingly objectionable deals with Democratic holdouts,

they seriously stained his winning image as a smart, idealistic leader who

disdained rotten politics.

If the new Republican leaders in Congress dont display more wisdom and

greater problem-solving skills than the current crowd of losers, they will

be abandoned by the Tea Partiers and the countryand Obama will win a

second term by default.

The Big Shift

As the last millennium was drawing to a close, the First World was prospering

from the tech boom, and its financial systems were still strong from the

ongoing effects of Basel I. The Long-Term Capital Management (LTCM) crash

was unnerving, but it had frightened the Fed into massive reliquification,

which was sending Nasdaq to the moon. No financial leaders seemed

perturbed that LTCM, a firm manned by two Nobel economists using Value

at Risk Algorithms, would implode because of turmoil following an event

as obscure as Russias defaultand that Wall Street was busily gearing up to

deploy those strategies on a scale that would threaten the foundations of the

global economy.

Nor were any Western leaders pondering the possibility that, in the coming

decade, global economic growth would be driven primarily by Asia, and an

economic collapse would be driven entirely by financial systems in the US

and Europe.

In nine years the leadershipin terms of upward momentumof the global

economy shifted from the nations that had dominated it since the dawn of

the Industrial Revolution to two of the worlds poorest nations as recently as

1975.

In nine years

the leadership...

of the global

economy shifted


32/5128 October 2010



Within one decade the OECD economies were hit by two recessions (the

second of which was worse than any since the Depression) and sustained

relentless loss of manufacturing jobs to Asian economies which had been

conspicuous foreign aid recipients for most of the postwar era. The Crash

devastated one of the last remaining components of Western productive

superiorityits banking and finance systems.

Given the suddenness and ferocity of the Wests fall from global leadership,

the only surprise about the performance of the S&P is that it almost managed

to break evenin nominal termsover the decade.

Basic Points has chronicled this shift of power from the factories and financial

giants of the West to the new Asian trendsetters. Because we saw the erosion

of economic power to be of such stupendous historical proportions, we havetended to be less enthusiastic about the leading stocks in the leading stock

marketsparticularly the S&Pthan most strategists. We have consistently

recommended that clients emphasize stocks of companies that produce what

these new world champions need to buyand sell the shares of companies

which produce what Asia produces nowor soon will.

Worth pondering: If Mao Zedong and Pandit Nehru had been able to

ensure that their successors for the next three decades would continue

to enforce their pure socialist preceptswhich were overwhelmingly

admired by the intellectually fashionable in university campuses, movie

and TV studios, and newspaper editorial rooms across the worldthen

the balance of global economic power today would look roughly the way

it did in 1999.

However, we recognize that we do our clients a disservice if we dont keep an

eye on the US stock market for those times when it will rally appreciably

within the context of a long bear market. Empires can take a long time to

disappear: it took four centuries for Rome to succumb to the barbarians after

Caligulas brief, inglorious time on the throne signaled that the Empire had

seen its best days. (Caligula remains well-known: when Neville Chamberlain

passed over Churchill for a crucial Cabinet post, a Tory backbencher said it

was the worst appointment since Caligula named his horse as Consul.)

Since we last published, the economic news has been mostly weak, but the

US stock market has been very strong.

The Crash

devastated one of

the last remaining

components of

Western productive

superiority

its banking and

finance systems.


33/5129October 2010

We believe the three key factors in this happy disconnect have been the

perceptions about (1) renewed liquidity growth from further Fed and ECB

easing, (2) easier-than-feared Basel III rules, and (3) optimism about an

economy-and-investor-friendly US midterm election.

Moreover, investors with an international perspective have shown signs of

a willingness to consider the evidence that total global growth has become

strong enough to maintain earnings momentum even if the US economy

remains sluggishor worse. Decoupling may be a realitynot just an

economists hypothesis. Chinese growth remains powerful in comparison

with almost any economic experience of the modern era except its own

growth rate from 1992 through 2007. Apart from Japan, the important

Asian economiesIndia, Singapore, Taiwan, Korea, and Indonesiaremain

robust. The Eurozones overall growth rate has improved, but mostly

because of powerful performance by the export industries of Germany. Latin

America, led by Brazil, is performing well. Canadian growth has moderated

in response to the American slowdown and a much-needed pause in the real

estate boom.

In other words, the financial heroin and other stimulus programs in North

America and Europe have combined with the big story of our timethe

modernization and industrialization of Asiato give equity investors reasons

to buy stocks.

The renewed bear market in the dollar is itself a contributor to expansion of

global liquidity, and helps explain the stock market rally:


January 1, 2010 to October 8, 2010

76

78

80

82

84

86

88

90

Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10

77.43

Decoupling may be a

realitynot just an

economists hypothesis.


34/5130 October 2010



2. The Commodity Markets Respond to Increased Availability of Risk Money

The industrial commodity markets have naturally responded to the greateravailability of risk money:

Crude Oil


67

70

73

76

79

82

85

88


81.69

Zinc


1,500

1,700

1,900

2,100

2,300

2,500

2,700


2232.00

Copper


270

290

310

330

350

370

390


379.20


35/5131October 2010

The biggest commodity rallies, however, have been driven primarily by the

lack of liquidity: drought in key grain-growing regions of Eastern Europe and

Russia stopped the developing bear market in grain in its tracks, turning it

into a roaring bull:

Soybeans


8.9

9.3

9.7

10.1

10.5

10.9

11.3

11.7


11.75

Corn


3.0

3.4

3.8

4.2

4.6

5.0

5.4

5.8


5.71

Wheat


400

450

500

550

600

650

700

750

800


713.00

Russia stopped the

developing bear

market in grain

in its tracks...


36/5132 October 2010



Corns decline was accelerating at midyear, amid evidence that this years

crop would break all records, and it was pulling down soybeans and wheat

along with it. Then the roles reversed: word that the wheat crops in Russia

and Ukraine were being devastated by drought was confirmed with the

market-shocking news that Putin was embargoing wheat exports, including

previously-contracted shipments. Wheat shot up, pulling the other grains

in its wake. Then the USDA announced that, even with a record corn crop,

global corn carryovers would decline. Then, over subsequent weeks, the

USDA continuously reduced its estimates of per-acre yields and the size of

carryovers. Last weeks announcement was a stunner, generating historys

two biggest up-limit days for corn at Chicagoand fury at the USDA from

farmers who had sold their crops forward to speculators.

The United Nations Food and Agriculture Organization (FAO) this week

proclaimed a new food crisis affecting thirty countries around the world. This

came despite the third biggest year for global grain production in history.

Given the political sensitivities of key donors to the FAO, the organization

did not cite ethanol and biodiesel demands, or the grain embargoes from

Russia and Ukraine.

Corn Futures

December 2012 contract


3.0

3.4

3.8

4.2

4.6

5.0

5.4

Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Au -10 Sep-10 Oct-10

4.93

There is , of course, another grain-related bull story: BHPs $130 per share bid

for Potash Corporation instantly became the worlds biggest takeover battle.

(We suspect that some of the arbitrageurs who leapt into the trading were

frantically reading up on what potash was and why mere fertilizer could be

so valuable. Liebigs Law of Minimumsthe basis of the chemical fertilizer

industryhas been, we understand, discussed infrequently in the better Wall

Street watering holes.)

...historys two

biggest up-limit

days for corn...


37/5133October 2010

Our sentiments about the uniqueness of Potash Corporation are well-known

to our clients. It has the longest-duration assets of any commodity producer

we follow, and great management. We hope that the decision about its future

ownership and management will be made primarily by long-term-oriented

investors who understand the companys important role in the global food

situationnot arbitrageurs, whose time horizon is the next lunchnot the

availability of adequate lunches across the world in coming decades.

The grains reversal from bearish to bullish triggered the one of the fastest

and strongest rallies in agricultural stocks we can recall:

CNH Global (CNH)


20

24

28

32

36

40

44


42.52

Deere (DE)


45

50

55

60

65

70

75


74.20

The grains reversal

from bearish to bullish

triggered the one

of the fastest and

strongest rallies in

agricultural stocks...


38/5134 October 2010



And, finally, there are the monetary metals:

Agrium (AGU)


45

50

55

60

65

70

75

80

85


84.70

Silver


1,400

1,550

1,700

1,850

2,000

2,150

2,300


2,318.00

Gold


1,000

1,050

1,100

1,150

1,200

1,250

1,300

1,350

1,400


1,347.80


39/5135October 2010

Despite all the media hype about the roaring bull market in gold, and all

the TV advertisements about the fabulous returns from gold and silver, the

precious metal markets have behaved in almost stately fashionrising to

new peaks, pausing, then rising to higher peaks. Having lived through the

hyperkinetic precious metal markets of the Seventies, we can assure clients

that This Time is Different. (There, we actually said those accursed wordsand

within weeks of Halloween, too.)

By that we mean that theres more talk than action, and this is a rally based

on sound reasoning about government policies, not runaway greed. We recall

the lineups of eager bullion buyers outside Canadas premier gold market

at the Bank of Nova Scotia in Toronto in the late Seventies. We also recall

standing in line for an hour to deliver our sons piggybank full of true silver

coins accumulated over the 13 years since his birth to a metal dealer and

being paid more than two thousand dollars in cash. The man in front of us

had superb antique silver candlesticks. The dealer weighed them and paid

him: they would be melted down within hours. We also recall that the dealer

was bankrupt within the week, and then the Hunt Brothers went bust and

the mania was over.

This time, there is no mania, no double-digit inflation, and no talk of

Biblically-based rules of valuation. Then there was frenzy, now there are

friendly disagreements about Fed policy, a possible double-dip, deficits,

derivatives, PIIGS, peak gold, and currency warfare.

This time,

there is no mania...


40/5136 October 2010



The Real Thing and the Global Currency Wars

This topic came to the fore last month when Brazil publicly denouncedgovernments abroad which were driving down the values of their currencies

against each other but, most particularly against the Brazilian real.

Brazilian Real versus US Dollar


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A fortnight before, Japan had angrily denounced Chinafor buying yen for

its awe-inspiring Foreign Exchange Fund. The yuan-yen war was on.

The world has gone mad today,And goods bad today,

And blacks white today

Cole PorterAnything Goes

Over the centuries, China and Japan have had their quarrels and their wars.

But this is, as far as we know, the first time that the ordinary civilities of

discussion between two nations whose trade with each other is one of the

three largest cross-border relationships in the world was abandoned because

of the insult of one buying the others currency as an investment.

These two recent dust-ups come as the long argument between the US andChina about the undervaluation of the yuan (or renminbi) was being moved

to a potentially perilous battleground as the House passed a demand for

renminbi revaluation, and Senator Schumer introduced similar legislation in

the Senate. With an election looming, both parties found time to act tough

with the currency manipulating Chinese.

The yuan-yen war

was on.


41/5137October 2010

To the extent that Chinas currency is undervalued, it is a force for inflation

at home and abroad. China is being told it must drive up its currency value

compared with the greenbackor face retribution. The yuans value against

the dollar is up about 20% in the past three years, but Chinas trade surplus

with the US keeps increasing, so, in the minds of Congresspersons whose

minds may not be massive, China must revalue its currency sharply higher.

Currency traders understand that Washington is at the front of the parade of

nations wanting to cheapen their currencies values:



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When nearly all the governments of economies that matter in the world

would like to see the exchange value of their currencies reduced, its not hard

to see why shrewd investors would want to exchange paper currencies for

gold. If those who issue the stuff want it cheapened, why should anybody

who has money to lose believe in the printed paper promises of politicians?

The pound was the store of value for two centuries because of one of Newtons

Lesser Laws. When he ran the Royal Mint, he made the golden guinea, worth

21 shillings, the standard of exchange. (That was on a good day for him; he

had another good day not long after when he sold his interest in the South

Sea Bubble for a 7,000 pound profit; but then he had a really bad day when

he bought back in and ended up losing 20,000 poundsa fortune for that

time.)

...why should anybody

who has money to lose

believe in the printed

paper promises of

politicians?


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The idea of having no metal backing to a currency would have been dismissed

as absurd as recently as the 19th Century. When purely paper money became

the medium of exchange, the idea of deliberately debasing it would have

been dismissed as absurd and perilous until very, very recently.

The idea of holding gold or silver, rather than paper money, was around for

a very long time, but went out of fashion briefly.

Its back. For a long run.

Its back.

For a long run.


43/5139October 2010

INVESTMENT ENVIRONMENT


The Stock Markets Changing Dynamics

We recognize that the recent trend has been to macro-driven investing,

and away from stock-picking. The correlations among equities have been

extraordinarily higheven on an intraday basis. This appears to be one

consequence of the increasing role of high-frequency traders in stock markets.

They switch from the buy to the sell side, which means their stockholdings

move with the synchronization of locust swarms.

For compliance reasons, Basic Points does not make stock-specific buy and sell

recommendations. But we try to give clients the criteria to achieve superior

results through recommendations on criteria for evaluating securities, sector

weightings and weightings within commodity groups. But if all stocks are

mere commodities to be bought and sold based on intraday sentiment

changes, is there much value in our work?

We have long argued that commodity stocks are, first and foremost, stocks.

Therefore, their beta is the stock market. But their alpha comes from the

buildup of reserves and production of specific commodities (or of supplying

technologies or inputs to commodity producers). We see large variations in

endogenous value across and within the commodity sectors, due primarily

to the Streets reliance on short-term earnings forecastsas if commodity

stocks should be valued like any other stocks. We respectfully disagree, as weexplain each time we give the lecture on Investing in Commodity Stocks at

the CFA Institutes Annual Equity Conference.

When the Flash Crash occurred, we expressed hope that the investigators

would find some trader, a follower of Black-Scholes algorithms backed by

enough computer power to manage Wal-Marts inventories whotoo late

discovered a tiny glitch in his system.

No such luck.

We are disinclined to treat Basel III as the kind of good news that makes us

want to make a major increase in equity exposure. That banks will be allowedto continue to put the entire system at risk delivers short-term gainfor

bankers and investors, with a demonstrated risk of longer-term painfor

investors and the economy, and, just maybe, for a few bankers.

...the recent trend has

been to macro-driven

investing, and away

from stock-picking.


44/5140 October 2010



We know what happens to the stock market when banks start to implode. We

also know that governments, regulators, legislatures and voters have battle

fatigue from bank rescues and may lack the resources or will to save big

institutions the next time they face collapse.

As the spiritual says, This time water: the fire next time.

There will be a next time.

American banks still hold trillions in dubious or downright terrible assets

for which there is no bid at the value the banks ascribe to them. The bailouts

saved the system, but at the longer-run cost of preventing market clearance.

We are told that 40% or so of single-family homes are worth less than their

mortgages and other registered liens. Most banks did not take advantage of

the strong rally in financial stocks during the first four months of this to

issue more equity. Bernanke has said that significant time will be needed

to restore the 8.5 million jobs lost in 2008-9. Nearly half of the unemployed

have been out of work for more than six months. We are also told that the

real unemployment rate is more than one-fifth of the workforce. Reasonable

conclusion: there wont be a new housing boom for a verylong time.

The other sector of the US financial system that concerns us is the municipal

debt market. The SEC is finally taking up the cudgels to compel states and

municipalities to disclose their real liabilities under employee benefit plans.

Since union agreements preclude pay cuts for current employees, or benefitscuts for pensioners, state and local governments are going to have to fire

people, and cut back on other expenses. In Illinois, which is a conspicuous

financial offender, things have gotten so bad that some prisons havent even

be able buy toilet paper for inmates. And that deprivation comes despite

Illinois receiving, as one might expect, excellent treatment from Washingtons

stimulus programwhich is about to enter the history books.

The Street loves to point out that the S&P is heavily weighted to companies

operating internationally, so faster growth abroad will pay off for US

stocks. We take that point, but note that a great percentage of that offshore

commitment is to Europe, whose growth rate ex-Germany isnt likely toexceed Americas: the PIIGS problems are probably as severe as those facing

California, Michigan, and Illinoisto name some of the most egregious

examples of mismanagement and underfunding.

We prefer to concentrate on the equity group that is targeted to sales

in countries whose middle class is growing, whose industrialization is

expanding, whose governments arein comparison with the US or Greece

As the spiritual says,

This time water:

the fire next time.

There will be a

next time.


45/5141October 2010

or Ireland or the UK, or Portugalwell-financed, whose pension programs

are in their infancy, not their dotage, whose household debts relative to GDP

are modest, and whose banks are, by and large, healthy.

That means investing in commodity-oriented stocks. Whatever they produce

is priced globallyprimarily off demand from Asia. Their core concept is

scarcity: there is no Moores Law for the production and pricing of corn,

copper, oil or gold. For most metals, the obvious, high-quality mines, in

politically-secure regions with access to electricity and transportation, have

been in production for years and are near their peak or already in decline.

Higher metal prices mean that low-grade deposits that were virtually worthless

a decade ago are now attractive, but they require huge capex and they may

involve excavation on a scale that local residents will reject.

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