don coxe basic points nov. 2011

Basic PointsIt's the Economy Banks, Stupid!

November 18, 2011

Published by Coxe Advisors LLP

Distributed by BMO Capital Markets

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Company Name Stock Ticker Disclosures Company Name Stock Ticker Disclosures

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Don CoxeTHE COXE STRATEGY JOURNAL

It's the Economy Banks, Stupid!

November 18, 2011

published by

Coxe Advisors LLPChicago, IL

THE COXE STRATEGY JOURNALIt's the Economy Banks, Stupid!November 18, 2011

Coxe Advisors LLP.Author: Donald Coxe 312-461-5365 [email protected]

Editor: Angela Trudeau 604-929-8791 [email protected] South LaSalle Street, 4th Floor Chicago, Illinois USA 60603

Basic Points is published exclusively for BMO Financial Group and distributed by BMO Capital Markets Equity Research for clients of BMO Capital Markets, BMO Nesbitt Burns, BMO Harris Private Banking and Harris Private Bank.

BMO Capital Markets Equity ResearchManager, Publishing: Monica Shin [email protected]

Desktop Publishing and Anna GoducoDistribution Coordinator [email protected]

1November 2011

OVERVIEW


Too many equity investors are getting sick of the stock market. Glowing corporate earnings don't seem to matter anymore, and the market is subject to absurdly wide price swings. Many American equity investors who are pulling money out of their mutual funds are telling advisors they think the stock market must be rigged.

The seemingly endless pattern of risk-on risk-off days in European and North American stocks which scares investors originates from the Wagnerian-scale drama of the existential crisis of the euro, and the problems of European and, to a somewhat lesser extent, American banks.

These dramas play out against the backdrop of growing fears of a new global recession, which could, some analysts fear, be at least as challenging as its predecessor, because governments have exhausted their bailout funds.

We are not convinced that a North American recession is inevitable and, in any case, we doubt that its severity would approach 2008 levels. Zero interest rates and record defi cits should be good cushions.

This month we explain why investors should indeed be worried about those badly-managed Wall Street and European banks in the light of the collapse of their asset pricing models.

But we suggest that those endless crises in the eurozone could very likely trigger a policy response that would dramatically improve the outlook for European banks—and stocks generally.

We also consider the implications of the politicization of the Keystone application in a broader context of debates on US energy policies. The Canadian government and much of the Canadian oil industry were surprisingly naive about Keystone's chances, actually believing that environmental issues were the only barriers to an Obama OK.

We are leaving our Asset Mix recommendations unchanged.

THE COXE STRATEGY JOURNAL2 November 2011

3November 2011


The wise Northrop Frye once told students of a trans-continental trip he had taken in the observation car of a train. He noted that passengers could choose seats that faced forward or backward. This was a option not available to the pioneers who came by foot, horseback or canoe. They had to look ahead.

He said that those train passengers who looked backwards were refl ecting on where they had been, and that this was, on balance, a better strategy than looking ahead, because one could gradually build one's understanding about the land—and the nation—without trying to peer ahead to what would come next.

We are going to follow Frye's precept by beginning with two pages of charts about where we have been. We want clients to refl ect on how ghastly the performance of the [non-Canadian] bank stocks has been.

While musing on these horror stories of failures and bailouts, clients should also be refl ecting on the fact that the men who run big US and European banks are collectively the most publicly controversial segment of Big Business in claiming that they deserve to be paid more than they earn. Really? Were they football or baseball coaches with such disastrous records, they'd have been ridiculed and fi red. Bizarrely, they have managed to elicit support from many naive conservatives who drink the Kool-Aid that Wall Street is composed of capitalist giants beset by leftist political Lilliputians. Even in the midst of the worst crash since 1929, they insisted that their bonuses had to be paid or they might decamp to....

No one seemed to ask where they could go with their blown-up risk models.

Zimbabwe?

...the men who run

big US and European

banks are collectively

the most publicly

controversial segment

of Big Business...

4 November 2011


THE COXE STRATEGY JOURNAL

Citigroup (C)

January 1, 1986 to November 17, 2011

0

100

200

300

400

500

600

Jan-86 Jan-89 Jan-92 Jan-95 Jan-98 Jan-01 Jan-04 Jan-07 Jan-10

31.59

Bank of America (BA)


0

10

20

30

40

50

60


6.83

Goldman Sachs (GS)

May 1, 1999 to November 17, 2011

50

75

100

125

150

175

200

225

250

May-99 Nov-00 May-02 Nov-03 May-05 Nov-06 May-08 Nov-09 May-11

92.35

Banco Santander (SAN)


0

2

4

6

8

10

12

14

16


6.18

Deutsche Bank (DB)


0

20

40

60

80

100

120


30.35

UBS (UBS)


0

10

20

30

40

50

60

70

80


11.21

Societe Generale (GLE)


0

20

40

60

80

100

120

140

160


21.10

Credit Suisse (CS)


0

20

40

60

80

100


25.60

5November 2011

It looks as if the Big Banks could be in a Triple Waterfall collapse formation that would force further assistance.

We are frequently asked when the next Triple Waterfall would arrive. As discussed in our book1, fi nancial markets of the last three decades of the past millennium were driven by three Triple Waterfall rises and crashes—commodities in the 70s, Japan in the 80s, and technology in 90s.

Each of these convulsions sucked in vast amounts of capital on the way up and became a source of funds for the next mania on the way down. The housing bubble which infl ated the Big Bank Bubble sucked in far more capital than its predecessors, because a 60% rise in house prices at a time of shrinking or vanishing 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 crash with gigantic bailouts, unbelievably cheap money, and extremely generous guarantees on deposits, the past decade would have been defi ned by a crash of 1929 proportions in which many American and European banks would have been wiped out. That would have been a rather sudden Triple Waterfall, but the collateral damage from letting so many wretchedly-managed banks fail 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. We have long wondered why Lehman was the last to go. Reading Ron Suskind's perceptive account of the Obama Administration (The Confi dence Men), we were interested to learn that President Obama issued orders to let Citigroup go bust. This was, to us, a remarkably wise decision, and our respect for Obama rose on reading it. Regrettably, Obama didn't follow up to ensure compliance. Mr. Geithner somehow never got around to implementing those orders, and Citi has lived on, a sickly multi-strategy hedge fund masquerading as a bank. Was it saved because Robert Rubin had been collecting fees totaling more than $100 million for dispensing strategic advice—including increasing the bank's leverage during the later stages of the bubble?

1 The New Reality of Wall Street, 2003, McGraw Hill.

...the herd of

Too Big to Fail banks

should have been

culled...

6 November 2011



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 suffi ciently punished for their sins against capitalism and, thus cleansed, were ready to resume their industry's 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].

KBW US Bank Stock Index (BKX)

October 1, 1992 to November 17, 2011

0

20

40

60

80

100

120

140

Sep-92 Oct-94 Nov-96 Dec-98 Jan-01 Feb-03 Mar-05 Apr-07 May-09 Jun-11

37.30

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].

7November 2011

Like the Bourbons, they lost their heads, if only metaphorically. In the earlier case, there was never a question of showering more wealth on King Louis and Marie Antoinette in hope that they would clean up their acts and strengthen the French economy. However one might disparage the Jacobins, they weren't naïve.

What about those earlier Triple Waterfalls?

Commodities remain in a long-term bull market that shows scant signs of the excesses of the 1970s. Even gold, which is frequently cited as being in bubble mode, is merely catching up to long-term monetary expansion. (Its price multiplied 22 times in the Seventies mania.)

Gold ($/oz) vs. Currency in Circulation* ($billion)


*source: Federal ReserveChart courtesy of Meridian Macro Research ([email protected])

100

300

500

700

900

1,100

1,300

1,500

1,700

1,900

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

450

500

550

600

650

700

750

800

850

900

950

1,000

1,050

1,100

Gold ($/oz) Currency in Circulation ($billions)

Last 1,052.15 1 Wk chng +6.79

Last 1,721.00 1 Wk chng –67.68

Japan, to our disappointment, remains in its Triple Waterfall mode 21 years after the crash began. As the Olympus scandal now reveals, investors are not convinced that Japanese businesses have been able to shrug off either the corruption of the yakuza (the Japanese mafi a) or the nation's disastrous demography.

Like the Bourbons,

they lost their heads...

8 November 2011



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 wasn't public at the peak and Apple was not the company in 2000 that it would become with the 2nd Jobs incarnation.

Cisco (CSCO)


0

10

20

30

40

50

60

70

80

Nov-91 Nov-93 Nov-95 Nov-97 Nov-99 Nov-01 Nov-03 Nov-05 Nov-07 Nov-09 Nov-11

18.53

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 fi nance 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 UK's 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 fi gures to 30% at the peak."

We all know what happened next.

"In the 1880s, total UK

bank assets were equal

to 5% of GDP. At the

bubble peak they were

500%..."

9November 2011

Have the Big, Bad, Bonused Bailout Banks (hereinafter called B5) learned from their near-death experience?

Apparently not.

The bonus fi xation that has driven the desire for excess leverage is part of Wall Street's self-spawned DNA. After the crash, not only did Merrill Lynch pay their fallen "stars" based on phantom earnings that ignored losses on subprimes, but in the case of UBS, bonuses were paid from a pool that had been totally drained by rogue trader fraud.

Bonus promises for bankers are, it would appear, like excessive pension promises for unionized government employees created by deals for union support for politicians in elections: they must be honored even when they are funded from over-greedy investment projections, and by imploded capital asset risk models.

Not all big banks are run to enrich insiders with returns from perilously high leverage and dubious investments: the index of Canadian bank stocks reveals an industry that has continued its long tradition of behaving itself, thereby dramatically outperforming its counterparts in the US and Europe:

Source: S&P/TSX Bank Stocks; GICS, Industry Group

S&P/TSX Canadian Bank Stocks vs. KBW US Bank Index (BKX)

June 1, 2002 to November 17, 2011

0

50

100

150

200

250

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)

175.73

-45.48

...in the case of UBS,

bonuses were paid

from a pool that had

been totally drained by

rogue trader fraud.

10 November 2011



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 decade—David Dodge and Mark Carney. That Mr. Carney was recently chosen to lead the global Financial Standards Board (replacing Mario Draghi who moved to the European Central Bank) should be reassuring to investors—and a spit in the eye for JPMorgan Chase's CEO, Jamie Dimon, who had assailed him in Washington weeks before. Mr. Dimon is one of those big bankers whose public displays of arrogance helped spawn the Occupy Wall Street demonstrations. Although the occupiers of Zuccotti Park are leaderless, undisciplined and largely incoherent in their demands, they tap into rage that the banks who were the biggest private sector causes of the crash and recession show little remorse and little willingness to accept constraints on their leverage and proprietary trading. (One TV clip showed some signs they 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.

...the occupiers of

Zuccotti Park...tap

into rage that the

banks who were the

biggest private sector

causes of the crash

and recession show

little remorse and

little willingness to

accept constraints on

their leverage and

proprietary trading.

11November 2011

The Eurozone Crisis—and the BanksSince May, we have been warning that the Basel banking version of the Capital Asset Pricing Model was obsolete and misleading—and could trigger a new collapse.

The Dexia collapse is a form of fi nancial sick joke: a major fi nancial institution that passed the European Banking Authority's supposedly-demanding stress test with fl ying colors in July thereupon vaporized within weeks. Imagine someone dying of cancer who had taken out a $10 million term life insurance policy at a reduced premium for exceptional health two months earlier. Would the insurer and its reinsurer continue to retain the examining doctor?

The proximate cause of the Dexia demise was the worsening of the Greek crisis at a time the prices for outstanding debt of other PIIGS—most notably Italy—were weakening. As this is written, despite at least €70 billion of ECB purchases, the benchmark ten-year Italian government bond yields 7.04%—a scary 5.25% more than German bunds, and 3.38% more than French bonds—whose yield spread above bunds has been also been widening recently. (By way of comparison, Treasurys yield 2% and Canadas yield 2.13%.)

Italy's outstanding debt—120% of GDP—is the world's third-largest, and it must roll over more than €200 billion next year—let alone fi nance its growing fi scal defi cit. Spanish yields have also been climbing sharply and are now 6.29%. The market is convinced that Italian yields are unsustainable, and is getting rapidly becoming panicky about Spain's.

At the G-20 Meeting—held on the site of the famed Film Festival, (but might have been better held in a morgue), Silvio Berlusconi was in fi ne form for the role of Harlequin in a Commedia Dell' Arte farce. He airily dismissed talks of an Italian debt crisis, saying he had turned down an IMF loan, as being unnecessary. He said the plunging price of Italian bonds was "Yesterday's story, the restaurants are full, it is diffi cult to reserve a seat on a plane...I can't see another fi gure on the Italian scene capable of representing Italy on the international stage."

...the G-20 Meeting—

held on the site of the

famed Film Festival,

(but might have been

better held in a morgue)

12 November 2011



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 of other technocrats—no elected politicians. (Plato would have approved of an all-guardian government with no voter input.) A bank portfolio manager prepared to take a big bet on Italian bonds based on the belief that the Italian parliament and population will submit to Monti's medicines for more than a few months probably shouldn't even be managing his or her own money—let alone anyone else's.

Meanwhile, where the eurocrisis began, another leader has fallen. George 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 Europe's 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 offi cials justifi ed the bailout plan by expostulating, "We cannot make war on the nation of Plato."

...no external

conclave could

humiliate Greece as

dramatically as its

own bureaucrats,

union leaders and

tax-dodging rich

have...

13November 2011

Plato, it will be recalled, abandoned Athens for Sicily, where he tried to make the regime of a local dictator the demonstration of his views on Guardians and the Cave. The project failed dismally, and Greece only got good government briefl y during the reign of Alexander the Great—a Macedonian. It has had little—if any—experience with wise government since 323 B.C. A proposed €120 billion bailout 2,334 years later that is justifi ed on the basis of helping Plato's heirs could only be conceived by an eurocrat who would never think of putting the proposal to a vote of his own nationals.

But the fact that this emotional resort to Platonic philosophy was adduced in the midst of a modern crisis set us to thinking about the importance of philosophy in the Continental leaders' learning.

They have all studied the same philosophers, albeit with natural national predispositions to their own great minds. Descartes' cool, geometric logic was at the root of French socialist Jacques Delors' design of the euro: a perfectly-designed currency with no provision for exits, like the succession of perfectly-drafted French constitutions, which in practice have only been amended by the Paris mob. Rousseau's concept of the supremacy of the General Will untrammeled by popular elections on fi xed schedules therefore has enormous appeal for the new European aristocracy.

The classic liberalism of the Scottish and English philosophers and economists—Berkeley, Hume, Smith, Locke, Ricardo and Mill—has had only modest infl uence 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 are studied intensively.

Angela Merkel emerged from that dramatic eurocrisis meeting of Oct. 26 as the leader of the eurozone, outlasting all the male elitists in a marathon that extended 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 the most Marxist of the Eastern European Soviet dictatorships, she would have been taught Hegel's "great waltz" dialectic, which had been incorporated by Marx and Lenin into Communist dogma. If so, she might have taken the euro regime and rules as the Thesis, the Greek rebellion against it as the Antithesis, and sought to achieve a Synthesis with the 50% haircut on the value of Greece's outstanding bonds as the price of a new, durable euro.

Greece only got good

government briefl y

during the reign of

Alexander the Great—

a Macedonian.

14 November 2011



Crucial to this synthesis was—and is—a rule that a Hegelian might admire: a decree that slashing the value of Greece's 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 design of the euro or euro bond markets, they must not be allowed to dictate the terms of any new synthesis.

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 fi nd out which banks were big writers of Greek CDS and which banks were big buyers.

If a 50% slash in

principal value is not a

credit event—what is?

KBW European Large-Cap Banking Index (KEBI)


10

20

30

40

50

60

70

80

90

Jan-05 Nov-05 Sep-06 Jul-07 May-08 Mar-09 Jan-10 Nov-10 Sep-11

18.46

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.

15November 2011

European banks collectively have four times the assets of their American counterparts—but, malheureusement, do not have four times their tangible net equity. That huge trans-Atlantic asset variation comes from the difference in savings habits of the two continents. American savings rates were near-zero in the years pre-crash, while Europeans have had relatively stronger savings rates. Also, Europeans are far more inclined to save through banks than Americans. That helps to explain why Europe—notably Germany—is so overbanked compared to the US.

That disparity worked out disastrously for European banks during the force-fed US housing bubble. The past decade was the fi rst time the American economy experienced the full effect of collapse in US fertility rates. As fertility rates fell from approximately 2 babies per female during the Seventies and Eighties to 1.4 or less, the result was that the number of fi rst-time jobholders and homebuyers was drastically reduced during the "noughts." Europe experienced the same demographic collapse, but its governments did not, like Washington, introduce stringent rules for banks that forced banks to make loans to minorities somewhat commensurate with the volume of loans they were making to whites. Barney Frank was the leader in Congress in demanding strict enforcement of these rules.

Regional banks which plunged into the origination of dubious loans found that Wall Street and Washington were eager to take them off the banks' hands. Through complex derivatives, the Street achieved the miracle of AAA ratings even when signifi cant portions of the loans in the product were to borrowers who—if they actually existed and were not in jail, (requirements which were not always enforced during the manic years)—were unlikely to be able to service the debts when the music stopped, as the dancing man, Citigroup’s Chuck Prince, so memorably framed it. Angelo Mozilo of Countrywide Financial, and a long list of brand-new upstart lenders eagerly arranged the deals and sent them to Wall Street, where the physics PhDs (turned fi nancial alchemists) converted leadpipe losers into gold.

To an astounding degree, they peddled them to European banks. When the housing bubble burst, the fallout was a TransAtlantic disaster.

Wall Street, where the

physics PhDs (turned

fi nancial alchemists)

converted leadpipe

losers into gold.

16 November 2011



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 (when we shared a platform in 2007), the Street was relying on terribly unrealistic risk models, managed by arrogant fools who knew physics and mathematics but almost nothing about fi nance. This would lead, he said, to a crash that might recall 1929. He was exulting because a journal devoted to statistics (The American Statistician, August 2007) had just devoted an entire issue to attacking him and defending the models.

The Basel version of the Capital Asset Pricing Model decreed that AAA-rated mortgage derivatives required no allocations of the [scarce] capital of 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. Today's badly-performing banks lack bedpans, but they're swimming in perfumed portfolios excreted by mathematical models. This is called progress.

...the term "legacy

assets" to describe

rotting remnants of the

past binge based on

investment models...

is of a piece with such

Victorian euphemisms

as "nightsoil" for the

contents of bedpans.

17November 2011

One possible benefi t of the "legacies" of the misplaced enthusiasms of European banks for American subprime paper could be that the European Central Bank—now under the leadership of Mario Draghi—will be swift to continue cutting the competitively skyhigh rates imposed by previous management under Jean-Claude Trichet.

M. Trichet may have been the world's most obdurate infl ation fi ghter. The ECB, unlike the Fed and many other central banks—has only one mandate—fi ghting infl ation. With rising commodity prices driving up costs of food and fuels, M. Trichet drove ECB rates to levels infi nitely higher than Ben Bernanke's zero-level prices. (Dr. Bernanke is seemingly pleased to be giving his money away free: he is promising to continue this largesse at least until 2014. That will mean six years of free money. Who can tell the long-term effect of consuming fi nancial heroin on such a scale?)

M. Trichet actually raised his rate twice this year at a time eurozone economies were visibly sagging. He pronounced that his record as an infl ation fi ghter was better than the Bundesbank's. He proudly characterized his performance as "Impeccable! Impeccable!"

We agree. He was an infl ation-fi ghting central banker who put his American counterparts to shame. The euro's rise in value on his watch accurately refl ects his impeccable infl ation credentials. He managed to make a global store of value out of a dubious theory.

His enthusiastic self-appraisal was his swan song, as M. Draghi was already in the waiting room. He dropped the Trichet rate 25 bp his fi rst day on the job.

As grim as the outlook for peripheral bonds may be, contagion is spreading across eurozone non-German bonds since the decision to reject the payouts under Greek CDS was announced. According to Gillian Tett of the Financial Times, American banks may have issued a half-trillion dollars’ worth of such paper. What investors in eurobonds now face is the prospect of problems across the zone. As more and more economies face recession, this process is elevating their debt costs.

When will the Germans face the fact that they can’t remain obdurate when all their supposedly strong partners are facing fi nancing problems?

[M. Trichet] was an

infl ation-fi ghting central

banker who put his

American counterparts

to shame.

18 November 2011



American BanksWith the exception of Wall Street, American banks seem to have made some fi nancial progress since 2008.

Their stock prices have underperformed the S&P but have recently been 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)


-40

-30

-20

-10

0

10

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)

-13.14

-28.59

So why do bank stocks look bleak?

The answer, of course, is that they couldn't 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 fi nally 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.

So why do bank stocks

look bleak?

19November 2011

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 from derivatives they can't sell and egos they can’t control. Result: so much of Wall Street debt trades at a discount, and their shares sell at discounts to net asset value.

An unwary investor who saw that a bank's shares and debts were selling at a sizable discount to stated net asset value might assume that the bank's bosses wouldn't be getting bonuses.

In capitalist theory, executive pay is for value-creating performance of a kind that drives share prices to large premiums over book value—and makes their outstanding debts rise in value at a time of zero interest rates from Gentle Ben Bernanke.

The bosses of those B5 banks, who are long on greed and short on shame, dodge capitalist principles they fi nd inconvenient for setting their own compensation. They assume that, when their debts trade at discounts, that reduces their debts and therefore generates earnings, which beget bonuses.

Nearly one-half of some of the big banks' recently-reported earnings came from the declining market value of their debt. Not the repayment of debt, mind you—merely the bid price of their paper.

The regional banks' bosses don't get those Wall Street benefi ts, because so little of their debt trades actively. Their bosses are old-fashioned enough to believe that they'd like to see their debt trade at a premium to par value.

The problem is that until more of those vacant shopping centers and homes fi nd lessees or buyers, the regionals will be struggling. The regionals are also worried about their exposure to debt from subprime state and local governments—like Illinois, California and Harrisburg.

One bright spot for some local banks: among the best-run of the regionals are banks that have maintained high exposure to Treasurys. Since Treasurys have been a superb investment this year, some of these banks must have benefi ted greatly—providing that they didn't confi ne themselves to the front end of the curve.

We'll stick to our long-stated view that the KRE will give the signal that the economy is really on its way back when it solidly outperforms both the S&P and the BKX at a time of rallying equity prices.

At the moment, the KRE is treading water—and winter is coming.

With the Wall Street

banks, we know

that most of their

problems come from

derivatives they can't

sell and egos they

can’t control.

20 November 2011



What Happens to Investment Risk Perceptions With Italy Joining Greece in the Calculations?

We believe investors should make the following assumptions:

1. The fi ght to keep Greece within the eurozone has been so intense because the prospect of a sudden Grecian exit would unleash chaos across the zone.

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 month's 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 fi rst 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 fi nancials 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.

Somehow, this must

stop.

Stein’s Law says that

it will.

21November 2011

The Implications for GoldTo date, the major asset class which has benefi ted most from the PIIGS dramas is gold.

When the possibility of a Greek default fi rst came under serious discussion in May 2010, gold was trading in the $1100 range, and the S&P was in the 1166 range. Ten-Year Treasury yields were roughly 3.8%. Remarkably, the euro was roughly 1.35 in dollar terms—where it is today. The KEBI Index was roughly 35: it is now 19.5.

We have been arguing for more than a year that the existential challenge to the euro from the plight of the PIIGS is the primary driver of gold prices. Europeans who fi nd that their bank deposits, paychecks, life insurance and pensions are all euro-denominated have been buying some protection in the form of gold. Other investors, contemplating the possible implosion of the currency of the world's second-largest trading zone have been making similar moves. The growing problems in the zone have been shrinking global economic activity and central banks other than the ECB are—as of now—virtually unanimous in lowering rates to minuscule levels to avert recessions...and to depreciate their currencies.

For the fi rst time since the abandonment of the gold standard, central banks are overwhelmingly dedicated to weakening the exchange rates of their currencies. When faith in the “printed paper promises of politicians" fl ags, gold offers an incorruptible store of value. This is beginning to look like Gold Bug Nirvana—where panicky people protect their wealth by selling paper to buy gold. (Maybe the bankers are ahead of the pack: central banks bought 148 tonnes of gold in the third quarter.)

Ben Bernanke has said zero interest rates will remain until at least 2014. That means the fi nancial heroin will continue to fl ow, which means continuation—and exacerbation—of negative real interest rates as far as most eyes can see.

What the US and Europe seem to be experiencing is a modifi ed stagfl ation, in which food and fuel prices stay stubbornly high, and interest rates remain at losing levels for investors.

Gold is the only historic medium of exchange whose value has been rising for nearly 11 straight years.

The forces driving it upward are accelerating.

Conclusion: Once gold breaks through its August peak of 1920, it will challenge the magic millennium level of 2000—and will eventually pierce it.

This is beginning to

look like Gold Bug

Nirvana...

22 November 2011



US Energy Policies: Political Risk for Oil Investing Rises

1. The Politics of Keystone XL

For coolly-calculated political reasons, President Obama has kicked the Keystone XL oil can down the road.

We had thought that would be his likeliest response, and raised the political risk issue in Basic Points and our Conference Calls—(albeit merely as a signifi cant 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 fi rm.

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 Hollywood's leading experts on environmental science issues, who fl ew 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 Department's exhaustive review—were about the pipeline itself, the NGOs made it clear they want to kill Keystone to stop the oil sands operations. They've been horrifi ed about the Canadian publicity that the oil sands are "the new Saudi Arabia." This is their chance to ensure that there's no North American Saudi Arabia.

[President Obama] is

back to doing what

he enjoys most and

does better than

anyone—campaigning.

23November 2011

Weeks ago, we watched an interview on public television's "News Hour," featuring some celebrity (whose name escapes us) who had demonstrated in Washington and had spent a night in jail. He never mentioned the Nebraskan environmental questions. He said that blocking the pipeline was the only way to stop oil sands expansion and perhaps even force shutdowns. When told that the Alberta government said that Canada could just divert the output to the Pacifi c Coast to ship to China, he said that their information was that indigenous people would kill any such proposal. (We are inclined to agree with him in that appraisal.)

The opposition to Alberta went global when the European Union issued a policy statement that European refi ners were not to use fuel from "dirty oil production"—which is a term used by the Banana (Build Absolutely Nothing Anywhere Near Anything) school of enviro-enthusiasm.

Mr. Obama is not such an extremist—at least not outside North America. On his trip to Brazil he renewed US fi nancial support for that nation's ambitious program of developing offshore oil, at a time exploration in the Gulf of Mexico was largely shut down. (The US, through government-guaranteed loans, is participating in a big way in developing those fi elds.)

Until recently, the main NGO fund-raising campaigns focused on blocking oil projects in Alaska, and drilling on any US coast. The litmus test for fi ghting a vile energy project is that it has the potential for raising many millions of dollars for tax-exempt organizations with strong records in using litigation to tie up energy (and mining) developments. The Alberta oil sands became their Hate #1 because they not only produce oil, but, until recently, most of it came from mining. (Steam-Assisted Gravity Drilling, which leaves a footprint smaller than a football fi eld, is a more recent development, but it gets lumped in with the open pits that supposedly despoil boreal forests and kill birds. That a typical wind farm kills many more birds and bats in a year than all the oil sands projects have accomplished throughout their history is, of course, irrelevant. Truth is the fi rst victim in such scorched-earth campaigns waged by wealthy enthusiasts who travel in jet planes and automobiles to kill oil exploration.)

When TransCanada agreed to all the State Department requirements for permitting, its management thought their long approval campaign was over. The State Department had the authority to draft the rules, with EPA assistance, and that was that.

Truth is the fi rst victim

in such scorched-earth

campaigns waged by

wealthy enthusiasts who

travel in jet planes and

automobiles to kill

oil exploration.

24 November 2011



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 fi nal decision. By postponing the decision until after the elections, he has virtually guaranteed his campaign huge support from the major left-wing and environmental funding sources, because they now know that if he loses next year, the decision on Keystone 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 won't 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 didn't score any points, because the quip wasn't original.)

One Canadian company—Enbridge—seems to have made the correct calculations about Obama's 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 fl ow 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 doesn't 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 he's raising a billion dollars in campaign funds and no one seems to doubt he'll do it, even though his campaign oratory is loaded with attacks on "the rich," and his overwhelming support in mainstream media means he doesn't 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.

American drivers will

be paying more for

their gasoline...

25November 2011

It looks as if the oil industry is making its plans on the assumption that Keystone will not proceed. Big Obama backer Warren Buffett's railroad stands to win big, because the huge growth in Dakotas oil production will have to go by train if Keystone isn't approved.

The odds, as of now, are that Keystone is in mortal peril. The death certifi cate is due November 2012.

It takes a re-elected Democrat to sign it.

2. Shale Gas and Oil

The other relatively new campaign against production of fossil fuels is the opposition to shale gas and oil produced through fracking.

To date, this has been a regional struggle. Most states are thrilled with the money pouring into local economies—not to mention the soaring royalty payments. To date, hundreds of thousands of high-paying jobs have been created. Example: the Dakotas' economies are booming as never before, and most residents cannot believe their good fortune. As Dennis Gartman reports, North Dakota now produces more oil than an OPEC member, Ecuador—and production is headed much higher—if environmentalists don't stop it.

In communities with colleges, and other centers of employment for leftist enthusiasts—such as upstate New York—opposition to fracking has been fi erce—and successful. The opponents allege pollution of aquifers and cite numerous examples of headaches ascribed to air pollution.

Until very recently, the prevailing viewpoint of big-picture thinkers without ties to litigating NGOs or oil and gas companies was that the US benefi ts hugely from the cheapest natural gas in the industrial world, and the prospect of cheap gas prices for perhaps a century is one reason to be bullish on America.

Keystone is in mortal

peril. The death

certifi cate is due

November 2012.

It takes a re-elected

Democrat to sign it.

26 November 2011



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 by fracking. At least one seismologist has publicly argued that earthquakes in low-risk earthquake areas were probably caused by fracking.

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 infl uential 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 confi ne most of its worrying to gas prices.

...man-made quakes

in low-or-no-risk

zones are a new

concept.

27November 2011

1. How the Capital Markets Could Eventually Reach A Happy Ending

THE INVESTMENT ENVIRONMENT

Euro vs. US Dollar


0.8

0.9

1.0

1.1

1.2

1.3

1.4

1.5

1.6

1.7

Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11

1.35

How much longer must global investors start their days by checking whether their stock markets will be up or down based on the latest news in Greece and/or Italy?

Would anyone have predicted 15 months ago that Greek politics, promises and riots would have more sustained impact on stock prices in North America than US GDP changes, US payroll employment data and changes in earnings forecasts? Greece hasn't been truly important since the death of Alexander the Great, (although its revolt against Turkish rule did lead to Lord Byron's death from fever).

In the past year, Greece has gone from being renowned for its ruins to being renowned for the ruin it infl icts on the eurozone's economy and on share prices of European—and even some major American—bank stocks.

Greek disease spread swiftly across the Aegean, and Italy now reels, with fallout as far as Spain. If Italy fails, then there is no hope of saving the euro or 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 of Italian bonds.)

...Greece has gone

from being renowned

for its ruins to being

renowned for the

ruin it infl icts on

the eurozone's

economy...


28 November 2011



When the euro was forged, the Bundesbank did its best to ensure that, even if governments broke the rules, monetary policies would be noninfl ationary. Jean-Claude Trichet has consciously imitated Karl-Otto Pöhl, Axel Weber, and other revered Bundesbankers.

Meanwhile, across the rest of the world, as we have discussed, central bankers and their governments are doing their best to drive down the value of their currencies. When the Swiss National Bank was transformed from being a model of prudence to looking like a Weimar banker in drag, it was clear that global infl ation threats would rise—eventually.

But the European Central Bank stuck to its Bundesbanque idée fi xe of fi ghting infl ation 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 Euro's 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 fi nd their global competitiveness challenged by the strength of their currencies.

The weak southern economies wasted the major benefi ts 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 sacrifi ced 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 defi cit controls that were brutally restrictive compared to the loose fi scal 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 infl ate their defi cits at a time the adamant euroelites demand they cut their defi cits—or else. Their economies contract because of the sickening declines in their competitiveness, and the contractionary policies hammering their feeble societies.

...during a full year in

which most of the news

from the eurozone has

been of crises...

the Euro's exchange

rate against the dollar

is unchanged.

29November 2011

The Bundesbank mentality served the Northern economies well for the decades in which most global economies were usually concerned that their currencies were strong—or at least stable.

But this new era when strong currencies are despised by their own central banks is unforgiving for the only large economy that practices the old-time currency religion.

This week's disorderly eurobond markets have triggered an open fl ap between the two Euroguardian nations about the ECB's responsibility for stabilizing bond prices. Each time Italian and Spanish bond yields soar, the ECB steps in, but only to prevent chaos. France argues that the ECB should do far more than Germany says is legal under EU rules.

The Germans and Jean-Claude Trichet have been pleased that the anti-infl ationary policies of the ECB have worked for 11 years, delivering lower infl ation and a far higher market price for the currency than the dollar.

But infl ation isn't the issue now.

It's survival.

Therefore:

The euro must be devalued. The target should be its value as of its inception for accounting on 1/1/99—$1.16—although the ECB should allow for downsize overshoot.

The process of devaluing it will involve massive liquidity expansion within the eurozone, thereby reliquifying the parched banking system and restoring lending activity across the eurozone.

It's time for the eurozone to start pumping out its own brand of Bernanke heroin—until the euro reaches a globally competitive range and the European banks have rebuilt themselves to at least the minimal-to-modest strength of their American counterparts

When eurobanks no longer have to pay infi nitely higher rates on short-term deposits than American banks, they will be better able to handle the problems of (1) putrefying American CDOs purchased when the euro was trading far above par on the dollar, and (2) depreciating PIIGS bonds lending their own peculiar odors to their balance sheets.

It's time for the

eurozone to start

pumping out its

own brand of

Bernanke heroin...

30 November 2011



But how can such reliquifi cation and monetary depreciation be sold to the Germans? They know of two disastrous policy regimes—hyperinfl ation and Hitler. They believe that one begot the other. Never again!

Sarkozy talks of a new Franco-German domain within the eurozone, and Finland now argues that the six members with AAA ratings should have a greater measure of control: (Slovakia shouldn't 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 we'd be left with a mark whose value was up 40% over the peripherals and we couldn't sell in the South or in most of the world!"

She can also point out that infl ation in major non-euro economies with weak currencies is roughly at—or even less than—eurozone levels. There's room for currency depreciation and bank reliquifi cation.

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 fi nances 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, refl ated 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 fi nancial 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.

James Carville,

where art thou now?

31November 2011

It is not too Panglossian to expect that the fi nancial crisis of the eurozone would gradually migrate from Page One of newspapers within Europe—and across the world.

If—or when—that happened, share prices of major US banks would also stop falling and start rising.

If—or when—that happened, a new global equity bull market would be born.

But even before that overall rally was returning smiles to Wall Street and the world, that other bull market that never really went away would be exciting investors...

2. Gold Moves From the Sidelines to Center Stage

As the only medium of exchange that cannot be synthesized or devalued by high-speed central bank printing presses, gold wins from eurodespair or eurodevaluation.

If the ECB—the last holdout against fi nancial heroin—joins the lotus-eating majority of central bankers, gold would enter a spectacular bull market once it became apparent that the euroelites had decided to save their banks and their 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 monetary system by using it to back long-duration bonds of profl igate nations such as Italy and the USA. That still could happen, but we've had no takers. Keynesian orthodoxy lives among intellectual elites, even as they lose faith in the Old-Time Religion.

But the failure to rebrand gold as the backing for long-duration infl ation-hedged bonds doesn't mean gold has no future.

If investors in other assets sense that the last holdout against monetary excess has decided that virtue is punishing all members of its currency zone, they will rush into gold as the last refuge in a universe of Paper Moonshine.

Monetary virtue works

well in theory, but how

does it work in practice

when nobody seems to

prize it anymore?

32 November 2011



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 profi tability 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 fi lled with fear, and seek the safety of "the asset that is nobody’s liability."

The ETF has been the sweet spot in this year's strong gold rally.

33November 2011

Gold Royalty and Streaming Companies

These companies have unique business models that allow them to minimize risk and maximize upside reward from rising metal prices:

Because their earnings come from dozens of mines, they provide a diversifi ed portfolio of known revenue streams.

They have fi xed costs—they don't have to provide more money as capital 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 participate in the future of gold.

Large-Cap Gold Miners

All long-term gold investors should have some exposure to the major mining companies.

Our core investment thesis is: “invest in companies with unhedged reserves in the ground in politically-secure areas of the world”.

Furthermore, gold miners (and royalty companies) provide a levered play on gold price increases.

The relative value of unhedged reserves compared with the investment value of holding spot gold is changing as strong gold prices improve both the profi tability of existing production and the volume of economic reserves. As the price of gold goes up, not only does the value of currently recorded reserves rise with it, but the total reserves economic for mining increase.

Investors in well-managed large-cap gold mines have been greatly disappointed at their stocks' recent price performance.

Why? Because the investor consensus on gold, which shifts from fear of infl ation to fear of a defl ationary crash, is in one of its confused periods. That means speculative enthusiasm for the miners and exploration companies is at a relatively low ebb.

...gold miners (and

royalty companies)

provide a levered play

on gold price increases.

34 November 2011



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 about deterioration in some formerly favorable nations.)

We believe investors have soured on the large caps stocks unduly and expect them to benefi t when gold shows signs of a new upside breakout.

Medium- and Small-Cap Gold Miners, and Exploration Companies

When gold was surging toward $1,900 the bullion and the exploration companies were outperforming the established miners—the bookends of enthusiasm.

When retail investors regain the confi dence to take bets on the exploration companies' ability to fi nd 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 unprofi table unless the ore grade was near one ounce per ton. These days, even mines with grades near one gram per ton can be very profi table—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.

...while gold reserves

are increasing, so

are political risks.

Investors must

be wary about

deterioration in some

formerly favorable

nations.

35November 2011

3. The Bullet-Proof Dividend Stocks

Since we began recommending these stocks as a discrete asset class, we have been receiving a growing number of inquiries about our selection and management criteria.

We plan to make this concept and the implications for pension funds of holding exposure in such securities within what is ordinarily classifi ed as the Fixed Income section of their portfolios, the core of our January issue.

In the meantime, we notice such developments as Warren Buffett's purchase of a 5.4% stake in IBM stock as evidence that something big is unfolding for companies with strong fi nances, strong managements, and strong dividend policies.

...we began

recommending these

stocks as a discrete

asset class...

36 November 2011



Allocations ChangeUS Equities 14 unch

Foreign Equities: European Equities 0 unch Japanese and Korean Equities 2 unch Canadian and Australian Equities 4 unch Emerging Markets 5 unch

Commodities and Commodity Equities* 5 unch

Gold & Gold Stocks 5 unch

Income Generating Assets Dividend Stocks 10 unch Bonds: US Bonds 20 unch Canadian Bonds 8 unch International Bonds 4 unch Infl ation Hedged Bonds 12 unch

Cash 11 unch

Recommended Asset AllocationCapital Markets Investments

US Pension Funds

Years ChangeUS 7.00 unchCanada 7.00 unchInternational 5.00 unchInfl ation Hedged Bonds 9.00 unch

Bond Durations

ChangeAgriculture 32% unchPrecious Metals 37% unchEnergy 19% unchBase Metals & Steel 12% unch

Global Exposure to Commodity Equities

We recommend these sector weightings to all clients for commodity exposure—whether in pure commoditystock portfolios or as the commodity component of equity and balanced funds.

RECOMMENDED ASSET ALLOCATION

37November 2011


RECOMMENDED ASSET ALLOCATION

Allocations Change

Equities: Canadian Equities 14 unch US Equities 4 unch European Equities 0 unch Japanese, Korean & Australian Equities 2 unch Emerging Markets 5 unch

Commodities and Commodity Equities 5 unch

Gold & Gold Stocks 5 unch

Income Generating Assets Dividend Stocks 10 unch Bonds: Canadian Market-Related 32 unch Canadian Real-Return Bonds 12 unch International Bonds 3 unchCash 8 unch

Recommended Asset AllocationCapital Markets InvestmentsCanadian Pension Funds

Global Exposure to Commodity Equities

ChangeAgriculture 32% unchPrecious Metals 37% unchEnergy 19% unchBase Metals & Steel 12% unch

We recommend these sector weightings to all clients for commodity exposure—whether in pure commoditystock portfolios or as the commodity component of equity and balanced funds.

Years ChangeUS (Hedged) 7.00 unchCanada: – Market Index-Related 7.00 unch – Real-Return Bonds 9.00 unchInternational 5.00 unch

Bond Durations

Canadian investors should hedge their exposure to the US Dollar.

38 November 2011



INVESTMENT RECOMMENDATIONS

1. Move to large overweights in commodity stocks within equity portfolios, emphasizing precious metal producers, oil producers and agricultural stocks.

2. The euro is headed much lower. Bond investors should scale back euro exposure and corporate treasurers should try to borrow in euros.

3. Reduce exposure in non-Canadian bank stocks to a minimum. The B5 stocks look cheap but they may actually be greatly overvalued. The single cockroach principle applies: Dexia is not unique.

4. Accumulate the great bullet-proof dividend-paying stocks. They are not the obvious high-yielders, like utilities, although such shares may be appropriate in overall equity strategies. They are great, well-managed, fi nancially powerful companies that emphasize total return for shareholders through rising dividends against a background of consistently-improving earnings.

5. The most serious endogenous risk in major equity indices doesn't come from recession probabilities this time. It comes from banking risks. With near-zero interest rates, the next recession in North America should be mild compared with its predecessor.

6. There is no longer any currency pride left in most central banks. They are collectively competing with each other to see who can make his currency the most competitive. Since this situation is unprecedented outside of global Depression, the infl ation risks are moving to the upside.

7. In bond portfolios, ignore the Capital Asset Pricing Model and look for high-quality corporate bonds to replace over-valued government bonds.

8. A buying opportunity for non-financial equities could be coming surprisingly soon if the eurozone takes the tough and dramatic policy changes to terminate the seemingly endless era of struggling and/or collapsing bank stocks. Keep some dry powder and be ready to look for an entry point amid sea changes in Europe—and soaring bank stocks.

Keep some dry powder

and be ready to look

for an entry point

amid sea changes in

Europe—and soaring

bank stocks.

39November 2011

9. An Israeli defensive attack on an Iranian nuke facility is still an unlikely outcome, but the concerted global attempts to isolate Israel may make its leaders feel they must act alone, defying critics abroad who have never been true friends of Israel anyway. Don't buy oil stocks to bet on a raid, but maintain good exposures. Most good oil stocks are cheap anyway, so you get protection for free.

10. We have long recommended against investing in shale gas companies as compared with oil producers. We reiterate that recommendation because of the possibility—still remote—of political risk.

11. The Canadian oil sands stocks have always been favorites of ours because they have met our two most crucial criteria: long-duration reserves and minimal political risk. They still have those long-duration reserves. They now have powerful US political enemies who will go to great length to constrain their output, and a President who is far more attuned to these activists than to the oil industry—which is his main whipping boy in his promotion of "Green Energy." It is time for Canada to realize that its friendship with the US isn't necessarily reciprocated at the top, and to adopt new pipeline and export strategies. In the meantime, institutional investors who hold oil sands stocks can expect to be unfairly hectored by some of their greenish clients.

THE COXE STRATEGY JOURNAL© Coxe Advisors LLP 2011. All rights reserved. Unauthorized reproduction, distribution, transmission or publication without the prior express written consent of Coxe Advisors LLP (“Coxe”) is strictly prohibited. Coxe is an investment adviser registered with the U.S. Securities and Exchange Commission. Nothing herein implies that the fi rm is recommended or approved by the United States government or any regulatory agency.

Information, opinions, estimates, projections and other materials (referred to collectively herein as, “Information”) contained herein are provided as of the date hereof and are subject to change without notice. From time to time, Coxe publications may contain Information with regard to securities, commodities, derivatives or other investment assets (each referred to herein as an “Investment,” or collectively, the “Investments”), or investment strategies. Due to staggered publication dates, any Information contained herein may differ from Information contained in prior or subsequent publications. Information discussed herein may have been obtained from various unaffi liated third party sources believed to be reliable, but has not been independently verifi ed by Coxe. Coxe makes no representation or warranty, express or implied, in respect thereof, takes no responsibility for any errors and omissions which may be contained herein, and accepts no liability whatsoever for any loss arising from any use of or reliance on such third party Information, whether relied upon by the recipient or user, or any other third party (including, without limitation, any customer of the recipient or user). Foreign currency denominated Investments are subject to fl uctuations in exchange rates that could have a positive or adverse effect on the investor’s return. Unless otherwise stated, any pricing information in this publication is indicative only.

No Information included herein constitutes a recommendation that any particular Investment or investment strategy is suitable for any specifi c person. Coxe publications are not intended as investment advice tailored to the particular circumstances, investment objectives, and risk tolerances of any entity or individual. Coxe publications do not continuously follow any Investments or their issuers. Accordingly, users must regard each Coxe publication as providing stand-alone analysis as of the date of publication and should not expect continuing analysis or additional reports related to such Investments or their issuers. The Information contained herein is not to be construed as a solicitation for or an offer to buy or sell any referenced Investments, or any service related to such Investments, nor shall such Information be considered as individualized investment advice or as a recommendation to enter into any transaction. Coxe separately provides individualized, nondiscretionary advice on an exclusive basis to an unaffi liated adviser to various separate accounts and to a limited number of foreign and domestic investment companies. However, the nature and timing of Coxe publications is separate from the nature and timing of such individualized portfolio advice.

Coxe and any offi cer, employee or independent contractor of Coxe, may from time to time have long or short positions in any Investments discussed. Coxe’s principal, Mr. Coxe, and other access persons privy to information contained in a Coxe publication prior to publication, are restricted from entering into any transaction concerning any Investments discussed therein for the fi ve days before and after publication, and are required to hold any such positions for a minimum of one month.

Coxe has entered into a distribution agreement with certain affi liates of the Bank of Montreal (“BMO”) to redistribute its publications. Coxe may enter into similar distribution agreements either with additional BMO affi liates or others. To the extent that any publication is reproduced, redistributed, or retransmitted, Coxe is not privy to, and makes no representations regarding, such unaffi liated third parties’ positions in any Investments discussed therein. Any distributor authorized by agreement with Coxe to redistribute this publication is not affi liated with Coxe. Third parties having permission to reproduce, redistribute, or retransmit Coxe publications may offer to effect transactions in some or all discussed Investments. Coxe makes no recommendation with respect to the use of any particular brokers or agents, and no such recommendation should be inferred by virtue of any distribution agreements that Coxe may enter into with third parties.

Published by Coxe Advisors LLP

Distributed by BMO Capital Markets

don coxe basic points nov. 2011

Economy & Finance