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Basic Points
THE FINAL PROBLEM
December 21, 2012
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
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CNOOC CEO 4 Progress Energy PRQ.TO 3, 4
International Business Machines IBM 2 Syngenta SYT
Microsoft MSFT 2
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Don Coxe
THE COXE STRATEGY JOURNAL
THE FINAL PROBLEM
December 21, 2012
published by
Coxe Advisors LLP
Chicago, IL
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THE COXE STRATEGY JOURNAL
THE FINAL PROBLEMDecember 21, 2012
Coxe Advisors LLP.Author: Donald Coxe 312-461-5365
Editor: Angela Trudeau [email protected]
115 South LaSalle Street, 11th FloorChicago, IL 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 BMO Private Bank.
BMO Capital Markets Equity ResearchManager, Publishing: Monica Shin
Desktop Publishing and Anna GoducoDistribution Coordinator [email protected]
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OVERVIEW
THE FINAL PROBLEM
In this nal issue o Basic Points, we discuss what we consider The Final Problem or central banks,governments and investors in the industrial world.
Tragically, capitalism's greatest triumph and the powerul global economic expansion were interrupted by
capitalism's greatest inamy. The Crash was caused primarily by the major banks o Wall Street and Europe
that we have long labeled as the B5The Big, Bad, Bonused, Bail-out Banks. A recession spread rapidly
across the Industrial World, and panicky central banks and governments united to rescue collapsing banks,
at enormous taxpayer cost. Interest rates were slashed to near-zero during the crisis, when outright defation
loomed.
The ensuing recoveries have been so tepid that money continues to be astonishingly cheap or governments,
and corporationsand, bizarrely, or banks. What we have called The Financial Heroin continues to fowinto the veins o once-vibrant economies.
Meanwhile, the segments o the population still being punished or the bankers' sins are in the lower- and
middle-classes, who have long relied on saving through banks and short-term instruments.
In this nal issue, we cite Homer's description o a society in The Odysseyas we consider the question: When
will it be possible to phase out their emergency economic and social support programs?
We discuss the likelihood that the sustained dependence o governments on zero interest rates and more-
generous social benets creates a sel-sustaining system that pushes risk-taking and capitalism o to
increasingly distant horizons.
In the short term, i a scal deal in Washington survives the demands o extremists in Congress and the White
House, the US economy should continue with its modest growth. The towering decits will continue, but
the inevitable crisis will probably be pushed urther down the road. Canada, with the best-managed banks
and the soundest macro policies, will continue to grow moderately. In the eurozone, there are currently
no alarm bells to drown out the Christmas bells, but economies remain weak and the PIIGS remain crisis-
prone.
Our long-cycle view remains intact: Global economic leadership will continue to reside with the ormer
socialist Asian economies that most enthusiastically embraced capitalism to emerge rom poverty. We
call their astonishing perormance "The greatest eforescence o personal economic liberty in history."
Since these economies have ar higher commodity content than the rail, senescent Western economies,commodity prices should remain rm.
Best wishes or the holiday season and next year. For those who wish to keep inormed on our views, a new
product oering will come shortly to those who express interest to us via our website.
Many thanks or your sustained, enthusiastic support over this long timespan. You have been truly
wonderul!
Don Coxe
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THE COXE STRATEGY JOURNAL2 December 2012
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THE FINAL PROBLEM
President Reagan observed that nothing in Washington is so permanent as a
temporary government program. This time, the Crash-spawned record levels
o scal decits have endured three years into the recovery, as have the Fed's
zero interest rates.
Investors and businesses have become accustomed to zero and near-zero
rates on debt and economic growth.
What happens when (i?) central banks start raising rates and government
social spending is cut while unemploymentparticularly long-term
unemploymentremains high?
Should investors long or a reversion to normal scal and monetary policies,
or be terried o the likely consequences?
This discussion o The Final Problem is appropriate or the nal issue o
this publication's two decades o commentarya long liespan or a strategy
journal.
We began publishing just ater the collapse o Marxism's greatest triumph,
the Soviet Union. Thanks largely to President Reagan and Margaret Thatcher,
Stalin's empire joined the Bourbons and Ozymandias, shattering not with a
bang, but a whimper. The West had won.
The sudden death o Mother Russia was a horrendous shock to most
socialists. China, India and Indonesia drew the appropriate conclusions, andcommitted their economies to progress along capitalist lines.
That momentous global revolution meant thatBasic Points was blessed with
a near-perect background or its concepts at its birth and in its rst teen
years o distribution. As long as industrial nations' stock and bond markets
prospered amid economies progressing on mostly capitalist lines, and
the principal challenge to these economies was rom emerging economic
powerhouses embracing ruggedly capitalist themes to create competitiveness
and progress, our ree market-based recommendations drew a wide audience
o investors.
For the frst time in the modern era, massive monetary expansion and plunging
yields have ailed to ignite an economic recovery that would drive investors
rom bonds to stocks.
That is the root o the investment problem.
Should investors
long or a reversion
to normal scal and
monetary policies?
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THE FINAL PROBLEM
THE COXE STRATEGY JOURNAL
US Treasury Two-Year Note YieldDecember 19, 2007 to December 19, 2012
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
Dec-07 Aug-08 Apr-09 Dec-09 Aug-10 Apr-11 Dec-11 Aug-12
0.25
Basic Points and the Bond Bull
Basic Points was created in 1992 primarily as a bond-oriented strategy
publication that would also comment on important trends in equity
markets.
Most o us involved in its design assumed that the bond bull market born
in August 1981 would, like all its predecessors, soon succumb to the bond
bears born amid strong economic growth. Ater blowing out the candles on
its eleventh birthday, it would surely age rapidly and die.
We elt vindicated in that bond orecast when, a year later, bonds stopped
rallying and were hit hard, with the Treasury Ten-Year's yield climbing rom
5.2% to 8%.
Little did we know that the bond bull had barely reached puberty. He has
recently attained Methuselah status, celebrating his 31st birthday shortly
ater attaining a record 1.43% Ten-Year yield. Romping on sunlit uplands,
the bond bull has the last laughoutlivingBasic Points.
However, this boo bovine has long since outlived his welcome. In recent
years, his success has been achieved, not or his own value, but as the deault
asset among an unappealing range o choices.
Little did we know
that the bond bull had
barely reached puberty.
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30-Year Treasury Bond Yield
December 19, 1982 to December 19, 2012
2
4
6
8
10
12
14
Dec-82 Dec-86 Dec-90 Dec-94 Dec-98 Dec-02 Dec-06 Dec-10
2.81
Three years ago, we coined the term "nancial heroin" or the zero and near-
zero yields central banks were providing. A nancial historian contemplating
that yield chart or the Treasury Two-Year Note can only marvel. How, based
on history, can there be a unctioning US economy? Five years ago that note
yielded 3%, modestly above the infation rate. Now it seems to have been
transmogried into a North American extension oJaponaiserie, yielding
a barely-perceptible 0.24%, as investors jettison concerns or a return on
money in avor o preoccupation with a return omoney.
But, as remarkable as those Two-Year yields may be, over the long term, the
bond bull has been most impressiveand rewardingor investors in long-
term Treasurys.
I capitalism were in a hospital and this chart were at the end o its bed,
visitors would be ordering fowers or the widow.
The long-term perormance o the Long Treasury documents a trend unique
in modern economic history:
Long-term, non-callable, high-quality bonds have, on a cumulative basis,
outperormed US stocks over 31 years.
Under ree-market economic theory, that is supposedly impossible.
The basic math o capitalismits Law o Gravitystates that Risk Assets,
such as stocks and real estate, must, over the long term, deliver higher returns
than risk-ree assets.
Long-term, non-callable,
high-quality bonds have,
on a cumulative basis,
outperormed US stocks
over 31 years.
Under ree-market
economic theory, that is
supposedly impossible.
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THE FINAL PROBLEM
THE COXE STRATEGY JOURNAL
This cumulative long-term underperormance o the risk assets, which have
historically been the incentives or capitalist managers and investors, arose
because o two gigantic busts coming within just eight years:
The rst blow to the Reagan-born Boom mentality o the late 20th Century
was the Triple Waterall Crash o Technology Stocks, starting just ater the
old Millennium died.
Then came the rantic, orce-ed housing booms in the US and most
European countries, which ended with the Momma Bear1 Bank Crash o
2007-9.
KBW US Bank Stock Index (BKX )
July 1, 2002 to December 19, 2012
20
30
40
50
60
70
80
90
100
110
120
Jul-02 Oct-03 Jan-05 Apr-06 Jul-07 Oct-08 Jan-10 Apr-11 Jul-12
48.56
Those disasters continue to infict pain on nancial markets, and, more
importantly, economies across the Industrial World.
Capitalism bleeds not rom its ailure but because o wounds inficted by a
tiny minority o greedy people masquerading as capitalists. They are the bad
priests in the secular church o capitalism.
Result: the S&P this year has been trading where it did thirteen years ago, and
bonds have been trading where they have neverbeore. The global economy
continues to grow, albeit modestly.
Thankully, capitalism isn't deadyet.
1 Teddy Bears, Baby Bears, Momma and Papa Bears are described in Chapter One: The Taxonomy o Bears;
The New Reality o Wall Street (2003, McGraw Hill)
They are the bad
priests in the secular
church o capitalism.
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However, thirteen years o cumulative zero returns is enough to induce
nancial triskaidekaphobia.
Shell-shocked pension unds are feeing rom stocks to bonds; in response
to the zero capital appreciation on stocks and central bank promises o
sustained zero short-term rates, they are overweighting the asset class that
seems to keep on outperorming, even though current bond yields are o the
bottom o the charts.
The result is an historic rejection o the Capital Asset Pricing Model (CAPM)
with its Ecient Frontier or projecting asset returns according to risk. (For
readers unamiliar with this ormula, an oversimplied denition might be
helpul: the CAPM ranks asset classes according to risk and expected long-
term returns, with Treasurys and other AAA-rated government bonds beingthe risk-ree asset classes against which all others are measured. A pension
und decides what its long-term expected rate o return should be, and
constructs an asset mix composed o a wide range o asset classes, based on
their respective risks and historical rates o return.)
With current yields so low, this investor fight to bonds is the money under
the mattress approach to wealth-building.
According to The Financial Times, US public and many private pension unds
are still projecting that they will, or decades ahead, earn 7-8% long-term
returns, while European and Asian unds have been slashing their projectionsto 5%. The US practice makes as much sense as promising to pay aging,
expensive sports stars at their current rate or a urther 20 years. Not even the
Cubs would do that.
How can US pension plans get away with orecasting such optimistic expected
returns?
In part, the US projections could be rooted in a peculiarity o pension
unding rules under the Employee Retirement Income Security Act (ERISA)
and the pension und costing rules or calculating corporate prots as set out
in Financial Accounting Standard Board's pension protability rules under
FASB 87.
How can US pension
plans get away
with orecasting
such optimistic
expected returns?
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THE FINAL PROBLEM
THE COXE STRATEGY JOURNAL
We commented on this anomaly in 2003, when we discussed the report o
IBM's pension und, which was based on its own version o the CAPM.
IBM was projecting an 8% uture rate o return on its und's bonds, at a
time the Thirty-Year was yielding roughly 4.8%down rom 9.4% in 1990.
According to practices under ERISA, regulators can look at unds' previous
asset class returns as the basis or uture projections. The regulators accepted
IBM's contention that its long-term annual bond returns were ar above
8%, so there was apparently nothing wrong with projecting those splendid
returns orward. The IBM pension und return implicitly assumed a never-
ending bond bull; as a result o the rules o FASB 87, that projection produced
earnings-per-share gains that were most welcome when the company was
struggling in rebuilding mode.
The CAPM aces an existential challenge to its ormula o projected returns
above the Risk-Free Rate o Return on government bonds. Meanwhile,
the Basel rules or bank investing and accounting ace a dierent kind o
existential challenge. The increasingly perilous nances across most o
Europe have meant that the risk-ree rating applied to sovereign bonds has
become increasingly dubious.
Previously, the eurozone's proclaimed rule o admitting only nancially-
sound governments committed to modest decits had convinced bond
rating services and investors that all European sovereign bonds were risk-ree.
Result: portolios o banks and pension unds became heavily laden with
debt rom what came to be known as the PIIGS (and now, in the Orwellian
sanitized orm, as the GIIPS)Portugal, Ireland, Italy, Greece and Spain. At
an early stage in the Grand Illusion, Greek Ten-Year bonds briefy yielded
as ew as eleven bps above German Bundswhich were the unquestioned
standard o excellence.
In a Chicago speech last year, Axel Weber, ormer head o the Bundesbank,
cited this dependence on a fawed model as a major actor in the ongoing
eurozone crisis. "The banker who bought Greek bonds or eleven bps over
Bunds wasn't making an investment decision, but was buying o the model,
seeking a bonus or outperormance," he said, with an audible sneer.
...what came to be
known as the PIIGS
(and now, in the
Orwellian sanitized
orm, as the GIIPS)...
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According to The Financial Times, "UK pension unds are holding more bonds
than equities or rst time since the so-called cult o equities in the 1950s.....
Alan Wilde, head o xed income and currency at Barings, added, 'The cult o
equity is dead or at least has been on lie support since 2002/3 ollowing the
dotcom crash and corporate problems in the US with the likes o Enron'.....
Pension unds have been slowly switching back to bonds in an attempt to
best the volatility o equity markets and receive a guaranteed income stream
to meet pension payments.....The Pensions Regulator.....said UK unds hold
43.2% in gilts [UK government bonds] and xed interest compared with
38.5% in equities."
The Long-Term Capital Market crisis o 1998 came rom reliance on a atally-
fawed modelthe Value at Risk model based on Black-Scholes. The Crash
o 2008 came rom reliance on yet another atally-fawed model: decades
o reliable returns on home mortgages and instruments tied to home
mortgages gave AAA ratings to home mortgage portolios. That blanket
approach stimulated a cancerous growth in complex instruments with heavy
weightings in dubious or outright raudulent mortgages.
Where there are losers, there must be winners.
There have been some notable beneciaries rom the lemming-like fow o
investment unds into bonds. Financially strong cash-generating companies
with records o modest or nonexistent dividends, such as IBM and Microsot,
have been borrowing big at rates o 1% or less to pay dividends, thereby
attracting equity investors committed to stocks yielding more than the
Financial Heroin ratezero, or near-zero. Historically, companies that
foated bonds to pay dividends were regarded with disdain. Now, they are
the new blue chips or conservative dividend unds.
Benjamin Graham would be aghast.
There have been some
notable beneciaries
rom the lemming-like
ow o investment
unds into bonds.
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THE FINAL PROBLEM
THE COXE STRATEGY JOURNAL
Central Banks Fatten Up As Economies Slim Down
Those microscopic yields on debt o governments deemed sound were the
products o the 2008 crisis, as central bankers and governments rushed to
rescue banks and economies. The central bankers assured investors that
zero and near-zero rates were temporary emergency injections that would
not trigger stagfation, because economies were so weak. Once economies
rebounded, rates would return to normal. The surge in gold prices was, Street
economists assured us, based on fawed analysis o the supposed infation
risks rom what some o us considered the nancial elephantiasis suddenly
bloating central bank balance sheets.
US Monetary Base
January 1,1992 to December 19, 2012
0
500
1,000
1,500
2,000
2,500
Jan-92 Jul-94 Jan-97 Jul-99 Jan-02 Jul-04 Jan-07 Jul-09 Jan-12
2,651.80
Source: Federal Reserve Bank o St. Louis
Japan: Monetary Base
January 1,1992 to December 19, 2012
Source: Bank o Japan
300,000
400,000
500,000
600,000
700,000
800,000
900,000
1,000,000
1,100,000
1,200,000
1,300,000
Jan-92 Jul-94 Jan-97 Jul-99 Jan-02 Jul-04 Jan-07 Jul-09 Jan-12
1,244,449
The central bankers
assured investors that
zero and near-zero
rates were temporary
emergency injections...
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What we have ound most worrisome is the poor US economic perormance
since 2009 despite an all-out eort rom Washington to revive the sick
economy. The Obama Administration and the Fed have united to pull the
US out o recession by employing the techniques recommended by the two
best-known macro economists o the last centuryJohn Maynard Keynes
and Milton Friedman.
The Fed has ballooned its Monetary Base more dramatically than ever beore
(and is about to do much more) and has hugely lengthened the duration o
its assets; simultaneously the ederal government has been spending on a
scale not seen since World War II, boosting the National Debt by more than
40% in just our years.
Switzerland: Monetary Base
January 1,1992 to December 19, 2012
0
50
100
150
200
250
300
350
Jan-92 Jul-94 Jan-97 Jul-99 Jan-02 Jul-04 Jan-07 Jul-09 Jan-12
348.950
Source: Swiss National Bank
Source: European Central Bank
European Central Bank: Base Money (Monetary Base)
February 1,1999 to December 19, 2012
400,000
600,000
800,000
1,000,000
1,200,000
1,400,000
1,600,000
1,800,000
Feb-99 Feb-01 Feb-03 Feb-05 Feb-07 Feb-09 Feb-11
347,812.00
...the ederal
government has been
spending on a scale not
seen since World War II,
boosting the National
Debt by more than 40%
in just our years.
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THE FINAL PROBLEM
THE COXE STRATEGY JOURNAL
Yet, despite all that Fed monetization and all that spending and all that new
debt, the US economy has barely avoided sliding back into the recessionary
bog. Unemployment rates remain high, but would be truly grim were it not
or the many millions who have given up looking or jobs and goneItalian
styleonto disability benets and ood stamps. Example: last month's
Nonarm Payroll report showed a slight decline in the unemployment rate,
largely because a urther 330,000 people dropped out o the workorce.
Where have all the workers gone?
The Presidentand most economistsassumed that all that scal and
monetary stimulus would kick-start a sustained recovery. Republicans have
wasted the nation's time in wailing o the waste in the $798 billion o
Obama-Pelosi stimulus spending. O course, much o the stimulus money
was wasted on cronyism, but Keynesian economics decrees that what counts
is spending the moneynot how eciently it is spent. Keynes said that even
paying men to dig ditches and ll them up was better than practicing tight-
sted monetary policies. The ditch-diggers would immediately spend their
paychecks, and the economy would rebound. In today's enlightened times,
men (and women) aren't paid to report or work to do something useless:
they're paid to stay home and watch TV. But they are still consumers.
Had Obama not turned on the spending re hoses ull blast, the economy
might well have slipped back into recession. Where the hoses were directed
is less important. Government is, by its nature and employment practices,ar less ecient than the private (non-big-banking) sector in allocating
resources, except or maintaining civil order and deending the nation against
enemies.
As or waste, the Bush Administration was no model o finty prociency. Its
"No Child Let Behind Act" ailedat large costto improve the tragically
low academic standards in so many o the major metropolitan school
districts. It also launched a war against Iraq at a time the nation was already
at war in Aghanistan based on dubious intelligence about Weapons o Mass
Destruction. (They weren't there, but the Pentagon is now alarmed that they
were trucked to Syria or saety prior to the invasion and are available to thedesperate Assad.)
The reason the economy is struggling to stay above water is not because o government
waste and corruption. Even Ben Bernanke suggested, hal-seriously, that scattering
money rom airplanes was better than doing nothing.
Republicans have
wasted the nation's
time in wailing o
the waste...
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Thereore, what investorsand legislatorsshould ask is, "Why won't the
economy grow?"
Apart rom Paul Krugman and his allies on the Extreme Let, nobody believes
the nation can go nearly a hundred billion deeper in debt every month
orever. When will the economy be strong enough or a return to something
even vaguely approaching scal prudence?
We suggest two explanations: one rom a respected economist, and one o
our own.
1. Robert Gordon's Thesis
Proessor Robert Gordon o Northwestern University, a distinguished
economist with a global reputation, has recently advanced a provocative
thesis that is attracting considerable attention.2
In the early days o the Obama Administration he, like most academic
economists, was very optimistic that Obama's and Bernanke's policies would
pull the nation out o the recession and put it on a sustained path to strong
growth. He was condent enough to predict 4% GDP growth or late 2009
and thereater.
That never happened.
Why?
Dr. Gordon has pondered this question and come up with a worrisome
answer: we aren't getting the huge, sustained gains rom transormative and
disruptive new technologies that kick-started and sustained earlier recoveries
because o multiplier eects that stimulated job creation across broad sectors
o the economy.And we may not be seeing any more o them.
In his thesis, the rapid growth and ascent to world economic leadership o
the United States is due to three successive industrial revolutions:
No. 1 - steam and railroads rom 1750 to 1830;
No. 2 - electricity, internal combustion engine, running water, indoor
toilets, communications, entertainment, chemicals, petroleum, rom 1870
to 1900; and
No. 3 - computers, the web, mobile phones rom 1960 to present.
2 (See, or example, Martin Wol's admiring analysis o his work in The Financial Times: Is unlimited growth
a thing o the past? October 2, 2012)
...we aren't getting the
huge, sustained gains
rom transormative
and disruptive new
technologies that kick-
started and sustained
earlier recoveries...
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THE FINAL PROBLEM
THE COXE STRATEGY JOURNAL
He notes that the Edison light bulb and the Bell telephone came out almost
simultaneously, and those inventions stimulated the birth and rapid growth
o the US electricity and telephone industries which became major drivers
o economic progress or decades, creating millions o jobs directly and
indirectly, while improving productivity on a sustained basis.
At about the same time, Benz was perecting the internal combustion engine;
within a ew decades came the Model T Fordpriced at $850 initially and
thanks to assembly-line production, just $300 by 1925. Nearly everyone
could aord a car, and that meant roads, gas stations, and repair shops had
to be built, year in, year out, and the oil and gas industry had to produce
more uel, year-in, year-out.
Eisenhower's peacetime victory o getting Congress to commit to theInterstate Highway System re-launched the altering economy in the 1950s.
Such a huge series o projects took a while to build momentum. Perhaps
more importantly, it took a ew years to generate the multiplier eects rom
interchanges and new supply chains. That growth had just begun to eed on
itsel as JFK won an election on the platorm o "Getting America moving
again."
Here are some other examples o key productivity and economically-
stimulative breakthroughs:
1. The Otis elevator (Technology's git to the Chicago Loop) was one othe important spinos ater electricity became available. It meant that
buildings where people worked (and later, lived) could be more than eight
stories high. The multiplier eects have continuedon and oor more
than a century. Skyscrapers changed city's skylines and created workspaces
within range o each other that led to sustained productivity gains.
2. Willis Carrier's invention o air conditioning had major implications or
skyscraper development. But its most crucial eect began in the 1920s,
as air conditioners spread into the backward and depressed American
South. The multiplier eects o this breakthrough have continued within
the USA, and across much o the tropical and sub-tropical world.
3. Air travel created millions o good jobs worldwide, spawned growth in
vacation communities and conventions, and eventually became the basis
...came the
Model T Ford
priced at $850
initially and thanks
to assembly-line
production,
just $300 by 1925.
-
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o high-end global supply chains. It is, or example, estimated that there
is more than one job on the ground or every plane landing at Chicago's
O'Hare airport. However, Gordon notes, it has long since ceased to be
progressing in a transormative way. With the abandonment o the Super-
Sonic Transport service operated by British Airways and Air France, airlines
have actually increased signicantly the time it takes to fy the astest
civilian airplanes across the Atlantic in the most modern aircrat, a setback
he considers virtually unique in the history o industrial technology.
Then came the digital revolution, which in comparison to the two industrial
revolutions, has come and matured quickly. For three decades, computers,
the Internet and cellphones have promoted global growth in ways planned
and unplanned. He doesnt downplay the signicance o this revolution, but
is skeptical that it will be a big job-generator in the USA going orward.
Dr. Gordon hasn't seen many transormative breakthroughs on a net US
job-creating basis in recent years, and suspects they may not happenbecause
uture advances will ace the headwinds generated, in part, by that very success.
These include demography, education, inequality, globalization, energy and the
overhang o consumer and government debt.
The Internet is a classic capitalist creation which promotes creative destruction
across wide sectors o society, but, at least or the USA, he doubts that it
will be the basis o major net jobs gains in the oreseeable uture. Those
who lament the loss o brick-and-mortar bookstores and shops are probably
sentimentalists. However, it is unclear that Web distribution, which, in its
early stages was ueled by evasion o state and municipal sales taxes, is a
sustainable macro-model or job creation and GDP growth.
He believes that net global productivity growth will continue, but the
productivity growth o the US will abate while the rest o the world
advances.
Dr. Gordon is an enthusiast about inrastructure investmentroads and
bridgesbut doesn't see such projects as inherently transormative in a macro
sense. It costs a lot more to build a bridge today than in the Depressionandemploys ar ewer workers.
His thesis has evoked debate, but nobody has, to our knowledge, ridiculed
it or reuted it.
...uture advances will
ace the headwinds
generated, in part,
by that very success.
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THE FINAL PROBLEM
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AgricultureSustained Productivity Gainer
In a small group discussion o Gordon's thesis o the great economic
inventions, I suggested he include agriculture by adding Justus von Liebig's
discovery o the Law o Limits to Plant Growth, which triggered the
development o the ertilizer industry, thereby launching the expansion o
yields per hectare, and allowing the planet's population to multiply while
starvation rates ell. He ound that the three elements o plant growth were
potassium, nitrogen, and phosphorus. Each plant growing in each locale had
specic needs or each o the three chemicals, and spreading more o one or
two without the third would not deliver good returns. Chemical ertilizers
became huge contributors to global population growth.
Potash Corporation's charismatic Bill Doyle tells o an exchange he had at a
social event with a guest who asked him what he did. When he said he was
head o the world's biggest ertilizer company, the reply was, "Well, o course,
I believe we should only use natural ertilizers."
"An appealing idea, I'm sure," smiled Doyle, "but we'd have to close all the
national parks and orests."
"Why?"
"Because we'd need all that land to provide grassland or all the cattle we'd
need to produce the manure we'd need to produce the crops we need."
Pharmaceuticals as Transformative
What about pharmaceutical breakthroughs that lengthen lives and make
millions o people more productive? They are truly wondrous, but they
come at huge cost: Social Security, Medicare and pension plans are being
undermined and even bankrupted by keeping people alive longermuch
longer. (We discussed Peter Thiel, o PayPal ame, who is one o the
successul entrepreneurs who are committing themselves to unding research
into what they call immortalitylengthening lives by centuries. They talkcoolly o the prospects o achieving such longevity within decades. He is
not, we understand, behind the eerie project o keeping Ted Williams' brain
cryogenically or the day when technology will permit installing it in some
lucky athlete's craniumwho could be transormed into the next batter to
hit .400.)
...we'd need all that
land to provide
grassland or all the
cattle we'd need to
produce the manure
we'd need...
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2. Our Thesis
We agree with Dr. Gordon's macro view, but suggest that there are special
actors hampering the economy this time. Collectively these problems orm
today's Final Problem.
We are o the view that two orces stand in the path o resuming rapid,
sustained economic growth in the USA and Europe. In essence, we believe
that by prolonging the administration o the cure or the Crash, the economic
impact might well prove to be almost as debilitating over the longer term
as the disease. We also wonder whether a series o interlocking and sel-
reinorcing actors guarantee that what we call "nancial heroin" must keep
fowing.As a result o the implosion o much o the private economy, and the explosion
o government programs and entitlements, the private sector may not be able
to produce enough real wealth to pay or the government and still nance its
own sustained growth. Under Obama, Washington's share o the economy
has soared to a postwar record o 24%, up sharply rom the mid-teens in the
Clinton and Bush eras. However the Fiscal Cli clash between the Far Let and
the Far Right is ultimately resolved, Obama is emerging the victor, leading a
united party, and the Republicans are deeply dividedso Washington's share
o GDP will continue to grow, and the economy will continue to struggle. Big
government is what 52% o the voters wanted and that's what they'll get.Elections matteras they should.
Meanwhile, as too many politicians and pundits are preoccupied with the
Fiscal Cli and in reghting the election, the continued fow o nancial
heroin may already be undermining the unctioning o the private economy.
Clients will recall that we coined that term three years ago when we were on a
panel in Denver with the eminent David Dodge, who had recently retired as
Governor o the Bank o Canada. He said in his speech that it was important
that central banks move interest rates back to normal levels as soon as
possible, primarilybut not entirelybecause o the risk o infation.
Obama is emerging
the victor, leading
a united party, and
the Republicans are
deeply divided...
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THE FINAL PROBLEM
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As he spoke, I thought o what my ather had told me o his experience in
the Italian Campaign in WWII. He perormed more battleeld anesthetics
than any other Canadian doctor, or which he was cited. He said that the
key skills needed were (1) identiying which wounded soldiers needed
heroinwhich was, by ar, both the riskiest and most potent anesthetic, and
(2) when it was necessary to withdraw it in avor o morphine. That switch
produced great pain or wounded soldiers accustomed to heroin, because
morphine wasn't as potent. But the soldiers had to be taken o heroin as
soon as possible because they would soon be addictsuseless as soldiers
and possibly destroyed as human beings.
I began my speech by suggesting that zero interest rates were nancial heroin.
Mr. Dodge commended me, saying this was a great analogy. In discussion later,
we agreed that ailure to exit rom zero rates would create huge problems.
As the years pass, and the heroin and handouts keep fowing, we increasingly
worry about the longer-term harm to the US economy rom zero interest
rates, the extensions o the duration o unemployment benets, and the
dramatic increases in the numbers o recipients o ood stamps and disability
benets. Could the cumulative eect o all that well-intended government
assistance mean that too much o the population might be morphing into a
new version o the lethargic Lotus-eaters Homer describes in The Odyssey?
Odysseus' ship was blown o course and landed on an island (supposedly
near present-day Libya) where the residents, who dined on the lotus fowers,
were peaceul, happy and sleepy. They willingly shared the fowers with crew
members:
Any crewman who ate the lotus, the honey-sweet ruit, lost all desire to send a
message back, much less return, their only wish to linger there with the Lotus-eaters,
grazing on lotus, all memory o the journey home dissolved orever. But I brought
them back. I orced them, hauled them under the rowing benches, lashed them
ast.3
This account o Odysseus's alarm at the eects on his battle-hardened crew
rom the opiate in the fowers, and his orcible roundup made us wonderwhether years o government support and poverty programs at a time that
manuacturing and heavy labor jobs have been disappearing might have a
similar eect on millions o Americansand on the seemingly dwindling
lan vital o the American economy.
3 The Odyssey/ Homer; translated by Robert Fagles, 1996
...their only wish to
linger there with the
Lotus-eaters, grazing
on lotus...
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Millions o Americansparticularly menhave been dropping out o the
workorce and migrating to disability benets (and ood stamps, and other
benets) at participation rates approaching those or which Southern Italy
has been long renowned. They are replacing time in the workplace with the TV
and its hundreds o channels to dull their intellects and drive. As economists
note with increasing concern, the percentage o the Long-Term Unemployed
keeps growing even as overall unemployment numbers shrink modestly. This
is a slowly-unolding national tragedy, because the longer these people are
o work, the less likely are they to qualiy or the available jobsat least in
the eyes o potential employers who aren't eager to add employees anyway, in
ace o rising taxes, slow demand growth, and the onset o ObamaCare. The
result is that each deal between Obama and Congress includes a provision to
renew support or the long-term unemployed.
How do the zero interest rates gure into this large-scale lassitude?
(1) Banks and businesses are hoarding cash, even though it yields near-zero.
Why take needless risk? (There is already discussion about the possibility
o negative short-term unds.) As cash grows, the economy doesn't. The
Keynesian multiplierin the orm o rapid growth o M-1 and M-2hasn't
kicked in. Bernanke keeps increasing the supply o water but he can't make
the horses drink.
(2) The Fed's Operation Twist has so depressed long-term rates that a High-
Yield bond today yields what an AA corporate yielded even a ew years ago.
Biggest losers (apart rom pension unds) rom Ben's Lotusian ormulas
or bad banks: seniors saving through bank deposits and "sae" Treasurys.
Their incomes decline inexorably.
(3) More and more investors satisy themselves with the lotus-like dreamy risk
aversion o investment in bonds whose yields are as minimally nutritious
as fowers, shrinking rom the unpalatable stock market that has given a
zero return or approximately the time it took Odysseus to return rom
Troy to Ithaca.
(4) The longer the Lotusian heroin fows, the more dauntingand remotebecomes the possibility o central banks returning rates to normalcy.
Is the economy already too dulled and disappointed to withstand the
changes accompanying an economic recovery? The US decit is already
More and more investors
satisy themselves
with the lotus-like
dreamy risk aversion
o investment in bonds
whose yields are
as minimally nutritious
as owers...
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THE FINAL PROBLEM
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at Himalayan levels, although the cost oservicing the debt rises only
modestly in comparison, because, as outstanding bonds incurred in more
muscular times mature, they are rolled over into heroin-priced bonds
and bills. Mr. Obama brashly claims credit or the drop in interest costs
below orecasts as his big spending cut in his bargaining with Mr. Boehner.
What will happen when (i?) Treasury ten-year rates move back to their
average levels o the ve years beore the Crashroughly 4.25%? What
programs would have to be slashed or eliminated? What would happen
to rates on the $1 trillion in student loans, the increasingly osteoporotic
backbones o the over-priced and over-tenured university and college
system, that now exceed national credit card debt? What would happen to
the already-ragile stock market? Would the rail housing recovery survive
the onset o higher-rate mortgages? As or the government, a 2% rise inblended Treasury yields would add roughly $300 billion to annual debt
servicing costsroughly three months' current decits, and roughly hal
the presumably painul non-military spending cuts proposed in one o
the many proposed decit-reduction compromises that circulate in the
smog o Washington. How could Dr. Bernanke take his still-ragile patient
o the nancial heroin and infict such terrible pain?
The heroin analogy suggests serious problems preventing the economy rom
regaining its mojo through risk-taking.
One o capitalism's crucial attributes is its cold-eyed use o the pricemechanism to allocate resources and evaluate risk. When the economy is
vibrant, equity prices rise, the Keynesian animal spirits revive, and money
fows to increasingly-risky investments.
CBOE S&P 500 Volatility Index (VIX)
January 1, 2012 to December 21, 2012
12
14
16
18
20
22
24
26
28
Jan-12 Mar-12 May-12 Jul-12 Sep-12 Nov-12
17.11
How could
Dr. Bernanke take his
still-ragile patient of
the nancial heroin
and inict
such terrible pain?
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But the sustained fow o nancial heroin may be diluting the eectiveness
o the capital pricing mechanisms. The VIX Index has this year treated
disappointing economic growth, ears o the scal cli, and intermittent
eurozone crises with a Lotusian "What Me Worry?" attitude. As more and
more Street commentators assure us, central bankers have, ater years o
struggling, accumulated the knowledge, connections, strategies and repower
to handle almost any crisis. So we don't need volatility protection anymore.
Relax and sni the fowers!
Capitalism only works well when its Risk/Reward principles are unctioning
eectivelyand there are both winners and losers. Its ailure came when the Big
Bad Bonused Bailout Bankers collectively agreed on risk and leverage strategies
that rewarded them on Croesus scale, with the risk being assumed rst by
their counterparties, then by their stockholders, then by their governments,
andultimatelythe global economybut not by the greedy, reckless risk-
creators. Yes, through pressuring the banks under the amendments to the
Community Reinvestment Act in 1997 to make loans to minority applicants
with 3% or less down, the government, and Fannie and Freddie, pushed
the industry toward what turned out to be the abyss. IBD (Investors Business
Daily) cites a recent study showing the leap o such high-risk loans rom less
than $300 billion in 1997 to $6.1 trillion in 2008. It quotes Jamie Gorelick,
(during her brie $120 million tour at Fannie Mae when it bulked up on
subprimes) telling a bankers' convention Fannie wanted more "CRA-riendly
loans."
The banks caved because (as we have learned rom discussions with bank
executives) i their CRA scores weren't high enough to satisy the government,
they'd be banned rom mergers and would ace a wide range o other
penalties, including constraints on bonuses. But "The Devil made me do
it" is a pathetic deense or a betrayal o capitalist principles that triggered a
global nancial collapse.
Investors collectively seem to believe that risk has been marginalized because
The System has learned how to prevent crashes, and thereore they need not
eel pain.
Is the pricing mechanism o capitalismpain vs. gainso anesthetized, and
has the economy been so weakened that it cannot withstand normal interest
rates?
Capitalism only
works well when its
Risk/Reward principles
are unctioning
efectively
and there are both
winners and losers.
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THE FINAL PROBLEM
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We can't resist summing up our concerns with a limerick:
Flower Power's Hour
Ben gives us the Land o the Lotus.
The Dems give us chances to vote us
More Washington gits,
With no need or thrit,
While we drink in the dream words rom POTUS.4
Fortunately, there are a ew strong Asian economies that still believe inand
practicesome o the core concepts o capitalism. Most o The West's
economies are being reduced to being handmaidens to big, nancially-stressed
governments and big, nancially-distressed banks. Economic growth under
Capitalism has never been driven by those institutions and bureaucracies. It
has been driven by inventions, ree trade, risk-taking, upward mobility and
creative destruction.
Until that muscular, risk-accepting society returns, the historic high returns
on the stock market will not. The only competitive and risky Lotus is a racing
car.
4 For those not steeped in Beltway acronyms, POTUS stands or President o the United States.
Most o The West's
economies are being
reduced to being
handmaidens to big,
nancially-stressed
governments and big,
nancially-distressed
banks.
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The Arab Revolutions
We received criticism when we expressed doubts about the likelihood o
happy outcomes rom the dreamy demonstrators in Tahrir Square, and their
cell-phone-linked counterparts across most o the Arab world.
To us, this was a spontaneous and probably ragile outpouring that would
probably be taken over by illiberal men with tough agendas who had long
been awaiting the all o the old-line dictators with limited agendas. It is
what happened to the liberal Girondists in the French Revolution and the
liberal Mensheviks in the Russian Revolution.
The Egyptian Revolution is particularly tragic, because it evolved spontaneously
and was broadcast live globally on TV, and seemed to come to a bloodless,
successul conclusion because o the intervention o the American President,
who had long been identied with support or Aricans seeking reedom
rom oppression. Those o us who questioned the likelihood that the
secretive and determined Muslim Brotherhood had suddenly become a
liberal, tolerant, non-sectarian orce or democracy crossed our ngers. Its
Constitution commits it to Shariah and jihad, but this wouldn'twe were
toldaect the Brotherhood's behavior in government. Early reviews in the
mainstream media were breathlessly optimistic: the Brotherhood accepted
ull rights or women and Christians, would respect Egypt's treaty with Israel,
and welcomed Western tourists. Its leadership promised not to contest theparliamentary elections or the election or the Presidency.
Egyptians now know how those promises have worked out. They see how
courts have begun imposing lengthy jail sentences on Coptic Christians or
making remarks deemed insulting to Islam. They see how the army has, to
preserve some o its privileges and prots, become the protector o the new
regimeand not o the dissidents.
Nor is there much reason to be optimistic about Libya. The Benghazi deaths
o our brave Americans in a terrorist raid on the anniversary o 9/11 are
testimonials to the Administrations delusion that Al Qaeda had beenvanquishedand to the chaos that ollows the collapse o a dictatorship.
Egyptians now know
how those promises
have worked out.
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THE FINAL PROBLEM
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As this week's devastating report conrms, weeks o requests or increased
protection were denied by State. No one in the Administration thought that
9/11 might be an anniversary event or terrorists, because "The War on Terror"
is a term banned rom usage by anyone in authority. When the slaughters
occurred, they blamed it on a videoand jailed the creator.
To us, the worst outcome o the Libyan "liberation" or Aricans to date
has been the takeover o peaceul, historic Timbuktu by orces allied to Al
Qaeda in the Mahgreb who were battle-hardened and armed in the Libyan
campaign.
But even in our most pessimistic moments, we did not anticipate the horror
story that Syria has become. Aleppo is said to be the oldest continuously-
inhabited city in Asiaperhaps the world. Damascus has long beencharacterized by scholars as the birthplace o the Christian Church, because
o Paul's conversion. Throughout the sweep o history, those cities have never
experienced savagery on such a scale.
Amid the unraveling o authoritarian regimes across the Mideast, Israel, as
the lone democracy, is now more isolated than it has been since the Yom
Kippur War. Its Iron Domethe latest triumph o its amazing technology
industriesprotected it against the rockets Hamas had accumulated rom
Iran and other sources. However, Turkey is no longer a quiet ally, with
President Erdogan dismissing Israel as "a terrorist state." Next year, according
to almost all the experts, Iran will be testing its rst nuclear weapon.
Summing up, i you, like us, ound the news rom the Mediterranean
distressing this year, prepare or greater disappointments in 2013.
To us, the worst
outcome o the
Libyan "liberation"
or Aricans to date
has been the takeover
o peaceul, historic
Timbuktu...
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The Commodity Outlook in Coming Years
The second commodity boom since Nixon closed the gold window was
interrupted by the Bank Crash.
That Crash let scars worldwide, but mostly in the industrial world, where
government debt suddenly exploded, and continues to grow aster than
GDPs.
Thanks to medical science and the pharmaceutical industry, Baby Boomers
will be living longer than they expected, and, thanks to the tech mania and
the Crash, with less money than they expected. Thanks to their collective
reproductive restraint, there will be ewer workers to pay or their Social
Security and ObamaCare.
Fortunately or them, there are several billion people in Asia who will
keep global GDP increasing even as Europe and the US will be collectively
engaged in Sisyphean struggles to grow economies ast enough to service
the government debts or which the Boomers and Gen-Xers can claim the
greatest credit.
The Emerging Economies which gave us The Greatest-Ever Commodity
Boom got a sharp shock rom Wall Street in 2008, and are now adjusting to
the reality that their basic economic and business models need redrating.
China and India, in particular, assumed that the capitalist economies wouldcontinue to prosper rom their reliance on the sound economic principles
which these new economic powerhouses had eagerly adopted.
Unortunately or the Asians, the West is, with a ew exceptions, no longer
driven primarily by capitalist risk-taking, and its new political leadership
is collectively dedicated to collectivist approaches to paying or welare
statism.
The economic fab and fatulence that now characterize the eurozone and
is gaining credence in the US, means Asian powerhouses won't have strong
export markets in the Old World.
So what does this mean or commodity prices?
The ashionable view on Wall Street these days is that, i there ever was a
"Commodity Supercycle," it's over. Strategists long adept at nding new
parades and leaping in ront o the marchers are telling us that commodities
are losersor even kaput.
...Baby Boomers will
be living longer than
they expected, and,
thanks to the tech
mania and the Crash,
with less money than
they expected.
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THE FINAL PROBLEM
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What is the evidence or this catastrophic commodity price collapse?
Compared with ve years ago, Brent Crude Oil is up 16%, Copper 14%, Iron
Ore 24%, Corn 64%, and Soybeans 30%, while Wheat is down 9%. As or
the precious metals, Gold is up 98% and Silver has doubled.
The one major commodity that makes the collapse case or these trend-
ollowers is Natural Gas, which has plunged 52%. That however, is the US
price, which is a victim o the shale miracle. Elsewhere in the world, natgas
sells or as much as three or our times the US priceand ar higher than
where US prices were ve years ago.
Yes, many commodity prices are below their peaks, but so is the S&P, which
doesn't prove that equities are dead. (We cannot resist noting that one o
the most determined proclaimers o the end o the commodity boom isCitigroup, whose stock price ve years ago [reverse split-adjusted] was $311,
and now trades or $37.25).
Since we have so oten made the case or well-chosen commodity stocks, and
since we could be deemed partis pris because we are established commodity
stock portolio managers, we'll just note that the economies growing ar
aster than any North American or European economies continue to be the
price-setters or commodities. The commodity stock investor is, in essence, relying
on that growth disparity to continue, whereas the commodity stock rejecter is saying
it will not. Those who ridicule commodity stock investing are tacitly saying
that the GDP o the OECD countries will, once again, outperorm the GDP
growth o China, India, Indonesia et al over the next ve years.
Apart rom momentum, what makes that implied orecast look absurd is
that the national debts and national cash fows o leading Asian nations look
blue chip compared to the US and the eurozone.
We can understand that the Obama backers on the Street have rose-colored
glasses about what he will achieve in his second term, and thereore reject
commodity stocks, but we do not share their belie in his nancial prudence.
He submitted no budgets in his rst two years in oce, then submitted one
that was voted down 79-0 in the Democratically-controlled Senate. His entirere-election campaign was based on endless insistence that "i the millionaires
and billionaires paid their are share," the rest o society wouldn't be acing
tax increases. Boehner tried to get the House to pass such a tax boost, but by
that time Obama had moved the goalposts: he wanted tax increases orall
the "rich"including those earning $250,000 a year.
We can understand
that the Obama
backers on the Street
have rose-colored
glasses about what
he will achieve in his
second term...
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This could have been a teaching moment in the world's leading democracy.
As George Will pithily puts it, "Americans have become happily accustomed
to receiving $100 worth o government services and paying $60 or the
privilege." The truth is that nearly everybody is going to have to pay more
taxes.
What we nd most disturbing is that by denouncing the rich and, until last
week, making no other scal proposals, the President is demagoguing. His
argument is the equivalent o those yahoo Republican Tea Partiers who
demand that Washington eliminate its decits by cutting o oreign aid. He
has been unwilling to put real reorm o Social Security and Medicare on the
table, and he excluded tort reorm rom ObamaCarewhich would have
generated huge savings at the expense o a collectively dubious group o tort
lawyers, who are, coincidentally, big backers o the Democratic party.
The President has "bargained" by doing what he enjoys mostfying out in
his wondrousand extremely costlyplane to speak to adoring audiences.
He still wants to believe that he can singlehandedly solve all the nation's
problems by talking to riendly crowds or TV clips. His only announced
sizable budget cut in the Fiscal Cli negotiations is to slash $1 trillion rom
uture costs o ghting two wars. Conservatives compare this to cutting
spending by pledging not to build a ski resort on Mars.
Neither side in the current negotiations is addressing realistically the problems
o nancing unsustainable entitlements in a slow-growth economy.
So we retain our enthusiasm or commodities and commodity stocks.
We do, however, agree with the conclusions rom Leuthold's latest bulletin,
that commodity stocks tend to outperorm when the Producer Price Index
rises aster than the Consumer Price Index. That has been the case or most
o this century, but not recently. During the Stagfation era, that relationship
prevailed most o the time.
Which leads, naturally, to...
Conservatives
compare this to
cutting spending by
pledging not to build
a ski resort on Mars.
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THE FINAL PROBLEM
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The Special Case of Gold
How could we let the nal issue oBasic Points reach readers without updating
our views on the absolute necessity o maintaining portolio investment in
goldand primarily through gold mining stocks?
Some may sigh, "Can he possibly have anything new to say on this subject?
Haven't we heard it alland all too oten?"
Gold
October 1, 1992 to December 21, 2012
200
400
600
800
1,000
1,200
1,400
1,600
1,800
2,000
Jan-92 Jul-94 Jan-97 Jul-99 Jan-02 Jul-04 Jan-07 Jul-09 Jan-12
1,645.90
The agony or gold investors o Gold's Triple Waterall collapse nally ended
the week the War on Terror began.
The rst gold bull market began in August 1971, when Nixon closed the
Gold Window and ended in 1980, ollowed immediately by two decades o
Triple Waterall decline. Central bankers were heavy gold buyers as long as
the Gold Window was open, and in more measured activity thereater until,
by common agreement, gold prices rises needed to be discouraged because
they ostered an infation mania. The central bankers thereater became gold
sellers. When interest rates collapsed and concerns about the dollar began to
re-emerge during the Obama era, central bankers began creeping back into
bullion on little cat eet.
In part, their willingness to buy gold is because o past over-gorging on dollars.
When the bankers began to worry about their perilously high dollar exposure,
the Eurozone came to their rescue with a great new alternative in the orm o
the currency o the world's second-biggest and second-richest economic unit.
So the bankers eagerly plunged into euro-denominated paper.
When it became apparent that not only were many o the eurozone issuers
dubious credits, but just maybe the currency itsel was a post-modern
metaction that could easily go out o ashion, then the central bankers
began to go back to bullion.
...just maybe the
currency itsel was
a post-modern
metaction that
could easily go out
o ashion...
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The astonishing recent increases in Chinese and Indian economic power and
personal wealth have naturally meant that interest in gold as an investment
among citizens in those countries has surged. As we wrote ater our rst trip
to India, poverty-stricken women working in the elds o Uttar Pradesh were
wearing gold armbands. When we asked our guide how such poor people
could aord gold, we were told it was their dowry. Under Indian law, at
marriage, title to the bride's property and possessions goes to her husband;
except her gold. She retains title to gold in her dowry. We asked whether such
displays o wealth in such poor communities would not put the women at
risk rom robbers, our guide was shocked, "No one would be so evil as to rob
a wie o her dowry!"
In China, the leading banks have, with government encouragement
and support, made bullion-buying (gold, silver and platinum) easy or
customerseven the poor. Result: Chinese have become the world's biggest
gold-buyers.
The richer Indian people become, and the richer Chinese people become,
and the more that central bankers have reason to worry about the politics
and profigacy o the eurozone and the US, the more those gold buyers will
infuence gold prices.
What has produced the big swings in gold prices in recent years has been
participation by major hedge unds in gold utures, Gold ETFs (and, to a
limited extent, in bullion).
Source: Meridian Macro Research LLC
Gold Commitment o Traders: Net Speculative Positions
(number o contracts)
December 19, 2012
0
50,000
100,000
150,000
200,000
250,000
300,000
Jan-04 Apr-05 Jul-06 Oct-07 Jan-09 Apr-10 Jul-11 Oct-12
163,699
As this chart shows, interest in gold rom commodity speculators has waned
latelyalong with the bullion price.
In China, the
leading banks have,
with government
encouragement
and support, made
bullion-buying
easy or customers
even the poor.
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34/5630 December 2012
THE FINAL PROBLEM
THE COXE STRATEGY JOURNAL
We were surprised to learn that there is a Gold version o the VIX Index. In
recent months, it has behaved like the traditional VIXshowing little more
expectation o coming excitement than one would expect rom a community
o lotus-eaters:
CBOE Gold ETF VIX Index (GVZ)
October 1, 2011 to December 19, 2012
10
15
20
25
30
35
40
45
Oct-11 Dec-11 Feb-12 Apr-12 Jun-12 Aug-12 Oct-12 Dec-12
13.69
We remain o the view that gold's long-term outlook remains bright. It may
be the last asset let standing i governments run out o money to spend and
central banks run out o money that people believe in. But it doesn't require
Apocalypse to be a sound, long-term investment. We have even coined (we
say, blushingly) a mnemonic o why gold is a necessary investment based onour own initialsDGMC:
D or Demographic Decay
G or Government Policy Failures
M or Monetary policies that debase money
C or Crises arising rom any or all o the above
Why is Demographic Decay a reason or buying gold? Because it is at the core
o the scal challenges to the Welare State. As we have been saying since this
publication was born, birth dearths are temporary scal benets but long-
term scal disasters. In the near term, they increase emale participation in the
work orce, swelling GDP growth and tax receipts, and slowing the increases
in public educational costs. In the long term, they make infation-hedged
pension and medicare promises costly, then burdensome, and eventually
unaordable.
...showing little
more expectation o
coming excitement
than one would
expect rom a
community o
lotus-eaters...
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35/5631December 2012
We routinely cite Japan as the model or most Western economies in the era o
demographic decline and decay. A decade ago, we noted that Japan had more
morticians than obstetricians, as deaths overtook births. The latest statistic is
that sales o adult diapers there now exceed sales o babies' diapers. Canada
will be in that x within a ew decades, and only the Latinos are keeping the
US rom a similar prolealthough second-generation Latinos' birth rates
are plummeting.
Gold's intrinsic value rises inversely to the unding levels o government
social programs. In the US, Medicare aces nancial collapse within a decade
without major unding boosts; the Social Security Trust Fund is a victim
not only o longevity, (which most people know), but also o Washington's
continuous cuts in payroll taxes, and o the collapse in interest rates; the date
or the Fund 's extinction now approximates the expected liespan o a new
octogenarian.
Conclusion
Thesoi-disantsophisticates who sneer at commodities don't tell their clients
that gold bullion's perormance since Nixon closed the gold window is almost
exactly equal to the perormance o the S&P with dividends reinvested. That
was a our-decade period when monetary policies were mostly moderate
most o the time.
There has never been a three-year period since 1975 when monetary base
growth in the industrial world was remotely close to where it has been since
2008. That process is set to continue as ar as the eye can see. Moreover, the
growth in government debt and in the size o balance sheets o the major
banks that have already been bailed out once has no historic precedent.
Thereore, in our view, the likelihood that the S&P will perorm as well as
gold in the next three years is remote.
There has never been a
three-year period since
1975 when monetary
base growth in the
industrial world was
remotely close to where
it has been since 2008.
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36/5632 December 2012
THE FINAL PROBLEM
THE COXE STRATEGY JOURNAL
Agricultural Commodities
Soybeans
January 1, 1992 to December 21, 2012
3
6
9
12
15
18
Jan-92 Jul-94 Jan-97 Jul-99 Jan-02 Jul-04 Jan-07 Jul-09 Jan-12
14.09
Corn
January 1, 1992 to December 21, 2012
1
2
3
4
5
6
7
8
9
Jan-92 Jul-94 Jan-97 Jul-99 Jan-02 Jul-04 Jan-07 Jul-09 Jan-12
6.97
Wheat
January 1, 1992 to December 21, 2012
2
3
4
56
7
8
9
10
11
Jan-92 Jul-94 Jan-97 Jul-99 Jan-02 Jul-04 Jan-07 Jul-09 Jan-12
7.91
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37/5633December 2012
Thanks to the Great Midwest Drought o 2012, we now know that genetically-
modied seeds work splendidly to mitigate drought damage.
Corn prices shot up rom $5.55 a bushel in June to $8.39 in August amid talk
o a new Dust Bowl beore slumping to $7.12 in September as thousands
o armers reported unexpectedly high harvests. The FAO had scheduled a
crisis meeting in Rome and was ready to proclaim the third world ood crisis
until the USDA reported that it was going to be raising its per-acre returns
substantially.
Those happy returns were a source o pride or the big seed companies,
a source o joy or their investors, and a source o shock or the anti-GM
activists. The GM seeds ar outperormed the "natural" seeds.
Monsanto (MON)
December 19, 2011 to December 19, 2012
65
70
75
80
85
90
95
Dec-11 Feb-12 Apr-12 Jun-12 Aug-12 Oct-12 Dec-12
91.68
Syngenta (SYT)
December 19, 2011 to December 19, 2012
250
270
290
310
330
350
370
390
Dec-11 Feb-12 Apr-12 Jun-12 Aug-12 Oct-12 Dec-12
376.50
It has been our case since 2007 that investing in the leading and emerging
agricultural input companies with strong management, technology, vision
and distribution is to be participating in one o the most momentous aspects
o human progressprotably, and at low risk.
We stick by that orecast.
Those happy returns
were a source o
pride or the
big seed companies,
a source o joy or
their investors...
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THE FINAL PROBLEM
THE COXE STRATEGY JOURNAL
Energy
Crude Oil (West Texas)
January 1, 1992 to December 19, 2012
0
20
40
60
80
100
120
140
Jan-92 Jul-94 Jan-97 Jul-99 Jan-02 Jul-04 Jan-07 Jul-09 Jan-12
88.91
Crude Oil (Brent)
January 1, 1992 to December 19, 2012
0
20
4060
80
100
120
140
Jan-92 Jul-94 Jan-97 Jul-99 Jan-02 Jul-04 Jan-07 Jul-09 Jan-12
110.10
Natgas
January 1, 1992 to December 19, 2012
1
3
5
7
9
11
13
15
Jan-92 Jul-94 Jan-97 Jul-99 Jan-02 Jul-04 Jan-07 Jul-09 Jan-12
3.56
-
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39/5635December 2012
During the election campaign President Obama had some good things to
say about the nation's production o oil and gas, along with the ritualistic
bashing o oil and gas companies' tax breaks and "subsidies."
He has the great good ortune to be President at the time o one o US
history's greatest oil and gas discovery, and production boomsan economic
miracle the Let has refexively opposed. This despised sector created ar
more wealth and jobs than his Green Energy boondoggles. But i the Far
Let doesn't nd ways to block its progress, it will transormatively trigger a
vast expansion o US industry in Robert Gordon-style, as major plastics and
chemicals plants migrate to the US. This year, experts proclaimed that North
America is now on the cusp o becomingonce againenergy-independent
and a net exporter o oil and gas.
With all that oil in the shale and oil sands being developed, it is time or
oil enthusiasts to admit that we may not see $145or even $125or West
Texas Intermediate (WTI) or many years. We don't even know how long
WTI will deserve the name "benchmark," as a multiplicity o crude oil prices
complicates calculations o oil companies' protability.
That said, North American exploration and production companies with great
reserves and smarts can look at the rest o this decade with enthusiasm. The
new stars o the oil industrythe nimblest o the long-suering renersare
beneting enormously rom the new arbitrages and price spreads arising
rom those ast-changing patterns in production, distribution and exports oNorth American crude oil and products.
More challenging or investors in coming years will be the prot outlook
or costly deepwater ocean exploration as oil production ramps up onshore
rom Texas to Fort McMurray.
Nevertheless, the continuing crises in the Mideast will likely keep a premium
valuation or oil and gas properties in politically-secure countries.
Thirty-ve years ago, the Shah o Iran proclaimed "Oil and politics don't mix."
He was warning his ellow OPEC members that they had to get over their
resentments against Israel and its Western supporters and become partnersin global economic progress through reliableand reliably-pricedoil
production. Three years later, he was deposed in the revolution that brought
in the Ayatollah Khomeini, whom Jimmy Carter rapturously embraced as a
"saint."
The Shah was wrong, and he was soon dead wrong. Oil and politics mix
mightily when politics turn radical, as the Keystone dispute attests. We shall
soon know whether this President is oil-wise, or a more charming update o
Jimmy Carter.
The Shah was wrong,
and he was soon
dead wrong.
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THE FINAL PROBLEM
THE COXE STRATEGY JOURNAL
Base Metals
Copper
January 1, 1992 to December 19, 2012
0.00.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
Jan-92 Jul-94 Jan-97 Jul-99 Jan-02 Jul-04 Jan-07 Jul-09 Jan-12
3.65
In all previous boom cycles or base metals, copper was "King Copper."
In this century, the oldest base metal o them allironhas been King.
Chinese steel production remains remarkably strong, although observers
keep predicting a severe sotening.
We continue to recommend underweighting in the base metals, but the
outlook or copper and iron ore prices is improving amid signs o renewedeconomic vitality. Major iron ore expansions have been put on hold, and
optimists think supply and demand are back in balance. Longer term, we
recommend maintaining exposure to companies with the best ore bodies
in the best countries. Political risk is becoming a more challenging problem
or investors as rich tax-exempt NGOs and other organizedand sometimes
disorganizedopposition threatens more and more projects, even in
countries with records o mostly honest and accommodative politics and
policies.
As a ormer colleague o ours used to say, "Capital is a coward." By that he
meant that wise investors naturally fee rom political and litigation risks.
We strongly recommend capital cowardice as a core investment policy to
clients.
We strongly
recommend capital
cowardice as a core
investment policy
to clients.
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41/5637December 2012
The Big Picture
1. China
The new leaders took over in China as the US was voting to keep the same
leaders in place. Each decade when a new Triple-P is announced (President,
Premier and Politburo) the wisdom o Deng Xiaoping is rearmed.
This changeover was more challenging than the previous switch, because o
the revelations o corruption and the Bo Xilai scandal, which embarrassed
the leadership on the ront pages o newspapers around the world. But
despite that unwonted tabloidism, the Old Order prevailed in the orm o
the New. Only the Papacy or the British Royal Family handle succession moresmoothly.
We know no more about the new Beijing duo than we have been reading
rom respected Western sources. We admire the prociency o the change-
over, and are relieved that the sordid and sensational aspects have been
suitably addressed.
What we know is that the astonishing growth o Deng's eradouble-digit
or three decadescontinues despite all those Wall Street "experts" who told
us that the supposed miracle is about to burst, kaleidoscope-style, due to
raudulent nancial statements and rampant corruption. They were telling
us rom 2006 onward o a coming collapse and it turned out they were right:
they just got the geography wrong. (O course, they never warned o Wall
Street's pending disaster.)
The Chinese and Indians watched capitalism's implosion with disbelieand
continued on with their progress.
So we are pleased that the predictors o Sinodoom 2012 are once again shown
to be hopelessly wrong.
We have been told annually that Chinese GDP is overstated. However, when
independent experts and the IMF add up external and internal data, the
results tend to conrm the Chinese claims as being o considerably greaterreliability than the nancial statements o many leading Western banks.
So, let us accept the skeptics' claim that China's growth may actually have
shrunken to merely 6%. That means it is growing only 2.5 times as ast as the
US, ve times as ast as the UK and seven times as ast as the eurozone.
We should collectively rejoice in China's success. China is ast on its way to
being the world GDP leader and the most reliable major economy. Already,
China's progress has hauled more than 900 million people out o poverty
The Chinese and
Indians watched
capitalism's implosion
with disbelie
and continued on
with their progress.
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42/5638 December 2012
THE FINAL PROBLEM
THE COXE STRATEGY JOURNAL
and onto healthy diets in just two decadesthe most stupendous large-scale
improvement in human wellbeing in history. That is Momentum, with a
capital M.
Some day, Chinese growth will cease to be miraculous and will become
merely impressive.
Not soon, say we.
2. The Fed Sets a New Benchmark
Last week's Fed announcement reiterated that the Board sees little chance o
abandoning its zero rate policy in the next three years. In a surprising policy
change, it proposes to target monetary growth to a fawed statisticthe
unemployment rate.
The Fed has been targeting infation since Volcker's era. What is a relatively
recent phenomenon is that it has been targeting "desirable" infation
2%31 bps above the yield on the Ten-Year Note. That has changed: the Fed
now thinks 2.5% infation would be just ne. We have long believed that central
bankers who want to create higher rates o ination get their wishes ulflled. Japan
is the sole exception, but Japanese demography has long been uniquein
human history. It will be a ew decades beore European and North American
population shrinkage reaches Japanese levelsand a ew centuries beore
Japan ceases to exist.
3. European Woes
There is no end to the eurozone rescue dramas, but in recent weeks three new
distractions have emerged or Euroelites:
CatalonianpressurestoexitfromSpainhaveintensied;
BritishpatiencewiththeEUisbeingexhausted,andDavidCameronfacesa
party revolt that may orce him to hold a reerendum on exiting the EU;
Ritorna,Silvio!Wewere,perhaps,prematurewhenwewroteLa Commedia
e Finita! Mario Monti (briefy known as Super Mario) is stepping down as
Premier and the rash Berlusconi is running againrom two potentially
devastating court convictions and toward another premiership, which
would grant him immunityagain. Marx observed that history repeats
itsel, rst as tragedy, then as arce. The mercurial Berlusconi may be about
to reverse the Marxian order o destiny.
We have long believed
that central bankers
who want to create
higher rates o
ination get their
wishes ulflled.
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The Final Problem
Four years and counting...
When will Washington summon the courage to slow the fow o Lotusian-
liquidity and tell people and marginal businesses and banks that the time to
revert to normalcy has nally come?
The longer the exit is delayed, the costlier it will be or governments, the
unemployed, and the underemployed. Telling addicts they have to start the
path to cold turkeyhoodand meaning ittakes political courage.
But, as my ather noted about the vehement reactions rom wounded soldiers
when their heroin was withdrawn, addiction is easy, but withdrawal is hard.
How can the White House, Congress and the Fed slow the fow o Lotusian-
liquidity when more people and marginal businesses are getting hooked
every week?
By targeting the unemployment rate, and eschewing the economic indicators
that central banks have learned over the decades, the Fed has apparently put
itsel on autopilot. The longer the nation accepts this radical change in the
monetary rules, the more obsolete will Fed meetings become. This makes
sense or Bernanke and his colleagues: they won't be demonized or yanking
away the punch bowl: they will be letting the economy decree that zero is no
longer the right price or money.
When the unemployment rate alls below 7% at a time o better economic
growth, a new generation o bond vigilantes will emerge, and yield curves
will begin to steepen. The Fed can step up its money printing, but the market
will soon take charge. Assuming, (as seems reasonable) that this occurs at a
time that Washington is bracing or another debt ceiling "crisis," Risk will
return to nancial markets.
Conclusion
Our assumption: there will be more interim deals and debt ceiling dramas,
b