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Basic Points The Power of Zero November 12,2009 Published by Coxe Advisors LLC Distributed by BMO Capital Markets Disclosure Statement This third party publication is not prepared by BMO Capital Markets Corp., BMO Nesbitt Burns Inc., BMO Nesbitt Burns Ltee/ Ltd and BMO Capital Markets Limited. The information, opinions, estimates, projections and other materials contained herein are provided as of the date hereof and are subject to change without notice. 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DonCoxe THECOXESTRATEGYJOURNAL ThePowerofZero November12,2009 published by CoxeAdvisorsLLC Chicago,IL THECOXESTRATEGYJOURNAL ThePowerofZero November 12, 2009 312-461-5365 Coxe Author: Don DC@CoxeAdvisors.com 604-929-8791 Trudeau Editor: Angela AT@CoxeAdvisors.com CoxeAdvisorsLLC. www.CoxeAdvisors.com 190SouthLaSalleStreet, 4thFloor Chicago,Illinois USA 60603 ThePowerofZero OVERVIEW So what was all that Depression fuss about? The US economy grew 3.5% in the Third Quarter, and all the major economic numbers now being reported suggest this one will be even stronger. Stock Only Lehman was allowed to experience prices are soaring. the Schumpeteresque- In case, you’ve forgotten: slaughter reserved for Sixteen months ago we were heading into the Midnight Massacre, when capitalist cupidity and Messrs. Bernanke and Paulson launched the rescue of Fannie, Freddie and stupidity. Wall Street. That swiftly evolved into the Age of Bailouts, with Congress enlisted in emergency funding for Wall Street’s biggest, boldest and brashest bankers on a scale that made IMF rescues of entire nations look like chump change. Only Lehman was allowed to experience the Schumpeteresque-slaughter reserved for capitalist cupidity and stupidity. Operating with scripts and strategies conceived on the ﬂy, varying prescriptions of emergency assistance were extended, under panic conditions, to Citigroup, Merrill Lynch, Morgan Stanley, AIG and Goldman Sachs. Since then, the Obama Administration and the Pelosi-led Congress have been moving to take charge of some of the commanding heights and strategic valleys of the US economy. Highlights: takeovers of General Motors and Chrysler, a deﬁcit of 12% of GDP, $790 billion in handouts and assistance under the rubric of economic stimulus, a costly new national health care system, and a vast array of tax and trade global warming programs whose tentacles will reach into almost every sector of the economy. To date, his rescue operations are succeeding. As Joe Biden put it, “A year ago we were talking about falling into Depression. Now we’re talking about the shape of the recovery.” But deeply-wounded investors should be cautious about throwing caution to the winds. Among the signs that the stimulus package didn’t repair the potholed yellow brick road to prosperity is the upside breakout in the Bad News Asset: Gold. This month, we begin our analysis by discussing the anniversaries of the births of two new eras. First, the Age of Global Capitalism, which began 20 years ago with the Fall of the Wall. Second, the apparent ending of that era a year ago with the return of Big Government as Economy Manager with the election of Barack Obama. We weren’t sure then how he was going to deliver November 1 everything his thrilled backers wanted, but we knew that he wanted to be a transformative President and he cited Reagan as such a leader—even though he said Reagan had the wrong views. we have decided to With that background, we search for an appropriate investment strategy for focus on a humble tumultuous times. While the talk is of trillions in stimulus, foreclosures, bailouts and deﬁcits, we have decided to focus on a humble number— number—Zero... Zero—which is roughly the rate on government short-term funds, high-grade money market funds and inﬂation across the US, Canada, Japan, and most of Europe. We are leaving our cautious Asset Mix unchanged. Risk assets—other than US real estate prices—are bubbling upward everywhere, but the big banks’ balance sheets remain overloaded with the unmarketable unmentionables, and US regional banks—the backbone of the real economy—are now being engulfed by their exposure to commercial real estate and consumer loans as unemployment continues to climb. 2 November THECOXESTRATEGYJOURNAL ThePowerofZero I. Capitalism’s Triumph Every week, someone publishes an analysis of the global economy by noting that the triumph of free trade and free markets across most of the globe began in the Reagan-Thatcher era. Now, they agree, it’s over. Each month, Washington’s reach into the American economy expands rapidly, while the “If it moves,tax it; if it keeps moving, economy expands—at best—grudgingly. regulate it;and if It is certainly true that almost no one predicted the suddenness and scale it stops moving, of US government intervention in the West’s ﬂ agship economy that had subsidize it.” been, until last year, a testimony to the wisdom of Milton Friedman and the courage of Ronald Reagan. (The cheerful Reagan charmed voters by teasing his opponents. He summed up Democratic economics as, “If it moves, tax it; if it keeps moving, regulate it; and if it stops moving, subsidize it.” He summed up the goal of his policies toward the Soviets: “We win; they lose.”) The political bipartisanship began with the Midnight Massacre of July 13, 2008 but lasted only until the grandiose goals of the new Administration were revealed. The Pelosi-Obama stimulus package passed with no Republican votes in the House, despite heavy lobbying from some segments of the business community, notably General Electric, which became Obama’s most dedicated corporate cheerleader—itself and through MSNBC—after receiving many billions in low-cost loans to its ﬂ agging ﬁnance subsidiary, GE Capital. The GM and Chrysler rescues were accomplished with minimal Republican support. By then, the concern that the Administration was actually seeking a major transformation of the structure of the US economy was developing rapidly among conservatives and moderates. In addition, the pitchfork politics in the House had terriﬁed many business leaders that they and their families could be the next victims of the fast-spreading rage against the bailed-out rich. Twenty-seven years ago, when the newborn Reagan and Thatcher Revolutions seemed headed for death from double-digit interest rates, Chairman Volcker declared victory over inﬂation and began expanding the money supply and cutting interest rates. For those who didn’t manage money during that recession, the fed fund rates at the time that great easing began must seem surreal: 18%. November 3 ThePowerofZero Question: How did the economy survive with rates so high? Answer: with great difﬁculty. Those rates were not only punitive for businesses and potential homebuyers, Why not,they asked, but they meant that money market funds were well-nigh-irresistible take those huge investments—huge, risk-free returns with zero market volatility. risk-free upfront We can recall the challenges we faced in convincing pension fund clients returns from Cash? about our asset mix in late 1982: zero Cash, with the balance being roughly equally divided between long-duration bonds (19 years) and equities—with minimal exposure to commodities. Why not, they asked, take those huge risk- free upfront returns from Cash, rather than bet on a sustained, steep drop in interest rates and inﬂation and a sharp, sustained economic recovery? Because, we argued, inﬂ ation and long-term interest rates were already falling sharply and would continue to do so, following commodity prices down, lowering costs for businesses and consumers, particularly for energy. Those three interlinked slides would virtually guarantee a strong economy and strong stock prices for years to come. We insisted that short rates would plummet. That wasn’t all that would fall from the Reagan and Thatcher revolutions… II. The Fall of the Wall Those three interlinked declines—rates, inﬂ ation, and commodity prices—and that one robust rise—economic activity in the free market economies across the West, led by the USA—were the underpinnings of the Reagan-Thatcher accomplishments and the “triumph” of capitalism. Of particular importance, the strength of the US, British and German economies was matched by the robustness of their interlinked foreign policy in the face of Communist threats to Western Europe. Thatcher and Reagan, with Helmut Kohl’s support, installed Pershing nuclear missiles in Western Europe, despite strong opposition from France, and widespread “anti-war” demonstrations on Ivy League campuses and across Europe. The free market team’s stand against the faltering Bolsheviks, and their strong economies at a time of economic stagnation in Russia and its occupied territories in Western Europe, led to political unraveling in the Communist world; the Wall fell and two years later the Communists were gone—even from the Kremlin. (On his trip to England in 1979, Deng Xiaoping learned why free economies were outperforming Russia and China, and he returned to launch the Sino-Capitalist Revolution which keeps astonishing the world, 4 November THECOXESTRATEGYJOURNAL even as faith in capitalism fades across much of the OECD. He had learned why Hong Kong, Taiwan and South Korea could keep creating jobs and wealth by rejecting socialism—whether on the Maoist, Bolshevik, or Indian models.) The KGB were the Putin calls the collapse of Bolshevism, “The greatest geopolitical catastrophe Jesuits of Russian of the 20 Century.” It was certainly bad news for him and his fellow KGB Communism... ofﬁcers, but they regrouped amid the chaotic Yeltsin era and eventually took control of Russia. The KGB were the Jesuits of Russian Communism, and they worked loyally to advance the Kremlin’s goals. But their relationship to the Party was—like the Jesuits’ relation to the Vatican—at times problematic. Example: Khrushchev once claimed that he had personally shot Beria, the KGB leader, who wasn’t deemed sufﬁciently submissive to the Central Committee, (although the later version was that he’d died before a ﬁring squad). Like the Jesuits, the KGB considered themselves the elites, and remained loyal to each other. Now that they are the ruling class, they no longer have to answer to bureaucrats and theorists. It was also bad news for leftists across most of the Free World. They had convinced themselves that, as the leader of Canada’s New Democratic Party put it after returning from a trip to Russia shortly before the Fall, “I admire their economics, but not their politics.” It turned out that everywhere, like Germany under National Socialism, “Good Communists” were as rare as “Good Nazis.” Free markets and free economies worked: socialism didn’t. There were no Nobel Peace Prizes for Reagan or Thatcher. Instead the prize for the end of the Cold war went to … Mikhail Gorbachev. (The Nobel Committee’s apparent love of losers is shown by its award of the prize to the most conspicuous American foreign policy loser—Jimmy Carter—and rejection of the most conspicuous American foreign policy winner—Reagan. By coincidence, last week was also the anniversary of Carter’s most memorable ﬂop—the seizure of the American Embassy hostages by Ayatollah Khomeini’s radicals. They were imprisoned and abused for the 444 days it took to elect Reagan. Carter had withdrawn support for the Shah and expressed America’s joy at the Khomeini revolution.) Gorbachev’s Nobel was the beginning of the rewriting of the history of Reagan and Thatcher’s roles in Communism’s fall. The culmination of this process is arriving in the torrent of new books that airbrush out those doughty anti- Communists from the portrayals of friendly people reaching out to hug each other from both sides of the Wall—Pyramus and Thisbe writ large. November 5 ThePowerofZero In that sense, President Obama is riding the tide of history’s restatement, and vindicating the Nobel decision about who was the real peacemaker of that era. Speaking to the cheering throng in Berlin this year, he said that “the world” forced down the Berlin Wall. He didn’t mention NATO, Reagan, It was,in the Thatcher, or Kohl. It was, in the sophistication of itsvin blanc et brieanalysis, a sophistication of causality claim comparable to the rooster’s renowned boast that his crowing its vinblancetbrie had brought the sun up. Which “world” did he have in mind? A coalition of analysis,a causality China, India, Russia, Vietnam, Burma, the United Nations and Iceland? claim comparable to the rooster’s III. The Obama Triumph renowned boast A year ago, Grant Park in Chicago was the scene of the Democrats’ most that his crowing had historic get-together since the party’s Left spoiled then-Mayor Daley’s party to brought the sun up. celebrate his party’s national convention. Back then, there was an unseemly riot, which helped elect Nixon. This time, there was pride, cheering, hugging and wondrous exultation. We can attest that it was a great time to be a Chicagoan, and a great time for America. So how has the President anointed that night performed? He remains the most charming and charismatic President of modern times, and is still, quite probably, liked by more Americans—and more people abroad—than any American President. He and his radiant wife are, as The New York Times notes, America’s greatest global brand. But the reality of the Presidency is that handsome is as handsome does. His approval ratings have descended from the Heavenly to the ordinary. All polls disclose that while most Americans still like and admire him personally, they disapprove of his policies. Gallup published a poll on the First Anniversary of his election, comparing what Americans thought of him then and now. Here are key ﬁndings: Percent Now Then He will heal political divisions 54 28 He will control federal spending 52 31 He will improve the healthcare System 64 46 He will increase respect for America abroad 76 60 6 November THECOXESTRATEGYJOURNAL Other polls conﬁrm that the basic political dynamic of America hasn’t changed much from its historical pattern: 40% of Americans still call themselves conservatives, 20% liberals, and the rest style themselves as moderates. Obama won by convincing an overwhelming majority of moderates that he would rule from the center, and—most importantly—he wasn’t George Bush. ...many global investors are alarmed about Despite a brilliant campaign, adoration from the media, a divided Republican Obama’s policies and party, and a ﬂ agging economy, he was actually behind the Bush-baggaged are reducing their McCain in the polls until Lehman imploded, and suddenly it looked as if the world could end. As Larry Summers would later joke, a new Messiah was exposure to US assets accordingly. what was needed. (It hasn’t come to an end, although a recent New Yorker cartoon shows a gentleman consoling a friend, saying, “It isn’t the End of the World.” Just around the corner, riding furiously toward them, are the Four Horsemen of the Apocalypse.) He won in a landslide, as the undecideds, en masse, became converts. A year ago, Obama was impressing the nation (and, we admit, us) by unveiling his economic policy team that included the magisterial Paul Volcker. Volcker has been rarely seen since; three weeks ago, he corrected an interviewer who said that the ﬁnancial community felt that in recent months he’d been marginalized. Volcker said, “I did not have inﬂuence to start with.” The rescue of the plummeting ﬁnancial system was actually orchestrated by Bush appointees—Ben Bernanke and Hank Paulson, with the help of Tim Geithner. Their policies have continued—for good and ill—and Bernanke and Geithner remain as partners. The jury is still out on the Pelosi-Obama stimulus package, as it is on his plans to run trillion-dollar deﬁcits for a decade—and on Congress’s national health care bill—which remains in negotiation, despite its narrow victory in the House. Based on our recent trip to visit European clients, and numerous emails from foreign clients across much of the world, many global investors are alarmed about Obama’s policies and are reducing their exposure to US assets accordingly. The dollar’s decline may be one symptom of these doubts about the actions of Obama and the Democratic Congress. November 7 ThePowerofZero US Dollar Index (DXY) November 10,2008 to November 10,2009 90 88 Few Americans would 86 have expected that 84 America would make 82 Italy look restrained 80 and prudent in 78 comparison. 76 75.10 74 Nov-08 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 The US deﬁcit/GDP ratio is above 12%—at World War II levels, and is the highest in the G-7, except for the UK. It is, for example, more than twice Canada’s. Few Americans would have expected that America would make Italy look restrained and prudent in comparison. There is widespread disappointment about how all that money has been spent, but as Keynes observed, paying workers to dig ditches and then reﬁ ll them is better than not spending the money at all when consumer and business spending collapse and Depression looms. Last week, The Economist, which backed Obama enthusiastically during the election campaign, published a full-page critique of his pro-union policies titled “Love of Labour.” Contrasting his recovery policies with Reagan’s response to the Air Trafﬁc Controllers’ strike, it said, “Mr. Obama is the most pro-union president since Jimmy Carter, at least.” It went on to describe the implications of Obama’s backing for the unions’ top priority—card check— which would abolish secret ballots for union representation. Abroad, his popularity remains high (except in Israel, where his approval rating is a mere 4%), as evidenced by his Nobel Peace Prize. However, as his attempt to replicate Tony Blair’s success at charming the IOC into awarding Chicago the Olympic Games demonstrated, he has been notably unsuccessful in translating that popularity into signiﬁcant diplomatic successes. Perhaps the biggest difference between him and Reagan is in his views about American history. He was raised in the post-Sixties era, when the Left—abroad and within the US—routinely demonized America for its alleged racism and imperialism. 8 November THECOXESTRATEGYJOURNAL His own beliefs, as expressed in his speeches worldwide, certainly don’t condemn America with the fervor of the hard Left, but show little of the powerful pride in America’s history that animated Reagan. Obama has told countries around the world about all the ways that America has misbehaved or disappointed them—and has apologized….most recently to the Iranian His own beliefs... mullahs for Eisenhower’s role in dumping Mossadegh in 1953. For his public show little of the apologies he has generally been greeted with applause—but he has captured powerful pride in almost no new support for his foreign policy initiatives. America’s history The exception to his Administration’s pattern of passivity and apologetic that animated Reagan. coaxing came with the return of Hillary Clinton to prominence, in Pakistan, after months of seeming ineffectiveness by Obama’s appointee, Richard Holbrooke. On her recent trip there, she displayed coolness, gutsiness and a sensitivity toward Pakistan’s great internal challenges that did America proud. On balance, a year after he won the Presidency, and while he still enjoys widespread good will, Obama has only begun to prove his effectiveness (1) in managing the US economy without damaging the nation’s longer-term ﬁnancial position, and (2) in protecting America’s interests abroad. Last week’s three off-year elections certainly do not prove that voters have suddenly forgiven Bush and are ready to reinstate Republicans. Obama was not on the ballots, unemployment was still climbing even after the economists said the recession had ended, and the Democrats’ deﬁ cits had scared a majority of independents into switching their preference to the Republicans. The next elections are a year away, by which time the economy should be stronger, the rage over the 1990-page health care bill might have dissipated, and the Republicans will still lack a Newt Gingrich-style leader to put together the various resentments and enthusiasms into a winning coalition. It took rd rare talent for the current leadership to lose the 23 Congressional District in New York the Republicans had held for 72 years. Obama may fear serious voter backlash about the scale and wisdom of the new programs being legislated, but at least for now, he doesn’t need to fear the Republicans. The Republican Party is leaderless, and frequently clueless, so Obama doesn’t need to be a Roosevelt or Reagan to stay on top. November 9 ThePowerofZero The Highs and Lows of Zero Rates Zero is a seemingly-small number, but it is demonstrating its power to change the world. We have seen many examples in individual countries of The Power of One: this is that kind of power on global scale. Zero is a seemingly- small number,but it We are regularly told that we should expect a roaring recovery—Reagan-style. is demonstrating its But if Reagan were alive, and Margaret Thatcher were in good health, they power to change the would be astounded at how their two nations’ economies are struggling at a world. time of zero interest rates—when they had to launch recoveries at a time of record-high rates. The US and British economies are performing at roughly the level they were during the late stages of the 1981-82 recession—when corporations’ and consumers borrowing costs’ were inﬁ nitely higher. That inﬂ ation could be in the zero range would also astonish them, even though the biggest factor in their ﬁrst election victories was the run away inﬂation of the Carter and Callaghan era—when “malaise” was the Presidential euphemism for the spreading despair. So why shouldn’t the economic recovery be at least as strong as Reagan’s—if not even more robust? It’s because those Zero rates tell us that the ﬁnancial system’s problems that triggered the economic collapse aren’t going away quickly—and could even be getting worse. Reagan and Thatcher didn’t have to deal with serious demographic problems that meant housing prices could not—for the ﬁ rst time since World War II—leap in response to plunging interest rates. Reagan and Thatcher didn’t have to mortgage their nations’ futures to bail out bad banks, which, upon being rescued, diverted the succor they were given to rebuild their devastated capital to speculation and bonuses, thereby making their saviors—politicians and taxpayers—look like suckers. Nor did they have to face the certainty that interest rates and inﬂation would have to go up sometime—and that could be very inconvenient for both the politicians and the economic recovery. 10 November THECOXESTRATEGYJOURNAL US interest rates and inﬂation could remain at current levels, were America to mimic Japan’s experience from 1990 to Koizumi’s election. But those early years of Japan’s Triple Waterfall Crash occurred at a time of rapid global growth that meant Japan’s trade surpluses grew robustly, and the immense levels of domestic savings were adequate to ﬁ nance Tokyo’s endless ﬁ scal “Those aren’t real forecasts:they’re deﬁcits. (Currently, Japanese investors are not quite able to absorb all the debt coming from record deﬁ cits, but they’re certainly embarrassing their Mickey Mouse American counterparts: they’re absorbing 94% of new government debt numbers.” offerings.) In contrast, America’s trade deﬁ cits are a permanent feature of the US economy, and even the current uptick in US household savings is no match for the fast-growing ﬂ ow of new Treasurys, which means the US becomes more dependent on foreign bond-buyers by the month. The Administration’s forecast through 2019 assumes that foreign creditors’ appetites for Treasurys will grow at least as fast as the national debt. It predicts sustained real GDP growth of 3% per year, with no recessions, no increases in taxpayer cost for health care, and—despite sustained deﬁcits and a doubling of the national debt-to-GDP ratio (excluding Fannie and Freddie debt) from 41% to 82%—long Treasury yields will not rise more than 1%. (We spoke at a Canadian ﬁnancial conference last month at which Niall Ferguson was the star. He ﬂashed that forecast up on the screen and said, “Those aren’t real forecasts: they’re Mickey Mouse numbers.”) Despite the current deﬁcit of 12% of GDP, and despite increasing grumbling about Washington’s willingness to incur huge deﬁcits in bad times and good, the foreign support of the dollar by buying Treasurys continues. There has been one little-remarked change in the investment strategy of America’s Sugar Daddy #1: in recent months, China has been rolling over its maturing Treasury notes into T-Bills. It thereby chooses to forgo interest of 2%–3.4% in favor of near-Zero yields. What power, one wonders, does Beijing think, comes from a Zero return in a weakening currency? And why is that putative power growing so relentlessly? November 11 ThePowerofZero A fast-growing Monetary Base at a time of Zero yields is the best a central bank can do to prevent a Depression and get the economy moving again. But it is based on redistributive justice: it takes wealth from savers and gives it to the bad banks that caused the crisis. To add insult to that injury, many ...it is based on of the most prominent of those bankers are paying themselves huge bonuses redistributive justice: for being so brilliant and creative as to take the free money and invest it it takes wealth from up the yield curve—or across the wide range of risk assets, which are rising savers and gives it to robustly together. Goldman is the biggest winner from this wealth transfer: the bad banks that even its mid-term debt only costs around 2%. Its CEO told the audience in a caused the crisis. London church that he does “God’s work.” This is the bank that, according to reports about the tense bailout days, would have been dead within hours had Paulson and Bernanke and friends not rescued AIG and Morgan Stanley. Goldman’s bonuses for this year will exceed the GDPs of 107 nations. Ain’t free enterprise grand? A Zero yield has been the Bank of Japan’s policy for most of the time since its Triple Waterfall Crash commenced nearly 19 years ago. Our personal favorite member of the BOJ’s Board then, was its only female, Eiko Shinozuka. She consistently voted against near-Zero deposit rates. She claimed to represent the generation that had pulled Japan out of its desperate condition after World War II through its hard work and high savings rate. With state pensions being so modest, and with the children of postwar generations being less willing to perform the historic role of looking after their parents and grandparents, people had to save for their old age—and nobody on Planet Earth seemed to live as long as the Japanese. Amazingly, these people did save remarkable amounts, and their favored deposit institution was the Post Ofﬁce, particularly after the banks began to implode. As interest rates on deposits fell by more than 90%, “her people” were driven into penury to prop up the bad bankers. She reiterated those vigorous objections at almost every BOJ Board meeting, and the male gerontocrats who made up the rest of the Board thanked her for her contribution—and continued to make the near-Zero-cost contributions to the banks. Led by the Fed, central banks across the OECD have been Japonized. They drive rates of bank deposits and money market funds toward Zero to stimulate borrowing and enrich a ﬂagging, ﬂabby banking system. 12 November THECOXESTRATEGYJOURNAL Not that the top dogs at the big, bad, bonused bailout banks (Hereinafter called the B5) show penitence, gratitude or humility about this process: they consider controls on their bloated incomes “socialistic,” and warn loudly about the dire consequences for a free enterprise economy if Washington and Whitehall suppress their astonishing bonuses. ...the big,bad, bonused bailout Wherever his spirit rests, Benjamin Franklin must be livid. When the hard- banks (Hereinafter earned savings of ordinary people are looted to enrich greedy bankers, and called the B5)... when they are told that this process is necessary to make America prosperous again, no wonder so many citizens have displayed so much anger at “Tea Parties.” But the problems of the thrifty members of the lower- and middle-classes who are losing so heavily from Zero yields may not continue endlessly in a Japonaise stasis. They could get worse: today’s extreme monetary policies and humongous deﬁcits are laying and fertilizing the seeds of the next inﬂation, which will be characterized, in the early stages, by sharp increases in the prices of such necessities as food and fuels. Milton Friedman correctly predicted in 1973 that fast monetary expansion at near-Zero real yields would ultimately trigger inﬂation—and he was vindicated when US CPI reached double-digits during the next recession. We recently participated in a panel discussion organized by the Canadian Consulate in Denver. The lead speaker was David Dodge, retired Governor of the Bank of Canada. (Longtime readers will remember that we were calling him “North America’s Greatest Central Banker” during the years when Alan Greenspan was being accorded mythic powers.) We were there to discuss when and how governments and central banks should employ exit strategies from their current expansionary policies. With one exception (a portfolio manager who insisted government deﬁ citsshould be expanded until unemployment reached zero), the panel agreed that the level of current monetary expansion and deﬁ cits was unsustainable and potentially dangerous. Mr. Dodge was particularly eloquent on the high risks of maintaining current monetary and ﬁscal policies. He is really worried about the potential for worrisome inﬂation and much higher interest rates that would choke off any recovery. November 13 ThePowerofZero The ﬁrst sign that the foreign central banks who’ve been trying to protect their currencies from over-appreciation against the dollar may be reassessing their forex strategies came with last week’s announcement by the Reserve Bank of India that it was swapping a portion of its holdings into 200 tonnes ZeroT-Bills form the of gold the IMF is selling. That helped send gold to new highs. base of a debased MacroMavens, a routinely brilliant and thoughtful contrarian research debt market. publication produced by our friend Stephanie Pomboy (who presciently predicted the Crash with her in-depth studies of banks’ balance sheet problems and the unfolding real estate collapse), issued the following chart last month: Global Forex Reserves Real vs.Nominal (adjusted for the dollar decline) February 1,2003 to October 23,2009 3.2 2.9 3.19 2.6 2.3 2.0 1.7 1.4 1.06 1.1 0.8 Feb-03 Oct-03 Jun-04 Feb-05 Oct-05 Jun-06 Feb-07 Oct-07 Jun-08 Feb-09 Oct-09 Nominal Real Source:Stephanie Pomboy,MacroMavens,LLC. The chart displays the extent of the monetary masochism of the banks abroad whose purchases keep yields across the curve on Treasurys, Fannie and Freddie at unrealistically low yields. Zero T-Bills form the base of a debased debt market. As troubling as Zero is for savers, it also poses problems for portfolio strategists…. 14 November THECOXESTRATEGYJOURNAL The Problem of Zero in Portfolio Construction Although portfolio construction for pension and endowment funds has become far more sophisticated and mathematical in recent years, its basic process can be easily summarized. How does a portfolio In the classic capital asset pricing model for balanced portfolios, the investor optimizer deal with the sets the projected long-term rate of return for the “Risk-Free Asset” (Cash) Problem of Zero? and then assigns expected return rates based on volatility and endogenous risk assumptions for the other asset classes that are under consideration for inclusion in the Fund. The expected rates of return rise along with the perceived risks in each asset class. An Efﬁ cient Frontier is then created that mathematically balances risk and reward to achieve the minimum needed rate of overall portfolio return. A pension fund meets its regulatory requirements for funding if the value of its current holdings, plus the compounded projected returns of the asset classes meet its liabilities. We have participated in many such portfolio designs over the decades, and well recall how high rates of return on Cash bedeviled the process. When the risk-free rate was as high—or higher—than the historic long-term rate of return on equities, it meant committees had to use the long-term rates on Cash to build the model. That was accomplished by assuming a lower rate going forward, because the duration of Cash is near-zero. Moreover, as of August 1982, when the Reagan bull market began, the Constant Dollar Dow Jones was at 1929 levels, indicating that the only real returns that had been earned on equities in 53 years were dividends. How does a portfolio optimizer deal with the Problem of Zero? The obvious answer might be, “Easily. It means all asset classes are hugely attractive relative to Cash and no allowance for Cash will be made apart from minimal liquidity concerns.” A more thoughtful answer should be, “Zero Cash means big problems for overall construction. Assuming that a Fund needs to earn a nominal 7% overall, net of fees and costs, then the higher the Cash component, the higher must be the rate of return assumptions for the other asset classes. Without tinkering with those assumptions, then the higher the Cash component, the higher the risk and volatility the portfolio must assume. Such asset classes as Junk Bonds, Leveraged Loans, and small Emerging Markets might have to be quite big commitments for the Fund to meet its objectives.” This is a challenging time to be designing pension fund portfolios—or asset mixes for individual investors. November 15 ThePowerofZero According to BCA Research, US stocks have delivered an annual compounded real rate of return of negative 4% for the past decade, while 10-year Treasurys have given a positive annual real rate of 3.6%. (Embarrassingly, gold was the top-performing asset class, delivering an annual real rate of return of ...capitalism has 10.8% in that same time period. Commodities futures did 5.2%. How many failed its most basic consultants or equity analysts during the perfervid period when tech stocks test—delivering were heading skyward told pension plans gold bullion would do three times higher returns to as well as US stocks for the next decade? Or, for that matter, how many investors than was told their clients Emerging Markets shares would outperform the S&P by a paid on risk-free compounded real rate of 11.5%?) government bonds. Amid all the enthusiasm about soaring stocks and an economic recovery, it is wise to retain one’s perspective about what has happened to investors. Last week, the Bank of America summed up the disappointments of our era for institutional investors. It noted that there were 42 trading days left this year, and the S&P would have to rise 42% to deliver a Zero rate of return for the past decade. By some calculations, on a compounded basis, long Treasurys have outperformed the S&P since the beginning of the Reagan bull market. The problem with those data is that they assume sustained reinvestment of interest at the long end of the curve, but most bond managers would have been below benchmark duration for extended periods, which meant their cash income would have been reduced. Apart from that nitpick, what that number shows is that capitalism has failed its most basic test—delivering higher returns to investors than was paid on risk-free government bonds. And this was the best of all times in the best of all capitalist worlds: classic economic liberalism was becoming the fashion everywhere outside North Korea, most of the Arab world, and Cuba. There were more playing ﬁ elds for multinationals than ever, corporate tax rates were generally declining, there were no major wars, the supply of highly- educated engineers, MBAs and CFAs was at record levels, and business was more respected than it had been since the onset of the Depression. 16 November THECOXESTRATEGYJOURNAL And yet a robot reinvesting 30-year Treasury coupons would have out- performed the S&P Index—which itself outperformed most managed accounts. Constructing a pension fund portfolio and projecting its forward returns in the These bankers toil Age of Zero could be termed “a faith-based initiative.” not much,but they One of the biggest cheerleaders for the 1990s US bull market was Jeremy spin like mad... Siegel. The ﬁrst edition of his best-selling Stocks for the Long Run came out in 1994. His data demonstrated the near-certainty of stocks as winners showing inter alia “For horizons of 20 years or more, bonds are riskier than stocks.” Then came Nasdaq’s Triple Waterfall Crash and a recession, and his “Absolute Law” had joined the phlogiston theory in history’s trash heap. After the 2008 Crash, we were hit with blizzards of advice about how wise it was to hold Cash. Some money managers got heavily into Cash before the Crash, and many other managers assured worried clients that they would be holding higher levels of Cash until the next bull market was established (whenever that happened). The amount of Cash and Excess Bank Reserves in the US economy is at all-time records, mostly because of Bernanke’s panicky doubling of the Fed’s balance sheet. But this is a construct, not a solidly-based ﬁnancial reality. It recalls a well-known passage in the Bible: Consider the lilies of the ﬁeld, how they grow. They toil not, neither do they spin: And yet I say unto you, not even Solomon in all his glory was arrayed like one of these. Cash was splashed among the B5 to array their balance sheets, which were looking Gandhian in their skinniness. But the B5 re-deposited a huge slug of those funds with the Fed as excess reserves: why go through all the nuisance involved in making loans to individual companies? They also bought up the Treasury curve. These bankers toil not much, but they spin like mad: they keep trying to convince us that they didn’t cause the Crash, and they really deserve their big bonuses. November 17 ThePowerofZero USMonetaryBase(adjusted for Changes in Reserve Requirements) January 1,1970 to October 30,2009 Source:St Louis Federal Reserve,database:FRED® (Federal Reserve Economic Data) Fed Funds (Effective Federal Funds Rate) January 1,1970 to November 6,2009 Source:St Louis Federal Reserve,database:FRED® (Federal Reserve Economic Data) 30Year Mortgage Rates April 1,1971 to October 1,2009 Note:Shaded areas indicate US recessions;seasonally adjusted Source:St Louis Federal Reserve,database:FRED® (Federal Reserve Economic Data) 18 November THECOXESTRATEGYJOURNAL Wall Street keeps reassuring us that it will eventually earn satisfactory returns on its trillions in complex mortgage-backed derivatives. But the courts could pose a problem for the holders of these dubious products. As millions of the mortgages in those Wall Street packaged vast numbers of mortgages of quality ranging from hopeless to malodorous to acceptable to high quality. Because of their putrescent packages variety—regional and otherwise—the Street arranged to create a servicing went into arrears... agency that would handle the payments and enforce the covenants. As millions of the mortgages in those putrescent packages went into arrears, they were foreclosed. In two recent court decisions, the mortgagors have been able to defeat or delay foreclosure by arguing that the agent could not prove it had a direct ﬁnancial interest and could not produce the real owner(s). These decisions—which could put a large percentage of US home mortgage debt at risk from something other than mortgagor default—are under appeal. Those courts agreed with mortgagors’ assertion that they have a common-law right to negotiate with their mortgagee about altering the terms of the loan prior to completion of foreclosure. Produce, the judges, demanded, the mortgagees. It certainly makes sense to us that a person’s home is his castle, and it can only be put at risk in a transaction made between consenting adults. So tens-of-trillions in face value of mortgages in arrears held by those who didn’t know to whom they were lending—or whether the borrower even had a job or was in jail—might not, according to this theory, be legally foreclosed because the mortgagor and mortgagee never knew each other. All those math and physics PhDs who built the products, and the bankers who distributed them, never thought about a principle in mortgages that dates back to the 14 tcentury and the emergence of Courts of Equity. (That’s where the word “equity” comes from.) Equity was based on the Chancellor’s religious-based concern for welfare of people of the middle- and lower-classes who suffered under the rigors of Common Law. If more US courts decide that those ancient protections for homeowners need to be protected against derivatives, the results for the B5, Fannie and Freddie would be very…..interesting. November 19 ThePowerofZero Zero and Market Volatility Why is it that all risky asset classes suddenly seem positively correlated to each other? They dance to the The answer is that near-Zero borrowing costs at a time banking systems are global risk music of being ﬂooded with funds—both from government-insured deposits and the markets. the buildup of liquidity from the Fed—constitute an historically-unique inducement to the big banks and to their leading hedge fund clients to borrow and speculate. Last week, according to The Wall Street Journal , the World Bank expressed alarm about “asset price bubbles in equity markets across Asia, and in real estate in China, Hong Kong, Singapore and Vietnam,” and the IMF chimed in with fears “that surging Hong Kong asset prices are driven by a ﬂ ood of capital ‘divorced from fundamental forces of supply and demand.’’’ Hong Kong, of course, pegs its currency to the dollar, which means it outsources its monetary policy to Ben Bernanke. The Zero rate automatically means a weak dollar—here and in Hong Kong. To a somewhat lesser degree it means a weak renminbi. Central bankers have soothed us with assurances that rapid monetary growth will not trigger inﬂation as long as economies remain weak.But they said that in the 1970s, and commodity inﬂation proved them wrong. The price of oil in recent months has traded almost in inverse lock-step with the value of the dollar. This isn’t the longer-term adjustment that characterized the 1970s—it’s occurring in real-time. This daily activity mocks the reliance traders used to place on actual data about oil supplies and demands—particularly the weekly data about US supplies of oil and reﬁned products. Many of the metals—notably aluminum—no longer trade primarily based on LME inventory data. They dance to the global risk music of the markets. Stocks trade together globally on a day-to-day basis. Yes, Emerging Markets continue to outperform the S&P, rising more than New York on bullish days, and not falling as hard, on days risk is being unwound. 20 November THECOXESTRATEGYJOURNAL The Barons of the B5 are reporting record trading proﬁ ts, which means, as Nouriel Roubini warns, thatsystemic risk is increasing, not decreasing. The locus of this new risk has moved from toxic, untraded products whose values are shielded against market pricing to marketable investments of nearly all stripes. ...the thousands of regional US That the Canadian dollar should rise and fall with metal and oil prices is not banks on which an surprising, but the euro also rises and falls, though not as much, as the loonie economic recovery on days of dollar weakness as dollars are borrowed and invested outside the dollar zone in commodities and stocks across the world. depends.....have to make their money Problem: if the US economic recovery falters, a myriad of global risk assets the old-fashioned could be simultaneously subjected to the same kind of risk-unwinding way—and that’s devastation as occurred after the Midnight Massacre and the collapse of tough these days. Lehman, which were US-speciﬁc events. But this time, the Fed and most other central banks would not be able to unleash needed liquidity by lowering rates. The banking crisis was tied initially to subprime and other illiquid and unmarketable assets. The Fed, the Bank of England and the European Central Bank have taken trillions in overpriced toxic assets from the banking system, directly, and through support of mortgage lenders such as Fannie and Freddie, the Federal Home Loan Banks, and various European lenders. ( The Financial Times cites a Bank of England study that pegs total government and central bank aid to private ﬁnancial institutions at $14 trillion, which it calls “socialism for the rich.”) That unprecedented process was designed to prevent a Depression, revive the banks, and free their capital for productive lending. However, the B5 banks have used the funds to reload their trading desks, concentrating on market- priced assets and derivatives tied to those assets. As for the thousands of regional US banks on which an economic recovery depends, they have not participated in the sudden explosion of trading proﬁts that have restored the B5 banks and their bloated bonuses. They have to make their money the old-fashioned way—and that’s tough these days. November 21 ThePowerofZero KBW Regional Bank Index ETF (KRE) relative to S&P 500 November 10,2008 to November 10,2009