The Deficient Frontier: European Banks' Risk Exposures Become UnknowableTITLE

Basic Points
The Deficient Frontier

September 16, 2011

Published by Coxe Advisors LLP

Distributed by BMO Capital Markets

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Don Coxe
THE COXE STRATEGY JOURNAL


September 16, 2011

published by
Coxe Advisors LLP
Chicago, IL

THE COXE STRATEGY JOURNAL
September 16, 2011

Coxe Advisors LLP.
Author: Donald Coxe 312-461-5365
dc@coxeadvisors.com
Editor: Angela Trudeau 604-929-8791
at@coxeadvisors.com
190 South LaSalle Street, 4th Floor
Chicago, Illinois USA 60603

Basic Points is published exclusively for BMO Financial Group and distributed by BMO Capital Markets Equity Research
for clients of BMO Capital Markets, BMO Nesbitt Burns, BMO Harris Private Banking and Harris Private Bank.
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OVERVIEW
Since mid-May, we have been growing increasingly bearish about the stock
markets and the economies of Europe and, to a somewhat lesser extent, the
USA.

In our Conference Call on August 12, we moved Recommended Equity exposure
to the bottom of our 40 - 60 pension fund range.

Our core concern has been the breakdown of public finances, particularly in the
eurozone, which is undermining the traditional Capital Asset Pricing Model.
European banks are collectively heavily over-levered, and any "haircuts" to
the valuations of eurosovereign bonds could be devastating to the financial
system. In a momentous paradox, the epicenters of European risk today are
not toxic mortgage securities or junk bonds, but the debts of overindebted
and underachieving eurozone nations. The financial crises in the eurozone are
rooted in the breakdown of the Risk-Free Rate of Return on government bonds,
which exposes many European banks—particularly the major French banks—to
towering levels of risk, thereby rendering Basel III valuations near-useless.

The Atlantic has not proved to be a secure moat for financial models in the
United States: Collateral Debt Swap pricing for Treasurys now costs slightly more
than the pricing of prime corporate debts, and major American banks and money
market funds have huge exposures to struggling European banks.

The once-impregnable Efficient Frontier is becoming the Deficient Frontier,
pushing pension fund risk/return projections into no-man's-land.

There would never be a good time for an implosion of the risk models that have
served banks, pension funds, and other financial institutions so well for so long.
But a time when economic weakness is intensifying and spreading across the
OECD is a uniquely grim time for an existential challenge to risk management
systems.

It is fair to say that investors in eurozone banks—and institutions lending to
them—are assuming unknowable levels of risk. Whatever those risks are today,
they can only worsen if, as seems probable, a recession engulfs Europe.

This month we suggest a new approach to portfolio design in our pension
fund models at a time of near-record-low short-term interest rates and very
low confidence that the bullish consensus of summer will survive the chills of
autumn. We suggest a strategy of scaling back beta exposure in favor of very high
quality dividends.

We are retaining our very cautious portfolio recommendations issued last
month.

September 2011 1

2 September 2011 THE COXE STRATEGY JOURNAL


I. European Banks' Risk-Free Exposures Become Disease Carriers
German DAX Index
September 14, 2010 to September 14, 2011
8,000

7,500

7,000

6,500

6,000

5,500 5,508.24

5,000
Sep-10 Nov-10 Jan-11 Mar-11 May-11 Jul-11 Sep-11

French CAC 40 Index
4,350

4,150

3,950

3,750

3,550

3,350

3,150
3,045.62
2,950

2,750

Italy FTSE MIB Index
25,000

23,000

21,000

19,000

17,000

15,000
14,642.72

13,000

September 2011 3


Spain IBEX 35 Index
11,500

11,000

There is, (we were to 10,500
learn to our horror 10,000
in 2008) a literary 9,500
model for the creation 9,000
of these financial
8,500
horrors— 8,337.90
8,000
Mary Shelley's classic
7,500
Frankenstein. Sep-10 Nov-10 Jan-11 Mar-11 May-11 Jul-11 Sep-11

The financial crisis and crash of 2008 were rooted in American "risk-free"
assets—AAA-rated collateralized mortgage securities. It turned out they
should have been rated TTT—for toxicity.

There is, (we were to learn to our horror in 2008) a literary model for the
creation of these financial horrors—Mary Shelley's classic Frankenstein. They
were confected by amoral geniuses and immoral associates through the
blending of small quantities of healthy financial tissues with large dollops of
polluted financial tissues to deliver a falsely reassuring appearance, fooling the
rating agencies into characterizing them as financial super-entities endowed
with the AAA ratings that had previously been largely the preserve of well-run
governments fully backed by the taxation systems of strong economies.

Under the Basel rules, banks which bought these supposedly superb
agglomerations, did not have to allocate any of their regrettably scarce capital
to support them on their balance sheets.

A typical bank bulking up on these attractively-yielding wonders was,
unknowingly, in the position of a US army regiment in Europe during World
War I, filling its barracks with recruits off the latest troop ship who were
carrying the flu virus.

The Crash of 2008 that nearly disemboweled many major US banks was
spawned in the toxic relationship between Wall Street's factories and the
more demagogic elements of Congress, eager to use Fannie, Freddie and
rules against bank "discrimination" to force-feed mortgage lending to—
or even above—real home values to borrowers who had little or no evidence
of their ability to service such debts. The Ninja Mortgage—no income, no
job, and no assets—was the crowning achievement of that process. Barney
Frank's name is on the legislation passed to prevent future bailouts—


a wondrously hilarious restatement of financial and economic history.
That one of Congress's biggest boosters of bad lending practices should be
co-author of laws allegedly designed to prevent repeats of such disasters is a
delicious self-parody of Congressional misbehavior.
"From here on, we're
The Made-In-The-USA mortgage catastrophe should have merely flattened
going to invest our
financial institutions here. Astonishingly, many major and mid-sized
capital in good, safe
European banks loaded up on these Financial Frankenstein Monsters.
government bonds
Why, we wondered, would banks and pension funds abroad buy these
issued by members of
Frankensteinian blends of Wall Street and Washington greed, and disastrous
the eurozone!"
design? That their face value ran into the trillions was rooted in blind faith in
AAA mortgage product ratings, without considering that collapsing middle
class fertility rates precluded a new housing boom: the naught decade middle
class generation was roughly 60% the size of its predecessor, so house prices
in aggregate could hardly be expected to go up the way they had when fertility
had been strong—as it had been since Plymouth Rock.

Sadly, the bursting of the US real estate bubble inflicted huge damage on the
psyches and balance sheets of leading European financial institutions whose
managements had believed, (as a German banker recently told Michael
Lewis), that the US was a rules-based society. Result: many leading European
banks—including even some top Swiss banks—had to be bailed out by their
governments.

"Never again!" was the motto of regulators, risk managers and investors.
"From here on, we're going to invest our capital in good, safe government
bonds issued by members of the eurozone!"

That some members of the eurozone had histories of revolutions, civil wars
and/or defaults within living memory was dismissed as irrelevant. In an
efflorescence of enthusiasm about the wondrous new currency that would
supplant the dollar as the global #1 currency, European banks loaded up on
all the risk-free eurobonds they could buy: in particular, they loved to buy
bonds from Portugal, Ireland, Italy, Greece and Spain—five countries eager
to borrow big at rates ranging to 16 basis points above the rate available on
good-as-gold German Bunds.

None of the European banks who bought truckloads of these bonds seemed
the least concerned that these countries had never previously been able to
borrow at such modest premiums to Bunds. The bankers were as gobsmacked
by Jacques Delors' effulgent vision of a eurozone that would outperform the
USA and ratify the European social contract, as were his fellow elitists who
worked with him on the master plan that led to the Maastricht Treaty and
the euro.

September 2011 5


As bad luck would have it, a wag in Goldman noted that those five big
borrowers and spenders with suspect track records could be collectively
nicknamed PIIGS.

The five PIIGS were happily feeding at the eurobond trough when the Irish
The five PIIGS were
crisis of 2008-9 forced the Emerald Isle into bailout mode.
happily feeding
at the eurobond That shock made some eurobankers begin to think the unthinkable—What
trough... about Greece, Portugal, Spain and Italy?

And then the first existential crisis burst on the scene.

KBW European Large-Cap Bank Index (KEBI)
January 1, 2008 to September 14, 2011
70

60

50

40

30

20 19.42

10

0
Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11

KBW European Mid & Small-Cap Bank Index (KMBI)
70

60

50

40

30

20
14.99
10

0
Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11


The European banking system has been lurching from crisis to crisis for
more than a year. Greece, which led the way to the creation of European
civilization, is leading the way to European disintegration. As this is written,
short-term Greek government debt is yielding 85%, but the European Central
Bank (ECB) is holding down rates on longer-term benchmark Greek debts to Greece, which led
teens by large-scale buying. the way to the
creation of European
The ECB has had to become the buyer of first and last resort for other PIIGS
civilization, is leading
offerings, and investors are already looking ahead to Italy's need to roll
the way to European
over €400 billion in bonds over the next two years—apart from funding its
disintegration.
operating deficits.

Jean-Claude Trichet of the ECB is obviously looking over his shoulder at the
plight of the big French banks. On Monday, Societe Generale shares fell to
a 20-year low, accompanied by double-digit declines for BNP Paribas and
Credit Agricole. (Since June, those banks' shares are down, on average, more than
50%.)

We have considerable sympathy for the overworked Trichet, who has
performed heroically, as the debt of one PIIG after another begins to emit
noxious odors. He even had the courage to respond to rising food and fuel
inflation by raising the eurozone interest rate in the midst of the latest financial
crisis. He has visibly aged, and will be replaced the day after Hallowe-en—by
a respected Italian, Mario Draghi.

Although Greece’s unions and leftist radicals still manage to capture headlines
and strangle the nation's economy, the real challenges to the survival of the
euro—and much of the European banking system—come from Italy and,
to a lesser extent, Spain. (Ireland and Portugal are broke, but mostly polite,
and don't grab global headlines by trashing cars and buildings or publicly
ravaging what is left of their economies.)

September 2011 7


Forza Italia!
At the moment, it is possible that Italy will be nearing mendicant status
within months after Mr. Draghi takes office: Italy's notably uncivil servants
...with all his faults, took to the streets last week to protest Premier Berlusconi's first real attempt
Berlusconi has to impose something approaching austerity on Italy's finances.
provided more stability We are not among those Puritans—including the editors of The Economist—who
for the fissiparous and have been demanding that Silvio Berlusconi step down. As we wrote when
barely-governable Italy his plight first moved to Page One, with all his faults, Berlusconi has provided
than almost any of his more stability for the fissiparous and barely-governable Italy than almost any
predecessors... of his predecessors.

Italy was put together by Garibaldi, Cavour and King Vittorio Emmanuele in
the Risorgimento out of a large collection of states, city-states and Papal States
150 years ago. Much of what is important in the history of the Middle Ages,
the Renaissance and the Enlightenment was achieved despite seemingly
endless wars and coups. (Ironically, apart from Puccini, Lampedusa, Eco and
some great film-makers, the quality of the cultural output since Italy became
a united country isn't at the level of the Renaissance or Enlightenment eras,
when internecine warfare was a persistent pastime.)

The greatest of modern Italian novels, The Leopard, which covers the period
of unification, includes a memorable quotation from one of the young
liberals who had fought in the revolution: "Everything must change so that
everything can stay the same."

That pretty much sums up modern Italian history. The North provides the
economic dynamism, and Rome the government, while most of southern
Italy and Sicily is ruled—if at all—by the Mafia and/or the Church.

Mussolini tried to give this nation a sense of destiny through fascism—an
attempt to revive the glory of Rome through semiotics and slogans—and
ill-starred African invasions. But he could not disguise the essential evil and
outright absurdity of fascism. He had to be propped up by Hitler, destroying
the last vestige of his claim to be the New Roman, and met justice at the end
of a rope.

Few of his successors have had much success in imposing a national
consciousness and an effective government on Italy. Governments tended to
stay in power only long enough for the leaders to pay off their supporters and
were then succeeded by others with different labels and similar cynicism.


Berlusconi, a TV magnate, had surprising success in raising the national
consciousness, using the soccer slogan Forza Italia! as his party designation.
Italy may well have been governed better during his tenure than at almost any
time since Constantine moved the capital of the Empire to Constantinople
in 330. Italy may well have
been governed better
But not by much.
during his tenure than
Taxes still aren't collected reliably. The far-Left unions continue to block at almost any time since
industrial progress and the far-Left civil service unions continue to impede Constantine moved the
attempts to open up the economy and operate public systems honestly. Those capital of the Empire to
rioters you see on TV are collectively well-paid: according to Bridgewater, Constantinople in 330.
Italian unit labor costs since the euro appeared are up more than those in
any other large European economy—40%.

Despite his obvious faults, we are inclined to view Berlusconi as a raffish
rogue, with a deep appreciation of the Italian love of the bella figura—the
striking face, image, gestures and self-assurance. In the midst of the crisis this
summer, responding to a prosecution about his involvement with an under-
aged woman, he appeared in Sicily and told a crowd, "The latest poll asked
1,000 Italian women, 'Would you like to sleep with Berlusconi?' One-third
said 'Yes' and two-thirds said 'What? Again?' "

The sands in Berlusconi's hourglass are finally running out; he will probably
not survive this latest crisis.

Nor, we suspect—sadly—will Italy or, ultimately, the euro.

Italy is too big to fail and too big to bail....

And too inefficient, indebted and corrupt to succeed.

This just in: the Dow is rallying strongly this afternoon because of word out of
Italy of a potential new one-off wealth tax of €400 billion that would make Italian
bonds look magnifico—and do wonders for the beaten-down share prices of those big
French banks which collectively have made the biggest French commitment to Italy
since Napoleon—stuffing their coffers with €400 billion in Italian bonds.

To us, the chances of passing—and enforcing—such a tax are equivalent to
the chances of making Italian the sole acceptable language at meetings of all
eurozone agencies—and the European parliament.

But we had a smile as we were reading the breathless stories, seeing the fine
hand of the irrepressible Berlusconi at work.

He'll be missed.

September 2011 9


The Rescuers
The European Financial Stability Fund (EFSF) has been working with the
International Monetary Fund (IMF) and the European Central Bank to
...eurozone sovereign prevent defaults or other crises that could put the eurozone at risk.
debt problems are the More or less by organizational default, Germany's Angela Merkel has been
biggest problem facing forced into the role of unhappy savior of the euro.
OECD financial markets.
New eurozone bailout agencies have been springing up, causing some
challenges for the acronymically challenged.

Last week, the eurobailout era was given a crucial reprieve, when Germany’s
Constitutional Court upheld Germany's backing for the EFSF's projected
payments to Greece. Although leading analysts assured the markets that the
court would back Angela Merkel's tottering regime's participation in the
eurozone rescues, the announcement triggered a huge stock market rally
across Europe, and a 275 point leap on the Dow.

Tellingly, at New York, the BKX (the index for the B5—the Big, Bad, Bonused,
Bailout banks and some others) had one of its best days in a year, leaping
5.9%—and gold gapped down $40 after the announcement and closed down
$55.70.

We cite those massive market responses to what was supposedly a foregone
court decision in support of our longstanding argument that eurozone
sovereign debt problems are the biggest problem facing OECD financial
markets.

But the Court didn't endorse new blank checks and Brussels bailouts:
it insisted that the Bundestag must ratify each new deal—including the
pending Greek bailout. The first Greek bailout triggered the resignation from
the ECB board of Axel Weber, former Bundesbank CEO. The prospect of a
second was, it would seem, the reason his successor, Jurgen Stark, resigned
suddenly—citing "personal reasons."

In theory, despite those high-profile resignations and polls showing
widespread voter resistance to further bailouts, the Court's stipulation
of Bundesbank assent should not be a problem: the leftist opposition to
Merkel's center-right coalition is, of course, enthusiastic about shoveling out
sky's-the-limit aid to governments that are either socialist, spendthrift, or
both.


But Merkel's own coalition is unraveling, as it loses one regional election
after another. In the most recent vote, in her homeland of Mecklenburg-
Western Pomerania, her party's vote plunged and the Free Democrat Party,
the conservative conscience of her coalition, was annihilated.
Deutschland über alles
Merkel's Christian Democratic Union and Christian Social Union supporters
has been cleansed
are fed up after more than a half-century of picking up the biggest share
and sanitized to
of the tab for Brussels' vast spending programs—and two years of bailouts
read Deutschland
for profligate PIIGS—with no end in sight. Middle-class Germans note—
pays for alles.
bitterly—that the rest of Europe didn't chip in for the €100 billion costs of
rescuing East Germany after the Fall of the Wall.

Some analysts report that, despite defections from her own parties, Merkel's
Greek bailout bill should pass the Bundestag because of support from the
Opposition. But that would be a terrible humiliation for the Chancellor and
would probably be the beginning of the end of her government.

It might also signal an important shift in European politics: after years
of center-right rule in most of Europe, the Left could be on the verge of a
major comeback, as voters worry about their politically-promised perks
and pensions. In France, even Dominique Strauss-Kahn's implosion has
done little to raise Premier Sarkozy's pitiful poll standing—with an election
looming next year. The Strauss-Kahnless Socialists are strongly favored.

Markets rallied strongly Wednesday on the report that EU Commission
President Manuel Barroso will be presenting optional routes for creating and
issuing eurozone bonds. (Mr. Barroso, a former President of Portugal, is now
Eurocrat-in-Charge atop the vast EU bureaucracy.)

Eurozone bonds—the unholy grail of europhiles—would be backed by the
full faith and credit of all members. This "Solidarity forever" instrument
would mean that all members would be, in theory, equal as guarantors,
but investors would pay on the basis of Bund yields. Angela Merkel swiftly
ruled out such asymmetric involvement, knowing of its huge unpopularity at
home. But the eurocrats will try to keep the pressure on—thereby protecting
their own privileges and pensions. Deutschland über alles has been cleansed
and sanitized to read Deutschland pays for alles.

How bad is the situation now? The Wall Street Journal quotes an unnamed
executive for Bank Paribas, "We can no longer borrow dollars... Since we
don't have access to dollars, we're creating a market in euros...we hope it will
work, otherwise the downward spiral will be hell....and no one will lend to
us anymore."

September 2011 11


The Journal cites BIS statistics showing that the three biggest French banks held
"nearly $57 billion in Greek sovereign and private debt vs. $34 billion held
by the largest German banks. French banks held more than €140 billion in
total Spanish debt and almost €400 billion in Italian debt as of December."
As noted Fabian Socialist
The Journal continues..."Now that the situation is bordering on catastrophe,
George Bernard Shaw
analysts are suggesting that the government is set to start nationalizing French
long ago observed,
banks."
"He who promises to rob
Peter to pay Paul can The situation will get worse: it's baked into the socialist principles underlying
count on Paul's vote." the EU's social contract. As noted Fabian Socialist George Bernard Shaw long
ago observed, "He who promises to rob Peter to pay Paul can count on Paul's
vote."

Peter and friends have long been generating the wealth that Brussels has
been dispensing.

Now that monstrous new demands are being made monthly on Peter and
friends, Paul and friends are getting anxious—and feel a strong need to take
political power to ensure the handouts and bailouts not only continue—but
grow—even as the European economy contracts. That's just sensible
socialism.

As everywhere else, there are more Pauls than Peters in the eurozone. In
Greece, the Pauls so far outnumber the Peters that the nation needs to raise
€140 billion in loans within weeks.

(That internal divide between Peters and Pauls might even become a potent
political force in the USA: latest statistics show that nearly half of Americans
pay no income tax and roughly 70% receive more from Washington in Social
Security, Medicaid, Medicare, food stamps and other goodies than they pay
in taxes. As the President explains his policies, "We're all in this together and
it's time that the rich paid their fair share." When will the upper 30% of the
population begin arguing that in Europe and Canada, Value-Added Taxes—
paid by all consumers—finance a big chunk of the costs for health care and
other universal benefits. The US has no VAT.)


II. The Third Neo-Stagflationary Recession?
A decade ago, the US was entering a recession. Three years ago, the US, and
most of the OECD were entering a recession. Many observers—including
us—think that the US and OECD are on the cusp of another recession. At the bottom of that
There is a precedent. brutal bear market
(August 1982),
The last time three recessions occurred in one decade was during the the constant-dollar
stagflationary Seventies, with recessions in 1970, 1974, and 1980—which Dow-Jones Industrials
was briefly interrupted to be swiftly followed by an even deeper recession traded at
that lasted into 1983. The last of those recessions began with oil and gold October 1929 levels.
prices at all-time highs, and inflation at a near-record high, triggering the
third bear market. At the bottom of that brutal bear market (August 1982),
the constant-dollar Dow-Jones Industrials traded at October 1929 levels. In
real terms, a long-term investor had barely broken even on a 53-year hold—
apart from dividends.

How does recent experience mimic that melancholy past?

As this journal was going to press, we note that today's major US economic
reports included the second straight month for deeply-negative Philadelphia
Fed and Empire State Indices, an unexpected increase in weekly jobless claims,
a year-over-year rise in CPI to 3.8%, which was 2% ex-food and energy, and a
decline in workers' real earnings of .8%—against expectations of -.1%.

Not a good day.

As for other signs in recent months:

• Gold prices reached all-time highs;

• Oil prices touched all-time highs just before the recession of 2008 began,
and rallied again this year—although not to previous peaks;

• Prices of most other commodities—including the Three "Big Cs"—cotton,
corn and copper— touched record highs;

• Economic growth rates coming out of the recession have been modest;
GDP growth in the US and Europe in the past 11 months has been barely
perceptible—driving unemployment rates higher at a time of painful fiscal
deficits;

• Voters' faith in their governments' abilities to manage economies has
eroded sharply, and few political leaders (apart from Canada's Stephen
Harper) have reason to feel politically secure.

September 2011 13


The biggest difference between the Seventies and now is that interest rates and
inflation rates today are at levels that Seventies governments and investors
would have considered Heaven-sent.

So why refer to stagflation?
...interest rates and
inflation rates today Because producers of foods, fuels, and metals have been among the biggest
are at levels that winners (other than the trial lawyers) in this decade—after two decades of
Seventies governments misery.
and investors would
Contrast the performance in this decade of what was—albeit briefly—the
have considered
most-valuable stock in 1999 with that of the world's biggest oil company,
Heaven-sent.
the world's biggest mining company, and the world's the world's biggest
fertilizer company:

Cisco Systems (CSCO)
80

70

60

50

40

30

20
16.67
10

0
Jan-00 Apr-01 Jul-02 Oct-03 Jan-05 Apr-06 Jul-07 Oct-08 Jan-10 Apr-11

Exxon Mobil (XOM)
105

95

85

75 74.01
65

55

45

35

25


BHP Billiton (BHP)
120

100
Dull stuff is
80 78.78 outperforming
60 brilliantly-engineered
wonder products.
40

20

0

Potash Corporation (POT)
80

70

60
57.14
50

40

30

20

10

0

Yes, Apple (AAPL) and Google (GOOG) have been spectacular performers,
but Nasdaq is back to where it was a dozen years ago. Without those two
sensations, its performance in recent years would have been dull. Technology
became an even bigger part of the global economy in this decade than its
most enthusiastic boosters in the 1990s would have predicted. However,
ease of entry, ease of technology theft, and relentless competition have
meant that most tech products have proved to be commodities that generate
lower profits than those received by producers of industrial commodities or
precious metals. Dull stuff is outperforming brilliantly-engineered wonder
products.

September 2011 15


An OECD economic cycle in which prices of foods, fuels and precious metals
rise far more strongly than prices of manufactured goods—or workers'
wages—is inherently stagflationary. A greater and greater share of total
consumer spending goes to the commodity producers who own the farmland,
Bernanke and Obama the mines or the oil wells. The industrial and service-based economies find
are challenging they cannot deliver the kind of strong, sustained, low-inflation economic
conventional growth that was the pattern for most of the postwar era.
economics—
During the Seventies Stagflation Era, OECD demand drove food, fuel and
and winning.
metals prices at inflationary rates.
At least for now.
This time, consumers in the OECD are paying uncomfortably high prices for
food, fuel and industrial metals because of soaring demand from the new
economic powerhouses of the Third World. Inflation is being imported—not
caused—by the US and Europe. Apart from the wages and benefits costs for
some powerful public employee groups, workers are unable to improve their
incomes more rapidly than their costs for foods and fuels.

This is a paradox:

• Led by the Greenspan and Bernanke Feds, OECD central banks have printed
money at astonishingly high rates;

• Led by Obama and many leaders in the eurozone, OECD nations have
collectively been running deficits that make the profligate Western
governments of the Seventies look positively Puritanical.

Yet overall nominal CPI rates have, (until recent months) remained benign,
giving central bankers justification for aggressive monetary expansions.
Right-wing activists may fulminate that money-printing and deficits have
produced terrible inflation, but—commodities apart—the evidence is
hardly persuasive. Bernanke and Obama are challenging conventional
economics—and winning.

At least for now.


What? We Worry?
With major stock markets across the world in bearish mode, and a new
global banking crisis looming, the S&P is not in deeply bearish mode and
few economists are predicting a recession. Eurosclerosis, many
of our critics feel,
S&P 500
is not necessarily a
transmissible disease.
1,400

1,350

1,300

1,250

1,209.11
1,200

1,150

1,100

Naturally, we are being asked daily about our dour outlook for US stocks and
the US economy. Are we overdoing it? Eurosclerosis, many of our critics feel,
is not necessarily a transmissible disease.

We hear several reasons for this calm reaction to bad news. The dollar has
stopped plunging and, mostly because of the 58% weighting of the euro in
the DXY, has been strengthening recently:

US Dollar Index (DXY)
90
88
86
84
82
80
78
76 76.35
74
72
70
Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10 Jan-11 Mar-11 May-11 Jul-11 Sep-11

September 2011 17


1. Treasurys have been in a runaway bull market as global investors rush to
what looks—at the very least—like the best of a bad lot of government
bonds.

Among major benchmark government bonds, only Bunds (–0.24), Japan
So much for the scare
(–0.98), Sweden (–0.23) and Switzerland (–1.10) yield less than Treasurys.
talk that the world
So much for the scare talk that the world would stop financing runaway
would stop financing
US deficits.
runaway US deficits.
10-Year US Treasury Yield
4.0

3.5

3.0

2.5

2.07
2.0

1.5
Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11

2. American energy costs are the lowest in the industrial world, with
Natgas at $4, and West Texas at $89—compared with the new global
benchmark—Brent—$109.

3. America's domestic political fissures are wide and widening, and Obama's
political approval ratings have been weak and falling, but (as noted above),
incumbency is no political advantage almost anywhere these days. Obama
still has unique charm, and, as he showed last week, when he reaches back
to the platform dynamism that mesmerized not just the US, but much of
the world—including the Nobel committee, he is formidable. His approval
ratings are falling, but which other OECD leader has such magnetism?
And which of the Republican candidates has the right ingredients to knock
him off his pedestal?

4. The huge US commitments to Iraq and Afghanistan are trending down
and will shrink to mere nuisance range within a year.

5. The rest of the world doesn't have companies such as Apple. The US still
leads the world in innovation.


6. US companies' profits have remained strong even as the economy
weakens—and they hold record levels of cash.

7. Smart young people from all over the world still rush to attend American
universities.
We long ago lost our
8. Thanks to Dodd-Frank, the problems of the US financial system are being confidence in the
addressed, and an economic slowdown—or even a mild recession—will oft-trumpeted restraint,
not produce a systemic financial crisis à la 2008. shrewdness, and honest
financial reporting
9. Just about the only economists and pundits who are bears on stocks and
of many of the major
predict a US economic downturn have been doom-and-gloomers for years.
banking institutions...
Why believe them now?

10. The run-up in gold is merely a bubble blown up by over aged cranks and
is of no economically-predictive value.

11. Finally, (and most often cited), the multiple on the S&P is at bargain levels;
only a financial recession could make buying US stocks now a bad idea.
It’s always darkest just before the dawn.

We find the first eight arguments persuasive—in varying degrees. We strongly
disagree with #10; as for #9, we have deep respect for at least two prominent
bears—David Rosenberg, of Gluskin Sheff + Associates, and Stephanie Pomboy
of MacroMavens who have been consistently and cogently challenging #11.

The Big Banking Problem for Bullishness
We became increasingly nervous that those smart seers were bang-on about
the fundamental US economic weakness as the news from big banks became
more worrisome, but we didn’t join their bearish camp until May. We held
out hope as long as we thought the rot, misrepresentation, mismanagement
and delusions in the financial systems of Europe and the US would not
necessarily drag down the so-called "real economy."

We long ago lost our confidence in the oft-trumpeted restraint, shrewdness,
and honest financial reporting of many of the major banking institutions
that are crucial for the US economy—all of whom are bigger than Lehman.
But as long as there was even a fair chance that these drags on the economy
would be skated onside by total economic and financial strength abroad, we
were prepared to keep our high recommended equity weightings.

September 2011 19


From decades of experience—some of it painful—we have learned that
unsolved banking problems can trump pure economic performance in
terms of stock market returns. Bad business managers usually wound only
their investors and creditors; bad bankers, when acting in concert with each
...bad bankers, when other—and with bad politicians—destroy entire economies.
acting in concert with
Although the US banks are in better shape than their European counterparts
each other—and
because they aren't stuffed to their aortas with toxic risk-free bonds, they
with bad politicians—
don't engender confidence.
destroy entire
economies.
JPMorgan Chase (JPM)
55

50

45

40

35
33.81
30

25

20

15
Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11

Bank of America (BAC)
60

50

40

30

20

10
7.33

0


Citigroup (C)
600

500
Do Wall Street CEOs
400 have fat wallets and
300 thin skins?

200 Lloyd Blankfein
responded to criticisms
100
by saying he was doing
28.59
0 God's work.

KBW US Bank Index (BKX)
140

120

100

80

60

40 38.85

20

0

Each of those three giants was bailed out—or substantially helped—by the
taxpayers. The rage that would find its expression in the Tea Party came—in
considerable measure—from those bailouts.

How have the big bailout banks behaved since then?

Is the Tea Party merely a collection of ignoramuses who don't understand
high finance?

JPMorgan has been much in the news this year, partly because CEO Jamie
Dimon says he's sick and tired of being criticized by politicians. He also says
that Basel III's rules are "anti-American" and it might be wise for the US to
pull out of Basel. (Do Wall Street CEOs have fat wallets and thin skins? Lloyd
Blankfein responded to criticisms by saying he was doing God's work.)

September 2011 21


We wonder what Ben Bernanke would say about Dimon's contribution to
the economic recovery if he were free to comment.

Bernanke has been pumping astounding quantities of reserves into the banks
to stimulate the moribund economy. Mr. Dimon helps himself to gobs of
Mr. Dimon helps
that stimulus money and the returns on the almost-free FDIC-guaranteed
himself to gobs of
deposits to buy back his stock—$4.3 billion worth this year. (Not quite
that stimulus money
true: that's what he spent—as of now, those shares are worth about $3.6
and the returns on
billion. He was buying big when the stock was in the high forties. It's called
the almost-free FDIC
"generating shareholder value" by returning money to the stockholders.
guaranteed deposits
Dimon's investment expertise could, perhaps, be questioned, but there are
to buy back his stock—
lots of finance professors who'd say he's doing the right thing. Those smart
$4.3 billion worth
stockholders who looked at the economy and rushed to take Bernanke's
this year.
money as packaged by Dimon should be thanking Bernanke for improving
their standard of living. Meanwhile, Ron Paul, the Tea Party and Rick Perry
are calling for Bernanke's hide because they think he's too cozy with Wall
Street. )

Bank of America's Brian Moynihan responded to Obama's call for business
to hire more workers by announcing plans to fire about 30,000 workers. Of
course, he's trying to deal with the disaster arising from his predecessor Ken
Lewis's decisions to buy Merrill Lynch and Countrywide Financial. Those
acquisitions were made in the depths of the worst financial crisis since the
Depression—when BAC stock was selling for more than twice today's price. The
greatest retail bank in the USA decided to become the biggest bank in the
USA by buying its way into Wall Street.

(Full disclosure: we had strongly and repeatedly endorsed CEO Ken Lewis's
performance at BAC for the years leading up to 2006. In response to a question
from us about the scale of their Eurodollar liabilities at a meeting in our office
in 2002, Mr. Lewis, grinned at his CEO and said, " We're proud to answer
that question—and you're the first person who's ever asked us: the answer
is zero! And we're probably the only large institution in the world that can
make that statement." We were impressed, and strongly recommended BAC
stock for four years—arguing that such Bagehotian prudence warranted at
least 2 points on the bank's P/E. Four years later, as we examined his reports,
we began to worry that he might be straying from the straight and narrow
path. After repeated phone calls, we learned that BAC had abandoned this
exemplary caution, and stopped recommending the stock, partly because we
thought he should have told investors of his decision to join a club that
included so many dubious members.


Citigroup stock is having a somewhat better year than it has had in its recent
past: it’s only down from $49 to $27. (As clients are aware, we consider Citi
a multi-strategy hedge fund masquerading as a bank and benefiting from
cheap deposits through that role-playing, managed by a former hedge fund
manager who got the largest signing bonus of our time, shortly before ...we consider Citi
presiding over a 95% drop in its stock price.) That $49 valuation came when a multi-strategy hedge
its management finally figured out a way to get the stock price up—through fund masquerading as a
a mammoth reverse split. (Our chart adjusts for this: the stock never traded bank and benefiting from
at $500: even Apple never got that high—Steve Jobs' technique for taking cheap deposits through
AAPL from $9 to $390 differs somewhat from Wall Street's shareholder value that role-playing,
concepts.) managed by a former
hedge fund manager who
Why do we devote such analysis to these three mega-banks? They’ve certainly
got the largest signing
had better years than most of their European counterparts.
bonus of our time...
But the melancholy reality is that Obama and Bernanke—and US equity
investors—need these banks to be big parts of the solution to the problem of
microscopic economic growth.

We know they all have huge exposures to European banks. Based on their
demonstrated expertise in building shareholder value, we would not be
surprised to find out that one or more of them is deeply worried about some
of his bank's euro-exposure.

The Old World may be about to come to redress some imbalances in the
New.

Returning to our list, as we discuss in the next section, we believe that
argument #11 (about a gold bubble) will prove to be 100% wrong. Gold is
telling the political and financial elites what they don't want to hear. It is a
big bet that the risk-free asset class—and the banks who bet on it—will prove
to be a delusion almost as grotesque as the risk-free mortgage products that
caused the crash.

As for the last argument, if the big name Street economists who say the
economic pause is past are right, then

But we cannot help recalling the story of the eternal Wall Street optimist who
fell off the top of the Empire State Building. As he was passing the 65th floor
he was heard to shout, "So far, so good!"

But a possible politico-economic sea change of opinion might give investors
confidence that high gold prices are here to stay.

What if Obama and his counterparts in Europe decide to do a Roosevelt?

September 2011 23


III. Governments, Central Banks, and Gold

Gold Holdings of Selected Central Banks and the IMF

...why don't the big Tonnes
United States 8,133.5
holders revalue their
IMF 2,814.0
gold to, say, $2,200 BIS 119.0
an ounce and declare ECB 502.1
themselves willing
EUROPE
sellers at that price? Germany 3,401.0
Italy 2,451.8
France 2,435.4
Switzerland 1,040.1
Netherlands 612.5
Portugal 382.5
United Kingdom 310.3
Spain 281.6
Austria 280.0
Belgium 227.5
Sweden 125.7
Turkey 116.1
Greece 111.5
Poland 102.9

Source: World Gold Council, World Official Gold Holdings
International Financial Statistics, September 2011

Perhaps the most enduring paradox in all finance is the way major governments
and central banks treat their gold holdings: they ignore them.

When nearly all OECD economies are running huge deficits at a time of near-
zero interest rates, and nearly all governments are looking for ways to raise
revenues without imposing economy-unfriendly taxes, why don't the big
holders revalue their gold to, say, $2,200 an ounce and declare themselves
willing sellers at that price—in bars or in bonds backed by gold—and willing
buyers at, say, $2,000?

Roosevelt revalued gold from $20.67 an ounce to $35 and declared that the
US was a buyer and seller at that price. He also made it illegal for US citizens
to own gold.

By the end of the Depression, most of the world's visible gold reserves were
in Fort Knox.


Apart from all the jobs created in Nevada and other gold-mining states, this
attempt to introduce controlled inflation at a time of surging deflation was at
least mildly salutary. Having most of the world's gold also proved extremely
useful in helping to finance the recoveries in war-torn Western Europe.
The best way to take
Gold's roaring run to $1800 must be a huge embarrassment to the central
gold out of its newfound
bankers. Why should investors be rushing out of government bonds into
role as moral arbiter of
bullion? Don't they believe us when we tell them that printing all this money
governments' fiscal and
isn't going to debauch the currency?
monetary policies
The best way to take gold out of its newfound role as moral arbiter of may be to cap it.
governments' fiscal and monetary policies may be to cap it.

Yes, captious critics would say that this is the equivalent of buying a
bathroom scale whose highest reading is three pounds above the buyer's
current weight.

But desperate times call for desperate measures.

The gold bugs have long proclaimed their own version of the Golden Rule:
“He who has the gold makes the rules."

By that standard, Barack Obama could become the leader of the world
overnight.

Proclaiming a cap on gold and making all the gold in Western central banks'
vaults available for sale—or as backing for convertible bonds—would be a blow
to speculators.

Ironically, it would be good news for most gold mining stocks.

And wonderful news for gold mine prospects that are barely more than a
hole in the ground.

Why?

Back in the 1930s, gold mining stocks were stock market darlings. Who else
could sell everything they produced to the government at a guaranteed price?
Roosevelt was a hero to miners, prospectors and stock pushers.

It was the golden age for penny gold stocks. Anyone could take a flutter
on them. There were no lotteries, and the only legal gambling was church
basement bingo games. Anybody with a dream and a drill hole was able to
peddle his shares, and securities regulation ranged from lax to nonexistent.

September 2011 25


A story about an unexpected side effect of all the prospecting in that
speculative era.

Management of Gunnar Gold, one of the numerous speculative stocks of the
early 1940s, thought it had a promising gold deposit in the Yukon. There was
We believe a new era
some funny impurity in the ore, but it didn't seem to worry management.
in which gold was
Suddenly, the Canadian government nationalized the company—paying the
back into the very
stock market price, which was less than $2 a share. Only after the war was
centre of central banks'
over did the surprised shareholders learn that Gunnar's ore was radioactive.
operations would be
The uranium it contained went to a hush-hush US government operation in
a great time for gold
Los Alamos and some of it ended up in the bomb bay of Enola Gay to be
prospecting and gold
dropped on Japan.
mine development.
Without the guaranteed price for gold, that mine might never have been
discovered.

We believe a new era in which gold was back into the very centre of central
banks' operations would be a great time for gold prospecting and gold mine
development.

As for the strong, well-financed producing gold mines with huge, politically-
secure reserves—the Goldcorps, Barricks, Newmonts and their brethren—
they would no longer be white chips: they'd be blue chips, paying secure
dividends which, at a time of low-low interest rates, would be prized.

The upward revaluation would permit some of the better-endowed PIIGS
to issue gold-backed bonds at minuscule interest rates. As for the US, which
has more gold than anybody else, and doesn't seem to have the faintest idea
why it has it—or what to do with it—Obama could apply net sales proceeds
directly to the deficits.

The cap on gold would take a major bearish investment medium out of the
stock market—gold bullion. For months, on the days stocks have gone down,
gold has gone up.

If gold were capped and governments combined their willingness to sell gold
with a ban on naked short-selling of bank shares, and on naked Collateralized
Debt Swaps, governments and banks might get a breathing spell.

Why ban naked Collateralized Debt Swaps?

Because they violate the centuries-old rule for insurance products—an
insurable interest. When life insurance was first created in England,
companies let anyone buy a life insurance policy on anyone else. Then they


found that those lives insured by people who weren’t personally related to
the life insured tended to die violently. So the concept of insurable interest
developed—just as the fire insurers had never let people buy insurance on
dwellings in which they had no ownership interest.
UBS had to be bailed
AIG would never have gone down (at a cost to taxpayers of more than $100
out by Swiss taxpayers
billion), if it hadn't violated its insurance principles by going gung-ho into
because it was levered
Collateralized Debt Swaps.
more than 40 to one
As the eminent Paul Volcker has said so often, why should economies and and had monstrous
taxpayers be at risk for banks that get deeply into newfangled financial holdings of putrescent
products? Western economies grew satisfactorily in the decades before all US mortgage paper.
these monstrosities were developed, and the bank failures that happened
were easily managed.

Today's announcement that UBS has apparently blown $2 billion in its
trading operations is a perfect case in point: UBS had to be bailed out by Swiss
taxpayers because it was levered more than 40 to one and had monstrous
holdings of putrescent US mortgage paper. A great bank that had survived
for more than a century as a pillar of Swiss prudence and rectitude had tried
to become Goldman Swiss—and it lacked both the smarts and the capital
for that remake. Less than three years later, it's due to report a quarterly loss
it blames on a rogue trader. Axel Weber of Bundesbank fame is due to take
charge next year of this organization whose financial structure in recent years
seems to have been modeled on Swiss cheese.

As the chart shows, he's needed now.

UBS
70

60

50

40

30

20
11.41
10

0

September 2011 27


Why do we devote so much space to making political proposals?

Because we are deeply worried that another financial crisis is coming, at a
time when governments' bailut budgets are seriously constrained.
"If it moves, tax it; if it President Obama's long-awaited speech about his great plans for creating
still moves, regulate it; jobs was greeted with reactions ranging from boredom to disdain. It was
if it fails, subsidize it." a highly-energized and well-delivered rouser. However, all he could do is
promote a new batch of "shovel-ready" projects and jobs for teachers that
would be financed by higher taxes on the rich. He is seen as someone who
spent $800 billion on stimulus that didn't work, and he's now largely devoid
of both ideas and money.

Obama and his European counterparts look at the performance of shares of
the big banks and must feel that, (as we put it in Basic Points), Naught's Had,
All's Spent.

The government-owned gold that could provide such support to the leaders
in the US and Europe is a nuisance to them, because its strong performance in
the marketplace is a daily reminder of the futility of their seemingly endless
crisis meetings and new acronymic rescue mechanisms backed by..........
what?

Bernanke has expressed a yearning for some inflation (but not in foods or
fuels) to help the hapless housing market.

Obama has failed to put the economy on a growth path. Most of his
Republican opponents are as doctrinaire as he—while mouthing different
dated dogmas of equivalent futility.

As Reagan put it, when the nation faced similar crisis, "If not us, who? And
if not now, when?" (He also summed up the Democrats' economic program
pithily, "If it moves, tax it; if it still moves, regulate it; if it fails, subsidize
it." That perfectly distills today's Demodogmatism. But the Republicans'
dogmatic refusal to permit any tax increases—even on the carried interest of
hedge fund managers who create few jobs—is equally unhelpful.

If there were ever a time to start accessing the gold Roosevelt bought at
$35—and reducing endogenous risk in the global banking system—this is
it.


Gold-backed bonds and gold for sale at $2,200 to all bidders would, of
course, be selling off "the family silver." But desperate times call for desperate
solutions. The biggest and most obvious asset Obama has is the one asset
that he supposedly can't touch.
The biggest and most
Why not?
obvious asset Obama
Long-duration Gold-backed Treasurys paying, say, .5% interest would be one has is the one asset
way of selling off much of the Treasury's hoard without swamping the cash that he supposedly
gold market. can't touch.

Those with long memories will recall when Jacques Rueff, DeGaulle's gold Why not?
guru, convinced France to issue some gold-backed bonds as proof that the
nation didn't face serious inflation risk. Then came stagflation and the runaway
gold market and those gold-backed bonds became fabulous investments.

Most central bankers know that embarrassing story, which may preclude
their willingness to make any recommendations now. To be remembered
as the guy who sold gold at $2,000 in a long-term bond and gold went to
$5,000 would be ghastly.

But the reason why Rueff lost so big was that Nixon closed the gold window
in 1971 and then oil prices quadrupled and stagflation—which had never
existed before—took charge. Under this tentative scenario, the US would
transfer all bullion needed to back the bonds, and Congress would pass
legislation guaranteeing those gold bond conversions until the bonds
matured.

Finally, the wise, witty folk at the Leuthold Group have published the Chart
of the Year showing the cumulative total return on gold vs. the cumulative
total return on the S&P since Nixon closed the gold window, repealing the
cap on gold imposed by Bretton Woods.

Remarkably, gold's bull market in this millennium has meant that its
annualized return has caught up with the S&P—9.9% vs. the S&P's 9.8%.
If you'd put a bar of gold in a vault and left it there for 40 years, you'd
have slightly outperformed most equity investors. The S&P has been long
proclaimed as proof of the triumph of American capitalism with its business
schools, management training, and superb collection of so many of the
world's greatest companies. Buy and hold the S&P and you're going to be
rewarded by the very best wealth-generators. Buy and hold gold and you're
as outdated as believers in the phlogiston theory.

September 2011 29


This statistic could be used by Obama to argue that now is a good time to
lock in the gold bull market by monetizing the nation's holdings through
various strategies and vehicles forty years after Nixon uncapped gold and 78
years after Roosevelt boosted it 70%.
Why don't the
The same strategy would apply to some of the more desperate European
governments bring out
nations. They have gold; they need to sell bonds and the market doesn't
their gold and use it to
want them; their deficits are scary and they're all supposed to retrench
back their bonds?
simultaneously. Issuing long-term bonds with a fixed call on gold would
make their bonds marketable.

Most of the gold sitting in vaults in the US and Europe was accumulated at
significant cost to the taxpayers of the time. It is performing no usual function
at a time when it seems as if all governments—notably Switzerland—want
the value of their currencies to decline. The reason nations wanted and
needed gold was to back their currencies.

Pawn shops and jewellery stores report high levels of gold cashouts from
middle class people who are having trouble getting by. The point of gold is
that for all of history, it has been the one certain thing that can be used to
buy goods and services or discharge debts.

Why don't the governments bring out their gold and use it to back their
bonds?

Obama should, in our view, try to find one non-Keynesian economist who
understands gold to advise him. We’re sure he could get an old-fashioned
scholar from the University of Chicago to help him out if he made a few
calls.


Francly, Ma Chère, I Do Give a Damn
In our September 16, 2011 Client Conference Call, we discussed the
momentous implications of Swiss Central Bank Governor Hildebrand's
decision to peg the Swiss franc to the euro. Francly, Ma Chère,
I Do Give a Damn
Swiss Franc vs. US Dollar
1.5

1.4

1.3

1.2
1.15
1.1

1.0

0.9

0.8
Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10 Jan-11 Mar-11 May-11 Jul-11 Sep-11

The franc tracked gold for much of this year, as investors with a sense of
history bought the one currency that was a reliable store of value.

The franc had that stature during the stagflation era.

There were two prime reasons:

1. Switzerland prized its status as an island of financial stability in an
inflationary world, and gold was a major component of its foreign
exchange reserves.

2. Swiss banks were growing their managed assets rapidly, partly due to the
allure of secrecy and tax dodging, but also because the rich wanted to own
franc-denominated assets at a time the banks had a firm rule that 10%
of each account had to be held in gold. As wealth denominated in other
currencies was converted into francs, the upward pressure on the franc
became enormous.

September 2011 31


By the late Seventies, the soaring franc was threatening Swiss industries—
particularly watch manufacturing.

So Bern imposed special taxes on capital inflows, and pegged the franc to the
Deutschemark. Once the gold bull market turned into a crash, the Reagan
It could be deemed the
recovery began, and the dollar entered a roaring bull market, the pressure
singular case of a crowd
came off the franc.
rushing from the safety
of a dock onto a sinking This time is different.
ship. Or, possibly,
Not only has the franc risen by nearly a third against the euro from early 2009
leaving Haven for Hell.
to last week, but Swiss residents have been switching their routine shopping
needs to France, Germany or Italy, creating a crisis for Swiss retailers. This
despite cutting Swiss rates to zero and massive forex intervention that has
quintupled Swiss central bank holdings of euros, dollars, pounds and other
currencies—including the Canadian dollar. Instead of the franc being a haven
(which could be deemed earthly Heaven), the declared national policy now
is to tie the currency and the economy to the euro.

This is amazing. The currency that has long been synonymous with prudence
and safety is adopting as its sole objective the fate of the only currency that
lacks the backing of any government, tax system, army or navy—a mere meta-
currency. It could be deemed the singular case of a crowd rushing from the
safety of a dock onto a sinking ship. Or, possibly, leaving Haven for Hell.

Speculators may still choose to use this period of euro-parity to sell euro-
assets and buy Swiss assets—notably real estate—on the assumption that
the endogenous risk in the euro is so great that it will eventually implode,
forcing the Swiss to abandon their self-imposed peg.

What particularly interests us is that this Swiss decision to replace the
nation's traditional protective systems from walls to Swiss cheese should
mean massive new inflows into gold.

Rhett Butler delivered his classic dismissal to Scarlett before walking out.

Mr. Hildebrand is walking out on Swiss traditions that have been part of the
national character for centuries.


IV. A Model for a Post-CAPM World
1. Bullet-proof Dividend Payers
With the CAPM's elegant formulas and rules under daily challenge, and with The justifications used
high-grade bond yields so far below traditional funding assumptions, we for such programs
believe institutions and high net worth investors should reconsider the rules are inherently
used in portfolio construction. contradictory: they are
said to be returning
We suggest that
money to stockholders,
1. The portfolio's beta-rated Equities exposure—including stocks and but they actually give
commodities—should be reduced to 35% in favor of income components funds only to those who
for as long as the threats of financial crisis and recession remain highly want to sell their shares.
visible. If we learned anything from the horrors of 2008, it is that life-
threatening diseases within banking systems can overwhelm economies
and equity markets.

2. The Income sector—traditionally composed solely of debt instruments—
should be reconstituted to include 10% in bullet-proof high dividend
reliability stocks. Companies selected must have great dividend and
dividend growth records—and must not be big allocators of cash in stock
buybacks.

The justifications used for such programs are inherently contradictory: they
are said to be returning money to stockholders, but they actually give funds
only to those who want to sell their shares. If the companies also have
generous stock option schemes for top executives, the programs could easily
be construed as being, at least in effect if not in design, cover-ups about
the real cost of such dilution, and as extra enrichment to the insiders by
financing the purchase of their low-cost shares at higher prices. Dividends
go only to those who choose to remain as partners in the enterprise. Stock
buybacks go only to those who want out—in whole or in part—or those who
are selling the stock short. It is unclear why those groups of investors should
be the objects of corporate solicitude or corporate cash.

We recommend that investors using this approach to portfolio construction
assign the dividend stocks into a sector designated for five-year returns—à
la private equity agreements. The portfolio should be measured against the
yield for five-years Treasurys or five-year Canadas or Bunds. To illustrate:
today's 5-year Treasurys yield .94%. Assume the dividend portfolio yields
2.75% initially and increases at an thereafter at an expected average growth
rate of 5%. (This would be a big part of the investment thesis: don't just buy

September 2011 33


high-yielding stocks, but buy those with acceptable yields and a corporate
policy of increasing payouts.) All income above .94% would be credited to
the book cost of the shares. At the end of five years the total return would be
calculated—Market Value, less Adjusted Book Cost.
...dividends were—
Those managing such portfolios would contact company managements
overwhelmingly—
about their dividend policies—not about earnings and capex forecasts. We
the most important
would expect that if this approach became popular, companies would change
component of equity
their payout policies to qualify for inclusion in dividend portfolios.
valuations by major
institutions for more The portfolio manager would ignore Street Buy, Sell or Hold recommen-
than a century after the dations, which are overwhelmingly beta-based. Beta analyses would be
advent of joint stock crucial in the Equity portfolios.
companies.
But it has a lot of history behind it. Until the growth stock era of the 1960s,
most pension funds and insurance companies invested in stocks for their
dividends. (We well remember when we joined Mutual Life of Canada in
1970 that its largest stockholding was IBM. When we queried this, we were
told that the company began buying IBM for its dividends during the Depression
and kept reinvesting them for years. Then, when the holding became large
and worrisome, they would sell off chunks, but the darned stock kept roaring
back and kept boosting its dividends. We finally convinced management to
sell one-third of the position when we argued that IBM could lose the Telex
anti-trust lawsuit. We wrote a mock trial judgment based on the General
Motors-DuPont Supreme Court decision. Fortunately for our investment
career, that's the way the case went at trial a few weeks later. The NYSE had
to open late the next day because of the torrents of selling and it took more
than a decade for IBM stock to recover its former glory.)

In fact, until very recently (as British actuaries measure these things), large
British pension funds valued their stockholdings primarily on the basis of the reliability
and potential growth of their dividends—not on increases in earnings or the P/E
ratios. We recalled this last year after the BC Macondo disaster, when there
was so much discussion about whether BP would pay its dividend—which
was crucial for a huge amount of British pension fund assets.

It is fair to say that dividends were—overwhelmingly—the most important
component of equity valuations by major institutions for more than a century
after the advent of joint stock companies.


Bernie Cornfeld and his like peddled the growth stock concept to retail and
institutional investors at a time when dividends were heavily taxed and
capital gains were taxed at lower levels.

But the importance of dividends even in the "modern era" was confirmed
That the Efficient
in a Financial Times survey of long-term equity returns with reinvestment
Frontier has become the
of dividends by industry classification published a few years ago. The
Deficient Frontier is,
winner—by a wide margin—was the big petroleum companies, which
to date, understood
routinely distributed generous dividends. Reinvesting those payouts was,
by surprisingly
over the long term, a superb investment strategy. (It has doubtless dwindled
few investors and
in these days of consultants and investment specialists; an equity specialist
commentators.
rarely gets control of the dividends from the funds under management, so
reinvestment is almost an abstract concept.)

In a recent meeting with a board of directors, we illustrated the concept of
low endogenous risk with bullet-proof dividend payers by asking rhetorically,
"Can anyone in this room imagine a world of the near future where Bristol
Myers won't be able to pay a dividend? By that test, isn’t Bristol Myers a safer
income investment by far than, say, an Italian government bond?"

We strongly recommend that institutional and retail investors break the
shackles of labeling and look at security of income—whether in dividends
or interest. In a zero interest rate environment, there is a long list of great
companies with a long record of dividend payments on schedule—and of
sustained growth in those payouts.

We also recommend that companies' managements consider the changed
situation for dividend-payers in a zero interest rate world and decide to
eliminate stock buybacks against promises to boost dividends year-in, year
out—on a five-year time horizon basis. Companies that took that public
pledge would, we believe, be then eligible for enrolment in the bullet-proof
dividend category, making them eligible to be held within the income section
of both pension fund and high net worth portfolios.

The new value of dividends is one logical outcome of the etiolation or
outright collapse of the Capital Asset Pricing Model.

That the Efficient Frontier has become the Deficient Frontier is, to date,
understood by surprisingly few investors and commentators. As more come
to understand the great void in their analytical processes, we suspect that
even more financial turmoil will develop.

September 2011 35

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