3. Don Coxe
THE COXE STRATEGY JOURNAL
It's the Economy Banks, Stupid!
November 18, 2011
published by
Coxe Advisors LLP
Chicago, IL
4. THE COXE STRATEGY JOURNAL
It's the Economy Banks, Stupid!
November 18, 2011
Coxe Advisors LLP.
Author: Donald Coxe 312-461-5365
dc@coxeadvisors.com
Editor: Angela Trudeau 604-929-8791
at@coxeadvisors.com
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5. It's the Economy Banks, Stupid!
OVERVIEW
Too many equity investors are getting sick of the stock market. Glowing
corporate earnings don't seem to matter anymore, and the market is subject
to absurdly wide price swings. Many American equity investors who are
pulling money out of their mutual funds are telling advisors they think the
stock market must be rigged.
The seemingly endless pattern of risk-on risk-off days in European and North
American stocks which scares investors originates from the Wagnerian-scale
drama of the existential crisis of the euro, and the problems of European
and, to a somewhat lesser extent, American banks.
These dramas play out against the backdrop of growing fears of a new global
recession, which could, some analysts fear, be at least as challenging as its
predecessor, because governments have exhausted their bailout funds.
We are not convinced that a North American recession is inevitable and, in
any case, we doubt that its severity would approach 2008 levels. Zero interest
rates and record deficits should be good cushions.
This month we explain why investors should indeed be worried about those
badly-managed Wall Street and European banks in the light of the collapse
of their asset pricing models.
But we suggest that those endless crises in the eurozone could very likely
trigger a policy response that would dramatically improve the outlook for
European banks—and stocks generally.
We also consider the implications of the politicization of the Keystone
application in a broader context of debates on US energy policies. The Canadian
government and much of the Canadian oil industry were surprisingly naive
about Keystone's chances, actually believing that environmental issues were
the only barriers to an Obama OK.
We are leaving our Asset Mix recommendations unchanged.
November 2011 1
7. It's the Economy Banks, Stupid!
The wise Northrop Frye once told students of a trans-continental trip he had
taken in the observation car of a train. He noted that passengers could choose
seats that faced forward or backward. This was a option not available to the
pioneers who came by foot, horseback or canoe. They had to look ahead.
...the men who run
He said that those train passengers who looked backwards were reflecting
big US and European
on where they had been, and that this was, on balance, a better strategy
banks are collectively
than looking ahead, because one could gradually build one's understanding
the most publicly
about the land—and the nation—without trying to peer ahead to what
controversial segment
would come next.
of Big Business...
We are going to follow Frye's precept by beginning with two pages of charts
about where we have been. We want clients to reflect on how ghastly the
performance of the [non-Canadian] bank stocks has been.
While musing on these horror stories of failures and bailouts, clients should
also be reflecting on the fact that the men who run big US and European banks
are collectively the most publicly controversial segment of Big Business in
claiming that they deserve to be paid more than they earn. Really? Were they
football or baseball coaches with such disastrous records, they'd have been
ridiculed and fired. Bizarrely, they have managed to elicit support from many
naive conservatives who drink the Kool-Aid that Wall Street is composed of
capitalist giants beset by leftist political Lilliputians. Even in the midst of the
worst crash since 1929, they insisted that their bonuses had to be paid or
they might decamp to....
No one seemed to ask where they could go with their blown-up risk models.
Zimbabwe?
November 2011 3
8. It's the Economy Banks, Stupid!
Citigroup (C) Bank of America (BA)
January 1, 1986 to November 17, 2011 January 1, 1985 to November 17, 2011
600 60
500 50
400 40
300 30
200 20
100 10
6.83
31.59
0 0
Jan-86 Jan-89 Jan-92 Jan-95 Jan-98 Jan-01 Jan-04 Jan-07 Jan-10 Jan-85 Jan-88 Jan-91 Jan-94 Jan-97 Jan-00 Jan-03 Jan-06 Jan-09
Goldman Sachs (GS) Banco Santander (SAN)
May 1, 1999 to November 17, 2011 January 1, 1985 to November 17, 2011
250 16
225 14
200 12
175 10
150 8
125 6 6.18
100 4
92.35
75 2
50 0
May-99 Nov-00 May-02 Nov-03 May-05 Nov-06 May-08 Nov-09 May-11 Jan-85 Jan-88 Jan-91 Jan-94 Jan-97 Jan-00 Jan-03 Jan-06 Jan-09
Deutsche Bank (DB) UBS (UBS)
January 1, 1985 to November 17, 2011 January 1, 1985 to November 17, 2011
120 80
70
100
60
80
50
60 40
30
40
30.35 20
20
10 11.21
0 0
Jan-85 Jan-88 Jan-91 Jan-94 Jan-97 Jan-00 Jan-03 Jan-06 Jan-09 Jan-85 Jan-88 Jan-91 Jan-94 Jan-97 Jan-00 Jan-03 Jan-06 Jan-09
Societe Generale (GLE) Credit Suisse (CS)
January 1, 1987 to November 17, 2011 January 1, 1985 to November 17, 2011
160 100
140
80
120
100 60
80
60 40
40 25.60
20
20 21.10
0 0
Jan-87 Jan-90 Jan-93 Jan-96 Jan-99 Jan-02 Jan-05 Jan-08 Jan-11 Jan-85 Jan-88 Jan-91 Jan-94 Jan-97 Jan-00 Jan-03 Jan-06 Jan-09
4 November 2011 THE COXE STRATEGY JOURNAL
9. It looks as if the Big Banks could be in a Triple Waterfall collapse formation
that would force further assistance.
We are frequently asked when the next Triple Waterfall would arrive. As
discussed in our book1, financial markets of the last three decades of the
...the herd of
past millennium were driven by three Triple Waterfall rises and crashes—
Too Big to Fail banks
commodities in the 70s, Japan in the 80s, and technology in 90s.
should have been
Each of these convulsions sucked in vast amounts of capital on the way up and culled...
became a source of funds for the next mania on the way down. The housing
bubble which inflated the Big Bank Bubble sucked in far more capital than
its predecessors, because a 60% rise in house prices at a time of shrinking or
vanishing down payments imposed monstrous demands on debt markets.
The Greenspan Put obliged, as did so many central banks abroad.
We have no doubt that, had governments not intervened during the 2008 crash
with gigantic bailouts, unbelievably cheap money, and extremely generous
guarantees on deposits, the past decade would have been defined by a crash
of 1929 proportions in which many American and European banks would
have been wiped out. That would have been a rather sudden Triple Waterfall,
but the collateral damage from letting so many wretchedly-managed banks
fail simultaneously would have been catastrophic.
Nevertheless, the herd of Too Big to Fail banks should have been culled,
thereby freeing up liquidity and capital for well-managed organizations. We
have long wondered why Lehman was the last to go. Reading Ron Suskind's
perceptive account of the Obama Administration (The Confidence Men), we
were interested to learn that President Obama issued orders to let Citigroup go
bust. This was, to us, a remarkably wise decision, and our respect for Obama
rose on reading it. Regrettably, Obama didn't follow up to ensure compliance.
Mr. Geithner somehow never got around to implementing those orders, and
Citi has lived on, a sickly multi-strategy hedge fund masquerading as a bank.
Was it saved because Robert Rubin had been collecting fees totaling more
than $100 million for dispensing strategic advice—including increasing the
bank's leverage during the later stages of the bubble?
1
The New Reality of Wall Street, 2003, McGraw Hill.
November 2011 5
10. It's the Economy Banks, Stupid!
KBW US Bank Stock Index (BKX)
October 1, 1992 to November 17, 2011
140
120
The big bankers of
100
Wall Street and Europe
are, it would seem, 80
modern Bourbons, 60
who have forgotten 40 37.30
nothing [about their
20
boom-built bonuses]
and learned nothing 0
[about the perils of Sep-92 Oct-94 Nov-96 Dec-98 Jan-01 Feb-03 Mar-05 Apr-07 May-09 Jun-11
physics-based risk
models and excess
leverage]. This chart of the history of the BKX shows Leg One taking the Big Banks up
roughly 200% to the Long-Term Capital crisis, which produced a swift 45%
crash; this was halted by the Greenspan Put, which continued to pump in
liquidity, taking them back to their peaks in a long sideways move, followed
by a retrenchment. Then came the second Greenspan Put taking them to a new
peak during the real estate bubble which took them to a peak that was 300%
above the 1995 lows. The entire rallying process consumed 12 years—two to
three years longer than the rallies of the previous Triple Waterfalls.
An optimist would argue that the 2008-09 crash ended the banks' equivalent
of a Triple Waterfall crash, which means they had been sufficiently punished
for their sins against capitalism and, thus cleansed, were ready to resume their
industry's historic role in economic expansion: less leverage, more lending,
reduced risks, and more contribution to economic progress.
Sadly, this never happened. The big bankers of Wall Street and Europe are,
it would seem, modern Bourbons, who have forgotten nothing [about their
boom-built bonuses] and learned nothing [about the perils of physics-based
risk models and excess leverage].
6 November 2011 THE COXE STRATEGY JOURNAL
11. Like the Bourbons, they lost their heads, if only metaphorically. In the earlier
case, there was never a question of showering more wealth on King Louis and
Marie Antoinette in hope that they would clean up their acts and strengthen
the French economy. However one might disparage the Jacobins, they weren't
naïve. Like the Bourbons,
they lost their heads...
What about those earlier Triple Waterfalls?
Commodities remain in a long-term bull market that shows scant signs of
the excesses of the 1970s. Even gold, which is frequently cited as being in
bubble mode, is merely catching up to long-term monetary expansion. (Its
price multiplied 22 times in the Seventies mania.)
Gold ($/oz) vs. Currency in Circulation* ($billion)
January 1, 1998 to November 17, 2011
1,900 1,100
1,050
1,700
1,000
Last 1,052.15
1,500 1 Wk chng +6.79 950
1,300 900
850
1,100 800
900 750
700
700 650
500 Last 1,721.00 600
1 Wk chng –67.68
550
300
500
100 450
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Gold ($/oz) Currency in Circulation ($billions)
*source: Federal Reserve
Chart courtesy of Meridian Macro Research (info@meridianmacro.com)
Japan, to our disappointment, remains in its Triple Waterfall mode 21 years
after the crash began. As the Olympus scandal now reveals, investors are
not convinced that Japanese businesses have been able to shrug off either
the corruption of the yakuza (the Japanese mafia) or the nation's disastrous
demography.
November 2011 7
12. It's the Economy Banks, Stupid!
As an industry, Technology has survived Nasdaq’s Triple Waterfall collapse,
and has remained an engine of global growth, although investors who held
onto such 1990s darlings as Cisco may not be consoled. Google wasn't public
at the peak and Apple was not the company in 2000 that it would become
"In the 1880s, total UK with the 2nd Jobs incarnation.
bank assets were equal
to 5% of GDP. At the Cisco (CSCO)
bubble peak they were January 1, 1991 to November 17, 2011
500%..."
80
70
60
50
40
30
20
18.53
10
0
Nov-91 Nov-93 Nov-95 Nov-97 Nov-99 Nov-01 Nov-03 Nov-05 Nov-07 Nov-09 Nov-11
The perceptive Tony Jackson wrote in The Financial Times (Nov. 6, 2011)
about a speech delivered by Andrew Haldane of the Bank of England, "that
most of the harmful developments in finance in the last century came from
the banks' ‘desire to break their balance sheet chains’."
"In the 1880s, total UK bank assets were equal to 5% of GDP. At
the bubble peak they were 500%. As to consolidation, the assets of
the UK's three biggest banks at the start of the 20th Century
were 7% of GDP. By the end of it they were 75% and by 2007—
astonishingly—200%. Leverage climbed from 3 - 4 times in the
19th Century to 30 times in the bubble. And return on equity—
unsurprisingly—went from modest single figures to 30% at the
peak."
We all know what happened next.
8 November 2011 THE COXE STRATEGY JOURNAL
13. Have the Big, Bad, Bonused Bailout Banks (hereinafter called B5) learned
from their near-death experience?
Apparently not.
The bonus fixation that has driven the desire for excess leverage is part of ...in the case of UBS,
Wall Street's self-spawned DNA. After the crash, not only did Merrill Lynch bonuses were paid
pay their fallen "stars" based on phantom earnings that ignored losses on from a pool that had
subprimes, but in the case of UBS, bonuses were paid from a pool that had been totally drained by
been totally drained by rogue trader fraud. rogue trader fraud.
Bonus promises for bankers are, it would appear, like excessive pension
promises for unionized government employees created by deals for union
support for politicians in elections: they must be honored even when they
are funded from over-greedy investment projections, and by imploded capital
asset risk models.
Not all big banks are run to enrich insiders with returns from perilously high
leverage and dubious investments: the index of Canadian bank stocks reveals
an industry that has continued its long tradition of behaving itself, thereby
dramatically outperforming its counterparts in the US and Europe:
S&P/TSX Canadian Bank Stocks vs. KBW US Bank Index (BKX)
June 1, 2002 to November 17, 2011
250
200
175.73
150
100
50 -45.48
0
May-02 Jul-03 Sep-04 Nov-05 Jan-07 Mar-08 May-09 Jul-10 Sep-11
S&P/TSX Canadian Bank Stocks KBW US Bank Index (BKX)
Source: S&P/TSX Bank Stocks; GICS, Industry Group
November 2011 9
14. It's the Economy Banks, Stupid!
No Canadian bank went bust in the Depression, so it was no surprise that
all the Canadian banks came through the worst banking crash since the
Thirties in solid condition. Credit good management, constrained leverage,
and supervision by the Bank of Canada under its great governors in the past
...the occupiers of decade—David Dodge and Mark Carney. That Mr. Carney was recently chosen
Zuccotti Park...tap to lead the global Financial Standards Board (replacing Mario Draghi who
into rage that the moved to the European Central Bank) should be reassuring to investors—
banks who were the and a spit in the eye for JPMorgan Chase's CEO, Jamie Dimon, who had
biggest private sector assailed him in Washington weeks before. Mr. Dimon is one of those big
causes of the crash bankers whose public displays of arrogance helped spawn the Occupy Wall
and recession show Street demonstrations. Although the occupiers of Zuccotti Park are leaderless,
little remorse and undisciplined and largely incoherent in their demands, they tap into rage
little willingness to that the banks who were the biggest private sector causes of the crash and
accept constraints on recession show little remorse and little willingness to accept constraints on
their leverage and their leverage and proprietary trading. (One TV clip showed some signs they
proprietary trading. were holding, including one that impressed us: "Bring Back Glass-Steagall.")
The demonstrators should also, of course, be targeting Barney Frank and his
politically-correct Fannie Mae allies, who probably deserve as much of the
blame as the banks for the housing collapse, but that is a complicated story
to explain, and the mainstream media have certainly not chosen to cite the
catastrophic misdeeds of politicians they favor.
10 November 2011 THE COXE STRATEGY JOURNAL
15. The Eurozone Crisis—and the Banks
Since May, we have been warning that the Basel banking version of the
Capital Asset Pricing Model was obsolete and misleading—and could trigger
a new collapse. ...the G-20 Meeting—
The Dexia collapse is a form of financial sick joke: a major financial institution held on the site of the
that passed the European Banking Authority's supposedly-demanding stress famed Film Festival,
test with flying colors in July thereupon vaporized within weeks. Imagine (but might have been
someone dying of cancer who had taken out a $10 million term life insurance better held in a morgue)
policy at a reduced premium for exceptional health two months earlier. Would
the insurer and its reinsurer continue to retain the examining doctor?
The proximate cause of the Dexia demise was the worsening of the Greek
crisis at a time the prices for outstanding debt of other PIIGS—most notably
Italy—were weakening. As this is written, despite at least €70 billion of ECB
purchases, the benchmark ten-year Italian government bond yields 7.04%—a
scary 5.25% more than German bunds, and 3.38% more than French bonds—
whose yield spread above bunds has been also been widening recently. (By
way of comparison, Treasurys yield 2% and Canadas yield 2.13%.)
Italy's outstanding debt—120% of GDP—is the world's third-largest, and
it must roll over more than €200 billion next year—let alone finance its
growing fiscal deficit. Spanish yields have also been climbing sharply and are
now 6.29%. The market is convinced that Italian yields are unsustainable,
and is getting rapidly becoming panicky about Spain's.
At the G-20 Meeting—held on the site of the famed Film Festival, (but might
have been better held in a morgue), Silvio Berlusconi was in fine form for
the role of Harlequin in a Commedia Dell' Arte farce. He airily dismissed talks
of an Italian debt crisis, saying he had turned down an IMF loan, as being
unnecessary. He said the plunging price of Italian bonds was "Yesterday's
story, the restaurants are full, it is difficult to reserve a seat on a plane...I can't
see another figure on the Italian scene capable of representing Italy on the
international stage."
November 2011 11
16. It's the Economy Banks, Stupid!
Despite that (probably accurate) self-assessment, he lost his parliamentary
majority in a vote on Nov. 8th, and got the hook from Stage Left. He is replaced
by Mario Monti, a non-elected technocrat, with a glowing resume who began
his political career as a Communist. He announced a Cabinet composed of
...no external other technocrats—no elected politicians. (Plato would have approved of an
conclave could all-guardian government with no voter input.) A bank portfolio manager
humiliate Greece as prepared to take a big bet on Italian bonds based on the belief that the
dramatically as its Italian parliament and population will submit to Monti's medicines for
own bureaucrats, more than a few months probably shouldn't even be managing his or her
union leaders and own money—let alone anyone else's.
tax-dodging rich
Meanwhile, where the eurocrisis began, another leader has fallen. George
have...
Papandreou is gone.
Nothing became Papandreou in his premiership as the leaving of it: he
tried to give the voters a chance to ratify the Draconic terms of the nation’s
bailout.
We were sorry the EU banned that resort to democracy. The terms of the rescue
package have been denounced as "humiliating" for Greece, but no external
conclave could humiliate Greece as dramatically as its own bureaucrats,
union leaders and tax-dodging rich have during the many months that little
Greece has been making big waves in global markets.
What really upset Sarkozy, Merkel, et al. was the idea of putting terms of a
eurodeal to the voters. The euro was a confection of the elites and they have
been congratulating each other for years on its wondrous qualities. It was only
put to the electorate of a few members—not including the Germans—and
barely survived. The members of the eurozone ruling class tend to be more
comfortable with each other—despite personal rivalries—than with their
voters. They graduate from the best universities and are virtually unanimous
that the route to repealing Europe's bloody past is with supranational
institutions that, through one-time constitution-style agreements, are placed
permanently above and beyond the direct control of voters.
Prior to the "make or break" euro meetings of October 25th, one of the
officials justified the bailout plan by expostulating, "We cannot make war on
the nation of Plato."
12 November 2011 THE COXE STRATEGY JOURNAL
17. Plato, it will be recalled, abandoned Athens for Sicily, where he tried to make
the regime of a local dictator the demonstration of his views on Guardians and
the Cave. The project failed dismally, and Greece only got good government
briefly during the reign of Alexander the Great—a Macedonian. It has had
little—if any—experience with wise government since 323 B.C. A proposed Greece only got good
€120 billion bailout 2,334 years later that is justified on the basis of helping government briefly
Plato's heirs could only be conceived by an eurocrat who would never think during the reign of
of putting the proposal to a vote of his own nationals. Alexander the Great—
a Macedonian.
But the fact that this emotional resort to Platonic philosophy was adduced
in the midst of a modern crisis set us to thinking about the importance of
philosophy in the Continental leaders' learning.
They have all studied the same philosophers, albeit with natural national
predispositions to their own great minds. Descartes' cool, geometric logic
was at the root of French socialist Jacques Delors' design of the euro: a
perfectly-designed currency with no provision for exits, like the succession
of perfectly-drafted French constitutions, which in practice have only been
amended by the Paris mob. Rousseau's concept of the supremacy of the
General Will untrammeled by popular elections on fixed schedules therefore
has enormous appeal for the new European aristocracy.
The classic liberalism of the Scottish and English philosophers and
economists—Berkeley, Hume, Smith, Locke, Ricardo and Mill—has had only
modest influence with the Continental elites, where the French philosophes—
such as Voltaire, Rousseau, and Condorcet, and more recently, Durkheim,
and the German schools of Leibniz, Kant, Schopenhauer and Hegel are
studied intensively.
Angela Merkel emerged from that dramatic eurocrisis meeting of Oct. 26 as
the leader of the eurozone, outlasting all the male elitists in a marathon that
extended to 3 a.m. Her triumph triggered a gigantic global stock market rally,
driven (as we learned later), mostly by short-covering.
We wondered whether her own philosophic training was crucial. Raised in the
most Marxist of the Eastern European Soviet dictatorships, she would have
been taught Hegel's "great waltz" dialectic, which had been incorporated
by Marx and Lenin into Communist dogma. If so, she might have taken
the euro regime and rules as the Thesis, the Greek rebellion against it as the
Antithesis, and sought to achieve a Synthesis with the 50% haircut on the
value of Greece's outstanding bonds as the price of a new, durable euro.
November 2011 13
18. It's the Economy Banks, Stupid!
Crucial to this synthesis was—and is—a rule that a Hegelian might admire:
a decree that slashing the value of Greece's bonds shall not be deemed a
"credit event" that would automatically trigger the many billions in credit
default swaps (CDS). Since these instruments were never part of the design
If a 50% slash in of the euro or euro bond markets, they must not be allowed to dictate the
principal value is not a terms of any new synthesis.
credit event—what is?
This bold concept has doubtless been a shock to holders of CDS—Greek and
otherwise. If a 50% slash in principal value is not a credit event—what is?
This ruling creates big winners and big losers. That apparently leaves it to
investors to try to find out which banks were big writers of Greek CDS and
which banks were big buyers.
KBW European Large-Cap Banking Index (KEBI)
January 1, 2005 to November 17, 2011
90
80
70
60
50
40
30
20 18.46
10
Jan-05 Nov-05 Sep-06 Jul-07 May-08 Mar-09 Jan-10 Nov-10 Sep-11
The KEBI chart of the large European banks shows that they broke through
their 200-day moving average on the downside for good in January 2008 and
have failed to rally back close to it since the crash. They are down 76% from
their 2007 highs, outdistancing the BKX, which is down by two-thirds.
Some investors tell us that the US banks are considerably stronger than their
European counterparts. Based on the record of Dexia and earlier collapses
of European banks within weeks of passing stress tests, that argument has
appeal.
14 November 2011 THE COXE STRATEGY JOURNAL
19. European banks collectively have four times the assets of their American
counterparts—but, malheureusement, do not have four times their tangible
net equity. That huge trans-Atlantic asset variation comes from the difference
in savings habits of the two continents. American savings rates were near-
zero in the years pre-crash, while Europeans have had relatively stronger Wall Street, where the
savings rates. Also, Europeans are far more inclined to save through banks physics PhDs (turned
than Americans. That helps to explain why Europe—notably Germany—is financial alchemists)
so overbanked compared to the US. converted leadpipe
losers into gold.
That disparity worked out disastrously for European banks during the
force-fed US housing bubble. The past decade was the first time the American
economy experienced the full effect of collapse in US fertility rates. As fertility
rates fell from approximately 2 babies per female during the Seventies and
Eighties to 1.4 or less, the result was that the number of first-time jobholders
and homebuyers was drastically reduced during the "noughts." Europe
experienced the same demographic collapse, but its governments did not,
like Washington, introduce stringent rules for banks that forced banks to
make loans to minorities somewhat commensurate with the volume of
loans they were making to whites. Barney Frank was the leader in Congress
in demanding strict enforcement of these rules.
Regional banks which plunged into the origination of dubious loans found
that Wall Street and Washington were eager to take them off the banks' hands.
Through complex derivatives, the Street achieved the miracle of AAA ratings
even when significant portions of the loans in the product were to borrowers
who—if they actually existed and were not in jail, (requirements which were
not always enforced during the manic years)—were unlikely to be able to
service the debts when the music stopped, as the dancing man, Citigroup’s
Chuck Prince, so memorably framed it. Angelo Mozilo of Countrywide
Financial, and a long list of brand-new upstart lenders eagerly arranged the
deals and sent them to Wall Street, where the physics PhDs (turned financial
alchemists) converted leadpipe losers into gold.
To an astounding degree, they peddled them to European banks. When the
housing bubble burst, the fallout was a TransAtlantic disaster.
November 2011 15
20. It's the Economy Banks, Stupid!
As Michael Lewis records in Vanity Fair, German bankers bought the CDOs
because they were AAA-rated, and "we thought America was a rules-based
society." (Germany is, of course, the quintessential rules-based society.)
Wall Street was, in a way, a rules-based society. As Nassim Taleb explained
...the term "legacy (when we shared a platform in 2007), the Street was relying on terribly
assets" to describe unrealistic risk models, managed by arrogant fools who knew physics and
rotting remnants of the mathematics but almost nothing about finance. This would lead, he said, to
past binge based on a crash that might recall 1929. He was exulting because a journal devoted to
investment models... statistics (The American Statistician, August 2007) had just devoted an entire
is of a piece with such issue to attacking him and defending the models.
Victorian euphemisms
The Basel version of the Capital Asset Pricing Model decreed that AAA-rated
as "nightsoil" for the
mortgage derivatives required no allocations of the [scarce] capital of
contents of bedpans.
European banks. Result: before the eurobanks began to lose on sovereign
PIIGS debt, they were already ailing from the effects of overexposure to
putrid products backed by American real estate.
According to The Wall Street Journal, "Sixteen top European banks are holding
a total of about €386 billion ($532 billion) of potentially suspect credit
market and real estate assets.....more than the €339 billion of Greek, Irish,
Italian, Portuguese and Spanish government debt that those same banks were
holding at the end of last year....European banks, on average, have roughly
halved their stockpiles of legacy assets since 2007...meanwhile the top three
US banks, Bank of America, Citigroup and JPMorgan Chase have slashed
such assets by well over 80% over a similar period."
We had not previously heard the term "legacy assets" to describe rotting
remnants of the past binge based on investment models. It is of a piece
with such Victorian euphemisms as "nightsoil" for the contents of bedpans.
The Victorians lacked complex mathematical models, and they made no
bets on bedpans. Today's badly-performing banks lack bedpans, but they're
swimming in perfumed portfolios excreted by mathematical models. This is
called progress.
16 November 2011 THE COXE STRATEGY JOURNAL
21. One possible benefit of the "legacies" of the misplaced enthusiasms of
European banks for American subprime paper could be that the European
Central Bank—now under the leadership of Mario Draghi—will be swift
to continue cutting the competitively skyhigh rates imposed by previous
management under Jean-Claude Trichet. [M. Trichet] was an
inflation-fighting central
M. Trichet may have been the world's most obdurate inflation fighter. The
banker who put his
ECB, unlike the Fed and many other central banks—has only one mandate—
American counterparts
fighting inflation. With rising commodity prices driving up costs of food
to shame.
and fuels, M. Trichet drove ECB rates to levels infinitely higher than Ben
Bernanke's zero-level prices. (Dr. Bernanke is seemingly pleased to be giving
his money away free: he is promising to continue this largesse at least until
2014. That will mean six years of free money. Who can tell the long-term
effect of consuming financial heroin on such a scale?)
M. Trichet actually raised his rate twice this year at a time eurozone economies
were visibly sagging. He pronounced that his record as an inflation fighter
was better than the Bundesbank's. He proudly characterized his performance
as "Impeccable! Impeccable!"
We agree. He was an inflation-fighting central banker who put his American
counterparts to shame. The euro's rise in value on his watch accurately reflects
his impeccable inflation credentials. He managed to make a global store of
value out of a dubious theory.
His enthusiastic self-appraisal was his swan song, as M. Draghi was already
in the waiting room. He dropped the Trichet rate 25 bp his first day on the
job.
As grim as the outlook for peripheral bonds may be, contagion is spreading
across eurozone non-German bonds since the decision to reject the payouts
under Greek CDS was announced. According to Gillian Tett of the Financial
Times, American banks may have issued a half-trillion dollars’ worth of such
paper. What investors in eurobonds now face is the prospect of problems
across the zone. As more and more economies face recession, this process is
elevating their debt costs.
When will the Germans face the fact that they can’t remain obdurate when
all their supposedly strong partners are facing financing problems?
November 2011 17
22. It's the Economy Banks, Stupid!
American Banks
With the exception of Wall Street, American banks seem to have made some
financial progress since 2008.
So why do bank stocks Their stock prices have underperformed the S&P but have recently been
look bleak? outperforming the big banks represented in the BKX.
The S&P—which includes bank stocks—is up roughly 25% in that time.
KBW US Bank Index (BKX) vs. KBW US Regional Banking Index ETF (KRE)
January 1, 2011 to November 17, 2011
10
0
-10
-13.14
-20
-30 -28.59
-40
Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11 Oct-11 Nov-11
KBW US Regional Banking Index ETF (KRE) KBW US Bank Index (BKX)
So why do bank stocks look bleak?
The answer, of course, is that they couldn't lay off all their suspect real estate
loan exposure on Wall Street, Fannie Mae, Freddie Mac, or the Federal Home
Loan Bank, (although the taxpayers are down $170 billion and counting on
Fan and Fred). It will be recalled that when the Bush Administration finally
became concerned about F&F in 2007, and tried to rein them in, Barney Frank
led a successful Congressional campaign to protect them from interference
by the Fed or the Comptroller.
Collectively, the regional banks had large exposure to Fannie and Freddie
preferred shares. They loved those tax-exempt dividends.
Until there were no dividends...although Fannie and Freddie continue to pay
their bosses big bonuses.
Depending on the location of the regional banks, their biggest problem is
commercial real estate. They may not have any complex real estate derivatives
on their books, but they are saddled with piles of debt on vacant stores and
shuttered warehouses, and large exposure to municipal bonds of varying
quality.
18 November 2011 THE COXE STRATEGY JOURNAL
23. That is one reason why we have been so concerned about the sickly KRE.
With the Wall Street banks, we know that most of their problems come from
derivatives they can't sell and egos they can’t control. Result: so much of Wall
Street debt trades at a discount, and their shares sell at discounts to net asset
value. With the Wall Street
banks, we know
An unwary investor who saw that a bank's shares and debts were selling at a
that most of their
sizable discount to stated net asset value might assume that the bank's bosses
problems come from
wouldn't be getting bonuses.
derivatives they can't
In capitalist theory, executive pay is for value-creating performance of a kind sell and egos they
that drives share prices to large premiums over book value—and makes their can’t control.
outstanding debts rise in value at a time of zero interest rates from Gentle
Ben Bernanke.
The bosses of those B5 banks, who are long on greed and short on shame,
dodge capitalist principles they find inconvenient for setting their own
compensation. They assume that, when their debts trade at discounts, that
reduces their debts and therefore generates earnings, which beget bonuses.
Nearly one-half of some of the big banks' recently-reported earnings came from
the declining market value of their debt. Not the repayment of debt, mind
you—merely the bid price of their paper.
The regional banks' bosses don't get those Wall Street benefits, because so
little of their debt trades actively. Their bosses are old-fashioned enough to
believe that they'd like to see their debt trade at a premium to par value.
The problem is that until more of those vacant shopping centers and homes
find lessees or buyers, the regionals will be struggling. The regionals are
also worried about their exposure to debt from subprime state and local
governments—like Illinois, California and Harrisburg.
One bright spot for some local banks: among the best-run of the regionals
are banks that have maintained high exposure to Treasurys. Since Treasurys
have been a superb investment this year, some of these banks must have
benefited greatly—providing that they didn't confine themselves to the front
end of the curve.
We'll stick to our long-stated view that the KRE will give the signal that the
economy is really on its way back when it solidly outperforms both the S&P and
the BKX at a time of rallying equity prices.
At the moment, the KRE is treading water—and winter is coming.
November 2011 19
24. It's the Economy Banks, Stupid!
What Happens to Investment Risk Perceptions
With Italy Joining Greece in the Calculations?
We believe investors should make the following assumptions:
Somehow, this must
stop. 1. The fight to keep Greece within the eurozone has been so intense because the
prospect of a sudden Grecian exit would unleash chaos across the zone.
Stein’s Law says that
it will. Greek individuals and companies would rush to withdraw funds from
Greek banks, and bank lending would come to a standstill. (Already,
there is evidence that some Greeks are frightened: bank deposits are down
roughly 25% since December 2009.)
Outside Greece, banks and companies having Greek counterparties would
be frantically trying to rearrange agreements, and Greece would fall into
a Depression.
The prospect of such an implosion spreading to Italy would be an
existential challenge to the eurozone. Italian bond yields—already at levels
unsustainable over the longer term—would skyrocket, and banks inside
and outside the zone would default.
2. Although Berlusconi is no longer Premier, his party has the most seats
in Parliament. Investors should not assume that a new coalition after a
future election would have the kind of stability that occurs in Northern
Europe after a government loses an election.
3. Spanish bond yields will probably continue to climb after this month's
election, putting that nation into deeper recession.
4. Investors assume that Ireland and Portugal have been stabilized, but
when banks across Europe are pulling in lines of credit in response to a
collapse in Greece and a potential collapse in Italy, all lesser-grade credits
will suffer.
Since Greece first went on investors' radar there have been dozens of days
in which global stocks have plunged because of a threatened Greek default,
followed by brief rallies because of a new rescue package, followed by more
riots and yet another bailout proposal, followed by another selloff because
of a crisis in another country.
It is unacceptable that global stock markets are being held hostage to the
follies and fake financials of a few underachieving, overindebted economies
in a zone with an overvalued currency and over-stringent monetary policies.
Somehow, this must stop.
Stein’s Law says that it will.
20 November 2011 THE COXE STRATEGY JOURNAL
25. The Implications for Gold
To date, the major asset class which has benefited most from the PIIGS
dramas is gold.
When the possibility of a Greek default first came under serious discussion in This is beginning to
May 2010, gold was trading in the $1100 range, and the S&P was in the 1166 look like Gold Bug
range. Ten-Year Treasury yields were roughly 3.8%. Remarkably, the euro was Nirvana...
roughly 1.35 in dollar terms—where it is today. The KEBI Index was roughly
35: it is now 19.5.
We have been arguing for more than a year that the existential challenge to
the euro from the plight of the PIIGS is the primary driver of gold prices.
Europeans who find that their bank deposits, paychecks, life insurance and
pensions are all euro-denominated have been buying some protection in
the form of gold. Other investors, contemplating the possible implosion of
the currency of the world's second-largest trading zone have been making
similar moves. The growing problems in the zone have been shrinking
global economic activity and central banks other than the ECB are—as of
now—virtually unanimous in lowering rates to minuscule levels to avert
recessions...and to depreciate their currencies.
For the first time since the abandonment of the gold standard, central banks
are overwhelmingly dedicated to weakening the exchange rates of their
currencies. When faith in the “printed paper promises of politicians" flags,
gold offers an incorruptible store of value. This is beginning to look like Gold
Bug Nirvana—where panicky people protect their wealth by selling paper to
buy gold. (Maybe the bankers are ahead of the pack: central banks bought
148 tonnes of gold in the third quarter.)
Ben Bernanke has said zero interest rates will remain until at least 2014.
That means the financial heroin will continue to flow, which means
continuation—and exacerbation—of negative real interest rates as far as
most eyes can see.
What the US and Europe seem to be experiencing is a modified stagflation,
in which food and fuel prices stay stubbornly high, and interest rates remain
at losing levels for investors.
Gold is the only historic medium of exchange whose value has been rising
for nearly 11 straight years.
The forces driving it upward are accelerating.
Conclusion: Once gold breaks through its August peak of 1920, it will challenge
the magic millennium level of 2000—and will eventually pierce it.
November 2011 21
26. It's the Economy Banks, Stupid!
US Energy Policies: Political Risk for Oil Investing Rises
1. The Politics of Keystone XL
[President Obama] is For coolly-calculated political reasons, President Obama has kicked the
back to doing what Keystone XL oil can down the road.
he enjoys most and
We had thought that would be his likeliest response, and raised the political
does better than
risk issue in Basic Points and our Conference Calls—(albeit merely as a
anyone—campaigning.
significant possibility investors should consider). He cited environmental
concerns about aquifers, but those were never the gut issue on Keystone,
and were already being fully addressed by TransCanada (TRP) in response to
a long list of State Department requirements. Even the Nebraska Governor
who led the opposition agreed that some relatively modest tweaks would
meet his state’s concerns, and joined all the state governors on the pipeline
route in praising the opportunities, jobs and progress the line would deliver.
TransCanada swiftly agreed to those changes—but Obama held firm.
He is back to doing what he enjoys most and does better than
anyone—campaigning.
The pipeline was a big, obvious victim of calculations in Presidential politics
made by the most muscular environmental NGOs and the White House.
The wealthiest NGOs had made it their signature issue. They were candid
that they needed “a big win” to revive their coalitions and supporters, such
as Hollywood's leading experts on environmental science issues, who flew to
Washington to protect the environment by spending a night in jail protesting
"dirty oil."
From the NGOs' standpoint, after polls showed that only a small minority of
the population believed in man-made global warming as a relevant political
issue, something big and preferably foreign was needed.
Although most of the actual debate and analysis on the issue—and the State
Department's exhaustive review—were about the pipeline itself, the NGOs
made it clear they want to kill Keystone to stop the oil sands operations. They've
been horrified about the Canadian publicity that the oil sands are "the new
Saudi Arabia." This is their chance to ensure that there's no North American
Saudi Arabia.
22 November 2011 THE COXE STRATEGY JOURNAL
27. Weeks ago, we watched an interview on public television's "News Hour,"
featuring some celebrity (whose name escapes us) who had demonstrated in
Washington and had spent a night in jail. He never mentioned the Nebraskan
environmental questions. He said that blocking the pipeline was the only way
to stop oil sands expansion and perhaps even force shutdowns. When told Truth is the first victim
that the Alberta government said that Canada could just divert the output in such scorched-earth
to the Pacific Coast to ship to China, he said that their information was that campaigns waged by
indigenous people would kill any such proposal. (We are inclined to agree wealthy enthusiasts who
with him in that appraisal.) travel in jet planes and
automobiles to kill
The opposition to Alberta went global when the European Union issued a
oil exploration.
policy statement that European refiners were not to use fuel from "dirty oil
production"—which is a term used by the Banana (Build Absolutely Nothing
Anywhere Near Anything) school of enviro-enthusiasm.
Mr. Obama is not such an extremist—at least not outside North America. On
his trip to Brazil he renewed US financial support for that nation's ambitious
program of developing offshore oil, at a time exploration in the Gulf of
Mexico was largely shut down. (The US, through government-guaranteed
loans, is participating in a big way in developing those fields.)
Until recently, the main NGO fund-raising campaigns focused on blocking
oil projects in Alaska, and drilling on any US coast. The litmus test for fighting
a vile energy project is that it has the potential for raising many millions of
dollars for tax-exempt organizations with strong records in using litigation
to tie up energy (and mining) developments. The Alberta oil sands became
their Hate #1 because they not only produce oil, but, until recently, most
of it came from mining. (Steam-Assisted Gravity Drilling, which leaves a
footprint smaller than a football field, is a more recent development, but
it gets lumped in with the open pits that supposedly despoil boreal forests
and kill birds. That a typical wind farm kills many more birds and bats in
a year than all the oil sands projects have accomplished throughout their
history is, of course, irrelevant. Truth is the first victim in such scorched-
earth campaigns waged by wealthy enthusiasts who travel in jet planes and
automobiles to kill oil exploration.)
When TransCanada agreed to all the State Department requirements for
permitting, its management thought their long approval campaign was
over. The State Department had the authority to draft the rules, with EPA
assistance, and that was that.
November 2011 23
28. It's the Economy Banks, Stupid!
But, very late in the game, well after the time Canadian authorities and the
US oil industry were convinced Keystone was a "Go," Obama announced
he was intervening and would make the final decision. By postponing the
decision until after the elections, he has virtually guaranteed his campaign
American drivers will huge support from the major left-wing and environmental funding sources,
be paying more for because they now know that if he loses next year, the decision on Keystone
their gasoline... will be made by a Republican—and Republicans are overwhelmingly in
favor.
Speaker John Boehner spoke last week of its many thousands of high-pay
immediate "shovel-ready" construction and maintenance jobs that won't
cost US taxpayers a dime. (Obama spent hundreds of billions allegedly for
"shovel-ready" jobs, but it turned out only a minuscule amount went for
such jobs. Most went for unionized bureaucrats and teachers employed by
state and local governments. As Rick Perry scoffed, "My dog has created more
shovel-ready jobs than Obama." He may have been on target, but, as has
been his experience in his ill-starred campaign, he didn't score any points,
because the quip wasn't original.)
One Canadian company—Enbridge—seems to have made the correct
calculations about Obama's plans. Within days after the Obama rejection,
it, with backing from the Caisse de Depot, it bought a pipeline from
ConocoPhillips and plans to switch the direction of its flow northward from
the Gulf to Cushing. That means the huge discount on WTI to Brent must
narrow—and it did narrow on Wednesday. American drivers will be paying
more for their gasoline, but that doesn't offend the NGOs, who want high
gas prices to supply a pricing umbrella for their various green strategies.
As of now, Obama stands likely to win re-election. He says he's raising a
billion dollars in campaign funds and no one seems to doubt he'll do it, even
though his campaign oratory is loaded with attacks on "the rich," and his
overwhelming support in mainstream media means he doesn't really need
that kind of money. The Republicans will not be running an opponent with
his Teleprompter talents, charisma, or charm—or heartwarming personal
biography…
And he will not be facing a Reagan.
24 November 2011 THE COXE STRATEGY JOURNAL
29. It looks as if the oil industry is making its plans on the assumption that
Keystone will not proceed. Big Obama backer Warren Buffett's railroad stands
to win big, because the huge growth in Dakotas oil production will have to
go by train if Keystone isn't approved.
Keystone is in mortal
The odds, as of now, are that Keystone is in mortal peril. The death certificate
peril. The death
is due November 2012.
certificate is due
It takes a re-elected Democrat to sign it. November 2012.
It takes a re-elected
2. Shale Gas and Oil Democrat to sign it.
The other relatively new campaign against production of fossil fuels is the
opposition to shale gas and oil produced through fracking.
To date, this has been a regional struggle. Most states are thrilled with the
money pouring into local economies—not to mention the soaring royalty
payments. To date, hundreds of thousands of high-paying jobs have been
created. Example: the Dakotas' economies are booming as never before, and
most residents cannot believe their good fortune. As Dennis Gartman reports,
North Dakota now produces more oil than an OPEC member, Ecuador—and
production is headed much higher—if environmentalists don't stop it.
In communities with colleges, and other centers of employment for leftist
enthusiasts—such as upstate New York—opposition to fracking has been
fierce—and successful. The opponents allege pollution of aquifers and cite
numerous examples of headaches ascribed to air pollution.
Until very recently, the prevailing viewpoint of big-picture thinkers without
ties to litigating NGOs or oil and gas companies was that the US benefits
hugely from the cheapest natural gas in the industrial world, and the
prospect of cheap gas prices for perhaps a century is one reason to be bullish
on America.
November 2011 25
30. It's the Economy Banks, Stupid!
The environmentalists who oppose all fossil fuels (as opposed to people
who oppose polluting coal plants) were becoming desperate.
Then a potentially seismic shift in public opinion suddenly emerged: some
recent small earthquakes in the Midwest just may have been caused by
...man-made quakes
fracking. At least one seismologist has publicly argued that earthquakes in
in low-or-no-risk
low-risk earthquake areas were probably caused by fracking.
zones are a new
concept. These are early days for this brand-new debate, but investors should not
dismiss the possibility that gas producers could be faced with gigantic liability
lawsuits brought by deep-pocketed NGOs should a quake cause meaningful
damage.
Seismology is still evolving. Scientists have learned to develop probability
forecasts for big quakes in earthquake-prone zones such as the San Andreas
Fault.
But man-made quakes in low-or-no-risk zones are a new concept. Lawsuits
alleging them would probably, until now, be considered as fanciful as
alleging that tribal gods had been angered. (We recall—with awe—how
leading liberals renowned for killing conventional energy projects elsewhere
and supporting Green projects across the nation managed to kill a wind farm
off Cape Cod by having a section of the ocean declared as religiously sacred
for aborigines. This land is their land—even when under the sea.)
One hopeful sign: the influential Natural Resources Defense Council asserts
that fracking has, in fact, caused two small quakes. However, it goes on
to outline safety procedures—such as avoiding fracking along major fault
zones—that should minimize fracquake risks. In other words, the industry
should be able to progress as long as it follows stringent rules.
So—just maybe—the shale gas industry can confine most of its worrying to
gas prices.
26 November 2011 THE COXE STRATEGY JOURNAL
31. It's the Economy Banks, Stupid!
THE INVESTMENT ENVIRONMENT
1. How the Capital Markets Could Eventually Reach A Happy Ending
...Greece has gone
Euro vs. US Dollar
from being renowned
January 1, 1999 to November 17, 2011 for its ruins to being
1.7
renowned for the
1.6 ruin it inflicts on
1.5 the eurozone's
1.4 economy...
1.35
1.3
1.2
1.1
1.0
0.9
0.8
Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11
How much longer must global investors start their days by checking whether
their stock markets will be up or down based on the latest news in Greece
and/or Italy?
Would anyone have predicted 15 months ago that Greek politics, promises
and riots would have more sustained impact on stock prices in North America
than US GDP changes, US payroll employment data and changes in earnings
forecasts? Greece hasn't been truly important since the death of Alexander
the Great, (although its revolt against Turkish rule did lead to Lord Byron's
death from fever).
In the past year, Greece has gone from being renowned for its ruins to being
renowned for the ruin it inflicts on the eurozone's economy and on share
prices of European—and even some major American—bank stocks.
Greek disease spread swiftly across the Aegean, and Italy now reels, with
fallout as far as Spain. If Italy fails, then there is no hope of saving the euro
or averting a deep recession. Thanks to the Basel capital asset pricing rules,
banks across Europe not only have Greek exposure but big bets on Italy.
(According to Reuters, as of June, French banks held $416.4 billion worth of
Italian bonds.)
November 2011 27
32. It's the Economy Banks, Stupid!
When the euro was forged, the Bundesbank did its best to ensure that, even
if governments broke the rules, monetary policies would be noninflationary.
Jean-Claude Trichet has consciously imitated Karl-Otto Pöhl, Axel Weber,
and other revered Bundesbankers.
...during a full year in
Meanwhile, across the rest of the world, as we have discussed, central bankers
which most of the news
and their governments are doing their best to drive down the value of their
from the eurozone has
currencies. When the Swiss National Bank was transformed from being a
been of crises...
model of prudence to looking like a Weimar banker in drag, it was clear that
the Euro's exchange
global inflation threats would rise—eventually.
rate against the dollar
is unchanged. But the European Central Bank stuck to its Bundesbanque idée fixe of fighting
inflation through a strong currency that has, by dint of sound monetary
policies, inherited the global respect long accorded to the Deutschemark.
Result: during a full year in which most of the news from the eurozone has
been of crises, interrupted by crisis meetings, followed by new crises, and new
crisis meetings, the Euro's exchange rate against the dollar is unchanged.
This is probably the most arresting economic statistic of the year.
But the euro formidable in a world where nearly every other central bank and
government craves weakness for its currency has long since become a major
source of weakness for eurozone economies:
The strong Northern economies find their global competitiveness challenged
by the strength of their currencies.
The weak southern economies wasted the major benefits to them of the
euro—low interest rates and seemingly unquenchable demand for their
bonds. They became uncompetitive with Northern economies—notably
Germany, which had sacrificed for 15 years to rebuild East Germany; during
that long period, German unions accepted pay increases that were laughably
low compared to wage gains for workers and civil servants in the South (and
Ireland) , and to tight deficit controls that were brutally restrictive compared
to the loose fiscal policies practiced by most of the PIIGS.
The peripherals ignored their declining competitiveness in markets outside
the eurozone as the euro gained strength in a currency world of weaklings.
They were thus hit with a double whammy: they lost competitiveness almost
everywhere, and now slide into recessions that inflate their deficits at a time the
adamant euroelites demand they cut their deficits—or else. Their economies
contract because of the sickening declines in their competitiveness, and the
contractionary policies hammering their feeble societies.
28 November 2011 THE COXE STRATEGY JOURNAL
33. The Bundesbank mentality served the Northern economies well for the
decades in which most global economies were usually concerned that their
currencies were strong—or at least stable.
But this new era when strong currencies are despised by their own central
It's time for the
banks is unforgiving for the only large economy that practices the old-time
eurozone to start
currency religion.
pumping out its
This week's disorderly eurobond markets have triggered an open flap between own brand of
the two Euroguardian nations about the ECB's responsibility for stabilizing Bernanke heroin...
bond prices. Each time Italian and Spanish bond yields soar, the ECB steps
in, but only to prevent chaos. France argues that the ECB should do far more
than Germany says is legal under EU rules.
The Germans and Jean-Claude Trichet have been pleased that the anti-
inflationary policies of the ECB have worked for 11 years, delivering lower
inflation and a far higher market price for the currency than the dollar.
But inflation isn't the issue now.
It's survival.
Therefore:
The euro must be devalued. The target should be its value as of its inception for
accounting on 1/1/99—$1.16—although the ECB should allow for downsize
overshoot.
The process of devaluing it will involve massive liquidity expansion within
the eurozone, thereby reliquifying the parched banking system and restoring
lending activity across the eurozone.
It's time for the eurozone to start pumping out its own brand of Bernanke
heroin—until the euro reaches a globally competitive range and the European
banks have rebuilt themselves to at least the minimal-to-modest strength of
their American counterparts
When eurobanks no longer have to pay infinitely higher rates on short-term
deposits than American banks, they will be better able to handle the problems
of (1) putrefying American CDOs purchased when the euro was trading far
above par on the dollar, and (2) depreciating PIIGS bonds lending their own
peculiar odors to their balance sheets.
November 2011 29
34. It's the Economy Banks, Stupid!
But how can such reliquification and monetary depreciation be sold to the
Germans? They know of two disastrous policy regimes—hyperinflation and
Hitler. They believe that one begot the other. Never again!
Sarkozy talks of a new Franco-German domain within the eurozone, and
James Carville,
Finland now argues that the six members with AAA ratings should have a
where art thou now?
greater measure of control: (Slovakia shouldn't have a veto.)
The Germans still act publicly as if there can be no retreat from the sound
money policies that have prevailed under Duisenberg and Trichet.
But Angela Merkel is a realist and she is the new uncrowned queen Angela of
the eurozone. She can expect powerful support from German manufacturers
who fear losing their competitiveness in peripheral economies that abandon
the euro—and are losing competitiveness globally because of the levitating
euro. As one German auto manufacturing CEO told a friend of ours, " If the
euro comes apart in a crash, then we'd be left with a mark whose value was
up 40% over the peripherals and we couldn't sell in the South or in most of
the world!"
She can also point out that inflation in major non-euro economies with weak
currencies is roughly at—or even less than—eurozone levels. There's room
for currency depreciation and bank reliquification.
She has shown herself open to discussions of a new core decisionmaking
structure for the euro. With French yields soaring far above bunds, the
partnership that is crucial for euro-survival risks destruction by the new bond
vigilantes. (James Carville, where art thou now?)
We suspect that what could bring Merkel and the German political leaders to
accept (temporary) Bernankization of the ECB is the rapid deterioration of
finances for the European banking system. This is, in reality, the core issue that
is destabilizing global capital markets.
If the European Central Bank, backed by the full eurozone membership,
reflated money supplies and drove short-term rates to America levels, there
would be strong rallies among the beaten-down bank stocks, giving them
the opportunity to raise new infusions of equity—a process of financial
strengthening that would feed on itself as global investors stopped worrying
about an epidemic of Dexia-itis and looked at the rising values of banks' net
equity.
30 November 2011 THE COXE STRATEGY JOURNAL
35. It is not too Panglossian to expect that the financial crisis of the eurozone
would gradually migrate from Page One of newspapers within Europe—and
across the world.
If—or when—that happened, share prices of major US banks would also
Monetary virtue works
stop falling and start rising.
well in theory, but how
If—or when—that happened, a new global equity bull market would be does it work in practice
born. when nobody seems to
prize it anymore?
But even before that overall rally was returning smiles to Wall Street and the
world, that other bull market that never really went away would be exciting
investors...
2. Gold Moves From the Sidelines to Center Stage
As the only medium of exchange that cannot be synthesized or devalued
by high-speed central bank printing presses, gold wins from eurodespair or
eurodevaluation.
If the ECB—the last holdout against financial heroin—joins the lotus-eating
majority of central bankers, gold would enter a spectacular bull market once
it became apparent that the euroelites had decided to save their banks and
their economies by rejoining the world. Monetary virtue works well in theory,
but how does it work in practice when nobody seems to prize it anymore?
We have been advocating the reintroduction of gold into the world monetary
system by using it to back long-duration bonds of profligate nations such
as Italy and the USA. That still could happen, but we've had no takers.
Keynesian orthodoxy lives among intellectual elites, even as they lose faith
in the Old-Time Religion.
But the failure to rebrand gold as the backing for long-duration inflation-
hedged bonds doesn't mean gold has no future.
If investors in other assets sense that the last holdout against monetary excess
has decided that virtue is punishing all members of its currency zone, they
will rush into gold as the last refuge in a universe of Paper Moonshine.
November 2011 31
36. It's the Economy Banks, Stupid!
For those who wish to protect their wealth against monetary excesses on a
global scale, there are several options:
Gold Bullion or ETFs
Gold Royalty and Streaming companies
Large-Cap Gold Miners
Medium- and Small-Cap Gold Miners, and Exploration Companies
Gold Bullion or ETFs
We believe gold bullion—in specie or ETF—should be a cornerstone of
almost any long-term portfolio.
It meets the KISS principle of simplicity, and is devoid of the execution and
other risks that beset the mining stocks. It provides liquidity, security and a
foundation for performance, based on current and near-term prices for the
metal.
We disagree with those who say you can’t trust the ETFs because governments
could block access to the bullion. The major bullion ETFs track spot gold
prices.
Dennis Gartman is the most articulate exponent of the view that investors
should only buy the GLD or other bullion equivalents—not gold miners. He
notes that the profitability of mining gold has failed to keep pace with the
rise in bullion, and the mines have great political risks.
Rather than avoiding all miners, we recommend that investors seek the
opportunities offered by mining companies with the right characteristics:
great assets, good management, operating in politically-secure areas of the
world.
Gold bullion, and the royalty and streaming companies, perform well when
investors are filled with fear, and seek the safety of "the asset that is nobody’s
liability."
The ETF has been the sweet spot in this year's strong gold rally.
32 November 2011 THE COXE STRATEGY JOURNAL
37. Gold Royalty and Streaming Companies
These companies have unique business models that allow them to minimize
risk and maximize upside reward from rising metal prices:
Because their earnings come from dozens of mines, they provide a ...gold miners (and
diversified portfolio of known revenue streams. royalty companies)
provide a levered play
They have fixed costs—they don't have to provide more money as capital on gold price increases.
costs for opening and extending mines increase.
Despite having huge and growing revenues, they have staff counts and
overheads that are normally found only in companies too small to apply
for stock exchange listings. The auto dealer from whom we purchased our
family car has roughly as many employees as one of these companies.
They are core investments for almost any investor who wants to participate
in the future of gold.
Large-Cap Gold Miners
All long-term gold investors should have some exposure to the major mining
companies.
Our core investment thesis is: “invest in companies with unhedged reserves in the
ground in politically-secure areas of the world”.
Furthermore, gold miners (and royalty companies) provide a levered play on
gold price increases.
The relative value of unhedged reserves compared with the investment value
of holding spot gold is changing as strong gold prices improve both the
profitability of existing production and the volume of economic reserves.
As the price of gold goes up, not only does the value of currently recorded
reserves rise with it, but the total reserves economic for mining increase.
Investors in well-managed large-cap gold mines have been greatly
disappointed at their stocks' recent price performance.
Why? Because the investor consensus on gold, which shifts from fear of
inflation to fear of a deflationary crash, is in one of its confused periods. That
means speculative enthusiasm for the miners and exploration companies is
at a relatively low ebb.
November 2011 33
38. It's the Economy Banks, Stupid!
The North American and Australian-based majors are all serious companies,
with strong management teams, and most boast splendid properties and
long-life reserves in politically-secure regions. (We note, however, that, while
gold reserves are increasing, so are political risks. Investors must be wary
...while gold reserves about deterioration in some formerly favorable nations.)
are increasing, so
We believe investors have soured on the large caps stocks unduly and expect
are political risks.
them to benefit when gold shows signs of a new upside breakout.
Investors must
be wary about
deterioration in some Medium- and Small-Cap Gold Miners, and Exploration Companies
formerly favorable When gold was surging toward $1,900 the bullion and the exploration
nations. companies were outperforming the established miners—the bookends of
enthusiasm.
When retail investors regain the confidence to take bets on the exploration
companies' ability to find orebodies that are strong candidates for acquisition
by the major miners, this group can deliver sensational returns.
We strongly recommend exposure to those smaller companies that have
proven management teams, proven reserves in politically-secure areas of the
world, and properties with potential for major additions to reserves within
the next four years.
We are old enough to remember the days of $35 gold when mines were
unprofitable unless the ore grade was near one ounce per ton. These days,
even mines with grades near one gram per ton can be very profitable—if
the resources are large enough, the local communities and governments
are greatly supportive, and the management is adept, realistic, long-term-
oriented—and gutsy.
Silver and Other Precious Metals
We have always recommended some exposure to silver. We believe silver will
be pulled skyward with gold, but do not recommend that investors maintain
large silver or platinum exposure at the expense of gold.
Gold is the clear-cut choice—and the metal that offers the greatest chance for
reintegration into global monetary programs.
34 November 2011 THE COXE STRATEGY JOURNAL
39. 3. The Bullet-Proof Dividend Stocks
Since we began recommending these stocks as a discrete asset class, we have
been receiving a growing number of inquiries about our selection and
management criteria. ...we began
We plan to make this concept and the implications for pension funds of recommending these
holding exposure in such securities within what is ordinarily classified as the stocks as a discrete
Fixed Income section of their portfolios, the core of our January issue. asset class...
In the meantime, we notice such developments as Warren Buffett's purchase
of a 5.4% stake in IBM stock as evidence that something big is unfolding for
companies with strong finances, strong managements, and strong dividend
policies.
November 2011 35
