I was very fortunate to have had access to Don Coxe’s weekly podcasts while he was BMO’s Global Financial Strategist. His subscribers were high net-worth individuals, fund managers and financial advisors (none of which describe me.) This made Don the investment advisor to investment advisors. I may never again be privy to such exclusive commentary. The great financial General is giving his marching orders to his financial Lieutenants to rally the troops (and I’m merely the fly on the wall.)

            He has announced his retirement from BMO. I think this explains why his last half dozen discussions were so unusually positive. I suspect his retirement package was based on him going out on an upbeat note. This made if easy for me to take a few pot-shots at him recently rather than at the perennial optimist John Mauldin (shooting fish in a barrel.) 

            In his second last podcast, he said 2008 was the “Year of the Big Lie” in the world of finance as evidenced by the CDO’s, CDS’s, MBS’s, etc. We got along without these financial derivatives in a period of free trade growth of Ronald Reagan and Margaret Thatcher until a group of immoral and amoral men, in order to grow their own wealth, created the big lie that you could have triple “A” securities not based on cash flow. Instead it would be alleged asset based lending but then they drove up the value of the assets themselves by pumping out these products where the borrowers had inadequate cash flow or none at all. 

            My comments below are in Bold Italics. 

            Now, no economic or financial system can operate on a basis that cash flow is irrelevant. Prior to this, there were only 7 Triple “A” borrowers in the U.S. Trillions of dollars of Triple “A” assets based on “the lie” were created so it was only a matter of time before it all blew up. It would lead to the greatest financial crisis of our time and that only a few saw in advance. Not to toot my own horn but, I was warning about this since September of 2007 shortly after the stock market crash and credit freeze the previous July. But then, I’m seeing it with fresh eyes having only recently (2005) piled back into the stock markets after dabbling in stocks in the 1960’s & 70’s and commodities in the 1980’s. Because of this, I noticed the startling changes over the past 4 decades whereas to experienced pros like Don the changes are gradual and less evident so they see only what they are used to seeing. Also, I am the greatest of skeptics. I believe NOTHING.

Even Don said last October that, although we were in a financial bear market, he underestimated the sheer scale of the problem. He assumed there was underlying value when in fact, it was all financial fraud. That the year came to an end with the exposure of the Bernie Maddoff scandal is symbolic of the “Big Lie.” And, thus, Don discovers there’s no Santa Claus. In spite of the foregoing, Don is still not a skeptic.

            He believes (and that word “belief” has all my skeptical alarm bells ringing”) that we will NOT go into a Depression for the following reasons (get ready for some healthy doses of my skepticism.)

            – all the lies are exposed. How incredibly #@&%$*@!# naïve! We’ve only seen the tip of the iceberg. There’s lots more lies and scandals lying in wait.

            – Keynesian and Friedman’s programs are in place globally. I already covered this in December’s article. Think of a fart in a hurricane.

            – U.S. Fed and the European Central Bank have tripled their balance sheets. More farting in a hurricane. Their balance sheets aren’t big enough to contain $700 trillion in derivatives. 

            – 1972 – 74 was much worse. So far, but, the Depression has just begun. Give it another 3 years, then compare.  

            – Warren Buffet began buying. Warren buffet is losing a shit-load of money and that, too, has  just begun. 

            – Inflation was rapid then.  Give it another 2 years and you’ll see rapid  Today we have deflation. Yes, today. Wait 2 years.  Food and energy are cheap. For now. Give it another two years

            – Powerful public sector unions demanded wage increases. True. Today, unions aren’t as powerful (in North America anyway but France is a different case.) This means wage increases won’t keep up with price increases which means the end of the middle class in North America. 

            – BKX (bank index) in an uptrend. This month. I’ve been watching it swing up and down like a yo-yo which is how I’ve been making money trading SKF. 

           – VIX (fear index based on volatility) is retreating,  Until the Obama honeymoon is over.  

           – TED spread (perceived risk indicator) is lowering. It couldn’t have gotten much higher. Also same volatility as BKX previous.

            – Obama will provide better leadership.  True. So what? We need a lot more than leadership. ”He will be the savior, so it’s a useful myth.” Santa Clause, again!

            – EU is unified. Malarkey! The European Union southern flank is peeling off.

–       He also says we’ll continue getting bad news. No shit! 

–       Stocks will anticipate the upturn. They always do. The question is when? Don’t let a possible counter-rally for the next couple months fool you. That will end when the bad news overwhelms Obama’s honeymoon. 

–       Unemployment is small VS recession the 1970’s and 1982. 1) So far. 2) They’re fudging the numbers more now than they did back then. 3) Unemployment numbers, fudged though they be, are getting worse every month and no respite in sight. 

            He still thinks commodities will be the wave of the future. I hope so but the question is when and which commodities? Forget base metals (copper, lead, zinc, nickel, etc.) – we’re going into a depression and there’ll be less demand. Gold and silver will continue going up. Platinum and Palladium demand will lessen (catalytic converters) as fewer cars are built. Grains, I don’t know but continuing extreme weather may create shortages, increase demand, thus prices. Same for fertilizer like Potash but the severity of a Depression will lessen demand.   

          We need patience and hope. Yes. See, I’m not totally disagreeable. When the U.S. Treasury Bill bubble bursts it will divert money to the banks where it is badly needed. After all these bubbles bursting, will there be much money left? If there is, it’ll go to buy debt like corporate bonds and their high yield just in time to create another bursting bubble which will coincide with corporate bankruptcies for a double whammy.   

        As for hyper-inflation, he doesn’t see that far ahead and admits it will be very challenging for the U.S. Treasury to withdraw from the system in time to prevent hyper-inflation. “Very challenging” is an understatement. When have you ever known a government to anything on time? Get ready for hyper-inflation in a few years.   

            Gold will go to 4 digits and hard assets will outperform Yes, most likely but selectively. Hard assets (anything that’s not paper) is another way of saying commodities, Don’s mantra is commodities but you have to be careful and selective. I’ve commented on a few above. There’s be less demand for uranium as no one has the capital or financing for new nuclear  plants. Oil is low now and should trade between $50 – $60 barrel which means Alberta tar sands will struggle. Tangible assets like land and buildings will allow wealth to escape hyper-inflation but the trick is to wait until prices bottom out and just before hyper-inflation kicks in; a tricky balancing act. All in all, it will be like the ancient Chinese curse; “May you live in interesting times.”                

            In his last discussion before retiring, Don is more forthright since this was his swan song. I’ve transcribed this last podcast as best as I could further below. Although he still tried to sound positive he admitted there were a lot of conditions that had to be met and a large degree of hope in his analysis. His cheerleading may have rallied his Lieutenants and his analysis was good but his fairy tale conclusions didn’t impress this fly on the wall.

            He began with a discussion of Demographics, an issue I’ve raised in previous articles and his analysis is both fresh and startling. In the interests of accuracy, Demographics, as used by Don and myself, should more accurately be called Demography; the study of population dynamics but, I’m not going to split hairs. 

            Demographic decline among OECD (Western) countries as well as Russia and the Asian countries of South Korea, Japan and China is a fundamental factor that is still largely ignored. The over-arching reality of our time is that these countries have made a collective decision not to reproduce themselves as seen in their falling birth rates. Demographic reality is not going to improve. One of the worst performing stock indexes is the Japanese Nikkei. It is no coincidence that Japan also has the most drastic demographic decline. The year-end issue of the Economist magazine featured an article on Darwin and lots of analysis of how people make decisions. Yet, no mention was made about demographic decline because it is a sacred cow. Consider California with its rapidly growing Latino population and shrinking white population and you’ll see what a political hot potato that is. It is politically incorrect to discuss this issue. As if that’s ever stopped me. And, as I’ve mentioned before in previous articles, Demography is the key to understanding one of the greatest forces affecting us all. We ignore Demographics at our peril.

            Trillions of dollars are needed for re-financing in both developed and emerging markets. This is the key to economic recovery and lifting the economy back onto its growth path. Wall Street ignored Demographics by pushing house prices higher with Ninja loans (No Income & No Jobs or Assets) but you cannot ignore Demographics because you need more people to buy homes at a time when Boomers are retiring and selling. You need people with real savings and real equity in housing (instead of speculatively inflated house prices) as a basis for financing trillions of dollars of “obscure paper” (I’ve mentioned before these derivatives – structured instruments based on assets.) You cannot have sustained growth when there is no growth in young families and first-time home buyers. Without that, Don says there won’t be a recovery even with massive government “re-flation” and stimulus. Nothing positive there, I’m afraid. In other words, long-term economic decline is baked into the cake. 

            However, he does have hope (although I’ve long said that hope is an act of desperation and not a plan.) He says there can be a fundamental re-balancing of global balance sheets if (and I’ve also said that “IF” is one of the most important and misunderstood words in the English language because it transforms a declarative sentence into a conditional one) … so, IF the following conditions are met: 

a)    – interest rates can be left low (easier said than done because governments will need to raise rates to raise demand for the increased issuance of bonds and treasuries and to fight future inflation.)

b)    – as long as central banks can retain liquidity (how much money can they print before the dam bursts?)

c)    – as long as solvency can be injected into the banking system (they’ve been trying that for more than a year and a half and it hasn’t worked yet because, as I’ve mentioned numerous times, most of the largest financial systems are insolvent and  beyond all the money in the world to repair.)  

            Do you see now what I mean about his note of hope?

            Below, I’ve transcribed the remainder of his commentary. 

            “The bullish case for equities (stocks) in 2009 is not just that we can’t have a second year of anything like last year without having a 1930’s style depression which is “a posteriori” reasoning. (i.e. based on experience) The bullish case is simply that the reconstruction of the balance sheets can proceed as long as the debt servicing costs keeps shrinking because debt is being rolled over at lower interest rates and equity prices continue to rally. Even if we don’t have a big rally (in 2009) that you can rebuild the world’s balance sheet but the other part of the world’s balance sheet is the value of mortgage debt outstanding relative to the value of houses and it’s much more difficult to construct a bullish model for that.” Especially since later Don admits house prices will continue falling this year.   

            “The Case-Schiller index as announced in October which was their most recent month, was down 18% – that’s a record drop so the affordability index starts to look much better as house prices fell. The problem now that has got to be faced in trying to look for some bottom for the housing collapse given the fact they’re no longer permitting loans (mortgages) at full face value (and that’s if you can get a mortgage in the first place) and the idiocies of the kind that were described in great detail in the great New York Times report on how Kerry Kellinger and his people at WAMU (Washington Mutual whose banking assets were placed into the receivership of JP Morgan Chase) and how the people at Golden West Financial totally transformed the mortgage markets so that the ability of the borrowers to handle the debt was not the important point. It was asset-based lending based on the idiotic view that house prices would always keep going up because they’d always been going up.”

            “So what we have then is, as reasonable underwriting practices emerge and banks take over the mortgage markets with help from Fannie and Freddie (they) were going to get all the money they need.
(Closing the barn door long after the horses escaped.)Then the question is, are there enough people who have the jobs, the resources, the credit records and the will to be buying houses that become progressively cheaper because the potential marketplace is so drastically reduced by taking out people who should never have been able to borrow a mortgage at all and, as house prices fall, you still have to find first-time buyers or people who are prepared to trade up and, even though mortgage rates have fallen, the underwriting rules will be sufficiently rational that we gotta find out just what percentage of the un-housed in the U.S. have the ability to execute a contract that will get the conventional financing needed.” (Wow, that’s a lot of negatives to put a positive spin on. He forgets his previous discussion of Demographics leaving us with a shortage of buyers. Yes, mortgage rates have fallen but not as much as bank rates plus fewer people qualify because banks don’t want to lend. He also overlooks a dangerous effect of deflation- why buy now if future prices will be lower? Also, recent statistics can be misleading. In December, it was announced that existing home sales increased but this overlooks the fact that foreclosed homes are reported as a sale back to the financial institution. If a foreclosed home is then sold it is has been counted twice which make s the statistics look better than they actually are.)

            “So, the unwinding of the excesses in the home mortgage area will continue for at least another year or so. Therefore, in terms of re-balancing the world’s balance sheet of debt/equity ratio, I’m looking to the equity markets to be the key and I’m flatly of the view that there cannot be a sustained or realistic global economic recovery without a bull market in equities – a world-wide bull market. So, therefore that is “a posteriori” reasoning.”

            “I’ll make the case that given the signals we’re getting of the kinds of reasons that would allow you to be buying stocks again from our favorite indicators. If this translates into any kind of a sustained rally for equities (then) that has a marvelous healing effect for the global balance sheet and therefore the global economic recovery feeds off that and you can expect that these things would reinforce each other, whereas we’ve had a negative reinforcement process going on as the debt in relation to equity become more and more powerful and the global balance sheet became worse and worse the global economy kept doing down.” 

            “So we’ve got to turn that around and, in a way for those of you who want to follow the progress here, you probably want to put on your (computer) screen the LQD which is the IBOX ETF for investment grade corporate bonds. The chart for the LQD was a ghastly chart for quite a while (and) is now a chart with a huge rally in it and that means, I believe, it will be another indicator that we’ll be following as we go forward because lots of investors out there, including some of our most respected clients, are saying they are not going to be putting a lot of new money in at this point because the corporate bond market which was its own disaster area (will) rally first and it’s the rally in the corporate bond market which first will take a lot of pressure off the banking system then because corporations will be able to finance not just Capex but ordinary transactions with corporate debt. So, that will be another feedback loop of great importance so we will be following that indicator.” Lots of hope here. 

            “As for the high yield corporate market, its been so distorted by LBO loans (Leveraged Buy-Outs where a large part of the acquisition of a company is by borrowed funds) and these are the loans in which – as that part of the market went absolutely crazy – the private equity takeovers where they removed the covenants from them, the yields on those are astronomical levels and that will remain a speculative market for some time and because the LBO loans are not loans that are actually tied to expanding corporations but actually creating new shackles for them, it will probably be the last one to recover. When we had a situation where Dow Chemical can’t raise the financing to complete a takeover of their own Roman Hass (sic?) it’s a sign that real companies are struggling in this environment and, again, all of that has to heal before we’ve got a sustained economic recovery or a sustained equity bull market. But, I believe that will happen in the year (more hope but where’s the evidence?)  but because these things will not proceed seamlessly and easily because to the damage that’s been done there’ll be lots of bumps along the way” No shit! 

            “So, what do you do? Well, and where does this all affect commodities? Well, the commodities bear market was the last to develop, the commodities bull market peaked out just before the government pulled the trigger on the “Midnight Massacre” (July, 2008) at a time when all other kinds of risk assets were already in major bear markets and that, on the other hand, is something that can heal rather faster because the overhang of commodity supplies remains, in most cases, very modest for the food stuffs and they can come back just based on the easiest adjustment which is short term supply and demand.”

            “The oil market, the king of the commodities, we don’t know at the moment just how much of an overhang there is but the future’s curve, the contango, does suggest that there’s much higher oil prices on the horizon. Spot oil today is $38.34 but at 12 months from now is $53.45, oil 2 years is $61.50 and oil out 7 years from now is $72.50. Therefore, if you’re using our favorite metric which is un-hedged reserves in the ground in politically secure areas of the world, what you still have is fundamental value then in the companies that have met our criteria for good management and having un-hedged reserves in the ground in secure areas of the world. That those stocks which have been blasted and battered during this, because investors trade off spot prices and of course the earnings of the companies are what they sell their product now, as against what they may have had in some foreign arrangements; either actual futures contracts or entered into delivery contracts off the board with consumers who wanted to lock up this oil.”

            “So, we’re going to have a period where the P/E ratios of the oil companies are going to have to climb dramatically and yet you could have the situation where these stocks could rally quite strongly based on the perception that the global recession is not going to turn into a depression and the emerging economies are still going to be consuming more energy simply because there are going to be more people who are going to consume energy.”

            “So, there are so many of these factors that complicate an analysis here so some of you may say, well you can lay much too much emphasis on your favorite indicators. I do that simply because I’m not much good to you if I don’t use the experience that I got from being through two “Mamma Bear markets” 1973-74 and 1981-82 (those were Recessions, not Depressions) and since these indicators were the ones that allowed me to make good bullish moves back then and getting me out of them at the right time, I have to believe (belief again?) that kind of truth has not been repealed even though it’s a much different world (no shit! See my comments at the end about bubbles bursting ) At the very least what you can say is that the TED which is down to 94 is showing that people are saying is that everything that Bernanke and Paulson are doing, is it actually working? This is proof positive that at least in the short term, it’s achieving the required results.” Yeah, banks are “starting” to lend to each other but not to Dow Chemical and the rest of the economy. 

            “The banking system is thawing out and it’s the kind of thaw that those of you who read or saw “The Witch and the Wardrobe” is associated with the sudden thawing of Narnia which is a sign that Asland has come back and that the reign of the white witch is finally going to be challenged and that Narnia is no longer going to stay in a deep freeze.” Any comments on fairy tales are hardly necessary. 

            So that’s where we’re at and where we’ve ended the year on a modestly positive note but as far as the idea that we’re going to lose 3 financial institutions, that is now only a remote prospect with the TED spread at 94 and the direction of it coming down so dramatically. Oops, we lost them! In fact, of the 5 huge U.S. investment banks, one was allowed to fail (Lehman) two were absorbed by others (Bear Sterns and Merrill Lynch) and the remaining two (JP Morgan Chase and Goldman Sachs) became “bank holding companies” hanging on to the governments apron strings. The largest commercial bank, Citigroup, is splitting itself up and trying to sell off its best assets in a last-ditch attempt to avoid bankruptcy. Most other large U.S. banks are in various stages of insolvency. 

            “When we did our call on the TED spread a couple weeks ago, we were expressing enthusiasm because it was at 132, so we’re at 94. That was a fabulous move so let’s just trust that if this is projected forward that by the time Mr. Paulson hands over the reins to Mr. Geithner that it will be seen that their techniques are delivering great results in the short term for what was the most immediate crisis which was the freeze within the financial system.”  One and a half years and more than $8 trillion and all that’s been accomplished is banks are “starting” to lend to one another, let alone not lending to their customers, let alone not stopping the global economy from melting down. The operation was a success but the patient died!

          There are many definitions of an economic Depression. I’m not going to get into a lengthy discussion because the semantics are less important than the pain. One commonly accepted definition of a recession is two quarters of negative growth and a depression is five. The U.S. officially went into recession one year ago in December, 2007. By the end of March, 2009 it will officially be in a depression. Don’t expect to see that on the evening news.   

            What is truly frightening is comparing this depression with all others that preceded it. Neither the Great Depressions of the 1930’s or the 1870’s nor the Panics of 1893 or 1907 had more than TWO bubbles bursting. Now we have SIX bubbles bursting:

1) Residential and commercial real estate

2) U.S. dollar

3) Global debt

4) Stock market (equities)

5) Commodities

6) Derivatives 

          This is unprecedented in world history. Unprecedented means we have never seen anything like it. It means we have no experience with it. It means there’s no playbook that can guide us. It means no one, not even Obama can save us. So, batten the hatches and if you haven’t already started, then start doing all the things I’ve been advising this past year and a half.  

            Speaking of derivatives, the latest report I’ve seen with all the trillions of dollars squeezed out of the global economy, lost in housing and stock markets, written off by banks and corporations and offsetting some derivatives against others, of the $1,114 trillion in derivatives last year there are still more than $700 trillion toxic derivatives remaining. Few analyst, pundits or newsletter writers talk about derivatives because supposedly NO ON UNDERSTANDS THEM although I suspect this may be a marketing ploy (“They’re complicated but they’re safe –don’t ask,  trust us.”)  

          There you have it. We are afraid to talk about Demographics because it is politically incorrect. And we cannot discuss derivatives because no one understands them. Two of the most important factors affecting the world economy and we pretend they don’t exist. How do you solve a problem if we can’t even talk about it? No wonder we’re in a shit load of trouble. Forget Obama. Forget the government. Rely on yourself. 

          If anyone has any good news, please let me know.

Gerold

January 31, 2009
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Disclaimer: I’m not an investment advisor and these articles are for commentary only. For specific advice you should consult your own investment professional.

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