BMO Capital Markets Client Conference Call for November 7, 2008
Don Coxe
Chicago
“Buyers Remorse?”
Thank you all for tuning in to the call which comes to you from Chicago. The chart that we faxed out was the Dow Industrials showing the two days leading up to the election and then the collapse in the stock market coming out of the election. And the tag line was “Buyers Remorse?”
And so I want to address the question of the fact that we had had six straight days in which the S&P rose 18%, which was one of the most powerful rallies of all time. And then giving virtually all of it back up and the question then is, where are we at after all of this?
So, I want to take you through the buyers, I think, going on the up side and why they turned from being eager to add to risk assets and then rushed back into T-Bills so suddenly.
So the first, of course, is the question of the election result itself. And we congratulate incoming President Obama who ran the greatest primary election campaign of our generation. And an absolutely brilliant election campaign. And with terrific results. He got 2 1/2% more of the popular vote than Al Gore got and he got 4% more of the popular vote than John Kerry got. A tremendous performance from sea to shining sea. And he’s the President of all Americans and we join everybody else in wishing him a successful presidency.
This was a feel-good election for America. It addressed the sore at the center of the American spirit by electing a Tiger Woods-type figure who transcends racial stereotypes. And from a standpoint within America and America’s image in the world, the election of this President was a great experience.
So, in that sense, you can say “Well then there was no surprise, so why was there remorse?” Well, it’s always difficult to pick through the tea leaves in trying to analyze how emotions come into it, so I’ve got a collection of what I think were the remorses that set in overnight.
The first is that the Obama victory has really altered the balance of power in Congress. And those who were watching the election night returns seeing a triumphant Nancy Pelosi on TV, that reminded investors that the sweep was heavily financed by such far left activists as the Daily Coast, MoveOn.org, ACORN and the American Trial Lawyers Association. And that collection of advocacy groups is truly scary for investors.
Furthermore, Obama himself and the Congressional Democrats are pledged to pass card check. And card check would decisively alter the balance of power within labor relations in the US. Because instead of having a secret ballot to put a union in at a shop, it could be done by the fact that as long as people have signed union cards and they’re over the 50%, that they get put in.
Now the reason why this never passed before is because if you have a couple of burly union members who come in talk to you around the kitchen table and you sign their document, that’s a somewhat different decision than you make in secrecy. In fact, the record over the last twenty years of union elections which were based on having the cards and what actually happened when they have a closed door vote, is that the unions would lose a huge percentage of all those elections.
So this is designed to eliminate the secret ballot and that’s so much at the core of the American experience that all polls show that not only are about 80% of Americans opposed to it, but a huge majority of union members are opposed to it. And so that’s something that naturally scared investors.
Now, hedge fund investors, that is, the investors in the hedge funds, have been cashing out at record rates because for the first time, hedge funds failed to deliver positive or breakeven returns in a market sell off. And cash in the hundreds of billions is building up in the system.
But when you see even a master craftsman of hedge funds, Ken Griffin at Citadel, announcing a 40% loss on the funds, you sort of figure that the enthusiasm of pension funds for hedge funds has probably altered in a way that’s going to change the basic structure of pension fund investing.
But in the near term what it does is force the hedge funds to unload their assets. And of course this means that those who had such winning asset classes as commodities and emerging markets, have been forced to sell heavily to meet cash calls. So this is bigger than a margin call situation that you have when you have a market sell off by far. It’s much more concentrated because now you have the pension funds and the hedge funds together in effect, being on the sell side of these asset classes so that you’ve got such strong markets as India down 50% this year.
Yes, the Indian economy – and I’m going to be saying more about it next week when I take a group if investors to India – but the Indian economy will be slowing down a bit, but this is not a disaster situation by any means. But, it’s the kind of asset class that gets sold off. And indeed heavy shorting, because one place, one market where you could short sell with impunity.
The third group of buyers remorse, I think, was equity investors who now seeing with such a decisive mandate, that President-elect Obama and Congress will be able to implement the tax changes which will be higher taxes on people who have higher incomes. So the investor class was rushing, I think, to lock in tax losses in the last couple of days, because they can be carried forward into a year of higher taxes. So that’s a response of intelligent tax-planning investors to a situation where if the election results in Congress had been something less than they were, they might not have felt as frightened about what was coming next.
Then another class of buyers remorse was European investors. And their remorse was a little different. We had those big rate cuts. The Bank of England shocked people with a 1 ½ point cut, with more apparently coming. And the European central bank made a fifty basis point cut. The European stock markets sold off and of course, they’re huge holders of US stocks, so that selling continued into our market.
And you say “Well, why is that? Ordinarily if you cut rates, that’s just a reason to buy stocks. Historically it’s been that way.” But the reason for that is the recognition that out of the situation globally is more severe than perhaps they thought. And most particularly within Europe, and that’s Europe from the Atlantic to the Urals, because the situation in Eastern Europe is getting truly dire. So many of those economies over there were borrowing heavily. That is, homeowners and countries, were borrowing heavily in the Euro currency so they have terrible balance of payment deficits. And their economies are in terrible recessions.
So, this effected emerging markets indices very decisively because if you add in all those Eastern European countries plus Russia, again you have a situation where that asset class as measured in the global emerging market indices was getting hammered, which was further pressure on risk assets.
That’s a big collection, but then we add in the fact that coming out of this, we had a renewed commodity collapse and that reinforced the view that the global economy may be in worse shape than investors were thinking as they were eagerly buying stocks in those six days where we had firmness in commodity prices and the view that the various liquidity and other special injections were going to give us a much stronger outlook for next year than had been feared.
Well, of course as far as the stronger outlook, we got the ghastly US employment numbers this morning. And although that gave us a somewhat weak opening, the market does seem to be firming now. But we get to the stage where Ben Bernanke faces the problem of the zero rate of interest, which is the Japanese dilemma that when you get down to zero or near zero, that the basic mechanism of central banks to stimulate the economy no longer can function.
And that was something that Keynes talked about that’s always been out there as a question mark about the limits of central bank powers. And the Japanese example is a horror story that a lot of investors say “Well, we can’t really see therefore that the kind of curative mechanisms that we’ve been getting up ‘til now can be projected forward.”
Well that’s the bad news.
But as you know, on the last few calls, I’ve been expressing the view that we are forming a bottom for the stock market. So I’ll just mention one other asset…or collection of investors who have had remorse. The cash outs of mutual funds are running at an unbelievably high pace. And that was flagged by the fact that before we had the stock market sell off – in other words, back to June – that the ten-year rate of return on the S&P was zero. And that was the kind of thing that meant that 401-K numbers would have been disappointing when they got their September statements anyway, but by that time, we’d had the Lehman collapse. So that investors were saying “Look, I over-levered my house because housing was a good asset, but I was saving through my 401-K and that’s failed me. And so I guess I’ve got to get in to cash.” And that, of course, is capitulation, which is a condition of forming a market bottom.
As you know, we have emphasized - perhaps to the level of boring some of you – that a bear market which is lead by the financials ends when you’ve had a sustained period of outperformance by the banks relative to the S&P. And boy do we have that…in spades. Unless that indicator is totally a false signal this time, what we’ve got is a situation where the performance of the BKX to the S&P is very powerful.
Now, of course it doesn’t mean they’ve gone up. But we’ve had a huge rally on relative strength without going to a new low.
So I have to tell you I try to live by the rules. And this tells me that the Bernanke-Paulson mechanisms are working. And they haven’t run out of ingenuity and they haven’t run out of money. Therefore, I’m of the view that this Mama Bear market should have bottomed out at around these levels, because of the Mama Bear markets of our time, the ones which were in the early ‘70s, at the end of the ‘70s, those two, both of them were down 47 and 48%. And we got to those levels at the depths.
So once again, I would say that unless we are going to have a global depression or this is unique, that we had the required amount to classify it as a Mama Bear not a Papa Bear and that this particular grizzly had done her work.
Now, the argument this of course is well, it’s different this time, because things are worse this time. But I’m not prepared to accept that. Because we’re measuring an index which is basically tied to economic growth within the OECD. And although the collapse in emerging markets would tell you that there’s trouble for the economies that commodities are tied to, and that global growth is tied to, I believe that there were special factors in those and those markets which are volatile anyway will rebound because those economies are not collapsing.
That is, if you take out Russia and Eastern Europe out of the question of the emerging market index, then if you take the ones that we’ve been emphasizing which are China, India, Brazil and Southeast Asia, I still believe that those economies have fundamentals including demography, which are favorable and therefore over any reasonable time horizon, we’re going to have economic growth. And that economic growth is automatically tied into acquisition of commodities.
So the asset class which is most tied to growth and emerging markets, whereas you could say that they went down together, I believe the adjusted index will show you that even within a few months, people will say “Yeah, this is, ah…we overdid it.”
Well, does this suggest I’m trying to catch at straws? No! It’s that we were looking for a Papa Bear market which would signal a recession. It was worse because of the Lehman collapse and the collapse of so many banks in Europe and the bailouts and so forth, which meant that the financial excesses were worse in this cycle than in any previous cycle. And therefore, we got a Mama Bear.
But unless the BKX breaks through to a new low, than I think that we will have found, even if we have to look back on it, that we were forming a base here amidst all the pain and anguish. And so I’m not going to throw in any towels here. And yes, we’re close to where the low was on the BKX, which was 49, so this is not a big one, but the relative strength is the most crucial thing in that and the relative strength is so dramatically in favor of the bank stocks relative to the rest of the market that I think that that signals what we need.
Now we’ve told you that coming out of this the stock groups that were going to lead it were going to be the bookends of the market: the banks, because once people no longer feared that there would be renewed collapses, that they would be prepared to buy these battered banks. And on the other side, the commodities which would be tied to a renewed growth pattern of relative strength for the commodity consuming economies.
So, the financials which are tied directly into the economies of the OECD that the huge bailouts and the huge injections of capital and liquidity would stop the OECD from plummeting further and that we would get the signal from abroad. So after all of this adjustment we would go in to a new weighting of global GDP and the commodity investors would be tied to the economies whose weighting in global GDP would be much higher in the next cycle than it was in the last. And that means an all-time record high for emerging markets vs. established markets.
So one of the things we will be doing in the next issue of Basic Points that I’m working on now, will be to increase exposure to emerging markets. But we are going to put an asterisk that that means the non-Eastern European emerging markets.
Well, as to the commodities themselves, you can pretty much say that as oil goes, all the commodities seem to go. Yet, that’s not the right way to view the situation. Because most particularly for India and China, if the oil prices are lower, that is a huge stimulus to those economies. India in particular, the biggest problem that the Indian economy has faced on an international basis, has been its bill for oil. And China not as much because China had a significant amount of domestic production. But collectively, China accounted for about 1/3 of the growth in oil consumption so far in this decade. And if the bill for oil is more moderate than it was before, than that’s going to mean more prosperity. Consumers are going to be in better shape. And the industrial recovery will be stronger.
So the fact that investors in the commodities…the Goldman Sachs index which is sort of two-thirds in hydrocarbons, is the one that most people look at. And that index, I think, overstates the demand/supply situation for commodities.
Well, the next one is “Well why didn’t we get, with all of this bad fear spreading through the markets for all of the reasons I’ve outlined, why didn’t we get a bounce in gold?” And I wish I could give you a firm answer on that. I’m still of the view that when you have the kind of expansion of monetary resources that we’re getting here – and we have no precedent for anything on this scale being done – that this ultimately is gold-bullish.
The US monetary base is up fifty percent in a few weeks. Well there’s no precedent for anything like that before. So, going back to the other two Mama Bear markets, we had nothing like that. And of course the grand mama of them all, which was the crash in ’29, we had actually a drop in the monetary base.
So I have to say that the basics say that when you have this kind of expansion of monetary resources, ultimately it translates into a pickup in economic activity. It allows you to have the debt write downs. And it allows a healing process. But if you consider the global economy as having been in the intensive care unit, the intensive care unit basically puts in glucose to the patient. And the glucose in this case is monetary.
I think the patient will be out of the intensive care unit fairly soon, in the recovery room. And the recovery, I think, will actually be stock-friendly, because this bear market unlike those other bear equity markets did not start from a level of great equity overvaluations, not at all. If you take the financials out of the market, this market was trading at sort of historic P/E ratios. And the excesses were not within the stock market, they were in other markets. And therefore I’m of the view that the values in stocks relative to other asset classes now, if we use other asset classes being particularly housing, that this is an asset class that over the next five to ten years is one that people are going to feel comfortable with again.
Now there’s been so much devastation done to the baby boomers psyches and their finances, because they of course bid up the tech mania on the basis that P/E ratios no longer mattered. So they’re going to have to slowly rebuild their finances. We’re not going to have a rush back in to equities, I don’t believe, but for pension funds, which are building up cash at a tremendous rate as they close out hedge fund positions, they’re going to be looking at their equity exposures and pension funds who do truly have long-term investment programs based on relative exposures to historic asset classes, I think they’re going to be keener to rebuild their equity exposure. The big fad for pension funds in this decade was not stocks. The big fad was alternative investments. And leading the pack in alternative investments was hedge funds. And private equity. And the private equity funds – and this is where I conclude this part of the call - the private equity funds are reporting nothing but losses on a big scale.
So where do you go, as a pension fund, to meet your long-term liabilities? Now you can go in to corporate bonds because the spreads between Treasuries and corporates are at tremendous levels of the kind that would entice bond investors. I’m talking of investment-grade bonds. But, when you see that the equity percentage of your total fund is back down to the bottom of any range you would have ever expected historically, I have to believe that when they’re looking at what to do with all that cash on which the returns they get will keep falling as central banks cut their rates, that they will be forced – even if it’s being dragged screaming and kicking – back into investing in quality equities.
They may take a while to get back into emerging markets and more sexy equity investments, but we are not dealing with a situation where the 48% sell off in the S&P merely corrected a wild overvaluation of the S&P. That’s not the case. Ten years of a flat return was in itself a huge adjustment, in effect a huge bear market, which therefore had put equity valuations back to the kind of levels that would attract a Benjamin Graham.
And then, when we have the gigantic sell off in the panic, what it’s done is produced a whole range of stocks that long-term investors will be able to say “Well, unless everything we’ve learned about stocks is now obsolete, this is our last chance to rebuild our funds against those liabilities. And this is the asset class that we’re going to want to emphasize.
So my prediction is that whereas the pension funds have been a negative force in the last few weeks, precisely because they’ve been unwinding their exposure to hedge funds, I think that they will be back, in size, and investing for their own account rather than paying two and twenty for hedge fund managers.
And as for the private equity firms, they’re going to have great trouble getting them, the hedge funds, to make new commitments. And they’re going to be making a lot of phone calls to get them to actually live up to the commitments they’ve made.
So the stars on Wall Street, in this cycle, these stars have turned out to be supernovas. And after that, we look to where in the universe you go.
That's the story. Any questions?
Question 1 (David Miller): The TED spread seems to have come in a lot more than the VIX or the BKX. What, if anything, can we read into that?
DC: Thank you. I neglected to mention the indicator that has been my favorite and I managed to skip over that. The good news is that as of this morning we're at 197 which is still a high range for it but when it's down from 500, you would say that that's real progress.
The VIX index is a volatility index. Now there's a difference. Risk and volatility usually go together but you can separate them out if you need to and what's happened with the VIX although it's come down today. The VIX is remember the index that's used by those who are trading the S&P futures to protect their exposure on a very short term basis and when you have routinely as we've had days in which the S&P has 40 point swings intraday, the VIX index is the way you hedge that wild and unprecedented hourly volatility.
So it is measuring the volatility on a short term basis of the S&P and as such point as the S&P stops having these wild intraday swings then the VIX can retreat and follow the TED spread down into a range at which people feel comfortable.
So the TED is a more reliable index in that it definitely is an index that measures the fear and risk within the financial system itself. And it measures it on a global basis because it takes away the yield from treasury bills and measures them against the yield on EuroDollars and therefore it is a pure risk index.
What banks have learned to their unhappiness in all past crises is the TED spread leaps and you aren't sure which banks it is that are going to be in the most trouble and because it's a global index based in London then it means that each of the central banks that does checking on their own banks has to sort of scurry around to find out whether their bank is the one that's causing the problem. And there's no question about it that London was a big center in this with these hedge funds collapsing after Lehman where 65 billion in hedge fund assets got locked up and are being sold up into the marketplace.
So the TED spread should lead on the downside and although it's still at an elevated range to use my intensive care unit, the patient is out of intensive care and in the recovery room. If it continues to move downwards from that 200 level - we were at 215 the day of the crash in '87 and this time the TED spread after all only skyrocketed to those levels when Lehman went down and that's because of the Lehman and then the AIG coming together it meant that all those banks who had counterparty arrangements that you had a whole bunch of banks simultaneously then getting into trouble.
So the fact that they've managed to deal with the consequences of those collapses ... it wasn't in time to save John McCain because he was virtually tied with Obama for about two weeks until Lehman went down Obama jumped to a 4 and then a 5 and then a 6 point lead that he never relinquished but from an investment concern what's happened is we soared from 165 to 500. We're back to 197. That means that risk in the financial system is dwindling.
DM: The BKX how does that layer over. I would have thought it sort of measures somewhere in between the VIX and the TED spread then?
DC: Well the BKX is telling you what the bank stocks collectively are worth and of course it's a much more complicated index because people may decide that banks aren't going bust but that they aren't going to make much money and then therefore they aren't a prime investment and I got an e-mail message from a frequent participant on this call who was unable to get through for whatever reason and he's asked me to comment on the fact that how is it that the BKX seems to be doing so well while Goldman keeps gapping lower and I'm afraid I can't answer that because Goldman is sort of the gold standard for investment banks. But frankly this whole financial crisis came, now that we look back on it, from the fact that banks after Glass-Steagal decided that the way to grow their earnings and get bonuses for their top people was to become investment banks.
So they got into businesses they didn't know that much about. They levered up. They took risks that they didn't understand and they got away from the basic business of banking. The crash in '29 and the collapse of banks then was because their borrowers couldn't cover their loans because of the depth of the recession. The collapse this time wasn't with 6 1/2% unemployment because all of the borrowers out there can't meet their liabilities. It's because of all these kinds of toxic paper that banks added to their book instead of their conventional business of making loans to borrowers that they knew and had relationships with.
So I think that you can separate out in this the bank banks which we assume are going to be going back to the business of banking and when they do there will be credit flows to regular bank customers like small businesses and exporters and those kinds of customers and I hope the banks have learned from this that they shouldn't try to put on the trappings of Wall Street stars.
When I was watching the election returns and that North Carolina voted for this time for the Democrats and one of the big reasons when they were analyzing it was the drop in the Republican vote in Charlotte. Well Charlotte lost one of their two big banks. Charlotte was on its way to being the second financial center in the United States and because of Wachovia's takeover of Golden West Financial where they got all of these toxic mortgages, what they did is they went outside their basic business.
Wachovia was a well-managed bank and so they had to be taken over. And I think that is another example that this crisis is different from the others because of the fact that the risk practices of investment banks who could lever up to 20 and 30 times were adopted by bank banks and those bank bankers didn't have experience with this but they told themselves, "We're as smart as Goldman. We're as smart as Bear Stearns," We may in fact dramatically reduce the role of pure investment banks for a while because they are not performing the economically necessary function that pure banks are. So as people troop back to doing the businesses that they know best, the economy will stabilize out.
So I apologize for the length of this answer but in order to analyze something as big as this you've got to understand how it is that mistakes could be made on this scale and what happened was that the investment banks took risks that they didn't understand but you could lose investment banks as long as you had bail outs so that the counterparty risk was covered. We can't afford to lose the bank banks.
Thank you. Any other questions?
Question 2 (Steve Osmak): Don, I was wondering if you could talk about the grains because I can understand why all the other commodities, the base metals and the oils would collapse in the context of a global recession but I mean last winter it was the Philippines I believe rioting over rice and Costco had a limit on how much you could buy. I just can't understand how the grains could completely collapse after all you say people have to eat. So any insight as to why that's been so severe?
DC: Well one of the reports that we follow closely is the Chicago Board of Trade, the CME daily report on commodities and they always begin with the report on the grains and on days that there's grain sell offs they always point out right at the beginning that they tie it in with sell offs by commodity funds at the same time they were selling off other commodities and so therefore the kind of lapidary distinctions between foods and fuels and fuels and metals don't get reflected when these commodity funds are finding out that their investors are pulling out their money.
So frankly in my view the most undervalued commodities now are the grains and I'll reiterate that the evidence about the cooling trend just gets stronger by the day and by the week. London had its first snow since 1922 in October. Yesterday in the high Prairies we had snow storms with snowfalls of more than 2 feet in some places and this is early November. Brazil has experienced extensive snowfalls.
So the evidence is that we're going to have another winter which will be bad for crops. China experienced such huge crop losses because of the bad winter last year which was a force that undergirded the commodity rally of the spring. That looks like that trend is still in place but I realize that for a lot of people on the call the idea that there could be a global cooling trend is still the ultimate heresy.
So I will just mention that the carryovers of grains remain inadequate and the fundamental story for the grains remains intact but I'll be able to discuss this in perhaps greater detail and knowledge I hope after my return from my India trip at the end of this month.
Thank you. Any other questions?
Question 3 (Anthony O'Malley): Thank you for the Basic Points. I read it every time it gets published. I'm very interested in the Dollar and the 10 trillion dollar national debt which I'm doing some research for a college where I work at and how would you point to the Dollar in the next year perhaps?
DC: Well the Dollar had better come down because the strongest component of the US GDP so far this year has been the export side. So this is taking away some of the dynamism in the US economy at a time that there's not much else that's dynamic.
So there will be no reason for the Fed to try to do anything that's Dollar friendly like raising interest rates. The Dollar is the currency of the debt as they repatriate these hedge funds. I regard that as a temporary development and so I would expect the Dollar to fall and the next big currency is from the EuroZone and since the news from that zone gets bleaker by the week you say, "Well how can the Euro rally?" The difference is you've got high savings rate in many of the European countries whereas the US savings rate remains at zero. The US has to import vast quantities of money each month to cover its current account deficit and offset its lack of domestic savings.
So at such moment as that inflow dries up or weakens, the Dollar will fall and of course commodities still as an asset class tend to trade inversely to the Dollar not just gold but commodities as an asset class. So what we're seeing today with the strengthening of commodity prices, well the Dollar is somewhat weaker.
But then the other big currency zone of course is the Yen and it's hard to make out a case for that except for the fact that people borrow in Yen, people that is outside of Japan and meanwhile Japanese savers are still rushing to take their money out of Japan and invest it at higher interest rates abroad. The gap between Japanese and foreign rates however is narrowing as central banks rush to rescue their own economies. So that Mrs. Watanabe may be more constrained in exporting from Japan her savings.
So putting it all together, the Dollar is stronger than it should be but I think it's partly reflecting:- (a) the repatriation of hedge fund money, (b) the perceived weaknesses in those other two currencies. But what it does mean is currencies other than the Dollar should strengthen and particularly the Canadian Dollar, which was way oversold, should rally back because the fundamentals in Canada remain very strong relative to those south of the border.
But the Dollar remains at the center of the global system and so therefore it does acquire haven characteristics but at such time as people start believing in a global economy then they're going to look at the fundamentals for the Dollar and the fundamentals for the Dollar remain bleak.
Thank you. Any other questions?
Question 4 (Kirk Aldridge): Yes, Don, could you just comment on the high yield bonds.
DC: Thank you. Frankly I think that for investors who are looking at some point at unloading cash and going into an asset class, corporate bonds as an asset class look good and within the high yield market as long as you aren't dealing with the LBO bonds where they've stripped out their covenance pretty much in order that they could have birthday parties for the private equity people. I would within the high yield group there are lots of companies that you have to believe unless this is a depression are going to be able to service their debt and again people have been rushing away from risks of all kinds. So this is an asset class which grew dramatically in size because of the private equity mania.
So again within the group what you've got to separate out is those whose bonds have been used to finance machinery and equipment and business purposes and as long as you look at the underlying companies and what they're doing that would be an asset class that should have terrific attractions over the next twelve months but this is a case in which more than the ordinary degree of study is required and is a game for specialists. We have a partner company, Monegy, that's really good at these. There are other fund managers out there who are good at private equity and high yield and distinguishing the ones that don't have the proper convenance in them. To have a covenant free bond at a time of global recession, to have a devastated balance sheet is to have an asset that has very little apparent value.
Thank you. Any other questions?
Question 5 (Donna Short): Just quickly for clients who are using tax losses to their advantage can you just reiterate the sectors that are the leading sectors that one should still stay in?
DC: Well I'll go back to it that on the assumption that there will be a brighter day tomorrow if you argue a posteriori then what you can say is the banks have to be in better shape twelve months from now than they are today. They've been hammered down, and bank banks that is as opposed to investment banks have to have intrinsic merit because their earnings should be tied to the recovery of economies.
So although it's been a long time since you've heard me recommending bank stocks on these calls I'm saying that they make sense now if you assume that equities as an asset class because we just cannot get a rally in the stock market now from these levels without having some leadership from the good banks and again the global economy if it comes back is going to be led by those economies that have positive demography and where high savings rates and growing labor forces and these are economies that have a greater appetite for commodities than the advanced economies.
So by having the asset class that will do relatively well as the OECD economies recover which is the banks and the commodities tied to the economies that are going to have the greatest growth rates over the next few years. So what you do is you take the two bookends and in between it's a stock by stock basis.
Thank you. Any other questions?
Question 6 (Marcus Backham): On the monetary expansion that we are witnessing at the moment is truly impressive. There is just one concern that the patient being the global economy being in IC. We in check should really help him to get back on his feet but you get somehow the impression that the drip is blocked. We see that in anecdotal examples that companies struggle to get patient and family financing. We still see that reflected in a very depressed Baltic Freight Index. Is there a risk that the patient being the economy is probably more seriously damaged than we wish to think because of potentially that blocked drain that we're seeing at the moment or are these concerns maybe too overstated?
DC: Thank you. Well the Baltic Dry Index is a classic index that's a short term measuring commitments for charters and at a time when the banking system of the world is at bay one of the big problems with these is getting letters of credit and having the certainty that if you load up a ship and send it off to sea that when it reaches its destination that there will be somebody there who can definitely pay for the cargo. So in that sense it's very much levered to the BKX because of the squeezing or the freezing of the financial flows.
I might just mention that I was talking to a short term fund manager and asking for an update on how the short term paper market is behaving and he says, "Well, it is certainly looking better but we've got a different problem now. We've got loads and loads of money but we have fewer assets that we can invest in," and that's because we're losing all sorts of investment classes that were AAA rated earlier in the cycle that funds could use. They're being taken off the list because we find out now that things like auto loans, home equity loans, these trusts that were set up where they could maintain their AAA rating by just substituting new credits as credits went bad. These are being taken off the table.
So the oddity is that one of the things constraining the regrowth here is that we are not flowing it from the short term investors now who have money to invest into a lot of economically sensitive classes. Again I regard that as a short term problem. In general once you keep piling up lots of loose cash it eventually starts moving out of treasury bills and starts moving into other kinds of paper but with the Lehman collapse was such a catastrophe for short term investors that acquiring an appetite for any kind of risk is going to take some time to do but I don't regard this as a sign when you put them together that the Baltic Dry Index indicates that the global economy is in a depression situation. I think it's simply that nobody is prepared to take the risk when they aren't sure about the counter party on the other side. It is a counter party relationship and so we need a process of healing to get that functioning again.
Thank you. Any other questions?
Question 7 (Mr Growenwagen): Hi Don. I would like to ask you something with respect to the currencies because I believe that what we will see going forward is that the currencies will basically show weaknesses and strengths according to the fundamentals in the economy and I was wondering you touched upon the high savings rate of Europe and so on and potentially also debt levels. What do you see happening because you were mentioning the gold and I think it has been a big question mark for a lot of people that gold didn't rise despite the fact that it doesn't have any counter party risk and as you said that the US monetary base has expanded by 50% in the last couple of weeks. So there is something odd going on here. So what's your view on this and how do you think that the currencies will behave going forward and what will determine their strength?
DC: Well that's a huge question about the currencies and you're right they'll eventually be behaving in response to the behavior of their domestic economies and what their domestic savers do with their funds and that's a case by case basis.
The gold story is one where we moved from fearing inflation when gold was trading at 940 and then we had the Midnight Massacre and then we had the collapse of Lehman and so the result is that we stopped fearing inflation and feared only deflation and people said, "Why do I need an inflation hedge asset," and although it's haven assets for a financial crisis seem pretty weak it's because it was coming off a high peak which was driven off inflation fears. Remember as recently as July the 10th the CPI was 4.5% the highest in 15 years and the question was how much the Fed was going to have to tighten.
So my view is that gold as a store of value - by the way again if you want to take a horrible example of going back to 1929, gold was a great place to be because it held its value better than other assets and then eventually of course got revalued upwards after the 1932 elections from $20.67 an ounce up to 35 as part of the reliquification of the US economy.
So we haven't been through such disorganized chaotic conditions in my lifetime and so trying to put these things together and suggest there's something rational behind everything is a venture in futility. What I can say simply is that as investors what you try to say is there's going to be a world out there and when we've gotten back to some kind of normalcy how will these assets relate to each other and I believe that when all this is done that gold is going to be considerably higher than it is today because people will recall Milton Friedman's dictum's that inflation is always a monetary phenomenon.
I can tell you that back in the '70s when inflation was soaring, gold for a while hesitated. It didn't start moving until later on when the horrible bear market of '72-74 was over. So gold can take a pause even when the fundamentals for it are getting dramatically better.
I've got time for one more question.
Question 8 (Catherine Morrisey ): A couple of things. I'm wondering if the prospects for one North American currency have risen of late and then the second question is are you worried about protectionism here.
DC: There won't be one North American currency because in order to do that you'd have to amend the Federal Reserve Act and that's only slightly easier to amend than the US constitution. So that won't happen and your second part of your question was protectionism?
Well at the time of all economic crises you get a lot of protectionist talk. It's not so easy to bring back protectionism now because there's treaties out there and tearing up treaties is a very difficult act and in the case of incoming President Obama, he's going to have a big NAFTA problem which has nothing to do with Canada.
It has to do with Mexico because over 50% of the budget of the Mexican government comes from revenues from the Mexican oil company, Pemex, and $61 oil means a coming financial crisis for the Mexican government which means a big increase in attempts from Mexicans to come into the US illegally and he wouldn't have carried a lot of the states he did carry had it not been for carrying the Latino vote by such big margins. It's going to create such a dilemma for him that he's not going to be placing any phone calls to Ottawa.
DC: So thank you all for tuning into the call. I try to as a matter of justification for doing these calls limit them to one hour so that you can get back to your work. I appreciate your participation. I'm leaving for India in the middle of next week. We will try to arrange a call at some point from India but it will probably be at a somewhat different time given time zones but given as there is so much going on I will try to stay in touch with you. Thank you again.
And so I want to address the question of the fact that we had had six straight days in which the S&P rose 18%, which was one of the most powerful rallies of all time. And then giving virtually all of it back up and the question then is, where are we at after all of this?
So, I want to take you through the buyers, I think, going on the up side and why they turned from being eager to add to risk assets and then rushed back into T-Bills so suddenly.
So the first, of course, is the question of the election result itself. And we congratulate incoming President Obama who ran the greatest primary election campaign of our generation. And an absolutely brilliant election campaign. And with terrific results. He got 2 1/2% more of the popular vote than Al Gore got and he got 4% more of the popular vote than John Kerry got. A tremendous performance from sea to shining sea. And he’s the President of all Americans and we join everybody else in wishing him a successful presidency.
This was a feel-good election for America. It addressed the sore at the center of the American spirit by electing a Tiger Woods-type figure who transcends racial stereotypes. And from a standpoint within America and America’s image in the world, the election of this President was a great experience.
So, in that sense, you can say “Well then there was no surprise, so why was there remorse?” Well, it’s always difficult to pick through the tea leaves in trying to analyze how emotions come into it, so I’ve got a collection of what I think were the remorses that set in overnight.
The first is that the Obama victory has really altered the balance of power in Congress. And those who were watching the election night returns seeing a triumphant Nancy Pelosi on TV, that reminded investors that the sweep was heavily financed by such far left activists as the Daily Coast, MoveOn.org, ACORN and the American Trial Lawyers Association. And that collection of advocacy groups is truly scary for investors.
Furthermore, Obama himself and the Congressional Democrats are pledged to pass card check. And card check would decisively alter the balance of power within labor relations in the US. Because instead of having a secret ballot to put a union in at a shop, it could be done by the fact that as long as people have signed union cards and they’re over the 50%, that they get put in.
Now the reason why this never passed before is because if you have a couple of burly union members who come in talk to you around the kitchen table and you sign their document, that’s a somewhat different decision than you make in secrecy. In fact, the record over the last twenty years of union elections which were based on having the cards and what actually happened when they have a closed door vote, is that the unions would lose a huge percentage of all those elections.
So this is designed to eliminate the secret ballot and that’s so much at the core of the American experience that all polls show that not only are about 80% of Americans opposed to it, but a huge majority of union members are opposed to it. And so that’s something that naturally scared investors.
Now, hedge fund investors, that is, the investors in the hedge funds, have been cashing out at record rates because for the first time, hedge funds failed to deliver positive or breakeven returns in a market sell off. And cash in the hundreds of billions is building up in the system.
But when you see even a master craftsman of hedge funds, Ken Griffin at Citadel, announcing a 40% loss on the funds, you sort of figure that the enthusiasm of pension funds for hedge funds has probably altered in a way that’s going to change the basic structure of pension fund investing.
But in the near term what it does is force the hedge funds to unload their assets. And of course this means that those who had such winning asset classes as commodities and emerging markets, have been forced to sell heavily to meet cash calls. So this is bigger than a margin call situation that you have when you have a market sell off by far. It’s much more concentrated because now you have the pension funds and the hedge funds together in effect, being on the sell side of these asset classes so that you’ve got such strong markets as India down 50% this year.
Yes, the Indian economy – and I’m going to be saying more about it next week when I take a group if investors to India – but the Indian economy will be slowing down a bit, but this is not a disaster situation by any means. But, it’s the kind of asset class that gets sold off. And indeed heavy shorting, because one place, one market where you could short sell with impunity.
The third group of buyers remorse, I think, was equity investors who now seeing with such a decisive mandate, that President-elect Obama and Congress will be able to implement the tax changes which will be higher taxes on people who have higher incomes. So the investor class was rushing, I think, to lock in tax losses in the last couple of days, because they can be carried forward into a year of higher taxes. So that’s a response of intelligent tax-planning investors to a situation where if the election results in Congress had been something less than they were, they might not have felt as frightened about what was coming next.
Then another class of buyers remorse was European investors. And their remorse was a little different. We had those big rate cuts. The Bank of England shocked people with a 1 ½ point cut, with more apparently coming. And the European central bank made a fifty basis point cut. The European stock markets sold off and of course, they’re huge holders of US stocks, so that selling continued into our market.
And you say “Well, why is that? Ordinarily if you cut rates, that’s just a reason to buy stocks. Historically it’s been that way.” But the reason for that is the recognition that out of the situation globally is more severe than perhaps they thought. And most particularly within Europe, and that’s Europe from the Atlantic to the Urals, because the situation in Eastern Europe is getting truly dire. So many of those economies over there were borrowing heavily. That is, homeowners and countries, were borrowing heavily in the Euro currency so they have terrible balance of payment deficits. And their economies are in terrible recessions.
So, this effected emerging markets indices very decisively because if you add in all those Eastern European countries plus Russia, again you have a situation where that asset class as measured in the global emerging market indices was getting hammered, which was further pressure on risk assets.
That’s a big collection, but then we add in the fact that coming out of this, we had a renewed commodity collapse and that reinforced the view that the global economy may be in worse shape than investors were thinking as they were eagerly buying stocks in those six days where we had firmness in commodity prices and the view that the various liquidity and other special injections were going to give us a much stronger outlook for next year than had been feared.
Well, of course as far as the stronger outlook, we got the ghastly US employment numbers this morning. And although that gave us a somewhat weak opening, the market does seem to be firming now. But we get to the stage where Ben Bernanke faces the problem of the zero rate of interest, which is the Japanese dilemma that when you get down to zero or near zero, that the basic mechanism of central banks to stimulate the economy no longer can function.
And that was something that Keynes talked about that’s always been out there as a question mark about the limits of central bank powers. And the Japanese example is a horror story that a lot of investors say “Well, we can’t really see therefore that the kind of curative mechanisms that we’ve been getting up ‘til now can be projected forward.”
Well that’s the bad news.
But as you know, on the last few calls, I’ve been expressing the view that we are forming a bottom for the stock market. So I’ll just mention one other asset…or collection of investors who have had remorse. The cash outs of mutual funds are running at an unbelievably high pace. And that was flagged by the fact that before we had the stock market sell off – in other words, back to June – that the ten-year rate of return on the S&P was zero. And that was the kind of thing that meant that 401-K numbers would have been disappointing when they got their September statements anyway, but by that time, we’d had the Lehman collapse. So that investors were saying “Look, I over-levered my house because housing was a good asset, but I was saving through my 401-K and that’s failed me. And so I guess I’ve got to get in to cash.” And that, of course, is capitulation, which is a condition of forming a market bottom.
As you know, we have emphasized - perhaps to the level of boring some of you – that a bear market which is lead by the financials ends when you’ve had a sustained period of outperformance by the banks relative to the S&P. And boy do we have that…in spades. Unless that indicator is totally a false signal this time, what we’ve got is a situation where the performance of the BKX to the S&P is very powerful.
Now, of course it doesn’t mean they’ve gone up. But we’ve had a huge rally on relative strength without going to a new low.
So I have to tell you I try to live by the rules. And this tells me that the Bernanke-Paulson mechanisms are working. And they haven’t run out of ingenuity and they haven’t run out of money. Therefore, I’m of the view that this Mama Bear market should have bottomed out at around these levels, because of the Mama Bear markets of our time, the ones which were in the early ‘70s, at the end of the ‘70s, those two, both of them were down 47 and 48%. And we got to those levels at the depths.
So once again, I would say that unless we are going to have a global depression or this is unique, that we had the required amount to classify it as a Mama Bear not a Papa Bear and that this particular grizzly had done her work.
Now, the argument this of course is well, it’s different this time, because things are worse this time. But I’m not prepared to accept that. Because we’re measuring an index which is basically tied to economic growth within the OECD. And although the collapse in emerging markets would tell you that there’s trouble for the economies that commodities are tied to, and that global growth is tied to, I believe that there were special factors in those and those markets which are volatile anyway will rebound because those economies are not collapsing.
That is, if you take out Russia and Eastern Europe out of the question of the emerging market index, then if you take the ones that we’ve been emphasizing which are China, India, Brazil and Southeast Asia, I still believe that those economies have fundamentals including demography, which are favorable and therefore over any reasonable time horizon, we’re going to have economic growth. And that economic growth is automatically tied into acquisition of commodities.
So the asset class which is most tied to growth and emerging markets, whereas you could say that they went down together, I believe the adjusted index will show you that even within a few months, people will say “Yeah, this is, ah…we overdid it.”
Well, does this suggest I’m trying to catch at straws? No! It’s that we were looking for a Papa Bear market which would signal a recession. It was worse because of the Lehman collapse and the collapse of so many banks in Europe and the bailouts and so forth, which meant that the financial excesses were worse in this cycle than in any previous cycle. And therefore, we got a Mama Bear.
But unless the BKX breaks through to a new low, than I think that we will have found, even if we have to look back on it, that we were forming a base here amidst all the pain and anguish. And so I’m not going to throw in any towels here. And yes, we’re close to where the low was on the BKX, which was 49, so this is not a big one, but the relative strength is the most crucial thing in that and the relative strength is so dramatically in favor of the bank stocks relative to the rest of the market that I think that that signals what we need.
Now we’ve told you that coming out of this the stock groups that were going to lead it were going to be the bookends of the market: the banks, because once people no longer feared that there would be renewed collapses, that they would be prepared to buy these battered banks. And on the other side, the commodities which would be tied to a renewed growth pattern of relative strength for the commodity consuming economies.
So, the financials which are tied directly into the economies of the OECD that the huge bailouts and the huge injections of capital and liquidity would stop the OECD from plummeting further and that we would get the signal from abroad. So after all of this adjustment we would go in to a new weighting of global GDP and the commodity investors would be tied to the economies whose weighting in global GDP would be much higher in the next cycle than it was in the last. And that means an all-time record high for emerging markets vs. established markets.
So one of the things we will be doing in the next issue of Basic Points that I’m working on now, will be to increase exposure to emerging markets. But we are going to put an asterisk that that means the non-Eastern European emerging markets.
Well, as to the commodities themselves, you can pretty much say that as oil goes, all the commodities seem to go. Yet, that’s not the right way to view the situation. Because most particularly for India and China, if the oil prices are lower, that is a huge stimulus to those economies. India in particular, the biggest problem that the Indian economy has faced on an international basis, has been its bill for oil. And China not as much because China had a significant amount of domestic production. But collectively, China accounted for about 1/3 of the growth in oil consumption so far in this decade. And if the bill for oil is more moderate than it was before, than that’s going to mean more prosperity. Consumers are going to be in better shape. And the industrial recovery will be stronger.
So the fact that investors in the commodities…the Goldman Sachs index which is sort of two-thirds in hydrocarbons, is the one that most people look at. And that index, I think, overstates the demand/supply situation for commodities.
Well, the next one is “Well why didn’t we get, with all of this bad fear spreading through the markets for all of the reasons I’ve outlined, why didn’t we get a bounce in gold?” And I wish I could give you a firm answer on that. I’m still of the view that when you have the kind of expansion of monetary resources that we’re getting here – and we have no precedent for anything on this scale being done – that this ultimately is gold-bullish.
The US monetary base is up fifty percent in a few weeks. Well there’s no precedent for anything like that before. So, going back to the other two Mama Bear markets, we had nothing like that. And of course the grand mama of them all, which was the crash in ’29, we had actually a drop in the monetary base.
So I have to say that the basics say that when you have this kind of expansion of monetary resources, ultimately it translates into a pickup in economic activity. It allows you to have the debt write downs. And it allows a healing process. But if you consider the global economy as having been in the intensive care unit, the intensive care unit basically puts in glucose to the patient. And the glucose in this case is monetary.
I think the patient will be out of the intensive care unit fairly soon, in the recovery room. And the recovery, I think, will actually be stock-friendly, because this bear market unlike those other bear equity markets did not start from a level of great equity overvaluations, not at all. If you take the financials out of the market, this market was trading at sort of historic P/E ratios. And the excesses were not within the stock market, they were in other markets. And therefore I’m of the view that the values in stocks relative to other asset classes now, if we use other asset classes being particularly housing, that this is an asset class that over the next five to ten years is one that people are going to feel comfortable with again.
Now there’s been so much devastation done to the baby boomers psyches and their finances, because they of course bid up the tech mania on the basis that P/E ratios no longer mattered. So they’re going to have to slowly rebuild their finances. We’re not going to have a rush back in to equities, I don’t believe, but for pension funds, which are building up cash at a tremendous rate as they close out hedge fund positions, they’re going to be looking at their equity exposures and pension funds who do truly have long-term investment programs based on relative exposures to historic asset classes, I think they’re going to be keener to rebuild their equity exposure. The big fad for pension funds in this decade was not stocks. The big fad was alternative investments. And leading the pack in alternative investments was hedge funds. And private equity. And the private equity funds – and this is where I conclude this part of the call - the private equity funds are reporting nothing but losses on a big scale.
So where do you go, as a pension fund, to meet your long-term liabilities? Now you can go in to corporate bonds because the spreads between Treasuries and corporates are at tremendous levels of the kind that would entice bond investors. I’m talking of investment-grade bonds. But, when you see that the equity percentage of your total fund is back down to the bottom of any range you would have ever expected historically, I have to believe that when they’re looking at what to do with all that cash on which the returns they get will keep falling as central banks cut their rates, that they will be forced – even if it’s being dragged screaming and kicking – back into investing in quality equities.
They may take a while to get back into emerging markets and more sexy equity investments, but we are not dealing with a situation where the 48% sell off in the S&P merely corrected a wild overvaluation of the S&P. That’s not the case. Ten years of a flat return was in itself a huge adjustment, in effect a huge bear market, which therefore had put equity valuations back to the kind of levels that would attract a Benjamin Graham.
And then, when we have the gigantic sell off in the panic, what it’s done is produced a whole range of stocks that long-term investors will be able to say “Well, unless everything we’ve learned about stocks is now obsolete, this is our last chance to rebuild our funds against those liabilities. And this is the asset class that we’re going to want to emphasize.
So my prediction is that whereas the pension funds have been a negative force in the last few weeks, precisely because they’ve been unwinding their exposure to hedge funds, I think that they will be back, in size, and investing for their own account rather than paying two and twenty for hedge fund managers.
And as for the private equity firms, they’re going to have great trouble getting them, the hedge funds, to make new commitments. And they’re going to be making a lot of phone calls to get them to actually live up to the commitments they’ve made.
So the stars on Wall Street, in this cycle, these stars have turned out to be supernovas. And after that, we look to where in the universe you go.
That's the story. Any questions?
Question 1 (David Miller): The TED spread seems to have come in a lot more than the VIX or the BKX. What, if anything, can we read into that?
DC: Thank you. I neglected to mention the indicator that has been my favorite and I managed to skip over that. The good news is that as of this morning we're at 197 which is still a high range for it but when it's down from 500, you would say that that's real progress.
The VIX index is a volatility index. Now there's a difference. Risk and volatility usually go together but you can separate them out if you need to and what's happened with the VIX although it's come down today. The VIX is remember the index that's used by those who are trading the S&P futures to protect their exposure on a very short term basis and when you have routinely as we've had days in which the S&P has 40 point swings intraday, the VIX index is the way you hedge that wild and unprecedented hourly volatility.
So it is measuring the volatility on a short term basis of the S&P and as such point as the S&P stops having these wild intraday swings then the VIX can retreat and follow the TED spread down into a range at which people feel comfortable.
So the TED is a more reliable index in that it definitely is an index that measures the fear and risk within the financial system itself. And it measures it on a global basis because it takes away the yield from treasury bills and measures them against the yield on EuroDollars and therefore it is a pure risk index.
What banks have learned to their unhappiness in all past crises is the TED spread leaps and you aren't sure which banks it is that are going to be in the most trouble and because it's a global index based in London then it means that each of the central banks that does checking on their own banks has to sort of scurry around to find out whether their bank is the one that's causing the problem. And there's no question about it that London was a big center in this with these hedge funds collapsing after Lehman where 65 billion in hedge fund assets got locked up and are being sold up into the marketplace.
So the TED spread should lead on the downside and although it's still at an elevated range to use my intensive care unit, the patient is out of intensive care and in the recovery room. If it continues to move downwards from that 200 level - we were at 215 the day of the crash in '87 and this time the TED spread after all only skyrocketed to those levels when Lehman went down and that's because of the Lehman and then the AIG coming together it meant that all those banks who had counterparty arrangements that you had a whole bunch of banks simultaneously then getting into trouble.
So the fact that they've managed to deal with the consequences of those collapses ... it wasn't in time to save John McCain because he was virtually tied with Obama for about two weeks until Lehman went down Obama jumped to a 4 and then a 5 and then a 6 point lead that he never relinquished but from an investment concern what's happened is we soared from 165 to 500. We're back to 197. That means that risk in the financial system is dwindling.
DM: The BKX how does that layer over. I would have thought it sort of measures somewhere in between the VIX and the TED spread then?
DC: Well the BKX is telling you what the bank stocks collectively are worth and of course it's a much more complicated index because people may decide that banks aren't going bust but that they aren't going to make much money and then therefore they aren't a prime investment and I got an e-mail message from a frequent participant on this call who was unable to get through for whatever reason and he's asked me to comment on the fact that how is it that the BKX seems to be doing so well while Goldman keeps gapping lower and I'm afraid I can't answer that because Goldman is sort of the gold standard for investment banks. But frankly this whole financial crisis came, now that we look back on it, from the fact that banks after Glass-Steagal decided that the way to grow their earnings and get bonuses for their top people was to become investment banks.
So they got into businesses they didn't know that much about. They levered up. They took risks that they didn't understand and they got away from the basic business of banking. The crash in '29 and the collapse of banks then was because their borrowers couldn't cover their loans because of the depth of the recession. The collapse this time wasn't with 6 1/2% unemployment because all of the borrowers out there can't meet their liabilities. It's because of all these kinds of toxic paper that banks added to their book instead of their conventional business of making loans to borrowers that they knew and had relationships with.
So I think that you can separate out in this the bank banks which we assume are going to be going back to the business of banking and when they do there will be credit flows to regular bank customers like small businesses and exporters and those kinds of customers and I hope the banks have learned from this that they shouldn't try to put on the trappings of Wall Street stars.
When I was watching the election returns and that North Carolina voted for this time for the Democrats and one of the big reasons when they were analyzing it was the drop in the Republican vote in Charlotte. Well Charlotte lost one of their two big banks. Charlotte was on its way to being the second financial center in the United States and because of Wachovia's takeover of Golden West Financial where they got all of these toxic mortgages, what they did is they went outside their basic business.
Wachovia was a well-managed bank and so they had to be taken over. And I think that is another example that this crisis is different from the others because of the fact that the risk practices of investment banks who could lever up to 20 and 30 times were adopted by bank banks and those bank bankers didn't have experience with this but they told themselves, "We're as smart as Goldman. We're as smart as Bear Stearns," We may in fact dramatically reduce the role of pure investment banks for a while because they are not performing the economically necessary function that pure banks are. So as people troop back to doing the businesses that they know best, the economy will stabilize out.
So I apologize for the length of this answer but in order to analyze something as big as this you've got to understand how it is that mistakes could be made on this scale and what happened was that the investment banks took risks that they didn't understand but you could lose investment banks as long as you had bail outs so that the counterparty risk was covered. We can't afford to lose the bank banks.
Thank you. Any other questions?
Question 2 (Steve Osmak): Don, I was wondering if you could talk about the grains because I can understand why all the other commodities, the base metals and the oils would collapse in the context of a global recession but I mean last winter it was the Philippines I believe rioting over rice and Costco had a limit on how much you could buy. I just can't understand how the grains could completely collapse after all you say people have to eat. So any insight as to why that's been so severe?
DC: Well one of the reports that we follow closely is the Chicago Board of Trade, the CME daily report on commodities and they always begin with the report on the grains and on days that there's grain sell offs they always point out right at the beginning that they tie it in with sell offs by commodity funds at the same time they were selling off other commodities and so therefore the kind of lapidary distinctions between foods and fuels and fuels and metals don't get reflected when these commodity funds are finding out that their investors are pulling out their money.
So frankly in my view the most undervalued commodities now are the grains and I'll reiterate that the evidence about the cooling trend just gets stronger by the day and by the week. London had its first snow since 1922 in October. Yesterday in the high Prairies we had snow storms with snowfalls of more than 2 feet in some places and this is early November. Brazil has experienced extensive snowfalls.
So the evidence is that we're going to have another winter which will be bad for crops. China experienced such huge crop losses because of the bad winter last year which was a force that undergirded the commodity rally of the spring. That looks like that trend is still in place but I realize that for a lot of people on the call the idea that there could be a global cooling trend is still the ultimate heresy.
So I will just mention that the carryovers of grains remain inadequate and the fundamental story for the grains remains intact but I'll be able to discuss this in perhaps greater detail and knowledge I hope after my return from my India trip at the end of this month.
Thank you. Any other questions?
Question 3 (Anthony O'Malley): Thank you for the Basic Points. I read it every time it gets published. I'm very interested in the Dollar and the 10 trillion dollar national debt which I'm doing some research for a college where I work at and how would you point to the Dollar in the next year perhaps?
DC: Well the Dollar had better come down because the strongest component of the US GDP so far this year has been the export side. So this is taking away some of the dynamism in the US economy at a time that there's not much else that's dynamic.
So there will be no reason for the Fed to try to do anything that's Dollar friendly like raising interest rates. The Dollar is the currency of the debt as they repatriate these hedge funds. I regard that as a temporary development and so I would expect the Dollar to fall and the next big currency is from the EuroZone and since the news from that zone gets bleaker by the week you say, "Well how can the Euro rally?" The difference is you've got high savings rate in many of the European countries whereas the US savings rate remains at zero. The US has to import vast quantities of money each month to cover its current account deficit and offset its lack of domestic savings.
So at such moment as that inflow dries up or weakens, the Dollar will fall and of course commodities still as an asset class tend to trade inversely to the Dollar not just gold but commodities as an asset class. So what we're seeing today with the strengthening of commodity prices, well the Dollar is somewhat weaker.
But then the other big currency zone of course is the Yen and it's hard to make out a case for that except for the fact that people borrow in Yen, people that is outside of Japan and meanwhile Japanese savers are still rushing to take their money out of Japan and invest it at higher interest rates abroad. The gap between Japanese and foreign rates however is narrowing as central banks rush to rescue their own economies. So that Mrs. Watanabe may be more constrained in exporting from Japan her savings.
So putting it all together, the Dollar is stronger than it should be but I think it's partly reflecting:- (a) the repatriation of hedge fund money, (b) the perceived weaknesses in those other two currencies. But what it does mean is currencies other than the Dollar should strengthen and particularly the Canadian Dollar, which was way oversold, should rally back because the fundamentals in Canada remain very strong relative to those south of the border.
But the Dollar remains at the center of the global system and so therefore it does acquire haven characteristics but at such time as people start believing in a global economy then they're going to look at the fundamentals for the Dollar and the fundamentals for the Dollar remain bleak.
Thank you. Any other questions?
Question 4 (Kirk Aldridge): Yes, Don, could you just comment on the high yield bonds.
DC: Thank you. Frankly I think that for investors who are looking at some point at unloading cash and going into an asset class, corporate bonds as an asset class look good and within the high yield market as long as you aren't dealing with the LBO bonds where they've stripped out their covenance pretty much in order that they could have birthday parties for the private equity people. I would within the high yield group there are lots of companies that you have to believe unless this is a depression are going to be able to service their debt and again people have been rushing away from risks of all kinds. So this is an asset class which grew dramatically in size because of the private equity mania.
So again within the group what you've got to separate out is those whose bonds have been used to finance machinery and equipment and business purposes and as long as you look at the underlying companies and what they're doing that would be an asset class that should have terrific attractions over the next twelve months but this is a case in which more than the ordinary degree of study is required and is a game for specialists. We have a partner company, Monegy, that's really good at these. There are other fund managers out there who are good at private equity and high yield and distinguishing the ones that don't have the proper convenance in them. To have a covenant free bond at a time of global recession, to have a devastated balance sheet is to have an asset that has very little apparent value.
Thank you. Any other questions?
Question 5 (Donna Short): Just quickly for clients who are using tax losses to their advantage can you just reiterate the sectors that are the leading sectors that one should still stay in?
DC: Well I'll go back to it that on the assumption that there will be a brighter day tomorrow if you argue a posteriori then what you can say is the banks have to be in better shape twelve months from now than they are today. They've been hammered down, and bank banks that is as opposed to investment banks have to have intrinsic merit because their earnings should be tied to the recovery of economies.
So although it's been a long time since you've heard me recommending bank stocks on these calls I'm saying that they make sense now if you assume that equities as an asset class because we just cannot get a rally in the stock market now from these levels without having some leadership from the good banks and again the global economy if it comes back is going to be led by those economies that have positive demography and where high savings rates and growing labor forces and these are economies that have a greater appetite for commodities than the advanced economies.
So by having the asset class that will do relatively well as the OECD economies recover which is the banks and the commodities tied to the economies that are going to have the greatest growth rates over the next few years. So what you do is you take the two bookends and in between it's a stock by stock basis.
Thank you. Any other questions?
Question 6 (Marcus Backham): On the monetary expansion that we are witnessing at the moment is truly impressive. There is just one concern that the patient being the global economy being in IC. We in check should really help him to get back on his feet but you get somehow the impression that the drip is blocked. We see that in anecdotal examples that companies struggle to get patient and family financing. We still see that reflected in a very depressed Baltic Freight Index. Is there a risk that the patient being the economy is probably more seriously damaged than we wish to think because of potentially that blocked drain that we're seeing at the moment or are these concerns maybe too overstated?
DC: Thank you. Well the Baltic Dry Index is a classic index that's a short term measuring commitments for charters and at a time when the banking system of the world is at bay one of the big problems with these is getting letters of credit and having the certainty that if you load up a ship and send it off to sea that when it reaches its destination that there will be somebody there who can definitely pay for the cargo. So in that sense it's very much levered to the BKX because of the squeezing or the freezing of the financial flows.
I might just mention that I was talking to a short term fund manager and asking for an update on how the short term paper market is behaving and he says, "Well, it is certainly looking better but we've got a different problem now. We've got loads and loads of money but we have fewer assets that we can invest in," and that's because we're losing all sorts of investment classes that were AAA rated earlier in the cycle that funds could use. They're being taken off the list because we find out now that things like auto loans, home equity loans, these trusts that were set up where they could maintain their AAA rating by just substituting new credits as credits went bad. These are being taken off the table.
So the oddity is that one of the things constraining the regrowth here is that we are not flowing it from the short term investors now who have money to invest into a lot of economically sensitive classes. Again I regard that as a short term problem. In general once you keep piling up lots of loose cash it eventually starts moving out of treasury bills and starts moving into other kinds of paper but with the Lehman collapse was such a catastrophe for short term investors that acquiring an appetite for any kind of risk is going to take some time to do but I don't regard this as a sign when you put them together that the Baltic Dry Index indicates that the global economy is in a depression situation. I think it's simply that nobody is prepared to take the risk when they aren't sure about the counter party on the other side. It is a counter party relationship and so we need a process of healing to get that functioning again.
Thank you. Any other questions?
Question 7 (Mr Growenwagen): Hi Don. I would like to ask you something with respect to the currencies because I believe that what we will see going forward is that the currencies will basically show weaknesses and strengths according to the fundamentals in the economy and I was wondering you touched upon the high savings rate of Europe and so on and potentially also debt levels. What do you see happening because you were mentioning the gold and I think it has been a big question mark for a lot of people that gold didn't rise despite the fact that it doesn't have any counter party risk and as you said that the US monetary base has expanded by 50% in the last couple of weeks. So there is something odd going on here. So what's your view on this and how do you think that the currencies will behave going forward and what will determine their strength?
DC: Well that's a huge question about the currencies and you're right they'll eventually be behaving in response to the behavior of their domestic economies and what their domestic savers do with their funds and that's a case by case basis.
The gold story is one where we moved from fearing inflation when gold was trading at 940 and then we had the Midnight Massacre and then we had the collapse of Lehman and so the result is that we stopped fearing inflation and feared only deflation and people said, "Why do I need an inflation hedge asset," and although it's haven assets for a financial crisis seem pretty weak it's because it was coming off a high peak which was driven off inflation fears. Remember as recently as July the 10th the CPI was 4.5% the highest in 15 years and the question was how much the Fed was going to have to tighten.
So my view is that gold as a store of value - by the way again if you want to take a horrible example of going back to 1929, gold was a great place to be because it held its value better than other assets and then eventually of course got revalued upwards after the 1932 elections from $20.67 an ounce up to 35 as part of the reliquification of the US economy.
So we haven't been through such disorganized chaotic conditions in my lifetime and so trying to put these things together and suggest there's something rational behind everything is a venture in futility. What I can say simply is that as investors what you try to say is there's going to be a world out there and when we've gotten back to some kind of normalcy how will these assets relate to each other and I believe that when all this is done that gold is going to be considerably higher than it is today because people will recall Milton Friedman's dictum's that inflation is always a monetary phenomenon.
I can tell you that back in the '70s when inflation was soaring, gold for a while hesitated. It didn't start moving until later on when the horrible bear market of '72-74 was over. So gold can take a pause even when the fundamentals for it are getting dramatically better.
I've got time for one more question.
Question 8 (Catherine Morrisey ): A couple of things. I'm wondering if the prospects for one North American currency have risen of late and then the second question is are you worried about protectionism here.
DC: There won't be one North American currency because in order to do that you'd have to amend the Federal Reserve Act and that's only slightly easier to amend than the US constitution. So that won't happen and your second part of your question was protectionism?
Well at the time of all economic crises you get a lot of protectionist talk. It's not so easy to bring back protectionism now because there's treaties out there and tearing up treaties is a very difficult act and in the case of incoming President Obama, he's going to have a big NAFTA problem which has nothing to do with Canada.
It has to do with Mexico because over 50% of the budget of the Mexican government comes from revenues from the Mexican oil company, Pemex, and $61 oil means a coming financial crisis for the Mexican government which means a big increase in attempts from Mexicans to come into the US illegally and he wouldn't have carried a lot of the states he did carry had it not been for carrying the Latino vote by such big margins. It's going to create such a dilemma for him that he's not going to be placing any phone calls to Ottawa.
DC: So thank you all for tuning into the call. I try to as a matter of justification for doing these calls limit them to one hour so that you can get back to your work. I appreciate your participation. I'm leaving for India in the middle of next week. We will try to arrange a call at some point from India but it will probably be at a somewhat different time given time zones but given as there is so much going on I will try to stay in touch with you. Thank you again.