Basic Points

All Clear?

March 16, 2012

Published by Coxe Advisors LLP

Distributed by BMO Capital Markets

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Company Name Agnico-Eagle Mines Barrick Gold BHP Billiton Citigroup Deere Exxon Mobil Freeport-McMoRan Goldcorp International Business Machines Stock Ticker AEM ABX BHP C DE XOM FCX GG IBM Disclosures 1, 2 1, 2, 3, 4 2 Company Name Kinross Gold McDonald's Nasdaq Newmont Mining Potash Rio Tinto Vale Walt Disney Stock Ticker KGC MCD NDAQ NEM POT RIO VALE DIS Disclosures 1, 2, 3, 4 2 1, 2, 3, 4 1, 2 2 2

2 1, 2 2

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Don Coxe THE COXE STRATEGY JOURNAL

All Clear?

March 16, 2012

published by

Coxe Advisors LLP Chicago, IL

THE COXE STRATEGY JOURNAL All Clear?

March 16, 2012

Coxe Advisors LLP. Author: Editor: 115 S. LaSalle Street, 11th Floor Chicago, IL USA 60603

Donald Coxe dc@coxeadvisors.com Angela Trudeau at@coxeadvisors.com

312-461-5365 604-929-8791

Basic Points is published exclusively for BMO Financial Group and distributed by BMO Capital Markets Equity Research for clients of BMO Capital Markets, BMO Nesbitt Burns, BMO Harris Private Banking and Harris Private Bank. BMO Capital Markets Equity Research Manager, Publishing: Desktop Publishing and Distribution Coordinator Monica Shin monica.shin@bmo.com Anna Goduco anna.goduco@bmo.com

All Clear? OVERVIEW

Are we in a new global bull market for equities and commodities? Or is this just a replay of last year's wintry rush into risk assets before a summer-autumn return to bearishness? Yes, stocks have been climbing handsomely, but not because of a sudden onset of unanimity that a roaring economic recovery has begun. The fraternity of leading central bankers is hardly ebullient, asserting that their economies are too fragile. Ben Bernanke remains so concerned that he says his rates will stay near zero until 2014. The European Central Bank and the International Monetary Fund are in euro-crisis mode, after the ECB's breathtaking balance sheet explosion. The Bank of Japan has now joined the club of currency debasers, and Japanese stocks are on a tear. Nor do the tired, angry eurozone political leaders believe that the strong stock markets of the first two months of the year portend a return to normalcy. They fear that they are perched on PIIGS powder kegs, knowing that most of their economies are in recession. In the USA, if you are conspicuously ebullient, chances are youre a Democratic politician or strategist. Last summer Democrats were even more frightened of the future than were equity investors. They have recently been rejoicingat the nation's strengthening economic numbers and their strong poll numberswhile the Republicans continue to impale themselves on points of political purity in an increasingly nasty nominating process that repels voters. Even the investors in gold, the top-performing asset class of the past decade, are showing signs of sulking that their metal has lost its mettle. Finally, there is the pervasive existential fearthat an Israeli-Iran war will trigger a global recession. This month we step back from the fears and furies, and ask a simple question: when central banks and governments unite to fight recession threats through large-scale reliquification of their banks and depreciation of their currencies at a time of near-zero yields, should prudent investors be holding high reserves of cash? We answer that question emphatically: "No." There are better alternatives, which we discuss in detail in this issue. The ECB's trillion euro refinancing of eurozone banks and the Fed's massive reliquification, combined with the positive announcement of big banks' stress tests virtually take the threat of a new banking crisis off the tableat least for now. That means the endogenous risks for equities as an asset class are sharply reducedat a time when the S&P is trading near 1999 price levels. The financial heroin still flows. We are adjusting our Recommended Asset Mixes accordingly.

March 2012

March 2012

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All Clear?
The Paper Money Era Faces New Risks
US Dollar Index (DXY) March 1, 2009 to March 14, 2012
90 88 86 84 82 80 78 76 74 72 70 Mar-09 Sep-09 Mar-10 Sep-10 Mar-11 Sep-11 Mar-12 80.55

Yen vs. US Dollar March 1, 2009 to March 14, 2012

105 100 95 90 85 80 75 Mar-09 Sep-09 Mar-10 Sep-10 Mar-11 Sep-11 Mar-12

83.74

Euro March 1, 2009 to March 14, 2012

1.55 1.50 1.45 1.40 1.35 1.30 1.25 1.20 1.15 1.10 Mar-09 Sep-09 Mar-10 Sep-10 Mar-11 Sep-11 Mar-12 1.30

Brazilian Real March 1, 2009 to March 14, 2012

0.70 0.65 0.60 0.55 0.50 0.45 0.40 Mar-09 Sep-09 Mar-10 Sep-10 Mar-11 Sep-11 Mar-12 0.55

Swiss Franc March 1, 2009 to March 14, 2012

1.4 1.3 1.2 1.1 1.0 0.9 0.8 Mar-09 Sep-09 Mar-10 Sep-10 Mar-11 Sep-11 Mar-12

Canadian dollar March 1, 2009 to March 14, 2012

1.10 1.05 1.00 0.95 1.01

1.07

0.90 0.85 0.80 0.75 Mar-09 Sep-09 Mar-10 Sep-10 Mar-11 Sep-11 Mar-12

March 2012

All Clear?
Between New Year's Day and Leap Year Day, gold was climbing beautifully, rising from $1600 to $1792, and outperforming the US stock market. Then it fell $80 within minutes, and is now within a bad day's trading range of giving up all its gain. The sudden sell-off and the subsequent bearish bullion action has unnerved some believers in gold, while presumably pleasing some leftists who see faith in gold as being even more primitive than faith in God. We don't see this as a faith-based debate. We see it as a discussion of what makes sense for governments, central banksand investors. A store of value can be something unique and intrinsically beautiful, like a great antique or an Old Master paintingor something rare, portable and readily exchangeable, like gold or, to a lesser extent, silver. Gold was an unquestioned store of value for millennia, until the horrors and destruction of World Wars I and II. The first consequence of those disasters was that the US government had, by 1944, become the owner of most of the known gold in the world, and the second was that the dollar had become the universally-prized medium of exchange. J.M. Keynes, who died prematurely, lived long enough to participate in the Bretton Woods conference that codified these observable realities into monetary law, thereby enthroning the dollar as the international standard of value; the US would make its gold reserves available to other central banks, (few of whom would presumably want much), but it would remain an illegal investment for Americans. He died believing he'd buried the barbarous relic for good. Bretton Woods was a radical innovation achieved at a time most of the world was preoccupied with war and cared little for monetarism. However, a mere four decades earlier, the renowned J. Pierpont Morgan, in commenting on the possibility of creation of the Federal Reserve, had summed up the shared belief of the wise through history that the only real money was gold: all else was credit. After the Fed was born, its banknotes would, for a half-century, include the designation "Silver Certificate," and were convertible even-up into silver dollars.

...the shared belief of the wise through history that the only real money was gold: all else was credit.

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In 1957, six years before the US finally ran out of all its monetary silver, some apparently prescient people arranged to have a printed piety appear on the currency: "In God We Trust." That restatement of the backing claimed for the greenback came, perhaps coincidentally, at roughly the same time that a new breed of activists had begun the decades of lawsuits establishing it as an offense against the Constitution to worship God in the public square. As a result, the real backing for todays beleaguered buck is both obscure and controversiala major reason for the birth of the Tea Party. (It is, however, better-backed than the euro, which does not claim support from God, any government, tax system, army or navy. Its value is based on faith and hope, not clarity.) During the glory years of the British Empire, the British pound was goldbacked and a holder need only present himself to Threadneedle Street to exchange pound notes for gold sovereigns. The Bretton Woods formula worked well during the early postwar years, but by 1960, the reviving economies of Western Europe were draining Fort Knox's gold with gusto. Washingtons first response to this Eureffrontery was an appeal to American patriotism: Buy American and Save Our Gold! Pan Am, then the nation's leading Transatlantic carrier, began running full-page ads beseeching Americans to fly in its planes to Europe, with the unspoken suggestion that flying in planes of the gold-buying European nations was unpatriotic. In 1963, John Kennedy imposed the heavily-punitive Interest Equalization Tax on all foreign investments by Americans. But the dollar continued to lose value and the gold kept flowing out. Eight years later, Richard Nixon broke the dollar's last link with gold by closing the gold window to foreign central banks. Had he not done this, the US would have lost most of its remaining gold. His Treasury Secretary, John Connally, told the Europeans, Its our currency and your problem, a point confirmed when the President imposed an emergency 10% tax on most US imports. In 1974, the Republican-led Congress set a standard of wisdom for all subsequent Congresses by enacting two of the most sensible pieces of legislation in the nations historyrepealing the Interest Equalization Tax and legalizing ownership of gold for Americans.

...some apparently prescient people arranged to have a printed piety appear on the currency: "In God We Trust."

March 2012

All Clear?
The monetary story since the Volcker era was largely the story of the yin-yang of paper money: all governments wanted their paper to be considered a viable store of value acceptable in trade, but few could stand having their scrip so strong that it could weaken their economies' global competitiveness. With the advent of freer global trade from the formation of the World Trade Organization in 1995, the problems for strong currencies intensified. Leading central banks' performance tended to be judged not on the basis of the international strength of their paper, but on the rates for inflation and GDP growth in their economies. The landmark currency event of the 1980s had been the Plaza Accord of 1985, which was a devaluation of the dollar imposed on Japan, Germany and Britain. The primary target was Japan, because the yen had fallen 50% in value during the Volcker years when Japanese investors were loading up on high-yielding Treasury bonds. Over the next two years, the yen's value against the dollar appreciated by half. The expression "Sound as a dollar" began to lose its logicalor even emotionalbasis and became as quaint and rare as spittoons. (Those Roosevelt, Nixon and Reagan devaluations are often cited by foreign critics as evidence that the US has a history of major currency manipulations, which make its sustained attacks on China's currency policies seriously hypocritical. We find those arguments convincing and are very uncomfortable with the strident attacks on Chinese currency policies of American politicians in general, and Mitt Romney in particular. Why is no one pointing out that Reagan, supposedly the model of all Republican political virtues, was a currency manipulator whose audacity makes today's Chinese policies of renminbi management look virtuous in comparison?) Under Paul Volcker, the Fed became the greatest inflation-fighter in its history. His successor, Alan Greenspan, was an unlikely Fed Chairman because of his youthful dedication to the anti-Fed theories of Ayn Rand. He accepted his dual responsibilities (fighting inflation and keeping the economy strong) and became a master at goosing the printing presses when banks (or the hilariously misnamed Long Term Capital Management) got into trouble. He denied that his robust monetary effusions after that bailout of elite fools were a major factor in the Gadarene Swinish rush of Nasdaq from 2200 to 5200and then over the cliffarguing that the stock boom reflected the anti-inflationary effects of the new technologies. For his manipulations and money-printing, he became known as the Maestro who could do almost anything with liquidity.

..."Sound as a dollar" began to lose its logicalor even emotionalbasis and became as quaint and rare as spittoons.

March 2012

THE COXE STRATEGY JOURNAL

When the euro was born, amidst widespread doubts about its security, it was trading at less than 90 cents on the dollar. Under the anti-inflationary tutelage of Jean-Claude Trichet, it rose to $1.60. He was disappointed that the citizenry of his member states didn't applaud him for his tight-fistedness, which was crushing eurozone competitiveness abroadmost notably compared with businesses headquartered in the UKonce again known derisively by Continentals as "Perfidious Albion." The euro had fallen as low as $1.32 before Mario Draghi succeeded Trichet and began his trillion-euro refinancing programs this year. Although Jens Weidmann, CEO of the Bundesbank, has expressed strong concern about these potentially inflationary moves to prevent European banks from being impaled on their investments in eurozone government bonds, most investors and politicians were heaving sighs of relief until Greece once again moved back to Page One. Mr. Weidmann isn't getting widespread support for his inflation concerns, because most of the ECB's spectacular loan growth is coming back to the ECB in the form of short-term deposits. Banks are using his money to give some appearance of health to their skeletal balance sheets. Remarkably, Philipp Hildebrand, former head of the Swiss National Bank, devalued the long-cherished Swiss franc last year with an astonishing expansion of the Swiss balance sheet, in an attempt to tie it to the euro. This unlikely pairing of the most prestigious European currency with its most dubious was forced on him, he said, by the desperate position of Swiss watch manufacturers, shopkeepers, and hoteliers. It was a singular case of a group of expert sailors leaping onto a sinking ship. The gap between the franc and the euro had become almost too much of the Swiss economy. Hildebrand was able to cite the precedent of the bank in the late 1970s, when the watch manufacturers demanded a halt to the francs flight skyward, which was achieved by imposing taxes on inflows of capital into Switzerland at a time the franc was the only paper money considered to be almost as good as gold. While the dollar was becoming dubious through QE2 and zero interest rates, and the euro and Swiss franc were forming the Odd Coupling, the last strong paper money left standing was the yen.

It was a singular case of a group of expert sailors leaping onto a sinking ship.

March 2012

All Clear?
It may seem surreal to investors who don't trade currencies for a living, that the yen, the paper issued by the oldest and most indebted population on earth, rose to new highs after the onset of the Fukushima-induced recession. Wasn't this rather like life insurers rushing to issue large policies at reduced premium rates on septuagenarians living within ten kilometers of the reactors? The long rise in the yen's value had been a life-saver for many American manufacturers, but was even more important for Koreas chaebol. After years of lobbying, the big Japanese electronic, machinery and automobile companies finally convinced the Ministry of Finance and the Bank of Japan that something drastic had to be done to save Japan's economy from collapse at a time of soaring energy costs due to the end of nuclear power.
Yen March 1, 2007 to March 14, 2012
130 120 110 100 90 80 70 Jan-07 Sep-07 May-08 Jan-09 Sep-09 May-10 Jan-11 Sep-11 83.76

...rather like life insurers rushing to issue large policies at reduced premium rates on septuagenarians living within ten kilometers of the reactors?

The era of paper money began long ago with the determination of most key issuers to keep their currencies strongso as to resist demands for return to gold or silver as media of exchange. However, when almost no country other than Zimbabwe seems to want to strengthen its currency, the end of the era of paper money backed by nothing but paper promises may be at hand. When even Brazil, source of some of the most spectacular devaluations in world history, seeks to arrest its currency's rise, investors should start preparing for the time when inflation returns in earnest, and interest rates start on a market-driven drive toward real returns.

March 2012

THE COXE STRATEGY JOURNAL

For more than a century, currencies had been loved for their financially chaste virtue. Today, they are loved when being publicly deflowered. Six years of Bernanke's financial heroin were successful in preventing collapses among the Big, Bad Bonused Bailout Banks, (and protecting their bosses' bonuses) but they have been devastating pension funds, and for savers through fixed incomemost notably seniors who, by custom or lack of sophistication, saved through bank deposits. A 2% yield on 10-year Treasurys is a disaster for corporate pension funds which, like most state and local employee plans, assume 7.5% to 8% in their plans' expected returns. Already, some major private sector plans are collectively seeking legislative exemption from having to plunge more than $100 billion into their plans to improve their funding at a time IBM is borrowing for three years at .55%, Disney for five years at 1.125% and McDonald's for 30 years at 3%. What highly-ranked asset yields 8% these days? We believe a major bond bear market is inevitable within two yearsif only to move rates toward normalcy. Before then gold will become increasingly respected as the universal store of value when the pretenders have fallen into contempt. Will gold once again become an officially-recognized store of value in a world of etiolating paper printed by desperate central banks to cover endless deficits across most of the industrial world at a time the fastest-modernizing emerging economies are collectively managing their finances responsibly? Last summer, we spelled out a strategy for using the gold reserves of the leading PIIGS to back 50-year bonds convertible at any time into gold. The recommendations did not go unnoticed, but little has happened to date to indicate that governments are prepared for such a controversial resort to their currency reserves. From conversations, we understand that the costfinancial and reputationalto France for acceding to Jacques Rueffs longstanding recommendation to issue a 15-year gold-backed bond in 1973 was nearcatastrophic. Those bonds skyrocketed in value. As one central banker told us, Every central banker learned from Rueff that recommending a goldbacked bond would be a career-defining event.

...Every central banker learned from Rueff that recommending a gold-backed bond would be a career-defining event.

March 2012

All Clear?
Yet gold began to trade as a store of value last year when the euro was under attack from potential defaults that could even extend to Spain and Italy. Frightened Europeans bought gold coins with their eurosa major factor in the gold rush of 2011, when the price shot up from $1380 to as high as $1918, before plunging to the $1600 range as investors began to anticipate the replacement of Jean-Claude Trichet at the ECB with Mario Draghi, a suave technocrat. (Admittedly, there were mordant jokes after he took over in the midst of new crises for Greece and for Italian bonds. Example: "You see what happens to Europe with a German Pope and an Italian head of the ECB!") Once Mr. Draghi took charge at the ECB and the Merkel-Sarkozy-Lagarde team took charge of rescue operations, gold once again became a risk asset, because by then too many hedge funds held too much gold, and the mostlevered hedge funds' trading time horizonlunchreturned to break golds ascent to $1920, carrying it down to a close of just $1566 at year-end. It traded up along with the liquidity expansions this year, only to break down on Leap Year Dayand slid even further when Bernanke announced that the economy was strengthening and no new monetary stimulus was being contemplated. But more bad news for gold was coming from the Fedin the form of announcements that nearly all the big banks had passed stress tests, which meant they could boost dividends and buy back more stock. That basically took the prospect of another banking crisis off the tabletarnishing gold. One doesn't need hurricane insurance after the season is over. If conventional stocks form the asset class of Greed, then gold is the asset class of Fearfear of inflation, and/or fear of system breakdown. With Five-Year Treasurys yielding 1%, a casual investor might assume that the fear of inflation is as outdated as fear of Dragons or of "things that go bump in the night." Yet, within the economically-comatose eurozone, inflation has reached 2.74%well above the ECB targeta suspiciously stagflationary relationship. Golds role in monetary and wealth-protection strategies may be going through tortuous twistsbut at $1650 an ounceup 12% year-over-year irrelevance is not on its horizon.

If conventional stocks form the asset class of Greed, then gold is the asset class of Fear...

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There's Gold in Them Thar Hills, But Who Cares?

Barrick Gold (ABX) vs. SPDR Gold Trust (GLD) March 1, 2007 to March 14, 2012
140 130 120 110 100 90 80 70 60 Mar-07 Nov-07 Jul-08 Mar-09 Nov-09 Jul-10 Mar-11 Nov-11 62.64 50 30 Mar-07 Nov-07 Jul-08 Mar-09 Nov-09 Jul-10 Mar-11 Nov-11 37.05 110 90 70

Agnico Eagle (AEM) vs. SPDR Gold Trust (GLD) March 1, 2007 to March 14, 2012
150 130

Goldcorp (GG) vs. SPDR Gold Trust (GLD) March 1, 2007 to March 14, 2012
145 135 125 115 105 95 85 75 65 55 Mar-07 Nov-07 Jul-08 Mar-09 Nov-09 Jul-10 Mar-11 Nov-11 72.67

Kinross Gold (KGC) vs. SPDR Gold Trust (GLD) March 1, 2007 to March 14, 2012
145 125 105 85 65 45 30.40 25 Mar-07 Nov-07 Jul-08 Mar-09 Nov-09 Jul-10 Mar-11 Nov-11

Newmont Gold (NEM) vs. SPDR Gold Trust (GLD) March 1, 2007 to March 14, 2012
110 100 90 80 70 60 50 40 Mar-07 Nov-07 Jul-08 Mar-09 Nov-09 Jul-10 Mar-11 Nov-11 51.95

PHLX Gold vs. SPDR Gold Trust (GLD) March 1, 2007 to March 14, 2012
130 120 110 100 90 80 70 60 50 40 Mar-07 Nov-07 Jul-08 Mar-09 Nov-09 Jul-10 Mar-11 Nov-11 54.33

March 2012

11

All Clear?
If there were one over-arching theme at the BMO Global Metals & Mining Conference, it was that the gold miners are upset and even embarrassed that their shares have so dramatically underperformed bullion. ...the gold miners are upset and even embarrassed that their shares have so dramatically underperformed bullion. On the one hand, they were delighted in 2011 when it was reported that since Nixon closed the gold window, a bar of bullion had delivered higher investment returns than the S&P for forty yearswith dividends re-invested. But some gold mining CEOs find it an insult that what they mine is more respected than their companies shares. These people are justly proud of their skill and guts in finding and developing mines, and in extracting increasingly minute percentages of gold from tons of ore in increasingly challenging environments. If the automatic pitching machine used for training hitters on a baseball team was striking them out more frequently than most members of the pitching staff, the GM would be looking for new pitchers. Like them, we are disappointed at this sustained underperformance because it challenges the validity of our core theme for successful investing in mining and oil stocks: Buy companies with the best record for continuously increasing their proven and probable reservesand resourcesin the ground in politically-stable regions of the world. Don't buy them on current earningsthe earnings will come eventuallyit's stuff in the ground that matters. Notice how reserves tend to grow faster than metal price increases, because accounting rules prevent companies from converting resources into proven or probable reserves unless they are economic based on the metal's average price over the previous three years. There is no question that most miners' cost increases have in recent years outpaced expectations. But they haven't outpaced prices for gold and silver, although they have, in some cases, outpaced prices for base metals. There is also no question that soaring precious metal prices have attracted lustful responses from governments in many regions of the worldincluding some that had previously been morally pristine. To date, most of the requestsor outright demandshave been modest in comparison with metal price boosts. (An apparent exception to this assertion is the recent challenge to Freeport-McMoRan, owner of Grasberg, the largest gold-bearing orebody in the world and one of the world's biggest copper mines; this treasure has been a big contributor to the finances of the government of Indonesia. Rather suddenly, the government has demanded a huge increase in its participation in the mine. Result: FCX's stock price has slumped sharply:

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Freeport McMoRan (FCX) February 1, 2012 to March 14, 2012

49 47 45 43 41 39 37 35 1-Feb 3-Feb 8-Feb 13-Feb 16-Feb 22-Feb 27-Feb 1-Mar 6-Mar 8-Mar 13-Mar
38.12

...we have entered the most favorable era for gold prices in our lifetime...

But in considering the impact of higher per-ounce costs and taxes, there are few, if any, miners who predicted $1700 gold and $33 silver four years ago (when prices were $950 and $18, respectively). Moreover, today's metal prices only modestly reflect the impact on future gold prices from the massive monetary moves of recent months.
Gold ($/oz) vs. Currency in Circulation ($billion)* March 9, 2012
2,000 1,800 1,600 1,400 1,200 1,000 800 600 400 200 Jan-98 Jan-00 Jan-02 Gold
Source: Federal Reserve * Meridian Macro Research LLC

1,100,000 1,000,000 900,000 800,000 700,000 600,000 500,000 400,000 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12 Currency in Circulation

In our view, we have entered the most favorable era for gold prices in our lifetimeand the share prices of the great mining companies will eventually outperform bullion prices.

March 2012

13

All Clear?
Governments are running deficits beyond the forecasts of all but the hardiest goldbugs five years ago; central banks are printing money and creating liquidity beyond the forecasts of all but the most paranoid goldbugs a year ago. Real interest ratesa long-time measure of gold's attractionremain stuck in deeply negative territory in the United States and elsewhere in the world. Moreover, there remains the possibility that the eurocrisis will return, and this time some of the PIIGS will be forced to open their bank vaults and back new bond offeringsand rollovers of existing debtswith a long-term call on gold. Warren Buffett has of late become highly visible in backing various of Obama's pet concernsmost notably on income taxes. That he has become almost strident in ridiculing gold as an investment could be with some prompting from Democratic friends who see the soaring price of gold as an indictment of Washington and all its worksincluding the Fed. There is no gainsaying that gold is the 24 karat rejection of Big, Badly-Run Governmentthe political reality of our times. The Progressives would have us believe we can have most of what we want and charge most of it to future generations without creating inflation that would be particularly painful for the elderly. Paul Krugman, probably the highest-profile Progressive commentator, thinks that the current fiscal situation in which Washington gets 41 cents of each spending dollar through deficit financing is too restrictive: the deficits should be much larger. To read Krugman's columns, if you are not a far-Leftist, is to experience a growing affection for gold. Indeed, those TV gold pitchmen should consider hiring him to tell viewers what he thinks should be done for the economy to send them rushing to the phones to buy gold. Gold miners control most of the known gold deposits in the world, including mineralized properties that are uneconomic at current gold prices. The stock market is therefore paying nothing for the imbedded leverage to much higher gold prices through undeveloped resources and utterly undeveloped prospects. Think of them as a few strong NFL teams with consistent winning records and great coaching who have somehow managed to accumulate extra allocations of first and second round draft choices for the next five years, without having mortgaged their futures by paying excessively for their current crop of overachievers. In other words, good gold mines deserve a good place in almost any investment portfolio. 14 March 2012
THE COXE STRATEGY JOURNAL

...central banks are printing money and creating liquidity beyond the forecasts of all but the most paranoid goldbugs...

Is This a Bad News Bull Marketor a Head Fake?

S&P 500 March 1, 2007 to March 14, 2012
1,800 1,600 1,400 1,200 1,000 800 600 Mar-07 Nov-07 Jul-08 Mar-09 Nov-09 Jul-10 Mar-11 Nov-11 1,386.40

FTSE 100 Index March 1, 2007 to March 14, 2012

7,000 6,500 6,000 5,500 5,000 4,500 4,000 3,500 3,000 Mar-07 Nov-07 Jul-08 Mar-09 Nov-09 Jul-10 Mar-11 Nov-11 5,945.43

Nasdaq Composite Index March 1, 2007 to March 14, 2012

3,500 3,040.73

DAXX Index March 1, 2007 to March 14, 2012

9,000 8,000 7,000 7,079.42

3,000

2,500 6,000 2,000 5,000 4,000 3,000 Nov-07 Jul-08 Mar-09 Nov-09 Jul-10 Mar-11 Nov-11 Mar-07 Nov-07 Jul-08 Mar-09 Nov-09 Jul-10 Mar-11 Nov-11

1,500

1,000 Mar-07

Toronto TSX Composite Index March 1, 2007 to March 14, 2012

16,000 15,000 14,000 13,000 12,000 11,000 10,000 9,000 8,000 7,000 Jan-07 Sep-07 May-08 Jan-09 Sep-09 May-10 Jan-11 Sep-11 12,455.82

Nikkei 225 Index March 1, 2007 to March 14, 2012

20,000 18,000 16,000 14,000 12,000 10,000 8,000 6,000 Mar-07 Nov-07 Jul-08 Mar-09 Nov-09 Jul-10 Mar-11 Nov-11 10,050.52

March 2012

15

All Clear?
There is so much rationally-based bearishness and gloom around that one is tempted to assert that this stock market rally should be shorted. Let us recite the big fears: ..."Care of Canada's Aged is Grave Problem." 1. Central banks have driven interest rates down to levels that would have seemed impossible even a few years ago. Although their economies have not responded to these injections of what we call financial heroin with anything approaching ecstasy, they are as hooked on near-free money as any drug addict, so the central banks have to keep pumping. 2. The political class is running out of what Margaret Thatcher called "other people's money" in most Western nations and is forced to resort to what it calls restraintwhich is horrendous deficits that provide little economic stimulus but shower enough on public sector unions to keep them from disabling the economy by going on strike. Many decades ago, The Calgary Herald published a story on the plight of the aging poor with the arresting headline "Care of Canada's Aged is Grave Problem." But those were the days of the Baby Boom, and oldsters were a small fraction of the population. Today, the situation is "graver." 3. To the extent that the deficit has been strongly stimulative, the prospect of major US tax increases at year-end is bad news for equity investors. Congressional agreement on tax provisions prior to the election is extremely doubtful. Result: the Bush tax cuts will expire, which means big increases in income tax revenuesand a potentially painful contraction in the fiscal stimulus which has undergirded the modest economic growth of recent years. Some clients have questioned our new (for us) optimism this year, pointing to these tax boosts. We have taken the position that they will actually beon balancehelpful to the economy, because they will push back the specter of total national financial collapse from political intransigencea big constraint on private sector investing. Perhaps the only way the nation will get needed tax boosts is by default, because the only people anybody in Washington seems to want to tax these days are "the Rich"and there aren't enough of them to make a big difference.

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4. For most investors, the most important effect will be the end of the special 15% tax rate on dividends. They will become ordinary income, which, with Social Security surcharges, will be approximately 40% for the top-bracket taxpayers. This could be a constraint on US stock prices at a time when stocks known for their reliable and growing dividends have been strongly outpacing the rest of the stock market. 5. The stock market itself is becoming, in the eyes of manyif not most small investors, a sort of electronic casino rigged for traders operating in micro-seconds, producing the occasional Flash Crash, and a tendency for overall correlations of returns that seem to make investment research a waste of time, money and emotional energy. 6. Abroad, there are real reasons for concern: China's growth is slowing, the Arab Spring has sprung bloody leaks, and now there's a real possibility of war between Israel and Iran. We recognize the validity of all these concerns. However, now that Japan has joined the club, the global liquidity explosion will continue, which means several things: 1. A double-dip recession is only a remote possibility, when both indebted producers and indebted consumers are benefiting from phantasmagoricallyattractive financing costs. 2. Cheap money delivers benefits inversely to quality: well-run governments, like Saskatchewan, Texas and the Netherlands, which run small deficits, and account carefully for their pension plans, receive modest benefits from low borrowing costs, whereas overindebted governments with monstrous, and traditionally understated, pension liabilities (like Illinois, California and Portugal) benefit from both the availability and the low cost of loans. 3. There are more badly-run governments than well-managed governments, so cheap money is keeping ghastly governments afloatto the benefit of the private sector participants in those economies. We think a modest global economic recovery is more probable than a global recession, mostly because zero interest rates are so beneficial for companies carrying significant amounts of debt on their balance sheetsas long as that debt was accumulated to buy assets, machinery and equipment, and not to cover costs of an LBO, where the company gets the liability and the bond investors get the returns. (We aren't totally opposed to LBOs, of course, and would have no problem with investing in their debts in a high yield fund.)

The stock market itself is becoming, in the eyes of manyif not most small investors, a sort of electronic casino...

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All Clear?
We don't see this as the beginning of a great long-term bull market, because the central banks can't keep pumping out virtually free money forever. As interest rates return to normal levels, today's level of fiscal deficits may seem like an era of great restraint. The Tea Party's well-meaning efforts to cut government waste could, if implemented, have only minimal impact on the nation's deficits in face of a trillion-dollar increase in Treasury borrowing costs from even a 1% increase in yields. A 1970s-style bond bear would add trillions to annual deficits and disembowel the rosy Obama budget projections showing only modest increases in borrowing costs. The underpinnings for sustained growth aren't there, because governments will, in desperation, eventually have to raise taxes and impose constraints on growth. (They raise most taxes because they have no choice, but they impose carbon taxes, which severely constrain growth, because they are addicted to a dubious ideology. China's furious response to the EU's proposed carbon taxes on jetliners' "footprints"switching orders for civilian jetliners from Airbus to Boeingis a sign that carbon taxes may not be the financial panacea the enthusiasts believe.) But investors cannot afford to miss even a moderately bullish market, because what comes after could be so painful. Governments now account for roughly half of GDP in the industrial world. Most citizens get more from government than they pay in taxes or social security contributions. In the US, nearly half the population pays no income tax at all, and therefore is supportive of the demands of the Occupiers that the 1% pay far more. In France, the likely next President says he'll raise the income tax rate on the rich to 75% because it is an affront to French society that anyone should earn more than one million euros per year. Obama uses some of the same rhetoric, but knows that he'd never get Congressional (or Hollywood) approval of a top tax rate that high. But he also knows that he's close to achieving the Roman system of power maintenancebread and circuses. Free bread (through food stamps), rousing speeches, and no taxes for more than half the population, and they shouldat least in theorysupport you forever.

...he's close to achieving the Roman system of power maintenance bread and circuses.

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Consider Obama's shrewd strategy: When deficit-cutting was the political rage, the Tea Party formed the shock troops for Republican victories nationwide, including taking control of the House from Pelosis legions. Obama responded by creating the Bowles-Simpson Commission to propose a new era of fiscal common sense. These were the right men for the job; they represented the best of the common sense and cooperation in their parties and they were articulate and persuasive. They came up with a program that would, most independent observers agreed, avert disaster. He thanked them, but with his own re-election looming, he buried their report, never mentioning it in his 2012 State of the Union address or his own budget, which basically deferred all pain for at least a year. (Congress hasnt approved a budget for years, even for the two years when Democrats had control of both Houses of Congress.) With Orwellian coolness, he dropped the Bowles-Simpson report down The Memory Hole and has never said a word about their recommendations since. He believesand may well be rightthat he won't be re-elected if he levels with the voters about the real outlook for entitlements, and he is urged in this strategy by the Far Left in his party. The Republican Congressman, Paul Ryan, prepared his partys response, and the House actually passed a budget without any Democratic votes. It was supposedly modeled on Bowles-Simpson, but while it accepted their recommendations on deletion of tax deductions and simplification of the Code, it was longer on entitlement cutbacks. However, the far-Right Club for Growth attacked Ryan's proposals as being too heavy on tax increases. Once again came the secular-religious baying, No tax increases! They had the unmitigated gall to assert that their doctrinaire approach was modeled on Reagans tax policies, but Reagan assented to substantial tax increases once the recovery got under way.

With Orwellian coolness, he dropped the Bowles-Simpson report down The Memory Hole...

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All Clear?
Bizarrely, the biggest battle between the Republicans and Obama was on his insistence on continuing the crisis-born reductions of middle class taxes without offsetting revenue increases elsewhere. No tax increases on the middle class! was the Presidents slogan, and he tied up Air Force One in trips across the land to denounce Republican intransigence. But these "payroll taxes" are contributions to two desperately underfunded Trust Fundsfor Social Security and Medicarewhich arent part of the spending budget, and which are the support systems for today's and tomorrow's elderly. Result: the Republican capitulated, Obama was a hero, his ratings climbedand the financial implosion of those funds was moved forward an additional year. (To our knowledge, only some vocal elements in the Tea Party saw through this mislabeling and called for maintenance of contributions to the Trust Funds.) All one needs to know about the financial crisis in America's future is in that sad, short story of betrayal by the extremes in Washington. But that disaster won't happen as long as Bernanke keeps buying Treasurys and the dollar retains its ranking relative to other key currencies. China has cut back drastically on its purchases of Treasurys in order to finance its dramatic, globe-girdling purchases of commodity-producing assets, (as discussed in the next section), but other nations seeking to prevent their currencies values from escalating have been buying Treasurys, so the barelyobservable interest rates continue. Europes loss is Washingtons gain: China and other Asian nations had proclaimed their desire to diversify their forex purchases away from Treasurys into eurobonds, but the PIIGS plight changed that, even in China where pork is the most-favored source of protein. Our call, then, is to respond to what the market is offering: zero returns on cash, absurdly low returns on quality bonds, average-level returns on most stock groups, and above-average returns on commodity stocks.

...that disaster won't happen as long as Bernanke keeps buying Treasurys and the dollar retains its ranking relative to other key currencies.

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Chinas Leaders Go Leninist and Buy Commodity Assets

The Crash of commodity prices in 2008 caught mining and oil companies in the midst of massive expansion programs. At first, they tried to put some of them on hold. Then, Chinas massive economic stimulus program put a floor under the prices of metals, oil, and feed grains, and existing capitalist capex programs were resumed worldwide. However, the commodity game changed in 2008. Today, no matter where in the commodity-rich Third World one looks, there are Chinese investors, followed by Chinese construction and geology teams. (At the end of 2011, more than 800,000 Chinese workers were employed abroad, and that is not counting students engaged in various studies and projects.) Those personnel support Chinese investmentsin exploration, development, and outright acquisition of companies and properties deemed propitious for copper, nickel, iron ore, oil and gas. Some of these new investments and projects were in countries where Western companies were well-established, or had recently made discoveries they were now developing. But many of the countries that are now experiencing mining or oil booms have been off limits for established publicly-traded resource companies for yearseither because the political risks are too toxic for stockholders, or because the only way to the minerals is with bribes and the introduction of ones own security staff. Mining and oil companies which operated in Third World dictatorships have for years been objects of demonstrations at their stockholder meetings or defendants in costly litigation brought by pious NGOs about their rape of resources in poor countries. In some cases, the accusations against the companies were well-founded. In others, the screams from local politicians or strongmen found favor as far as the International Court of Justice. Today, even the most sensational discovery in Lower Slobbovia or Brutalland is rarely worth the costs of developing for a substantial mining or oil company whose shares trade on Western exchangesif the NGOs are opposed. They will lobby pension and endowment funds about the alleged crimes and atrocities committed by the ugly Americans or Brits, and, whatever the truth, the prudent course of action is retreat. In particular, even if a project is peacefully developed and is making a major contribution to a povertystricken nations economyincluding schools and hospitalsall that is needed is an accusation that a local politician was bribed to trigger a frenzy of litigation from rapacious tort lawyers looking for treble damages.

...all that is needed is an accusation that a local politician was bribed to trigger a frenzy of litigation from rapacious tort lawyers...

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All Clear?
Enter the Chinese. The most fascinating aspect of this worldwide movement of Chinese workers, students, scientists and security personnel, and the gushing flows of investments capital is that there seems to be no country too primitive, chaotic or corrupt for Chinese investment and developmentas long as the geology is favorable. They live by their rules of non-interference in local laws, customs or politics. So they do bribes. They do tough tactics on demonstrators. They do deals with evil or incompetent governments. They get 6% of their oil from the Government of Sudan, which they have backed with advanced military equipment, including fighter planes, to back its brutal slaughters in South Sudanwhere the oil comes from. The head of the Sudanese government is under indictment by the International Court of Justice, but he remains at largemostly because of China's military muscle. In considering the seemingly sudden spread of Chinese commodity investing and operations globally, it helps if there is a guidebook. We think there is: a really good textbook. One of the few works of leftist literature from Marx to Krugman that is devoid of the turgid paranoia of socialism is Lenins Imperialism, the Highest Stage of Capitalism. Written from Switzerland during World War One, it is a shrewd analysis of how cartels and colonialism broke down the era of global free trade that Britain had launched, beginning with repeal of the Corn Lawsa regimen enforced by the British navy. He shows how two forces combined to drive Britain, the USA, France, Austria, Belgium, Holland and Germany into colonization and occupation of most of the world outside Europe and the Western Hemisphere by 1900. First, was each countrys need for commodities to support its factories. Second was the great buildup of capital within American, British and European banking systems that needed to find profitable outlets abroad under that nations flagwhere no other imperialist power could compete.

One of the few works of leftist literature from Marx to Krugman that is devoid of the turgid paranoia of socialism is Lenins Imperialism, the Highest Stage of Capitalism.

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We recently re-read this book wed enjoyed long ago when studying economic history. It stands up remarkably well, and it is hard to escape the conclusion that it is the textbook for Chinas sudden burst of global expansion. China needs commodities and it was shocked into blocking an extremely threatening monopolist creation when Rio Tinto nearly merged with BHP Billiton to develop the iron mines of Pilbara. Had that merger gone through, then those companies and Vale would have had monopoly pricing power over Chinas most important metal import. No wonder that China is now engagedfull blastin developing major iron ore deposits in West Africa. With the completion of the widening of the Panama Canal, those mines will be able to compete with Vale and lay down iron ore in China at prices that will most assuredly restrain the pricing power of Rio Tinto and BHP. China also needs to export capital to restrain the rise in value of the renminbiand buying commodity assets certainly makes more sense than buying Treasurys or Italian euro-denominated bonds. Most of this massive Chinese global efflorescence leaves local politics and relationships intact. However, its large territorial claims to potentially huge hydrocarbon deposits in seawaters off Southeast Asia have the potential for major confrontations with neighboring nationsand with the USA. The days are ending when the big global mining companies could choose where to investand would usually either cooperate with each other or refrain from outright competition. China Inc. will soon be the world's biggest commodity developer. That doesn't mean there will be large, sustained surpluses of most major commodities. It means China will be a participant in price-settingafter two decades of price-taking. The sudden, spectacular Chinese global commodity investment programs will be negative for longer-term prices of iron ore and potentially copper. As large as they are, they will have minimal impact on global oil and gas prices. Their farmland acquisitions will assuredly increase global grain and hog output, but, at least for the next decade, should have only marginal impacts on agricultural prices.

...buying commodity assets certainly makes more sense than buying Treasurys or Italian euro-denominated bonds.

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All Clear?
Commodity Stocks Now
A big reason CPI has been so painful despite the supposed prestidigitation of Greenspan et al has been commodity prices. Our case for investing begins with the fact that, after the spirited recent rally, the S&P is today precisely where it was in February 1999. Meanwhile, most Americans' real earnings have failed to keep up with inflation. A big reason CPI has been so painful despite the supposed prestidigitation of Greenspan et al has been commodity prices. Since the dawn of the millennium, corn is up from $2.05 to $6.50, wheat from $2.50 to $6.50, soybeans from $4.70 to $13.25, feeder cattle from $86.50 to $154, hogs from $54 to $87, West Texas oil from $25 to $106, and copper from $0.83 to $3.85. The only saving grace has been natgas which went from $2.34 to $2.24 thanks to the shale miracle. Suppose an investor had decided that China and commodities would be the big story for the decade, and simply bought the biggest oil company, the biggest base metal miner, the biggest gold miner, the biggest farm equipment manufacturer and the biggest fertilizer company in September, 1999when the S&P was trading at today's level. Here's how the investor would have done (dividends excluded).
Split Adjusted USD Price USD Price September 1999 September 1999 EXXON BHP BARRICK DEERE POTASH 76.00 11.53 21.79 38.69 51.93 38.00 5.03 21.79 19.34 2.89

USD Price March 2012 86.50 38.90 47.98 82.93 46.65

Price Gain 127.63% 673.25% 120.14% 328.72% 1516.97%

We cite these numbers to illustrate a point: the stock market performance of the 1990s was all about US tech stocks that were reshaping the world. In sharp contrast, the stock market of this century to date is primarily about China's reshaping of the world. Many industrial companies in North America and Europe that were sound investments in the 1990s are gone victims of Chinese or Korean competition. The most-admired corporation was probably the General Electric of Jack Welch: its stock price back then was $37, (up from $8 in just seven years); it's $20 now.

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Commodity price increases have far outrun broad inflation, and companies tied to those commodities delivered great relative results for investors. That has not been the case recently. Investors are once again becoming US-centric, because the US economy is relatively stronger than most of the other members of the G-7, and a growth rate for Chinese GDP under double digits is considered evidence of a busted boom. West Texas trades at a 14% discount to Brent, and US natgas is astonishingly cheap compared to almost anywhere else in the world. Moreover, Europe is at far greater risk of economic crunch from a closure of the Strait of Hormuz than the USparticularly if Keystone XL were built promptly. Our answer to those arguments is that Chinese GDP is still growing three times as rapidly as the US, which is on two unsustainable steroidsdouble digit deficits, and incredibly low interest rates that are maintained by the pain inflicted on thrifty Americans, and pension funds, public and private which are collectively in crisis. For 14 years we have been saying "Buy what China seeks to buy." In the coming cycle, as China continues to deploy its capital around the globe buying commodity companies, that remains a powerful investment concept.

...as the US, which is on two unsustainable steroidsdouble digit deficits, and incredibly low interest rates...

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All Clear?
The Search for Yield When Growth is Elusive
Since the grim 1970s, the over-arching investment priority has been capital growth. The investment management industry boomed, and pension fund consultants developed sophisticated performance measurement surveys to identify outperformance. Specialist management became the norm, after a lengthy period of total fund management in which managers balanced stocks of different categories, bonds, and cash. "Cash is trash" became the slogan during the glory years of the 1990s. Cash became the default asset to reduce portfolio risk for market timing. Bonds became the province of specialistsmost notably Bill Gross, known as "The Warren Buffett of Bonds." But the best-paid investment managers were usually equity specialists. This time is different: US Bonds have outperformed US stocks on a cumulative basis for three decades; so much for "Stocks for the Long Run". The S&P has been as flat as the prairie over 13 years, apart from dividends. That was supposed to happen only in a Thirties-style Depression with 30% unemployment. However, during those 13 years, leading corporations were reaping great productivity gains, improving their global marketing and competitiveness, and improving their balance sheets. Bonds have outperformed for three decades, but their yields are now so minimal that they absolutely must underperform once the economy strengthens. (If it doesn't strengthen, bond yields will eventually rise anyway, as trillions in government debt engulf bond markets.) Bond yields have reached levels that challenge the basic mathematics of pension fundingand the income needs of retirees. The agreed-on strategy for personal portfolios had been successive reductions of equity exposure during the late "earning years" in favor of bonds, with high bond weightings for "The Golden Years." (Almost nobody recommended Gold for the Golden Years, the asset class that was quietly outperforming almost everything else.) The old division in portfolios between stocks for risk-adjusted growth and bonds for income and reduced risk is collapsing, along with the Capital Asset Pricing Model. High-grade bonds now offer two unpleasant certainties: minimal yields todayand massive capital losses tomorrow if the economy revives or if stagflation returns.

Almost nobody recommended Gold for the Golden Years, the asset class that was quietly outperforming almost everything else.

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(One fixed income category that has performed well over the longer term, with lower volatility than equities, while delivering reasonably attractive yields is quality High Yield Debt of non-financial corporations. We spoke with a long time colleague in this specialized category this week and are convinced that this product should be included in pension fund portfolios in this era of ultra-low yields.) What is emerging is a shared recognition by pension funds and private investorsparticularly retireesthat secure growth in dividend income makes stocks worth a lot more in a zero-interest post-Crash environment where capital gains have become so unreliableor even evanescent. Deleveraging in the private sector strengthens weak bank and consumer balance sheets and tends to reduce both interest rates and growth. It has only begun, and will be a drag on growth and ebullience for at least the rest of this decade. In the state and local government sector, the US will eventually face a PIIGS-style confrontation between bond markets and politicians' proclivities. European consumers don't benefit from $2.40 natgas to hold down home heating and electrical generating costs, and the low gasoline taxes here make Europeans' refueling costs look horrifying. A very popular new equity product for troubling times is low-volatility equities that outperform the S&P when stock markets sell down. Such funds overwhelmingly own reliable dividend-paying stocks. These responses to the World of Zero show that the investment management industry canand indeed mustrefashion its products and services to remain relevant.

...secure growth in dividend income makes stocks worth a lot more in a zero-interest post-Crash environment where capital gains have become so unreliable...

Show me the money

One reason for a flat S&P was the change in executive compensation from paycheck increases to stock options, leading to huge increases in senior management's incomes through massive issuance of stock options. Jack Welch's General Electric was the exemplar of this system, and high-paid consultants and boards composed heavily of top execs from other corporations who were earning such rewards from their option programs ensured the near-universality of this system. It worked to widen the gap between top management's incomes and those of lower-level workers to record levels, spawning the frequently incoherent and indecorous "Occupier" revolts. A rarely-noted aspect of this compensation system was a sustained diminution in dividend payouts as a percentage of earnings: companies took to buying their own stock as their means of "returning money to stockholders," rather than distributing increasing dividends. March 2012 27

All Clear?
Retail investors' disillusionment with the growth stock culture of the 1990s is soundly-basedbecause the sector of the market with the highest earnings growth since 2000 is commodity stocks, which, by their very reliance on the price swings in raw materials, lack the steady earnings gains the stock market darling of the 1990s reported. Since then, we have learned that, as with General Electric, those endless profit increases were due only partly to actual earnings improvements from brilliant managements who could seemingly do no wrong, but, in significant measure, to brilliant massaging techniques. Even some of the big US and European banks resorted to the off-balance sheet scams of Enron, hiding the risks of their excess leverage while boosting ROEs that generated gigantic bonuses for the geniuses who could do no wrong. Robert Rubin and his Citi friends were particular wizards, for which they earned king's ransoms; the stockholders who believed those reports and held on "for the long run" picked up the tab:
Citibank January 1, 1995 to March 14, 2012
600 500 400 300 200 100 0 Jan-95 Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11 35.21

Retail investors' disillusionment with the growth stock culture of the 1990s is soundly-based because the sector of the market with the highest earnings growth since 2000 is commodity stocks...

After years in which most stockholders benefited little, while so many bosses benefited greatly, a new pattern has emerged: stocks with great records for reliableand reliably-increasingdividends have been far outperforming broad stock indices. In a world where big businesses have routinely understated their endogenous risks and overstated their real earnings, dividends become the one certitudeand dividend yields are no longer lower than yields on cashor even on Ten-Year Treasurys.

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The great dividend-payers have been outperforming the broad stock markets since last summer, and the expiry of the US dividend tax credit has been cited as reason that this run-up is destined to fade. Our take on this is that tax-exempt investors like pension funds are collectively huge holders of highquality dividend-paying stocks, and their needs for cash income are rising as interest income keeps falling and pension costs climb. The other argument for increasing corporate dividends is that the money companies give back in dividends will reduce the money they spend on buying back their stock. Few companies have shown any consistent skill in that application of shareholder capital. In particular, the big US banks, have tended to display the kind of poor judgment in timing stock purchases that they demonstrated in levering up their balance sheets with putrescent trash. To our knowledge, no CEO's compensation has been affected negatively by bad timing of stock purchaseseven though the record shows that when insiders buy for their own accounts their short-term forecasting tends to be good. Better to give the money to all owners directly, many of whom participate in dividend reinvestment programs. That is a far better system than using the money for stock buybacks that support generous stock option programsand pay money to those getting out of the companies' shares, not to those holding on for the long term. To the extent that buybacks drive companies P/Es higher, they reduce the propensity of value-oriented investors to buy the company's stock. Everyone knew that retirees' percentage of both the population and stock ownership would be rising in the new millennium, but surprisingly few corporate managements recognizeduntil recentlythat meeting the income needs of these investors would be good for relative equity performance. They thought that growth in EPS was all that was needed even when the Crash provedin all too many casesthat those beautiful earnings were part dream and part deception. Those bad old days are giving way to shareholder-friendly days: portfolios of shares in well-managed companies operated for stockholders' benefit through rising dividends and reduced levels of stock options are outperforming the major indices.

...the big US banks, have tended to display the kind of poor judgment in timing stock purchases that they demonstrated in levering up their balance sheets with putrescent trash.

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All Clear? THE INVESTMENT ENVIRONMENT

Today, investors gigantic and small are reconsidering their commitments to both high-grade bonds and growth and concept stocks. "Show me the moneyand do it consistently" is the themeas it was before the term "Growth stock" was invented. Well-chosen equity portfolios with strong exposure to commodity stocks can deliver higher-than-bond yields now, and capital gains if the economy recovers or if stagflation returns. Good dividends now and good stuff in the ground are what investorslarge and smallneed now, and for the future.

Good dividends now and good stuff in the ground are what investorslarge and smallneed now, and for the future.

Defined [Benefit] Risks

To us, the biggest reason not to invest in many major US companies is the sickliness of their defined benefit plans. This is the precise reverse of the situation when FAS 87 came into effect, requiring companies to report the profits of their pension funds within ordinary earnings. Because the typical fund held long-duration bonds during the greatest bond bull market of all time, their profitsin many caseswere huge in relation to the companies' earnings on their basic businesses. At that time, we were advising investors on how to do their own calculations of the companies' hidden earnings, and buy the stocks accordingly. At that time, we did some work on the Street's calculations of these buried bonanzas, and found most of the "research"particularly on mid- and small-cap companieswas dreadful. So we are skeptical that the Street is doing an adequate job of explaining how much is at risk for companies using the generally accepted assumed return rates of 7-8% for Defined Benefit Plans (DBs). We recall that in 2001, companies such as IBM were getting away with assuming 8.5% returns on their high-grade bond portfolioswith the Ten-Year Treasury yielding roughly 5%because they had earned that for the previous five years as interest rates were falling and their bond values were climbing. So we recommend caution in buying stocks of US (and Canadian and European) companies with longestablished Defined Benefit Plans, where the size of the covered workforce and the retired lives is large in relation to companies' pretax revenues. That companies are scrambling to replace their DBs with Defined Contribution plans is inevitable, but it is unclear how soon and how successful those rescues will be.

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Insider Selling
Finally, we address a major objection to our somewhat bullish stance: insiders in US corporations are selling at prodigious levels, week after week. In general, insiders know more about their companies' near-term outlook than public investors or street analysts do. As the stock market continues to climb, this group seems to be the most conspicuously bearish. What do we think we know that they don't? Answer: we don't. But the selling has accelerated along with Obama's poll rankings and the bets on Intrade about his re-election. The insiders know that if he is re-elected and the Democrats also do well in the Congressional races, the capital gains tax rate in the Bush tax cuts will be among the first to be dumped. If they go up to the 40% range from 15%, that would be a huge hit for those with big stock options. We'll go out on a limb and predict the insider selling will plummet if Romney moves into a sustained lead in the pollsand Intrade. But don't bet big on that happening.

We'll go out on a limb and predict the insider selling will plummet if Romney moves into a sustained lead in the polls...

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All Clear? RECOMMENDED ASSET ALLOCATION

Recommended Asset Allocation Capital Markets Investments US Pension Funds
US Equities Foreign Equities: European Equities Japanese and Korean Equities Canadian and Australian Equities Emerging Markets Commodities and Commodity Equities
(ex-Gold & Gold Stocks)

Allocations 23 1 3 4 5 6 6 15 11 4 2 10 2 8

Change +3 unch +1 unch unch +1 +1 +5 5 2 2 2 +2 2

Gold & Gold Stocks Income Generating Assets Dividend Stocks Bonds: US Bonds Canadian Bonds International Bonds Inflation Hedged Bonds Quality High-Yield Bonds Cash

Bond Durations
US Canada International Inflation Hedged Bonds Years 5.25 5.25 4.00 7.25 Change unch unch unch unch

Global Exposure to Commodity Equities

Agriculture Precious Metals Energy Base Metals & Steel
We recommend these sector weightings to all clients for commodity exposurewhether in pure commodity stock portfolios or as the commodity component of equity and balanced funds.

32% 29% 26% 13%

Change +2 3 +1 unch

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All Clear? RECOMMENDED ASSET ALLOCATION

Recommended Asset Allocation Capital Markets Investments Canadian Pension Funds
Allocations Equities: Canadian Equities US Equities European Equities Japanese, Korean & Australian Equities Emerging Markets Commodities and Commodity Equities
(ex-Gold & Gold Stocks)

Change +1 unch unch unch unch +1 +1 +3

18 7 2 2 5 6 6 15

Gold & Gold Stocks Income Generating Assets Dividend Stocks Bonds: Canadian Bond Market Index-Related Real-Return Bonds International Bonds Quality High-Yield Bonds Cash

17 10 3 2 7

8 1 unch +2 1

Canadian investors should hedge their exposure to the US Dollar.

Bond Durations
US (Hedged) Canada: Market Index-Related Real-Return Bonds International Years 5.25 5.25 7.25 4.00 Change unch unch unch unch

Global Exposure to Commodity Equities

Agriculture Precious Metals Energy Base Metals & Steel
We recommend these sector weightings to all clients for commodity exposurewhether in pure commodity stock portfolios or as the commodity component of equity and balanced funds.

32% 29% 26% 13%

Change +2 3 +1 unch

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All Clear? INVESTMENT RECOMMENDATIONS

1. Income investing is here to stay in a deleveraging, slow-or-no growth world. Collapse of the CAPM means bond investors should runnot walkaway from government bonds and seek quality corporatesand find new equity-based income vehicles. 2. Emerging Markets stocks and bonds look relatively attractive. The vast oversupply of debt means economic growth in the industrial world will be, at best, modest. The relative scarcity of debt in the Emerging Economies means their growth rates relative to the First World will improve. 3. Go with growthbuy commodity stocks. Emerging Markets citizens spend more of their earnings on commodities than we do, and their demography is more favorable for economic growth than ours. A world in which EMs' share of growth continues to increase is a world in which commodity prices will be strong relative to other prices. 4. Within the industrial commodity stock groups emphasize oil stocks over gas stocks, and emphasize copper stocks over aluminum stocks. As the Freeport McMoRan debacle shows, miners in Third World countries sometimes face worse risks than commodity price risks. 5. Record-low Treasury yields and record-high real fiscal deficits have combined to produce 2% economic growth. Those stimuli are unsustainable but they should sustain the Obama Presidency. He will have to deal with the problems in his second term, and that will mean much higher taxesif not higher interest rates. US economic growth will be closer to Continental growth rates next year. Invest for dividendsnot growth. 6. Gold's yield is now roughly the same as T-Bills'. It was an excellent investment when T-Bills yielded 5%. Its relative value continues to improve, as economies struggle and governmental finances deteriorate. It belongs in all portfolioseither as bullion or stocks. Bullion has been better for a surprisingly long time. The next time gold is nearing $2,000, investors will take the stocks more seriously. Those with virtually no political risks are astonishingly cheap.

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7. The really oily Canadian and US stocks are excellent value, particularly the oil sands companies. Oil stocks haven't kept up with oil prices, mostly because of the drag from collapsing gas prices. Obama is losing big with voters on Keystone, and he may need to disappoint his deep-pocketed environmentalist backers who invest in government-backed windmills that slaughter birds and bats, and in government-backed, money-losing solar panels, and cars that catch fire. Naturally, they hate profitable pipelines that supply low-cost, reliable energy with near-zero impact on animal populations. 8. Grain prices remain strong, despite mostly good crops worldwide and a mild winter in the US corn belt. The agricultural sector has the best blend of profitability and economic variability in an uncertain world. It is also the sector that has the greatest offering of great global companies at modest cost. (The risk of crop disappointments due to Colony Collapse Disorder in apiaries continuesas does the absence of certainty about the cause of the annual destruction of at least one-third of the honeybee population.) 9. An Israeli attack on Iran need not lead to strangulation of Gulf oil flowsas long as Iran's oil production facilities and the mullahs' cash flows are left largely intact. The surprise could be that Israel launches a surgical strike, and Iran's Hezbollah minions launch hundreds of rockets from Lebanon and Gaza, and oil prices spikethen fall back. In other words, investment programs should not, perhaps, be held hostage to Armageddon fears.

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