Basic Points

That Seventies Show?

May 31, 2006

Basic Points
An Investment Journal
Donald G. M. Coxe
Global Portfolio Strategist, BMO Financial Group Global Portfolio Strategist, Harris Chairman, Harris Investment Management, Inc. Chairman, Jones Heward Investments Inc. (312) 461-5365 e-mail: don.coxe@harrisbank.com Research/Editing: Production: Distribution: Angela Trudeau e-mail: angela.trudeau@shaw.ca Sandra Naccarato e-mail: sandra.naccarato@jonesheward.com Anna Goduco (print orders and mailing lists) e-mail: basicpoints@bmonb.com

Go to www.bmoharris.com to listen to Don Coxe's weekly conference call.

That Seventies Show?

Overview
Do the financial storms of May portend a replay of the Seventies? As oil climbed to $75, gold leapt to $720 and copper levitated to $4, market pundits began warning that those soaring prices meant that inflation was coming back. Other pessimists claimed that the Bernanke Fed had fallen behind the curve, and that the sheer scale of the tightening required would bring the US economy down, in a reprise of that Seventies DiseaseStagflation. Then, almost as quickly as the prices had leapt, they plunged, carrying the share prices of commodity producers down with them. These violent reactions convinced some longstanding commodity skeptics to proclaim that the commodity bubble had burst. As equity prices worldwide sagged, some pundits announced that the commodity collapses, which accompanied plunges in Emerging Markets, REITs, and junk bonds, were the harbingers of a major global bear market. We see these developments as the first large-scale results of the Evolutionary Shock we wrote about last month. The Global Amazonizing of liquidity that supplied hedge funds and other levered players with seemingly endless flows of cheap money peaked in the First Quarter. Even piranhas are at risk when the river dries up. April and May's parabolic leaps in metal prices were driven by hedge funds awash in cheap, Japanese-supplied liquidity. That the fuel for those correlated liftoffs was yen borrowed at near-zero rates was proved first, when the Bank of Japan slashed monetary growth to get itself ready for the eventual imposition of interest charges on borrowings, and commodity futures collapsed, and second, when the BOJ blinked, and made a sudden, large-scale liquidity injection as markets were being roiled across the world, and spirited rallies in commodity futures and in share prices of commodity producers ensued. We maintain our caution on equities, particularly US equities. We also maintain our recommended overweighting in the energy and mining stocks.

May

Recommended Asset Allocations

American Portfolios
U.S. Pension Fund
Allocations 24 21 20 5 15 15 Change unch unch unch unch unch unch

Domestic Equities Foreign Equities Domestic Bonds Long-Duration Bonds Foreign and Foreign-Pay-Bonds Cash

Foreign Equity Allocations

Allocations 6 5 6 4 Change unch unch unch unch

European Equities Japanese and Asian Equities Canadian & Australian Equities Emerging Markets

Bond Durations
Years 3.75 4.25 4.50 Change unch unch unch

Global US Canada

May

Basic Points
That Seventies Show?
Philadelphia Stock Exchange Gold and Silver Index May 2005 - May 2006

Amercian Stock Exhange Oil Index May 2005 - May 2006

S&P/TSX Capped Metals & Mining Index May 2005 - May 2006

May

Once again, Japanese Zeroes were making world headlines...

For more than a year, we have been telling clients that we were increasingly hopeful that Japan would finally develop a normal financial system, with normal interest rates and normal central banking practices, permitting that beleaguered nation to emerge from its fifteen years in financial Purgatory. We argued that normalcy would mean that the world's second-largest economy would become a positive force for global growth, the Nikkei would be an outperforming stock market, and the global economy would adjust quite comfortably to a US economic slowdown, which would surely follow the deflation of the housing bubble. So we were pleased with the BOJ's announcement on March 9th that it was moving toward ending its quantitative easingthe precursor to actually charging some realistic interest rate on its borrowings, ending the zero rate policies that have been in place for five years. We assumed that hedge funds and the trading departments of major global banks would respond to the announcement of this coming policy change, adjusting their exposures accordingly. When you've been getting incredibly rich by borrowing at near-zero rates, and you're told that your lender is now dispensing clarity about future costs, rather than planning to continue dispensing trillion yen charity to some of the world's richest people, you make new arrangements. Instead, Japan's sudden emergence from the fog of the Triple Waterfall became a financial Pearl Harbor for many hedge funds. Once again, Japanese Zeroes were making world headlines: The Bank of Japan's announcement that the game was changing was followed immediately by a collapse in growth of the Japanese Monetary Base (which is substantially bigger than its US counterpart) below the Zero line. Result: the Amazonian flow from Tokyo that was producing lush growth for hedges in such upscale environs as Greenwich, Boston, New York, London and Curaao shrank to mere Hudson proportions, and was threatening to become a trickle. The results were painful for all risky asset classesincluding junk bonds, Emerging Markets, small-cap stocks, and, of course, commodities. Hedge funds and other levered institutional investors used the virtually free money from Japan (and the liquidity in the Treasury yield curve provided by the $1.3 trillion joint support operations of the Beijing-Tokyo Axis operating under what we have been calling since Feb. 2004 "The Great Symbiosis") to invest in commoditiesmostly in futures contracts. In April and early May, the enthusiasm of the newly-converted became a mini-mania. Commodity

May

Basic Points
futures and stocks of commodity producers soared to records; commentators not only spoke darkly of a potentially disastrous commodity bubble, but openly speculated on the financial viability of the London Metals Exchange. The mania ended almost as soon as it began, thanks to that momentous policy switch by the BOJ. Now that the BOJ has proclaimed its intention of abandoning that five-yearlong Zero Rate policy, it is useful to reflect on how it was possible that the world's second-largest economy could maintain Depression-era interest rates during a healthy global economic recovery. This historically unique paradox came from the economically lethal combination of financial and demographic deflation. The BOJ's monetary response to this double whammy was disarmingly simple: it simply opened the spigots wide and held them that way. Japan's Monetary Base expanded so powerfully that it outgrew the Fed's Monetary Base, which serious global monetary analysts have long considered the most important component of global liquidity. Just imagine: a central bank that is always open to borrowers and always charges zero rates. Think of how enthusiastically its domestic clients would borrow! Yet Japanese banks' loans fell for 94 straight months until August 2005, when they began a slow climb back toward normalcy. For nearly eight years, all the financial horses were being led to waterand they never took a drink. If Japanese banks weren't bathing in the Amazonian flow, who was? Obviously, it was the heavily-levered fast-money artists abroad, who were no longer prepared to pay the Greenspan rate for Eurodollar-based loans. According to some surveys of hedge fund returns we have read, some of the biggest payouts were earned by the proprietors who netted 9% or so for their investors. Imagine if those masters of the universe had had to pay 5.5% on their borrowings, rather than just .75% plus a modest charge for hedging their yen liabilities. The biggest investment brains were able to earn last year what a rating service called "mundane" returns by borrowing cheapnot by investing dear. If they had had to pay what equity investors pay for borrowing, their returns might have been so insipid as to raise questions about whether they were really worth those 2% plus 20% fees. The Bane of Brains, was, therefore, the Pain of Paying Plain-ordinary interest charges on their borrowing. ...all the financial horses were being led to waterand they never took a drink.

May

Mumbai's Sensex...kept its leadership role as the once-emerging markets merged in submerging.

When the announcement came that their free pass to the bank would be withdrawn within months, they had to rethink their strategies. We would naturally have expected a measured, sweat-free response from these cool, calculating colossi. Not quite: it appears they showed the calm, careful survivor instincts of people in a crowded theater when smoke is sniffed, and someone shouts, "Fire!" After three years in which volatility was threatening to become as antiquated as good taste in Hollywood, Risk and Fear came out of the wings, and those riskier asset classes that had outperformed so hugely during the period of sustained liquidity expansion sold off heavily, while the formerly dull and unloved suddenly got respect. The VIX Index, the best-known measure of US stock volatility, which had been so dull for so long that it had begun to seem irrelevant, suddenly looked like the electrocardiogram of a doomed man. Commodity futures prices nosedived, followed by commodity stocks; Emerging Markets were pummeled worldwide. Mumbai's Sensex, which had been the world leader on the upside, kept its leadership role, as the once-emerging markets merged in submerging. Once again, the term "commodity bubble" was heard in the land, but this time it was accurate: this year's 100% rise in copper to $4 wasn't so much a statement of economic reality as it was a squeeze play by hedge funds against the huge hedge positions of copper producers such as Phelps Dodge. Those big bad calls the miners had made on the future of metal prices because of their 21 years of commodity misery meant they were now sitting ducks. The new breed of hedgers plotted to win big at the expense of the old-style hedgers, assuming that the miners wouldn't dare add heavily to their own short positions because of the need to mark their forward positions to market on their Second Quarter Earnings Statements, in pursuance of Rule 133. That rule came into force at yearend 2004 for publicly-traded mining and oil companies. It was a perfect example of the Asymmetric Age in Investment Regulation: the Completely Unregulated can mercilessly take advantage of the impact of a tough new rule change on the Tightly Regulated. There were sighs of relief among the trapped mining hedgers as liquidity shocks hit the hedge funds, and they were forced to dump their commodity futures, sending base metals prices back down to within sight of where they had been just weeks earlier. As I learned in conversations with industry figures at their global convention in Colorado this month, what miners

May

Basic Points
were wondering was how to stop these nouveaux billionaires from driving copper to $5 or more, threatening the viability of some long-established mining companiesand the copper and brass industries. The miners remembered well what had happened to Ashanti Gold. That determined hedger nearly fashioned its own prearranged suicide when gold prices finally rallied strongly after the twenty-year Triple Waterfall. As stock and commodity prices were plunging, many equity investors responded to Wall Street's shrill warnings of an impending commodity stock collapse of tech-stock proportions. Mining and oil stocks fell faster and harder than commodity prices. The more mining and oil stocks fell, the more Wall Street warned of disasters to come. There are two extremes when Wall Street is at its least credible: when, as in the late 1990s, it screams for new bacchantes to sustain an orgy that is already overlong, and when, as now, it issues warnings of the dangers of speculation. Such rare public Puritanism as we are now seeing occurs only during a bull market in an asset the Street has either overlooked, or despisedor both. This long, powerful commodity bull market has been a particular affront to Wall Street, because it appears to threaten the prospects for most stocks and all bonds. Historically, strong commodity prices have meant weak prices for those major product lines that give the Street its raison d'tre. In particular, the idea that we are fated to revisit the 1970swhen returns from virtually all investments except commodities and cash were appallingis as chilling to the Street as would be the suggestion of having George Bush as Commencement speaker to the habitus of Harvard's faculty lounge. Then, on May 25th and 26th, commodity stocks stopped falling and staged brisk rallies. Commodity prices had stopped falling days earlier, but that hadn't done anything for the shares of the producers, who continued to sag as if oil had plunged to $50, gold to $525, and copper to $2.00. What caused the stocks to rally so suddenly? Japan blinked. Apparently in response to a call from the International Monetary Fund, the Bank of Japan injected the yen equivalent of $4.5 billion into the system.

What caused the stocks to rally so suddenly? Japan blinked.

May

Risk of all kinds became acceptable again for a few days, until gloomy economic news reminded investors that there's more to life than liquidity. If the world is, as some gloomsters aver, really about to replay the Seventies, then this truly is a selling opportunity for risky stocks and bonds, even though the Bank of Japan, under open pressure from the IMF, made a further massive $13 billion liquidity injection in the past two days. This potent adrenalin shot didn't restore friskiness to the aging bull, which shows signs of fearing steerdom without anesthetic at bestor the abattoir at worst. How strong is the evidence for that Seventies analogy?

"The Seventies were mostly ghastly most of the time."

Remember When?
Few of today's portfolio managers were managing money during the Seventies. We, on the other hand, are old and battle-hardened: we came into the business in 1972, which meant we were there for all the horrors of that miserable era. The Seventies were mostly ghastly most of the time. This was a decade that included: The worst stock market crash since 1929. Adjusted for inflation from the time of the Dow's peak to its bottom in December 1974, the crash was 89%. In comparison, from the peak in 1929 to the bottom in 1932, the Great Crash was 92%. The worst-ever inflation across the industrial world. Nearly all the major central banks were led by followers of Keynes, who believed that inflation was occasioned by excessively strong economic growth, monopolistic profits, and overpriced commodities. Wage and Price Controls, which had worked during World War II, could be used in the unlikely event that inflation became dangerous. These bankers responded to OPEC's oil price shocks by printing more money to give consumers the wherewithal to pay for gasoline and heating oil. This policy, the monetary equivalent of prescribing trebled alcohol consumption as the cure for hangovers, had exactly the inflationary effect Milton Friedman predicted. An Arab oil boycott that helped trigger a severe recession; its purpose was to punish the US and, to a lesser extent, Europe, for supporting

May

Basic Points
Israel in a war launched by the Arabs on Yom Kippurthe Jews' holiest day. The surprise attack failed to terminate the basic grudge in the Mideast: Israel's defiant determination to exist. Once again, the armies representing five million Jews humiliated the armies representing 200 million Arabs. Gideon would have understood. Iranian rebels backing Ayatollah Khomeini overturned the Peacock Throne, sending the Shah into exile and triggering another global oil shock. Under the limp-wristed leadership of Jimmy Carter, the US failed to support the Shah, expecting the "freedom fighters" to embrace both democracy and the US. Instead, student gangs seized the staff of the American Embassy and held them hostage. Carter finally brought himself to try an opera buffa rescue attempt, which failed miserably. One of those students who learned what would be useful lessons for him about the apparent ineptitude and weakness of the US when defied by brave Islamists was named Mahmoud Ahmadinejad. Democracy was in retreat across the world, as dictatorships replaced democracies in Africa ("One man, one vote, once") and Latin America. The US defeat in Vietnam cleared the path for Pol Pot's genocide, which was in percentage terms the 20th Century record for such slaughters until the UN troops stood around keeping score in Rwanda. A new word Stagflationcame to meet the new needs of new times: It had long been an article of secular faith among the regnant Keynesian economists that inflation and recession could not coexist. The Phillips curve, touted almost everywhere as the tool for setting monetary policy, asserted a close correlation between growth in the rate of employment and growth in the rate of inflation. Ergo, when unemployment rises sharply, money can be pumped out at mind-boggling rates without triggering inflation. That the most conspicuous unemployment across the industrial world in the 1970s came from the soaring population of youthful Baby Boomers seeking jobs was not deemed a reason to reject Phillips. It was, instead, the key reason the Club of Rome and other intellectuals projected that the world's population would continue to increase at 1960s rates, producing disastrous scarcities in foods, metals, and oil. That was the Shared Mistake which unleashed the Triple Waterfall commodity mania that peaked in 1980. In the US, a pervasive despair emerged: the challenges of this era were too much for democratic governments. This angst arose first among the intellectuals, and then spread among a substantial segment of the That was the Shared Mistake which unleashed the Triple Waterfall commodity mania that peaked in 1980.

May

population. President Carter called it a "malaise." He talked to the nation of this problem and of the need to conserve energy, wearing, appropriately enough, a Cardigan, one of two sweater styles named after the British commanders who ordered the disastrous Charge of the Light Brigade. (The other was Lord Raglan). ...the runaway commodity bull market transferred wealth and economic power from the advanced industrial world to the USSR and the dictatorships, kleptocracies and kingdoms which together formed OPEC. Most importantly, the runaway commodity bull market transferred wealth and economic power from the advanced industrial world to the USSR and the dictatorships, kleptocracies and kingdoms which together formed OPEC. Petrodollars, "recycled" back into the industrial world through the Eurodollar desks in London, became a major new source of global liquidityand a major engine of inflation and economic instability. Walter Wriston gave bankerly credibility to the concept of lending those dollars deposited in banks by the oil-richin the hundreds of billionsto Third World countries, no matter how unstable or corrupt. "Countries don't go bankrupt" was his memorable contribution to the principles of high finance. Mr. Wriston had had extensive personal experience in making large loans to large corporations that went bankrupt in almost indecent haste, so Indonesia, Zimbabwe, or even Sudan seemed like great credits in comparison. The peak of the frenzy may have come when a Canadian bank led a large syndicated loan to North Korea. Within days, Canadian newspapers began carrying fullpage advertisements from North Korea reprinting letters from Kim DaiJung to various Communist leaders across the world, discussing arcane Marxist principles. They were printed in the Business section of the newspapers, presumably on the theory that the capitalists could benefit from The Great Leader's sparkling updates of Marx and Mao. Apart from boosting the revenues of the favored newspapers, and providing a modest stimulus to demand for Canadian newsprint, there is no evidence that these abstruse effusions achieved anything. However, not all the money raised by the bank was wasted. It would later appear that the greater part of the funds was spent more productivelyin developing nuclear weapons and three-stage missiles. The loans have long since been written down to zero, and the Marxist analysis has been long forgotten. Only the missiles and H-Bombs remain. Since so many pundits are now suggesting that we could be reliving the Seventies, how fair is that comparison?

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Basic Points
Back then, oil quadrupled: today it has trebled. Back then, gold got to $800: today it's over $600 and has traded above $700. Back then, the dollar was weak against all major currencies; ditto today. Back then, Nixon's approval rating had become a disapproval rating, and, under threat of impeachment, he was forced to resign: today, Bush has a similar (dis)approval rating, and some Democrats are crowing that, when they seize control of the House in this year's election, they will seek to impeach him. Dj vu? Perhaps. However: Back then, inflation was rising to double-digit levels; today, it remains at levels that would have seemed Heaven-sent to suffering Seventies consumers. Back then, money supply was growing at warp speed; today, money supplies have generally been growing at moderate rates, notably in the US, where real M-2 growth has recently turned negative, and Japanese monetary growth, even after the panicky injections of recent days, remains negative. Back then, the combination of an El Nio that destroyed the anchovy harvest off Peru, and a crop failure in the USSR that was noteworthy even by the pathetic standards of that sustained economic underachiever, drove wheat prices from $1.65 a bushel to $5, and soybeans from $3.25 to $10.50, kicking off global food price inflation; today, wheat is $3.85 and soybeans are $6.05, and governmental price supports across the industrial world are what protect farm income from crashing. Back then, the economies of Europe and Japan were sharply outperforming the US; today (or at least until recent months), the roles are largely reversed. However, if US house prices were to crash, as gloomsters predict, the US could fall into a recession that would send it to the bottom of the G-7 tables. Back then, the US was surrendering in Vietnam; today, the US has won militarily in Iraq, but has been unable to maintain order as various varieties of jihadists, Sunni absolutists, Shia fundamentalists, Baathists, and Iranianbacked saboteurs kill mostly each other. As in Lebanon, Sudan, and Palestine, Muslims are being slaughtered by other Muslims, and the US is

...if US house prices were to crash, as gloomsters predict, the US could fall into a recession that would send it to the bottom of the G-7 tables.

May

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unable to guarantee the safety of whichever Muslims are being targeted on any given day. This is failure to achieve the objective of a stable, progressive, democratic Iraq, but it's not a disaster comparable to the abandonment of the government of South Vietnam and the panicky scrambling into the last helicopter out of Hanoi. If hydrocarbon history repeats itself, first as tragedy, then as farce Back then, the US was despised worldwide as a discredited #2 to the great unfolding success storythe USSR. Militarily, there was almost no comparison: the US was a defeated power, with a cowed Pentagon, and milquetoast leadership. But a great majority of the leading intellectuals also believed the USSR had a stronger economy, and were impressed because more and more countries were falling under Soviet sway. Khrushchev's shoe-pounding UN boast "We will bury you" was treated with respect by US-loathing intellectuals from Berkeley to France. Today, the world is fascinated by the dramatic emergence of China, and the US is once again despised by leading intellectualsbut now for abusing its great power as the sole superpower. Although the Russian economy is once again growing, based on gas, oil, metals, and sales of military and nuclear materiel to pariah states, not even Berkeleyan or Parisian intellectuals still believe that Russia is an attractive economic model. That the G-7 is trooping to the former Leningrad in July for a meeting of what is now the G-8 is a propaganda coup for Putin, but the Kremlin's agitprop operations that used to employ so many people of so many nationalities worldwide and deceive so many intellectuals and media personnel of so many nationalities worldwide are now largely defunct. If hydrocarbon history repeats itself, first as tragedy, then as farce, then the 1970s record in which control of world oil production went from the Seven Sisters to OPEC returns, as real leverage shifts to Hugo Chavez, MEND (the Nigerian rebels), the Iranian mullahs, and Vladimir (Gas)Putin. Mikhail Khodorkovsky, ranked, because of his ownership of oil and gas operations, as one of the world's richest men as the Final Act began, ends this drama in a Siberian Gulag prison cell shared with two other men. However, former KGB officer Putin, who apparently masterminded his downfall, is no Stalin or Khrushchev, and this is no replay of Solzhenitsyn's One Day in the Life of Ivan Denisovich: Khodorkovsky has not been shot, and he does get to bathe once a week. His prison labor is sewing.

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Basic Points
Perhaps the Problem This Time Is Deflation?
Despite those frequently-noted superficial resemblances, this is not, in our view, a Seventies-style Stagflationary boom-bust. 1. The US, Britain and Canada all tried price controls to combat rising inflation in the 1970s. Those experiments failed ingloriously, and inflicted enormous economic damage. That won't happen this time. 2. However, all three of those economies have experienced housing bubbles this time, and the last two house price bull markets had entered their bear phase in the months before the last two US recessions. (Canada and Britain had slowdowns, but not recessions.) 3. This US housing bubble, which remains primarily a phenomenon of the coasts and vacationlands, has been inflated by the latest bank lending fad. As we commented last month, the growth in mortgage debt has been particularly strong among the weakest creditsthe kind who, for varying reasons, weren't crucial in most earlier housing cycles. This is also the first cycle in which a significant share of all mortgage borrowing is to finance spending unrelated to the home itselfthe built-in-ATM phenomenon. We find it hard to believe that the Sandlers' decision to sell their control of Golden West Financial was purely prompted by their septuagenarian status. These brilliantly successful lenders had been through past big, bad California housing busts without ever showing a loss ratio that would raise an S&L inspector's eyebrow. This time, the spectacular growth in Option ARMs (Adjustable Rate Mortgages with bells and whistles) has come from lending by Golden West competitors who had been insignificant in earlier cyclesincluding Internet-based lenders who advertise approvals on-line in minutes. The mushroom crop growth of new lenders and new loan products are alleged by some skeptics to have been a major motivator in the Sandlers' decision to sell to Wachovia. Skeptics fear that much of the banking system's housing mortgage portfolios will become fetid ARMpits. On a national basis, this is almost assuredly an excessive response to horror stories of regional excesses. Nevertheless, the history of US banking is that lenders do learn from their mistakes. Sort of. Whatever was the disaster area in the last cycle doesn't get deluged with easy money the next time. However, some new sector or form of credit emerges that fuels rapid growth in lending and profits, and becomes the next catastrophe.

Skeptics fear that much of the banking system's housing mortgage portfolios will become fetid ARMpits.

May

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Time will tell whether that trillion dollar-a-year growth in housing mortgage debt at a time when both Fanny and Freddy have been revealed to be either dishonest or incompetent in analyzing and reporting their finances is, for the US banking system, a horrendous problem. "We have problems with another kind of forecast: the New Complacency." 4. According to ISI, the US economy is more sensitive to global short-term interest rate boosts than to fed funds increases. Central bankers abroad have been almost unanimously in tightening mode for more than a year. The global liquidity that was growing like the sea in global warming horror movies has crested, and all too soon, we can expect titillation from the latest replay of Warren Buffett's beach drama: "It's only when the tide goes out that you learn who's been swimming naked." Back in the Seventies, the world's central banks were united in printing money. Now they're virtually united in controlling it. 5. The housing boom provided the strong economic stimulus that more than offset the net economic contraction from the trebling of oil prices. (Net economic contraction is total contractionary impact less beneficial impactdrilling, ethanol plan construction, etc.) House price increases have been responsible, according to some estimates, for funding nearly half of consumers' non-food spending increases during a time when real wages have grown grudgingly. So the end of house price appreciation will be a powerful deflationary force in the US economy, by forcing consumers to retrench. 6. We have problems with another kind of forecast: the New Complacency. This is the confidence, as expressed in the economic consensus, that the economy will continue to grow at or above trend despite $70 oil. Why? Because leading economic forecasters have long relied on economic models that showed downturns within a year after an outsized oil price increase. "The economy just can't keep growing with $50 oil" was the oft-heard forecast. But the consumer just kept spending, even as the cost of filling up the tank on his SUV was rising many times faster than his income. This time, US consumer spending shrugged off crude oil's price doubling from October 2001 to March '04, and then, even more remarkably the 75% increase in the ensuing 18 months. An Optimist would say, "See? The old models don't work anymore, in part because the real cost of buying cars has fallen so far." A Pessimist would say, "You haven't waited long enough for the impact on consumer discretionary spending to show up." A Realist would say, "Wait to see how consumers

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Basic Points
fare when their borrowing against their houses can expand no further." According to recent charts comparing house prices nationally to house rents, the spread is the widest on record, while the affordability index is at one of its weakest readings in many decades. House prices have finally begun to decline in some regions, and are still rising modestly in others. What if the decline becomes nationwide? And what if it begins to feed on itself? And what if that process builds momentum at a time gasoline prices actually move higher, in response to crude oil supply problems abroad? 7. Perhaps the most reassuring distinction between Then and Now is longterm interest ratesnotably on mortgages. Because of Synthetic Liquidity (as discussed fully in last month's issue), the Fed's quintupling of the fed funds rate failed to produce higher mortgage rates in this cycle. The downside of those low mortgage rates is that they financed the excesses in the housing market. But, over the longer term, those historically low rates cushion the economy against a serious downturn driven by intolerably high home financing costs. 8. Back then, Japan was an Emerging Market and the other EMs, such as Argentina, Hong Kong, South Korea and Taiwan, were marginal to the global economy. China and India didn't count. The Western industrial nations effectively created and maintained the global pricing structure for manufactured goods. The benign aspect of this Club was that competition in global trade was no great challenge to the wage structure or to job creation among the rich nations. The malign aspect was that this oligopolistic pricing structure meant that prices failed to fall during recessionsand rose swiftly thereafter, goosed by rapid money growth among the rich nations and protectionism against Emerging nations. This time, the powerful pricing pressure from China, South Korea, Taiwan and India in what has been the freest global trading environment in more than a century prevented price increases as economies emerged from the tech-crash-induced recession. This historically unique pattern, in which growth in industrial capacity in Asia far outpaces their economic or export growth has meant that these economies export deflation, which offsets commodity-driven inflation. 9. In perhaps just one major respect is this economy more inflationary than were the Seventies. For many American families, the most obvious "Back then, Japan was an Emerging Market...China and India didn't count."

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The dollar is the currency for which central banks pay a highand growingpremium for convenience, liquidity, and nostalgia.

and painful inflation is college tuitions. They have been rising at double-digit rates, whether the economy is strong or weak, and whether oil prices are low or high. The segment of society hit hardest is the middle class, whose children must somehow find funding for fullpriced tuitions for themselves, and their share of the subsidies for the children of poor families. That tuitions are such brazen defiers of overall price trends is inevitable because attempts at boosting professorial productivity, such as Larry Summers' efforts at Harvard, produce faculty revolts from the pampered tenured. Nearly all societies have privileged classes, who command disproportionate shares of national output. What is remarkable in America is just how large and economically powerful the professoriate has become in relation to its counterpart in most other economiesand how successful it has become at extracting gigantic wealth from alumni and other donors without ameliorating its operating procedures. Under such circumstances, no one should be surprised that so many universities are engines of inflation in an economy that is otherwise pressured by deflation. 10. Back then, there was no real alternative to the dollar. When it was debased during the Nixon-Carter eras, inflation was pumped across the world, just as Charles de Gaulle had predicted years earlier. The dollar remains the global store of value by default, and because of the $1.3 trillion of buying of Treasurys by China and Japan to maintain The Great Symbiosis. However, alternatives are emerging. Today, there are the euro and the yen, and someday there will be the yuan. The dollar is the currency for which central banks pay a highand growing premium for convenience, liquidity, and nostalgia. The pound filled that role for nearly a century. World War I ended that imperium. The dollar thereupon took the throne. Its reign will, we suspect, prove to be of Sterling quality. 11. Finally, back then, most of the prominently concerned scientists who spoke at environmental crisis meetings and wrote articles and op-eds were warning of a coming ice age. Indeed, this was part of the story about long-term food shortages, because the growing season in Canada, the Northern US prairie, Ukraine, Russia and Northern China was already showing unmistakable signs of shrinking. Fortunately, the world dodged that bullet, leaving the prominently concerned scientists to warn of warming.

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Basic Points
Looking back to the American economic nadir (the Carter era), the US was able to export its inflation and force even virtuous central bankssuch as the Bundesbankto share in the monetary debauchery. They finally rebelled, forcing Carter to dump his hapless Fed Chairman and appoint Paul Volcker. 'Twas a far, far better thing than Carter had done before or would do after, and it would prove enough to give Reagan and Thatcher the monetarist backing they needed to crush inflation as successfully as they would later crush Soviet Communism. That crushing of inflation was, we believe, not just a one-off event. It proved that central bankers, backed by free trade-oriented governments, could suck the oxygen from inflationary fires. Before the advent of paper money inconvertible into gold, Adam Smith, David Ricardo and their followers had believed that inflation was a purely cyclical phenomenon related to wars and/or crop failures. What Volcker, Thatcher and Reagan (with the help of the Bundesbank's KarlOtto Pohl) would later show was that a global economy based on paper money need not be inflationary, if central banks were firm in restricting monetary growth to overall economic growth levels, trade were relatively free, and if monopoly public sector unions who had the power to shut down key public facilities were not free to raise their incomes regardless of the conditions of workers' incomes in the private sector in their economies. What gave the Greenspan Fed in its later years the conviction that it could abandon the Friedmanesque monetary policies of the Volcker era was a sudden excess of good luck: Plunging defense budgets because of the end of the Cold War (and the fall of Cold Warriors from power in the US and UK); Tech-driven productivity gains; WTO-driven growth in global trade to a rate far faster than the growth of the OECD economies; Plunging commodity prices during the last, lingering agonies of the Triple Waterfall collapses; Public unwillingness to tolerate outsized public sector wage settlements that would feed inflationary pressures.

...Central bankers, backed by free trade-oriented governments, could suck the oxygen from inflationary fires.

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Commodity Inflation: Then and Now

From 1970 to the CRB's peak in 1980-81, many important commodities had sensational moves:

Commodities were blamed for the inflation of the 1970s...

Commodities were blamed for the inflation of the 1970s because: 1. Obese Arab oil sheikhs became the new cartoon symbol of high-priced gas among the mainstream American media, a form of racism that amused most of the population, including parlor pinks, who were ordinarily sensitive to racial slurs. 2. Economists in leading universities other than the University of Chicago continued to insist that it wasn't their policies that were responsible for double-digit inflation, because stagflation was an impossibility. (After Reagan and Volcker imposed Friedman's policies on America, and inflation collapsed and the economy boomed, an Ivy League professor was quoted as sniffing, "Yes, these tax cut and deregulation policies seem to work in practice, but will they work in theory?") 3. The Club of Rome, the epitome of the international elite, claimed that commodity inflation was inevitable because commodity production was the New Economy of Scarcity. Endless population growth and endless inflation were now the fate of humankind. No Club members noticed that the birth rate was collapsing across the non-Muslim world. No Club members noticed that the Green Revolution was doubling and trebling crop yields across the world. The Club went into decline during the 1980s, when the food problem became the exact opposite of what the Club had predicted: how could governments prevent farmers from going bankrupt because of massive overproduction? The European governments found a way that absorbed half the budget of the new

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European Union, and other industrial governments were forced to ratchet up their farm spending to "compete." (Margaret Thatcher liked to tell the story of working late at night in Whitehall during the first year of her term. She heard a man crying and went out to find him. He turned out to be an official in the Department of Agriculture. When she asked why he was weeping so copiously, he sobbed, "My farmer died.") The kind of brilliance of insight that characterized the Glory of Rome returned to the world during the 1990s when it became fascinated by another "New Economy." The Club members didn't even bother inventing a new term for the tech era. Why waste a perfectly workable term that had merely been misapplied? Remarkably, there were millions of otherwise intelligent people who were surprised to find out that the "New Economy: The Sequel" didn't provide any more panaceas than had the first New Economy.

...the "New Economy: The Sequel" didn't provide any more panaceas than had the first New Economy.

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THE INVESTMENT ENVIRONMENT

The bull market in global equities that started in 2002 is in trouble, because it is too reliant on hedge fund buying, financed by a sustained liquidity gush from Japan. Emerging Marketsthe best-performing equities markets were the hardest-hit bourses this month when Japan's Monetary Base growth turned negative and the BOJ was publicly promising that real interest rates were coming soon. The pattern in which the riskiest asset group outperforms the highest quality groups broke down: Treasurys finally outperformed junk bonds and single "B"s, the S&P 100 finally began outperforming the Russell 2000, and the Dow-Jones Industrials outperformed Nasdaq. In this "May Day" Pirandello-style role switch, commodity stocks, for three years the cynosures of cyclical growth portfolios, were suddenly trashed. Apart from the panic unwinding by heavily-leveraged hedge funds, investors and speculators began rushing into the new consensus that a US housing collapse would trigger a recessionthat would bankrupt China and bring the entire global economic recovery to its kneesthe Bernanke Fed would accelerate this collapse by tightening too longthe global recession would bring commodity prices back to 2002 levelsthereby setting the stage for an eventual recovery. What do we think of these gloom scenarios? We are impressed with the fact that most of the past housing recessions led to overall recessions. Since US mortgage debt has been rising by $1 trillion or so a year, and has financed such a significant percentage of overall consumer spending, it is certainly reasonable to assume that this housing bubble could prove to be almost as serious a threat to the US economy as the tech mania. We remain of the view that the primary threat to the global economy comes from deflation, not inflation. The combination of freer trade, tech-driven productivity gains and deteriorating demography across the industrial world argues for sustained deflationary risks on a scale not seen in a century. The next recessionwhenever it comeswill drive long-term interest rates to levels not seen since the Depression. The inflationary pressures now being experienced have alarmed central bankers, and they will not ratify the commodity prices increases that have been driven by robust demand at a

...the primary threat to the global economy comes from deflation, not inflation.

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time producers are having difficulty maintaining current production levels, let alone growing supplies at the rates seen in previous postwar economic cycles. We agree that investors who strongly believe that a serious recession looms would be happiest if they got out of cyclical and financial stocksin all markets. However, any recession would likely be brief: the central bankers would restore liquidity flows once they saw that the global economy was falling, bringing prices with it. Interest rates have not risen to the levels they touched in previous postwar cycles. Commodity prices would certainly fallincluding gold and platinum. We have seen what marginal pricing does to commodity prices when demand slightly exceeds supply, so we know what to expect when supply slightly exceeds demand. Nevertheless, we think the quality commodity stocks have inherent investment merits that do not apply to cyclical stocks in general. Oil and mining companies have record levels of financial strength. In all past recessions, the companies had loaded up with debt just prior to the onset of recession, and they were forced into sustained spectators' roles as their stock prices and those of their competitors, slumped. This week's announcement of the Kinder Morgan buyout at a 19% premium illustrates our conviction that true investorsas opposed to traders and others with short-term horizonsshould stick with the high-quality commodity producers particularly those with substantial oil sands exposure. The next recession will unleash commodity producer consolidation at record levels. Companies that, for antitrust reasons, cannot merge with other companies, will buy in their own shares. This is the first commodity boom in which the stock market chose to remain largely on the sidelines. The mining and oil companies' absolute and relative p/es have declined: in the past bull markets, their absolute and relative p/es increased. Stock prices have failed to keep up with the companies' earnings gains. What about the old saw that you buy these stocks when their p/es are infinite and sell them when they're single-digit? That rule applied to cycles in which commodity inflation was part of a generalized increase in inflation, and the commodity companies' balance

Stock prices have failed to keep up with the companies' earnings gains.

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sheets deteriorated because of big debt buildups to finance overall industry capacity expansions, which tended to come on stream after commodity prices had peaked. This time, such new capacity as has been coming on stream has barely been able to keep up with declines from existing mines and oil wells. One of our clients, Clarium, recently published a splendid analysis of the oil outlook, which included some remarks made by Dick Cheney in 1999, whilst he was still at Halliburton. He observed that, "By some estimates there will be an average of two percent annual growth in global oil demand over the years ahead along with conservatively a three percent natural decline in production from existing reserves. That means by 2010 we will need on the order of an additional fifty million barrels a day. So where is the oil going to come from?" Readers who assume that Cheney is the Devil Incarnate may choose to ignore that analysis, but others should ponder the implications. To date, we have watched as North Sea production has plummeted and output from the world's three biggest fieldsGhawar, Cantarell and Burganhas been declining, led by a particularly steep drop in light oil output. As copper trades above $3.50, disbelievers lament the production declines that have driven inventories on the commodity markets to two days' supply (yes, that's days, not weeks). Especially prominent have been the cuts from Codelco and Freeport McMorannot due to strikes, but to the mining of lower-grade ore. It has long been a rule of basic mining practice that, when metals prices rise above expected long-term averages, prudent miners adjust their emphasis away from "long-term average grade of the orebody" to lower-grade zones, thereby extending the life of the mines. It has, however, become a basic rule of Wall Street's metal price forecasting in this cycle that such historic operating practices would not be followed by miners in this cycle, thereby helping to ensure that supply would exceed demand, and that the hedging they urged on the miners would be both prudent and profitable. That a few leading Wall Street firms have been making fabulous profits in their commodity trading operations suggests, perhaps, that arranging for the counterparties in those hedging programs has been a justly-earned reward for meritorious investment banks who selflessly risk their capital to help clients achieve their goals.

...new capacity as has been coming on stream has barely been able to keep up with declines from existing mines and oil wells.

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INVESTMENT CONCLUSION
That global markets can be whipped around so wildly because of hedge funds and changes in Bank of Japan policy suggests we are late in this bull market. But nothing that has happened challenges our basic thesis about the real values in the leading commodity stocks. We were surprised last week by how many times we were asked whether we might be ready to abandon our thesis. For the record, then: We remain committed to our policy of making five-yearnot one-year forecasts in Basic Points. We update those long-term views in our weekly Conference Calls, which are our way of keeping in touch with our readers between publications. We are more than ever convinced that our core metric of commodity stock investingholding stocks of companies based on their unhedged reserves in politically secure areas of the worldis being validated by the year. We remain somewhat disappointed that the stock market has yet to discover the power of this analytical tool in identifying long-term value. Yes, the stocks we have applauded have far outperformed stock markets. But they have lost on their price-earnings ratiosin both absolute and relative terms. They are, therefore, clearer investment values than ever. Only a serious economic slowdown will make these stocks truly riskyand that will be a relatively short-term downturn.

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INVESTMENT RECOMMENDATIONS
1. Financial fragility has reappeared, and the equity bull market is overdue for a correction of at least 10%. Cash is likely to outperform the S&P 500 in the near termas it has year-to-date. 2. A market correction within a continuing bull market should be led by the market sector that is in Triple Waterfall descentinformation technology stocks. 3. A market correction that marks the onset of a true bear market would most probably be led by Financial stocks. 4. The sharp selloff in commodity stocks in late May at a time commodity stocks were already selling at a p/e discount to the broad market was a reminder that most investors (and most commodity stock company managements) still believe these are short-cycle cyclical stocks. The commodity futures may, from time to time, be in short-term bubbles driven by hedge fund speculation, but the stocks themselves continue to be among the best overall value stocks in the market. 5. That value is highlighted by their low absolute and relative p/es, but their true worth lies in the value of their unhedged reserves in the ground in politically secure areas of the world. 6. In balanced portfolios, begin to increase the commitment to very longterm, high-quality bonds, adding to the exposure as evidence of US economic slowing becomes more convincing. The best portfolio hedge against a severe economic downturn is very long-term bonds and zeros. 7. The dollar turned briefly stronger as Emerging Markets, small-cap stocks and junk bonds were getting hit hard. That was a reassuring sign that this was not the opening growls of a serious, sudden bear market. In all, or almost all financial panics since 1971, the dollar has led financial markets down. 8. Gold stocks are excellent portfolio insurance if acquired during times of commodity stock selloffs. There is still far too much talk among gold bulls that inflation is about to come back big. That is, admittedly, a somewhat more probable event than a Cubs World Series appearance, but it is by no means a sure thing. 9. What we call "The Great Dividend-Paying Stocks" are Blue Chips with at least a decade's record for increasing dividends faster than inflation, a

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payout ratio less than 60%, and the reasonable likelihood that dividends will continue to advance in real terms. They are attractive for almost any investor, but particularly for retirees. 10. Remain alert for the kind of disasters that bedevil economic and financial forecasting. Hurricane season is arriving, so watch for Alberto, Beryl, Chris, Debby, and Ernestoand hope we don't reach Williamor Zebulun. Experts are divided as to whether this one will be normalor worse. Continue to watch the news on Avian Flu. It hasn't mutated into a person-to-person peril, but it hasn't gone away either. And it continues to kill more than half the people it is known to infect.

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Harris Investment Management Disclosure: Basic Points is a publication prepared by Donald Coxe of Harris Investment Management, Inc. ("HIM") and BMO Harris Investment Management, Inc. ("BMO HIMI") for the exclusive use of clients of BMO Nesbitt Burns Inc., Harris Nesbitt Corp., HIM, Harris Trust & Savings Bank (HTSB), BMO HIMI and Jones Heward Investment Counsel Inc. (collectively referred to as the "Global Asset Managers"). All rights reserved. The opinions, estimates and projections contained herein are those of Donald Coxe and do not necessarily represent the opinions of HIM and BMO HIMI as of the date hereof, and are subject to change without notice. HIM, BMO HIMI and the other Global Asset Managers believe that the contents hereof have been prepared by, compiled or derived from sources believed to be reliable and contain information and opinions which are accurate and complete. However, the Global Asset Managers make no representation or warranty, express or implied, in respect hereof, take no responsibility for any errors and omissions which may be contained herein and accept no liability whatsoever for any loss arising from any use or reliance on this report or its contents. Information may be available to the Global Asset Managers which is not reflected herein. This report is not to be construed as an offer to sell or solicitation for or an offer to buy any securities. The Global Asset Managers and their affiliates and respective officers, directors or employees may from time to time acquire, hold or sell securities mentioned herein as principal or agent. Any of the Global Asset Managers may act as financial advisor and/or underwriter for certain of the corporations mentioned herein and may receive remuneration for same. Each of the Global Asset Managers is a direct or indirect subsidiary of Bank of Montreal. Bank of Montreal or its affiliates may act as lender or provide certain other services to certain of the corporations mentioned herein and may receive remuneration from the same.