Basic Points

Baubles, Bangles & Needs

February 20, 2007

Produced by BMO Financial Group

Distributed by BMO Capital Markets
Basic Points
An Investment Journal

Donald G. M. Coxe
Global Portfolio Strategist, BMO Financial Group
(312) 461-5365
e-mail: don.coxe@bmo.com

Research/Editing Angela Trudeau

e-mail: angela.trudeau@shaw.ca
Production/ Anna Goduco (print orders and mailing lists)
Distribution e-mail: basicpoints@bmo.com

Baubles, Bangles & Needs

Overview

This month, we are making three significant changes to our strategy recom-
mendations.

First, we have changed our view on gold. Until now, we have recommended
holding an overweight position in gold (through mining shares and the ETF)
to reduce endogenous risk—strictly a foul-weather friend. After our trip to
India, we began to consider gold’s attractions for investors as a fair-weather
friend.

Secondly, we now recommend a strong overweighting in agriculturally-re-

lated stocks. We first recommended the agriculture stocks in October. We be-
lieve that the investment opportunities in stocks tied to production of grains,
oilseeds and meats could be somewhat reminiscent of what we saw three
years ago in the oil and gas stocks. Ethanol is an environmentally dubious
idea whose time has come, because it offers the chance of controlling petro-
leum prices, and, therefore, of controlling the cash flows to the promoters of
Islamic terrorism. If all the corn and soybean fuel projects under discussion
were to come on stream, they could put a cap on oil prices, which would be
good news for the global economy—and great news for mining companies.
The basic supply/demand balance for coarse grains and oilseeds globally
would probably be transformed. Prices of grains and oilseeds will continue
to experience upward pressure, and problems for the livestock industries and
food price inflation have only begun.

Thirdly, we are reducing our bond exposure, both in duration and in per-
centage allocation. Despite our five-year-long enthusiasm for hard assets, we
continued to recommend exposure to long-duration bonds. Changing that
long-held viewpoint requires an explanation in some detail.

In January, we began consideration of the impact of demographic changes

on investment strategies. This month we carry that process forward, looking
at future changes in long-term attractiveness of some major asset classes.

These changes in viewpoint trigger significant changes to our Recommended

Asset Mix. We recommend that clients use the increased exposure to equi-
ties—US and foreign—to build positions in agricultural, gold, base metal,
and energy stocks. Commodity stocks remain our favorite equity asset class.

February 1
 Recommended Asset Allocation

American Portfolios

U.S. Pension Fund

Allocations Change
Domestic Equities 27 +3
Foreign Equities 29 +3
Domestic Bonds 12 -3
Long-Duration Bonds 10 -5
Foreign Bonds 15 unch
Cash 7 +2

Foreign Equity Allocations

Allocations Change
European Equities 6 unch
Japanese and Asian Equities 6 unch
Canadian & Australian Equities 6 unch
Emerging Markets 11 +3

Bond Durations

Years Change
Global 4.25 -.25
US 4.50 -.75
Canada 4.75 -.75

2 February
 Basic Points
Baubles, Bangles & Needs

We began rethinking our long-held views on gold during our visit to India.
Driving through the rural villages of South Rajasthan, one of the economi-
cally poorest areas in North India, we were struck by seeing so many impov-
Even without the
erished women wearing gold bangles.
mystique... gold is
We knew that gold was an historic dowry component in regions where only now looking
a small percentage of the population owned land, but the surprise was such attractive...
widespread wearing of wealth; in villages and in cities we saw women wear-
ing gold jewelry. We were thinking about the meaning of all that jewelry
when we began writing this essay, while listening to music of Borodin’s beau-
tiful Second String Quartet—later adapted as the 1953 hit Kismet—thereby
our title.

Given that India has the highest inflation rate (6%+) of any of the large econ-
omies, gold is a logical investment. But gold’s role in the intellectual and
cultural history of India is a far more significant inducement to buy bangles
than the current CPI growth rate. India is the biggest gold-consuming nation
in the world, and its consumption has risen so strongly that it more than
matches central bank gold sales. As more and more Indians become even
modestly wealthy, more and more of their saved rupees go to gold.

Even without the mystique of three millennia of history in which gold was
synonymous with wealth, power and personal security, gold is now looking
attractive to the rising Indian middle class as a market investment, compared
with other readily-available investment alternatives.

The banking system outside large urban centers is dominated by great num-
bers of small, local deposit institutions, of widely varying financial stabil-
ity. That kind of diversity and financial archaism does not encourage the
newly wealthy to invest their life savings in bank deposits at near-zero or
even negative real interest rates. The Indian stock market has become one of
the wonders of the financial world, but it is still an Emerging Market, and its
success is a very recent phenomenon. The components of the Indian econ-
omy represented in that rather narrow index are collectively overheating, as
has been widely observed in recent months. India’s classic problems haven’t
gone away—the seemingly impenetrable bureaucracy of the License Raj, the

February 3
 infrastructure problems bedeviling a fast-growing economy that moves on
outdated or even primitive roads. Then there is the corruption and influ-
ence-peddling within the decision-making structure of a federalist state that
has historically protected outmoded vested interests in a fashion that would
evoke envy from Jacques Chirac, but scorn from any official of the WTO.
...gold is the Real estate is, as always, the most obvious investment asset class, but, apart
readily available, from home ownership, it is a market that requires patience and capital. In
and easily that somewhat colorful and chaotic array of investment options, risks and
understood option rewards, gold is the readily available, and easily understood option for a siz-
for a sizable chunk able chunk of the new middle class’s discretionary resources.
of the new middle
Even for wealthier investors, gold has attractions at a time of very low real
class’s discretionary
interest rates on bonds and short-term deposits offered by major issuers and
resources.
institutions.

Gold is big in India, but it has always had allure elsewhere in Asia. Indeed,
the Chinese have long accorded it a special place in their historical musings
about the nature of things.

As we wrote last year, Zarathustra’s Four Elements—Earth, Air, Fire and Wa-
ter—were brought to India by Persians. From there, the concept was taken to
China by Buddhist priests. (Buddha was an Indian, and his revelations came
to him at a spot just outside Varanasi, Hinduism’s holiest place.) The Hindus
added a fifth element—Sky—being the forces in the heavens. The Chinese
rejected that addition, substituting gold as the Fifth Element. Despite that
status, gold has not been for today’s Chinese the kind of investment treasure
it has been for Indians. Perhaps the availability of a wider range of local in-
vestment alternatives generated by China’s awe-inspiring growth has made
gold seem less interesting—or less necessary.

We have long cited central banks’ eagerness to sell their gold as a reason for
rejecting gold bugs’ insistence that gold is the safest investment medium and
the only “real” money. Since most of the central banks who hold most of the
bullion have been trying for decades to downsize or (as in Canada’s case)
to get out entirely, why assume that all other assets should be denominated
in gold, or that gold prices must go up? The World Gold Council, working
through the IMF and other international agencies, managed to get an agree-
ment constraining central bank gold sales—to save the African gold industry
from collapse.

4 February
 Basic Points
Why should anyone have an intellectual and emotional attachment to some-
thing whose price might still be $250 an ounce if all those sellers weren’t
sticking to a deal they made, under pressure from Bono and the banking
boys, to join a gigantic global price-fixing agreement which could have been
derived from such spurious deals as the EU’s Common Agricultural Policy?
gold...will not be
We have reconsidered our view that gold had too many of the attributes of
a commodity
an overpriced, sickly hothouse plant that could not endure the chill winds
propped up by
of free markets. It is finding enough real buyers to give it credibility, and the
governments—
companies who made fortunes in the last decade betting against it through
like American or
hedging now must face the reality that they overstayed their bets.
Canadian milk or
Our revised thinking on gold assumes that the central bankers will continue almost anything
to sell their permitted quantities each year, and the entire overhang will be produced by
out of the way within a few years. French farmers.
Long before then, gold will be in its own long-term bull market based on
real market forces, and will not be a commodity propped up by govern-
ments—like American or Canadian milk or almost anything produced by
French farmers.

Gold
January 1972 to February 2007

900

750

600

450

300

150

0
Jan-72 Jan-75 Jan-78 Jan-81 Jan-84 Jan-87 Jan-90 Jan-93 Jan-96 Jan-99 Jan-02 Jan-05

February 5
 Philadelphia Gold Stock Index
December 1983 to February 2007
180
160
140
120
Gold’s big problem 100
has not been those 80
big holdings by big 60
central banks who 40
wanted to get out in 20

a big way... 0
Dec-83 Dec-85 Dec-87 Dec-89 Dec-91 Dec-93 Dec-95 Dec-97 Dec-99 Dec-01 Dec-03 Dec-05

US CPI
January 1972 to February 2007
225
205
185
165
145
125
105
85
65
45
25
Jan-72 Jan-75 Jan-78 Jan-81 Jan-84 Jan-87 Jan-90 Jan-93 Jan-96 Jan-99 Jan-02 Jan-05

Gold’s big problem has not been those big holdings by big central banks
who wanted to get out in a big way: it was that inflation had not been a big
problem for years. How much should investors pay for a hedge against a
dwindling nuisance? For two decades, most investors’ willingness to pay up
for inflation protection gradually faded away, as they put their money into
more productive investments.

Milton Friedman’s breakthrough insight that sound central bank policies

and freer trade would end the inflation that had haunted the Free World
since the 1950s eventually attracted enough support in high places to prove
that it worked.

6 February
 Basic Points
Volcker, Reagan, Thatcher and the Bundesbank’s Karl-Otto Pohl were the
leaders in the successful war on inflation. Thanks to them, the mania that
had driven Gold to $825 and Silver to $50 was crushed, the first crash in
what would become the Triple Waterfall collapse of commodities. In the kill-
ing fields, the corpse of chrysophilia would eventually be found—with gold
at $250 and silver at $4. By then, the specter haunting global price systems The Age of Reverse
had become deflation. Japan was the first major economy to suffer outright Alchemy had
deflation, but by 2000, a collection of global deflationary forces was driving arrived...
world inflation down to levels that sent long-term interest rates to such mini-
mal levels that numerous private pension plans were facing funding crises.
The hoary maxim, “Be careful what you wish for” was proved anew, as pen-
sion plans, which had for decades despaired of their ability to earn enough
to offset inflation, now found their tech investments devastated, while the
fastest-growing category on their balance sheets had become their discount-
ed liabilities.

Irony of ironies: from 1981 through 2001, gold was just about the worst-
performing asset class, and long zero-coupon Treasurys—the asset most de-
spised and ridiculed by gold bugs—were just about the best-performing asset
class.

Even when gold finally rallied from its tarnished state in the Slough of De-
spond, it faced a new humiliation: it underperformed the asset its supporters
had been sneering at for millennia—the base metals. The Age of Reverse Al-
chemy had arrived: step right up and get rich by letting us convert your lousy
gold into lovely base metals!

Gold
January 2001 to December 2005
550

500

450

400

350

300

250
Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05

February 7
 Copper
January 2001 to December 2005
250

200

150

100

50
Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05

Nickel
January 2001 to December 2005
18,500
16,500
14,500
12,500
10,500
8,500
6,500
4,500
2,500
Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05

Zinc
January 2001 to December 2005
2,000

1,800

1,600

1,400

1,200

1,000

800

600
Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05

8 February
 Basic Points
Investors who dumped their Barrick, Gold Fields or Newmont and put the
proceeds into such base metal producers as Inco, Falconbridge, BHP Billiton,
Phelps Dodge or Teck Cominco were the new Alchemists.

Barrick Gold Corp. (ABX)

January 2002 to December 2006
37

33

29

25

21

17

13
Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06

Newmont Mining Company (NEM)

January 2002 to December 2006
65

55

45

35

25

15
Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06

Gold Fields Limited (GFI)

January 2002 to December 2006
30

25

20

15

10

0
Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06

February 9
 Inco Ltd. (N)
January 2002 to December 2006
90
80
70
60
50
40
30
20
10
Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06

Falconbridge (FAL)
January 2002 to December 2006

55

45

35

25

15

5
Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06

Phelps Dodge Corporation (PD)

January 2002 to December 2006

120

100

80

60

40

20

0
Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06

10 February
 Basic Points
Teck Cominco Limited (TCK.B: TSX)
January 2002 to December 2006
95
85
75
65
55 To the true
45 gold bug, all
35 government-
25
created inflation
15
5 statistics are lies.
Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Really Big Lies.

But in recent months the ground has begun to shift. Gold began to outper-
form the base metals, even though global inflation and interest rates were
still declining. In the background was a renewed debate about inflation and
gold.

1. Gold’s sharp rise has revived the gold bugs. Members of this mutant
species, whose recorded sightings had shrunk to tiger levels, are once again
gamboling enthusiastically. One of them was recently quoted in Barron’s
as predicting that coffee would sell at one million dollars a cup within his
lifetime—and he is no beardless youth. (Yes, the cost of a cup of coffee has
gone from its Depression level of a dime to $2.00, if Starbucks’ price is
taken as the global standard, but one should be hesitant about using that
statistic to justify a forecast that Weimar inflation rates are about to engulf
the world.) To these hardy cynics, all paper currencies have ultimately
proved worthless, so it’s only a matter of [relatively short] time before the
dollar joins the tsarist rouble and the Zimbabwe dollar as proof of the
universal frailty, venality and mendacity of governments.

Strange that these self-proclaimed realists aren’t making these same

predictions about the Swiss franc, the renminbi, or, for that matter, even
the once-despised rupee.

To the true gold bug, all government-created inflation statistics are lies.
Really Big Lies.

How, they ask, can anyone talk of 3% inflation when one looks at the real
world: the soaring costs of tuition at prep schools and elite universities,
and the nonstop increases in prices for Park Avenue residences, great wines,

February 11
 and paintings by deceased artists? That the costs of cars and computers
are hedonically adjusted to reflect greater value is, to these skeptics, more
proof that the Bureau of Labor Statistics suppresses the real cost of living
to make the government look good.

We are asked to believe that those thousands of Bureau of Labor Statistics

Those countless
employees who visit Wal-Mart, Target, Macy’s, Home Depot, Ace Hardware,
thousands of BLS
and the nation’s supermarkets each week to check the prices of thousands
employees must
of items are co-conspirators in a plot to cover up George Bush’s debauching
be...the closest
of the dollar.
approximation of
collective devotion Moreover, these data-collectors are the same people, or the successors to
unto death seen the same people, who performed the same mountebankery for Clinton,
since those storied with the same precision. Amazingly, not one of them, after retiring or
300 Spartans at being fired, ever went public with the biggest fraud story of all time.
Thermopylae. Those countless thousands of BLS employees must be, according to this
viewpoint, the closest approximation of collective devotion unto death
seen since those storied 300 Spartans at Thermopylae.

2. Inflation believers who aren’t gold bugs say, “Well, yes, we understand that
the central bankers are dedicated to fighting inflation, but isn’t it a fact
that prices keep going up? As the wags say, the only money that goes as
far today as it did twenty years ago is the quarter that rolls under the bed.
And $60 oil and $17 nickel and $10,000 Barbra Streisand tickets show
that the brief period of price stability that came after the Tech Crash is
long gone.”

3. The fundamental weakness of the dollar is another component of

predictions of rising inflation. The dollar’s powerful bull market from
1995 to 2002 was a major contributor to the drop in inflation rates,
particularly—though by no means exclusively—in the US. Since then,
the dollar’s value has been sustained by the willingness of Asian central
banks to fund the US trade deficit, which is approaching the levels of the
GDP of all but the richest nations. This gigantic vendor financing program
obviously cannot last forever. When the financial music stops, the dollar
will collapse and inflation will soar out of control.

We agree that what we call “The Great Symbiosis” cannot be a permanent

arrangement. But we do not agree with the contention that a 20% drop in
the greenback’s value would mean 20% inflation. Many overseas suppliers
would doubtless eat much of the dollar’s depreciation, in order to protect
their share of the US market.

12 February
 Basic Points
Currency is not the whole story: the Swiss franc has been strong against
the dollar in recent years. But, as any visitor to Geneva or Zurich can attest,
Swiss prices for a wide range of products and services are far higher than
American prices. Or consider the pound: the pound lacks the prestige
of the Swiss franc, but it has been very strong against the greenback. Yet
London is, according to those who calculate these things, a far costlier city ...when food and
for residents and businesspeople than New York—let alone Chicago. fuel prices rose
sharply together,
Why Inflation Could Accelerate to “Moderate” from “Low” inflation always
David Hackett Fischer’s The Great Wave records the history of European in- occurred.
flation since medieval times. He shows that when food and fuel prices rose
sharply together, inflation always occurred. What is interesting is that if only
one of those commodity groups experienced rising prices, inflation quite
frequently did not occur.

What of Friedman’s contention that only the printing of money causes infla-
tion?

He was more careful than that. He said, “Money matters most,” and “Always
and at all times, inflation is a monetary phenomenon.” Inflation naturally
occurs when fuel and/or food prices spike—even during the long centuries
of the gold standard—but those sudden boosts did not form a sustained pat-
tern of price increases without excess monetary creation. (Pre-paper money,
the debasement occurred in the coinage itself.)

What is clear is that some of the important economic contributors to disin-

flation that assisted central banks’ restrictive policies in bringing inflation
down and keeping it down have changed since 2001-2003—when talk of
deflation was heard far beyond Tokyo.

Why Hasn’t the Commodity Boom Raised

Inflation Rates Sharply?
Had investors known in 2001 that oil was headed for $70, copper for $3, and
corn for $4, they might naturally have assumed that this decade would have
been a replay of the 1970s. That didn’t happen, mostly because central bank-
ers didn’t print money to offset the commodity price increases. But there
were other important factors at work.

February 13
 Businesses in the major economies have managed to absorb a doubling of
oil prices—and even greater rises in base metal prices—because of global
competitive forces, productivity gains, the wage arbitrage out of Asia, low
interest rates, and low food prices, (which helped to prevent worker unrest at
a time of wage restraint).
Gold’s new luster
Looking forward, there is little risk of high percentage increases in energy and
does not come
metals prices from current levels. That so many central banks chose to use
because the
Core Inflation as the major guide to setting economic policy and that no in-
inflation beast
flation mania developed meant that economies did not experience a true oil
has arisen from
shock despite a runup in oil prices from $25 to $75: real money growth con-
its crypt.
tinued adequate but never frenetic, while consumers never came to assume
that inflation was headed for double-digit levels. As we have noted many
times before, central bankers must fight a two-front war against inflation:
the first is to suppress price increases across the broad swath of economies
by controlling money growth; the second is to prevent the mental metasta-
sization of the inflation virus among consumers, governments, unions, and
businesses. If those major sectors come to believe inflation is headed out of
control, only draconic central bank tightening (à la Volcker and Thatcher)
will arrest the spread of the disease through the economy.

Gold’s new luster does not come because the inflation beast has arisen from
its crypt. Gold is attracting buyers who look at the hundreds of trillions of
dollars’ worth of derivatives that have been spawned in this decade, and won-
der whether these will always continue to be useful droids, or whether they
will become runaway robots. (In particular, the astounding growth of Credit
Default Swaps raises worries for the system. When, as is now often the case,
the face value of the default swaps on debt of a corporation can be many
times greater than the company’s debts, changes in the company’s capital
structure can set off shock waves. That investment banks have no trouble
finding hedge funds willing to participate in creating debt out of thin air sug-
gests there could be something perilous in the air.)

But gold is also winning because there are so many more people willing to
buy jewelry—and so many of that group like the idea of buying 22 carat gold
jewelry because it is a neat way to invest. Yes, there are still people who pay
fortunes for towels held by Marilyn Monroe, or for autographs of John Len-
non. But gold jewelry collectors shopping in Abu Dhabi or Dubai just want
“the real thing”—and they want it now.

14 February
 Basic Points
Meanwhile, another commodity bull market has come out of nowhere, (or
more accurately, out of the ground), and it raises questions about the con-
tinuance of disinflation: the grains and beans are on a tear, and a Big New
Idea is the reason for these big gains.

Could food price inflation come back? And if it does, what will that mean for
The tortilla is to
the anodyne idea that inflation is yesterday’s story?
Mexico City what
What has been unfolding in Mexico gives pause. bread was to
Rome...
Falling inflation, falling interest rates, soaring returns from oil, and huge
cash inflows from Mexican workers in the US helped Mexico to achieve
balanced—if subdued economic growth. Unfortunately, the Vicente Fox
government lacked the will to use the breathing space to enact and imple-
ment much-needed economic reforms. Since then, global interest rates have
been rising, whilst output from Cantarell, Mexico’s major oilfield (and once
the third largest in the world) has been collapsing—down a half-million
barrels/day last year alone. Pemex, the state-owned oil company, has long
been forced to cede most of the net revenues from its production to the
federal treasury: its “profits” have accounted for roughly one-third of gov-
ernment revenues. The potential demise of Cantarell would be a national
disaster. The new Calderon government, which won election over a fire-
eating Chavista by the kind of nail-biting margin Bush achieved in Florida, is
unable to help Pemex, partly because the Mexican constitution treats foreign
participation in its oilfields with the kind of xenophobia American admirers
of Lou Dobbs feel for undocumented Mexican immigrants.

In the midst of this fast-developing crisis, corn prices have skyrocketed,

sending tortilla prices up 35%. Food riots have broken out. The tortilla is to
Mexico City what bread was to Rome, and every emperor (except Caligu-
la) knew that if bread became too expensive for the urban mob, he was in
trouble—and might not be able to count on the loyalty of the Praetorian
Guard.

What is happening to the price of Mexico’s staple food is part of a much big-
ger global grain price runup. Grain and oilseed prices would have been firm
anyway, because world stocks have been falling for years, and demand from
livestock producers has been rising.

February 15
 For five years, we have been counseling clients to buy the mining and oil stocks
because of rising demand from the new Third World middle class, particularly
in China and India. All those new cars, apartment buildings and air condition-
ers were swallowing the world’s production of oil and base metals.

And so it has been with feed grains and oilseeds. When people get richer,
...they learned—to
those who are not committed vegetarians are no longer content with a diet
their horror—that
of bread, rice and vegetables. They want meat. Just as the worldly-wise of the
the new middle
world thought cheap oil would last forever, and were shocked—shocked!—at
class were of
$50 oil, these same wise people assumed that the only problems with grains
carnivorous
would be about having to pay farmers too much to grow them, and then
disposition.
finding some place to get rid of their output. Then they learned—to their hor-
ror—that the new middle class were of carnivorous disposition. Why weren’t
they content to have a loaf of bread and a jug of wine in the wilderness—like
the enlightened Omar? (Come to think of it, where did the wilderness go?)

And, just as the planners were trying to figure out how to feed all the needed
ducks, chickens, pigs and cattle, some other planners came up with an idea
to solve another set of problems by generating demand for coarse grains and
oilseeds—as fuels.

The strain on grain supplies shows plainly in the charts:

Wheat
January 2002 to February 2007
550

500

450

400

350

300

250

200
Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07

16 February
 Basic Points
Corn
January 2002 to February 2007
450

400

350

300

250

200

150
Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07

Soybeans
January 2002 to February 2007
1100

1000

900

800

700

600

500

400
Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07

Soybean Meal
January 2002 to February 2007
350

300

250

200

150

100
Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07

February 17
 1. Global wheat prices are up sharply, mostly because of a severe drought
in Australia, and yet another setback to wheat production from the
former USSR. India, the world’s second-largest wheat producer, this week
announced a ban on wheat exports. (It was not long ago that one of the
hardest-fought issues in trying to reach new international trade deals was
Hamilton’s Law: the widespread subsidization of wheat exports.)
“Where you stand
2. Ethanol is now becoming the fuel of choice for (a) global warming
depends on where
enthusiasts; (b) those articulate students of Mideast affairs, like Thomas
you sit.”
Friedman of The New York Times, who argue that high oil prices finance
Saudi export of jihadism through madrassas and “Islamic charities”
across the world; (c) grain farmers, particularly in Ohio, Illinois, Iowa,
Minnesota, Wisconsin, Nebraska, Missouri, Oklahoma and Kentucky, who
haven’t luxuriated in such lush returns from their fields since the 1970s,
and (d) voters in the above states, for whom ethanol has become a secular
religion. Ethanol demand has already transformed corn markets from glut
to scarcity, and threatens to transform the pricing structure for grains and
oilseeds.

Of particular importance are the voters in the Iowa Caucuses, the first test
for presidential candidates next year. As a result of changes unfolding in the
dating of other primaries, Iowa could have even greater leverage than ever: it
and New Hampshire could be the only races before “Super-Duper Tuesday”
in February, where more than one-third of all electoral votes would be up for
grabs. In effect, the mini-campaigns in the two small, snowy states could pro-
vide the momentum for a candidate to go into the nationwide primary with
the momentum and the money to blow away his—or her—competition.

Iowa is a typical US state only if one believes that tractors, fertilizer, hockey
and ethanol are everyday preoccupations of voters in such states as New York,
California, Florida, Michigan and Arizona.

Given Iowa’s potentially decisive political prominence, is it any surprise that

two senators known for their skepticism on ethanol—Clinton and McCain—
have rather suddenly discovered it to be a national treasure?

Their past opposition came from practicing Hamilton’s Law: “Where you
stand depends on where you sit.” Their constituents have been forced to pay
higher prices for gasoline to subsidize ethanol production and distribution.
That tradeoff doesn’t sell well in Tucson or Westchester.

18 February
 Basic Points
Now, however, these Presidential candidates can justify their switches on
national security grounds, since both have good records in that area of pub-
lic policy. The worst of the violence in Iraq comes from radical Sunnis—
al Qaeda and others—who get most of their funding from jihadist Wah-
habites in Saudi Arabia, and from radical Shias, who get funding from the
Shias who rule Iran. The most obvious way to slash cash flows to killers of The most obvious
American troops is to slash oil prices. way to slash cash
flows to killers of
(Yes, yes, we know that the nation could save on oil and save the earth from
American troops is
overheating by abolishing SUVs and imposing punitive gasoline taxes. We
to slash oil prices.
also know that many of the organizations and groups most vociferously ad-
vocating such constraints on the middle and lower classes are heavily backed
by rich people who fly in private jet planes, which are—by far—the most
egregious contributors to high oil prices and global warming per person
served. We suggest that the debates on these crucial policy issues will become
more rational once voters reject any recommendations on energy conserva-
tion or global warming from any corporation, politician or NGO that uses
private jets.)

The McCain and Clinton conversions from stouthearted skepticism to pas-

sionate public protestations of belief are grim news for Mexico’s President
Calderon. Because Mexico is a member of NAFTA, US corn prices indirectly
contribute to the escalation of the prices of tortillas for Mexicans. (Not as
much as Mexican gringo-bashers love to allege, but there’s no doubt that
when a quarter of the US corn crop goes into producing fuel, not feed, corn
and soybean prices are going higher. The Mexican government’s long history
of manipulating tortilla prices, while tolerating a system in which a handful
of private companies produce all the tortillas and corn flour, may have to
reconsider its ways now that global corn prices look to stay painfully high.)
Ethanol is stimulating the building of new production facilities across the
Midwest at the speed that high oil prices are stimulating the building of
nuclear plants in Iran. Bad politics happen anywhere.

When prices of corn and soybeans soar, it is a tough time for livestock pro-
ducers. Hog farmers in China may have a special problem: This is The Year of
the Pig in China, which is considered such an auspicious year to be born that
China expects a baby boom. Chinese parents will be cutting back on the use
of fetal identity systems to detect, and, in millions of cases, abort, unwanted
girls in a One Child Policy regime. With China having such a huge surplus of
young males compared to the female population, the authorities are hinting
that this would be a good year for a baby boomlet that includes girls.

February 19
 Not that the Chinese government has forgotten its foreign policy goals
amidst all this excitement. According to reports, Beijing has instructed tele-
vision stations not to show too many images of pigs, because such displays
could offend Muslims.

Meanwhile, South Koreans aren’t worrying about giving porcine offense, and
...it isn’t the Year of
are swamping maternity wards with reservations because many fortune-tell-
the Pig in the US.
ers there claim this The Year of the Golden Pig, which comes every 600 years:
Nor is it the Year of
to be born this year means truly wondrous prospects.
the Steer:
But it isn’t the Year of the Pig in the US. Nor is it the Year of the Steer:

Feeder Cattle
February 2006 to February 2007
125

115

105

95

85
Jan-06 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07

Lean Hogs
February 2006 to February 2007
80

75

70

65

60

55

50
Jan-06 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07

20 February
 Basic Points
When it becomes very costly to feed cattle in the final weeks prior to slaugh-
ter, feedlot operators reduce their bid prices for feeder cattle. Ranchers must
then decide whether to sell at painfully low prices, or keep their steers longer.
Result: Live Cattle prices stay higher.

Live Cattle
...prices of
February 2006 to February 2007
hamburger will
100
be moving toward
today’s steak prices.
90

80

70
Jan-06 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07

But that retention policy cannot last. Soon those range-fed cattle will be
heading for the last roundup. That means meat prices will remain weak for
at least six more months. Then, we can expect that prices of hamburger will
be moving toward today’s steak prices.

According to the US Dept. of Agriculture, ending world stocks of coarse grains

fell from 197 million tons in 2002 to the current level of 167 million tons,
and an expected level of just 121.6 million tons by this crop yearend.

Total world acreage for production of all grains is flat since 2002. With in-
creasing urbanization and industrialization, land is being withdrawn from
production in the major crop-producing countries, but denuding of forests
and land reclamations have kept total acreage in balance.

The sudden enthusiasm for biofuels threatens to create grain and oilseed
shortages worldwide—and to lengthen the list of endangered species as nat-
ural habitats are converted to fuel production.

February 21
 A large, and rapidly growing proportion of corn now goes to ethanol—a
gasoline substitute or extender—while a small, but growing, proportion of
soybeans is going to biodiesel fuel. In the US the number of diesel automo-
biles is small, but the number of diesel trucks is large. In Europe, diesel cars
are widespread. Although the focus and hype on ethanol has meant that
...meat and corn prices have risen most sharply, global soybean prices will probably track
aquaculture-fed corn more closely, in the future, if only because so little corn will be available
fish are about to for animal feeds.
become hostages
Prices of meat and aquaculture-fed fish are about to become hostages to
to grain demand
grain demand from cars and trucks. Ultimately meat and fish prices will have
from cars and
to go up.
trucks.
For investors, this means that companies which can produce genetically-modi-
fied seeds to produce grains and beans from marginal lands, or seeds with built-in
resistance to pests and weeds, are now core investment concepts in a commodity-
oriented portfolio, as are shares of companies who supply equipment and fertilizers
to farmers.

The Cradle Will Rock

The phenomenon of record low percentage levels of unemployment across
most of the industrial world at a time of historically-modest economic growth
is proof positive that the birth dearth of the 1970s and 1980s has begun to
reshape industrial economies.

As we wrote last month, the basic numbers are simple: GDP growth is growth
in output per worker multiplied by the number of workers. More workers
mean more nominal GDP. More productivity means more GDP per work-
er. Together, these twin forces produce the most important of all economic
data—growth in real GDP.

This is not a new challenge for Western Europe: Germany and Holland led
postwar Europe in producing growth at a rate that used up the supply of
available home-grown workers. Result: these countries, followed by France,
then Italy and then Scandinavia, began importing workers—from the south
side of the Mediterranean and the Bosporus. The strategy was to bring in mil-
lions of neighbors who wanted to escape from the poverty in Turkey, Algeria,
Morocco and Egypt. Meanwhile, Britain, which had a relatively open-door
policy toward Commonwealth immigration, attracted millions from Africa,
India, Pakistan and Bangladesh.

22 February
 Basic Points
Germany was more cautious than some of its neighbors: it labeled the Turks
and other “exotics” as “Gastarbeiters”—guest workers, who could stay for
a few years, then go home. They could not qualify for German citizenship
except after many years—and then rarely. The system worked very well, and
those hard-working young Turks made up the gaps in the workforce from the
number of Germans who were killed in the war. Sadly, the rage of
a minority within
France’s imports were heavily from its former colony, Algeria, and they
a minority hurts
helped keep GDP growth strong. (By surrendering quickly, France didn’t
the majority of the
lose as many young men fighting in WWII as Germany or Britain, the US or
minority...
Canada.)

The immigrants to the Continent—mostly Muslim—helped keep GDP

growth strong until the late 1990s. By then, rising levels of unemployment
among Muslim residents was increasing welfare and health care budgets fast-
er than GDP.

Why did unemployment rise disproportionately among Muslims? There are

many answers. First, was that European economic growth rates slowed, but
implementation of technology meant that productivity improved; Result:
fewer workers needed. Another is the seniority rules enforced by powerful
unions fell most heavily on the young—where the Muslim population per-
centage is highest. Another is that young Turks and Arabs have been victims
of workplace discrimination. It is a melancholy fact of human history that
whenever the number of jobs no longer matches the number of available
workers, “foreigners”—even if they are native-born—will become objects
of discrimination, resentment and blame. Another reason is that too many
youthful Arabs chose to drop out of schools and live on welfare, or to switch
to Islamic schools where the instruction was religiously focused—not job-
oriented.

Since 9/11, of course, an increasingly disaffected minority among the tens of

millions of Muslim immigrants living in Europe has created other kinds of
problems. With jihadism now the fashion among some highly visible young
Muslim males, almost nobody suggests any more that Europe should deal
with its birth dearth problems by importing tens of millions more young
Muslims. Sadly, the rage of a minority within a minority hurts the majority
of the minority that wants to build better lives by participating in the oppor-
tunities of advanced, open, free market economies. Although racism is never
justifiable, its roots are recognizable when the established population comes
to feel threatened by the public misbehavior of a few.

February 23
 With a fertility rate among non-Muslim European women in the 1.1 range,
that decision to discontinue large-scale immigration from the Muslim world
means that each ensuing European generation will be roughly half the size
of the current generation.

“If we depend What does that imply for GDP rates?

entirely on birth It means those economies cannot be as large in the future as they are today.
rate, we are going As Alan Greenspan told attendees at a dinner hosted by Republican Sena-
to turn into tor Bob Bennett, the demographic outlook for major economies abroad is
Europe” frightening, notably for Japan, Germany, Russia, and even China (31% of
whose population will be over age 60 by mid-century). Senator Bennett is
using those data to remind fellow Senators to use caution about changing
immigration laws. “If we depend entirely on birth rate, we are going to turn
into Europe,” he observes.

What does the coming scarcity of working-age people imply for real estate
values?

The great attraction of real estate as a long-term investment has always been,
as Will Rogers put it, “Buy land. They aren’t making any more of it.” He
didn’t have to add, “And they’ll keep on making more babies,” because that
was always the way it had been. Apart from wars, plagues, and famines, ur-
ban populations kept rising from generation to generation. Areas where old
industries were the economic backbone, and new industries did not come in
to take their place, lost population—as was the case for Lancashire in Eng-
land, and Detroit after the race riots—but overall urban populations contin-
ued to increase. Sao Paulo and Rio de Janeiro, for example, now hold nearly
half Brazil’s population, while population growth across much of that giant
country’s area has been modest or stagnant.

But when each succeeding generation—roughly 35 years—is half its prede-

cessor, why should real estate values rise? If there are half as many shoppers,
why should shopping centers keep—let alone increase—their value? If there
are half as many workers, why should office buildings keep—let alone in-
crease—their value? And if there are half as many people, why should houses
or apartments keep—let alone increase—their value?

Sam Zell, one of Chicago’s shrewdest investors, has just had a $900 million
payday, selling Equity Office Properties. Pension funds have been huge buy-
ers of office buildings, because they need long-duration assets whose value
rises faster than inflation. But what if the statistics on the inevitability of
long-term profits turns out to be wrong because there aren’t enough people

24 February
 Basic Points
around? Based on population statistics since 1971, a 100-year reversion on
a lease executed today (what we call a ground rent) would expire at a time
when the population of workers in the 18-50 age range would be two-thirds less
than today. That couldn’t happen to Chicago or Los Angeles, as long as Latino
immigration continues to make up for the fall in the domestic birth rate, but
it could happen to many major cities elsewhere. If Europeans were
wild animals, they
These comments do not, of course, apply to leases on office buildings in
would soon qualify
Delhi or Mumbai—or even to Shanghai, where the national demographics
for the endangered
are nowhere near as favorable as India’s: the continued inward migration
species list.
from rural areas will sustain growth in the major cities. But European cities
cannot expect to gain population increases from inward migration at a time
the overall birth rate is far below replacement level. If Europeans were wild
animals, they would soon qualify for the endangered species list.

Mark Steyn makes this point cogently in his new book, America Alone. We
found the book useful because it looks at Europe’s statistics in a longer-term
perspective. We had been looking at the questions from the standpoint of
GDP growth, but his work argues (with the lively polemicism that is his
trademark) Europe has entered a “population death spiral.” Because of the
grandiose generosity of European retirement and welfare provisions, (in-
cluding, in some countries, pensionable retirement ages for public servants
in their 40s and 50s), what was once called the “population pyramid” comes
to resemble a triangle perched on its apex.

We are not convinced that the Europe (and, for that matter, Canada) of the
somewhat distant future will be depopulated. But we are convinced that in-
vestors should be building demographic calculations into their longer-term
calculations. The US, largely because of those controversial undocumented
Latinos, has the best population profile of the industrial nations. Already,
50% of the new Americans—either by birth or by immigration—are Latinos.
Within a few years that number will be 75%.

Europe cannot emulate that rate of almost accidental Americanism with a

flood of young Muslims. The overwhelming majority of Latinos want to be-
come part of the American Way of Life. They don’t seek to import the legal or
political systems of the countries they have left. They do not yearn to be ruled
by a theocracy based in a foreign culture, no do they riot when a film or news-
paper distributes anti-Catholic material. They accept democracy, and they ac-
cept the reality that so many of the freedoms of which Americans are so proud
spring from the nation’s deeply-rooted Protestant Christian traditions.

February 25
 Happily, those observations also apply to the overwhelming majority of
American Muslims, most of whom have been living and working in this
country for generations. The American melting pot approach to absorbing
aliens still works: this country has experienced no riots, and only a smatter-
ing of homebrew terrorist threats.
The Street
equivalent of A Change of Opinion on Bonds
succumbing to We are making a substantial reduction in bond duration.
a mirage is
Our reasoning is as follows:
4th quartile
performance, 1. It is far easier—and far less risky—for pension funds to make a major
followed by a shift in bond exposure than in their equity portfolios. Making large-
pink slip. scale equity shifts can be problematic and is rarely appropriate for major
institutions. However, even the biggest pension funds can change bond
durations quickly and at modest cost, either through outright switches
or through use of derivatives. Furthermore, they can always reverse the
trade—the bonds sold will still be there, or bonds of similar quality and
liquidity will always be available. Conversely, if one slashes one’s exposure,
say, to mining stocks, there is near-zero guarantee they, or similar quality
stocks, will be available when the mining cycle seems more propitious. So
investors should always be far more willing to consider major portfolio
shifts in bonds than in stocks.

2. We have been fans of long-term bonds and zeros because (1) they offer
the best capital gains potential once the Fed (and/or other major central
banks) resume lowering rates, and (2) they are the best hedges against
deflation. A buyer of long-term zero coupon Japanese Government Bonds
(JGBs) in 1990 who held on as deflation gradually tightened its grip on
Japan had far better returns during the rest of the decade than a holder of
Microsoft or Dell.

3. Once the yield curve inverts, a holder of long bonds has to pay a carrying
cost for keeping them, rather than switching into shorter-term, higher-
yielding—and less risky—bonds. That those conditions (what Alan
Greenspan ridiculed as a desire to lose money) have persisted so long
during this cycle is because the market sees an era of rate cutting lying just
beyond the horizon. Seeing something that is just beyond the horizon can
be a money-making experience on the Street, but can be an invitation to
death in the desert. The Street equivalent of succumbing to a mirage is 4th
quartile performance, followed by a pink slip.

26 February
 Basic Points
4. Because we have for eight years believed that the primary challenge to the
price system came from deflation, we have generally favored long bonds.
Although we do not see a return to central-bank-spawned inflation, we
note that two contributors to falling inflation since the late 1990s—
oversupply of labor and oversupply of commodities—have been deleted
from the disinflation and deflation rosters. With near-record-low rates of ...what if the
unemployment, wage rates have finally begun to grow—at a time corporate slowdown is
profit growth is slowing. just a pause?
5. Not only do long bonds now yield less than short-term bonds, they deliver
historically low real yields. That condition of sustained low returns at
higher than normal risk is driven, in part, by fear. The longest-running Page
One Economic Scare Story of our time is the tale of the coming housing
collapse. The Rule of Page Sixteen says one should not be investing on the
basis of those Page One horror stories. The recent recovery in homebuilding
stocks suggests that the worst of the downturn is behind us. Who will be
delighted with long-term bonds yielding less than 5% if it turns out that
fears of a housing crisis were overblown? (And who, by the way, is holding
all that sub-prime mortgage paper?)

6. Another argument for holding long bonds, even though they deliver
low real rates of return, is that US and European economic growth rates
are finally slowing down, following two years of central bank monetary
restraint. This is just the time for maximum capital gains by holding long
bonds and zeros. But what if the slowdown is just a pause that clears the
decks for even faster growth, as happened a decade ago? Once investors
began to sense such a pattern, they would run, not walk, to unload. With
the US Leading Indicators declining below the zero growth line, and US
Q4 GDP growth about to be retroactively written down, the slowdown
that bondholders have been waiting for looks to be unfolding. So why
cut back on exposure now? Answer: liquidity levels remain high, whereas
during previous Fed tightenings, liquidity droughts emerged. Furthermore
global growth remains strong, so the bet on sharply lower rates soon is
no sure thing.

7. Long bonds have gained support during this decade from global changes
in pension fund valuations. In the past, actuaries and regulators did not
fret about pension funds’ bond durations, because their large holdings
of equities meant their long-duration liabilities were covered by high-
performing long-duration stocks. The Triple Waterfall Tech Stock collapse

February 27
 exposed the risks in extremely long-duration stocks (those with high p/e
ratios and low or zero dividends). Pension funds thereupon rushed to
acquire long-term noncallable government bonds, which were then as
rare as tech companies who accurately reported the costs of their stock
option programs. Governments have naturally been responding to this
“The bond crop actuarially-driven longing for long bonds, and the shortage could soon
never fails” go away. “The bond crop never fails” is one of the oldest maxims in the
government bond market. It became obsolete in, say, 1999. It will soon
be back to thrill you again.

8. We have particularly stressed the attractiveness of long zeros as hedges

against downside risks in commodity stocks. We said we did not expect a
recession, but the sustained contraction of central-bank-spawned liquidity
meant that, unless we had truly entered a Brave New World, there would
be a global slowing which would hurt prices of industrial commodities.
We have seen sharp selloffs in prices of oil, gas, and most of the base
metals. Lately, we have been seeing rallies. Maybe the worst is already over,
in which case investors can take off some of their hedges. (Nickel is the
notable exception to this pattern. Alas, the two pure-play nickel stocks we
discussed for years in this journal were yanked away by shrewd acquisitors,
while most Street analysts continued to predict nickel prices falling to the
$5 range.) Meanwhile, one pattern we have been writing about for three
years continues: big mining companies continue to be on the prowl to
buy smaller mining companies.

9. Most global stock indices are trading at, or near, all-time highs. This week
all three Dow Jones indices touched records, and the Nikkei reached a
six-year high. Barring a sudden financial crash caused by metastasizing
derivative disease, it is hard to maintain the view that one should keep
remain overweighted in an asset class that looks best when all else looks
worst. Stock markets are, of course, imperfect forecasters, but they have
a better record of predicting the economic future than the economic
consensus—which has never predicted a recession. (Who dares to call
economics “The Dismal Science” after so many decades of sustained
optimism?) If stock prices dismiss the probability of the onset of an
economic environment that would make long bonds irresistible, then
investors should certainly consider reducing both their exposure and their
durations.

28 February
 Basic Points
10. Why did we not make this recommendation last November when the
Ten-Year Treasury yielded 4.44%, instead of waiting it to correct to 4.69%?
Because oil was leading industrial commodity prices down, and, despite
our pious protestations of immunity toward Page One stories, we were
finally getting worried that systemic risk from bad housing-related debt
could hurt the US economy. We were comfortable keeping our hedges in Who dares to call
place. That was the wrong call. economics
“The Dismal
11. What happens if industrial commodity prices plunge anew and it begins
Science” after
to look as if the housing bubble has truly burst? Then we can extend bond
so many decades
durations again, with the damage being greater to what remains of our
of sustained
reputation than to our portfolios.
optimism?

February 29
 INVESTMENT ENVIRONMENT
The continued runup in grain prices is great news for the US federal govern-
ment, because it will automatically slash its farm subsidies, which will allow
it to be even more sanctimonious in its wrangling with the EU over the Doha
Until recently, trade round.
the only pork
whose cost was It is also great news in the grain belt, which begins just beyond the horizon
rising sharply and we see at sunset from our 27th floor condo on Lakeshore Drive—and it ain’t
steadily was of a mirage.
the Congressional But the impacts on farming are uneven: it takes 10-11 bushels of feed to
variety. ready a barrow or gilt for market, and the $0.68 a pound price paid for a hog
on the Chicago Merc is down 6 cents from the time when corn was $2.00
a bushel. Major producers, such as Smithfield, have hedged heavily against
higher grain prices, but those hedges expire this year. If prices for bacon and
pork do not move significantly higher, the factory farms will cut production.
Until recently, the only pork whose cost was rising sharply and steadily was
of the Congressional variety. If—and that is a big “if”—the new rules against
Earmarking constrain the Congressional tax hogs, that burden on taxpayers
will not worsen. But the cost of the more traditional forms of pork may be
about to rise in time to make the barbecue season a costly experience.

The short product life cycle means the poultry industry is already feeling
virtually the full impact of $4 corn. Cattle ranchers have had the option of
delaying delivery to market, but the recent snapback in feeder cattle prices
should shift inventories in coming weeks to the feedlots—and consumers.

Once these varying short-term adjustments are complete, consumers will be

paying higher prices for meat and eggs. Doubtless the dairy cartels and sup-
ply-management structures will soon ensure that prices for milk and other
dairy products rise to offset soaring feed costs.

Meanwhile, oil prices are back up above $58, and copper refuses to stay be-
low $2.50. As this is written, there is talk of a BHP or Rio Tinto bid for Al-
coa, or maybe Alcan. In discussing those rumors with a caller, we pointed
out that the major mining companies are gushing cash at spectacular rates,
and there are few targets for mine development. The key constraints—lit-
igation and political risks—draw more boardroom scrutiny than ever.

30 February
 Basic Points
This week, Chavista Evo Morales of Bolivia nationalized the tin smelter
owned by Glencore, which was for years (and still could be, for all we know)
a Marc Rich vehicle. Morales (when has any Latin politician had a surname
that was less descriptive?) says he has no intention of paying any compen-
sation for the property. Glencore has announced it will sue to recover the
fair market value of the smelter. We certainly wish them luck, but wonder Everybody wins, si?
how an international tribunal would assess the real value of a smelter in a
state whose leader proclaims old-style socialist principles. Maybe Morales
can defend himself by saying the fair market value is zero, because what sane
investor would want to own a property in Marxist Bolivia? The Patinos once
owned the Bolivian tin industry, but they had to flee from earlier looters, and
may have been the models for Francisco d’Anconia in Atlas Shrugged. Given
Morales’ propensity for making outrageously inflammatory utterances, we
wouldn’t be surprised if he chose to delight his followers by offering coca for
tin. It was the coca farmers who were decisive in electing Morales, and they
always face distribution problems for their output. Glencore’s founder, Marc
Rich, had decades of experience in unloading contraband around the world
on a tax-free basis. Everybody wins, si?

What may be unfolding is a new and unsettling commodity pricing environ-

ment for consumers: high energy prices + high metals prices + high grain
prices + high meat prices. What makes this cycle unique is that the high en-
ergy prices for the first time ever are driving up grain prices, which will surely
lead to higher meat prices. Until now, energy costs were, for most pig and
broiler chicken producers, the second largest input cost—but far below the
cost of feed. Now, there is a positive upward correlation between energy and
feed costs. Colonel Harlan Sanders would have had trouble maintaining his
cheery smile when confronted with that story.

The ethanol story was for years mostly the story of ADM’s mostly successful
attempts to upgrade corn into higher returns through politics. What changed
it to a market-shaking success was 9/11 and the growing realization that high
oil prices were indirectly funding al Qaeda and other Wahhabite terrorist
operations worldwide. As Saudi oil revenues climbed far above the regime’s
ability to deploy them at home or in the Gulf, more and more funds, (ana-
lysts insist), were disseminated abroad through the Department of Islamic
Affairs, which is dominated by Wahhabites.

February 31
 A retired Indian foreign affairs officer told me how it has worked. Saudi rep-
resentatives abroad visit a mosque whose membership is mostly poor and
mostly unpolitical. The representatives volunteer to provide six months’ resi-
dential training for a local cleric or would-be cleric, along with funding for
expanding the mosque. They also offer further training programs in subse-
When Bush quent years. After a few years, the preaching in the mosque may no longer
dramatically deal purely with pieties, but becomes heavy on jihadism, and denunciation
announced...that of Jews and Americans. This pattern has been repeated around the world.
America had to “And,” he smiled, “all along the Saudis keep assuring the Americans they are
break its their most loyal Mideast allies!”
“addiction to oil,”
Tony Blair has begun trying to deport radical imams who preach violence
it was a shock to
and hate, but courts are leery of becoming involved in what the defendants
Texas...
say are purely religious issues.

For two years, America’s most influential foreign affairs columnist, Thomas
Friedman of The New York Times, who strongly backed Bush on Iraq, has
been demanding that Washington cap oil prices through strict fuel con-
sumption regulations and mandatory use of biofuels. For Friedman, Saudi
Arabia’s most important export is not oil: it is jihadism, allied with violent
anti-Semitism.

George Bush took a long time coming to grips with this problem. One the
first imams he recruited for public prayers after 9/11 was later convicted of
crimes involving money-laundering for terrorist groups abroad. The Bush
family has been famously pro-Saudi for decades—and, it is rumored, very
profitably so.

When Bush dramatically announced in the 2005 State of the Union address
that America had to break its “addiction to oil,” it was a shock to Texas, and
an occasion for rejoicing in Illinois and Iowa—and among many surprised
liberals, who were delighted that Bush was finally agreeing with them. This
year, he raised the ante, insisting that the US produce at least 35 billion gal-
lons of renewable fuels a year within ten years—roughly 10% of expected
gasoline consumption.

Bills in Congress would mandate production of 60 billion gallons by 2030.

Meanwhile, over in the EU, rising interest in biofuels has nothing to do with
the War on Terror (as befits a grouping who are collectively doing their best
to have nothing to do with the War on Terror). Brussels has decreed that
5.75% of Eurodiesel fuel must be crop-generated by 2010. (Only in Brussels

32 February
 Basic Points
would they come up with a percentage for fuel content of 5.75%: not 5%—
not 6%, but 5.75%). Lord Browne of BP (Surprise!) insists his company will
do all it can to support these initiatives. He may be a bit too busy defending
himself before Congressional committees and American courts to tour any
corn fields or break ground for any ethanol plants, but we feel sure he will do
his best to continue promoting BP as the greenest of the oil companies. The ...ethanol...
survivors of all those American workers who lost their lives working under is corrosive
wretched conditions in his Texas refinery can console themselves that their for politics,
boss was a great environmentalist who meant well. automobiles,
and pipelines.
We have not changed our view that ethanol is of dubious economic and
environmental merit. It is corrosive for politics, automobiles, and pipelines.
If only for the problems of transporting it across mountain ranges, it would
not become an overnight sensation in a free market environment. However,
autarky may be justifiable in the War on Terror. If oil prices can be held
below $75 over the longer term through use of biofuels, then the growth in
terrorism’s cash flows will be moderated. That is a worthy objective, even if
it means we pay a lot more for hamburgers, sausage, and fried chicken—let
alone steak.

When faddish enthusiasms suddenly engulf the political arena, little time is
spent addressing what Donald Rumsfeld called “the known unknowns and
the unknown unknowns.” (He certainly did not spend enough time on them
before it was too late.)

Global warming is being blamed as the likely progenitor of everything from

Katrina to the record cold we have been experiencing in Chicago. Without
getting into that debate, we suggest a rather more obvious outcome of sus-
tained warming: longer growing seasons in the temperate zones—where
most of the world’s grain is produced.

Three decades ago, the US Secretary of Agriculture told a dinner of the Toron-
to Society of Financial Analysts that the scientific community was in agree-
ment that the period of global cooling we had been experiencing threatened
a new “Ice Age.” The first signs were a reduction in the growing season. There
had been some painful experiences with late plantings and early frosts in
the Upper Midwest and the Canadian West, and these were the precursors
of disasters to come. We needed, he said, to develop new hybrid grains and
oilseeds that could survive shortened growing seasons.

We did.

February 33
 Or, more accurately, Monsanto and Pioneer did. (Pioneer was later acquired
by DuPont.)

According to the climate studies, the world is 0.7 degrees warmer now than
a century ago. It is sharply warmer than it was in 1992, because the world’s
temperature fell by more than a full degree after the eruption of Mt. Pina-
If the rise in earth’s
tubo in July 1991, which filled the global atmosphere with volcanic ash and
temperatures since
hydrosulfurous acid particles, creating a global mirror, reflecting sunlight
then continues to
back into space.
progress...farmers
can look forward If the rise in earth’s temperatures since then continues to progress, then
to record-long North American and British, Scandinavian, Ukrainian and Russian farmers
growing seasons can look forward to record-long growing seasons and record grain produc-
and record grain tion, assuming that they control the likely increase in pests who survive the
production, mild winters.

Whether longer seasons will offset the drawdown of corn and other grains
for biofuels is, of course, a known unknown. Indeed, without global warm-
ing, it is hard to see how the world will produce enough coarse grains and
oilseeds and sugar and grass to meet what we are being told of the coming
demands for sustainable, atmospheric-friendly, fuels.

(Corn used for ethanol is not completely subtracted from the animal feed
market. The residue of the milling process—distillers grain—can be used for
cattle feed, the way the moonshiners fed their cows in the good old days.
That byproduct isn’t considered good pig meal, so if corn prices stay at these
remarkable levels, hog producers will be worse off than beef producers.)

This new demand for coarse grains couldn’t come at a worse time from Chi-
na’s standpoint: China consumes roughly twelve times India’s level of feed
grains, because of the scale of its livestock industry and the wealth of its pop-
ulation. According to the USDA, Chinese demand for meat, dairy and fish
products grows at about the same rate as incomes. The Chinese have been
busy making up to such toxic regimes as Iran and Zimbabwe to get access to
needed oil and metals. If corn and soybeans are to be the new commodity
stars, then perhaps China could do the world a favor by “helping” regimes
such as Mugabe’s produce grain.

34 February
 Basic Points
There would have been a serious shortage of global feed grains and oilseeds
within a few years in any case, because India’s incomes are rising at a rate that
means they can no longer rely on grass and scraps for their livestock. Now,
thanks to what may well turn out to be biofuelishness, feed grains look to be
in short supply—and very expensive—for years to come.
...biofuelishness
Rex Tillerson, CEO of the Exxon, the company we are supposed to hate, (as
opposed to BP, the company which, despite its occasional sins, we are sup-
posed to love), told a conference this week that he was no expert on “moon-
shine.” (Ethanol is the scientific term for what hillbillies called “corn likker.”
It must have a special additive to prevent its use for…recreational purposes.)
Mr. Tillerson dismissed the idea that ethanol and other plant-derived fuels
were threats to the petroleum industry.

Despite Mr. Tillerson’s insouciance, we think it likely that this most unlikely
coalition of farmers, liberals, greens, and patriots will ensure that biofuels
become, at the very least, a costly fad, and more likely a mania. They will
surely become the automobile form of the school milk program, so that
car owners will have to use them. One result: talk of $100 oil in the near fu-
ture should be sequestered into those chat rooms where enthusiasts discuss
the likelihood of Cub World Series victories and people report flying saucer
sightings. If the US taxpayers could put men on the moon, they can turn
green enthusiasms into long green for producers of feed grains, oilseeds, and
other sugar-containing plants.

The space program was a money maker for some companies and individu-
als.

So will green fuels: There will be splendor in the grass.

February 35
 INVESTMENT RECOMMMENDATIONS
1. Reduce bond exposure—both in percentage of portfolio and in
duration.

2. Upgrade the quality of your bonds, because at some stage in this tightening
process, some asset class will crash, and spreads will widen.

3. Continue to build exposure to Emerging Markets equities, but at a

restrained pace. Some markets, such as China and India, are frothy, and
Russia is becoming a projection of Putin’s attempt to resurrect Russian
global power. The rewards still outweigh the risks.

4. Remain overweight the commodity-producing stocks.

5. Build gold stock exposure, emphasizing companies which do not hedge

their gold output.

6. We recommend only a modest overweighting in energy, but continue to

argue that the producing Alberta Oil Sands companies should be major
components of that energy portfolio. Shell is being forced to pay up to
acquire the shares in Shell Canada it does not own. Biofuels are likely, at
least for the next few years, to constrain oil price increases, so that should
slow down development of the oil sands—which would be great news for
today’s producers, because they would no longer be hit by soaring costs
because of bidding wars for men and materials caused by new entrants
to the sands.

7. The biofuels craze should encourage investors who were building exposure
to the agricultural stocks to accelerate their investment programs, with
emphasis on companies directly involved in US and Canadian production
of coarse grains and oilseeds. Investors should think of the companies
tied to grains as being more than farm stocks—they are also becoming
significant parts of the global gasoline and diesel fuel industries.

36 February
 Basic Points
8. We do not know whether a major mining company will bid for Alcan or
Alcoa. We do think the aluminum stocks are good value in any event.

9. High-quality publicly-traded base metal companies are an endangered

species. Buy them while they are still cheap and still available, using the
Basic Points criterion: long-life reserves in the ground in politically secure
regions of the world. Fast growth in global supplies of biofuels should
make energy users feel far more confident about security of supply at
moderate prices—and that would mean global economic growth would
be faster than otherwise—triggering higher metal prices.

10. Nasdaq and the Dow have delivered virtually identical total returns (ex-
dividends) over the past five years. That suggests either that Techs have
done somewhat better than they deserve or the rest of the market has done
somewhat worse than it deserves. Either way, underweight Technology.

11. In case you have forgotten, avian flu is still spreading among global
bird populations, particularly among farm-raised fowl, and among cats
of many species. It hasn’t—yet—mutated to acquire human-to-human
transmission. In one sense, it is getting stronger: the human mortality rate
from the disease, which was less than 50% when we first wrote about it
in August 2005, is now 61%. If the mortality rate were a stock, you’d buy
it. To put that rate into perspective, the death rate from the worst modern
pandemic—the Spanish Flu of 1918—was 2% in the US, and closer to 5%
in India. More than fifty million people died.

February 37
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