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December 31, 2002

December 31, 2002

Hello, and warmest holiday wishes to you all. I’m hoping that you all are enjoying good health and happiness at the year’s end, and that 2003 will bring even better things to you and yours. It is time again to discuss our outlook on world stocks, currencies and precious metals for a new year.

We were happy with our performance in 2002 which was helped by our view that gold and the Euro would rise, that tech stocks would fall and that in the fourth quarter of 2002 many small and medium sized solidly growing companies were undervalued. Our view for 2003 is that opportunities abound. Especially in precious metals, energy companies, and companies in other commodity oriented and in some foreign currencies. We describe our industry favorites later in this letter.


Global Economics

In our view, the world today faces five challenges. Two are rather ordinary, another two are larger, and one is an extraordinarily large challenge.

Challenges One and Two; The Ordinary or Typical Challenges

The general strike in Venezuela, with its ancillary effect on oil prices and oil supplies in North America, is a typical or ordinary challenge. It will be resolved with a probable change in government and possibly a revolution in Venezuela. The upheaval will cause oil price instability in the short run. In the long run, its impact will be minimal, assuming that there is no long term oil disruption from the Middle East.

The current nuclear face-off in North Korea about nuclear weapons is another ordinary challenge and has been quite possibly instigated by China and/or Russia to undermine U.S. global political power. Tensions will likely de-escalate as the U.S. gradually backs down.

Events like this may occur periodically as the U.S. is tested by our economic allies. China and Russia who are concerned about the growth of our global political, military and economic power. Those of us over forty remember these type of events occurring regularly during the Cold War and Vietnam decades.

Challenge Three; The Iraqi confrontation and Possible Mid- East conflagrations.

This is a larger challenge, but not one that has emerged suddenly. We expect there will be either no war or a quick victory. If either one of these occurs we expect we will have a much higher stock market by December 2003. Should we suffer a loss in this war, or should a long war develop, the U.S. equity market may be flat or down in 2003.

Challenge Four; The ongoing threat of global terrorism.

As a result of the Iraq war or other events, it may be that the world will experience continued and escalating terrorism. This is a long term challenge, one that may be much more time consuming and expensive than has been initially forecast. We view this challenge as a long term depressant to the value of bonds, as it will create deficit spending and possibly inflation. Terrorism also acts as a long term depressant to investor psychology. However, like they did during the cold war, people eventually adapt. Over time, we will become accustomed to the inconvenience of fighting terrorism, and investor psychology will improve.

The fifth and largest challenge; Inflation or Deflation

The is the big challenge or question is will we have inflation or deflation in the U.S. economy over the next two or three years? In our view the importance of this issue cannot be overemphasized. The economic news in coming weeks will tell us which is developing.

Japan has been in a deflation for several years, Germany is flirting with deflation. We need the European authorities and Japanese authorities to stop playing politics and to start to act in a way that will strengthen global economic activity. Japanese officials are speaking as if they have finally developed the spine to take appropriate action. Germany is being prodded by other European countries to cut interest rates vigorously, which may help solve their problems. We believe that probability is 80% that we will avoid deflation. Once the market realizes that deflation is not a problem and that the future will be slow, steady, inflationary growth, the U.S. and European stock markets will benefit. We will continue to carefully monitor economic developments and reverse course if necessary. However, as we now see it, higher inflation is the most likely scenario to develop.


Global Demographics

Looking at the world demographically, the opportunity for the most rapid growth is in China. China has become the manufacturing leader of the world. Their strengths are a large cheap labor pool, a good educational system and adequate technology. They will eventually have the ability to make most goods more cheaply than anyone else. Demographics also favor the U.S.A. due to the continued immigration of high tech and medical professionals to this country.


Currencies

The U.S. dollar is under pressure. The five challenges mentioned previously make the over owned dollar vulnerable. However, the primary factor weighing on the dollar is the looming cost of a major war in the Middle East.

We believe the yen and Euro will continue to rise versus the dollar throughout most of 2003.


Precious Metals

The weak U.S. dollar and global uncertainty caused by the five challenges are sending gold prices higher. We expect gold to be volatile but trend higher throughout 2003. We have noticed that global commodities prices are discounting the 80% probability that a deflation will be avoided and that a new inflationary phase is beginning. Gold will continue to benefit from the realization that inflation, and not deflation, will be the issue dominating the news reports for the next several years.

Although inflation is not a perfect environment, a controlled inflation is far more desirable than a deflation. A mild inflation will attract money to stocks, precious metals and real assets and away from bonds and savings accounts. Should the 20% probability of a deflation be realized, bonds represent the best investment. For those who can sell short, high P/E technology and consumer stocks would remain vulnerable to decline.


Summary

In our opinion, the odds are four to one that 2003 will be a decent year for stocks and a difficult year for bonds. Among the stocks we see benefiting are:
1) Low P/E growth companies in the U.S. and Europe. Inexpensive growth provides opportunity for appreciation in both inflationary or deflationary environments.
2) Precious metals (gold and silver) mining companies.
3) Companies that supply technology and services to China, or companies that produce their goods in China to save money.
4) Companies that provide commodities to the large industrial nations such as domestic oil companies, natural gas companies and paper companies.

In addition, we would avoid or sell short high P/E companies, where growth is flagging in the following areas:
1) Technology
2) Hospitals
3) Home Health Care
4) Health Insurance and HMO’s

Currently we are long low P/E growth stocks and gold shares. For our short selling accounts we are also short high P/E technology stocks. For all accounts we are holding a large cash balance preparing to invest in beneficiaries of inflation or deflation as the economic news delineates where we are heading. We believe that the news of the next several weeks will indicate that Japan and Germany are addressing their deflation problems, so we continue to research companies in the above mentioned industries with low P/E ratios and solid growth rates. We look forward to your feedback so please call with any questions or suggestions.