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February 1, 2003

February 1, 2003

I’m writing to report on January events and markets and offer our outlook. January began with a strong rally in U.S. and foreign stock markets, which soon dissipated and turned into a sell off. Simultaneously, gold and foreign currencies continued to rise.

It is not hard to see the logic behind the rise in foreign currencies and their proxy, gold, versus the dollar, when one examines the global geopolitical and economic landscape.

Global Economics

Geopolitically, the continued strong rhetoric from President Bush about Iraq has sent fear into the hearts of our European allies. They are geographically closer to Iraq, with fewer resources to allocate to homeland defense than the U.S. They are arguing that Iraq has had weapons of mass destruction for decades and now if provoked they may use them on the West. They believe themselves to be more vulnerable than the U.S. They are also struggling with economic growth, which is as weak as, or weaker than, the U.S. Deflation may be taking root in Germany, which with the deflation taking place in Japan, paints an ugly picture.

The gold markets and foreign investors know that war is expensive. In our opinion, war is not an intelligent method of stimulating the U.S. economy as some have suggested. Money spent on defensive or offensive weapons, which are then destroyed, is not as economically productive as resources spent on R & D or on capital equipment, which are built to increase business productivity. The war itself will involve untold suffering and loss of life. After that, we will also bear the costs of occupying and rebuilding Iraq after the war.

World Markets

War creates uncertainty. Above all else, investors hate uncertainty. Because the threat of war has existed for about a year, corporate capital spending decisions have been delayed. This delay has had a depressing effect on world economic growth. Capital spending creates income, jobs and eventually economic growth.

Because of the threat, foreign stock markets have been uncertain and generally trending lower. Because of the cost of the war and the cost of occupying Iraq after the war, global investors are getting out of countries where budget deficits will be increasing and into the currencies of countries where budget deficits will be moderating or stable.

Currencies

In our opinion currencies are mainly influenced by three variables.

1. Short term: Relative interest rates between currencies adjusted for the inflation rate (real interest rate differentials).

2. Intermediate term: Relative balance of payments deficits or surpluses and their trend. Surpluses rising are good. Falling is bad.

3. Long term: Real economic growth after inflation.

The U.S. dollar is falling because:

1. Short term: U.S. interest rates are lower than Europe and much of Asia, with the exception being Japan.

2. Intermediate term: The U.S. balance of payments deficit is immense and rising.

3. Long term: The U.S. real economic growth after inflation was about zero in the fourth quarter of 2002. President Bush’s tax cut program will not be enacted until mid-year and will have a limited initial impact. Capital spending and R&D spending, which are the vehicles by which economic growth is ultimately driven, have been cancelled and delayed by uncertainty over the future. The U.S. budget deficit continues to grow.

Precious Metals

Gold has risen commensurate with the rise in the Euro, British pound and Swiss franc versus the dollar. However, in terms of European currencies gold has not risen. Gold has been used now, as it has been in the past, as a vehicle to own when one wants to avoid owning dollars. Other commodities; oil, natural gas and soft commodities have also risen as investors have moved into them as a way to avoid holding dollars.

As is the tradition, during times of weak currencies people look for other vehicles in which to invest. Now it is extremely obvious that Japanese, European and Asian investors are looking to European currencies and to gold as a way to diversify away from the depreciating U.S. currency.

Stock Markets

Eventually, especially if inflation once again begins to develop, people will see stock markets as a good way to hedge against the wealth eroding impact of inflation. In a deflationary environment, stocks do poorly. Today we are surveying a world where deflation has gained a small foothold. Governments are fighting this deflationary trend, and as we mentioned in our last letter, we believe mildly inflationary growth is the most likely long-term outcome.

Summary

Currently, we are lightly invested in U.S. shares and foreign shares where P/E ratios are low and growth is highly visible. They are primarily in the business services, financial and technology sectors.

Our largest position is in foreign currencies or foreign currency denominated bonds, primarily Euro or Swiss franc denominated. For those clients who sell short we are short the U.S. dollar and long Euro and Swiss francs. We will expand our positions in this area if prices become more attractive. Our clients are 10% to 15% in gold shares, primarily Canadian companies with a few South African companies. We see gold currencies and a few low priced stocks as the most obvious winners of 2003.

Please call with any insights, criticisms or comments.