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March 11, 2003

March 11, 2003

Hi and welcome to another letter about global economies, currencies, stocks and commodities. In general, this is not a happy time. The world is suffering from slow economic growth, fear of war and the divisive argument about the need to invade Iraq.

Before getting into the body of the letter, let me summarize some of my conclusions. In our opinion, government bonds denominated in the major world currencies could go much higher versus the US Dollar. We own some of these, and will use any buying opportunity created by fighting in Iraq to buy more. We believe that this will provide us with good returns with a combination of price appreciation and interest income. As the Euro, Swiss Franc, Canadian Dollar, Australian Dollar and other currencies rise in dollar terms, opportunities are created for us. We believe gold is in the second year of a multi-year bull market, thereby creating another opportunity. In general, we believe world stock markets are unattractive. A few stocks are attractive as long opportunities; others are attractive as short sale candidates. We continue to look for opportunities and are evaluating companies based on our risk reward criteria in light of the current global economic condition.

Global Economics and the Dollar

The price of oil, which is up over 80% in the last twelve months, is bad for the economy, for consumer spending, and bad for the balance of payments of oil importing countries. Europe, Japan, U.S., India, much of South America and a large part of developed Asia fall into this category.

Recent declines in interest rates in the U.S., Europe and Asia have helped to balance out the negative effects of high energy prices, but higher energy prices remains a problem. Simplistically, higher oil prices mean less consumer confidence, less free cash for the consumer, less consumer spending, and lower corporate earnings. The economic growth of 2% to 3% that we were looking for in the U.S. has been erased by the higher energy costs. Even if oil prices return to $25 per barrel and gasoline prices drop, consumer spending and economic growth will probably be negligible for most of 2003.

Other factors undermining the health of the global economy are the threat of war and terrorism. The economic costs of terrorism are real and persistent. They dampen economic growth worldwide, but especially in the U.S. which has become a primary target for terrorism.

These factors leave us bearish on the U.S. and European economic outlook for the next six to twelve months. One might ask, ‘Given your bearish view, how can you make money?’ Our answer, ‘By buying foreign currencies and foreign currency denominated bonds’.

Currently, the U.S. balance of payments deficit requires us to borrow the great majority of the world’s balance of payments surplus to finance our imports. Will the world continue to loan us money by buying our bonds to finance our consumerist lifestyle? Probably not, unless we lower the price of our bonds.

This can be accomplished two ways: One way is to raise interest rates. However, raising interest rates is something we will not want to do, as it would raise the cost of our borrowing, just as our total borrowing is skyrocketing. The second way is to lower the value of the dollar in terms of other foreign currencies. This can have two positive effects. Lowering the price of the U.S. dollar effectively increases the long-term return to foreign bondholders (assuming they believe the dollar will eventually recover). Lowering the price of the dollar can also lower the price of oil, which for the present, is denominated in U.S. dollars.

Lowering the value of the dollar versus other currencies does have potentially one very negative effect. It could create a panic out of dollar assets, or it could create a ‘wait and see’ attitude among foreign investors and cause them pause before they buy U.S. bonds.

Another reason the dollar is likely headed lower is the growing budget deficit. According to the Congressional Budget Office, the proposed budget will create an increase in the deficit of $1.8 trillion in the next 10 years.

If we fight a war and follow it with a traditional occupation, it is estimated that an additional $1.2 trillion could be added to the deficit over the 10 years, according to respected European sources. If they are right, and we believe they are, we will further mortgage the future of our children and grandchildren. We will in essence be guaranteeing them a lower standard of living than we have enjoyed.

I am not a political pundit or a military expert, so I will not comment about whether we should invade Iraq or not, but we should be aware that if we run up the bill for our political and military adventures, we are asking future generations to pay for it. This remains an overhanging problem for the economy of the future. Although this does not guarantee that the U.S. dollar will decline, it certainly creates negative sentiment about the dollar by investors.

The Euro

The European community has economic problems. Germany is depressed. France is unable to grow. Europe however, will probably do a better job avoiding the costs of war. In addition, Europe will get the benefit of becoming a safe haven for investors leaving dollar assets. All foreign currencies get the benefits of being lesser targets for terrorism than the U.S. With the exception of the United Kingdom and Spain, the countries in Europe have been much less verbal in their criticism of Iraq and thus have created less animosity with the Middle East.

The Swiss Franc

The Swiss insurance industry, like the world insurance sector, is in trouble because of declining investment portfolios and risky reinsurance and derivative contracts entered into in the last several years. On the other hand, Swiss construction, food and pharmaceutical companies are doing OK. We believe Swiss Franc denominated bonds will continue to rise versus the dollar from the same ’safe haven’ away from the dollar that the Euro enjoys. The Swiss Central Bank is likely to fight to keep the franc from rising too rapidly against the dollar, however.

The Canadian Dollar

The Canadian dollar has broken out and we expect it to continue to rise even though their large export, automobiles to the U.S., is slowing down. Inflation is becoming a modest problem and interests rates may begin to rise. Canada’s currency is rising because of investors’ desire to own those currencies that are beneficiaries of strong commodity prices. Canada, a large producer of natural gas, gold and timber, all of which are in renewed uptrends, is benefiting from this psychology.

Canada may also fight against Iraq, but they will not be verbally berating Iraq and thus Canada is likely to have much less terrorism directed toward it than will the U.S. We expect the Canadian dollar to rise another 10% versus the U.S. dollar. We have been buying this currency on dips.

Australian Dollar

The Aussie dollar is rising versus the U.S. dollar due to Australia’s commodity-based economy and the fact that the Aussie dollar has been undervalued for years. It rallied back strongly and it is now pulling back. We believe it should be bought on the correction. Also, Australia’s proximity to China’s expanding economy puts it in a good position to sell commodities to the Chinese.

Gold

What is Gold? Gold is an asset that people hold when they don’t want currencies. We have been saying that the dollar appears to be headed lower, because it looks bad versus the Euro, Swiss Franc, etc. All of those currencies also look bad when the quality of their governments’ economic and political outlook is examined closely. Europe, Japan, Canada, the United States, Latin America and much of Asia are under economic stress. We are seeing low productivity increases, low economic growth, rising inflation, large and rising budget deficits, spending by politicians eager to supply give-aways in exchange for votes, leaving future generations to bail out the countries finances.

Gold is the asset of choice for those who see the currencies as fiat, and eventually being reduced greatly in value. Gold can be manipulated as well. It will be manipulated by speculators greedy for profit and by central bankers who have to put a brave face on the overspending of the politicians that they serve.

We believe all the major currencies are being poorly managed and thus gold and other commodities could easily rise versus all of them. The gold shares, which are currently in a violent decline phase, could put in double and triple bottoms during the next several weeks. As longer term investors we will look closely at purchasing shares of non-hedged gold producers at that time.

I should remind you that we are not permanent gold bugs. We owned gold and gold shares through the 1970’s and sold the last of our clients’ positions very near the top in bullion in 1979-1980. We did not reenter the gold market in a significant way until 2002. We are not averse to selling all of our gold should economic, social, and political events dictate. However, we are convinced that due to eminently unwise economic decisions by world governments, bullish stances on several foreign currency denominated bonds versus the U.S. dollar, and on gold versus the dollar and most foreign currencies, is warranted.

Equities

Presently, we are doing very little in equities. We love owning good companies at low prices, and it is not easy to sit and wait on the sidelines. We would rather own stocks that have the ability to appreciate, but the truth is that almost no stocks fit our risk/reward parameters. Yes, stocks are cheaper than they were 3 years ago, and many are much cheaper. However, we have found only a few cheap, well-run companies at low P/E ratios that also have high visible growth. We own a few, but not many. We will continue to hunt for opportunities and at the same time look for signs that the overall situation is improving.

Historically, since the 1960’s stocks have been attractive 80% of the time. This implies that opportunities in stocks will again present themselves. Waiting on the sidelines may not be any fun, but at least there are other opportunities like foreign bonds. Also, being on the sidelines in times like this can help preserve the investor’s psyche and make it easier to return to stocks when they become cheaper and/or their prospects improve.

Summary

In summary, we are moving cash balances out of dollars. We see opportunities in some stocks (inexpensive, low P/E stocks on the long side and overvalued companies on the short side), but the only areas we see with long-term uptrends in place are currencies, oil, gold and a few other commodities. This is where we will focus our attention, until we see improvement in the global economic outlook.

What would improve the global economic outlook? The most immediate factor would be no war with Iraq. With this, the dollar will rise and the U.S. market could put on a huge relief rally. If Saddam Hussein were to go into exile, the rally could be even larger. If we see this happy event, we will become much more optimistic about the U.S. budget deficit and about lower oil prices. Still, terrorism fears and the impact of the recent oil price increases could dampen economic growth for the remainder of 2003.