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September 5, 2003

September 5, 2003

Here are a few new ideas and opinions. I hope this fall season finds you well and happy.

Energy
I am not surprised by the strength in energy prices during this “shoulder season” when prices usually decline; the reasons are many and obvious. The most obvious is the failure of the U.S. reconstruction plan in Iraq to unfold the way the Administration’s PR said it would. It appears the cynics, myself included, were correct to doubt that progress would be quick and Iraqi oil would again flow. As we anticipated, sabotage has been one factor. The costs, both human and financial, of the reconstruction of Iraq are much higher than advertised. There will be an economic drag on the US in terms of higher interest rates, higher deficits and subsequent higher bond issuance by the US Treasury, which, in our opinion, will lead to a lower Dollar in the long run.

Also, Russia and Saudi Arabia recently made a deal to work together to control the supply of oil. This was passed off in the press as an innocuous event promulgated primarily to ease production bottlenecks. Those of us who remember the 1970’s know that it is a much more important event. In time, when the geopolitical and economic landscape is appropriate, the Saudis and Russians may well use this relationship to create a profitable cartel for themselves or perhaps use it as leverage to obtain military or economic favors for Russian and Saudi interests. It is well known that from the time of Sheikh Ahmed Zaki Yamani, who was the Saudi oil minister in the 70’s the Saudis have done a thorough study of oil and energy market economics and supply and demand bottlenecks. They are extremely organized and knowledgeable about these issues (which are of utmost import to their survival as a nation and as an economic power). The fact that they may be maneuvering with the Russians to manage this information to their joint advantage should chill us, if not downright frighten us.

Before the OPEC engineered oil price hikes of the 70’s similar bilateral arrangements were being constructed between various oil producing states. At that time the price of oil rose more than 10 fold. Imagine what would happen to the energy-dependant West and to the price of gold if oil prices were to rise only 100% from the current levels.

The natural gas market, after getting a lot of attention this past spring and early summer, has been quiet for a couple months. Weather forecasts are predicting a very cold winter, colder than normal for the U.S. and Canada. This should bode well for higher natural gas prices.

Gold and Precious Metals
Gold has continued to rally and Platinum has just hit a 23-year high (I don’t believe increased demand for catalytic converters is the reason for Platinum’s move).

I see a lot of parallels between the current time and the late 70’s. During that time gold was rising while US stocks as measured by the S&P 500 were trending slightly higher, with a lot of volatility, and periodic short (1or 3 calendar quarter) bear phases. At the same time, smaller growth stocks in the US were flying.

There was a general increase in the rate of inflation from low single digits to double digits, a retreat from bonds into inflation hedges such as gold, growth stocks, real estate and commodities. There was a liquidity bubble and gold and the small growth stocks attracted a lot of attention and investor dollars. For example, between June 1975 and March 1978 when the S&P 500 was up about 5% per year, small growth stocks, commodities and gold were very strong.

Currently, the small growth stocks are flying, as are the emerging markets, which tend to attract the same kind of buyer. Gold is breaking out, oil and natural gas are seasonally strong and many of the other commodity participants of the move in the late 70’s are once again moving higher in chorus.

Inflation has begun to appear, especially in consumer goods. Deflationary pressures, primarily caused by lower prices of manufactured goods from China, and the sending of manufacturing jobs to China, is moderating the effect thus far. Long-term we see inflation rising to mid single digits from the current low single digits. A rise in the inflation rate from 1% to 5-6% will send people scurrying to gold and other stores of value.

I do not believe a weak US stock market is necessary to supplement gold’s move. I think a period of slowly rising stocks, volatility, and a strong move up in the fast growing companies that attract speculative money, is enough to make the parallels to the late 1970’s quite compelling.

It has long been our contention that both inflation and deflation can be beneficial to gold, as well as to companies, industries and countries who are able to grow faster than inflation or, in the case of deflation, can continue to grow. In both scenarios, investment dollars will find their way to the stores of value or to growing enterprises.

Clearly there are some who will always prefer stocks to gold (in many cases their income derives from selling stocks or managing stock funds). To me, it is instructive to see that these people are investing in China, Korea, Taiwan, other fast growing economic environments and in small growth stocks as an alternative to unattractive bonds, slow growing big caps and overvalued large tech companies.

In a rising inflation rate environment, growth is the second best hedge. Historically, the best hedge is the unmanipulatable, unimpeachable value represented by gold.

I am happy to see stocks rising and money flowing out of high yield bonds and large cap stocks into investments which have much smaller market capitalizations.

Speculative money adds marginal strength to the price moves in investment vehicles. Much of this speculative money has been trapped in junk bonds, REITS, financial stocks and real estate. We believe we are seeing the beginning of a long-term move away from these instruments into gold, commodities (especially energy), metals and small fast growing companies and markets. Hence our focus on gold, silver, natural gas, small growth stocks and emerging market stocks.

Obviously, there are many differences between the present and the late 1970’s but to me these parallels stand out.

I have not mentioned government bonds (and the U.S. government’s impending big need for cash) in this discussion because I don’t believe that the buyers of U.S. Treasuries are the same crowd who buy the more speculative instruments discussed above. I do however, believe high yield, “junk bond” buyers are the in the same crowd who buy commodities and growth companies.

Currencies
How about this for a simple analysis? The Euro has declined because of the fact that Germany, and therefore other European countries, are dipping into their second recession in a very short period.

Japan, mainly due to the guts of the accounting profession, is finding the will to make some changes for the better. Investors believe that the economy may be shaking off the effects of deflation. As a result the Japanese stock market has been attracting a large quantity of foreign money (ours included) because it is cheaper than it has been in 3 decades.

The US economy may be strengthening, but the rate of change is not as large as in Japan. Lately, investors have been demonstrating that they want Yen first, Dollars second and the Euro last.

The Euro outperformed the Yen from 2001 to 2003 and the Dollar since 2002. Due to Japanese government intervening repeatedly to keep the Yen down, it now has a lot of catching up to do. Recently, we have seen Yen rise against the Euro and the Dollar, and the Dollar rise against the Euro. As long as people perceive Germany and the European economies doing worse and the US economy perhaps doing better, this Euro decline could continue.

The Dollar has not been able to rally versus the yen. We expect the Yen strength to continue and we suspect that the recent rally in the Dollar versus the other major currencies may be nearing an end. The Euro’s strong rally peaked in late May, then rested by drifting down over the next three months. The Dollar rose about 9% versus the Euro. This represents about a 30% correction of the move upward, which began in early 2002. We expect the Dollar to resume its decline versus the major currencies in the not-too-distant future.

Currencies also tend to move in the short term as a result of short-term interest rate differentials or the second derivative of interest rate differentials, or the rate of change of the rate of change.

Intermediate term moves, in my opinion, are usually due to changes of balance of payments situation. The currency of the country whose balance of payments was improving would appreciate against the currency of the country whose balance of payments was constant or deteriorating.

Long term, I think that the important variable in currency moves has been the trend in a country’s GDP growth relative to another country’s GDP. The currency of the country with the better long-term economic prospects rises versus the currency of the other country.

These models may sound simplistic and naive, but it seems to me that most currency speculators are just as naive as I am, and so they may indeed hew to these kind of unsophisticated models.

Summary
The markets are enjoying an influx of liquidity. People perceive (and I think correctly) that inflation is beginning an ascent. Inflation is ascending from a low level but its percentage increase, its rate of change, is high. Its 2nd derivative is also high.

People also perceive, that while deflation is impacting some manufacturing and service industries, the prices of consumer goods and commodities, such as energy, are quite firm.

Liquidity is being pumped into the economic system at a rapid rate in North America, Europe and Asia. Asia is importing this liquidity by exporting many more goods than it is consuming. This added liquidity is creating increased demand for financial instruments and commodities.

Gold and growth stocks are two types of financial instruments that are in demand in an environment of rising commodity prices. This is because it is believed that growing profits act as a hedge against the declining purchasing power caused by inflation. On the other hand, bonds are the instruments that do the worst. Bonds are currently under liquidation by investors while growth stocks are under accumulation.

Growth stocks can either be the stocks in developed economies that for some reason grow fast, due to a new market, a new product or a new service even perhaps, a new way to deliver or finance an older product or service. Growth stocks can also be stocks of fast growing economies. Some examples are China, Russia, Taiwan, and Korea.

Currently, we are exposed in China, Japan, Taiwan, Korea, India, Brazil, Canada and the US. Our largest commitment is China where we own Sohu.com and NetEase.com, which are two fast growing Internet related companies. We also own Petro China and China National Petroleum two Chinese energy stocks. We own a substantial position in UT Starcom, a Chinese and worldwide supplier of low cost phone hookups.

In North America we own primarily gold, energy, technology and medical companies including Ultra Petroleum, Chesapeake Energy, Newmont Mining, Tan Range Exploration Corp., Agnico Eagle Mines, Sandisk Corp, M Flash Disk Pioneer Ltd, Vishay Intertechnology, Kos Pharmaceuticals, and SFBC International. In India our holding is Satyam Computer Services. In Taiwan, Korea and Brazil we participate in the markets through market tracking shares called Ishares index funds which are organized for each specific market.

The dollar rally should be getting close to its reaching and end and we expect it will retreat in the coming months. Gold will benefit from three or four positives: 1) increasing liquidity in the global financial system, 2) increasing inflation in certain goods, 3) fear of deflation, and 4) a resumption to a declining U.S. dollar.