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February 25, 2004

February 25, 2004

VOLATILITY

Volatility is alive and well, and the world’s markets are as volatile as they have been in some time. The volatility has a few causes. One is the intervention by the Japanese, Europeans and others to adjust or slow down the downtrend in the U.S. Dollar. Another is the short-term approach of many stock market traders active in world markets today.

In our opinion, the volatility created by central bank intervention in the markets is going to continue, and perhaps grow because central banks are now frightened. They are frightened that their plans for economic growth and the financing of their deficits are becoming increasingly difficult to implement. The trend in the dollar to the downside that has been in place for over two years now is on the minds of most of the worlds’ investors and speculators. The fact that they are moving to the bear side of the dollar is making central bankers’ jobs more difficult.

The emperor (read U.S. Dollar) has no clothes, and the worlds’ investors and speculators are betting that more and more politicians and citizens in the street will come to the same conclusion. Even top U.S. officials, such as Treasury Secretary Snow, are acting as if they would not mind at all if the dollar were to fall another 10 to 15 percent. The media has also picked up the message and now more and more investors are realizing that the dollar is not in good shape. More and more investors are now looking for opportunities outside of the U.S.

ROTATION BETWEEN COUNTRIES AND INVESTMENT SECTORS

While the volatility has increased, another phenomenon is also impacting world markets. Investors are nervous and are moving aggressively from one country to another and from one industry to another in an indecisive manner. Investors and their favored investments are in 2 camps.

In the first camp you have the beneficiaries of a weak dollar. This includes precious metals, base metals, foreign currencies, most commodities, real estate and growth stocks.

In the second camp you have the beneficiaries of a stronger dollar. These are companies which import a lot of goods or raw materials from overseas and who report earnings primarily from U.S. operations.

For a few weeks, the dollar has been putting on a tepid and shallow rally sending the stocks in the first group into a bit of a correction while the stocks of the second group have been bouncing. Obviously, we are in the weak dollar camp and we are using this rest period to add to our positions especially in precious metals shares. We believe that the dollar rally is still attempting to get off of the ground and may continue for a few weeks more. After the dollar’s rally, we expect it to resume its decline and our metals, precious metals and energy stocks should continue their rise.

Hopefully, the rally in the dollar will be larger and longer than the pathetic rise so far. We do not want to see the dollar unable to rally at all, as that may foretell serious problems ahead. While we believe the dollar has lower to go, we don’t want serious problems for the U.S., or any country for that matter.

GLOBAL COMMODITIES AND ENERGY ARE DWINDLING IN SUPPLY AND EXPERIENCING RISING DEMAND

Recently, a number of informed sources have been saying that Saudi Arabia’s’ oil reserves are not nearly as large as has been projected. Additionally, in order to protect themselves from the decline in the dollar, the OPEC members have adjusted the oil price. They have not done this publicly, but instead they have increased the price of oil each time that the dollar has a substantial decline. If the dollar continues to decline, we can expect rising oil and natural gas prices for years to come.

China’s demand for raw materials to support its building boom has lead to dramatic rises in the prices of commodities like steel, copper, zinc and nickel. While the Chinese building boom may cool off soon (we discuss this in the next section of this letter), we still expect that prices for raw materials to gradually rise over the next decade or so, after peaks and troughs are smoothed out.

CHINA INVESTMENTS IN DANGER IF INTEREST RATES RISE

I have not been concerned about China having problems with the banking system and have not fallen for the panic about Chinese stocks that began in some circles in August of last year. However, something that has happened recently has concerned me. China has seen their annual rate of inflation rate go from 1.9% in November 2003 to 3.5% in January 2004.

Rising inflation in China is not unexpected; it is a result of the rapid growth in the money supply of China in the last year. During 2003 China’s money supply grew by about 20% due to direct foreign investment adding money to the monetary base. This means two things. The first is that money supply is 20% greater than one year ago. Secondly, the fact that the government of China did not create this growth, and foreign investors did, means that China does not control their money supply growth. Should the growth reverse and start to shrink, this can be devastating. How would this happen? Rising inflation could scare foreign investors into curtailing their investment projects in China. This scenario becomes a greater possibility every month that the inflation rate increases. If the inflation rate gets to about 7% or 8%, foreign investment and money supply growth might diminish dramatically.

The Chinese market and neighboring stock markets are up in 2004, but a resurgence of inflation could cause foreign investors to rethink their commitment to China.

Further, in order to curry favor with their biggest consumer market, the U.S., and to support President Bush who is generally pro free trade, we expect the Chinese to let their currency float upward in value a few weeks before the presidential election. The President will then be in a position to confront the Democratic shouts for protectionism with some political ammunition courtesy of the Chinese.

A rise in the Chinese Yuan could further unsettle investors in China about the profitability of Chinese companies. Frankly, we believe a rise of 15% or so would not hurt Chinese exports, but it could temporarily give the Chinese market a big setback.

U.S. MARKET

The U.S. market has had a substantial setback in recent weeks and in our opinion this is largely because both Senator Edwards and Senator Kerry have been battering the concept of free trade in their stump speeches.

When the chairman of the President’s Council of Economic Advisors had the temerity to defend free trade as beneficial to economic growth before Congress, he was strongly criticized by Democrats and some Republicans. The problem for us is that he was correct. Free trade is very good for world and U.S. economic growth. This is an economic truism that all respected economists agree upon. President Bush and President Clinton before him have been very wise to support free trade. It is more than a little frightening to see major political party candidates bash free trade. Without free trade the standard of living here in the U.S. would decline substantially.

For those of you who wish to educate yourselves on this issue, may I direct your attention to the recent issue of The Economist dated February 21-27, 2004 which gives an excellent series of expositions about the economics of trade and why all Democratic and Republican economists believe that free trade and outsourcing actually create jobs.

This is not new economic theory but rather a 200 year-old theory that has been proven in the real world marketplace repeatedly. Only the far-left elements of the economics profession disagree with the free trade concept. Yet the politicians have unsettled the markets once again in order to garner votes from the uninformed. This kind of political noise is one reason that the U.S. market has been so skittish in recent weeks.

INDIA

India and China have seen many of their tech stocks decline as calls for U.S. protectionism do nothing to create security about the future of exporting nations.

This political grandstanding is not unexpected in an election year. It is comforting to know that although politicians often say terrifying things to garner votes, rarely do they become actual law or national policy.

We must also remember that 2004 is a major election year, not only in the U.S., but also in India as well as many countries in the Southeast and East Asian area surrounding China. Politicians in all parts of the world are adept at saying things that terrify the markets. This brings us back to where we started this letter, and discussing the reasons we expect more market volatility in the U.S. and throughout the world.

SUMMARY

This is likely to be a volatile year for world markets. The elections taking place in many countries and the ongoing intervention to combat the falling dollar are two reasons. China’s potential slow down caused by rising inflation may cut demand for raw materials and for Chinese and East Asian stocks is another.

Fears over the talk about protectionism and how it could hurt other emerging economies, and even slow the economic growth in the U.S. (if protectionist policies are implemented) are giving investors a reason to pause. As long as these protectionist statements remain as just talk, economic growth will continue. We all need to be concerned about them becoming legal reality.

We are using this period of rest and market decline to add to our precious metals positions and to quality companies with visible earnings growth and low valuations.