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July 7, 2004

July 7, 2004

OVERVIEW AND ENERGY OUTLOOK

I was prompted to write to you today by a recent article on the front page of the Wall Street Journal. This article encapsulated many of the thoughts that we have been having for years about the vulnerability of the middle eastern oil sources on which the developed world is highly dependent. The article discussed a few methods to protect oil flows from terrorism, wars, and internal upheavals.

We believe that it is possible that the U.S. may end up taking over control of these waterways to protect the free transportation of oil to the west from the Persian Gulf area through the straits of Hormuz. Approximately 16 million barrels of oil pass through the straits and out of the gulf every day.

Oil security, even more than economic growth in China, or the fighting in Afghanistan and Iraq, is an extremely important piece of the current economic and political puzzle. In our opinion, the U.S. may be in for a couple of very difficult years on the energy supply front. It is highly possible we could see economic dislocations caused by disruptions in the supply of oil from the mid east and possibly Venezuela. Continued strong demand for oil from China and the rest of the developed world increases the possibility.

As we have been saying for over a year, energy is an important sector in which to be invested. We are substantially committed to energy shares, and we have been enjoying the benefits. Only recently, oil industry analysts, who had previously been saying that oil prices would fall below $30 per barrel, are admitting one by one that oil will average in the mid to high $30’s throughout 2004.

We see possible interruptions in supply due to political instability in Iraq, Saudi Arabia, Venezuela, Indonesia and possibly several other countries including Nigeria. Therefore, we own several natural gas producers and we will add more on any declines in oil prices during what is usually (but not this year) the slow summer season. We continue to believe that oil will approach $50 per barrel in the U.S. within a year or two.

U.S. STOCKS

The U.S. market will probably rise for the next few months. I believe that President Bush’s popularity is highly correlated with U.S. stock market rises, and I believe that his popularity has hit its nadir. Political involvement in Iraq by the U.S. appears to be decreasing. It most certainly is not decreasing, but appearances are appearances. U.S. corporate profits and economic growth should be strong for the remainder of the year at least.

The market has not moved much this year, but we may see a rally in the next few weeks. We will use this as an opportunity to take profits in many areas other than energy. We believe the economy could suffer from the high possibility of disruptions in the flow of oil. We must be willing to take profits in most companies as they appear and hold only very inexpensive fast growing companies and energy shares for the long run.

WE WERE ACCURATE TO SAY INFLATION WOULD ACCELERATE, HOWEVER NOW WE ARE AT A CROSS ROADS

Beginning in the first quarter of 2003 we began to communicate that the period of disinflation in the U.S. and deflation in Japan had ended. At the time we stated that, in our opinion, the new trend in North America is inflation.

Since that time inflation has reemerged to some degree and the public has once again become aware of inflation. Perhaps we should be congratulating ourselves for our accurate prognostication but instead we are concerned that the seeds of a future disinflation or deflation may have been sown.

The U.S. finally raised interest rates a few days ago. This has been long expected, as a result of the stronger influence of inflation on world business activity in recent months. Thus far, inflation remains a problem and may remain one for some time. We are very grateful for our many years of experience in handling investment portfolios during the last big inflationary period in the 1970’s, which has given us a strong insight how to invest profitably during any inflationary cycle.

DEFLATION IS STILL A POTENTIAL PROBLEM

We believe that there is a high probability that a problem of some kind will develop in coming months. The problem may originate with oil delivery or supply, or it may be the large and growing debt bomb that could easily lead us into a recession and a very poor stock market in 2005.

Our current investment strategy is appropriate for the early stages of inflation. We may have to adjust our strategy as the economic statistics indicate which of the following 3 scenarios develop. 1. Inflation remains moderate. 2. Inflation accelerates. 3. Inflation decelerates. If inflation remains moderate we will maintain our current investment approach. If inflation accelerates we will modify our approach. If inflation decelerates due to a slowdown in China, an oil price increase, or an oil supply disruption we will adjust our strategy accordingly.

Not many observers see it yet but we believe that the U.S. economy could be in a recession by late 2005. In case of a recession our ability to sell short would be an important weapon in our arsenal.

CURRENCIES

Logically the U.S. dollar should be weak. Our deficits are large and our interest rate increases are later, and often smaller, than those initiated in other countries. Still, the dollar remains in a trading range from which it is threatening to decline. We will continue to monitor events and expect the dollar to decline substantially over the longer term.

INVESTMENT OPPORTUNITIES AND SECTORS DEPEND ON THE INFLATIONARY CLIMATE

If inflation continues to build slowly (probable for the next few months):
Best investment: Energy and growth companies.

If inflation accelerates:
Best investment: Energy, base metals and precious metals companies.

If inflation gives way to deflation caused by a recession (quite possible in late 2005):
Best investment: Short sales of stocks and purchase of government bonds.

SOME READING SUGGESTIONS

It is summer reading season and I wanted to recommend three books that I have read and enjoyed recently.

Charlie Wilson’s War by George Crile is a thoroughly researched study of how the Afghani freedom fighters got support from the U.S. It describes how after defeating the Soviets some of the Afghani leaders turned on the U.S. to create support for Osama Bin Laden and other terrorists. Although it is nonfiction the story is wilder than almost any novel.

Another book is The Pentagon’s New Map by Thomas Barnett. A Defense Department analyst’s story of how the U.S. defense establishment has restructured its worldview since the military decline of the Soviet Union. This is a very useful book to understand the present and future of world military policy.

Thirdly, I recommend the new biography Benjamin Franklin by Walter Isaacson. This book is more than a biography. It is an elegant explanation of how American economic and political history evolved as a result of the ideas of Franklin and his contemporaries.

We hope you are enjoying the Summer and look forward to hearing from you if you have any questions or comments.