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August 2, 2004

August 2, 2004

The month of July was a hairy one and we escaped most of the damage, suffering only modestly due to our avoidance of the hardest-hit sectors like high tech, and especially biotech. We held a lot of short-term debt instruments, primarily British Pound Government Bonds, during the month and have recently begun to invest the sale proceeds of these into U.S. and Japanese stocks.

We escaped much of the carnage, but what interests us most is that the market started to rally on Tuesday, July 27 and at that time we started to get back into the market. We anticipate that there will be a stock market rally for a few weeks as the political conventions draw to a close and people begin to accentuate the positives about the U.S., and about economic growth.

No matter what your political persuasion is, it is obvious from viewing recent market activity that the markets currently prefer Bush to Kerry. I make the following observation. When Kerry’s poll ratings rose in July, the market fell dramatically. The NASDAQ was down 8% in one month. I believe that now that the Democratic convention is over Bush’s ratings should rise, and so will the market.

The big question is; what happens after the market rallies? Within a few weeks there will be a growing realization that economic growth is not rapid, and that interest rates will not increase very much. This will be viewed as negative of some industries, and positive for others. Whether the economy continues to contract will in great part be a function of the price of oil. I have been harping on the price of oil for over a year. I continue to believe that the oil price holds the key to economic growth and consumer spending.

MAJOR TRENDS

-WORLDWIDE ECONOMIC GROWTH IS SLOWING, BUT IS STILL OK.

The U.S. economy came in with 2nd quarter GDP growth of 3.1%. While not great, it is acceptable. The growth rate has been slipping further and we expect it to average about 3.0% in the second half of 2004. This slow down in economic growth indicates to us that there will not be many increases in interest rates in coming months.

The budget deficit is $440 billion this year. Typically, such deficit spending is hugely stimulative to economic activity, yet the economy is growing slowly. How much stimulus will be required to get the economy going if it slows down? I hate to think what the possible implications of such behavior are to the prospects for inflation and or deflation.

-FUTURE ECONOMIC GROWTH WORLDWIDE IS A FUNCTION OF OIL PRICES

If oil continues to rise in price as a result of fears of terrorism, the Russian situation, Venezuelan elections in late 2004 and other issues, then we will see a definite slowdown in the U.S. economy in later 2005. It is a fact we must face, continued world economic growth very much depends on oil availability and price.

Because of this, almost every country is stockpiling oil. Hence, we are experiencing higher prices during a period of lesser oil usage [summertime]. Japan, China, the U.S., Europe, and India all use more oil than they produce and energy self-sufficiency is a key consideration for each of these countries. We expect consumer spending worldwide to be adversely impacted by the energy cost increases that have already occurred. Should further oil price increases develop, we expect retail sales to weaken further.

Given the current rise in the price of oil we have already seen a modest slowdown of growth in the U.S., Japan and Europe. However, Japan and the U.S. should be able to grow at 3.0% or better for the remainder of 2004, which is not bad for mature economies.

Currently, the U.S. and Japan appear to be reasonably attractive markets, however as we all know the markets are a discounting mechanism and are discounting events nine to eighteen months in the future. Thus, we are cautious as we continue to expect an economic slowdown in late 2005.

-SOME INDUSTRIES WILL BENEFIT, WHILE OTHERS ARE DAMAGED

Retailers’ sales will be adversely affected by the current economic trends, while oil and coal production companies will benefit. As investors we favor smaller oil and coal production companies that are increasing their reserves with new low cost discoveries. These discoveries will lead to big profits in years to come, no matter where energy prices gravitate in the long run.

I recently returned from a trip to London where we met with eight prospective companies of this type. In addition, an industry analyst who works with us is attending an energy conference in Denver this week. We will be visiting with the management teams of numerous possible energy investments to seek out value and opportunity.

INTEREST RATES

For months, interest rates have been a primary subject of attention for the markets. Many observers believe that rates will rise substantially. Due to the economy slowing down we do not see too much of an interest rate increase immediately. Should the economy accelerate then rates could rise more rapidly. For now, we are predicting a slow and modest rise in interest rates between now and year-end.

CURRENCIES

The U.S. dollar has risen in the last two weeks and some technical analysts are saying that the charts indicate that the dollar will rise 5 or 10 % more against the Euro, Yen and Pound etc.

We can understand a technical rally based on a relief from an overbought trend, but we do not understand what could cause the dollar to rally for any prolonged period of time. The U.S. continues to run immense budget, trade and balance of payments deficits and there is no end in sight. In 2001, it was predicted that the U.S. would run a budget surplus of over $200 billion in 2004 year. Instead, it looks like 2004 will bring a huge deficit. How can the dollar rise for a prolonged period under these circumstances?

We have covered our shorts in the dollar by selling our British and Euro bonds for clients who are not exclusively income oriented. We expect that sometime in the next few months we will reestablish our commitment to the British and euro denominated bonds for all clients.

WORLD STOCK MARKETS

The European markets continue to experience malaise and we find them unattractive. The exception is energy shares, especially those headquartered in England, Scotland, Ireland and Norway. Some of these companies have ventured into successful exploration ventures in South Asia [India, Bangladesh, Pakistan and Myanmar] and in offshore West Africa, Morocco and Egypt.

Numerous substantial oil and natural gas discoveries have been made in these regions over the last few years. Several of these companies are substantially undervalued by North American standards.

Asian markets, with the exception of India, seem to be highly correlated with the U.S. This is not unexpected as most East and Southeast Asian countries export a large percentage of their production to the U.S. and Europe. We are not attracted to China or Southeast Asian markets at the present time. Japan and the U.S. appear to be the most attractive markets and their appeal is dependent upon interest rates rising moderately and not substantially.
Short sales will be an important part of our portfolios that allow short selling. We see plenty of opportunity to make money shorting overpriced technology and retail stocks.

SUMMARY

We believe that the U.S. market has begun to rally and the rally will continue for at least a few weeks, possibly for several months. We believe that Japan continues to be an attractive market for investment and we continue to favor smaller and medium-sized Japanese companies that can grow rapidly. After a thirteen year bear market that ended in the first quarter of 2003, the Japanese market may continue to rise for several more years.

Energy has been a theme of ours for quite a while and we continue to believe that coal and independent natural gas and oil production companies are attractive areas for investment. Energy has very positive investment characteristics and we continue to be attracted to energy stocks.

For short selling clients we will emphasize short sales by retail and technology companies which are overvalued and which are stumbling and unable to grow in a consistent manner.

We look forward to hearing from you and wish you a pleasant summer season.