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August 17, 2004

August 17, 2004

WORLD ECONOMICS

It is no surprise that oil prices have been rising for a year and four months and continue to go higher.

Higher oil prices mean less consumer cash. Less consumer cash means lower economic growth (the U.S. economy being 65% consumer spending). Lower economic growth means lower corporate profits and lower inflationary pressures. All of this leads us to predict slower economic growth and slower inflation in 2005.

We believe that economists will gradually rein in their predictions for economic expansion next year and consumers may continue to rein in their expenditures.

Recent economic statistics from Japan and Europe corroborate this trend. Because we saw the rise in oil prices coming, we have been less optimistic about economic growth than many others. Now, we expect the newspapers and magazines will be full of predictions of a recession in 2005. We think that this is unlikely. We expect growth in the 1 to 2 1?2 % range in 2005, slower than 2004, but not a recession. We will discuss this in more detail later in the letter.

US STOCKS WILL CONTINUE TO BE VOLATILE

Over the next few quarters, we expect more and increasing volatility and a sideways trending market punctuated by short and violent rising and falling trends. In general, a mediocre environment for most stocks. It is good however for some stocks, and we are confident that (like the 1970’s, when oil prices rose for six years and by 1500%) we have a strategy for dealing with the current oil market turmoil. For some clients we can sell short. And for every client we can avoid overpriced stocks to focus on cheap stocks that benefit from economic changes. This has been our tradition for many years.

Although we have been expecting a rise in oil prices (suggesting $50 or higher even), we have been surprised by the rapidity of the rise. Many nations simultaneously are fearful of supply disruptions and several countries are expanding their strategic petroleum reserves at current elevated prices, further increasing demand in a period of restricted supply.

INVESTMENT STRATEGY DURING A PROLONGED PERIOD OF RISING INSTABILITY IN THE GLOBAL OIL SUPPLY.

Today most investors we speak to believe that the current oil price is unsustainable and will be soon followed by a decrease in prices to $35 per barrel in the near future from the current $46 level.

This may happen, but what will happen even if the terrorism premium dissipates? Will it stay minimal, or will terrorism in general and oil terrorism in particular remain a fact of life for a very long time to come?

We continue to see oil prices in the high and unpleasant $40 and above levels for some time to come. This is due to several variables. I will review them here.

1. Increased demand from the developed and developing countries. Especially China, India and southeast Asian countries as the newly wealthy Asians buy cars and other energy consuming appliances and use much more energy to manage their business affairs [run factories, manage their power grid, etc.]
2. Increased stockpiling by major oil consuming nations who wish to have a cushion in case of politically or economically originated supply restrictions.
3. Decreased availability of oil and natural gas as existing fields deplete and few new major discoveries are made.
4. Increased costs of new discoveries. Smaller fields in distant locations increase costs of delivery of energy to consuming nations.
5. Continuing problems with terrorism. Many observers wrongly conclude that the current rise in oil prices is all about a terror premium. We disagree. In our opinion terror premium is about $8 or $10 per barrel. We believe terrorism will continue. The terror premium could, for a few weeks or months, dissipate. However, we believe that the premium will continue for years to come in some form or another.

Let us be aware that there are solutions to these problems of increased demand and limited supply, but they will be neither quick nor easy to implement. The obvious solutions include, but are not limited to, less consumption, alternative energy sources, lifestyle changes, and/or military and political diplomacy.

WHAT ECONOMIC RESULTS HATH THESE HIGHER ENERGY PRICES WROUGHT? STAGNATION?

The U.S. economy is weakening and most people are loath to admit that further weakness may follow. Historical precedent says this is not the way it’s supposed to work. The economy just began its expansion a year and a half ago, and is supposed to last several more quarters.

I agree that this is true based upon historical precedent. My concern continues to be that for over a year I have been predicting that high oil and commodity prices will occur. Then I predicted that economic growth would slow, leading to either inflation or stagnation. It looks like economic stagnation is the effect that is taking hold.

The cause of this stagnation is simple and straightforward. The average American is paying more for gasoline and heating and cooling energy and thus has less left for consumption of goods and services.

Not surprisingly, retail sales are weak and corporate profits are slowing their rate of increase as higher energy costs cut into corporate profit margins. Corporate planning is being impacted by the increasingly murky economic outlook.

Gross Domestic Product is slowing to a 3% or lower rate in the second half of 2004. Well-respected economists believe that the economic growth rate could fall below 2% in 2005.

WORLD STOCK MARKETS ARE BEGINNING TO GRASP THE DURATION AND MAGNITUDE OF THE OIL PRICE INCREASE AND ITS ECONOMIC IMPLICATIONS.

Clearly, with a P/E ratio of 16 times 2005 earnings the S&P 500 is not expecting a slowdown in corporate profits next year. This vulnerability is leading to a stock market decline.

HOW HAVE WE COPED?

1. We have been conservative and held primarily energy stocks and low P/E, fast growing small capitalization companies who are not highly visible to the day-to-day speculators.
2. We will at opportune times, continue to buy and hold European government bonds denominated in foreign currencies to take advantage of the growing U.S. deficits.
3. We are focusing on income generating companies in the natural resources sector which have dividend yields in excess of 6% and which can grow their income as the price of energy, natural gas, oil and coal rises in years to come.

Many economic realities may be visited upon us in the next few years as energy gradually becomes more scarce, more expensive and more important to maintaining our lifestyle.

FOREIGN CURRENCIES

It’s the same old song rising balance of trade deficits, rising balance of payments deficits and rising budget deficits. The beat is the same; a lower dollar will result from rising deficits especially as they rise faster than those of our trading partners.

When the dollar rallies we will use it as an opportunity to buy foreign currencies debt instruments.

INCOME STOCKS TIED TO NATURAL RESOURCES ASSETS

Income stocks tied to oil, natural gas and coal assets provide good income and an opportunity to benefit from increased profits as the prices of these materials rise. Many of these stocks pay dividends of 6 or 8 percent and have potential for price appreciation in coming years as energy assets rise in price.

SMALL GROWTH COMPANIES

Many small growth companies have been battered in price for no reason except that short sellers can illegally short the stocks on foreign exchanges without borrowing the stocks and without observing the uptick rule. When the inevitable short squeezes develop, these stocks can appreciate substantially. We have found several fast growing small companies selling at remarkably low prices and are purchasing them when opportunities develop.

MANY AMERICAN ENERGY COMPANIES ARE OVERPRICED, BUT MANY FOREIGN ENERGY COMPANIES ARE UNDERPRICED.

In terms of under priced companies, we speak specifically of English, Scottish, Irish and Norwegian companies with reserves in the developing world. In our opinion, it is just a matter of time before global investors begin to see the magnitude of the under-valuation and begin to invest in these companies.

SUMMARY

We believe that the market is in a sideways trend and could experience violent rallies and/or declines at anytime.

We believe that although oil prices can fall by 8 or 10 dollars per barrel at anytime, over the next year or more oil prices will maintain a high level.

We believe that the dollar will decline versus the major European currencies and this will be due to the large deficits being run by the U.S.

There are several strategies for dealing with the current situation and we have enumerated several in the section above.

Please call with any questions, suggestions or criticisms. I hope that you enjoy what remains of your summer season.