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THIS LETTER STARTS TALKING ABOUT FEAR, BUT ENDS WITH OPTIMISM

THIS LETTER STARTS TALKING ABOUT FEAR, BUT ENDS WITH OPTIMISM

In some ways, today reminds me of 1973. Let me list a few. Fear dominates. You have: fear of inflation, fear of slower economic growth, fear of political crisis, fear of loss of tax cuts, fear of expanding budget deficits, fear of higher interest rates.

FEAR AND GREED CREATE IMBALANCES WHICH CREATE OPPORTUNITY

I believe that many of the fears in the markets are well founded. Rather than wax negatively about the problems that the U.S. faces as a country, let us look on the bright side.

I do not see these fears as an impediment to success. Rather, I see them as the instrument, which will create market imbalance and thus the opportunity to make money. As frightened or greedy people react to their fears, they often make unwise economic decisions. As a result of these fear and greed driven decisions, they often push the markets to unreasonably low or unreasonably high levels.

OUR STRATEGY HAS ALWAYS BEEN TO TAKE ADVANTAGE OF PERIODS OF FEAR AND GREED TO INVEST CONTRA TO THE MOB PSYCHOLOGY

For three decades, it has been our strategy to do what the mob is not doing. By walking a different path we can see the imbalances in the system. By seeing the imbalances, we can be in a position to be buying when negative imbalances dominate, and to be selling when positive imbalances dominate. This has been our approach for over 30 years.

OUR STRATEGY HAS BEEN VERY SUCCESSFUL – IT HAS WORKED IN PERIODS OF EXCESSIVE FEAR AND EXCESSIVE GREED

In 1973 and 1974, the worst bear market since the Great Depression, the Watergate scandal and finally the resignation of President Nixon rocked the nation and the markets. We waited until prices became unreasonably low and fear dominated investment decision making of the public, and then, we bought good companies in industries with good long-term growth prospects. At the time inflation was reviving, so we owned energy and metals shares along with retailers and restaurants. As more women joined the workforce in record numbers, the demand was created for more meals away from home and more consumer clothing purchases. As a result of this approach we outperformed the market averages by a very large margin during the 1970’s.

During several later imbalances of greed and fear, including the crash of 1987 and to Internet bubble of 2000, the strategy continued to allow us to avoid bubbles and to benefit from low prices caused by fear.

PRESIDENT BUSH HAS PROBLEMS WITH REPUBLICANS

The Republican Party has three main factions emphasizing different ideologies: Social conservatives [focused on social/religious issues], economic/pro-business conservatives [focused on balanced budgets, taxation, free trade, and economic issues], and pro-military Republicans [focused on expanding the military and increasing our presence Iraq and Afghanistan and other countries of concern].

Presently, two of these three groups are disaffected. The pro-business and pro-military groups are both dissatisfied with the president and with the Republican priorities. The large and growing budget deficit angers one group, and no growth in the military angers another.

In order to lead effectively he must reassemble his majority. I expect that he will try to cut government spending, while giving a lot of credit and respect to our service men and women. If he is successful, he will be able to lead. If he cannot, he has already entered “lame duck” status.

ENERGY

Every thing is cyclical and nothing lasts forever. For example we have had a good run up in energy stocks and now they are getting a correction. It won’t last forever, and soon the weather will get colder and demand will rise. Energy imports may stay strong, but demand will rise and prices will rise with them.

When they have risen for a few months by mid winter we will probably take profits on most of our energy shares and look for other groups in which to invest.

Is the energy story going to be over by mid winter? We don’t think so. We believe that energy demand will be strong for years, but even bull markets have corrections and the energy bull will be no exception. Energy prices may fall for months and that will not bother us, as we will look for a point at which to reenter.

US STOCKS ARE DEPENDENT ON INTEREST RATES.

In our opinion, interest rates compete with stocks for investor’s dollars. If short-term rates, say one year or shorter, fewer rise to a high enough level, investors will choose to keep their money in money market funds or treasury bills and not stocks. This is a very logical behavior. We believe that a certain amount of this is occurring now. Interestingly enough, when U.S. interest rates decline in 2006, we can expect the U.S. stock market to rise in response to the lower interest available on the instruments that compete with stocks for money.

THERE IS A WORLD WIDE CACHE OF CAPITAL SEEKING INVESTMENT OPPORTUNITIES THAT TOTALS ABOUT $46 TRILLION. THIS IS BULLISH FOR GOLD AND COPPER AND FOR STOCKS IN INDUSTRIES WITH A TAILWIND.

We have mentioned this worldwide capital wave many times in the past. Now it is even being recognized in the mainstream media. Today’s Wall Street Journal mentioned it in a front-page story.

This worldwide wave of capital caused the Internet bubble that peaked in early 2000. It caused the real estate bubbles, which have appeared in many parts of the developed world in the last few years. In our opinion, it will flow next into commodities such as gold and into stocks in the developed and developing world. Any industries with a tailwind that will stimulate growth, like commodities, health care and some consumer sectors are seeing a wave of money, which is seeking higher than average returns. Usually a glut of capital would argue for low returns, so much of this money is going to areas that are riskier and have the potential for greater return and risk.

Global demand for commodities and non-depreciating money so that India, China, Brazil and Russia and others can grow, is bullish for scarce commodities and for assets viewed by the world’s peoples as real.

Gold is the classic real asset. Copper is also scarce and thus is in demand. To say it another way, both are scarce and gold is real money.

PRICES ARE COOLING IN THE HOUSING MARKETS AND COUNTER INTUITIVELY, THIS IS GOOD FOR STOCK PRICES

On the other side of the coin, it is more than obvious that housing prices have hit an air pocket and have dropped a few thousand feet in just the last few months. Many of my sources tell me stories about the decline of values in the formerly hot residential home prices in their geographic area. This is to be expected and is very normal.

The housing market, like all financial markets, is subject to cycles, which are, in our opinion, highly correlated with interest rates. It takes a few months, but the same higher interest rates, which cause real estate to be less attractive, will also create an increase in free cash for those who have liquidity. Realizing that real estate momentum has peaked for a few years, those who have assets will eventually invest their cash in stocks for higher returns in stocks.

Growth stocks in the U.S. have done very poorly in 2005. We think they will continue to do poorly until interest rates peak. But, after rates peak, people will gravitate to stocks as they realize that t-bills and real estate will not continue to deliver outsized returns. That is when you might see the next bull market for stocks begin.