April 11, 2003

April 11, 2003

As you know, the U.S. led coalition forces established themselves firmly in Baghdad and for all practical purposes; Saddam Hussein’s regime has fallen. So far, the market has not shared the jubilation of the Iraqi people. It fell 1.2% on the day Baghdad fell.

The market rally that began on March 12, a few days before the first attacks on March 19th, peaked on March 21st, two days after the initial missile attacks on Saddam Hussein’s bunker. The rally was caused when market participants became more certain that an invasion would take place and the uncertainty (which the markets hate) was coming to an end. Since the peak on March 21st, the market has drifted slightly lower, but remains about 1% above the lows reached in early March.

Why did the market rally end and begin to sell off? In our opinion, the market, once again reprising its role as a discounting mechanism, was discounting the poor economic environment the world faces in 2003 and the many renewed uncertainties about the future of international relations.

For example, to where have the Baath party officials and other war criminals of Hussein’s regime fled? Have they taken harbor in Syria? Will the coalition demand their return? If they are not returned, will the coalition continue to search for them in other countries? How will the Iraqi Reconstruction be organized? Will Iraq, with its many different tribal, ethnic, and religious groups splinter like the former Yugoslavia did once its strong man was deposed? What will the cost of the restructuring be? Who will bear that cost? Will the benefit to U.S. companies equal the amount it costs the U.S. taxpayers? What will happen to Iraq’s $100 billion on foreign debt?

The market is coming to grips with these and many other questions. Once these global events play themselves out some, we will know more. Once the market digests the news it may decide to move up or down based on its own fundamentals. Now it is in the process of analyzing the inputs to decide what the future will be.

What do we do now?

We know that:

1) The dollar did not rally much right before and during the capitulation of Iraq as stocks rallied. At its peak the dollar had rallied 5% from its lows and today sits 2% below its pre-invasion high. We are surprised by the limited magnitude of the rally for the dollar and the rapid reversal towards its low versus the Euro.

We believe that this is because the good feelings toward the dollar caused by the swift fall of Saddam’s forces in Iraq do not solve the fundamental problems such as the budget, trade and balance of payments deficits, which are large and growing.

2) The economic statistics are not robust. Unemployment is rising, retail sales are stagnant, industrial production is weak, technological innovation continues, but at a slower level (subjectively evaluated) than during the boom years of the nineties.

3) Foreign markets, which are as dependent as ever on the U.S. as the prime engine of world economic growth, are stagnant, with the exceptions being Ireland, Spain, China and Taiwan. Of the markets that are of any substantial impact and size China remains the only robust economy with double-digit growth so far this year.

It’s not hard to see why China is a standout. They are the most efficient producers of goods in the world. Their costs are low, their work ethic is strong, and their entrepreneurs are well prepared to produce whatever the developed world wants at low prices, on time, and to specifications.

Taiwan benefits from its business expertise, Mandarin language skills, and knowledge of Chinese customs. They are bringing expertise, capital and technology to the mainland at a rapid rate and are making a substantial profit for themselves by doing so.

In our opinion, China will be the world’s factory and Taiwan the partner who benefits. We own positions in one technology company and are closely examining other opportunities in Taiwan and China.


1) Inflation, which has been quiescent for two decades, is beginning to raise its ugly head. Inflation will reach 3-4% in 2004. The public will become aware that inflation has arrived within one or two years. We hope inflation becomes prevalent. It will mean that deflation has been avoided. Three to four percent inflation will not be psychologically destructive. Deflation however, would be very psychologically destructive.

2) U.S. Economic growth will be sluggish. The shortness of the war means a rapid decrease in oil prices to the $22-$28 per barrel range. This should allow economic growth to remain positive, albeit slow for the remainder of 2003. We do not see bonds rising in value, but see them declining in value as interest rates gradually rise.

3) Global Economic growth is likely to be poor except for supplier countries. Primary supplier countries for manufactured goods, China and Taiwan and primary supplier countries for software and computer services like India should do better.

4) The U.S. dollar needs to weaken in order to attract investors. This weakness will continue for the next few months.

5) Gold’s value today as a proxy for foreign currency, not as a store of value against inflation. Inflation of 3% to 4% will be too low to create a panic out of dollars into real assets such as real estate and commodities.

6) Real Estate in many parts of the United States is at bubble valuations. Low interest rates and high liquidity (cash in circulation) has created a shortage mentality in real estate. We see this as dangerous. Real estate in many local areas is vulnerable to decline when interest rates rise.

7) Deflation remains about a 1-in-4 or 5 possibility. We do not like to imagine what will happen if deflation takes hold in the world as it has begun to do in Japan and in Germany.

Japan, with its bubble valuations in real estate, overpriced stocks and their mentality to invoke incremental solutions instead of admitting that the business and government over speculated, was guilty of cronyism, and was afraid to allow bankruptcies.

By avoiding clearing the bad debt from the economy, and the necessary cleansing and restructuring of debt to realistic valuations, the economy developed hardening of the financial arteries. The financial system could not operate to lend and leverage real assets for growth because previous excesses were never purged from the system. To put it another way, banks won’t lend to new credit worthy borrowers if their balance sheets are clogged with old bad debts. Until the bad debts are marked down to market prices and transactions take place to buy assets at their real prices, there will only be limited economic growth. The fractional reserve banking system cannot lend and the borrowers cannot borrow what is needed to grow. Bad debt ends up keeping zombie companies alive and thwarting new companies who want to grow.

In Germany, the economy is the victim of the government paying way too much for the acquisitions of East Germany in the 1990’s. West Germany grossly overpaid for the assets by valuing the East German mark at ridiculous levels that did not correspond to their economic output. Germany was not able to create enough entrepreneurial spirit to absorb and restructure the underemployed and moribund businesses of the East. The reason being that labor laws and social welfare requirements stifled the natural entrepreneurial spirit of many German businesses. It became too expensive to hire and invest in untrained people who had a communist work ethic. East Germany has not been able to grow enough and the whole country is flirting with deflation.

Will the rest of the world, including the U.S. follow? It is possible, but not probable. As I have been saying ad nauseum for months, the U.S. must stop, or at least slow, its consumption in order to decrease its balance of payments and trade deficits. By doing so, we will strengthen this economy which is the engine of many other economies around the world.


The world’s markets look weak. Our favorites are those that benefit from low-cost production and high tech expertise, China and Taiwan first among them. We see some U.S. stocks as attractive, and some are overvalued. We believe the decline in the U.S. dollar and the rise of the Euro, Australian and Canadian dollars is an obvious and continuing way to profit from U.S. economic mismanagement. We are focusing our investments in this arena. We will buy U.S. and foreign shares, including gold shares, on the expected declines that occur in the volatile market environment we expect will continue. In today’s market, the prudent axiom and watchwords are “Safety First”.

I hope you will call with your inputs, comments and criticisms. I look forward to hearing from you. My warmest regards and have a pleasant Spring.