November 8, 2004

November 8, 2004

TO: Friends

In the aftermath of the U.S. election and President Bush’s announcement of new initiatives that he will undertake in the next four years, let us analyze the impact of the proposed initiatives and the historical events on the world markets.

Clearly, President Bush has big plans for the next few years. The plans include an overhaul of the tax code and of social security. They include a continuance of the foreign affairs policies of the first Bush term. These initiatives will be extremely expensive. I have heard, for instance, that the overhaul of social security, including private investment accounts instead of the current system, could cost up to $10 trillion over the next 20 years. This is on top of a projected $6 trillion to $10 trillion budget deficit already projected.


I will summarize the economic situation in the U.S. today without making any type of political statement, critical or supportive, of any political party.

Today, we find ourselves in a guns and butter economy. Just like first-year college economics textbook state; most governments focus on either military expenditures or social expenditures (guns or butter). Currently, the U.S. is focusing spending on both military and social programs and thus is creating major budget deficits. U.S. revenues are substantially eclipsed by expenditures for both military and social spending. The current budget deficit is in excess of $400 billion per year.

Because the President is talking about making the tax cuts permanent, this leaves only one alternative for handling the deficit: economic growth. If we were to get rapid economic growth in the U.S., it would stimulate tax revenues and simultaneously diminish the demand for public welfare services.

What are the prospects for rapid economic growth in the U.S. over the next one or two years? In our opinion they are extremely low. Higher oil prices will act as a drag on economic growth and the economy will grow slowly throughout 2005. If this scenario is correct, how can we expect the dollar to rise?

The answer is simple. We cannot expect the dollar to rise. The dollar will fall. Simultaneously, gold will continue to rise in price as the dollar declines. We expect U.S. economic growth of less than 3% in 2005.


Most stocks will have a hard time. However, the exceptions will be those that export, or those that benefit from higher costs from competitors who are in Asia or Europe. A third group that often does well in a period of falling currency, is commodity stocks. Commodity prices rise as the commodity stays constantly priced in most currencies, but the price rises in the currency that is losing value versus its peers. As an example, the recent rise in oil has been 20% less in Euros, Yen and Canadian dollars as these currencies have appreciated 20% versus the dollar over the last 2 years. In summary, most stocks will not do well and some stocks will do very well.

Between now and year-end, we expect one area of U.S. investment to do very well. We believe that U.S. small capitalization growth stocks will rise for the next few months. This is a result of the Bush honeymoon period, which has sent stock indices up. Many small capitalization investors who have seen their stocks decline throughout 2004 have been heartened by the increased visibility in the markets and by the fact that the economy has continued to keep its forward traction.

Usually, stocks that have fallen all year continue to decline into December as tax loss sellers take losses. We expect that tax loss sellers have finished their selling earlier than usual this year, and we expect many small companies to enjoy a year-end rise in their stock prices. We have found a number of undervalued companies in this category.


Most pundits have consistently and repeatedly argued that oil is over priced and must fall. Some go so far as to say it will fall to $25 per barrel as soon as Saudi Arabia increases production. They have been very wrong, yet they remain undeterred and continue to predict that Saudi Arabia will raise production substantially. In past memos we have explained what has caused the big increase in oil price that we correctly predicted. [You may review our predictions on oil and many other subjects at]

However, we remain confident that although oil has reached our price objective of $55 per barrel it will not fall dramatically and will remain in a trading range between $40 and $ 60 for at least a few more months. Saudi Arabia will not, and, even cannot, raise production as much as they have stated. The reasons for this have been cogently laid out in the past by Matthew Simmons; the oil investment banker and founder of Simmons and Company. He explains that Saudi Arabia does not have the capability to raise production by a lot due to a massive water injection program which has been going on at their major field for years. There are other technical problems as well.


Those of you who have read our memos for some time know that we have been less than optimistic about Chinese stocks for many months. We have not had any exposure to China because we felt that China was over exploited in the media and that stocks had run up to much for our comfort. In essence, stocks were overpriced in China. In the last few months, Chinese stocks have declined in general, and Hong Kong stocks have gone sideways.

Our attitude about Chinese investments has turned from negative to cautiously optimistic. We continue to remain selective while gradually expanding our optimistic view about China. Many of you who have been reading about a slowdown in the Chinese economy predicted for 2005 may wonder about our timing.

First, let us explain our opinion about the Chinese slowdown projected by pundits for next year. A major U.S. brokerage house came out with a bearish prediction about Chinese growth in August 2003. Since that time, the Chinese growth rate has actually accelerated to about 9% in 2004. Recently, China has raised interest rates, and in the speculative market, people are betting that the Chinese currency will rise by several percent against the US dollar. As you know, the Chinese currency is currently pegged to the dollar by Chinese government edict. We believe that China will slow its growth rate in 2005 to about 6% but this growth will be focused in different areas. There will be more focus on the production of consumer goods and less focus on real estate speculation and growth in basic industries like steel.

Item #1
The Chinese will not willingly remove their peg to the U.S. dollar. If they have to do other favors for the U.S. in order to keep this peg, they will do so. For example, they will continue to buy US government bonds to fund the US deficits.

Item #2
China will decrease their emphasis on the production of capital goods, such as factories for production of steel and heavy industrial materials, and focus on growing their factories that create consumer goods. They will grow their steel and other heavy industrial capacity, but at a slower rate, and they will shift resources to the production of furniture autos and other consumer goods that the very large and very fast growing upper class, upper middle class and middle class are demanding.

Item #3
China still remains a top-down managed economy with regard to the allocation of capital to major projects. The Chinese officials are slowing their lending to heavy industrial projects and refocusing it toward consumer goods manufacturing, and the production of increased electricity and utility infrastructure.

Item #4
The Chinese export industries of textile, toys, consumer goods that are ubiquitous in the west will continue to expand. These industries are mostly privately owned and do not depend on allocation of government resources or government financing for their growth. These industries will continue to grow and to export to the developed world. In fact, in terms of textiles, China’s growth is getting ready to take off at the expense of many smaller countries.

In summary, we like consumer products retailers in China. The retailers of furniture, autos, motorcycles, jewelry and household appliances are remarkably well positioned to grow in the current Chinese environment. The manufacturers of some of the same types of products are also well positioned. The Chinese consumer is very status conscious. Within China they buy brand names or brand name knock offs. When they travel abroad, and are doing much more foreign traveling, they buy status names like Gucci, Hermes, etc.

India continues to be an attractive destination for investment. Indian GDP has been growing just as fast as China, and in 2005 we see economic growth of about 7%. Within India, technology will remain a major area of growth, but financial services, energy self sufficiency and several consumer areas will also continue to grow.

India is not as energy rich as China but recent major natural gas discoveries have improved the outlook for the domestic energy industry.

Item #2
The new coalition government has not been hostile to business and although bureaucracy remains a problem, there are rays of hope.

Item #3
The election of President Bush has taken the attention off of the anti-outsourcing proponents. India has developed several new areas of outsourcing. Recently, more foreigners have been traveling to India to have medical procedures performed for 10% of what it would cost to perform them in Europe or North America. New drug research is being outsourced to China and India and much drug discovery and toxicology research is being performed in these two countries. This work is being outsourced by major pharmaceutical and biotech companies in Europe and North America.


We continue to buy and own foreign currencies as the dollar looks like a continued declining asset. We believe gold will rise above $450 per ounce soon and at that time we will begin to consider taking partial profits on some our trading positions in our gold stocks. We continue to believe that gold will go much higher over the long run.


We see certain industries in the western world as attractive, with careful stock selection being the key to success.

We like consumer stocks in China and companies of several industries in India for investment. Japan remains problematic. Although good progress is being made, Japan is still a slow-growing economy and although profits can be made, we prefer faster growing areas.

Within Europe, bonds remain an attractive area for investment as interest rates may not rise much right away, and U.S. investors will enjoy the rise in European currencies versus the dollar.

Currencies and gold look like appreciating assets to us as the consequences of the major deficits become more visible to investors worldwide.


For those among you who are professional investors, may I draw your attention to a new book by the very famous mathematician Benoit Mandelbrot. He is the inventor of fractal geometry and a powerful force in the creation of chaos theory. He is extremely critical of orthodox financial mathematics and points out that conventional models grossly underestimate market turbulence and the frequency of occurrence of extreme events. Secondly, he states that unlike random walk, markets have their own sense of time. He points out that volatility clusters together contrary to the theory.

He goes on to say that because of the irrefutable evidence of these flaws in the models, corrective patches have been put in place to work around the problems instead of explaining the evidence and creating a new theory that explains it.

He argues that this may cause people to put together portfolios incorrectly and may be magnifying instead of managing risk. The book is called The (Mis)behavior Of Markets: A Fractal View Of Risk, Ruin And Reward by Benoit Mandelbrot and Richard Hudson.