Third Quarter, 2003

We have been experiencing a sub-par economic recovery since the end of the recent recession.  The stock market, on the other hand, continues to party like it’s 1999.  Investor expectations for a strong economic recovery during the balance of this year and for 2004 have resulted in stock market valuations which equal or exceed that which we last experienced in early 2000 just before the crash.  Investors hear only what they want to hear; and what people are mostly hearing is that the economy is firing up and the unemployment figures have stopped getting worse. Investors believe the weak recovery  is about to become much stronger.  Hence the stock market today is fully discounting strong future growth.  We all hope this is so, but we don’t invest our clients’ hard-earned money based upon this hope.

 We continue to have concern that “global outsourcing”—resulting in permanent domestic job losses in manufacturing, and now increasingly in the service sector—will take its toll on future economic growth.  We believe that permanent job losses among an increasing number of blue and white collar professions is a growing negative feature of our economy in the new millennium.

 Other fundamental economic factors which we keep uppermost in our mind when structuring client portfolios include:

1.      Trade with the Far East—China, India, and other Asian nations produce merchandise and provide services to U.S. consumers for a fraction of the cost of what those items and services cost when originated in the U.S.  Our trade deficit with these nations continues to grow at an alarming rate and there are no good political solutions that will achieve a better balance between the volume of imported vs. exported goods.  American companies shift manufacturing and service employment jobs to low-cost areas of the world in order to remain price competitive in the global marketplace.  Our economy will continue to shed jobs, perhaps at an increasing rate in the future, as the scope of foreign-originated products and services expands.  While a major devaluation of the dollar (which is occurring now) will make U.S. products more price competitive, it will certainly not solve our lack of wage competitiveness in the global trade arena.

 2.      The federal budget—It’s out of control.  Social spending needs continue to explode upward while the war on terrorism has added tens of billions of dollars of incremental annual expenditure to the overall budget.  The Federal government covers its budgetary shortfall by selling more debt to nations around the world.  China and Japan today are two of our three largest creditors.  It will be interesting to see when these countries decide to cut back on their willingness to acquire additional hundreds of billions of our intrinsically worthless paper money.  Our foreign creditors don’t have to stop buying U.S. treasury securities.  If they simply slow down their rate of acquisition, domestic interest rates will rise and our recovery will be damaged.  This point leads into the next “big picture” concern, being the continued ability of the dollar to remain as the world’s reserve currency.

 3.      The U.S. dollar—It’s been the world’s primary reserve currency during the past 60 years.  By this we mean that other nations have held dollars in reserve as backing for their own currencies which perhaps were not as liquid or as well respected in the world marketplace.  The times are changing rapidly, however.  Islamic nations are in the early stages of an effort to create a gold-backed currency for international trade, citing vulnerability of the current monetary system (meaning the U.S. dollar as the world’s reserve currency) to ongoing currency debasement.  These countries are reacting to the need for more monetary stability which a gold-backed currency can bring.  The Islamic nations reportedly represent a trading block of 1.5 billion people around the world.

Russia (the world’s second largest oil producer behind Saudi Arabia) is considering a growing role for the euro as a reserve currency and as a second currency to conduct its international oil trading.

The relevance to our investor clients of a weakening dollar vis-à-vis gold and other key currencies is simply this:  When our currency weakens, long-term interest rates tend to rise and hard asset-type investments tend to outperform financial assets (stocks and bonds).  It takes more current yield to entice buyers to continue owning U.S. denominated securities. The Fed may successfully manipulate short-term interest rates lower, but it is much more difficult to override global market forces which are expected to result in rising longer-term interest rates.

4.     Gold, the commodity, has been in a bull market since early 2001.  During these past two and a half years, the dollar price of gold bullion has risen by roughly 50% while gold stocks have seen a four-fold increase in prices since December, 2000.  Rising gold prices reflect a lack of confidence in a nation’s currency.  By contrast, the price of gold in terms of yen or euros has not risen in the past 18 months.

In spite of these fundamental economic negatives, which may continue to play out over the coming years, investors remain extraordinarily bullish on the prospects for our domestic stock markets.  Particular emphasis is once again being placed upon tech stock prospects. The NASD, for example, has just reported that margin loans through brokerage firms have quadrupled this year to $26 billion as of July.  By comparison, margin loans topped out at $21.4 billion at the peak of the last bull market in March 2000, according to the Wall Street Journal.  Stock market mania has returned!

In the face of these various concerns enumerated above, a growing number of economic indicators have continued to improve since our last quarterly letter, and for this we are thankful.  Nevertheless, we continue to maintain a defensive strategy with client portfolios rather than throw caution to the wind by aggressively pursuing overpriced stocks in the hope that they will rise further and that we will be smart enough to sell out before they crash—again.

In our last quarterly letter, we advised that our focus on factors such as dividends, reasonably-priced stocks, and insurance against further dollar debasement has led us away from more traditionally-structured stock portfolios and into gold-related and foreign-denominated securities for a portion of client holdings.  One result of our strategy is that indexes such as the S&P 500 and the Dow Jones Industrial Average have become less relevant as comparisons to a portfolio’s equity performance.  In our opinion, the securities underlying these indices have become very overpriced which, history has demonstrated, will translate into low or negative returns during the next five to ten years.

 P.S.   From Richard Russell’s Dow Theory Letters:   “During the third quarter of this year, insiders bought $239 million  worth of their own stock and sold $8.7 billion of their own stocks.  This is 36 shares sold for each share bought, the heaviest ratio of insider selling in the past ten years.”