Third Quarter, 2004

With China and India entering the global economy (this is old news, actually), the industrialized nations of the world, with their high wage bases, continue finding it difficult to compete on the price of manufactured "stuff". Rising productivity (more work accomplished by fewer workers) here at home has helped many of our domestic manufacturing industries to slow down the Asian onslaught, but the downside of rising productivity is a continuing stream of permanent job losses. Where productivity can’t be increased enough for a company to remain globally competitive, outsourcing is the other viable alternative. People lose their jobs at home, but American businesses survive and perhaps even prosper. Dell Computer is a good example.

The above statement is a fundamental, economic fact of life in the U.S. for many years to come. Furthermore, tens of millions of people from the developing world are entering the global economy at wage rates equal to a fraction of industrialized nation wage rates. This situation will also continue indefinitely into the future. Wage competition of this type will serve to gradually lower wages across most, if not perhaps all, professions in the U.S. and other developed nations around the world. These global economic tides cannot be reversed by the leaders of any country, or by our Federal Reserve, for that matter.

Both of these trends are deflationary, and the implications to investment markets in general and your wealth in particular, are profound. Deflationary periods generally favor bonds over stocks, and we continue to hold stocks at levels below that suggested by the "conventional wisdom". The Federal Reserve continues to fight the deflationary onslaught with massive REflationary efforts which appear up to the present time not to be working. Evidence of the inability of the Fed to bring inflation back is seen in the direction of long-term interest rates which have been falling since May. Back then, not a single economist or money manager had predicted that lower long-term rates could possibly occur as the Federal Reserve began signaling its intention to raise short-term rates.

The Fed’s reflationary efforts have led to continuing massive debasement of our dollar-denominated currency. The investment implications of this are, or will be at some point in the future, a decline in the dollar vis-à-vis other currencies and a rise in the dollar value of gold (and other commodities to varying degrees). We have anticipated these outcomes by diversifying portfolios into foreign securities (both stocks and bonds) and gold-related investments.

Our recent bull market rally gave way in February to the power of the secular bear market which began in 2000. We have now experienced eight months of renewed declining stock market activity. What is the market telling us? Why isn’t the global economic recovery raising investor optimism? Perhaps the market is saying that the risks that are "out there" are of greater consequence than today’s economic recovery. The bond market appears to be confirming this possibility. As noted above, intermediate- to long-term interest rates have been falling since May. Back then, the yield of a 10-year treasury bond peaked at 4.9%. Today, it is 4.1%.

For the year’s first nine months, client stock portfolios have done extraordinarily well vis-à-vis the broader stock market averages. Some of the strongest performing areas of investment were energy companies, utilities and real estate funds. Our client own stocks in each of the three areas. Tech stocks were one of the worst performing sectors of the market, and we continue to underweight investment in that sector. The tech industry is presently lobbying Congress to prevent the Accounting Standards Board from instituting a procedure that would require all companies to expense their stock options. Should the tech industry fail in this lobbying effort, approximately 70% of reported industry earnings will vanish and tech P/E’s will appear monstrously high. The risk of tech stock ownership is thus very high at this time. Finally, gold stocks experienced a strong resurgence in the third quarter and you participated in this gain.

We continue to believe we are in a low stock market return environment—also called a bear market. If we are correct, P/E multiples should continue to decline even as corporate earnings continue to advance. In other words, improvement in corporate earnings may not result in higher stock prices. Historical precedent bears out this possibility.