PERFORMANCE ANNOUNCEMENT

As Of: January 28, 2004

Change Is In The Wind

Watch For Rising Interest Rates.

      The traditional "Santa Claus Rally" is supposed to end on the second trading day of January. That didn't happen this month. In fact, you could still call this a war rally and a summer rally as well as a Santa Claus rally because the stock market has continued straight up without a meaningful correction since March 12, 2003. This leads to the increasingly widespread conclusion that the stock market is richly valued, perhaps over valued relative to the general economy and future growth potential.

      When is a rally not a rally? One disturbing fact about the 2003 performance of the U.S. stock market is that it hardly went up at all when measured in a major foreign currency. While our stock market was moving up, the U.S. dollar was moving down. The Euro has moved from about .86 to 1.28 and the Japanese yen has moved from about .80 to .94. This means that a low single-digit interest rate Euro bond outperformed the U.S. stock market.

      Understanding what has happened to currency exchange rates helps to explain the rise in the price of gold and the rise in the price of energy (oil & gas). Foreign goods and services become more expensive when our currency drops in value. A depreciating currency creates a kind of inflation which eventually impoverishes the citizens. Our growing budget deficit, foreign trade deficit, and high levels of private sector debt will exacerbate the problem. Because the United States is a debtor nation, if foreigners become reluctant to invest in U.S. debt, interest rates will have to go up.

      Low interest rates have caused an explosion of debt in the United States (witness the record rate of home refinancing). A rise in interest rates will cause a tremendous strain on the financial system. (Perhaps this is why the Federal Reserve has been resisting any suggestion to increase rates). Institutional lenders have become much smarter about hedging their interest rate risk when rates go up, but retail borrowers are relatively clueless. All those adjustable rate loans are going to bite their borrowers.

      There are lots of interesting things that might affect the markets in 2004, but the most significant events are likely to be a continued loss of purchasing power and an increase in interest rates. When rates go up, the price-earnings ratio of the stock market should contract. The stock market should have corrected five to ten percent in the fall of 2003. The fact that it did not, causes me to worry that we may be setting up for a 20% correction in the near future.