Asset Allocation Choices                                November 4, 2002

We believe to be prepared for what is coming over the next five years, one should be positioned with large cash or gold holdings, (preferably gold, as the cash could be devalued by excessive money printing), short most large cap stocks, long some inflation-protected government bonds, and possibly some foreign stocks or other assets, and stocks and commodities with good supply-demand fundamentals such as gold and oil. Debt should be paid down with any available funds.

There is a massive worldwide campaign of money printing and seemingly unlimited availability of credit providers in an attempt to sustain economic and corporate growth. The battle is being lost, as more and more debt is required to add smaller and smaller increments of growth. The danger is that a rise in the very low, and in some cases 0%, interest rates will implode the system, resulting in massive defaults. While it is becoming clear that we are in a deflationary environment, there is an ongoing risk that governments will attempt a coordinated re-inflation, which could have quite opposite implications for different asset classes.

In view of these developments, you should seriously consider the impact these reckless economic policies could have on your choice of assets for investment and wealth preservation. We will give a brief rundown of various asset choices and the pros and cons of each.

STOCKS - While it is always possible to find some good stocks, stocks in general, are largely overvalued. We are in an economy where companies can no longer produce sufficient earnings, due to a structural decline in profits that has everything to do with excessive use of debt. Easy credit has resulted in a serious misallocation of capital that is in the early stages of being unwound. Stocks can provide some hedge against inflation, but generally perform miserably in deflationary times. If we encounter an inflationary environment, certain stocks, which are commodity-based, such as oil stocks can thrive, however, in a deflationary environment such stocks might be especially vulnerable. Financial stocks, such as banks and insurers, could be most at risk as defaults mount.

As with stocks, bonds depend on huge inflows of foreign capital as a balancing mechanism to the huge and growing trade and budget deficits the US is running. Continued money printing could scare off foreign funds, resulting in sharply higher rates. Government bonds do well in deflationary times, however, corporates and municipals could be risky during periods of high defaults. Many advisors are recommending municipal bonds and insured bonds to investors that are currently looking for safety. For those that are risk averse, this is questionable advice. Currently, a high level of municipalities and states are running severe and growing budget deficits that can only be remedied by tax increases, which would be a drag on the economy, or spending cuts, which would have the same negative effect. States and municipalities do not have the luxury of simply printing more money, as does the Federal Government. Government bonds are really the only good choice and with the risk of re-inflation prevalent, short-term maturities are the only safe choice considering risk and return. Insured bonds are only as good as the insurer, which is also highly suspect in this environment. Bonds, with the exception of inflation-adjusted bonds do poorly during inflationary times. They are an excellent choice in the current environment, particularly considering the low opportunity cost versus potential reward.

CASH - Cash performs during deflationary times as prices of things go down, but purchasing power is seriously eroded during inflationary times. A strong caution is warranted regarding money market funds and now one should ONLY invest in Treasury-only money market funds. Generic money market funds today invest in commercial paper, asset-backed securities such as credit card receivables backed by dubious assets that have much more equity-type risk than is widely perceived. Stay away. Also avoid money center banks that are much more leveraged on their equity than smaller conservative banks. In particular, avoid JP Morgan Chase, which could be the most leveraged company of our times. Cash has the ultimate advantage of being highly liquid and can be reallocated most easily if conditions change. Currently, cash is safe, however, if the US along with other governments begin a policy of re-inflation, there should be sufficient time to switch into other assets that would protect you from inflation such as gold or inflation-adjusted securities.

REAL ESTATE - Normally, real estate provides a good hedge against inflation, however, in today's environment, the record levels of debt per property make the asset class overly vulnerable to rising interest rates. Prices have been outpacing income growth and are therefore clearly unsustainable. Foreclosures could cause prices and rents to plunge. It is not widely known that after the depression in the 1930's rents did not bottom until 1942, which should caution those holders of income-producing properties that the rental incomes they are counting on to service their debt may not hold up as planned. Local government budgets, which are already widely strained, could also result in unexpected tax increases at the worst possible time.

COMMODITIES - Commodities provide a good hedge against inflation and the CRB index has been breaking out to the upside, in spite of an economy, which threatens to tip into deflation. This could be due to the low levels of investment in this area over the past decades. In a serious deflation, commodities with favorable supply - demand characteristics could see the demand unexpectedly drop off. In an inflationary environment, this should be among the best performing asset classes as the price of all real things rise.

GOLD - Gold is not widely considered money in the U.S., however, actions in Japan, Argentina, and India argue otherwise. Gold is the ultimate money or cash. In spite of that debate, gold stands as an attractive investment, even simply as a commodity. Jewelry demand alone has not been satisfied by new mine production for many years due to low investment in gold exploration and production. Production is in decline and will require much higher gold prices to stimulate new mine production. A re-linking of gold to paper money could possibly set off an unprecedented appreciation in the price of gold. After totally de-linking from gold in 1971, gold rose from $35 an ounce to a peak of around $850 an ounce, a 30-fold increase in less than ten years time. It is highly recommended to own physical gold and take possession, storing it in a safe place. With all of the derivatives activity revolving around gold over the past decade, you want to be certain that the gold you think you own actually exists.

- Gold stocks can be strong investments during periods of inflation, a weakening dollar, and excessive printing of paper money as the world slowly loses confidence in the paper money. Gold performs at its best when central banks fight deflation. Gold stocks are generally leveraged to gold, although have not had a history of keeping up with huge moves in gold such as we saw in the 70's. They are riskier than gold itself due to debt levels and price hedges but they have the advantage of liquidity and no need for storage.

FOREIGN ASSETS - Foreign assets must be considered on a country-by-country basis and should be considered when the US goes on a money printing spree as it has over the past few years. Countries with high savings rates and conservative spending policies should hold up much better than the US dollar if the printing of money continues unabated and encouraged as it has in the US.

- Based on what we view as an increasingly deflationary worldwide environment the big question is, what might the government and central bank responses be? If central banks are not aggressive in fighting the deflation, bonds should continue to perform quite well. That seems unlikely in light of the ongoing accelerating worldwide money printing we are seeing, so bonds of any duration over two years offer very poor risk to reward. Cash will serve holders quite well as in Japan, if deflation does keep its grip on the world and has the advantage of being liquid and most easily and readily re-deployable. This will be important if money printing continues and the value of currencies fritter away as with Germany in the 1920's. In such a case, there will be a need to shift into real assets such as gold, oil, lumber, real estate, etc. Real estate currently has a major drawback in that record levels of debt are attached and appreciation has vastly exceeded income growth, paving the way for potential defaults. Stocks, excepting special situations, look to be a poor choice based on extremely high valuations, poor earnings prospects, and over-leveraged holders. In this environment it is most important to hold on to your money as well as its purchasing power. Gold stands out in that it does well as deflation is fought.

Richard J. Greene