THE LIOKOSSIS LETTER Overview of Investment Fundamentals

SPECIAL REPORT 2005

“There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of the voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”

- Ludwig von Mises, Human Action, A Treatise of Economics, 1949

This report is divided into three parts. In Part one we discuss how the stock market moves in giant cycles averaging 15-20 years in length and how, in my opinion, we are in the early stages of a long bear market. Part two summarizes the compelling evidence that supports this thesis. Part three looks at what history tells us will be the contrarian investments that should do extremely well during these difficult times.

This document is intended as a guide to constructing a portfolio for the next decade, not the next 12 months. Although predicting the future is impossible, the themes discussed here are very long-term trends that are already well under way.

At various times I will use the term “financial assets”. This refers to all stocks other than those of physical assets such as oil, gas, base metals, precious metals, timberland etc.

PART ONE - THE CYCLE OF THE MARKET

The cycle of the stock market can be distilled down to a very simple process. Bull markets, once born, last many years and reach absurd valuation levels. Bear markets also last years and do not end until stocks are selling for bargain prices. Then the whole process repeats itself, again and again. Look at the last 100+ years of the market:

Market Cycle # Of Years Bull or Gain (+) Period (DJIA) Bear Market Lasted or Loss (-) 1900-1929 29 + 702% 1929-1949 20 - 48% 1949-1966 17 + 402% 1966-1982 17 - 22% 1982-2000 18 +1,402% 2000-2004 5 (so far) - 8% Source: djindexes.com, Jan. 2005 Table 1 2

In each case, a big up cycle was followed by a big down cycle. So far, the bigger the up cycle, the bigger the down cycle. In 2000 we finished the biggest up cycle of them all, 19 years and a 1,400% (djindexes.com, Jan. 2005) gain. Looking at Table 1, does it fit with history that this bear market is over after only five years and all of –8%?

Think of the market as a pendulum. One end of the arc represents the peak of a bull market. At the other end is the trough of a bear market. The pendulum spends very little time at the mid-point of the arc, where stocks are fairly valued and the average rate of return is about 10% per year. It would be nice if markets delivered a nice, round 10% per year every year but they don’t.

Once you understand this concept, you will have a framework that puts things into context. For example, the market today is at the same level it was roughly 6 years ago. This is confusing for investors who were conditioned by the 1990s to expect 20% gains every year. However, it makes perfect sense if you look at the big picture. The market topped out in 2000 with the bursting of the technology bubble, after an almost 20 year rise from the depths of pessimism in 1981. That was one swing of the pendulum. Now we are working our way back to cheaper stock valuations from which we can begin a new bull market. With this perspective, it makes sense that the process will take years and much pain before it is over.

These last few years are the first tough times ever seen by two generations of investors. They have no idea what is going on and they certainly are not counting on another 5 or 10 or 15 years of this. Look again at Table 1 and note the length of the cycles. Each expansion and contraction lasted 15-20 years. Because a complete cycle takes so long to unfold, there is always a new generation of investors who are experiencing it for the first time. Each generation learns the hard way, through experience.

It takes a while for a big change in the market to register with most investors. They do not want to believe it, even in the face of mounting evidence to the contrary.

So if you have a 25-year time horizon, no problem. But if you are two years from retirement and your advisor uses net return assumptions of 10% for stocks, 7% for bonds and 2% for inflation for the next 10 years, you might want to ask some questions. If we are in a long bear market with accelerating inflation, investing based upon the conditions of the last 25 years is not going to work. It is worthwhile considering an alternative.

PART TWO – EVIDENCE OF A LONG BEAR MARKET

All the ingredients necessary for a massive bull market were strongly present in 1981 and it’s no surprise they spawned the mother of all bulls. Collectively, we had very high inflation, sky-high interest rates, big dividend yields on stocks and rock bottom stock valuations. Furthermore, the market had done poorly for many years leading up to 1981. In other words, conditions had reached their nadir and stock returns were set to improve dramatically.

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Inflation and interest rates had nowhere to go but down and high dividends complimented robust capital gains from depressed stocks that had nowhere to go but up. Today, all these factors are stacked against us. Inflation has been low and is now accelerating, interest rates are already low and have begun to climb, dividend yields on stocks are poor by historical standards and stocks are extremely overvalued. These are very stiff headwinds facing the market, fundamental forces that reflect deep dislocations in the markets and the economy and they will take a lot of pain and many years to fix. Let’s look at the evidence.

1. PRICE / EARNINGS RATIO (P/E)

The price/earnings ratio (P/E) is one of the simplest measures of whether a stock is overvalued or undervalued. Divide a company’s share price by the earnings per share and you get the P/E. A company that trades for $20 per share that earned $1.00 in the last 12 months has a P/E of 20. The higher the number, the more expensive is the stock and the less likely you are to make money on it. This measure can be applied to an entire market by taking the average of the P/Es of all the stocks in the index. There are many other measures we can use but they all tell pretty much the same story.

As we entered 2005, the P/E on the S&P 500 Index was 20.6 (Source: Standard & Poor’s (standardandpoors.com), Jan. 2005) and the P/E on Canada’s TSX Index was at 18.8 (Source: TSX Group (TSE.com), Jan. 2005). These numbers by themselves don’t tell you much unless you know how high is high, and these numbers are sky high. Table 2 below shows you what an investment in the S&P 500 Index earned over the ten-year period after it reached a P/E of 20 or more (like where it is today):

Starting Starting Annual Gain (+) or Loss (-) Year P/E Over the Next Decade 1902 22.0 +1% 1928 21.8 -3% 1929 27.6 -9% 1930 21.5 -6% 1961 20.5 +3% 1963 20.3 +5% 1964 22.6 +3% 1965 23.3 -1% 1966 21.3 +0% 1967 21.6 +1% 1968 21.5 +0% 1993 20.7 +9% Source: Crestmont Research(1), Jan. 2005 Table 2

Historically, anyone investing in a market when it is this expensive will tend to do very poorly over the next 10-20 years (yes, years).

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Looking at Table 2, it all fits well until we get to 1993, where the following decade produced a respectable 9% per annum. Here the rule suddenly seems to break down. In reality this is a warning sign that things have gotten really out of hand. On several occasions after 1993, there occurred spectacular events in world markets that would likely have acted as catalysts for a market downturn. These events include the Asian currency crisis of 1997, the Russian 1998 debt default that precipitated the collapse of the giant hedge fund Long Term Capital Management and, most obviously, the collapse of the technology bubble in early 2000.

However, what we got in response to each of these events was massive, historically unprecedented monetary stimulus by the U.S. Federal Reserve under Alan Greenspan. While successful in re-floating the markets and staving off potential catastrophes, what they have done is exacerbate the conditions that led to these crises in the fist place. In so doing they have delayed the inevitable and created a situation where the downside, when it comes, will be much worse than it would otherwise have been.

Another way to look at this is that since 2000, despite truly breathtaking monetary and fiscal stimulus and debt accumulation, the market still hasn’t taken off. It’s a sign of a very unhealthy and unbalanced economy.

To put a P/E of 20 into perspective, the Dow Jones Industrial Average reached 20.1 just before the Great Crash of 1929, it was 15.5 before the 1973/74 meltdown that devastated so many investors, it was 20.3 the month before the crash of 1987 and the P/E reached 27 in January 2000, just before the technology bubble blew up*. Keep in mind that if we had better accounting standards, corporate earnings (E) today would be even lower than what is reported and thus, P/Es, as high as they are, would be even higher.

So a P/E over 20 is extremely high, but what is normal? The long term historical average P/E for the S&P 500 Index has fluctuated in the range of 11-12 (Source: James Montier, Global Equity Strategist, Kleinwort Dresdner). Some analysts believe a P/E of 14-15 is more representative. Either way, the market is overvalued. Furthermore, the decline in the market will likely take it well past fair value and into bargain basement territory. Remember the pendulum analogy. Historically, the market does not hit rock bottom until it reaches a P/E somewhere in the 7 to 9 range*. That’s a long way from 20.

We can get back to a cheap and attractive P/E in one of three different ways. One way is for stocks to go straight down from here. This would mean a devastating decline of up to 60% or more. Historically, this is unlikely. Alternatively, the market can go sideways for many years while the earnings of companies grow enough to catch up to the valuations of the stocks (raising the “E” in the P/E so that that overall number shrinks to a more normal level). Indeed, this has been our experience since the bear market began in 2000. Most likely, we will see some combination of the two.

*(Source: PrudentBear.com, “Why the Bear Market is Not Over”, Sept., 2004).

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The final insult is that the market returns in Table 2 above do not represent what investors actually earned during those periods. From these, subtract fees (say 2-3%), inflation (assume 2-3%) and taxes (say 20% of earnings). If you want to be really pessimistic, add in the fact that most investors do not perform as well as the index even before these items are deducted, for various reasons including poor market timing. I’ll let you do the math; suffice it to say this is not the path to wealth creation that the financial media has led us to believe.

Investors need to do something other than simply hope that the market will once again deliver the returns needed to accumulate the wealth necessary for retirement.

2. INTEREST RATES

Simply put, falling interest rates are good for stocks and bonds and rising interest rates are not. I will defer to whatever your personal opinion is of their future direction. However, one thing that is certain is that the 15% (!) decline in interest rates that fueled the stock market boom of 1982 to 2000 cannot be repeated today.

When falling interest rates cause stocks to go up in price for reasons that have nothing to do with the fundamentals of the companies, it’s called “multiple expansion”. This refers to the P/E multiple. In other words, stocks are getting more expensive simply because more money is pouring into the market. When rates rise, we get the opposite effect, namely “multiple contraction”. Depending upon what kind of market you’re in, this will be a wind either in your sails or in your face.

Declining interest rates were by far the biggest driver behind our most recent bull market. It wasn’t technological innovation, or productivity gains, nor increased profitability that levitated stock prices, despite what you hear on CNN. (In fact, according to esteemed Austrian Economist Dr. Kurt Richebacher, corporate earnings as a percentage of GDP have been in continual decline since the late 1960s.) The simple truth is that a stock that would have cost you $20 in 1982 was worth $100 by the time 2000 rolled around.

John Mauldin, author of the best seller Bulls Eye Investing, delves into this:

“…typically about 80% of the rise of stocks during bull markets can be explained by a rise in valuation or a rising P/E ratio (what some call a multiple expansion). Only a small part of the rise in stocks is due to an actual rise in earnings.”

Mauldin continues, quoting James Montier:

"Here the fallacy of low rates being good for equities is clearly exposed. Your best chance of high real returns is buying when interest rates are high, not low. Indeed, buying when rates are low has on average resulted in a negative real return over the next decade!…Let me repeat that: for the ten years following low interest rate environments such as we are in today, stock market returns are

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actually negative. Not surprisingly, the conclusion is that the best time to invest is when rates are high and the worst time is when rates are low. This is just one more reason to believe that we are in a long-term secular bear market.”

Today bullish forecasters will often refer to benign low interest rates supporting the high price of stocks. This is true. However, falling interest rates are what got stocks to this point in the first place. Rising interest rates will have the exact opposite effect: multiple contraction, P/Es going down regardless of what the company is doing.

In summary, bull markets are driven largely by declining interest rates. They cause the valuations of companies to go up. The opposite is true of rising interest rates and that is what is most important for investors to understand today.

3. DIVIDEND YIELDS

Jim Puplava of Financial Sense Online estimates that about 2/3 of total stock market returns over time come from the compounding of dividends. In the early 80s, at the beginning of the biggest bull market in history, dividends in the market averaged around 6% at their peak. That’s a far cry from what’s available today (Source: PrudentBear.com, “Why the Bear Market is Not Over”, Sept, 2004).

(The higher the price of the stock goes, the lower the dividend is as a percentage of the price. A $20 stock that pays a $1 dividend has a 5% yield. If the stock doubles to $40 and the dividend stays the same, then the yield drops to 2.5%).

Because stock prices have reached such absurd levels of valuation, dividend yields over the last 5 years are the lowest they have been in over 130 years - and by a wide margin (Source: PrudentBear.com, “Why the Bear Market is Not Over”, Sept, 2004). The implications are obvious. Since dividends are critically important to the market’s overall return, low yields portend low overall returns.

Let’s quantify “low”. At the beginning of 2005 the dividend yield on the S&P 500 was 1.72% (Source: Standard & Poor’s (standardandpoors.com), Index Table, Jan. 2005) while the yield for the Canadian TSX stood at just 1.67% (Source: TSX Group (TSE.com), S&P/TSX Composite Index, Dec. 31, 2004). On the following table you can see the average yield on the S&P 500 in the recent past:

Year S&P 500 Dividend Yield 1981 5.57% 1999 1.14% 2004 1.70% Source: Jim Puplava, “Trading Places”, October 29, 2004 Table 3

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What this tells you is that when the market was cheap in 1981, it showed up in the high dividend yields. Today, the market is very expensive and yields are correspondingly low. The numbers in Table 3 are perfectly consistent with the fact the bull market that started in 1981 peaked in 1999 and that we are now about 5 years into a bear market. Dividend yields slowly rise as stocks get cheaper, precisely our experience since 1999.

We have a long way to go. If history is our guide, when we reach the bottom of this bear market, expect to see dividend yields north of 5% and maybe as high as 8% or more on the average stock. Today it is almost impossible to find enough stocks with that kind of yield to even fill a small portfolio.

Dividend yields, like P/E multiples, are a barometer of value. If you are wondering whether stocks have reached bottom yet, one thing you can look at is their yields. Just like the P/Es of today, they are not consistent with what you’d expect to see at the bottom of a bear market. They are one more piece of the puzzle that points to tough times ahead for stocks.

4. INFLATION

Don’t believe what they tell you about inflation. If inflation is so low, why has the price of gold appreciated against every major currency in the world over the last 5 years, including the Euro, Yen, Swiss Franc, British Pound and U.S. and Canadian dollars? Do you see the price of gasoline, tuition, food, cable TV, natural gas, houses etc. going down in value? Does it feel like you have a lot more money left over every month after paying your bills than you did a few years ago? The fact is that for the last century, the era of central banking, we have had nothing but inflation – sometimes high, sometimes low, but always there. Today we are already into a period of accelerating inflation and all the havoc that it wreaks.

The U.S. prints massive amounts of currency to keep their citizens spending so they can keep their markets and economy from imploding, which puts downward pressure on the U.S. dollar. Their trading partner nations print massive amounts of their own domestic currency, using it to buy U.S. dollars in order to keep the U.S. dollar from imploding. A strong dollar allows the U.S. to continue importing from (and sustaining) these other nations’ export industries.

When governments and consumers are spending heavily and amassing ever more debt, and when politicians realize that their future spending commitments will require borrowing at an even more furious pace, they have three ways to deal with that debt. They can raise taxes, which is unpalatable, or they can meaningfully cut spending, which is unlikely, or they can print so much currency that inflation reduces the burden of the debt. Destroying the value of the currency in which your debt is denominated is the easiest way to fix the problem. The simplest way to destroy the value of a currency is to print a lot of it, as much as is necessary to create the inflation you want. It lets debtors

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off the hook, short changes creditors and acts as a tax on all citizens because incomes have never kept up to cost-of-living increases.

There are consequences when governments take an inflationary course of action. Most obviously, inflation must be subtracted from your investment returns to get a real rate of return, a true measure of your increase in purchasing power. Secondly, rising inflation will normally lead to rising interest rates as a country’s currency comes under pressure. The bigger the inflationary problem is, the more vicious the rise in rates will be to compensate. As we have already seen, rising interest rates are negative for stock returns.

5. INDEX LEVELS – LONG TERM RETURNS VS. RECENT PERFORMANCE

Up to this point we have analyzed P/E ratios, interest rates, dividend yields and inflation. Looking at these factors we can conclude that we have just been through a period of extraordinary growth in markets and it makes intuitive sense that we are now in a period of correction and consolidation. This is borne out of my own studies of long-term returns in the markets.

As we discussed, total market returns are composed of capital gains and dividends. We have established that dividends are so low that they are going to contribute very little to overall returns today. Thus, if we are going to make money on stocks, then the only thing left to really drive the market is capital gains. This is principally what investors count on today as dividends are almost passé. Unfortunately, we have seen spectacular capital gains in the last quarter century that are far above long-term trends and they are clearly unsustainable.

The raw numbers confirm that recent gains in the market are completely out of touch with long-term averages. From the interesting statistics file:

• On May 26, 1896, the Dow Jones Industrial Average closed at 40.94*. On December 31, 2004 it closed at 10,783.00 (Source: StarQuote Data Pro data service), representing an annual compound rate of return of 5.26% before fees, taxes and inflation. Interestingly, the vast majority of that move came in the last 20-odd years.

• Consider that from May 26, 1896 to August 10, 1982, the market went from 40.94 to 779.3*, a rate of growth of 3.47% per annum. It took the market 86 years to multiply 19-fold from 40.94 to 779.3. Then, it accelerated from 779.3 to 10428, a 13-fold increase, in just over 22 years! For 86 years the market appreciated at 3.47% per year but it has appreciated at 12.7% per year since then. This has been the formative experience for two generations of investors. No wonder they can’t accept the idea of a long bear market, they’ve never seen anything but a relentlessly advancing market.

*(Source: djindexes.com, Jan. 2005)

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Incidentally, the 3.47% growth rate up to 1982 is quite consistent with real GDP growth of about 3.53% during that time (Source: Economic History Services (EH.net), Jan. 2005). The earnings of companies determine GDP so the market cannot, over time, grow faster than GDP because earnings are also what determine the prices of stocks over the very long term.

I would argue that we are quite a bit ahead of ourselves. The economy didn’t grow anywhere near 12.7% per year during this period. What we’ve seen is inflation in stock values that took us way above average. Now we are now heading into a period where capital gains should be much lower to re-set the clock.

PART THREE – WHAT TO OWN IN THE YEARS AHEAD

If you are still reading this report you should be commended! Now we get to the good part. Not all classes of stocks are going to do poorly. If I am correct, some investors will build generational wealth with the spectacular returns we will see in two areas: precious metals and commodities.

WHAT TO BUY #1 - GOLD AND PRECIOUS METALS

Gold bullion is generally quoted in U.S. dollars. After more than 20 years of general decline, during which it was relegated to the dustbin of history in the minds of many, it finally bottomed in April of 2001 at US$256/oz*. It closed out 2004 at US$438/oz*, up 71% from its low. During the same period of time U.S., Canadian and world stock indices have not fared nearly as well:

Cumulative % Gain Index April 2, 2001 – Dec. 31, 2004 S&P500 (U.S.) 5.76% Dow World Index 18.33% TSX (Canada) 20.98% Gold Bullion 71.09% HUI Gold Stock Index 112.44% Table 4*

*(Source: StarQuote Data Pro data service, Jan. 2005)

This reality escapes most people. Typical of a sea change, the beginning of a major multi-year bull market begins in obscurity and progresses through its initial stages with the vast majority of the investing public completely unaware. More importantly, they refuse to believe the previous bull market in stocks is dead.

My own anecdotal experience tells me that very few investors have actually made any commitment to the precious metals over the last 3 years or so. Nevertheless, this small participation has been enough to propel gold from $256/oz to a recent high of $458/oz.

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The rise in gold has been fuelled by sophisticated money, very wealthy individuals seeking to protect their considerable fortunes from the ravages of accelerating inflation.

The next group to participate will likely be pension funds and large endowments making an allocation of 5% or 10% of their portfolios to gold. This change in particular will be massive for the universe of gold investments. The combined market capitalization of all the gold mining companies on earth is less than that of GE. If you get even 5% allocation to gold, it will mean hundreds of billions of dollars chasing a very small gold market.

Eventually a broad range of investors, the general public, will join in like they did with Nortel and the technology mania in the late 90s. The results will be what you’d expect. This is years away and the great news is that, despite the gains we have enjoyed thus far, the vast majority of the money to be made is still ahead of us. Before we look at the compelling empirical evidence for a big move in the price of precious metals, let’s try to understand the fundamentals of why owning some gold is so important.

The importance of gold as money began 6,000 years ago with the Egyptians. Since then, every era of peace, prosperity, stable prices and sound commerce has coincided with the use of gold, or currency backed by gold, as the means of trade. Not a single monetary system that was not backed by gold has ever stood the test of time. They have universally ended in over-issuance of the currency, rampant speculation, inflation, monetary chaos and a general decline in the standard of living.

By severing its link to gold and falling prey to the seduction of printing easy money, a country sets its currency on a path of self-destruction. This is what is happening to the U.S. dollar today, but the whole world operates on the same system.

Most non-gold backed monetary regimes last only 40 or 50 years. Our own most recent experiences have continued this trend. In 1944 it was established that the U.S. dollar would become the world’s reserve currency and that it would in turn be backed by gold exchangeable at a price of US$35/oz. The idea was that a U.S. greenback would be as good as gold because any nation could, at any time, exchange their dollars for bullion from the treasury’s vaults.

The problem was that the United States started printing too many dollars. As dollars started to flood the world’s economies several nations, particularly France, realized that the U.S. dollar was being debased. Finding themselves with excess dollar reserves from trade with the U.S., they began converting them into gold. Every time this happened, gold was shipped out of Fort Knox. The U.S. lost a huge amount of its gold reserves over the next 26 years until President Nixon “closed the gold window”, a euphemism for basically reneging on the promise of US$/gold exchangeability. This opened the window for the U.S. government to do what no sovereign nation has been able to resist doing going back to the Roman Empire: inflate their currency, printing up as many fresh dollars as they liked to spend as they saw fit.

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Nixon’s actions in 1971 eliminated the last link of paper money to gold. It spelled the end of the dollar but not immediately. Serious inflation, having been absent for 300 years in the U.S., began with WWI but dramatically accelerated after 1971. This initial surge in the price level in the 1970s caused gold to reach past $800 per ounce by 1980. The then-chairman of the Federal Reserve, Paul Volcker, understood the destructive influence of rampant inflation and began tightening the money supply until interest rates reached levels never before seen. It worked. In stopping inflation he also crippled the economy and killed the price of gold, causing it to go into a 20-year hibernation from which it has only recently awakened. It set the stage for the gradual lowering of interest rates from 1982 to the present, which fuelled the stock market boom (discussed above) and marginalized the idea of gold as an investment. The vast majority of investors continue to believe this today.

Fast forward to the present. If you are the United States Government, how do you support an aging population of 260 million, a world wide military budget equal to that of the next 20 United Nations combined, a $650 billion per year trade deficit and a $300+ billion dollar per year interest bill on a $7.6 trillion national debt (and climbing)? You print money and print it fast. There is no other way out. The parallels with the past are remarkable. There is no reason to think that the U.S. will be any more successful at preserving the value of an intrinsically value-less currency, backed by nothing and reproduced to excess, than have all the literally thousands of such experiments that have gone before.

These days it does not even require that you chop down trees – all you have to do is add zeros on a screen. There is almost no cost or effort involved in creating more dollars. According to Kenneth J. Gerbino, founder and President of his eponymous investment firm, the money supply in the U.S. has increased 17% in the last 3 years; China and India have each grown theirs by over 50% in the same time frame. This is leading to accelerating inflation, which is very bullish for gold.

Lest you think that Canada’s rich abundance of resources and our dollar’s recent performance mean that these facts do not apply to us, I will share a quote by Nick Barisheff, President of Bullion Management Services, from his presentation to the Toronto Club, January 2005:

“Canadians need to pay attention to these issues as well. While I have focused on increases in the US money supply, you may be surprised to know that the Canadian money supply has risen at twice the rate of the U.S. Because of the fractional reserve banking system and global fiat currencies, the U.S. has exported credit bubbles to the countries that run a trade surplus with it. In Canada, we are particularly vulnerable to the state of the U.S. economy and its monetary policy. We depend on the U.S. to buy our exports, and U.S. dollars represent 50% of our currency reserves. Canada is now the only G8 country without any gold bullion to back its currency…”

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“While there is $50 trillion in global financial assets, there is less than $1.5 trillion in above-ground gold, less than $1 billion in above-ground silver and practically no above-ground platinum. Eventually there may even be shortages. You cannot simply print more bullion to meet demand. New mines take 5 – 10 years to bring into production. In 2005 whether the price of gold will be $400 or $500 does not really matter. Would it have mattered whether you bought the NASDAQ at 400 or 500 in the mid-80’s?”

The implications for gold are clear. Now we move on to the compelling evidence.

1. THE DOW: GOLD RATIO

The price of gold ended 2004 at US$438. The Dow Jones Industrial Average (DJIA) closed at 10,783 on the same day, so the DJIA-to-gold ratio was about 25:1 (Source: StarQuote Data Pro data service, Jan. 2005). In 1980, gold surpassed US$850/oz*. What you might not remember is that the DJIA spent much of that year at a level between 800 and 900 (Source: djindexes.com, Jan. 2005), so the DJIA-to-gold ratio in 1980 was roughly 1:1. Remarkably, the price of an ounce of gold would buy up the entire Dow Index. Over the next 25 years the Dow went up and gold declined to the point that today an ounce of gold only buys 1/25th or 4% of the index.

The fact of the matter is that the stock market and gold tend to move in opposite directions over the long term. When gold peaks, the stock market is bottoming, like in 1980. Today we have the opposite situation. This cycle has repeated itself many times in history and it is doing so again today:

Period Ratio of DJIA-to-Gold 1929 (August) 18.44 1933 (February) 1.95 1966 (January) 28.00 1980 (June 1.33 1999 (August) 42.35 Today (Dec. 31, 2004) 24.61 Table 5*

*(Source: Newmont Mining “Gold: Back to the Future”, presented to the San Francisco Gold and Precious Metals Conference, Nov. 29, 2004)

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Here is the same information represented graphically:

prudentbear.com Dow to Gold Dow Jones Industrials divided by Gold Price 1920 - 2004 $40.00

$35.00 Stock mania

$30.00 Aug. '04 $25.00 Stock $20.00

$15.00

$10.00

$5.00 Gold mania $0.00 1920 1928 1936 1944 1952 1960 1968 1976 1984 1992 2000

Source: PrudentBear.com, “Why the Bear Market Chart 1 is Not Over”, Sept, 2004 (reproduced with permission)

What the graph and the chart tell you is that at the great stock market peaks in 1929, 1966 and 1999, each of which presaged a big, multi-year decline, the Dow Index was very expensive relative to gold. From these lofty levels, as the stock market started to decline, gold rose and they did not stop their respective trends until the Dow and gold were close to parity. The most recent peak occurred in 1999 when the Dow was valued at a massive 42 times as much as an ounce of gold, a historical record. Since then it has been trending towards parity.

Twice in the last 75 years the ratio has reached under 2:1. If the Dow stays where it is, gold would have to rally to over $5,000/oz to get the ratio back to 2:1. If the Dow falls by half, gold would have to rally to over $2,600/oz. Will it happen? No one has the answer but those who are dismissive of these scenarios are also discounting historical precedent, as illustrated above in Table 5 and Chart 1.

2. THE FAIR VALUE OF AN OUNCE OF GOLD

Paul van Eeden, Managing Director of Cranberry Capital, in late 2003 produced a very elegant solution to the question of what the fair value of gold should be in U.S. dollars today. If you are so inclined, that essay can be found at

http://www.goldmoney.com/en/commentary/2003-11-26.html

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To save you the effort, the basic conclusion is that gold was fairly valued at US$35 per ounce in 1947 and that today, adjusting for inflation, it should be around $800 per ounce.

If this is true, it makes gold a huge bargain today. My thesis, however, goes back to our pendulum analogy. First of all, by the time gold reaches $800/oz, its fair value will likely have climbed higher still because inflation is accelerating every day. Secondly, it will not stop appreciating when it reaches fair value. Instead it will likely go well beyond fair value (whether that be $800 or $1,000 or higher) before reaching its eventual peak.

Pierre Lassonde, President of the world’s largest gold producer Newmont Mining, openly predicted at the November 2004 San Francisco Gold and Precious Metals Conference that he expected gold to reach four figures in 5-8 years (2009-2012). This would represent a return of 130% in 5-8 years. Not bad until you consider the leverage of gold mining stocks to the price of gold is 4-5 times (Source: Adam Hamilton, Zeal LLC). In other words, if gold goes up 130%, gold mining companies would go up 650-780%.

Richard Russell has been writing the Dow Theory Letter for over 40 years. He was very bearish on gold in 1980, accurately calling for a 20-year bear market. He also called both the bottom of the stock market in 1981 and the top in 1999. According to Russell, his best guess is that gold will reach US$3,000/oz. Going back to our Dow-to-Gold ratio, at 2:1 this would mean that the Dow would decline to around 6,000, a 35% drop from year- end 2004 levels. This is perfectly in sync with historical precedent.

3. THE OIL: GOLD RATIO

For the entire period of 1946 to 2000, an ounce of gold has been worth roughly 15 times as much as a barrel of oil (Source: Adam Hamilton, Zeal LLC). More recent history suggests that gold has been gaining value against oil, pushing this ratio higher. Until recently, that is. As is well known, the price of oil skyrocketed in 2004, reaching over US$55 per barrel. After a correction, it entered 2005 in the mid-$40s. Oil at $45-55 per barrel equates to gold at $675 – 935 per ounce, if you go by the last half-century. This is quite consistent with the previous section where we derived a fair value of gold of US$800/oz based on inflation and provides further support for the thesis that gold is severely undervalued.

Of course, you can also re-establish the long-term relationship between gold and oil by having oil drop back to $25 per barrel. In the next section on commodities, you’ll see why a drop in oil of this magnitude is unlikely.

For now, dealing with the price of gold, we need to ask why gold has lagged the increases in the price of oil. Despite gold’s sterling performance since 2001, oil has done even better. No one knows the answer for certain. However, the simple explanation is that the oil market is far too large to manipulate, whereas the gold market is relatively small and the gold price has been under severe attack for several years now. The concept of gold as sound money is anathema to central banks around the world. For them a rising gold price

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is an obvious warning signal that their efforts to print money and manage economies without igniting accelerating inflation have been unsuccessful. It has thus been in their best interests to suppress the price of gold. Although the topic of gold price manipulation is beyond the scope of this report, it is well documented on the website of the Gold Anti- Trust Action: www.GATA.org.

Far from being a bad thing, however, this suppression in gold prices has given us a fantastic opportunity to accumulate precious metals at extreme bargain prices. A rising oil price is another powerful indicator that the direction for the price of gold is up.

4. THE GOLD: SILVER RATIO

What about the forgotten precious metal, silver? The gold: silver ratio as it occurs in the earth’s crust is 17.5:1*. Not coincidentally, their respective prices have spent much of the last 200+ years in that range*. The ratio today is around 60:1. For silver to revert back to 1/17th the price of gold today, it would have to more than triple in price. *(Source: “The Gold/Silver Ratio Strategy & the Case for Silver”, March 5, 2003)

As with gold, you can buy either physical silver bullion or silver mining stocks. Like gold, the gains in mining shares will be a multiple of the gains in the bullion price itself.

So, to summarize, the price of oil has risen strongly. The price of gold is historically very cheap relative to oil. The price of silver is historically very cheap relative to gold. The fundamentals for silver, in terms of supply and demand, are very bullish, superior even to those of gold. Annual demand is far outstripping supply and the difference is being made up from selling the decades-old stockpiles held by the U.S. and Chinese governments, among others, which are dwindling as we speak.

This makes the price of silver absurdly cheap and the appreciation potential of silver mining companies absolutely stunning. Of all the commodities in the world that I can think of, silver probably is the least interesting to most investors but has, by far, the biggest potential.

WHAT TO BUY #2 - COMMODITIES

“Once a long-term trend is broken, it is replaced by another trend…At such milestones in financial history, the rules of the investment game are altered; but alas, the vast majority of investors continue to play by the old rules and therefore either lose money or miss out on the substantial capital gains which the new opportunity of leadership brings about…I suppose that one reason the road to ruin is broad is to accommodate the great amount travel in that direction…The key to successful investing is to understand that, with nearly 100% certainty, the bursting of a bubble leads to a permanent change in leadership.” - Jim Puplava, “Trading Places”, October 29, 2004

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Of course Puplava is referring to the change in leadership from financial assets and technology to hard assets like precious metals and commodities.

In the fall of 2003 I attended a small gathering of industry professionals in Toronto, who were there to hear Jim Rogers’ thoughts on investing. This was well before the recent run in oil prices. [In case you do not know him, Jim Rogers, after graduating first in his class at Oxford, co-founded one of the earliest hedge funds with George Soros in 1968. It was called the Quantum fund and, 12 years later at the ripe old age of 37, Rogers retired with enough money to pursue a life long craving for adventure. He subsequently circled the globe twice, most recently returning in 2002. His adventures were viewed through the lens of a self-made investor and his conclusions have proven to be astoundingly profitable.] Following that meeting, I spoke with Rogers one-on-one and he asserted, unequivocally, that he was “wildly bullish on commodities”. He has, thus far, been proven absolutely correct. So, more than a year later, what has Rogers got to say?

“The current bull market in commodities started in 1999, and if you go back in history, the shortest bull-market period was 15 years and the longest was 23 years. Most commodities like sugar and coffee remain at low prices. Even oil, adjusted for inflation, remains 50% below its all time high.”

In other words there is still a long way to go and a lot of money to be made in this commodity bull market.

Always remember the pendulum analogy. In 1980, it was at one extreme of its arc – commodities dominated the index and Business Week proclaimed the “Death of Equities” loudly on its cover (Source: Business Week Magazine, Aug. 13, 1979). Business Week and the typical investor were, as usual, looking in the rearview mirror to figure out what to invest in at that point.

Note the composition of the S&P 500 Index over the last 25 years:

Percentage of the S&P 500 Index 1980 1990 2000 2004 Basic Materials + Energy 38.99% 22.92% 9.58% 11.28% Technology + Financials 17.77% 16.79% 48.09% 39.69% Source: Jim Puplava, “Trading Places”, October 29, 2004 Table 6

As you can see, tangibles were a huge part of the index in 1980, their valuations reflecting the end of the very inflationary and tumultuous 1970s. The technology and banking sector was much smaller. At the peak of the market in 2000, the exact opposite was true. Oil, gas, base metals, precious metals etc. were no longer of any importance to investors, shrinking to one-quarter of their 1980 peak, while technology and financials had grown three-fold to dominate indices.

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Today it’s financial assets that are shrinking in their share of the index while commodities are growing. I believe that it will not reverse again until the commodities and precious metals complex are again a dominant component of the overall market. This will happen at the expense of the financial assets that most investors are still focused upon today. Critically, even though these trends are well established and almost 5 years old now, people still either don’t believe it’s happening or are simply unaware.

If you compare the year 2000 to 2004 in Table 6 above, you can clearly see that the trend away from commodities that started 25 years ago has now stopped and reversed. It likely has a long way to go.

There are two powerful forces driving commodity prices.

SUPPLY AND DEMAND

Right now we have an incredible confluence of events. First of all, the overheated commodity prices of the late 70s precipitated a long and very large correction in that sector. Very little investment in raw materials was made over the last 25 years. Not much new gold, oil, lead, uranium etc. was found and very few mines were built. No money was being invested in these areas because commodity prices were so low. However, a rapidly expanding global economy ensured that stockpiles were depleted and mines were stripped. In part, cheap prices for a variety of raw materials were what fueled world economic growth through the 80s and 90s.

The net result is that mines were gradually sucked dry and facilities were not maintained and fell into disrepair. In the words of Jim Rogers, when was the last time you read about a new lead mine in the business press? And yet, lead is used in many applications, not the least of which is car batteries. So the first factor is that you have a very restricted supply infrastructure. It takes years and huge amounts of money to build an oil refinery or a gold mine and ramp it up to meet new demand.

The second factor is the emergence of India, China, South Korea (and other Asian nations) and their voracious appetite for raw materials. These countries will certainly have their problems as they battle their way to full industrialized status but their growth is a major force that will be years in the making. They are emerging as great competitors to the world’s industrialized nations for the planet’s raw materials.

When you have limited supply capacity and rapidly increasing demand, the inevitable result is higher prices.

INFLATION

We have already discussed the emergence of higher inflation. This eventually manifests itself as higher commodity prices. When money is rapidly losing its value due to inflation, people try to get rid of it as fast as they can. The obvious targets are things of

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tangible value that can be consumed or used as a store of wealth; things that have utility and that will still be there no matter how bad things become.

The most obvious example is when people lose confidence in a currency, which has happened, not hundreds, but literally thousands of times in history. If your money is losing value at a rate of 5% or 10% per annum, let alone 60% per year like Turkey today or a complete meltdown like we just had in Argentina, you simply cannot get your money out of that currency fast enough. Gold is the ultimate save haven from these panics, but so too is anything that has real, intrinsic value.

CONCLUSION

The evidence overwhelmingly points to a continued, lengthy bull market in precious metals and commodities. The investment establishment has traditionally viewed these assets as carrying above-average risk. I would suggest, however, that it is more risky not to invest at least a portion of your portfolio in this area. This is especially true of gold. If everything you own is denominated in paper assets, then you have very little protection against inflation and a decline in the price of financial assets.

Referring to the fact that we may yet again see the level of the Dow Index and the price of an ounce of gold at the same level, Nick Barisheff (again in his aforementioned speech to the Toronto Club) ponders at what price that might happen – with gold at $1,000, $2,000 or perhaps $5,000? He continues:

“As far-fetched as these possibilities may sound today, they may in fact come to pass. In 1989, investors would have found it hard to imagine the 80% decline in Japanese equities that ensued over the next 13 years. Equally difficult to foresee in the early 80’s, when the NASDAQ was 400, was its rise to 5000. In 1971, when gold was $35 an ounce, no one imagined the 23-fold increase that gold would experience over the next nine years.”

In other words, prices gains that may seem absurd today are absolutely possible. Although Barisheff is referring specifically to precious metals, the same is true for the entire spectrum of commodities.

If these events come to pass, and you have even a modest allocation to these contrarian assets in your portfolio, it could make all the difference in the world. If you decide to have more than a modest allocation, it could prove to be a seminal decision that creates wealth that lasts a lifetime.

To find out more about how to take advantage of the opportunities, please contact me at any of the numbers below. I also offer a complimentary review for your existing portfolio, with no obligation.

I wish you and your family good health and successful investing.

The Liokossis Letter, Special Report, 2005 19

1. This third party publication is not prepared or approved by BMO Nesbitt Burns Inc. and BMO Nesbitt Burns Ltee/Ltd. (“BMO Nesbitt Burns”) and therefore may not meet Canadian research disclosure requirements applicable to BMO Nesbitt Burns. The opinions, estimates and projections contained in the publication are those of the author as of the date indicated and are subject to change without notice. BMO Nesbitt Burns makes no representation or warranty, express or implied, in respect thereof, takes no responsibility for any errors or omissions which may be contained therein and accepts no liability whatsoever for any loss arising from any use of or reliance on the report or its contents. The provision of this publication is not to be construed as an offer to sell or a solicitation for or an offer to buy any securities. BMO Nesbitt Burns or its affiliates may buy from or sell to customers the securities of issuers mentioned in this publication on a principal basis. BMO Nesbitt Burns, its affiliates and/or their respective officers, directors or employees may from time to time acquire, hold or sell securities of issuers mentioned in the publication, related securities, or options, futures or other derivative instruments based thereon. BMO Nesbitt Burns may act as financial advisor and/or underwriter for certain of the issuers mentioned therein and may receive remuneration for same. BMO Nesbitt Burns is a wholly owned subsidiary of BMO Nesbitt Burns Corporation Limited, which is an indirect wholly-owned subsidiary of Bank of Montreal. Bank of Montreal or its affiliates may have lending arrangements with, or provide other remunerated services to, the issuers mentioned herein. The reader should assume that BMO Nesbitt Burns or its affiliates may have a conflict of interest and should not rely solely on this publication in evaluating whether or not to buy or sell securities of issuers discussed herein.

Tony Liokossis, Investment Advisor BMO Nesbitt Burns ph (519) 646-2305 One London Place toll free (800) 265-4195 1900-255 Queens Ave facsimile (519) 679-8848 London, ON N6A 5R8

[email protected] www.bmonesbittburns.com

THE LIOKOSSIS LETTER The opinions, estimates and projections contained herein are those of the author as of the date hereof and are subject to change without notice and may not reflect those of BMO Nesbitt Burns Inc. (“BMO NBI”). Every effort has been made to ensure that the contents have been compiled or derived from sources believed to be reliable and contain information and opinions which are accurate and complete. However, neither the author nor BMO NBI makes any representation or warranty, express or implied, in respect thereof, takes any responsibility for any errors or omissions which may be contained herein or accepts any liability whatsoever for any loss arising from any use of or reliance on this report or its contents. Information may be available to BMO NBI which is not reflected herein. This report is not to be construed as an offer to sell or a solicitation for or an offer to buy any securities. BMO NBI, its affiliates and/or their respective officers, directors or employees may from time to time acquire, hold or sell securities mentioned herein as principal or agent. BMO NBI may act as financial advisor and/or underwriter for certain of the corporations mentioned herein and may receive remuneration for same. BMO NBI is a wholly owned subsidiary of BMO Nesbitt Burns Corporation Limited which is an indirect majority-owned subsidiary of Bank of Montreal. To U.S. Residents: BMO Nesbitt Burns Corp. and/or BMO Nesbitt Burns Securities Ltd., affiliates of BMO NBI, accept responsibility for the contents herein, subject to the terms as set out above. Any U.S. person wishing to effect transactions in any security discussed herein should do so through BMO Nesbitt Burns Corp. and/or BMO Nesbitt Burns Securities Ltd.

The Liokossis Letter, Special Report, 2005