4^th Quarter

The fourth quarter saw a recovery from the lows at the end of September in many markets. Our US Growth Strategy recovered from depressed levels; our US Value strategy also recovered and showed a respectable performance for the year. And our select increases in gold exposure have paid off so far.

The falling dollar has dampened the recovery impact for European based investors. Our European Value strategy had a setback late in the year as a court ruling put a tender offer related to Degussa shares in Germany in jeopardy.

The American consumer is hesitant. Late last year, Americans for the first time in a long time slightly reduced their debt levels. i.e. the consumer put some money into the bank account rather than spend it. This is a double edged sword: on the one hand, US consumers have too much debt, and must reduce their debt level in order not to collapse when interest rates start to rise again. On the other hand, we continue to have very high production capacities around the world (producing products to be sold to consumers), which require further adjustment. And maybe most importantly, sustainable economic growth must come from investment, not consumer spending. The question is, whether such investments will take place in an environment where we are told every day that we are at war, where the trust into corporate America has been tainted by scandals. Such investments must be made to increase productivity and efficiency.

The beneficiaries of this economic environment may be high technology firms who help firms to improve their efficiencies. High technology firms have seen a very tough environment as businesses and consumers have not spent much money; on the other hand, businesses realize that they must invest if they are to have a chance at being profitable in this environment; many of them have postponed purchased already too long. And many high technolgy firms have proven that they can adjust their costs to the current economic environment.

Many US high technology firms, but also many large US corporations such as those we hold in our US Value strategy derive a significant portion of their income from outside the US; this income will translate to higher US dollar earnings. As a result, we expect higher share prices for these firms should the dollar weaken further, giving a welcome buffer.

The Bush administration has proposed to eliminate the double taxation of dividends to US residents; please see the separate discussion on this topic which is a bit technical. It is unclear whether and how this tax cut is going to be realised at this stage. Overall, stocks, in particular dividend paying value stocks, should profit. It should be cautioned, however, that the plan contains many fine points that may actually discourage companies from paying dividends – if these fine points are implemented, we would see it as a major missed opportunity.

Germany has proposed to change the way it taxes dividends after reforming dividend taxation not too long ago, which should result in a lower tax burden on individuals in a high tax bracket. This is a welcome relief in Germany, which is suffering from what seems to become never ending economic weakness; the rise in the Euro combined with a timid US consumer makes it all the more difficult for European corporations. The high cyclicality of the German economy, together with the further opening up of Eastern Europe should have a medium term positive impact.

In recent months, the dollar has fallen significantly. Aside from a reflection of the current US economy and the less friendly investment climate, it is a direct result of US monetary policy to inject money into the economy. The US is very determined to fight off deflation and is determined to succeed; however, the price is very high: a lower dollar, and an economy that might run faster than it should to heal itself of the excesses of the past. The result will be higher long-term interest rates, which in turn will hurt corporations trying to issue debt, but also consumers with high mortgages. The situation is made more complex as other countries also want to devalue their currencies – only Europe has not yet jumped on the bandwagon. The winner in this dangerous game is gold as a neutral currency.

There are many cross-currents in today’s environment. We will monitor them closely and adapt our portfolios as we see the scenarios unfold.

Please contact us with any questions.

Axel Merk
Merk Investments