My Annual Report Card for 2003

The Lady Writing A Letter With Her Maid
Johannes Vermeer - 1670 - Oil on Panel - National Gallery of Ireland, Dublin

“The longing for security moves us all; the commodity itself proves elusive.

Alas the quest for security is too often shaped by illusions constrained by

fears and pursued within limits which exist only in our minds. Living carefully,

cautiously, prudently yields only the illusions of security, never the reality.”

Rev. Elly Bradley, United Church Minister

Johannes Vermeer was one of the greatest Dutch painters of the 17^th century. Today his creations demand large amounts of dollars, euros or yen but like a good painting there is also such a thing as a good investment. Not all paintings are worth the same as Johannes Vermeer paintings are. The same applies to investments of the paper kind. Some are terrible, as we have seen during the biggest stock market bubble and mania in history, some are mediocre and others are just excellent because they are in harmony with the underlying fundamentals.

The key is to be able to identify such an investment or sector realizing that it is in a long-term bull market and then an advisor must have the discipline to just sit and let it ride until it is time to take some money off the table or exit the sector(s) entirely. One would think that this would be an easy task to accomplish. Not so. Financial markets and sectors can turn on a dime and humble an advisor. Therefore one has to be ever vigilant and cognizant of global economics, macro and micro, monetary policy and other underlying fundamentals, which move the financial markets.

The myth of the populist stock market

In a recent article in The Christian Science Monitor David Callahan wrote:

“Stock market gains have reflected the top-heavy ownership patterns. Between 1989 and 1997, the most recent year for which there is good data, 86 percent of stock market gains went to just the top 10% of households. Yet when the market tanked, it was often ordinary investors who felt the sharpest pain – pain that many will cope with well into retirement. Investors on Main Street think good times are here again. Yet amid signs of a returning bull market, there is plenty of evidence that Wall Street has not fully mended its ways. In this climate, the most important asset for any smart investor is a long memory.”

All That Glitters May Just Be Gold Again and Canadian Resources

Maybe I got lucky again for the fourth year in a row. Of course, there’s more to it than just “luck.”

My philosophy and strategy past, present and future....

In the often-misleading vocabulary of the fund business, my strategy is not based on allocation in specialty funds such as ‘growth fund’ or ‘value fund’ or an ‘index fund’. Therefore my strategy does not have a fancy description. In reality, I have merely been aiming at the preservation of your capital which was entrusted to me in a manner not dissimilar to that of a wise man looking after his fortune - entirely uninterested in what anyone else is doing. Alas, capital preservation of purchasing power is far more difficult in practice than the words seem to suggest. In order to understand the quality of investment results, it is important to look beyond the unqualified presentation of its numerical performance. When someone tells you proudly of his returns, you must question him closely as to the risks he ran in achieving them. It is one thing to earn $1 and quite another to earn $100 by betting $100 at the game of roulette. In each case, the outcome might be the same, but both the chances of success and the consequences of failure - i.e. the risks - could not have been more different.

In yet another way, compare the case of a gold jeweller working on a commission from a familiar and creditworthy customer, with that of a lone prospector, pick-axe in hand, leading his mule up a rocky trail into the bandit-ridden high country. Now ask yourself: who took more risk to make a profit from the possession of a few ounces of gold? Despite the obvious satisfaction, which would accrue to all in comparing our results to the general markets, I will not do so. Competition with others is not my game. Wall Street and Bay Street choose to measure returns (whether positive or negative) relative to one’s peers rather than in absolute terms. In my view, the practice could not be any more dishonest than that of relying on luck. Where I stand: it would be inappropriate and disingenuous to make any forecasts. In short, I view the economic environment at best as anaemic and view risks to capital missing out in some ‘imminent’ stock market rally.

Although I do practice ‘sector allocation’ it is only put into practice when one or more sectors are in harmony with the underlying fundamentals. You will not hear me proudly talking of ‘beating the index’, while losing my clients’ money, or intoning that I should ‘dollar cost average’, or ‘buy and hold’. Regardless of trends or the noise that surrounds me, the only thing I seek is under-esteemed value and the only thing I will hold fast to are my principles, eschewing all fads and talk of new ‘metrics’ or ‘paradigms’. My methodology, though difficult in execution, is simple to enunciate. It is as follows: Firstly I prefer to hold what is least risky - or, conversely, what seems to be the most safe - whatever form that holding takes and wherever in the world it may be found. Simple as it may sound, it isn’t. It requires that I have a sound understanding of the macroeconomic forces that are shaping our world and the courage to do what is right rather than what sells or what the herd is following. Doing this I will best be able to preserve the sacred capital which I manage - the most important of all duties - while using it to support the needs of its owners where possible, and, perhaps, of returning more talents than those with which I was first entrusted. My aim is stewardship - not speculation.

Sector-Allocation

A financial planner or broker should have the courage to advise clients to be invested in sectors which are either friendly to the underlying fundamentals, or exit the market when it becomes obviously overpriced. An advisor's job is to temper the herd mentality, to move you into a safer sector-allocation model. Traditional asset allocation is a simplistic notion of handling the market. An investor should remain content to sit in cash or in fundamentals-friendly sectors.

Now that 2003 is behind us and the performance of all mutual funds is public knowledge let’s have a look at the sectors, which have generated excellent returns for mutual fund investors. Although these returns are exemplary in a secular bear market these are only 2003 – One Year Returns and when spread over 3 years the majority of asset classes post either lack-lustre or minus returns. On average I must assume that mutual fund investors have not recovered their losses, which were first inflicted upon their portfolios in March 2000. Average mutual fund sector returns were as follows;

Average Annual Returns

Asset Class	1 Year (2003)	3 Years

Asia ex-Japan	23.2%	-0.9%
Canadian Balanced	11.5%	1.5%
Canadian Bond	5.4%	6.0%
Canadian Dividend	18.1%	6.2%
Canadian Equity	20.6%	1.1%
Canadian Income Trusts	25.0%	15.4%
Canadian Small Cap	31.2%	9.4%
Emerging Markets	29.1%	4.2%
European Equity	12.8%	-9.9%
Financial Services	18.1%	-1.8%
Global Equity	12.8%	-7.6%
International Equity	13.5%	-9.4%
Japanese Equity	19.5%	-9.7%
Natural Resources	34.2%	16.7%
Precious Metals	38.8%	48.6%
Science & Technology	26.5%	21.1%
U.S. Equity	8.9%	-10.4%

Because of our over-weighting in Precious Metals Funds and Canadian Natural Resources Funds, my clients’ accounts on average increased last year by:

2003 Average Client Account Increased + 34%

November 1, 1999, to December 31, 2003 (50 months) Total Return: +110%

*NOTE: Individual client returns may differ slightly according to your age and risk-tolerance levels.

PLEASE always remember that our past performance is no guarantee of future performance results.

The following are a cross-section of the funds held in my clients’ accounts with the fund’s % returns for 2003:

AGF Canadian Bond Fund	5.05%	Dynamic Global Precious Metals	71.70%
AGF Canadian Large Cap Fund	21.01%	Guardian Monthly High Income	32.67%
AGF Canadian Resources Fund	43.26%	Mackenzie Growth Fund	23.23%
AGF Precious Metals Fund	64.45%	Mackenzie Maxxum Dividend Growth	15.31%
AGF Japan Fund	13.46%	Mackenzie Sentinel Bond Fund	5.04%
AIM Trimark Canadian Resources	38.56%	Mackenzie Univ. Cdn. Resources	43.76%
CI Global Energy	23.81%	Mackenzie Univ. Precious Metals	30.78%
CI Signature Canadian Resources	34.82%	Mackenzie Univ. Select Japan Mgr	25.60%
CI Signature High Income	22.65%	Sprott Canadian Equity Fund	30.04%
Dynamic Canadian Precious Metals	52.33%	Sprott Gold & Precious Minerals	72.43%
Dynamic Focus Plus Div. Inc. Trust	29.06%	Sentry Select Canadian Income	34.38%
Dynamic Focus Plus Resources	42.56%

Summary: I do not make bold predictions and neither do I compete with my peers. My track record speaks for itself. For 2004 I will continue on our disciplined path by being over-weighted in those sectors which offer the greatest amount of defensive safety and best possible return prospects

And, I promise to continue to adhere to Warren Buffett’s Two Cardinal Rules of Investing:

Rule No. 1 – Never lose money

And

Rule No.2 Never forget Rule No.1

My most sincere thanks go to Edmund (Ed) Bugos of Vancouver for his excellent analytical work and brilliant essays.

Also to Alan M. Newman of Longboat Global Advisors in New York. http://wwwcrosscurrents.net

The excellent work these gentlemen share with me is imperative and pivotal to the strategies I have followed

There are several others who with their brilliant work, articles and essays have helped me in formulating a “safety first” investment strategy. Thank you: Doug Noland, Marshall Auerback, Bill Fleckenstein and David Chapman.

The biggest “thank you” goes to you, my clients for your continued confidence, trust and the privilege that you have extended to me to be your financial well-being advisor.

Yours truly,

Hans Merkelbach

Following is an analytical prognosis by my brilliant friend Edmund J. Bugos entitled:

2004, A Time Out Ahead
By Edmond J. Bugos

I am honored, having been asked by Hans to write a short blurb about my outlook this year. Let me say first that a good understanding of markets, often elusive to begin with, is only half the battle. The other half is guessing right. Nothing is certain after all. Nothing.

Uncertainty, though, is not the same as risk.

Risk is calculable, and even avoidable as a result. Uncertainty isn’t. We all live with it, and we’re all forced to make our best guess in light of it. Scientists make guesses. So do portfolio managers. The difference between the winners and losers is often determined by which are marginally better guessers than the rest.

Still, an educated guess is different from a blind gamble. Speculation is not gambling. It is an inevitability in the business of managing money, because all assets are valued by individuals according to their outlooks for the future – none of which is certain. Yes, we adhere to the value approach to investing. But it is not enough to look at value in the context of the past.

Many practitioners of so-called value investing (so-called because all investing is value investing) delude themselves if they exclude from their assessment of an asset’s value what may or may not happen in the future, or even if they just mechanistically extrapolate the past into the future. For, that is not value investing. It is only the necessary beginning.

Many investors, having looked at gold stocks in 2002, concluded that they were too expensive relative to the rest of the market, because some of these stocks traded at 40 or 50 times earnings. Of course, we could argue that gold stocks are valued differently, or that the PE ratio is not relevant at all today. In both cases, while true, it is beside the point.

Markets tend to factor the sum of investors’ individual outlooks for the future, which means – in the mining business – that if gold stocks trade at 20 times cashflows instead of their average (12 to 15 times cashflows), the market is obviously expecting gold prices to rise. In this example, we could say it expects gold prices to rise enough such that the average gold producer is going to see a 33.33% increase in cashflows. Gold prices need not rise 30% for this to happen. Maybe 10% is enough.

To illustrate my point on value, consider that today gold prices are trading at just over $400, and the market is pricing gold stocks as though gold were trading at $450 to $500. The investor who believes gold will never surpass $450, or is likely to fall in value naturally will conclude that gold stocks trading at 20 times expected cash flows, or more, are expensive. On the other hand, the investor believing that gold is going to $500, $600, or ultimately $2000 is absolutely correct to argue that gold stocks are cheap if all that the market has factored into their prices is $450.

This is what makes markets. If everyone always agreed, there’d be no liquidity. Of course, that is impossible in the first place, because if everyone agreed the market would simply move to where there was more balance, or towards equilibrium as academics like to say.

We are of the conviction that gold prices are headed towards new all time highs. My personal belief is that gold will surpass $2,000 an ounce sometime this decade.

Although that might sound somewhat extreme, it seemed more so when we first said it four years ago as gold prices were flirting with $255, and most everyone thought they would fall to under $200… even some of those that were bullish in the long term felt this way at the time.

Since 2000, however, gold prices have surged more than 60% from trough to their recent peak at $428. The leading gold share index (AMEX Gold Bugs) has surged an astounding 600% since late 2001 when the Bull Run began. By contrast, the XAU is up only 165% in that period, while the Johannesburg gold share index is up 240%. Most (bullish) gold share investors have at least doubled their money over the past few years. This has occurred amidst a general bear market in the broader equity hemispheres – one that is increasingly challenged – and a 30% drop in the value of the international reserve currency, the US dollar… the world’s current, but bad money!

Precious metals mutual funds have been among the best performing funds of the market for three years running now. Even in 2003, a year when the Dow Industrials roared back 25%, gold shares outperformed most everything but the most speculative technology and foreign country funds.

This gold bull is hot. But now comes a time for many investors to make a decision in their investment strategy. Nothing goes straight up, or straight down.

And doing nothing also involves a decision. It could well be the best decision.

For, in light of our long-term view of the gold market, gold stocks are still cheap today. However, gold stock corrections – when they come – can be steep, particularly at the early stages of a developing bull market. We expect reversals in many markets during 2004, and consequently, an interruption to the gold share bull market sometime after the first quarter or maybe sooner.

Specifically, our outlook for most of the main global stock market averages is that the bear market will reassert itself this year. Our outlook for interest rates is that they will go higher as bond prices “initiate” their own bear market. We expect the US dollar to fall further (our target is 78 for the US dollar trade-weighted index – which is about 10% lower than today and near a two decade low), but to start a bear market rally soon afterwards nearing the climax of the US election this year.

As the US dollar index falls to its early nineties’ lows, we expect gold prices to peak at between $450 and $475 in 2004, then to hibernate until after the election when the related motivations behind supporting the US dollar diminish, and when the central bank rhetoric surrounding the new Washington accord have had their desired effect this spring/summer.

Although it is true that gold stocks typically trade inversely to the broader stock market, and in the same direction as gold, it is truest in theory. In practice, it doesn’t always work that way. For instance, since April 2003, gold stocks and the Dow have soared in tandem. And since November gold has continued higher without gold stocks.

Consequently, and in harmony with our other outlooks above, our view is less sanguine for the performance of gold shares in 2004 “overall” (particularly for the HUI) than it has been over the past 3 years, and than it is for the years immediately following 2004 and beyond. In other words, the gold bull market’s confidence will see a gut-wrenching test this year. If we’re right, many investors will throw in the towel in the last inning. Investors with a bullish long-term outlook and lots of Tums are right to sit tight.

But for those who try to maximize their performance annually and are fully invested in the precious metals sectors today, building a small cash reserve couldn’t hurt. In our view, 2004 is going to be the year that all stocks and bonds fall in value, and the question of outperformance is left to the consideration of which sectors will fall least… aside from cash and certain commodities.

In this sense, the precious metals, and resource stocks are still the best bet. In fact, our outlook comes down to this. This year’s correction may well be the last good buying opportunity for many years to come.

Ed Bugos
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Ed Bugos is the editor of The Goldenbar Report (www.goldenbar.com), a gold and currency newsletter covering the global equity, commodity, bond, and currency markets for investors seeking investment and trading opportunities across a wider spectrum of assets than just equities - with a focus on gold and the US dollar.

The Goldenbar Report is not a registered advisory service and does not give investment advice. Our comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. While we believe our statements to be true, they always depend on the reliability of our own credible sources.