Leuthold: Right now, I think the best thing the market has going for it is, the economy is still pretty sound and still pretty strong. Even though you may see the economy typically back off a little bit in the first year of the new presidential term, half of one percent of the GDP or something like that, it’s nothing terribly serious, but we have to remember, too, that this economic expansion is now about three years old. All the economic expansions that we see aren’t the long, drawn-out ones like we’ve seen the last two times around where we saw eight to ten years of expansion. If we take the average economic expansion or the median going back to World War II, it’s only about three and a half years. Unless this is one of those long, drawn-out economic expansions, we kind of have to be pretty cautious going into 2005. The market typically will peak out before the economy, anywhere from six to seven months. I think 2005 could be a troublesome year. What we’ve got going for us, which I think is constructive in terms of this expansion, is that the rate of the expansion has been relatively modest by historical standards. That may end up making this a longer expansion than we otherwise might see with the typical economic expansion. I think, though, the whole message here is, we may be a little cautious about 2005.

Even though we had the market’s obvious favorite win the presidency, the economy, by normal standards, is getting a little bit long in the tooth. The work we do, in trying to analyze the market from all different angles is still mildly on the positive side, but we have had a couple of weeks where we had retreated to neutral with this work. Right now, as we finished doing our latest analysis, we were still on the positive side of the margin. Positives to negatives are about 1.1 to 1. On an intrinsic value basis, if we’re taking a look at all the fundamental comparisons with history, the market, although it isn’t extremely overvalued, is certainly somewhat overvalued. It is not a cheap market from a valuation perspective in any sense of the word. In the economic work we perform, I think we’re concerned more than anything else about a pickup in inflation. We view inflation as being kind of a special factor. It’s something that we really have to keep a close eye on, especially concerning oil and some other commodities. In terms of the attitudinal work, we come from a contrarian standpoint. If we look at things like the market survey of investor attitudes or the American Association of Individual Investors, or even market letter writers, the bullishness has certainly returned. If you look at the mutual fund inflows, we’ve certainly seen a big pickup in inflows. I’m not terribly comfortable going into 2005 with so many people having very recently shifted to the bullish side, and the market being overbought. We’re approaching this next year as being somewhat cautious. The cyclical run of this market from the lows a couple of years ago is also kind of old in terms of normal cyclical bull markets. I think 2005 is going to be a tricky, difficult year. 2004 was bad enough, but 2005 might even be a little harder to navigate in.

LEUTHOLD: That’s right.

Leuthold: Well, it might, but, I mean, to get to a neutral stance, I think the Fed would have to raise short-term rates up to maybe three, three and a half percent. So there is still some room from here since we are only at two percent. Actually, now that short rates are continuing to edge up a bit, I think it is further confirmation that the economy is staying healthy. We’d actually view a mild uptick as much as say, even a hundred basis points, from here in short rates, as being somewhat bullish, because it is indicative of underlying economic strength.

Leuthold: Yes, bullish for stocks. This is the first time in 22 years, 23 years in the business that we have not owned any bonds whatsoever. We have looked at the risk-reward in bonds and we just can’t find anything that’s attractive. The last ones we had were the high-yield bonds, but now the spreads are too narrow there when you consider the risk. We’ve looked at some foreign bonds in the past. We at times have owned Canadian bonds and New Zealand bonds which was partly a currency play but those currencies have moved up quite sharply. We are supposed to be running a flexible account. Normally we would have a minimum of 30% in bonds, but for the first time in long, long time, we don’t own any because we think there’s more downside risk than there is upside potential both over the next six months and twelve months. In fact, Morningstar was going to reclassify us out of their moderate asset allocation category because we didn’t own any bonds and in fact they did reclassify us momentarily. We had to explain to the analyst at Morningstar why we didn’t own any and send them a few risk-reward charts and so on and so forth. It’s really hard to find a proxy for fixed income. About all you can find is 5.5%, 5.25% yield on high-yield utility common stock. We do have about 10% of that. But it is difficult, as you well know, to find any income generation in this area that is what you’d view as a minimal risk or a low-risk situation.

Leuthold: We have. Right now, I think you’re probably going to see rates edge higher pretty much both in Asia and in Europe. We’ve already seen them up in the UK. I’m a little wary of the number of closed-end funds, because so many of them have a leverage component in them to jack the yields up. When I look at fixed income, I’m trying to find safety and a decent return. We just can’t find much of that around lately.

Leuthold: At this point, I really don’t find the TIPS very attractive. I think the CPI, first of all, understates the true inflation that we’ll be experiencing. If you see rates rise 100 basis points, you’re going to lose money on the TIPS, also.

Leuthold: We are short some 10-year and some 20-year Treasury zero bonds. It hasn’t paid off much yet. We made a little money this month, but not very much. This is also a very unusual posture for us in what’s supposed to be a conservative portfolio, but when we look at the risk and reward in fixed income, this holding makes a lot of sense to us. We have about an 8% short U.S. Government Bond position in our Core Investment Fund.

Leuthold: That makes sense when we look at the valuation numbers. Assuming we don’t get a great exaggeration on valuations like we saw in 1999 and 2000, that would seem to make sense. What we have been anticipating over the next decade is a series of cyclical (short-term cycles of one and one-half to two and one-half years) bull markets and bear markets where you see advances such as we’ve seen or maybe a little bit more, and then you’ll see a decline of maybe 20% to 30%, and then another cyclical bull market, and then a decline. It’s going to be kind of rough seas for the buy and hold people, I think. It would be somewhat like the configuration that we saw in the market back from 1969 through 1983, where you didn’t have a strong secular trend. You had a secular bear market (a market run of 15 to 20 years where the total return is approximately what the inflation rate is), but you didn’t get a new secular bull market (1983 through March of 2000) until you had quite a few ups and downs before that next secular bull market. That would seem to be the logical progression now. However, it always bothers me when so many people are in agreement. It would be the logical thing for the market to do, but, unfortunately for us, the market isn’t always logical. We’ll look at it and take it as it comes. I certainly would be a little bit hesitant to try and set an investment stance for the next ten years based on what I think the market should do.

Leuthold: Within equities, we’ve looked for some special situations. First of all, we think that there is a basic imbalance between supply and demand in the industrial metals. We have a pretty good chunk of our portfolio in physical industrial metals. We’ve been there since last January and currently hold a little over six percent. I think we’re relatively early in the game in terms of copper and aluminum. Certainly, the growing demand in Asia and also in eastern Europe, I think, are important factors there. The fact that, in terms of investment in mining, both in the mines and also in the smelters and the other equipment that’s needed, we’ve had underinvestment there for the last 15 years because people couldn’t make any money. Investment growth has been about 1%, where demand has continued to grow at 2.5%. We just had a fellow in here last week from London, from the London Metals Exchange where we have had dealings in metals previously. He stated that he pretty much agrees that we are still early in the game. Most people regard what you’re seeing, and this big pop-up in copper over the last year and a half and the pop-up that you see in other things like tin and lead, nickel and so on, is that we’ve had the big move and it’s probably come to an end. I disagree. I tend to look upon this as very unusual circumstances, maybe not quite qualifying as unique, but very close to it in terms of my experience with the business. Additionally, we have about 20% of our equity portfolio in industrial metal stocks including some of the big internationals like BHP (the old Broken Hill Properties) and also in Rio Tuinto. I feel pretty good about those. We’ve held the metal stocks for over two years.

Another area that I think is really appealing is something we call non-regulated electrical producers. To us, a lot of these companies that were way, way overleveraged, have straightened out their balance sheets considerably over the last year and a half, with the low interest rates. As you see long-term growth in electrical usage in this country grow at a rate of 2% to 3% per year, we’re going to need the added capacity that those companies can provide to us. I think that’s a very interesting area.

Another area where we have a major thematic play is in what we call healthcare cost containment. I think over the last year we’ve had about a 28% or 29% return from those stocks. These are not the big drug companies. These are companies that are important in helping control healthcare costs, whether it’s from an accounting standpoint, or from an outpatient treatment standpoint. I think with continued pressure on healthcare costs, that this is a niche within the healthcare industry that is probably going to benefit.

Leuthold: Well, they sure do. They look awfully, awfully cheap. In fact, about six months ago I thought they looked pretty cheap. Personally I bought a package of those, I’m down about 8% on them primarily because Merck wasn’t what I thought it was. We will not put them in the fund or in managed accounts until we get confirmation with some of the quantitative disciplines that we use called our group selection scores. At this point, they are still not terribly attractive on that basis, so we are staying away from them in terms of our managed accounts. I sometimes am a little early, but I agree completely with the notion that they will rise.

Leuthold: For our clients, we tend to take a little more conservative attitude and I’m not quite as likely to try and catch a falling knife as I might with my own money.

Leuthold: : Absolutely. I would love to own them in the fund and love to own them in our private accounts, but our disciplines prohibit it so far.

Leuthold: We still have about 10% of the equity portfolio in oil and gas exploration and development. We have about 32% or 33% all told in commodities such as metals, oil and gas. That’s a pretty hefty percentage, alright.

Leuthold: Now they’re all getting excited because we’re going to have an Exchange Traded Fund in gold. People are goosed pretty easily. I think gold is sometimes a hedge against inflation, sometimes not. Sometimes it may hedge against international uncertainty, and sometimes not. I actually own some physical gold, personally, but I do that because I view it as being my flight insurance. It’s about only two or three percent of my net worth. I can see people maybe wanting to do that, so that if this whole thing blows up, if we don’t get control of the deficit, if the dollar continues to fall, we’d have some hedge against it. At $437.00, $438.00, gold looks awfully expensive to me. We do own silver, but that’s an industrial play. About 57% or 58% of silver production is now used in electronics, and is used in industrial applications. We don’t really view that as a precious metal. We view it as an industrial metal.

Leuthold: We thought we looked pretty smart earlier in the year when we got rid of the last of the REITs because the next month they fell 20%. They have had a strong comeback and made almost all of that back. When we look at REITs now, the one thing that disturbs us is, if we’re looking at underlying assets comparing it with the price of the REIT stocks, they are selling at about 17% or 18% premium over what we would view as being their book value. We may buy them again at a 5% to 10% discount. I think the REITs have a couple of negatives going for them. One is the state of overvaluation. Another is, what is probably not a bubble in Pennsylvania, but in many parts of the country, we do have a real estate bubble. That includes commercial real estate as well. Also, if you see higher inflation, that’s a positive for the REITs, but higher interest rates are not, because most of them have either floating rate debt or fixed debt that will cost them more money as they take on more debt when they buy additional properties. We’re kind of neutral towards the REITs right now. We’re not negative, but we do have a couple of REITs sold short in our AdvantHedge program and the Grizzly Short Fund, but nothing really significant.

Leuthold: I think most of the drop we’ve seen since the election is a Bush bear market on the dollar because he is certainly not appreciated and not liked by many foreigners, especially in Europe. I think there is a great concern that the United States, is not going to get their fiscal house in order, that they are going to go on another escapade in terms of the military. I think that is probably the primary reason for the last 5 to 7% fall in the dollar. I think that the Euro is extremely expensive relative to the dollar. The economies over there are lagging far behind the U.S. When you’re looking at Euro-land, almost every country in the European Union has now violated its covenant in terms of its deficit exceeding 3% of GDP. They’ve kind of waived the rule. Also, if we look at history, we see that there has never been a long-term surviving currency that has been made up of a union of independent countries. The one that lasted the longest was one in Scandinavia, which lasted for about 11 or 12 years. I think that the differences between the Germans and the French and the Portuguese and so on are going to be so great that, eventually, the Euro may not exist anymore.

In terms of Asia, it’s a little bit different picture. It’s very clear that the dollar is undervalued. I would think that in the next year or so, you will see the Chinese probably either create a wider trading band instead of being fixed to the dollar or perhaps even let it float against a basket of currencies. I think the dollar weakness relative to Asia could continue, but I think we may be getting kind of close to the end of it in terms of the Euro. Having spent some time in Europe this summer and looking at the relative values even back then with the Euro at $1.23 and now we’re at $1.29, I just can’t see this persisting for a whole lot longer. It’s a real imbalance right now. I think, if you could do it, an interesting trade would be, go long the dollar and go short the Euro. There’s a law that we can’t do that in our funds.

Leuthold: If you look at them in terms of P/E multiples, and if you look at them in terms of the intrinsic growth in the emerging country economies as maybe being 6% or 7% versus maybe 3% here in the U.S., they would seem pretty cheap. We have 10% of the Core Fund assets in emerging countries right now, with the focus being in Latin America and Asia with a little bit in eastern Europe and Russia. I feel quite comfortable with that except that they are getting terribly popular. Even in the U.S., a look at the last fund inflow data where we had $9 billion in inflows coming in, almost half of that money went into foreign funds. When we look at the closed-end funds, which we often look as a place where we can find bargains because they’re selling at a discount to net asset value, you’re not seeing attractive discounts anymore. You’re seeing premiums. You’re seeing a number of the other Asian countries, except maybe for Korea, that are being bid up as well. I always get uncomfortable when anything seems to be gathering a crowd, and the emerging countries seem to be gathering a pretty big crowd today in terms of public interest.

Leuthold: Well, no, I still own them. We normally will max out at maybe 12% in the emerging countries. We’re now at about 10%, up from about 6% well over a year ago. I’d say that the next step is probably cutting back to some degree. I think there will be real opportunities coming up in the bond market, maybe 6 months to a year from now. I think there are pockets in the equity market that look fairly decent, but as an asset class, bonds just don’t hold much interest for me because of what I perceive them as being low return relative to the risk levels. We’re right now 63% in equities, and out of that, 10% is still in emerging markets. Our normal maximum is 70%. We recently lifted some of our hedge which had reduced equity exposure down to around 55%, 56%. Shorter-term, we’ve become more optimistic about the market. Again, it becomes a little disconcerting when you see so many of these attitudinal measures that have swung so rapidly to the positive side. We’re sitting with a gain of about 7% for this year, and I think I’d be very satisfied to nail down 10% for the year. Year over year through September, which is when our fiscal year ends, we were up about 18%. We were better than the S&P by a pretty good margin and I think we will maintain some advantage there. With our basic portfolios, the Core approach, we still have 5% that’s short common stocks and we’ve got 10% that’s short bonds.

Leuthold: I do think that the energy area is probably an area where I would like to increase exposure. I think that many institutions, which all were underweight energy a year ago, are now probably up to a market weight. We are seeing a move, though, to overweight energy by a lot of institutions. You can kind of tell that by the action. A couple of months ago, we thought that oil was going to decline so we lightened up on some energy stocks and instead of going down with the price of oil, they all went up. That demonstrates something to you. Someone is buying them. We’ve seen much the same thing in this recent decline which has taken oil down from 55 down to 47. The energy portion of our portfolio is actually up 4% this month. I do think one of the best pieces that you’ll read on energy was in Barron’s in early October. Charlie Maxwell, who’s an old friend of mine and who’s kind of the dean of oil analysts, wrote in Barron’s, in the commentary section that’s well worth reading, about the long-term picture in energy and about what we’re probably facing going out over the next seven to ten years. Charlie really believes that there is a limit to how much more can be extracted with energy usage growing 2% a year. You have to find about 6% a year in new energy sources. He thinks that is going to be very difficult to do. An area that I think could eventually be very big would be, although it’s probably too early, would be companies that focus on energy conservation that provide more efficient use of what we have. We made a little move into alternative energy stocks earlier this year and lost a fast 30% in them. So we’re being a little cautious about that play right now. If you look at Toyota really leading in terms of the hybrid cars by a big, big margin, it’s companies like that that I think could be very attractive on a longer-term basis. With every problem there’s a silver lining, and I think here it’s going to be in the energy alternatives and conservation stocks.

Leuthold: You’re welcome!