The dollar rally, which began early in the year and accelerated mid-year in the aftermath of France's rejection of the E.U. Constitution, recently found new life, with the dollar index hitting new multi-year highs in mid-November. However, in the past week the dollar has fallen sharply, with the dollar index back below the 90 level for this first time in over a month.

Prior to this reversal, the dollar's rally had been significant enough that many now expect it to continue, including some who had previously forecast the reverse. However, despite the dollar's rise, the fundamentals behind its original decline have actually intensified. As a result, when this reprieve ends, the dollar's subsequent fall will likely be swift and precipitous.

Powering the advance has been short-covering by leveraged speculators that held short positions in the dollar as the year began. Though those bets may have made sense based on the dollar's long-term fundamentals, and the prevailing down-trend then in place, they are now extremely expensive to maintain given the extent of the dollar's rise and the negative carry short-dollar positions currently produce.

Providing further fuel had been the one time effects of American companies repatriating foreign earnings to take advantage of a one-time tax break expiring at the end of the year. Such flows required the selling of yen and euros and the buying of dollars.

But the main driver behind the dollar's clime has been a string of ¼ point interest rate hikes by the Fed while the BOJ, and until Dec 1, the ECB have left their rates unchanged (Immediately following its 1/4 point rate hike, the ECB quickly talked down expectations of future increases.) As a result, short-term currency traders have been able to profit not only by interest rates differentials (borrowing yen and euros and buying dollars) but though the appreciation on the dollar.

However, the interest rate differential theme, which has dominated the long-dollar trade, is flawed on three accounts:

First, it ignores the fact that although nominal rates have risen, real rates, which are far more relevant to investors, have not. When the market begins to appreciate this reality, the dollar's fortunes will quickly reverse.

Second, those buying dollars based on higher interest rates are ignoring the damage higher rates themselves will ultimately inflict on the highly leveraged U.S. economy. The resulting negative capital flows will be very bearish for the dollar. In addition, as the Fed will certainly try to fend off any recession by cutting rates, higher interest rates now actually sow the seeds for lower rates in the future. Given the fact that the next recession is likely to be accompanied by sharply higher consumer prices as well, any rate cuts in such an environment would cause real yields to plunge even further, most likely well into negative territory - a condition extremely negative for the dollar.

Third, it fails to consider that rate hikes in Europe and Japan are inevitable, and that once begun they will cut into the dollar's yield advantage. Also, as inflation rates in Europe and Japan are lower than that of the U.S., the real yield advantages of the euro and the yen will widen. Most importantly, as Europe and Japan are creditors, their economies will fare much better under a rising rate environment than would that of the United States, the world's largest debtor nation.

Gold's relentless rise provides evidence that the dollar's bear-market rally is more indicative of yen and euro weakness than legitimate dollar strength. Despite tough talk about raising interest rates, the BOJ has done nothing and the ECB only recently moved by a meaningless ¼ point. I believe currency traders will continue badgering these barking dogs until one of them actually bites. As long as gold and other commodities continue to strengthen in yen and euro terms, Japanese and European consumer prices will rise and their currencies will be under pressure. Ultimately this game of monetary chicken will end, the ECB and BOJ will raise rates decisively, causing the dollar to suffer greatly as a result.

Any further weakness in the euro and yen will likely be tempered by the horrible long-term fundamental outlook for dollar. In fact, with the 8.2 trillion dollar debt ceiling likely to be breached early in 2006, it is possible that America's problems will shortly return to the center ring, with those relatively more benign problems of Europe and Japan fading from the spot light.

Furthermore, behind the scenes, the dollar continues to weaken against many of the world's other major currencies. For example so far this year the Canadian dollar is up 4% and the New Zealand dollar is up 3%. Stealth strength in secondary currencies further reveals the false character of the dollar's rise. In actuality, it has merely benefited from concerns over the euro and yen which have temporality overshadowed its own. More importantly, against gold, the ultimately barometer of a currency's value, the dollar has declined by over 20% thus far this year!

In the end, the dollar rally of 2005 will have been significant for investors for two reasons. Number one, by allowing America's problems to worsen, it will ironically assure that the dollar's ultimate decline will be that much more severe. Second, not only has the dollar's rise provided a great opportunity to sell it, but as a result of number one, an even more compelling reason for doing so.

My advice is to speak with a Euro Pacific Capital investment representative to discuss the various investment strategies designed to help achieve the crucial goal of greater non-dollar diversification.

In March 1956 an unpleasant man by the name of M. King Hubbert addressed the spring meeting of the American Petroleum Institute in San Antonio, Texas. In his presentation he repeated a thesis he had been articulating since 1949. Its message was simple: broadly speaking U.S. oil production would peak about 1970, and world oil production about the same.

As world economic growth exploded in the ensuing half-century, yielding unprecedented levels of prosperity to ever-larger segments of the world's population, "Hubbert's Peak" fell into obscurity, except among a tiny band of geologists, industry specialists, and elements of the lunatic fringe. Was this man --- a geophysicist and Chief Consultant at Shell Development Company --- a crank? After all, even the "energy crises" of the early 1970's were caused by deliberate acts of politics, not by shortages.

Well, no. Just a few days ago, in November 2005, the prestigious International Energy Agency, the government-sponsored energy watchdog of the industrialized nations, issued a startling report covering energy prices through 2030. It raised its long-term oil price forecast by one-third under certain investment scenarios, and speculated on a pessimistic outlook for world economic growth without reduction in use of oil and natural gas. As weather-related events in the Gulf of Mexico have shown, with the world now burning about 85 million barrels of oil a day and supplies tight, small supply disruptions can send prices soaring. The numbers are starkly simple: the world uses more than 26 billion barrels of oil per year, while new discoveries are running at the equivalent of less than 7 billion barrels per year. Other things being equal, therefore, oil production will peak within our lifetimes.

At present, oil and gas account for more than 50% of energy supply usage. The overwhelming bulk of the rest involves coal and nuclear power. The remainder (solar, biomass like wood and sugar for ethanol, wind power, and geothermal) are useful but marginal factors, accounting for about 4% of world total electricity generating capacity.

The search for alternative energy is bound to continue, and probably accelerate as prices increase, over time. This search will focus both on non-renewable sources (oil, gas, coal, oil sands, and nuclear), including making more productive use of them, and renewable sources (biomass, such as wood and sugar, solar, wind, waves, ocean thermal).

Two important observations.

The first is that in the rush to find trendy and imaginative solutions it is easy to lose sight of the fact that they carry costs, and sometimes very high ones. These will typically involve heavy capital expenditures, and high transportation costs; these are highly likely to keep the use of the new energy sources localized, and/or involve building expensive transmission facilities, further ensuring that transition periods to the new systems will be gradual. There are no quick or painless fixes or tradeoffs. The Greens who rhapsodize about the attraction of burning clean energy derived from sugar-based ethanol need to know that Brazil, which is the world's leading force in this field, is involved in massive deforestation to clear land for sugar plantations. Life is about choices, unfortunately. In short, investors need to be careful that they focus on the steak and not the sizzle.

A second observation is even more important: economic growth requires energy. It's that simple, and there's no escaping it. Intelligent solutions to oil and gas supply shortfalls must not involve restricting economic growth, but in using energy most effectively. Complaining about "high" energy costs, or taxing "windfall profits", will only discourage exploration and innovation and make the problem worse. Better to set the system free and incentivize it to come up with solutions. It will accommodate and deliver the requisite results, even if painfully and sometimes slowly.

The 4% of world electricity supply generated by "alternative" methods mentioned above will undoubtedly grow. Forty eight countries already have renewable energy promotion policies. The largest of these by far involves harnessing solar energy through photovoltaic solar panels that trap the sun's energy. Enthusiasts like to remind us that during every day, as the earth revolves around the sun, the latter releases more energy than has been created on earth since the beginning of time, trapped in oil, gas, coal, etc…Some 400,000 rooftop solar panels already exist worldwide, but these are of strictly localized benefit. In recent weeks two major projects were announced by Stirling Energy Systems of Phoenix. They involve installation of 20,000 solar dishes in the Mojave Desert to transmit 500 megawatts of electricity 80 miles away to meet the daytime needs of 300,000 homes in Los Angeles, and a project to transmit 300 megawatts to San Diego.

Caution: these are demonstration projects only and it is still uncertain whether they can be turned into utility-scale production. They are dependent on tax credits and subsidies, and involve large uses of land.

Biofuels, primarily involving sugar-, corn-, and timber-derived ethanol to fuel cars, including hybrid cars that utilize a combination of gasoline as well as synthetic fuel, also are growing in importance. Ethanol already fuels 40% of cars in Brazil, where the process has advanced the most, vs. 3% in the U.S. Brazil produces 4 billion gallons of ethanol vs. 3.4 billion in the U.S. The largest sugar and ethanol producer in Brazil, Cosana, had its Initial Public Offering only in October of 2005, and it is therefore too early.

Practically speaking, we conclude that the three most promising and realistic areas for seeking long-term investment opportunities in alternatives to oil and gas are to be found in Canadian tar sands, nuclear, and coal.

The tar sands deposits in Canada's province of Alberta are enormous. They are spread in an area the size of Florida, and are estimated by the U.S. Department of Energy to contain 175 billion barrels of oil, exceeded only by reserves in Saudi Arabia and possibly Venezuela. Much of the deposits are shallow, suitable for open-pit mining. Deeper deposits would involve injecting steam into wells, and surfacing the bitumen. (For a scale of reference, 2 tons of oil sands yield 1.25 barrels of bitumen and 1 barrel of oil.) Issues:

1. Up-front costs. The process itself requires vast quantities of energy to create and inject the steam. The most logical source would be to use nuclear power, but environmentalists are objecting, and in all probability natural gas will be used.
2. Transportation via pipeline from Edmonton to the Pacific Coast across the Rocky Mountains. Two competing oil pipelines are being built, while the operators seek to nail down commitments from U.S. West Coast customers to purchase the oil.
3. Environmental objections.

That said, the tar sands operators' conclusion that the projects would be viable in an oil price region of $20-30 per barrel is attracting serious players, including both large companies (Exxon, Chevron, Conoco-Philips, Husky Energy, Total of France, and 2 Chinese groups) and venture capitalists. We believe that the oil tar sands sector offers attractive opportunities.

Similarly, investment in nuclear energy related companies --- primarily uranium producers --- also seem attractive to us on a long-term basis. Nuclear power has suffered from a bad reputation since the accidents at Three Mile Harbor in 1979 and Chernobyl in 1986. To environmental risks must now be added the issue of terrorism. The reality, however, is that nuclear energy does offer a large-scale potential solution to the oil and gas shortage, a fact recognized by President Bush in his recent energy policy initiative. Indeed, other countries have long since decided to go that route: today France obtains 85% of its electricity from nuclear power, and China has announced that it plans to add 2 reactors per year to the 9 it currently operates. Twenty three new atomic plants are under construction in 11 countries at the present time, with 441 plants in operation (103 in the United States). Most of the additions are in Asia, with 12 in China and India alone as these rapidly-growing countries scramble to nail down long term sources of energy to fuel their rapidly growing economies.

All these nuclear stations feed on uranium. Prices have risen from $6 per pound in 2001 to $30 at present. Some analysts, including those at Merrill Lynch, have predicted a uranium supply shortfall until at least 2015.

Our final realistic area of interest is coal. It is not in short supply (though the right type for particular purposes in the right place sometimes is), but it too has been under a cloud for many years on environmental grounds. We believe we have identified an interesting way of participating in the growth of demand.

A final and potentially important point: when making investments, company location is important. All the companies we have focused on are in comparatively "safe" geographical locations from a political standpoint. See "New Recomendations and Investment Ideas" below.

It has become hackneyed to call this “the century of Asia”, yet it is none-the-less true for that. And the next several years are likely to see outperformance among Asian economies and markets based on China’s continued development and Japan’s turnaround. Although Asian stock markets generally have been strong performers, it is by no means too late to look for opportunities in the region.

Stronger and less dependent on the U.S. than before

Many investors have steered clear because of all-too-deep scars from the 1997 Asian crisis. Yet fundamental conditions throughout the region are quite different from what they were back then: the currencies, having fallen dramatically, are now much more reasonably valued (arguably undervalued); banks, having liquidated bad debt, are much stronger; and balance sheets—at the government, business and consumer levels—are much more solid.

In addition, what has been the bane of Asian economies—their over-reliance on the U.S. for foreign direct investment as well as a consumer of their exports—has diminished over time. FDI from Japan, Korea and other major economies has become increasingly important as the higher cost economies seek low-cost manufacturing bases, and trade is notably open in the region (notwithstanding some Japanese peculiarities). In aggregate, over 40% of the region’s trade is with other Asian countries, and only 12% with the U.S. Asia could be much more resilient to a U.S. slowdown than in the past.

In the near-term, business conditions throughout the region are strong amid low interest rates and easing monetary conditions. This should keep the business boom going.

Asia’s two giants will boost regional economies

Even more important to the medium term are the economic conditions in China and Japan, the two giants of the region. China, of course, has been one of the world’s fastest growing economies in recent years; over the past five years, China and the U.S. together accounted for well over half of global economic growth. Japan is still the world’s second-largest economy, so a recovery there would be very significant for the region, as a buyer of goods and as a direct investor.

In China, after a slowdown towards the end of last year, growth is accelerating again, but at a more restrained pace. Though government statistics are unreliable, growth seems to be running at about 10%, while inflation remains moderate. This impressive improvement is despite the Chinese economy being among the more energy-sensitive in the world; though coal remains more important than oil, China is still the world’s second-largest consumer of oil products. The economy may have escaped the feared hard landing.

Looking ahead, the run-up to the Beijing Olympics in 2008 will surely involve a lot of infrastructure projects and, therefore, continued imports of raw materials.

Has Japan finally turned?

As for Japan, the economy is exhibiting signs of a fundamental turn, after 15 years of recession alternating with deflation. In fits and starts, conditions are improving. Banks’ non-performing loans have shrunk from nearly 30 trillion yen in 2002 to just 7 trillion today, the lowest level for over a decade. Manufacturing is up; corporate profits are up; unemployment is at a seven-year low. In all, the economy grew at a faster rate than expected in the latest quarter, marking the longest expansion in eight years.

To some extent, this marks the end of an agonizing period of the liquidation of the excesses of the 1980s. It also reflects the new reform initiatives by Prime Minister Junichiro Koizumi. This helps fuel optimism that this recovery may be sustained, not simply a dead-cat bounce such as the country has experienced before.

The reform program—endorsed by the electorate in the recent election—may signal a major change in Japanese society, a freer labor and corporate structure. Importantly, both business and consumer confidence has improved, along with capital investment and retail spending. Japanese households, like many companies, have solid balance sheets, and continued improvement in sentiment will see money flow out of low-yielding bank deposits and into stocks and real assets. That has not happened yet, but the reform of the postal system may provoke the shift.

Along with the improved economy is a change in the corporate environment with a new shareholder-friendly culture fighting the old guard (exemplified by the battle between Livedoor and Fuji Television over Nippon Broadcasting earlier this year).

Japanese stocks are strong, but still offer potential

Although the Nikkei is at a four-year high—up 35% (in yen terms) since May—we think there is a long way to go over the next few years. (The fall in the yen this year means Japanese stocks have not risen so much for U.S. dollar-based investors.) If the economic turnaround holds, then Japanese profits have tremendous leverage from their low levels, with high p/e ratios belying reasonable value.

Moreover, many Japanese companies have significant amounts of cash on their balance sheets, sometimes representing 30, 50 percent or more of a company’s market capitalization. This means that p/e’s on the operating businesses are lower, while the balance sheet strength means companies are in a position to invest if circumstances warrant (or return money to shareholders).

Opportunities throughout the region

Continued strength in China and a turnaround in Japan will support the small Asian economies, and lead to continued economic growth and market performance. We believe the next several years will see outperformance by Asia and investors should look for opportunities to position themselves. Where to look?

First, the currencies themselves offer solid long-term opportunities. This is not the place for a long discussion of the U.S. dollar, but suffice it to say our view is that the U.S. dollar will experience a long-term slide. We have been experiencing just such a correction this year, based primarily on interest rate differentials between the U.S. and other major economies. Though this rally may have further to go, early in the New Year, we expect the dollar to peak, and resume its long-term decline. In the next leg, the Asian currencies may well outperform the Euro whose main advantages are that it has liquidity and is not the dollar. We would focus on currencies of the Asian-Pacific region, including the Australian and New Zealand dollars, the Singapore dollar and the Thai baht.

Look for strong companies with good yields

Equities are the preferred avenue for investing in the region and taking advantage of China’s emergence, Japan’s turnaround, and the Asian economies’ growth.We would avoid for the most part domestic Chinese companies because of the opaqueness of corporate activities and finances.
But one can take advantage of China’s growth by investing in high-quality Hong Kong companies (where corporate governance and accounting standards are among the best in the world) and in companies throughout the region that stand to benefit by producing the goods that China needs. China needs many natural resources, the leading producers of oil and gas, uranium, the base metals, and other commodities are another way to take advantage of the dragon’s voracious appetite.

In Japan, I favor cash-rich domestic companies, de-emphasizing the exporters who would be hurt by a stronger yen or a slowdown in the U.S. And elsewhere through the region, I favor Singapore and Thailand. The first is one of the strongest economies in the region. Because of its large refinery industry and also its strategic position amid the world’s shipping lanes, Singapore will benefit from two major global trends: high oil prices and increased trade with China and Asia. Thailand’s economy is also undergoing market-friendly transformation with many good quality export companies.

In all circumstances, I would look for high-quality companies with strong balance sheets and preferably good yields, to minimize the risk if things go wrong and to benefit from the increased liquidity such companies offer. Many of the region’s best companies are world-class companies offering significantly higher yields than the markets of North America or Europe, while the 10-year growth outlook is also substantially greater. The Hong Kong market yields 3.5% at a p/e of 14; Singapore over 4 ½% on a p/e of 12.6; and Thailand over 4% on a p/e under 10. Of course, there are many fine companies in each market with considerably better values and yields. There is no need to chase prices, particularly in Japan, but selectively pick away at these high-quality, high-yielding stocks as opportunities arise.