Dear Friends,

Welcome to 2009! A happy, healthy, comfortable and creative New Year to you all. Can it be prosperous? Maybe! Investing in the environment I envision will, at best, be an adventure; protecting one’s assets with an opportunity of building on the base, a challenge. How, what and when? There are possibilities, none without risk; one with a better risk/reward history in difficult times than any of the others, “Art”! More about that later. We start this year on the cusp of a crisis-a failed financial system, manufacturing industries sinking rapidly, consumer spending having declined precipitously and still shrinking, housing prices down, mortgage defaults at an all-time high, unemployment growing, governments competing to debase their national currencies and commercial real estate about to go into free fall. The story goes on, but suffice it to say we are in a period or extreme contraction in the economy. Whether we will experience a contraction similar to the 1930’s or the 1970’s remains to be seen. Much will depend on the course taken by the Obama team.

A short recount of Bush-Paulson bungling of the mess they created goes like this: Close to nine trillion dollars have been spent, “invested”, loaned or guaranteed to the financial community. This includes “saving” Bear Stearns through huge guarantees to J.P. Morgan Chase to be capped by “investments” in J.P. Morgan Chase to be capped by the purchase of toxic paper at one hundred cents on the dollar from J.P. Morgan Chase to be capped by guaranteeing certain counterparty dealings with J.P. Morgan Chase to be capped by a series of other follies. So as not to show favoritism in gifting-Citicorp has been given more than two hundred billion dollars as a gift courtesy of the taxpayers–$400 billion of toxic paper (worth about 30-50% of face was either bought or guaranteed at 100% of face), Citicorp was also given guarantees, “invested in” the full works in even greater amounts than J.P. Morgan chase. Goldman Sachs would be insolvent had the U.S. government not stepped in and “invested” in Goldman Sachs. The taxpayer got terms of about 50% of those obtained from Goldman by Warren Buffet, but Mr. Paulson was at one time the key man at Goldman! Goldman was at risk for about $20-25 billion in losses should AIG have failed. AIG was about to fail when this nasty detail was discovered. Since the enlightenment AIG has, so far, received $150 billion in assistance from the taxpayers. The story is the same with Bank of America, Morgan Stanley, Fannie Mae, Freddie Mac, American Express, etc, etc.

Nine billion US dollars of taxpayer money is at risk to the same folks and allocated by the same administration who brought on our current “contraction”. I doubt that, if marked to the market any of these “saved” financial institutions are solvent. Little or no attempt has been made to reach into the crux of the problem, the near bankruptcy of all but the very wealthy. The middle class and the poor are in shambles. Without substantial direct aid to those sectors of the economy the first nine trillion dollars will have been wasted. Government aid to the middle and poorer classes will need to approach another eight to ten trillion dollars for the first nine trillion to have a chance to do its job. The business of the favored few depends on the financial health of the whole. One hopes the new administration will get it. So far the indications are bleak; the choices for economic leadership sadly mirror those of the Bush administration.

The length and depth of the contraction will reflect the next moves, those decisions of the Obama administration. With the wrong choices, like those of the Bush administration, the nine trillion committed to the financial community will go down the proverbial tubes. With the right choices those monies might be saved-however foolishly these expenditures were made. Do we have a 1930’s contraction or a 1970’s one? So far 1930’s is the model.

The second economic engine the economic Czars have kicked off is a massive reduction of short term interest rates aiming for a zero rate for Treasury bills. The focus on long term rates through the purchase of five, ten and thirty year government debt has brought long rates (government paper) to the 2-3 % range. These rate reductions and manipulations have had no positive effect on anything! Someone needs to re-read Keynes prior to further reducing rates if unaccompanied by the other necessary steps to stimulate the economy. Rate manipulation does not work as a stimulant in isolation; it is only useful as an arrow when the rest of the quiver of arrows are carefully aimed and fired. What we can rest assured of is that such action, in isolation, will debase our currency against those of the rest of the world EXCEPT this time most of the rest of the world’s leaders have begun to plan debasement of their own currencies in the hope of stimulating their economies. In the mutually dependent economic world of today it is impossible for any country with heavy manufacturing content to maintain a strong currency while others are debased. To this aim many countries (the U.S. in the lead) have not only reduced rates but also have begun to effectively print money without offsetting borrowings. Ugh!!

However long and however deep the contraction (think in years not months) we will experience an inflation of great proportions. Will it be simultaneous with the contraction, as it was in the Weimar Republic and in the 1970’s stagflation, or will it come at the tail end of the contraction? The Obama recovery programs can affect this but my guess is for simultaneous inflation/contraction. In any event, there will be an inflation of dynamic proportions taking hold within a couple of years or, just as easily, in 2009.

Though much is said about the financial institutional crisis and the mortgage and housing crises, little, if anything at all, is mentioned about the imbalance in the economic landscape caused by war. It is always the case that wars draw on certain productive facilities and commodities in a pattern which throws the economy out of balance. An almost unnoticed phenomenon in prosperous times war becomes a segmented inflationary propellant in a period of contraction. The economic factors in place today are those which have led to wide unrest and war in earlier days. Though the past is not an absolute predictor of the future, the thought of greater conflagrations cannot be dismissed.

What does all of this mean to the investor? Clearly we are already in a contraction-greater than any since the Great Depression, Contraction is a given! Inflation, though not yet apparent on most fronts is clearly on the way. As the Bush Administration fed monies to its favored friends the dollar declined about 20% against the Yen and the Euro. A high degree of risk is still prevalent on the financial scene. It is likely that we will experience more banking insolvency, perhaps even amongst those banks which have been “saved”. The counterparty and derivatives risk may, once again, bring the financial system to its knees. It is in this light we look at where to place money for security and eventual profit:

Gold – the traditional safe haven in times of contraction and inflation. The risk here is that of the system. Most gold transactions take place in the form of derivatives. The banks, brokers and commodities exchanges guarantee the counterparty responsibility of these derivative trades. At the time of the Hunt silver debacle, the exchanges and the important commodities brokerages were unable to deliver physical silver, and, to a lesser degree, gold against contracts which required delivery. The system was saved by a clever commodity trader who convinced the Hunts that he and the exchanges would go broke and not live up to their contracts unless the Hunts provided the physical commodity to the market. Fearing for the disappearance of their gains and capital they foolishly filled the need of the brokers and exchanges, put up physical silver and eased the pressure on the market at which time the gold and silver markets collapsed! The Hunts lost all! The system was saved. The proportions of the current physical/derivative relationship are far beyond what any group (government included) could be called upon successfully to “save” the system. There simply is not enough physical gold stock to satisfy the future and option markets should physical be demanded. Were the exchange and counterparties to collapse, investors who held derivative gold positions will have lost their “safe” gold positions, no gold! Whether or not this is a long shot remains to be seen but keep in mind the system is funded by the same crowd who brought us the mortgage crisis. Once burnt, their fault, twice, our own. A solution could be to buy physical gold or coins. The premiums, cost and simple practicality of this approach makes it an unworkable solution for a substantial investor.

Silver, platinum, palladium and the lesser metals – All of the same issues as gold apply but more importantly all of these metals are industrially driven as to price. Should the contraction/inflation syndrome take hold it is unlikely these metals will keep pace with the inflation? Only if industrial demand grows will they have a base from which to rise.

Foodstuffs – A  good hedge-but most Foodstuffs can not be stored for any length of time. We are once again dealing with derivatives, and derivatives rollover to maintain our positions-not where I would like to be.

Oil and Gas – Maybe-but industrially driven demand is in direct proportion to economic health. In a severe long-term contraction, regardless of inflation, this sector will not perform. Real demand will shrink!

Shares in companies – Which ones will be here when it’s all over? Once we would have said, GM, Chrysler, Ford, Citibank, J.P. Morgan, AIG, etc. Which ones will be here in the next couple of years?

Bonds – Quality debt instruments such as governments (considered to be quality regardless of poor management) are already substantially over priced as a result of government manipulation of interest rates. The risks in an inflationary environment are extraordinary as to any debt of mid or long term duration. Bonds will be a trader’s paradise but only for the fleet of foot. Don’t even consider low quality corporate debt. Some of the so called sure debt, GMAC for example, is all ready being restructured.

Real Estate – Commercial real estate has just begun to show the effects of the recent debacle. The decline will be steep and long. Remember, commercial real estate values are determined by cash flow and cash flow is a function of rents.

Residential – I know of a ten thousand square foot penthouse in one of the best buildings in N.Y. that sold for $1.00 in 1974. Certainly anecdotal as cost of carry was high etc, but less anecdotally townhouses sold at $50,000 and under in the 1970’s with a few exceptional ones reaching $200,000- $300,000. The best of coop apartments on Fifth and Park Avenues sold in the low hundreds of thousands of dollars. I would not rush a residential purchase.

Art – Art, like gold, has intrinsic value. It is portable (even under previous U.S. currency controls one could move one’s art freely). It has maintained at least some of its value in all of the wars, contractions and inflations of modern times. There is no derivatives market. There are the risks of lazy research such as forgery repainting, false attributions, etc. all of which can be dealt with by careful research and selection. It is less liquid than the investments reviewed prior, in fact, the narrowest of the markets we have explored. However, I can not identify a time in modern history that it has not served as a store of value when no others have been available or sustainable. Today the knowledge and appreciation of art has proliferated throughout the world. There are transactions taking place. They take place at new market prices. With the coming inflation important art will, as it always has, outpace the prices of most competing investments. What I mean by art for investment is proven art of proven artists where the work has clearly made inroads in the growth of artistic expression and is recognized for that quality among others. A short description of a few areas of art with recent market reactions to the contraction is in order.

Ancient Art – Primarily Egyptian, Greek and Roman. Recent sales have shown almost no price decline, perhaps even small increases, from 2007. A small market.

Old Masters – Recent prices quite the same as last year’s though interest is drying up in works of secondary quality.

Impressionist and Modern- Market is down about 30-40 % from the highs of 2007, 2008, perhaps more in artistic works that are not great but were pushed to extraordinary prices.

Post War – Contemporary – Great and good works are down about 30-50 % from the highs. Works which are of secondary quality but were promoted to prices in the stratosphere have yet to find a market. I would venture a guess that this art will be available at discounts of 60 to 70% from the highs reached in 2007-2008. Many primary contemporary artists can be purchased at 50% below last year’s prices, even from their galleries.

Masterpieces, great and good works of important artists will come quietly to the market as owners seek liquidity in this time. Many of the Maddoff victims are cultured, educated folks who have built quite spectacular collections over the years. A few of the hedge fund managers have bought good to great art though most just followed what was in style, the style of the day, week or year. Real estate developers, financiers and investors will access their collections, some quite spectacular, to raise cash for their businesses and other purposes. Banks will be pushing collectors and dealers to sell art to pay down debt. All of the dislocations of markets, industry and business will bring quality art to the market at prices which we can begin to consider realistic if art is to be a store of value and an inflation hedge. Of course art must be purchased over time with a careful view towards quality.

As many of you know, in the past I have been reluctant to present art as an investment. It has served me well over the years but my early purchases many years ago were without even thought of financial gain. It is only in the last twenty five years that I developed an awareness of the financial benefits of collecting art. The numbers have been quite extraordinary.  At this juncture in the market place art seems to me to present the clearest course of medium and long term profit for the non-trading investor.