To say it's been a tumultuous time in the markets since our last letter is perhaps the height of understatement. Just when we had thought we had seen it all, new revelations have shaken investors like us to the very core of our fundamental beliefs.

The ongoing Enron-Anderson debacle, Tyco, Adelphia, Global Crossing, ImClone & Martha Stewart have only served to set the stage. The WorldCom meltdown and now, rumours of aggressive financial reporting at General Electric, Merck, and perhaps others, have taken basic accounting issues to the forefront of investor concerns. Investors now rightfully wonder whether owning obligations of corporate America is akin to a trip to Las Vegas. Clearly, the fundamental trust of many has been broken by a mere few. And while we do not believe that our capitalist system is inherently flawed or broken, trust is a virtue that is hard to engender and easily lost. As a result we have a stock market slump unlike no other. Despite a recovering economy and interest rates at levels that haven’t been seen in generations, the NASDAQ is now at 70% below its peak levels and the S&P 500 index is mired some 36% below its record close. Markets appear to be adrift. Some sort of credit crunch related to the stock market bubble appears inevitable as the unwinding continues. If recent events don’t succeed in washing all the excesses out of this market, then we wonder what it will take.

Yet amidst all this bad news, we need to keep a few things in perspective. While U.S. markets have suffered, other equity markets have fared even worse. For example, the German DAX and the French CAC 40 are both down both down approximately 45% from their respective peak levels. In other words, the perception of U.S. markets relative to others appears worse than the reality due to the shocking revelations of a few high profile U.S. companies. In addition, the long overdue weakness in the U.S. dollar may in fact simply reflect weakness in the global economy and its impact on trade flows. On this point, we have perhaps had less concern than others. A lower U.S. dollar, while contributing to higher inflation in the short term, will help redress trade imbalances and stimulate U.S. manufacturing over time. Of greater immediate concern is the protectionist trade stance of the Bush Administration. For a president that is supposedly pro-free enterprise, George W. seems intent on raising barriers to free trade in many sectors. To us, this strategy appears contrary to what is needed at this time of global weakness.

We would be remiss at this point to not comment on gold and the shares of gold producers. Given the weakness of the U.S. dollar, the negative investor psychology and the turbulent geopolitical environment, the price of gold would appear to be headed higher in the medium term (3-9 months). However, the majority of gold producers have exhibited flat to declining production over the last ten years and price hedging has been rampant. We have spent considerable time trying to identify companies that can expand reserves and production during the next one to two years and that opt for minimal hedging in their corporate strategies. We believe that a weighting in gold shares is prudent in this environment and we have worked diligently to find the best growth orientated companies available in this sector.

From our perspective, the U.S. Federal Reserve appears to be caught in a box. Interest rates already have been reduced to levels not seen in generations. Any further reductions from here would connote serious economic difficulties and send the wrong signal. At the same time, higher rates at the moment seem untenable. Therefore, it is our view that interest rates will remain unchanged at their current levels for some time to come.

The threat of the terrorist actions, while perhaps more muted, has not gone away. Terrorism hangs like a cloud over markets in general. We suspect that like it or not, this will remain a concern that we will have to adjust to over time and will be negatively reflected in earnings multiples.

In sum, share valuations that have already suffered from a lack of earnings visibility, are now also dealing with a lack of credibility. We believe that markets need to reach the capitulation stage in order to clear the air. This will likely be characterized by high volume and a sharp, swift downward move. Shares need to be taken out of weak hands. The result of this cleansing process will be more stringent accounting, better reporting and disclosure and improved corporate governance. We believe that these changes are
already underway. Unlike in Japan, the U.S. economy tends to respond quickly to changes in markets.

In all this swirling morass, stocks have become disconnected from the economy and underlying business fundamentals. As the saying goes, markets are often too quick to throw the baby out with the bath water. While accounting and governance issues plague a relatively limited number of high profile companies, the vast majority of U.S. corporations have conducted business according to the rules and with reasonable judgement. While inventory rebuilds have overstated the case, the U.S. economy is recovering, auto and housing sales have displayed tremendous resilience and, demand from Asian economies (ex: Japan) could surprise on the upside. We are now able to find solid growth companies selling at much more reasonable multiples to their growth rates. In fact, we are very confident that on a relative basis, our portfolios now hold stocks that are reasonably valued when compared to their growth rates. Our portfolios are constructed with a very diversified list of companies that have out-performed relative to growth indices since the beginning of the year.

A summer rally not withstanding, we believe that equity markets will remain range-bound for the foreseeable future. As a result, a higher level of trading than normal is anticipated in your portfolio. Cash will also be used when appropriate to position us to take advantage of market weakness.

In this environment, we recognise that valuation is key to achieving out performance relative to benchmarks. Growth stocks have been out of favour for the past two years, we suspect a change in sentiment is not too far off. We are encouraged by the outlook because we believe we are in a stock-pickers’ market. This is our forte.

Disclaimer:
This report is intended for clients of Galileo Global Equity Advisors Inc. Galileo Global Equity Advisors Inc. invests on behalf of its clients in the issuers mentioned in this report. Employees of Galileo Global Equity Advisors Inc. may own shares. This document is not intended to sell or promote securities.

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