The Inflation Cycle of 2002 to 2015 - Uhlmann Price Securities

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The Inflation Cycle of 2002 to 2015 - Uhlmann Price Securities

For a printed copy of this report, contact your Legg Mason account representative.

Equity Research

Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015

We Began With “Do Commodity-Serving Companies Deserve Your Capital?”

• We believe that inflation versus deflation is underappreciated as a determinant of sector selection success.

• In the past century, stocks and commodities have alternated leadership in regular cycles averaging 18 years.

• During commodity deflation, stocks rose 11.6% per year, but during inflation stocks rose 3.4% per year.

• Although war contributes to inflation, stocks often faltered in the pre-war decade for a variety of reasons.

• We see strong developing country (China, FSU, etc.) usage relative to supply boosting commodity prices.

• Or, if oil deflates, we see Persian Gulf instability leading to major conflict that disrupts oil supply.

• By 2015, we expect $60/bbl. oil, $4.50/bu. corn, and a 5.8% S&P 500 annual total return over the period.

• Commodity strength may benefit machinery EPS, while inflation reduces real capital costs.

• This potential widening of the EVA ® spread may be a reason for the machinery stocks’ high P/Es.

April 19, 2002

• We upgraded our rating on Caterpillar, Deere and Joy Global shares from Market Performance to Buy.

100

U.S. Stock Market Index Performance Relative to The Commodity Market Index, 1870 to 2015E

Rising red bars = Stocks are beating commodity returns.

Falling blue bars = Commodities are beating stock returns.

10

Stocks and commodities have alternated leadership seven

times since 1877 for periods averaging 18 years in length.

1

2002

to

2015

are Legg

Mason

Estimates

0

1870

1880

1890

1900

1910

1920

1930

1940

1950

1960

1970

1980

1990

2000

U.S. Stock Market Composite Price index divided by the PPI Commodities Price Index, years 1871 to 2015E

2010E

Source: NBER, Standard & Poor’s Corporation, U.S. Dept. of Commerce, Legg Mason format and estimates

Barry B. Bannister, CFA

Paul Forward

(410) 454-4496 Associate Analyst

bbbannister@leggmason.com (410) 454-4138

pforward@leggmason.com

Legg Mason Wood Walker, Inc. - Legg Mason Headquarters - P.O. Box 1476 Baltimore, MD 21203 - Member New York Stock Exchange, Inc. - (410) 539-0000


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -2- Legg Mason Wood Walker, Inc.

Table of Contents

Executive Summary……………………………………………………………………………….……… 5 – 6

Report Conclusion: “History Doesn’t Repeat Itself, But It Does Rhyme” – Mark Twain………7 – 25

Stock Rating Changes……………………………..…………………………………………… 8 – 15

Inflation As a Trade-Off Between Hard Assets and Financial Assets……………………….. 16 – 23

The Structure of This Report ..….……………………………………………………………..… 24 – 25

Scenario (1) Continued Deflation, the U.S. Equity Bull Market, and Strong “Tech”

Capital Spending: Probability: 15%……………………………………………………………………26 – 38

Continued Deflation?………………………………………………………………………...… 26

The Historical Parallels in Monetary Policy History………………...…………………….. 26 – 27

Money Supply Growth and Deteriorating Velocity as Precursors of Inflation ..…………. 27 – 29

The Outlook for Domestic Productivity as An Offset To Loose Monetary Policy……….. 29 – 30

The Outlook for Productivity Improvement Overseas That Affects U.S. Competitiveness. 30 – 32

The Commodity Price Sensitivity of the U.S. Economy…………………………………….… 32 – 35

Continuation of the Bull Market and Strong “Tech” Spending (?)...………………………… 35 – 37

The End of the Status Quo?……………...…………………………………………………..… 38

Scenario (2) Rapid Developing Country Modernization And Global Economic Growth Leading

To a Sustained and Inflationary Boom in Commodity Demand: Probability: 60%…….…….39 – 62

Will Surging Demand Create Peacetime Commodity Inflation?…….……………………… 39 – 40

The Energy Price Drivers, 1870 to 2015E………………………...…………….…………… 40 – 43

The Demand Side of the Oil Equation – The 2001 to 2015 Environment……. ..………..… 43

The China Example – Pushing the Oil Demand Envelope…………………….…………… 43 – 45

The Supply Side of the Oil Equation – The 2001 to 2015 Environment.…………………… 45 – 48

Substitute Fuels – Promising, But Enough to Make a Difference?…………………………... 49 – 50

U.S. Farm Commodity Export and Inflation Prospects, 2002 to 2015E…………………... 51 – 62

U.S. Farm Commodity Price Cycles…………………...…………….……………………..… 51 – 53

The U.S. Farm Export Outlook………….………………………...…………….…………… 53 – 57

U.S. Agricultural Exports and Deere Stock……………………………….…. ..…………… 57 – 58

The Global Competitiveness of the U.S. Farm Economy….…………………….…………. 58 – 62

Scenario (3) Middle East War(s) in the Period 2002 to 2015 That Result in Extended Oil

Supply Disruptions: Probability: 25%………………………………………………………...… 63 – 81

The Risk of U.S. Military Action to Change the Iraqi Regime That May

Lead to a Destabilized Region…………………………………………….………………….. 65 – 66

The Risk That Iraq Has or Will Soon Succeed in the Development

of Nuclear Weapons………………………………………………...……………….….…….66 – 69

The Risk of Civil War That Targets Saudi Arabia's Ruling al-Saud Monarchy ..…………..69 – 74

The Risk of Conventional (Non-Nuclear) War Between States in the Region……………... 74 – 77

The Risk of Terrorists Obtaining Nuclear Weapons Developed in the Soviet Union……...78


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -3- Legg Mason Wood Walker, Inc.

Non-Economic Contrasts Between East and West That Affect the Investment Outlook... 79 – 81

Political and Cultural Differences Between East and West………………………………..… 79 – 80

Areas of Instability in the Political and Cultural Relations Between East and West………. 80 – 81

The Fork in the Road – Investors are Along For the Ride………………….…. ..…………. 81

Index of Exhibits

Exhibit 1 – The Stock Market Versus Machinery and the Stock Market Versus Commodities,

1945 to 2001 - Is this a new, secular bull market for machinery?…………..…………………. 8

Exhibit 2 – Machinery Index (CAT+DE+IR+PH) Price Cycles, January 1981 to Present…...…….…. 9

Exhibit 3 – Machinery Index (CAT+DE+IR+PH) Price Cycles, January 1965 to April 1981.…….…. 10

Exhibit 4 – CAT Financial History and Our Projections to 2006, including EVA…….……………….. 11

Exhibit 5 – CAT Price-to-Sales Multiple Versus EVA, 1970 to 2006P…………………....……………. 12

Exhibit 6 – DE stock Versus U.S. Farm Exports, 1962 to 2015E…………………………….……….….. 13

Exhibit 7 – U.S. Electricity Generation By Fuel Source, 1920-2001, Total and % Share By Fuel.…... 15

Exhibit 8 – Coal Prices Versus Stock Prices, real (index year 2000) prices, 1901 to 2001….………… 15

Exhibit 9 – Inflation and Deflation Cycles, 1898 to 2001……………………………………….…….…... 16

Exhibit 10 – PPI All Commodities Index Y/Y % Change Compared to the PPI Subindices for

Energy, Farm Products and Metals, 1870 to 2001…….…………………………………………... 17

Exhibit 11 – Machinery Purchasers XOM, PD, IP and HM Fixed Asset Replacement Rate Versus

Average Remaining Useful Life Of Property, Plant and Equipment, 1950 to 2001…..………. 18

Exhibit 12 – PPI for All Commodities Index, 1870 to 2001, With Our Forecast to 2015……………... 19

Exhibit 13 – U.S. Stock Market Index, 1870 to 2001, With Our Forecast to 2015…………………….. 19

Exhibit 14 – U.S. CPI Inflation Cycles, 1880 to 2001, With Our 2002 to 2015 Estimates………….…. 20

Exhibit 15 – Stock Returns Minus Inflation, 1880 to 2001, with our 2002 to 2015 Estimates………... 21

Exhibit 16 – The Inflation-Adjusted U.S. Stock Market Index, M2 Money Supply, and U.S. Consumer

Price Inflation, The 1901 and 1933 Inflation Cycle Turning Points +/- 12 Years……………... 22

Exhibit 16 Cont’d. – Inflation-Adjusted U.S. Stock Market Index, M2 Money Supply, and U.S.

Consumer Inflation, The 1963 and 2001(E) Inflation Cycle Turning Points +/- 12 Years…….. 23

Exhibit 17 – Return and Growth Table for Commodities, Stocks and Inflation, 2002 to 2015E……….. 25

Exhibit 18 – M2 Money Supply Vs. Consumer Inflation, 10-Year Moving Avg., 1880 to 2001……….. 28

Exhibit 19 – M2 Velocity Versus Consumer Inflation, 10-Year Moving Average, 1880 to 2001………. 28

Exhibit 20 – M2 Velocity Versus CPI Inflation, 1960 to 2001………………………………………………. 29

Exhibit 21 – U.S. Productivity Growth Versus Demographic Measures: The Ratio of Experienced Workers

to Less Experienced Workers as a Driver For U.S. Productivity Growth………………………. 30

Exhibit 22 – Comparative Demographic Trends That We Believe Shape Productivity, the Ratio of 35-49

Year Olds to 20-34 Year Olds, China, Japan and the U.S., 1950 to 2050E………………...…….. 31

Exhibit 23 – U.S. End-Use Energy as a Percentage of GDP……………………………………………..…... 32

Exhibit 24 – U.S. Home Size Versus Energy Costs……………………………………………………………. 33

Exhibit 25 – Long-Term Temperature Trends And Energy Price Inflation……………………………….... 34

Exhibit 26 – S&P Composite P/E Ratios And Inflation Based On the Experience of the Period 1927

to 2001..…………………………………………………………………………………………………... 35

Exhibit 27 – S&P Stock Market Composite Average Annual P/E, 1927 to 2015(E)……………………... 36

Exhibit 28 – U.S. Financing Gap, 1952 to Present……………………………………………………………. 37

Exhibit 29 – The Declining Ability Of Debt to Underpin U.S. GDP Growth……………………………... 39

Exhibit 30 – Raw Materials Intensity At Different Stages of Economic Development………………….. 39


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -4- Legg Mason Wood Walker, Inc.

Exhibit 31 – PPI Energy Price History and Supply/Demand Drivers, 1870 to 2015E...………………... 41

Exhibit 32 – Oil Consumption Per Capita Versus Oil Intensity of GDP, 62 Nations, As Of Year 2000 42

Exhibit 33 – Oil Consumption Per Capita for Japan, South Korea, and China, 1950-2001……………. 44

Exhibit 34 – U.S. Oil Consumption vs. GDP, 1902 to 2001, and for China, 1975 to 2015E…………... 45

Exhibit 35 – World Oil Supply And Demand History and Our Projection to 2015……………………... 46

Exhibit 36 – Oil Export-Based Economies as Share of World Oil Production, 1965-2015E…………… 47

Exhibit 37 – Non-OPEC Reserve-To-Production Ratio, 1952 to 2015E…………………………………... 47

Exhibit 38 – Net Exports and Imports of Oil, and Oil Prices, 1965-2015E..……………………………… 48

Exhibit 39 – Deere Stock Is Driven By Food Exports………………………………………………………. 51

Exhibit 40 – The PPI Price History and Our Estimates For U.S. Agriculture, 1870 to 2015E…………. 52

Exhibit 41 – Deere Stock Is Not Driven By Farm Aid……………………………………………………… 53

Exhibit 42 – Grain Import Hubs Shift Over Time………………………………………………………….. 54

Exhibit 43 – The Transition from Old to New Grain Markets……………………………………………. 54

Exhibit 44 – U.S. Grain Trade Market Share……………………………………………………………….. 55

Exhibit 45 – Key Drivers In Meat Product Trade…………………………………………………………... 56

Exhibit 46 – Deere Stock Follows Tractor Sales Trends…………………………………………………... 58

Exhibit 47 – U.S. Farm Acres and Farm Commodity Pricing……………………………………………... 58

Exhibit 48 – Food Exports Help Drive Food Prices………………………………………………………... 59

Exhibit 49 – Currency Moves Inversely to Food Exports………………………………………………….. 59

Exhibit 50 – U.S. Corn Yields, +/(-) 10% From Trend…………………………………………………….. 60

Exhibit 51 – U.S. Corn Yields and Fertilizer Usage………………………………………………………... 60

Exhibit 52 – Deere Stock and Corn Prices…………………………………………………………………... 62

Exhibit 53 – Persian Gulf Oil as a Percentage of U.S. Consumption, 1970 to 2001……………………. 64

Exhibit 54 – Persian Gulf Oil Exports in Real (Year 2000) U.S. Dollars, 1970 to 2015E…………….. 64

Discussion: Iraq’s Potential Approach to Nuclear Weapons………………………………………………. 66

Exhibit 55 – Cumulative Effect of Oil Price Swings on Wealth Transfer, 1970 to 2001E……………... 70

Discussion: A Brief History of Saudi Arabia and the al Saud Royal Family…………………………….. 71

Exhibit 56 – Saudi Arabian GNP Per Capita and Urbanization………………………………………..…... 73

Exhibit 57 – Saudi Arabia Youth Wave, 1974 to 2040E……………………………………………….……. 73

Exhibit 58 – Middle East Map………………………………………………………………………………….. 74

Exhibit 59 – The Persian Gulf Military Balance in 2001 ………………………………………………….... 75

Exhibit 60 – Military Quality versus Quantity in the Persian Gulf, 2001….………………………….…... 75

Appendix A – U.S. Inflation Cycles From a Monetary History Perspective, 1898 to 2001……….... ….. 82

Appendix B – Caterpillar Inc. Data Used To Build EVA Model, 1970 to 2006E………………………... 85


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -5- Legg Mason Wood Walker, Inc.

Executive Summary

By 2015, we estimate prices of $60 per barrel for oil, $4.50 per bushel for corn, and a 5.8% S&P 500

annual total return (0.4% after inflation) point-to-point from 2002 to 2015. Since a reduction of S&P

500 prospective returns lowers the opportunity cost of capital for machinery companies, and machinery EPS

are often enhanced when the commodity producers they serve have pricing power, we upgraded our rating

on the shares of Caterpillar Inc. (CAT), Deere and Company (DE) and Joy Global Inc. (JOYG) from

Market Performance to Buy. In short, we believe that a secular bull market has begun for commodities

and commodity-serving companies, with the normal peaks and valleys along the way. We are keeping some

powder dry and deferring a Strong Buy rating on the basis of current valuation, the seasonality of machinery

stock performance (which often peaks in May and bottoms in October), as well as our concern that gradually

but steadily rising inflation, which is the view we describe in this report, ultimately will destabilize the

prevailing market sentiment, which we believe retains a long-duration asset bias. The Fed has allowed a

money supply “mountain” to build in recent years, and investments that benefit from even modest inflation,

such as machinery stocks, have a small capitalization relative to the liquidity that now seeks them. For that

reason, as well as the positive spread between commodity industry-leveraged machinery company EPS and

declining machinery company real capital costs as a result of inflation, we would expect machinery valuation

multiples to remain high even as EPS recover, rather than compress rapidly as EPS rise, which is the

historical norm. We believe that the machinery stocks we upgraded would be especially attractive if they

were to retrench, all else being equal, but despite their recent price run, CAT and DE stocks are still within

the multiyear trading range that began after the previous earnings peak in 1997 to 1998. We expect the

stocks we upgraded to lurch out of that multiyear trading range sometime in 2003.

For a sense of history, many commodity producers and the machinery stocks serving them enjoyed a

“secular” bull market from June 1970 to April 1981, but the festivities ended with the collapse of a commodity

bubble around 1980, just as the Fed moved to break inflation, and OPEC overplayed its pricing

hand, causing commodity prices to tumble. After a painful economic adjustment in 1980–82, the old inflation

beneficiaries of the 1970s attempted a false rally in 1982–83, but quickly yielded price leadership to

the new “disinflation” plays. Stocks received a further boost around 1990 when the U.S.S.R. collapsed in a

heap around the same time the U.S. military defeated Iraq in the Gulf War, creating a decade-long peace

dividend, fiscal policy cover for an “easy money” Fed, and U.S. hegemony in the Persian Gulf that ensured

cheap oil for years to come. We believe that the post-Gulf War “New World Order” began to unravel

in 2000, signaled by the NASDAQ composite and then the S&P 500 rolling over, and we do not believe

it was a coincidence that commodity prices and machinery stocks beginning to rise around the

same time.

Commodity-serving machinery generally underperformed in the 1982 to 2000 period we described. But in

historical terms, a shift from the 1982 to 2000 equity bull market to a new period of stronger commodity

prices and, presumably, machinery stock performance, is completely normal. Stocks and commodities, in

fact, have alternated relative and absolute price leadership in cycles averaging 18 years for over a century.

Since 1870, and excluding dividends, U.S. stock prices rose 11.6% per year during deflation cycles and

3.4% per year during inflation cycles. Commodity price bubbles tend to burst (ca. 1920, 1950, 1980) after

military (or economic) warfare and before equity bull markets, the latter of which usually feature declining

commodity input costs that improve business profit margins, falling inflation that increases the P/E multiple

applied to those earnings, and rising debt ratios facilitated by cheaper credit. We do not find those "growth"


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -6- Legg Mason Wood Walker, Inc.

markets to be receptive to machinery stock investing, generally speaking. Alternatively, when stock price

bubbles begin to deflate or burst (ca. 1909, 1929, 1968, 2000), inflation cycles usually follow, largely because

legacy debt must be reduced via some combination of inflation, increased export growth, or default,

and the dislocation of this transition often leads to an “easy” monetary policy and, unfortunately, to military

or economic warfare. The U.S. was embroiled in major (lengthy and global) periods of hot or economic

warfare for 26% of the 20th century. Although war contributed greatly to inflation, stocks often faltered in

the pre-war decade for several reasons, the most common of which was excessive money supply growth

relative to GDP as the central bankers sought to assuage debt problems or fight off wars.

We embarked on our report because we believe that the greatest rewards for investors accrue to those who

are best positioned for the era's big winners, not the occasional cyclical or product growth story. This report

is organized as a probability array of expected values, based on what we believe are the three most plausible

2002 to 2015 outcomes that shape the inflation and market returns picture, which, in turn, shapes the machinery

sales outlook, in our view. We use over 100 years of historical precedent (since 1898) as the

“effect,” and our assessment of facts and our forecasts as the “cause.” For such a long forecast period, we

would expect some combination of these events, so a probability analysis seems the best approach, in our

view. Of course, the scenarios are not mutually exclusive; for example, increased trade could forestall the

risk of war. The scenarios we analyze are as follows.

Scenario (1) Continued price disinflation/deflation, the Western-dominated status quo, resumption of

the technology capital expenditure boom, and prolonged strength for U.S. equity index returns

(probability 15%). In the current cycle, we believe that a reliance on short-term debt has developed, and

we also note the unsustainable divergence between rising debt as a percentage of U.S. GDP and the falling

nominal GDP growth derived from that debt, which causes us to believe that the Fed will not be as aggressive

raising rates this cycle. That is bullish for machinery, in our view, because the Fed's aggressive rate

hikes in the mid-1990s helped cap the recovery in machinery stocks despite generally strong EPS at the

time.

Scenario (2) Rapid developing country modernization and recovering U.S. growth that results in

strong and sustained commodity demand relative to more inelastic supply (probability 60%). We analyze

commodity supply and demand cycles since 1870, as well as the intensity of commodity use during

those phases in which economies modernize and then mature. We believe that the world is in a transition

from slack to generally tight oil supply, the result of strong Asian oil demand, recovering Former Soviet

Union internal usage despite rising production, and the absence of any new “North Sea-sized” non-OPEC,

price-spoiling, discoveries. Whereas OPEC's ability to constrict supply was the “oil weapon” of the 1970s,

we believe that the key to OPEC's strength in the coming years will be its rising share in filling world demand

for oil.

Scenario (3) Major wars produce high inflation, and even minor wars can interrupt trade, so we devote

a section of this report to analyzing the potential for major conflict in the Persian Gulf that may

constrict oil supply (probability 25%). Newton's Third Law of Motion states, "For every action, there is

an equal and opposite reaction.” We believe that the downward force applied to the Persian Gulf as a result

of oil deflation may lead to an upward explosion of war, fueled by the unfortunate recruitment of increasingly

young, disenfranchised male populations by radical leaders making a bid for power. We analyze the

Persian Gulf risks we see, to include those involving Iraq, civil war risk in Saudi Arabia, and other threats.


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -7- Legg Mason Wood Walker, Inc.

Report Conclusion: “History Doesn’t Repeat Itself, But It Does

Rhyme” – Mark Twain

This report began with the question “Do commodity-serving companies, which have generally been

poor investments since the early 1980s, deserve investors’ capital in the coming decade?” Commodityserving

companies generally perform best when commodity supply is tight and/or demand is strong, which

generally has not been the case since 1981. The chart on the cover of this report shows that the U.S. stock

market and the Producer Price Index for commodities have alternated leadership seven times since 1877, in

cycles averaging 18 years, and the hard asset versus financial asset trade-off is clearly driven by inflation.

From 1982 to 2000, commodity prices deflated relative to the S&P 500, and the commodity-serving industries

generally underperformed in that period.

After deliberating on this subject since the growth stock bubble burst in 1Q00, we have come to the

conclusion that the inflation cycle is currently turning up, and we further conclude that this is generally

bullish for the stocks of companies that serve the commodity producers (and, of course, the producers themselves).

We believe signs include surging real estate prices, strong money supply growth, oil and gold

strength, increasing geopolitical instability that may lead to inflationary warfare, and a potential peaking of

the trade-weighted U.S. dollar. While deflation benefits companies with high unit growth and negative pricing

(e.g., computers, software), inflation benefits companies with operating leverage and pricing power.

Throughout this report we use the term deflation in lieu of “disinflation,” but the intent is the same.

We believe a forward-looking approach, if correct, allows investors to position themselves for outsized

investment returns. Positioning is the key word, because analysts are one- or two-trick ponies insofar

as they are generally “wedded” (for richer or poorer) to one or two narrow industry groups, and even

non-specialist investors often require several years to build sector expertise. Foresight is, of course, difficult,

but adversity often has commensurate reward. For example, in 1970, when Middle East troubles were

brewing (after the 1967 war but before the 1973 war) and OPEC (founded in Iraq in 1960) was little known,

a forecast that called for oil to rise tenfold to $30 per barrel within a decade would have been outlandish. In

1980, near the height of inflation, a prediction of double-digit real bond yields in less than a decade would

have seemed absurd. In 1990, when technology stocks were “value” stocks because their earnings were

volatile (sound familiar?), a prediction of a greater-than-tenfold increase to over 5,000 for the NASDAQ

composite within a decade would have seemed ludicrous. But in each of those cases, investors able to anticipate

the environment were well positioned to capitalize on the changes. For the period 2002 to 2015,

we expect a macro-backdrop for our stocks (and the market) with the following features.





Strong nominal GDP growth, with a large real (ex-inflation) GDP component in the first half of

the 2002 to 2015 period, and a larger inflation component in the second half of the period.

Sharply rising GDP leading to Fed rate hikes, but the Fed may have little choice but to return to

an accommodative stance due to the “hangover” of past financial excesses and, potentially, war.

Strong global commodity demand and commodity prices; poor profits have discouraged commodity

producer investment since around 1981, and Persian Gulf instability may constrict supply.

Commodity price pressure that contributes to higher consumer inflation, or, in the case of commodity-consuming

industries with excess capacity, cost pressure may compress profit margins.


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -8- Legg Mason Wood Walker, Inc.




We expect the PPI All Commodities index to outpace the S&P 500 over the 2002 to 2015 period;

we see commodity outperformance particularly strong later in the period.

We see single-digit compounded S&P 500 price returns over the 2002 to 2015 period, as the focus

shifts from liquidity plus rising P/Es to falling P/Es plus EPS growth driving earnings “power.”

Inflation could be made significantly worse if increasing geopolitical instability leads to wars in

the 2002 to 2015 period, possibly in the volatile Middle East where pressures are intense.

Stock Rating Changes

As a result of our research and the preparation of this report, we have upgraded our rating on Caterpillar

Inc. (CAT – $54.92), Deere & Company (DE – $43.25), and Joy Global (JOYG – $16.25) shares

from Market Performance to Buy, since machinery tracks the relative strength of commodity prices,

shown in Exhibit 1. Although none of the stocks appear inexpensive to us on our 2003 estimates, they are

Exhibit 1 – The Stock Market Versus Machinery (Black Line) and the Stock Market Versus

Commodities (Green Line), 1945 to 2001 - Is this a new, secular bull market for machinery?

3.00

2.50

2.00

Note the red and blue lines of alternating stock

market and commodity price leadership correspond

to the cover chart of this report.

S&P beats machinery

and

S&P beats commodities

12.00

?

10.00

8.00

6.00

1.50

S&P beats machinery

and

S&P beats commodities

Machinery beats S&P

and

Commodities beat S&P

4.00

1.00

2.00

0.50

0.00

1945

1950

1955

1960

1965

1970

1975

1980

1985

1990

1995

2000

Stock Market Relative to Machinery

Stock Market Relative to Commodities

Source: U.S. Department of Commerce, Standard & Poor’s Corporation


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -9- Legg Mason Wood Walker, Inc.

moderately attractive because of their leverage to the environment we expect in the coming years. For example,

Caterpillar is the leading provider of engines used in the production and movement of hydrocarbons, as

well as the leading provider of heavy machinery used to extract minerals or build basic infrastructure in

many emerging markets, a number of which are commodity producers. Deere & Company is the leading provider

of farm machinery in the world, and Joy Global has a leading position in electric shovels and underground

coal mining equipment. Our posture since 2000 with respect to CAT and DE has been to trade the

stocks within a price range until EPS began to recover. Both CAT and DE have performed well since 3Q00,

around the same time the price of the S&P 500 began to decline, which we do not believe is coincidental

since that is around the same time the secular changes we outline in this report began to emerge. We turned

neutral on CAT and DE in December 2001 as a result of macroeconomic “balance sheet” concerns that have

since been overshadowed by aggressive (preinflationary?) policy bandages applied to the “cash flow” side of

the economy.

Exhibit 2 – Machinery Index (CAT+DE+IR+PH) Price Cycles, January 1981 to Present

250.00

200.00

150.00

100.00

50.00

Secular

peak

Apr. 1981

Trading

Range

CAT+DE+IR+PH Combined Stock Price Jan-1981 to Present

A pull-back is possible,

our view.

"Cyclical"

+150%

July 1984 to

May 1990

vs. S&P 500 up

140% in the same

period.

Trading

Range

"Cyclical"

+293%

Aug. 1992 to

Mar. 1998 vs. S&P

500 up 223% in the

same period.

Trading

Range

0.00

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

Source: S&P CompuStat, Legg Mason

The machinery stocks have enjoyed a considerable rally since they bottomed in 3Q00, although the

group has not yet broken out of the roughly four-year trading range in which it has been locked. As shown in

Exhibit 2, if there is “only” a post-recession, cyclical recovery in store for machinery, similar to the July

1984 to May 1990 period (+150% absolute performance and +10% relative to the S&P 500), or perhaps

August 1992 to March 1998 (+293% absolute and +70% relative), then we may see a mild pullback before a

multiyear recovery begins. As a result, we are keeping some powder dry and deferring a Strong Buy rating

until we see lower stock prices or a more sustainable EPS recovery on the horizon, all else being

equal.

Our greater interest, and the subject of this report, is a secular, long-term story that may be brewing

for commodities. Since such a story is tied to the inflation outlook, we are mindful that there may be numerous

market dislocations if the inflation mentality changes, and those dislocations may provide lower prices


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -10- Legg Mason Wood Walker, Inc.

Exhibit 3 – Machinery Index (CAT+DE+IR+PH) Price Cycles, January 1965 to April 1981

55.00

50.00

45.00

40.00

CAT+DE+IR+PH Combined Stock Price Jan-1965 to Apr-1981

"Secular"

+221% Machinery

Jun. 1970 to Apr. 1981

vs. S&P Stock Composite +83% in

same period.

35.00

30.00

25.00

Trading

Range

20.00

15.00

1965

1966

1967

1968

1969

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

Source: S&P CompuStat, Legg Mason

for new investors in machinery stocks, even though the group may outperform on a relative basis since it

has historically benefited from commodity inflation. For example, in Exhibit 3 we show the secular bull

market for the machinery stocks in our index during the 1970s, when the group rose 221% from June 1970

to April 1981, versus only an 83% increase for the S&P 500. We note in the chart the sharp price decline

for our machinery index after the 1973 to 1974 OPEC oil embargo and related recession/bear market, and

the sharp rebound when markets realized that machinery stocks were a beneficiary of the inflation that was

created. Potential dislocations may include falling bond prices if 2002 GDP growth is sharply higher, some

Fed rate hikes, commodity and CPI inflation pressure, Middle East political instability, and overseas economic

woes. In addition, as an element of caution, machinery stocks are seasonal, often peaking in May and

bottoming in October, per our research, so we are cautious in a seasonal sense. Lastly, Exhibit 3 shows

that machinery stocks in bullish cycles do have price dips along the way, so we are patient. But we believe

that a longer-term horizon justifies a Buy rating, however, and if there is a pullback in the interim, it may

warrant a Strong Buy rating for CAT, DE or JOYG stock, all else being equal.

Caterpillar’s vertical integration makes it the quintessential operating leverage play in machinery, in

our view. Our approach to CAT and all machinery stocks is to separate the “P” from the “E” in the P/E ratio.

In Exhibit 4, we provide a long-term analysis of CAT in terms of sales, profit margins, EPS and, most

importantly in our view, Economic Value Added (EVA ® ), which is the excess of return on capital over the

cost of capital employed. (Supporting data for these charts are contained in Appendix B.) Starting from the

top left, we forecast that by 2006, CAT’s consolidated sales and revenue growth should climb to the

historical average. In the top right chart, our view is that CAT’s net profit margin as a percent of sales and

revenues should benefit from cost reduction and recovering commodity markets, with a potentially weaker


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -11- Legg Mason Wood Walker, Inc.

Exhibit 4 – CAT Financial History and Our Projections to 2006, including EVA

25.0%

21.0%

17.0%

13.0%

9.0%

5.0%

1.0%

-3.0%

-7.0%

-11.0%

-15.0%

CAT Sales & Revenue, 3-Year Growth, 1950-2006E

We estimate

moderate sales

growth to 2006.

50

52

54

56

58

60

62

64

66

68

70

72

74

76

78

80

82

84

86

88

90

92

94

96

98

00

02E

04E

06E

CAT Sales and Revenues, 3-Year Moving Average Growth Rate

LM

Ests.

13.0%

11.0%

9.0%

7.0%

5.0%

3.0%

1.0%

-1.0%

-3.0%

-5.0%

-7.0%

CAT Consolidated Net Profit Margin, 1950 to 2006E

We estimate net margin

to recover substantially

by 2006.

50

52

54

56

58

60

62

64

66

68

70

72

74

76

78

80

82

84

86

88

90

92

94

96

98

00

02E

04E

06E

CAT Consolidated Net Profit Percent of Sales and Revenues

LM

Ests.

$10.00

$1.00

$0.10

CAT EPS (Excl. Loss Years), 1963 to 2006E

We expect EPS to

recover on a log scale

to a top-of-trend level

by 2006.

L

O

S

S

E

S

63

65

67

69

71

73

75

77

79

81

83

85

87

89

91

93

95

97

99

01

03E

05E

L

O

S

S

E

S

LM

Ests.

NOPAT ROIC Minus WACC

12.00%

10.00%

8.00%

6.00%

4.00%

2.00%

0.00%

(2.00%)

(4.00%)

(6.00%)

(8.00%)

(10.00%)

(12.00%)

(14.00%)

(16.00%)

(18.00%)

Caterpillar EVA (%) Each Year, 1970 to 2001 Actual

With Our 2002 to 2006 Estimates and Projections

EVA finally recovers significantly

through 2006 in our model.

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002E

2004E

2006E

Caterpillar EPS (Log Scale, Excludes Loss Years)

(20.00%)

Source: Company reports, Moody’s Industrial Manuals, Standard and Poor’s Corporation, Legg Mason estimates. EVA is a registered

U.S. dollar as well. As a result, by 2006, we foresee a 9.6% net profit margin, eclipsing the 8.8% peak

achieved in 1997, thus rivaling the best of the post-World War II years, since CAT is significantly more

lean and well managed after 20 years of surviving hardship, in our view. Multiplying the results from the

preceding charts, and dividing by shares outstanding, in the bottom left chart we show CAT’s EPS tracking

to a potential “cyclical peak” level of about $8.00 by 2006. In the bottom right chart, we show the net

operating profit after taxes (NOPAT) return on invested capital (ROIC) comfortably rising above the

weighted average cost of capital (WACC), generating positive EVA in the 2002 to 2006 period.

There is a clear relationship between CAT’s stock price as a multiple of consolidated sales and

revenues per share (i.e., P/S) and CAT’s EVA, shown in Exhibit 5. By analyzing the period 1970 to

2006E in our chart, we capture most of one entire inflation cycle (the 1970s), one deflation cycle (1980s

and 1990s), and the beginnings of what we view to be another moderate inflation cycle (the first five years


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -12- Legg Mason Wood Walker, Inc.

Exhibit 5 – CAT Price-to-Sales Multiple Versus EVA, 1970 to 2006E

1.30

CAT Price/Sales vs. Annual EVA , 1970 to 2006P

(1997 (Prior EPS Peak) = Black Circle; 2000 (Cyclical Trough Price) = Blue Triangle; Current Price/Sales Multiple on

2003E = Red Circle, Current Price/Sales on 2006P Potential Cyclical Peak = Green Square)

Price / Sales Multiple

1.20

1.10

1.00

0.90

0.80

0.70

0.60

0.50

0.40

0.30

0.20

0.10

CAT's price/sales multiple versus

EVA guides our full-cycle trading

range expectations.

0.00

(18.00%) (15.00%) (12.00%) (9.00%) (6.00%) (3.00%) 0.00% 3.00% 6.00% 9.00% 12.00%

Caterpillar Annual EVA % (NOPAT ROIC minus WACC)

2003E

2000

1997

2006P

Source: Moody’s Industrial Manual, Company reports, Legg Mason 2002 to 2006 estimates

of 2001 to 2015). Of course, part of Caterpillar’s improvement in EVA since the absolute trough in 1984 is

that CAT has developed a large finance company, which tends to lower the WACC but increase debt leverage.

Largely for that reason, Caterpillar’s consolidated debt divided by the market value of equity rose from

48% in 1984 to 97% in 2001. At CAT’s prior cyclical peak EPS ($4.37) in 1997, the company’s EVA was

584 basis points, and the P/S multiple was 0.97x, shown in Exhibit 5 as a black circle. By 2000, at what we

believe to be the cyclical trough for CAT’s average annual stock price ($37.90), CAT investors were

positioned for only about 100 basis points, on average, of EVA in the subsequent two years, and the P/S in

2000 was only 0.65x, shown by a blue triangle. Currently, CAT stock trades at a P/S of 0.89x our 2003

expectation for sales and revenues per share, with an EVA of 100 basis points, shown by a red circle. In

our view, CAT’s 2003 P/S multiple is a bit rich, but does not negate the likelihood of positive absolute

returns if one sees CAT nearing cyclical peak EPS in the year 2006. If CAT’s results track as we expect

to 2006, then the EPS of $8.00 and consolidated sales and revenues of $28.9 billion in that year produce a

current P/S multiple (using the current price divided by sales and revenues per share in 2006E) of 0.66x,

and an EVA of 552 basis points that year.

The purchase decision with respect to CAT stock is, of course, tied to what sort of return expectations

satisfy the buyer of the shares. We believe CAT stock could earn a P/S multiple of 1.00x in 2006, a

premium to the regression line in Exhibit 5, as a result of then-expected cyclical optimism, equating to a

price of $83 in our model ($28.9 billion 2006E sales and revenues divided by 348.5 million shares). This

price is also a P/E just over 10x our “peak” projected level of $8.00. From the current price of

approximately $54.92, that is a price return potential of about 11% and a total return potential of 13%

including dividends on an annual basis. We prefer a 20% annual total return for a Strong Buy rating, which

equates to a price of $43 for CAT stock now, all else being equal. Returns are often relative, however, and


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -13- Legg Mason Wood Walker, Inc.

our previous WACC calculations contained a S&P 500 “opportunity cost” price return projection. For the

period of this writing to 2006, we forecast an annual total return for the S&P 500 of approximately 8.0%

(2.1% dividend reinvested, 5.9% price). CAT stock appears to offer a superior relative total return of over

300 basis points, warranting a Buy rating, in our view. In addition to the normal retinue of cyclical

economic indicators in recovery mode, as a nonstandard indicator we also cite the recent strength of gold.

Recall that in February 1993 gold prices began to rise sharply, and CAT stock also continued a strong,

cyclical recovery in that year. Later in this report we outline a view that the Greespan Fed depends upon the

U.S. consumer to sustain the economic recovery, and since the consumer appears to require low interest

rates to avoid a painful and abrupt decline in consumer activity, we doubt the Fed will pursue an

aggressive rate policy in 2002–2003 as it did in the earlier, mid-1990s cyclical economic recovery.

Deere stock is the quintessential farm economy “macro-play,” in our view. Despite diversification efforts

that often have proven fruitless, Deere, fortunately, has enhanced its leadership position in farm machinery.

In Exhibit 6, we show that DE stock tracks U.S. agricultural exports, the latter being driven by a

complex mix of global GDP, dietary enrichment, foreign exchange, hydrocarbon input costs, weather, free

trade practices, interest rates, and government payments to farmers. But a 20-year period of hardship has a

way of warping the mindset of an industry, and we believe most analyses of agriculture are not sufficiently

Exhibit 6 – DE stock Versus U.S. Farm Exports, 1962 to 2015E

Real U.S. Agricultural Exports ($ Mil.)

$110,000

$100,000

$90,000

$80,000

$70,000

$60,000

$50,000

$40,000

$30,000

$20,000

Deere Performance Tracks U.S. Food Exports

Real Export

CAGR 1962 to

1996 =

2.7%/year

Machinery industry and farmer over-capacity

plagued profits, but consolidation resulted.

1962

1964

1966

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002E

2004E

LM

Ests.

Real Export

CAGR 1996 to

2015E =

2.4%/year

2006E

2008E

2010E

2012E

2014E

14.0%

12.0%

10.0%

8.0%

6.0%

4.0%

2.0%

Deere Relative to the S&P 500

Real U.S. Farm Product Exports, U.S. $ Mil. (Left)

Deere Stock Relative to the S&P Composite (Right)

Source: USDA, S&P Compustat, Legg Mason 2002 to 2015 estimates


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -14- Legg Mason Wood Walker, Inc.

open to the improving conditions. The actual trend for real U.S. agricultural exports was 2.7% growth (PPI

index year 2000) from 1962 to 1996, and we see real growth of only 2.4% from 1996 to 2015E, or from

$64.3 billion of real U.S. agricultural exports in 1996 ($52.3 billion in current, 2001 dollars) to $100 billion

in 2015. U.S. agricultural exports have been volatile, with inflation-adjusted U.S. agricultural exports rising

from $27 billion in 1969 to a peak of $67.2 billion in 1980, but then plunging to $32.4 billion in 1986. Exports

then climbed to a peak of $64.3 billion in 1996, on the strength of developing country demand and

weather-related supply disruptions, but fell to $50.8 billion in 2000 before beginning a gradual recovery.

Generally speaking, we see higher commodity prices, a weaker U.S. dollar, and improved emerging

market economies, all of which support export prospects for U.S. farmers, in our view. The diminution

of European Union (EU) and Former Soviet Union (FSU) grain and meat import markets, which had been

the “story” of the 1970s and 1980s but burst in the 1990s, is key. While the EU and FSU have contracted,

the “new” markets in the Atlantic, Pacific and Middle East have continued to expand, which we believe is

key to U.S. export prospects. A weaker U.S. dollar cycle also would assist U.S. farm exports, since U.S. agricultural

exports fell 14.1% from 1995 to 2000, as the U.S. farm trade-weighted dollar rose 18.9% in that

period. Since the U.S. farmer competes with currencies that may appreciate along with commodity prices (e.

g., those of Canada, Australia, and the FSU), as well as against the low-priced European euro, the stage may

be set for stronger U.S. agricultural exports in the coming decade. The U.S. Department of Agriculture

(USDA) estimates agricultural exports of $54.5 billion in 2002, up 10.8% from the trough of $49.2 billion

in 1998, which we see as the beginning of a long-term recovery for various reasons outlined later in this report.

As a result, we expect DE stock to outperform the S&P 500 more frequently in the period from 2002

to 2015.

Although conditions have been less rosy for Deere in terms of U.S. agricultural trade since 1981, a favorable

side effect has been farm machinery industry capacity rationalization. As total U.S. row crop

tractor plus combine harvester unit sales fell from 94,700 units in 1979 to 23,482 units in 2001, the farm

machinery industry consolidated to a handful of global players. Also, the number of U.S. farms fell 10.9%

from 1979 to 2001, and U.S. planted acreage fell 7.9%. Were it not for farm subsidies, capacity would have

been reduced further, but we note that Deere targets larger, more profitable farms that tend to purchase and

turn over equipment fleets more frequently. We discuss the farm outlook in greater detail later in this report.

We view Joy Global (JOYG) as the quintessential coal play; seeking to participate in those cycles, we

upgraded our rating on JOYG stock from Market Performance to Buy. We view JOYG stock as a

prime beneficiary of the recovery of the worldwide coal, copper, and steel (via iron ore) prices, as well as

the recent strength in gold mining, since the company is a dominant niche producer of electric shovels and

underground coal mining machines. Having emerged from bankruptcy on July 12, 2001, with greatly reduced

debt, Joy Global (formerly known as Harnischfeger Inc.) has been buffeted by an unusually warm

winter that depressed electric utility output, and thus coal mining, since approximately 90% of U.S. coal is

used to provide electricity, and utilities have accumulated coal inventory left over from the mild winter. We

note, however, that coal inventory at electricity producers as a percentage of trailing 5-year average annual

usage was 13.9% in 2001, versus 11.1% in 2000, but still below the 10-year average of 14.6%. In addition,

electricity utility industrial production has begun to recover from the recession. Weak housing, auto and

electronics markets also have depressed the copper and steel (iron ore) markets to which Joy Global sells,

but those markets appear to be resilient and, as we said, we do not wish to fight the Fed anymore with respect

to those early cycle groups, at least for the time being. Given that Joy’s wagon is tied to coal, in Exhibit

7 we show that coal has provided 52% of growing U.S. electric power for the past 80 years with an an-


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -15- Legg Mason Wood Walker, Inc.

nual standard deviation of only 3%, and coal’s

outlook as a domestic, thermally efficient, increasingly

clean source of power remains solid,

in our view.

Exhibit 7 – U.S. Electricity Generation By Fuel

Source, 1920-2001, Total and % Share By Fuel

100%

Other

Joy Global has more “low-hanging fruit” costreduction

potential than most machinery makers,

in our opinion, such as inventory turns of only

1.9x (FIFO basis), the improvement of which could

reduce Joy Global’s modest 30% net debt to capital.

Whether management will improve the company

is difficult to say, but the cycle is our main

interest, and the cycle is largely beyond management’s

control, in our opinion. In Exhibit 8, we

show that the inflation-adjusted price of coal and

the U.S. stock market move in opposite directions,

and appear to be converging yet again. For more

information on JOYG stock, we refer investors to

our basic report on the company dated September

10, 2001.

90%

80%

70%

60%

50%

40%

30%

20%

10%

0%

1920

1925

1930

1935

1940

1945

1950

Hydroelectric

Gas

Coal

1955

1960

Petroleum

Nuclear

1965

1970

1975

1980

1985

1990

1995

2000

Source: Bureau of Labor Statistics;.EIA; U.S. Census Bureau, Historical

Statistics of the United States, Colonial Times to 1970

Exhibit 8 – Coal Prices Versus Stock Prices, real (index year 2000) prices, 1901 to 2001.

$100.00

Good for coal = bad for stock prices:

There is a 100 year precedent showing an inverse

relationship between coal prices and the S&P

Stock Market Composite price.

10,000

1,000

Average

2001 coal

spot price

100

$10.00

10

1901

1905

1909

1913

1917

1921

1925

1929

1933

1937

1941

1945

1949

1953

1957

1961

1965

1969

1973

1977

1981

1985

1989

1993

1997

2001

Bituminous Coal FOB Mine, $ per Short Ton, Real (year 2000) Prices, Left

S&P Stock Market Composite, Real (year 2000) Prices, Right

Source: EIA; U.S. Census Bureau, Historical Statistics of the United States, Colonial Times to 1970


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -16- Legg Mason Wood Walker, Inc.

Inflation As a Trade-Off Between Hard Assets and Financial Assets

Until now, we have discussed our conclusions, but now it is time to discuss the reasoning behind those

conclusions. Exhibit 9 shows the three U.S. commodity inflation (pre-war and wartime) and deflation periods

of the 20th century. We note the following cyclical characteristics and similarities.


The commodity inflation periods averaged 19 years in length, but have grown shorter, and regardless of

whether the pre-war or war years are examined, the entire period featured generally high money supply

(M2) growth, moderately high or high inflation, and uniformly low stock market returns.

Exhibit 9 – Inflation and Deflation Cycles, 1898 to 2001

Inflation (Pre-War and War) Cycles CAGR of CAGR of CAGR of CAGR of CAGR of CAGR of CAGR of

PPI - All PPI PPI M2 Money Real U.S. CPI U.S. Stock

Com- Farm Fuels Supply Economic Urban Market

Start End Yrs. modities Products & Power Growth Growth (1) Inflation Index (2)

Cycle One 1898 to 1920 22 5.4% 5.7% 7.3% 7.6% 3.4% 4.1% 2.2%

Pre-war period was: 1898 to 1914 16 2.2% 2.9% 3.1% 6.5% 3.9% 1.2% 3.0%

War years were (3) : 1914 to 1920 6 14.6% 13.3% 19.4% 10.8% 1.1% 12.2% 0.1%

Cycle Two 1933 to 1951 18 5.6% 7.9% 3.6% 8.2% 5.4% 4.0% 5.6%

Pre-war period was: 1933 to 1939 6 2.6% 4.1% 1.6% 7.7% 5.7% 1.2% 5.8%

War years were (4) : 1939 to 1951 12 7.1% 9.9% 4.7% 8.5% 5.5% 5.3% 5.5%

Cycle Three 1965 to 1981 16 7.2% 8.1% 13.2% 8.4% 3.4% 6.8% 2.3%

Pre-Oil Embargo (5) was: 1965 to 1973 8 4.3% 4.1% 4.4% 7.7% 4.2% 4.4% 2.3%

Oil Embargo(es) were: 1973 to 1981 8 10.2% 12.2% 22.8% 9.2% 2.9% 9.4% 2.3%

Cycle One, Two, and Three Average:

of which the pre-war average was:

and the war-related (6) average was:

19 6.1% 7.2% 8.1% 8.1% 4.1% 5.0% 3.4%

10 3.0% 3.7% 3.0% 7.3% 4.6% 2.3% 3.7%

9 10.7% 11.8% 15.6% 9.5% 3.2% 9.0% 2.6%

Deflation (Post-War) Cycles

CAGR of CAGR of CAGR of CAGR of CAGR of CAGR of CAGR of

PPI - All PPI PPI M2 Real U.S. CPI U.S. Stock

Com- Farm Fuels Y/Y % Economic Urban Market

Start End Yrs. modities Products & Power Growth Growth (1) Inflation Index (2)

Cycle One 1920 to 1933 13 ( 6.3 )% ( 8.0 )% ( 6.7 )% 1.0% 0.1% ( 3.3 )% ( 0.1 )%

Roaring 20s were: 1920 to 1929 9 ( 5.2 )% ( 4.0 )% ( 7.2 )% 4.3% 3.6% ( 1.7 )% 12.8%

Cycle Two 1951 to 1965 14 0.4% ( 1.6 )% 0.4% 5.6% 4.0% 1.4% 10.4%

Cycle Three 1981 to 2001 20 1.6% 1.8% 0.4% 5.8% 3.1% 3.4% 11.8%

Cycle One, Two, and Three Average (7): 14 ( 1.1 )% ( 1.3 )% ( 2.2 )% 5.2% 3.6% 1.0% 11.7%

(1) For U.S. economic growth, we use real GNP prior to 1947, and GDP thereafter, indexed to year 2001 U.S. dollars.

(2) This is the U.S. stock market composite index price return only, and does not include reinvested dividends.

(3) Though World War I ended in 1918, we include 1919 to 1920 because the war's commodity bubble and deficit spending continued.

(4) We include the post-World War Two period since price controls were lifted after the war, and the Korean Conflict had some impact.

(5) The Great Society "war" on poverty, plus Vietnam, were more regional rather that global in focus, in our view.

(6) Average of World Wars I and II, as well as the global economic warfare of the Middle East war-related Oil Embargoes of the 1970s.

(7) Average of Roaring 20s, Cycle Two and Three; the deflationary calamity of the early 1930s renders comparable analysis meaningless.

Source: Legg Mason, data from U.S. Dept. of Commerce, U.S. Census publication “Historical Statistics of the United States, Colonial

Times to 1970,” Standard and Poor’s Corporation, National Bureau of Economic Research macroeconomic database


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -17- Legg Mason Wood Walker, Inc.

The commodity inflation cycles were followed by deflation (peace dividend) cycles that averaged 14

years in length, but have grown longer, and featured moderate M2 and real GDP growth, low inflation

and high equity returns.

We foresee a period in the 2002 to 2015 time frame in which M2 growth generally maintains its current,

high growth rate, inflation gradually begins to accelerate, and stock market returns moderate. We also believe

that the 2002 to 2015 period may feature either a “pre-war” phase, or a new type of global

“growth explosion” phase, and that issue is the subject of this report.

Even though commodities have different applications, inflation is a uniting factor, and in Exhibit 10

we show that their prices tend to rise and fall in unison. The three major commodity inflation periods highlighted

in Exhibit 10 are labeled “A” for inflation Cycle One (1898 to 1920), “B” for Cycle Two (1933 to

1951), and “C” for Cycle Three (1965 to 1981). The fourth expected cycle, 2002 to 2015, is the subject of

this report. Note that in addition to the PPI for All Commodities, shown as a red line in Exhibit 10, we provide

the subindices for Fuels and Electricity, Farm Products, and Metals, all of which are of interest in our

machinery research. The polarizing inflation effect of major wars is clear, but we observe that the commodity

inflation periods generally began before the “hot” or economic warfare began in earnest. For the years

2002 to 2015, we forecast a 6.1% compound annual growth rate for the PPI for All Commodities index.

Exhibit 10 – PPI All Commodities Index Y/Y % Change Compared to the PPI Subindices for

Energy, Farm Products and Metals, 1870 to 2001

25%

Commodity inflations tend to occur in unison.

20%

y/y %, 10-year moving average

15%

10%

5%

0%

A

B

C

LM forecast

for PPI All

Commodities

2002 to 2015

-5%

-10%

1880

1890

1900

1910

1920

1930

1940

1950

1960

1970

1980

1990

2000

2010E

PPI All Commodities 10-Yr. Moving Average

PPI Fuels and Electric Power 10-Yr. Moving Average

PPI Farm Products 10-Yr. Moving Average

PPI Metals and Metal Products 10-Yr. Moving Average

Source: U.S. Dept. of Commerce, U.S. Census publication “Historical Statistics of the United States, Colonial Times to 1970,” Standard

and Poor’s Corporation, National Bureau of Economic Research macroeconomic database, Legg Mason estimates for 2002 to


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -18- Legg Mason Wood Walker, Inc.

Companies that produce commodities spend more on capital assets when they are profitable, which

occurs when commodity prices and demand are strong. In Exhibit 11, for the half-century period 1950

to 2001, we show the fixed asset replacement rate relative to annual depreciation, depletion and amortization

(DD&A), as well as the remaining useful (book) life of fixed assets, for four consumers of various

types of machinery produced by Caterpillar, Deere, or Joy Global. Those companies are Exxon Mobil

(XOM), Phelps Dodge (PD), International Paper (IP), and the former Homestake Mining (HM is latest 12

months through September 2001). Note the way in which those companies spent capital when they had pricing

and volume, circa 1965 to 1980. Times have changed, and we expect those companies, as well as other

survivors in their industries, to be more careful with respect to spending than they were in the commodity

bubble of the 1970s. Nevertheless, we find it interesting that capital spending is currently at a historically

low level relative to DD&A, and there is room to increase the remaining useful life of the producers’ net

fixed assets if profits allow for capital spending, which we believe would require demand and pricing for

commodities to surprise on the upside. Even without a repeat of the 1970s aberration, our goal is to position

investors to take advantage of the demand and pricing recovery cycle we see from 2002 to 2015.

Exhibit 11 – Machinery Purchasers XOM, PD, IP and HM Fixed Asset Replacement Rate

Versus Average Remaining Useful Life Of Property, Plant and Equipment, 1950 to 2001

Capital Exp. Divided by DD&A (%

400%

300%

200%

100%

0%

1950

The Average Fixed Asset Replacement And The Remaining Useful (Book) Life Of Fixed

Assets, For Several Major Commodity Producers, 1950 to 2001

18 Yrs.

The prior

commodity

16 Yrs.

inflation.

1955

1960

1965

1970

1975

1980

1985

Capital Expenditures Divided By DD&A for XOM, PD, HM, and IP, Straight Average (Left Axis)

Net PP&E Divided By DD&A for XOM, PD, HM, and IP, Straight Average (Right Axis)

1990

1995

2000

2005E

?

2010E

2015E

14 Yrs.

12 Yrs.

10 Yrs.

8Yrs.

Net PP&E Divided By DD&A

(Average Remaining Life of Net

PP&E), years

Source: Company reports

The relative performance of commodities versus stocks, shown on the cover of this report, is an interesting

concept, but investors cannot “spend relative performance.” In Exhibit 12, we drill deeper into

our cover page chart, and show the actual values for the PPI All Commodities index in the years 1870 to

2001, with our forecast for the period 2002 to 2015. In Exhibit 13, we show the same for the U.S. stock

market.


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -19- Legg Mason Wood Walker, Inc.

Exhibit 12 – PPI for All Commodities Index, 1870 to 2001, With Our Forecast to 2015

1000

100

Note the trade-off between

commodity and stock price

leadership.

1898 to

1920

+219%

(57)%

1933

to

1951

+167%

+6%

1965

to

1981

+204%

+38%

2001 to

2015?

+130%

LM

Ests.

10

1

1870

1880

1890

1900

1910

1920

1930

1940

1950

1960

1970

1980

1990

2000

2010E

PPI- All Commodities Index

Source: U.S. Dept. of Commerce, U.S. Census publication “Historical Statistics of the United States, Colonial Times to 1970,” Standard

and Poor’s Corporation, National Bureau of Economic Research macroeconomic database, Legg Mason estimates for 2002 to

Exhibit 13 – U.S. Stock Market Index, 1870 to 2001, With Our Forecast to 2015

10000

1000

100

Note the trade-off between

stock and commodity price

leadership.

1898 to

1920

61%

+196%

1920

to

1929

1933

to

1951

+167%

1933-51

+299%

1965

to

1981

+45%

+798%

2001 to

2015?

+83%

LM

Ests.

10

1

1870

1880

1890

1900

1910

1920

1930

1940

1950

1960

1970

1980

1990

2000

2010E

S&P Stock Market Composite (Log Scale)

Source: U.S. Dept. of Commerce, U.S. Census publication “Historical Statistics of the United States, Colonial Times to 1970,” Standard

and Poor’s Corporation, National Bureau of Economic Research macroeconomic database, Legg Mason estimates for 2002 to


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -20- Legg Mason Wood Walker, Inc.

We believe inflation cycles are more regular and pronounced when viewed through the lens of longterm

history. In Exhibit 14, we show the 10-year moving average of consumer price inflation, with our

forecast for the 2002 to 2015 period. The trough years for the inflation index cycles were 1901, 1933, 1963

and, we believe, 2001. Bonds are usually the first to react to those inflation concerns, and thus far we note

that there is little reason for alarm. For example, Treasury Inflation-Protected Securities (TIPS) spreads

have widened, but no differently than they did in the Spring of 2001 when there was also economic recovery

optimism. The fact that so little inflation risk is embedded in market expectations only raises the risk to

investors if we are correct about the direction change.

Exhibit 14 – U.S. CPI Inflation Cycles, 1880 to 2001, With Our 2002 to 2015 Estimates

CPI - Urban Inflation Rate, 10-Yr. Moving Average

10%

8%

6%

4%

2%

0%

-2%

-4%

Periods of commodity inflation have similar implications for consumer inflation, as well

as the stock market via compression of valuation and profit margins.

1901

1933

CPI Inflation Cycles

1880

1885

1890

1895

1900

1905

1910

1915

1920

1925

1930

1935

1940

1945

1950

1955

1960

1965

1970

1975

1980

1985

1990

1995

2000

2005E

2010E

2015E

1963

CPI Urban Inflation Rate, 10-Yr. Moving Average

2001

2002 to

2015

LMWW

Ests.

Repeat

of the

Cycle?

Source: U.S. Department of Commerce, U.S. Bureau of the Census, Standard and Poor’s Corp., Legg Mason estimates for 2002 to

For investors with a long-term horizon, acknowledging the inflation cycle enables them to position

portfolios by better understanding the real return cycles of the inflating and deflating assets. In Exhibit

15, we show the 10-year moving average of the real (after consumer inflation) price return of the U.S.

stock market composite for the 1880 to 2015E period. We note the way in which the real price return of

stocks fluctuates around 0% plus-or-minus 10%. After a fairly normal retrace from negative-to-positive returns

in the 1982 to 2000 period, we believe the recent market break foreshadows a period of declining real

returns, with the greatest adversity felt later in the 2002 to 2015 period.


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -21- Legg Mason Wood Walker, Inc.

Exhibit 15 – Stock Returns Minus Inflation, 1880 to 2001, with our 2002 to 2015 Estimates

Stock Price Return Minus CPI Inflation, 10-Year M.A.

15%

10%

5%

0%

-5%

-10%

-15%

CPI inflation cycles shown in boxes. Note that stocks follow a +/- 10% real return track.

1880

1885

1890

1895

1900

1905

1910

1915

1920

1925

1930

1935

1940

1945

1950

1955

1960

1965

1970

1975

1980

1985

1990

1995

2000

2005E

2010E

2015E

S&P Stock Composite Return Minus Consumer Inflation 10-yr. Moving Average

2002 to

2015

LMWW

Ests.

Source: U.S. Department of Commerce, U.S. Bureau of the Census, Standard & Poor’s Corp., Legg Mason estimates for 2002 to 2015

Although we have stated that war and inflation are linked, we observe that rapid money supply

growth typically has begun several years before wars. In Exhibit 16, we walk through the quantitative

side of the macro-history of U.S. inflation and stock market cycles, and demonstrate the effect each has on

the stock market. The chart pairs are displayed as follows:





Each of the chart pairs in Exhibit 16 is centered on the trough year for the inflation cycle previously

identified as 1901, 1933, 1963 and, we believe, 2001.

For each of those years, we show the inflation-adjusted U.S. stock market index versus M2 money supply

growth (left chart) and versus the U.S. consumer price inflation index (right chart), in the 12 years

before and after the inflation cycle trough year. Each point is a 12-month average.

The charts show the way in which, approximately every one-third of a century, (1) M2 rises, (2) stocks

rise, (3) inflation rises, (4) stocks go flat in real terms, and (5) war in one form or another ensues.

Not shown in the charts, but discussed later in this report, is the fact that there often has been a deterioration

of the velocity of M2 (rearranged as M2 divided by real GDP or GNP in our analysis).

Regardless of the “New Era” thinking of the time, or the transitory effects of liquidity preferences,

we believe that money supply growth is at the core of inflation cycles. Later in this report we discuss

recent trends in M2, real U.S. GDP and CPI inflation growth.


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -22- Legg Mason Wood Walker, Inc.

Exhibit 16 – The Inflation-Adjusted U.S. Stock Market Index, M2 Money Supply, and U.S.

Consumer Price Inflation, The 1901 and 1933 Inflation Cycle Turning Points +/- 12 Years

Note the way in which rising money supply precedes and then feeds inflation, ultimately causing

real stock prices to enter a secular bear market, and then, finally, war results.

M2 Money Supply $ Bil.

25

23

21

19

17

15

13

11

9

7

5

(2)

Stocks

rise.

1901 +/- 12 yrs.

(1) M2

rises.

210

190

170

150

130

110

90

70

50

U.S. Price Inflation Index, 2000 = 100.00

6.00

5.75

5.50

5.25

5.00

4.75

1901 +/- 12 yrs.

(4) Stocks

flatten.

(3) Inflation

rises.

210

190

170

150

130

110

90

(5)

70

War

begins.

50

U.S. Stock Market Index

1889

1891

1893

1895

1897

1899

1901

1903

1905

1907

1909

1911

1913

U.S. Price Inflation Index, Year 2000 = 100.00 (Left Axis)

Inflation-adjusted U.S. Stock Market Index (Right Axis)

M2 Money Supply $ Bil.

195

175

155

135

115

95

75

55

35

1933 +/- 12 yrs.

1921

1923

1925

1927

1929

1931

1933

1935

1937

1939

1941

1943

1945

(2)

Stocks

rise.

(1) M2

rises.

300

250

200

150

100

50

US. Stock Market Index

10.75

10.50

10.25

10.00

9.75

9.50

9.25

9.00

8.75

8.50

8.25

8.00

7.75

7.50

7.25

7.00

1921

1923

1925

1927

1929

1931

1933

1935

1937

1939

1941

1943

1945

1889

1891

1893

1895

1897

1899

1901

1903

1905

1907

1909

1911

1913

US. Stock Market Index

U.S. M2 Money Supply (Left Axis)

Inflation Adjusted U.S. Stock Market Index (Right Axis)

U.S. Price Inflation Index, 2000 = 100.00

1933 +/- 12 yrs.

(4) Stocks

flatten.

(3) Inflation

rises.

300

250

200

150

100

(5) War

begins.

50

U.S. Stock Market Index

U.S. M2 Money Supply (Left Axis)

Inflation-adjusted U.S. Stock Market Index (Right Axis)

U.S. Price Inflation Index, Year 2000 = 100.00 (Left Axis)

Inflation-adjusted U.S. Stock Market Index (Right Axis)

Source: NBER, Standard & Poor’s Corporation, U.S. Dept. of Commerce, Legg Mason format and estimates


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -23- Legg Mason Wood Walker, Inc.

Exhibit 16 Cont’d. – Inflation-Adjusted U.S. Stock Market Index, M2 Money Supply, and

U.S. Consumer Inflation, The 1963 and 2001(E) Inflation Cycle Turning Points +/- 12 Years

1,035

1963 +/- 12 yrs.

525

37.00

1963 +/- 12 yrs.

525

M2 Money Supply $ Bil.

935

835

735

635

535

435

335

235

135

(2)

Stocks

rise.

(1) M2

rises.

1951

1953

1955

1957

1959

1961

1963

1965

1967

1969

1971

1973

1975

U.S. M2 Money Supply (Left Axis)

Inflation-adjusted U.S. Stock Market Index (Right Axis)

475

425

375

325

275

225

175

125

US. Stock Market Index

U.S. Price Inflation Index, 2000 = 100.00

32.00

27.00

22.00

17.00

12.00

(4)

Stocks

flatten.

(3) Inflation

rises.

1951

1953

1955

1957

1959

1961

1963

1965

1967

1969

1971

1973

1975

475

425

375

325

275

225

(5) Economic

warfare. 175 *

U.S. Price Inflation Index, Year 2000 = 100.00 (Left Axis)

Inflation-adjusted U.S. Stock Market Index (Right Axis)

7,000

2001 +/- 12 yrs.

1,525

6,500

6,000

5,500

5,000

4,500

4,000

3,500

3,000

2,500

1989

1991

1993

1995

1997

1999

2001

2003E

2005E

2007E

2009E

2011E

2013E

* This report makes a case that the OPEC embargo w as global economic w arfare.

125

U.S. Stock Market Index

200.00

2001 +/- 12 yrs.

1,525

M2 Money Supply $ Bil.

(2)

Stocks

rise.

(1) M2

rises.

1,325

1,125

925

725

525

US. Stock Market Index

U.S. Price Inflation Index, 2000 = 100.00

175.00

150.00

125.00

100.00

75.00

(4)

Stocks

flatten.

(3) Inflation

rises.

1,325

1,125

925

725

(5) War 525

risk.

325

50.00

1989

1991

1993

1995

1997

1999

2001

2003E

2005E

2007E

2009E

2011E

2013E

U.S. Stock Market Index

325

U.S. M2 Money Supply (Left Axis)

Inflation-adjusted U.S. Stock Market Index (Right Axis)

U.S. Price Inflation Index, Year 2000 = 100.00 (Left Axis)

Inflation-adjusted U.S. Stock Market Index (Right Axis)

Source: NBER, Standard & Poor’s Corporation, U.S. Dept. of Commerce, Legg Mason format and estimates


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -24- Legg Mason Wood Walker, Inc.

The Structure of This Report

This report is constructed as a probability array of expected values, based on what we believe are the

three most plausible 2002 to 2015 outcomes; we use historical precedent as the “effect,” and our objective

assessment of the facts presented in the remainder of this report as the “cause.” For a long period

such as 2002 to 2015, we would expect some combination of the often mutually exclusive events we

cite, so a probability-weighted analysis seems the best approach, in our view. The scenarios we describe are

as follows.




Scenario (1) Continued deflation and a continuation of the western-dominated status quo, to include

the (technology) capital spending boom and sustained, double-digit U.S. equity bull market returns in

the 2002 to 2015 period. (Probability 15%)

Scenario (2) Rapid developing country modernization, combined with synchronous G-7 economic recovery,

leading to a sustained boom in commodity demand relative to more inelastic supply. There is

the potential for Persian Gulf conflict that may periodically constrict supply, further tilting the supply/

demand equation in favor of commodity inflation in the 2002 to 2015 period. (Probability 60%)

Scenario (3) Middle East war(s) that result in large oil supply disruptions. Because major wars produce

high inflation and low real stock price gains, and even minor wars can interrupt trade, we devote a

section of this report to analyzing the potential for conflict in the Persian Gulf. (Probability 25%)

As a result of this probability matrix, for the period 2002 to 2015, we see the PPI All Commodities as

outpacing the price return of the broad U.S. stock market (S&P 500) index, and we expect gradually

rising CPI inflation. As Exhibit 17 shows, we expect the following:

• 6.1% CAGR for the PPI commodities (back-half higher),

• 4.4% price only CAGR for the U.S. stock market (front-half higher),

• 5.4% CAGR for consumer price inflation (back-half higher), and

• CPI-urban inflation cresting at a rate of almost 8% late in the 2002 to 2015 period.

This is not a forecast for specific years, in which leadership may alternate from one year to the next, but

rather, it is a full-cycle view meant to position long-term investors, as well as guide short-term investors

who may employ a trading discipline. History and probability assessments based on current events are imperfect

as forecasting tools, but using the tools to the best of our ability is our purpose as an analyst. Our

report concludes that Caterpillar, Deere, and Joy Global would be beneficiaries of the environment

we foresee to 2015, which is a marked change from the environment of the last two decades.


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -25- Legg Mason Wood Walker, Inc.

Exhibit 17 – Return and Growth Table for Commodities, Stocks and Inflation, 2002 to 2015E

2002 to 2002 to

PPI All Commodities Expected Growth, 2002 to 2015E 2015E PPI 2015E PPI

Com- Com-

Prob- modities modities

ability Growth Est. CAGR%

Status Quo 15.0% x ( 1.1 )% = ( 0.2 )%

Sharply Higher World GDP Growth, Some Warfare 60.0% x 6.1% = 3.6%

Major Middle East Conflicts That Disrupt Oil Supply 25.0% x 10.7% = 2.7%

Sum or Average 100.0% nmf 6.1%

2002 to 2002 to

S&P 500 Expected Price Return, 2002 to 2015E

2015E S&P 2015E S&P

Composite Composite

Prob- Price Price

ability Growth Est. CAGR%

Status Quo 15.0% x 11.7% = 1.7%

Sharply Higher World GDP Growth, Some Warfare 60.0% x 3.4% = 2.0%

Major Middle East War 25.0% x 2.6% = 0.7%

Sum or Average 100.0% nmf 4.4%

2002 to 2002 to

U.S. Consumer Price Inflation, 2002 to 2015E

2015E CPI 2015E CPI

Urban Urban

Prob- Inflation Inflation

ability Growth Est. CAGR%

Status Quo 15.0% x 1.0% = 0.2%

Sharply Higher World GDP Growth, Some Warfare 60.0% x 5.0% = 3.0%

Major Middle East War 25.0% x 9.0% = 2.2%

Sum or Average 100.0% nmf 5.4%

Source: Legg Mason estimates and format


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -26- Legg Mason Wood Walker, Inc.

Scenario (1) Continued Deflation, the U.S. Equity Bull Market, and

Strong “Tech” Capital Spending: Probability: 15%

Continued Deflation?

To gauge the potential for continued deflation, a cornerstone of the status quo and a negative for Caterpillar,

Deere and Joy Global, in our view, we highlight the following five issues.

(1) The historical parallels in monetary policy history.

(2) Money supply growth and deteriorating velocity as precursors of inflation.

(3) The outlook for domestic productivity as an offset to loose monetary policy.

(4) The outlook for productivity improvement overseas that affects U.S. competitiveness.

(5) The commodity price sensitivity of the U.S. economy.

The Historical Parallels in Monetary Policy History

To frame the issue in a historical context, in Appendix A we provide a brief review of the 20th

century monetary history of the United States, which we believe shows several parallels to current

events. Although no two cycles are exactly alike, as Mark Twain said, they do rhyme. The following are examples.

• All of the major “hot” or economic wars of the past century were preceded by high growth in reserve

currencies. This was the case with gold supplies before World War I, the U.S. dollar and the U.

K. pound in the 1930s as the world struggled to shake off the Great Depression, and during the 1960s

and 1970s as the U.S. pursued a “guns and butter” policy of domestic spending and foreign war, but

was ultimately roiled by the economic warfare of the OPEC oil embargoes.

The type of asset bubble that bursts has been a reliable predictor of the future inflation or deflation

cycle, and the future potential of warfare. The asset price inflation/deflation phenomenon has

been repeated several times, with commodity price bubbles occurring and then bursting after wars and

before deflation, and equity price bubbles occurring and then bursting after peace and before inflation.

Examining the decades, bubbles burst for commodities around 1920, 1950 and 1980, and for stocks

around 1909, 1929, 1968, and 2000.

The Fed places the support of war and/or avoidance of panic ahead of price stability in its mission,

a point that is sometimes lost on investors since wars and panics are separated by long intervals.

When war arrives, dollars are furnished to the strained financial system. The aggressive response by the

current Fed to recent world crises stems from a desire not to repeat past mistakes caused by Fed lethargy,

or to be caught in a liquidity trap that renders the Fed impotent, in our view.

• Also sparking inflation, history shows that reserve currency devaluation has been employed as a

policy tool. In 1933, President Roosevelt devalued the dollar versus gold to escape from the Great Depression.

In 1971, President Nixon abandoned the Bretton Woods Agreement. In the modern period of


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -27- Legg Mason Wood Walker, Inc.

currency “blocs,” perhaps the competitive devaluation of the European euro, Japanese yen, Brazilian

real and Argentine peso mark a return to economic unilateralism, since we believe those countries seem

unwilling to make structural adjustments and thus avoid devaluation. Is the U.S. dollar next?

• Social costs are again on the rise, and inflation expectations are low, reminiscent of the 1960s. The

“Great Society” of President Johnson proved more costly than expected, and we believe that the aging

of the baby boomer generation may eclipse the cost of the Great Society. U.S. government forecasts for

medical price inflation are below what recent trends would indicate, and government CPI inflation projections

are below what historical precedent would suggest. Also, 70% of federal debt matures by February

28, 2007, heightening the financing roll-over rate risk, in our view.

• Open-ended wars like the current War on Terrorism and Vietnam have a meaningful inflation

impact. In his Third Law of Motion, Sir Isaac Newton said "For every action, there is an equal and

opposite reaction.” We believe that the downward force applied to the Persian Gulf as a result of oil deflation

may lead to an upward explosion of war, fueled by the recruitment of young, disenfranched male

populations by radical leaders making a bid for power. In past wars, we observe that the seeds of the

future conflict were planted a decade or more before the outbreak of hostilities.

Money Supply Growth and Deteriorating Velocity as Precursors of Inflation

Excessive monetary growth relative to GDP growth has historically been inflationary. In Exhibit 18,

we compare U.S. M2 money supply growth to consumer price inflation, with annual data for the period

1870 to 2001 used to calculate 10-year moving averages. We use M2, which required some reconstruction

prior to 1959, as a compromise between narrow M1 and broad M3. Although the charts show a close relationship

between money supply and inflation, what matters is the rate of growth of money relative to GDP

(GNP prior to 1947), which is the velocity equation. Money supply growth has historically turned inflationary

when the rate of expansion exceeded real GDP for a prolonged period, and in Exhibit 19, we show velocity

versus inflation turning up in recent years (note that we rearrange the velocity formula to be M2 divided

by real GDP). In Exhibit 20, we take a closer look at the upturn in M2 growth relative to GDP in the

past few decades, and note that the rise in money supply relative to GDP began in 1994, at the same time

the second leg of the 1990s bull market began, which we do not believe is coincidental. Our view is that

money supply growth initially provides an aura of prosperity, but comes home to roost via higher inflation.

Money supply growth was instrumental in facilitating the 1990s’ consumer spending and corporate

capital spending surge that was funded, in large part, by debt and equity offerings in the case of corporations,

and balance sheet inflation and low-cost credit in the case of consumers. The surge in money supply

required safety valves to mitigate the inflation impact, and two of those valves were labor productivity and

tight fiscal policy. We discuss productivity later in this section, for which the news may be favorable in the

near term, in our view. But on the subject of fiscal policy, we believe that the brief U.S. federal budget surplus

of former President Clinton’s second term provided the fiscal cover (surplus = tight fiscal policy, and

deficit = loose fiscal policy) that gave the Fed some room to pursue an expansionary monetary policy. But

with the rapidly eroding fiscal discipline in Washington, D.C., the War On Terrorism (and possibly Iraq’s

political leadership), as well as the mounting Medicare and Social Security burden on society, we would

contend that we have seen the end of federal budget surpluses for the foreseeable future.


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -28- Legg Mason Wood Walker, Inc.

Exhibit 18 – M2 Money Supply Vs. Consumer Inflation, 10-Year Moving Avg., 1880 to 2001

12.0%

10.0%

Money supply growth and inflation are inexorably linked.

10.0%

8.0%

M2 Y/Y % Growth

8.0%

6.0%

4.0%

2.0%

0.0%

U.S. Federal

Reserve Act of 1913

Too much money

supply?

6.0%

4.0%

2.0%

0.0%

-2.0%

-4.0%

1880

1890

1900

1910

1920

1930

CPI Inflation Rate

1940

1950

1960

1970

1980

1990

2000

M2 Money Supply, 10-Yr. Moving Avg. of y/y % Growth, (Left axis)

U.S. CPI Inflation, 10-Yr. Moving Avg. of y/y % Growth (Right axis)

Source: National Bureau of Economic Research macroeconomic database, U.S. Federal Reserve for M2 1970 to present, for M2 prior

to 1970 we add M1 + time deposits in banks + bank vault cash + monetary gold stock + mutual savings bank deposits + S&L deposits

as provided in the U.S. Census publication “Historical Statistics of the United States, Colonial Times to 1970”

Exhibit 19 – M2 Velocity Versus Consumer Inflation, 10-Year Moving Average, 1880 to 2001

8.0%

We believe the upturn in M2relative to real GDP growth (Left axis, green)

is a catalyst for rising CPI inflation (Right axis, red)

10.0%

6.0%

8.0%

M2 / Real GDP, Y/Y%

4.0%

2.0%

0.0%

-2.0%

6.0%

4.0%

2.0%

0.0%

CPI Inflation Rate

-4.0%

-6.0%

1880

1890

1900

1910

1920

1930

1940

1950

1960

1970

1980

1990

2000

Too much money supply

relative to GDP?

-2.0%

-4.0%

M2 Divided by Real GDP, y/y% Chg., 10-Yr. Moving Avg., (Left)

U.S. CPI Inflation 10-Yr. Moving Avg. of y/y % Growth (Right)

Source: Note that we use GDP data from 1947 to present, and U.S. GNP 1870 to 1946, U.S. Department of Commerce, Standard &

Poor’s Corporation, National Bureau of Economic Research macroeconomic database, U.S. Federal Reserve for M2 1970 to present,

for M2 prior to 1970 we add M1 + time deposits in banks + bank vault cash + monetary gold stock + mutual savings bank deposits +

S&L deposits as provided in the U.S. Census publication “Historical Statistics of the United States, Colonial Times to 1970”


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -29- Legg Mason Wood Walker, Inc.

Exhibit 20 – M2 Velocity Versus CPI Inflation, 1960 to 2001

16.0%

14.0%

12.0%

M2 growth is back to the 1960s

to 1970s level. Future inflation

trouble?

10.0%

8.0%

6.0%

4.0%

2.0%

0.0%

-2.0%

-4.0%

Mar-60

Mar-62

Mar-64

Mar-66

Mar-68

Mar-70

Mar-72

Mar-74

Mar-76

Mar-78

Mar-80

Mar-82

Mar-84

Mar-86

Mar-88

Mar-90

Mar-92

Mar-94

Mar-96

Mar-98

Mar-00

M2 money supply, SA, y/y% change

CPI Urban inflation, all items, y/y% change

Real U.S. GDP, y/y% change

Source: U.S. Dept. of Commerce, U.S. Bureau of the Census, U.S. Federal Reserve

Although investors have benefited from the 1990s’ monetary policy, we would not confuse benefit

with benevolence. As an offset to inflation, we do expect a cyclical bounce in productivity in the next few

years, as the demographics that support labor productivity are now at their zenith, in our view. Later, however,

if productivity loses momentum as we expect, prompting unit labor costs to climb, we ask rhetorically

“Will the Fed tighten and risk bringing lingering balance sheet problems to the fore, possibly laying waste

to a leveraged global financial system?” We do not think so. Despite a rise in liquidity preferences, asset

inflation and debt are less fleeting, in our view, and we know of no example in which prolonged money

supply growth above the rate of GDP expansion, or borrowing based on inflated assets, did not invite

financial difficulties and, as a response, Fed over-accommodation that reduces real equity values.

The Outlook for Domestic Productivity as An Offset To Loose Monetary Policy

The outlook for domestic productivity as an offset to loose monetary policy is favorable, in our view,

but may be peaking in terms of beneficial impact in the next few years. Productivity quantifies output

per hour, and if a case can be made for exceptionally strong real GDP growth via productivity and/or labor

force expansion, inflation may be kept at bay. Taking a longer view, employers in the next decade may be

forced to pay more for workers, health benefits packages, and the commodity inputs to cost of goods sold,

which has the effect of squeezing profit margins unless prices and/or productivity can be raised to offset the

pressure. In Exhibit 21, we show U.S. productivity growth in relation to the experience profile of the U.S.


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -30- Legg Mason Wood Walker, Inc.

work force. The huge influx of young and less experienced people joining the U.S. work force in the 1970s

contributed to low productivity, as well as the political expediency of higher inflation for the purposes of job

creation, in our view. The subsequent rebound of older, more experienced workers relative to young people

since 1981 has boosted productivity, but that is nearing a peak, as Exhibit 21 shows. Perhaps it is the glacial

pace at which demographic changes progress that causes population trends to be downplayed as a key driver

of productivity. But if human capital is related to human experience, then it follows that human capital is cumulative,

net of deletions (the retirement or death rate). As a result, our view is that human experience is the

base from which productivity grows. Furthermore, we believe that the age 35 to 49 group forms the heart of

the economy of any country, since they tend to invest in homes, families, and retirement savings. Our outlook

calls for the level of productivity growth to be favorable in the next few years, but then slow appreciably

as demographic headwinds emerge.

Exhibit 21 – U.S. Productivity Growth Versus Demographic Measures: The Ratio of Experienced

Workers to Less Experienced Workers as a Driver For U.S. Productivity Growth

1.25x

1961 age

wave

peak and

productivity peak

2001 age wave peak

4.5%

4.0%

3.5%

Ratio of 35 - 49 to 20 - 34 Year Olds

1.00x

0.75x

Three-year centered

average

through 12/31/01

U.S. Census

Bureau population

estimates 2002 to 2020

3.0%

2.5%

2.0%

1.5%

1.0%

0.5%

0.50x

Dec-48

Dec-53

Dec-58

Dec-63

Dec-68

Dec-73

Dec-78

Dec-83

Dec-88

U.S. Productivity Growth

Dec-93

Dec-98

Dec-03

Dec-08

Dec-13

Dec-18

1981 = age wave

trough and

productivity trough

0.0%

-0.5%

U.S. Ratio of Experienced People Age 35-49 To Less Experienced People Age 20-34 (Left axis)

Nonfarm Business Output Per Hour y/y % Change 3-Year Centered Avg. (Right axis)

Source: U.S. Bureau of Labor Statistics, U.S. Bureau of the Census

The Outlook for Productivity Improvement Overseas That Affects U.S. Competitiveness

On an international basis, the demographics of productivity have implications for inflation cycles, profits

growth and thus, stock market performance. As we show in Exhibit 22, both Japan and the United

States began to show strong economic gains and robust stock markets at precisely the same time that the ratio

of 35–49 year olds to 20–34 year olds began to rise rapidly. Japan’s postwar baby boom crested 10 years be-


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -31- Legg Mason Wood Walker, Inc.

fore that of the United States, and peaked around 1990, which was the same year that the Nikkei stock index

peaked. Since that time, Japan’s economy has had the twin demographic burdens of a rising retiree population

and the absorption of a second wave of younger workers into the economy. Currently, we believe most

investors focus on Japan’s large retiree population. But on an optimistic note, we observe that the ratio of

older and presumably more productive workers to younger and presumably less productive workers in Japan

is projected to bottom in 2002 and rise through 2019, perhaps signaling that a demographic cornerstone is

in place to help bring Japan back from the economic brink. In contrast, as Exhibit 22 shows, the U.S. demographic

situation in the period to 2015 emerges as a headwind, by this measure. Although we expect the

situation to be less severe than the Japanese experience of the 1990s, or the U.S. experience of the late

1960s to early 1980s, the implication is clear to us: the need to absorb a wave of young workers into the

economy at the same time that the most experienced hands are preparing for retirement has historically not

been a recipe for strong economic or stock price performance.

Also on the subject of rising powers, we observe in Exhibit 22 that China already has entered a favorable,

rising demographic tide of mature workers relative to younger workers. China’s great baby boom did

not occur until 1963–1975, due to the postwar shocks of the 1949 revolution and the severe 1959–1962

famine. The period from the beginning of famine recovery in 1963 to the widespread implementation of

family planning in the early 1970s created a baby boom in China, and by 2012 the U.S. Census Bureau proj-

Exhibit 22 – Comparative Demographic Trends That We Believe Shape Productivity, the Ratio

of 35-49 Year Olds to 20-34 Year Olds, China, Japan and the U.S., 1950 to 2050E

Ratio 35-49 Year Olds to 20-34 Year Olds

150%

140%

130%

120%

110%

100%

90%

80%

70%

60%

50%

Nikkei 225 and

Japan age wave

peak (1990)

DJIA and U.S. age

wave bottom (1982)

DJIA and U.S.

age wave peak

(2000)

Japan rebounds?

U.S. Census Bureau Projections

China markets

strong through 2015?

1950

1960

1970

1980

1990

2000

2010

2020

2030

2040

2050

Japan United States China

Source: U.S. Bureau of the Census., Bureau of the Census International Database


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -32- Legg Mason Wood Walker, Inc.

ects that China will have 349 million people aged 35 to 49. In addition to economic growth implications, we

believe that China is a developing country with a greater propensity to consume raw materials and foreign

capital. This situation may aggravate the U.S. current account deficit in the coming years by reducing the

succor provided by the capital account surplus, and weakening the U.S. dollar, in our view.

The Commodity Price Sensitivity of the U.S. Economy

The commodity price sensitivity of the U.S. economy may be greater than most investors expect, even

though energy usage as a percentage of U.S. GDP declined from 14% in 1978 to only 6% in 1999, as shown

in Exhibit 23. We discuss the energy price outlook later in this report, but our focus in this section is the inflation

consequences of higher domestic energy costs. According to Energy Information Administration

(EIA) data, energy consumption (measured in British Thermal Units) per dollar of real GDP (1996 dollars)

fell from 18.1 Btu in 1974 to 13.0 Btu in 1987, a decline of 28% that was prompted by the oil price inflation

of that era, with the customary lag for conservation programs already in place. From 1987 to 2000, however,

the decline was from 13.0 Btu to 10.6 Btu, or just 18%, with two-thirds of the drop occurring in the

1996 to 2000 period, when GDP was stimulated by a consumer and capital markets bubble, in our view.

This trend is evident in the tools of day-to-day life. For example, by 1985, a new U.S. refrigerator used only

54% of the electricity of one in 1972, and the average new car in 1981 was 65% more fuel-efficient than

one in 1970. Even as fuel prices began to fall after 1981, the continued penetration of long-lead-time technologies

kept downward pressure on energy consumption, until prolonged, low energy prices removed a

good portion of the economic motivation to conserve and locate new energy sources. We make the following

four observations about energy intensity and the importance of low energy prices to U.S. GDP growth.

• Although the amount of petroleum

used in the U.S. economy has declined,

the types of uses are a

more important factor, in our

view. For example, transportation

consumed 53% of all petroleum

supplied in the U.S. in 1978, but

in 2000 that proportion was 67%.

Oil demand in the U.S. may therefore

be more inelastic now than it

was in the late 1970s, which

means that the price of energy has

more impact than a simplistic “oil

intensity of GDP” analysis would

imply.

Exhibit 23 – U.S. end-use energy as a percentage of GDP

14%

12%

10%

8%

6%

4%

2%

• Most readers are aware of the

popularity of large sport utility

vehicles and vans. In the earlier

era, U.S. motor vehicle fuel efficiency

bottomed in 1973 at 11.9 Source: EIA for energy expenditures, BEA for GDP figures

0%

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

Coal/Other Gas Electricity Oil

1998


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -33- Legg Mason Wood Walker, Inc.

miles per gallon, after a decline of over three decades, and the U.S. consumer was ill-prepared for the

1973–1974 OPEC oil embargo. In the current period, despite a 1.2% annual rise in average U.S. vehicle

fuel efficiency from 1981 to 2000, the mileage of new U.S. light vehicles hit a 20-year low in 2001 due

mainly to the substitution of light trucks for cars. In our view, this is indicative of a U.S. consumer that

is ill-prepared for higher fuel prices.

The energy intensity of GDP did not decline as much after energy prices went into free fall in the

1980s. We believe that the reason was a reduction of the market imperative for conservation, alternative

energy development, or new oil and gas exploration and development. Our view is that it will take several

years for the marketplace to react in a meaningful way to a sudden and steady rise in energy costs

in the future, having experienced only deflation with occasional price spikes since 1981.

The U.S. merchandise trade deficit as a percentage of GDP has expanded from approximately neutral in

3Q 1980 to minus 2.9% of GDP as of 3Q 2001. Since oil is priced in U.S. dollars, and imports of goods

from developing countries often require more energy in their manufacture, we would expect a rise in

energy costs to produce broad-based import price inflation.

The effect of rising energy prices does not always show up in standard U.S. economic releases. In Exhibit

24 we show that the average size of U.S. single-family homes has increased almost one-third since energy

costs began to plummet in the early 1980s. U.S. demographics led to a need for larger homes, but we

believe cheap energy made it possible to afford those residences, and with large homes to heat and cool, we

reiterate that energy demand in the U.S. may be more inelastic now than it was in the late 1970s.

Exhibit 24 – U.S. Home Size Versus Energy Costs

105

2,300

Residential energy prices (1983=100)

95

85

75

65

55

Demographics made larger homes

desirable, but cheap energy made

larger homes possible, in our view.

2,100

1,900

1,700

45

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

New U.S. Sing. Fam. Home Size (sq. ft.)

1,500

Residential natural gas price (1983=100, left axis)

Average size of new U.S. single-family homes (right axis)

Residential electricity price per kWh (1983=100, left axis)

Source: EIA


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -34- Legg Mason Wood Walker, Inc.

Given that Western energy demand is mature, we show in Exhibit 25 the way in which energy use

and weather are linked in the long term. The top half of the exhibit shows that Northern Hemisphere

temperatures rose in the 1880 to 1940 timeframe, fell from 1940 to the late 1970s, and have increased

sharply since that time. The relationship is not tight, but below the temperature chart we show that warming

trends produced low energy inflation, and for cold trends the effect is the opposite. A reversal of the twodecade

trend of higher temperatures could be a catalyst for higher energy prices.

Exhibit 25 – Long-Term Temperature Trends And Energy Price Inflation

N. Hemisphere Surface Temperatures,

Degrees Celsius deviation from normal, 5-

yr moving average

0.8

0.6

0.4

0.2

0

-0.2

-0.4

-0.6

-0.8

1880

(1) Rising

temperatures...

1890

1900

1910

1920

1930

1940

(3) Falling

temperatures...

1950

1960

1970

(5) Rising

temperatures...

1980

1990

2000

PPI Fuels and Electric Power Index (2000

= 100)

100

10

1

1880

1890

(2) …equals

modest prices.

1900

1910

1920

1930

1940

(4) …equals

rising prices.

1950

1960

(6) …equals flat prices.

1970

1980

1990

2000

Temperature source: http://co2science.org data from Jones, P.D., Parker, D.E., Osborn, T.J. and Briffa, K.R. 1999. Global and hemispheric

temperature anomalies -- land and marine instrument records. In Trends: A Compendium of Data on Global Change. Carbon

Dioxide Information Analysis Center, Oak Ridge National Laboratory, U.S. Department of Energy, Oak Ridge, TN, USA. Data presented

are the 5-year average of temperature deviations from the 1961-1990 average for latitudes 10 through 60 of the Northern Hemisphere

(where most of the world's population and the vast majority of fuel consumption for heating purposes are located). PPI Fuels and Electric

Power 1880 to 1889 Warren & Pearson study, 1890 to 1969 PPI is the shipment-weighted annual averages of monthly prices prepared

by the U.S. BLS, 1970 to Present is the PPI Fuels and Electric Power (NSA), from the U.S. BLS; PPI index has been placed in a

continuous reweighted series so that the 12-month average of 2000 = 100.


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -35- Legg Mason Wood Walker, Inc.

Since inflation is relative, it follows that deflation is as well, so perhaps the net effect of commodity

inflation will be profit margin compression if excess capacity constrains pricing power for the commodity

end users. There is currently a low level of capacity utilization in U.S. industry, and there is excess

capacity in the consumer and manufacturing sectors. As a result, it is possible that strength in commodity

markets could lead to profit margin compression rather than consumer price inflation. The way we describe

this phenomenon is to think of the Producer Price Index as a large part of “cost of goods sold” in nonservice

industries. The price at which those items are sold may influence the Consumer Price Index, but if a

company is forced to pay more for its cost of goods sold, but receives little pricing relief as a result of excess

capacity, then profit margins will suffer. Since inflation of corporate profits and P/E multiples were

leading contributors to the bull market that began in its various phases after the 1981 to 1982 recession, it

follows that deflation of profit margins and thus common stocks may be a natural “mean reversion” result

of pricing power shifting from the CPI to the PPI. Although there has been a shake-out of capacity in

many of Caterpillar, Deere and Joy Global’s markets, some of which is an ongoing process, we believe

it is necessary to monitor the potential for margin pressure if the companies pay more for inputs

than their pricing power can offset in the 2002 to 2015 period.

Continuation of the Bull Market and Strong “Tech” Spending (?)

To estimate the relative performance

prospects for CAT and DE stocks, we

must first estimate the return of the

S&P 500 benchmark. Based partly on

the matrix in Exhibit 26, we see a mere

4.4% annual price return for the S&P

500 through 2015, equal to a cumulative

gain of 83% from the 2001 average price

of $1,186 to a 2015 forecast level of

$2,173. To that price return we add the

S&P 500 current dividend yield of 1.4%,

to derive an approximate annual total

return estimate of 5.8% for the period.

With P/E ratios restrained or compressed

by inflation, one of the best ways to outperform

the S&P 500 may be to locate

stocks with consistent dividend growth

and superior dividend yields. To address

questions of whether a 4.4% price return

forecast is realistic, we consider the two

elements of price movement, which are

EPS and the P/E. Since 1962, S&P 500

Exhibit 26 – S&P Composite P/E Ratios And Inflation

Based On the Experience of the Period 1927 to 2001

Consumer

S&P 500 Price

LTM Avg. Inflation

Annual P/E Yrly. Avg.

Ratio Y/Y%

During deflation: Midpoint 14.9x -3.2%

During inflation, in the following ranges:

Inflation Inflation The Avg. And Inflation

From To P/E Was Averaged

0.0% 1.9% 1.0% 16.2x 1.2%

2.0% 3.9% 3.0% 18.3x 3.0%

4.0% 5.9% 5.0% 14.6x 4.9%

6.0% 7.9% 7.0% 11.0x 7.1%

During high inflation, the following occurred:

Inflation

Produced a And Inflation

Over P/E of Averaged

8.0% + 9.2x 11.5%

Source: Standard & Poor’s Corp.

EPS have grown at an average year-over-year rate of 7.4%, and CPI inflation has averaged 4.7% in the same

period, so real S&P 500 EPS growth has been 2.7% (7.4% minus 4.7%). Our view is that the CPI index

from 2002 to 2015 will compound at a rate of 5.4% per annum (back-end loaded), so by adding the historical

real (after inflation) EPS growth of 2.7% to 5.4% inflation we derive an estimate of nominal S&P 500

EPS growth of 8.1% for the 2002 to 2015 period. Because of favorable near-term productivity trends, we


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -36- Legg Mason Wood Walker, Inc.

decided to increase the S&P 500 nominal EPS growth forecast to 9.0%. To calculate potential S&P 500

EPS in 2015, we begin with the First Call consensus for 2002 “operating” EPS of $50.25, and grow that figure

by 9% per year for 13 years, producing estimated S&P 500 EPS of $154 per unit in 2015.

Although $154 of S&P 500 EPS in 2015 sounds impressive, higher inflation produces a lower P/E, and

in Exhibit 27 we show that if we expect inflation to range from approximately 6.4% to 7.9% in the 2010 to

2015 period, the P/E normally associated with that level of inflation is 9.3x to 12.1x. In Exhibit 27, we combine

our forecast for inflation and the P/E ratios associated with each level of inflation, and derive a hypothetical

1927 to 2015E S&P 500 P/E chart. A glance at that chart causes us to believe that our 4.4% S&P

500 projected price return may be on the high side. Given that the chart implies an inflation-penalized P/E

of only 11.2x for the S&P 500 in 2015, and we have estimated EPS of $154, the hypothetical S&P 500

would be only $1,725 in 2015, well below the $2,173 implied by our matrix.

The “New Economy” or “New Paradigm” thinking of the second half of the 1990s that we believe

underpinned much of the investor exuberance in that period was not unprecedented. Even the creation

of the Federal Reserve System in 1913 was hailed in the 1920s bull market (before the 1930s Great

Depression) as the beginning of “New Era” economics that would remove the “boom and bust” cycle of the

U.S. economy. When we look back on the characteristics and drivers of the “tech” story of the 1990s, we

believe that many of the catalysts are no longer present, since they were based on the following chain: (1)

rising inflation-adjusted labor costs and real sales led businesses to ask “Can I raise prices?” or “Do I

Exhibit 27 – S&P Stock Market Composite Average Annual P/E, 1927 to 2015(E)

S&P Composite Average Annual P/E

35x

30x

25x

20x

15x

10x

5x

0x

(3)

Much has changed to affect comparability, but restraining

upside may be the fact that the S&P 500 year 2001 average P/E

of 26.3x is almost 50% above the"normal" P/E of 17.7x that is

associated with 2002 inflation of only 2.4%.

(1)

The 2001 P/E

of 26.3x is the

2001 average

S&P 500 price

of $1,186

divided by 2001

S&P 500

Operating EPS

of $45.16A.

(2)

The fair value P/E of 17.7x for the S&P 500 in 2002 is based on a CPI inflation estimate of 2.4%, and the "normal" P/E

associated with that level of historical inflation. Rising inflation from 2002 to a crest in 2013 of 7.9% produces the lower

P/E ratios. As inflation abates in 2014 to 2015, the P/E rebounds somewhat, as it has in past cycles.

1927

1930

1933

1936

1939

1942

1945

1948

1951

1954

1957

1960

1963

1966

1969

1972

1975

1978

1981

1984

1987

1990

1993

1996

1999

2002E

2005E

2008E

2011E

2014E

Composite Average Annual P/E (Left)

Source: Standard & Poor’s Corp., Legg Mason estimates for 2002 to 2015


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -37- Legg Mason Wood Walker, Inc.

substitute capital for labor to improve productivity?”; (2) central bank inflation vigilance increased the

value of financial assets (claims on cash flow streams) by lowering interest rates; (3) the resulting bull

market in capital lowered the cost of capital spending relative to labor; (4) a decline in pricing power

(inflation) made the price option untenable or undesirable, and industries (technology, etc.) actually causing

deflation were at the top of the economic food chain; (5) government budget surpluses (tight fiscal policy)

and rising productivity made loose monetary policy possible; (6) U.S. hegemony in the world after the Gulf

War and the collapse of the Soviet Union boosted the U.S. dollar and encouraged domestic consumption;

(7) the returns to capital increased in the U.S., attracting foreign capital, as well as more U.S. capital; (8)

capital was reallocated from public to private hands; (9) private hands chose to spend while letting foreign

capital substitute for the lack of domestic savings, and businesses chose to invest in productivity-enhancing

technology; (10) too much capital began to chase productivity-enhancing companies, and investors became

skittish as returns were diluted; (11) the NASDAQ and other markets that were dominated by companies

selling productivity-enhancing wares fell sharply; and (12) capital costs rose as stock markets declined and

bond market spreads widened. The virtuous circle previously described then went into reverse.

In our view, one of the

greatest obstacles to a resumption

of the capital expenditure

growth rate of the

second half of the 1990s is

the poor state of the U.S. financing

gap, shown in Exhibit

28 as a percentage of

GDP. The financing gap

measures the degree to which

corporate capital spending

exceeds or lags the sum of

internally generated funds

plus the change in the value

of inventories. Internally generated

funds are further defined

as after-tax profits minus

dividends plus capital

consumption, or, essentially,

free cash flow before growthoriented

capital spending. The

U.S. financing gap as a percentage

of GDP reached a 20-

year high of 3.0% in the third

quarter of 2000. That was

Exhibit 28 – U.S. Financing Gap, 1952 to Present

4.0%

3.5%

3.0%

2.5%

2.0%

1.5%

1.0%

0.5%

0.0%

-0.5%

-1.0%

-1.5%

Dec-52

The financing gap

measures the amount by

which capital expenditures

exceed internally generated

funds + inventory valuation

changes.

Dec-55

Dec-58

Dec-61

Dec-64

Source: U.S. Bureau of Labor Statistics, U.S. Bureau of the Census

also the peak of the S&P 500 index, which is not coincidental, in our opinion. We believe that a resumption

of robust technology capital spending growth faces two head winds in the near term: (1) difficult capital

markets conditions and strained corporate balance sheets, and (2) overcapacity after years of exceptionally

strong capital spending, which is not solved by more investment.

Dec-67

Dec-70

Dec-73

Dec-76

Dec-79

Dec-82

Dec-85

Dec-88

Financing Gap % of GDP, 4-Qtr. Avg.

A financing gap must be funded by

capital markets activities such as

borrowing or equity offerings.

Dec-91

Dec-94

Dec-97

Dec-00


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -38- Legg Mason Wood Walker, Inc.

The End Of The Status Quo?

There are signs that the status quo, as we have described it, has deteriorated in the past two years to

such a degree that its continuation is highly unlikely, in our view. Price inflation is an insidious and efficient

destroyer of capital, and the ratio of the U.S. stock market to nominal GDP, which may be one way to

measure the over- or undercapitalization of the U.S. economy, turned down from a record level two years

ago. In contrast, the inflation cycle inversely follows the ratio of stock market capitalization to nominal

GDP, and we expect the new inflation regime to gradually come into focus, becoming the “new” status quo

late in the 2002 to 2015 period. Investors have grown accustomed to the current status quo, which we’ve

summarized as deflation via productivity growth, the U.S. equity bull market, and strong “tech” capital

spending. As we have stated, we estimate the 2002 to 2015 period will feature 6.1% compound annual commodity

inflation (back-end loaded in the period), 5.4% consumer price inflation (also back-end loaded), and

a 4.4% annual price return for the U.S. stock market (with great volatility). These percentages are based on

the subtle changes in historical cycles that “rhyme” with what we believe are coming events. We feel confident

that the probability of maintaining the status quo in the 2002 to 2015 period is only about 15%, if not

lower. The next section examines our second scenario of rapid developing country modernization and

global economic growth leading to a sustained and inflationary boom in commodity demand. The third

probability scenario, which is one or more major Persian Gulf intra-country (civil) or cross-border conflicts

that may constrict commodity supply for more prolonged periods, is discussed later in this report. Throughout

this report we highlight the potential positive and negative aspects of this environment for Caterpillar,

Deere and Joy Global.


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -39- Legg Mason Wood Walker, Inc.

Scenario (2) Rapid Developing Country Modernization And Global Economic

Growth Leading to a Sustained and Inflationary Boom in Commodity

Demand: Probability: 60%

Will Surging Demand Create Peacetime Commodity Inflation?

In a peacetime scenario, we believe that the U.S.’s need for sustainable growth to service its debts will

require the creation of new markets to sell its goods and services, primarily in the developing world.

In an unusual twist versus the historical norm of trade-based deflation, we believe that there is a 60% probability

that the post-Communist, World Trade Organization-inspired, fertile mix of cheap labor, freeflowing

capital, and technology transfer will create extraordinarily rapid global economic growth that

places stresses on key raw material markets. Many raw materials producers have scaled back their internal

investment as they have incurred poor returns since the previous inflation cycle, which ended approximately

20 years ago. The combination of sustained, strong demand plus relatively inelastic supply, along with a

Fed that remains somewhat accommodative as a result of the financial and political stresses discussed earlier,

could spur a demand-led price inflation cycle in the 2002 to 2015 period.

Change is difficult, but pain is the ultimate catalyst. In addition to the well-known U.S. propensity to

consume in excess of domestic savings (the current account deficit), and U.S. reliance on declining input

costs (via falling commodity prices) to boost producer profits, we highlight in Exhibit 29 what we believe to

be a much more insidious problem, which is that incremental U.S. debt is no longer having the desired ef-

Exhibit 29 – The Declining Ability Of Debt to

Underpin U.S. GDP Growth

U.S. Total Debt / Nominal GDP

3.0x

2.5x

2.0x

1.5x

1.0x

0.5x

Inflation

Deflation

New GDP

from new

debt is

declining.

1962

1965

1968

1971

1974

1977

1980

1983

1986

1989

1992

1995

1998

2001

17.0%

15.0%

13.0%

11.0%

9.0%

7.0%

5.0%

3.0%

1.0%

U.S. Total Debt Divided By Nominal GDP (Left)

Y/Y Change U.S. Nominal GDP (Right)

Source: U.S. Federal Reserve, U.S. Census, U.S. Department of

Commerce, Legg Mason format

U.S. Nominal GDP Yr./Yr. % Change

Exhibit 30 – Raw Materials Intensity At Different

Stages of Economic Development

Growth in Materials Consumption

Minus Real GDP growth, 10-Yr. Avg.

7%

6%

5%

4%

3%

2%

1%

0%

-1%

-2%

-3%

-4%

Emerging Economy

Maturing Economy

1910

1915

1920

1925

1930

1935

1940

1945

1950

1955

1960

1965

1970

1975

1980

1985

1990

1995

U.S. Raw Materials * Consumption Growth Minus U.S. Real GDP

Growth, 10-Yr. Moving Avg.

* Average of fuel, metals, other minerals, organics, paper.

Sources: EIA; Department of Commerce; for pre-1947 period, GNP is

used as a substitute for GDP; U.S. Geological Survey data materials

data updated through 1998


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -40- Legg Mason Wood Walker, Inc.

fect of producing meaningful incremental U.S. growth. The ratio of U.S. total debt to nominal GDP is rising

sharply, but nominal GDP is falling just as quickly, and the only solutions we envision are a combination of

(global) growth, (moderate) inflation, and (private) default. From 1980 to the present, the U.S. ratio of aggregate

debt to GDP has risen from 1.56x to 2.74x, and the growth rate of nominal GDP has fallen from

8.9% to 3.4% in the same period. In order to grow the economy out of this situation, we expect U.S. business

and policymakers to increasingly emphasize exports and foreign market development, but a side-effect

of fostering strong emerging market growth is that it hyperstimulates raw materials usage. As Exhibit 30

shows, the early stage of economic ascendancy, such as the U.S. enjoyed in the first half of the 20th century,

is highly natural resources-intensive. As the emerging market per capita GDP bell curve shifts from

left to right with growing income, the percentage change along the horizontal axis with respect to income is

dwarfed by the number of new, materials-intensive consumers it creates in the area under the curve.

There were signs of this commodity intensity phenomenon prior to the Asia-Pacific Crisis, when many

commodity prices rose in unison, and the stocks of commodity-producing and -serving companies reflected

the pricing prosperity. But as emerging economies fell like dominos, and commodity markets and related

equities capitulated, the U.S. Fed turned more accommodative and global savings fled to the U.S., acting as

a catalyst for the U.S. equity price bubble of the late 1990s. The subsequent collapse of U.S. equity indices

that began in 2000 (earlier, if deteriorating breadth is counted), and the relative outperformance of many

commodities and commodity-serving companies such as Caterpillar versus the broad stock market since that

time, may foreshadow an inflationary turn in the price cycle. As we noted earlier in this report, bursting equity

bubbles have preceded every major inflation (and war) of the past century, just as bursting commodity

bubbles have preceded every major stock price inflation (i.e., bull market) for a century.

The Energy Price Drivers, 1870 to 2015E

There have been seven price cycles for the U.S. PPI for Fuels and Electric Power since 1870, averaging

approximately 18 years in length. Shown in Exhibit 31, the three energy inflation cycles produced average

annual energy price growth of 8.0%, whereas the four deflationary periods produced an average annual

decline of 2.1%. The energy inflation cycles largely coincided with inflation in the broad PPI All

Commodities Index, although the timing was not always exact.

We cite some of the supply and demand drivers in those cycles, highlighting the “rhymes” over time.

• Deflation 1870 to 1898: Post-Civil War peace dividend, and enhanced coal mining and drilling technology.

Coal replaced wood as the primary source of energy for homes and industrial uses.

Inflation 1898 to 1920: Demand-led; 10 million autos were registered by 1920, contributing to oil

price inflation of 6.3% annually. Later, World War I helped triple energy prices from the years 1915 to

1920.

• Deflation 1920 to 1933: Post-war peace dividend, then the collapsing demand of the Great Depression,

as per capita energy use fell 2.5%, on average.

Inflation 1933 to 1951: Demand-led; real power plant building rose 13% annually in the period. Later,

World War II constricted supply, but vehicle ownership grew 4.3% per year over the entire period.


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -41- Legg Mason Wood Walker, Inc.

Exhibit 31 – PPI Energy Price History and Supply/Demand Drivers, 1870 to 2015E

1,000

100

10

Coal replaces wood;

oil drilling ramp.

1870 to 1898 CAGR

(2.5)%

1898 to

1920

CAGR

7.3%

World

War I,

U.S.

GNP

growth,

autos.

1920 to

1933

CAGR

(6.7)%

1933 to

1951

CAGR

3.6%

Deflation,

depression.

Electric

power

growth,

World War

II.

1951

to 1965

CAGR

0.4%

1965 to

1981

CAGR

13.2%

Cheap oil

imports, coal

mechanization.

OPEC embargo,

U.S. well

depletion, more

coal, nuclear.

2001 to

2015E

CAGR

6.1%

1981 to Non-

2001 OPEC

CAGR production

0.4% increase,

fuel

efficiency

measures.

FSU,

China,

shift.

1

1870

1880

1890

1900

1910

1920

1930

1940

1950

1960

1970

1980

1990

2000

2010E

PPI Fuels and Electric Power

SUPPLY-SIDE ISSUES

DEMAND-SIDE ISSUES

U.S. U.S. Power

PPI- Fuels CAGR % U.S. U.S. Oil U.S. Light Plant Per

and Electric of PPI Crude Crude Output Coal (2) U.S. U.S. Duty Construc. Capita

Power Fuels and Oil Oil per Output World Real Motor Vehicles Expend- Energy

Inflation or Electric Imports Cost/bbl Well (1) per Miner War? GDP (3) Vehicles MPG itures Cons.

Deflation Power Growth Growth Growth Growth YES Growth Growth Growth Growth Growth

Period Yrs. Index Rate Rate Rate Rate or NO Rate Rate (4) Rate (5) Rate (6) Rate (7)

1870 to 1898 28 (2.5)% na (5.5)% na (1.5)% NO 5.0% na na na 4.4%

1898 to 1920 22 7.3% na 6.3% na 1.4% YES 3.3% 42.3% na na 3.2%

1920 to 1933 13 (6.7)% (8.9)% (11.1)% 1.3% (0.8)% NO 0.1% 7.7% na (4.4)% (2.5)%

1933 to 1951 18 3.6% 10.1% 7.7% 3.0% 3.3% YES 5.6% 4.3% (0.5)% 13.1% 3.5%

1951 to 1965 14 0.4% 6.8% 0.9% 0.2% 7.3% NO 3.7% 4.0% (0.2)% 3.2% 1.1%

1965 to 1981 16 13.2% 8.2% 16.2% 0.9% (0.8)% NO 3.2% 3.6% 0.5% 5.6% 1.1%

1981 to 2001 20 0.4% 3.7% (2.0)% (1.8)% 7.6% NO 3.1% 1.7% 1.2% (4.0)% 0.4%

2001 to 2015E 14E 6.1%E 3.2%E 7.4%E ne ne 25%E 3.0%E 1.0%E 0.2%E ne 0.7%E

(1) Period 1920 to 1933 is restated as 1925 to 1933, and period 1981 to 2001 is restated as 1981 to 2000, due to data constraints.

(2) Anthracite coal for 1870-1898 period; bituminous coal for other periods.

(3) Real GNP prior to 1947.

(4) Period 1898 to 1920 is restated as 1900 to 1920, and period 1981 to 2001 restated as 1981 to 1998, due to data constraints.

(5) Period 1933 to 1951 is restated as 1936 to 1951, and period 1981 to 2001 restated as 1981 to 1999, due to data constraints.

(6) Used three-year centered average. Period 1981 to 2001 is restated as 1981 to 1999, due to data constraints.

(7) Period 1981 to 2001 is restated as 1981 to 2000, due to data constraints.

Source: PPI - Fuels and Electric Power 1870 to 1889 Warren & Pearson study, 1890 to 1969 PPI is the shipment-weighted annual averages of monthly prices

prepared by the U.S. BLS, 1970 to Present is the PPI Fuels and Electric Power (NSA), from the U.S. BLS, all Indices have been placed in a continuous re-weighted

series so that the 12-month average of 2000 = 100; Crude oil imports 1920 to 1948: American Petroleum Institute (API); 1949 to 2001: EIA Annual Energy Review

Tables; Crude Oil price: 1870-1905: U.S. Census, Historical Statistics of the United States, Colonial Times to 1970; 1906-1948: API, average price of crude oil in the

United States. 1949-2001: EIA, Annual Energy Review Tables, Domestic Crude First Purchase Price. U.S. oil and coal production: 1870 to 1948: U.S. Census,

Historical Statistics of the United States, Colonial Times to 1970; 1949-2001: 1949-2001: EIA, Annual Energy Review Tables. Oil Wells: 1925 to 1948: API, 1949 to

2000: EIA, Annual Energy Review Tables; Coal miners: 1870 to 1970: U.S. Census, Historical Statistics of the United States, Colonial Times to 1970; 1971- present:

Bureau of Labor Statistics; GNP (1870 to 1947) and GDP (1947 to 2001) per capita based upon NBER and U.S. Census data. Motor vehicle registrations: 1900 to

1970: U.S. Census, Historical Statistics of the United States, Colonial Times to 1970; 1971 to 1998: Bureau of Transportation Statistics. Includes all highway

vehicles except motorcycles. Vehicle Fuel Economy: 1936 to 1948: U.S. Census, Historical Statistics of the United States, Colonial Times to 1970; 1949 to 1999:

EIA, Annual Energy Review Tables; Utility Construction Expenditures: Census Bureau; Per capita energy consumption: 1870 to 1948: U.S. Census, Historical

Statistics of the United States, Colonial Times to 1970; 1949 to 2000: EIA, Annual Energy Review Tables. 2001 to 2015 estimates are Legg Mason estimates based

on EIA, International Energy Outlook 2002, and Annual Energy Outlook 2002. World War risk is a Legg Mason estimate.


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -42- Legg Mason Wood Walker, Inc.

• Deflation 1951 to 1965: Postwar peace dividend, with overseas oil production growth that caused

U.S. oil imports to grow at a rate of 6.8% per year. Also, U.S. vehicle growth matured.

Inflation 1965 to 1981: OPEC supply embargoes, U.S. oil output peaked in 1970, U.S. oil imports

grew 8.2% annually, there were cold winters. Energy prices rose 13.2% per annum from 1965 to 1981.

• Deflation 1981 to 2001: Conservation, non-OPEC supply, a utility power glut, Gulf and Cold War

peace dividends; $1 million of real GDP in 2000 used 765 barrels of oil, versus 1,537 barrels in 1972.

We believe that the price mechanism still drives the energy market, and prices periodically inflate

and deflate. For one to accept the argument that oil prices will perennially deflate (recall that disinflation is

relative deflation) from the last cyclical peak in 1981 to infinity, then one must also believe that the price

mechanism resulting from the push-pull relationship of supply and demand, and the effect it has on oil producer

investment in new technologies,

has been suspended.

Our view is that crude oil is a

form of wealth, and wealth

flows to where it can obtain the

highest return. If we consider

gross domestic product to be the

return that is gained from the

“investment” of crude oil (among

other inputs) in an economy, we

would expect higher rates of oil

consumption by economies that

produce the most GDP output from

each barrel of oil. This is shown in

Exhibit 32, which contrasts per

capita oil consumption rates on the

vertical axis with the oil intensity

of GDP on the horizontal axis, for

62 countries for which oil consumption

and GDP information

were available for the year 2000.

The upper-left quadrant of the chart

contains most of the world’s advanced

economies, which are the

largest oil consumers, yet justify

Exhibit 32 – Oil Consumption Per Capita Versus Oil

Intensity of GDP, 62 Nations, As Of Year 2000

Barrels of oil per capita, 2000

100

10

1

Lower oil intensity,

higher oil

consumption.

Higher oil intensity

of GDP, yet lower oil

consumption rates.

0

100 1,000 10,000

Barrels of oil per $1 million of GDP, 2000

Source: Oil consumption: BP Statistical Review of World Energy June 2001; Population:

this consumption through more energy-efficient GDP output. Poorer countries tend to occupy the lower

right portion of the graph, where low levels of oil consumption are associated with the inefficient use of oil

in producing GDP output. (Many of the outliers in the upper-right portion of the graph are oil-producing nations

that consume a disproportionate amount of oil in relation to their size).

Our view is that as the world economy becomes more integrated over time, then we would expect

greater global energy efficiency, which would manifest itself in a clustering around the trend line in Exhibit

32. The alternative to that clustering would be a migration to the upper-right quadrant of Exhibit 32, or

U.S.A.

China


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -43- Legg Mason Wood Walker, Inc.

high energy consumption per capita with low efficiency in relation to GDP, which we view as unlikely unless

there is a discovery of some civilization-changing new source of low-cost energy. Unless that occurs,

our view is that normal supply and demand forces will result in a periodic inflation of oil prices, and

we believe that the economic adjustment to the next energy inflation, in terms of substitutes and conservation,

may be shorter than the 1970s to 1980s experience but longer than a few years.

The Demand Side of the Oil Equation – The 2001 to 2015 Environment

We view the change in the location of world GDP growth to be more critical than the makeup of GDP

growth. From 1980 to 2000, North America, Western Europe, and Japan combined accounted for 73% of

the world’s incremental GDP growth, measured in constant U.S. dollars. We project that those highly

developed economies will only account for 54% of incremental GDP growth from 2001 to 2015, and we

also estimate that China alone, which accounted for 8.8% of world GDP growth from 1980 to 2000, should

contribute 14.4% of incremental world GDP growth in that period. In terms of raw materials intensity, as

developing economies become a greater component of world GDP growth, we look for those consumers to

add “plumbing to the home” or even a “better home” long before “fiber to the home” becomes much of a

desire.

The experience of the U.S. in the 20th century is instrumental in gauging the future for developing

world raw materials usage. According to the Second Law of Thermodynamics, the amount of disorder in

the universe always increases. Since economic growth is the creation of order out of disorder, it follows that

the consumption of energy (and materials) is required to offset nature’s tendency toward disorder. The experience

of the U.S. in its early growth stages is instructive in that regard. In the period 1900 to 1950, U.S.

real GNP grew at a rate of 3.1%, compared to 3.5% GDP growth in the 1950 to 2000 period. As we noted

previously, however, per capita material consumption was far higher in the first half of the century than in

the second half. U.S. per capita GDP growth from 1900 to 1950 grew by 128%, but per capita materials

usage grew 2700% for petroleum, 890% for non-fuel organics, 400% for paper and board products, 310%

for metals, and 220% for industrial minerals. Although U.S. real GDP per capita grew 183% from 1950 to

1998, a larger gain than in the first half of the century, per capita usage grew only 64% for petroleum, 143%

for non-fuel organics, 93% for paper and board products, 13% for metals, and 37% for industrial minerals.

Material consumption growth correlates closely with living standards improvements; desiring the

latter, developing nations can be expected to ramp up demand for the former as a means to an end.

Life expectancy at birth in the U.S. grew from 47 years in 1900 to 68 years in 1950, and then to 77 years in

2000. The average U.S. work week fell from 59 hours in 1900 to 40.5 hours in 1950, and then to 34.5 hours

in 1999. Since poor sanitation has been the leading cause of death in human history, it is noteworthy that

10% of U.S. households had flush toilets in 1900, versus 76% in 1950 and 98% in 2000. For these and

countless other reasons, we believe the first half of the 20th century in the United States represented the

steep part of the curve for U.S. living standards. Our view is that much of the developing world and the

former communist countries of the FSU and Eastern Europe are following – or soon will be

following – a similar trajectory to the United States in the first half of the 20th century.

The China Example – Pushing The Oil Demand Envelope - 2001 to 2015

By several measures, Chinese economic development matches that of the U.S. in the late 19th and

early 20th centuries. Both in terms of real per capita income and urbanization rate, China’s economic de-


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -44- Legg Mason Wood Walker, Inc.

velopment compares to that of the U.S. in the last decade of the 19th century. The U.S. currently has four

times more inland freight transport avenues (paved roads, railways, and navigable waterways) per square

mile than China does. So, typical of a developing country, China’s freight capabilities are heavily skewed

toward inland waterways, which handle 51% of freight traffic versus only 14% in the U.S. As a result,

China has embarked on a major road-building campaign, the scale of which has not been seen since the

building of the Eisenhower U.S. Interstate network, and if the U.S. experience is a guide, China plans to

populate those highways with automobiles rapidly. China built 8,000 miles of expressway in the past three

years, with plans to build seven additional east-west and five north-south expressways by 2008. Using those

roads will be 72 million motor vehicles (excluding motorcycles) by 2010, according to a recent Chinese

government study, up from only 20 million in 2001, for a growth rate of over 15% annually, similar to the

U.S. experience of the first half of the 20th century. China imposes a tariff of 80% to 100% on imported

autos, but WTO entrance requires China to lower that rate to 25% by July 2006. Many of the world’s major

automakers are establishing manufacturing facilities in China, with the main purpose of selling cars to the

domestic market rather than exporting them.

Economic expansion can produce tremendous gains in oil consumption. Exhibit 33 shows the way in

which Japan in the 1960s and South Korea in the 1990s made rapid gains in oil consumption around the

same time that their economies became manufacturing powerhouses. In a recent interview, U.S. Treasury

Secretary Paul O’Neill stated that South Korea transformed itself from a “13th century economy” to

“middle- class prosperity” in the space of 40 years, and wondered aloud why that model could not be replicated

more frequently. Point “A” in Exhibit 33 represents Chinese oil demand at the Japanese/South Korean

level, equivalent to 69 million barrels per day (18 barrels per capita annually). Since that level is equal to

88% of current global oil production, we believe it is beyond our forecast horizon. Point “B” is Chinese oil

demand of 10 million barrels per day

(2.6 barrels per capita per year) in

2015, versus 4.9 million barrels per

day in 2001, equal to EIA’s “high

economic growth” case for China.

EIA projects that China’s domestic

oil production will decline slightly to

just over three million barrels per day

through 2015, so China must increase

oil imports over current levels

by 5.3 million barrels per day by

2015, an amount greater than the

total of Iraq’s + Kuwait’s + Qatar’s

2001 exports, simply to bring

China’s per capita oil consumption

to one-tenth the current U.S. level.

Again, the U.S. experience in the first

half of the 20th century is instructive.

In Exhibit 34, we compare U.S. oil

consumption to real GDP on a per

capita basis for the 1902 to 2001 period,

and overlay data for China for

the period 1975 to 2000, with our

Exhibit 33 – Oil consumption per capita for Japan, South

Korea, and China, 1950-2001

Oil consumption per capita (barrels/yr.)

25

20

15

10

5

0

1950

1955

1960

1965

1970

Tremendous surges in oil

consumption and quality of life

Cost differential

drives manufacturing

to "Asia Tigers"

1975

1980

Source: Oil consumption: 1950-1964: U.N Energy Statistics Database; 1965-2000: BP

Statistical Review of World Energy. 2001: EIA

1985

1990

1995

2000

Japan South Korea China

Cost differential

drives manufacturing

to China

2005

2010

A

B

2015


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -45- Legg Mason Wood Walker, Inc.

forecast to 2015 for China (China

amounts are purchasing power

parity, in an effort to improve

comparability.)

Exhibit 34 – U.S. Oil Consumption vs. GDP, 1902 to 2001,

And For China, 1975 to 2015E

100 bbl.

The energy story is much the

same throughout Asia. In 2000,

Asia (outside of the Middle East

and the former Soviet Union) accounted

for 28% of the world’s

oil consumption, yet produced

only 11% of the world’s oil supply

and had only 4% of the

world’s oil reserves. The region’s

population of 3.5 billion, 56% of

the world total, presents a tremendous

labor resource for the

world’s manufacturers and potentially

the world’s largest consumer

market. Of course, the

abundance of even less expensive

labor in China is a concern

among those who feel that China

will come to dominate regional

trade in much the way it already

Oil Consumption Per Capita

10 bbl.

1 bbl.

China in 1975

0 bbl.

China Forecast

through 2015

China in

2000

USA in 1902

USA in 2001

$100 $1,000 $10,000 $100,000

U.S. oil consumption Real vs. GDP GDP Per per Capita Capita, (PPP 1902 for to 2001 China)

China's oil consumption vs. Real (PPP) GDP, Per Capita, 1975 to 2015E

Source: U.S.: pre-1970: U.S. Census publication “Historical Statistics of the United

States, Colonial Times to 1970.” GNP used in place of GDP pre-1947. 1970-2001: GDP:

BEA. Oil: EIA. China: Oil: 1965-2000: BP Statistical Review of World Energy. 2001: EIA;

2002-2015: LM projection. GDP to 2000: World Bank; Projection uses GDP growth rate

from EIA, International Energy Outlook 2002, high growth case

dominates foreign direct investment flows. But we are optimistic that the successful U.S. bilateral experience

with Mexico in the post-NAFTA period is more applicable to the Asian situation than a “crowdingout”

assumption, the latter of which does not adequately account for an expanding economic pie, in our

view. We anticipate that rising Asian demand for energy will stretch the world’s ability to meet its vast

needs, and demand-pull inflation for commodities could result.

The Supply Side of the Oil Equation – The 2001 to 2015 Environment

Our projection of near-zero growth in production in the world’s major industrial nations makes the

supply situation in oil-exporting regions critical to continued world economic growth. Our oil supply

and demand forecast, summarized in Exhibit 35, is largely EIA’s model, customized to account for our

higher demand estimates in certain oil-producing and Asia-Pacific markets. Our adjustments add 4.6 million

barrels per day to demand in 2015, a 4% increase over EIA’s reference case. On the supply side, we use

EIA’s reference case forecast through 2015, adjusted upward to account for the added demand. We believe

several striking developments in this forecast, including the following.

• Middle East sources account for 47% of the incremental growth in oil supply in the 2001 to 2015 period,

an increase from the 37% Middle Eastern share of incremental supply in the 1981 to 2001 period.

Our projection assumes that Saudi Arabian production capacity alone will rise from 9.4 million barrels

per day in 2000 to 18.2 million barrels per day by 2015, enriching the Kingdom and, potentially, enabling

the al-Saud family to continue its historical practice of employing financial largesse to fund domestic

development, and thus maintain power.


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -46- Legg Mason Wood Walker, Inc.

• European share of new oil supply growth falls from 24% in 1981 to 2001 to 1% in the 2001 to 2015

period. This is caused by maturing North Sea fields, which were major non-OPEC producers after 1981.

• FSU and Eastern European demand collapsed after 1981, subtracting 41% from the change in world

oil supply, but rebounding post-Communist demand in those countries adds 15% to 2001–15 estimated

growth. Although we expect FSU oil production in 2015 of 14.4 million barrels per day to eclipse the

prior production peak of 12.7 million barrels per day in 1987, the rebound in FSU demand to 8.3 million

barrels per day we forecast in 2015 is still below the 9.1 million barrels per day consumed in the

peak year of 1982, 33 years earlier, for perspective.

• African oil production, 66% of which comes from three OPEC members, Nigeria, Algeria, and Libya,

could be joined by newly discovered oilfields in offshore Angola, which is not an OPEC member. Development

of these fields should add about 2 million barrels per day by 2015, representing about onethird

of Africa’s incremental growth in production over that time per EIA estimates.

Whereas OPEC’s ability to periodically constrict supply was the “oil weapon” of the 1970s, we believe

that the key to OPEC’s strength in the coming years will be its rising market position filling incremental

world demand for oil. In our view, this shift in market power from the western oil-consuming nations

to the generally eastern and southern oil-producing ones will probably have widespread economic and

political ramifications that lead to still more developing country modernization. In Exhibit 36, we show the

percent of world oil production held by oil export-based countries recovering from 57% in 2001 to 66% in

2015, and even though this is a sharp rebound, it is still below the 1976 peak of 70%. In Exhibit 37, we

Exhibit 35 – World Oil Supply And Demand History and Our Projection to 2015

World

2001 / 1981 2015 / 2001 World

2001 / 1981 2015 / 2001

Oil Demand Demand As Demand As Oil Supply Supply As Supply As

(million bbl/day) % of Total % of Total (million bbl/day) % of Total % of Total

Incremental Incremental Incremental Incremental

1981 2001 2015 Demand Demand 1981 2001 2015 Production Production

Net importers:

USA/Canada 17.8 21.7 27.4 26% 16% 12.4 11.9 13.3 -3% 4%

W. Europe 12.3 13.8 15.5 10% 5% 2.9 6.7 6.9 24% 1%

E. Europe 2.3 1.4 2.0 -6% 2% 0.5 0.2 0.3 -1% 0%

Japan 4.8 5.4 6.6 4% 3% 0.0 0.1 0.1 0% 0%

China 1.8 4.9 10.0 21% 14% 2.0 3.3 3.1 8% -1%

India 0.7 2.0 4.1 9% 6% 0.3 0.7 0.7 3% 0%

Other East Asia 2.5 7.4 11.7 33% 12% 2.2 3.2 3.3 6% 0%

Australasia 0.8 1.1 1.8 2% 2% 0.5 0.8 0.8 2% 0%

Net exporters:

Middle East 2.5 5.2 8.6 18% 9% 16.5 22.3 38.8 37% 47%

Africa 1.6 2.4 4.5 6% 6% 4.9 8.2 14.4 21% 18%

Latin America 4.9 6.8 11.3 13% 13% 6.4 10.3 15.6 24% 15%

Former Soviet U. 8.9 3.7 8.3 -35% 13% 12.2 8.8 14.4 -21% 16%

World

60.9 75.8 111.8 100% 100% 60.7 76.6 111.7 100% 100%

Source: 1981: BP Statistical Review of World Energy 2001; 2001: EIA Monthly Energy Review, March 2002; 2015: EIA’s International

Energy Outlook 2002 reference case forecast, except high economic growth forecast was used to estimate demand in China, Japan,

Middle East, FSU, and Australasia. EIA IEO 2002 reference case supply forecast was used. Because demand forecast exceed reference

case supply forecast, incremental supply increases were added to each region, with the regional shares based on 2001-2015

reference case supply growth as a percentage of the world total.


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -47- Legg Mason Wood Walker, Inc.

Exhibit 36 – Oil export-based economies as

share of world oil production, 1965-2015E

Exhibit 37 – Non-OPEC Reserve-To-

Production Ratio, 1952 to 2015E

Percent of World Oil Production Held

By Oil-Export-Based Countries

70%

65%

60%

55%

LM

Estimate

Non-OPEC Reserve/Production

24

22

20

18

16

14

12

10

Major new non-OPEC discoveries 1968-

1975 in North Sea, Alaska, Siberia, but

rate of new discoveries has declined.

Forecast assumes

non-OPEC reserve

additions continue at

1986-2001 rate.

LM

Estimate

50%

1965

1969

1973

1977

1981

1985

1989

1993

1997

2001

2005

2009

2013

8

1952

1956

1960

1964

1968

1972

1976

1980

1984

1988

1992

1996

2000

2004

2008

2012

Source: BP Statistical Review of World Energy June 2001, 1965-

2000. 2001 data: EIA. 2002-2015: Legg Mason projection based

on EIA, international Energy Outlook 2002, March 2002. “Oil

export-based economies” include OPEC, FSU, and non-OPEC

Africa and Middle East.

Source: Production: Source: UN 1952-1964; BP 1965-2000. EIA

2001. Reserves: 1952-2002: OGJ Energy Statistics Sourcebook, Oil

& Gas Journal. Legg Mason projection

show the reserve-to-production ratio of non-OPEC producers falling from 13.3 in 2001 to 8.2 in 2015, far

below the 1975 peak of 22.3. Although higher oil prices, if they occur, would prompt increased exploration

and reserve additions, the cost of those wells may rise as an offsetting factor. For example, successful experiences

in Brazil, Argentina, and Angola demonstrate that deepwater drilling at water depths that test the

limits of available exploration technologies can result in new discoveries, but at great expense.

To summarize, we believe that the world appears to be in a transition phase from generally slack to

generally tight oil supply, thanks to Asian oil demand and recovering FSU and satellite usage in excess

of rising production, with no North Sea-sized non-OPEC price spoiling discoveries expected. Exhibit

38 summarizes the global import/export balance of petroleum from 1965 through our 2015 estimate,

with net oil exporters shown on the top half of the graph and net importers shown on the bottom half. From

2001 to 2015, we project that 62% of the incremental growth in net imports by region will be in Asia/

Pacific ex-Japan. On the supply side, 69% of the growth in net exports is seen coming from the Middle

East, followed by 21% from Africa and the rest from FSU and Latin America. The major story is the increasing

reliance of Asia on Middle East oil on a scale that reorients economic and security alliances.

Exhibit 38 also contains our oil price forecast, in both real (2000$) and nominal terms. We project that

U.S. crude oil prices, expressed in real 2000 dollars, will rise from $22.40 in 2001 to $26.11 in 2015 (with

sharply higher inflation that accrues to oil producers), and that the U.S. average nominal crude price will

rise from $23.01 in 2001 to $62.81 in 2015, in line with our estimate of growth for the PPI for All Commodities

index, shown in Exhibit 31.


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -48- Legg Mason Wood Walker, Inc.

Exhibit 38 – Net Exports and Imports of Oil, 1965-2015E. Oil prices shown below.

60

Projection

Net oil exports (imports), Million barrels per day

40

20

0

(20)

(40)

Latin America

Fm r. Sovie t U.

Africa

Middle East

US/Canada

Europe

Japan

Asia/Pacific

ex-Japan

(60)

1965

1968

1971

1974

1977

1980

1983

1986

Crude oil price per barrel

1989

1992

1995

1998

2001

2004

2007

2010

2013

$80

$60

$40

$20

$0

Projection

Nominal

$/barrel

Real

2000$/barrel

1965

1968

1971

1974

1977

1980

1983

1986

1989

1992

1995

1998

2001

2004

2007

2010

2013

Source: 1965 to 2000 data: 2001 BP Statistical Review of World Energy. Projection: 2001 and 2002 net exports from International Energy Agency

and EIA Monthly Energy Review, March 2002. 2001 price: EIA, Monthly Energy Review March 2002. 2002 and later net export projections from

Legg Mason based on EIA International Energy Annual 2002. Oil price projections for 2003 and later are Legg Mason projections.


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -49- Legg Mason Wood Walker, Inc.

Substitute Fuels – Promising, But Enough to Make a Difference?

We believe that the use of substitutes first requires an inflation in the “old” fuel to stimulate the

switch. The world has migrated in patterns from solid fuels (wood, coal), to liquid fuels (kerosene, oil,

gasoline) and then to gasses (natural gas, hydrogen fuel cells in the future). For now, however, crude oil is,

in many ways, the ideal fuel, and the only catalyst we see for developing a new energy infrastructure and

encouraging fuel switching is prolonged, high prices for crude oil, which fulfills our thesis, anyway. Crude

oil has an energy density that is over 50% higher than high-grade coal and 1,000 times greater than natural

gas at atmospheric pressure; it can be transported cheaply via tanker or pipeline; it can be refined into a

range of products from jet fuel to home heating oil to petrochemicals; when refined into gasoline, it burns

cleanly and just 90 pounds of gasoline can fuel a 3,000 pound vehicle for hundreds of miles; and most importantly,

it is available in very large quantities. More than for other commodities such as food or metals,

the demand for energy and petroleum by-products often expands to utilize available supply. As early as

1901, the oil gusher at Spindletop, Texas, instantly doubled world oil supplies, and within a decade, autos

and trucks in the U.S. had soared from 8,000 vehicles fueled by a variety of fuels to a mass-produced, gasoline-powered

fleet of 640,000 vehicles growing at over 40% per year.

On the demand side of consumption, fuel switching is likely to occur, moving oil users away from

low-value applications and more toward high-value transportation uses. Low-value applications include

power plants, industrial use of distillate and residual fuel oils, and residential/commercial use of distillate

fuel. The U.S. has already made major strides in reducing low-value uses, but some developing markets

are lagging behind. For example, U.S. non-transportation oil consumption went from 48% of total U.S.

oil consumption in 1965 to 41% in 1981 and then to only 33% in 2000. Low-value oil consumption in the

U.S. went from 23% of U.S. oil demand in 1965 to 18% in 1981 and then to only 10% in 2000. The rest of

the world presents more opportunities for replacing oil with other fuels such as coal or natural gas in lowvalue

applications. In 1999, global oil consumption in low-value applications was 25% of total petroleum

demand, representing substantial “low-hanging fruit” if high oil prices force all nations to use oil more efficiently.

And on the supply side, we do see the door opening for a host of energy supply alternatives,

but they face a chicken and egg conundrum. The modern petroleum market has a highly efficient system

of delivering around 76 million barrels of oil to consumers around the world every day, so even those crude

oil substitutes that are able to prove some cost or performance advantage must reckon with the fact that a

new retail distribution infrastructure will require many years to develop fully, and the development of that

infrastructure will not come, in our view, unless crude oil prices are high for a similar period. Still, there are

promising alternatives, such as liquefied natural gas (LNG) and the oil sands of Canada.

The growing use of LNG solves two problems: what to do with excess natural gas in oil-producing regions

with low domestic energy demand needs, and how to expand fuel consumption in areas with little native

fossil fuel resources, such as Japan and China. LNG is natural gas that has been liquefied through pressurization

and cooling to low temperatures in a liquefaction plant located close to a natural gas source. The

liquefied gas is loaded onto a special double-hulled refrigerated tanker, transported across the water to an

unloading terminal, and converted back to gaseous form in a regasification plant. The process is energyintensive

and capital-intensive, but LNG provides a supply option that bypasses the use of gas pipelines,

which may be impractical (e.g., distance) or nearly impossible (e.g., distant islands). Depending on the gas

production cost and the distance between source and destination, total costs of natural gas via LNG range

from about $2.50 to $4.00 per million Btu (MMBtu), making it very competitive with natural gas supplied

via pipelines. For comparison purposes, the average U.S. city gate natural gas price in 1999 was $3.01/


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -50- Legg Mason Wood Walker, Inc.

MMBtu, and in 2000 the average was $4.49/MMBtu. The average for the first 11 months of 2001 was

$5.91/MMBtu, but prices in recent months have dropped below $4.00/MMBtu as the natural gas shortages

of early 2001 have eased in the record warm winter of 2001/02.

Asia has made extensive use of LNG where pipelines are not as feasible, but the capital investments

for LNG are large. LNG is competitive in the U.S., but its greatest potential is in serving areas such as

East Asia with very limited gas supplies and almost no pipeline infrastructure. LNG currently accounts for

6% of the world’s natural gas consumption and 26% of cross-border gas flows. The largest importers of

LNG are the island nation of Japan (53% of the world total), South Korea (14%), France (8%) and Spain

(6%), and the largest LNG exporters are Indonesia (29%), Algeria (19%), Malaysia (15%), and Qatar

(10%). Well over 90% of Japan’s and South Korea’s natural gas supply is provided by LNG, and China is

preparing to follow suit by building its own LNG terminals, beginning with a $600 million, 3 million metric

ton per year terminal in Shenzhen (Guangdong Province) scheduled to be completed in 2005. Three million

metric tons is the equivalent of 146 billion cubic feet, or about 17% of China’s natural gas consumption in

2000. The capital cost differential between LNG projects such as this and a planned $18 billion PetroChina

gas development and pipeline project to connect Shanghai with western China gas resources, providing only

three to five times as much gas as the Shenzhen LNG terminal, illuminates LNG’s attractiveness. The presence

of some of the world’s largest known gas deposits in Irkutsk, Siberia, less than 2,000 miles from Beijing,

creates another option for China in lieu of LNG, but such a pipeline requires many years to build.

Canadian oil sands are another intriguing alternative supply option, but high capital costs and long

project lead times hinder the growth potential for the next decade. In a remote section of Alberta, Canada

lies a viscous mixture of sand, bitumen, clay and water with the consistency of cold molasses known as

“oil sands,” which contains at least 300 billion barrels of economic reserves of oil, and total deposits (most

of which are beyond current economic limits) of 1.7 trillion barrels of oil. The presence of 300 billion barrels

of recoverable oil reserves — greater than the 262 billion barrels of proved reserves in Saudi Arabia —

in the oil sands of Alberta, Canada, is attracting substantial investment. Engineering News Record magazine

estimates that there are now 34 oil sands projects either planned or under construction, with a total cost of

U.S. $28.9 billion and 2.9 million barrels per day of planned oil production. The new planned or in-process

projects detailed by ENR average $10,000 of capital investment per barrel per day of oil production, compared

with $5,500 for Persian Gulf OPEC nations, so we believe their construction is more likely to occur

on schedule if oil prices inflate. Of the new capacity for which extraction methods are known, 80% use

truck-and-shovel mining, which is a key potential market for Joy Global’s shovels and Caterpillar’s mining

trucks, while 20% use in-situ (drilling) extraction. To put the oil sands in perspective, however, the incremental

oil supply that would be provided by 2010 if all of the known projects are completed represents

only 8% of our forecast of incremental growth in world oil demand over that period. Like LNG

projects, investment in the oil sands requires very long lead times and high capital investments. Some

planned projects will not begin oil production until 2010, so they will have little ability to influence oil

prices over the next decade, in our view. However, the decline in production costs and the location in a secure

non-OPEC location ensure that oil sands production will attract investment in the coming years if our

thesis is correct.

The security of OPEC oil supply, which has implications for supply, demand, and substitutes within the energy

markets, is an issue we address later in this report. But next, we discuss the outlook for agricultural

commodities, which are driven by many of the same global supply and demand factors as oil, and consume

substantial energy in their production.


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -51- Legg Mason Wood Walker, Inc.

U.S. Farm Commodity Export and Inflation Prospects, 2002 to 2015E

U.S. Farm Commodity Price Cycles

In Exhibit 40, we show the seven inflationary or deflationary price cycles of the PPI for Farm Products

(PPI-Farm) index from 1870 to present. The cycles have lasted an average of 19 years, with prices

in the average inflation cycle rising 8.0% per year, in a range of 6.2% to 9.8% per year. Prices in the average

deflation cycle declined 2.6% per year, in a range of minus 8.7% to positive 1.6%. We find it interesting

that inflation cycles are more uniform and regular than cycles of deflation in the farm industry. As Exhibit

40 shows, some of the determinants of those cycles have been rising or falling input costs, farm productivity,

and acreage, but one of the most important determinants has been the growth of exports. For clues as to

the direction of U.S. agricultural export growth we turn to the U.S. dollar. The declines in the agricultural

trade-weighted U.S. dollar from 1970 to 1978 and 1985 to 1993 were associated with a surge in the export

of U.S. agricultural products, just as U.S. dollar strength in 1978 to 1985 and 1995 to 2002 pressured U.S.

food exports. An important difference between agricultural exports and oil exports is that the latter is denominated

in U.S. dollars worldwide, whereas the fluctuations in home currency have a disproportionate

effect on farmers (and numerous other commodity producers, for that matter).

We show in Exhibit 39 that the stock price of Deere & Company (DE) has a close, positive relationship

with U.S. agricultural exports, and that is the primary focus of this section of our report. Noted agricultural

analyst and historian Bill Hudson of the ProExporter Network in Olathe, Kansas, states that the U.

S. has about 5% of the world's population, but about one-fifth of the world's farmland capacity, a fact that

underscores exports as the key to farmer success. In Exhibit 41, we dismiss the current controversy surrounding

U.S. Farm Bill delays, showing that from an investor's viewpoint, DE stock moves inversely to

government assistance. Since most

farm aid flows to either very small

or very large farms, our view has

been that smaller farmers are not

Deere's customer base, and larger

farms tend to maintain and turn

over their fleets on a more regular

schedule.

We see another food price inflation

on the horizon. If the world

becomes a more dangerous place

in the 2002 to 2015 period, we

doubt food security will be subordinated

to the WTO-inspired

movement to lower state support

and protectionism for agriculture.

If, on the other hand, the world

experiences an explosion of

growth, the combination of higher

input costs and strong demand

Exhibit 39 – Deere Stock Is Driven By Food Exports

Real U.S. Ag-Exports ($ Mil.)

$110,000

$100,000

$90,000

$80,000

$70,000

$60,000

$50,000

$40,000

$30,000

$20,000

1962

1967

Deere Performance Tracks U.S. Food

Exports

1972

1977

Source: USDA, S&P Compustat, Legg Mason estimates 2002 to 2015

1982

Real Export CAGR

1962 to 1996 =

2.7%/year

1987

1992

1997

2002E

LM

Ests.

Real U.S. Farm Product Exports, U.S. $ Bil. (Left)

2007E

Deere Stock Relative to the S&P Composite (Right)

Real

CAGR 1996 to

2015E = 2.4/year

2012E

14.0%

12.0%

10.0%

8.0%

6.0%

4.0%

2.0%

Deere Relative to the S&P 500


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -52- Legg Mason Wood Walker, Inc.

Exhibit 40 – The PPI Price History and Our Estimates For U.S. Agriculture, 1870 to 2015E

1,000

100

10

1870 to

1896

CAGR

(2.6)%

1896 to

1919

CAGR

6.2%

Horses, land grants,

larger farms.

U.S. Agricultural Price Cycles, 1870 to 2015E

U.S. urban

migration,

farm exports,

W.W. I.

1919 to

1932

CAGR

(8.7)%

1932 to

1951

CAGR

7.9%

Supply

controls,

machinery,

W.W. II.

Mechanization, postwar

deflation, trade

barriers.

1951

to 1969

CAGR

(1.1)%

1969 to

1982

CAGR

9.8%

Exports

to EU

and

USSR,

costly

fertilizer

and fuel.

Post-war

price

support overproduction,

more

fertilizer.

1982 to

2001

CAGR

1.6%

2001 to

2015E

CAGR

6.1%

Export

decline,

lower

U.S.

export

market

share,

strong

U.S. $.

Exports,

costly

fuel and

fertilizer,

weak $.

1

1870

1880

1890

1900

1910

1920

1930

1940

1950

1960

1970

1980

1990

2000

2010E

PPI Farm Products

SUPPLY-SIDE ISSUES

DEMAND-SIDE ISSUES

U.S. Growth Comm'l. U.S. U.S. U.S. Nominal Real

PPI- Farm CAGR % Farm U.S. Rate Fertilizer Corn Real Meat (3) Growth Growth

Products of PPI Horses Farm of U.S. Used Yield World GDP (2) Con- Rate of Rate (4)

Inflation and Farm and Tractor Acreage Lbs/Acre Bu./acre War? Per sumption U.S. of Farm

Deflation Products Mules Unit All Major Growth Growth (1) YES Capita Growth Food & Food

Period Yrs. Index Growth Growth Crops Rate Rate or NO Growth Rate Exports Exports

1870 to 1896 26 (2.6)% 3.3% na 3.2% 3.7% 0.2% NO 2.7% na 1.7% 4.3%

1896 to 1919 23 6.2% 1.1% na 1.7% 3.9% (0.1)% YES 2.1% na 5.2% (1.0)%

1919 to 1932 13 (8.7)% (3.0)% 15.4% 0.2% (3.6)% (0.7)% NO (1.4)% 0.9% (11.3)% (2.6)%

1932 to 1951 19 7.9% (4.4)% 7.0% (0.4)% 9.1% 2.5% YES 4.0% 1.9% 9.3% 1.4%

1951 to 1969 18 (0.7)% nmf 1.5% (1.0)% 4.5% 4.0% NO 2.3% 3.6% 2.2% 3.0%

1969 to 1982 13 9.8% nmf -0.5% 1.7% 0.02% 1.9% YES (5) 1.4% 1.0% 14.9% 5.1%

1982 to 2001 19 1.6% nmf na (0.6)% 1.2% 1.6% NO 2.5% 1.6% 1.9% 0.4%

2001 to 2015E 14E 6.1% nmf ne ne 0.0%E 1.0%E 25%E ne ne 11.2%E 5.0%E

(1) To reduce the effect of weather, we compare three-year centered averages for each period, with a 2002 corn yield estimate from PRX ProExporter.

(2) Real GNP prior to 1947.

(3) Red meat, pork and poulty; per-capita values multiplied by U.S. resident population annually; CAGR between periods.

(4) Growth rate of real U.S. food exports is nominal exports minus the PPI for agricultural products; trade-weighted deflator data were not available.

(5) The Great Society “war” on poverty, Vietnam, and the Oil Embargoes of the 1970s, the latter being more global in their effect.

Source: PPI - Farm Products 1870 to 1889 Warren & Pearson study, 1890 to 1969 PPI is the shipment-w eighted annual averages of monthly prices prepared by

the U.S. BLS, 1970 to Present is the PPI Farm Products (NSA), from the U.S. BLS, all Indices have been placed in a continuous rew eighted series so that the 12-

month average of 2000 = 100; horses, mules and tractors from USDA and U.S. Census; acreage is from the USDA and data include corn , w heat, oats, barley,

flaxseed, soybeans, sorghum, rye, potatoes, sw eet potatoes, rice, sugarcane, sugarbeets, peanuts, hay, cotton, and tobacco; fertilizer usage, corn yield; meat

consumption and food exports are from USDA, NASS and predecessor bureaus; food exports 1901 to 1933 is from the FATUS section of the USDA and the U.S.

Census, agricultural exports from 1934 to 2000 data are from the USDA, older food exports data for the years 1870 to 1900 are the dollar value of U.S. exports

of cotton, tobacco, w heat, flour, animal fats and oils, fruits, nuts, and 1870 to 1880 are cotton, tobacco and w heat only; GNP (1870 to 1947) and GDP (1947 to

2001) per capita based upon NBER and U.S. Census data


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -53- Legg Mason Wood Walker, Inc.

may strain supply long enough

to create a somewhat typical

PPI-Farm inflation cycle. Lost in

20 years of energy deflation

thinking, in our view, is the fact

that higher energy costs have a

significant bearing on farm

prices. According to the USDA,

fertilizer, fuel and electricity account

for 40% to 45% of the total

variable costs in the production

of corn, and about 20% of

the variable cost of soybean production.

Corn is an especially

heavy user of anhydrous ammonia

(natural gas derived) fertilizer,

but soybeans receive most

of their nitrogen needs from the

atmosphere.

Exhibit 41 – Deere Stock Is Not Driven By Farm Aid

Real U.S. Farm Aid ($Bil.) (INVERSE)

$0

$5

$10

$15

$20

$25

1962

1967

Source: USDA, S&P Compustat, Legg Mason estimates 2002.

Another fuel-price spillover

effect could be in the ethanol markets. Each billon gallons of ethanol fuel oxygenate requires approximately

365 million bushels of corn, and from a level of just 300 million bushels in the 1980s, corn used to

produce ethanol rose to 565 million bushels in 1999 to 2000 (6% of production). If all of California's fuel

oxygenation needs were eventually to be met by ethanol, 350 million additional bushels of corn would be

needed. Furthermore, if New York and Connecticut eventually turn to 100% ethanol, then 250 million bushels

of corn would be needed.

Our forecast of food price inflation is not without controversy. In fact, history often suggests that increased

grain trade leads to lower prices. Agricultural analyst Bill Hudson reminds us that when the U.K.

repealed the Corn Laws in 1846, British imports of grain grew 4% per year for the next 68 years, but the

price of grain actually declined as new acreage expanded in the U.S., which was then a developing country.

Robert Malthus (b. 1766, d.1834), in his Principle of Population series, failed to recognize the ability of

technology to address the supply side constraints on agricultural production, and analysts have fallen into

the Malthusian trap ever since. Mr. Hudson also states that a reduction of world subsidies could be deflationary,

since world economies spend about $350 billion per year on farm support, causing expenditures to

be 47% above the true world price of food. Our view is that hydrocarbon inflation plus a positive demand

shock could be catalysts for a food price inflation.

The U.S. Farm Export Outlook

The modern grain trade story is one of shifting grain demand “hubs,” shown in Exhibit 42. We note

that combined world imports of corn, wheat and soybeans grew at an annual rate of 8.6% from 1970 to

1980, but stagnated at a rate of minus 0.1% from 1980 to 1995 as the decline of EU and FSU imports overshadowed

growth in the rest of the world. But from 1995 to 2000, after the roles of the EU and FSU were

minimized in terms of their effect on the world grain import markets, world grain trade increased 3.7% per

1972

1977

1982

1987

Deere Performs Inversely to

Farm Aid Payments

Real U.S. Gov. Pmnt. to Farms, INVERTED AXIS, U.S. $96 Bil. (Left)

Deere Stock Relative to the S&P Composite (Right)

1992

1997

2002E

14.0%

12.0%

10.0%

8.0%

6.0%

4.0%

2.0%

0.0%

Deere Relative to the S&P


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -54- Legg Mason Wood Walker, Inc.

year despite rolling recessions.

We look for a continuation of

trend growth at a 3.2% rate from

2002 to 2015, shown in Exhibit

43. We believe the key is growth

in markets outside the EU and

FSU, to include Central and

South America, Africa, the Middle

East and, of course, Asia-

Pacific. For example, higher petroleum

prices would stimulate

food demand in the predominantly

Islamic countries, which

account for about 27% of the

world corn trade. As we have

stated, we believe that U.S. farmers

have been priced out of many

markets by the strong U.S. dollar,

but the factors we outline in this

report may change that situation.

The U.S. grain export share

also has been affected by competition.

Total U.S. corn, wheat

and soybean exports from 1970

to 1979 were 805 million metric

tones (MMT), and the stocks-touse

averaged 18%. U.S. grain

exports to the EU and FSU were

particularly strong in the 1970s,

as well as part of the 1980s in the

case of the FSU. From 1980 to

1989, grain import demand from

the EU collapsed, and though total

U.S. exports for that period

were 1.05 billion metric tonnes,

the average stocks-to-use was

about 37%. In the 1990s, total

U.S. corn, wheat and soybean

exports were 982 MMT, continuing

a period of stagnation as

Exhibit 42 – Grain Import Hubs Shift Over Time

Bushels Per Capita Imported

Source: PRX ProExporter data and format, Legg Mason estimates 2002 to 2015

Exhibit 43 – The Transition from Old to New Grain Markets

Millions of Metric Tonnes Per Year

12.00

10.00

8.00

6.00

4.00

2.00

0.00

(2.00)

(4.00)

350

300

250

200

150

100

50

0

Grain Import Hubs Through History Drive Exports; Is Non-EU/FSU Next?

1970

1850

1860

1870

Source: USDA, PRX ProExporter format, Legg Mason estimates 2002 to 2015

the grain imports of the FSU collapsed, and Brazil became a major competitor to the U.S. in soybeans.

European imports had previously collapsed in the 1980s as Common Agricultural Policy turned the EU

from a net importer to an exporter of heavily subsidized grain, although the trend for EU soybean imports

has since been higher. The effect on U.S. grain export share is shown in Exhibit 44. Although we look for

continued pressure on U.S. soybean export market share, we believe that U.S. farmers are well positioned to

1880

1890

1900

1910

1920

1930

1940

1950

1960

Grain Imports Bu./Capita Western Europe

Grain Imports Bu./Capita FSU

1970

1980

1990

World Excluding the EU and FSU Grain + Meat Equivalent

Grain Impurts Bu./Capita United Kingdom

World Imports of Corn, Wheat & Soybeans

The effect of the EU and FSU import decline

is over, and the other world trade continues

unabated.

1970 to

1980 =

8.6%

CAGR

1975

EU-15

1980

FSU

1985

1980 to

1995 =

(0.1)%

CAGR

1990

1995

1995 to

2000 =

3.7%

CAGR

2000

Asia Rest of World EU-15 FSU

2005E

2000

2000 to 2015

= 3.2%E

CAGR

Asia

LM

Ests.

2010

Rest of World

2010E

2020

LM

Ests.

2015E


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -55- Legg Mason Wood Walker, Inc.

hold onto and improve corn

share, and wheat share should

stabilize, in our view.

Exhibit 44 – The U.S. Grain Trade Market Share

100%

90%

80%

70%

60%

50%

40%

30%

20%

U.S. Grain Export Market Share: Major competitors include

Argentina & Brazil (Soybeans, Corn) and Europe & Canada

(Wheat)

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002E

2004E

2006E

2008E

2010E

2012E

2014E

U.S. Export Share of Corn+Wheat+Soybeans By Weight

U.S. Corn Share By Weight

U.S. Soybean Share By Weight

U.S. Wheat Share By Weight

Source: USDA, Legg Mason estimates 2002 to 2015

LM Ests.

China holds long-term promise

as an importer of U.S.

foodstuffs, in our view.

China's GDP grew by an amazing

340% in the 1990s. According

to the Scowcroft Group, 490

million Chinese are poised to

achieve true "middle class"

status or better by 2010, implying

dietary enrichment and urban

migration. We are careful,

however, not to set great expectations

for U.S. agricultural exports

to the Chinese market,

largely because China has

shown such great ingenuity in

supplying its own food needs

internally. But our view is that

three facts will weigh on

China’s food self-sufficiency in

the long term: (1) China's ratio

of arable acreage to population

is one of the lowest among fastgrowing

countries in the developing world, (2) China’s per capita GDP growth is among the highest in the developing

world, and (3) China is not endowed with the hydrocarbon resources that will enable low-cost production

of food if we are correct about the upward trend in fuel and fertilizer input costs. Water scarcity may

also be a factor affecting grain production in the Asia Pacific region, as rapid urbanization and related demands

for water compete with agriculture. Contradicting reports that exaggerate the problem in Asia, however,

USDA states that farming accounts for 64% of Asia Pacific water use versus 79% globally.

In the near term, we believe that China has no intention of disclosing its food import needs, or destabilizing

its agricultural sector. Not unlike most countries with a long history and a record of success, we see

China as forthright when it is in a position of strength, passive when it is weakened, and cunning as it begins

ascendancy, and we believe China is currently in a period of ascendancy. We further believe China’s task today

is to encourage reform and commercialization, while softening the blow of competition for the agricultural

and state-owned enterprise (SOE) sectors. For example, according to China's agriculture ministry, the

country's 800 million agricultural residents earned an average 2,300 yuan ($278) per capita last year, and a

majority had never even heard of the WTO. In addition, about 78 million rural workers, mostly from agricultural

backgrounds, migrated to the cities to find work last year. Chinese Minister of Agriculture Du Quinglin

has stated that China will "try every means WTO allows" to protect the post-WTO Chinese agricultural sector

from upheaval. Nevertheless, the new tariff-rate quota system resulting from WTO accession slowly scales

back the power of the State Trading Enterprises, leading to more private import company control over im-


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -56- Legg Mason Wood Walker, Inc.

ports, where demand is believed to be

greater and less subject to political

considerations.

Despite the competitive pressure,

we believe Chinese agriculture

should not be underestimated. Chinese

production of corn, wheat and

rice grew from about 100 MMT in the

early 1960s, just before a disastrous

famine, to 200 MMT in the late 1970s,

as labor and land were applied to the

shortage problem. Since China introduced

certain agricultural market reforms

in 1978, followed by an additional

round in the mid-1990s termed

the "Governor's Grain Bag" policy,

total agricultural staples production

rose to about 390 MMT in the late

1990s, an increase of 90% in two decades.

China set its tariff rate quotas

(TRQs) high enough for corn and

wheat that they are unlikely to be a

problem for exporters to China in

FY02, and notably absent is a TRQ

for soybeans, of which China has

been a prodigious importer. In fact,

Chinese imports of soybeans represent

about 20% of the global oilseed

trade, and China imported approximately

14 MMT of soybeans last

year. China has maintained a liberal

import policy with respect to soybean

imports to feed its growing domestic

needs, so we are not alarmed by the

genetically modified organism (GMO)

talk, which may simply be posturing

to protect other segments of the Chinese

farming sector.

Exhibit 45 – Key Drivers In Meat Product Trade

U.S. Meat Consumed Per Capita

25,000

20,000

15,000

10,000

200 lbs.

180 lbs.

160 lbs.

140 lbs.

120 lbs.

100 lbs.

Meat Consumption Is Income-Dependent

1935

80 lbs.

$5,000 $10,000 $15,000 $20,000 $25,000 $30,000 $35,000

Real GDP Per Capita ($96, Uses GNP pre-1947)

Meat remains one of the most exciting

stories in agricultural trade. In 0

Exhibit 45 we show that meat consumption

is income-driven, the world

U.S. Meat Exports, 000s Tons (Left)

meat market is growing, and we believe

U.S. market share should benefit Source: USDA, Legg Mason estimates 2002 to 2015

5,000

0

12,000

10,000

8,000

6,000

4,000

2,000

1980

1980

1982

1984

1986

1988

1990

1971

1992

2001

As previous commodity charts have shown, the peak

rate of consumption growth in the U.S. occurred at

roughly the same time, from the mid-1930s to the early

1970s, or from about $7,500 of per capita real GDP to

about $17,500 per capita. This may have implications

overseas, in our view.

The World Meat Trade (000s of Tonnes) Is Strong

LM Estimates

Dietary enrichment has boosted the

2001 to

migration from grain to poultry. Typically, the

2015 =

next step is to pork, then beef.

5.3%

CAGR

1983

1980 to

2001 =

5.8%

CAGR

U.S. Meat

Exports

1980-01

= 10.3%/yr.

1986

1994

1996

1998

2000

2002E

Beef Pork Poultry

2004E

We See U.S. Meat Exports Rising

1989

1992

1995

1998

2001

2004E

2006E

2008E

LM

Estimates

2007E

2010E

Poultry

2010E

Beef

2013E

Pork

2012E

U.S. Meat Exports 2001

to 2015E

= 5.9%/yr.

U.S. Meat Market Share % (Right)

2014E

60%

50%

40%

30%

20%

10%

0%


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -57- Legg Mason Wood Walker, Inc.

now that competitors’ currency-related advantages in market share have begun to run their course. Agricultural

analyst Bill Hudson has stated that in 1900 only 5% of the world could afford fresh meat every day, by

1950 the number was 20%, and today it is about 35%. We believe that the worldwide meat intensity of use

penetration rate should rise to approximately 60% to 70% by 2050, almost doubling from the current level,

with global population growth added to that figure. High-value products, which include meats, are approximately

two-thirds of total U.S. agricultural exports, and have been the lifting force for U.S. farm exports for

the last two years. High-value products added $2.1 billion more than the prior year to U.S. agricultural exports

of $53 billion this year, versus a $77 million decline in bulk grain exports. Currently, exports account

for 10% of U.S. beef production, 7% of pork and 17% of poultry. In the 1990s alone, the grain and oilseed

equivalent of U.S. meat and poultry exports has increased by about 400 million bushels, since one unit of

additional meat trade is equal to approximately 3.6 units of grain as feed (although poultry is less grainintensive

than beef or pork).

Meat stimulates feed grain consumption, but at a decreasing rate. Greater meat production efficiencies

and the popularity of the less grain-intensive poultry industry have had a moderating effect on feed-grain

demand, and from 1964 to 1999, the global production of meat and poultry rose by 450%, with only a 110%

feed grain consumption increase. Of course, the increased share of poultry in the meat diet was a factor. In

fact, poultry has been the star attraction of U.S. agricultural exports, with U.S. poultry export growth of

10.6% from 1980 to 2001, and 2001 exports of 6.2 billion pounds, or about 20% of U.S. production, with

over one-half of that volume going to China and the FSU. We look for U.S. poultry exports to grow at a rate

of 6.8% per year from 2001 to 2015, perhaps assisted by a weaker U.S. dollar that allows for greater export

cost advantage. In recent years, U.S. total meat exports have been hurt by animal disease concerns the world

over, and economic recessions, and the USDA expects total U.S. meat exports to increase only 0.5% in the

current fiscal year. There are short-term impediments on the supply side. For example, if the liquidation

phase of the cattle cycle were to come to a close this year, it is possible that animals bred in 2003 would not

be ready for beef production until 2005, possibly restraining beef exports in the intervening period, and

leading to substitution.

Still, the long-term export picture is exciting if developing countries continue to embrace meat in

their diets. From 1997 to 2001, Chinese beef imports rose 50% to 90,000 metric tonnes, pork imports rose

206% to 450,000 metric tonnes, and poultry imports rose 31% to 1.9 MMT. Using 1995 data, if we index

the U.S. to equal 1.00 and examine total annual meat plus fish consumption in various countries, the Japanese

consume 0.81x the U.S. level, South Korea 0.74x, and China only 0.23x. Fish is less of a factor in the

U.S. and, to the surprise of many, China. China's increasing preference for meat shows up in the substitution

numbers as well. From 1990 to 2000, Chinese consumption of food grains (rice and wheat) declined

13%, while China's population expanded 11%. A lack of cold storage and transportation infrastructure in

China may restrain growth in the import of meats, but given that China has abundant labor and restrictive

land and water resources, we are optimistic that China's competitive advantage will gravitate toward laborintensive

crops such as fruits, vegetables, and specialty crops rather than field crops and certain meats.

U.S. Agricultural Exports and Deere Stock

The implications of greater farm industry prosperity are favorable for machinery sales, and thus

Deere & Company. North American industry farm machinery inventories as a percentage of forward-12-

month sales for 100+ horsepower, two-wheel drive (row crop) tractors are currently 29%, which is well be-


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -58- Legg Mason Wood Walker, Inc.

low the 10-year average of 48%,

and combine harvester inventories

are 17% versus a 38% 10-

year average. In Exhibit 46, we

show the sharp recoveries in row

crop tractor sales in the 1987 to

1988 and 1992 to 1994 periods

coincided with sharp periods of

outperformance for DE stock

versus the S&P 500. The row

crop tractor sales recovery in

this cycle has been more mild

than in those prior cycles, we

believe, because of the reduced

incidences of steep discounting

and lower dealer inventories,

which have reduced the "fire

sale" mentality. A recovery in

the fortunes of farmers would be

a bullish event for Deere stock,

in our view. We believe that the

key to more tractor sales over

the long term may be acreage,

and in Exhibit 47 we show that

acreage and farm commodity

prices are related.

The Global Competitiveness

of the U.S. Farm Economy

Exhibit 46 – Deere Stock Follows Tractor Sales Trends

35,000

30,000

25,000

20,000

15,000

10,000

5,000

Jan-85

Deere Stock Relative to the S&P 500 Tracks Tractor Sales

Jan-86

Jan-87

Jan-88

Jan-89

Jan-90

Source: Equipment Manufacturers Institute

Exhibit 47 – U.S. Farm Acres and Farm Commodity Pricing

It has been two decades since

all was rosy on the U.S. farm,

so the sector can be forgiven a

pessimistic mindset. As we

have stated, in the 2002 to 2015

period, we foresee higher exports

of U.S. agricultural product,

265,000

245,000

225,000

-5%

-10%

-15%

a weaker U.S. dollar versus

the primary competitor nations

U.S. Acreage Harvested, Thousands of Acres, (Left)

PPI Agri-Products, Y/Y % Chng., 5-Yr. Moving Avg., (Right)

in the world food trade, and

Source: Equipment Manufacturers Institute, S&P CompuStat

higher hydrocarbon prices that

raise agricultural inputs (often globally) and lead to food commodity inflation. In Exhibit 48, we show that

real food exports help drive prices, and in Exhibit 49, we show that currency facilitates food exports. Hardship

related to both supply and demand factors caused U.S. government direct payments to farmers to average

$21.5 billion per year each of the past three years, resulting in stable net cash income averaging $58 billion

in the same period. In addition to income statement stability, we believe that the U.S. farm balance

Jan-91

Jan-92

Jan-93

Jan-94

Jan-95

12-mo. trailing sum, N.A. 100+ hp. tractor sales (Left)

365,000

345,000

325,000

305,000

285,000

1945

1950

Machinery

discounting

boosted

demand in the

past.

1955

1960

Discounting

is more mild

with reduced

capacity.

Jan-96

Jan-97

Jan-98

Pricing Helps Drive Acreage

1965

1970

1975

1980

1985

1990

Jan-99

Jan-00

Jan-01

Jan-02

L

M

e

s

t

s.

8.00%

7.00%

6.00%

5.00%

4.00%

3.00%

2.00%

1.00%

Deere stock rel. to S&P 500 (Right)

1995

2000

2005E

LM

Ests.

2010E

2015E

15%

10%

5%

0%


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -59- Legg Mason Wood Walker, Inc.

sheet is well positioned for a resumption

of growth and machinery

purchases. Again, it was not

always so. Leverage has often

proved to be the enemy of farming,

and we note that the farm

debt-to-asset ratio peaked in

1985 at 23%, but it is only

15.6% currently. In the 1970s,

farmland asset values inflated,

and borrowing was based more

on asset collateral than on sustainable

cash flow. The natural

result was the agricultural bust

of the 1980s, and the sector has

been careful not to repeat past

mistakes.

Exhibit 48 – Food Exports Help Drive Food Prices

$1,000,000

$100,000

$10,000

$1,000

1895

1905

1915

1925

1935

1945

1955

1965

1975

1985

1995

LM

Ests.

2005E

U.S. Agri-Exports in Real (Yr. 2000) U.S.$ Mil., (Left, Log)

PPI Agricultural Products (Year 2000 = 100), (Right, Log)

2015E

1,000

100

10

1

Land is the farmer's largest

asset, and it has steadily appreciated

during this agricultural

recession, which should

benefit the sentiment that supports

the purchase of farm

machinery of the sort manufactured

by Deere. Real estate accounts

for 79% of farm assets

but only 53% of farm debt, and

farmland values rose about 61%

in Iowa in the past decade, with

about 3% increases for farms

nationwide in each of the past

three years. Reasons for the

strength in farmland values are

many, but we note that 62% of

program cropland in the U.S. is

owned by non-operating landlords,

and those owners have had

to bid in the thin market for

Source: USDA, Legg Mason estimates 2002 to 2015

Exhibit 49 – Currency Moves Inversely to Food Exports

130

125

120

115

110

105

100

95

90

85

80

1970

Source: USDA

1975

farmland to settle like-kind exchanges and postpone capital gains taxation. These exchanges occur when

farmland is sold to other farmers seeking economies of scale, or to developers who convert the farmland to

alternative uses, or even to nature conservancy funds that leave the land fallow.

Oversupply caused largely by ideal growing weather has overshadowed improving demand trends.

Corn yields in the U.S., measured in bushels per acre, have been at or above trend for six consecutive years,

1996 to 2001. In fact, those six years were the first time since the years 1902 to 1908 that corn yields have

1980

1985

1990

1995

2000

$75,000

$70,000

$65,000

$60,000

$55,000

$50,000

$45,000

$40,000

$35,000

$30,000

$25,000

Real U.S. Agricultural Trade-Weighted Dollar, 1995 = 100, (Left)

Real U.S. Agricultural Exports, $U.S. Million, (Right)


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -60- Legg Mason Wood Walker, Inc.

been at or above trend six consecutive

years. In Exhibit 50, we

show that it is highly unusual for

U.S. corn yields not to be adversely

weather-affected. If 2002

corn yields fell 10% from the

trend (i.e., to 124.2 bu./acre), we

estimate about 62% of U.S. corn

stocks (inventory in storage)

would be eliminated to make up

the shortfall, and, of course, corn

prices would likely rise in that

environment. Despite the nearterm

worries about oversupply,

however, the USDA states that in

the 2001 to 2002 crop year, the

stocks-to-use (inventory-to-sales)

ratio for corn is 15.7%, below

the five-year average stocks-touse

of 17.5%. For the 2002 to

2003 crop year, ProExporter estimates

the corn, wheat and soybean

combined stocks-to-use to

be down further, to 16.9%. On

the world stage, U.S. yields relative

to those of export competitors

are increasing strongly for

feedgrains and modestly for oilseeds,

but wheat yields in the U.

S. are in a relative downtrend.

Also on the subject of yields, if

we are correct and hydrocarbon

prices rise in the coming years,

the reduced application of nitrogen

fertilizer would probably

reduce yield growth, as shown in

Exhibit 51.

Exhibit 50 – U.S. Corn Yields, +/(-) 10% From Trend

Bushels Per Acre

Source: USDA

Exhibit 51 – U.S. Corn Yields and Fertilizer Usage

1000

Fertilizer Use Affects Yields

100

10

165

155

145

135

125

115

105

95

85

75

65

55

1900

Higher natural gas prices from

2002 to 2015 may impact grain

yields by inhibiting fertilizer use.

1910

U.S. Average Corn Yield in Bushels Per Acre

Volatile, weather-driven corn yields are the norm. The recent string

of excellent yields is highly unusual. A 10% yield decline in 2002 (to

124.2 bu./acre) would reduce U.S. corn inventory by 62% to 600 mil.

bu., all else being equal.

1962

1964

1966

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

Corn Yield bu./acre Corn Trend Plus 10%

Corn Yield Minus 10%

Corn Yield 10-yr. Centered Average

1920

By far, we believe that the

Source: USDA

greatest competitive threats to

the U.S. farmer are in South America, although we note that Deere and other farm equipment makers

have incorporated that region into their acquisition and marketing strategy for many years. Brazil's strength

is soybeans, and the country exported almost 75% of its year 2000 soybean production in raw beans or finished

products, equivalent to about 1 billion bushels. We doubt that Brazil will emerge as a major corn exporter

because of the absence of suitable tropical corn varieties, and the rapid growth of Brazil's poultry industry

which consumes domestic feed corn. Despite Argentina's complementary strengths in soybeans, soy-

1930

1940

1950

1960

1970

U.S. Fertilizer Applied, Lbs./Acre, (Left, Log)

1980

U.S. Corn Yields, Bushels/Acre, (Right, Log)

1990

2000

1000

100

10


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -61- Legg Mason Wood Walker, Inc.

bean meal and soybean oil, and though Argentina also has emerged as export competitor in corn, we believe

that Argentina's economic difficulties will give a moderate lift to U.S. corn export market share in the coming

years. Total shipments of soybeans and soybean products from Brazil and Argentina eclipsed the U.S.

around 1996, and the gap has continued to widen. In addition to soybean products, Brazil has about 107 million

acres under cultivation, versus 226 million in the U.S. But by adding the vast "Cerrados" region's potential

acreage, Brazil eventually could reach 353 million planted acres. Brazil's corn yields in 2000 were

about one-third those of the U.S., and soybean yields are comparable to those in the U.S. heartland.

Our view is that South America has used the devaluation bullet, and now it must stand on its own. It

was an unfortunate act of timing (for them) that Argentina tied the peso, and Brazil tied the real, to the U.S.

dollar in the mid-1990s, since both suffered through a multiyear bull market for the U.S. currency. Now that

both Brazil (1999) and Argentina (2001) have removed their dollar pegs, their farm product exports have

become more competitive, although the financial and infrastructure inefficiencies in both countries still

exist, in our view. To be sure, however, Brazil has made great strides in stabilizing its economy, improving

farmer access to credit, enhancing the country's grain logistics network, globalizing its farm input sources

and technology, and streamlining its taxation and export policies. But Argentina is mired in debt, and

paying devalued pesos for dollar-denominated imports of farm inputs is not a recipe for agricultural

success, in our view. As an offset, Argentina's farmers have increasingly turned to barter systems to

purchase needed inputs such as seed, fertilizer and chemicals.

South America is not immune from a reversal of agricultural fortunes, in our view. The Cerrados land

in Brazil requires heavy doses of lime and phosphorus to reduce aluminum toxicity and acidity, so our view

is that the Cerrados’ lands will be brought into production slowly, and only in response to strong world demand

for soybeans. In addition, some of the Cerrados’ soil is fragile, being subject to significant erosion in

the frequent, tropical rains. Although Brazil does not suffer a major weed problem, the country's farmers

have largely made the switch to no-till (i.e., avoids the use of plows to till the land after harvest) to avoid

erosion, and weeds often follow no-till with a lag. In fact, our view is that this eventually may lead Brazil to

abandon its "GMO-free" policy, which is official in name only, in our view, since there are widespread reports

of Brazilian farmers already using “Roundup Ready ® ” soybeans. Combined with the pressing need to

continue increasing crop yields, we see Brazil's GMO-free soybean export price premium eroding over time.

Currency is only part of the issue, as cost differentials often go much deeper in world food production

and competition. Equalizing North and South America for differences in land cost, an Agroconsult

study provides data that Midwestern U.S. farmers’ variable costs per bushel of soybeans produced are about

15% below those in Brazil and Argentina, and for corn the U.S. advantage is about 45% to 50% below Brazil

and Argentina. Where the South Americans have an advantage is total capitalized costs including land,

as that causes U.S. total costs to be 63% higher for soybeans and 5% higher for corn. A recent Iowa State

University study put Brazil's all-in soybean production costs at port of exit at $4.60 per bushel, and for the

U.S. the figure is $6.38 per bushel. What is interesting is that if we exclude the capitalized cost of land, then

the U.S. cost is only $3.58 per bushel and for Brazilian it is $4.09. Since U.S. farmland often has no other

use but farming, we believe its value is often situation-dependent on farming. As a result, we view non-land

costs as a better measure of relative costs. Also on the subject of other costs, the Agroconsult study shows

that Brazil's grain production has risen at a compound rate of 5.5% per year in the past decade, but its fertilizer

consumption has risen at an annual rate of 6%, and usage of ag-chemicals has risen at 8% per year. If

input costs rise, we would expect Brazil’s all-in cost advantage to shrink, all else being equal.


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -62- Legg Mason Wood Walker, Inc.

We see the EU slowly fading as an export competitor, but not overnight or without a fight. The devaluation

of the European euro and the EU export of subsidized agricultural overproduction have been competitive

issues for U.S. farmers in the past. Also, the EU has quietly built a network of preferential trade

agreements with all but 10 countries in the world, and many of these agreements have bilateral trade terms

that lock in food markets. Unfortunately for Deere and its customers, the U.S. has typically had a less organized

public/private cooperative effort to facilitate exports. The EU is not without export competition

worries, however, because it faces its own "Brazil-like" competitors for regional export market share in the

form of the rapidly recovering FSU grain sector, and the enlargement of the EU Common Agricultural Policy

(CAP) to include central and eastern European candidates. The EU proposes a phased-in subsidy for its

Eastern European neighbors, whereby the new members of the CAP would receive only 25% of the Western

subsidy level in 2004, rising to 100% by 2013. From 2004 to 2006, the subsidies would cost the CAP $36

billion in total, a heady sum for the EU budget. The combination of low-cost competitors in the back yard

of a higher-cost producer, and the liability of bringing some emerging market competitors with large farm

populations into a generous subsidy scheme, is not favorable for Western EU agricultural production in the

long term, in our opinion.

Though we like DE stock for

macro-reasons, the valuation

should give pause. Currently,

DE stock trades at a P/E of 19.7x

the First Call consensus for

FY03, and earnings “power”

given the mix of businesses is

less than clear, in our view. In

addition, using a less orthodox

scale that we sometimes use, DE

stock appears to be ahead of itself

relative to corn prices,

shown in Exhibit 52. As a result,

we are keeping some powder

dry, deferring a Strong Buy rating

until we see some sign that

the DE stock price and the company’s

EPS potential have

moved closer together, or that

industry conditions (including

the outlook for corn prices) are

markedly higher in the near

term, all else being equal.

Exhibit 52 – Deere Stock and Corn Prices

$50.000

$48.000

$46.000

$44.000

$42.000

$40.000

$38.000

$36.000

$34.000

$32.000

$30.000

3/1/00

Deere Stock Vs. Corn Prices March 2000 to March 2002

6/1/00

Source: S&P Compustat

9/1/00

12/1/00

Deere Stock Price (Left)

There is a relationship between

Deere stock and corn prices,

although a divergence has developed

in 2002.

3/1/01

6/1/01

9/1/01

12/1/01

Corn Near Futures Price Per Bushel (Right)

3/1/02

$2.50

$2.40

$2.30

$2.20

$2.10

$2.00

$1.90

$1.80

$1.70


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -63- Legg Mason Wood Walker, Inc.

Scenario (3) Middle East War(s) in the Period 2002 to 2015 That

Result in Extended Oil Supply Disruptions: Probability: 25%

Analyzing the potential for major war is key to determining the outlook for inflation, as well as the

allocation of public versus private resources, both of which affect stock market returns. Earlier in this

report we showed that 26% of the 20th century featured major (lengthy and global) periods of hot or economic

warfare that involved the U.S. Those periods produced mean annual inflation of 10.7% for commodities,

9.0% for consumer prices, and 2.6% annual (minus 6.4% real) U.S. stock market price returns. We believe

that the “peace dividend” of the 1990s was the end of the Soviet Union that reduced U.S. defense

spending as a percentage of GDP, combined with the post-Gulf War implicit agreement with Saudi Arabia

that America would provide a defense umbrella in exchange for Saudi Arabia, as OPEC “swing producer,”

enforcing reasonable world oil prices. Both peace dividends appear to be spent, in our view, and since we

believe the Middle East is the most unstable region in the world today, this section describes the Persian

Gulf war risk under various scenarios. Our opinion is that as investors we must be keen, disciplined and impartial

observers, and our investment view is that the “New World Order” created after the Gulf War and

the fall of the Soviet Union is crumbling. If the transition to the next world order goes badly, then we

note that major wars in U.S. history have, without exception, been inflationary.

A key risk we see is that the economic pressure on the oil producers resulting from renewed oil price

deflation could light the powder keg in the Middle East and lead to inflation via major war. Earlier in

this report we described our view that the voracious appetite we expect for oil from Asia/Pacific net oil importers

can only be met by expanded production from the Persian Gulf. Competing with Asia, however, are

the U.S. and other developed and developing countries. Even without disruption in Middle East oil flow,

our view is also that U.S. oil import demands are likely to collide with sharply rising Asia/Pacific demands

in the coming decade, leading to higher prices for all, and outstripping the capability of alternative fuels and

oil sources to overtake demand for several years. In Exhibit 53, we show Persian Gulf oil as a percentage of

U.S. oil consumption, and observe that the Persian Gulf’s share of U.S. oil consumption was 13.9% in

2001, above the prior peak of 13.5% in 1977. More importantly, U.S. oil imports as a percentage of U.S.

consumption were 46.5% in 2001, hovering at a post-World War II high. In our opinion, analysts who cite

decreased U.S. reliance on Persian Gulf oil as a percentage of total oil imports conveniently overlook the

fact that total U.S. oil imports as a percentage of consumption are sharply higher than two decades ago. Our

view is that oil is like a game of musical chairs among the importers: if several chairs (producers) are removed,

and given that all oil importing nations must sit down (consume oil), then the price of the remaining

chairs rises substantially once the music (steady oil flow) stops. Past oil shocks include the 1973 to 1974

Oil Embargo, the Iranian Revolution of 1979, and the period after the start of the Iran/Iraq War of 1980 to

1988. In Exhibit 54, we show the total Persian Gulf oil exports in real U.S. dollars for the period 1970 to

2015E. The bubble of the 1970s is evident, but the prolonged bust that followed may resume an upward direction

to 2015, if our estimates are correct.

The Persian Gulf war risks we see, in descending order of likelihood, are as follows.

(1) U.S. military action to change the Iraqi regime which may lead to a destabilized region.

(2) The risk that Iraq currently has or will soon succeed in the development of nuclear weapons.

(3) The risk of civil war that targets Saudi Arabia's ruling al-Saud monarchy.

(4) The risk of conventional (non-nuclear) warfare within the Persian Gulf region.

(5) The risk of terrorists obtaining nuclear weapons developed in the former Soviet Union.


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -64- Legg Mason Wood Walker, Inc.

Exhibit 53 - Persian Gulf Oil as a Percentage of U.S. Consumption, 1970 to 2001

Persian Gulf and Total Imports as a % of U.S. Oil Consumption

50.0%

45.0%

All-time high dependence on the world oil "bucket"

40.0%

35.0%

30.0%

25.0%

20.0%

15.0%

Back up to mid-1970s level.

10.0%

5.0%

0.0%

1950

1952

1954

1956

1958

1960

1962

1964

1966

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

Persian Gulf imports % of U.S. Consumption

All Imports % of U.S. Consumption

Source: U.S. EIA

Exhibit 54 - Persian Gulf Oil Exports in Real (Year 2000) U.S. Dollars, 1970 to 2015E

$450

$400

Projection

Persian Gulf Oil Exports, Real $ (2000) Bil

$350

$300

$250

$200

$150

$100

$50

$0

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

Saudi Arabia Iran Iraq Other Gulf

Source: U.S. EIA. Legg Mason projection based on EIA’s International Energy Outlook 2002


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Our approach is to watch actions rather than statements, and we believe the Bush Administration

has adopted a far more pervasive wartime footing than is currently recognized by the markets. The

distinct shift in budget priorities and deficit spending tolerance, as well as the risk to energy commodity

trade, have significant implications for investors. For example, the movement of the U.S. to a “shadow government”

is an unusual step. The shadow government concept originated in the Cold War, and requires a

group of senior federal government officials to rotate in a secure, off-site location to ensure government,

and particularly executive branch, continuity in case of an attack on Washington, D.C. In addition, on December

13, 2001, the U.S. pulled out of the Anti-Ballistic Missile treaty, and on January 8, 2002, the U.S.

modified its nuclear strategy, called the Single Integrated Operational Plan (SIOP), by lowering the bar for

first-use of nuclear weapons and shifting the focus from Cold War thinking to an increased awareness of

China, Iran, Iraq, Libya, North Korea, Syria and Russia. The revised plan appears to loosen the traditional

restraints the U.S. had in place with regard to its use of nuclear arms. We believe that this was not a budget

ploy, or a belated update of outdated Cold War strategy, but rather a deliberate decision by the Administration

that the 1970 Nuclear Nonproliferation Treaty (NNPT) has failed. We believe that the Bush Administration

weighed the risk of existing and emerging nuclear threats (including the proliferation risk presented

by Iraq, a NNPT signatory) against the risk of sending a signal to non-nuclear countries (in contravention to

the NNPT implicit guarantee) that simply because they are non-nuclear they are no longer protected from a

nuclear response to their hostile actions. After considering all of the ramifications, we believe the Administration

decided that the increased wartime footing of the U.S. justified the shift, and we interpret the shift

as added risk that is underappreciated by investors for the potential impact it may have.

Nuclear weapons are a complex subject, but they present a risk with potential repercussions for investors

that must be analyzed. In the box on page 66 we provide a primer on nuclear weapons, with an

emphasis on the sort that we believe the Bush Administration fears may be now or in the near future in

Iraq’s possession. We believe investors often receive incorrect information regarding the highly complex

world nuclear threat, and since misinformation is the enemy of markets, we believe that it obscures the appropriate

equity risk premium as well as commodity price reactions. For example, media reports have occasionally

failed to differentiate between weapons-grade highly enriched uranium-235 (HEU, having >80%

U-235 content) and ordinary low-enriched uranium (LEU, having 3% to 5% U-235 content) nuclear reactor

fuel. Later in this report we express our doubts about the widely reported “suitcase nuke” threat, for example,

in terms of the devices’ reputed destructive capabilities, and the likelihood that terror groups could obtain

or use them even if they ever existed in the Former Soviet Union or were ever misplaced.

The Risk of U.S. Military Action to Change the Iraqi Regime Which May Lead

to a Destabilized Region

An emerging war scenario that we believe is underestimated by investors involves U.S.-led efforts to

oust Saddam Hussein of Iraq, possibly with conventional military force. Since the expulsion of United

Nations (UNSCOM) weapons inspectors in late 1998, the only checks on Iraq’s WMD nuclear program

have come from International Atomic Energy Administration (IAEA) visits to Iraq, but we feel those inspections

are too limited to be of value, and note that other countries have developed nuclear weapons despite

being subject to IAEA inspections. Former Iraqi nuclear scientists and UNSCOM inspectors have provided

statements and evidence of a long-standing WMD nuclear program, possibly one that was revitalized

after the expulsion of the inspection regimen. In addition, former UNSCOM inspectors have uncovered evidence

that Iraq employed an elaborate scheme for hiding its WMD programs from inspectors. Although we


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do not believe any of the major

Persian Gulf leaders would regret

the removal of Saddam Hussein,

the reality of the current political

situation in the Persian Gulf as it

differs from the Gulf War period a

decade earlier is that such a move

could easily play into the hands of

the radical factions that threaten

moderate regimes, including Saudi

Arabia. In our view, the Gulf War

of 1991 was successful precisely

because of the scope and size of

the coalition forces build-up and

bombing campaign before the

ground war began. The difficulty

in assembling a coalition to conducting

a similar size operation

today, and the risk that Iraq may

have improved its nuclear counterattack

capabilities, are other risks

to consider. In this period of uncertainty,

we hope to leave investors

more prepared for whatever

may occur. Rather than speculate

on operational details, we focus on

the motivation for such a U.S.-led

operation in the following section.

The Risk that Iraq Has or

Will Soon Succeed in the

Development of Nuclear

Weapons

We believe that Iraq’s nuclear

weapons program is the primary

Middle East concern of the Bush

Administration. Our research

concludes that a combination of

four principal items have kept Iraq

from successfully developing a nuclear

weapon (or limited the number

of such weapons if one or

more exist) despite billions of dollars

of expenditures and over a

Iraq’s Potential Approach to Nuclear Weapons

We believe that the U.S. fears development in Iraq of nuclear fissiontype

weapons, which use the energy released from splitting atoms. Fission

occurs when fissile nuclear material is forcibly combined in a critical mass

capable of sustaining the free release of atomic particles called neutrons,

which leads to the splitting of still more atomic nuclei, releasing energy in a

chain reaction. We believe that if Iraq is close to developing nuclear weapons,

or has a few of them, they are probably larger in physical size (thus difficult

to deliver), and lower-yielding (in a explosive equivalent sense, expressed

as 1 kiloton = 1,000 tons of high explosive TNT-equivalent) fissiononly

devices, possibly using a simple “gun” assembly approach that fires together

two subcritical masses of highly enriched Uranium-235 (HEU, generally

containing >80% U-235) to create a super-critical mass and a fission

chain reaction. The weapon we have described is similar to “Little Boy,”

which was one of two nuclear device designs developed by the U.S. in the

Manhattan Project of World War II, albeit smaller in dimensions than Little

Boy as a result of technological progress to-date. The other Manhattan Project

nuclear weapon was called “Fat Man,” which used Plutonium-239 (Pu-

239) as a more efficient-by-weight fissile material, and a design that imploded

a core of Pu-239 to produce a chain reaction (although either U-235

or Pu-239 can be used in a implosion design). Having found PU-239 reprocessing

more difficult than U-235 enrichment, we believe Iraq may have chosen

– and may be well on the way to producing – a Manhattan Projecttype,

U-235-based, Fat Man or Little Boy weapon. Though we do not

minimize it, Little Boy, for example, was “only” about 1/100th as powerful

as many of the modern thermonuclear devices currently in western and Russian

arsenals, it weighed 8,900 pounds (far heavier than any Iraqi ballistic

missile payload capability), and it was 120 inches in length (far too long for

any Iraqi combat aircraft to carry). To maximize its effect by minimizing

blast deflection resulting from ground clutter, Little Boy was detonated at

1,800 feet above Hiroshima, Japan. But given the advanced state of modern

air defenses, such an air-burst would be a difficult feat for Iraq, in our view,

given the difficulty Iraq has faced in continuing its ballistic missile or tactical

aircraft training programs since the Gulf War. Although ground delivery

would greatly reduce the weapon’s lethal range, more radioactive fallout

would be created, a problem for surrounding countries. We have no doubt

that Iraq’s potential device(s) would differ sharply from the much more

powerful and sophisticated arsenals of the long-standing nuclear powers,

the latter of which employ a three-stage fission, fusion, and then secondary

fission thermonuclear process of much greater – often 100x and in a few

cases over 1,000x greater – explosive equivalent yield, with superior missile,

aircraft or submarine delivery systems. Basically, these fusion-based weapons

use the energy released in fission as only a first-stage “trigger” to fuse together

(as opposed to fission, which is to split) atomic nuclei, releasing far

greater energy in the process, which then can be used to create a large secondary

fission reaction of the casing of the device itself. Such yields can be arbitrarily

high; for example, the Soviet Union detonated a 58 megaton (58 million

tons of TNT) fusion weapon in 1961.


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quarter century of effort. Those reasons are: (1) the effectiveness of previous UNSCOM inspections and U.

S. bombing in the Gulf War, (2) a lack of focus by Iraqi nuclear scientists with regard to first taking the

easiest path to build a basic fission bomb before embarking on more sophisticated devices, (3) Saddam

Hussein’s own handling of his nuclear scientists which may have contributed to problem (#2), and finally

(4) Israeli military and security force preventive actions since the mid-1970s to sabotage Iraq’s nuclear program.

We believe that if Iraq is close to developing nuclear weapons, or has a small number of them, they

are probably of the type described in the box on the preceding page, which is similar in design to one of the

two nuclear weapons the U.S. developed in the Manhattan Project of World War II.

We have no doubt that Iraq’s potential or prospective device would differ sharply from the much

larger and more powerful arsenals of the long-standing nuclear powers. To date, we believe that the

Iraqi nuclear program has probably obtained or produced many of the components for a fission-only nuclear

device using HEU, but may lack some of the components as well as a critical mass of the much more difficult

to obtain HEU fissile material. The distinction in terms of Iraq’s nuclear ambitions and capabilities by

weapon type is important, because it has implications for delivery method, use, damage and threat level. Although

a Plutonium-239 (Pu-239) fission device is smaller, for example, and thus more easily delivered to a

target, we doubt that Iraq has a Pu-239 device because those tend to be a more sophisticated second-step

weapon for proliferants. In fact, it may have been a quest for Pu-239 from Iraq’s Tammuz-1/Osirak nuclear

reactor fiasco of 20 years ago that contributed to delays in Iraqi nuclear success to date. For a sense of history,

beginning in 1974, Iraq pursued the purchase from France of a nuclear research reactor (a materials

test reactor) that was fueled by weapon’s grade HEU rather than LEU. Such a reactor could quickly produce

weapon’s grade Pu-239 (U-238 “targets” would become Pu-239 by capturing an additional neutron), and

since a critical mass of Pu-239 weighs only 11 kilograms, as opposed to a critical mass of U-235 weighing

56 kilograms (less if using a component known as a neutron reflector in either case; Iraq reportedly has experimented

with reflectors), a Pu-239 fission bomb using explosives to implode the Pu-239 core into a fissile

mass would be easier to conceal and deliver via a small missile. But Iraq’s compact Pu-239-based bomb

plans, which may have been sought, in our view, to accommodate Iraq’s limited missile delivery technology,

proved too lofty a goal, since such a large research reactor provided an easy target. In less than two

minutes, on June 7, 1981, Israeli F-16 jets destroyed the Tammuz-1/Osirak reactor before it was fueled for

operation. Questions of whether Israel had inside help with the French team on-site have been raised but

never publicly acknowledged. Since Iraq was already embroiled in a war with Iran that begun in September

1980, the Iraqi nuclear program may have been set back several years.

After the Tammuz-1/Osirak setback, we believe that Iraq switched to a simpler U-235 based nuclear

weapon design, and began to employ large but relatively simple electromagnetic separation devices called

calutrons to slowly refine the non-weapons-grade uranium compound feed down to weapons grade U-235.

Analysts and Iraqi defectors report that centrifuges and other methods also have been used in the Iraqi U-

235 refinement effort, but we are most aware of the fact that it was the calutron approach that the UN-

SCOM inspectors documented in Iraq in the period immediately after the Gulf War. This slow but simple

calutron process had been employed by the U.S. during the World War II Manhattan Project to create the

“Little Boy” 15-kiloton gun-assembly type atom bomb that was dropped on Hiroshima, Japan.

We view Israel’s suspected (but never formally acknowledged) nuclear deterrent as a defensive regional

peace-keeper, but its existence probably has prompted Iraq to pursue a nuclear strategy. Israel

is the only generally accepted, indigenous nuclear power in the Middle East, with weapons that were probably

developed in close cooperation between French and Israeli nuclear researchers beginning in the 1950s,


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after the construction of the Pu-239-producing underground nuclear research reactor facility at Dimona in

the Negev Desert. Israel is suspected of possessing about 200 nuclear weapons, mostly of a tactical

(battlefield applicability, as opposed to strategic, or intercontinental) size. Some of the weapons are believed

to be “neutron bombs,” capable of large and fatal bursts of short-lived radiation without quite as

much of a blast effect or any meaningful radioactive fallout. Though little is publicly known of Israeli defensive

nuclear alerts, two are believed to have occurred in the past three decades. The first probably happened

during the October 1973 Egyptian and Syrian attacks on Israel. The second alert is believed to have

occurred during the Gulf War, when Iraq fired "Scud" missiles on Tel Aviv and Haifa. This raised the threat

of chemical and biological attacks on Israel that may have led to an Israeli nuclear response had U.S. antimissile

(Patriot and other) units and aircraft sorties not been diverted to protect Israel by locating and destroying

Scud launchers. Israel's longest-known range ballistic missile is the 1,500 kilometer (932 mile),

1,000 kilogram payload, Jericho-2 (J-2), but since Iran’s capital city of Tehran is 1,600 kilometers and

Saudi Arabia’s Riyadh is 1,400 kilometers from Israel, we believe that Israel’s nuclear forces are defensive

in nature. There are reports that Israel is developing a J-2B successor missile with a 2,500 kilometer (1,553

mile) range, but we do not believe that this move alters Israel’s defensive posture. In all, the nuclear deterrent

and the potential for a disproportionate response probably have kept the peace for Israel since the 1973

War, and may have helped keep the Gulf War from expanding, in our opinion.

We believe the Bush Administration has adopted the goal of a regime change in Iraq because it fears

the Iraq of the future much more than the Iraq of the present. The history of nuclear proliferation has

been that just because a country obtains the nuclear card, it does not necessarily follow that the card will be

played. So, instead of a short-run view, we believe the Bush Administration fears that if Iraq holds the reins

of nuclear power it may later pursue more advanced ICBM-based fusion weapons and expansionary avenues

it otherwise would not have chosen. The continuation of the rebound in Iraqi oil exports from very low

levels in the 1990s to our estimate of 3.5 million barrels per day by 2015, combined with the higher oil

prices we expect, could provide Iraq with a windfall in the coming years. Our best estimate is that from

2002 to 2015, Iraq may receive approximately $373 billion of cumulative oil revenues in real (year

2000) U.S. dollars, versus about $121 billion received in the 1988 to 2001 period. Whether those funds

are used to enrich the Iraqi people and diversify the economy, or to fund Saddam Hussein’s war machine, is

a question we believe the world will have to face.

If Iraq becomes a nuclear threat, the risks compound, in our view. Generally speaking, we believe the

risk of a nuclear exchange between two equally armed parties is guided and deterred by the principle of Mutually

Assured Destruction (MAD). Given that a MAD balance is not the case in the Middle East, the attention

next shifts to Israel’s intentions. Since Israel has shown its posture with respect to its (suspected and

implied) superior nuclear weapons to be defensive in nature on several occasions, we do not believe the

country plans a preemptive nuclear strike. When nuclear forces are uneven, we believe that the risk of a preemptive

strike by a country that has recently acquired nuclear weapons is an unpredictable mixture of proximity,

psychology and response. In terms of proximity, Israel’s location and small land area (222 miles from

Elat to Haifa, for example) are legitimate concerns. In terms of psychology, and also on the subject of Iraq,

that country’s rout in a conventional-only foray into Kuwait in the Gulf War, as well as Iraq’s inability to

modernize its military in the subsequent decade, probably reduces Iraq’s appetite for conventional invasion.

On the subject of response, we also doubt that a new nuclear power such as, hypothetically, Iraq, would see

a great deal to gain in a preemptive strike (or even a retaliatory strike to a conventional invasion) with crude

fission devices having limited destruction capability when the subsequent retaliation would likely be an


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overwhelming thermonuclear (fusion device) response by one or more countries with more sophisticated

weapons. Even if Iraq were to become a neo-nuclear state, given the lopsided nuclear capabilities we

see in the foreseeable future, and after successive Arab defeats in wars with Israel in 1948 to 1949,

1967, and 1973 (plus the U.S. in the 1991), we doubt potential Arab (or Persian) state combatants are

anxious to repeat past mistakes.

Adding fuel, and perhaps an element of irrationality, to the Middle East soup, is the Palestinian issue.

History has shown that the human suffering on both sides of the region can be used to mold public support

for actions that have largely economic or political roots. The failure of U.S. peace efforts may lead to an uncharacteristically

unified Islamic country position against U.S. and Israeli interests, though the current

Saudi regime does not appear to place great trust in Iraq’s Saddam Hussein in any case. As a result, we shift

our focus to what we believe to be an underrated risk to regional stability in the Persian Gulf, which is the

risk of internal rebellion if moderate regimes are perceived to be ineffective, and unfavorable demographics

plus oil price deflation aggravates the economic situation.

The Risk of Civil War That Targets Saudi Arabia's Ruling al-Saud Monarchy

We believe that a key internal risk to Persian Gulf peace is Saudi Arabian political continuity, though

we remind ourselves that it is all too easy to underestimate the resilience and adaptability of Saudi Arabia's

ruling al-Saud family, who have been an important part of Arabian life for over two centuries, and especially

since the early 20th century. It is easy to overestimate Saudi Arabia's potential internal and external

foes, most of which are poorly armed or trained in relation to the security and military forces of the Kingdom

of Saudi Arabia. Nevertheless, extremist elements in Saudi Arabia are preying upon social and economic

pressures to further their goals, one of which is replacing or bending the Saudi monarchy toward the

Sunni version of the Shiite government that toppled the Shah of Iran in 1979. We believe that the Israeli/

Palestinian question has migrated from a regional problem to a more volatile “East versus West” issue, and

strengthened the hand of the radical factions in Saudi Arabia. In our view, Saudi Crown Prince Abdullah’s

peace plan overtures are a sign that he is aware of the gravity of the situation on a personal and regional basis.

Our view is that even if the al-Saud family were to be replaced, the realization of the radical’s nostalgic

and to some degree mythical goal for Muslim unification is by no means certain, since a coup or a disorderly

royal succession could devolve into a fractious Yugoslavia-type quagmire on a much larger scale,

given the large land area, oil resources, and diverse tribal and religious interests of Saudi Arabia.

Radical factions in Saudi Arabia have been especially critical of the Monarchy’s decision to allow the

presence of the U.S. military in Saudi Arabia, the home of Islam’s holy sites in Mecca and Medina.

Our analysis concludes that some of the criticism of this continuing U.S. presence on religious pretexts is a

ruse by insurgent parties to rally popular support and encourage the exit of the one force capable of maintaining

the equipment already sold to Saudi Arabia, and capable of coordinating military stability in the region.

In addition, we believe King Fahd’s implicit understanding with the U.S. after the Gulf War, which

entailed Saudi cooperation in the prevention of oil price inflation in exchange for a U.S. defense umbrella,

may be wearing thin. Given the poor state of Persian Gulf joint military cooperation and, to a degree, readiness,

then unless U.S. forces are unexpectedly ousted by the government in the interim, our view is that a U.

S. military exit from Saudi Arabia may be many years away.

Civil unrest in Saudi Arabia has been an major issue since rapid “westernization” in the 1970s led to

an extremist uprising at Mecca in 1979, but we believe that unrest has been revived in recent years by


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the cumulative economic pressure of low oil prices since the early 1980s. Exhibit 55 is our graphic depiction

of the pressure brought to bear on the Persian Gulf region by low oil prices. The chart shows the cumulative

transfer of wealth from the Western nations to the Persian Gulf from 1970 to 1981, followed by

the transfer of wealth from the Persian Gulf back to the West in the period 1982 to 2001. We show the

West-to-East transfer by measuring the cumulative dollar value of the annual barrels of oil exported by the

Persian Gulf nations multiplied by the annual average real (inflation-adjusted) price for that oil above the

1970 base level of $6.01 per barrel (in real, year 2000 dollars). Then, to demonstrate the East-to-West

wealth reversal, we show the cumulative value of the annual barrels of oil exported by the Persian Gulf nations

multiplied by the annual average real price for that oil below the 1981 base level of $65.37 per barrel

(also in real, year 2000 dollars). Because of the differing importance of oil in relation to GDP, this zero-sum

game has been more difficult for the Persian Gulf since 1981 than it was for the West in the 1970s when the

tables were turned. It may be mere coincidence, but in 1995 the cumulative inflation-adjusted transfer of

wealth out of the Persian Gulf exceeded $1.8 trillion, finally matching the cumulative inflow of $1.8 trillion

from 1970 to 1981. In the very next year, Osama bin Laden’s al-Qaeda network unified a variety of disaffected

groups, and thereafter commenced a bombing campaign. While the West has achieved considerable

success dismantling and destroying al-Qaeda, we believe it is difficult to kill the Hydra without stanching

the blood flow that sustains it. In the case of Saudi Arabia, radicals increasingly are exporting their beliefs

to other countries, and their recruitment is sustained by the economic difficulties resulting from oil price

deflation, in our view. This terrorist export is, of course, unwelcome in the West, and the risk it poses to

Exhibit 55 – Cumulative Effect of Oil Price Swings on Wealth Transfer, 1970 to 2001E

$2,000B

Cumulative effect of oil price swings on wealth transfer into and out of Persian Gulf

Cumulative real $ billion (index year = 2000)

$1,000B

$0B

-$1,000B

-$2,000B

-$3,000B

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

Cumulative wealth transfer to

Persian Gulf nations resulting

from crude oil price increase

over the 1970 real price level of

$6.01/bbl (priced in year 2000

dollars).

Cumulative wealth transfer away from Persian

Gulf nations due to crude oil price decrease

from the 1981 real price level of $65.37/bbl

(priced in year 2000 dollars).

2001E

-$4,000B

Source: Legg Mason format and concept, Persian Gulf states included in this analysis are Saudi Arabia, Iran, Iraq, U.A.E., Kuwait and

Qatar. Data from the Energy Information Administration, United Nations Energy Statistics Database, OPEC Annual Statistical Bulletin,

U.S. Bureau of Labor Statistics


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Saudi Arabia’s standing in the

international community raises

the diplomatic ante, and destabilizes

the oil price outlook, in

our view.

To better understand Saudi

political succession risk,

which could have implications

for oil prices, we provide

a box history of Saudi

Arabia and its monarchy.

King Fahd is the eldest brother

in a group of seven males who

have held key positions in the

Kingdom, known as the Sudairi

Seven, all sons of Ibn

Saud, but who also share a

common mother (Hassa bint

Ahmad al-Sudairi). Ibn Saud

had 22 wives, many for political

alliance purposes, and

found a way around the Muslim

limitation of four wives

reportedly by utilizing divorce.

Aside from Fahd, another

member of the Sudairi Seven

whom we discuss in this report

is Prince Sultan (b. 1928), the

Minister of Defense and Aviation

and Second Deputy Prime

Minister. Sultan’s son, Bandar

(b. 1949), is also widely recognized

in America as the longtime

Saudi Ambassador to the

United States. Crown Prince

Abdullah, Fahd’s half-brother,

is Saudi Arabia’s de facto

ruler since Fahd was incapacitated

by stroke in the late

1990s. Prince Abdullah has no

brothers with whom to form a

familial power base, and has

led the more pluralistic and

Bedouin (but highly skilled)

A Brief History of Saudi Arabia and the al-Saud Royal Family

Saudi Arabia leapt from a nomadic and agrarian society to an urban, oilbased

one in the space of a few decades, and we do not believe it has the historical

gravitas of other states in the region that are now majority Muslim, such as

the Ottomans (Turkey), the Sumerian then Babylonians (Iraq) or the Persians

(Iran). What Saudi Arabia does have is sudden wealth via the region’s most vast

oil reserves, and that quantum leap into modernity goes a long way toward explaining

its internal struggles. Before oil was an issue, the ancestors of the al-

Saud family first gained prominence in the year 1744 when a local leader

named Muhammad Ibn Saud (b. 1710, d. 1765) struck an alliance with Islamic

religious leader Muhammad Ibn Abd al Wahhab, namesake of the purist Wahhabi

form of Islam, and the two began a volatile but successful alliance that continues

today. Muhammad Ibn Saud's son, Abdul Aziz, conquered most of the Arabian

Peninsula by 1806, but was captured and executed by the Ottomans in the early

19th century, and what is now Saudi Arabia changed hands several times over the

next century. The foundations of the modern Saudi Arabia began when King Abdul

Aziz (b. 1879, d.1953, now known as Ibn Saud), the great-great grandson of

Muhammad Ibn Saud, retook Riyadh in 1902. Ibn Saud wore down the Ottomans,

who left in 1912, raising Ibn Saud’s stature and laying the groundwork for his

conquest and unification of the peninsula from 1920 to 1932 with the help of

Wahhabi soldiers, known as Ikhwan (brethren). In 1929, Ibn Saud had to put

down the rebellious and warlike Ikhwan at the Battle of Sibilla, a poignant example

of the internal struggle between the al-Saud and Wahhabi. The modern economic

base in Saudi Arabia began in 1933, when Ibn Saud signed a royalty

oil concession with America's Standard Oil Company. Ibn Saud died in 1953,

and was succeeded by his eldest son Saud, who ruled for 11 years, engaging in

profligate spending and defending Saudi Arabia from the “Pan-Arab” ambitions

of Egypt’s Gamal Adbel Nasser (b. 1918, d. 1970). Saud eventually ceded power

to his half-brother Faisal, who was Crown Prince and Prime Minister. Faisal continued

the internal and external struggle against Nasser, to include a defense

build-up after 1966, but perhaps Faisal’s legacy, in our view, is his recognition of

the intrinsic value of the country's vast oil reserves, which led to the Oil Embargo

of 1974. Faisal was assassinated in 1975 by a deranged nephew who acted alone,

and Faisal’s half-brother and successor, King Khalid, presided over five-year

plans that modernized the country in a period of great wealth. As with Saud,

Khalid’s rule featured a strong role by his Crown Prince Fahd (b. 1923). Saud

and Khalid faced their own insurgency, similar to the Battle of Sibilla, when in

1979 they had to put down an extremist uprising and occupation in Mecca. When

Khalid died in 1982, he was succeeded by Fahd, who has ruled in some of Saudi

Arabia’s most challenging years, including the oil price deflation of the 1980s,

the Gulf War, and the doubling of Saudi Arabia’s population to over 20 million

during his reign. Fahd suffered a stroke in 1995, and since 1997 Crown

Prince and half-brother Abdullah (b. 1924), who is the First Deputy Prime

Minister, has assumed the day-to-day responsibilities of the crown. In early

2002, Abdullah reproposed a land (pre-1967 borders, a Palestinian State) for

peace (full diplomatic recognition of Israel) plan with Israel.


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Saudi National Guard since 1963. Prince Abdullah is generally regarded as having a more fundamentalist

approach to Islam than Fahd, and is reputed to be a strong-willed reformer and a pragmatist.

Royal succession could cause political turmoil in Saudi Arabia. Though Prince Abdullah is reportedly

healthy, at age 78, royal succession is still an open question vis-à-vis other members of the Sudairi Seven,

their descendants, or other members of the royal family. We note that there is a strong relationship between

Abdullah and Saudi Minister of Foreign Affairs Saud al-Faisal, the latter being the son of former Saudi

King Faisal, and it is possible that Saud al-Faisal could emerge as the next Saudi Crown prince upon King

Fahd’s passing, in our view. The lack of clarity with regard to succession is not a major deviation from the

political history of Saudi Arabia. Although Saudi Arabia has established a number of consultative or democratic

institutions, to include the Majlis al Shuria (Consultative Council) that was revived by King Fahd after

the Gulf War, our view is that for the success of the al-Saud monarchy, the next Saudi King must

be a reformer and have more national prosperity via higher oil prices.

In our view, the power structure that has evolved in Saudi Arabia is a triumvirate, and its continued

stability is of global interest to avoid major war and commodity and consumer inflation. In one corner of the

Saudi triumvirate, there is the secular political authority of the al-Saud monarchy. The Saud family derives

inspiration and occasional force from the Islamic religious authorities, who occupy the opposite corner,

some of whom are the descendants of Abdul Wahhab, and are known as the al-Sheiks. Both parties derive

earthly sustenance from the region’s economic interests - mainly related to oil in the modern era – which

occupies the third corner. We believe that oil price deflation since the early 1980s has destabilized the economic

interests of the region, since the history of the Saudi monarchy has been to use financial largesse to

“buy off” discontent. We believe that this economic pressure has created a situation in which some of the

long-simmering religious authorities have used the economic malaise to blame the political authorities for

economic failure and its consequences, potentially in a bid for power and increased religious governance.

The rapid urbanization and collapse of per capita GNP in Saudi Arabia, shown in Exhibit 56, has left

the country with a rising cadre of disaffected young men, in our view. The situation is aggravated by a

birth rate that is among the highest in the world, and a surge from 2000 to 2015 of potentially disenfranchised

young Saudis relative to older, more established, and presumably less fiery Saudis, depicted in Exhibit

57. Unless the oil-based economy of Saudi Arabia receives a boost, and parlays that wealth into a successful

diversification effort, we believe this youth explosion will collide with a dearth of private industry

job opportunities, pushing the existing unemployment rate of approximately 25% even higher. In fact, youth

explosion is a pan-Gulf problem. Among the Gulf states, ex-Iran and Iraq, non-citizens make up 37% of the

population of 32.4 million, and residents under age 15 make up 40% of the population. In Saudi Arabia in

particular, where the economy has failed to diversify beyond oil, in our view, this raises the prospect that

more people will fall under the spell of the radical elements.

With approximately 5,000 Saudi princes, the odds of at least several hundred “black sheep” are quite

high, in our view. Those “bad apples” fuel resentment and may give the approximately 100 ruling princes a

bad name, so we believe that current discussions regarding a culling of the royal roster may gain momentum,

especially since high birth rates make royal expansion an increasingly serious problem.

As a result, Saudi capital flight and corruption are serious issues, the result of some members of the

royal family and high-level technocrats protecting their self-interest in a period of economic pressure. There


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is approximately $700 billion

of private Saudi wealth

abroad, as well as $266 billion

from the United Arab

Emirates, $163 billion from

Kuwait, and $65 billion

from the other members of

the Gulf Cooperation Council.

This wealth is in the

hands of an estimated

200,000 individuals, equal

to about $6 million per capita

among the holders. It is

noteworthy that an estimated

$400 billion of this

capital has been invested in

Western stock markets, and

has thus benefited from the

very same disinflationdriven

equity bull market of

the 1982 to 2001 period

that was the antithesis of

the poor economic opportunity

afforded the oil-based

economies. Domestic uses

for the capital are few, as

we believe Saudi Arabia

suffers from inadequate diversification

beyond oil,

and an embryonic work

ethic that relies too heavily

on foreign workers and

meaningless government

jobs. Oil still represents approximately

70% of state

revenues and 40% of GDP,

according to the EIA. Government

positions account

for 40% of all jobs, versus

25% in industry (mostly

petrochemicals) and oil. In

time, free markets and high

rate-of-return domestic oilrelated

projects could repatriate

much of this wealth,

Exhibit 56 – Saudi Arabian GNP Per Capita and Urbanization

Saudi Arabian GNP Per Capita, Constant 1995 U.S.$

$12,000

$11,000

$10,000

$9,000

$8,000

$7,000

$6,000

Exhibit 57 – Saudi Arabia Youth Wave, 1974 to 2040E

200%

190%

180%

170%

160%

150%

140%

130%

120%

110%

100%

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

Saudi Arabia GNP per Capita (Constant 1995 U.S.$)

Source: The International Monetary Fund, World Economic Outlook Database 2001

Saudi Arabia: A Measure of the Passions of a Population?

1980

1990

2000

Ratio of Less Stable (age 20-34) to More Established (age 35-49)

Source: U.S. Census Bureau, International Data Base, 2000

2010

A

volatile

combination

The rise in young Saudis with

few job opportunities relative

to older, and presumably more

stable Saudis, provides fodder

for religious extremists in the

2002 to 2015 period, in our

view.

2020

2030

90%

85%

80%

75%

70%

65%

60%

55%

50%

Saudi Arabian Urban Population % of Total

Saudi Arabia Urban Population as a % of The Total

2040


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if free markets are given time to work. In addition to improved oil-based prosperity, we believe repatriation

of capital in Saudi Arabia will require greater privatization, some form of taxation, a reduction of corruption

and bribery, improved legal standards and property rights protection, and social reforms such as improved

use of female human capital. The success without excessive reliance on hydrocarbons of Oman,

Bahrain, and Dubai would appear to offer examples that Saudi Arabia could follow, albeit selectively, moderately,

and slowly, in our view.

The Risk of Conventional (Non-Nuclear) War Between States in the Region

Because our interest is the oil resources of the Persian Gulf, this section does not address other regional

hot spots. For example, the Israeli-Palestinian imbroglio, or a worsening of the contentious Pakistan/

India face-off, could destabilize the region. As investors, our focus is on the oil-rich Persian Gulf, particularly

Saudi Arabia, Iraq and Iran, although any conflict could have a contagion effect in the region.

The U.S. military presence in the Persian Gulf is invited, and regionwide. In Exhibit 58, we provide a

Middle East map. The U.S. Central Command (CENTCOM) and coalition partners maintain a personnel or

forward-deployed material presence in Kuwait and several border states, including the United Arab Emirates,

Bahrain, Oman and Qatar. The major CENTCOM facility in Saudi Arabia is Prince Sultan Airbase,

but since aircraft carriers play a large role in force projection, we note that CENTCOM’s naval presence is

Exhibit 58 – Middle East Map

Source: Legg Mason Wood Walker; map outline from www.graphicmaps.com


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the Fifth Fleet, headquartered

in Bahrain. If the U.

S. military presence were

to be phased out prematurely

in Saudi Arabia, our

view is that it would be

difficult to perform a deterrence

role with only forward-deployed

material

and naval facilities.

Exhibit 59 - The Persian Gulf Military Balance in 2001

Other Artillery + Fixed

Active Main Armored Multiple Wing

Military Battle Fighting Rocket Combat Armed

Personnel Tanks Vehicles Launchers Aircraft Helicopters

Iraq 429,000 2,700 3,400 2,200 353 120

Saudi Arabia 226,500 1,055 4,285 568 432 33

Saudi military readiness

has been a thorny issue.

The all-in life cycle costs

of a weapons system are

usually at least twice the

purchase price. The pressure

from low oil prices

has slowed Saudi Arabia’s

military purchases, and

spurred a desire to better

utilize equipment on hand.

Prior efforts to diversify

arms vendors have proved

to be an obstacle to force

integration and

interoperability, however,

and aggravated an alreadydifficult

readiness situation.

This has contributed

to the long-standing U.S.

advisor presence in the

Kingdom, aggravating the

Islamic radical groups, and

creating a problem for

which there is no easy solution.

The balance of military

power in the Persian

Gulf requires more than

a cursory examination.

In Exhibit 59, we provide

a survey of the Persian

Gulf military strength. On

Kuwait 15,300 385 455 68 76 20

Bahrain 11,000 106 411 107 24 26

Oman 43,500 141 219 109 40 -

Qatar 12,330 44 284 44 18 12

UAE 65,000 237 1,138 289 99 49

Yemen 66,300 1,030 1,290 702 89 8

Total Other Gulf (1) 213,430 1,943 3,797 1,319 346 115

Iran 513,000 1,410 1,105 3,224 304 100

(1) Smaller Gulf states bordering or bridging Saudi Arabia. Military readiness is a problem, and there is

generally considered to be little military cooperation within the Gulf Cooperation Counsel.

Source: Center for Strategic and International Studies’ Anthony H. Cordesman draft report titled

Saudi Military Forces Enter the 21st Century

Exhibit 60 - Military Quality vs. Quantity in the Persian Gulf, 2001

Total Medium- to % Medium- Fixed Medium- to % Medium-

Main High- to High- Wing High- to High-

Battle Quality (1) Quality Combat Quality (2) Quality

Tanks Tanks Tanks Aircraft Aircraft Aircraft

Iraq 2,700 1,000 37% 353 112 32%

Saudi Arabia 1,055 765 73% 432 281 65%

Kuwait 385 368 96% 76 60 79%

Bahrain 106 106 100% 24 12 50%

Oman 141 117 83% 40 28 70%

Qatar 44 - 0% 18 12 67%

UAE 237 192 81% 99 84 85%

Yemen 1,030 310 30% 89 22 25%

Total Other Gulf (3) 1,943 1,093 56% 346 218 63%

Iran 1,410 715 51% 304 175 58%

(1) Medium- to high-quality tanks, primarily M-1 and M-60 (U.S.), Tupolev-72 and Tupolev-62 (F.S.U.)

(2) Medium- to high-quality aircraft are F-15 C/D/S (U.S.), Mirage F-1 (Fr.), MiG-29/25 and Su-20/22 (F.S.U.),

Tornado IDS/ADV (UK), F-14 (U.S.), F-4E (U.S.)

(3) Smaller Gulf states bordering or bridging Saudi Arabia. Military readiness is a problem, and there is

generally considered to be little military cooperation within the Gulf Cooperation Counsel.

Source: Center for Strategic and International Studies’ Anthony H. Cordesman draft report titled

Saudi Military Forces Enter the 21st Century


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paper, Iraq appears to have a formidable conventional military, to include the region’s second-largest number

of active military personnel (429,000), and the largest number of main battle tanks (2,700). Saudi Arabia

has the most armored fighting vehicles (4,285) and fixed wing combat aircraft (432), and Iran has the

most active military personnel (513,000), the most artillery pieces (3,224) and the only indigenous navy.

But a closer examination of quality rather than quantity tells a different story. In Exhibit 60, we observe that

73% of Saudi Arabia's tanks are medium- to high-quality, compared to 37% in Iraq and 51% in Iran. In addition,

65% of Saudi Arabia's combat aircraft are medium- to high-quality, versus 32% for Iraq and 58% for

Iran.

We do not believe that Iraq has ever recovered militarily from the Gulf War defeat. According to U.S.

Army Lieutenant General Tom Kelly, during the Gulf War "Iraq went from the fourth-largest army in the

world to the second-largest army in Iraq in 100 hours." Little appears to have changed for Iraq’s conventional

forces since 1991, in our view. Since 1989, the year before the Iraqi invasion of Kuwait, the troop

strength of Iraq has declined 52%, and its main battle tank inventory is down 51%, with most of the losses

occurring during the Gulf War itself. In contrast, Saudi Arabia's troop strength is up 179%, and its main battle

tank inventory is up 92%.

Sparked by fear and vigilance, Saudi Arabia has been one of the largest importers of military hardware

in the world each year for the last two decades. Saudi Arabia ranked first in the years 1989 to 1999 in

terms of new arm deliveries. Saudi Arabia took heed when the Shah fell in Iran in 1979, ousted by a Shiite

rebellion, and Saudi Arabia was further alarmed when there was a risk that Iraq would lose the Iran-Iraq

War in the period 1984 to 1987. The Gulf War of 1990 to 1991 caused a similar reaction in Saudi Arabia,

which saw a brewing threat to its borders. In the period 1995 to 2000E, military expenditures totaled $109.7

billion for Saudi Arabia, $8.4 billion for Iraq, $28 billion for Iran, and $60.1 billion for the bordering Gulf

states. As a percentage of GDP, Saudi military expenditures are now 14.5%, almost three times larger than

Iraq and five times larger than Iran. Arms imports as a percentage of total imports of Saudi Arabia are approximately

40%, as compared to approximately 12% for the Middle East as a whole. Prince Sultan has

been instrumental in the Saudi military build-up, often buying what we believe are superior U.S. armaments,

but because of U.S. ties to Israel and occasional Israeli resistance to U.S. sales to Saudi Arabia, the

Kingdom has diversified its purchases.

Central to the ability of Saudi Arabia to face a conventional war threat from a neighboring country is

the structure of the Saudi military itself, and the level of esprit de corps. Saudi Arabia and Iraq have

comparable pools of men of military age. Iran, with its larger population, has more draft-age men. The unsuccessful

experience of Saudi Arabia in the Gulf War with respect to Pakistani troops contributed to a lack

of faith among the Saudi military establishment of relying upon foreign troops at the combat level, and a

decision was made to rely upon a professional military in the future. The level of education and training of

the Saudi officer group, many of whom are drawn from the royal family, has greatly improved since the pre-

Oil Embargo years, but Saudi officers performing military training in the U.S. are down approximately 85%

since the early 1990s, and American advisors and civilian contractors are key to maintaining Saudi Arabia’s

military hardware. Another problem Saudi Arabia has faced in the creation of a professional military

class is the seniority-based system found in portions of the Saudi officer corps, which is perceived as an

even greater problem than royal nepotism. But as evidence that Saudi officer positions are considered to be

highly prestigious, the Saudi Arabian National Guard (SANG) Academy, which is the more proletarian

branch of the service had a 15% acceptance rate last year, which was, coincidentally, approximately the


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same acceptance rate as the U.S. Military Academy at West Point. Even the SANG quality of troops, many

of whom were simple Bedouin just a couple of decades ago, has improved. Our view is that Prince Sultan's

build-up of Saudi defense forces has shown admirable foresight, given the rising tensions in the region, and

Prince Abdullah’s stewardship of the SANG has helped produce an impressive, motivated fighting force.

Still, there is hope among many in the Saudi royal family, and many outside the family, that if Prince Abdullah

becomes King, he will shift the focus from military hardware purchases to the less glamorous, but

more critical, readiness and integration issue, and gradually reducing the reliance on outside advisors.

The Soviet-era weaponry of Saudi Arabia's potential opposition does not enjoy a favorable history

versus American military equipment, which lessens the conventional war risk, in our view. As evidence,

we cite Operation Galilee in the spring of 1982, in which Israel responded to Palestinian attacks launched

from southern Lebanon. In that operation, Israeli Air Force (IAF) pilots flying U.S. F-15 (Eagle) and F-16

(Falcon) aircraft, both of which are still in the IAF and U.S. arsenal in updated models, engaged the Syrian

Air Force flying Soviet MiG-21 and MiG-23 aircraft over the Bekaa Valley. The IAF downed 90 Syrian

MiGs in aerial combat without a single aircraft lost. Another example occurred in the Gulf War, when the

U.S. VII Corps, under the command of Lieutenant General Fred Franks, defeated Iraqi units in February

1991. The VII Corps arsenal included equipment such as the U.S.-made Apache helicopter and M1 Abrams

main battle tank, while the Iraqi forces employed Soviet-made Tupolev main battle tanks and other combat

vehicles. In 90 hours of movement and combat, VII Corps reportedly destroyed more than a dozen Iraqi divisions,

approximately 1,300 tanks, 1,200 fighting vehicles and armored personnel carriers, 285 artillery

pieces, 100 air defense systems, and captured around 22,000 enemy soldiers. At the same time, VII Corps

had extremely light casualties and equipment losses. Reports from the Gulf War stated that the superior

range of the M1 Abrams gun and fire control system, and the superior ability of the M1 to see through the

smoke and heat generated by burning oil fields, contributed to the armored rout. Based on these and other

historical precedents, we believe investors should not overreact to face-offs between U.S.-equipped and

trained forces when confronted with older generation Soviet era conventional weapons, although the level

of training is, of course, a key to success. The latest generations of Russian military hardware are more formidable,

such as the MiG-29 Fulcrum combat aircraft and the Tupolev-90 main battle tank, but that hardware

has not been exported to Iraq or Iran, to the best of our knowledge.

In summary, we do not believe Iraq or Iran poses a major, conventional warfare threat to Saudi Arabia,

especially with improved aerial and signal intelligence that can detect troop movements before they become

an invading force. Not to be overlooked, on the subject of external risk we note that Iran and Syria are

Shiite strongholds, and their governments are indicted terrorist sponsors whose goals are not easily discernable.

Internecine feuds between Shiite and Sunni (the Sunni are the majority in Saudi Arabia) Muslims have

produced bloodshed occasionally, and may do so again, including within Saudia Arabia, in the Shiite-heavy

eastern oil-producing region. On the subject of conventional threats to the flow of oil, we do view the surface

navy of Iran and shore-launched anti-ship missiles as a viable threat to the Straits of Hormuz, through

which 16 million barrels of oil pass every day. Given that the other Gulf states have not developed a major

naval counter force to Iran, however, we must deduce that the states are confident in the ability of the Saudi

and U.S. military to neutralize small and moderate threats to shipping at the mouth of the Persian Gulf.


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The Risk of Terrorists Obtaining Nuclear Weapons Developed in the Soviet Union

Nuclear complexity inhibits proliferation. The difficulty of producing weapons grade U-235 or Pu-239

probably places fission and certainly fusion devices beyond the grasp of terrorists, at least for the time being.

On the other hand, reactor grade plutonium, other processed waste, as well as the political instability of

new nuclear powers such as Pakistan, are continuing risks. As for the nuclear arsenal of the former Soviet

Union, we believe that the highly centralized command and control system of the Soviet military led to the

widespread use of Permissive Access Links (PALs) such as those used in the U.S. (There is some speculation

the U.S. willingly gave the technology to the U.S.S.R.) PALs use heavily encrypted code systems to

activate a weapon, and are as complex as the weapons are dangerous. We also believe that there have been

numerous public and private U.S. efforts to assist Russia in securing its nuclear weapons over the decades.

We highlight the infamous “missing” Soviet “suitcase nukes,” if they ever existed at all, as a case in

point for how investors may receive misinformation in the media. The nuclear weapons cited were mentioned

by Alexander Lebed (b. 1950), a former deputy commander of the Soviet Airborne (paratrooper)

forces and former National Security Advisor (1996) to Russian President Boris Yeltsin. In a private meeting

with U.S. congressmen in May 1997, Mr. Lebed cited up to 84 missing nuclear weapons of a suitcase size.

In August of the same year, in a 60 Minutes news program interview, Mr. Lebed upped the number to 100

missing nuclear weapons of that type. Although similar weapons did exist in the U.S. arsenal (the W54 Special

Atomic Demolition Munition, called SADM, and later variants), we have several reasons to doubt the

veracity of Mr. Lebed’s claim.





Mr. Lebed’s claim was based on a preliminary study commissioned by Mr. Lebed when he was President

Yeltsin’s National Security chief in 1996, but he did not stay in office long enough to obtain the

results – he was fired by President Yeltsin for other reasons, some of which have been attributed to Mr.

Lebed’s political aspirations while President Yeltsin was in ill health.

Mr. Lebed is a self-made combat (rather than political) general from a proletarian background, who

made the transition to politician in the melee of post-Communist Russia. As a result, he is given to bold

political statements that seize the public imagination, in our view.

These weapons were ostensibly produced outside of the Soviet military establishment for use by operatives,

but since such small devices would have to be Pu-239-based, we doubt the Soviet military would

have lost track of that quantity of extremely difficult-to-produce Pu-239, which requires a complex reactor-based

refinement effort.

The alleged weapons have been touted as having large-citywide destructive capability. But the effective

lethal radius (50% casualty rate) of a one kiloton “suitcase nuke” fission device detonated at ground

level in an urban setting would be 800 yards, which is nowhere close to the six mile lethal radius of a

one megaton thermonuclear device of the sort found in the arsenals of advanced nuclear states.

As we have stated, we believe it is difficult for investors to separate fact from fiction in the complex and

arcane world of political and military analysis. In this section of the report, our goal has been to shed more

light on the subject so that investors may be better informed.


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Non-Economic Contrasts Between East and West That Affect The Investment

Outlook

Until this point, we have only discussed economic contrasts between the West and the Middle East,

but there are political and social facets to the relationship. Some of the radical elements of the East and

West believe that there is an inevitable conflict between Islam and Christianity. A few even cite the four

Crusades, which occurred between 1099 A.D. and 1198 A.D., as evidence of Christian hostility toward Islam.

In reality, the Crusades, as brutish as they were, were often bitter defeats for the Christian forces, and

perhaps the Crusades’ only real contribution to history was the opening of mutually beneficial trade routes,

in our opinion. Fast forward a millennium, and we believe that the modern conflict on both sides is a complex

mix of greed, envy, jealousy, righteousness and, at its core, the rivalry between secular and religious

interests that has existed since Christ instructed Peter to “Render unto Caesar that which is Caesar's, and

unto God that which is God’s.” In this section we explore the West versus East non-economic factors that

we believe will affect investment and commodity prices in the coming years.

Political and Cultural Differences Between East and West

In general, we believe that the Western model is a secular, capitalist republic with a monotheistic religious

conscience. In our opinion, religion often functions as an effective offset to the self-interest of individualistic,

nationalistic societies by alternately acting as a brake and a rudder in the “pursuit of happiness,”

one component of which is improving secular living standards. In the Western capitalist system, markets

consist of consumers and producers for whom the psychology alternates over cycles between fear and

greed. We observe that during periods of extreme greed, religion functions as a self-correcting mechanism

by emphasizing charity, and in periods of extreme fear, religion provides a moral compass that helps markets

(people) emerge from the economic paralysis associated with a loss of hope. The exact question of the

mix between greed, fear and religion is much like observing a pendulum, in our view, because just how far

an arc may travel before it begins a return is key. But an overwhelming confidence in the ability of the selfcorrecting,

pendulum mechanisms to work, as they often do, is a trait of Western secular systems.

We believe that the prevailing secular view of religious governance is that the latter structure leads to

a decay of material living standards and a loss of national ambition. This occurs because the systems of

religious governance often subordinate the needs of the individual to the needs of the many, removing the

motivation of self-interest, and leaving only the self-correcting mechanisms that normally restrain such motivations.

As a result, some secular adherents view this devolution of living standards in a theological dictatorship

as a by-product of faith by force, which is little changed from the missteps that contributed to the

folly of the Crusades and the stagnation of the Middle Ages. The prevailing secular view from afar may be

that the leaders in a theological dictatorship, with the foibles of mortals and the vanity of scholars, seek to

insert themselves as the men between Man and God as arbiters of the faith beyond that which is clearly circumscribed

by holy texts (even in the least obtuse Bucaille-based or other quasi-scientific interpretations).

The prevailing, Western secular view in this regard is not without experience, as Europe had its own period

of theological dictatorship, the bulk of which occurred during the Middle Ages, roughly the period between

Saint Augustine’s The City of God (ca. 426 AD) and Dante Alighieri’s The Divine Comedy (ca. 1300 AD).

The temporary triumph of centralized faith over diffused knowledge that marked the Middle Ages segued to

the accomplishments of the Renaissance, as well as the modern era, if human achievement is the standard of


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measurement. That experience later became a cornerstone of the separation of church and state in the newly

created United States of America almost five centuries later.

In contrast, some adherents to religious governance, particularly in the East, believe that religion

serves as a framework for a society rather than the foundation for a philosophy. For example, the Koran

was compiled late enough (ca. the 7th century A.D.) in the development of modern civilization to serve

as a practical guide for living rather than principally as a guide for moral behavior, and forms the basis of

the political constitution of Saudi Arabia, for example. In practice, advocates of religious governance find

the religious way of life to be a fulfilling, powerful, unifying force, capable of focusing the disciplined will

of the many on a single goal, rather than the individual, factional, or nationalist diversity of interests more

typically associated with secular systems. To some of those practitioners, this sense of community, order

and personal virtue is worth the admission price of lost personal freedom and secular wealth, although history

has shown that once the theological dictatorship path is chosen, there is little democratic recourse for

peaceful change if the popular sentiment shifts (which is, in our view, increasingly the case in Iran today,

for example).

Areas of Instability in the Political and Cultural Relations Between East and West

Some believers in religious governance feel that powerful secular interests are destabilizing their universal

belief system and undermining the internal order in their societies. Since a society that deemphasizes

the primacy of the individual and embraces a universal belief system may also be especially

susceptible to crowd psychology, the concept of “Holy War” may be an extension of this crowd behavior.

Although an emphasis on peace, which is another central tenet of some religious systems, may serve as a

counterweight to the unruly caprice of crowd psychology, it is often not enough, and where conflict results

there is often reprisal, leading to a downward spiral. In addition, there is also a view among some in the

East that the pervasive influence of modern technology, such as the Internet and television, creates a corrupting

influence on their societies. Since the propagation of electronic information is guided by physics,

not politics, and history has shown that it is virtually impossible to put the technology information “genie”

back into the bottle, we doubt that situation will reverse itself. In fact, we observe that the West also struggles

with its own “technology genie” in the form of nuclear proliferation.

Overarching the conflict and feeding the extremist flames at the periphery is the lack of a satisfactory

resolution of the Israeli/Palestinian issue, which we believe is polarizing the conflict among the masses

on both sides and thus expanding the number of extremist combatants. In our view, the lack of a resolution

of this issue strengthens the hand of the radical elements of East and West. Since the periphery consists of

economic disenfranchisement and the evils of terrorism in the East, and political proselytizing without the

goal of bilateral improvement by the West, such actions fan the flames of radicalism and resentment, and,

we believe, raise the risk of war.

Although we see no parallels in the past century to the current situation, veterans of the Cold War

shape policy on the world governmental stage. In fact, veterans of the Cold War have lingered or

emerged as political leaders in the East and the West. In a few cases, extremists among them already perceive

the conflict as a “civilization war” of absolute dominion, similar to the Communist versus Capitalist

struggle. We believe that the error of this assumption begins with a comparison of Middle Eastern versus

Western characteristics in the context of the Cold War. In the latter struggle, the viability of “pure” commu-


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nism was threatened by the presence of capitalism in its midst, making a final resolution inevitable since the

utopian end game of pure communism required the abolition of private ownership of the “means of production”

before the state could “wither away.” As a practical matter, we believe that the Soviet communist dictatorship

had no intention of withering away, but that did not reduce the necessity that government felt to

expand globally and eliminate the temptation of the “Western way” wherever it was encountered. As a result,

arguments in the 1970s and 1980s among some in the West that there could be no moral absolution for

Communism via détente were genuine, and the resulting victory of capitalism over communism, as the latter

was originally envisioned, was a hallmark of the late 20th century. Given that history, we fail to see the

similarities between the current conflict and the Cold War. We do not expect the West and East to converge

on a common set of values for quite some time, if ever, but the key conclusion we draw is that

differences between the East and West do not appear to require one system to replace the other, either,

except, perhaps, in the minds of the extremist periphery.

The Fork In The Road – Investors Are Along For the Ride

This is a new century, and instead of an antiquated Cold War model, our focus for investment research

on this subject has been on the new realities of Iraq, Israel, Saudi Arabia and the Persian

Gulf. We have described the Saudi power structure as a triumvirate, with political, religious and economic

interests. We have drawn a separate line around Saddam Hussein’s Iraqi government, which appears to be

guided by secular, territorial, and updated “Pan-Arab” goals rather than theological ideals. In this report, we

have discussed the often self-inflicted Middle Eastern lack of prosperity in an economic sense, and the need

for improved governance and reduced corruption in a political sense, while fending off the radical elements

seeking greater political power. Ensuring the victory of the more moderate voices on both sides would appear

to be in the best interest of investors in both the West and the East, in our view, but to do so requires

that the radical elements in both regions be removed from a position of power by undermining their appeal

via increased global trade and enlargement of the global “economic pie.” Since the U.S. dependence on

Persian Gulf oil is back to the highest levels of the mid-1970s, and total U.S. oil import dependence is

at the highest level in history, while Persian Gulf regimes are at a political and economic crossroads,

the stakes are raised accordingly. As investors we believe that it is necessary to be keen, disciplined and

impartial observers. Our investment observation is that we believe that the risk of Middle East war is gradually

rising, and major wars in U.S. history, without exception, have been inflationary.


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Appendix A – U.S. Inflation Cycles From a Monetary History Perspective, 1898 to 2001

No two cycles are ever alike, but as Mark Twain said, they do rhyme. In the following paragraphs, we summarize

the conditions that surrounded the inflation cycles of the past century, and describe current similarities.

The Inflation Cycle of 1898 to 1920 The years 1898 to 1914, before World War I, featured 2.2% annual commodity

inflation, 1.2% annual consumer inflation, and a 3.0% annual price return for the U.S. stock market. The wartime period

as we define it, from 1914 to 1920, featured inflation of 14.6% per year for commodities, 12.2% consumer inflation and

a 0.1% U.S. annualized stock market return. The 1898 to 1914 period of even mild inflation without a major war was

unprecedented in U.S. history, and the reason most widely accepted was that large gold discoveries and improved mining

technology debased the world’s currency reserve by causing world gold inventories to grow at twice the historical

rate. For example, U.S. monetary gold holdings increased 220% from 1897 to 1914. This peacetime increase in gold

supply as the world reserve currency may be similar to the strong peacetime (pre-war?) rate of increase in U.S.

money supply since the mid-1990s, since the U.S. dollar is the de facto world reserve currency. When World War I

arrived, the combatants began to buy supplies from the U.S., which increased the gold stock of the U.S. The normal

wartime diversion of production fueled inflation, but the factor that launched a more robust inflation cycle was the decision

by most of the warring parties in Europe to suspend the gold standard. Just before the outbreak of World War I, the

U.S. Congress creating the Federal Reserve System with a mandate to “furnish an elastic currency.” But the new Fed

had as its first task fighting a world war, and did not pursue a restrictive monetary policy in its formative years. Also,

direct U.S. involvement in the war caused large budget deficits in 1918 and 1919. If a future Persian Gulf war were to

occur, we believe that oil prices, which are dollar-denominated, would increase. U.S. dollars would then have to be

furnished by the Fed to the strained global financial system, despite the inflationary implications, as the lesser of

two evils, in our view. In addition, the U.S. would likely experience federal budget deficits. After World War I, several

countries repegged currencies to gold at the pre-war level, a fateful decision that was later blamed on the gold standard

when, in reality, it was a misapplication of the gold standard to attempt to turn back time and return to pre-war

price levels. In addition, the new Fed authorized higher interest rates in late 1919 and early 1920 because it saw declining

free reserves in the U.S. banking system. Since 1920 also featured a bursting commodity speculation bubble

(Exhibit 10, labeled point “A”) as the last hurrah of the inflation cycle, the stage was set for a major recession that year,

and a price deflation concurrent with money supply growth that underpinned a new bull market for stocks from 1921 to

1929. We observe that the commodity speculation bubble of 1920 was an asset price phenomenon that would be repeated

several times in subsequent decades, with commodity price bubbles succeeding wars and preceding deflation

and equity bull markets, and equity price bubbles succeeding peace and preceding inflation and secular bear markets

for the equities that were not inflation beneficiaries.

Deflation from 1921 to 1932 then led to

The Inflation Cycle of 1933 to 1951 In the midst of the Great Depression, between August 1931 and January 1932, a

total of 1,860 U.S. banks with $1.45 billion of deposits failed in a liquidity crisis. The Fed had terminated a bank credit

inflation in 1928, but tried desperately from 1929 to 1931 to ward off the emerging crisis by inflating controlled reserves,

although the Fed was simply out-gunned by the liquidity trap, and the aftermath was a financial calamity. Perhaps

the Fed was distracted by the devaluation of the (overvalued) U.K. pound sterling in September 1931, which resulted

in a drain of U.S. gold reserves to overseas, thereby overshadowing the domestic crisis. After some semblance of

U.S. banking stability was established, a misguided U.S. government published in 1933 a list of banks seeking federal

agency assistance from the Reconstruction Financing Corporation, causing an already-skittish public to associate the list

with weakness. Another run on deposits and banking panic ensued, worsening the Great Depression. The aggressive

response of the Greenspan Fed to crises such as Long-Term Capital Management and the Asia Crisis grows directly

out of a desire not to fall behind the power curve, or be caught in a liquidity trap. It should not be lost on investors

that the Fed appears to place the support of war efforts and/or avoidance of financial panic ahead of price stability

in its mission hierarchy. We believe a number of events launched the inflation cycle of 1933 to 1951. First, President


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Franklin D. Roosevelt effectively “nationalized” the U.S. monetary gold supply in 1933, ordering that all (monetary)

gold must be turned into the Federal Reserve System in exchange for $35 per troy ounce of U.S. currency. Thereafter,

the U.S. Mint would buy, but not sell domestically, gold at $35 per ounce. Since this price was a sharp devaluation of

the U.S. dollar’s prior legal weight in gold, Europe had little choice but to follow the U.S. devaluation, since a huge

“avalanche” of foreign gold began to make its way to the U.S., greatly increasing banking reserves. Second, the New

Deal programs increased the role of the federal government. And third, the U.S. Supreme Count upheld the 1935 National

Labor Relations Act, enabling workers to organize and employ strikes for better wages. As a result, 1933 to 1937

featured a 53% increase in the U.S. money stock, offsetting most of the one-third decline in money stock from 1929 to

1933. By 1937, U.S. real incomes had recovered to a level that was 3% above the 1929 peak, since the preliminary effect

of inflationary policies is to shrug off the stagnation of the prior deflation. But the pursuit of unilateral self-interest

by the U.S. and other nations made the world a more dangerous place by the late 1930s, replete with trade and foreign

exchange restrictions, competitive devaluation and rising political extremism in Europe. In the modern period, perhaps

the competitive devaluation of the European euro and Japanese yen mark a return to economic unilateralism. In

the case of Europe, politicians seem unwilling to make the structural adjustments to avoid reliance on devaluation,

and in the case of Japan, a weaker yen appears to be an act of economic desperation. The beginning of World War II

in Europe in 1939 produced events similar to World War I, with an initial inflow to the U.S. of gold to purchase

goods, and such purchases were later funded by U.S. credit to our allies. Monetary policy served the war effort, and U.

S. budget deficits averaged about 30% of GNP from 1942 to 1945 after the U.S. entered the war. For the entire war period

September 1939 to August 1948, the U.S. money stock rose 12.1% per year, and wholesale prices rose 8.7% per

year. Inflation was restrained by price controls from early 1942 to mid-1946. Those controls were instituted to contain

the sort of inflation that had occurred in World War I. But as traditional economic theory would suggest, the side effects

of price controls included substitution price differentials, barter, and a thriving black market. After 1948, there was a

revival of prudent monetary policy, but the outbreak of hostilities in Korea in 1950 triggered a renewed round of commodity

inflation and hoarding (Exhibit 10, point labeled “B”). As historical parallels would suggest, this late stage

speculative blow-off heralded the end of the preceding inflation mentality (similar to 1920) and the start of a deflationary

economic and stock market boom in the 1950s and early 1960s.

Deflation from 1952 to 1964 then led to

The Commodity Inflation Cycle of 1965 to 1981 In 1944, the Allied Powers economic ministers signed the Bretton

Woods Agreement, so named for the ski resort in New Hampshire at which talks were held. In accordance with the

agreement, from 1947 until the system was abandoned in 1971, the U.S. agreed to exchange U.S. dollars for gold at $35

per ounce (for foreign treasury signatories), and member governments agreed to peg their currencies to the gold-backed

U.S. dollar. Combined with the U.S. manufacturing and service base that emerged from World War II unscathed, the

primacy of U.S. economic and political power was sealed. The U.S. enjoyed a golden age of power in the 1950s that we

do not believe was seen again until the fall of Communism ushered in a similar period of hegemony in the 1990s. But,

as history has shown, reliance on a “leading” central bank to put currency bloc altruistic interests ahead of nationalist

interests was a fatal flaw. The “Guns and Butter” policy of pursuing an aggressive social agenda in the 1960s as part of

President Johnson’s “Great Society,” while simultaneously fighting a prolonged war in Vietnam, led to deficits and a

debasing of the U.S. dollar. In a hauntingly similar parallel to today, we note that the cost of the War on Terrorism is

just beginning to rise. Also similar to the 1960s, the Great Society cost may pale in comparison to the medical and

Social Security costs associated with the aging of the Baby Boom generation. By year-end 1965, U.S. capacity utilization

was about 90%, and unemployment was only 4.0% versus the 5.5% average from 1960 to 1965. This fullemployment

economy collided with fiscal and monetary stimulus to undermine the price stability discipline of Bretton

Woods. No longer wishing to import U.S. inflation, the U.K. and France teamed up to challenge the U.S. by demanding

that their dollars be converted into gold in the summer of 1971. In response, President Nixon closed the U.S. gold window

on August 15, 1971, ending the Bretton Woods Agreement, and laying the foundations for the 1970s’ inflation. All

that was missing was a catalyst, and we cite two. First, the wave of U.S. Baby Boomers born in 1946 began to graduate

from high school in 1964 and college in 1968 or 1970, depending on military service. As each year passed, more

“Boomers” required meaningful employment, which created the political imperative of a Phillips Curve full-


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The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -84- Legg Mason Wood Walker, Inc.

employment inflation. Second, the oil embargoes made it impossible to offset the inflation of dollar-denominated oil,

because any reduction in the value of the U.S. dollar simply raised the dollar cost of oil. Thus, the great inflation of the

1970s began, and from 1965 to 1980, the average year-over-year growth rate for U.S. M2 was 8.7%, for the U.S. PPI

all commodities index it was 6.9%, and for the CPI inflation rate it was 6.3%. Arguably, had there not been a Mutually

Assured Destruction (MAD) balance between the U.S. and the Soviet Union, this combination of events plus such flareups

as the 1973 Arab-Israeli War (with Syria and Egypt backed by the U.S.S.R) may have led to a Third World War.

Instead, the economies of the West were forced to pay the price for pursuing inflationary policies after the mid-1960s,

and for the folly of assuming that imported energy would always be abundant and inexpensive. For this reason, and

given the MAD balance that probably forestalled a broad war, we refer to the decade of the 1970s as a period of global

economic warfare. Relating those events to today, we observe that the post-Cold War U.S. economic and military hegemony

in the world has produced losers on the receiving end of commodity deflation. It further stands to reason

that the response of some elements in countries overly reliant on oil prices has been to engage in asymmetric warfare

(indirect, terrorist, stateless or informally state-sponsored, opportunistic, and focused) against U.S. interests.

The late 1970s featured a typical speculative blow-off for commodity prices (Exhibit 10, point labeled “C”) and inflation,

which, as we have seen, heralded the end of the inflation regime and the beginning of deflation. By 1980, the

Boomers born in 1957, the latter being the peak year of births as a percentage of the U.S. population (4.31 million live

births in 1957, 2.51% of the population) turned approximately age 23 and entered the workforce if they had chosen to

go to college. Those who had not gone to college entered the workforce in the late 1970s, no doubt contributing to the

heightened inflation of that brief period, in our view. At the same time this demographic (and political) weight was being

lifted in 1980, the unreliability of—and economic price umbrella afforded by—OPEC oil was encouraging fuel conservation

and non-OPEC oil exploration and production. New Fed Chairman Paul Volcker, perhaps sensing these

changes, instituted a monetary course that replaced the waning political imperatives of the 1970s, and set out to break

the back of inflation. For the third time in a century, around 1980 a commodity bubble was pierced. Following the major

recession of 1981 to 1982 a 10-year, disinflationary equity bull market began, and this was later supplemented by

the dual U.S. war victories of the Cold War and the Gulf War around 1990 to 1991, furthering the disinflationary peace

dividend, and stringing together a 20-year, unprecedented, U.S. equity bull market and a largely unbroken deflation

trend that we believe is now ending.

Deflation from 1982 to 2001 then led to


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The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -85- Legg Mason Wood Walker, Inc.

Appendix B – Caterpillar, Inc. Data Used to Build EVA Model, 1970 to 2006E

A B C D = E = F G H I = J = K L

B x C A + B - D F - G - H E / I

Consolidated NOPAT Non- Invested NOPAT

Consolidated Tax Rate % Tax Shield on (Net Inc. + Consolidated Interest Capital ROIC CAT Caterpillar

Net Profit Net Interest (Some are Net Interest + Int. Expense Total Short-term Bearing (Assets - Cash on Aver. Average Shares

After Expense multi-year Expense - Int. Tax Shield Assets Investments Current Liab. & Eq. - NIBCL) Capital Annual Outstg.

Year Tax $000 $000 averages) $000 $000 $000 & Cash $000 $000 $000 $000 Price 000s

1970 $143,785 $37,705 47.2% $17,808 $163,682 $1,798,397 $37,471 $302,907 $1,458,019 11.2% $6.19 341,364

1971 $128,290 $32,334 45.6% $14,748 $145,876 $1,808,759 $49,316 $273,876 $1,485,567 9.9% $8.06 341,676

1972 $206,445 $24,751 43.8% $10,842 $220,354 $1,912,278 $81,248 $394,262 $1,436,768 15.1% $9.89 341,864

1973 $246,845 $29,802 38.2% $11,382 $265,265 $2,232,800 $47,100 $413,300 $1,772,400 16.5% $10.73 342,658

1974 $229,200 $62,400 36.8% $22,989 $268,611 $2,934,000 $80,300 $589,300 $2,264,400 13.3% $9.10 343,242

1975 $398,700 $83,800 38.4% $32,200 $450,300 $3,386,600 $121,300 $712,500 $2,552,800 18.7% $11.02 343,410

1976 $383,200 $78,400 41.0% $32,151 $429,449 $3,893,900 $88,100 $761,300 $3,044,500 15.3% $14.43 344,294

1977 $445,000 $99,800 43.0% $42,900 $501,900 $4,345,600 $209,400 $856,000 $3,280,200 15.9% $13.46 344,906

1978 $566,000 $111,900 41.2% $46,131 $631,769 $5,031,100 $244,500 $1,090,000 $3,696,600 18.1% $13.79 345,262

1979 $492,000 $139,100 33.8% $47,037 $584,063 $5,403,300 $147,200 $923,000 $4,333,100 14.5% $13.94 345,624

1980 $565,000 $173,200 30.1% $52,185 $686,015 $6,098,200 $104,000 $1,265,000 $4,729,200 15.1% $13.59 345,834

1981 $579,000 $224,800 28.5% $64,065 $739,735 $7,284,900 $81,000 $2,194,300 $5,009,600 15.2% $15.14 348,714

1982 $(180,000) $334,000 39.0%Avg. $130,197 $23,803 $7,201,000 $81,000 $974,000 $6,146,000 0.4% $10.32 351,996

1983 $(345,000) $306,000 39.0%Avg. $119,282 ($158,282) $6,968,000 $71,000 $1,223,000 $5,674,000 -2.7% $11.00 369,514

1984 $(428,000) $265,000 39.0%Avg. $103,300 ($266,300) $6,223,000 $62,000 $1,462,000 $4,699,000 -5.1% $9.82 383,680

1985 $198,000 $234,000 12.5% $29,250 $402,750 $6,016,000 $282,000 $1,515,000 $4,219,000 9.0% $8.82 391,168

1986 $76,000 $197,000 23.2% $45,768 $227,232 $6,288,000 $124,000 $1,561,000 $4,603,000 5.2% $11.63 394,508

1987 $350,000 $252,000 25.7% $64,784 $537,216 $7,631,000 $155,000 $1,849,000 $5,627,000 10.5% $13.75 398,672

1988 $616,000 $340,000 31.1% $105,796 $850,204 $9,686,000 $74,000 $2,128,000 $7,484,000 13.0% $15.46 405,642

1989 $497,000 $372,000 26.1% $97,043 $771,957 $10,926,000 $148,000 $2,198,000 $8,580,000 9.6% $14.97 405,668

1990 $210,000 $406,000 29.9% $121,333 $494,667 $11,951,000 $110,000 $2,428,000 $9,413,000 5.5% $12.94 404,960

1991 $(404,000) $469,000 27.2%Avg. $127,595 ($62,595) $12,042,000 $104,000 $2,504,000 $9,434,000 -0.7% $11.99 403,640

1992 $(218,000) $497,000 27.2%Avg. $135,213 $143,787 $13,935,000 $119,000 $2,674,000 $11,142,000 1.4% $13.21 403,736

1993 $652,000 $440,000 27.2%Avg. $119,705 $972,295 $14,807,000 $83,000 $3,138,000 $11,586,000 8.6% $18.60 405,200

1994 $955,000 $410,000 27.8% $114,014 $1,250,986 $16,250,000 $419,000 $3,865,000 $11,966,000 10.6% $27.33 406,383

1995 $1,136,000 $484,000 31.0% $150,145 $1,469,855 $16,830,000 $638,000 $3,613,000 $12,579,000 12.0% $29.70 396,858

1996 $1,361,000 $510,000 31.6% $161,066 $1,709,934 $18,728,000 $487,000 $4,086,000 $14,155,000 12.8% $34.57 384,960

1997 $1,665,000 $580,000 33.0% $191,330 $2,053,670 $20,756,000 $292,000 $4,753,000 $15,711,000 13.8% $48.40 381,000

1998 $1,513,000 $753,000 30.6% $230,333 $2,035,667 $25,128,000 $360,000 $4,897,000 $19,871,000 11.4% $49.82 368,130

1999 $946,000 $829,000 32.0% $265,443 $1,509,557 $26,711,000 $548,000 $4,380,000 $21,783,000 7.2% $52.74 359,181

2000 $1,053,000 $980,000 29.3% $286,688 $1,746,312 $28,464,000 $334,000 $4,835,000 $23,295,000 7.7% $37.90 348,898

2001 $805,000 $942,000 31.4% $295,735 $1,451,265 $30,657,000 $400,000 $4,965,000 $25,292,000 6.0% $48.24 347,092

2002E $729,691 $799,704 32.7% $261,162 $1,268,232 $33,659,895 $688,783 $5,385,583 $27,585,529 4.8% $54.92 347,737

2003E $1,106,425 $885,857 32.6% $289,141 $1,703,141 $36,763,202 $114,217 $6,249,744 $30,399,241 5.9% $54.92 347,092

2004E $1,311,783 $959,584 33.3% $319,713 $1,951,653 $40,263,170 $203,588 $7,247,371 $32,812,212 6.2% $54.92 347,092

2005E $1,957,980 $1,105,446 33.0% $364,422 $2,699,005 $44,087,292 $142,614 $7,935,713 $36,008,965 7.8% $54.92 347,092

2006E $2,775,888 $1,155,155 32.8% $378,872 $3,552,171 $48,544,089 $109,564 $8,737,936 $39,696,589 9.4% $54.92 347,092

2007E NA NA NA NA NA NA NA NA NA NA NA NA

2008E NA NA NA NA NA NA NA NA NA NA NA NA

2009E NA NA NA NA NA NA NA NA NA NA NA NA

2010E NA NA NA NA NA NA NA NA NA NA NA NA

2011E NA NA NA NA NA NA NA NA NA NA NA NA

2012E NA NA NA NA NA NA NA NA NA NA NA NA

2013E NA NA NA NA NA NA NA NA NA NA NA NA

2014E NA NA NA NA NA NA NA NA NA NA NA NA

2015E NA NA NA NA NA NA NA NA NA NA NA NA

Source: Company reports, Moody’s Industrial Manuals, Legg Mason estimates and projections for 2002 to 2006E


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The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -86- Legg Mason Wood Walker, Inc.

Appendix B – Cont’d., Caterpillar, Inc. Data Used to Build EVA Model, 1970 to 2006E

M N O P Q = R = S = T = U V = W = X

B / P Q x (1-C) [M/(M+P)] J - S M / U (M+P-G)/

x O U

Forward Consol. +[P/(M+P)]

CAT 10-yr. Consolid. Interest After-Tax x R CAT Avg. CAT Avg. CAT Tot.

Mkt. Val. S&P 500 S&P 500 Gross Rate on Cost of CAT Total Annual Annual Net Debt/

of Eqty. Yrly. Total Total Ret. Debt Average Debt % EVA Sales & Price/ EV/ Mkt. Val.

Year 000s Return = Ke $000 Debt % = Kd WACC % Revs. $000 Sales Mult. Sales Mult. Equity %

1970 $2,113,374 3.9% 5.9% $517,642 7.3% 3.8% 5.5% 5.74% $2,127,751 0.99 1.22 23%

1971 $2,754,761 14.3% 8.5% $504,092 6.3% 3.4% 7.7% 2.21% $2,175,169 1.27 1.48 17%

1972 $3,380,060 19.0% 6.5% $358,039 5.7% 3.2% 6.2% 8.89% $2,602,178 1.30 1.41 8%

1973 $3,677,623 -14.7% 6.7% $482,700 7.1% 4.4% 6.5% 10.07% $3,182,358 1.16 1.29 12%

1974 $3,121,951 -26.4% 10.7% $881,200 9.2% 5.8% 9.6% 3.72% $4,082,100 0.76 0.96 26%

1975 $3,785,259 37.2% 14.8% $913,400 9.3% 5.8% 13.1% 5.64% $4,963,700 0.76 0.92 21%

1976 $4,969,249 23.9% 14.3% $1,094,000 7.8% 4.6% 12.6% 2.76% $5,042,300 0.99 1.19 20%

1977 $4,643,656 -7.2% 13.9% $1,110,900 9.1% 5.2% 12.2% 3.70% $5,848,900 0.79 0.95 19%

1978 $4,762,638 6.6% 15.3% $1,164,900 9.8% 5.8% 13.4% 4.69% $7,219,200 0.66 0.79 19%

1979 $4,818,035 18.6% 16.3% $1,415,100 10.8% 7.1% 14.2% 0.31% $7,613,200 0.63 0.80 26%

1980 $4,701,181 32.5% 17.5% $1,378,200 12.4% 8.7% 15.5% (0.39%) $8,603,000 0.55 0.69 27%

1981 $5,280,656 -4.9% 13.9% $1,808,500 14.1% 10.1% 12.9% 2.25% $9,160,000 0.58 0.77 33%

1982 $3,633,625 21.6% 17.6% $2,612,000 15.1% 9.2% 14.1% (13.66%) $6,472,000 0.56 0.95 70%

1983 $4,065,616 22.6% 16.2% $2,247,000 12.6% 7.7% 13.1% (15.82%) $5,429,000 0.75 1.15 54%

1984 $3,767,858 6.3% 14.9% $1,861,000 12.9% 7.9% 12.6% (17.72%) $6,597,000 0.57 0.84 48%

1985 $3,450,224 31.7% 14.4% $1,404,000 14.3% 12.5% 13.8% (4.80%) $6,760,000 0.51 0.68 33%

1986 $4,587,183 18.7% 14.9% $1,582,000 13.2% 10.1% 13.6% (8.49%) $7,380,000 0.62 0.82 32%

1987 $5,480,702 5.2% 15.3% $2,196,000 13.3% 9.9% 13.7% (3.23%) $8,294,000 0.66 0.91 37%

1988 $6,272,662 16.6% 18.0% $3,260,000 12.5% 8.6% 14.8% (1.83%) $10,435,000 0.60 0.91 51%

1989 $6,072,343 31.6% 19.2% $3,994,000 10.3% 7.6% 14.6% (4.97%) $11,126,000 0.55 0.89 63%

1990 $5,240,225 -3.1% 18.2% $4,721,000 9.3% 6.5% 12.7% (7.17%) $11,436,000 0.46 0.86 88%

1991 $4,838,424 30.4% 17.4% $5,247,000 9.4% 6.9% 11.9% (12.60%) $10,182,000 0.48 0.98 106%

1992 $5,333,731 7.6% 12.9% $5,672,000 9.1% 6.6% 9.7% (8.28%) $10,194,000 0.52 1.07 104%

1993 $7,537,353 10.1% 13.1% $5,428,000 7.9% 5.8% 10.0% (1.47%) $11,615,000 0.65 1.11 71%

1994 $11,104,627 1.3% 12.9% $5,903,000 7.2% 5.2% 10.3% 0.36% $14,328,000 0.78 1.16 49%

1995 $11,785,856 37.5% 13.7% $6,400,000 7.9% 5.4% 10.8% 1.21% $16,072,000 0.73 1.09 49%

1996 $13,309,190 22.9% 10.9% $7,459,000 7.4% 5.0% 8.8% 4.01% $16,522,000 0.81 1.23 52%

1997 $18,438,765 33.4% 9.3% $8,568,000 7.2% 4.9% 7.9% 5.84% $18,949,000 0.97 1.41 45%

1998 $18,338,404 28.6% 6.9% $12,452,000 7.2% 5.0% 6.1% 5.33% $21,089,000 0.87 1.44 66%

1999 $18,943,030 21.0% 4.8% $13,802,000 6.3% 4.3% 4.6% 2.68% $19,836,000 0.95 1.62 70%

2000 $13,221,780 -9.1% 3.3% $15,067,000 6.8% 4.8% 4.1% 3.66% $20,378,000 0.65 1.37 111%

2001 $16,744,295 -11.9% 4.7% $16,602,000 5.9% 4.1% 4.4% 1.58% $20,672,000 0.81 1.59 97%

2002E $19,097,716 9.2% 6.4% $17,231,595 4.7% 3.2% 4.9% (0.10%) $20,283,690 0.94 1.76 87%

2003E $19,062,293 8.6% 5.9% $18,523,643 5.0% 3.3% 4.6% 1.25% $21,503,665 0.89 1.74 97%

2004E $19,062,293 8.0% 5.3% $19,692,760 5.0% 3.3% 4.3% 1.86% $23,786,587 0.80 1.62 102%

2005E $19,062,293 7.4% 4.8% $21,874,171 5.3% 3.6% 4.1% 3.69% $26,372,535 0.72 1.55 114%

2006E $19,062,293 6.8% 4.4% $23,293,352 5.1% 3.4% 3.9% 5.52% $28,887,074 0.66 1.46 122%

2007E NA 6.3% NA NA NA NA NA NA NA NA NA NA

2008E NA 5.3% NA NA NA NA NA NA NA NA NA NA

2009E NA 4.8% NA NA NA NA NA NA NA NA NA NA

2010E NA 4.3% NA NA NA NA NA NA NA NA NA NA

2011E NA 3.9% NA NA NA NA NA NA NA NA NA NA

2012E NA 3.4% NA NA NA NA NA NA NA NA NA NA

2013E NA 3.0% NA NA NA NA NA NA NA NA NA NA

2014E NA 3.0% NA NA NA NA NA NA NA NA NA NA

2015E NA 3.0% NA NA NA NA NA NA NA NA NA NA

Source: Company reports, Moody’s Industrial Manuals, Legg Mason estimates and projections for 2002 to 2006E


Industrial Portfolio Strategy

The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -87- Legg Mason Wood Walker, Inc.

Legg Mason Wood Walker, Inc. makes a market in the shares of Joy Global, Inc.

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© Copyright 2002 Legg Mason Wood Walker, Inc.

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