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 


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


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



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



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



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"



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.



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.



 

 

 

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



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 


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



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



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



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



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 


2004E 

LM 

Ests. 

Real Export 


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



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-



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



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



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



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 


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.



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 


1951 

+167% 

+6% 

1965 


1981 

+204% 

+38% 


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 


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. 


1920 

61% 

+196% 

1920 


1929 

1933 


1951 

+167% 

1933-51 

+299% 

1965 


1981 

+45% 

+798% 


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) 


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



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 


1963 

CPI Urban Inflation Rate, 10-Yr. Moving Average 

2001 

2002 to 


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.



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 


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

2002 to 


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.



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) 


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) 


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 


U.S. M2 Money Supply (Left Axis) 

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


1933 +/- 12 yrs. 

(4) Stocks 

flatten. 


rises. 

300 

250 

200 

150 

100 

(5) War 

begins. 

50 






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



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 


935 

835 

735 

635 

535 

435 

335 

235 

135 

(2) 


rise. 

(1) M2 

rises. 

1951 

1953 

1955 

1957 

1959 

1961 

1963 

1965 

1967 

1969 

1971 

1973 

1975 



475 

425 

375 

325 

275 

225 

175 

125 



32.00 

27.00 

22.00 

17.00 

12.00 

(4) 


flatten. 


rises. 

1951 

1953 

1955 

1957 

1959 

1961 

1963 

1965 

1967 

1969 

1971 

1973 

1975 

475 

425 

375 

325 

275 

225 

(5) Economic 

warfare. 175 * 



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 


200.00 

2001 +/- 12 yrs. 

1,525 


(2) 


rise. 

(1) M2 

rises. 

1,325 

1,125 

925 

725 

525 



175.00 

150.00 

125.00 

100.00 

75.00 

(4) 


flatten. 


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 


325 





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



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.



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% 


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

2015E S&P 2015E S&P 

Composite Composite 

Prob- Price Price 


Status Quo 15.0% x 11.7% = 1.7% 


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



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

2015E CPI 2015E CPI 

Urban Urban 

Prob- Inflation Inflation 


Status Quo 15.0% x 1.0% = 0.2% 


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


Source: Legg Mason estimates and format



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



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.



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”



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.



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-



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



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



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



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 


1950 

1960 

1970 

(5) Rising 


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.



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



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 


2005E 

2008E 

2011E 

2014E 

Composite Average Annual P/E (Left) 

Source: Standard & Poor’s Corp., Legg Mason estimates for 2002 to 2015



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



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.



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



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.



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)% 


1920 

CAGR 

7.3% 

World 

War I, 

U.S. 

GNP 

growth, 

autos. 


1933 

CAGR 

(6.7)% 


1951 

CAGR 

3.6% 

Deflation, 

depression. 

Electric 

power 

growth, 

World War 

II. 

1951 

to 1965 

CAGR 

0.4% 


1981 

CAGR 

13.2% 

Cheap oil 

imports, coal 

mechanization. 

OPEC embargo, 

U.S. well 

depletion, more 

coal, nuclear. 



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.



• 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



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-



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



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.



• 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.



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.



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.



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/



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.



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 


LM 

Ests. 

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

2007E 


Real 


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



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

1,000 

100 

10 


1896 

CAGR 

(2.6)% 


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. 


1932 

CAGR 

(8.7)% 


1951 

CAGR 

7.9% 

Supply 

controls, 

machinery, 

W.W. II. 

Mechanization, postwar 

deflation, trade 

barriers. 

1951 

to 1969 

CAGR 

(1.1)% 


1982 

CAGR 

9.8% 

Exports 

to EU 

and 

USSR, 

costly 

fertilizer 

and fuel. 

Post-war 

price 

support overproduction, 

more 

fertilizer. 


2001 

CAGR 

1.6% 



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



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) 


1992 

1997 


14.0% 

12.0% 

10.0% 

8.0% 

6.0% 

4.0% 

2.0% 

0.0% 

Deere Relative to the S&P



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. 


1980 = 

8.6% 

CAGR 

1975 

EU-15 

1980 

FSU 

1985 


1995 = 

(0.1)% 

CAGR 

1990 

1995 


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



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 


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-



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 


migration from grain to poultry. Typically, the 

2015 = 

next step is to pork, then beef. 

5.3% 

CAGR 

1983 


2001 = 

5.8% 

CAGR 

U.S. Meat 

Exports 

1980-01 

= 10.3%/yr. 

1986 

1994 

1996 

1998 

2000 


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%



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-



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 


15% 

10% 

5% 

0%



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) 


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)



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



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.



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



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.



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 


2003 

2004 

2005 

2006 

2007 

2008 

2009 

2010 

2011 

2012 

2013 

2014 


Saudi Arabia Iran Iraq Other Gulf 

Source: U.S. EIA. Legg Mason projection based on EIA’s International Energy Outlook 2002



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



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.



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,



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



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



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



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.



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



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



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



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



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



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.



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.



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



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-



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.



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



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-



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…



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 








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



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 








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



Legg Mason Wood Walker, Inc. makes a market in the shares of Joy Global, Inc. 

Additional information is available upon request 

The information contained herein has been prepared from sources believed to be reliable but is not guaranteed by us 

and is not a complete summary or statement of all available data, nor is it considered an offer to buy or sell and securities 

referenced herein. Opinions expressed are subject to change without notice and do not take into account the particular 

investment objectives, financial situation or needs of individual investors. No investments or services mentioned 

are available in the European Economic Area to “private customers” or to anyone in Canada other than a 

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preparation or issuance of the communication may have positions in the securities or options of the recommended issuer. 

© Copyright 2002 Legg Mason Wood Walker, Inc.

The Inflation Cycle of 2002 to 2015 - Uhlmann Price Securities

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