February 27, 2007

A Good Start for 2007 . . .
. . . Then a Stumble

John N. Mayberry

Notwithstanding a sharp sell off that began in China and extended around the world today, the year has begun well for the assets in which we invest and our portfolios show good gains. The stock market rally that began last summer--after a brief shudder in May and June--continued its steady gains in US and foreign markets. Prior to today’s activity, the character of the market persists as it has, with brief interruptions, for the last three years: there is a sense of confidence in the markets that arises from the seeming abundance of money to invest, from the slow and steady growth of economies and of markets, and from the very resilience of the markets when confronted with unsettling news. Is today’s selling the beginning of a bear market, or is this just another interruption in the stately advance of the world’s investment markets?

Core’s portfolios appreciated in the opening weeks of this year. Favorable investment conditions prevail and investors demonstrate confidence in the assets in which we invest. Will today’s world-wide selling in financial markets undercut this confidence?

The major investment themes that we have identified and acted upon over the recent years continue: World economies grow apace. Asian countries gain wealth, power and political influence. Relatively free movement of capital around the world broadens and deepens the markets in which we invest. Demand for commodities to fuel economic activity grows (although the cycle of commodity price gains has become somewhat advanced). Economic growth and wealth creation is generally faster outside the United States than within it. Core has continued to invest much of the capital we supervise outside the United States and, as the years unfold, we expect ever-greater commitment to foreign markets.

We have written many letters discussing the risks that should give the markets pause. Indeed, we have seen “pauses.” In the spring of 2004 and again in last year in May and June, markets experienced sharp, but very brief bouts of selling. On both occasions, the selling appeared to come out of the blue. That is, there was not a clear event, either in the financial markets or in the world at large, that triggered the selling. As the selling began, many market participants joined in and virtually all major markets fell sharply in price. Then the selling dried up, nothing appeared to have changed, and investors resumed their buying. Is today’s selling the beginning of a more serious decline, or is this just another brief interruption? This question will be before us in the coming days and weeks.

The various unsettling geopolitical, economic and financial events since 2003 have been brushed off by the markets. The war in Iraq worsens; al Qaeda regroups in Afghanistan and Pakistan; North Korea detonates an atomic bomb; Iran tries to build them; Hezbollah and Israel fight to a bloody stand off in Lebanon; the Amaranth hedge fund loses $6 billion in a few short weeks; oil prices more than double; and the United States incurs $800 billion of new foreign indebtedness each year. The markets have ignored the bad news and moved ahead.

Investors have ignored geopolitical risks and invested as if all were well in the world. At some time, a bear market will begin.The trigger may be a political or economic event, or it may come from within the financial system.If we remain alert and ready to take action, we are likely to preserve capital during bear markets and to invest productively when falling prices create good opportunities.

Some event will trigger the next bear market. There can be no doubt that we will see the end of this bullish period. When the bear market begins is utterly unknowable. Whether today’s sharp selling is day one cannot be known now. We prepare for the next bear market by observing the markets and the world as things unfold, by being alert to signs of problems, and by investing some of our capital in money market funds and other low risk assets that will not be pulled down when risky assets fall in price. (For example, during today’s selling, our foreign currency money market investments rose by one half percent.) When conditions change and the markets begin to worsen, we are likely to sell riskier investments in your portfolios. Perhaps we will sell too soon; we may sell too late; we have done both before. We certainly will be unable to pick the top of the markets unless by chance. But we will do well, if we avoid the delusion that markets will forever go up and if we prepare to invest opportunistically after the bear market.

Recent investments.Since the year began, we sold part of our commodities investments on the view that the balance between supply and demand is shifting and that the surest price gains are behind us. We have rejiggered positions in foreign currencies, by selling a portion of our investments in the Franklin Templeton Hard Currency fund (a foreign currency money market fund) and buying an exchange-traded fund that tracks the value of the euro in dollar terms. The Franklin Templeton fund has a big weighting in the yen and other Asian currencies and a smaller one in the euro. We thought the balance wrong for our portfolios--we favor a somewhat higher allocation to the euro. We are continuing our slow deployment of capital to foreign equity markets. Our investments in Germany and Japan, made two or three years ago, have been exceptionally productive; their prospects remain good. We are adding investments, through various exchange-traded funds, in Brazil, India and Singapore.

Investments after the bull market ends. The last two or three years have been characterized by low interest rates and readily available credit. Capital is at hand for almost any plausible investment--and for some pretty odd ones, as well. As we have discussed before, many investment assets have come to trade at levels never before thought plausible. When this cycle turns and some of the mountains of debt begin to totter, various markets may suffer.

But as prices fall, opportunities will arise. Then many investment assets, now quite expensive, will become much less dear and much more attractive. There will be very good opportunities in struggling or bankrupt companies, “distressed securities,” as they are called. We expect to be able to invest then in very low risk and good quality assets that will have fallen sharply in price as credit--now cheap and readily available--becomes scarce and expensive. When the cycle turns, we expect that our investments will continue to earn a healthy return.