April 10, 2007

A Brief Warning, then Buying Returns

John N. Mayberry

Despite sharp declines in stock markets around the world beginning in late February, and despite the swift increase in oil prices after Iran seized British sailors in the Persian Gulf, Core’s portfolios earned strong gains so far this year. Following nervous weeks of selling into mid-March as investors feared risky investments, appetite for risk returned. For now, investors have concluded that the specific problems of February and March do not pose immediate danger: Fears of a slow down in China’s growth (occasioned by its sudden sharp sell off) have receded. The worsening defaults in the sub-prime mortgage sector now seem unlikely to present widespread problems to the US banking system. The risk of a large increase in oil prices from the British/Iranian standoff has been rendered moot by the release of the sailors. The question, to use the metaphor suggested by the British/Iranian matter, is whether clear sailing lies ahead? What do these swift-passing squalls portend?

Core’s portfolios have made a good start to 2007. Energy-related and foreign stock markets were the strongest parts of our investments.

Since the year end, the aggregate of all Core’s accounts has risen by 3.8% as of this writing. By contrast, major US stock market averages are ahead by less than 2%. Foreign stock markets have performed better than US markets. Our investments in commodities, traditional and alternative energy companies, utilities, and foreign stocks have been quite strong. These have provided a good portion of our investment earnings this year.

The sudden sell off and the rebound. In late February, seemingly out of the blue, came a sudden round of selling in stocks around the world. For months, the markets had been characterized by calm and confident advances. Troubling events--political, economic and financial--seemed incapable of disturbing investors. Since then, markets have fallen and risen by large amounts day after day. Judging by the wide daily price swings, it appears that investors are no longer complacent and have a renewed appreciation of risk. Belying this is the strong showing by the risky assets. The nearby chart shows prices of stock markets in developing countries; surely these are risky investments gaining while risk appetite is high and falling sharply when the investment world becomes nervous. After a quick 11% plunge in a few trading sessions, emerging markets regained their footing and last week surpassed their former highs from late February.

Despite geopolitical problems, despite difficulties in the US housing market, growth in Asia and Europe is solid. Further appreciation in stocks and commodities seems likely in 2007.

The geopolitical problems, of which the Persian Gulf episode is just the latest example, are always with us. At any time, a similar event may arise. This one was resolved by diplomacy; in the future, clumsy anger may give rise to devastating crises. By contrast to the uncertainties of the geopolitical messes is the apparently smooth progression of economic growth. As sub-prime lenders failed in recent weeks, the fear arose that this finally could trigger economic slowdown. On current evidence, it seems that the sub-prime defaults will not cause losses through the banking system. And, even as economic growth in America slows from the rates of previous years, the rest of the world grows more rapidly. It used to be said that when the United States caught a cold, the rest of the world suffered from pneumonia. As developing economies have grown so robustly over the last decade, dependence on US demand has waned. Indeed, the rapid growth of US exports provides further evidence of the size and importance of foreign economies. And, this suggests that America’s overall economy--and its domestic investment markets--may not suffer unduly with a modest decline in US domestic demand. Stock markets, American and (especially) foreign, may advance even as US economic growth slows.

What lies ahead. Our various investments have good prospects and we expect 2007 to produce reasonably strong returns. The demand for oil and other commodities remains robust; incidents like the recent one in Iran suggest that the combination of demand and political risk makes oil stocks attractive even after several years of big price gains. Growing economies around the world provide a good support for the global export powerhouses, Germany and Japan, in which we have very productive investments. We participate in the vibrant developing economies of Asia and Latin America through our investment in the Emerging Markets exchange-traded fund and in country-specific ETFs. The US dollar has fallen a bit this year and we expect this long-term, slow decline to continue. We have investments in a foreign currency money market fund and in a euro currency ETF. These appreciate in value as the dollar falls; like US dollar money market funds, they also are the best defensive holdings when markets are weak. (During the sharply falling markets at the end of February and early March, these positions gained in value.)

Prices of companies in energy markets are rising; economic and political prospects are favorable. Oil-related and alternative energy markets are attractive.

The late February and early March selling is another reminder that markets do not always go up. We did not make any significant investments changes last month in response to that selling, which we judged to be a temporary event. We consider the preservation of value of your investment capital to be our primary responsibility. We are alert and prepared to act.