2005, A Fitful, Quiet Year . . .
. . . A Racing Start to 2006
The significant feature of the financial markets in 2005 was the extent to which foreign stock markets beat the US market. Quite likely, this will continue in 2006 and beyond. During the course of 2005, we increased your investments in foreign stocks, through a variety of Exchange-Traded Funds (ETFs) and mutual funds. These foreign investments helped us earn returns higher than available in the US stock and bond markets. I expect to broaden our foreign investments in 2006 and expect we will again realize benefits from larger non-US investments.
The strength in foreign stock markets is, in part, a measure of the vibrancy of the developing economies in Asia. The ever-easier movement of capital around the world permits us to deploy your investment assets in these distant, rapidly growing markets. Globalization of investment capital and the “democratization” of investment opportunities--through ETFs and other types of securities--have broadened the range of available investments in ways barely imaginable two decades ago.
The new availability of low-cost foreign investments is timely: Investment opportunity in America will continue, but ours may not be the most dynamic economy nor the most attractive investment destination in the years just ahead of us. American stock and bond were essentially flat in 2005. The Dow fell by a fraction of a percent, the S&P 500 rose by less than 5% (including dividends) and broad measures of the US bond market showed gains, with interest, in the range of 2% to 3%. Foreign stock markets did better.
The aggregate return in 2005 for all the capital we manage was about 7% net of our fee. (Variation among individual accounts arises from the differing levels of risk we take for different people.) Without foreign investments and without targeted investments in energy-related equities and commodities, we would have been hard pressed to earn more than 3% to 5%.
Foreign stock markets. In addition to the dynamism and rapid economic growth in many of the developing economies, China, India and others, many of these stock markets are valued more attractively than the US stock market. Through these investments, we are able to buy faster growing companies at lower prices than in the US. Valuation measures favor foreign stock investments.
As we decreased our large investments in foreign (non-dollar denominated) bonds, we used the proceeds to buy foreign stocks both in developing markets and in Japan and Germany. Japan’s economy, prostrate for over a decade following the bursting of its stock market and real estate bubbles, has begun to grow. Its stock market, exceptionally weak for fifteen years, has rallied very strongly as optimism about Japan grows. Separately Germany, characterized by high unemployment and very low growth for years, shows increasing signs of vigor, rising exports and growing corporate profits. Its stock market has also come to life and shows promise for 2006.
Oil and related investments. China’s nearly insatiable appetite for oil, world-wide production problems, and hurricanes all were factors driving stocks of energy companies higher again this year. The oil-related stocks in the S&P 500 gained 39% in 2005, after a (mere) 32% gain in 2004. The adjacent chart shows the extraordinary rise in these investments in recent years. The recent peak in energy stocks and oil prices followed hurricanes Katrina and Rita in September. In the autumn, oil stocks and crude oil and gasoline prices traded below those levels, giving rise to calmer inflation reports and increasing consumer confidence. Notwithstanding recently favorable news, fundamental pressures on oil prices remain unsolved. These include constraints on extraction and refining of oil and its products, growing demand from developing economies (notably, but not only, India and China), anti-Western sentiment in many countries with oil reserves, and domestic US policies that encourage oil consumption. Because of longer-term forces keeping oil prices high, we retain significant energy investments.
Commodities. Core’s largest single investment is in Pimco’s Commodity fund, an investment that replicates a broad-based index of physical commodities denominated in dollars. The same global trends that drive oil prices higher move the prices of other commodities, as well. Industrialization in the developing economies in Asia, solid growth in America, and under-investment in commodity production over the last decades all push commodity prices higher.
We made this investment in January 2004 and it helped our portfolios with a 15% gain in 2004. In the year just past, commodity inflation increased further and we earned a 20% return in the fund. There is increased speculation in commodities; the headline-making news about oil prices and gold’s recent ascent to 20-year highs above $540 per ounce give cautious investors like ourselves some pause. Volatility in commodity prices will remain high, but it seems likely to me that most commodity prices will be higher as 2007 begins than they are now.
The commodity fund and a tax ruling. The Pimco fund employs certain “swap” transactions to replicate the performance of the Dow Jones-AIG commodity index. The Internal Revenue Service recently announced a ruling that appears to disallow the use of these swaps by a mutual fund. The rule will go into effect on June 30, 2006. This revenue ruling and its possible affect on our commodity fund has generated adverse press attention. It appears, however, that Pimco has solved the problem:
Last week in a conference call for institutional investors in the fund in which I participated, Pimco reported that it can use a different type of security, so-called “structured notes”, to achieve the same effect as its commodities swaps. These notes are widely used in the mutual fund industry and elsewhere and the IRS accepts them for mutual funds. Pimco assured us that it will be able to continue offering and managing its commodity fund after June 30, 2006. Pimco plans to make a public announcement to this effect shortly. I have confidence in Pimco and we have ample time--more than five months--to evaluate its proposed solution.
The dollar, the Fed, and the bond market. As usual--one might say invariably--the currency markets and the bond markets confounded expectations in 2005. A year ago, the Federal Reserve was in the midst of its well-advertised process of raising short-term interest rates. (Recall that after the bursting of stock market bubble, the 2001 recession, and the September 11th attacks, the Fed lowered short-term interest rates to 1%, and kept those rates very low for a long time.) In the middle of 2004, the Fed began raise these rates by 0.25% at each meeting of the Fed’s Open Market Committee (FOMC), every six weeks or so. Given the near certainty, as 2005 began, that the cycle of rate increases would continue, it was widely expected that long-term rates--and, quite importantly, mortgage interest rates--would also rise.
And, at the end of 2004, the US dollar had been falling for 30 months against major foreign currencies. America’s trade deficit was widening; its net debt to the rest of the world was huge and growing fast. Given the near certainty that America’s trade and current deficits would continue to grow, it was widely expected that the dollar’s value would decline further.
As we know now, these confident expectations about bonds and the dollar were confounded by reality. The dollar rallied quite strongly against major foreign currencies; the currency markets focused on rising short-term US rates and largely ignored our external deficits. And, yields on long-term bonds fell even as short-term rates rose, a phenomenon that occasioned much analysis but no convincing explanation. (When the Fed began raising short rates, the yield on the Treasury’s composite of bonds maturing in more than 10 years was 5.20%. At the end of 2004, that same yield was 4.71%. By the end of 2005, the yield had fallen further, to 4.58%.)
On January 3, the Fed released minutes of its December FOMC meeting, which suggested that its process of raising rates was nearing its end. This triggered an enormous world-wide rally in stocks, a rally in bonds and further decline in their yields, and the biggest two-day drop in the dollar’s value against the euro in years. Two days later, China announced that it intends to change the management of its foreign reserves, implying--probably--that it will be holding a smaller percentage of its reserves (which are approaching $1 trillion) in dollars. Taken together, the Fed’s announcement and China’s suggest that the dollar, having risen in value in 2005, will resume its decline. This will benefit our foreign bond and our commodity investments. I venture no prediction about yields on US bonds, but continue to focus on the Treasury’s inflation-adjusted bonds, discussed in previous letters.
IRA distributions and tax reports.
IRA distributions. Owners of IRAs and other qualified plans must take distributions from these plans beginning in the year in which one turns 70 1/2 years old. The brokers that hold one’s IRA--Schwab or others--report on the monthly statements the minimum amount that one is required to withdraw. Thus, one’s recently-received year-end brokerage statement shows this amount, which may be transferred to another taxable investment account or to one’s bank account. The distribution may be taken at any time during the year--many take regular monthly or quarterly distributions--or it may be withdrawn in a lump sum. If taken in a lump sum, it is probably sensible to take the distribution early in the year.
Reports of investment income. We can provide you or your tax preparer with clear and simple tax reports showing capital gains, interest and dividends in the form required for tax returns. We will be happy to assist in IRA distributions and to send or email tax reports. Please contact us by phone (800 451 2240 or 415 332 2000) or email (JNMayberry@coreasset.com), if you would like our help with either.