January 11, 2007

The Turn of Another Year

John N. Mayberry

2006 was a favorable year for Core’s investors; let us hope to have more like this one just past. In the aggregate, all of Core’s accounts earned 11 percent, a return commensurate with US stock market averages, but with far less risk. (Variation among individual accounts arises from the differing levels of risk we take for different people.) This letter addresses the broader issues that investors face in 2007.

Principal Factors for Investments

Stock markets generally were strong around the world in 2006. The chart below shows returns for the last five years for foreign stock markets in developed countries, including Japan, Australia, Canada, and the western European countries.

As was the case in 2006, a handful of issues will determine the course of investments. In no particular order, these include the huge amount of money available worldwide for investment; economic growth in the very dynamic Asian economies; the tremendous accumulation of money by China and other Asian exporters and by the oil-producing countries; the state of the US housing market and--related to it--potential problems in the mortgage market; the interconnections of global capital flows through financial derivatives; and the growing importance of borrowed capital. To understand these phenomena, the interplay among them and their influence on the assets in which we invest, is the real task in which we are engaged. Among other things, investors must seek to understand how these factors have caused the prices for many investment to rise to such exceptional levels.

Liquidity and leverage. The apparently enormous amount of money available world wide for investment has caused one asset class after another to attain prices previously thought impossibly high. Strong world-wide economic growth and the increasingly free flow of global capital provide ever-greater liquidity for investment. Perhaps equally important is the use of leverage. The creation of new financial derivatives and relatively low interest rates around the world have permitted much more investment with borrowed funds. Concurrently with this readily available investment capital, markets around the globe have opened up and expanded the range of assets in which we can invest.

The dollar declined against foreign currencies, particularly the euro and the pound sterling, in 2006. Many Asian countries continued to intervene in currency markets to keep their currencies from strengthening against the dollar.The strength in foreign currencies helped our foreign stock investments.

Trillions in Asia and OPEC countries. It is hard to overstate the importance of the stunning accumulation of capital by the Asian countries and by OPEC. China now holds more than one trillion dollars in foreign reserves. Other Asian exporting countries, Japan, Taiwan, Hong Kong, India, Singapore, Thailand, and South Korea, hold a trillion more. The oil exporting countries have gathered similarly enormous reserves as the price of oil has tripled in the last few years: Russia, a significant debtor until quite recently, now holds more than $280 billion in foreign reserves. These huge pools of capital have an enormous impact on global investments. (They also have a big influence on political affairs among nations, a subject beyond the scope of this letter.) For example, China plows much of its $200 billion annual trade surplus with the United States back into US treasury bonds. This keeps the prices of US bonds and the dollar higher than would otherwise be the case. OPEC countries, also holders of vast and growing reserves, are more willing to hold euros than dollars--indeed, Iran, for transparent political reasons, seeks to be paid in euros, rather than dollars, for its oil.

Neither the Asian exporters nor the OPEC countries invest as we do: we seek to earn a good total return without taking too much risk. We try to figure out what is cheap and what is dear; we assess the profit prospects for our investments before we deploy our capital. Different considerations inform the decisions of China, OPEC and the others. The Asian exporters are mercantilists; these countries seek to sell their goods at favorable prices in their export markets, especially America. The Chinese buy dollars as they accumulate reserves as a way to keep the value of the dollar high in relation to their currency. Low US interest rates help the housing market here and sustain consumer spending, including on Chinese imports. Thus, it makes sense for the Chinese willy-nilly to buy US treasury bonds with their export earnings without reference to whether these bonds represent good investments as we would analyze them. (Chinese bond purchases increase demand for US treasury bonds and keep their yields low.) Investment decisions made with considerations like these give rise to different asset prices than would prevail if all investors sought--as private investors do--to maximize returns and reduce risk.

Commodity markets have become more complicated arenas for investment. We invested in commodities in January 2004. For two years, most commodity markets were very strong and our investment gained 40 percent.In 2006, our commodity investment lost about 3%. Oil prices peaked in August 2006 and have since fallen from $78 a barrel to about $55 dollars. Other industrial commodities have been weak so far in 2007. We decided to sell one quarter of our commodity investment this week. We will consider how to invest the proceeds of that sale.

US residential real estate. It may seem parochial to discuss matters specific to America these days. But, despite the growing importance of China, India, Brazil, and the oil exporters, America remains the world’s largest economy and its most important investment player. As the new year begins, primary issues here include the further effects of residential real estate on the economy as whole. Much thought has been given and much ink spilt in considering the outcome of America’s adventures with housing, but all the questions remain unanswered. Will the “housing bubble” burst? Will its bursting damage the economy severely?

I do not have answers, but offer a couple of observations: Many are optimistic that the decline in the housing market will not wreak havoc with the economy and the markets. The view is that the worst of the slow-down in home building and the weakness in sales of homes is behind us. (There are lots of optimists on questions American and they are usually right.) The pessimists foresee a worse outcome and regard bullish monthly economic reports as insignificant upticks in a serious downtrend. No one knows yet how all this plays out: certainly the Fed, a vigilant and able organization, is waiting to see.

The collapse of a large hedge fund in 2006 proved not to cause a broad financial crisis. There remains concern that problems with a big investment house somewhere could cause a widespread crisis. The world's financial system is very interconnected. This makes the system stronger; it may also make it somewhat more brittle.

However, it is entirely possible that equity markets will be higher with either the outcome. If the pessimists are right, if the decline in the housing market continues, and if it proves to have broad and negative effects on the world--and it may--then the Fed and other central banks will take actions to stimulate economic activity and asset appreciation. If the optimists have it right and the housing ‘crisis’ proves to be a damp squib, then investment markets will not suffer unduly. This view--that things will be all right in either event--itself is an optimistic one, of course. But there is a difference in outcomes between the two choices: If things get bad and the Fed must ride to the rescue, we may have some real pain and suffering for a period, followed by big rallies in stocks. In the latter case, in which the housing market does not really collapse--the view on which markets have been acting--rallies continue without the intervention of a messy bear market.

Global imbalances, risks in financial derivatives. For years we have “known” that the enormous debt the United States accumulates each year with the rest of the world is unsustainable. So far, it has been sustained without dire consequences. For years, we have “known” that the proliferation of financial derivatives and its necessary contractual interlinks between unknown parties will surely cause a world-wide financial crisis. But in 2006, Amaranth, a rather large hedge fund, sustained a loss of $6 billion in one week. Its natural gas investments that went sour in a hurry surely involved counterparties around the world, but nothing bad happened. Amaranth’s investors sustained significant losses and institutions on the other side of its trades made lots of money. But the world’s financial markets and banking institutions did not budge. (One could write an interesting letter on the etymological ironies in the name this hedge fund chose for itself. A warning for those of us who like to play with words and to invest capital.)

We have observed in recent years that when there is a financial crisis, even a minor one, all most all investment assets decline together. We conclude that, at least these days, portfolio diversification does not offer much help during periods of sharp declines. In order to protect our portfolios against the inevitable declines, holding money market funds is best. Core holds large investments in money market funds, both US dollar funds and foreign currency money funds.

The Amaranth episode provides evidence that our very interconnected global financial system is quite robust. Can we conclude that the equanimity around Amaranth’s collapse means that we are safe now? In August 1998, after a year of disturbance in Asian currency markets, Russia renounced the debt of the Soviet Union. That event was not greeted with equanimity. Markets plunged. A few weeks thereafter, Long Term Capital, another large hedge fund, sustained large losses. Then the Fed was sufficiently concerned with the stability of the world’s financial system to cajole a number of big banks to buy Long Term Capital’s book of investments. The Fed cut interest rates in the US very sharply and pumped billions of dollars into the banking system. Did the Fed overreact in 1998? Did the world’s financial markets underreact this year when Amaranth collapsed? Easy questions. Difficult answers.

Managing risk in an unknowable environment. If the foregoing matters defy simple analysis--they do--then how do we manage the risks and uncertainties in our investment portfolios? It is an illusion to believe that portfolio diversification alone provides sufficient protection against investment risk. (I intend to discuss this in a later letter, but the basic point is that when there is even a minor financial crisis, virtually everything goes down in price.) If my observation is correct, then one must use cash as a buffer against these uncertainties.

Core can assist with required minimum distributions from IRAs and can provide reports for income tax returns. Please call us if you would like either of these.

Core holds significant amounts of cash in most portfolios. Our money market investments, which we hold in US dollar funds and in foreign currency funds, are safe. When markets do fall sharply again, as surely they will, our cash investments will be safe. Moreover, they will be available to us for investment in stocks, commodities, real estate, bonds, or other investment assets that may then be on offer for purchase at very attractive prices. If we can earn a good return on the risky assets we own, while keeping a meaningful portion of our capital in safe cash investments, we accomplish what we set out to do. We have been accomplishing just this. We will continue to think hard, because these apparently placid waters may become more turbulent.

IRA distributions and tax reports.

Each year, Core Asset Management Company files with the SEC a Form ADV with information about our company. If you would like a copy of Part II of Form ADV, please contact us and we will send one to you.

Owners of IRAs and other qualified plans must take distributions from these beginning in the year in which one turns 70 1/2 years old. We will be happy to assist in IRA distributions. We also stand ready to send or email tax reports to you or your tax advisor. 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.