July 12, 2006

Modest Investment Gains
in a Down Market

In the second quarter, stocks and bonds fell in price around the world. Our accounts, in the aggregate, earned a positive return.

Our investment activity over the last three months has had the effect of reducing portfolio risk.

The just-concluded second quarter of this year may have marked the end of the three-year bull market in stocks and other assets, and the beginning of a new cycle in financial markets. This new period, we believe, will be characterized by greater volatility and increased risk. In the last three months, Core has taken significant steps to reduce risk in the portfolios we manage. This letter will outline our investment actions and give our assessment of the investment picture. First, a brief review of major investment markets in the second quarter.

Stock markets around the world fell during the second quarter. In general, secondary markets--like the Nasdaq and stock markets in developing countries--fell by the most. Bond prices fell and interest rates rose around the world. The US dollar declined against major foreign currencies. Commodities, as a class, rose a little in price, although the aggregate results mask very big moves up and down in individual commodities. Given the losses in stocks and bonds, we are pleased to report that our accounts overall rose by a small amount during the very difficult quarter.

We have sold almost all bond investments and all emerging market equities, i.e., all stocks in companies in developing countries. We have invested proceeds of these sales in US dollar and in foreign currency money market funds. We have made these changes because the worldís major central banks are all pursuing restrictive monetary policies, which policies pose serious obstacles to many investment assets.

John N. Mayberry

When central bank policies were loose and interest rates were low, risky investments thrived. Now the tables have turned. Core has sold its riskier investments.

The extended period of extremely low interest rates and very loose monetary policy by the central banks of Japan, Europe, and the United States began in 2001, first to mitigate the effects of the bear market in stocks that began in 2000, then to forestall significant economic disruption from the September 11th attacks, and finally (in the United States) to prevent deflation (falling prices) from occurring. The effect of very cheap money, offered by the central banks in amounts far greater than needed for economic activity, was to encourage investment in risky assets. As markets around the world were flooded with liquidity, one asset class after another rose to quite astounding levels, levels that bore scant relation to the inherent risk in these asset classes. Residential real estate and commercial real estate (via REITs) have reached levels in relation to interest rates never before imagined. Similarly the stocks and bonds of developing countries--emerging market debt and equity--have increased enormously in price. Surely the effects of free flows of capital around the world and more sophisticated markets in developing countries has provided a sound basis for some of the increase, but by no means all of it.

For two years, the Federal Reserve Board has been increasing short-term interest rates in the US by baby steps. From such a low starting point--Fed funds stood at 1% until June 2004--rates remained abnormally low until this year. Now, at 5.25%, short-term rates are reasonably high and destined, I believe, to go higher still. The European Central Bank has also been raising rates for about a year and will raise rates further. A few months ago, Japanís central bank announced the end of its policy of Quantitative Easing, during which short-term interest rates have been 0% and the central bank has pumped enormous amounts of cash into the system. Since the announcement, Japanís money supply has fallen sharply, as the central bank has withdrawn funds otherwise available for investment. A number of very astute investors consider Japanís money supply decrease to be the primary cause of the world-wide sell off from mid May through mid June.

In the last three months of market turbulence, I have written several investment letters, which, read together, give a more rounded view than any of the single letters. These, and our other letters, may be found on Coreís website at www.coreasset.com/

What next? In my judgment, press reports and commentary to the effect that the Fed is nearly finished raising rates represent wishful thinking. Inflation is back and the Fed will keep raising rates--until there is a financial crisis or until there is a real economic slowdown. It seems likely that Japan and Europe will continue their restrictive monetary policies. In this environment, risky and overpriced investment assets may suffer, hence our sales of these. Our portfolios hold high-quality investments with relatively low risk and with good prospects for investment gains. Our investments in US dollar money funds and foreign currency money funds are now substantial; they have at least three good characteristics: Their risk is very low, the income earned is relatively high and set to go higher, and they provide a source of funds to make other investments as opportunities arise. If the restrictive monetary policies of which we write do result in a bear market in some assets, we will have cash available to invest when the dust settles.

Commodities, Oil and the Dollar. Although there have been some large swings in prices of individual commodities including oil, these still appear to be good investments for us, with relatively low risk. I expect that oil prices will remain high until there is a meaningful slow down in the economies of China and the United States. The sharp sell-off in the dollar in April is probably just one more step in its long-term decline. Our foreign currency money market investments will benefit as the dollar falls in value.