July 6, 2007

At the Halfway Point

Strong returns in the first half of 2007 demonstrated investors’ (so far) insatiable appetite for risk. Stock markets of developing countries are a good proxy for interest in risky investments.

Summary of recent market action and portfolio returns.The first half of 2007 produced very favorable gains for our portfolios. After a brief sell off in late February and early March, the markets were exceptionally strong through the end of May. In the aggregate, the accounts of Core’s clients gained 7.6% in the first half, essentially all in March, April and May. (Returns in individual accounts vary, generally because differing risk profiles.) In May and June, there was a rather sharp world-wide rise in bond yields (and corresponding decline in bond prices). At the same time, widening problems in the ‘sub-prime’ mortgage sector caused failures of some small hedge funds and a crisis at two large funds run by Bear Stearns. The combination of rising interest rates and these problems with mortgage-backed securities caused jitters in many markets and among many kinds of investment assets. Stock markets fell sharply for a brief period in June; investments sensitive to interest rate levels were hit hard. Utilities and financial stocks, and Real Estate Investment Trusts (REITs), were among those adversely affected.

Notwithstanding the increase in interest rates and the short waves of panic selling, the appetite for risky investments remains high. The exchange-traded fund for the stock markets of developing economies (symbol EEM), in which Core clients have investments, is a good proxy for risky assets. (See the adjacent chart.) It began the year at a price of about 115, fell to 105 during the late February and early March sell off, then climbed to 133 in late June. Investors show confidence that equity markets will continue to be strong.

After the housing bubble.We are well into the aftermath of the housing bubble. Median home prices have fallen in the last twelve months and masses of houses are languishing on the market. A couple of years ago, at the height of the frenzy to buy houses and create mortgages, some banks made loans to anyone with a heartbeat. Unsurprisingly, we now have an explosion of defaults in so-called “sub-prime” mortgages. These mortgages (like conventional ones) have been packaged into pools and sold to investors in various forms. The creativity of investment bankers who “securitize” these, the complaisance of the credit rating agencies (Moody’s and Standard & Poor’s), and the obtuse greed of investors—avid for yield but blind to risk—have created a newsworthy set of problems.

Geniuses at the investment houses created CDOs (Collateralized Debt Obligations), which put large numbers of loans, including sub-prime mortgages, into highly leveraged pools. Even though many of the underlying loans were of the poorest credit quality, their numbers were deemed sufficient collateral to give the pool as a whole the highest (AAA) credit rating. This is alchemy. As the borrowers of the underlying sub-prime mortgages stop making their payments—a growing trend—the defaults have chipped away at the cushion of prospective payments to support the AAA rating. The messy bailout a couple of weeks ago by Bear Stearns of two hedge funds it organized to invest in this arena forestalled the risk of wider damage to institutions and funds holding this rather toxic stuff.

So far, the banking system and financial markets have easily absorbed the failures and losses associated with sub-prime mortgages. Financial systems are certainly robust, but we have not yet watched the last reel of this film.

Several months ago, a number of small financial institutions that originated these sub-prime mortgages failed; a number of banks and investment banks have reported losses from the parts of their businesses that deal in this arena. So far, the losses from subprime mortgages have not caused a ripple on the banking system as a whole. There is a reasonable possibility that the Bear Stearns debacle is not the last act in the housing bubble aftermath. We remain vigilant, but so far the banking system has been sufficiently robust.

The alternative energy industry is in its infancy. Its future is very bright.The oil business is mature but is nowhere near its decline. We have investments in both and expect to benefit from both for several years to come.

Water and alternative energy. Last summer, we made initial investments in water-related industries and in alternative energy. It seems a near certainty that water will be increasingly valuable; investments in water utilities and in industrial companies involved in filtration, pumping, desalinization and the like will very likely be quite profitable in coming years. The same applies to investments in wind and solar energy industries. These investments have done well so far, ahead by 32% in the last twelve months for the water-related investment and by 24% for the alternative energy. I expect to make further investments in water and alternative energy in the future.

Oil-related investments. We began making oil-related investments four years ago; these have been very profitable investments, averaging 32% per year since the end of 2003. As is well known, economic growth in China and other developing Asian countries has accounted for much of the world-wide increase in demand. Constraints in meeting that demand, especially in increasing crude oil production and refining capacity, have caused prices to rise. Although there is an ever-wider search for alternative fuel sources, it seems to me very likely that oil demand will keep rising in coming years. (Within a few years, more cars will be sold in China each year than in the United States.) And, despite investment gains since 2003, energy stocks are somewhat undervalued at present. We expect the investment gains in oil-related stocks to continue.

The dollar has fallen further in 2007, continue its long-running decline. The euro and British pound have been the strongest currencies; most Asian currencies have been weaker than the dollar. In time, the dollar will decline against the Asian currencies, as well. Stock markets have been strong around the world. More gains lie ahead.

There are many ways to invest in energy. A new investment by Core has been in Brazilian stocks, via a security called (awkwardly) iShares MSCI Brazil Index, symbol EWZ. Brazil has become an energy exporter in recent years and its success with ethanol derived from sugar cane has been well publicized. Petrobras, its large oil company, is a big part of EWZ. Likewise, our commodity investments include oil and heating oil. Our total energy-related investments represent a big part of your portfolios.

The dollar and foreign currencies. The dollar has fallen a bit further this year on a trade-weighted basis. The euro and pound sterling have been quite strong; the Asian currencies, including the Japanese yen, have been notably weak. Since the end of 2001, the dollar has lost about one third of its value. Because we have had large foreign investments, in foreign bonds, foreign currency money funds and, especially, in non-US stock markets, our portfolios have benefitted from the weak US dollar. Further declines in the dollar, especially against the Asian currencies, are quite likely in coming years. We intend to maintain large foreign, non-dollar investments for the foreseeable future. We will continue to divide our cash reserves between US money market funds and foreign currency money funds.

Stock prices have become increasingly volatile this year. This is disconcerting to watch, but the big price swings present opportunities to sell at high prices and to buy other assets at favorable prices.

Equity investments, generally. Almost five years ago, the bear market in stocks came to an end and equities began a long bull market. Despite the duration and extent of this bull market, further gains lie ahead. Strong economic growth around the world and growing corporate profits provide the underpinnings of these favorable markets. The process of financial globalization, including free flows of investment capital world wide, has opened many more markets in which companies can raise capital and into which we may invest. The extraordinary surpluses being accumulated by China, Japan and other Asian exporters, and by the oil exporting countries provide more than a trillion dollars of new investment capital each year. As investors have becoming increasingly confident that relatively low inflation and relatively high growth will persist, the appetite for capital market investments has grown. Prices for stocks, real estate, and physical commodities have all risen. Asset markets will not forever go up, but they will probably continue to rise in the next six to twelve months.

The latter stages of a bull market. You may have noticed the growing number of days with big changes up or down in stock prices this year. In late February and March, and again in June we saw this. We should get used to it: as a bull market ages, price volatility increases. This bull market is more than half way through its fifth year.

Price volatility has its benefits: As mentioned, REIT prices have been adversely affected by rising bond yields. Since February, REIT prices generally have fallen by about 20 percent, after rising phenomenally for four years. Price volatility poses risks, of course, but it also presents opportunities to make long-term investments at favorable prices. We have very small REIT investments for many clients; I have kept positions small because prices have seemed unrealistically high. Should REITs fall further, they will become increasingly attractive candidates for purchase. I would be very happy to hold large REIT investments at the right price. Similarly, I would like to add to our investments in water-related industries and alternative energy. Sharp declines in stock prices may provide us with an opportunity to buy these at good prices. We remain alert to risks. As prices rise, risk increases. But, as markets shift, opportunities arise. We have two jobs: to manage risk, and to exploit opportunities.