June 6, 2006

Reducing Risk in
Turbulent Markets

A volatile period has given investors the jitters. We have been selling some investments. We hold large positions in US dollar and foreign currency money market funds, awaiting low-risk opportunities.

The character of investment markets has changed in the last two months. Core has been adjusting portfolios and selling riskier positions. An explanation of our actions and analysis of the present environment follows: In April, I wrote that the central banks of the United States, Europe, and Japan were, for the first time in years, all pursuing tighter monetary policies. The currency and bond markets began to respond to this by the middle of April: the dollar fell sharply against major foreign currencies and US treasury bond prices declined as yields rose above 5%. By the middle of May, commodities and equity markets world-wide began to fall. After two or three years of abnormally low volatility, large daily swings in prices have become the norm.

As this unfolded, we sold almost all bonds, domestic and foreign, in client portfolios and invested the proceeds in money market funds, both US dollar money funds and foreign currency funds. Our expectation was--and is--that bond prices will fall and that foreign currencies will gain in value against the dollar. We wrote in April that risky assets continued to flourish, despite the restrictive policies of the Fed and other central banks. Beginning in mid-May, the bloom came off equities, particularly the most risky ones: those of the developing countries, called “emerging markets” in the parlance of investment markets. After three years when risky investments performed extremely well, markets suddenly came to appreciate anew that risk implies the possibility of investment loss. All stock markets have fallen in recent weeks. The US market has fallen least; Japan and the European markets by a bit more; most emerging markets have fallen quite sharply. To a lesser degree, commodity prices also have fallen since mid May.

John N. Mayberry

Emerging Markets. In response to this new volatility and sudden declines in emerging markets--and because of the likelihood of further declines--we have sold a portion of our foreign stock positions, generally selling emerging market positions. The chart on the first page shows the remarkable rise in emerging markets in the last three years, during which the movement has been almost straight up. There have been periods of equally dramatic declines over the last few decades. The greater maturity of many stock markets in developing countries and the world-wide flow of investment capital that is a feature of globalization make a huge decline in emerging markets unlikely. However, in a situation like the present--when investment markets have turned cautious and prices are quite high--the prudent approach is to reduce risky positions and raise cash.

Commodities. Prices of physical commodities have also fallen since mid May, but the decline has been minor and, in my judgment, temporary. The rise in prices of many commodities since 2004 has been significant, but it appears likely that commodity prices will be higher next year. In the past century, bull markets in commodities have generally lasted for fifteen years or more. We are probably in early stages of a long period of rising commodity prices. Since 2004, we have had meaningful investments in a commodity fund and in oil-related stock investments. These have been productive. At present, I have no inclination to reduce the positions.

The US dollar. The dollar resumed its decline in April and today set a new one-year low against the euro. It seems likely that it will fall further in the months ahead. Because of this, we have invested a good portion of the proceeds of our sales in a foreign currency money fund.

Commodity markets and oil-related stocks continue to offer good returns with relatively low risk. We maintain these investments.

Investment risk. When markets become turbulent and selling appears, our approach is to reduce our risky positions. Long-term bonds are quite risky, as are the stock markets of developing countries. The dollar itself is an overpriced and somewhat risky asset. We have reduced investments in these assets. The assets that have relatively low risk and rather good prospects include commodities and oil-related stocks, as well as foreign currency money market funds. We have maintained or added to these positions. From time to time, a number of markets fall simultaneously and sharply. We have witnessed a moderate version of this in recent weeks. At such times, overall portfolio values are bound to suffer. However, large cash positions mitigate loss and safeguard capital that we will invest when the waves of selling subside and attractive opportunities are on offer.