May 15, 2006

The Turning Point…
...Markets Become Rational.

Core has been selling bonds, foreign and domestic, in recent weeks, as global interest rates rise. We have increased investments in currencies other than the dollar, to take advantage of the dollar’s decline.

Since the middle of April, global markets have become volatile. Reassuring progress in various investments assets has suddenly been interrupted; a whiff of panic is in the air. After more than a year of quiet gains, the dollar has fallen by 7% in a few weeks. Precious and industrial metals prices, following a stately period of advance, have risen at a manic pace to record highs for some metals, 25-year highs for others. Yields on bonds in America, Europe and Japan are rising; bond prices are falling. Crude oil prices exceeded post-Katrina highs and gasoline prices moved above $3 per gallon, stimulating panicked and irrational policy suggestions by elected officials. Until last week, stock markets around the world remained undisturbed by the ructions in currency, commodity and bond markets, then stocks cracked as well.

Over this period of weeks, Core has been making significant portfolio changes. This letter offers an analysis of the markets and an explanation of our investment actions. First the investment changes:

Yields on bonds have begun to rise around the world; bond prices are falling. Because I expect this to continue, we have sold most intermediate- and long-term bonds in your portfolios. (In the aggregate, among all our accounts, we have reduced bond holdings from about 25% to about 10%.) As discussed below, we have invested most of the proceeds in non-dollar money market funds.

The dollar is falling against the other major currencies; I expect this to continue. Hence, we decreased our US fixed-income investments and increased non-dollar money fund holdings. We may reduce US bond positions further.

John N. Mayberry

As mentioned, we have sold US and foreign bonds in recent weeks. We have purchased foreign, non-dollar money market funds with most of the proceeds. The Franklin Templeton Hard Currency fund is the non-dollar money fund in which we invest. (Note that while this is a “load” fund for retail investors, we can purchase it for our clients without a commission.) We have kept some of the proceeds of our US bond market sales in US money funds, the yields for which have become much more attractive as the Fed has raised rates.

The fall in bond prices and the dollar’s renewed decline make sense. There is more to come.

Our recent investment changes in equities have been few, but recall that we made significant equity investments last year. With the firm conviction that foreign stocks offered better prospective returns than US stocks, we increased aggregate foreign equity investments from 6% to 27% during the course of 2005. (Appreciation of the positions has caused it to grow further.) We are considering decreasing equity positions.

Rational Markets. The recent turbulence in investment markets seems like a delayed reaction to increased inflation and the extraordinary financial imbalances around the world, of which we have written repeatedly. One might conclude that the markets are finally beginning to act rationally: The dollar is falling, as it should, given America’s indebtedness to the rest of the world; bond yields are rising, reflecting the inflationary price increases in oil and other commodities. Higher volatility in global stock markets seems normal in the present environment: interest rates are rising and the major central banks have restrictive monetary policies, as I wrote last month.

Although some commodities have soared in price this year, especially industrial and precious metals, we plan to keep our commodity investments. The bull market in oil and other commodities is far from its end.

The recent volatility in prices of many investments indicates that risk is high. We are taking steps to protect your capital.

Commodities. There has been more comment in the general media about commodities this year than in the last two decades, or so it seems. Higher oil prices have, of course, been well observed for two years or more, but now the press has discovered the soaring prices of industrial commodities and precious metals. (Indeed, the parabolic curves described by charts of zinc and copper prices this year are a wonder to behold.) The question for us, investors since January 2004 in physical commodities, is whether we should sell or continue to hold our investments. I believe that we can hold our commodities investments, mindful that the ride may be less placid than in ‘04 and ‘05.

Price increases in industrial commodities like copper reflect significantly increased demand from China and the real constraints on producing enough to meet demand. An obvious example about demand is the need for copper wire to electrify the buildings China is putting up everywhere . Enormous price rises in gold and silver, which are much less significant for industrial purposes, may be caused in part by rising demand for jewelry in China and India. In addition, higher gold prices reflect profound (and well-founded) skepticism about the likelihood of America’s servicing its mountains of debt to the rest of the world. America’s debt increases at the rate of $800 billion per year. The dollars with which this debt will be repaid will be worth less than today’s dollars. It appears now that inflation and dollar depreciation will be America’s “solution” to its debt problem. A loss in confidence in the dollar’s future value makes gold prices rise.

Managing risk. Managing investment portfolios involves the seeking of opportunity and the mitigation of risk. With the increase in so many investment assets since the end of 2002, opportunities are far fewer and risk is much higher. Central banks are carefully, but surely, restricting liquidity and raising the cost of money. Risk management is our primary responsibility in this world with very high asset prices, with profound political and ideological tension between oil producers and the oil consumers, and with huge financial imbalances between the creditor countries (Japan and China) and the debtor, America. Our investment moves in the last month have lowered risk in your portfolios. We remain vigilant.