November 20, 2006

A Late Year Stock Rally

The Dow and other US stock market indices have set a series of new highs. The recovery from the 2000 to 2002 bear market is welcome and has helped the stock portion of your portfolios. If one takes inflation into account, the US stock market stands well below the records set in 2000.

In the last few months, stock markets around the world have rallied quietly but productively. The Dow Jones Industrial Average and the Russell 2000 (the main index for US small company stocks) have reached all-time highs. Core’s investments have thrived and we are on the way to another year of solid returns. Investors are confident and liquidity is ample around the globe. Worrisome factors from the spring and summer--fear of damage from hurricanes, the Israeli-Hezbollah war, Iran’s nuclear program, to name a few--no longer arouse anxiety. (The hurricane season was gentle; the cease fire in Lebanon holds; attention to the Iranian threat has waned.) The run up to the US elections and their outcome were benign to the markets. Even the faltering residential real estate market may be aiding securities investments: Last week saw another report of a deep decline in construction of new homes; housing starts in October were a whopping 27% below those in October 2005. It is plausible to think that, as investment in new home construction falls, more capital will find its way into stock markets.

Recent investments. In August, we made initial investments in two exchange-traded funds, one for alternative energy investments, the other for investments in water-related industries. More recently, we added an investment in the exchange-traded fund that invests in “emerging markets”, i.e., the stock markets of developing countries, an investment we have previously held. The alternative energy and water-related investments have, in fact, earned some money for us in the brief period of our investment. We are happy about that, but we view these as long-term investments, on the notion that the development of alternative energy sources and water resources is inevitable, necessary, and likely to be quite profitable.

John N. Mayberry

Investment risk. As you may remember, I have been writing all year about the high prices of risky assets. Our recent investments, in the aggregate, amount to only about 10 percent of your portfolios. Even after these new investments, money market funds (dollar-denominated and foreign) still comprise 25 to 40 percent of most portfolios. It is amply clear that my concerns about investment risk have not yet been realized. After a sharp but brief bout of selling in May and June, calm and confidence have returned. You may recall that during the late spring and early summer, I sold our investments in emerging equity markets, considering those to be our riskiest portfolio positions. Earlier this month, I took a small step back into this investment asset, by buying a position in the emerging markets fund.

The trading in stocks of oil-related companies is interesting. Crude oil itself has fallen by more than 20 percent since August. The fund holding all the oil-related stocks in the S&P 500, a long time investment of ours, traded last week less than 2% below its high from the summer. This tells us that companies in the oil business will make plenty of money with crude oil priced at $50 per barrel.

A proper assessment of risk is the most difficult aspect of investing. Risk is not a constant. Consideration of the stock markets of the developing countries--the emerging markets--may illustrate this: for the last five decades, the currency and securities of the United States, the dollar and our bonds and stocks, have been deemed the world’s least risky. Far to the other end of the spectrum have been the currencies and securities of the third world, to employ the old term. More recently, with the fall of the Soviet Union and the global spread of trade and investment capital, the developing countries have adopted many practices of the economies and markets of United States, Western Europe and Japan. As globalization of capital markets has progressed, the currencies and securities of emerging markets have become less risky. Because of the happy combination of increasing stability and appealing growth prospects in developing countries, emerging markets have attracted investment capital from around the world. Investors in emerging markets have been well rewarded and the investments have come to be a useful part of a well-conceived investment portfolio.

The interplay of liquidity and hedging instruments may account for the willingness of investors to pay up for risky assets.Some assets classes--notably emerging markets--that had been quite risky decades ago have become less risky as globalization has spread and economies and markets have matured.

Indeed, it may be argued that while emerging markets have become safer, American investments have become riskier. As the debt of the United States to the rest of the world grows and as our geopolitical position weakens, it is sensible to regard US investments as riskier than before. Over the last several years, Core has held greater proportions of foreign investments and we have cut our US bond and stock investments. These interconnected processes are not yet complete: the relative attractiveness of foreign investments will grow

High prices for risky assets; a possible explanation. Two other factors contribute, I believe, to ever higher prices for risky assets: Liquidity--the money to invest and spend--has grown worldwide, a result of central bank activity and of the proliferation of credit derivative products. Increasingly complex derivatives produce ever greater amounts of investment capital. With these same derivatives come tools to offset the risk of holding a given investment. Sophisticated investment funds can invest large amounts of capital in certain investments, confident that they can pass the risk of those investments on to other institutions. Hence, such a fund can invest greater amounts and pay higher prices for risky assets without increasing portfolio risk for their portfolios.

This is a complex subject that deserves more than one paragraph of comment. Core does not employ such derivatives to hedge the risk in our portfolios. When we consider portfolio risk to be high, we sell the risky positions and hold money market funds. Even with our large cash positions, we have earned a healthy return this year, while keeping risk low.