October 3, 2006

Investing Slowly

Short-term moves in markets are often driven by hedge funds and similar pools of fast-moving capital. We are long-term investors. We move slowly and cautiously, avoiding undue risk and seeking to identify the long trends in which we can earn money.

After a sharp but brief bout of selling in May and June, the markets recovered their poise in the summer and began to rise. From an inauspicious opening, the stock market staged a stately, if undramatic summer rally. Behind the rally lay events that did not happen: no awful hurricanes damaged oil production or refining facilities; the cease fire in Lebanon was not broken; Iran did not push the West too hard in its bomb development. These non events permitted oil prices to fall. Crude oil prices fell from $78 a barrel in late summer to $58 this week. As oil and gasoline prices fell, traders concluded that inflation risk was lower, and that consumers would keep spending, despite signs that the housing market had begun its fall. The tone of the stock market turned positive and stock prices pushed higher.

The bond market rendered a different interpretation of these developments. Long-term bond prices rose sharply and yields fell. Ten-year treasury bond yields fell to a level 0.5% below the yield on Fed funds and treasury bills, an uncommon development that usually predicts recession or a sharp decline in economic growth. Apparently, fixed-income investors interpreted the fall in oil prices to be a prediction that slowing economic growth would lessen demand for oil. Bond traders took the fall in home sales and in housing prices as the long-expected end of manic housing price appreciation. The bond market appears to conclude that as the housing market cools, consumers will spend less and the economy will slow. If the bond market is correct, the stock market is probably wrong: If the economy slows, corporate profits--the basic driver of stock prices--can hardly be expected to flourish.

Where does risk lurk and how do we price it? The apparent contradiction between the views of stock investors and bond investors raises the persistent investment question: Do the markets properly reflect the real risks that investors face? My answer: Sometimes. But not now.

John N. Mayberry

Oil prices have fallen by more than one fifth in a few weeks. What does this mean? Have the major oil exporters--Saudi Arabia, Iran, Venezuela, Nigeria, Russia and others--suddenly become paragons of political stability and friends to the West, ready to assure United States, Japan, Europe and China of steady and growing supplies of crude oil? Have the problems in extracting, transporting, and refining oil been solved, so that we can now be confident that oil supplies will grow as fast as the demand for oil? To pose these questions is to answer them. The world is not safe and its geopolitical frictions (to use a mild term) present real risks to the oil markets. Limitations in capacity to produce oil will remain for some time, until new sources of oil are developed and new refining facilities are built. While limited capacity persists, the risk of periodic interruption to oil supplies remains. It still seems to me that we can expect further problems in the oil market and higher prices once again. (In August and September, as oil and other commodity prices fell, our oil- and commodity-related investments, which have been so productive for a few years, pulled back in price. In our portfolios overall, gains in our other investments offset these declines.)

The trading in commodities and oil since August seems to suggest that the days of high oil and commodity prices are over. Maybe. But it is more likely that prices will move back up again. We remain holders of these positions.

My view is that the housing market in the United States presents serious risk to the economy and to investors--to say nothing of those who have borrowed money to make speculative investments in residential real estate. I stick to my warnings of global financial imbalances--characterized by huge indebtedness in the United States and huge surpluses in China, Japan, and other Asian mercantilist economies--although nothing untoward has yet come to pass.

In May and June, the markets seemed to recognize that these are serious problems; the prices of risky assets fell. Then calm was restored and prices began to rise again. The risks did not go away; the market’s focus was merely diverted from the risks by more immediately engaging stories about investment opportunity. The dollar stopped its decline, oil prices fell, and stock prices rose.

Experience teaches us that the markets often appear to present less risk than actually exists. (There is an old saw to the effect that if traders knew that the world would end at 3:00 this afternoon, they would hold off selling until 2:55.) One way in which risk is disguised is by the actions of very short-term traders, including hedge funds. Speculators are willing to take risky positions because they believe they will be able to exit positions quickly and at favorable prices. Markets are increasingly driven by hedge funds, alert for short-term opportunities. As opportunities emerge, huge sums are invested, causing price movements that are swifter and more exaggerated in amplitude that than the opportunities may really warrant.

Short-term price swings are not an impediment to long-term and conservative strategies. We can take advantage of “irrational” price moves to advance our slower and more cautious approach.

The investment capital for which Core has responsibility--yours--should not be moved at such a pace. Most hedge fund investors can take far greater risks than a typical Core client. For most of Core’s clients, it is best to make low-risk investments with good prospects for long-term gains. We can and should avoid chasing short-term but high-risk opportunities. We can be confident that with patience and discipline we will achieve our investment goals.

Although short-term movements in markets may be contrary to our investment positions from time to time, the markets do accommodate long-term investors like ourselves. If we are roughly accurate in our basic analysis of where the world is headed; if we can identify the types of investments that will benefit from the forthcoming developments; if we restrict investments in expensive and risky securities, then we will achieve good results. We will make money as the years roll by and we will avoid serious loss in the periodic and inevitable bear markets.

New investments. In August, I wrote of our proposed investments in alternative energy and in industries involved in all aspects of the water business. We have completed our initial investments in these, via two Exchange-Traded Funds. The world needs more non-oil sources of energy and more readily available clean water. I believe we will benefit from our new investments in the coming years.