2005 First Quarter Commentary
and Planning Ideas

April 20, 2005

By Preston S. Caves, CPA, CFA, MBA

I have enclosed a Market Review for the first quarter of 2005.  The review indicates it was a very weak quarter for both stocks and bonds.  An improving economic and geopolitical environment was tempered by fears of rising interest rates and rapidly rising oil prices.  A tabular attachment to the review provides global returns for the first quarter of this year and for twelve months ending  March 31, 2005 .  The “Economic Review and Market Perspective” providing a longer-term interpretation of current data will be presented at mid-year. 

Recent data indicate moderate U.S. economic expansion with on-going upward pressure on prices coming from pass through of increasingly high energy prices, slowing of worker productivity gains, and some increase of producer pricing power.  On the growth side, consumer spending slowed from the end of 2004 but was still considerably higher than a few years ago. Capital expenditure trends continued to be positive in early 2005. New orders and shipments for manufactured goods (excluding defense) were reported to have increased at 12% annual pace through early 2005. In aggregate, these trends led to resurgence in both measurable and expected inflation, especially at the producer level.

Around the globe, China’s economy continues strong, but growth is moderating (by Chinese standards), and the authorities seem to be engineering a “soft landing.”  Economic activity in the rest of Asia is generally robust, benefiting from China’s coattails, but weakness in the Europe zone continues partly because strength of the euro is hurting export industries.

The weak start for global stock prices so far this year may suggest a growing realization of the challenges facing the U.S. and the world as a whole, plus concerns over Bush’s policy agenda.  For example, engineering reduction in the huge and growing U.S. current account deficit without hurting either the United States  or its trading partners will be a daunting challenge for all.  Further, economic expansion and high energy prices are a threat to price stability.

It is important to note that concerns over Social Security and Medicare, the twin U.S. deficits, inflation, and the declining dollar do not necessarily imply cataclysmic events are imminent.  For example, the dollar is likely to drift downward rather than experience an abrupt crisis of confidence, though a crisis is possible (as noted in the Market Review, the dollar actually gained strength in the first quarter.)  Additionally, resolutions regarding Social Security, Medicare, and U.S. trade and governmental deficits will take years.

C&A discourages focusing much attention on short-term results because a broadly diversified portfolio is structured for the long-term.  As we often state, there is no way to completely eliminate short-term risk from an investment portfolio.  As you review the data, think in terms of markets (plural), not “the market.”  You will notice that typically at least some part of your portfolio is providing positive results.

We have discussed our concern about market volatility in previous correspondence.  We have also emphasized the need for investor discipline.  With the usual uncertainty about future outcomes, investors should develop and maintain a plan that has the potential to work over more than one scenario.  We believe strategic asset allocation is such a plan. 

So far we see no reason to change our 2005 outlook, as expressed as part of the communication dated  January 27, 2005 .  As one would expect, some elements of the outlook have been fairly accurate.  For others, particularly stock prices and the dollar, divergence has begun, but it’s too early to tell if this divergence will persist.  It is noteworthy that 1) Caves & Associates outlook is quite consistent with what might be judged the consensus 2005 forecast, and 2) the ensuing reality is typically significantly different from the consensus.

What’s Topical or Timely  

We remain committed to continuing education as well as keeping you abreast of anything with a significant impact on your wealth management. Please see the enclosed Timely Topics for information about the Terry Schiavo lessons, the Social Security debate, and other topics relevant to your financial planning.  Speaking of Social Security, please make sure that you are saving on a regular basis so you don’t have to rely on Social Security as your primary means of retirement income.  

I recently completed a course on small business retirement plans.  Please call if you are interested in this topic.

A Few Key Reminders from Previous Communications

Overall, our reasonable expectations for results over the next five to ten years do not need to be overly pessimistic.  Nonetheless, to be prudent, we need to hope for the best, but also align our expectations lower just in case, to be ready for the possibility of reduced results.  Prudent behavior includes reasonable reductions in spending and increases in our savings rates whenever possible

As quoted in my letter dated January 27, 2005 according to Professor Edmund S. Phelps of Columbia University: “At the present time [American] households are badly under-predicting their future tax liabilities – or, if the U.S. government is going to cut entitlements [such as Social Security] – over-predicting their future benefits.  Either way, they are spending too much….”

In addition to maintaining broad diversification and discipline, we can’t overemphasize the importance of maintaining adequate reserves for all potential needs to withdraw from your portfolio.  Please be reminded that periods of increasing interest rates can be bad for both stocks and bonds.  We note that strong bond returns in 2002 were a great benefit for overall portfolio results in a year in which stock returns nose-dived.  Going forward, we need to be prepared for a potential “double whammy”, when positive returns for bonds may not be available to mitigate the inevitable rough patches for stocks.  At such times portfolio returns may be even worse than experienced in weak markets over the last few years and decades.  Reserves allow us to avoid selling at these inopportune times.

Colin Powell: 

 “Avoid having your ego so close to your position that when your position falls, your ego goes with it. “

“Experience is not what happens to you. It is what you do with what happens to you.”

“Democracy's the worst form of government except for all the others.”

“The highest use of capital is not to make more money, but to make money do more for the betterment of life.” 

“I'm like old wine. They don't bring me out very often, but I'm well preserved.”

“There are three great friends: an old wife, an old dog, and ready money.”