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I
have enclosed your copy of Caves & Associates’ Market Review for
the second quarter of 2005.
The review highlights the modest to moderate rebound for most asset
classes during the quarter versus very weak results in the first quarter.
U.S.
stocks benefited from benign economic news and continuing solid corporate
earnings reports. Bond returns,
after losses in the first quarter, were back in the black in the
U.S. , reflecting a drop
in inflation and the unexpected downturn of long-term interest rates.
Finally, foreign stocks and bonds underperformed
U.S. counterparts due
largely to currency losses. The backside of the Market Review is a table
of global investment returns for the second quarter and six months year-to-date
ending June 30, 2005
. A second enclosure
headed "Economic Review and Market Perspective" provides a
longer-term interpretation of economic and market data and trends.
During the quarter there was good news about low core inflation, acceptable
U.S.
jobs and GDP growth, and prospects for continuing corporate earnings
growth. The news pushed
stock prices higher, to the point where results recovered to almost
breakeven year-to-date.
Caves & Associates discourages focusing much attention on short-term
investment 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.
Additionally, it is impossible to consider every possible cause
and effect with regard to markets.
Thus, we believe the more useful approach is to maintain a broadly
diversified investment plan customized to your specific time horizon
which can meet your investment objectives over a variety of potential
scenarios. Further, we continue
to believe that a disciplined investment approach emphasizing diligent
fundamental research, diversification, and rebalancing will provide
sound long-term investment returns.
Updated Outlook
Our outlook
for 2005 was promulgated January 27, 2005 .
We have noted that 1) our outlook was quite consistent with what
might be judged the consensus 2005 forecast at the time, and 2) the
ensuing reality is typically significantly different from the consensus
(in other words, if it’s considered a sure thing, it almost certainly
isn’t).
As we pass the mid-year point of 2005, it is clear the reality of the
U.S. dollar and long-term interest rates is rather different from the
outlook. As indicated by
the enclosures, the U.S. dollar has appreciated rather than depreciated.
Further, long-term interest rates have held steady rather than
increased. As a result,
U.S.
first half stock returns have been about on par with foreign stocks
(after adjusting for currency losses),
U.S. bonds have substantially outperformed
their foreign counterparts, and U.S.
bonds have even beaten
U.S. stocks.
Of course, these relative comparisons could flip-flop in the
second half of the year.
It remains hard to formulate a compelling argument ranking
U.S. over foreign stock
markets, but we are considerably less leery of intermediate and longer-term
bonds. Therefore, we are
adopting a market neutral stance relative to the stock/bond mix and
becoming less defensive in positioning of our bond maturities.
The reasons for the outlook can be gleaned from material in the next
section of this letter. However,
the outlook may change again soon because the Chinese yuan was revalued
upwards mildly yesterday against the U.S. dollar and progress and repercussions
of the yuan revaluation must be watched carefully.
As usual, we are assuming good fiscal and monetary policy decisions
and execution, gradual transitions, and no major external shocks to
support the overall sanguine outlook.
Economic/Market Summary
According
to the enclosed Economic Review and Market Perspective, Chairman Alan
Greenspan and the Fed successfully prevented a serious recession at
the beginning of this decade and subsequently avoided an ensuing overheated
economy, resulting in the current “soft landing” or a “Goldilocks” scenario,
wherein the economy is not too hot and not too cold.
Nonetheless, Greenspan is concerned about low long-term interest
rates, which have stayed down despite the Fed’s series of hikes in short-term
rates. That situation, which
Greenspan has called a “conundrum,” can be explained by the symbiotic
relationship between primarily Western consumers (particularly
U.S. consumers) and Asian
export manufacturers (primarily, Chinese).
It has produced a “stable disequilibrium,” meaning a non-recessionary
global economic regimen that is working despite unsustainable imbalances
is such areas as the twin U.S.
deficits, low long-term
U.S. interest rates, high levels of
commodity prices, especially oil and gas, and an undervalued Chinese
currency. If this regimen
has legs, and many believe it does, the outlook for most investments
remains positive because the “stable disequilibrium” supports, at least
for awhile, on-going low global inflation and real interest rates.
These are the two essential ingredients for stable bond prices
and stable, if not appreciating, stock and real estate values.
In spite of this sanguine outlook, the world situation remains tense.
The Iraq
insurgency shows no signs of losing strength, and just after the quarterend,
we witnessed the tragedy of the London
transit bombings. Additionally,
the quarter’s news included a host of negative factors as well, including
negligible improvement in U.S. trade deficits; high energy prices cutting
into spendable income and putting upward pressure on the general level
of prices; growing concerns about affordability and over-leveraging
relative to sky-rocketing real estate markets; and no real mergence
of economic strength outside of America, except for China and a few
other areas.
Further, in just the last few days, the Chinese revalued the yuan (modestly
upward 2.1% versus the dollar) and ended its peg to the U.S. dollar.
This change was not unexpected, but it could have significant
repercussions, including resolution of imbalances sooner rather than
later. In particular, if
the upward revaluation strengthens, Caves & Associates’ newfound
comfort level with long-term bonds will decrease significantly.
As addressed toward the end of the Economic Review and Market
Perspective, it is comforting that Fed Chairman Greenspan, relying on
history, takes the long view, which is that imbalances are inevitable,
and unwinding them is a natural process seldom leading to a crisis.
It is important to note that global economic and geopolitical issues
represent long-term challenges that need long-term solutions.
The timing and magnitude of the negative implications are unknowable,
the likelihood of any near-term negative financial impact is low, and
there is still time for corrective action.
In other words, future events are hard to predict, and it is
unclear how fast imbalances will unwind.
We expect the world to “muddle through” in the short run.
There is room for optimism, too, based on higher productivity,
upward convergence of income levels in developing countries to developed
country levels, increasing economic integration, and the resilience
of stock markets exhibited so often in the past.
What’s
Timely and Topical?
So we can
keep pace with needed work for clients, Timely Topics is on vacation
until fall.
Upcoming subjects will probably include:
1.
Tax planning could be turned on its head if we are in
higher tax brackets rather than lower in retirement.
What are the issues and implications for tactics now?
2.
In his retirement, my dad frequently complained: “Gee,
Pres, everything is so expensive.”
Do quality adjustments by the U.S. Bureau of Labor Statistics
in assembling the Consumer Price Index underestimate the real level
of inflation?
3.
A table shows, by age, how much you should have in accumulated
savings and how much debt you should have.
Are your finances on track and could soaring housing costs be
jeopardizing retirement savings?
4.
Is the Los Angeles
real estate bubble about to burst?
We asked this question one year ago and concluded speculators
beware! Well, speculators
(and just regular folks) have continued to profit, but new statistics
on plunging home affordability and the decline of “creative” financing
suggest the end of the boom is at hand (note, though, that prices may
not actually decline any time soon).
We’ll
also provide an update on the yuan revaluation, which is certainly a
timely topic.
The
Blog Department
The Blog
Department is also on vacation. If you’re interested in commentary
about a real estate bubble, and can’t wait for the next Timely Topics,
there are a number of websites you can find by entering “real estate
bubble bust” as a Google search (caution: many are selling newsletters).
Quotes
For Our Times and All Time
Warren
Buffett:
“Our favorite holding period
is forever.”
Charles
Darwin:
“It
is not the strongest of the species that survive, nor the most intelligent,
but the one most responsive to change.”
Bill
Gates:
“Is
the rich world aware of how 4 billion of the 6 billion live?
If we were, we would want to help out, we’d want to get involved.”
Ray Kroc:
“Luck
is the dividend of sweat. The
more you sweat, the luckier you get.”
George
Bernard Shaw:
“If
all economists were laid end to end, they would not reach a conclusion.”
In conclusion,
we are providing these materials for your information and as a means
to educate and stay in touch.
We hope you find this information helpful, and we would be pleased
to hear your comments and questions.
Also, you are welcome to share our views with your family and
friends if you think they will benefit.
These materials are available on our website, www.cavesassociates.net.
If you prefer to receive a quarterly email announcing their availability
on the website, rather than a hard copy, please let us know (we always
like to “save a tree” and postage costs, as well).
Thank
you for your continued support of Caves & Associates.
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