2005 Third Quarter Market Review and Timely Topics

October 25, 2005

By Preston S. Caves, CPA, CFA, MBA

I have enclosed your copy of Caves & Associates’ Market Review for the third quarter of 2005.

The review highlights the surprisingly strong results for many asset classes during the quarter versus weak results for the first half of the year. Perhaps more than usual, results varied significantly from best to worst. Energy stocks provided stellar returns generally in excess of 20% for the quarter. Foreign stocks were also strong performers. On the other hand, many categories of bonds sank into the red again after recovering in the second quarter. The backside of the Market Review is a table of global investment returns for the third quarter and nine months year-to-date ending September 30, 2005. The global returns provide reference points against which to judge results for your investment accounts. The semi-annual enclosure "Economic Review and Market Perspective," which provides a longer-term interpretation of economic and market data and trends, will be presented in January. Instead, Timely Topics and a fine Wall Street Journal article are enclosed.

During the third quarter: terrorists attacked London; China revalued the yuan and moved to break its peg versus the U.S. dollar; two devastating hurricanes hit the U.S.; crude oil prices rose to nearly $70 per barrel; unleaded gasoline prices rose an additional 40%; and a U.S. hedge fund collapsed, and its proprietors were charged with fraud. Despite these significant and dramatic events, most stock markets posted gains during the quarter. Indeed, U.S. investors appeared to increase their risk appetite, as shares in the more aggressive portions of the market did especially well. Foreign stocks were led by emerging markets’ shares, another risky asset class. This risk-taking was rewarded, and broadly diversified investors achieved decent single digit returns year-to-date, returns that were largely in direct proportion to the extent of exposure to energy industry securities.

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. We’ve chosen to provide the enclosed Wall Street Journal article because it describes and supports this approach.

What’s Timely and Topical?

We remain committed to continuing education as well as keeping abreast of anything with a significant impact on your wealth management. Please see the enclosed Timely Topics for in depth information about a new challenge for seniors: choosing a Medicare prescription drug benefit. (We hope non-seniors will benefit by our discourse; for example they may be asked to help their parents on the subject). Timely Topics also includes brief highlights about a number of other topics.

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).

At mid-year, we adjusted the target stock/bond mix to “market neutral.” We are retaining that stance at this time, even though we remain concerned about bonds. As we pass the three-quarters point of 2005, results for stocks are converging somewhat with the January 2005 outlook after diverging considerably at mid-year. The largest discrepancy continues to be year-to-date appreciation of the U.S. dollar rather than depreciation. Nonetheless, numerous fundamentals suggesting future dollar weakness remain in place, particularly continuing high twin U.S. deficits (trade and budget).

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.

As you can imagine, the answers to these questions will not come easily. Thus, it is fair to say that this much uncertainty may lead to more volatility in the capital markets in the period ahead. Our belief is that such volatility is a byproduct of an ever-changing and uncertain world, and should not be feared or avoided. Often, some of the best investment opportunities can be created during periods of increased volatility.

Additionally, 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. 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 as well as the latest quarter.

Enclosed Wall Street Journal Article

I’ve told a few of you that I just love Jonathan Clements, Wall Street Journal columnist. Well, make that “like”, so my wife won’t get concerned, and add respect for the quality and “correctness” of his weekly columns. And also add tremendous gratitude, because he inevitably confirms my views, and articulately, on various financial planning matters, and especially portfolio construction. I’ve decided to provide a transcription of his entire October 12th column.

I’ve enclosed Jonathan’s article because it demonstrates our defense-oriented thinking at Caves & Associates, namely, hope for the best, but plan for the worst. For football fans, you might relate to the frequently touted analysis that good defense beats good offense, that high-scoring teams get stopped in their tracks and beaten by their own mistakes. For baseball fans, the old adage paralleling our philosophy is good pitching beats good hitting. Those of you on board in 2000-2002 saw the benefits of our broadly diversified portfolios, which held value quite well during the bust of dot.coms and the tech wreck. Notwithstanding the proud tone of these words, no overconfidence for us! (This last sentence is a reference to Jonathan’s article; if you haven’t read it yet, please do so).

The Blog Department

The Blog Department remains on vacation due to time constraints. Various “controversial” topics begging for attention include the growing inequality in the U.S. (we certainly don’t seem to be delivering the American Dream, our public schools are failing, etc.); the need to find ways to pay for our deficit spending; the excesses of special interest lobbying; spiraling medical costs; and the polarization of politics and the overall American citizenry.

Quotes For Our Times and All Time

Noel Whittacker:

“The property boom has made us all feel wealthy, but unfortunately it has lulled many of those nearing retirement into a false sense of security.”

Ralph Waldo Emerson:

Thank you for your continued support of Caves & Associates.

There is no guarantee that the views and opinions expressed in the newsletter will come to pass, and they are not meant to provide investment advice. These views are as of October 18, 2005 and are subject to change based on subsequent developments.