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I
have enclosed your copy of Caves & Associates’ Market Perspective
Full Year 2005 and Outlook. The review of 2005 highlights: 1) continuing
global economic improvement but some increase of inflation caused by
surging prices for oil and gas, 2) mixed results for stock prices around
the world, including strong results overseas on average, but lackluster
returns for most U.S. equities other than energy and real estate-related
stocks, and 3) disappointing returns for bonds as a result of the Fed’s
aggressive increases of short-term interest rates in the U.S., the threat
of inflation, and retrenchment after a bond bull market for the previous
five years. Additionally, the review provides information on five-year
returns for perspective. The key observation is that global stock markets
shrugged off hurricanes and tsunamis, continuing threats from world
terrorism, and mounting deficits in the U.S. and provided reasonably
solid returns to the globally diversified investor.
This past year saw a new set of external shocks to replace those experienced
previously. In 2001 we endured the terrorist attacks of September 11th
and war in Afghanistan. In 2002 we faced continued unrest in Afghanistan
and the Middle East, plus corporate scandals, major bankruptcies, challenges
to Wall Street’s integrity, and the Iraq and North Korea crises. In
2003 we saw the dramatic decline of the dollar, mutual fund scandals,
accounting scandals, and the beginnings of an escalating insurgency
in Iraq. In 2004 geopolitical rumblings continued with the terrorist
attacks in Spain and defiance in Vallejo, and the world witnessed the
terrible disaster of a tsunami in southern Asia at the end of the year.
The main event not likely on investors’ minds in January 2005 was the
extensive, weather-caused destruction of major parts of New Orleans
and nearby Gulf Coast areas. Additionally, investors could have hoped
for better news out of Iraq, Iran, North Korea, Russia, Tel Aviv, and
the Doha Round of world trade talks. As usual, forecasters were confounded
by the unexpected. For 2005, the biggest surprise was the rebound of
the U.S. dollar after three years of decline. While at least some of
these events were (hopefully) nonrecurring items, one can only wonder
what potential disruptions and unexpected economic twists lurk for 2006.
As I have often indicated, investing in the capital markets involves
not only understanding risks that may be apparent, but also planning
for risks that are not.
I have also enclosed a Market Review
for the fourth quarter of 2005. The review indicates it was a strong
quarter for foreign stocks but a modest one for U.S. stocks and global
bonds. A tabular attachment to the review provides global returns for
the quarter and full year 2005.
Regarding the Outlook for 2006, we continue to have powerful
positive and negative forces impacting the economy and stock market,
plus continuing uncertainties of Iraq and terrorism, the emerging major
impact of China on global economics, and the increasing overhang of
government and consumer debt both here and abroad. These opposing forces
and uncertainties make it again difficult to provide definitive forecasts
for the next year. The careful reader with a good memory will note this
year’s outlook is very similar to last year’s. Our best guess is U.S.
stocks will perform somewhat below long-term historical averages, with
the best opportunities in large capitalization and growth-oriented equities
due to valuation concerns regarding small cap, value-oriented securities.
Overseas securities should provide good returns at or above historical
averages due to moderately lower valuations and expected weakness of
the U.S. dollar. In spite of the relatively poor outlook for U.S. bonds,
duration hedged positions must be maintained to offset geopolitical
risks and unforeseeable economic shocks. Additionally, notwithstanding
somewhat disappointing results in 2005, alternative strategies that
are carefully selected may well outperform in 2006 due to the lackluster
outlook for U.S. securities.
Mr. Gary Shugrue, Chief Investment Officer of a fund of hedge
funds, puts what we believe is the proper “spin” on outlooks, as follows
(emphasis added and slight paraphrasing):
After
reading many year-end letters from both hedge fund managers and
market prognosticators, I now feel qualified to expound upon the
consensus thinking for the coming year. I have been doing this
for a long time, and I am always amazed by the number of people
saying the same thing and how there is always a certain serial
correlation in their thinking. Meaning, what they think is going
to happen is never significantly different from what has just
happened. I guess it is just human nature, but very few people
ever predict anything out of the ordinary. We know that these
unexpected events are just the things we need to be on the lookout
for since the consensus is already reflected
in the prices of today’s securities. The consensus is only valuable
as a benchmark from which to identify surprises and will in
all likelihood be wrong. |
With
deference to Gary then, in all likelihood our outlook will be wrong,
at least partially.
We note that beyond 2006 the outlook is cloudy, even stormy.
Our concerns are not new and are presented toward the end of the enclosed
Market Perspective and Outlook. It is important to note that concerns
over Social Security and Medicare, the twin U.S. deficits, 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 an eventual crisis is possible.
Additionally, resolutions regarding Social Security, Medicare, and U.S.
trade and governmental deficits will take years.
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.
A scorecard at the end of the Outlook rates last year’s predictions.
It also provides an evaluation of the success of C&A's strategies
and portfolio supervision in 2005. Generally speaking, economic and
market predictions were on target and investment results were good.
The only disappointments involved international bonds, which were down
on currency losses rather than up, and alternative strategies, whose
defensiveness prevented us from participating in the full extent of
gains in areas of the markets where strength was exhibited. Overall,
we are very pleased with the results of our diversification strategies.
We have discussed our concern about market volatility in previous correspondence.
We have also emphasized the need for investor discipline. History can
be an ally in this situation. History shows that U.S. and global markets
have exhibited overconfidence in the past. There have been many cycles
during which investors became enamored with an equity theme. Compelling
reasons seemed to support the enthusiasm that often led to valuation
extremes. Ultimately, reality set in and the equity asset class underperformed
in the following cycle. Examples include U.S. small cap stocks after
the 1975-1983 run-up and international stocks after the late 1980’s
run-up. More recently, growth stocks became the latest hot asset class
to underperform significantly in a new cycle (i.e., the Internet boom
and bust). Currently, REIT’s and energy stocks may pose such a risk.
Accordingly, a life-long commitment to a diversification plan, at least
to some degree, helps to avoid an overallocation to an equity asset
class that often occurs by being tempted late in the game by earlier
impressive performance. After three years of down markets in 2000-2002,
we are grateful for the return to positive returns in 2003-2005. Nonetheless,
it is important to temper our enthusiasm with an appreciation of the
positives and negatives of the big picture.
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.
Of course, corollaries of diversification that you will also notice
are: 1) some parts of your portfolio will always be lagging the market
averages, and 2) your overall portfolio return will lag the return of
the market’s current hot areas.
What’s Timely and Topical?
We remain committed to continuing education as well as keeping
you abreast of anything crucially affecting your wealth management.
We will provide the next edition of Timely Topics on an ad hoc basis
as the need arises. Timeless topics expected to be included are as follows:
| 1. |
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? |
| 2. |
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?
How about those of your adult children? |
| 3. |
More
tips on preventing identity theft. Unfortunately, this is also a
timely topic for me, because I’ve just had two fraudulent transactions
processed by my bank against my home equity line. Who would have
thought it?! |
Some
Guidance Regarding Attainment of Long-Term Life Goals
Although the outlook for 2006 is good, numerous challenges do await
the U.S. and international community, and investment returns may be
negatively impacted. 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.
2005 IRA Contribution Deadline is 4/17/06
We would like to remind you that an annual IRA contribution
is almost always a good strategy. Congress is raising the limits, and
IRA contributions should be of interest to all taxpayers who have earned
income at least equal to the limits. Please note income from investments,
Social Security, and pensions does not constitute earned income. The
allowable contribution to an IRA attributable to 2005 is $4,000 for
anyone under 50 years of age and $4,500 for those over 50 as of the
last day of the calendar year. Accordingly, for a married couple the
2005 contribution limits total $8,000 - $9,000, depending on age. These
single and married limits are high enough to make a considerable difference
over time in the rate of after-tax wealth accumulation for all but the
wealthiest U.S. taxpayers (i.e., not a big enough impact for the really
wealthy).
There are many issues affecting tax deductibility and whether to contribute
to a traditional IRA or a Roth IRA (the latter are never tax deductible).
Your tax preparer is usually the best source for guidance regarding
IRA contributions as each individual case differs.
In summary, the annual IRA contribution is a perishable commodity: once
the deadline passes, you are out of luck for 2005. Please call us if
you have any questions not handled by your tax preparer and for any
assistance you might need actually getting your contribution into your
IRA account by the deadline.
2006 IRA Contribution Limits
For those wanting to get a jump on the 2006 contribution,
the allowable catch-up contribution increases to $1,000. Therefore,
the allowable contribution to an IRA attributable to 2006 remains $4,000
for anyone under 50 years of age but is $5,000 for those over 50 as
of the last day of the calendar year. Further, for a married couple
the 2006 contribution limits total $8,000 - $10,000, depending on age.
Contributing early in the year is a good strategy, but you must be sure
you will have earned income at least as high as your contribution.
A final
note on IRA contributions: helping a younger person who has earned income
but trouble making the contribution is usually a very good strategy
from a multi-generational planning perspective.
Need a Planning Update?
If something important has changed in your personal situation
(career, family, health, cash needs, etc.), don’t hesitate to let us
know. A significant change in your life may indicate you need a review
of your insurance, financial, or investment planning. Examples are family
matters (births, deaths, divorces, and marriages), business matters
(promotions, lay-offs, sale, and impending retirement), and significant
changes of your health or that of family members.
Quotes For Our Times and All Time
J. Paul Getty:
“I was brought up in an era when thrift was still considered a virtue.”
Alan Greenspan:
“It is decidedly not true that ‘nice guys finish last,’ as that
highly original American baseball philosopher, Leo Durocher, was alleged
to have said.”
Paul A. Volcker:
“What's the subject of life - to get rich? All of those fellows
out there getting rich could be dancing around the real subject of life”.
Paul Samuelson:
“Investing should be more like watching paint dry or watching grass
grow. If you want excitement, take $800 and go to Las Vegas.”
Harry S. Truman:
“You want a friend in Washington? Get a dog.”
Gertrude Stein:
“Everybody gets so much information all day long that they
lose their common sense.”
Goethe:
“Correction does much, but encouragement does more.”
Phil Pastoret:
“If you think dogs can't count, try putting three dog biscuits
in your pocket and then give him only two of them.”
Form ADV Available for Your Review
The ADV is our registration as an investment advisor with
the SEC. It is available free upon request. Please call if interested.
In 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. This letter
and the enclosures, as well as an overview of our staff, advisory philosophy,
and methods, is available on our website, http://www.cavesassociates.com/.
We appreciate your referrals and suggest you steer those who might be
interested to our website as a convenient and private way to initially
make our acquaintance.
The information is of a general nature and should not be acted upon
without further details and/or assistance.
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