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I
have enclosed your copy of Caves & Associates Market Review for
the first quarter of 2006. The review indicates it was a very weak quarter
for bonds. Regarding equities markets, the continuation of strong global
economics and a relatively calm geopolitical environment were enough
to overcome continuing concerns regarding rising interest rates, high
oil prices, and signs of a housing slowdown. As a result, U.S. and foreign
stocks had a very strong quarter. The backside of the Market Review
provides global returns for the first quarter of this year and for twelve
months ending March 31, 2006. The global returns provide reference points
against which to judge results for your investment accounts. For the
quarter, global diversification was both a benefit (exposure to foreign
stocks) and a bane (allocation to bonds), as usual.
The “Economic Review and Market Perspective” providing a longer-term
interpretation of current data will be presented at mid-year. Instead,
a new edition of Timely Topics is enclosed for your information. Additionally,
the Blog Department is back after a long absence; it is a separate enclosure.
The global economic expansion appears
to be gaining strength and breadth, with Japan and Europe showing positive
signs at a time when the long U.S. economic expansion may be peaking
due to the Federal Reserve’s aggressive monetary policy over the past
few years (i.e., rate increases to slow the economy). Meanwhile, dramatic
increases in economic activity continue in many emerging markets, particularly
Brazil, Russia, India, and China (leading to coining of a new acronym
BRIC).
U.S. economic reports issued during the first quarter were mixed.
On the positive side, a better-than-expected February report lifted
the three-month average for employment growth to just under 200,000
jobs. The Institute for Supply Management’s widely followed survey of
manufacturing activity also rose in February and, after a surprising
spike in January, the U.S. Consumer Price Index (CPI) and Producer Price
Index (PPI) rose only modestly during February. On the negative side,
notable declines in housing starts and building permits for February
provided evidence of a cooling housing market. February retail sales
also fell moderately, primarily due to sluggish automobile and auto
parts sales.
Outside the U.S., economic fundamentals continued to improve.
Japan’s unemployment rate fell to 4.1% in February, which was the lowest
reading since July 1998, and down from 5.5% in 2002-2003. Such improvements
have prompted speculation that the Bank of Japan may move to increase
short-term rates for the first time in over five years. Meanwhile Euro
Zone sentiment reached its highest point since mid-2001.
The U.S. consumer remains the key driver of the U.S. economy, dwarfing
business investment and housing. Consumer spending has increased for
52 consecutive quarters dating back to the fourth quarter of 1991 –
the longest spending binge in U.S. History. Yet, this streak is threatened
by multiple negative influences. These include:
| 1. |
The
U.S. Consumer is overextended. Both debt load and debt servicing
costs are at all time highs (see Timely Topics and the Blog Department
for related commentary). |
| 2. |
The
cost of servicing this debt has increased as interest rates have
risen. For example, borrowing rates on home equity loans have increased
from about 4.7% in 2004 to just under 8% today. |
| 3. |
Americans
are paying much more at the pump. They spent approximately $130
billion more on gasoline and home heating oil in 2005 than 2004.
Clearly, so far in 2006, this drain on disposable income is continuing
and increasing. These higher energy costs are in effect higher taxes
diluting consumers ability to purchase other goods and services.
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| 4. |
Home
prices are poised to decline. Although there has never been a drop
in home prices nationwide, there have been steep declines in the
past in several major metropolitan areas. Home prices in California
declined more than 30% between 1990-1995. |
| 5. |
The
correlation between net worth, meaning Americans’ balance sheets,
and consumer spending has averaged around 75% historically. If housing
prices decline substantially, the hit to consumer confidence will
likely translate into lower consumer spending. The braking of the
U.S. economy would be pronounced. |
So far
we see no reason to change our 2006 outlook, as expressed as part of
the communication dated January 27, 2006. As one would expect, some
elements of the outlook have been fairly accurate. In fact, most are
on target so far. For a few others, particularly the relative performance
of large capitalization versus small capitalization U.S. stocks, 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 2006 forecast, and 2) the ensuing
reality is typically significantly different from the consensus.
As you know, Caves & Associates 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.
What’s Timely and Topical?
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 possible
underreporting of inflation, a key economic factor that can derail even
a good financial plan; educating children (and grandchildren) about
money; and the impact of soaring housing costs on savings for retirement.
Could it be that an over application of hedonics in February led to
only a modest increase in the reported CPI, as indicated above? (Don’t
take me too seriously, but please read Timely Topics)
The Blog Department
As you may recall, the Blog Department is our occasional
expression of opinion. Whereas Timely Topics may involve some disagreement
among experts, its primary purpose is to educate in the realms of financial
planning and wealth management. The Blog Department ventures into broader
topics which may be more controversial.
The enclosed edition of the Blog Department takes a shot at behavior
of a majority of Americans. After you read it, ask yourself if our elected
representatives should establish policies and pass legislation more
of a “carrot and stick” nature to encourage our citizenry to more responsibility
insure against life’s risks and increase investments for old age.
Staff News
We are very sorry to announce that senior staff member
Valerie Trumbull is retiring. She has been a valuable member of our
analytical and portfolio reporting team. Valarie wants to spend more
time with her children and increase her commitment to their secondary
education and to Manhattan Beach civic matters. We will miss Valerie
and wish her well in this new phase of her life.
A Few Key Reminders from Previous Communications
You’re probably noticing a few common threads of Timely
Topics and the Blog Department: overspending, poor money management,
and failure to adequately prepare financially for retirement. Thankfully,
these issues don’t apply for clients of Caves & Associates, and
we’d like to keep it that way. However, they can and probably do apply
to children and grandchildren of our clients. Given that the household
savings rate in the United States is historically low, has been steadily
declining, and turned negative in 2005 for the first time since the
Great Depression, we feel a few reminders are in order.
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. Going forward, we need to be prepared for a potential “double
whammy”, when returns for bonds are weak (as they are now), and they
do not significantly 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.
Quotes For Our Times and All Time
Charles Dickens:
“A wonderful fact to reflect upon, that every human creature is
constituted to be that profound secret and mystery to every other.”
Ralph Waldo Emerson:
“Don't be too timid and squeamish about your actions. All life is
an experiment. The more experiments you make the better.”
Unknown:
“Nobody makes history by following conventional wisdom.”
Zig Ziglar:
“Goals are dreams we convert to plans and take action to fulfill.”
Paul Clitheroe:
“The amount of money you have has got nothing to do with
what you earn. People earning a million dollars a year can have no money
and people earning $35,000 a year can be quite well off. It's not what
you earn, it's what you spend.”
Josh Billings:
“A dog is the only thing on earth that loves you more than
you love yourself.”
In Conclusion
In conclusion, we are providing these materials for your
information and as a means to 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. Nonetheless, the information is of a
general nature and should not be acted upon without further details
and/or professional assistance. This letter and the enclosures, as well
as an overview of our staff, advisory philosophy, and methods, are available
on our website, 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.
There is no guarantee that the views and opinions expressed
in this newsletter will come to pass, and they are not meant to provide
investment advice. These views are as of April 27, 2006 and are subject
to change based on subsequent developments.
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