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Dear Clients and Friends,
I have enclosed your copy of Caves & Associates’ Market Review for the second quarter of 2006. The review highlights the reversal of fortune for almost all asset classes during the quarter versus quite strong results in the first quarter. U.S. stocks lost ground on concerns about continued Fed tightening, high energy costs, and increasing inflation. The weakness in bonds continued for about the same reasons that stocks declined; bonds provided essentially no return, the same as in the first quarter, as the drop in price offset the income from interest. Finally, foreign stocks and bonds outperformed U.S. counterparts due largely to currency gains on continued weakness of the U.S. dollar. 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, 2006. A second enclosure headed "Economic Review and Market Perspective" provides a longer-term interpretation of economic and market data and trends.
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. Finally, it is crucial to maintain adequate cash reserves to avoid forced portfolio liquidations at cyclical market lows, bearing in mind that such lows are unpredictable.
Updated Outlook
Our outlook for 2006 was promulgated January 27, 2006. We have noted that 1) our outlook was quite consistent with what might be judged the consensus 2006 forecast at the time, and 2) the ensuing reality is typically significantly different from the consensus because the consensus is already factored into prices at the start of the year, and inevitable departures from expectations cause divergence of actual conditions.
As we pass the mid-year point of 2006, the consensus forecasts and Caves & Associates outlook are proving to be surprisingly accurate. As supported by the enclosures, the only significant variances involve the pecking order of various U.S. equity styles: previous comparative performance divergence coupled with reversion to the mean were expected to favor larger capitalization, growth-oriented styles; instead value-oriented, smaller capitalization styles have prevailed. Of course, these relative comparisons could flip-flop in the second half of the year, and indeed were already beginning to do so in June.
Investors’ perception of risk (geopolitical and economic) has risen, but is not extreme. Liquidity continues to be gradually drained from the markets as central banks around the globe tighten. The Fed appears to be applying the right amount of braking and also appears to be sensitive to overdoing efforts to slow the U.S. economy. If so, a “soft-landing” is in the offing, at least that’s what new Fed Chairman Ben Bernanke recently reported to the U.S. Congress in a benign forecast (see below and the accompanying Economic Review and Market Perspective).
From a global perspective, desirable gradual corrections of imbalances are taking hold. As explained in the accompanying Economic Review and Market Perspective, one example is the U.S. trade deficit, which is finally showing some improvement this year, aided by a weaker dollar. Though there is still a long way to go, this improvement is defusing at least a little what many economists have regarded as a major threat to world economic and financial stability, as Caves & Associates has reported on a number of occasions in the past.
Stock markets seem to be moderately priced such that investors are either discounting only moderate future earnings growth or rising interest rates. The flat yield curve implies the former. Whether or not the global economy is at an inflection point is not clear, and the markets will be sensitive to signals and surprises in either direction. Hence, we should expect to see continued volatility. We continue to believe that a diversified portfolio with a generous amount of non-dollar securities, a judicious amount of alternative strategies, and some defensiveness has the highest probability of offering positive returns over the next several quarters.
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, former Fed 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, the world is closely monitoring the symbiotic relationship between primarily Western consumers (particularly U.S. consumers) and Asian export manufacturers (primarily, Chinese). The relationship 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, and it does not unravel too quickly, and most believe it won’t, then 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 favorable outlook, the world situation remains tense. The Iraq situation appears to be sliding into chaos and undeclared civil war, and just after the quarterend, escalating conflict began between Israel and the Lebanon-based Hezbollah. Not tense yet, but still of utmost concern, are increasing indications that global warming is real.
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. We expect the world to “muddle through” in the short run. There is room for optimism, too, based on higher productivity and technological progress, upward convergence of income levels in developing countries to developed country levels, increasing economic integration, a positive global economic outlook, 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. |
Longevity insurance: new products attempt to solve an age-old problem of running out of money in retirement. |
| 3. |
Update on identity theft prevention techniques. |
| 4. |
Community property with right of survivorship: You’ve heard about joint tenancy with right of survivorship, but with this “newish” alternative form of title now available in California, what are the advantages, drawbacks, and applications? |
| 5. |
Delayed gratification: when postponing Social Security payments is a smart move. |
The Blog Department
The Blog Department is also on vacation.
Quotes For Our Times and All Time
Peter F. Drucker
“Time is the scarcest resource and unless it is managed nothing else can be managed.”
George Elliott
“One must be poor to know the luxury of giving.”
W. Somerset Maugham
“It’s a funny thing about life; if you refuse to accept anything but the best, you very often get it.”
Benjamin Franklin
“Creditors have better memories than debtors.”
Malcolm S. Forbes
“Education’s purpose is to replace an empty mind with an open one.”
Lady Bird Johnson
“Children are likely to live up to what you believe of them.”
Dave Barry
“You can say any fool thing to a dog, and the dog will give you this look that says,
‘My God, you’re RIGHT! I NEVER would’ve thought of that’.”
Privacy of Non-Public Information
We are enclosing our annual privacy notice (see accompanying Caves & Associates Privacy Statement). Confidentiality of client information is one of our most important company values and a very high priority. Maintaining confidentiality is one of the many ways we seek to earn and keep your trust.
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.
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 July 21, 2006 and are subject to change based on subsequent developments.
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