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Dear Clients and Friends,
I have enclosed your copy of Caves & Associates’ Market Review for the third quarter of 2006.
The review highlights solid results for all asset classes during the quarter versus widespread negative results for the previous quarter. The third quarter recovery combined with strong first quarter returns to produce year-to-date results through September 30th about equal to historical averages. Only energy and other natural resources stocks were in the red among major U.S. sectors for the quarter. All major foreign markets except Japan also provided positive returns, and bonds finally had their first good quarter of the year, aided by the Fed’s refraining from raising interest rates at its August meeting for the first time in more than two years.
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, 2006. 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 an educational Wall Street Journal article are enclosed.
Counterintuitive aspects of global financial markets were illustrated in the third quarter in a number of ways. A year ago, we reported heightened risk-taking by investors in the summer of 2005 notwithstanding extremely disturbing external events such as the terrorist attack in London, two devastating hurricanes in the U.S., and sky-rocketing energy prices. By contrast, this summer there were no significant geopolitical shocks (I’ll discount the North Korean declared nuclear test in early October and the continuous drone of bad news in Iraq and Afghanistan), and oil prices declined significantly during the quarter. Though third quarter 2006 markets moved upward similarly with last summer, they exhibited a considerable tendency toward for quality over risk-taking. Thus, investors favored bonds. Further, they bought the stocks of large, established U.S. companies having lower growth expectations rather than the stocks of companies with shorter earnings histories and higher expectations of earnings growth. In conclusion, the more benign geopolitical situation lead unexpectedly to less rather than more risk-taking and investors favored the reliable over high growth expectations that could disappoint.
It also seems counterintuitive that stock markets would recover upon evidence of economic slowing. The probable explanation if that stock price decreases of May, June, and early July were largely a result of uncertainty about the Fed’s actions and distrust in the Fed’s ability to engineer a “soft landing” (economic moderation without recession). Much of the uncertainty was removed when the Fed recognized the slowing and, indeed, held rates steady in August. It is also worth a reminder that stock market valuations are predicated not on current conditions but on the outlook in 9-12 months.
As was widely anticipated, the U.S. housing market rolled over, and is now clearly weakening. For instance, the most recent measures of both housing starts and new houses sold dropped 20% from one year ago. In addition, the year-over-year change in the median price of houses sold in the U.S. dropped in August for the first time in ten years.
As usual, there are a multitude of factors to consider, and market and economic indications are mixed. Thus, we’ll leave further analysis to just after the yearend, as noted above. Nonetheless, I’ll note again that risk-taking has been 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 U.S. and foreign equity 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.
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 an analysis of a very important Social Security decision, namely when to begin receiving retirement benefits. The analysis is titled “Delayed Gratification” and was adapted from an article by financial columnist Jonathan Clements of the
Wall Street Journal. By the way, 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 describes a tax change detrimental to custodial accounts and a few ways to mitigate the tax increase.
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 (in other words, if it’s considered a sure thing, it almost certainly isn’t).
Through three quarters, economic and market results are tracking quite closely to the January outlook. Therefore, we have made no adjustments to portfolio strategy.
As usual, we are assuming good fiscal and monetary policy decisions and execution, gradual transitions, and no major external shocks to support the guardedly optimistic outlook.
Heading into the final quarter of 2006, there is general disagreement as to whether the breaking of the housing bubble will have a significant effect on consumer spending or the economy in general. As a consequence, there continues to be uncertainty about whether or not the economy will remain in a slow growth mode (“soft-landing”) or will continue weakening into a recession. The yield curve inversion implies a recession, the rapid pace of the housing decline has surprised many, and the Fed has not always been able to manufacture a soft landing. The good news is that as the markets try to decipher whether the economy is slipping into recession or achieving Goldilocks equilibrium, the expectations priced into stocks are quite modest. Hence, any confirmation of strength or positive surprise should be well rewarded. Furthermore, in the absence of geopolitical shocks, the global economy appears to be improving. Another positive factor is retreating energy prices which should impact the economy favorably, particularly with regard to consumer spending. Conversely, as we move into election season, increasing uncertainty will likely restrain valuations. Finally, will energy prices stay down, and what direction will U.S. monetary policy take?
As you can imagine, the answers to these questions will not come easily. Thus, it is fair to say that much uncertainty remains and will likely 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.
Enclosed Wall Street Journal Article
In addition to Timely Topics, we have enclosed an article on the sad and sensitive topic of dying. As we experience another year growing closer to an end, we are reminded that all things cease in time. The passing of a loved one is never easy to cope with; however, it is important to recognize and accept our own mortality as a significant part of the life cycle. The article has much it can teach us from a number of perspectives, including young children’s. As with financial planning, preparation can make events go smoother. Finally, the article describes a number of recommended books for reference.
The Blog Department
The Blog Department remains on vacation due to time constraints. Various “controversial” topics continue to 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; political corruption; failed strategies in Iraq and Afghanistan; and the decline of honest debate and dialogue. The Blog Department might also note that Congress has been quite fickle when it comes to tax advantages for college savings. Decades ago (I’m not sure Caves & Associates was yet in business), Congress instituted what was deemed the “Kiddie Tax” aimed mainly at custodial accounts. The new rule made it harder to transfer income to minors for college savings. Then in the late 1990’s, Congress enabled so-called Section 529 college savings plans, which contained huge tax advantages involving transferring income to minors. Billions has flowed into these plans, which notably are not limited to lower-earning U.S. families. Finally, Congress reversed course recently by increasing the “Kiddie Tax” on custodial accounts while leaving the much more advantageous Section529 plans untouched. What was Congress thinking? In a “blog mode,” we’ll guess that lots of expensive earmarks needed funding (earmarks are pet projects for Congressional home districts to keep an incumbent in office). Please read about the “Increased Kiddie Tax” in Timely Topics for a fuller explanation.
Quotes for Our Times and All Time
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 Emerson Fosdick
“Don't simply retire from something; have something to retire to.”
John Muir
“God has cared for these trees, saved them from drought, disease, avalanches, and a thousand tempests and floods. But he cannot save them from fools.”
Albert Einstein
“When you are courting a nice girl an hour seems like a second. When you sit on a red-hot cinder a second seems like an hour. That's relativity.”
Mark Twain
“There is no sadder sight than a young pessimist.”
Mother Teresa
“Peace begins with a smile.”
Andy Rooney
”The average dog is a nicer person than the average person.”
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. The information is of a general nature and should not be acted upon without further details and/or assistance.
This letter and the enclosures, advisory philosophy, and staff overview 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 way to initially make our acquaintance.
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 23, 2006 and are subject to change based on subsequent developments.
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