Market Perspective Full Year 2006 And Outlook

As noted previously, value stock returns should equal or exceed growth stock returns, and small cap returns should equal or exceed large cap returns in the long run. 

Healthcare and technology were the worst performing sectors at 5.8% and 7.7% respectively. The energy sector was very volatile during the year but ended 2006 as one of the best performing sectors at plus 22% approximately. Further, REIT’s and other real estate securities were top performers in 2006 and had very good results for the seventh year in a row. Returns were approximately 21 percentage points above the average diversified U.S. equity mutual fund. They were also an astounding average per year of over 16 percentage points above the diversified stock average over the latest five years because REIT’s and other real estate securities actually had positive returns during the 2002 market nosedive (in fact, REIT’s and other real estate securities actually had very positive results during the entire 2000-2002 bear market).

In 2006, the strong returns for broad, capitalization-weighted market indexes were indeed representative of performance at the level of individual stocks. For the three U.S. stock exchanges combined, 5,376 stocks advanced and 2,272 stocks declined. The corresponding advance/decline ratio of 2.37 lands in about the top quarter of the 17-year period we have been tracking. The history of the advance/decline ratio for 1990-2006 is shown in the following table returns for the equally weighted version of the Wilshire 5000, a broad market indicator, are included to aid in calibrating the data shown for the advance/decline ratio.

* Mutual fund return data are from Morningstar.
** Capitalization-weighted index of 500 very large U.S. companies. The 500 are chosen to achieve a fair 
cross-section of U.S. industrial and service sectors. Recent median capitalization of approximately $53 billion.
# Index of small U.S. companies. Recent median capitalization of approximately $1,025 million. Somewhat 
overweighted toward financial stocks.
## International stock index indicating return of large foreign companies of 21 major developed countries (Japan, 
UK, and Germany have the highest weightings). Returns are unhedged and converted to U.S. dollars. No emerging 
market stocks are included.

Stock Fund Managers Versus Indexes

For only the second year out of the last eight, active U.S. stock pickers were beaten by the S&P 500 Index. This 
result was particularly surprising given that small caps, which are usually favored by stock pickers and typically 
comprise a higher allocation of fund portfolios than found in market indexes, had stronger results than large caps for 
the year. A detailed explanation is beyond the scope of this review, but we observed during 2006 a considerable style 
drift among active managers toward larger capitalization stocks and toward more growth-oriented stocks. This drift 
hurt results because the adjustments were away from what turned out to be better performing stocks (we noted 
several pages earlier that value beat growth in 2006 and small beat large). Regarding the drift toward larger caps, 
managers were probably letting their winners run, at least to some extent, to minimize tax and transaction costs (a 
stock’s capitalization increases about in proportion to the appreciating stock price, so an up market tends to push 
small-cap stocks into the mid-cap range and mid-cap stocks into the large-cap range). As for the drift toward growth 
stocks, this probably reflected a number of factors. Two main factors were 1) in hindsight, managers were misled by 
consensus forecasts going into 2006 that growth stocks, particularly technology, were positioned to outperform, and 
2) because of outsized and seemingly unsustainable gains early in 2006 plus in prior years, managers took profits 
prematurely in their value-oriented real estate and energy stocks, which ended 2006 strongly. Finally, an obvious, 
perennial factor explaining underperformance by stock pickers is fees for management of typically 1-2% per year 
versus zero cost for indexes.

For 2006, the average diversified foreign equity mutual fund underperformed the MSCI-EAFE index by about 1.3%. For 
the five years ending December 2006, the foreign fund annual average provided an improved comparison but was still 
below the index by approximately .2%

Alternative Strategies

The five funds we used during most of 2006 provided a combined return of about 8.7% for the year, above the returns 
for all but very aggressive bonds but below those for U.S. and foreign stock fund averages. For a typical Caves & 
Associates portfolio, the inclusion of alternative strategies produced a decrease in 2006 return of about .3-.6% (30-60 
basis points) but an increase in stability due to low correlation of results with stock and bond markets. It should be 
noted that alternative strategies are particularly effective in down markets. However, markets were strongly up in all 
but the second quarter of 2006, which was indeed a time period when alternative strategies had a notable positive 
impact on returns of client portfolios.

The five funds generally underperformed versus results for indexes of hedge fund performance compiled by Credit 
Suisse/Tremont. More specifically, one fund outperformed an index for hedge funds with a comparable approach, and 
one was about on par with its comparable Tremont index. The range of underperformance for the other three was 
from 6-8 percentage points for the year. Reasons for the underperformance were considerable noncomparability 
versus the Tremont indexes and performance-enhancing leverage employed by many funds included in the indexes. 
Additionally, the Tremont indexes have an upward bias due to reporting peculiarities of hedge funds, but some of the 
underperformance of Caves & Associates alternative strategies funds must be attributed to subpar execution by 
management and unique characteristics of two of the funds. Returns for one of the two stock-oriented strategies 
were seriously below the broad market and the roughly comparable Tremont index due to the defensive nature of the 
strategy employed, which is designed to be measured from market peak to market peak, in other words, over a full 
market cycle. Its results were solidly positive during the 2000-2002 bear market, but it has lagged rather dramatically 
during the current four-year bull phase. Finally, the other lagging fund was hurt during the first half of the year by its 
exposure to Treasury Inflation-Protected Securities but rebounded during the second half.



Fixed Income Review

It was a tale of two bond markets in 2006. In the year’s first half, the Federal Reserve continued to push its target 
interest rate higher, pressuring bond prices across the maturity spectrum. The average short-term bond fund 
delivered a small gain, but the average intermediate- and long-term funds posted small losses. However, the Fed took 
a breather in August to assess the impact of its 17 rate hikes, and the bond market rallied over the ensuing months as 
the Fed’s pause seemingly turned into a full stop.

Overall in 2006, U.S. bonds earned mid-single digit returns, made more palatable because returns improved as the year 
went on. The Lehman Brothers U.S. Aggregate Bond Index rose 4.3% versus a gain of 2.4% in 2005. Aided by 
currency gains, unhedged foreign bond investors found generally superior results. They earned 6.9% as measured by 
the Citigroup Non-U.S. World Government Bond Index. Finally, high yield bond mutual funds averaged a much higher 
return of 10.1% in 2006, reflecting the usual correlation with U.S. equity results and investors’ positive outlook and 
comfort with much reduced risk premiums. 

The U.S. bond market was sending mixed signals as the year drew to a close. The yield curve for Treasury bonds has 
been inverted since mid-July, an unusual phenomenon because investors commonly require higher returns to 
compensate them for holding assets over a longer period. The inverted yield curve usually signals the possibility of an 
economic recession, or at least slower expansion, and increases the likelihood of the Fed lowering short-term rates to 
increase economic expansion. On the other hand, the corporate bond markets have been very healthy. Corporate 
bonds have been trading at levels that indicate the economy will continue to grow and enable companies to earn 
healthy profits. Corporate default rates are also near their historical lows and yield spreads between Treasuries and 
high yield corporate bonds have narrowed considerably over the last year. 

Home mortgage rates were supportive of housing prices. After moving up moderately for the first half of the year, 
they too declined when the Fed ended its rate increases. Thirty-year fixed rates ended 2006 at 6.23%, down slightly 
form the end of 2005.

The following table below and footnotes on the following page present fixed income results:

Key Issues and Outlook for 2007

We don’t favor market predictions, especially in absolute terms. As you know, we argue that the future is 
unknowable. The interplay of socio-economic and geopolitical factors is just too complicated to predict. Thus, we are 
against trying to time the market. However, we will identify factors and issues that are important in 2007 and beyond. 
These are typically historical macroeconomic waypoints and trends which can help us narrow the range of potential 
outcomes in the future. Examples involve such key factors as global economic strength, energy consumption and 
price trends, Chinese currency policy, and the level of foreign investment in U.S. assets that allow us to finance our 
on-going balance of payments and Federal budget deficits (also known as the twin deficits). Thus, we will venture a 
general outlook and some comments regarding relative performance.

To save time, we are presenting a condensed version this year. The reader is referred to last year’s outlook for 
expanded analysis and discussion of key issues.

The first key issue is the strength of the U.S. and global economy, an important issue every year. The future course 
of the global economy and the outlook for corporate profits will have a significant impact on global stock and bond 
markets. In particular, will the “salad days” for U.S. and foreign corporations continue? Also, is the slowdown in the 
housing market over, or will it deepen and seriously dampen U.S. economic activity? Further, whether the U.S. 
economy achieves a “soft landing” and the future strength of foreign economies depends to a considerable extent on 
the moves of the various central banks, including the Fed, EU, and Chinese authorities. Finally, the global 
ramifications of China’s currency policy and stupendous economic growth are a major factor in evaluating the outlook 
for 2007 and beyond. Will “stable disequilibrium” continue such that China remains a big facilitator of U.S. deficit 
spending, which has substantially mitigated downward pressure on the dollar and upward pressure on U.S. interest 
rates. In conclusion, the Chinese economy must remain strong for continuing health of the global economy. 

The second key issue for 2007 is the direction of the U.S. dollar. If the greenback continues depreciating, unhedged 
U.S. investors will enjoy currency gains as occurred in 2006.

The outlook for interest rates and the shape of the U.S. yield curve are again significant issues heading into 2007. A 
real difference of opinion about future moves by the Fed has developed as the U.S. economy has shown surprising 
strength. Could there possibly be further increases in short term rates in 2007? On the other hand, as the borderline 
inversion of the yield curve suggests, will rates come down?

We also have to mention the challenging geopolitical situation. This of course includes the tenuous situation in Iraq, 
possible additional civil wars in the mid-east, and the heightened tension over nuclear proliferation, now in Iran, and 
on-going in North Korea. Domestically, will partisan “warfare” erupt in Washington, D.C. over the Iraq war strategy 
and domestic policy issues now that the Democrats (tenuously) control Congress? 

The final key issue (every year) is the level of inflation and resource usage worldwide. To a large degree, these levels 
will determine the fate of tangible asset prices and in turn the returns of real estate and energy funds and inflation 
indexed bonds. The inflation rate also impacts the financials sector as well as the broader markets for stocks and 
bonds. The issue hinges on 1) successful tightrope-walking by the Fed and other central banks, as discussed last 
year, and 2) a balance between the mitigating impact of low cost manufactured goods from emerging economies 
versus the multiple upward pressures on prices globally.

In considering these very difficult, interrelated issues, we are swayed, as usual, by what history reveals, namely, that 
economies and markets are cyclical and seek equilibrium and that investment results regress to the mean. Therefore, 
historical patterns and averages will ultimately prevail. Keeping in mind the historical perspective and many favorable 
long-term secular trends, here is a summary of our 2007 outlook, which is really just an educated guess; if you desire 
additional details, please call:

1.  The global economy seems to be on solid footing and equity valuations are not extreme, which leads one to 
   believe that there is fairly strong upside potential in various stock markets. The primary factor restraining valuations is 
   the legitimate concern that companies will not improve or even sustain the profit growth they have achieved over the 
   past few years. The trend has already far exceeded most profit expansions and would be particularly vulnerable if the 
   U.S. economy’s landing is not soft. While there remains the possibility that the U.S. economy could slide over the 
   edge, we believe this is unlikely. From a historical standpoint, we seem to be quite overdue for a reasonable (10%+) 
   stock market correction. Nonetheless, trying to predict or trade around it is unwise.

2.  Inflation will stay contained and corporate profits will remain strong as corporations worldwide 
   continue/increase their access to low labor costs in emerging economies such as China and India. In other words, the 
   ongoing globalization of production and distribution capabilities respecting an ever-broadening array of goods and 
   services suggests that the secular reduction of the world economy’s inflation propensities that emerged over ten years 
   ago remains in force.

3.  With inflation contained, U.S. interest rates and the shape of the yield curve will be little changed during 
   2007. A few rate cuts by the Fed are possible toward yearend but will have little effect on U.S. fixed income returns. 
   With investment grade yields remaining low, we expect continued unexciting but positive total returns for most bonds, 
   but the risks of a bond debacle are also low. 
   

4. The outlook is again good for foreign stocks and bonds as a result of reasonably solid economic and market 
   conditions, lower valuations compared with U.S. securities, and a reasonable opportunity of currency gains.

 

As usual, we have found it difficult to develop an outlook for the coming year. We have limited time and resources for 
the relevant research. Also, the outlook makes a number of assumptions which may prove incorrect. The outlook 
puts considerable faith in sound decision-making by government officials! Additionally, you may have noticed the 
outlook is very similar to last year’s. Finally, it selects certain factors for emphasis which may prove to be wrong.

Over and over again, we have seen the unreliability of short-term economic and market forecasts and the 
unpredictable nature of markets. As usual, geopolitical risks could wreak havoc with these predictions, and there is 
always the risk of the totally unexpected. If the concerns expressed below manifest themselves earlier than 
expected, results in 2007 could be considerably worse, or at least different, than indicated above.

Beyond 2007

As for the outlook beyond 2007, we have the same increasing concerns expressed in previous years. The first 
concern stems at least in part from a long career in finance advocating living within one’s means and saving for both a 
rainy day and retirement security. We believe the tax-cut and deficit spree of the last several years, which have 
juiced up the economy, will exact a price in later stagnation. At present, there seems to be no end in sight to U.S. 
deficit spending. The various potential remedies for our growing debt levels and trade deficits are tax increases, 
spending cuts, and higher interest rates, in some combination. These remedies will all inflict pain, pain which we are 
currently deferring. Further, as some 77 million baby boomers begin to retire this decade, U.S. Social Security and 
Medicare will begin to move into the red as well, eventually by trillions of dollars. Some analysts predict no pro-growth 
strategy can make up such shortages and warn that mounting U.S. debt jeopardizes global financial stability. 

Just last week Fed chairman Bernanke delivered a stern warning to Congress addressing the national debt, saying 
spiraling government spending could lead to a vicious cycle of even bigger federal budget deficits. “The longer we 
wait, the more severe, the more draconian, the more difficult the objectives are going to be” in responding to the 
crisis, he said. “The right time to start was about 10 years ago.” Although the federal budget deficit reached a 
four-year low of $248 billion last year, Bernanke called it “the calm before the storm” given the projected growth in 
federal spending. The Congressional Budget Office is projecting a $286-billion deficit this year; the White House 
estimates it at $339 billion.

The second concern stems from the global imbalance of aggregate demand and investment versus saving. We have 
exported some of our strong demand for products and services to bolster the world’s economy, and foreigners have 
returned the favor by deferring their consumption and increasing their savings to offset our lack thereof. How long 
this “co-dependency” or “symbiotic relationship” can last is one of the larger long-term uncertainties facing the global 
economy. 

Implications for Asset Allocation

Because an outlook is to a considerable degree an attempt to have a crystal ball, the prognostications need to be 
discounted or even completely ignored. Accordingly, we plan to maintain stock and bond allocations approximately at 
long-term targets and avoid making active bets, as usual. We plan to keep bond maturities shorter than normal. 
Because bond investors are not being adequately compensated for the risks born, we also plan on maintaining an 
allocation to cash. We will also attempt to profit from a declining dollar. We are bullish on oil and gas for the long run 
so we will maintain positions in tangibles stocks. 

Relevance of Market Review and Outlook for the Strategic Allocator

Before concluding, let’s address the relevance of a review and outlook and clarify why we are planning only fine-tuning 
and not major allocation changes, as follows:

1. Asset allocation is a long-term approach utilized to manage long-term money according to long-term 
historical evidence. Asset allocation defined in this manner requires a disciplined adherence to a relatively fixed asset 
mix. It is also quite contrarian, because when an asset class proportion declines due to relatively poor performance, 
the asset allocator buys more. Hence, asset allocation entails periodically selling your winners and buying your losers 
to maintain the strategic balance. This rebalancing is done periodically and “religiously” and is definitely not “market 
timing” or “chasing performance.” Therefore, near-term outlooks are of little interest to the strategic asset allocator.

2. An outlook is really a best guess over 6-18 months, which is not a long-term period. Thus, most outlooks 
support tactical maneuvering for short-term gain. Most outlooks are also trend following, not contrarian. It is human 
nature to expect continuation of recent trends. It takes a brave soul to predict a reversal. We try to develop our 
outlook to avoid this common problem, but we are human, too. 

3. As described in the Outlook Scorecard section below, our outlook is not too reliable. Thus, it is not a sound 
basis for big bets. We could make cohesive, plausible arguments for predictions that would be both much more 
negative and much more positive than those above.

4. Caves & Associates prepares a market review so we do not blindly follow history or ignore the markets. We 
also stay abreast of the latest research that might shed new light on historical bases for portfolio design. We monitor 
market trends, but mainly to be able to properly evaluate mutual fund managers’ performance and explain the 
performance of client portfolios. Finally, we prepare an outlook because the exercise has a small possibility of allowing 
us to foresee major problems requiring extraordinary strategies. Thus, it's prudent, and part of our responsibility to 
clients.

Outlook Scorecard and Impact on Results

Last year was the eighth time we attempted something resembling an outlook. A scorecard is in order to see if we are 
gaining anything from the effort. 

Our past report cards have been generally favorable: we have had more predictions right than wrong, and our errors 
have not been harmful to returns. Fortunately, we can say the same for our 2006 outlook.

Last year, we made eight main economic and market predictions. Each year one major surprise lurks. In 2004, it was 
the surprising strength of U.S. bonds. In 2005, it was the surprising strength of the U.S. dollar. Again there were 
surprises, and as a result, two of the eight 2006 predictions were off the mark. One, of course, was the predicted 
“positive but unexciting” returns of U.S. stocks, which were forecast to be below historical averages; in reality, U.S. 
equity returns were significantly average. Additionally, in the same paragraph, we predicted corporate earnings 
would weaken in view of probable housing market weakness. Though housing did weaken, corporate earnings in a 
surprise to many economists, continued to be extremely strong. The other wrong forecast was the indication larger 
capitalization, growth-oriented U.S. securities would outperform smaller capitalization, value-oriented stocks. This 
forecast did not come to pass, as the latter continued their long winning streak.

The other six predictions for 2006 essentially came to pass. It could be quibbled that bond returns by maturity were 
not quite as predicted, but they generally did favor shorter maturities, and core inflation was in the predicted range, 
but total inflation was not (it was lower than the 3-4% range indicated in the outlook.

Portfolio strategies were largely successful in 2006. During the year we removed the partial hedge of the international 
bond position, thus enjoying the currency gains for unhedged international bonds. Additionally, overweighting of 
international stock positions was particularly beneficial. Further, during the year we underweighted U.S. bonds 
because we were unexcited about their prospects. Thus, our underestimate of results for U.S. stocks did not in any 
way hurt portfolio results. Further, we retained most of our usual overweight of U.S. value stocks for most of the 
year and compensated for style drift toward larger capitalization growth stocks by several mutual funds held in client 
accounts by appropriate rebalancing. Finally, for the first time in our firm’s history, we established a tactical cash 
position. Returns for cash were slightly above investment grade intermediate-term U.S. bonds, and client accounts 
were exposed to substantially less risk. 

In terms of unfavorable portfolio strategies, our use of alternative strategies for diversification did hurt results because 
they lagged considerably, as described above. Additionally, during the year we kept our tangibles allocation at or 
above target, but we revised the composition of the tangibles allocation to increase oil and gas and decrease real 
estate securities. The former was generally favorable, but we were premature in reducing the real estate weighting 
(as with most of our moves, the reduction was rather modest).

Finally, mutual funds we employ in client portfolios remained highly rated by and large. As evidence, Morningstar has 
just named its 2006 managers of the year (Morningstar is highly regarded for its mutual fund databases and mutual 
fund ratings). Essentially, all Caves & Associates clients own Morningstar’s 2006 domestic equity fund of the year and 
runner-up international equity fund of the year. Many Caves & Associates clients also own the runner-up 2006 bond 
fund of the year (not all clients own this fund because it is quite aggressive).

We believe the scorecard highlights why we recommend strategic asset allocation rather than tactical allocation or 
market timing. Over the long run, we are convinced that correct predictions will be largely offset by incorrect 
predictions, especially when the predictions have to deal with such a broad scope as global stock and bond markets. 
Thus, the effort adds little or no value but can reduce returns by increasing capital gains taxes, transaction costs, 
and management fees if the effort induces a short-term, tactical approach.