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2006 Year-End Commentary and Planning Ideas |
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| January 30, 2007 |
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Preston S. Caves, CPA, CFA, MBA
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| Dear Clients and Friends,
The lack of major negatives was a big contributor to surprisingly good investment returns in 2006. Each year from 2001-2005 included multiple external shocks which hurt financial markets, the most severe being 2001 when we endured the terrorist attacks of September 11th. Since then we also faced continued unrest in Afghanistan and the Middle East; corporate scandals; major bankruptcies; challenges to Wall Street’s integrity; mutual fund scandals; accounting scandals; and escalating insurgency in Iraq, compounded by increasing sectarian violence; terrorist attacks in Spain and London; and the terrible tsunami in southern Asia and hurricane in New Orleans and along the Mississippi coast. The main event not likely on investors’ minds in January 2006 was the stock options back-dating scandal. Additionally, investors could have hoped for better news out of Iraq, Iran, North Korea, Beirut, the Sudan, Tel Aviv, and Afghanistan. Nonetheless, the back-dating scandal and continuing geopolitical challenges were seemingly treated as “old news” by investors who focused on the key factor of corporate profit growth and generally benign economic news. One can only wonder what potential disruptions and unexpected economic twists lurk for 2007. As we 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. We have also enclosed a Market Review for the fourth quarter of 2006. The review indicates it was a strong quarter for U.S. and foreign stocks, some U.S. indexes hit all-time highs. It was a positive but modest quarter for U.S. bonds and an above average one for overseas bonds due to currency gains. A tabular attachment to the review provides global returns for the quarter and full year 2006. Regarding the Outlook for 2007, 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 that for the last two year’s. Our best guess is U.S. stocks will perform at about long-term historical averages, with increasing risk as the year progresses if the U.S. economy or corporate profits falter. Overseas securities should provide good returns at or above historical averages due to moderately lower valuations and expected continued weakness of the U.S. dollar. In spite of an unenthusiastic outlook for U.S. bonds, duration hedged positions must be maintained to offset geopolitical risks and unforeseeable economic shocks. Additionally, alternative strategies in moderate doses should provide upside versus bonds and downside protection if an overdue U.S. equity correction develops. Last year we quoted the cautionary comments of Mr. Gary Shugrue, Chief Investment Officer of a fund of hedge funds, on outlooks. To reiterate and summarize, he criticizes the number of people saying the same thing and how there is always a certain serial correlation in their thinking, meaning what they project is never significantly different from what has just happened. Further, since the consensus is already reflected in the prices of today’s securities, it is the unexpected and very hard to predict events that will determine the future direction of prices. Accordingly, the consensus will in all likelihood be wrong. We note that beyond 2007 the outlook is cloudy, even stormy. Our concerns are not new and are presented toward the end of the enclosed Market Perspective and Outlook. A scorecard at the end of the Outlook rates last year’s predictions. It also provides an evaluation of the success of Caves & Associates’ strategies and portfolio supervision in 2006. Generally speaking, economic and market predictions were on target and investment results were good. As usual, there was one big surprise. In 2006, it was the surprisingly high returns for U.S. stocks, which were powered upward by unexpectedly high corporate earnings. We did not predict such high results for U.S. stocks, but notwithstanding, we maintained a small overweight of stocks due to our low expectation for bonds. Therefore, clients “fully” participated in U.S. equity strength. As usual, the defensiveness of alternative strategies held down returns a bit, as to be expected in a strong bull year. Overall, we are very pleased with the results of our diversification strategies. It is also noteworthy that several funds employed in portfolios of Caves & Associates clients have recently been selected by Morningstar for their manager of the year awards. This recognition of our fund selections occurs in most years. Additional Perspective and Cautions 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. 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. 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. Several other observers of 2006 results have also categorized them as a pleasant surprise. In this regard, we need to keep our perspective and remember that markets often provide us with unpleasant surprises as well. We have just completed the fourth year of a bull market, and we’ve been hearing about markets hitting all-time highs. Such news can be interpreted both positively and negatively. While we are grateful for such a long bull market, we must recall that risk is not just a quaint concept or one reserved for only academics. After a long run-up in the 1990’s, markets reached all-time highs and some pundits proclaimed a new paradigm wherein stocks were no longer risky. There followed one of the deepest bear markets in history from 2000-2002. It is instructive that new highs established in late 2006 for the Dow Jones Industrials and S&P 500 Index took almost seven years to occur after previous highs in early 2000. This long recovery period reminds us how far markets can fall, especially after previous excess on the upside. Even more sobering is the fact that the NASDAQ index has not yet come anywhere close to re-attaining the highs of the internet boom of the late 1990’s (NASDAQ over 5000 then and at only 2500 recently). We do not mean to equate 2006 with 1999; we just want to remind us that markets move in cycles. In conclusion, it is important to temper our enthusiasm with an appreciation of the positives and negatives of the big picture. 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. 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 Topical or Timely 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 (probably with our first quarter Market Review in April). Timeless topics expected to be included are as follows:
Some Guidance Regarding Attainment of Long-Term Life Goals Although the outlook for 2007 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: 1) reasonable reductions in spending and increases in our savings rates whenever possible, and 2) maintenance of reserves for all foreseeable large portfolio withdrawals. 2006 IRA Contribution Deadline is 4/16/07; Limits and Considerations We would like to remind you that an annual IRA contribution is almost always a good strategy. Congress has been 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 2006 remains at $4,000 for anyone under 50 years of age and increases to $5,000 for those over 50 as of the last day of the calendar year. Accordingly, for a married couple the 2006 contribution limits total $8,000 - $10,000, 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. It is also important to note that a non-working spouse may qualify for a deductible IRA contribution depending on the other spouse’s company-sponsored retirement plan participation status and the level of family income. Again, your tax preparer is your best advisor on these matters. In summary, the annual IRA contribution is a perishable commodity: once the deadline passes, you are out of luck for 2006. 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. 2007 IRA Contribution Limits For those wanting to get a jump on the 2007 contribution, the contribution limits remain the same respecting 2007. Contributing early in the year is a good strategy, and it’s not too early to make your contribution for this year as long as you’re sure you or your spouse will have enough earned income to qualify for the 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 Charles Schwab “The man who does not work for the love of work but only for money is not likely to make money nor find much fun in life.” Walter Annenberg “You will not be satisfied unless you are contributing something to or for the benefit of others.” George Steinbrenner “I will never have a heart attack. I give them.” Madeleine Albright “While democracy in the long run is the most stable form of government, in the short run, it is among the most fragile.” Colin Powell “Many interviewers when they come to talk to me think they're being progressive by not mentioning in their stories any longer that I'm black. I tell them, 'Don't stop now. If I shot somebody you'd mention it.” John Muir “Everybody needs beauty as well as bread, places to play in and pray in, where nature may heal and give strength to body and soul.” George Carlin “Some people see things that are and ask, Why? Some people dream of things that never were and ask, Why not? Some people have to go to work and don't have time for all that.” James Thurber “It's a naive domestic Burgundy without any breeding, but I think you'll be amused by its presumption.” Jeff Foxworthy “I turned down a movie this summer because it was nine weeks in Vancouver and my oldest daughter is 14. I've got four more summers with her. I'm not giving away nine weeks of her summer to go do a silly movie.” Rita Rudner “I wonder if other dogs think poodles are members of a weird religious cult.” 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 in this letter and accompanying materials is of a general nature and should not be acted upon without further details and/or assistance. Best wishes for a happy, healthy, peaceful, and successful 2007.
This publication does not constitute an offer or solicitation of any transaction in any securities. Information contained in this publication has been obtained by sources we believe to be reliable, but cannot be guaranteed.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. There is also no guarantee of future results. These views are as of January 25, 2007 and are subject to change based on subsequent developments. |
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