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Dear Clients and Friends,
Your copy of Caves & Associates’ Market Review for the first quarter of 2007 is enclosed or is an attachment if you are receiving this by email. The review indicates markets turned volatile for the quarter. Due to a fairly sharp drop toward the end of February, equities markets finished generally in the black but well off highs reached earlier in the year. As usual (but not always), bonds provided stability amidst market turmoil and provided returns not much below those for stocks. The backside of the Market Review provides global returns for the first quarter of this year and for twelve months ending March 31, 2007. The global returns provide reference points against which to judge results for your investment accounts. For the quarter, global diversification was beneficial as foreign stocks generally continued to outperform U.S. stocks, but the differential between stock and bond returns narrowed considerably versus the previous four years of bull markets.
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 (or attached) for your information. Additionally, the Blog Department is back with a third party perspective that the “war on terror” is an overreaction and a third party’s 21 suggestions for successful living; it is a separate document.
The global economic expansion appears to be sustaining itself, but U.S. economic reports issued during the first quarter were mixed. On the positive side, inflation remains reasonably contained, and employment growth is well above recession levels. Thus, most economists are still projecting a soft landing for the U.S. economy. On the negative side are the much publicized cooling of the housing market and the associated gloomy news about sub-prime mortgages, which previously had provided a big boost to housing demand and thereby prices in recent years. The bad news includes rapidly mounting defaults and bankrupt lenders. For example, in California, defaults are currently running eight times the level a year ago, and Newport Beach-based lender New Century, a major player in sub-prime lending, has announced lay-offs of 3,200 people and filed for bankruptcy protection.
The sub-prime malaise could spread further into the housing market and the broader economy. The fear is that a loss of liquidity in the housing market would depress home prices, which would then have a trickle-down effect on consumer spending and hurt employment. As a reminder, the U.S. consumer remains the key driver of the U.S. economy, dwarfing business investment and housing. 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 2007 outlook, as expressed as part of the communication dated January 25, 2007. There are no major disappointments yet among first quarter U.S. corporate earnings reports, and U.S. stock markets have recovered and stabilized since the downdraft in late February. The Dow index recently extended its run of record closes. Further, as mentioned above, international stocks are on track for another good year, the Chinese economy appears to have tacked on another quarter of breathtaking growth, and the global economy is generally healthy. Finally, merger and acquisition activity does not show signs of abating anytime soon, which suggests there is still abundant cash out there to keep markets lubricated. It is noteworthy that 1) Caves & Associates outlook is quite consistent with what might be judged the consensus 2007 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. The precipitous drop in late February was yet another example. 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 Topical or Timely
We remain committed to continuing education as well as keeping you abreast of information which may have a significant impact on your wealth management. Please see the enclosed Timely Topics for an article adapted from a retirement column in the Wall Street Journal. It provides a good primer about Medicare and also addresses some specific questions when one approaches age 65. A second article provides a timeless education about the math of investment returns. The article helps explain why Caves & Associates is so adamant about broad diversification, avoidance of making any big bets on the future, and risk management. All three help us minimize volatility of client accounts and thereby maximize wealth growth.
Finally, a few timely topical briefs are as
follows:
1. The Pension Protection Act of 2006 enacted an exclusion from gross income for certain distributions up to $100,000 from IRA’s if they are directed to a tax-exempt organization. The provision presents a planning opportunity for well-healed seniors subject to required minimum distributions from their IRA’s who have charitable objectives and don’t need their full distribution for living expenses. The provision expires at the end of this year.
2. Notwithstanding careful preventative measures by Caves & Associates on behalf of our clients, you may have noticed the increase in mutual funds’ taxable capital gains distributions when you filed your 2006 tax return or made a tax estimate with your April extension. Last year’s stock- and bond-fund distributions totaled nearly $260 billion, the highest since $325.8 billion was paid out in 2000, according to the Investment Company Institute trade group. Also, the average capital-gains distribution from a U.S. stock fund last year totaled nearly 4.2% of the fund’s assets, more than doubling since 2004, says Morningstar, Inc. To some degree, this is a good problem, created because stocks have averaged double-digit gains over the past four years. Nonetheless, we want to remind you of the need to plan for the potentiality of “unexpected” taxable income from your portfolio every year. Meanwhile, looking ahead, more headaches seem likely. After the 2000-2002 bear market, the average U.S. stock fund carried forward net capital losses equal to 56% of assets. That’s down to 2%, meaning many funds have used up stockpiled losses. Barring a bear market, we need to expect these payouts to continue to drift up for a while.
Please read Timely Topics, and let us know if you need further assistance on these matters.
The Blog Department
As you 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 is not our own prose. Instead, the edition presents the writing of others. In his opinion piece, “Apocalypse No,” which we have somewhat abridged, David Bell, professor of history at Johns Hopkins University, argues that the U.S. has overreacted to 9/11 by its “war on terror,” that Al Qaeda does not have the capacity to really threaten out existence. Further, characterizing our situation as an apocalyptic struggle is being used to justify a full-scale war against an adversary that is not really an apocalyptic threat. The Blog Department might add that the characterization also is being used to justify curtailment of Americans’ rights and privacies, which could ultimately prove to be the greater threat to our existence as a freedom-loving democracy. Further, it must be that this characterization is sincerely accepted by the leaders of the Bush administration, for how else do we explain the stubbornness with which they pursue the war in Iraq in spite of mounting evidence of failed policies and the war’s unwinability? The Blog Department is deeply concerned by all the suffering in Iraq caused to a large degree by U.S. policies and by the massive expenditure of resources which are sorely needed for a more pragmatic defense against terrorism and for myriad societal needs within the U.S. and elsewhere around the globe as well.
In its second part, the Blog Department “lightens up” and presents 21 Suggestions for Successful Living. We don’t know whom to credit for these very useful admonitions, and we assume you may have already run across at least a few of them somewhere along the way.
A Key Reminder from Previous Communications
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. Reserves have not been needed over the last four years it turns out, using the beauty of hindsight, because stocks have gone about straight up. But what if they go way down as most did in 2000-2002? That’s when you need adequate reserves because reserves allow us to avoid selling at these inopportune times. Further, markets can change direction abruptly, without warning, as we saw in late February. The broad retreat then was a reminder that, while generally healthy, the global economy is a balancing act that could fall off its wire with marginal negative influences. Economic problems typically induce market sell-offs, which could last years depending on the causes of economic malaise.
Quotes for Our Times
We’ll defer quotes until our next quarterly communication, but we refer you to the second part of the enclosed Blog Department for some wise commentary on living.
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 the newsletter will come to pass, and they are not meant to provide investment advice. These views are as of April 24, 2007 and are subject to change based on subsequent developments.
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