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Dear Clients and Friends,
Your copy of Caves & Associates’ Market Review for the second quarter of 2007 is enclosed or is an attachment if you are receiving this by email. The review describes a very strong quarter for almost all stock asset classes but quite poor results for U.S. and foreign bonds; bonds provided essentially no return as the drop in price offset the income from interest. Foreign stocks were particularly strong, supported by surging global economic growth. They also benefited from currency gains on continued weakness of the U.S. dollar. U.S. stocks have been shrugging off the weakness in housing and increasingly bad news about sub-prime mortgages, but bonds values have been more directly impacted by increasing concerns about credit risk. 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, 2007. 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. Further, we continue to believe that a disciplined investment approach emphasizing diligent fundamental research, a generally buy-and-hold approach, cost minimization, 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. As we often state, there is no way to completely eliminate short-term risk from an investment portfolio.
Updated Outlook
Our outlook for 2007 was promulgated January 25, 2007. We have noted that 1) our outlook was quite consistent with what might be judged the consensus 2007 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 2007, the consensus forecasts and Caves & Associates outlook are proving to be relatively accurate but possibly underestimates of returns for stocks and overestimates for bonds. As supported by the enclosures (or attachments), the previous outlook of “unexciting but positive total returns for most bonds” is still fairly likely for U.S. bonds (positive returns of about 1.5% year-to-date), but not for foreign bonds. Due to the higher volatility of stocks, it is never safe to annualize part-year returns. Thus, comparisons of actual to forecast could flip-flop in the second half of the year, especially for stocks. Notwithstanding, strong equities results month-to-date in July plus supportive economic and market conditions suggest U.S. and foreign stocks will achieve the 2007 forecasts, which were “returns consistent with historical averages” and “above historical averages,” respectively (see below and the accompanying Economic Review and Market Perspective).
U.S. and foreign developed markets have been appreciating in line with corporate earnings growth so that price-earnings ratios have remained basically stable. Most stock market observers agree that valuation ratios are reasonable and very close to long-term averages. Therefore, market direction will be driven by investor perception of economic developments rather than by any need for any particular market to correct from valuations that are either too high or low.
In the U.S., the wild cards economically relate to housing prices and sub-prime mortgages defaults. These factors are working in tandem to weaken the outlook for employment and personal spending and thus GDP growth. If the problems become worse than already discounted in stock prices, U.S. markets could suffer. Our sanguine view depends upon continuing achievement of a “soft landing” and enough domestic economic strength from current positive factors such as service and export sector growth to offset housing weakness.
In contrast to U.S. and foreign developed markets, emerging markets stocks have been outrunning their strong fundamental growth so that the price-earnings ratio of the MSCI Emerging Markets Index is at a five-year high. While this clearly adds price risk to the equation, it is appropriate to remember that emerging markets in general have much healthier balance sheets than ever before, are generating positive cash flow, and are growing significantly faster than developed markets. Although these factors cannot be sustained indefinitely, they can, without a shock or catalyst, remain in place for some time.
Noting the clear evidence that the U.S. economy has slowed, we believe that the current strength of the global economy, the current full U.S. employment picture, and the continued high levels of corporate free cash flow will all help to pull the U.S. economy through a period of slow growth. Overall, investors should maintain their portfolios with allocations near their long-run targets. 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 from bonds 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.
What’s Timely and Topical?
So we can keep pace with needed work for clients, Timely Topics is on vacation until fall.
Upcoming subjects may 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. Valuable alternatives for life insurance policies no longer needed.
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?
The Blog Department
The Blog Department is also on vacation.
Quotes for Our Times and All Time
Thomas Edison:
“Opportunity is missed by most people because it is dressed in overalls and looks like work.”
Harrison Ford:
“You know you're getting old when all the names in your black book have M. D. after them.”
David Brinkley:
“A successful man is one who can lay a firm foundation with the bricks others have thrown at him.“
Jimmy Carter:
“Like music and art, love of nature is a common language that can transcend political or social boundaries.”
Booker T. Washington:
“Excellence is to do a common thing in an uncommon way.”
Immanual Kant:
“We can judge the heart of a man by his treatment of animals.”
James Branch Cabell:
“The optimist proclaims that we live in the best of all possible worlds, the pessimist fears this is true.”
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 20, 2007 and are subject to change based on subsequent developments.
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