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Dear Clients and Friends,
Your copy of Caves & Associates’ Market Review for the third quarter of 2007 is enclosed or you are reviewing this mailing via the Internet. The review highlights a volatile but ultimately profitable quarter for both equity and fixed income asset classes. The quarter exhibited not only significant intra-period shifts in investment performance, but also substantial disparities among investment approaches. After lagging value-oriented funds since 2000, growth-oriented funds significantly outperformed across all market capitalization's. Similarly, large-cap funds substantially outperformed small-caps across the style spectrum. Bond markets were unusually volatile due to a mid-period credit crisis, and credit spreads widened significantly. The Fed lowered interest rates at a greater than expected rate and was successful at calming global markets. The U.S. dollar declined relative to all major currencies.
The backside of the Market Review is a table of global investment returns for the third quarter and nine months ending September 30, 2007. The global returns provide reference points against which to judge results for your investment accounts. As usual, but not guaranteed, broad diversification smoothed results and provided net gains overall in spite of very poor performance in some investment categories.
This summer’s rapid increase in financial market volatility is a healthy and rational development for several reasons. Most importantly, volatility helps to expose risks and weaknesses that would otherwise remain hidden. Most recently it helped expose a fair amount of leverage, or borrowing, that had gathered in the global markets and forced a pull-back. We believe leverage itself is not bad, but too much of anything is problematic. Also, the amount of leverage should generally be inversely proportional to the level of risk taken. Finally, volatility is a rational reflection of the market’s diverse perception about the health of the U.S. economy and the factors affecting it (see below).
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.
Economic Overview
The U.S. economy continued to exhibit mixed signals but turned in a rather robust 3.8% growth rate for the second quarter (due to data collection lags, reported and revised during the third quarter). Although the rate of job growth has been slowing all year, the unemployment rate has remained quite low at 4.6%. Manufacturing activity has picked up, and the Institute for Supply Management index of business sentiment remains in healthy territory (above 50); however, it pulled back modestly in July and August. The Index of Leading Economic Indicators has remained flat, hence undecided, for well over the past year. Despite significant increases in the price of crude oil and gold, inflation, as measured by CPI and core CPI (ex food & energy), has moved lower, thus providing the Federal Reserve more latitude to support the economy.
The Fed took advantage and demonstrated its concern for the economy by cutting the discount rate twice during the quarter (0.50% each), and in mid-September, voting to reduce the highly-watched Fed Funds Target Rate by 50 basis points (0.50%), from 5.25% to 4.75%. In lowering the rate, the Fed noted that “the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally.” The Fed took action “to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time.”
Many economists consider the relatively weak first quarter and rather strong second quarter GDP results to be a reflection of unusual seasonal effects. Looking at the two quarters together, they demonstrated a rather lackluster annualized growth rate of about 2.2%. Given the challenging credit environment and the extended slump in residential housing, most pundits are forecasting continued slowing, and there remains controversy about whether the U.S. economy muddles along with slow growth or slips into recession.
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.
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 (in other words, if it’s considered a sure thing, it almost certainly isn’t). As usual, our outlook is assuming good fiscal and monetary policy decisions and execution, gradual transitions, and no major external shocks to support the guardedly optimistic outlook.
Through three quarters, economic and market results are tracking quite closely to the January outlook. The 2007 forecast for stocks was “returns consistent with historical averages” for U.S. stocks and “above historical averages” for international stocks; both forecasts are about on target through the third quarter. The bond forecast for “unexciting but positive returns for most bonds” remains fairly likely for U.S. bonds (positive returns of about 3.9% year-to-date as measured by the Lehman Brothers Aggregate Index). International bonds, which were down slightly for the first half of the year, now are on track to exceed the forecast (positive returns of 7.3% year-to-date after a heady 8.1% increase during the third quarter).
At this juncture, the economy is very difficult to forecast. We believe the U.S. residential real estate market will remain weak for an extended period and that this will have a negative impact on employment, household income, and consumer spending. The global economy is diversifying, and there is a growing overseas middle class consumer base that we believe is likely to have a positive impact on the U.S. economy and corporate earnings, especially for those companies doing substantial business overseas. Which of these impacts is stronger, and whether there will be other significant influences, remains to be seen. Nonetheless, our guardedly optimistic outlook is predicated on the U.S. economy achieving a soft landing and positive global economic forces outweighing our domestic troubles. Year to date market performance is supporting this evaluation.
Therefore, we continue to believe that investors should maintain their portfolios with allocations near their long-run targets, and we have made no major adjustments to portfolio strategy.
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 expect to receive our occasional Timely Topics before yearend, when we expect to have better resource availability for this task.
The Blog Department
The Blog Department remains on vacation due to time constraints as well as and our current disinterest in climbing onto the soapbox. We’ll leave that to the many Republican and Democratic Presidential candidates, who are providing their share of controversy and coining ever more fearful terminology, including a new polemic we’ve recently been hearing: “Islamic Fascism.”
Quotes of Our Times and All Time
Carl Sandburg:
“Time is the coin of your life. It is the only coin you have, and only you can determine how it will be spent. Be careful lest you let other people spend it for you.”
Abraham Lincoln:
“Nearly all men can stand adversity, but if you want to test a man's character, give him power.”
Robert H. Schuller:
“If you listen to your fears, you will die never knowing what a great person you might have been.”
Helen Keller:
“I long to accomplish a great and noble task, but it is my chief duty to accomplish small tasks as if they were great and noble.”
Jimmy Carter:
“Globalization, as defined by rich people like us, is a very nice thing... you are talking about the Internet, you are talking about cell phones, you are talking about computers. This doesn't affect two-thirds of the people of the world.”
Saint Thomas Aquinas:
“Love takes up where knowledge leaves off.”
Alan Greenspan:
“I guess I should warn you, if I turn out to be particularly clear, you’ve probably misunderstood what I’ve said.”
Sue Murphy:
“Did you ever walk into a room and forget why you walked in? I think that is how dogs spend their lives.”
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, but please note that 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, 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 and private way to initially make our acquaintance.
Thank you for your continued support of Caves & Associates.
Thanks and credit must go to the many sources for this writing, including Managers and PIMCO mutual fund families, Morningstar, the Wall Street Journal, and the Los Angeles Times.
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 29, 2007 and are subject to change based on subsequent developments.
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