2007 Year End Commentary and Planning Ideas

February 4, 2008

By Caves & Associates

Preston S. Caves, CPA, CFA, MBA

Sandra Gafney, MBA

Dear Clients and Friends,

We are pleased to present Caves & Associates’ Market Perspective Full Year 2007 and Outlook. The review of 2007 highlights: 1) a backdrop for global financial markets of reasonably well-contained inflation, a deteriorating U.S. economy, but continuing strong emerging country GDP growth, 2) moderate and somewhat mixed results for stock prices around the world, including lackluster local currency results overseas for many developed countries but very strong foreign currency gains producing quite good returns in U.S. dollars, 3) continuing stellar results for emerging markets securities with and without currency changes, and 4) unexciting but positive returns for investment grade bonds which benefited from a generally declining interest rate environment globally. Additionally, the review provides information on five-year returns for perspective. The key observation is that global stock markets had an up and down year and a substantial increase in volatility. Markets continued to be encouraged by the growth of emerging country economies but witnessed a flight to safety caused by the unexpected sharp onset of the subprime mortgage crisis and a global credit crunch with origins in lax regulation of lending practices and a serious U.S. housing bear market. Finally, diversification shielded a good part of the increased volatility and provided a reasonably profitable year for the prudent global investor.

Results for 2007 are already being overshadowed by the sharp declines of stock prices worldwide in the first three weeks of this month and the dramatic moves by the U.S. Federal Reserve (the Fed) to stimulate the U.S. economy and restore investor confidence. These moves have generally been successful, and we encourage you to avoid focusing on any short time period, because stock prices are historically quite volatile in the short-run.

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. During the period we also faced major corporate, mutual fund, and accounting scandals; escalating mid-East tension; additional terrorist attacks; and terrible natural disasters in southern Asia and along the Mississippi coast. The lack of major negatives was a big contributor to surprisingly good investment returns in 2007, 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. Though investors were cognizant of the weakening U.S. housing market and our struggles in Iraq a year ago, the main events not likely on their minds in January 2007 were the rapid deterioration of the value of subprime mortgages and the related, equally sudden credit crunch. One can only wonder what potential disruptions and unexpected economic twists lurk for 2008. 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 2007. The review indicates it was a broadly weak quarter for U.S. and foreign stocks due to a flight to economic concerns. Of some interest, it was the first negative fourth quarter for the Dow Jones Industrial Average in 10 years. On the other hand, it was an above average quarter for U.S. and foreign bonds due to a flight to safety and due to currency gains for the latter. A tabular attachment to the review provides global returns for the quarter and full year 2007.

Regarding the Outlook for 2008, 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. Additionally, in the U.S. it is a Presidential election year. These opposing forces and uncertainties make it again difficult to provide definitive forecasts for the next year. Our best guess is mild recession in the U.S., with the commensurate negative impact on U.S. and foreign stocks, much of which has already occurred month to date. (Economists generally define a recession as a significant, broad-based decline in economic activity, usually lasting more that six months). The outlook for bond returns is positive due to the downward direction of interest rates based on central bank recession fighting policies, but there is increasing risk as the year progresses if inflationary pressures become too great. Overseas securities should provide good returns at or above historical averages due to moderately lower valuations than in the U.S. and expected continued weakness of the U.S. dollar. In spite of an unenthusiastic outlook for U.S. stocks, positions must be maintained to recognize the fallibility of the recession forecast and to allow mutual fund managers to attempt to exploit the current climate of fear. We’re also paying heed to the adage of not fighting the Fed. Additionally, alternative strategies in above average doses should provide upside versus bonds and downside protection if the U.S. and global economy performs below expectations. 

We noted last year that beyond 2007 we believed the outlook would be cloudy, even stormy. Our concerns were not new; they were presented in last year’s Market Perspective and Outlook. The point is that 2008 is now here, and indeed conditions in the developed world are stormy. Thus, we are looking somewhat prophetic. Nonetheless, we believe the “day of reckoning” has been postponed by the recent decisive Fed action to calm financial markets and boost the U.S. economy.

We have previously 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.

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 2007. Generally speaking, the accuracy of economic and market predictions was mixed, but many were about on target, and investment results were quite good. As usual, there were a few surprises. In 2007, it was the subprime mortgage financial disaster coupled with the ensuing global credit crunch. These related surprises precipitously reduced global risk appetite and derailed what was shaping up as another very good year for stocks. We did not predict such a mediocre year for U.S. stocks, but we did maintain a considerable overweight of foreign stocks due to our correct expectation of currency gains. Therefore, clients “fully” participated in strong foreign equity returns, and the position in U.S. stocks, though not as profitable, at least beat U.S. bonds. As usual, the defensiveness of alternative strategies held down returns a bit, as to be expected in a year when stocks beat bonds. 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. It is impossible to consider every possible cause and effect with regard to markets. Thus, we believe the more useful approach is to maintain a broadly diversified investment plan customized to your specific time horizon which can meet your investment objectives over a variety of potential scenarios. Further, we continue to believe that a disciplined investment approach emphasizing diligent fundamental research, diversification, and rebalancing will provide sound long-term investment returns. 

Some observers of 2006 results have categorized them as a pleasant surprise. Last year at this time we reminded readers that markets often provide us with unpleasant surprises as well, and 2007 is a pretty good example. We were again hearing about markets hitting all-time highs in July 2007, and then a significant reversal occurred, reminding us that news of market records can be interpreted both positively and negatively. It may be that the long bull market, which began in 2003, ended last July. In fact, the decline that began then had almost qualified as a bear market (defined as a loss of 20%) when the Fed’s big January 22nd rate drop stemmed the downtrend, at least for now. We hope the July to January downturn remains a mere “correction” (defined as a loss of 10%) within an on-going bull market, but we can not be sure. In conclusion, markets move in cycles, and it is always 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’ve enclosed the latest edition of Timely Topics. It amplifies on some information we presented on Social Security 15 months ago, including an interesting “angle” that may apply in your situation, and reports another increase of the “Kiddie Tax.” It also includes a refresher on the estate planning technique of annual gifting and provides our usual reminder that an IRA contribution is almost always a good strategy.

The Blog Department

The blog department remains on vacation.

Some Guidance Regarding Attainment of Long-Term Life Goals

Although the outlook for 2008 is mixed amid numerous challenges to the U.S. and international community, 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. 

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 of Our Times and All Time

Anonymous: 

“Life is not measured by the number of breaths we take, but by the moments that take our breath away.”

Margaret Mead: 

“Never doubt that a small group of thoughtful, committed citizens can change the world. Indeed it is the only thing that ever has.”

Martin Luther King, Jr.

“When you are right you cannot be too radical; when you are wrong you cannot be too conservative.”

Joe Gores: 

“Old age means realizing you will never own all the dogs you wanted to.”

Form ADV Available for Your Review

The ADV is our registration as an investment advisor with the SEC. It shows fees and services and other information that may be of interest. 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, are 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 2008.

    
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 30, 2008 and are subject to change based on subsequent developments.