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Dear Clients and Friends,
Your copy of Caves & Associates’ Market Review for the first quarter of 2008 is enclosed or is available on our website if you have chosen to receive email notification. The quarter was one of the most volatile periods we have seen in some time. Surging oil prices, the collapse of the 5th largest U.S. investment bank, a plummeting dollar, a credit crisis, and fears of a recession all made for a very difficult period. As usual (but not always), bonds provided stability amidst market turmoil and buffered investors from double-digit losses 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, 2008. 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 and bonds generally continued to outperform their U.S. counterparts due to currency gains, and allocations to alternative strategies also buffered investors from the tribulations of equities 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 included for your information. Additionally, the Blog Department is back with a third party perspective on the tremendous cost of the wars in Iraq and Afghanistan as they enter their sixth year and engender even more controversy that ever; the authors take the position we are just beginning to pay the full costs of the war, and they estimate the ultimate total cost at three trillion dollars assuming a meaningful troop pullback begins in 2009. The Blog Department is presented as a separate document.
You are undoubtedly aware that for the past six months the financial system and financial markets have been under pressure, pulling the stock market into negative territory. This has been mostly due to the decline in U.S. home values and the related devaluation of the mortgage securities market, which have had a significant impact on our economic well-being. These problems have become exaggerated because of the interconnected nature of the global credit markets.
When reviewing the economic environment that existed during this period of negative returns, as well as looking into the future, we believe that the worst of the economic news has now been seen and heard. To further illustrate the point that the cat is out of the bag in terms of bad news, note that virtually every economist now agrees that the U.S. economy is in recession, we have already experienced the virtual failure of Bear Stearns & Co (the demise of a prominent financial institution is often the peak marker of a financial crisis), and financial institutions worldwide have already written off over $300 billion related to losses in mortgage related securities – a sum greater than the S&L crisis of the 1980’s. Even though the news of this current financial crisis is fast becoming history, it is instructive to examine its origin and magnitude. Please see the Timely Topics for a useful explanation, which has been borrowed almost verbatim from the website of the Managers group of mutual funds due to its clarity and readability.
News of the housing and credit crisis is now well known, and significant damage has already been done to leveraged investors and short-term traders. In fact, much work has already been done to get the economy back on track, and this foundation will produce some positive surprises (albeit against the greatly reduced expectations caused by all the recent bad news) over the next few quarters. Although negative news about housing prices and credit problems will undoubtedly continue, we believe that long-term investors are now best served by focusing on the opportunities that will come as our government and business leaders deal with these known problems.
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.
Outlook
As we head into the second quarter of 2008, the debate has shifted from whether we are in a recession, to how long and deep the recession will be. Early this year we forecast a mild but prolonged U.S. recession, and indeed a number of factors will likely curtail economic activity for a good portion of 2008, with improvements possible but by no means certain later this year or in early 2009. Specifically, as mentioned above, we expect continued news of mortgage and credit defaults as the deleveraging of the financial system continues, further declines in U.S. home sales and prices, and continued pressure on consumers from high oil and commodity prices. As a result, we believe consumers and businesses alike will likely remain cautious, thus limiting or curtailing spending and investing, and thereby reducing economic growth.
The overwhelming concern is earnings sustainability and the worry that the economy could be entering a recession unlike in the past, one driven by a sharp slowdown in consumer spending caused by lower housing prices, higher energy costs, and tight credit. If a prolonged consumer driven recession occurs, earnings estimates for many companies are still too high.
On the other hand, the Fed is in full crisis management mode attempting to stabilize the housing and mortgage markets, an economic stimulus package has been signed into law, and we have seen a large financial institution merged to prevent its failure. Also, corporate balance sheets (investment banks not included) are in pretty good shape. In addition, U.S. exports continue to be robust, and should be further bolstered by continued weakness in the U.S. dollar.
So far we are hesitant to change our 2008 outlook, expressed as part of the communication dated January 31, 2008, mainly because it recognized the developing storm and called for conservative portfolio positioning. Other factors for no change include: (1) financial and economic problems are substantially incorporated in current equity prices; for example domestic price/earnings ratios are at their lowest levels in 10 years; (2) foreign equities appear much more appealing than at the beginning of the year given the recent sharp declines along with still solid growth prospects; (3) various fixed income sectors look much more attractive considering the much greater yield spreads; and (4) short-term cash vehicles are currently yielding negative real returns once inflation is appropriately factored in, not to mention additional worsening of real returns in the event of further Fed easing; they are thus unattractive alternatives to stocks and bonds.
So far this year, the largest divergence from our January outlook involves foreign stocks, which we forecast would provide good returns at or above historical averages. At losses approaching double digits through March 31, foreign stocks have a lot of ground to recover. Notwithstanding poor absolute results, they have outperformed U.S. stocks due to currency gains. Also, quite negative local currency returns have decreased valuations to levels much lower than in the U.S. Low foreign valuations provide solid upside if monetary and fiscal stimuli in the U.S. and elsewhere calm markets and facilitate a recovery of stock prices overseas.
Investors should not lose sight of the inevitable recovery that follows recession. It is important not to overreact to downbeat economic and financial news, since there is no way to know for sure when the market has truly toughed (or peaked). Market recoveries can occur quickly, without notice, and long before tangible evidence of improvement has occurred. For example, in three of the last four U.S. recessions, the S&P 500 returns were positive, and other recessionary periods saw the equity markets turn well before the recession ended. Meanwhile, challenging and volatile market conditions often lead to market dislocations which present opportunities for disciplined, long-term investors.
We have discussed our concern about market volatility in previous correspondence. 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 articles which are quite timely given current volatile markets and economic turbulence. The first is adapted from the website of the Managers funds. It provides a good primer about the history and global repercussions of the on-going credit crisis. A second article borrows from Wall Street Journal interviews published in December 2007. The article provides a still timely education by prominent investment experts, mainly top-name mutual fund managers, about lessons learned from 2007 and recommended approaches to the volatility and challenges of 2008. This second article provides third party endorsement of our portfolio and wealth management strategies and 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.
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.
This edition of the Blog Department is not our own prose. Instead, the edition presents the writing of others. In their opinion piece, “War’s Price Tag,” which we have somewhat abridged, the authors argue that the U.S. has only begun to pay what will ultimately be a three trillion dollar cost for the war in Iraq. The authors are: 1) Linda J. Bilmes, lecturer on public finance at Harvard University’s Kennedy School of Government, and former assistant secretary of Commerce, and 2) Joseph Stiglitz, a professor at Columbia University, former chief economist of the World Bank, and winner of the 2001 Nobel Prize in economics. 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 and environmental needs within the U.S. and elsewhere around the globe as well.
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, it turns out, were not needed for about four and one-half years from 2003 to mid-2007 because stocks went up steadily. But stocks have now retreated broadly and significantly since last July, and what if they go way down as they did in 2000-2002? That’s when you need adequate reserves because reserves allow us to avoid selling at such inopportune times.
Quotes for Our Times
We’ll defer quotes until our next quarterly communication, but we refer you to the second part of the enclosed Timely Topics for some very wise commentary on investing.
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 this newsletter will come to pass, and they are not meant to provide investment advice. These views are as of April 23, 2008 and are subject to change based on subsequent developments.
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