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Your copy of Caves & Associates’ Market Review for the second quarter of 2008 is enclosed or is an attachment if you are receiving this by email. The review describes a mixed but generally weak quarter for most stock asset classes, with the notable exception of energy and other commodity stocks, and quite poor results for U.S. and foreign bonds as well; bonds provided somewhat negative returns as the drop in price more than offset the income from interest. For the first quarter in several years, foreign stocks and bonds did not benefit from currency gains because the U.S. dollar experienced modest strength against a significant number of foreign currencies. U.S. stocks have been unable to cope with mounting news of economic challenges, including very high energy prices, housing’s persistent and increasing slump, and weakening consumer demand. 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, 2008. A second enclosure headed "Economic Review and Market Perspective" provides a longer-term interpretation of economic and market data and trends.
The statement from the Federal Reserve’s latest meeting suggests that Fed officials will continue to balance the twin risks of stubborn inflation and weak growth for the rest of the year. The Fed is walking a tightrope because U.S. economic challenges do not have common but rather mutually exclusive solutions. In consideration of the Fed’s dilemma and intensifying negative economic news, we find developing a reliable outlook increasingly difficult. More on our updated economic and market outlook is found in the next section 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.
Updated Outlook
About a year ago we said the recent failure of two Bear Sterns hedge funds which invested heavily in sub-prime mortgages may be the tip of the iceberg. We also indicated that the sub-prime area could prove to be a shock to the U.S. economy, but we asserted a belief that the economy was sound enough to handle the challenge. At the time, it seemed headed for a “soft” landing, and it was buttressed by strong economic conditions overseas. Finally, investor and consumer confidence remained fairly positive, again, just about a year ago.
Much has changed in the last year, mostly for the worse: the iceberg was bigger than expected, and it calved! By that we mean the housing slump has been far deeper than expected, and it has spawned a parallel credit crisis emanating from a massive number of bad mortgage loans. As a result, the current outlook is highly uncertain and clouded, but not necessarily entirely cloudy.
As we head into the second half of 2008, investors are wrestling with a variety of questions, including whether inflation or recession poses the greater threat. Investors are also coming to the realization that, despite all the Fed’s efforts, the combination of deteriorating home prices, a credit crunch, a beleaguered consumer, and rising oil prices is going to bedevil the economy, stock prices, and banks for months to come.
Our previous outlook for 2008 was promulgated January 31, 2008. We have noted that 1) our outlook was quite consistent with what might be judged the consensus 2008 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 2008, the consensus forecasts and Caves & Associates outlook are proving to be relatively inaccurate. Specifically, they underestimated the negative impact of the housing slump and the credit crisis and also did not foresee the continued strong escalation of oil prices from their already highly appreciated level at the end of 2007. Therefore, they were overly optimistic, especially regarding international stocks, and U.S. bonds have also under-performed the relatively positive outlook. Finally, the U.S. dollar has outperformed the projection of continued depreciation. Additionally, it is noteworthy that we indicated in April that we believed the worst of the economic news was now behind us. That has not been the case during the latest quarter. Please note that even though our initial 2008 outlook is looking overly optimistic, it called for conservative portfolio positioning.
Given the continuing spike in food and energy prices, combined with ongoing housing and credit market concerns, and a clear slowdown in much-needed consumer spending, it is still not clear whether the U.S. economy will achieve a “soft landing.” That same doubt applies to the U.K. and Euroland. Fortunately, strong emerging economies, some of which are the beneficiaries of higher commodities prices, are helping sustain global growth.
It would be supportable to have a very negative outlook at this point, and a prolonged and deep bear market is a possibility. Such a position would be based at least partly on the proposition that the Fed and Congress have basically run out of ammunition to fight the economic downturn without inducing substantially higher inflation. Since inflation is very negative itself for stock and bond markets, the Fed faces a no-win situation. Such a strongly negative outlook would also be based on a belief that much of the iceberg is still submerged, meaning the housing slump and loan losses have still only begun to run their courses.
We prefer a different investment perspective, and we remain cautious but not completely bearish. We believe government officials have taken enough stimulative action, especially if housing legislation just passed by the House becomes law soon, as expected. We need to remember that the Fed’s interest rate reductions have their main stimulative effect with a 1-2 year lag; the full effect is only beginning now. Further, it is true that most of the benefit of Congressional tax rebates is probably behind us, but the housing legislation just mentioned will have both short-term and long-term effects. Some have called the legislation just a bandaid, and that’s probably correct. But it is a much needed bandaid, and we judge it to be adequate to allow the housing market to establish a bottom soon. While the conditions for a sustained equity advance do not yet appear imminent, it should be noted that historically, stocks prices have traditionally bottomed in the middle of recessionary periods, not at the end. It is also important to bear in mind that while the fear of a recession is a legitimate concern for the economic well being of all Americans, a recession does not necessarily imply a weak or negative stock market. In fact, the U.S. equity market (as measured by the S&P 500) has experienced positive returns during over half of the nine recessionary periods since 1953.
At this writing, global stocks have rallied in mid-July, and the upward spiral of oil prices has stopped and partly reversed course. These two events are indeed linked and of course may be only temporary. Nonetheless, we believe oil demand has already started its inevitable decline, with consumption discouraged and conservation encouraged by sky-high prices. The law of supply and demand is taking its course. The oil price trend, if continued, will be bullish for the world economy and global stocks and bonds. Accordingly, we believe we see the proverbial light at the end of the tunnel. Also, we have incorporated in our
short-term outlook weakening of commodity returns, especially energy, and strengthening of the U.S. dollar versus such floating currencies as the euro, pound, and yen. Thus, we will decrease our risk of direct and indirect over-exposure to the dollar (see the next section of his letter for a description of one specific tactic). Please note this is a short-term outlook; the long-term, or secular, outlook remains bullish on oil and bearish of the dollar. Finally, because the anticipated improvement in the dollar, oil prices, and inflation are the context of an otherwise relatively bleak economic situation in the U.S. and to a lesser extent U.K. and Europe; because the beneficial impact will likely occur gradually, especially with respect to corporate profits and consumer spending; and because the anticipated improvement may not occur at all; for all these considerations, we’ll continue some overweighting of international stocks relative to U.S. stocks and bonds relative to stocks for risk control. Some conservatism is needed because we still can’t really know how big the iceberg is.
In summary, our subdued economic expectations for 2008, along with the negative sentiment still permeating the marketplace, could easily leave an investor to wonder how best to protect themselves. For astute long-term investors though, the answer to such a question is the same as it has always been: maintain a broad asset allocation with exposure to various asset classes. While we believe that maintaining a sound long-term asset-allocation strategy will not magically solve all the short-term issues a difficult market environment can bring, the diversification achieved by maintaining this approach can help investors limit their risk exposure, particularly when it is needed most — during challenging markets. 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 carefully selected 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. Further, gradual transitions means the avoidance of a “hard landing” by the economies of most western developed countries.
Decrease of the U.S. Dollar Exposure via Hedged International Bonds
For all those readers who have engaged our on-going mutual fund monitoring services, please be advised we are replacing PIMCO Foreign Bond (Unhedged) with the PIMCO Foreign Bond (Hedged). Thus, we are replacing ticker PFUIX with ticker PFORX. This is a tactical move per the preceding discussion and in no way a reflection of negative opinion about PFUIX. Both funds have the same management team and approach, except for currency hedging policy. Please let us know if you have any questions.
What’s Timely and Topical?
A recent major piece of negative economic news has involved the bankruptcy of Indymac Bank and growing concerns about the financial health of two crucial institutions, Fannie Mae and Freddie Mac. So we can keep pace with needed work for clients, Timely Topics is generally on vacation until fall, except an enclosure provides a brief background about mortgage-backed securities and the two mortgage giants. The enclosure concludes by indicating the two financial institutions are too big to be allowed to fail. Housing legislation about to pass Congress includes a Federal backstop for both Fannie and Freddie, moving close to the explicit Federal guarantee of Ginnie Mae debt.
The Blog Department
We’re concerned about accountability and consequences. As applied to the mortgage area, Angelo Mozillo, until recently Chairman of the Board and Chief Executive Office of Countrywide Financial, and also co-founder of Indymac Bank, should be held accountable for mismanagement, misrepresentation, and predatory lending practices at his companies and should suffer consequences. Likewise, thousands, perhaps hundreds of thousands, of Americans should be held accountable for predatory borrowing, including preparation of fraudulent loan applications and subsequent false claims of naiveness. They, too, should suffer consequences. Of course, much criticism should be directed at Federal and State banking and mortgage regulators, Wall Street, and the nation’s leading (we hesitate to use the term) securities rating agencies. Finally, “too big to fail” needs to be coupled with tighter, not looser regulation, to minimize or eliminate future bail-outs of reckless managers. In other words, laissez faire and government control need a better balance, and excessive risk-takers must suffer the negative consequences of their actions after having enjoyed the financial benefits when the upside occurred.
Other than this little rant, the Blog Department is also on vacation.
Staff News
Sandra Gafney completed the UCLA certificate program in Personal Financial Planning in June, fulfilling the educational requirement of the CFP® certification process. Sandra has already fulfilled the work experience requirement. She plans to take the 10-hour CFP® certification examination in November, at which time she hopes to add the CFP® designation to her already significant financial advisory qualifications.
Casey Bond, Susan’s highly competent part-time jack-of-all-trades assistant, has recently earned her Bachelor of Arts degree from Loyola Marymount University. She majored in English and graduated
cum laude. We hope to retain her services for quite awhile during her graduate studies in creative writing.
Congratulations to both Sandra and Casey.
Quotes for Our Times and All Time
Justice Louis Brandeis:
“The greatest dangers to liberty lurk in the insidious encroachment by men of zeal, well-meaning but without understanding.”
Andrew Samwick (Dartmouth economist)
“If an institution is deemed too big to fail, then it is only a matter of time before it finds a way to get big and fail.”
Proverb:
“A man stands taller when he stoops for a child.”
Robert Frost:
“In three words I can sum up everything I've learned about life. It goes on.”
William Taylor (Bill) Copeland:
“The trouble with not having a goal is that you can spend your life running up and down the field and never scoring.”
Clarence Seward Darrow:
“The man who fights for his fellow-man is a better man than the one who fights for himself.”
Anne Tyler (On dogs):
“Ever consider what they must think of us? I mean, here we come back from a grocery store with the most amazing haul- chicken, pork, half cow. They must think we're the greatest hunters on earth!”
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 this newsletter will come to pass, and they are not meant to provide investment advice. These views are as of July 25, 2008 and are subject to change based on subsequent developments.
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