Third Quarter 2008 Market Review and Timely Topics

October 17, 2008

Preston S. Caves, CPA, CFA, MBA

Sandra K. Gafney, MBA

Dear Clients and Friends,

Your copy of Caves & Associates’ abbreviated Market Review for the third quarter of 2008 is enclosed or you are reviewing this mailing via the Internet. The review highlights a volatile and very negative, broadly down quarter for both equity and fixed income asset classes. Bond markets were unusually volatile due to the accelerating financial crisis, and credit spreads widened significantly. The U.S. dollar strengthened relative to most major currencies, helping to produce lower results overseas than in the U.S. for both stocks and bonds. There were precious few positive results during the quarter; the most noteworthy were U.S. government bonds and stocks of U.S. financial firms and real estate investment trusts.

The backside of the Market Review is a table of global investment returns for the third quarter and nine months ending September 30, 2008. The global returns provide reference points against which to judge results for your investment accounts. As usual, but not guaranteed, broad diversification buffered portfolio results in spite of very poor performance in most investment categories.

We hasten to add that most of the summer quarter’s dive occurred in the last month of the period, and the downturn continued and steepened in the first 10 days of October. The following table indicates the extent of deterioration in global markets in the third quarter and as the fourth quarter started:

The data suggest that the latest selling in equities has been indiscriminate.

A U.S. bear market began about a year ago after market indices topped in mid-October 2007. The last 45 or so days could be described as a bear market within a bear market (a bear market is generally defined as a broad market decline greater than 20 percent). Overall, the 12-month decline ranks as one of the worst bear markets in modern U.S. history.

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.

We’ve enclosed or attached Timely Topics, which is comprised of an article condensed from the Wall Street Journal. The article argues that we need not worry about another 30’s style Great Depression, even though there are considerable similarities between now and 1929.

In a sense, this whole letter is a timely topic; it attempts to address today’s very tumultuous times. Found below are:

1. Our take on “what’s going on out there” (massive de-leveraging)

2. A very topical book recommendation by the Blog Department

3. Updated outlook

4. Our recommendations about short-term portfolio and spending tactics

5. Some reassuring information about the safety of accounts at Schwab and the safety of Schwab money market funds

Massive Global De-Leveraging

With essentially all the world’s assets on sale, and increasingly at what we may later identify as fire-sale prices, the question has become: where are the buyers? The answer is that much of the financial system and investment community is undergoing a massive de-leveraging. From our perspective this de-leveraging is long overdue and welcome.

Recall that leverage is essentially borrowing to buy an asset such as a home or other investment. Traditional finance, whether applied to personal financial planning, corporate finance, or management of a financial institution (Fannie Mae, a community bank, an insurance company portfolio, an investment bank, etc.) relies on a capital structure of both debt and equity to finance (or fund) family or company assets and postulates safe ratios of debt to equity.

Unfortunately, those safe ratios have been vastly exceeded, not so much by U.S. non-financial corporations, but definitely by many U.S. households and both small and large financial institutions. A 20 percent down payment to buy a home (debt-to-equity of four-to-one) became 10 percent down (debt-to-equity nine-to-one) and then zero percent down (an infinite debt to equity ratio). Meanwhile, traditional financial institutions and newer pools of investment capital such as hedge funds were using increasing levels of leverage to purchase, among other investments, securities backed by U.S. mortgages: commercial bank capital ratios supporting loan and investment portfolios decreased to about one dollar for even ten dollars of assets; investment banks increased their use of debt financing and achieved leverage ratios of 30-to-one; and some of the most aggressive hedge funds sported leverage ratios of 100-to-one.

The excessive run-up of U.S. housing prices became the Achilles heel of the world’s major financial institutions. As we have reviewed previously, increasingly lax loan underwriting standards over many years produced a huge increase in demand for houses and commensurate jump in house prices due to fairly inelastic supply. Securitized mortgage pools sold to investors became increasingly populated with borrowers having weak credit records and employment histories and inability to actually afford the houses in which they resided. The successful continuation of the highly leveraged system depended upon the key assumption that U.S. housing prices would not fall. Once waves of unqualified, unvetted U.S. homebuyers could not sustain their mortgage payments, the whole house of cards collapsed and precipitated the current global financial crisis.

The unwinding of leverage varies by type of institution and extent of investment in mortgage-backed securities (MBS). Generally, it is most easily illustrated using a commercial bank as an example, as follows (and as simplified):

1. The Asset and Liability sides of the bank’s balance sheet before the crisis are:

2.  If the value of the MBS declines by 50%, the bank’s capital is wiped out and the balance sheet becomes:

Assets				Liability and Equity
Investments in MBS		$ 10		Owed to depositors		$ 80
Investments in high quality bonds		$ 20		Loans from other banks		$ 10
Short-term debt of Lehman Brothers		$  5		Reserves and bank shareholder equity		$  0
Short-term loans to other banks		$ 15
Other investments (car loans, business loans, etc.)		$ 35
Cash on hand		$  5
		$ 90				$ 90

3. At this point, the bank cannot make any new loans, and banks regulators are requiring the bank to raise capital. The bank’s stock is probably depressed and potential investors are few and far between. The bank may sell some of its high quality bonds (when many banks do this, the prices of high quality bonds decrease, as seen in recent trading).

4. If Lehman Brothers defaults on its short-term debt owed the bank (Lehman did indeed go into bankruptcy not long ago), the bank’s capital is further impaired: it sells more high quality bonds and continues to try to find investors.

5. Rumors may fly about the bank’s MBS losses and questioning its solvency. It fears a “run on the bank” by depositors. It hoards cash, calls in loans to other banks, stops further such inter-bank loans (but sees its inter-bank borrowings cease, too), and makes no further loans to consumers, homeowners, and businesses. Given the near elimination of inter-bank lending, the banking system freezes up because banks depend on inter-bank loans to smooth out the highs and lows of their cash needs. Because of the contraction of credit to “Main Street,” the economy, too, begins to freeze up and threatens to produce a severe recession.

In summary, de-leveraging generally involves shoring up of the balance sheet, whether personal or institutional. Thus, it has necessitated asset sales to raise capital and/or pay down existing (excess) debt. Two aspects are of particular interest from a portfolio perspective. First, extensive asset selling by mainly cash-strapped financial institutions has put extreme downward pressure on prices of all types of high quality assets (sales by cash-strapped consumers have undoubtedly added to this pressure). Second, the downward pressure, coupled with increasing news of problems beyond Wall Street (i.e., the contagion of Main Street), have created considerable panic by investors, as reflected in the indiscriminate flight from stocks by those seeking to avoid being the last one out the door.



Finally, then, we can rephrase the answer to our question, “Where are the buyers?” They are “around,” but so far they have been completely overpowered and forced to the sidelines by actions of sellers.

To conclude, the on-going onslaught of bad news, beginning with the housing bubble and cascading into unprecedented mortgage defaults and the devaluation of exotic financial instruments, the credit crunch, and numerous financial failures, has been well chronicled by the media, especially coverage of Congressional deliberations about the $700 billion bailout. It seems every government remedy has been met by either more bad news or questions of efficacy and sufficiency, or both, leading to the on-going massive “flight to safety.” To be clear, we believe the bail-out has been needed. So are related actions government officials have taken, such as company bail-outs, forced mergers, government guarantees, and most recently, coordinated rate drops and direct government investment in banks. The question remains: Will they be sufficient?

The Blog Department

The Blog Department remains generally under wraps due to time constraints. We also assume you are currently besieged by the political campaigns. Rather than our climbing onto the soapbox, we’re recommending you read Andrew Bacevich’s The Limits of Power, which is a current non-fiction best-seller. The recommendation is based on his brilliant and thoughtful analysis of the U.S.’s current problems and challenges during a recent appearance on the Bill Moyer’s Journal, a show on PBS. The subtitle of the book is “End of U.S. Exceptionalism,” and the book is published by Metropolitan Books. Dr. Bacevich is a professor of history and international relations at Boston University.

To our readers who are Democrats: Dr. Bacevich describes himself as a conservative and is a retired Army colonel.

To our readers who are Republicans: Dr. Bacevich has lost a son in the current Iraq War, does not believe the U.S. has had a “just” war since World War II, and believes the application of military power seldom leads to the desired outcome (hence, the title of his book).

To our other readers: See above.

The Blog Department could have a “field day” critiquing well-intended but ultimately bad government policy, lax regulation, predatory lending and borrowing, greed and poor decisions by managers of financial institutions, consumers gone wild, and the excesses and built-in instabilities and cyclicalities of capitalism. However, we prefer to focus on investment policy, the performance of mutual funds used in Caves & Associates client portfolios, the successes and failures of our diversification strategies, and where we go from here (please see below).


Review of Investment Policy and Performance

In our meetings with clients about investment policy, we typically focus on two interrelated ideas: 1) Risk and return go hand-in-hand, and both increase as the portfolio stock percentage increases; and 2) select a target stock percentage such that expected losses do not exceed one’s tolerance for risk. Because risk management and client expectations are key aspects of investment policy, these two ideas lead to a discussion of the statistical variation of expected results above or below the expected average return for the client’s selected stock percentage. Based on statistics theory, we look at two standard deviations below the mean as “almost” a worst case. This construct allows each client to test their staying power during the strong downturns of bear markets. To be specific, according to statistics, 95% of portfolio results are expected to lie between two standard deviations above or below the mean. BUT we note that there can be outliers, namely the 2.5% of results below two standard deviations and the 2.5% above two standard deviations. For example, assuming an annual average expected return of 8% and a 10% standard deviation as the associated measure of portfolio return variability around the mean, the “almost” worst case would be an annual loss of -12% (8% minus 2 times 10%). Notwithstanding, there is a 2.5% chance that 12-month results could be worse than -12%, i.e., could be what we call an outlier. In this case, the outlier would be on the negative tail of the bell-shaped curve.

The point of all this background is that global market results for the twelve months ending October 10, 2008 have most likely been an outlier, i.e., much worse than two standard deviations below the expected mean return. Thus, your portfolio has experienced worse results than you may have expected. As you have probably heard, economic and stock market conditions are far worse than anything we have experienced since the 30’s Great Depression. It has been a “perfect storm” because stocks have performed extremely badly for reasons generally described above, and at the same time bonds have produced results substantially below historical averages, primarily because of a combination of forced selling during de-leveraging coupled with an upward adjustment of bond risk premiums, meaning bond investors are requiring higher interest rates due to the very uncertain financial and economic environment (remember that higher required rates mean bonds are repriced to lower values, producing investment losses). By contrast, the sharp downturn of global stocks in 2000-2002 (S&P 500 down almost 50%) was accompanied by bond returns well above historical averages (3-year cumulative returns of about 30%), which significantly cushioned results for the broadly diversified portfolio.

We have a number of salient comments: 1) We’ve experienced the same unexpectedly high losses ourselves and the attendant fear, concern, and disappointment; 2) Whereas an apology may not be appropriate, we want to express our frustration and dismay due to being “at the helm” during this most challenging and disappointing time period; and 3) We are extremely proud to have you as clients and congratulate you on your discipline: you have experienced about the maximum blow to the solar plexus the markets can deliver, and you have held your ground.

What about the performance of mutual funds recommended by Caves & Associates? We combine up to about 50 funds to design client portfolios, so we’ll spare you all the details. To summarize, our traditional stock and bond funds have performed admirably though not spectacularly on a relative basis this year. As one would suspect, when reviewing a rather short time period, some funds have done substantially better than average while some have performed considerably worse. Our selection process emphasizes funds with superior risk controls; level-headed, consistent management; reasonable expenses; and the taking of substantial stakes by managers in the funds they manage (for a convergence of their objectives and ours). Given that our funds are usually not high flyers, we are a bit disappointed that in general they have not held value much better than peers and appropriate indexes. To some extent, the indiscriminate selling we have noted is a contributor to this lackluster comparative result. Certainly, and to be clear, absolute performance has been poor, and our funds have not protected us from market-like losses. Nonetheless, we have had no such expectation and trust you have had that understanding, too.

Our alternative strategies funds have been the bright spot. They have provided superior relative performance and also did a reasonably good job of preserving capital. As a group, their nine-months performance through September 30 was a rather modest loss of -4.3%. Since bond returns were about breakeven for the same period, the performance of alternative strategies funds was not much worse than for bond funds but was substantially better than the rather large losses for stock funds (viz., loss of -18.2% for the average domestic stock funds and -29.7% for the average diversified international stock fund for the first nine months).

What about the performance of our diversification strategies and short-term tactics? Portfolio moves within a short time horizon (let’s say under a year) are very difficult to get right. Among others, one obstacle is the need to consider potentially overriding longer term trends. For example, the value of the U.S. dollar versus other currencies is in a long term downtrend. But when and to what extent will the dollar move upward for short durations?

We employ modest over- and underweightings pursuant to our economic and market outlook, which is reviewed at least once per quarter. In general, we add value because we have achieved more successes than failures. So far in 2008 that has continued to be the case. The following tactics have helped results:

1. Overweighting of bonds, including a far heavier dose of government bonds than specified in investment policies and a much lower level for high yield bonds.

2. Overweighting of alternative strategies.

3. Partial switch from unhedged to dollar-hedged foreign bonds in June.

A tactic which has hurt results is overweighting of foreign stocks versus U.S. stocks. The former have substantially underperformed, mainly due to currency losses and also somewhat lower local currency returns than in the U.S. Partially mitigating this incorrect tactic was the underweighting of stocks and tangibles as a whole. Additionally, of minor but negative impact, we eliminated tactical cash and replaced it with bonds when the yield curve returned to a more normal shape earlier this year. Since then cash has modestly outperformed bonds.



Economic and Market Overview

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.

To provide the latest market perspective in the presentation of our Outlook below, it may be useful to update the market data as of Friday, October 10, 2008 presented at the start of this letter to include the latest returns since then. U.S. markets have remained very volatile since Friday the 10th, but the net result has been a fairly modest rebound compared with very high losses year-to-date (S&P 500 Index at 899.22 at the end of the 10th and 946.43 at the market close Thursday 10/16, up about 5%). Foreign stock markets have been equally volatile. Since Friday the 10th, they too have recovered, though less so than in the U.S. (EAFE Index at 2,773.263 at the end of the 10th and 2,792.656 at the close of markets Thursday 10/16, up about .6%).

It may be that opportunistic buyers are surfacing in significant numbers below price levels established that Friday 10/10 and are preventing further decline. Warren Buffet is widely publicized to be just such a buyer currently. Technical analysts would refer to this as bottom-forming. Nonetheless, we must remember that major, unexpected positive or negative news will upset any temporary equilibrium between buyers and sellers and could sink stocks considerably further.

Updated Outlook

Our 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 (this is sometimes described as the various positive and negative expectations being “already discounted” by the market).

In July, we updated our outlook, noting our January projection had been too optimistic but postulating that we might be seeing the proverbial light at the end of the tunnel. Now, through three quarters, economic conditions are perhaps consistent with the projection of the U.S. slipping into a mild but prolonged recession. Nonetheless, market results are totally diverging from our original 2008 outlook and our July revision.

Any hope that the U.S. economy would achieve a “soft landing” has been obliterated by the escalating financial crisis, especially the seizing up of credit markets in the U.S., U.K., and Euroland. Coupled with trillions of dollars of stock losses, which casts a further pall over consumers, it is clear that developed Western economies, Japan, and Australia/New Zealand are entering recession, quite likely a deep one.

Our previous outlooks have been predicated on good fiscal and monetary policy decisions and execution, gradual transitions, and the absence of major external shocks. It can be argued, especially with 20/20 hindsight, that government officials have acted too slowly, inconsistently, and without coordination to combat the growing crisis of confidence. Additionally, the continued advance of oil prices to about $150 per barrel earlier this year qualified as an external shock, and just as oil prices were falling quite dramatically this summer toward 2007 levels, a second shock arrived in the form of the global credit freeze. Accordingly, consumer and businesses alike were faced with the loss of needed short-term borrowings. As a result, the financial crisis has expanded to become an increasingly economic crisis. In conclusion, for whatever reasons, including the above, our previous “cautious but not completely bearish” outlook last July has been way too optimistic.

We cannot have much confidence in our ability to forecast the future in these almost completely unprecedented times. We see three overriding issues. The first involves government policy and a number of interrelated questions. Have government officials developed adequate measures to unfreeze credit markets and rebuild confidence? Will they effectively and efficiently implement the measures? And will the bail-outs, government stakes, guarantees, etc., take effect soon enough to avoid a deep global recession? The second issue involves the psychology of consumers and investors. Collectively, will they remain calm and have the resolve to gradually overcome the challenges or will they panic, capitulate, and make matters worse? The third issue involves expectations already priced into global securities markets. Given that prices have already moved downward extremely rapidly and to a degree seldom matched in history, excluding the Depression, is a worst case economic scenario already discounted in current market price levels?

We don’t believe these questions are answerable. Also, it would likely be foolish to rely on a purely statistical analysis, namely, that 12-month results are at such extreme variation from the norm (in statistical language, way more than two standard deviations below the mean) that a market upturn must be imminent. Nonetheless, we can proceed to identify a reasonable strategy.

Recommended Actions

The market downturn over the past 45 days has reduced the equity and tangible percentage allocation in most client portfolios by 5-10 percentage points (hereafter, we’ll just refer to equity percentage for simplicity). Since many portfolios were already underweight equity, the current equity percentage is at or below minimums set in many investment policies. This situation implies that equities should not be sold for policy compliance reasons. We cannot know the future, but we can and do know the past. Due to very large recent losses, the past tells us now is a very bad time to sell.

We are not recommending equity purchases at this time. Extreme market volatility suggests investors are highly sensitive to new information and very uncertain about the future. Given the level of unpredictability and the on-going financial crisis, it seems prudent to keep portfolios as conservative as allowed without violating provisions of investment policies.

We have assisted clients in the establishment of reserves as a way to avoid selling long-term positions, especially those in equities, at cyclical market lows, such as now. Because a multi-year period of recession and low stock prices cannot be ruled out, it is important to conserve reserves to avoid their exhaustion. Thus, we recommend cuts in on-going expenditures by deferring outlays for big-ticket items and non-essentials whenever possible. A good target would be cuts of 5-15% of typical levels, hopefully cutting out the fat but not the fun.

Schwab Safety

As this financial crisis really broke loose in September, our first endeavor was to confirm the safety of your accounts and money market fund investments at Schwab. Specifically, in September there was alarming news about brokerage firms (Merrill Lynch, Lehman Brothers, Wachovia, and Bear Stearns), plus a long-established, large money market fund suffered significant losses, “broke the buck,” and placed limits on shareholder withdrawals.

Schwab was quite proactive, and our inquiries and review of the situation confirmed our confidence. Schwab is distinguishable from the firms mentioned above because it is not in the investment baking business (like Merrill, Lehman, and Bear Stearns) and only has a very small commercial banking operation (Wachovia is primarily a bank and secondarily a brokerage operation). Like all brokerage firms, Schwab must segregate customer assets from its own; it acts only as a custodian. If it should undergo fraud or other malfeasance in this role, SIPC insurance protects each account up to $500,000, and excess liability coverage through Lloyd’s of London provides $600 million collectively for all accounts.

Schwab has numerous taxable and tax-exempt money market funds. Schwab employs prudent, conservative investment policies for these funds and holds generally high quality investments. Its funds had no exposure to AIG, Lehman Brothers, and Washington Mutual. Its funds’ modest exposure to securities issued by Merrill Lynch and Wachovia was mooted by advent of the U.S. Treasury Temporary Guarantee Program for money market funds in which Schwab has applied to participate.

Please let us know if you need further information.

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 see the enclosed or attached Timely Topics.

Quotes of Our Times and All Time

Warren Buffet:

“A simple rule dictates my buying: Be fearful when others are greedy and be greedy when others are fearful.”

Will Rogers:

“I’m more concerned about the return of my capital than the return on it.”


John Fitzgerald Kennedy:

“The supreme reality of our time is ... the vulnerability of this planet.”

John Adams :

“Abuse of words has been the great instrument of sophistry and chicanery, of party, faction, and division of society.”

Henry Ward Beecher :

“In this world, it is not what we take up, but what we give up, that makes us rich.”

An old saying :

“When everyone is talking about stocks you should be worried about the stock market, and when everyone is worried about the stock market your should be talking about stocks.”

Shirley Temple Black :

“I stopped believing in Santa Claus when I was six. Mother took me to see him in a department store and he asked for my autograph.”

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 17, 2008 and are subject to change based on subsequent developments.