Market Perspective Full Year 2009 
2010 Outlook and 2009 Scorecard

Securities markets recorded one of the most impressive rebounds in the history of the capital markets after sinking to devastatingly low levels in early 2009. Global governments’ unprecedented efforts with respect to healing the world economy and stabilizing the securities markets seem to have achieved their desired short-term effects. The historic rebound saw both equities and credit-sensitive fixed income securities move substantially higher. The average diversified U.S. equity fund returned 32%, and the average diversified foreign equity fund returned 34% according to Morningstar. The Barclays Capital U.S. Aggregate Bond Index rose 6%; intermediate investment-grade and high yield bonds rebounded from 2008 losses and returned 16% and 46%, respectively. In contrast, U.S. government bonds, the only asset class to produce positive returns in 2008, declined across the yield curve in 2009; long-term U.S. treasuries were the hardest hit (down 13%). Finally, foreign government bonds rose 4%.

While the economy seems to be gradually improving on a variety of fronts, there are still many questions that remain unanswered. Most notably, how sustainable is an environment of nearly 0% short-term interest rates and massive deficit spending, and how will the economy and investors react when the Federal Reserve eventually raises rates and government stimuli are phased-out?

Economic Review

The extraordinary measures taken by the U.S. and other world governments to revive the financial system and world economies seem to have achieved their desired short-term effects, thereby avoiding a worldwide Great Depression II. Instead, the Great Recession that consumed the U.S. and other major economies of the Western world from the end of 2007 may have finally ended during the third quarter of 2009. The U.S. economy, as measured by gross domestic product (GDP) expanded 2.2% during the third quarter of 2009 following a modest contraction of 0.7% during the second quarter and versus the devastating 6.4% contraction of the first quarter and significant contractions in the third and fourth quarters of 2008 as well. It should be noted that an estimated two-thirds of the third quarter expansion was due to the “cash-for-clunkers” program that has since ended.

The U.S. economy showed gradual signs of improvement during the third and fourth quarters with the manufacturing segment leading the way. The Manufacturing ISM Index improved from 35.6 in January to above 50 in August, and finished the year at 55.9 in December. The Non-Manufacturing or Service ISM Index improved from 42.9 in January to above 50 in September, and finished the year at 50.1 in December. Readings above 50 indicate that the economy is generally expanding while readings below 50 indicate a contracting economy. December was the fifth consecutive month of growth in the manufacturing sector, the third month of growth in the last four months for the service sector, and the eighth straight month of expansion in the overall economy. The past relationship between the annual average for the Index and the overall economy indicates a 1.6 percent increase in real GDP for 2009.

The progress in manufacturing and other segments of the economy is consistent with the findings of the Federal Reserve Board as reported in its January Beige Book report. The report indicated that “while economic activity remains at low a level, conditions have improved modestly further, and those improvements are broader geographically than in the [November] report.” The Fed report also reported that consumer spending was “cautious, price sensitive, and focused on necessities.” Consumer spending is important, as up to 70% of the economic growth in the U.S. has historically been driven by the consumer. The Consumer Confidence Index rose to 52.9 in December to its highest level since December 2007. The Reuters/University of Michigan Sentiment Index increased to 72.8 in January 2010 from a 28-year low of 55.3 in November 2008. Nonetheless, a s Insight Economics stated in a recent newsletter, “The economic contraction may be over but consumers are not yet embracing it as households continue to worry about job losses, high unemployment, rising foreclosures, high energy costs, and tight credit conditions.” To illustrate, and given expiration of “cash-for-clunkers” in August, auto sales declined 9.5% from the summer to the fall quarter.

During the fall of 2009, the pace of monthly job losses continued to moderate substantially but ended the year on a sour note. According to the Bureau of Labor Statistics, employment losses in the first quarter of 2009 averaged 691,000 per month, compared with a much lower average loss of 65,000 per month in the fourth quarter. The Bureau reiterated an October job loss of 111,000, revised the November job loss of 11,000 to a 2,000 gain, but reported that 85,000 non-farm jobs were lost in December. Job losses continued in construction, manufacturing, and wholesale trade, while temporary help services and health care added jobs. The December unemployment rate remained unchanged from November at 10.0% after reaching a high of 10.1% in October. Unemployment had ended 2008 at 7.4%. Economists surveyed by Bloomberg forecast unemployment will peak at 10.2% in the first quarter of 2010 and average 10% for the year, hence the recovery being termed “jobless.”

Housing markets stabilized in 2009 as the Federal Reserve’s policies drove mortgage rates to 50-year lows. Home prices increased for seven consecutive months through November, and the number of foreclosed homes for sale declined as a result of the Obama administration’s program to keep at risk borrowers in their homes. Home sales were also supported by an $8,000 tax credit for first-time home buyers; it was originally set to expire in November, but Congress has extended that tax credit though the first half of 2010. In October, existing home sales were much stronger than expected, coming in at a seasonally adjusted annualized rate of 6.1 million units, which marked the highest level in two and a half years. In November, existing home sales jumped 7.4% to a seasonally adjusted annualized rate of 6.54 million units. The substantial increase in existing home sales may have partly been fueled by the anticipated expiration of the first time home buyer credit. The news for new home sales was mixed. Sales in October were stronger than expected, increasing by 6.3% to a seasonally adjusted and estimated annualized pace of 430,000. In November, however, sales of new single-family homes sank 11.3% to a seasonally adjusted annual rate of 355,000, marking the slowest pace since the spring of 2009. The outlook for housing markets in 2010 is uncertain. Only 31,000 borrowers have received a permanent loan modification under the Obama program. In addition, the number of problem loans is increasing. One in seven mortgages was either in foreclosure or delinquent on payments at the end of September, many due to lost jobs or borrowers walking away from underwater loans. In addition, many potential buyers wanting to “move up” are unable to sell their existing homes.

The problems for commercial real estate may be just beginning. As rents and occupancy rates have plummeted in virtually all markets, property values have also fallen significantly. The Federal Deposit Insurance Corp. (FDIC) has been forced to assume control of banks hurt by property loans and is providing private investors very attractive financing to buy and work out the loans. It is estimated that 65% of the more than $1.4 trillion in commercial mortgages that will come due by 2013 will have problems obtaining refinancing.

The financial sector had its share of notable events in addition to the news about Dubai World’s debt problems, which were ultimately resolved when Abu Dhabi, the capital of and second largest city in the United Arab Emirates provided Dubai World with a $10 billion lifeline. In the U.S., the banking sector continued to be under some pressure, with failures for the year reaching roughly 140 during the fourth quarter. This year’s total for bank failures is the highest number since 1992, when 181 banks failed but remains far lower than the 534 closures that took place during the peak of the savings and loan crisis (1989). To put this into perspective, over 9,000 banks failed during the Great Depression. While the environment remains challenging for many financial companies, conditions improved over the course of the year, prompting select prominent institutions to repay federal loans. In December, Bank of America reported that it had reached an agreement to repay $45 billion in federal bailout funds, which would allow the company to avoid pay restrictions and other curbs imposed by the U.S. Government. Bank of America became the first of seven companies to return its exceptional taxpayer-funded support.

Inflation remained low in 2009 as the Total Consumer Price Index (CPI) rose 2.7% and the Core CPI (excluding food and energy) rose 1.8%. The increase in Total CPI was primarily due to the energy index, which rose 18.2% for the year. Although U.S. government stimulus plans are expected to lead to higher inflation over the long term, growing unemployment and subdued inflation allowed the Federal Reserve to keep short-term interest rates close to zero for the year.

Large cash reserves and financially solvent banking systems that avoided the leverage problems in the U.S. and other Western countries positioned emerging market countries to take advantage of the global rebound. Asia’s fast growing economies, and particularly China, India, and Indonesia, recovered rapidly in 2009. In China, a giant government stimulus plan significantly spurred domestic consumption and offset the collapse in exports. Growth of China’s GDP was lowest, but still positive, in the first quarter of 2009; increased each subsequent quarter to an annualized rate of 10.7% in the fourth quarter; and had an overall rate of growth of 8.7% during 2009. In Latin America, accumulated government surpluses also provided stimulus funds and were also used to reduce debt.

In Europe, improving economic conditions were also reflected in manufacturing indexes and higher GDP. In December, Markit Economics reported that the Euro-zone Purchasing Managers Index (PMI) rose to 51.6, its highest level in 21 months. This news followed a significant improvement in third quarter European GDP, marking the first time in five quarters that output was positive. More specifically, Eurostat, the Statistical Office of the European Communities, reported that Euro area GDP rose by 0.4% relative to the prior quarter. This represents notable progress when compared with the third quarter of 2008, when seasonally adjusted GDP declined by 4.1% in the Euro area. Germany, one of the largest economies in the Euro-zone, was a significant contributor to the economic turnaround as its GDP grew by 0.7% thanks partly to improved exports. Japan, which returned to economic growth during the second quarter, also turned in a positive third quarter, with its GDP expanding by 0.3%.

Equity Review

The broad U.S. stock market gained 29.4% in 2010 as measured by the Wilshire 5000 Index (equal-weighted). The MSCI-EAFE Index of large developed country foreign stocks was up 31.8%, and the MSCI Emerging Markets Index rose an astonishing 78.5%; both figures are in U.S. dollars. The MSCI Latin America Index rose 98%, also in U.S. dollars. Investors gobbled up European stocks in 2009, staging the strongest rally in a decade. The pan-European Dow Jones Stoxx index of Europe’s 600 biggest companies rose 28.6%. Germany’s DAX index gained 23.8%, while Britain’s blue-chip FTSE 100 index rose 22.1%. Many markets farther east, such as Hungary and Russia, fared even better. The poorest performance by a major international market in 2009 was Japan. The MSCI AC Asia Ex-Japan Index rose 68.3%.

The year 2009 included two completely contrasting time intervals for stock returns, as shown by the following table:

Final Phase of 2008 Bear Market 1/1 – 3/9/09

Bull Rebound 3/10 – 12/31/09

 

 

 

S&P 500

-25%

 

68%

 

 

 

MSCI EAFE

-24%

 

85%

According to Morningstar, at the end of 2009, the average diversified U.S. equity fund was trading at a price-to-earnings (P/E) ratio of 17.4. The average diversified foreign developed and emerging countries stock funds were trading at 13.1 and 12.7, respectively. Although emerging stocks, which generated some of the highest returns in 2009, are trading at relatively low P/E ratios, those ratios have more than doubled from crisis lows last March. Also, they are traditionally lower due to the special additional risks of investing in emerging markets.

The sectors that declined the most in 2008 were the biggest gainers in 2009. Virtually all U.S. stock sectors provided outstanding double digit returns for the year. Technology (61.5%), communications (47.5%), and energy and other commodities (47.8%) were the biggest gainers but real estate (31.6%), financials (22.7%), and health (22.3%) stocks also provided outstanding, albeit lower returns.

Among the more common ways to differentiate among stocks is by size (larger capitalization versus smaller) and by style (value versus growth). Large-cap stocks are measured by the Russell 1000 Index, and they slightly outperformed small-cap stocks as measured by the Russell 2000 Index. Ignoring style considerations, large-caps gained 28.4%, and small-caps gained 27.2%. This year’s results represent an exception to the pattern of higher performance of small caps that has characterized markets since the Internet Bubble burst in 2000. This exception suggests a shift in investors’ preference to companies that might hold up better if the economic recovery slowed. For the full year, growth style indices significantly outperformed value style indices by about 17 percentage points. This variance primarily results from the relative underperformance by value-orientated financial stocks (plus 22.7%) when compared to the outstanding returns by growth-oriented technology stocks (up 61.5%) for the year.

Results by style for mutual funds were about the same as indices, though variations were somewhat smaller. Large-cap growth funds beat large-cap value funds by about 11 percentage points. Similarly, small-cap growth funds outperformed small-cap value funds by about 5 percentage points. The preference for value stocks had also persisted since the Internet Bubble burst in parallel with the small-cap preference noted above. Unlike the representative indices, the average diversified small cap fund modestly outperformed the average diversified large cap fund (33.4% versus 29.9%, respectively). Please note that classifications of mutual funds by style have their limitations.

Longer-term data reflect the deep 2008 slump and the extent of the 2000-2002 bear market correction, especially among larger capitalization and growth-oriented stocks. The table below covers two bear markets, one bull market (2003-2007), and the 2009 rebound, and shows annualized ten-year returns for 2000 – 2009:

Value

Growth

 

 

Large Cap Mutual Funds

1.8%

-3.4%

 

 

Small Cap Mutual Funds

7.9%

0.2%

As noted previously, value stock returns should equal or exceed growth stock returns, and small cap returns should equal or exceed large cap returns in the long run. The unwinding of the tremendous disparity this decade between the performance of small value funds and large growth funds made some headway in 2007, stalled in 2008, and improved again in 2009.

In 2009, the strong returns for broad, capitalization-weighted market indexes were indeed representative of performance at the level of individual stocks. For the three U.S. stock exchanges combined, 5,922 stocks advanced and 1,448 stocks declined. The corresponding advance/decline ratio of 4.09 places second in the 20-year period we have been tracking, behind only the high of 7.19 in 2003, which was also a rebound year.

As reviewed in the past, the advance/decline ratio has its limitations. Nonetheless, the extremely high value of the advance/decline ratio in 2009 provides some concern that U.S. stocks may have risen too quickly in the 2009 recovery. For example, after rocketing up to 7.19 in 2003, the advance decline ratio fell to 1.72 in 2004. Notwithstanding, stock returns in 2004 were solidly in the black.

Foreign stock markets generally outperformed the U.S. market in 2009. The U.S. dollar depreciated for most of 2009 and lost about 5.2% verses 19 currencies tracked by the J.P. Morgan Dollar Index. For U.S. investors, foreign returns in local currencies were increased by the currency gains associated with this weakening of the dollar. As indicated in the data table below, the average mutual fund investing in international stocks gained 34.2% for the year, a bit better than the MSCI EAFE return of 31.8% in U.S. dollars. The MSCI EAFE Index covers developed markets outside of the U.S. and Canada.

Emerging markets stocks were some of the best performers in 2009 , their best showing since 1993. The economies of emerging countries are growing faster than those of developed countries plus emerging countries have accumulated enormous cash reserves which can be invested to promote economic growth. The MSCI Emerging Markets Index gained 78.5% in U.S. dollars, boosted by currency gains due to a weakening U.S. dollar. Over the previous five years, emerging markets stocks have provided a spectacular return of 15.5% per year in U.S. dollars, as measured by the MSCI Index, notwithstanding catastrophic losses in 2008.

Looking at performance over the past five years, other salient observations are:

  1. Measured by mutual fund returns, U.S. stock average annual returns were barely above breakeven (positive 0.9%), and average annual returns of foreign developed nations’ stocks were fairly moderate (up 4.0%).

  2. Financial sector stocks lost 6.4% per year, whereas natural resources stocks gained 11.2%, as measured by mutual fund returns.

  3. Japanese stocks lost 4.6 annually, whereas other Asian/Pacific stocks returned 14.5% per year, again as measured by mutual fund returns.

Global stock returns are summarized in the following table; please see footnotes for enhanced understanding:

Annualized Return*

One
Year

Five
Years

U.S. Stocks

 

 

S & P 500 Index **

26.5%

0.4%

Average Diversified U.S. Equity Mutual Funds

32.2%

0.9%

Russell 2000 #

27.2%

0.5%

 

 

Sector Mutual Funds

 

 

 

Technology

61.5%

3.1%

 

Health

22.3%

3.3%

 

Communications

47.5%

-0.3%

 

Financial

22.7%

-6.4%

 

Real Estate

31.6%

-0.9%

 

Natural Resources

47.8%

11.2%

 

 

 

Foreign Stocks

 

 

MSCI Europe, Australasia & Far East (EAFE) USD ##

31.8%

3.5%

MSCI EAFE Local Currencies

20.9%

0.3%

Average Diversified Foreign Equity Mutual Fund

34.3%

4.0%

 

 

Regional/Specialty Mutual Funds

 

 

Europe

43.1%

4.7%

Japan

7.7%

-4.6%

Diversified Pacific/Asia Except Japan

71.5%

14.5%

Diversified Emerging Markets

73.7%

13.2%

 

 

* Mutual fund return data are from Morningstar.
** Capitalization-weighted index of 500 very large U.S. companies. The 500 are chosen to achieve a fair cross-section of U.S. industrial and service sectors. Recent median capitalization of approximately $44.1 billion.
*** Barclays index of U.S. Treasury bond total returns (i.e., interest plus or minus change in price). Bonds in index have intermediate maturity of about 4-7 years. No mortgage-backed securities included.
δ Barclays index of U.S. investment grade corporate bond total returns (i.e., interest plus or minus change in price). Bonds in index have intermediate maturity of about 4-7 years.
# Index of small U.S. companies. Recent median capitalization of approximately $799 million. Somewhat overweighted toward financial stocks.
## International stock index indicating return of large foreign companies of 21 major developed countries (Japan, UK, and Germany have the highest weightings). Returns are unhedged and converted to U.S. dollars. No emerging market stocks are included.

Stock Fund Managers Versus Indexes

Active U.S. stock pickers beat the S&P 500 Index in 2009, meaning they have beaten a passive or indexing approach for eight of the past eleven years. This result was particularly surprising given that small caps, which are usually favored by stock pickers and typically comprise a higher allocation of fund portfolios than found in capitalization-weighted market indexes, slightly underperformed large caps for the year. A detailed explanation is beyond the scope of this review. As reported above, active international stock pickers also beat the EAFE index of developed country market returns. This outperformance probably resulted primarily because most diversified foreign funds include some emerging market stocks, which had extraordinary returns for the year. Finally, it is noteworthy that active stock pickers were able to overcome fees for management of typically 1-2% per year versus zero cost for indexes.

Alternative Strategies

The six open-end funds we used during 2009 provided a weighted average return of about 12.7% for the year. Consistent with their hedged, defensive positioning, their returns were significantly worse than the returns of global stocks but were somewhat above those for global bonds. For a typical Caves & Associates portfolio, the inclusion of alternative strategies produced a decrease in 2009 return of about -4.2% (420 basis points) respecting the money allocated to alternative strategies but an increase in stability due to limited correlation of results with stock and bond markets. It should be noted that alternative strategies are particularly effective in down markets, and they had their best quarters compared with traditional asset classes when stocks were at their worst during the first quarter of 2009.

By comparison, for 2008, the six funds provided a weighted average return of about -13.2% last year (as corrected). Consistent with their hedged, defensive positioning, their returns were significantly better than the returns of global stocks but were substantially below those for global bonds. For a typical Caves & Associates portfolio, the inclusion of alternative strategies produced an increase in 2008 return of about 2.6% (260 basis points) for the money invested in alternative strategies (variance revised from last year’s Market Perspective, which reported an increase of 310 basis points, for consistency with methodology of variance calculation used in 2009 and reported above).

Looking at results covering the last two years of high market volatility, the six alternative strategy funds provided a two-year return of about -2.2% (cumulative; not annualized). For a typical Caves & Associates portfolio, the inclusion of alternative strategies therefore produced a very modest decrease in the cumulative 2008-2009 return of about 0.6% (60 basis points) for the money committed to alternative strategies, including the impact of compounding. Again, the inclusion of alternative strategies helped smooth client returns and thereby helped them “hold the course.”

Results for indexes of hedge fund performance in 2009 compiled by Credit Suisse/Tremont, Hedge Fund Research, and Dow Jones were generally inconsistent and not helpful in evaluating performance of the six alternative strategy open-end funds. Results available to us for three private limited partnership programs employing unregistered hedge funds suggest the six funds had returns about in line with returns hedge funds. Because hedge fund managers employ at least some leverage, one would expect their results to exceed those of the unleveraged open-end funds. Leverage generally helped results in 2009 when most bets were winners, not losers. One explanation is that one of our six funds had a very, very good year and helped the combination of six achieve performance about level with hedge funds in general even without the benefit of leverage. As previously reported, hedge funds usually have a lower amount of assets under management, which aids flexibility and concentration into best ideas, both of which can benefit returns.

Fixed Income Review

Fixed income performance varied notably across investment markets with investment grade and high-yield bonds substantially outperforming U.S. Treasuries. Although the Federal Reserve held short-term interest rates near zero throughout 2009, intermediate and long term Treasury interest rates rose on inflation fears and the need to attract buyers for huge new issues of debt due to the government’s funding needs for expensive stimulus programs and foreign wars. And since bond prices move inversely to interest rates, prices on “risk-free” government bonds began to fall. At the same time, skyrocketing demand for riskier assets by income-seeking investors reduced interest rates on investment grade and high yield bonds, or technically speaking, credit spreads fell throughout the year as investors preferred investment grade and high yield bonds to U.S. government bonds. The yield spread between investment grade bonds and comparable Treasury bonds fell about 6.25 percentage points and investment grade bonds at the end of the year yielded “only” about 2 percentage points more than the comparable maturity Treasury bonds. For high yield bonds, the spread narrowed from more than 20 to 6.4 percentage points. Long term government bonds returned a negative -12.2% and long-term investment grade and high yield bonds returned positive 16.8% and 58.2% for the year, respectively, according to Barclays Capital.

Unhedged foreign bonds received a boost in returns due to the weakening of the dollar during the year. The government bonds of major developed countries returned 4.4% in U.S. dollars for the year, as measured by the Citigroup Non-U.S. World Government Bond Index. It is clear that the currency gains were needed to offset local market value losses that occurred for the same reasons as losses in the U.S. for Treasury bonds. Demand for the bonds of emerging markets was high due to the relatively strong economic advantages discussed previously. Emerging market bonds returned 29.8% in U.S. dollars for the year, as measured by the JPM Emerging Markets Bond Index.

The following table and footnotes present fixed income results:

Annualized Return*

One
Year

 

Five
Years

U.S. Bonds

 

 

 

Barclays Intermediate Gov’t Bond Index **

-0.3%

 

4.7%

Barclays Intermediate Credit Index ***

15.9%

 

4.8%

Intermediate Municipal Bond Mutual Funds

11.2%

 

3.3%

Short/Intermediate Municipal Bond Mutual Funds (CA)

10.0%

 

3.0%

High Yield Bond Mutual Funds

46.2%

 

4.2%

 

 

 

Foreign Bonds

 

 

 

Citigroup Non-U.S. World Gov’t Bond Index #

4.4%

 

4.5%

* Mutual fund return data are from Morningstar.
** Barclays index of U.S. Treasury bond total returns (i.e., interest plus or minus change in price). Bonds in index have intermediate maturity of about 4-7 years. No mortgage-backed securities included.
*** Barclays index of U.S. investment grade corporate bond total returns (i.e., interest plus or minus change in price). Bonds in index have intermediate maturity of about 4-7 years.
# Citigroup index of total return of foreign government bonds issued by major developed foreign countries (Japan, Germany, France, and UK have the highest weightings). Returns are converted to US dollars.

Key Issues and Outlook for 2010

We don’t favor market predictions, especially in absolute terms. As you know, we argue that the future is unknowable. The interplay of socio-economic and geopolitical factors is just too complicated to predict. Thus, we are against trying to time the market. However, we usually try to identify factors and issues that are important in 2010 and beyond. These have been typically historical macroeconomic waypoints and trends which can help us narrow the range of potential outcomes in the future. Examples involve such key factors as global economic strength, energy consumption and price trends, the monetary and fiscal policies of the governments of major economic powers, and relative valuations of major securities markets. In 2010, the list of issues is even greater. For one, we must evaluate the outcome of two on-going opposing forces confronting each other: corporate and consumer de-leveraging (negative for businesses and markets) versus massive government economic stimulus (positive, at least in the short run). Additionally, the prospect of increased government regulation of business and consumer protection creates considerable uncertainty. As a consequence, developing an outlook is even more difficult than usual.

To save time, and because of the potential futility, we are again presenting a condensed version this year. The reader is referred to previous years’ outlooks for expanded analysis and discussion of key issues.

The first key issue is the strength of the U.S. and global economy, an important issue every year. The future course of the global economy is a major determinant of corporate profits and will therefore have a significant impact on global stock and bond markets. Like last year, the issue boils down to two main topics. The first relates to government stimulus programs, predominantly those in the U.S. and other developed economies. We can use the struggling U.S. economy as an example. Our economy has been on the life support of government deficit spending and Fed controlled low interest rates for several years. How much longer can we afford this life support? How is the patient doing? Has recovery been sufficient for our economy to stand on its own as life support is necessarily reduced? Will government officials decrease support at the right pace and time? Finally, the U.S. economy is not alone. The same issues exist in other mature western economies and in Japan, areas which combine to comprise a significant majority of global GDP. The second topic regarding the future strength of our interconnected global economy relates to emerging markets. To what extent will key emerging markets economies, particularly China and India, remain decoupled from the U.S. economy so they can bolster world economic activity while Euroland and the U.S. recover from life support? Can they maintain their growth in the face of increasing domestic inflation, environmental challenges, and trading partners demanding fairer currency policies (for example, upward revaluation of the Chinese yuan)?

The second key issue for 2009, and a repeat from prior years, is the trend of corporate profits. In the recent recession, many firms have preserved profit margins and returns on equity by aggressively cutting costs in the face of stagnant or shrinking sales. But that’s not a recipe for long-term success: you can’t perpetually trim your way to prosperity. At some point the top line needs to rebound or profitability will shrink. Whether the top line will rebound is unclear, especially amid mixed news about retail sales and business activity. Further, job growth data continue to be quite discouraging. In sum, there is significant risk corporate profits, which will face much tougher prior year comparisons later in 2010, could disappoint.

A third issue is whether the dramatic global stock price rebound over the last 10 months is justifiable and sustainable. In other words, has the rally gotten ahead of itself? We note that equi­ties on a historical basis have tended to rebound sharply from the bear market trough, gaining an average of about 47% for the one-year period following the bottom of the market. By comparison, the sharp rebound since March 9, 2009 to January 14, 2010, has produced a gain of roughly 76%. Because this recovery has been much stronger than the historical average, it raises the technical question whether the rebound represents an overly optimistic bull cycle. One rather obvious reply is that an above average rebound is to be expected given the bear market ending March 9, 2009 was itself much worse than average and had taken stock prices to unprecedented lows. Further, cumulative global stock returns since the previous peak in December 2007 remain seriously negative for U.S. stocks and only about breakeven for foreign stocks, suggesting the potential exists to extend the current bull rebound.

Two other issues, currency movements and interest rates, are particularly murky. Major forces are knocking heads as usual regarding the direction of the U.S. dollar. One is the on-going increase in investors’ risk appetite, which weakens the dollar. Further, huge deficit spending to stimulate our economy is combining with on-going trade deficits to flood the world with new U.S. debt. This large incremental supply of dollars may require a cheapening of the dollar to entice adequate incremental demand by buyers. Potentially offsetting is the relative strength of the U.S. economy, especially versus lagging ones in the UK and Euroland, which tends to support the Greenback.

The outlook for interest rates and the shape of the U.S. yield curve are uncertain mainly due to macroeconomic uncertainties in the U.S. as well as globally. The Fed is expected to keep short-term interest rates low indefinitely. Nonetheless, the Fed cannot control long-term rates, global interest rates, or credit risk premiums. In the U.S., risk premiums declined significantly, even dramatically since March 9. As noted respecting global stocks, the question becomes whether the rally is overdone. Additionally, especially later in 2010 or beyond, the Fed may need to increase rates if inflation becomes a threat, which could have various negative consequences for businesses and consumers.

Overseas, it is very difficult to predict the policies of various central banks, including the UK, EU, and Chinese authorities. Finally, it is still possible we could experience the “mother of all credit crunches,” wherein foreign buyers demand much higher interest rates to buy and hold our debt. Thus, we note the interrelated nature of these issues and the considerable difficulty in making projections involving both the dollar and interest rates.

As very evident in both 2008 and 2009, investor and consumer psychology will play an important role. The level of volatility in global financial markets for years had been very low until the latter part of 2007. For investors, this benign and profitable period encouraged not only complacency about risk but also an increasing appetite for risk. As we progressed from mid-2007 through 2008, a number of inconvenient truths were revealed about unsustainable and somewhat artificial boom times in the U.S. and abroad due largely to overly easy credit. Seemingly overnight, fear and retrenchment replaced complacency and greed, and we witnessed a massive downward repricing of essentially all risky assets.

Investor psychology not infrequently seems to turn on a dime and gain momentum quickly, and it did so last March. With bonds and at least some stocks priced for a global Depression, it did not take much encouraging news to begin a rebound. The major positive factors were the rapid implementation of global financial bail-outs and other types of government support which were able to end the slide of such economic indicators as housing, credit availability, and jobs and generally restore faith in major financial institutions. Though investors have a reputation of having short memories, it is unlikely they have forgotten the pain of 2008 (and even 2000-2002 earlier), so we should expect continued “jumpiness” by investors.

In considering these very difficult, interrelated issues, we are swayed, as usual, by what history reveals, namely, that economies and markets are cyclical and seek equilibrium and that investment results regress to the mean. Therefore, historical patterns and averages will ultimately prevail. The question is, when. Also, since the consensus outlook is already factored into current bond and stock price levels, how differently will the future unfold compared with the consensus?

As we have said before, we believe the future is unknowable, so we are again going to refrain from making a point-by-point 2010 projection. Our best guess is that the current consensus forecast is too optimistic. Nonetheless, it is only a guess. Accordingly, we are planning to avoid any major tactical underwriting or overwriting. We will position client portfolios in 2010 predicated upon 1) continued concern about the outlook for the global economy, and 2) another best guess, that the future will unfold somewhat more negatively than the consensus has forecast. Therefore, stocks are modestly to moderately over-valued at present and will be slightly underweighted, accordingly.

Over and over again, we have seen the unreliability of short-term economic and market forecasts and the unpredictable nature of markets. As usual, geopolitical risks, poor policy implementation, and a host of other factors could wreak havoc with these predictions, and there is always the risk of the totally unexpected. Therefore, results in 2010 could be considerably better or worse, or at least different, than indicated above.

Beyond 2010

We expect the economic recovery to continue in 2011 but remain largely “jobless.” We believe most western economies have been “kicking the can down the road,” meaning they have put off seriously addressing their socioeconomic problems. For the U.S., our wars in Iraq, Afghanistan, and against Al Qaida have certainly distracted us and limited our resource availability. Accordingly, in many respects, we have the same concerns expressed in previous years. They stem from the belief that the tax-cuts and deficit spree of the Bush administration, now followed by the Obama administration continuing the same basic fiscal policy and adding further to deficits and the Federal debt, have juiced up the economy but will exact a price in later stagnation. The various potential remedies for our growing debt levels and trade deficits are tax increases, spending cuts, and higher interest rates, in some combination. These remedies will all inflict pain, pain which we are currently deferring. According to Fed chairman Bernanke: “The longer we wait, the more severe, the more Draconian, the more difficult the objectives are going to be” in responding to the crisis. Given the depth of current economic challenges, and the on-going drain of war, it is clear we must postpone remedial action, but it is also clear we will have to face another day of reckoning in the not too distant future.

Implications for Asset Allocation

Because an outlook is to a considerable degree an attempt to have a crystal ball, the prognostications are very subject to error and need to be discounted. Therefore, we are avoiding anything resembling a significant departure from client policy allocations. In other words, we are returning to our longtime methodology of ignoring our outlook and maintaining portfolios quite near to long-term targets, a methodology which was partially not followed from December 2008 until recently. Nonetheless, we believe it is prudent to remain conservative in the face of challenging and uncertain economic, market, and geopolitical conditions. Because we recognize we could very well be wrong, we are taking actions to increase the emphasis on capital preservation but keep tactical adjustments to a minimum.

Relevance of Market Review and Outlook for the Strategic Allocator

Before concluding, let’s address the relevance of a review and outlook and clarify why we are minimizing tactical adjustments, as follows:

  1. An outlook is really a best guess over 6-18 months, which is not a long-term period. Thus, most outlooks support tactical maneuvering for short-term gain. Most outlooks are also trend following, not contrarian. It is human nature to expect continuation of recent trends. It takes a brave soul to predict a reversal. We try to develop our outlook to avoid this common problem, but we are human, too, as evidenced the last two years.

  2. As described in the Outlook Scorecard section below, our outlook has not been too reliable the last two years, when market extremes occurred. Thus, it is not a sound basis for big bets. We could make cohesive, plausible arguments for predictions that would be both much more negative and much more positive than those above.

  3. Caves & Associates prepares a market review so we do not blindly follow history or ignore the markets. We also stay abreast of the latest research that might shed new light on historical bases for portfolio design. We monitor market trends, but mainly to be able to properly evaluate mutual fund managers’ performance and explain the performance of client portfolios. Finally, we prepare an outlook because the exercise has a small possibility of allowing us to foresee major problems requiring extraordinary strategies. Thus, it's prudent, and part of our responsibility to clients.

  4. Asset allocation is a long-term approach utilized to manage long-term money according to long-term historical evidence. Asset allocation defined in this manner requires a disciplined adherence to a relatively fixed asset mix. It is also quite contrarian, because when an asset class proportion declines due to relatively poor performance, the asset allocator buys more. Hence, asset allocation entails periodically selling your winners and buying your losers to maintain the strategic balance. This rebalancing is done periodically and “religiously” and is definitely not “market timing” or “chasing performance.” Therefore, near-term outlooks are of limited interest to the strategic asset allocator.

Outlook Scorecard, Strategies Employed, and Impact on Results

Last year was the eleventh time we attempted something resembling an outlook. A scorecard is in order to see if we are gaining anything from the effort.

Until the 2008 outlook was way off the mark, our report cards for previous years were generally favorable: we had more predictions right than wrong, and our errors have not been harmful to returns. Unfortunately, we cannot say the same for our 2008 and 2009 outlooks and investment tactics. Notwithstanding, as indicated in the accompanying letter, an occasional negative report card is inevitable for a firm such as Caves & Associates, which generally follows a non-timing, strategic allocation approach. As an example, and to repeat the assessment of the 2008 outlook, it was the worst year in financial markets since the Great Depression; it was aberrational in almost every measurable way. There was only one recommendation that consistently made money, which was to sell everything and buy U.S. Treasuries. That’s the most defensive posture imaginable, and it could only have been the rare advisor who was suggesting such a radical, one-dimensional strategy going into 2008. To conclude respecting allocation strategy, the 2009 outlook did not contain any detailed asset class tactical forecasts, so we have no need for a point-by-point report card. Please refer to the accompanying letter for some review of last year’s outlook and the performance of our 2009 strategies.

Respecting a scorecard for the mutual funds we employ in client portfolios, they remained highly rated by and large. As evidence, four of “our” mutual funds were among the 15 recently nominated for Morningstar’s 2009 managers of the year (Morningstar is highly regarded for its mutual fund databases and mutual fund ratings), though ultimately, none won. However, in 2006 through 2008, one or more of the winners were well represented in the portfolios of Caves & Associates clients.

We believe the scorecard highlights why we recommend strategic asset allocation rather than tactical allocation or market timing. Over the long run, we are convinced that correct predictions will be largely offset by incorrect predictions, especially when the predictions have to deal with such a broad scope as global stock and bond markets. Thus, the effort adds little or no value but can reduce returns by increasing capital gains taxes, transaction costs, and management fees if the effort induces a short-term, tactical approach.

In a year which started with a very steep decline followed by an almost unprecedented rebound, the inaccuracy of our 2009 Outlook becomes a moot point in the sense that an accurate, very positive outlook would not have dramatically changed the returns of portfolios supervised by Caves & Associates. That’s because of the Caves & Associates philosophy of staying the course. Even though we underestimated future stock market strength in 2009, pursuing this philosophy meant clients did not miss significant gains as a result of being out of the market (or substantially underweight) because we generally “ignored” our 2009 outlook and maintained stock exposure last year.

Investors must take intelligent risks in order to be rewarded, and long term, stocks represent the best investment alternative. We know that markets go down, creating fear and the temptation to exit stocks, but we must hold the course, thereby “assuring” we will still be “in the game” when they inevitably go up.

Time is an investor’s best friend, and any year-end review is a snapshot of a short period. However, markets move upward as rapidly as they move down, and it is very easy to linger too long in the perceived safety of a decreased exposure to stocks, thereby incurring an opportunity cost by missing the benefit of the ensuing bull market run-up. To properly assess how the Caves & Associates portfolio strategies fared in 2009, we regret the small degree of market timing we tried and acknowledge we should have stayed more fully invested in stocks. We won’t repeat that mistake.

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