Third Quarter 2010 Market Review Plus
		Economic Review and Market Perspective
		October 21, 2010
		By Caves & Associates
		Preston S. Caves, CPA, CFA, MBA
		Sandra K. Gafney, CFP, MBA
		Dear Clients and Friends, Your copy of Caves & Associates' Market Review for the third quarter of 2010 is enclosed or you are reviewing this communication via the Internet. The review highlights a quarter that proved to be a major improvement over the difficult prior three months, as equities and credit sensitive fixed income securities posted their strongest gains this year notwithstanding mixed economic news globally. The U.S. dollar weakened significantly relative to most currencies, helping to produce higher results overseas than in the U.S. for both stocks and bonds. The backside of the Market Review is a table of global investment returns for the third quarter and nine months ending September 30, 2010. The global returns provide reference points against which to judge results for your investment accounts. As usual, but not guaranteed, broad diversification reduced volatility and rewarded the disciplined investor. 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 have enclosed or attached the latest economic outlook from PIMCO (results of their Cyclical Forum) and separately, the next edition of Timely Topics. The former is in lieu of our usual Economic Review and provides both a helpful global perspective and a look forward rather than a look back. It identifies a widening divergence between the outlook for growth in the developed world and the developing world, in their opinion. It should be noted that, according to conventional wisdom, bond managers such as PIMCO are notoriously conservative, even pessimistic, in their forecasts (as contrasted with ever optimistic stock managers). Notwithstanding, we have considerable agreement with the PIMCO analysis. The careful reader will also note that PIMCO's GDP growth estimates are considerably below those of the IMF presented in our communication three months ago. Timely Topics addresses three topics. The first is estate planning uncertainty as a result of the 2010 presumably temporary elimination of the federal estate tax. The second is an alert to the current home mortgage refinancing opportunity (again). The third is a potentially advantageous strategy for withdrawing from Social Security and then reclaiming benefits at a higher level (yes, there's a catch). In conclusion, matters of the head are crucial for our financial success, and when it comes to estate planning, mortgages, and Social Security benefits, it is definitely not one size fits all, so please consider a professional consultation. For those receiving this communication by mail, you will find Timely Topics on the backside of the PIMCO Cyclical Forum Recap. What Follows Market perspective and selected portfolio performance commentary. Updated outlook and portfolio strategy. Spotlight on emerging market bonds. What's Timely and Topical. A few items from the Blog Department. Quotes of our times and all time. Market Perspective and Selected Performance Commentary Salient observations about recent markets and longer-term market performance are: In the annual horse race between stocks and bonds, bonds are holding their own. Returns of about 8% year-to-date domestically and slightly less overseas are somewhat ahead of most U.S. and foreign stocks. As is fairly typical, stocks get the headlines, and bonds just plug along. Notwithstanding, as reported previously, two deep bear markets this decade have represented a textbook example of reversion to the mean for U.S. stock returns in this decade versus the previous. Likewise, some market watchers are raising a related alarm regarding bonds, warning of a reversion to the mean for their returns after almost three decades of returns that have been well above historical averages. If such a reversion occurs, it will be because interest rates have finally bottomed, meaning future rate increases will cause capital losses on bonds, producing lower or even negative total returns. Nonetheless, the timing and magnitude of rate increases are not knowable. Historical returns for the Barcap Aggregate Bond Index and U.S. Cost of Living are shown on the following page: Time Period Annualized Total Return Memo: Annualized U.S. CPI* 1976 – 1981 5.0% 9.2% 1982 – 1989 14.5% 3.8% 1990 – 1999 7.7% 2.9% 2000 – 2009 6.3% 2.6% 2010 Year-to-Date 7.9% .4% *Except 2010 year-to-date not annualized With the exception of first time period above, the annualized total returns included significant capital appreciation of bond values on the secondary markets. A long bull market in U.S. bonds began in 1982 and was the result of fiscal and monetary policies which overcame the high inflation of the 1970's and produced a significant long-term decline in U.S. interest rates. Highlights of rate changes are as follows: Yields on long-term government bonds increased from 8% in 1976 to a very high 14.5% in 1982. Rates then dropped to 8.625% by 1989. Yields on 10-year Treasuries declined from about 9% in mid-1990 to about 6.6% at the end of 1999. Thereafter, they fell further to about 3.8% at the end of 2009 and to a mere 2.5% as of September 30 of this year. The 2003-2007 bull market topped in October 2007. Since then, based on a weighted average of results for three broad equity indexes, the cumulative net loss of global stocks has been about -22%. However, global bonds have a cumulative net gain (i.e., total return from interest and price change) of approximately 23% over the same period. Thus, a bond/stock mix over the period of 50%/50% would be minimally in the black, and any portfolio strategy targeting over 50% in bonds would have a decent, or better, recovery by the end of September 2010 from the deep 11/07-3/09 bear market. That's the good news. Nonetheless, almost three years is a long time to wait to get back to breakeven, though there have been even longer recovery periods in the past. In reviewing performance results, we encourage evaluating both absolute and relative returns. One comparison investors frequently ignore is results relative to inflation. Thus, a thoughtful review should consider what economists call real returns (i.e., after inflation) rather than nominal returns (namely, before inflation). A corollary is that we should consider real rather than nominal interest rates. These notions are always apropos, but they are especially important in our current low-inflation era. One application pertains to evaluating portfolio returns. For example, an 8% nominal return from equity funds in a 1% inflation environment is equal to a 10% return in a 3% inflation environment, and might be even better after taxes. Likewise, a money market fund nominal yield of .5% in a 1% inflation environment is no worse than a 4.5% yield in a world of 5% inflation. Our alternative strategies funds, being hedged investment vehicles, were a drag on results in the third quarter. They provided solid positive performance of 3.9%, but results were generally closer to those of bonds than soaring stocks. As a six-fund group, their three months performance through September 30 lagged that of a balanced global traditional stock and bond portfolio by about 5 percentage points. As a reminder, the six-fund group provided a second quarter return that outperformed the results of a balanced global traditional stock and bond portfolio by about 3 percentage points, non-annualized. It is also important to note that these comparisons are for short time periods which were quite volatile. Finally, we believe investors are particularly adverse to losses; by minimizing second quarter losses, alternative strategies helped our clients to hold the course. Updated Outlook and Portfolio Strategy Our outlook for 2010 was promulgated January 22, 2010. We have noted that 1) our economic outlook and therefore our market outlook were somewhat more negative than what might be judged the consensus 2010 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). To summarize, our outlook was cautious but not pessimistic, and we advised a moderate but not high overweighting of bonds and alternative strategies in client portfolios. In April and July, we made negligible changes to our outlook and continued to advise a near target bond/stock mix but some continued conservatism. In September, the National Bureau of Economic Research, the organization charged with the responsibility of declaring the beginning and end of recessionary periods, finally announced that the recent contraction ended on June 30, 2009. This announcement came almost fifteen months after conclusion of the Great Recession. Since the recession's end, output has generally improved but the U.S economy has actually lost more jobs than it has added. As we begin the stretch run for the year, economic pundits and investors continue to wonder whether we are heading into a double-dip of economic activity. There continues to be talk of a jobless U.S. recovery due to permanent loss of jobs rather than merely cyclical and thus temporary loss of jobs. Historically, consumer spending, which has accounted for up to 70% of all economic activity, has been a key driver of growth. If a high percentage of consumers remain unemployed or are concerned about job security, then spending and, therefore, economic growth may continue to be subdued. Additionally, as noted by PIMCO, the wind down of Federal economic stimulus programs will soon begin to provide a relative drag on the U.S. economy. Accordingly, through three quarters, economic conditions are generally consistent with our original projection of weakness in the U.S. Additionally, the stock market rally in the third quarter has caused year-to-date market results to substantially coalesce with our original 2010 outlook, namely performance we needn't be pessimistic about. As we indicated three months ago, very deep recessions like the most recent one are commonly followed by gradual rather than rapid recovery. Thus, our evaluation (just an educated guess) remains that a double-dip is not likely. In this respect we agree with PIMCO's base case. At this time last year, we noted that economic recovery would likely be L-shaped rather than U- or V- shaped and would not be robust for several years. This view seems to have been accurate, and full jobs and GNP recovery will require additional patience. Given all the uncertainty, we believe it is important to err on the side of conservatism. Finally, we believe we have identified a reasonable strategy for 2010 that is working by smoothing results and hedging the downside. Thus, we are leaving our 2010 outlook unchanged. Our associated major portfolio strategies also are remaining unchanged, except we are increasing our allocation to emerging market bonds. As usual, our outlooks are predicated on good fiscal and monetary policy decisions and execution, gradual transitions, and the absence of major external shocks. Also, we encourage investors to focus on the longer-term in a manner consistent with their objectives, risk tolerances, financial circumstances, and stage of life. Finally, expectations need to be kept in check because of the many challenges ahead. Spotlight on Emerging Market Bonds Structural changes in emerging market countries have helped bring emerging markets bonds into the fixed income mainstream. Emerging economies are not only growing more quickly than developed economies, in many cases they are sounder financially, too. In fact, emerging markets bond funds were the best-performing fixed income category over trailing 5, 10, and 15 years as of June 30, 2010, according to Morningstar. In the 1990s, many developing countries had far higher debt levels, defaults were a constant threat, and they had to issue bonds in dollars (i.e., Brady or Yankee bonds) in order to entice U.S.-based investors. The Asian currency crisis in 1997 and the Russian default in 1998 spurred many developing governments to reduce debt levels and strengthen their balance sheets. The IMF estimates the average debt-to-GDP for the Emerging G-20 countries, including Brazil, Mexico, and Russia, is just 37%. By comparison, the U.S. ratio is fast approaching 100%, and Japan's is more than 200%. Credit quality has also improved dramatically, from 5% classed as investment-grade in 1993 to 60% today. Credit spreads versus U.S. Treasury bonds have narrowed. And 85% of emerging currencies floated freely against the U.S. dollar by 2007. As a result of these structural changes, emerging market bond issuance has moved beyond just sovereigns to include quasi-sovereign and corporate bonds, too. Many fund mangers view the latter as offering comparable credit quality to government bonds, but at more attractive prices. Finally, emerging bonds have produced currency gains for unhedged U.S. investors and are expected to continue to do so in the long run. The economic fundamentals in emerging markets look bright, but that doesn't mean the extraordinary returns will continue or that risk has been eliminated. Many of the positive structural improvements mentioned above were already in place in 2008, and yet the average emerging markets bond fund still dropped nearly 18% that year. Emerging markets could still be vulnerable to capital flight should there be a repeat of 2008. However, emerging bonds provide an additional source of diversification for investors, and whereas the asset class had once been considered quite speculative, it now seems worthy of a small, strategic allocation in many investors' portfolio. 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. The Blog Department The Blog Department remains generally under wraps due to time constraints. However, a few brief items follow: According to Rob Arnott, a respected researcher, global economic observer, and independent portfolio manager of PIMCO All Asset fund, the U.S. debt increases are "unconscionable." He has no doubt we will suffer the consequences someday. Rob indicates that on the basis of generally accepted accounting principles (unfortunately, not used by governments), our Federal 1) annual budget deficit, and 2) accumulated government debt outstanding, both as a percentage of GDP, are worse than Greece's! According to the Organization for Economic Cooperation and Development (OECD), an international organization helping governments tackle the challenge of a globalized economy, the U.S. has bigger budget problems than other advanced nations. The OECD's measure of budget deficit, which includes state and local governments, shows the U.S. shortfall running at about 10.5% of annual economic output. By comparison, the 33 OECD member countries overall have a shortfall running at about 8%. The key upshot: even after recession-fighting spending programs unwind, the U.S. will need tax increases AND spending cuts to get the budget under control, the OECD says. If Rob Arnott and the OECD are correct, the fireworks in Congress between Tea-Partyers and big spending liberals should be deafening. Deadlocks like those in Sacramento may become equally commonplace in Washington. Speaking of politicians, a fraternity brother of Pres passed on his "quote of day" last month. The cynical quote is from Peter Schmuck, a Baltimore sports writer, concerning the recent indictment of major league pitching great Roger Clemens and is as follows: "Isn't it great to live in a society where the penalty for lying to a congressman can be up to 30 years in jail, but the penalty for a congressman lying to you is another two years in office?" The Blog Department is of the opinion that the reference to "congressman lying" is a stretch, but sadly not too big a one, especially at campaign time. Quotes of Our Times and All Time Albert Einstein: "Unthinking respect for authority is the greatest enemy of truth." Robert Frost: "A diplomat is a man who always remembers a woman's birthday but never remembers her age." Mark Twain: "Travel is fatal to prejudice, bigotry, and narrow-mindedness." Alexander Pope: "Histories are more full of examples of the fidelity of dogs than of friends." 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 21, 2010 and are subject to change based on subsequent developments.
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