First Quarter 2011 Market Review Economic Review and Market Perspective Timely Topics and Blog Department
		April 22, 2011
		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 first quarter of 2011 is enclosed, or you are viewing this communication via the Internet. The first quarter continued a bull market that is now a little over two years old. Equities and credit-sensitive fixed income securities moved considerably higher again amid continuing strong corporate earnings and recovery of the U.S. economy. International stocks underperformed U.S. stocks due to concerns over Japan's earthquake, tsunami, and nuclear disasters and the continuing debt crisis in peripheral Europe. U.S. government bonds had about breakeven total returns for the quarter, and foreign government bonds had weak results in local currencies but were positive after currency gains for the unhedged U.S. dollar investor. Alternative strategies had results that were better than bonds but worse than stocks; overall, they were somewhat detrimental to portfolio results. Given few areas of major weakness for the quarter outside of Japan and Asia, diversification was not particularly helpful, but rewards were reasonably good for a prudent, broadly diversified investor. The backside of the Market Review provides global returns for the first quarter of this year and for twelve months ending March 31, 2011. The global returns provide reference points against which to judge results for your investment accounts. Solid results for the latest quarter served to maintain quite high 12-month returns, which have persisted for quite some time as a result of stocks astronomical rebound since the market's trough on March 9 of 2009. This amazing recovery of lost wealth underscores the importance of maintaining discipline in portfolio matters. Most global equity markets continued their ascent in the first quarter of 2011 despite concerns about various macroeconomic and geopolitical issues, such as tensions in the Middle East and North Africa and the enormous earthquake that shook Japan. In March, stocks briefly sold off immediately following the earthquake and at one point the S&P 500 Index had lost most of its gains for the year. Market activity suggested that the risk trade was finally "off." The equity markets, however, proved to be extraordinarily resilient, rebounding from the mid-March sell-off and finishing the quarter very strongly, presumably because investors chose to focus on the improvement in corporate earnings and reasonably good economic news. The "Economic Review and Market Perspective" providing a longer-term interpretation of current data is normally presented only at mid-year and yearend. Nonetheless, a condensed version is enclosed (or attached). New "editions" of Timely Topics and the Blog Department are also presented as separate enclosures (or attachments). Timely Topics addresses two important and rather different subjects. The first is timely for parents and grandparents who have been saving for their children's or grandchildren's college educations using Section 529 plans and provides tips on withdrawing money for college expenses from these plans (California's 529 plan is dubbed Golden State ScholarShare). The second subject is energy, and Timely Topics presents a short primer on the sources of current energy usage in the U.S. The primer is intended to give you a background for some of the issues facing U.S. energy policy. Sadly, Timely Topics has no answer for today's sky-high gasoline prices! Perhaps the biggest news item and timeliest topic of special importance to all Americans occurred just recently. On Monday, April 18, the credit rating firm Standard & Poor's changed its outlook on U.S. Treasury securities to "negative" from "stable." While the U.S. retains its top-notch AAA bond rating for now, this "shot across the bow" often precedes an actual credit rating downgrade and hopefully will serve as a catalyst to force both Republicans and Democrats in Washington to compromise on deficit reduction talks and take decisive action. The Blog Department provides background on 1) U.S. and global credit ratings and deficit spending, and 2) competing deficit reduction plans. You are encouraged to educate yourself, evaluate in earnest, and get involved in this future-changing debate. As you know, Caves & Associates discourages focusing much attention on short-term results because a broadly diversified portfolio is structured for the long-term. As we often state, there is no way to completely eliminate short-term risk from an investment portfolio. As you review the performance data, think in terms of markets (plural), not "the market." You will notice that typically at least some part of your portfolio is providing positive results. 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. What's Below Results for Alternative Strategies Updated Outlook Timely Topics (Reference to) Blog Department (Reference to) A Key Reminder about Reserves Quotes for Our Times and All-Time Results for Alternative Strategies Over full market cycles, our alternative strategies funds have consistently outperformed a traditional balanced mix of long-only global bond and stock positions. As a group, they have exhibited fairly low correlation with equities. They have generally lagged in bull markets but significantly outperformed in bear markets. These defensive strategies have generally been successful at preserving client capital for future growth opportunities. Our alternative strategies funds, being hedged investments, were a small drag on results for the first quarter. They provided positive performance, but results were generally closer to those of bonds than stocks, as indicated above. As a six-fund group, their three months performance through March 31 lagged that of a balanced global traditional stock and bond portfolio by about 1.4 percentage points, non-annualized. Updated Outlook Our outlook for 2011 was promulgated January 21, 2011. We have noted that 1) our economic outlook and therefore our market outlook were perhaps a bit more positive than what might be judged the consensus 2011 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 about bonds and was relatively optimistic about global stocks. Nonetheless, we advised no material underweighting or overweighting of the major asset groups in client portfolios, but we recommended careful selection of bond sectors to manage interest rate risk and respond to the negative outlook for U.S. government bonds entering 2011. So far this year, the global economy has generally performed according to our forecasts, and results for global stocks and bonds are about in line with our expectations. However, the upcoming challenge in developed country economies is to accelerate the third phase of recovery, when the private sector provides the major impetus for economic growth rather than global governments. What is also not completely clear is whether or not investors believe in the economic recovery and in the continued strong performance of the markets because uncertainty remains so elevated throughout the world. Several headwinds surfaced and/or re-surfaced during the first quarter that temporarily rattled investors. Most notably, the devastating earthquake in Japan, and related concerns about the effects on Japanese industrial production and worldwide product supply chains, weighed heavily on the minds of investors. Additionally, the news coming out of Europe sparked renewed concerns about the financial weakness of the PIIGS (Portugal, Ireland, Italy, Greece and Spain). In March, Moody's slashed Greece's credit rating three levels to junk status on fears the country's efforts to cut its debt will not be enough. Moody's also downgraded Spain's sovereign debt to Aa2 from AAA. Outside of the U.S. and Europe, there are a number of situations that warrant close monitoring for their potential impact on global markets. If the recent political unrest in the Middle East and Northern Africa becomes more widespread, oil prices are likely to spike higher, which could significantly impact global GDP growth. While currently in check in most developed markets, inflation concerns are growing quickly in many emerging market countries. Investors are uncomfortable with another uncertainty, that caused by the dramatically differing deficit reduction plans and partisan rhetoric in the U.S. They clearly took note of the "warning" from Standard & Poor's about the U.S. Treasury debt rating. Against these challenges and uncertainties, we continue to note three important on-going positive factors at work: Strength of a number of overseas emerging market economies. The dramatic restoration of global stock market wealth since the market low of March 2009. Barely detectable yields for U.S. savings accounts which therefore provide poor competition against potential higher returns for traditional risk-taking through bond and stock investments. Another positive is based on mutual fund cash flow data: investors seem to be gradually abandoning cash and bonds and moving into stocks. Since the March 9, 2009 bear market trough, a significant proportion of equity investors have stayed on the sidelines waiting for the proverbial other shoe to drop. According to the Federal Reserve, it is estimated that as much as $8.9 trillion in assets currently resides in short-term investment vehicles, the product of investors withdrawing assets from equity mutual funds in 2009 and much of 2010. This trend began to reverse in late 2010, however, and has continued during the first quarter of 2011. During the first two months of this year, investors poured roughly $47 billion into U.S. stock funds, the greatest two-month net inflow for this asset class since February of 2004. To recap, as we look forward, the overall economic environment seems to be gradually improving. However, as recent events in Japan have shown, unexpected events can quickly derail economic progress. On the positive end, the U.S. economy continues to grow, albeit at a slow pace. GDP growth appears to have bottomed at 1.7% in the second quarter of 2010, and recent consensus expectations for 2011 have been above 3%. While the unemployment rate remains elevated, it has fallen noticeably from its peak of 10.1% to the March reading of 8.8%. Despite the improving GDP growth numbers, they remain below normal post-recessionary levels, which means that higher than normal unemployment levels are likely to persist. As a result, the Federal Reserve is likely to remain accommodative. At some point, however, the Fed must end its quantitative easing program and let the economy and markets operate independently. Nonetheless, is such a change imminent or months or even years in the future? Our evaluation of all these negatives and positives is they are on balance supportive of a continuing global bull market. Also, not much time has passed since our January outlook. Thus, we are leaving our 2011 outlook and associated major portfolio strategies unchanged. We cannot have much confidence in our ability to forecast the future given all the variables globally. As usual, our outlooks are predicated on good fiscal and monetary policy decisions and execution, gradual transitions, and the absence of major external shocks. We realize that uncertain environments can be unsettling for investors. It is this uncertainty, however, for which we are compensated over the long-term. For now as always, we would encourage investors to focus on the longer-term in a manner consistent with their risk tolerances, financial circumstances, and other objectives. Timely Topics We remain committed to continuing education as well as keeping you abreast of information which may have a significant impact on your wealth management. Pres has recently completed a refresher course on Estate Planning. Both Pres and Sandra attend industry continuing education events and network with peers. We encourage you to read Timely Topics, which is enclosed or attached if you are viewing this on the Internet. As noted, the two subjects are withdrawals from Section 529 college savings plans and an energy primer. Blog Department The Blog Department is our occasional expression of opinion. Whereas Timely Topics may involve some disagreement among experts, its primary purpose is to educate in the realms of financial planning and wealth management. The Blog Department ventures into broader topics which may be more controversial. Again, we encourage you to read the enclosed or attached, which is intended to help you sort through the rhetoric and diatribes pertaining to a very important problem facing the U.S. which must be addressed immediately and decisively: deficit reduction. A Key Reminder about Reserves In addition to maintaining broad diversification and discipline, we can't overemphasize the importance of maintaining adequate reserves for all potential needs to withdraw from your portfolio. Reserves, it turns out, were not needed in the 1990's and for about four and one-half years from early 2003 to October 2007 because stocks went up steadily. But stocks experienced two deep downturns in the 2000's. The first was in 2000-2002. It was such a major decline that U.S. stocks needed over six years to recover to their level as of the end of the 1990's. The second deep downturn of stocks was the record-breaking bear market from November 2007 to early March 2009, a downturn from which they still have not completely recovered. It's these situations when you need adequate reserves because reserves allow us to avoid selling at such inopportune times. In this regard, it is important to note that a number of studies has shown that avoiding selling into downturns definitely helps prevent the premature exhaustion of retirement capital. Quotes for Our Time and All-Times Woody Allen: "Money is better than poverty, if only for financial reasons." Ronald Reagan: "The government's view of the economy could be summed up in a few short phrases: If it moves, tax it. If it keeps moving, regulate it. And if it stops moving, subsidize it." Barack Obama: "We believe, in the words of our first Republican president, Abraham Lincoln, that through government, we should do together what we cannot do as well for ourselves. And so we've built a strong military to keep us secure, and public schools and universities to educate our citizens. We've laid down railroads and highways to facilitate travel and commerce. We've supported the work of scientists and researchers whose discoveries have saved lives, unleashed repeated technological revolutions, and led to countless new jobs and entire industries." Jean-Paul Kauffmann: "The economy depends about as much on economists as the weather does on weather forecasters." David Bach: "Financial education needs to become a part of our national curriculum and scoring systems so that it's not just the rich kids that learn about money...it's all of us." Author Unknown: "In the old days a man who saved money was a miser; nowadays he's a wonder." In Conclusion We are providing these materials for your information and as a means to stay in touch. We hope you find this information helpful, and we would be pleased to hear your comments and questions. Also, you are welcome to share our views with your family and friends if you think they will benefit. Nonetheless, the information is of a general nature and should not be acted upon without further details and/or professional assistance. This letter and the enclosures, as well as an overview of our staff, advisory philosophy, and methods, are available on our website, www.cavesassociates.com. We appreciate your referrals and suggest you steer those who might be interested to our website as a convenient and private way to initially make our acquaintance. 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 this newsletter will come to pass, and they are not meant to provide investment advice. These views are as of April 22, 2011 and are subject to change based on subsequent developments.
		Back to Market Reviews