Second Quarter 2011 Market Review Economic Review and Market Perspective
		July 18, 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 second quarter of 2011 is enclosed, or you are viewing this mailing via the Internet. Global stock results turned down in the second quarter, from solidly in the black to start the year to generally slightly in the red for the second three months. External shocks and the continuing consumer and sovereign debt overhang helped propel on-going volatility and reduced confidence in the global economy. The retreat was relatively uniform around the world. Due to the flight to perceived lower risk, global bonds had quite good results for the quarter. This even included U.S. government bonds, notwithstanding the current deadlock in our nation's capital over raising the debt limit. The results of international stocks and bonds in local currencies were generally negative and underperformed U.S. markets. However, due to currency gains for unhedged U.S. investors caused by continued depreciation of the U.S. dollar, foreign stocks and bonds beat their U.S. counterparts when foreign results were translated into U.S. dollars. Alternative strategies had results that were mildly positive and therefore between those of bonds and those of slumping stocks. Given poor overall results for global stocks, mainly losses for U.S. stocks, the good returns for bonds, and decent returns for alternative strategies, were a valuable hedge, mitigated total portfolio losses, and preserved capital for a broadly diversified investor. Nonetheless, for a portfolio balanced evenly between stocks and bonds, alternative strategies had a mildly detrimental impact (i.e., a small opportunity cost) in the second quarter. Second quarter and first half returns for alternative strategies are reviewed in a separate section below. The backside of the Market Review provides global returns for the second quarter of this year and for six months year to date ending June 30, 2011. The global returns provide reference points against which to judge results for your investment accounts. Over the first two quarters of 2011, diversification was beneficial, though only mildly so because asset category results were not as wildly divergent as in previous years. As noted, bonds and alternative strategies performed as usual from a portfolio perspective to limit volatility. The accompanying "Economic Review and Market Perspective" provides a longer-term interpretation of current data and presents returns for the last 12 months, five years, and longer to allow evaluation of secular trends, market cycles, and comparative performance of bonds versus stocks. U.S. economic reports remain mixed at best, with the major positive being strong corporate profits and cash on hand, and the major negatives continuing to be high unemployment and very weak real estate. Thus, the U.S. economy is recovering but excruciatingly slowly. Meanwhile, Japan is only beginning to revive from the triple crisis, Europe is a very mixed bag, but China and other emerging markets are continuing their long-term secular expansion, albeit facing an intensifying threat of inflation. As has been the case, investors face worries about sovereign debt defaults; continued de-leveraging, especially by U.S. consumers; the usual geopolitical challenges; and awareness that U.S. and European governments have about reached the limit to their ability to bail-out weak financial institutions and economies should conditions worsen substantially. 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 General Perspective and Commentary Results for Alternative Strategies Investments Outlook Updated Timely Topics and Blog Department on Summer Vacation Privacy of Your Non-Public Information Quotes for Our Times and All-Time General Perspective and Commentary Investor losses on stocks in 2007 through early 2009 were unprecedented, except for the period of the Great Depression. Likewise, losses on bonds, especially the normally stable, high quality issues, were also unprecedented during roughly the same period. However, starting in early March 2009, one of the steepest declines for risk-based assets in history was followed by one of the sharpest rebounds on record. Investors, as they have done many times in the past, have looked beyond current economic conditions and have chosen to focus on the eventual recovery. As we have noted before, stock market price levels are based on the business outlook in 6-12 months. As reported previously, global markets were relatively profitable during the first quarter of 2011. As of March 31, 2011, in spite of over two years of very strong recovery of global stock markets, equity positions of the globally diversified investors had not re-attained the heights achieved at the end of the 2003-2007 bull market. Let's update cumulative results as impacted by the lackluster returns of the second quarter but factor in bonds. Based on a weighted average of results for three broad equity indexes, the cumulative net loss since the October 2007 market top has been about -8%. However, global bonds have a cumulative net gain (i.e., total return from interest and price change) of approximately 26% over the same period. Thus, a bond/stock mix over the period of 50%/50% would be solidly in the black, and any portfolio strategy targeting less than 76% stocks would have fully recovered by the end of June from the deep bear market in late 2007 through early 2009. Our conclusion is diversification works. In conclusion, given the usual uncertainty about future outcomes, investors should develop and maintain a plan that has the potential to work over more than one scenario. We still believe broadly diversified asset allocation is such a plan. Results for Alternative Strategies Investments As we have noted previously, over full market cycles, our alternative strategies funds have 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 been successful at preserving client capital for future growth opportunities. However, they are much less easily understood and have more moving parts compared with traditional long-only strategies. Therefore, we'll continue to make an exception about focusing on short-term results and report about alternative strategies. Our alternative strategies funds, being hedged investments, had a small negative impact on results for the second quarter. Though results were below those of bonds, alternative strategies were modestly in the black and thus outperformed returns of U.S. but not international stocks. As a six-fund group, their second quarter return underperformed that of a balanced global traditional stock and bond portfolio by about .6 percentage points, non-annualized. Year-to-date, the underperformance was approximately 1.8 percentage points. It is important to note that these comparisons are for short time periods which were quite volatile and do not reflect results over a full market cycle. 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 Our outlook for 2011 was promulgated January 22, 2011. We have noted that 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. 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. We presented an update to the January outlook in our client communication in April to reflect information revealed in the first quarter. To summarize, the update did not substantially revise the outlook and counseled continuation of January's tactics. The reader is referred to our April communication for in-depth commentary. The April evaluation is still applicable, except for the few updating comments and qualifier's noted below. 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, year-to-date the developed country economies have not been able to accelerate into the third phase of recovery, when the private sector provides the major impetus for economic growth rather than global governments. Additionally, over the first and second quarters of 2011, the inevitable external shocks have occurred and are holding back the global economy. The triple crisis of earthquake, tsunami, and reactor meltdown in Japan is a clear example. We would argue that the deepening debt crisis in peripheral Europe, a kind of contagion, is another example; the headlines have become more onerous because they now include Italy, with an economy much larger than previously "ill" Greece, Ireland, and Portugal. Another factor negatively affecting the outlook is the recent end of the Fed's Quantitative Easing II program. Whether this monetary stimulus program has been effective is debatable, but it has clearly been of some support to investor optimism and risk taking. We note that the central banks of Europe and China have both recently raised interest rates, providing additional drag on the global economy. Against these challenges and uncertainties, we continue to note a number of on-going positive factors at work, the most prominent being on-going strength of a number of overseas emerging market economies. As noted above, the strength and consistency of corporate profits also support a positive outlook. We feel the title of PIMCO's 2010 long-term forecast (called their Secular Forecast and having a 3-5 year horizon) is still an appropriate description of the global situation. It uses the title "Driving Without a Spare." We quote: "…we are heading into a world that is re-regulated, de-levered, and growing less rapidly in the industrial countries (the destination.)… The world is on a journey to an unstable destination, through unfamiliar territory, on an uneven road and, critically, having already used its spare tire(s)." When PIMCO refers to spare tires, they mean the various methods of economic stimulation, both monetary and fiscal, that governments and central monetary authorities have already used to avoid Great Depression II. In our opinion, the car in PIMCO's description has been roadworthy enough to withstand the bumps in the road described above; it hasn't broken down and needed a (non-existent) spare. Our evaluation of all these negatives and positives is they are on balance not particularly supportive of a continuing global bull market. On the other hand, the increased risks are about equally challenging to stocks and bonds. Thus, we are leaving our 2011 outlook and associated major portfolio strategies unchanged, subject to the following major qualifier. At the time our original 2011 outlook in January (and the subsequent April 2011 update), no one imagined that our nation would NOW (or STILL) be facing a possible debt default and credit rating downgrade. Yet, the date of U.S. debt default of August 2 is no longer over the horizon, and gridlock in Washington, D.C. continues on the highly partisan issue of deficit reduction. Failure to reach a default-preventing agreement acceptable to the rating agencies will produce yet another shock to the fragile U.S. economic recovery and will likely reverberate globally as well. Thus, we cannot overemphasize that this outlook is predicated on an assumption that the U.S. debt ceiling is raised in a timely manner and the U.S. retains its "Triple A" credit rating. It should be noted that we do not expect major changes in the long run if the U.S. does default. Nonetheless, the 2011 outlook is relatively short-term and will likely be affected negatively by the occurrence of a default. As financial advisors, we must address the risk of consciously or unconsciously skewing towards a positive view when the environment doesn't support it. When developing these communications, skewing is tempting because it feels better, but it would violate our responsibility to clients, and it is not a path to prudent investment decisions. Accordingly, we are always on guard to keep from being overly positive or overly negative. As to the potential U.S. debt default and downgrade, avoidance is no cinch, but the odds are against it happening, and we are maintaining our relatively sanguine outlook for now. We cannot have much confidence in our ability to forecast the future given all the variables globally and the vagarities of investor confidence and U.S. politicians. As usual, our outlooks are predicated on good fiscal and monetary policy decisions and execution, gradual transitions, and the absence of future major external shocks, even though another one (U.S. default) may be imminent. 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, because of the many challenges ahead, expectations need to be kept in check and liberally-estimated general, emergency, and withdrawal reserves need to be maintained. What's Topical or Timely We remain committed to continuing education as well as keeping you abreast of information which may have a significant impact on your wealth management. We continue to network with other advisors; participate in webcasts and conference calls with prominent market strategists, fund managers, and experts in behavioral finance; and generally work very hard to understand the U.S. and foreign reality in which we live. Timely Topics is not being presented at this time but will return after summer vacation. The possibility of a U.S. debt default is certainly timely and a highly germane topic respecting wealth management. We refer you to relevant commentary found in various other parts of this communication. We are monitoring the situation and will communicate later if appropriate. The Blog Department The Blog Department is our occasional expression of opinion, perhaps with a touch of controversy. For the time being, the Blog Department is under wraps due to time constraints. Notwithstanding, we strongly encourage you to reread the April 2011 "edition", which provided an extensive review regarding our country's debt and deficit problem and the on-going partisanship. We have been following this situation closely for some time, and we note with great frustration and disdain that deficit reduction negotiations have progressed from "just plain" partisanship to irrational brinksmanship on the part of some participants. Privacy of Non-Public Information We are enclosing our annual privacy notice (see accompanying Caves & Associates Privacy Statement), or it is an attachment to this email. Confidentiality of client information is one of our most important company values and a very high priority. Maintaining confidentiality is one of the many ways we seek to earn and keep your trust. Quotes for Our Time and All-Times Michael Josephson: "Everything you do sends a message about who you are and what you value." George Bernard Shaw: "The love of economy is the root of all virtue." Appius Claudius: "Every individual is the architect of his own fortune." Anonymous: "Dogs love company. They place it first in their short list of needs." 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, Oppenheimer, 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 July 15, 2011 and are subject to change based on subsequent developments.
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