Third Quarter Market Review and Timely Topics

Third Quarter Market Review and Timely Topics

October 21, 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 third quarter of 2011 is enclosed or you are reviewing this communication via the Internet. The review highlights a quarter that proved to be the worst-performing three-month period for stocks since the first quarter of 2009. Equities and credit sensitive fixed income securities posted steep losses as investors reacted with a flight to quality reflecting several key political and economic news items, the most salient of which were 1) near gridlock in Washington D.C. over raising the U.S. debt ceiling, 2) the subsequent downgrade of our credit rating by a major rating service, and 3) the intensifying European sovereign debt crisis. Additionally, negative macroeconomic headlines renewed fears that the global economic recovery had stalled. Investors fled into the perceived safety of quality bonds, which had good results and were the only mainstream investments to avoid red ink in the quarter. The U.S. dollar strengthened significantly relative to most currencies, helping to produce somewhat lower 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, 2011. 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.

We are not presenting a separate Economic Review and Market Perspective. The topics are briefly addressed later in this letter. Please note that previous presentations of an Economic Review and Market Perspective are available from our website.

Timely Topics is also enclosed or attached. It addresses fairly briefly several discouraging items of economic news. It also describes the procedural framework created by the August U.S. debt ceiling compromise as it relates to on-going deficit reduction political battles. Finally, it presents reminders about Roth IRA's and home refinancing. Let us know if you want additional information on any of these topics. As a reminder, previous Timely Topics are available on our website.

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.

What Follows

Economic Review, Market Perspective, and Salient Performance Commentary.

Results for Alternative Strategies Investments.

Updated Outlook and Portfolio Strategy.

Quotes of Our Times and All-Time.

Request for Your Key Planning Parameters.

The Blog Department is our occasional expression of opinion, perhaps with a touch of controversy. The Blog Department is on hiatus due to time constraints.

Economic Review, Market Perspective, and Salient Performance Commentary

At the beginning of the quarter, the impact of the supply chain disruptions caused by the early-March earthquake and tsunami in Japan began to reverberate across markets. While slowing car sales were evident (and a continuation of a trend that began in the latter portion of the second quarter), the supply disruption also began to impact other businesses either directly or indirectly tied to motor vehicle production. Rising commodity prices and stubbornly high unemployment were also significant headwinds to sustained global growth at the outset of the third quarter.

By mid-July, all eyes were on Washington and the political stalemate involving the U.S. debt ceiling. As the stalemate dragged on, risk aversion, along with high levels of volatility, returned to global capital markets with investors seeking safety. Although a temporary resolution was eventually reached, Standard & Poor's subsequent downgrade of the U.S. sovereign credit rating from AAA to AA+ unnerved investors. A very weak U.S. jobs report for June helped spark a sharp decline in equities in late July into August and fueled global recession fears. This led to rather large drops in confidence indicators as well, which threatened to dampen consumer spending. Markets also seemed generally unimpressed with the adoption of the so-called "Super Committee" charged with finding an additional $1.5 trillion in U.S. deficit reductions over the next ten years (see the accompanying Timely Topics for additional information). Meanwhile, the European sovereign debt crisis continued to be the focus of investors outside the U.S., with worries that peripheral Europe's issues might infect the rest of the continent and even the U.S.

In September, the positive economic indicators that existed in the market were generally ignored by investors focused more on downside risks and double-dip recession possibilities. For example, capital spending had begun to finally show signs of improving, as witnessed by the 15% annualized gain in capital shipments during the third quarter. In addition, runaway commodity prices, a concern as recently as six months ago as having the potential to choke off the economic recovery in its infancy, pulled back sharply, alleviating pressure on both businesses and consumers alike. Toward the end of the quarter, however, equities trended down again after the Federal Reserve resorted to an old strategy from its playbook by instituting the "twist", which shifted $400 billion in treasury holdings from short-term to long-term securities in an effort to further lower borrowing costs and thereby stimulate economic activity.

Excruciatingly slow job growth and associated high unemployment remain the key economic challenges in the U.S. and in many other economies around the world. U.S. nonfarm payrolls declined 3.6 million in 2008 and a further 5.1 million in 2009. U.S. employment increased .9 million in 2010 and a further 1.1 million year-to-date. U.S. employment peaked at 138.0 million in January 2008 and has only recovered modestly, to 131.3 million at the end of September 2011.

Very slow job growth, a slowdown in growth of U.S. Gross Domestic Product, and other unimpressive economic indicators caused economists surveyed by the Wall Street Journal to predict a one-in-three chance the U.S. will slip into recession (a double-dip) over the next 12 months. The survey was reported in mid-September.

Salient observations about recent markets and longer-term market performance are:

As indicated at the start of this letter, for the third quarter the only investments that were in the black were quite conservative, namely quality bonds. Likewise, for the year-to-date through three quarters, again only bonds were in the black. Because results for global stocks for the first half of 2011 were "only" positive in single digits for the most part, the double-digit third quarter losses overwhelmed moderately successful first half results.

The markets have been highly volatile and highly correlated, which is not an ideal environment for active managers. The correlation among stocks, which is a measure of their tendency to move together in the same direction, hit an all-time high in September. Most managers spend the majority of their time on individual company research looking for both long and short candidates. When the markets are being primarily driven by macro factors such as global recession and European debt defaults, it makes it difficult to earn returns. The market in turn, ends up treating the longs and shorts identically.

Another way of viewing the "correlation problem" is by analyzing the difference in performance between the best and worst performing stocks in the S&P 500 from 1986 to 2011. The level of disparity between returns of the best and worst stocks is hitting lows only seen during the market panics of 1987 and 2008. Thus, the market recently is making little distinction among stocks. Experience has taught us that periods of high and low individual stock correlations are a normal part of stock market behavior. Macro events often overwhelm individual company fundamentals and cause stocks to move in unison. The market's recent focus on these types of events has clearly made this a "stock market" not a "market of stocks". Price movements are detached from individual company fundamentals and stocks have been bought and sold indiscriminately through the use of ETF's or program trades. It is a statistical fact that, over time, individual stock prices are driven by their underlying fundamentals; hence, periods of high correlation must be viewed as an opportunity. Often, in times like this, "the baby gets thrown out with the bath water" and multiple bargains are created. When the market is focusing on individual company fundamentals, and that's much of the time, your managers get rewarded for their work.

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. The annualized total returns have been dramatically above historical averages and have included significant capital appreciation of bond values on the secondary markets.

Two deep bear markets since the turn of the century have represented a textbook example of reversion to the mean for U.S. stock returns versus the 1990's. Likewise, market watchers have been raising a related alarm regarding bonds, warning of a reversion to the mean for their returns after almost three decades of superior returns. 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.

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 -24%. However, global bonds have a cumulative net gain (i.e., total return from interest and price change) of approximately 27% over the same period. Thus, a bond/stock mix over the period of 50%/50% would be somewhat in the black, and any portfolio strategy targeting over 50% in bonds would have a decent, or better, recovery by the end of September 2011 from the deep 11/07-3/09 bear market. Nonetheless, we were able to make the same statement one year ago. Therefore, returns for the last 12 months have done little to build our wealth. Also, almost four years is a long time to endure roughly breakeven results for the overall portfolio and thus negligible progress toward, or maintenance of, capital adequacy.

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). For the period just discussed, namely 11/1/2007-9/30/2011, U.S. inflation averaged a relatively benign but not insignificant 2% per year. Thus, real returns over the period were only about breakeven for a 50%/50% portfolio.

Results for Alternative Strategies Investments

Our alternative strategies funds, being hedged investment vehicles, provided a boost to results in the third quarter. They provided a muted negative performance of -3.6%, but results were generally closer to those of bonds and much better than losses for stocks in the high teens. As a five-fund group, their three months performance through September 30 beat that of a balanced global traditional stock and bond portfolio by about 4 percentage points, non-annualized. Though the alternative strategies group provided a second quarter return that underperformed the results of a balanced global traditional stock and bond portfolio by about 1 percentage point, non-annualized, the group has benefitted portfolio results for five straight months.

It is important to note that these comparisons are for short time periods which were quite volatile. Additionally, we believe investors are particularly adverse to losses; by minimizing third quarter losses, alternative strategies helped our clients to hold the course.

Updated Outlook and Portfolio Strategy

Our outlook for 2011 was promulgated January 22, 2011. We believe our economic outlook and therefore our market outlook were somewhat more positive than what might be judged the consensus 2011 forecast at the time. To summarize, our outlook for bonds was cautious but not pessimistic, and our outlook for stocks was optimistic based on the economic outlook, positive trends of corporate earnings, and no inkling of the extreme dysfunction developing in Washington D.C. In spite of general optimism, we advised only a modest overweighting of stocks in client portfolios to maintain conservatism and avoid a short-term tactical allocation approach.

In April and July, we made negligible changes to our outlook and continued to advise a near target bond/stock mix. It is important to note that the July review was promulgated on July 18, four days before global stock markets began a precipitous decline on July 22. Also, the July review was predicated on 1) a timely raising of the U.S. debt ceiling (indeed did subsequently occur, but with a great deal of rancor and contingencies), and 2) U.S. retention of a "Triple A" credit rating (S&P subsequently downgraded U.S. to "Double A+").

In a matter of roughly only two weeks from July 22, global stock markets had dropped approximately 15%. We maintained our discipline and made no knee-jerk reactions. After the sharp drop, client portfolios were now underweight equities and thus sufficiently hedged given our best judgment of economic and market conditions then prevailing.

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. It is important to remember that very deep recessions like the most recent one (dubbed the Great Recession) are commonly followed by gradual rather than rapid recovery. Thus, our evaluation (just an educated guess) remains that a double-dip is not likely. We believe a gradual L-shaped U.S. recovery is still in progress.

While our cautious optimism has certainly been tested over the last several months due to market developments, we continue to believe that investment opportunities exist, particularly for the long-term investor with the discipline to recognize that shorter-term volatility can often be an opportunity to take advantage of mispriced assets. This opportunity continues to look particularly compelling for those investors who can withstand this shorter-term volatility because safe-haven assets such as money market accounts and U.S. Treasuries continue to offer historically low yields and negative real returns when factoring in inflation.

Our assessment at the beginning of the year included a considerable emphasis on relative expected future risk-adjusted performance. Our outlook favoring stocks was largely a function of an unenthusiastic view of bond prospects after a 30-year bull market. Now that bonds have further appreciated and stocks have given up considerable ground year-to-date, it seems prudent to maintain equity percentages near targets to recognize the relatively better prospects for stocks.

As usual, our outlooks are predicated on good fiscal and monetary policy decisions and execution, gradual transitions, and the absence of major external shocks. It is fair to observe that these conditions are rarely being met these days given extreme partisanship in our nation's capital and such precarious global conditions as the "Arab Spring" and European debt crisis. As we have noted, the short-term is unknowable and outlooks are not to be trusted. Thus, 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.

Quotes for Our Time and All-Times

Steve Jobs’ Stanford Commencement Address:

"Your time is limited, so don’t waste it living someone else’s life. Don’t be trapped by dogma – which is living with the results of other people’s thinking. Don’t let the noise of other’s opinions drown out your own inner voice. And most important, have the courage to follow your heart and intuition. They somehow already know what you truly want to become. Everything else is secondary."

Steve Jobs:

"I’m the only person I know that’s lost a quarter of a billion dollars in one year…. It’s very character-building."

Steve Jobs:

"I want to put a ding in the universe."

Albert Einstein:

"Imagination is more important than knowledge."

Thomas Huxley:

"Try to learn something about everything and everything about something."

Herman Cain (leading Republican presidential candidate):

"If you don’t have a job and you’re not rich, blame yourself."

Jerry Seinfeld:

"Dogs have no money. Isn't that amazing? They're broke their entire lives. But they get through. You know why dogs have no money?....No Pockets."

(The Blog Department may have something to say in the future about the Cain quote).

Request for Your Key Planning Parameters

Whether it's for portfolio supervision or other financial planning tasks, we need such key information as marginal tax bracket, mortgage status, and the latest about your health. We trust many of you regularly advise us of important changes, but just to make sure, we'll be sending a short information request form soon. We appreciate your spending a few minutes to supply us the requested information and apologize to those of you who have recently provided us such information.

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; our mission statement and advisory philosophy; and a 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, Gary Shugrue of Ascendant Capital Partners, 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, 2011 and are subject to change based on subsequent developments.

Back to Market Reviews


		Third Quarter Market Review and Timely Topics
		October 21, 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 third quarter of 2011 is enclosed or you are reviewing this communication via the Internet. The review highlights a quarter that proved to be the worst-performing three-month period for stocks since the first quarter of 2009. Equities and credit sensitive fixed income securities posted steep losses as investors reacted with a flight to quality reflecting several key political and economic news items, the most salient of which were 1) near gridlock in Washington D.C. over raising the U.S. debt ceiling, 2) the subsequent downgrade of our credit rating by a major rating service, and 3) the intensifying European sovereign debt crisis. Additionally, negative macroeconomic headlines renewed fears that the global economic recovery had stalled. Investors fled into the perceived safety of quality bonds, which had good results and were the only mainstream investments to avoid red ink in the quarter. The U.S. dollar strengthened significantly relative to most currencies, helping to produce somewhat lower 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, 2011. 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. We are not presenting a separate Economic Review and Market Perspective. The topics are briefly addressed later in this letter. Please note that previous presentations of an Economic Review and Market Perspective are available from our website. Timely Topics is also enclosed or attached. It addresses fairly briefly several discouraging items of economic news. It also describes the procedural framework created by the August U.S. debt ceiling compromise as it relates to on-going deficit reduction political battles. Finally, it presents reminders about Roth IRA's and home refinancing. Let us know if you want additional information on any of these topics. As a reminder, previous Timely Topics are available on our website. 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. What Follows Economic Review, Market Perspective, and Salient Performance Commentary. Results for Alternative Strategies Investments. Updated Outlook and Portfolio Strategy. Quotes of Our Times and All-Time. Request for Your Key Planning Parameters. The Blog Department is our occasional expression of opinion, perhaps with a touch of controversy. The Blog Department is on hiatus due to time constraints. Economic Review, Market Perspective, and Salient Performance Commentary At the beginning of the quarter, the impact of the supply chain disruptions caused by the early-March earthquake and tsunami in Japan began to reverberate across markets. While slowing car sales were evident (and a continuation of a trend that began in the latter portion of the second quarter), the supply disruption also began to impact other businesses either directly or indirectly tied to motor vehicle production. Rising commodity prices and stubbornly high unemployment were also significant headwinds to sustained global growth at the outset of the third quarter. By mid-July, all eyes were on Washington and the political stalemate involving the U.S. debt ceiling. As the stalemate dragged on, risk aversion, along with high levels of volatility, returned to global capital markets with investors seeking safety. Although a temporary resolution was eventually reached, Standard & Poor's subsequent downgrade of the U.S. sovereign credit rating from AAA to AA+ unnerved investors. A very weak U.S. jobs report for June helped spark a sharp decline in equities in late July into August and fueled global recession fears. This led to rather large drops in confidence indicators as well, which threatened to dampen consumer spending. Markets also seemed generally unimpressed with the adoption of the so-called "Super Committee" charged with finding an additional $1.5 trillion in U.S. deficit reductions over the next ten years (see the accompanying Timely Topics for additional information). Meanwhile, the European sovereign debt crisis continued to be the focus of investors outside the U.S., with worries that peripheral Europe's issues might infect the rest of the continent and even the U.S. In September, the positive economic indicators that existed in the market were generally ignored by investors focused more on downside risks and double-dip recession possibilities. For example, capital spending had begun to finally show signs of improving, as witnessed by the 15% annualized gain in capital shipments during the third quarter. In addition, runaway commodity prices, a concern as recently as six months ago as having the potential to choke off the economic recovery in its infancy, pulled back sharply, alleviating pressure on both businesses and consumers alike. Toward the end of the quarter, however, equities trended down again after the Federal Reserve resorted to an old strategy from its playbook by instituting the "twist", which shifted $400 billion in treasury holdings from short-term to long-term securities in an effort to further lower borrowing costs and thereby stimulate economic activity. Excruciatingly slow job growth and associated high unemployment remain the key economic challenges in the U.S. and in many other economies around the world. U.S. nonfarm payrolls declined 3.6 million in 2008 and a further 5.1 million in 2009. U.S. employment increased .9 million in 2010 and a further 1.1 million year-to-date. U.S. employment peaked at 138.0 million in January 2008 and has only recovered modestly, to 131.3 million at the end of September 2011. Very slow job growth, a slowdown in growth of U.S. Gross Domestic Product, and other unimpressive economic indicators caused economists surveyed by the Wall Street Journal to predict a one-in-three chance the U.S. will slip into recession (a double-dip) over the next 12 months. The survey was reported in mid-September. Salient observations about recent markets and longer-term market performance are: As indicated at the start of this letter, for the third quarter the only investments that were in the black were quite conservative, namely quality bonds. Likewise, for the year-to-date through three quarters, again only bonds were in the black. Because results for global stocks for the first half of 2011 were "only" positive in single digits for the most part, the double-digit third quarter losses overwhelmed moderately successful first half results. The markets have been highly volatile and highly correlated, which is not an ideal environment for active managers. The correlation among stocks, which is a measure of their tendency to move together in the same direction, hit an all-time high in September. Most managers spend the majority of their time on individual company research looking for both long and short candidates. When the markets are being primarily driven by macro factors such as global recession and European debt defaults, it makes it difficult to earn returns. The market in turn, ends up treating the longs and shorts identically. Another way of viewing the "correlation problem" is by analyzing the difference in performance between the best and worst performing stocks in the S&P 500 from 1986 to 2011. The level of disparity between returns of the best and worst stocks is hitting lows only seen during the market panics of 1987 and 2008. Thus, the market recently is making little distinction among stocks. Experience has taught us that periods of high and low individual stock correlations are a normal part of stock market behavior. Macro events often overwhelm individual company fundamentals and cause stocks to move in unison. The market's recent focus on these types of events has clearly made this a "stock market" not a "market of stocks". Price movements are detached from individual company fundamentals and stocks have been bought and sold indiscriminately through the use of ETF's or program trades. It is a statistical fact that, over time, individual stock prices are driven by their underlying fundamentals; hence, periods of high correlation must be viewed as an opportunity. Often, in times like this, "the baby gets thrown out with the bath water" and multiple bargains are created. When the market is focusing on individual company fundamentals, and that's much of the time, your managers get rewarded for their work. 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. The annualized total returns have been dramatically above historical averages and have included significant capital appreciation of bond values on the secondary markets. Two deep bear markets since the turn of the century have represented a textbook example of reversion to the mean for U.S. stock returns versus the 1990's. Likewise, market watchers have been raising a related alarm regarding bonds, warning of a reversion to the mean for their returns after almost three decades of superior returns. 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. 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 -24%. However, global bonds have a cumulative net gain (i.e., total return from interest and price change) of approximately 27% over the same period. Thus, a bond/stock mix over the period of 50%/50% would be somewhat in the black, and any portfolio strategy targeting over 50% in bonds would have a decent, or better, recovery by the end of September 2011 from the deep 11/07-3/09 bear market. Nonetheless, we were able to make the same statement one year ago. Therefore, returns for the last 12 months have done little to build our wealth. Also, almost four years is a long time to endure roughly breakeven results for the overall portfolio and thus negligible progress toward, or maintenance of, capital adequacy. 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). For the period just discussed, namely 11/1/2007-9/30/2011, U.S. inflation averaged a relatively benign but not insignificant 2% per year. Thus, real returns over the period were only about breakeven for a 50%/50% portfolio. Results for Alternative Strategies Investments Our alternative strategies funds, being hedged investment vehicles, provided a boost to results in the third quarter. They provided a muted negative performance of -3.6%, but results were generally closer to those of bonds and much better than losses for stocks in the high teens. As a five-fund group, their three months performance through September 30 beat that of a balanced global traditional stock and bond portfolio by about 4 percentage points, non-annualized. Though the alternative strategies group provided a second quarter return that underperformed the results of a balanced global traditional stock and bond portfolio by about 1 percentage point, non-annualized, the group has benefitted portfolio results for five straight months. It is important to note that these comparisons are for short time periods which were quite volatile. Additionally, we believe investors are particularly adverse to losses; by minimizing third quarter losses, alternative strategies helped our clients to hold the course. Updated Outlook and Portfolio Strategy Our outlook for 2011 was promulgated January 22, 2011. We believe our economic outlook and therefore our market outlook were somewhat more positive than what might be judged the consensus 2011 forecast at the time. To summarize, our outlook for bonds was cautious but not pessimistic, and our outlook for stocks was optimistic based on the economic outlook, positive trends of corporate earnings, and no inkling of the extreme dysfunction developing in Washington D.C. In spite of general optimism, we advised only a modest overweighting of stocks in client portfolios to maintain conservatism and avoid a short-term tactical allocation approach. In April and July, we made negligible changes to our outlook and continued to advise a near target bond/stock mix. It is important to note that the July review was promulgated on July 18, four days before global stock markets began a precipitous decline on July 22. Also, the July review was predicated on 1) a timely raising of the U.S. debt ceiling (indeed did subsequently occur, but with a great deal of rancor and contingencies), and 2) U.S. retention of a "Triple A" credit rating (S&P subsequently downgraded U.S. to "Double A+"). In a matter of roughly only two weeks from July 22, global stock markets had dropped approximately 15%. We maintained our discipline and made no knee-jerk reactions. After the sharp drop, client portfolios were now underweight equities and thus sufficiently hedged given our best judgment of economic and market conditions then prevailing. 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. It is important to remember that very deep recessions like the most recent one (dubbed the Great Recession) are commonly followed by gradual rather than rapid recovery. Thus, our evaluation (just an educated guess) remains that a double-dip is not likely. We believe a gradual L-shaped U.S. recovery is still in progress. While our cautious optimism has certainly been tested over the last several months due to market developments, we continue to believe that investment opportunities exist, particularly for the long-term investor with the discipline to recognize that shorter-term volatility can often be an opportunity to take advantage of mispriced assets. This opportunity continues to look particularly compelling for those investors who can withstand this shorter-term volatility because safe-haven assets such as money market accounts and U.S. Treasuries continue to offer historically low yields and negative real returns when factoring in inflation. Our assessment at the beginning of the year included a considerable emphasis on relative expected future risk-adjusted performance. Our outlook favoring stocks was largely a function of an unenthusiastic view of bond prospects after a 30-year bull market. Now that bonds have further appreciated and stocks have given up considerable ground year-to-date, it seems prudent to maintain equity percentages near targets to recognize the relatively better prospects for stocks. As usual, our outlooks are predicated on good fiscal and monetary policy decisions and execution, gradual transitions, and the absence of major external shocks. It is fair to observe that these conditions are rarely being met these days given extreme partisanship in our nation's capital and such precarious global conditions as the "Arab Spring" and European debt crisis. As we have noted, the short-term is unknowable and outlooks are not to be trusted. Thus, 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. Quotes for Our Time and All-Times Steve Jobs’ Stanford Commencement Address: "Your time is limited, so don’t waste it living someone else’s life. Don’t be trapped by dogma – which is living with the results of other people’s thinking. Don’t let the noise of other’s opinions drown out your own inner voice. And most important, have the courage to follow your heart and intuition. They somehow already know what you truly want to become. Everything else is secondary." Steve Jobs: "I’m the only person I know that’s lost a quarter of a billion dollars in one year…. It’s very character-building." Steve Jobs: "I want to put a ding in the universe." Albert Einstein: "Imagination is more important than knowledge." Thomas Huxley: "Try to learn something about everything and everything about something." Herman Cain (leading Republican presidential candidate): "If you don’t have a job and you’re not rich, blame yourself." Jerry Seinfeld: "Dogs have no money. Isn't that amazing? They're broke their entire lives. But they get through. You know why dogs have no money?....No Pockets." (The Blog Department may have something to say in the future about the Cain quote). Request for Your Key Planning Parameters Whether it's for portfolio supervision or other financial planning tasks, we need such key information as marginal tax bracket, mortgage status, and the latest about your health. We trust many of you regularly advise us of important changes, but just to make sure, we'll be sending a short information request form soon. We appreciate your spending a few minutes to supply us the requested information and apologize to those of you who have recently provided us such information. 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; our mission statement and advisory philosophy; and a 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, Gary Shugrue of Ascendant Capital Partners, 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, 2011 and are subject to change based on subsequent developments.

		Back to Market Reviews