2011 Year-End Commentary and Planning Ideas
		January 26, 2012
		By Caves & Associates
		Preston S. Caves, CFP, CFA, MBA
		Sandra K. Gafney, CFP, MBA
		Dear Clients and Friends, We are pleased to present Caves & Associates' Market Perspective Full Year 2011 and Outlook. The review indicates 2011 was a year of mixed investment results. Bonds earned solid returns, but stock results were generally weak. U.S. large cap stocks provided low but positive returns, whereas results for U.S. small caps were moderately in the red, and foreign stocks experienced double digit losses. Stock prices yo-yoed during the year, reacting with significant volatility to sputtering global economies and news about the credit-worthiness of European banks and sovereign bonds of Europe's peripheral countries (Greece, Ireland, Spain, Italy, and Portugal). Additionally, the review provides information on five-year returns for perspective; for most stock markets, the 2008 bear market was so severe that cumulative five-year returns were either breakeven, as for the U.S. and emerging countries, or rather negative, as for foreign developed countries. We encourage you to read the Market Perspective for a fuller review of major economic and market events in 2011. The Market Perspective also presents 1) an Economic Review of 2011, 2) our 2012 Outlook, 3) history of our scorecard rating the accuracy of our annual outlooks, and 4) a brief evaluation of the 2011 performance of Caves & Associates recommended mutual funds. The year 2011 might have been a repeat of the good results of 2010 if not for the European debt crisis and political stagnation in Washington, D.C. Global stock returns were quite strong through April, approaching gains of 10% for the first four months of the year. Thereafter, signs appeared that the global economic recovery from the Great Recession might be faltering notwithstanding on-going massive fiscal and monetary stimulus by the world's major governments and central banks. The June-July partisan battle in Congress and last-minute, stopgap "solution" to raising the U.S. debt limit to avoid an unprecedented U.S. default further heightened investors fears. Not completely impressed, one major debt-rating service, S&P, took away the U.S.'s triple-A credit rating, though Moody's did not. Meanwhile, European leaders continued to disagree about who would suffer the consequences and who would come to the rescue of profligate behavior by Euroland consumers and governments, especially in peripheral countries, as well as dubious loan underwriting by European banks. As policy makers kept "kicking the can down the road," the delay in finding solutions and increasing uncertainty over outcomes and secondary effects further unnerved investors. As a result, global equity markets swooned in late July – September. October featured downgrades to the sovereign debt of both Italy and Spain, while MF Global, a large U.S. commodity broker, filed for bankruptcy protection amid huge losses on European bond bets and millions missing from customer accounts. Capital markets maintained a high level of volatility during the last half of the year, with movements generally driven by the confidence, or the lack thereof, in European policymakers' ability to collectively find a tenable solution to the banking and sovereign debt crisis and assure the future of the euro. Governments and central banks continued high levels of economic stimulus in 2011. In the U.S., trillion dollar Federal deficits continued; the mid-December 2010 enactment of the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 ("2010 Tax Relief Act") was a significant contributor. Numerous state and local governments also experienced major budget shortfalls. The U.S. Congress did not enact any additional stimulus measures during 2011 due mainly to Republican resistance to increased deficits (assuming we ignore a two-month extension into 2012 of the Social Security payroll tax cuts and added unemployment benefit period of the 2010 Tax Relief Act, which were scheduled to sunset at December 31, 2011). However, the U.S. Federal Reserve continued its on-going efforts to energize the U.S. economy. Instead of a third round of Quantitative Easing (QE), which waits in the wings, the Fed initiated "Operation Twist" in an effort to lower long-term interest rates and stimulate the depressed housing and construction industries. Overseas, central banks were busy trying to stave off recession and stimulate economic growth. The Bank of England engaged in a very large QE program of its own. The European Central Bank (ECB), which had been reluctant to act awaiting definitive results of discussions between Germany's Merkel and France's Sarkozy and other European leaders, "finally" initiated a program termed Long Term Refinancing Operation ("LTRO"). The program offers banks three-year loans at a discount, secured by a wider-than-usual range of collateral. The ECB offer was welcome, and it immediately lent banks a massive Euro 490 billion (equivalent to about $640 billion) as a short-term measure. The loans helped banks shore up their capital and comply with regulatory ratios necessary to their continued operation. Banks' capital levels have been increasingly threatened by potential write-downs of huge holdings of the sovereign debt of peripheral European countries, which have been dramatically depreciating in value on fears of default by peripheral countries such as Greece. The ECB loans also served to lower rates on sovereign bonds and thereby save sovereigns significant interest costs. Finally, the Bank of Japan continued an easy money policy of very low interest rates, which it has followed for many years now due to a long-stagnant economy. The cost for short-term borrowing is zero and long-term Japanese government bonds yield a paltry 2% (versus the U.S Treasury 30-year bond at an abnormally low 3.1%). The usual pattern of reversion to the mean was on display in 2011 in several ways. In general, investors reversed their appetite for risk in 2011. Investors had exhibited an increased appetite for lower quality stocks and bonds during much of 2010; smaller cap stocks were favored over large caps and lower quality debt performed considerably better than government bonds. In the flight to quality of 2011, large caps beat small caps significantly; U.S. governments beat U.S. corporates, and high yield bonds lagged considerably; and investors fled foreign currencies for the relative safety of U.S. dollar-denominated investments. From a broader historical perspective, 2011 was also a reversion to the mean for global stock markets. Their weak results were significantly off historical averages after the stellar rebound years of 2009 (S&P 500 up 26.5%) and 2010 (S&P 500 up 15.1%). Another key observation is that diversification worked, preserved investors' capital in a very challenging environment, and provided a smoother ride during the year's major drop in late summer and again in November. As usual, we encourage you to avoid focusing on any short time period, because stock prices are historically quite volatile in the short-run. See the Economic Review section and the separate sections on stocks, bonds, and alternative strategies in the accompanying Market Perspective for further information. 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. We have also enclosed or attached a Market Review for the fourth quarter of 2011. The review indicates the year ended on an upbeat, and stocks recovered much but certainly not all of their third quarters' loss (Japan's market was down in the fourth quarter and was the lone exception among the world largest markets). All major asset categories except foreign bonds had at least decent returns, with U.S. stocks in double digits. Glimmers of hope for the U.S. economy and the ECB's LTRO program were the probable causes of the upswing in capital markets. A table accompanies the review and provides global returns for the quarter and full year 2011. Another enclosure, or attachment, is Timely Topics. Finally, we have enclosed or attached the latest from the Blog Department, our occasional opinion piece. Contents of both are described later in this letter. Outlook Summary and Caveats As noted above, the 2012 Outlook is included in the accompanying Market Perspective. The outlook is not rosy, but we feel it is realistic. It is cautious, and we expect muted results for both stocks and bonds. We continue to have powerful positive and negative forces impacting the economy and stock markets. On balance in 2012, the negative forces look stronger than the positive. Notwithstanding, we expect mildly positive results as a most likely case. As usual, the timing and future magnitude of gains and losses are impossible to reliably forecast. We are cautious because long-term problems are not decreasing; in fact, they are increasing, most notably in Euroland. The partisan stand-off in the U.S. capital seems endless, and it is not clear how much longer the U.S. can itself successfully "kick the can down the road." We also face the continuing uncertainties about 1) the impact of the inevitable eventual withdrawal of government stimulus programs around the world, especially in the U.S., and 2) sustainability of the strength of emerging economies like China, India, Russia, and Brazil. These uncertainties make it again difficult to provide definitive forecasts for the next year, and at this point we have declined to make a point-by-point forecast for 2012. As a result of these uncertainties and our usual aversion to market timing, we are planning to refrain from overweighting or underweighting stocks. See the Outlook section in the Market Perspective for some elaboration on various key issues and relevant government policy positions in 2012 and beyond. We have been commenting on external shocks for 11 years. We believe it is useful to observe the obstacles which have been ultimately overcome by the resiliency of the global economy and financial markets. In most cases, policy initiatives have been at least somewhat instrumental in supporting the long run progress. Each year from 2001-2011 included multiple external shocks which hurt financial markets, the two most severe being 2001, when we endured the terrorist attacks of September 11th, and 2008, when the housing and credit crises revealing a shockingly overleveraged, undercapitalized global financial system and an equally overextended U.S. consumer. During these years we also faced major corporate, mutual fund, and accounting scandals; escalating geopolitical tensions in countless countries and regions; additional terrorist attacks; terrible natural disasters, the most recent being the triple tragedy in Japan; spikes in energy prices; and credit rating downgrades to major western governments, including the U.S. last summer and France only days ago. Nonetheless, returns for all major global asset categories were positive for the 11 years, albeit at levels considerably less than long-term historical averages for most stocks. We can only wonder what potential disruptions and unexpected economic twists lurk for 2012. As we have often indicated, investing in the capital markets involves not only understanding risks that may be apparent, but also planning for risks that are not. As a reminder, most outlooks are saying the same thing. Also, there is typically a certain serial correlation in their thinking, meaning what they project is never significantly different from what has just happened. Further, since the consensus is already reflected in the prices of today's securities, it is the unexpected and very hard to predict events that will determine the future direction of stock prices, interest rates, etc. Accordingly, the consensus will in all likelihood be wrong. The same can be said of the Caves & Associates outlook. Brief Evaluation of Last Year's Predictions and Strategy This section is a brief scorecard of the predictions in last year's Outlook and an evaluation of the success of Caves & Associates' investment strategies and portfolio supervision in 2011. Generally speaking, the accuracy of economic and market projections was not good. The rapid decline of conditions in Euroland was not predicted, leading to a relatively sanguine forecast for stocks that way overshot their ultimate strength. Our prediction for bonds was closer to the ensuing reality, though the year's results were at or above historical averages rather than "at levels not much below historical standards," as forecast. Because we expected a stronger global economy would push up interest rates, we very modestly underweighted bonds for most of the year. The actual result was underperformance of stocks versus bonds which meant we "left some money on the table," accordingly. Because it was a very modest bond underweighting, the money left on the table versus no underweighting was indeed small. We did make various small adjustments that were helpful. For example, we increased the average maturity of clients' bond mutual funds when it became clear the global economy was weakening. The improved performance of alternative strategies was gratifying, especially when risk-adjusted. See the Market Perspective for additional reporting and analysis. Also, the Market Perspective has information about the success of our mutual funds during 2011, as indicated above. We note that our outlooks have been off the mark for the past several years. They have had a tendency to project about what had just happened and therefore suffered from one of the typical forecast failings noted above. As a result, we have been almost completely ignoring our outlooks and sticking to clients' policy allocations for their investment supervision. Let's hope our caution about 2012 is excessive and suffers from the same shortcoming as prior forecasts. Additional Perspective and Cautions Investors must take intelligent risks in order to be rewarded, and long term, stocks represent the best investment alternative. We know that markets go down, creating fear and temptation to exit stocks, but we must hold the course, thereby "assuring" we will still be "in the game" when stocks inevitably rebound. As we review the 10-, 20-, and even 30-year past periods of stock and bond results, we note that bonds have had extraordinary compound returns dramatically above their historical averages. Meanwhile stock compound returns have been about at historical averages. Over a 27-year period for which global data are available, we note an anomaly: stock returns have been only modestly higher than bond returns. Thus, stocks have earned a much smaller than usual equity premium. We note stocks endured the major bear markets of 2000-2002 and 2008 plus strong corrections in 1987 and 1990, and still managed good long-term results. Also, stock compound returns have been hurt by a high level of volatility compared with bonds (the reader is reminded of the negative impact of volatility on compound returns), but at its core, the abnormally low equity premium is due to the outstanding returns of bonds. Accordingly, as broad asset allocators, we must be psychologically ready for lower total portfolio absolute returns in the future. We can hope for similar results for stocks going forward, preferably with lower volatility and even higher returns, but we can't be certain this will occur. On the other hand, bonds cannot repeat the wonderful results of a 30-year bull market, and we must recognize going forward that a traditional portfolio combining publically traded stocks and bonds will very likely be providing returns below historical averages for many years to come. Investors should develop and maintain a plan that has the potential to work over most future scenarios. Thus, we believe the more useful approach is to maintain a broadly diversified investment plan customized to your specific time horizon which can meet your investment objectives over a variety of potential scenarios. Further, we continue to believe that a disciplined investment approach emphasizing diligent fundamental research, diversification, and regular rebalancing will provide the best possible long-term investment returns. Mutual Fund News Our mutual fund managers continue to receive well-deserved plaudits. The management team for two Artisan funds owned by many of our clients recently was selected by Morningstar as Domestic Stock Manager of the Year (for 2011). Additionally, in both the Fixed Income and International Stock Manager of the Year competitions, one of "our" managers was among five finalists in each category. We are proud our clients have been so well served. What's Topical or Timely We remain committed to continuing education as well as keeping you abreast of anything crucially affecting your wealth management. A separate enclosure or attachment has three subjects: The difficulty of achieving sufficient portfolio yield in the current low interest rate environment and Caves & Associates' approach. The usual annual reminder regarding the IRA contribution deadline. Two of a continuing series of featurettes about protecting your personal information and fighting cyber criminals. Avoiding identity theft is always a timely topic, unfortunately. Blog Department The Blog Department is our occasional expression of opinion and is enclosed or attached. 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. The accompanying Blog Department is brief and reports on recently released transcripts of closed-door Federal Reserve deliberations in 2006. The transcripts show little alarm at the dawn of the U.S. housing bust, a bust which was a major contributor to the Great Recession, the worst financial crisis since the Great Depression, and the ensuing stock market crash of 2008 and early 2009. The reader may wonder: "What were they thinking?" Our Usual Guidance Regarding Attainment of Long-Term Life Goals Although the outlook for 2012 and beyond is quite uncertain and not optimistic amid numerous continuing challenges to the U.S. and international community, our reasonable expectations for results over the next five to ten years do not need to be overly pessimistic. Nonetheless, to be prudent, we need to hope for the best, but also align our expectations lower just in case, to be ready for the possibility of reduced results. Prudent behavior includes: 1) reasonable reductions in spending and increases in our savings rates whenever possible, and 2) maintenance of reserves for all foreseeable large portfolio withdrawals, whether recurring or not. Need a Planning Update? If something important has changed in your personal situation (career, family, health, cash needs, etc.), don't hesitate to let us know. A significant change in your life may indicate you need a review of your insurance, financial, or investment planning. Examples are family matters (births, deaths, divorces, and marriages), business matters (promotions, lay-offs, sale, and impending retirement), and significant changes of your health or that of family members. Quotes for Our Time and All-Times Will Rogers: Why not go out on a limb? That's where the fruit is. Benjamin Franklin: Be civil to all; sociable to many; familiar with few; friend to one; enemy to none. Thomas Jefferson: On matters of style, swim with the current, on matters of principle, stand like a rock. We in America do not have government by the majority. We have government by the majority who participate. Albert Einstein: We can't solve problems by using the same kind of thinking we used when we created them. Warren Buffett: A public-opinion poll is no substitute for thought. Abe Lemons: The trouble with retirement is that you never get a day off. Martin Luther King, Jr.: Human progress is neither automatic nor inevitable...Every step toward the goal of justice requires sacrifice, suffering, and struggle; the tireless exertions and passionate concern of dedicated individuals. Company Brochure Available for Your Review Previously, we annually offered our Form ADV for your review. The ADV is our registration as an investment advisor with the SEC. New SEC rules have required us to prepare a similar but more user-friendly document, the Company Brochure. Like the ADV, it shows fees and services and other information that may be of interest. It is available free upon request. Please call if interested. 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 feedback. We are always grateful for our many clients, and we are especially thankful for your continued confidence. This coming year, we will continue to focus on doing everything we can to help you preserve your hard-earned wealth, grow it in appropriate ways, and ensure your money is supportive of the most important values and goals in your life. You are welcome to share our views with your family and friends if you think they will benefit. This letter and the enclosures, as well as an overview of our staff, advisory philosophy, and methods, are available on our website, http://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. The information in this letter and accompanying materials is of a general nature and should not be acted upon without further details and/or assistance. Best wishes for a happy, healthy, peaceful, and successful 2012. Thanks and credit go to the many sources for this letter and accompanying materials, including Managers and PIMCO mutual fund families, Morningstar, the Wall Street Journal, and the Los Angeles Times. This publication does not constitute an offer or solicitation of any transaction in any securities. Information contained in this publication has been obtained by sources we believe to be reliable, but cannot be guaranteed. 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. There is also no guarantee of future results. These views are as of January 26, 2012 and are subject to change based on subsequent developments.
		Back to Market Reviews