July 19, 2002

Dear Clients and Friends,                                    

I have enclosed your copy of Caves & Associates’ Market Review for the second quarter of 2002.  The review highlights investor loss of confidence, which produced a broad, steep drop of global stock prices and solid returns for bonds due to the flight to quality and safety.  The backside of the Market Review is a table of global investment returns for the quarter and first six months of 2002.   A second enclosure headed "Market Perspective" provides a longer-term interpretation of current data and discusses research impacting allocation strategy.

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 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. 

We are aware that global stocks are in their third consecutive year of decline.  Therefore, you may feel tolerable short-term losses are turning into intolerable long-term losses, especially if you are retired and depending entirely on your portfolio to sustain your standard of living.  I don't suppose we can completely placate your concerns.  Nonetheless, it is important to remember that many investment categories have resisted the downturn, and diversification has worked.  Since the end of the 1990's bull market in March 2000, the following positive returns have been available in the investment universe:

As you can see, tangibles, value stocks, and bonds have all prospered over this 27-month period.  Further, a broadly diversified, disciplined, strategic asset allocation approach has maintained exposure of a significant part of your portfolio to these asset categories, mitigating negatives in the many weak investment areas.  As the Wall Street Journal recently observed: "The stock market looks awful.  But maybe people are looking in the wrong place!"

Accordingly, we continue to encourage you to stay the course, subject to the qualifications in the enclosed Market Perspective.  Bear markets are normal, and this one is by no means historically unprecedented.  While the news media drones on about huge losses for the Nasdaq market and such blue chip indexes as the S&P 500, please remind yourself that these are not very representative of results for your broadly diversified portfolio.  Further, history has shown that the stock market has an excellent record of rebounding from difficult times.  Additionally, the rebound typically begins well before the news turns predominantly positive.

Finally, I encourage you to review the balance of this letter for short essays on three timely topics (first, California's conformity with Federal tax breaks; second, great tax deductions from SEP-IRA's; and third, more guidance from Warren Buffet); a peek at a topic I'll cover in more depth later this year; and some Caves & Associates personnel news.  I also direct your attention to an enclosure which revisits the subject of trust and business ethics.  This enclosure presents a follow-up to my essay in last quarter’s letter on these timely and troubling topics, which are so intertwined with many facets of our firm’s activities as wealth management advisors.

 WHAT’S TOPICAL OR TIMELY

California Conforms to Federal Tax Rules

In mid-May 2002, Gov. Gray Davis signed sweeping tax conformity bills making it possible for Californians to finally take full advantage of the enhanced savings options approved by Congress last summer.  The bills, which are retroactive to the beginning of 2002, allow individuals to save more for education and in a variety of tax-favored retirement plans, such as 401(k) plans and individual retirement accounts.  Another recently signed conformity law makes public employee retirement plans more flexible.  

Before the bills' passage, many companies feared that their retirement programs would be disqualified if they allowed Californians to boost their contribution levels to the new more generous amounts allowed by federal law, so they blocked their employees from saving more in tax-favored plans.  The state's residents also could not contribute as much to education IRA's as residents in other states ($500 a year versus $2,000 a year elsewhere) and to traditional and Roth IRA's ($2000 a year versus $3,000 a year elsewhere).

As a result of conformity, maximum contributions to so-called SIMPLE retirement plans now can jump to $7,000 in 2002 from $6,000.  Catch-up payments are allowed for those 50 or older.  The catch-up provision allows those contributing to an IRA or SIMPLE account to put in an extra $500 this year, for a total allowable contribution of $3,500 for IRA’s and $7,500 for SIMPLE accounts.  Additionally, those 50 or older contributing to 401(k), 403(b), or 457 accounts can make $1,000 in catch-up contributions this year, allowing them to save a total of $12,000 annually in these accounts.  Finally, double tax-free distributions from 529 plans are allowed when the money is used for education (double means free of state taxes as well as Federal).

There continue to be many differences between state and Federal tax law.  However, only a few, such as the fact that California does not differentiate between ordinary income and capital gains, affect individuals.

Tax Law Changes Benefit Small Business Owners

Many small business owners appreciate the flexibility and ease of administration of SEP-IRA business retirement plans.  Recent changes made by the IRS make a SEP-IRA even more beneficial to self-employed individuals and small business owners looking for a retirement plan that allows for adjustable and higher contributions. 

In March 2002, the IRS made changes to SEP-IRA contribution and deduction limits, increasing them to 25% of compensation, up to $40,000 per year.  The increase is retroactive to January 1, 2002, and results in an almost doubling of available tax-deductible contributions.

Warren Buffett Revisited

I have noted that Mr. Buffett is a disciplined, “purist” value investor and generally buys and holds.  He certainly always maintains adequate reserves and is also willing to put them to work when opportunity knocks.  He is quoted as saying: “A great investment opportunity occurs when a marvelous business encounters a one-time huge, but solvable, problem.”  Earlier this month, he joined with Longleaf Partners Funds (we like their management style, too) and Legg Mason Funds Management to invest $500 million or more into the troubled telecommunications industry.  It seems these long-term-oriented, contrarian investors are telling us to hold the course and even buy our losers, which is of course the Caves & Associates philosophy.

UPCOMING TIMELY TOPIC

Three months ago I indicated I would address the huge topic of planning for retirement.  My professional emphasis is on both accumulating and preserving the necessary resources for a secure, comfortable retirement.  Retirement planning becomes urgent as we near retirement and actually continues for the rest of our lives. 

Accumulating normally focuses on the need for adequate, tax-efficient, on-going savings coupled with effective, growth-oriented investments.  Caves & Associates helps with tax reduction strategies and selecting optimal retirement vehicles (i.e., types of retirement plans).  We also design and supervise an appropriate portfolio.  As an aside, we seldom deal with clients who are over-spenders during their working years (or for that matter, during retirement).  Because we have few tools and little disposition to enforce budgets, we are delighted to work predominantly with diligent savers and prudent spenders. 

Preserving accumulated retirement resources becomes increasingly important as retirement nears and is crucial after full-time retirement begins.  Thus, our prime responsibility during retirement becomes asset management with a focus on tax-efficient cash distribution and maintaining capital adequacy.

One of the primary causes of loss of capital adequacy status is forced sales of risk-oriented assets (especially stocks and real estate) at the bottom of market cycles.  As equity markets continue downward, it becomes an increasingly bad time to sell, at cyclical lows, shares which could be valued significantly higher in a few years, even in a few months.  We are at such a time now.  The solution is to have adequate reserves "parked" in relatively risk-free investments and readily available to cushion the long-term portfolio from invasion during bear markets.  I’ll provide details in next quarter’s letter. 

CAVES & ASSOCIATES STAFF NEWS

We are pleased to welcome Mrs. Valerie Trumbull as a financial analyst at our firm.  Valerie is a graduate of Stanford, my alma mater.  She has extensive experience working in the banking and real estate industries.  She is a splendid addition to our staff and quite eager to meet and assist our clientele.

Ms. Tryphenia “Try” Collins is also a welcome addition and assists Susan with the various duties of office administration.  Many of you know her as the beautiful smile and voice of the afternoon receptionist for the executive suite where we have our offices.

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.  As a reminder, these materials are also posted on our website, www.cavesassociates.net.

Thank you for your continued support of Caves & Associates.

Very truly yours,

Preston S. Caves, CFP, MBA, CFA

PSC/slm