2004 2nd Quarter Commentary
and Planning Ideas
Commentary and Planning Ideas, Market Perspective, and Market Review are
written and published quarterly by Caves & Associates.

August 5, 2004
  Dear Clients and Friends,
 

I have enclosed your copy of Caves & Associates’ Market Review for the second quarter of 2004. The review highlights the lackluster quarter for investors. Stock results continued the ramping down of returns after skyrocketing price appreciation in 2003. Bond returns, after a pleasant surprise in the first quarter, went into the red and may have finally heralded an end to the bond bull market. The backside of the Market Review is a table of global investment returns for the spring quarter this year and six months year to date ending June 30, 2004. A second enclosure headed "Economic Review and Market Perspective" provides a longer-term interpretation of current economic and market data.
  During the quarter there was reasonably good news about the U.S. economy and prospects for continuing corporate earnings growth, but the news hardly translated to higher stock prices. Stocks had risen so sharply from March 2003 that investors may have concluded that most of the good economic news was already reflected in 2004 price levels. Also, the news included a host of negative factors as well, including the U.S. Federal Open Market Committee moving away from its accommodative monetary policy; mixed reports on U.S. employment, slow growth of wages, and continuing concerns of a jobless recovery due to widespread outsourcing to overseas locations; high energy prices cutting into spendable income and putting upward pressure on the general level of prices; and no real emergence of economic strength outside of America, except for China, where policy makers were attempting to reign in an overheated economy.
  The world situation remains tense. With all eyes on Iraq, insurgency violence mounts, non-US foreign troops are being withdrawn, and world and even domestic support for the war are at their lowest points ever. Meanwhile, the world’s developed economies continue to heavily depend upon energy supplies from a volatile, Islamic middle east.
 

With this newsletter, we are introducing a new element, the Blog Department, so-called mainly because it will present opinions and commentary not particularly germane in the short-run to your money matters. The content is likely to be oriented to long-run economic and political issues, concerns that are not yet crises but need attention, and even matters that are strictly personal like a wine or restaurant recommendation. By the way, Blog is an internet term and is short for Web log.
  The Blog Department is clearly not must reading but may stimulate your thinking. It will be unscheduled rather than a regular part of this quarterly mailing, and it will be presented as an enclosure. This quarter, the Blog Department discusses U.S. monetary and fiscal policy, our massive Federal and trade deficits, and heavy use of debt by corporations and consumers. The concerns expressed coalesce with those highlighted in the recent Secular Forum of PIMCO, a leading bond management firm with a global perspective. As summarized by PIMCO, the debate over a balanced versus unbalanced global economy revolves around the fundamental proposition that bad things can happen in a levered economy. The Blog Department also touches on the huge fiscal challenge of shoring up the Social Security and Medicare systems.
  We believe the risks expressed in the enclosed Blog Department are real and disturbing. Nonetheless, it is important to note that the issues represent long-term challenges that need long-term solutions. The timing and magnitude of the negative implications are unknowable, the likelihood of any near-term negative financial impact is low, and there is still time for corrective action. In other words, future events of this magnitude are hard to predict, and it is unclear how fast imbalances will unwind. We expect the world to “muddle through” in the short run. There is room for optimism, too, based on higher productivity, upward convergence of income levels in developing countries to developed country levels, increasing economic integration, and the resilience of stock markets exhibited so often in the past.
  Our near-term market outlook is unchanged from what we wrote three months ago, which we have been describing as market neutral. That’s because it is hard to formulate a compelling argument favoring any particular asset class. Notwithstanding, we continue to be wary of interest rate increases and are quite defensive in our bond positioning. Additionally, we are assuming good fiscal and monetary policy decisions and execution, gradual transitions, and no major external shocks to support the sanguine outlook.
  Caves & Associates discourages focusing much attention on short-term investment 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.
  Additionally, it is impossible to consider every possible cause and effect with regard to markets. 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 rebalancing will provide sound long-term investment returns.
  Some Guidance
  In our world of lower margins for error and increased risk and uncertainty, conservatism and prudence are much needed. In addition to maintaining broad diversification and discipline, we can’t overemphasize the importance of maintaining adequate reserves for potential needs to withdraw from your portfolio. These reserves should be invested for maximum capital preservation and should cover known needs such as cars, weddings, home remodeling, and on-going cash withdrawals (typically in retirement) as well as unknown needs (i.e., provide a general/emergency reserve). We also encourage debt reduction and avoidance of variable rate debt (credit cards, home equity lines, and first mortgages that do not have a fixed rate). Additionally, it is a good idea to assess and reduce expenditure levels (tighten your belt a little) and avoid relying on overly optimistic retirement planning assumptions. Finally, return expectations should include an understanding that periods of increasing interest rates can be bad for both stocks and bonds. We note that strong bond returns in 2002 were a great benefit for overall portfolio results in a year in which stock returns nose-dived. Going forward, we need to be prepared for a “double whammy” at times, when positive returns for bonds may not be available to mitigate the inevitable rough patches for stocks. At such times portfolio returns may be even worse than experienced in weak markets over the last few years and decades.
  What’s Timely and Topical
  The following are of interest or concern; give us a call if you would like further information:
 
  • Is the Los Angeles real estate bubble about to burst? Real estate experts noticed that in May the number of homes sold that had been owned by the sellers for six or fewer months was 47% higher than it was a year earlier. And these constituted 3.1% of all homes sold in the month – nearing the flipping record of 3.5% set in early 1989, according to DataQuick, a La Jolla real estate information firm. A marked increase in flipping – the buying of a house for the sole purpose of selling it swiftly at a profit – is viewed in the industry as a sign of an overheated market. In fact, two years after the 3.5% flipping record was set, the Los Angeles housing market began to sputter, with prices deflating 22.2% from early 1991 through 1995. Finally, an additional sign of recent softening is a dramatic increase in new listings, which contrasts with what realtors describe as a ridiculously small inventory of houses for sale only a few months ago. In summary, speculators beware! (For our out-of-town readers, we’re not sure if the above applies to your area, but we suspect it is at least somewhat relevant.
 
  • Our long-term concerns about future lower securities returns after the historic U.S. bull market from 1982-2000 continue to be reinforced. John Bogle, former chairman of Vanguard, and Bill Gross, head of PIMCO, have already made the case. More recently, Jonathan Clements, fine columnist for the Wall Street Journal, has presented forceful arguments. All three are urging us to lower expectations by about 2-4 percentage points per year. Let us know if you want a copy of Jonathan’s article.
 
  • Work may hold one key to a longer life, and a quest for early retirement may be chasing the
    wrong dream. So reports Tara Parker-Pope in her recent Wall Street Journal column Health Matters. A transcription of her June 28th article is enclosed and is strongly recommended reading.
  As a reminder, see the Blog Department, which is topical though not necessarily timely yet.
  Quotes For Our Times and All Time
  Thomas Paine:
 

“Reputation is much easier kept than recovered.”
  Sharon Huffman:
 

“Feelings of gratitude release endorphins throughout the body, creating health.”
  Thomas Edison:
 

“Thinking is hard work.”
  Indira Gandhi:
 

“My grandfather once told me there were two kinds of people: those who do the work and those who take the credit. He told me to try to be in the first group; there was less competition there.”
 

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. These materials are available on our website, www.cavesassociates.net. If you prefer to receive a quarterly email announcing their availability on the website, rather than a hard copy, please let us know (we always like to “save a tree” and postage costs, as well).

 

Thank you for your continued support of Caves & Associates.
 

Very truly yours,


Preston S. Caves, CFP, MBA, CFA
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