2004 Year-End Commentary and Planning Ideas
Commentary and Planning Ideas, Market Perspective, and Market Review are
written and published quarterly by Caves & Associates.

January 31, 2005

  Dear Clients and Friends,
 

I have enclosed your copy of Caves & Associates’ Market Perspective Full Year 2004 and Outlook.  The review of 2004 highlights: 1) continuing global economic improvement but some increase of inflation caused by surging prices for oil and gas, which combined to produce sideways markets through October, 2) a sharp increase in stock prices around the world after some easing of energy prices toward yearend and the orderly, business-oriented outcome of the U.S. presidential election, and 3) moderate, even surprisingly solid returns for bonds as investors were not fazed by the Fed’s increase of short-term interest rates in the U.S.  Additionally, the review provides information on five-year returns for perspective.  The key observation is that global stock markets not only held on to big gains in 2003 but added to those gains in spite of continuing threats from world terrorism, mounting deficits in the U.S., and the beginnings of monetary restraint by some of the world’s central banks.
  This past year saw a new set of external shocks to replace those experienced previously.  In 2001 we endured the terrorist attacks of September 11th and war in Afghanistan.   In 2002 we faced continued unrest in Afghanistan and the Middle East, plus corporate scandals, major bankruptcies, challenges to Wall Street’s integrity, and the Iraq and North Korea crises.  In  2003 we saw the dramatic decline of the dollar, mutual fund scandals, accounting scandals, and the beginnings of an escalating insurgency in Iraq.  Events that were not likely on investors’ minds in January 2004 included the terrorist attacks in Spain, defiance in Falluja, and the tsunami in Southeast Asia.  While at least some of these were (hopefully) nonrecurring items, one can only wonder what potential disruptions lurk for 2005.  As I 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.
  The Iraq insurgency, the impact of higher energy prices, and the U.S. presidential election were certainly the wildcards in 2004.  Bush’s re-election has been initially well received, and the dollar’s decline even bottomed by the end of November.  The weak start for global stock prices so far this year may suggest a growing realization of the challenges facing the U.S. and the world as a whole, plus concerns over Bush’s policy agenda.  For example, engineering reduction in the huge and growing U.S. current account deficit without hurting either the United States or its trading partners will be a daunting challenge for all.
 

I have also enclosed a Market Review for the fourth quarter of 2004.  The review indicates it was a very strong quarter for stocks and about a normal one for bonds.  Due to the dollar’s decline in October and November, the U.S. dollar investor enjoyed particularly strong stock and bond returns overseas.  A tabular attachment to the review provides global returns for the quarter and full year 2004.
  Regarding the Outlook for 2005, we continue to have powerful positive and negative forces impacting the economy and stock market, plus continuing uncertainties of Iraq and terrorism, the emerging major impact of China on global economics, the weakening dollar, and the increasing overhang of government and consumer debt both here and abroad.  These opposing forces and uncertainties make it again difficult to provide definitive forecasts for the next year.  On the positive side are economic and stock market momentum, the highly stimulative U.S. deficit spending, and the continuing low levels for long-term interest rates.  On the negative side are concerns about U.S. high stock valuations viewed on an historical basis, a possible crisis of confidence in the U.S. dollar, inflation worries, and the worrisome outlook for bonds due to economic strength and the Fed’s raising of short-term interest rates.   My best guess is U.S. stocks will perform somewhat below long-term historical averages, with the best opportunities in large capitalization and growth-oriented equities due to valuation concerns regarding small cap, value-oriented securities. Overseas securities should provide good returns at or above historical averages due to lower valuations and expected continued weakness of the U.S. dollar.  In spite of the relatively poor outlook for bonds, duration hedged positions must be maintained to offset geopolitical risks and unforeseeable economic shocks.  Additionally, notwithstanding somewhat disappointing results in 2004, alternative strategies that are carefully selected may well outperform in 2005 due to the lackluster outlook for U.S. securities.
  Beyond 2005, the outlook is cloudy, even stormy.  Our concerns are presented toward the end of the enclosed Market Perspective and Outlook.  It is important to note that concerns over Social Security and Medicare, the twin U.S. deficits, and the declining dollar do not necessarily imply cataclysmic events are imminent.  For example, the dollar is likely to drift downward rather than experience an abrupt crisis of confidence, though a crisis is possible.  Additionally, resolutions regarding Social Security, Medicare, and U.S. trade and governmental deficits will take years.
  With 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 believe strategic asset allocation is such a plan. 
  A scorecard at the end of the Outlook rates last year’s predictions.  It also provides an evaluation of the success of C&A's strategies and portfolio supervision in 2004.  Generally speaking, economic and market predictions were on target and investment results were very good.  The only disappointment involved alternative strategies, whose defensiveness prevented us from participating in the full extent of the yearend rally.  Overall, we are very pleased with the results of our diversification strategies.
  We have discussed our concern about market volatility in previous correspondence.  We have also emphasized the need for investor discipline.  History can be an ally in this situation.  History shows (recent history at that, namely, the Internet bubble) that U.S. and global markets have exhibited overconfidence in the past.  Accordingly, after three years of down markets in 2000-2002, we are grateful for the return to positive returns in 2003-2004.  Nonetheless, it is important to temper our enthusiasm with an appreciation of the positives and negatives of the big picture.

C&A 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.  Of course, corollaries of diversification that you will also notice are:

1) some parts of your portfolio will always be lagging the market averages, and 2) your overall portfolio return will lag the return of the market’s current hot areas.
  What’s Topical or Timely
  We remain committed to continuing education as well as keeping you abreast of anything crucially affecting your wealth management.  I attended the Los Angeles Financial Planning Association Insurance Day last November.  Topics included the new Health Savings Accounts (recently authorized by Congress and better than predecessors), wealth transfer planning for retirement plan and annuity assets, exit strategies from unwanted life insurance policies, and the potential for reducing life insurance premiums and/or improving cash value accumulation due to impending implementation of new mortality tables by the life insurance industry based on Americans living longer (longer life expectations mean lower mortality, or insurance, charges within policies).  Please call if any of these topics interest you.
We will provide the next edition of Timely Topics on an ad hoc basis as the need arises.
  Some Guidance Regarding Attainment of Long-Term Life Goals
  Overall, 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 reasonable reductions in spending and increases in our savings rates whenever possible. 
  Coincidentally, solving one of our country’s problems would be assisted by such attitudes according to an opinion column in the Wall Street Journal dated December 28, 2004 by Professor Edmund S. Phelps of Columbia University.  He wrote: “At the present time [American] households are badly under-predicting their future tax liabilities – or, if the U.S. government is going to cut entitlements [such as Social Security] – over-predicting their future benefits.  Either way, they are spending too much….”  Professor Phelps goes on to argue that reduced consumption and increased savings would help increase U.S. exports and decrease U.S. imports, thus assisting in reducing one of our two twin deficits, namely the current account deficit, and restoring balance to our trade relations.  We think he makes a good point.
2004 IRA Contribution Deadline is 4/15/05
  As your financial advisor, we would like to remind you that an annual IRA contribution is almost always a good strategy.  Congress is raising the limits, and IRA contributions should be of interest to all taxpayers who have earned income at least equal to the limits.  The allowable contribution to an IRA attributable to 2004 is $3,000 for anyone under 50 years of age and $3,500 for those over 50 as of the last day of the calendar year.  Accordingly, for a married couple the 2004 contribution limits total $6,000 - $7,000, depending on age.  These single and married limits are high enough to make a considerable difference over time in the rate of after-tax wealth accumulation for all but the wealthiest U.S. taxpayers (i.e., not a big enough impact for the really wealthy).  Your tax preparer is usually the best source for guidance regarding IRA contributions as each individual case differs.
  There are many issues affecting tax deductibility and whether to contribute to a traditional IRA or a Roth IRA (the latter are never tax deductible).
In summary, the annual IRA contribution is a perishable commodity: once the deadline passes, you are out of luck for 2004.  Please call us if you have any questions not handled by your tax preparer and for any assistance you might need actually getting your contribution into your IRA account by the deadline.
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 Times and All Time
  Anonymous:
 

“We do not stop playing because we grow old; we grow old because we stop playing.”
  John Glenn:
 
“There is still no cure for the common birthday.”
  Japanese Proverb:
 

“Money grows on trees of persistence.”

  Frank Lloyd Wright:
 

“A doctor can bury his mistakes but an architect can only advise his clients to plant vines.”
 

Albert Einstein:
 

“Reality is merely an illusion, albeit a persistent one.”

Mahatma Gandhi:

“Honest disagreement is often a good sign of progress.”

Abraham Lincoln:

“Nearly all men can stand adversity, but if you want to test a man’s character, give him power.”
John Maynard Keyes:

“The difficulty lies not so much in developing new ideas as in escaping from old ones.”

Form ADV Available for Your Review

The ADV is our registration as an investment advisor with the SEC.  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 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.  This letter and the enclosures, as well as an overview of our staff, advisory philosophy, and methods, is 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.
 

Best wishes for a happy, healthy, peaceful, and successful 2005.
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