Dear Clients and Friends,

We normally say we are “pleased” to present Caves & Associates’ Market Perspective Full Year 2008 and Outlook.  However, for investors, 2008 was a year of turmoil, negative surprises, and investment losses, and prospects for 2009 do not look good.  Therefore, it is much more appropriate to say we are “dutifully” presenting the 2008 Market Perspective and 2009 Outlook.  The review of 2008 highlights: 1) the collapse of the U.S. economy, as the U. S. consumer finally succumbed to a combination of heavy debt, job losses, very high gas prices (mid-year), meager inflation-adjusted income growth, and collapsing personal net worth; 2) the failure of overseas economies to “de-couple” as credit, employment, consumption, and business activity generally paralleled the U.S. downward spiral in both developed and emerging economies; 3) the historic sell-off of financial markets amid gut-wrenching volatility; 4) surprisingly negative returns for investment grade bonds plus a significant rebound of the U.S. dollar as scared investors demanded the uppermost safety of U.S. Treasuries and the dollar; and 5) the lightening speed of market and economic changes illustrated not only by stock prices but also the whipsawing of energy prices and inflation rates.  Additionally, the review provides information on five-year returns for perspective; for most stocks, the 2008 bear market has more than reversed all the gains of the previous bull market.  We encourage you to read the Market Perspective for a fuller review of major economic and market events in 2008.

One key observation is that these challenges have elicited a prompt and unprecedented response by governments worldwide via what is potentially the largest and most broad-based economic stimulus effort in history.  Another key observation is that, unfortunately, diversification provided investors very little protection because the market carnage was global, and even defensive stocks and investment grade bonds were hard hit; in other words, there was almost nowhere to hide.  As usual, we encourage you to avoid focusing on any short time period, because stock prices are historically quite volatile in the short-run.

As suggested above, perhaps even more surprising than some of the remarkable 2008 events themselves was how quickly they unfolded. The U.S. stock market lost 40% of its value in just nine weeks from September through November. Venerable, century-old financial institutions disappeared overnight. A commodity boom became a commodity bust within four months. Billionaire tycoons went from accumulating mansions to defaulting on their debts.

Each year from 2001-2005 included multiple external shocks which hurt financial markets, the most severe being 2001 when we endured the terrorist attacks of September 11^th.   During the period we also faced major corporate, mutual fund, and accounting scandals; escalating mid-East tension; additional terrorist attacks; and terrible natural disasters in southern Asia and along the Mississippi coast.  The lack of major negatives was a big contributor to surprisingly good investment returns in 2006, and continuing geopolitical challenges were seemingly treated as “old news” by investors who focused on the key factor of corporate profit growth and generally benign economic news.  In 2007, investors became aware of the weakening U.S. housing market, dealt with our continuing struggles in Iraq, and then faced the rapid deterioration of the value of subprime mortgages and the related, equally sudden credit crunch.  Last year, the housing and credit crises spread to reveal a shockingly overleveraged, undercapitalized global financial system and an equally overextended U.S. consumer; additionally, the spike in energy prices and drastic reduction in home construction, auto purchases, and overall consumer spending combined to cause the collapse in the U.S. economy.   One can only wonder what potential disruptions and unexpected economic twists lurk for 2009.  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.

We have also enclosed a Market Review for the fourth quarter of 2008.  The review indicates it was a broadly and steeply down quarter for U.S. and foreign stocks due to economic concerns and the flight to safety.  In fact, the fourth quarter was an extension and acceleration of weak market conditions exhibited earlier in the year.  Stock losses were dramatic and were evident across all markets, capitalizations, and sectors.  U.S. and developed country foreign government bonds both had strong quarters, and the highest quality corporate bonds were also back in the black after losses for the first nine months.  A tabular attachment to the review provides global returns for the quarter and full year 2008.

The 2009 Outlook is included in the accompanying Market Perspective.  It is very cautious; some might even say pessimistic.  We continue to have powerful positive and negative forces impacting the economy and stock market, plus continuing uncertainties in the Middle East and emerging economies like China, India, Russia, and Brazil, whose economic strength was supposed to carry the global economy during weakness in the U.S., Europe, and Japan.  We have to deal with the increasing overhang of government and consumer debt both here and abroad, and the threats involving global warming and fundamentalist Muslims.  These opposing forces and 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 2009.  Nonetheless, the Outlook section in the Market Perspective does elaborate on various key issues in 2009 and beyond.

We have previously quoted the cautionary comments of Mr. Gary Shugrue, Chief Investment Officer of a fund of hedge funds, on outlooks. To reiterate and summarize, he criticizes the number of people saying the same thing.  He also notes there is always 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 prices.  Accordingly, the consensus will in all likelihood be wrong.  We have concluded that the current consensus is overly optimistic and plan a quite defensive strategy in 2009 accordingly.  Please see the Outlook section of the Market Perspective for additional discussion.

A scorecard at the end of the Market Perspective and Outlook rates last year’s predictions.  It also provides an evaluation of the success of Caves & Associates’ investment strategies and portfolio supervision in 2008.  Generally speaking, the accuracy of economic and market predictions was poor, and client results were about in line with the very weak market conditions.   We did not predict such a disastrous year for global stocks.  We did maintain some underweighting of U.S. and foreign stocks but not nearly enough in retrospect.  We also employed a small overweighting of alternative strategies during the year, and their defensiveness aided portfolio returns considerably, as to be expected in a year when bonds beat stocks.  While quite a few predictions were about on target, they had an inconsequential impact on investment results in the context of global financial markets where there was no place to hide.  The reader is referred to the Scorecard section of the Market Perspective for an extensive description and critique. 

Overall, we are not pleased with the results of our diversification strategies, but we realize 2008 was not a year in which diversification could do much to achieve good returns.  Rather, it was a year in which many things that sounded impossible at the start of the year now have to be accepted as facts.  Also, and of much importance, we are long-term investors, not market timers, so poor absolute returns are the inevitable result of an extreme bear market.  Further, we guess but can’t confirm that our results relative to other investment professionals were above average.  Finally, as noted by Warren Buffet, anyone with the skill or good luck to have been out of the equities markets in 2008 faces the remaining daunting challenge of properly timing their re-entry into stocks. 

Additional Perspective and Cautions

Bear markets are never fun for anyone. Nevertheless, bear markets are not unusual, having occurred 13 times since 1926. The average duration of these bear markets has been a little over one year, and investors, on average, made their money back in about three years. Furthermore, equities on a historical basis have tended to rebound sharply from the bear market trough, gaining an average of about 47% for the one-year period following the bottom of the market. With that said, it remains to be seen whether prices will rebound in a manner consistent with previous bear markets. As we recently learned, economists believe we have officially been in recession since December of 2007, and present expectations are that this recession will be steeper and longer than average.

With the usual uncertainty about future outcomes, investors should develop and maintain a plan that has the potential to work over most future scenarios.  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 observers of 2006 results have categorized them as a pleasant surprise.  We have been reminding readers that markets often provide us with unpleasant surprises as well, and 2008 is clearly a good example.  Markets move in cycles, and it is always important to temper our enthusiasm with an appreciation of the positives and negatives of the big picture.

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. 

Mutual Fund News

Charlie Dreifus, manager of Royce Special Equity, was recently named Morningstar’s 2008 Domestic Stock Manager of the Year.  When we first included Royce Special Equity (RYSEX) in many client portfolios a few years ago, it was rated 2-stars by Morningstar because of a period of poor performance due to Dreifus’ investment style being out-of-favor.  However, we liked Dreifus’ conservative long-term approach, very good early record at RYSEX, and previous track record at Lazard and Oppenheimer.  Dreifus buys stocks trading at what the Royce team judges to be a steep discount and also targets stocks with high returns on invested capital, clean accounting, and strong balance sheets.  We also liked the below average expense ratio of RYSEX.  Dreifus’ approach has excelled as markets have soured, and RYSEX has produced solid long-term returns with much less risk than comparable funds.  Royce Special Equity was ranked #1, #2, or #3 in total returns in the small value category over 3-month, 6-month, 1-year, and 3-year periods as of December 31, 2008, and it is now rated 5-stars by Morningstar.

No Exposure to Madoff Pyramid Scheme

Our predominant portfolio holdings are openend mutual funds.  Yes, they may seem a bit boring and lacking in flare, but at times like these their transparency and government regulation is reassuring.  Also, they have been essentially scandal-free when compared to the complete loss of a pyramid scheme like Bernie Madoff’s.  Additionally, we keep portfolios diversified among dozens of mutual fund alternatives so the negative impact of any one fund is greatly diluted. 

A few clients of Caves & Associates have exposure to lightly regulated hedge funds through fund of funds vehicles.  We are not surprised, and we are pleased to report, that none of these funds had any exposure to the Madoff investment programs.  Their due diligence is designed to eliminate such programs from consideration.  Also, they use the safety of broad diversification and multiple managers in a manner just described above for our mutual fund portfolios.

Exclusive.  Secret.  Proprietary.  These are words that have often been used when describing high flying, much sought-after investments.  Investors in investments using these adjectives are asked to forgo normal transparency and be glad that they have been accepted into these selective clubs.  Sadly, the recent Madoff scandal proves that marketing pitches like this work.  Investors, some supposedly sophisticated, overlooked many basic, common sense due diligence requirements because they desperately wanted access to Madoff’s supposedly “elite” firm.  Somehow, Bernie had found a way to make money in both up and down markets, and you were fortunate if he accepted you as a client.  He did not like to talk about his strategies lest he reveal his secrets and they lose their effectiveness.  We now know what the secret was.

What’s Topical or Timely

We remain committed to continuing education as well as keeping you abreast of anything crucially affecting your wealth management.  Rather than a separate enclosure or attachment, the following presents an abbreviated discussion of Timely Topics. 

The annual gift-tax exclusion rose to $13,000, up $1,000 from 2008.  This means you can give as much as $13,000 this year to anyone you wish, or to as many people as you want, without having to worry about taxes or even having to file any forms with the Internal Revenue Service.  It’s a simple way to help others and reduce the size of your taxable estate.  You can give even more than that by paying directly for someone else’s tuition or medical expenses.  Just be sure to pay the institution directly.  The lifetime gift-tax exclusion amount remains unchanged at $1 million.

Just before leaving office, President Bush signed legislation that allows millions of people who are 70 ½ or older to skip taking distributions from IRA’s and certain other retirement plans during 2009.  The new law, however, didn’t provide any relief for 2008.

Those subject to required minimum distributions have an excellent tax avoidance opportunity if they create a sourcing plan for 2009 cash needs that does not involve withdrawing cash from IRA’s and company retirement plans.  Given likely low capital gains exposure for assets held in personal accounts such as living trusts due to the steep decline of stock prices in 2008, liquidations of personal assets would be an easy choice as a source of alternate funding for one’s spending needs.

3.   2008 IRA Contribution Deadline is 4/15/09

Congress is again raising the limits, and IRA contributions should be of interest to all taxpayers who have earned income at least equal to the limits.  Please note income from investments, Social Security, and pensions does not constitute earned income.  The allowable contribution to an IRA attributable to 2008 is $5,000 for anyone under 50 years of age and $6,000 for those over 50 as of the last day of the calendar year.  Accordingly, for a married couple the 2008 contribution limits total $10,000 - $12,000, 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). 

There are complicated rules limiting ROTH IRA contributions and the deductibility (but not the allowability) of traditional IRA contributions.  Nonetheless, even non-deductible contributions of $10,000-$12,000 to traditional IRA’s repeated year after year can be valuable for enhanced wealth accumulation, especially for younger people, because of the long-term tax deferral respecting earnings attributable to the contributions.  It is also important to note that a non-working spouse may qualify for a deductible IRA contribution depending on the other spouse’s company-sponsored retirement plan participation status and the level of family income.  Your tax preparer is usually the best source for guidance regarding IRA contributions as each individual case differs. 

In summary, the annual IRA contribution is almost always a good strategy.  However, the contribution is a perishable commodity: once the deadline passes, you are out of luck for 2008. 

Staff News

Congratulations to Sandra Gafney.  She recently sat for and passed the rigorous, nationally-administered exam for the CFP (Certified Financial Planner) designation.  The exam’s pass rate is generally only about 50%.  Sandra has already satisfied all education and experience requirements, so it’s just a formality for her to add the CFP initials behind her name.  Sandra has a bachelor’s degree from the University of Florida, a Masters in Business from Loyola Marymount University, and has 18 years of experience in investment administration and consulting.

Some Guidance Regarding Attainment of Long-Term Life Goals

Although the outlook for 2009 is generally pessimistic amid numerous 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. 

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

Barack Obama:

“The fact that my 15 minutes of fame has extended a little longer than 15 minutes is somewhat surprising to me and completely baffling to my wife”.

Old Russian Proverb:

            “Patience doesn’t always help, but impatience never does.”

David Walker (former head of the Government Accountability Office):

            “It is imperative that we recognize that this country has been living beyond its means and that we face large and growing structural deficits even after we turn the economy around.”

Groucho Marx:

            “I do not care to belong to a club that accepts people like me as a member.”

Leonardo da Vinci:

“It had long since come to my attention that people of accomplishment rarely sat back and let things happen to them. They went out and happened to things.”

Franklin D. Roosevelt:

“A nation that destroys its soil destroys itself. Forests are the lungs of our land, purifying the air and giving fresh strength to our people.”

Rita Rudner:

“My husband and I are either going to buy a dog or have a child.  We can’t decide whether to ruin our carpets or ruin our lives.”

Form ADV Available for Your Review

The ADV is our registration as an investment advisor with the SEC.  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 comments and questions. 

During extraordinarily difficult times like 2008, it can be very challenging to see any light at the end of the tun­nel. We hold no illusions about the severity of the recent declines or about how detrimental the losses have been for many investors, especially those with aggressive asset allocations and short time horizons.  We are always grateful for our many clients, and we are especially thankful for continued confidence after such a difficult and humbling year.  Just as speakers are nothing without listeners, and performers are nothing without audiences, financial advisors are nothing without clients.

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 ourr 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.

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.