Dear Clients and Friends,

Your copy of Caves & Associates’ Market Review for the second quarter of 2009 is enclosed, or you are viewing this mailing via the Internet. The second quarter exhibited the extreme volatility of 2008, except on the upside thankfully rather than the downside. Continuing the steep run-up which started March 10, results for global equities were significantly positive during the second quarter notwithstanding moderate declines that began June 12 and continued through July10. Due to the return of risk-taking, U.S. government bonds lost money, and conversely, investment grade as well as high yield corporate bonds had a major rebound. International stocks outperformed U.S. stocks, primarily due to currency gains caused by renewed depreciation of the U.S. dollar due to investor’s increased willingness to hold foreign currencies (a reversal of the previous quarters’ flight to quality). Alternative strategies had mainly positive results that were closer to those of bonds than those of surging stocks. Given very robust results for global stocks, in the range of 15%-25% for the quarter, comparatively lower results for bonds and alternative strategies held down the total portfolio return for a broadly diversified investor, again a reversal from the first quarter. Second quarter and first half returns for alternative strategies are reviewed in a separate section below.

The backside of the Market Review provides global returns for the second quarter of this year and for six months year to date ending June 30, 2009. The global returns provide reference points against which to judge results for your investment accounts. For the first half of 2009, diversification was beneficial because it smoothed results that were wildly divergent for equities in the first quarter (major losses) compared to the second quarter (high gains). Bond and alternative strategies performed as usual from a portfolio perspective to limit volatility.

The accompanying “Economic Review and Market Perspective” provides a longer-term interpretation of current data and presents returns for the last 12 months, five years, and longer-term to allow evaluation of secular trends and comparative performance of bonds versus stocks. Two steep bear markets this decade have combined to produce a remarkable result: long-term U.S. Treasury bond returns have bettered results for U.S. blue chip stocks for the past five, 10, 15, 20, and 25 years. Is this a statistical aberration or do investors need to significantly revise the weights of stocks and bonds in their portfolios? See the Market Perspective for an evaluation (hint: misleading factoid).

As you know, 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 performance 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. Further, we continue to believe that a disciplined investment approach emphasizing diligent fundamental research, a generally buy-and-hold approach, cost minimization, and rebalancing will provide sound long-term investment returns. Finally, it is crucial to maintain adequate cash reserves to avoid forced portfolio liquidations at cyclical market lows, bearing in mind that such lows are unpredictable.

What’s Below

• General Perspective and Commentary
• Results for Alternative Strategies Investments
• Outlook Update
• Timely Topics and Blog Department on Hiatus
• Staff News

General Perspective and Commentary

You are undoubtedly aware that the decline in U.S. home values, the related devaluation of the mortgage securities market, the credit crisis, and the fairly rapid unwinding of excess use of leverage globally has put extreme downward pressure on worldwide economic activity. As a result, financial markets topped in October 2007, struggled unsuccessfully to hold value during the first eight months of 2008, and then collapsed in a roughly five-week debacle in September/October of 2008.

Extensive asset selling by cash-strapped financial institutions and consumers put extreme downward pressure on prices of all types of assets, including even high quality assets. A major flight to safety by increasingly risk adverse investors became so widespread that only dollar-denominated, U.S. Treasury-backed assets provided positive returns in 2008. Concomitantly, asset allocation had its worst performance since the Great Depression, and some questioned its viability.

After the September/October debacle, global markets generally see-sawed for the rest of 2008, but with a downward net effect, and then started 2009 with another major selling spree which thoroughly tested investors’ discipline and lasted until March 9, 2009. At that point, bonds were so discounted they were priced essentially as if another Great Depression was imminent. Stocks had not fared much better and were pretty much priced for a severe recession and a prolonged drop in corporate profits. In retrospect, both the bond and stock markets were oversold. They were ripe for a comeback if reports suggested an end to the economic freefall and any improvement in credit conditions. Both occurred, and it only took the sense that conditions were deteriorating at a slower rate for a resurgence of investors’ risk appetites. Accordingly, markets staged a strong three-month rally which may have topped on June 12. At this writing, a roughly month-long gradual decline in global stock prices through Friday July 10 has been largely but not completely offset by four strong daily results for stocks July 13 through July 16.

To review, investor losses on stocks in 2008 through early 2009 were unprecedented, except for the period of the Great Depression. Likewise, losses on bonds, especially the normally stable high quality issues during roughly the same period were also unprecedented. However, the current recession, though a severe one, is not unprecedented as to either magnitude (i.e., strength) or length. So far, U.S. GDP is off 3.1%. There has been one worse recession since the 1930’s, and there have been numerous comparable recessions as well. By comparison, U.S. GDP declined a whopping 26.5% during the Great Depression. Further, the average U.S. recession lasts 15 months. Assuming the U.S. economy was still in recession as of June 30, 2009 (very likely), at 18 months, the length of the current recession is only slightly longer than the average. Of course, the current recession is expected to last at least to this Fall.

Investors are searching for a light at the end of the tunnel regarding the economy and are seeking confirmation that the deep 2008 – early 2009 bear market is indeed behind us. Unfortunately, the signs that point to an economic turnaround and future prosperity are not readily evident at the moment. See the Updated Outlook for further discussion.

Nonetheless, investors should not lose sight of the inevitable recovery that follows recession. It is important not to overreact to downbeat economic and financial news, since there is no way to know for sure when the market has truly troughed (or peaked). As we have just seen this Spring, market recoveries can occur quickly, without notice, and long before tangible evidence of improvement has occurred. Meanwhile, challenging and volatile market conditions often lead to market dislocations which present opportunities for disciplined, long-term investors. Finally, very major government programs have been and are being implemented in the U.S. and abroad to meet the challenges we face. See last quarter’s communication in April for a recap of the major U.S. economic stimulus programs.

Returning to the subject of asset allocation, it certainly didn’t work as well during the 2008 – early 2009 bear market as in previous bear markets because it depends on un-synchronized return patterns over time for various asset classes. Unfortunately, due to prolonged, widespread panic, global stock performance exhibited much higher correlations than historically. Even more important, all but U.S. Treasury bonds had very poor results at the same time as stocks were crashing, unusual but not uncommon. Nonetheless, it is critical to note that asset allocation did not completely fail because cash and U.S. Treasuries, two key asset classes, did have positive results amidst the stock carnage. Further, non-U.S. bonds were down quite a lot, but they declined in value substantially less than global stocks, thereby also mitigating losses for the diversified investor. In conclusion, given 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 still believe broadly diversified asset allocation is such a plan.

Results for Alternative Strategies Investments

We’ll make an exception about focusing on short-term results, partly due to recent unprecedented market conditions, to note that our defensive strategies have generally been successful at preserving client capital for future growth opportunities. We have increasingly relied on alternative strategies funds. To summarize, they have been excellent diversifiers, have smoothed results, and have not hurt returns since a substantial increase in use last December when they were substituted for a portion of the equities allocation in client portfolios.

Over full market cycles, our alternative strategies funds have consistently outperformed a traditional balanced mix of long-only global bond and stock positions. As a group, they have exhibited fairly low correlation with equities. They have generally lagged in bull markets but significantly outperformed in bear markets. Results for the first half of 2009 versus equities are summarized below:

Based on the weighted average for six months, the alternative strategies funds and equity indexes provided quite comparable results. It is important to note that this comparison was for a short time period and one which was very volatile. Further, the six-month results hid a major divergence between the first and second quarters. In the first quarter alternative strategies funds hedged against markets which were dropping wildly and dramatically outperformed equities. The second quarter was a complete reversal, and the defensive nature of alternative strategies funds caused them to significantly lag equities. Importantly, the three alternative strategies funds provided a much smoother result, delivering about breakeven results through March 31 and then a 4.8% gain for the three months ending June 30. By contrast, the equity indexes lost 13.1% in the first quarter and gained 20.5% in the second quarter (the first quarter loss for equities is a corrected amount and supersedes the 14.6% loss we reported in April). Thus, on a risk-adjusted basis, alternative strategies provided superior returns. Finally, we believe investors are particularly adverse to losses; by avoiding first quarter losses, alternative strategies helped our clients to hold the course.

Updated Outlook

Our outlook for 2008 was promulgated January 31, 2009. We have noted that 1) our outlook was somewhat more negative than what might be judged the consensus 2009 forecast at the time, and 2) the ensuing reality is typically significantly different from the consensus because the consensus is already factored into prices at the start of the year (this is sometimes described as the various positive and negative expectations being “already discounted” by the market). To summarize, our outlook was very cautious, and we advised capital preservation and a defensive emphasis for client portfolios.

We presented an update to the January outlook in our client communication in April to reflect information revealed in the first quarter. To summarize, it did not substantially revise the outlook and counseled continued conservatism.

As we begin the second half of this year, economic pundits and investors continue to wonder whether the worst is over and whether we are heading into economic recovery and a sustained rebound of stock prices. Indeed, some economic indicators have improved such as the TED spread (an indication of banks’ willingness to loan to each other), consumer and business credit availability, and consumer confidence. Clearly, another Great Depression has been avoided according to not only economists but the generally reliable barometer which is the stock and bond markets themselves.

We were disheartened by the worsening of U.S. non-farm employment in June after signs of improvement in April and May. There is much talk of a jobless recovery due to permanent loss of jobs rather than merely cyclical and thus temporary loss of jobs. Investor sentiment is not particularly strong, as many people hesitate to commit additional capital in a very uncertain environment. It is unclear whether reviving the credit markets, and thus making it easier for individuals and institutions to borrow, will improve the economic and financial environment, and if it does, when that ultimately will happen.

Minutes released July 15 of the most recent Fed meeting support concerns about a jobless recovery. The Fed is preparing for a very unusual recovery in which the economy grows but unemployment also continues to rise, according to the minutes of the June meeting. Despite projecting a smaller decline in economic growth for 2009 and a slightly higher increase for 2010, the Fed is projecting a jobless rate of around 10% by the end of 2009, with jobless rates remaining above 9% in 2010 and 8% in 2011. The unemployment rate is currently 9.5%, a 26-year high. Thus, while the Fed warns that the risks of a worse recession have receded, they remain “significant,” and any recovery will be bumpy.

As for global stock markets and near-term strategy, the key question at this waypoint is whether the post-March 9 price increases are a house built on sand or bedrock: sand if the few “greenshoots” of economy recovery do not expand into a fully blossomed global economy and bedrock if the economic optimism implied by a rather spectacular three-month 23% gain of global equities has been warranted.

We are pleased by the end of the freefall and even some signs of improvement, but we have continuing concerns about the economy and financial markets. Our position remains that the economy is in a long bottoming process. Therefore, economic recovery, when it comes, will likely be L-shaped rather than U- or V- shaped; in other words, it will not be robust for several years.

Alternately, a W-shaped recovery is possible. This pattern to economic activity would mislead some to expect a V-shaped recovery which instead would later be revealed as a strong early bounce resulting from global governmental economic stimulus programs followed by a significant retrenchment as stimulus programs are curtailed and underlying long-term weakness resurfaces.

We cannot have much confidence in our ability to forecast the future in these almost completely unprecedented times. As just reviewed, we do not expect economic conditions to improve significantly anytime soon. Further, we think the mid-March to mid-June spurt in global equities prices overshot the target. Accordingly, the spurt has increased downside investment risk substantially and decreased short-term upside potential. Given all the uncertainty, we believe it is important to err on the side of conservatism. Finally, we believe we have identified a reasonable strategy that is working by smoothing results and hedging the downside. Thus, we are leaving our 2009 outlook and associated major portfolio strategies unchanged.

As usual, our outlooks are predicated on good fiscal and monetary policy decisions and execution, gradual transitions, and the absence of major external shocks. Also, we recognize that employment is a lagging economic indicator, and markets are forward looking, often preceding economic upturns by six-twelve months. The mere passage of time is a positive, bringing us closer to economic recovery, and we expect, or at least hope, to have an improved outlook later this year.

What’s Topical or Timely

We remain committed to continuing education as well as keeping you abreast of information which may have a significant impact on your wealth management. Preston recently attended a day-long investment outlook symposium and listened to prominent market strategists, fund managers, and experts in behavioral finance.

Timely Topics is not being presented at this time but will return in the future.

The Blog Department

The Blog Department is our occasional expression of opinion, perhaps with a touch of controversy. For the time being, the Blog Department is under wraps due to time constraints.

Staff News

We have welcomed back Valerie Trumbull as an important member of our staff. After having worked for Caves & Associates from 2002 through 2006, Valerie has rejoined the firm following a three-year hiatus. Now, as before, Valerie conducts investment and financial analysis and also handles portfolio monitoring and rebalancing, performance reporting, and mutual fund research. She not only generates periodic client reports, but she also performs ad hoc analyses and is partly responsible for client liaison on portfolio matters.

Valerie earned her B.A. in political science and international relations from Stanford University in 1982. She then worked in a variety of financial service positions in the Southern California area, focusing primarily in the real estate sector. Valerie is a Southern California native and has lived in Manhattan Beach since 1984. She is married to Terry and has a son and daughter in high school, and an adopted family dog. Now that her children are increasingly independent, she is happy to return to working at Caves & Associates.

Quotes of Our Times and All Time

Yogi Berra:

“When you come to a fork in the road, take it.”

Dr. Loretta Scott:

“We can’t help everyone, but everyone can help someone.”

Herbert Hoover:

“About the time we can make ends meet, somebody moves the end.”

Hugh Downs:

“A happy person is not a person in a certain set of circumstances but rather a person with a certain set of attitudes.”

Mary Bly:

“Dogs come when they’re called; cats take a message and get back to you.”

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. Nonetheless, the information is of a general nature and should not be acted upon without further details and/or professional assistance.

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.