Dear Clients and Friends,

Your copy of Caves & Associates’ Market Review for the third quarter of 2009 is enclosed or you are reviewing this mailing via the Internet. The review highlights a quarter that proved to be an extension of the prior three months, as equities and credit sensitive fixed income securities posted their strongest gains in many years amid preliminary signs that the recession might be coming to an end. The U.S. dollar continued to weaken relative to most major currencies, helping to produce higher results overseas than in the U.S. for both stocks and bonds.

The backside of the Market Review is a table of global investment returns for the third quarter and nine months ending September 30, 2009. The global returns provide reference points against which to judge results for your investment accounts. As usual, but not guaranteed, broad diversification reduced volatility and rewarded the disciplined investor.

Caves & Associates discourages focusing much attention on short-term investment results because a broadly diversified portfolio is structured for the long-term. 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. As we often state, there is no way to completely eliminate short-term risk from an investment portfolio.

We have enclosed or attached an updated Economic Review and separately, the next edition of Timely Topics. The latter addresses three topics. The first is selected excerpts of a recent Wall Street Journal article by Professor Meir Statman about the mental mistakes investors make and why they make them; this is a very important topic and highly recommended reading. The second is an introduction to a subject of importance starting in 2010, namely, how and whether to convert your traditional IRA to a Roth. The third is a potentially advantageous strategy for claiming Social Security. In conclusion, matters of the head are crucial for our investment success, and when it comes to Roth conversions and Social Security benefits, it is definitely not one size fits all, so please consider a professional consultation

What’s Follows

• A reminder that diversification still works
• Market perspective and portfolio performance
• Updated outlook and portfolio strategy
• A few items from the Blog Department
• Quotes of our times and all time

Reminder that Diversification Still Works

Diversification is perhaps the simplest and most popular investment concept, but in times of severe economic trouble, it may appear to lose its effectiveness. During the recent financial and credit crises, investors saw their portfolios tumble and started to fear that diversification was dead. It is true that a widespread decline in the economy affected most asset classes, particularly in the fourth quarter of 2008, but diversification, far from being dead, still offers protection against extreme losses over anything but quite short time periods. When looking at the entire 18-month bear market, putting some money in bonds did a good job of mitigating losses. Data for an all domestic portfolio for October 1, 2007 to March 31, 2009 are as follows (the dates approximately coincide with the start and end of the bear market):

The key observations are 1) the portfolio with no bond allocation was severely punished, losing almost twice as much as the portfolio with a still meaningful stock allocation of 60%, and 2) the 24% loss for the 40%/60% portfolio, though distressing, was fairly well contained given 40%/60% is not a low risk portfolio, and the bear market was by far the worst since the Great Depression.

Market Perspective and Portfolio Performance

We’ve been reviewing in recent client letters a number of important aspects of recent markets as well as longer-term market performance. Salient observations have been:

Notwithstanding the very weak returns for global stocks over the latest ten years, viz., about 2% cumulative decline for U.S. stocks and “only” 29% cumulative gain for foreign stocks, it should also be noted that certain niche areas of global markets did have decent and even impressive results over the latest 10 years. U.S. small cap stocks, as measured by the Russell 2000 Index, returned 61%, and emerging markets stocks had a cumulative return of almost 194% (or an annual average of about 11.4%).

What about the performance of mutual funds recommended by Caves & Associates? At mid-year, we reported our traditional stock and bond funds had performed admirably though not spectacularly over the prior 18 months. We noted that indiscriminate selling was pervasive during the first 15 months of that period and was a contributor to this lackluster comparative result. We are very pleased to report that the vast majority of our recommended funds have done dramatically better than average in the third quarter, showing their true colors as superior selections.

Our alternative strategies funds, being hedged investment vehicles, have been a drag on results since the rally began last March. They have provided solidly positive performance year to date, but results have generally been closer to those of bonds than stocks. As a six-fund group, their nine-months performance through September 30 lagged that of a balanced global traditional stock and bond portfolio by about 5 percentage points. Additionally, the year to date return of about 8% for the three funds that were used to replace a portion of the equities allocation in client portfolios last December is very much below the weighted average return of global equity funds of approximately 23%. It should be noted that the extent of replacement of equities funds was not that great, ranging from 5-15% of total portfolio value. In other words, there was a rather modest reliance on this tactic consistent with the investment discipline of Caves & Associates, which is to avoid making any big bets.

Updated Outlook and Portfolio Strategy

Our outlook for 2009 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).

In April and July, we made negligible changes to our outlook and continued to advise conservatism. Further, in July we opined that the mid-March through mid-June market rally had overshot appropriate price levels given the troubled U.S. economy. Now, through three quarters, economic conditions are perhaps consistent with the projection. Nonetheless, the renewed rally in the third quarter has caused market results to substantially exceed our original 2009 outlook and our April and July revisions. The accompanying Market Review reports that year-to-date stock returns have been 20%-30% globally, with markets up broadly and fairly uniformly. Thus, our previous conservative outlooks have been too pessimistic.

While the securities markets have moved out of crisis mode and the economy seems to be moving from the contraction to the expansion phase, many questions remain about the strength of the recovery, especially in light of the lack of significant improvement in the job market. Historically, consumer spending, which has accounted for up to 70% of all economic activity, has been a key driver of growth. If a high percentage of consumers remain unemployed or are concerned about job security, then spending and, therefore, economic growth may be subdued.

The latest data show us that the economy, while improving based on a number of fundamental metrics, is still fragile and vulnerable to domestic as well as global shocks. Large shocks, while not known at the moment, could produce high volatility and even a return to the fear and panic that gripped investors a year ago given the high valuations at present as a result of the last six months’ rally and current economic and geopolitical concerns. Furthermore, while inflation is generally not a concern at the moment and may not be an issue for the next year or two, it could weigh heavily on the economy in the longer-term given the issues associated with having an extended period of expansionary monetary and fiscal policy.

For this writing, we face the challenge of reconciling the surprising strength of global financial markets with our continuing concern about weakness of the global economy, particularly that of the U.S. We also must address our admitted fallibility in translating economic projections into market forecasts. Finally, the geopolitical environment, as muddled as ever with hot debates over U.S. health reform and massive deficit spending, nuclear proliferation, Iraq/Afghanistan/Pakistan/North Korea, etc., further complicates our ability to formulate a useful and accurate outlook.

Three of the more important positive factors at work presently are:

1. Strength of a number of overseas economies, which in general do seem to be headed for V-shaped recoveries.



2. The rather dramatic restoration of about $4.9 trillion in U.S. stock market value since the market low last March (a value of about $7.7 trillion then) which bolsters paper wealth and thereby encourages more spending by U.S. consumers.



3. Barely detectable yields for U.S. savings accounts which therefore provide poor competition against potential higher returns for traditional risk-taking through bond and stock investments.

Offsetting on the negative side are:

1. A U.S. economy depending to a considerable degree on life support from the government and very likely heading for a weak L-shaped recovery.



2. Continued job destruction, evidenced ironically by stronger than expected U.S. corporate earnings that derive much more from cost cutting than revenue growth.



3. Very recent backsliding in some U.S. economic reports that raise the specter of a W-shaped recovery even weaker than an L-shaped one.

Among numerous additional factors are uncertainties we have touched on in previous communications. These include 1) will government stimulus programs continue to be funded and effective, 2) what is the future course of consumer and investor psychology, and 3) what expectations are already priced into global securities markets. Governments around the globe had no choice but to use massive and unconventional methods to address the financial crisis.

While they may have considered the potential negative, if any, longer-term effects on the economy, this was generally a secondary consideration at the time. Further, consumers remain very reluctant to spend, and the return to much greater risk-taking by global investors in the last seven months does not eliminate the possibility of a quick change of heart. Finally, given that prices have already moved upward extremely rapidly and to a degree seldom matched in history, is the market overpriced at current price levels?

As usual, we don’t believe these questions are answerable with adequate certainty, and we cannot have much confidence in our ability to forecast the future in these almost completely unprecedented times. All things considered, we believe that the financial landscape will remain volatile while the economy and markets are in somewhat of a transition period. In general, we are no longer pessimistic but neither are we particularly optimistic about the future. Nonetheless, the passage of time itself is a positive because bad memories are pushed further to the rear and the advent of stronger economic times is that much closer. We believe that opportunities exist in the U.S. and abroad for patient investors. Finally, we’ve learned first hand the difficulty of developing a reliable forecast and timing the market. Therefore, we are moving portfolios closer to long-term targets and reducing the alternative strategies weighting somewhat while maintaining some, but considerably less, defensiveness than previously. For now and as always, we would encourage investors to focus on the longer-term in a manner consistent with their risk tolerances, financial circumstances, and other objectives.

The market rally over the past seven months has fattened the equity and tangible percentage allocation in most client portfolios by 5-10 percentage points (hereafter, we’ll just refer to equity percentage for simplicity). Since many portfolios were underweight equity to start 2009, the current equity percentage is typically approaching but still below long-term targets set in client investment policies. This situation implies that most portfolios are currently positioned somewhat conservatively, consistent with the current tactical thinking just outlined above. Thus, no major rebalancing is indicated at this time.

We have assisted clients in the establishment of reserves as a way to avoid selling long-term positions, especially those in equities, at cyclical market lows, such as now. Because a multi-year weak economy and another collapse of stock prices cannot be ruled out, it is important to conserve reserves to avoid their exhaustion. Additionally, stock price levels remain significantly below previous market highs in October 2007 notwithstanding this year’s strong recovery. Thus, we continue to recommend cuts in on-going expenditures by deferring outlays for big-ticket items and non-essentials whenever possible. A good target would be cuts of 5-15% of typical levels, hopefully cutting out the fat but not the fun.

As always, our outlooks and market strategy are predicated on good fiscal and monetary policy decisions and execution, gradual transitions, and the absence of major external shocks.

What’s Topical or Timely

We remain committed to continuing education as well as keeping abreast of anything with a significant impact on your wealth management. Please see the enclosed or attached Timely Topics.

The Blog Department

The Blog Department remains generally under wraps due to time constraints. However, a few brief items follow:

Last year at this time, we recommended you read Andrew Bacevich’s The Limits of Power, at the time a non-fiction best-seller. Dr. Bacevich is a professor of history and international relations at Boston University. Did anybody read the book? Your feedback is welcome.

Preston has a few recommendations from his soapbox:

1. Our long-run national health and global competitiveness depend upon our getting a handle on our health care costs. Social responsibility requires us to broaden insurance coverage, and the oligopolies (dare we say near monopolies) of medical insurance companies strongly suggest the need for the so-called public option, at least on a contingent basis.



2. Our national security policy should be predicated on counterterrorism, not counter-insurgency. It’s about time the debate is being couched in these terms; except for some assistance from us and our NATO allies, shouldn’t other countries be asked to fight their own (to oversimplify) “civil wars.”

Sandra is not sure she agrees with Pres! Of course, we both know our main job is to focus on investment policy, the performance of mutual funds used in Caves & Associates client portfolios, and the successes and failures of our diversification strategies.

Quotes of Our Times and All Time

Albert Einstein:

“Great spirits have always encountered violent opposition from mediocre minds.”

Mark Twain:

“If you tell the truth you don’t have to remember anything.”

Dr. Martin Luther King, Jr.:

“Injustice anywhere is a threat to justice everywhere.”

John F. Kennedy:

“The time to repair the roof is when the sun is shining.”

Thomas A. Edison:

“Hell, there are no rules here - we're trying to accomplish something.”

Sally Koch:

“Great opportunities to help others seldom come, but small ones surround us every day.”

Robert A Heinlein:

“Women and cats do as they please, and men and dogs should relax and get used to the idea.”

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, but please note that 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, advisory philosophy, as well as an overview of our staff are 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.