Dear Clients and Friends,

Your copy of Caves & Associates’ Market Review for the first quarter of 2010 is enclosed, or you are viewing this communication via the Internet. The first quarter continued the rebound of the last three quarters of 2009. Equities and credit-sensitive fixed income securities moved considerably higher again; the quite good returns compared most closely with the fourth quarter of 2009 but were significantly lower than the skyrocketing results for the prior two quarters of the rebound. International stocks underperformed U.S. stocks, partially due to the debt crisis in Greece and currency losses caused by continued strengthening of the U.S. dollar. U.S. government bonds had low but positive returns for the quarter, and foreign government bonds had roughly similar results in local currencies but were negative after currency losses for the unhedged U.S. investor. Alternative strategies had mixed results that were only modestly positive overall; accordingly, they were somewhat detrimental to portfolio results. Given few areas of major weakness for the quarter, diversification was not particularly helpful, but rewards were reasonably good for a prudent, broadly diversified investor.

The backside of the Market Review provides global returns for the first quarter of this year and for twelve months ending March 31, 2010. The global returns provide reference points against which to judge results for your investment accounts. One can’t help notice the very high 12-month returns. All told, the S&P 500 index rebounded 76.8% since the market’s trough on March 9 of last year. This amazing recovery of lost wealth underscores the importance of maintaining discipline in portfolio matters. Nonetheless, please do not expect a repeat of the 12-month returns as they were astronomical and reflected the depths that had been reached in 2008 and the first two months of 2009.

The “Economic Review and Market Perspective” providing a longer-term interpretation of current data is normally presented only at mid-year and yearend. Nonetheless, a condensed version is found later in this letter. Brief versions of Timely Topics and the Blog Department are also found below.

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

• Economic Review and Market Perspective
• Results for Alternative Strategies
• Updated Outlook
• Timely Topics
• Blog Department
• Key Reminders from Previous Communications
• Quotes for Our Times and All-Time

Economic Review and Market Perspective

Strong growth in emerging markets, the inventory cycle, and accommodative fiscal and monetary policy continue to support the global economy. The U.S. is now in the second stage of a three-stage recovery. First the economy was propped up by fiscal and monetary stimulus. Next came the current stage of inventory rebuilding. The final stage, much hoped for but not yet in evidence, involves job creation and the emergence of self-sustaining final demand.

In 2009’s fourth quarter, U.S. gross domestic product (GDP) grew at an annualized rate of 5.6% (preliminary first-quarter GDP will be released at the end of April, while revised numbers will be released in May.) This is a substantial improvement over the third quarter, which saw GDP increase by only 2.2% on an annualized basis. The acceleration in GDP reflected a slowdown in the rate at which businesses drew down inventories, an increase in business investment, including a sharp increase in equipment and software, as well as continued growth in the manufacturing sector.

Meanwhile, the Federal Reserve also painted an improved picture of the U.S. economy for the months of January and February of this year through their Summary of Commentary on Current Economic Conditions (“Beige Book”). Reports from the twelve Federal Reserve Districts indicated that economic conditions continued to expand since the last Beige Book report but in most cases the increases were modest. The Fed’s report did not suggest any meaningful change in the labor market and specifically noted that conditions remained soft.

U.S. inflation continues to be benign, partly reflecting the very slow nature of this recovery. In January, core CPI actually declined by 0.1%, largely reflecting weak pricing in the housing and auto markets. This decline was the first for core CPI since December 1982. In February, prices edged up slightly, with core CPI increasing 0.1%. For the last twelve months, core CPI rose 1.3%, the smallest increase since February 2004.

Outside the U.S., Greece became the focal point when it announced it would have difficulty paying on its debt. Greece has been trying to improve its financial condition and in early March announced new steps, such as implementing substantial public sector pay cuts and tax increases. Finally, at the end of March, the Eurozone countries struck a formal deal to help Greece should its economic condition deteriorate further. As part of the agreement, the International Monetary Fund will be involved.

While Greece’s woes weighed on the minds of investors, so did the region’s most recent GDP report, which was released in February and showed that growth slowed in the fourth quarter of last year. Specifically, GDP for both the Euro 16-country area and the larger EU27 area grew by a meager 0.1%, and GDP fell 2.1% and 2.3%, respectively, compared with the fourth quarter of 2008. While growth slowed in Europe, the opposite occurred in Japan, which showed considerable progress in the fourth quarter, as its GDP grew by 0.9%, or 3.8% on an annualized basis.

The amazing growth story from China continued. It’s economy was hardly phased by the global recession and grew 8.9% in 2009. GDP accelerated to 11.9% growth in the first quarter of 2010 compared with the first quarter of 2009 according to a recent report from Beijing. Considering the high rate of growth, inflation was fairly well contained at an unexpectedly low 2.2%.

Aside from a short-lived sell off toward the end of January, global markets were relatively stable during the first quarter of 2010 after going through an extremely tumultuous 2-year period, which saw one of the steepest declines for risk-based assets in history, followed by one of the sharpest rebounds on record. Investors, as they have done many times in the past, have looked beyond current economic conditions, which are far from robust, and have chosen to focus on the eventual recovery. As we have noted before, stock market price levels are based on the business outlook in 6-12 months. To illustrate, the U.S. stock market moved up strongly beginning in early March 2009 yet U.S. GDP was negative for the first half of 2009, not particularly strong in the summer (GDP up 2.2%), and not really robust until the Fall quarter of 2009. Thus, U.S. stock market strength preceded that of the economy by about seven months.

In spite of over four quarters of very strong performance of global stock markets, equity positions of the globally diversified investor as of March 31, 2010 have not re-attained the heights achieved at the end of the 2003-2007 bull market. Based on a weighted average of results for three broad equity indexes, the cumulative net loss since the October 2007 market top remains about -20%. However, global bonds have a cumulative net gain (i.e., total return) of approximately 16% over the same period. Thus, a bond/stock mix over the period of 50%/50% would still be slightly negative, but any portfolio strategy targeting 56% or more in bonds would have fully recovered from the recent deep bear market by the end of March.

It is important to note that this analysis of the extent of portfolio rebound has implications for reserve replenishment strategies. Please call if you would like to discuss.

Results for Alternative Strategies

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. These defensive strategies have generally been successful at preserving client capital for future growth opportunities, and we have increasingly relied on them as excellent diversifiers. However, they are much less easily understood and have more moving parts compared with traditional long-only strategies. Therefore, we’ll continue to make an exception about focusing on short-term results and report about alternative strategies.

Our alternative strategies funds, being hedged investments, were a small drag on results for the first quarter. They provided positive performance, but results were generally closer to those of bonds than stocks. As a six-fund group, their three months performance through March 31 lagged that of a balanced global traditional stock and bond portfolio by about 2 percentage points, non-annualized.

Updated Outlook

Our outlook for 2010 was promulgated January 22, 2010. We have noted that 1) our economic outlook and therefore our market outlook were somewhat more negative than what might be judged the consensus 2010 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 cautious but not pessimistic, and we advised a moderate but not high overweighting of bonds and alternative strategies in client portfolios.

So far this year, the global economy has performed according to our forecasts, but results for global stocks, especially U.S. stocks, have exceeded our expectations. For this writing, we face the challenge of reconciling the surprising strength of global financial markets with our continuing concern about weakness of the U.S. economy, particularly the on-going jobless recovery. We also must address our admitted fallibility in translating economic projections into market forecasts. Finally, the geopolitical environment is as muddled as ever, with hot debates over massive deficit spending, potential future sovereign debt defaults (Greece now, who’s next?), intensifying Islamic radicalism, and global warming.

The U.S. recovery is well underway, as evidenced by the surprisingly high fourth-quarter GDP reading and the improvement in corporate earnings – but is it sustainable? The 13-month strong performance of both equities and credit-sensitive fixed income securities certainly suggests that the economy is heading in the right direction. However, the upcoming challenge is to move into the third phase of recovery, when the private sector provides the major impetus for economic growth rather than global governments. What is also not completely clear is whether or not investors believe in the economic recovery and in the continued strong performance of the markets. As noted, stock market performance has remained well in the black but has decelerated since the initial months of the rebound last year. Moreover, year-over-year corporate earnings comparisons will become increasingly challenging in coming quarters. Finally, based on mutual fund cash flow data, investors seem to believe in the bond story, as evidenced by substantial inflows going into a variety of fixed income segments; so far this year, bond funds have taken in roughly $56 billion in new money. On the equity side, however, the results have been rather mixed. International equity funds continue to be popular, as indicated by the $12.7 billion dollars going into diversified international equity funds during the first two months of 2010. In contrast, diversified domestic equity funds are still out of favor from the investors’ perspective, with this group losing $1.3 billion in assets so far this year.

In our October 22 communication last year, we noted three important positive factors at work, and they seem to have overpowered the negatives so far. They include:

1. Strength of a number of overseas economies, which seem to have achieved V-shaped recoveries.

2. The dramatic restoration of global stock market wealth since the market low of March 2009.

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.

We cannot have much confidence in our ability to forecast the future given all the variables globally. Also, divergences are not too wide, and not much time has passed since our January outlook. Thus, we are leaving our 2010 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. For now 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.

Timely Topics

We remain committed to continuing education as well as keeping you abreast of information which may have a significant impact on your wealth management. Nonetheless, a lengthy Timely Topics is not being presented at this time but will return in the future.

Before proceeding, we should take note of a much-publicized recent event, namely, that the Democratic Congress passed comprehensive health care reform toward the end of the first quarter over the strong objections of Republicans, who voted unanimously against passage. This historic event, both timely and topical, has received massive media coverage, which we will not duplicate. A few salient comments are:

1. Many of the provisions are subject to phase-in or do not become effective until 2014 or later.

2. The reform will dramatically increase the number of Americans covered by health insurance.

3. Subsidies are a key part of the legislation. Individual families and individuals who make between 100% - 400% of the Federal Poverty Level (FPL) and want to purchase their own health insurance on an exchange are eligible for subsidies. (FPL for a family of four is $22,500).

4. Funding is via 1) a Medicare payroll tax of 3.8% on investment income starting in 2012 for families making more than $250,000 per year ($200,000 for individuals), 2) an excise tax beginning in 2018 on so-called “Cadillac” high-end insurance plans, and 3) a 10% excise tax on indoor tanning services.

5. Lower capitation payments to senior HMO plans (aka Medicare Advantage plans) allowed the Congressional Budget Office (CBO) to project that the legislation actually lowers the Federal deficit (we note that capitation levels could have been lowered separately from and independent of health reform, and the CBO projection has its doubters).

6. Repeal is certainly a possibility if Republicans gain control of Congress.

The Blog Department

The Blog Department is our occasional expression of opinion. Whereas Timely Topics may involve some disagreement among experts, its primary purpose is to educate in the realms of financial planning and wealth management. The Blog Department ventures into broader topics which may be more controversial. For the time being, the Blog Department is under wraps due to time constraints, except for the following.

The DVD “I.O.U.S.A.” is highly recommended watching. Though getting slightly dated, this 2008 documentary provides an excellent review of the growth of deficit spending in our country, presents causes, and projects the future, which is truly alarming and unfair to today’s young people. This terrain may not be new to you, but the DVD presents its case very clearly and includes, as an added feature, video of a panel discussion of the film and its content by Warren Buffet, the heads of AARP and the Cato Institute, and the filmmakers. The DVD and panel discussion are certainly a call to action.

In a similar vein, the Wall Street Journal recently reported that debt levels of the world’s leading developed nations are expanding rapidly. According to the International Monetary Fund, sovereign debt of Canada, the U.S., U.K., Germany, France, Italy, and Japan is up over three times levels in the 1970’s as a percentage of GDP. Further, the level projected this year represents the highest debt-to-GDP level since 1950, when war-battered nations were still paying down the cost of World War II and the subsequent rebuilding of Europe and Japan.

A Key Reminder from Previous Communications

In addition to maintaining broad diversification and discipline, we can’t overemphasize the importance of maintaining adequate reserves for all potential needs to withdraw from your portfolio. Reserves, it turns out, were not needed in the 1990’s and for about four and one-half years from 2003 to mid-2007 because stocks went up steadily. But stocks then experienced a record-breaking downturn from which they still have not completely recovered. It’s these situations when you need adequate reserves because reserves allow us to avoid selling at such inopportune times. Finally, a reduction of personal expenditures increases the likelihood reserves will not be exhausted before financial markets have either substantially or completely recovered.

We have discussed our concern about market volatility in previous correspondence. 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 broadly diversified asset allocation is such a plan.

Further, 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 toughed (or peaked). As in 2009 and noted above, 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.

Quotes for Our Time and All-Times

Harold Geneen:

“In the business world, everyone is paid in two coins: cash and experience. Take the experience first; the cash will come later.”

Robert Frost:

“By working faithfully eight hours a day you may eventually get to be boss and work twelve hours a day.”

Howard Aiken:

“Don't worry about people stealing your ideas. If your ideas are any good, you'll have to ram them down people's throats.”

Oscar Wilde:

“Always forgive your enemies; nothing annoys them so much.”

Winston Churchill:

"All the great things are simple, and many can be expressed in a single word: freedom, justice, honor, duty, mercy, hope."

Mark Twain:

"It is curious that physical courage should be so common in the world and moral courage so rare."

Bern Williams:

“No symphony orchestra ever played music like a two-year-old laughing with a puppy.”

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 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.