Dear Clients and Friends:

Your copy of Caves & Associates’ Market Review for the second quarter of 2010 is enclosed, or you are viewing this mailing via the Internet. The second quarter exhibited return of significant volatility amid lost confidence about the global economy. Accordingly, global stocks retreated in a correction that was almost uniform around the world, and results for global equities were significantly negative during the second quarter. Due to the flight to quality, U.S. government bonds had quite good results, and conversely, investment grade as well as high yield corporate bonds were relatively weak but still in the black. International stocks underperformed U.S. stocks, primarily due to currency losses caused by renewed appreciation of the U.S. dollar on investor’s decreased willingness to hold a number of developed country foreign currencies. Alternative strategies had results that were mildly negative and therefore between those of bonds and those of slumping stocks. Given very poor results for global stocks, namely losses in the range of 10%-14% for the quarter, results for bonds and alternative strategies were a valuable hedge, mitigated total portfolio losses, and preserved capital for a broadly diversified investor. Their beneficial impact this quarter was a reversal from their detrimental impact in 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, 2010. The global returns provide reference points against which to judge results for your investment accounts. Over the first two quarters of 2010, diversification was beneficial because it smoothed results that were wildly divergent for equities in the first quarter compared to the second quarter (major gains versus double-digit losses, respectively). As noted, bonds 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 10.25 years to allow evaluation of secular trends, market cycles, and comparative performance of bonds versus stocks. Though requiring patience, the U.S. economy is recovering and on a reasonably sound footing; the same could be said about Japan. Meanwhile, Europe is faltering, but China appears to be engineering a “soft landing,” and emerging markets are set to continue their long-term secular expansion. Supported by low interest rates and inflation and reasonable valuations, U.S. stocks may still have legs. Overseas, there are selective opportunities in both stocks and bonds. Nonetheless, investors face worries about sovereign debt defaults; continued de-leveraging, especially by U.S. consumers; the usual geopolitical challenges; and the growing awareness that governments are reaching the limit to their ability to bail-out weak economies should conditions worsen substantially.

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 Summer Vacation
• Staff News
• Privacy of Your Non-Public Information
• Quotes for Our Times and All-Time

General Perspective and Commentary

Investor losses on stocks in 2007 through early 2009 were unprecedented, except for the period of the Great Depression. Likewise, losses on bonds, especially the normally stable, high quality issues, were also unprecedented during roughly the same period. However, starting in early March 2009, one of the steepest declines for risk-based assets in history was 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 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 2009. Thus, stock market strength preceded that of the economy by about seven months.

Aside from a short-lived sell off toward the end of January, global markets were relatively stable and profitable during the first quarter of 2010. Nonetheless, as reported above, a sharp correction occurred in the second quarter. As of March 31, 2010, in spite of over four quarters of very strong performance of global stock markets, equity positions of the globally diversified investors had not re-attained the heights achieved at the end of the 2003-2007 bull market.

Let’s update cumulative results as impacted by the second quarter correction. Based on a weighted average of results for three broad equity indexes, the cumulative net loss since the October 2007 market top has been about -29%. However, global bonds have a cumulative net gain (i.e., total return from interest and price change) of approximately 20% over the same period. Thus, a bond/stock mix over the period of 50%/50% would still be negative, but any portfolio strategy targeting 60% or more of bonds would have fully recovered by the end of June from the recent deep bear market.

The news media have not overlooked this year’s return of high volatility, the sharp correction of stock prices in May, the BP spill, and the bleak sovereign credit landscape (e.g., Greece). If it bleeds, it leads - - - so goes the old newsroom saying.

We would argue there are two related over-emphases in the media which do a disservice to the serious, long-term investor. The media are overemphasizing worry and negative possibilities. These of course sell newspapers, attract us to news and blog websites, and keep us glued to our radios and TVs. However, they can cause us to lose sight of the positives (e.g., countries such as Canada and Brazil in superb fiscal shape) and probabilities (which are much more likely to occur than the possibilities, especially remote ones). For example, as reviewed in the Outlook section below, a double-dip recession is possible, but a continued gradual U.S. and global economic expansion is far more probable.

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 seen the last two Springs (of 2009 and 2010), market recoveries and corrections, respectively, can occur quickly, without notice, and long before tangible evidence of economic change occurred.

Yes, there are challenging years ahead. The repair of bank balance sheets in the wake of the financial crisis will take years. In the U. S., consumer deleveraging will continue to constrain growth. The temptation for some heavily indebted nations to debase their currencies in order to reduce the real value of the liabilities could prove almost irresistible, and many governments continue to write checks they won’t be able to cash.

The headlines that many seem to ignore, however, may be the most important of all. Brazil, India and China (yes, still) are enjoying double-digit growth rates, and growth remains strong in “dollar-bloc” nations – Australia, Canada, and New Zealand – and Latin America. Most of the world, in essence, is doing fine economically.

Therefore, opportunities abound. Many nations, particularly in emerging markets, have strong long-term growth prospects and are home to expanding, world-class global companies. Emerging-market consumers are likely to see their incomes continue to grow, which will help fuel demand, and therefore growth, for years to come. The expansion of credit from a very low base in many parts of the world should support increased consumption and help companies expand. In conclusion, there is ample justification for guarded optimism.

As financial advisors, we must address the risk of consciously or unconsciously skewing towards a positive view when the environment doesn’t support it. When developing these communications, skewing is tempting because it feels better, but it would violate our responsibility to clients, and it is not a path to prudent investment decisions. Accordingly, we are always on guard to keep from being overly positive or overly negative. We ask the same of clients.

Concluding with the subject of asset allocation, it certainly didn’t work as well during the 2007 – 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. 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, for the first six months of 2010, in what has been a poor year for stocks, all sectors of U.S. bonds have had positive results, thereby 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

As we have noted previously, 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 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, had a positive impact on results for the second quarter. Though results were below those of bonds, alternative strategies had much lower losses than global stocks. As a six-fund group, their second quarter return outperformed that of a balanced global traditional stock and bond portfolio by about 3 percentage points, non-annualized. Year-to-date, the outperformance was approximately 1 percentage point.

It is important to note that these comparisons are for short time periods which were quite volatile. Further, the six-month result hid a major divergence between the first and second quarters. In the first quarter alternative strategies funds hedged against escalating markets and hurt total portfolio results, as reported three months ago. The second quarter was a considerable reversal, and the defensive nature of alternative strategies funds caused them to significantly beat equity indexes. Importantly, the alternative strategies funds provided a much smoother result, delivering results of about .8% through March 31 and then a loss of “only” approximately by 2.2% for the three months ending June 30. By contrast, the equity indexes as a group gained about 4.7% in the first quarter but lost approximately 12.3% in the second quarter. Thus, on an absolute and risk-adjusted basis, alternative strategies provided superior returns versus equities. When the comparison is to a weighted average of global stock and bond indexes, the smoother returns of the average of six alternative strategies funds is less pronounced but still evident. Finally, we believe investors are particularly adverse to losses; by minimizing second quarter losses, alternative strategies helped our clients to hold the course.

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.

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

As we begin the second half of this year, economic pundits and investors continue to wonder whether we are heading into a double-dip of economic activity. There continues to be talk of a jobless recovery due to permanent loss of jobs rather than merely cyclical and thus temporary loss of jobs. Minutes released July 14 of the most recent Fed meeting reveal a cut in their assessment of the U.S. growth outlook, and many private forecasters have recently trimmed their second-half predictions.

Investor sentiment is not particularly strong, as many people hesitate to commit additional risk capital in a very uncertain environment highlighted by (perhaps excessive) worries about the sustainability of the global economic recovery. U.S. mutual fund flows continue to reflect this hesitation, with the vast majority of flows going into bond rather than equity funds.

Looking at past U.S. economic cycles, very deep recessions like the most recent one are commonly followed by gradual rather than rapid recovery. Thus, our evaluation (just an educated guess) is that a double-dip, though possible, is not probable. Instead, the full jobs and GNP recovery will merely require additional patience. At this time last year, we noted that economic recovery would likely be L-shaped rather than U- or V- shaped and would not be robust for several years. This view seems to have been accurate.

Against this lackluster U.S. review, we must remember what was noted above, namely, much of the world is essentially doing fine economically (emerging countries, the “dollar-bloc,” Scandinavia, etc.). According to a recent report from the International Monetary Fund (IMF), turbulence in the financial markets so far has had little negative impact on real economic activity at the global level. The IMF is forecasting only a modest slowing of economic growth in 2011. Key data in the IMF’s World Economic Outlook are shown as follows:

Thank you for your continued support of Caves & Associates.

Thanks and credit must go to the many sources for this writing, including Managers, Oppenheimer, and PIMCO mutual fund families, Morningstar, the Wall Street Journal, and the Los Angeles Times.

There is no guarantee that the views and opinions expressed in this newsletter will come to pass, and they are not meant to provide investment advice. These views are as of July 20, 2010 and are subject to change based on subsequent developments.