Stocks were sharply lower in June amid renewed concerns that fallout from the housing crisis and credit crunch will drag down the economy.

Meanwhile, inflationary pressures from higher gas and food prices make it more difficult for the Fed to balance the goals of boosting the economy with keeping inflation in check.

Stock valuations are more attractive, but not yet compelling. Our return outlook for stocks from current levels is in the high single digit range to the low double digits over the next five years. Our return expectation for bonds is lower—in the low-to-mid single digit range

We are nevertheless getting closer to seeing tactical opportunities in stocks, REITs, and high-yield bonds, and will continue to watch valuations closely.

Quarterly Investment Commentary

The first half of 2008 dramatically reinforced the idea that over the short term the stock market is predictably unpredictable. A sharply negative first quarter was followed by two months of positive returns, but the selloff resumed with a vengeance in June, with large-cap stocks (as measured by Vanguard’s 500 Index Fund) dropping 8.4% for the month and almost 3% in the second quarter. The S&P is now down over 12% for the first half of this year, and is about 21% below its October 2007 high as of this writing in early July. The market offered few places to hide. Mid- and smaller-cap stocks fared better than large in the second quarter, but still got slammed in June and now have high single-digit losses for the first half of 2008. Vanguard’s Total International Stock Index Fund also had a rough month, losing 9% in June and 2.2% in the second quarter. Foreign stocks are now down 10.9% through the first half. REITs were hit hard, dropping almost 11% for the month, putting them in the red for the first half and closer to valuation levels we’d view as attractive relative to stocks (more on this later).

Domestic high-quality bonds were flat in June and down just over 1% for the second quarter. Though not a good return in a normal environment, bonds nevertheless provided balanced investors with a margin of protection from stock-market losses, which is part of their role. The Vanguard Total Bond Market Index Fund, our proxy for the bond market, is up 1.1% through the first half of the year. The short-term emerging-markets local-currency bond benchmark gained almost 1% for the month and almost 4% for the second quarter, bringing its year-to-date gain to 8.7%. Our portfolios outperformed in the 2nd quarter, but are behind their benchmarks for the 1st half of the 2008.

What is Driving Stocks Lower Again?

As always happens in an environment of fear, we are being asked (and asking ourselves) a lot of questions. What is going on, and how bad could it get? Is there anything we should be doing about it in our portfolios? This environment is in many ways unique and presents its own set of challenges, which we’ll address more specifically in a moment. But more generally, we want to start by saying that we’ve been through a number of crises over more than two decades of managing portfolios, and while each of these periods presented its own particular challenges, one thing that is common to them all is that a sense of accelerating bad news, escalating risk, fear, and panic were almost always present.

The Federal Reserve’s unprecedented actions to shore up credit markets a few months back led many to hope that we were past the worst of the financial crisis and that the stock market had hit bottom. But while the Fed’s actions may have significantly reduced the risk of a full-scale financial meltdown, the losses from bad loans are continuing to be worse than expected. Meanwhile, the positive feedback loop of soaring home prices and easy credit is now gone, and with it has gone a major source of consumer spending (which of course is a major driver of the economy). Add in the impacts of high levels of household debt (which suggests the need to retrench rather than spend), higher gas and food prices, a weakening labor market, and, by one measure, consumer confidence at a 28-year low, and it seems increasingly likely that consumer spending will continue to deteriorate.

The damaging combination of a slowing economy and higher inflation (the widely feared “stagflation”) has also led to questions about the ability of the Fed to support economic growth and employment without stoking fears that it has gone soft on inflation. What it all means is that risks to the economy remain high, and the financial markets are now more fully discounting this risk, which is an unemotional way of describing the battering taken by stocks in recent weeks.

As always, there are positives as well. Outside the financial sector, corporate balance sheets remain generally healthy and earnings have been okay. One source of strength has been exports, which so far have managed to offset much of the impact of the housing decline on GDP. But this could diminish if our slowing economy means we also export economic weakness to the rest of the globe, and there are signs that this is happening.

Making Decisions in an Uncertain Environment

“History is merely a list of surprises. It can only prepare us to be surprised yet again.” —Kurt Vonnegut

Though we have experienced a multitude of market crises, we also recognize that history never repeats itself exactly, so almost anything can happen from here. One possibility is that things will get worse before they get better in the stock market. Even without a bad recession, fear and pessimism can take hold of investor psychology and send the market down further than what would be justified by long-term economic fundamentals.

In this type of environment, a sense of perspective and a reliance on our investment discipline helps us avoid becoming panicked by short-term concerns and paralyzed by longer-term uncertainty. Like it or not, we are always faced with making decisions in an uncertain world and this will not change. However, our experience in past market cycles and our analysis of the current market environment leads us to two important conclusions.

First, as we have written in previous commentaries, we do not believe it is time to get more defensive and reduce our equity exposure. It is easy to put too much weight on negative scenarios when bad news dominates the daily headlines, but we view stocks as priced to outperform bonds over most five-year scenarios.

Second, big market downturns invariably present opportunities, and without them, we would not have had the chance to identify some of the tactical allocations that have added value to our portfolios over the years. Bubbles lead investors to make errors in judgment and misprice assets on the way up. On the way down, riskier assets often fall to bargain prices when investors are in the grip of fear. Our investment discipline (and our focus on what is knowable) can help us identify those asset classes where investor panic has led to excessive undervaluation. Later in this commentary, we note three asset classes (U.S. equities, REITs, and high-yield bonds) that may be headed in this direction that we are monitoring carefully.

Setting Return Expectations

The annualized return for the S&P 500 over the past 10 years is just under 3% — more than 70 basis points below that of risk-free Treasury bills! In the decade prior, stocks returned a whopping 18.6%. It would be nice if this history meant that, having come through a decade of above-average returns and a decade of below-average returns; we could now start from scratch and simply expect “average” returns of 10% to 12% a year on equities. Unfortunately, though, the market is forward looking and doesn’t care where it’s been. As we look forward to the next five years, our general expectation is for a average environment overall—for both stocks and bonds. We note, however, that the market’s selloff in June has brought equity prices down far enough to make our potential return range on equities higher than it was just a few weeks earlier. Stocks are now priced at levels that are not all that far from the point at which we would Look to make our portfolios more aggressive.

As we wrote in our April commentary, a further decline in the S&P 500 could make stocks look attractive enough relative to fixed-income alternatives to justify a tactical overweighting. If this occurs, our plan is to increase exposure to large-cap stocks by purchasing an index fund. We would fund the overweight from our investment-grade bond exposure and from our short-term emerging-markets local-currency bond allocation.

As always, there are risks attached to any returns-based tactical (fat-pitch) opportunities and one worth mentioning now is the risk that an overweight to equities followed by a continued fall in stock prices could result in our portfolios violating their 12-month loss thresholds. As mentioned earlier, we would not be surprised if the stock market gets worse before it gets better, and though we believe we can identify a level at which stocks are attractive from a long-term perspective, it’s highly unlikely we’ll be buying stocks right at the bottom.

A decision to overweight stocks would become more complicated if we see additional asset classes also become attractive; REITs and high-yield bonds are two timely examples.

The Road Ahead

As we’ve said in our recent commentaries, this is one of the most challenging investment environments we’ve ever faced. We expect this to continue to be the case, at least for a while. Given our expectation of low to average returns in the mainstream asset classes, we are not only assessing fat-pitch opportunities, but we have added incentive to look at alternatives. A similar incentive led us to commodity futures and emerging-markets local-currency bonds in the past and going forward our research may enable us to identify other compelling alternative asset class opportunities. Most recently, our research has led us to review the landscape of publicly traded alternative funds, which encompass strategies such as long/short or absolute return. As you know, we have done this in the past and were unable to identify anything we thought was worthwhile. The good news is that there are many more to choose from then there was just a few years ago. We are still very early in the process and there is no guarantee that we will find any funds worth recommending or investing in, but we mention it as an example of our willingness to look outside conventional asset classes for potential sources of added value, especially in an environment where opportunities may be limited.

Despite our expectations for a challenging environment, we believe we can add value from both our tactical asset allocation and manager selection decisions. In terms of our current portfolios, we think our overweighting of large-cap stocks relative to small-cap stocks and our position in short-term emerging-markets local-currency bonds remain warranted and will add value relative to the neutral portfolios. And we believe that in aggregate, our actively managed funds will beat their benchmarks over the long term. Many of the fund managers we respect most tell us they are buying shares of high-quality companies at bargain-basement prices. Consequently, even though the overall market does not look compelling to us from a top-down valuation perspective, the current economic and market turmoil appears to be creating significant return opportunities at the bottom-up individual stock level. Indeed, it is often when the overall trend is negative that disciplined investors can build a portfolio for long-term outperformance by carefully taking advantage of the opportunities created by these dislocations. It requires patience and the ability to weight long-term analysis above short-term fear, but it is what distinguishes successful investors.

We appreciate your confidence and trust.

Best Regards,

Jon Houk, CFP®