Monthly Investment Commentary

Stocks saw their best one-month gain in March in more than six years, but while it was a welcome respite from the battering in January and February, the first quarter still ended with a double-digit loss for equities. The large-cap S&P 500 (based on Vanguard 500 Index Fund) surged by almost 9% in March, yet finished the first quarter with an 11% loss. While returns in March did not vary by much across equity styles, that was not the case for the quarter. Value sharply underperformed growth, and smaller-caps generally did worse than larger-caps. The best performing equity style was large growth (the iShares Russell 1000 Growth), which lost “only” 4.2% for the quarter. At the other extreme was small value (the iShares Russell 2000 Value), down just shy of 20%. REITs were beaten sharply lower as investors reacted negatively to deteriorating fundamentals and fears about debt rollovers, and after a weak rebound in March finished the quarter down 32.1%. High-yield bonds, on the other hand, had the best showing of any of the broad asset classes we track, with a gain of 5.3% for the opening quarter. Abroad, the results for developed market equities were similar to what we saw at home. Vanguard Total International Stock Index Fund gained over 9% in March, but their 13% loss for the quarter was a bit worse than that of domestic equities. In contrast, emerging markets equities had a great March and finished the first quarter slightly in the black, based on Vanguard Emerging Markets Stock Index Fund. Turning to bonds, Vanguard Total Bond Market Index Fund was up 1.5% for the month, bringing their year-to-date results slightly into the black.

Although we are obviously not happy to see another down quarter for our model portfolios, we are encouraged that relative performance has been strong versus our benchmarks so far in 2009 (as well as in the final month of 2008). This reflects value added in aggregate from our tactical asset allocation positions as well as improvement in the performance of our active managers. While this is admittedly a very short time period, it is a welcome change from 2008 when our active managers significantly detracted from our performance.

As we do in each quarterly commentary, we will update you on our current thinking about the investment landscape. We will also spend some time going into thorough detail on our analysis and outlook for equities in particular as well as other asset classes. In all, this commentary is unusually long. Because the environment has been so difficult and scary for many, we wanted to be sure to fully communicate the extent to which our research is taking into account the array of issues impacting the economy and investment outlook. For some nervous readers, knowing this detail may help them invest with confidence, which we believe is an essential component of investment success in times of turmoil and opportunity.

Recap of the Current Economic Situation

The list of issues affecting today’s investment landscape is dizzying and at the top is the dismal state of the global economy. The fundamental problem, as we have discussed in previous commentaries, is that over the past several economic cycles U.S. households and the financial sector took on increasing amounts of debt relative to their assets and income in order to fund consumption and investment. This trend was self-reinforcing as purchases with borrowed money drove up asset prices (such as homes) and profits, which supported even more borrowing. Ultimately the upward spiral was unsustainable, and now forced deleveraging has created a self-reinforcing adverse feedback loop of falling asset prices and lower spending and profits. As the economy deteriorates, contributing factors such as rising unemployment, mortgage defaults, loan write-offs, reduced lending, and overall fear all fuel one another. This “debt-deflation” cycle can be very difficult to break, and is essentially what happened in the U.S. during the 1930s and Japan in the 1990s. Japan has still not fully recovered from it.

Importantly, this is not just a U.S. economic problem, but a severe global economic slowdown —almost certainly the worst since the 1930s. It is estimated that there has been roughly $50 trillion of global wealth destruction over the last 18 months. U.S. households’ net worth fell by $11 trillion, or nearly 18%, in 2008. (By way of comparison, the entire U.S. GDP is around $14 trillion.) So the United States and other countries cannot count on export-driven growth (i.e., demand from foreigners) to help stimulate their economies. Indeed, the World Trade Organization recently forecast that global trade (export) volumes would drop by 9% in 2009, “the biggest such contraction since the Second World War.”

In short, we are in the midst of a global economic crisis. In such a situation, most experts agree, the government needs to step in as a consumer and lender of last resort to try to stop the adverse feedback loop, or at least to mitigate the extent of the damage from deleveraging within the private sector. In effect, the public sector (the government) must leverage up and spend in order to try to plug the gap created by the deleveraging in the private sector. The $800 billion fiscal stimulus package and the monetary and credit policy actions undertaken by the Federal Reserve and the Treasury to support the financial and credit markets are the result so far.

But there is significant doubt and disagreement as to whether and to what extent the current crop of economic policies and programs will be successful in stopping the economic slide. And as uncomfortable as it is to say it: no one really knows. Economics is an inexact science, to put it mildly. There are too many variables that interact in dynamic and unpredictable ways. Moreover, as globalization has led the world’s economies to become even more interconnected this complexity has only increased. And when you add politics and introduce the government as a player in markets and industries where they were previously only the referee (or not even that), the implications for and outcomes of economic policy decisions become even more uncertain. Fundamental questions about the role of government in our capitalist system—questions that were previously never taken seriously, such as the potential for major bank nationalizations—have exacerbated the already-high levels of uncertainty among market participants and investors. And as the saying goes: the market hates uncertainty.

Certainty and Uncertainty

While we freely admit to being uncertain about a lot of things in this environment, we are confident that the current administration and the Federal Reserve are very aware of the severity of the economic challenges we are facing. (That’s a start at least.) For example, Larry Summers, the head of the White House’s National Economic Council, has talked of the need to “contain what is a very damaging and potentially deflationary spiral.” And Federal Reserve chairman, Ben Bernanke, and President Obama’s chief economic advisor, Christina Romer, had previously written papers on the causes of and lessons from the Great Depression. We are also confident that they will try to do everything they can to break the downward momentum. Last December, for example, the Federal Reserve cut the Fed Funds interest rate to zero for the first time ever. It subsequently took additional unprecedented steps to inject more liquidity into the economy and loosen up the sclerotic credit markets, by announcing that it would buy up to $300 billion of longer-term Treasury bonds and $1.25 trillion of agency mortgage-backed securities. Most recently, the Treasury announced the details of its plan for a public-private fund to purchase up to $1 trillion of “toxic mortgage assets” from bank balance sheets with the goal of getting the lending markets to start functioning normally again.

While we think that the policies and programs recently announced are likely to help move the economy towards recovery, they will not solve the serious problems we are facing and we expect more government actions in the months ahead. But in our opinion, no matter what policies are introduced, the impact of consumer and financial system deleveraging will almost certainly be a significant drag on economic growth over the next several years as saving and paying down debt replaces borrowing and spending. We also believe that no matter what the short-term outcome, there will be a price to pay down the road for the current policy actions—potentially in the form of a weaker dollar, higher inflation, higher interest rates and tax rates and, consequently, subpar economic growth and corporate profits, and lower-than-normal stock market valuations (P/E multiples). So while we agree that preventing a debt-deflationary spiral from taking hold right now should be “job one” of the government, it is likely to be at the cost of lower growth and/or higher inflation down the road. And there is also no guarantee that policymakers will be able to prevent significant additional economic damage from being done in the near term, despite their best intentions.

So there is a huge amount of uncertainty as to how this all plays out. But it is important to remember that while uncertainty is uncomfortable, it is always an aspect of investing and it is what creates great long-term opportunities. (If there was perfect certainty about the future, one would never be able to buy an undervalued asset.) So how do we make investment decisions in this environment? We use the same framework that we have always used: assessing the potential risks and longer-term return opportunities in various scenarios across a variety of asset classes.

Our Longer-Term Outlook for Equities

The analytic framework for our equity return ranges—and the resulting asset allocation decisions—starts with four broad economic scenarios that we think have a reasonable likelihood of playing out over the next five years. We derive assumptions regarding earnings growth and valuations (P/E multiples) for the S&P 500 that we believe are consistent with each economic scenario. Our earnings and valuation assumptions are based on our analysis of stock market and economic history going back to the 1920s as well as a qualitative, forward-looking assessment that accounts for differences between this cycle and prior economic and market cycles.

Each earnings growth path and P/E multiple implies an ending value for the S&P 500 five years hence.

We can then calculate the approximate rate of return from capital appreciation and dividend yield for each of our scenarios. We can also test the sensitivity of the results to different growth and valuation assumptions. These scenarios and return expectations are not predictions. Rather, having calculated a range of potential five-year returns for equities (and other key asset classes as well), we use the results as key inputs in determining our tactical portfolio weightings.

Our four broad economic scenarios are as follows:

Scenario 1: “Muddle Through”

Economic recovery in late 2009/early 2010 but subpar recovery for several years. Inflation gradually rises.

Scenario 2: “Stagflation”

Economic recovery in late 2009/early 2010 but subpar recovery. Strong inflation (mid single digits) near the end of the five-year period.

Scenario 3: “Severe Recession/Deflation”

Extended/deep recession and potential deflation through 2010, due to severe deleveraging and negative wealth effects. Recession does end but recovery is anemic.

Scenario 4: “Goldilocks”

Government policies are effective and economy starts growing in the latter half of 2009. An average recovery with moderate inflation.

Equity Return Scenarios

Over the past several months we have spent a great deal of research time analyzing historical earnings and stock market cycles going back to the turn of the century and thinking about how the current cycle might play out over the next several years. We have focused a lot of attention on our worst-case severe recession (Scenario 3). In the past, we have been comfortable assuming the economy will go through normal cyclical downturns (recessions) and recoveries. But starting with the events last September, we no longer think that is the most likely outcome given the deleveraging/negative spiral process we appear to be facing. (Although we don’t think a normal recovery is the most likely outcome, we do not rule it out—see Scenario 4). This has led us to study the U.S. experience in the 1930s, the last time our country went through a massive deleveraging process, as well as more recent financial/banking crises in other countries.

We believe the growth path for corporate earnings over the next five years will likely fall somewhere between the worst post-recession recovery since World War II and the Great Depression (which saw the biggest drop in earnings in U.S. history). In our worst-case scenario we lean towards the latter. Note that we are not expecting the overall economy (GDP) or the unemployment rate to be anywhere near as bad as during the Great Depression. But we think the impact on corporate profits could be comparable. This is based on our judgment taking into account the extent of leverage in the system that must be unwound, balanced against the unprecedented fiscal and monetary actions the government is taking to prevent a repeat of the Great Depression.

Our Worst-Case Scenario

In our worst-case scenario (Scenario 3), we assume a peak to trough decline in nominal S&P earnings of about 65%. This compares to a 75% decline during the Great Depression and is worse than any other earnings decline since then. We think the trough earnings will likely occur around the middle of this year. From the trough, we assume earnings rebound at the median rate of post-World War II earnings recoveries for the first two years and then assume they revert to the long-term trend rate of roughly 6% growth. We think these are conservative assumptions because we are not assuming the sharp recovery in earnings that typically happens after sharp earnings declines. Again, this reflects our concern about the high amount of leverage in the system and the potentially long-lasting effects of its unwinding. As we come out of the current contraction, consumers may be reluctant to take on debt, and bank lending (which will also likely be more-heavily regulated) could be cautious, contributing to a subdued earnings recovery.

The above assumptions give us an estimate of S&P 500 earnings of about $51 five years out. To this earnings number we apply two valuation multiples. In one case we assume a P/E multiple of 16x. This is roughly the multiple we observed in the period after the earnings trough during the Great Depression. In the other case, we assume a lower multiple of 13x to account for the possibility that market psychology may be depressed if our worst-case economic scenario plays out. There are other macro risks as well, such as dollar depreciation and higher-than-expected inflation—both of which might compress valuation multiples. The market has experienced P/E multiples lower than 13x, but that has typically been during periods of high inflation (the 1970s), world war, or when earnings are growing very rapidly (e.g., after World War II)—none of which we expect five years from now in this scenario. So we feel that 13x is sufficiently pessimistic as an end-point multiple. But this does not mean the multiple couldn’t drop below 13x at some point during the next five years.

Multiplying the P/E multiple and our earnings number gives us an estimated S&P price level five years from now. We then calculate the annualized price return and add the estimated dividend yield to derive our return expectation. From the current S&P level of around 800, five-year estimated returns in this scenario are poor (-1% to 3.2%). We give this scenario significant weight in our overall return assessment for equities, and this is a key reason why we remain underweight to stocks despite their huge declines over the past 17 months.

Our Optimistic Scenario

In our most optimistic “Goldilocks” scenario (Scenario 4), we assume that S&P earnings revert to their long-term earnings trend line five years from now. Prior to the events of last summer when the financial crisis began to intensify this was our baseline scenario. That is, we assumed the most likely outcome was that we would experience a “normal” recession/expansion cycle and so our best guess was that in five years time earnings would be at or in the neighborhood of their very long-term earnings trend line (which reflects a 6% long-term average annual growth rate going back to the 1920s). However, given the deleveraging process as well as the potentially challenging longer-term consequences resulting from the current government intervention, we now view this scenario as less likely than our more negative scenarios, but still one that is reasonably possible and that therefore deserves to factor into our decision-making.

This scenario generates an earnings number of around $86 five years out. We apply an 18x P/E multiple, which is consistent with long-term historical average P/Es during periods of moderate inflation and normal economic growth. With the S&P currently around 800, this scenario suggests a stock market return of around 17% per year over the next five years. Such a return would be very attractive in absolute terms and relative to the other asset classes we follow, and is a key reason why we are not more underweight to equities than we currently are.

Our Other Scenarios

Our other two scenarios generate potential returns that fall between Scenarios 3 and 4. We won’t go into the details here, but qualitatively, both scenarios assume earnings growth better than in our worst-case scenario although still not as strong as in a normal cycle. The end-point earnings estimate for Scenario 1 is about 30% above our worst case and for Scenario 2 it is about 25% higher. We picked our end-point P/E multiples in these scenarios based on a variety of analyses. We looked at the very long-term average P/E going back to the 1920s and eliminated the extreme outlier multiples during the tech bubble in the late 1990s. We analyzed the relationship between P/E ratios and inflation. We also factored in the potential for P/E contraction due to higher investor risk aversion as this market cycle plays out. Putting all of this together led to lower multiples (14x to 15x) than we used in our optimistic scenario. With the S&P currently around 800, these scenarios imply mar­ket returns in the 5% to 8% range—decent but certainly not compelling enough to warrant a tactical overweight to stocks.

The table below summarizes our five-year average annualized return estimates under various scenarios and starting S&P levels.

We want to reiterate that we don’t expect any of the above scenarios to be pre­cisely right. But based on our extensive historical analysis coupled with a forward-looking approach that attempts to incorporate the unique circumstances of this particular cycle, we think we have captured a range of reasonably likely outcomes. This provides a solid yet flexible analytical framework for our assessment of equities, both in terms of absolute risk/return and relative to other asset classes. We are continually reassessing our scenario assumptions and analysis in light of new information, insights, and developments in the economy and financial markets. As such, we will continue to update these numbers as events unfold.

“Fair Value”

Based on our qualitative assessment of the likelihood of each of these scenarios playing out and the potential returns in each scenario, we view the fair-value range for the S&P index as roughly 650 to 850. We use a range rather than point estimate for fair value because we know our analysis is not that precise—and, in the words of Warren Buffett we’d “rather be approximately right rather than precisely wrong.” With the S&P currently around 800, we are within the fair-value range but towards the upper (expensive) end of it. All else equal, we’d need to see the S&P drop to around 650 before we would begin to consider a tactical addition to our equity exposure and reducing our bond exposure. At that level, the potential long-term (five-year) returns across our scenarios would begin to be high enough to compensate us for the added risk we’d be taking on by selling bonds for equities. Conversely, if the S&P were to get to around 850 or higher, we would start to consider a tactical reduction in our equity exposure. In either case, we would also be comparing equities relative to the risks/returns from competing asset classes such as REITs, high-yield bonds, emerging market equities, and international equities. Currently we are underweighted to equities because we find high-yield bonds more compelling.

Extending Our Time Horizon

As we extend our investment time horizon out towards 10 years, our expectations for equity returns move toward the more optimistic end of our range, in the upper-single-digit to lower-double-digit return range. This is because earnings and P/E multiples are more likely to normalize (revert to their long-term trend lines or averages) as time goes on and the global economy heals itself. However, we also believe earnings may be in the process of re-setting at a lower sustainable trend line as a result of the deleveraging process. It seems apparent now that the excessive use of leverage over the past decade led to unsustainably high profit margins in aggregate. We do not expect to see such leverage (at least in the private sector) repeated any time soon in our economy. Therefore, even when we do ultimately see a reversion to the mean, there is a good chance it will be a lower mean than recent history might suggest.

We want to emphasize that there will be a recovery in earnings at some point and we believe investors with a very long time horizon (greater than five years) should do at least okay owning equities at current prices and likely better than bonds. But the path from here to there is likely to be bumpy and there will probably be some big dips along the way. If so, we will look to opportunistically add to our equity exposure at lower valuations in order to generate higher long-term returns.

Active Equity Managers May Add Significant Value in this Environment

While our current return expectations for the overall market are muted, we continue to hear from the majority of our equity managers that they are finding tremendous, once-in-a-generation opportunities right now. In our calls and meetings with them we’ve discussed numerous stocks they own where they see 2x, 3x, or even bigger upside from current prices. While they don’t claim to know exactly when the market will reflect what they believe is the true underlying business value for these companies, they are highly confident that it will happen over the next several (typically, three to five) years and their shareholders will be well rewarded. They also argue, and we agree, that the price moves may be quick and sharp, as is typical coming out of a bear market, so one needs to be invested now and remain patient in the mean time.

While we know our fund managers will make some mistakes, we have a high degree of confidence that in aggregate they will beat the market indexes over the next five years. The panic and fear that have swept through the equity markets, not to mention forced stock liquidations from hedge funds and other leveraged players, have created some great opportunities for skilled investors. Moreover, in numerous conversations with managers we have gotten a good sense of the ways they have adjusted their assumptions to take into account the severity of the current environment and its potential impact on individual company earnings. So we think there is a good chance they can outperform the indexes by a wide margin. As we noted at the beginning of this letter, that has been the case over the past three to four months. We take this potential value-added from active management into account when we are assessing our overall equity exposure.

Our portfolio allocation decisions are based not only on our return expectations for equities, but those of other asset classes as well. Our views on other major asset classes follow.

High-Yield

We continue to hold a 12% to 15% tactical allocation to high-yield (junk) bonds, depending on the portfolio, which we have funded for the most part by reducing our weighting to equities. We don’t own high-yield bonds because we are optimistic about a quick or strong economic recovery. To the contrary, we expect this severe recession will lead to historically high default rates for junk bonds, quite possibly exceeding levels seen in the 1930s Depression. We also believe recovery rates from defaulted bonds will reach historically low levels. (Recovery refers to the value ultimately recovered by bond holders after a company defaults and restructures or its assets are sold. For example, a 20% recovery rate means the bondholder receives 20% of the face or par value of the bond.) Despite these pessimistic assumptions, our analysis suggests that the high-yield market is priced to compensate us for these risks over our five-year horizon. That is, we think the market has overshot on the downside and that the longer-term fundamentals support higher prices.

In our analysis of high-yield during this cycle, we have always factored in above-average defaults and below-average recoveries into our valuation model. Our worst-case scenario assumed a cumulative five-year default rate of over 50% and recovery rates of 25% (the average recovery historically has been around 40%). The cumulative default rate in the Great Depression didn’t hit that level because a very high single-year default rate (like 15% or 20%) is hard to sustain over a multiyear period as weaker companies disappear from the universe and the stronger remain. However, our ongoing analysis has led us to make some minor adjustments to our modeling assumptions. To account for factors such as a scarcity of debtor-in-possession (DIP) financing, which could force earlier bankruptcy filings and increase the odds for corporate liquidations, we have front-loaded our default-rate estimates, and lowered our recovery rate assumption. These adjustments shaved off about 1% from our five-year annualized return estimate. While this is not immaterial, it does not change our conclusion that high-yield continues to represent a compelling tactical opportunity right now. We believe our assumptions are conservative, yet they still result in potential low double-digit returns over five years. On both a risk-adjusted and absolute basis we think this is attractive relative to equities.

In implementing our exposure to high-yield, we continue to own a combination of active managers, all of which are currently more conservatively positioned than the benchmark. These funds have minimal exposure to the default-prone CCC-rated part of the market, and are concentrated in higher-quality bonds (e.g., BB-rated). The funds also have selective exposure to investment-grade credits, as well as bank loans, which are higher up in a company’s capital structure and theoretically less risky. Because of the funds’ more-conservative postures, the yields on these funds are lower than the index. Though the yields are lower, our expectation is that they will have lower defaults and higher recoveries than the index, and therefore their total returns should be in line with the index.

Since we established it late last year, our high-yield position has generated a positive return while equities have declined. As always, there is the risk of short-term volatility: just because we believe an asset class is fundamentally cheap doesn’t mean it can’t get cheaper. Another short-term risk is that if there was a sharp upward move in the high-yield market the funds we own would probably underperform the high-yield index due to their more conservative positioning. However, our active managers, to varying degrees, have said they will be willing to take on more risk (i.e., lower credit quality and higher yield) if and when they believe the fundamentals and expected returns justify such a move. All in all, we remain very confident in our high-yield tactical position.

REITs

REITs have continued to struggle as commercial real estate financing continues to be nonexistent (except for multifamily) and the economic downturn drives vacancies higher and the value of many properties lower. Though we had already factored in large dividend cuts and huge property price declines into our analysis we have made further reductions to our forecasts in most of our scenarios. Our opinion has also been influenced by the IRS Revenue Procedure that was issued late last year, after our REIT purchase. The procedure allows REITs to pay up to 90% of their dividend in stock rather than cash during 2009, and may be extended into 2010. Though we had believed our REIT assumptions were adequately pessimistic several months ago (more conservative than others we were aware of) the impact to dividends from the IRS change coupled with the liquidity squeeze and deterioration in fundamentals has led us to consider even more conservative assumptions in our REIT valuation model. Specifically, we are factoring in higher dividend cuts over the next five years in some of our scenarios, and are applying a lower valuation multiple to dividends. The lower valuation multiple is partly the result of an expectation of rising interest rates at the end of our five-year scenarios (our assumed yield on the 10-year Treasury in five years ranges from 4% to 8%). Our interest rate assumptions are somewhat higher than they had been and this change in particular has had a big negative impact, resulting in lower expected return estimates compared to when we initially established our REIT position last November. Our fair-value range for REITs has come down as well. We continue to evaluate and assess the economic impact on real estate fundamentals including the impact on the payout of cash dividends—an important component of REIT returns. With significant debt maturities approaching, REIT managements are holding onto as much cash as possible via dividend cuts, dividend suspensions, or issuing stock in lieu of cash dividends (per the new IRS guidelines). We also continue to zero in on the dilutive impact that equity issuance could have on profitability as REITs raise capital to pay down debt. And, we are evaluating the effect of higher debt costs, and ultimately, where asset prices will settle.

While our fair-value estimate for REITs has come down, REIT prices have also come down a lot—the REIT index has dropped more than 30% since mid-December and is down roughly 20% since our November purchase. It is down 75% from its February 2007 peak. At current levels, we believe REITs are priced to generate returns similar to U.S. equities over the next five years in the scenarios we think are most likely to play out. It is possible that we are being too conservative in our scenario forecasts. However, it has become increasingly difficult to confidently assess long-term income and dividend levels for REITs in this environment so we have chosen to be quite conservative. Unlike the equity asset class we don’t have a data history to study that goes back to the last dangerous banking crisis and global recession in the 1930s. Because our views have changed and REIT returns now don’t appear to us to have more upside than equities, we are considering whether this holding is still justified. For now we remain comfortable holding our 3% to 5% REIT position in lieu of equities. However, REITs continue to be incredibly volatile in the current environment, and we could move to quickly sell them if they have a sharp run-up relative to equities. Our sell price will be significantly below the level we initially envisioned when we established the position. We are still finalizing this piece of our analysis, but based on our current assumptions our sell target price for VNQ (the REIT ETF) will likely be in the upper $20s to low $30s. As always, our return expectations for other asset classes relative to REITs will also impact our sell decision.

Emerging Markets Equities

Based on the valuation measures we look at, emerging markets do not yet look convincingly cheap relative to U.S. equities. They look slightly attractive on a trailing price-to-earnings (P/E) basis, but not on a price-to-book-value (P/B) or cash-flow yield basis. Emerging markets trade at a trailing P/E of about 8x, well below their historical average of 16x. They now trade at an 18% discount to developed markets on a trailing P/E basis. Historically, they have traded at a median discount of over 23% and an average discount of 21%. We believe the historical average does not fully reflect the improvements in emerging markets fundamentals, i.e., we think the P/E discount should narrow over the next five years. So, based on P/E, emerging markets look attractive relative to both their own history and developed markets. However, looking at trailing P/B, which has been a more stable valuation measure than trailing P/E, emerging markets trade at a slight premium to the developed world. While some investors argue that emerging markets’ relatively high growth prospects warrant a valuation premium, they have generally traded at a discount to the developed world in the past because of their political uncertainty (which can lead to changes in macro policies that are not conducive for growth), susceptibility to macro shocks (this risk has diminished as macro fundamentals of emerging markets have improved), and relatively less-liquid markets. Finally, emerging markets do not look cheap when we compare their cash-flow yield relative to that of developed markets over time.

Our valuation analysis is also heavily influenced by our earnings scenario work. But unlike U.S. equities, where we have many decades of earnings data, we have just over one decade of reliable earnings data for emerging-market equities. So, we have to rely heavily on judgment.

In our most pessimistic macro/earnings scenario (Scenario 3 in the preceding table), we assume that emerging markets’ fundamental improvements are almost completely offset by the recession's severity in the developed world. We also assume that the developed world will likely recover with almost no growth in the next several years. In this scenario, we think emerging markets’ earnings could decline 50% from peak, mirroring the decline seen in the late 1990s when emerging markets suffered the effects of the Asian and Russian crises. From trough earnings, which we estimate can be reached by year end, emerging markets will likely compound nominal earnings at an average rate of about 5% for the next four-plus years. This rate seems reasonable to us in relation to the GDP growth we think emerging markets can achieve when the developed world is hardly growing. (We have factored in the currency effect in our earnings analysis.) We then apply a multiple of 11x to terminal earnings, about a 15% discount to what we assume for U.S. equities. This valuation discount is a judgment call based on historical observations and our qualitative assessment of how investors will view emerging-market fundamentals relative to the U.S. five years from now. Using these assumptions, we get an annualized return in the low- to mid-single digits over the next five years for emerging-market equities.

In the less pessimistic Scenario 1 (in the preceding table), we give more weight to the improved fundamentals of emerging markets and assume that the developed world will recover from its recession and grow in the low single digits, but below the average rates of 4% to 5% seen over the past five to 10 years. In this scenario, we assume emerging-market earnings will decline 35% from peak levels, and then grow at an average annual rate of 7%. Applying a multiple of 13x to earnings five years from now (using a 15% discount to what we assume for the United States) we get an annualized return in the low double digits to mid teens for emerging-market equities.

In both scenarios above, we are assuming a constant earnings growth from trough levels. We think this may be overly conservative as it does not factor in the snap-back in earnings (due to pent-up demand) that one tends to see after an earnings recession. Emerging markets should benefit from the pent-up demand from developed markets in the initial stages of their recovery (this is what we assume in our scenarios for U.S. equities). We will be analyzing this issue in the coming weeks.

Developed International Equities

For developed international, we focus on analyzing fundamentals of Europe and Japan since they make up the majority weighting in a developed international index. Economic conditions in Europe look at least as bad as they do in the United States. Like other regional equity markets, Europe looks cheap relative to its own history. However, the question that we spend most of our time on is how it stacks up versus U.S. equities. Europe looks fairly valued relative to U.S. equities on cash earnings, i.e., when depreciation and amortization charges are added back to earnings. In addition to valuations, we assess the risk of foreign currency depreciation versus the U.S. dollar, since it eats into a dollar-based investor’s returns. Currency appreciation was the primary reason why European equities outperformed U.S. equities for several years prior to the current financial crisis. The euro appreciated significantly and got to the point that it looked overvalued versus the dollar on a fundamental (purchasing power parity) basis going into 2008. Our belief was that as the euro got more in line with long-term fundamentals, this would pose a headwind to a dollar-based investor investing in Europe. Since the onset of the financial crisis, the dollar has appreciated versus the euro and the euro now looks fairly valued versus the dollar. The other major currency, the pound, looks undervalued versus the dollar. So, currency is less likely to be a headwind to investing in Europe going forward, though past history suggests currencies can deviate substantially from their long-term fundamental values in the short term.

Our view on Japan is mixed. The country depends heavily on exports for its growth and the recent contraction in global growth has hurt its economy such that it appears to be on the brink of deflation again. Equity valuations have started to look interesting though. In addition to looking very cheap relative to their own history, Japanese equities offer higher earnings and cash-flow yields than U.S. equities. However, the question we are assessing is whether or not this is fair compensation for what we believe is a relatively poor long-term earnings growth profile for Japan.

Bringing our views on Europe and Japan together, we think developed international equities will likely provide similar returns as U.S. equities over the next three to five years.

Investment-Grade Bonds

We continue to view the investment-grade bond universe, outside of U.S. Treasuries, as offering attractive investment opportunities resulting from the severe dislocations in the credit markets. Corporate, mortgage-backed, and municipal bonds all appear to offer good value. In our tax-exempt accounts, our investment-grade bond exposure comes from holdings in Loomis Sayles Bond, PIMCO Total Return, and PIMCO Unconstrained Bond funds, which in aggregate provide highly diversified exposure to a variety of bond market sectors. Moreover, Loomis Sayles Bond and PIMCO Unconstrained in particular have highly flexible mandates that should be ideal for capitalizing on the opportunities created in this environment.

The team at Loomis Sayles views the BAA-rated investment-grade corporate bond sector as most attractive right now and has almost 40% of their portfolio there. They also hold roughly 20% of the fund in high-yield bonds, as well as roughly 25% in nondollar bonds. The fund’s yield to maturity is 11%, reflecting its attractive longer-term total return potential.

PIMCO Total Return and PIMCO Unconstrained are more conservatively positioned than Loomis Sayles, with significant allocations to high-quality agency mortgage-backed securities in addition to a large weighting in corporate bonds. They also have smaller exposures to munis, TIPS, and non-U.S. securities. The funds’ SEC yields (as of the end of February) were 6.5% and 2.9%, respectively.

Intermediate-term municipal bonds, which we own in most taxable accounts, have had a modest rally this year and are outperforming the taxable bond index by roughly three percentage points. This reverses the trend from the last half of 2008 when munis sold off sharply due to a variety of technical and fundamental factors. However, munis remain relatively attractive. Intermediate-term munis are yielding around 3.3%, equivalent to a 5.1% pretax yield at a 35% tax bracket.

A Brief Word on Inflation and the U.S. Dollar

In previous commentaries we have discussed the potential consequences for inflation and the dollar of the current government efforts to reflate the economy. The most recent policy announcements from the Federal Reserve only serve to make us more cautious about a weakening dollar and increased inflation pressures at some point down the road (e.g., in the later years of our five-year horizon, if not sooner). As such, we continue to think about hedges against dollar depreciation and inflation. Although we still believe deflation is the primary concern for the time being, we are assessing the attractiveness of Treasury Inflation Protected Securities (TIPS), particularly in our most conservative portfolios that have a very heavy allocation to fixed income. TIPS appear to offer relatively cheap insurance against inflation right now. We also continue to follow commodities as an asset class and are also studying gold. While we would expect commodities to perform well in an inflationary environment, they can also be quite volatile and would probably perform poorly if the global economy continues to deteriorate. (This was one factor contributing to our sale of our commodity futures position in March 2008.) The same is probably true of emerging-market currencies, which we also previously owned as a dollar hedge. Thus, we are being cautious about reintroducing them into our portfolios right now despite our longer-term worries about inflation and the dollar.

Shorter-Term Risk Remains

We continue to stress that there remains significant short-term downside risk in the stock market. Though as we write this the market is in the midst of a 20%+ rally from its March 9 low of 676 on the S&P, we know that rallies of 20% or more within longer-term bear markets are the historical norm, not the exception. Prudent investors should be prepared for the possibility that the S&P 500 index could decline 25% to 30% from its current level (in the vicinity of 800). To be clear: we are not predicting the market will drop 30%, and the prior low could prove to be the bottom. But we think it is within the realm of reasonable worst-case outcomes, given the severity of the current economic crisis, the uncertainty as to its resolution and, importantly, the potential for market psychology (fear) to overshoot on the downside. That is, irrational pessimism can take hold and push the stock market to ridiculously low levels just as irrational exuberance pumped up stock prices to unsustainable heights during the tech bubble or other similar manias.

Our portfolios are not invested 100% in equities, so even in this scenario of a 30% stock market decline, the total portfolio loss would almost certainly be less. But the short-term decline in portfolio values could still be substantial. For example, for someone in our Balanced portfolio a 30% stock market decline might lead to a roughly 15% portfolio decline. Our Conservative Balanced portfolio might temporarily decline roughly 10% and our Equity-Tilted Balanced portfolio might drop 20%. We hope that actual portfolio losses in that scenario would be less, but for assessing risk tolerance it is better to err in the direction of overstating losses.

Given the pain investors have already suffered, their capacity to absorb further losses is probably lower now than at any other point in their investment lifetimes. Therefore it is important that investors make an honest assessment as to whether they have the financial and emotional ability to withstand short-term declines of the magnitude we describe. We want to emphasize that we do not believe these would be permanent losses of capital. And we would expect strong stock market returns starting from those depressed levels looking out over the next five years. We also would probably be making tactical moves to take advantage of the compelling longer-term returns. But none of these factors will make those losses less painful should they occur, and won’t change the fact that investors who throw in the towel and sell equities will be locking in their losses and hampering their ability to benefit from the rebound. For someone who believes they would not be able to make it through another bad stretch of stock market declines without bailing out, it makes sense to become more conservative now.

On the other hand, we recognize that becoming more conservative can also be a painful decision for someone who has already suffered sizable declines. What if the worst-case scenario does not play out and instead the market moves higher? An investor may feel great regret that they did not stick with the more aggressive portfolio, which will have outperformed their more-conservative portfolio in this scenario. The emotions triggered by each of these scenarios—anger, regret, fear, greed—can lead to poor investment decisions. Therefore, it is very important for clients to think in advance about how they are likely to react to the various potential outcomes and to invest accordingly. Part of our job is to help clients work through that decision so that their true risk tolerance and investment time horizon matches that of the portfolio they are in.

Shorter-Term Uncertainty Creates Longer-Term Opportunity

Investor psychology is a powerful force that can overwhelm rationality. We’ve seen this throughout history on both the upside and downside. Markets can and do overshoot what a rational analysis would suggest is fair value. While this can cause discomfort in the short term, it can also create terrific investment opportunities for those able to identify and willing to take advantage of such mispricings. We are working hard in applying our analytical and research capabilities towards identifying such opportunities, and we will act with discipline and conviction when we view the risk/reward as compelling. We have been successful doing so in the more than two decades we have been managing assets, and we are confident the market will continue to provide us with compelling opportunities to add value in the months and years ahead.

But taking advantage of those opportunities also requires patience, since we know that unless we are very lucky we won’t get the timing of our tactical moves exactly right. We will probably be early since markets tend to overshoot fundamentals, and our decisions are based on fundamentals. So the market will probably go against us for some period of time after we make a move, and that could be a trying experience since it will feel scary to own an asset class that has been performing terribly.

We usually talk about patience on the downside, but clients should also be prepared to be patient on the upside. That is, if the market were to spike higher it could lower our longer-term return expectations for equities and lead us to tactically reduce our equity exposure. We might then watch the market continue to move higher over a period of weeks or months, while our portfolios underperform. In that case we will need to have the patience to wait until prices come down (or fundamentals significantly improve) and returns look attractive again before adding back to equities. The common thread in both of these examples is that we don’t try to time short-term market moves, but instead base our tactical decisions on a longer-term investment horizon.

We Are Taking Nothing for Granted

We have talked a lot about the risks and uncertainty in the economy and the financial markets. At the same time, we want to emphasize that we are resolutely focused on meeting these challenges with process and discipline. In addition to analytical expertise, conviction, and patience, we think our ability to navigate this environment and make effective long-term decisions requires that we think creatively, expand our knowledge base, continually challenge our analysis and assumptions, seek new data, and discuss our views with other experts in the field, in particular those whose analysis or opinion may differ from ours. We want to think carefully about how we could be wrong, particularly in terms of assessing the downside risk. We also need to have the intellectual honesty and humility to change our view or admit a mistake if we find that the original reasons for our investment thesis no longer hold true as a result of new developments. (The evolution of our analysis of REITs is an example of this.) These are all core elements of Litman/Gregory’s research process. They have been critical to our past success and, we believe, bode well for our ability to continue to add value for our clients in the future.

Although we think a tough road is likely in the months ahead, both for the real economy and for the financial markets, ultimately we are confident that the economy will emerge from this deep and painful period, albeit on a more subdued growth path than in past recoveries. We hope we are positively surprised and that a sustainable recovery takes hold more quickly than we expect and that our optimistic scenario plays out. But we are not managing our portfolios based on that hope. Instead, as always, we strive to analyze the situation rationally and in depth, weighing the potential risks, rewards, and outcomes in order to make the best investment decisions we can on our clients’ behalf. No matter whether investor psychology has created a market bubble or a bust or something in between, sticking to those principles gives us a sound decision framework that is grounded in rational analysis and not emotion.

—Litman/Gregory Research Team (4/1/09)

(c) Litman Gregory

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