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Fear has clearly replaced euphoria as the dominant mood of U.S. equity markets. The shock wave that originated in the sub-prime mortgage sector last summer has become seismic as the credit crisis continues to unfold. Many economists feel that the U.S. economy tipped into recession early in 2008 when inflation worries resurfaced as oil and food prices hit new peaks.

It’s worth looking at history to put recession fears into context. Since 1945, recessions in the U.S. have become shorter, typically under 12 months compared to around 18 before World War II. Also, the U.S. stock market is a leading economic indicator – perhaps the best indicator of all – and usually turns down six to 12 months before the start of a recession. Typically the market has bottomed at the midpoint of a recession before bouncing sharply upwards, as shown in Figure 1.

No one knows when the bottom has been reached. But the volatility currently being displayed by the markets – large day-to-day swings in the vicinity of plus or minus 3% - is historically associated with the end of a decline. So we may have reached a point where investors who are under-allocated to U.S. equities should consider increasing their exposure, especially if they believe that the dollar’s decline has run its course – an added tailwind.

As for inflation, while oil and commodity prices generally have risen substantially, housing affordability is improving. The National Association of Realtors’ composite affordability index rose from 104.9 in June 2007 to a provisional 125.4 in May 2008 due to falling home prices and lower mortgage rates. We believe this will keep inflation in check. Indeed, the five-year forward rate of inflation, as implied by the TIPS/U.S. Treasury market, remains at between 2 and 3%.

Historically, growth strategies have outperformed value going into a recession because investors pay a premium for companies they believe can maintain some top- and bottom-line growth as the economy begins to deteriorate. However, at the midpoint of a recession value strategies take over the running because low valuations insulate investors against the increasing likelihood of earnings disappointments. One could say it is hard to get hurt falling out of a basement window.

There is one key lesson to remember: realizing opportunities through a value approach is all about being able to justify the price paid. That means using a bottom-up approach to finding stocks with 1) attractive valuations; 2) appealing fundamentals such as high returns on capital and strong balance sheets and 3) improving business momentum. It also implies casting the net wide to find the right candidates.

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