The Markets	06/30/08      Close	03/31/08    Close	2nd Qtr.  Change	06/30/07 Close	12 Mo. Change	YTD       Change
Dow	11,350	12,263	-7.45%	13409	-15.36%	-14.66%
NASDAQ	2,293	2,279	+0.61%	2603	-11.91%	-13.67%
S&P 500	1,280	1,323	-3.25%	1503	-14.84%	-13.10%
10-yr Treas. yield	3.98%	3.43%	+0.55%	5.03%	-1.05%	-0.06%
Fed funds rate	2.00%	2.25%	-0.25%	5.25%	-3.25%	-2.25%

(stock indices are before dividends; yield and rate changes are absolute changes)

The economy may have avoided a major shock in the second quarter, but the market suffered mightily from the accumulated ills of the last year. There are plenty of measures to illustrate how ugly it’s been – worst first half of the year since 1970, the Dow flirting with bear market territory (and diving into it on July 2), financial stocks down nearly 50% in a year and GM stock at a level last seen in the 1950’s. International markets have not been immune, with former high-fliers like China (Shanghai) down over 50% and India down 40%.

The employment picture darkened throughout the quarter, with the economy shedding jobs each month and the unemployment rate jumping 0.5% in June to 5.5%, the biggest one-month jump in 20 years. Consumer incomes have mostly kept pace with inflation and spending managed to increase ever so slightly, both helped by the economic stimulus payments. All in all, though, the consumer seems tapped out, and consumer confidence as tracked by the Conference Board hit its lowest level in 18 years, and was half the level of only a year ago. (The last time consumer confidence was this low was just before a prolonged rally in the markets and the economy.)

Financial companies suffered in a number of ways. Many have raised additional capital to strengthen both their balance sheets and market confidence, notably Lehman Brothers and UBS. This additional capital reduces the leverage and risk of the firms but will dilute future returns for existing shareholders, but it has improved the outlook for holders of these firms’ bonds. Some analysts have even placed a “sell’ recommendation on Citigroup stock, deeming the risk greater than any potential gain.

Oil steadily captured headlines and just as steadily hit new highs. The price of gas may have hit its “tipping point”, that level at which behavior begins to change. Gasoline use actually fell by over 2% over last year, which translates to billions fewer gallons, and housing closer to jobs and other services is becoming more sought after as the costs of far-flung suburbs are beginning to be recognized. Oil closed at $142 a barrel, with some calls for a short-term spike to $150 and an eventual rise to $200.

There are some positive signs, with first quarter productivity growing at 2.6% and exports showing steady strength. Despite the costs of gas and oil, and their impact on food and transportation, the CPI for May was only up 0.6%. First quarter GDP actually came in at an increase of 0.9%, but as we noted earlier that technical measure was easily overwhelmed by the general malaise of consumers.

The Fed lowered rates in April and finally left them unchanged in June, ending a string of 7 cuts in less than a year totaling 3.25%. Chairman Bernanke conceded that a recession is possible but the Fed statements in June noted that inflation poses an immediate threat and will be closely monitored.

Looking Forward

It may be a bit of a chicken-and-egg situation, but the dollar and the price of oil could both have significant impact. Oil is more obvious, as it has been the obsession of daily news and has caused financial strains for many consumers. Congress wants the oil companies and speculators to be the bad guys, while industry insiders blame tight supplies. If there is any indication that the US is serious about developing a long-term energy policy, some of the pressure under oil prices could be eased. If by an even greater miracle we decide to develop our own additional oil reserves, the pressure will be eased even more. That the oil from additional domestic drilling won’t hit the market for maybe 10 years doesn’t matter; anything that weakens the idea of “peak oil” in which demand increasingly outpaces supply will calm the frenzy.

The dollar should benefit if oil prices weaken, but part of the increase in oil prices is driven by a lack of confidence in the dollar. If interest rates are increased by the Fed, it will send a message to the financial markets that we are serious about the dollar and will ease the concerns of oil sellers that the dollars they receive are declining in value. The credit crunch is driven by lending standards and liquidity, not by interest rates, so an increase from 2% to 2.5% won’t really cramp the economy. And forget about that old saw that interest rates won’t be raised in an election year; the Fed was raising rates in both 2000 and 2004.

Our Portfolios

These are times that try investors’ souls, and nothing is more difficult than balancing short-term risk and long-term risk. Short-term risk aversion would argue that exposure to stocks should be dramatically reduced until some, if not most, of the clouds over the markets have been lifted. Long-term risk management combines short-term loss avoidance with an evaluation of risk and return over the investor’s time horizon and the ultimate portfolio objective. Money, and investments, are best viewed simply as tools to accomplish a goal; a disproportionate focus on investments as a goal in and of themselves invariably leads to short-term trading and poor results.

We have maintained balanced portfolios, moving to a slight underweighting in stocks. In varying degrees over the past 8 months we have taken profits on commodities (but still maintained some exposure), reduced exposure to international stocks, reduced exposure to US stocks in accounts that were too heavily weighted, and shifted from value to growth stocks. These moves have not completely insulated us from the pain, nor were they intended to. They will, however, soften the blow and better position us for a market recovery.

The silver lining of the market slide is for portfolios that are dollar-cost averaging and for retirement accounts that have regular contributions. This is the ideal time to be steadily buying at declining prices, which will reduce the average cost basis and, again, reduce the risk of making a large bet at any particular market level. And if the market continues to decline, it could present an opportunity to recommit some cash to stocks. The trick is to know when, and we may not know it until we get there.

Funky Stew

There is no question that the economy and the nation face some real challenges, which are clearly reflected in the markets, attitude polls and everyday conversation. Regardless of political beliefs, a seemingly endless presidential campaign has also focused on the negative.

Problems aside, we still live in abundance unparalleled in human history. Hard work and integrity will still fulfill personal needs in a way that is unimaginable in most of the rest of the world. The United States is still a society based on the rule of law. Most important, we still enjoy the precious freedoms of choice and opportunity. In short, with a little perspective things are not that bad, and have certainly been much worse even in our lifetimes.

Indeed, a recently publicized survey by the University of Michigan, with 17 years of data involving 52 countries and 350,000 people, shows that the Happiness Index increased in 40 countries between 1981 and 2007 and fell in the other 12. People of rich countries tended to be happier than those of poor countries, and societies “that allow people the freedom to choose how to live their lives” are much happier. Other factors cited as increasing happiness are economic growth in previously poor countries, growing democratization of other countries and rising social tolerance for women and minority groups. The US ranked 16th on the Happiness Index, while Denmark took the top spot.

Those happiness factors are definitely present in the US. However, a poll by the Pew Research Center found that 81 percent of Americans believe the country is on the “wrong track”, the most negative response in the 25 year history of the poll. (This despite another Pew poll that found that 52% of Americans feel they “can afford what they want”, up from 39% in 1992.) So, why are we so negative?

It is a difficult question to answer without extensive social research, but there are plenty of possibilities. A long and unpopular war in Iraq is seen as having no clear objectives and no end in sight. A feeling of helplessness is fueled by hapless elected officials who seem unable to address any of the problems facing the average American, from housing to energy to education to health care. That dissatisfaction is reflected in historically low approval ratings for both the administration and Congress.

Economic data would also lead to a conclusion that the sky is not falling, but we are understandably more concerned with our own direct experience than with abstract statistics. Those not directly affected by job loss or housing issues have close friends or relatives who have struggled, and the pain is contagious.

In a recent editorial in the Wall Street Journal, Gregg Easterbrook points out that the media is a big factor, and not in terms of either liberal or conservative “bias”. Rather, it is the growing pessimism and focus on the negative, with immediate live footage “creating the impression that threats and disasters are everywhere”. Every factory closing, every school cutback, every crime against a child is presented as if it is the norm, and the accompanying displays of grief and suffering only make the event feel more personal. The threats, while real, are exaggerated far beyond their true impact. This may all be good for ratings, but it is ultimately a disservice to the public psyche.

Add to these factors a popular culture that celebrates celebrity and wealth and is increasingly focused on wants rather than on needs, which in turn leads to unrealistic expectations, misguided priorities and a growing sense of entitlement. That is a recipe for one deep collective funk that could be hard to shake.