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 the market dropping 8.4% for the month and almost 3% in the second quarter. The phrase “June gloom” is used by residents of the Southern California coast to describe the cold and fog that persists this time of year, and it could also be used to describe investors’ moods as the quarter came to an end. The S&P is now down 12% for the first half of this year, and is about 18% below its October 2007 high. 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 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 11% for the month. Domestic high-quality bonds were flat in June and down just over 1% for the second quarter and up 1.1% for the year.

As always happens in an environment of fear, we are asking a lot of questions. What is going on, and how bad could it get? What else should we be doing in your 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.

Looking back to March, the Federal Reserve’s unprecedented actions to shore up credit markets and create liquidity led many to hope that we were past the worst of the financial crisis and that the stock market had hit bottom. Today it seems that while the Fed’s actions may have significantly reduced the risk and fear of a full-scale financial meltdown, the losses from bad loans are not only continuing, but are continuing to be worse than expected.

The positive impact of soaring home prices and easy credit is now gone, and with it has gone a major source of consumer spending. Add in the impacts of high levels of household debt, 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 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. At their latest meeting in June, the Fed held rates steady and expectations of higher rates later this year has also hurt stock prices. 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. Outside the financial sector, corporate balance sheets remain generally healthy and earnings have been okay. One source of strength has been exports, which 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.

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

One possibility is that things will get worse before they get better. 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. Though it is easy to put too much weight on negative scenarios when bad news dominates the daily headlines, our economy and financial markets generally find a way to work through all the problems and heal themselves. History is full of awful events if you look back over the years, but the economy is bigger and stronger and the markets are higher.

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 know that we can’t avoid all losses, but we do understand that it is our job to protect your portfolio from the full impact of a bear market. As such, we have adjusted most portfolios several times and significantly reduced stock market exposure. We know that it is prudent to be more defensive when little else is working. In due time, we’ll have the opportunities we need to produce the returns you need.

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 your portfolios over the last 18 years. Bubbles lead investors to make errors in judgment and misprice assets on the way up. On the way down, 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. Once again, there are several that may be headed in this direction that we are monitoring carefully.

For the 10 years through the end of June, the S&P 500 has compounded at just under 3% annually. From June 1988 to June 1998 the S&P 500 returned a whopping 18.6% annually. During this time interest rates fell, the growth rate for corporate earnings climbed, investors took their enthusiasm too far, stocks became overvalued, setting up the market decline from 2000 to 2002. So in a sense, the low returns of the past 10 years have forced investors to give back some of the excess earned in the previous decade. When both periods are combined, stocks have returned a little more than 10% annually in the 20 years through June 2008. That’s in line with their very long-term average.

Market conditions may continue to be challenging. However, we believe we can add value from both our tactical asset allocation and security selection decisions. In terms of our current portfolios, we continue to hold lots of extra cash as a margin of safety and to allow us to quickly deploy it back into the market to take advantage of the inevitable market upturn or any intermediate trading opportunities. Once the market begins its “real” upward movement we think an overweighting of large-cap growth stocks, foreign markets and high-yield bonds will add great value much like they did in 2003-2004.

We remain confident that our investments will beat their benchmarks over the long term. Many of the managers we use and respect tell us they are buying shares of high-quality companies at bargain-basement prices. Consequently, even though the overall market does not look compelling, the current economic and market turmoil is 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. At market tops and bottoms, what feels right isn’t. The proverbial mattress, or a CD may feel like the right thing today, but the odds are great that one year from now it will be obvious why they weren’t.