Stocks were down sharply in the first quarter. A few strong days at the end of March were not enough to offset the pain of the roughest quarter we've seen in a number of years. Large-cap stocks (based on the S&P 500 Index ) were off by 9.5% for the first three months of the year, with growth modestly underperforming value. Mid- and small-caps were down by roughly equivalent levels of around 10%, and growth's underperformance of value was more significant as market-cap dropped. International stocks also had a rough quarter with the Vanguard Total International Stock Index Fund losing 8.9% for the first three months. Commodity futures and emerging-markets local-currency bonds both did very well, gaining 9.6% and 4.7%, respectively, based on their indexes (see March Benchmark Returns table for a list of the indexes and returns we cite). REITs managed a decent quarter, with a 2.2% gain, while high-yield bonds were off by 3% as bond investors shunned risk.

Our Investment Views

In the 2001 Berkshire Hathaway Annual Shareholder Report, Warren Buffet wrote, "You only find out who is swimming naked when the tide goes out." Well the tide has gone out and it's not a pretty sight. Though we wore our swimsuits, we did not fully appreciate the economic risks that have become apparent. There were a handful of observers who saw this coming and and were able to respond appropriately. The All Cap Core strategy managed to be in cash for much of the drawdown and finished the quarter down less than 2%. In terms of stock market prices, it is likely but not certain that we are now closer to the end than the beginning of the bear market, though more downside remains very possible.

This quarter we've chosen to communicate with you in a Q&A format because we believe it is the most reader friendly and efficient way to explain our thinking on a range of sometimes complex topics, not all of which will be of interest to all readers.

The Economy

Though the label is unimportant, it's probable that we are already in a recession or on the verge of entering one. It's clear that the severely troubled housing and credit markets are beginning to have an impact on the health of the overall economy. The worst phase of the credit market problems could last for several more months, and the housing problems could continue into 2009. High energy costs don't help but are not the primary concern. The problems facing the economy are clear:

Housing: The housing market is in the worst downturn since the 1930s and the evidence strongly suggests there is still a ways to go. The Fed has not been successful in materially lowering mortgage rates, though actions since the Bear Stearns collapse have had some positive impact. And while home affordability is improving as home prices decline, there is still a massive backlog of unsold homes. Adding to that inventory will be waves of foreclosed properties that could continue into 2009. It could take a year or longer to get inventory levels back to normal. The weakness in the housing market reduces wealth and spending, increases unemployment, and continues to contribute to dysfunctional credit markets.

Dysfunctional Credit Markets: Despite the efforts of the Fed, credit markets are not functioning properly. Sizable losses on subprime loans have lowered the capital base of many financial institutions. The situation is exacerbated by a financial system that has, over a period of years, become intertwined in a spaghetti-like fashion through the spread of complex financial products (CDOs, CLOs, CDSs, and the like). This complexity makes it difficult to clearly understand what assets may be at risk, and also, how big those risks may be. This uncertainty has led financial institutions to retrench, which in turn makes credit (loans) more expensive and less available-even while the Fed tries to make credit less expensive and more available. But financial institutions are in self-preservation mode, protecting their own balance sheets and hoarding liquidity against known and unknown losses to come, not just in subprime but in leveraged loans (loans made to private equity investors), credit cards, auto, and business loans. This, in turn, is causing serious problems for entities who borrowed on a short-term basis and who now can't get new loans at reasonable prices (or at all) to replace their maturing loans. They then have to sell assets to pay off their maturing loans and they often start by selling their highest-quality assets because these are the easiest to sell. One example of this dynamic is the weakness in the tax-exempt bond market as a number of leveraged hedge funds lost on bets that muni bonds would outperform Treasuries, got margin calls, and had no choice but to sell them.

The bottom line is that credit markets are not functioning properly at present. There is an adverse feedback loop in play with losses impairing financial institutions' capital, which reinforces tight lending and asset sales to reduce leverage, which harms the economy and triggers more losses and so on. The ability to borrow money at a reasonable cost to support consumer spending and conduct business is essential for a healthy economy. Perhaps even more important to a stable economy is the ability to refinance maturing debt. The longer the problem lasts, the more damage there will be to the economy.

Labor Market and Consumer Spending: Not surprisingly, we are now beginning to see a clear weakening in employment and consumer spending, though not at levels that indicate recession-at least not yet. Continued deterioration in the labor market could feed back to trigger more defaults as people have a harder time servicing their debts. This could delay recovery in the housing and credit markets and become a self-reinforcing cycle. Meanwhile, declining consumer spending will impact corporate profits.

It is also worth noting that while most of the rest of the world is doing better than the U.S., Japan's economy is also struggling and Europe's is slowing. It seems likely that most of the developed world will continue to weaken. The emerging markets are in better shape with increased trade with each other, growing consumption, in some cases significant planned and self-funded infrastructure investment (China), and (somewhat ironically) stronger balance sheets. However, we don't expect them to be fully immune from economic weakness in the developed world.

How bad could the economy get in the near term?

It is always hard to say. In many ways some of the variables in play are similar to 1990-91 when there was a severe downturn in commercial real estate (some called it a real estate depression), war in the Middle East, a sharp spike in oil prices, and the S&L crisis. Consumer spending declined during that recession, unlike the 2000-02 recession, which was driven by a big drop in corporate activity. Overall, the 1990-91 recession lasted eight months and unemployment rose above 7%. Clearly there are similarities between then and now. Optimists point out that magnitude of financial sector write-offs (at least so far) was worse back then. Moreover, export growth is particularly strong now. However, the credit market problems are clearly worse this time around and that makes this potential downturn much more worrisome. The backdrop isn't comforting. There is much more debt relative to the size of the economy now and financial instruments are far more complex, making it difficult for even the financial institutions that hold them to assess the extent of the problem. This suggests that the economy has the potential to suffer a longer- and deeper-than-average recession. (The average post-WWII recession has lasted 10 months with a range of six to 16 months. Most have been clustered between eight and 11 months.)

There are always positives. What are they?

As mentioned, the biggest positive for the economy in the near term is the aggressive, and in some respects, unprecedented action of the Federal Reserve. Though the Fed's moves have not been as effective as they would like, they have made it clear that they will do what it takes to stop a major downturn and they still have weapons in their arsenal, such as directly buying mortgage securities in the public market. Recent actions, such as the establishment of the Primary Dealer Credit Facility, strike us as significant. The facility allows security dealers, such as Goldman Sachs, Lehman Brothers, and Morgan Stanley, to borrow directly from the Fed at a very low interest rate (currently 25 basis points above the federal funds rate) using a wide range of collateral, including investments that have been hard to sell in the current market environment.

The dollar's weakness has also significantly improved the competitiveness of U.S. businesses versus foreign competitors. As long as the dollar either stabilizes or gradually declines, as opposed to crashing (which we continue to view as quite unlikely), this should stimulate demand for U.S. goods. Export strength is already happening with exports contributing a significant one percentage point to economic growth over the last six quarters (annual rate). This almost offset the economic impact thus far of the housing downturn. One caveat: Exports will grow provided the global economy doesn't weaken so much so as to offset the market share increase. At this point this looks like a good assumption relative to the emerging markets but is less of a sure thing with the developed world.

Finally, outside of the financial sector, companies are generally flush with cash, especially relative to debt-service needs. Balance-sheet strength is surprisingly healthy for this late in an economic cycle-the result of strong profit growth and below-average capital investment in recent years. According to Bridgewater (a research firm and institutional money manager), the number of companies that may struggle to service their debt is at the lowest level ever (in this case the data goes back to 1970).

Closing Comments

As we write this, market volatility continues-but in the last few days it has been on the upside. However, we suspect this will continue to be one of the most challenging investment environments we've ever faced, at least for a while. We believe investors may still be underestimating the losses yet to be written off by the financial sector and the resulting economic ripple effects. But stocks are reasonably valued now, and if they fall much further, it will represent an attractive buying opportunity for long-term investors. And while we believe it is important for us to discuss the more negative possibilities, we reiterate that it is possible that we are close to a bottom, or that we have already reached a bottom. We can't know what the near-term is going to bring, but at times like this when economic uncertainty is high, our discipline and research process keep us grounded and give us confidence in our ability to make sound long-term decisions.