The first six months of 2010 have been a bit of a roller coaster—domestic stocks were up early in the year, then down 5% by early February, then up almost 10% for the year by late April, then down nearly 7% for the year by the end of June.

My commentary examines the economic "tug of war" being reflected in the stock market, with improving economic and company fundamentals on the one side, and concerns about debt-related stress points and the longer-term strength of the economic recovery on the other.

My view of the big-picture environment we face in the next few years remains unchanged. The recovery continues but it is not inspiring, and I see above-average risk in spite of being early in a recovery cycle.

Stocks continued their slide in June, ending the first half of 2010 with losses in every segment of the equity market. The DFA Global Equity Fund lost 11.64% for the quarter and is down 6.19% year to date. The large-cap Vanguard 500 Index lost 11.5% for the quarter, and is down 6.7% year to date. The small-cap iShares Russell 2000 and iShares Russell Midcap both lost 10% in the second quarter, though thanks to a strong first-quarter, both benchmarks are down just 2% year to date. Turning abroad, the story was similarly painful. The DFA International Core Equity Fund dropped 13.64% in the second quarter, bringing its year-to-date loss to 11.04%. The DFA Emerging Market Core Equity Fund lost over 8% for the quarter and 4.57% year to date.

Most of the positive news for the first six months of the year was in fixed income. The Vanguard Total Bond Market Index Fund, a proxy for high-quality, intermediate-term bonds, gained 3.6% over the second quarter, and is up 5.3% for the year through June. Foreign bonds were mixed. The Citigroup World Government Bond index was flat in the second quarter, but still down 1% year to date, and although the JPMorgan GBI-EM Global Diversified Index lost 2% for the quarter, it returned a positive 3.4% for the year through June.

Exposure in all portfolios benefited by the alternative asset strategies employed during the quarter. This reversal coincides with the end of the one of the more robust cyclical bull markets we’ve have ever experienced in the stock market that started in March 2009. I’ll talk more about my current views and future performance expectations in the commentary below:

As noted in the performance review above, the first six months of 2010 have been a bit of a roller coaster—domestic stocks were up early in the year, then down 5% by early February, then up almost 10% for the year by late April, then down nearly 7% for the year by the end of June. This reflects what I see as an economic "tug of war" in the stock market, with improving economic and company fundamentals on the one side, and concerns about debt-related stress points and the longer-term strength of the economic recovery on the other. The tension between these opposing forces has left investors uncertain and the stock markets stuck in a trading range (i.e., bouncing around within a range with no clear trend). I think that unusually high uncertainty could be with us for years to come because the economic challenges we face are serious and will not be resolved quickly.

Though we won’t forget the market freefall of 2008, now that there has been a strong stock market rebound from the bottom, it’s interesting to compare market levels today to three years ago. Despite the rebound they continue to reflect a level of economic stress:

As long-term investors, my views tend to evolve gradually rather than change suddenly based on new information (the fall of 2008 being a notable exception). That’s certainly been true in recent quarters with my assessment of the big picture unchanged.

It’s no secret that there is too much debt in most of the developed world—the United States, Europe, and Japan. I’ve written about it ad nauseam. That the problem is identified doesn’t lessen the challenge. In coming years the developed world must walk a tightrope as it deals with the pressing need to slow and ultimately reverse debt growth without also seriously harming economic growth rates.

The United States and other countries with excessive household sector debt are in the early stages of what is likely to be a long process of deleveraging. Though it is dropping, household debt relative to income remains excessively high. Most of these countries must also dramatically reduce public sector (government) debt growth and in some cases they will need to reduce the absolute amount of debt. This huge challenge has not yet begun. 

The timing and aggressiveness with which public sector debt and deficits are attacked will be extremely tricky to get right given current economic headwinds. On the one hand, too much austerity coming from very tight fiscal policy can be counterproductive because it risks smothering already weak growth, which reduces tax revenues, increases social safety net spending, and could weaken the political will that is needed to follow through on spending discipline. By doing nothing, the U.S. will incur one of the largest tax increases on record with the expiration of tax cuts made during the Bush administration. Christina Romer, Obama’s head of the Council for Economic Advisors has determined that if you raise taxes by 1%, it leads to a 3% drop in the economy. This will be matched by tax increases and lower spending from states and local jurisdictions. I hope they get this right because high taxes in a weak economy could lead to a rare double dip recession.

But waiting too long to tackle rising debt levels digs a deeper hole and risks a lenders’ strike, which could result in government borrowers (and all others too) being forced to pay a much higher interest rate to finance their debt. At the extreme, as we are seeing with Greece, debt levels become unmanageable as borrowing costs become untenable, resulting in a crippling crisis for the country and a ripple effect that in a global economy has reached far beyond Greece’s borders. A critical unknown is whether enough countries, including the United States, can thread the economic needle so that the recovery has time to gain steam while maintaining lender confidence that the deficit/debt problems will be addressed over time. Slowing and ultimately reversing the growth of debt is further complicated by aging populations—a reality that most of the developing world faces to different degrees.

An aging population presents several challenges. It means that savings rates will face downward pressure as more of the population moves from working and saving to retiring and depleting savings, and paying fewer taxes given lower income. More retirees also mean more government retirement and health care expenses (Social Security and Medicare in the United States). This is fine if pensions and health care are fully funded. But that is not the case.

While the private sector gradually de-levers, and we wait for the public sector to later do the same, at least the United States is experiencing an economic recovery, albeit a tepid one. There has been clear improvement from the depths of the recession. The economic cycle is, for now, a plus, but the big problems have not been resolved.

Three variables critical to improvement in private-sector consumption and a normal recovery—the labor markets, credit growth, and housing—remain weak. We are still down about eight million jobs from the peak and in the private sector job growth is barely positive – though that is an improvement from last year. Credit market debt is contracting as it has been for about two years, which removes an important driver of consumer spending. And the housing outlook, which is critical to household financial strength and the banking sector, remains cloudy and appears to be slipping backward with an expiration of the homebuyer tax credit.

The rest of the developed world looks worse. Europe is experiencing very slow growth, southern Europe is uncompetitive and has many countries in various stages of sovereign debt crisis, and economic policy is a challenge given a single monetary policy in the Eurozone, but no political union and differing economic situations.

Fortunately, key parts of the developing world are in much better shape with stronger balance sheets, higher growth rates, younger populations, and slowly emerging consumer sectors. Their strength is an important source of support for the global recovery. And there are other positives that help to mitigate the negatives. The continued impact of massive federal stimulus (though this will wane later this year in the United States), healthy corporate balance sheets and cash flow (after huge cuts to expenses), healthy technology growth and a natural rebound in economic activity after a huge decline are also sources of strength in the U.S. and global economy.

Thus, my view of the big-picture environment we face in the next few years remains unchanged. The recovery continues but is not inspiring, balancing debt reduction with economic growth is a tricky proposition and I see above-average risk in spite of being early in a recovery cycle.

In assessing potential returns, my scenario analysis approach has been invaluable when combined with traditional valuation analysis. This approach allows me to be forward-looking so that I can factor in a number of possibilities that impact potential returns over my decision horizon, and it gives me the advantage of considering a range of outcomes when I make investment decisions, rather than requiring me to correctly identify one specific forecast.

Stocks: After a huge stock rebound from the market depths of March 2009, my equity scenario analysis continues to suggest that developed stock markets offer mid-single-digit return potential over the next five years.

Bonds: Within bond allocations, while high quality investment-grade bonds only offer minimal return potential over a five-year horizon, they do offer a defensive investment that could perform well if the economy is very weak or falls back into recession. Additionally, the fixed-income vehicles held are more aggressive and potentially more volatile than a typical investment-grade bond portfolio, as I believe these fixed-income positions will capture materially higher returns and provide much better protection against unexpected inflation and in a rising rate environment.

Alternative Investments: In this secular bear market, I’ve increased the allowable exposure to alternative asset classes in most portfolios as I believe they are likely to provide better risk adjusted return opportunities than bonds over the next five years and have return patterns that don’t necessarily correlate with traditional stock or bond strategies; offering enhanced downside protection in most market environments. There have been an increased amount of these investment products coming out in mutual fund and exchange traded format and I continue to research new opportunities to determine if they viable investment candidates for future strategies. Meanwhile I continue to assess the fundamentals of current strategies I employ to determine their viability or if new candidates would make better replacements.

Assessing five-year return expectations is a critical step in my investment process; however, so is my portfolio-level risk analysis. This step involves assessing how each portfolio is likely to perform in various one-year risk scenarios, then using this information to further calibrate the exposure to various asset classes. This process, along with my individual asset class analysis, has resulted in portfolios being materially underweight to equities and therefore somewhat conservatively postured. I believe portfolios are positioned to perform better than benchmarks in a bear market or a low-return market. However, if stocks have a strong upward move, portfolios are almost certain to lag comparable traditional benchmark returns.