The following combines our thoughts with those provided to us by Litman/Gregory Analytics. We offer these opinions as a means of providing context for the broader decisions you make.

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. Domestic large-cap stocks (as respresented by the Standard & Poor's 500 Composite Stock Price Index) were off by (9.45%) for the first three months of the year, with growth style stocks modestly underperforming value style stocks. 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. 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. There were a handful of observers who saw this coming and here we must credit Bob Rodri-guez of FPA Capital who not only foresaw much of what has happened, but even wrote and spoke publicly about it months before the credit markets became dysfunctional.

This quarter we’ve chosen to use a Q&A format for our Commentary because we believe it is the most reader friendly and efficient way to explain our thinking on a range of sometimes complex top-ics, not all of which will be of interest to all readers.

What is your view of the U.S. 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 months more 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. With a massive backlog of unsold homes and waves of foreclosed properties continuing to hit the market, 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: The bottom line is that credit markets are not functioning properly at present. There is an adverse feedback loop in play with losses from leveraged entities forcing them to sell assets (deleverage), which 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. Employment numbers are a lagging indicator of economic health. They are now beginning to exhibit the weakness in the economy that other leading indicators have already suggested. A weak 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; however, we don’t expect them to be fully immune from economic weakness in the developed world.

What are the positives?

The biggest positive for the economy in the near term is the aggressive, and in some respects, un-precedented 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.

The dollar’s weakness has also significantly improved the competitiveness of U.S. businesses versus foreign competitors. 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 offsets the economic impact thus far of the housing downturn. This benefit could diminish if the global economy weakens significantly, however.

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 cy-cle—the result of strong profit growth and below-average capital investment in recent years.

Weighing the evidence, the odds seem to favor a worse-than-average recession but that outcome is far from inevitable.

Do today's economic stresses have any longer-term economic ramifications?

There are two potential long-term ramifications. First, as the Fed and policy makers attempt to break the adverse feedback loop, the amount of stimulus that is being required increases the potential for higher inflation down the road—not 1970s style inflation, but more than we’ve been accustomed to. Inflation is unlikely to be a near-term problem because a deleveraging (debt reduction) and reces-sionary environment is deflationary not inflationary. But longer-term, the increased supply of dol-lars has to go somewhere and that raises the risk of inflation. It also undermines the dollar’s value relative to other currencies. That’s also inflationary as imported goods cost more. The second rami-fication is the likelihood of continued deleveraging on the part of households for several years, re-sulting in slower credit growth (less borrowing) in the next recovery. If consumers borrow less and spend less, economic growth and corporate earnings growth will be slower than they would other-wise be. All this raises the risk of some stagflation in the next economic cycle.

Closing Comments

As we write this, at the beginning of Q 2, 2008, market volatility continues. 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 fi-nancial 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, a disciplined, long-term investment approach is the best way to build for long-term retirement sav-ings goals.