The second quarter was a tough period in the equity arena, as increased volatility made it difficult for all but the most steadfast investors to stick to their convictions. The sell-off was instigated by Ben Bernanke’s well-publicized uncertainty about the direction of the U.S. economy, and accelerated by the Fed’s announcement May 10 that more interest rate hikes were necessary to prevent inflation. This bad karma seemed ubiquitous throughout the equity realm. And now that prices are a bit lower than they were three months ago, it’s time to reallocate to equity markets where risk is most likely to be rewarded.

Valuations and interest rates are the biggest reasons why domestic small-cap stocks are not the place to be. Small company earnings have been sagging for the last year, making small-cap growth even more unappealing.

Emerging markets likewise fail to present a compelling valuation. Although I believe that such investments are good for long-term investors, many emerging equity funds have appreciated nearly 25% per year since 2003. Even though these funds fell 10-15% in June, their downside risk is still high. In other words, there may be a time to buy, but it’s not yet here.

Large-cap developed market indexes, however, provide some opportunities. Many of these stocks don’t suffer from the same extreme valuations as their smaller-cap brethren. The EAFE index, which can be purchased via the EFA exchange traded fund, is particularly attractive, and even managed a slight gain last month.

The MSCI Japan Index Fund (EWJ) is also a good purchase. After losing about 9% in June, the region’s growth prospects make it a good addition to a diversified portfolio.

Finally, large-cap stocks in the U.S. deserve a second look. Both the Russell 1000 Growth and Value ETFs (symbols IWF and IWD, respectively), while not bargains, are likely to benefit from the growing economy, and are reasonably priced based on earnings.

The Monthly Index Report for July 2006

Index

Jun-06

QTD

YTD

Description
S&P 500 Index*

0.01%

-1.90%

1.76%

Large-cap stocks
DJIA*

-0.16%

0.37%

4.04%

Large-cap stocks
Nasdaq Comp.*

-0.31%

-7.17%

-1.51%

Large-cap tech stocks
Russell 1000 Growth

-0.39%

-3.91%

-0.93%

Large-cap growth stocks
Russell 1000 Value

0.64%

0.59%

6.56%

Large-cap value stocks
Russell 2000 Growth

0.06%

-7.25%

6.07%

Small-cap growth stocks
Russell 2000 Value

1.23%

-2.70%

10.44%

Small-cap value stocks
EAFE

0.04%

0.95%

10.50%

Europe, Australasia & Far East Index
Lehman Aggregate

0.21%

-0.08%

-0.72%

U.S. Government Bonds
Lehman High Yield

-0.35%

1.25%

3.14%

High Yield Corporate Bonds
Calyon Financial Barclay Index**

-1.15%

-0.31%

2.21%

Managed Futures
3-month Treasury Bill

2.19%

All returns are estimates as of June 30, 2006. *Return numbers do not include dividends. ** Returns are estimates as of June 29, 2006.

Ben Warwick is CIO of Memphis-based Sovereign Wealth Management. He can be reached at ben@searchingforalpha.com.