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Markets Recover from Second-Quarter Swoon

Third-quarter surge turns red to green for the year to date.

John Coumarianos, 09/26/2006

Markets rebounded strongly in the third quarter, after second-quarter declines. The Morningstar U.S. Market Index added 5.5% for the trailing 13 weeks through Sept. 22. The second-quarter swoon brought the averages back to roughly even, so the third-quarter surges account for nearly all the gains in the indexes for the year.

The markets surged despite macroeconomic uncertainty. Toward the end of the quarter, Federal Reserve Chairman Ben Bernanke received some assistance, in the form of lower commodity prices, in his efforts to control inflation without crashing the economy. Crude oil futures dropped from over $75 per barrel to below $62 as of Sept. 22. Other commodity prices, including natural gas, plummeted, too. Higher energy prices present a central banker with unique difficulties because they tend to cause inflation or higher prices of goods and services, prompting the bank to raise rates, while also potentially slowing the economy by hurting consumers, prompting the bank to lower rates.

Bernanke wasn't as lucky with the bond market as he was with commodities, however. Traders continued to buy longer-term bonds, sending the yield down on the 10-year U.S. Treasury Note to around 4.6% as of Sept. 22, defying the Fed's rate-raising efforts through June. The yield curve (the plot of bond yields based on their maturities) is again inverted, indicating that investors are willing to be paid less to lend longer because they anticipate a weaker economy and an eventual lowering of rates.

If the commodity price drops helped the Fed, they caused troubles at hedge funds such as Amaranth Advisors, which has reportedly lost $6 billion primarily on bad natural-gas bets, prompting observers to wonder whether heavy use of derivative instruments by hedge funds will eventually cause an economic crisis. Other prominent investors remained mostly quiet for the quarter, though Warren Buffett's company Berkshire Hathaway BRK.B exercised warrants to purchase stock of sheet-rock maker USG USG, which emerged from bankruptcy.

Speaking of sheet rock, homebuilders continued to flounder, despite lower long-term interest rates, with many of the industry leaders such as Centex CTX, Pulte PHM, and Lennar LEN sitting on the 5-star stock list. Morningstar analysts Arthur Oduma and Eric Landry view them as solid long-term buys.

Although homebuilders remained weak, commercial real estate continued its torrid trend. Real estate investment trusts (REITs) enjoyed solid gains, spurred by private acquisitions of public companies. Morningstar analysts are cautious on REITs at their current prices.

Surveying the Sectors

Software was the strongest sector for the quarter, advancing nearly 14% for the trailing three months through Sept. 22. Morningstar growth favorites Electronic Arts ERTS and Activision ATVI added 38% and 29%, respectively, for the trailing three months. Analyst Norman Young awards Electronic Arts a wide-moat designation for its sustainable competitive advantages stemming from its exclusive licenses on popular software. Sector behemoth Microsoft MSFT added 19% on news that it will increase its five-year share buyback program. Analyst Toan Tran favors a special dividend as the best means of returning capital to shareholders and maintains his $34 per share fair value estimate.

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