Fasten-Seatbelt Sign Lights Up in Second Quarter

Fears of inflation and uncertainty regarding the sustainability of corporate profits led to a market sell-off late in the second quarter. Volatility rudely imposed itself on investors accustomed to calm after the end of the bear market in 2002. All Morningstar diversified equity indexes posted losses for the trailing 13 weeks through June 22, and the Morningstar U.S. Market Index shed 4.3% over the same period, but still managed to eke out a gain of about 1% for the year to date. Once again, smaller-cap and more value-oriented indexes are outperforming for the year, posting gains for 2006 despite second-quarter losses.

Macroeconomic questions gripped the markets, as new Federal Reserve Chairman Ben Bernanke appears poised to raise rates at least one more time as of this writing, precisely as the economy appears to be slowing. Investors fear the Fed tightening too hard, sending the economy into a recession. They also fear a return of "stagflation" from the 1970s, when rising prices (partly due to higher energy costs) and a slowdown visited the economy simultaneously.

There seemed to be no place to hide, with foreign markets also declining, the Lehman Brothers Aggregate Bond Index falling over 1%, and the Dow Jones-AIG Commodity Index dropping from nearly 190 at its peak in May to below 170 on June 22. However, large, slow-growing companies weathered the swoon rather well. The Morningstar large-cap indexes held up the best during the bloodletting of the past month, with the small-cap indexes bringing up the rear.

This didn't catch Morningstar analysts completely by surprise. First, Morningstar's director of stock analysis Pat Dorsey reported that a variety of factors pointed toward investor complacency and the inexpensiveness of high-quality stocks. Second, mutual fund analysts have been hearing from their favorite managers that high-quality large-cap stocks haven't looked this cheap in a long time. Fund analyst Gregg Wolper reported that world stock fund managers had noticed topnotch U.S. companies selling at more compelling prices than their foreign counterparts.

The domestic-foreign debate continues, however, with Warren Buffett telling shareholders of his company, Berkshire Hathaway BRK.B, not to be surprised if he follows up his recent acquisition of Israeli metal-cutter Iscar with other foreign purchases. Buffett also picked up shares of integrated oil company ConocoPhillips COP, industrial conglomerate General Electric GE, and package carrier United Parcel Service UPS, all of which share the theme of global operations, according to analyst Justin Fuller.

Surveying the Sectors
Media dragged itself up off the mat, posting a 2.4% return for the trailing 13 weeks through June 22. The worst five-year performing sector, media bounced back to the satisfaction of Morningstar analysts, who have viewed newspapers and other media enterprises as cheap for some time. Tribune TRB, owner of newspapers, radio and television stations, and the Chicago Cubs baseball team, surged 12.8% for the trailing three months through June 22 on pressure from the Chandler Trusts, which are 12% owners, to spin off the television-broadcasting assets. Analyst Jim Walden anticipates increasing pressure for the spin-off, and views Tribune as currently undervalued.

Media conglomerate Liberty Global LBTYA powered 12.4% higher for the trailing three months through June 22, while cable companies Comcast CMCSA and Cablevision CVC added over 20% each. Analyst Michael Hodel notes that Comcast has been signing up Internet access customers at a fast clip without yet showing signs of pricing pressure from the competition. Some of the cable providers' main rivals, the RBOCs (regional bell operating companies), also dialed up their returns. Qwest Communications International Q tacked on 8% for the trailing three months through June 22 and is up 33% for the year, while BellSouth BLS added about 4% during the quarter and is also up 33% for the year. Still, the RBOCs face an uphill battle, according to Morningstar analysts, because of huge capital outlays to deliver video, a declining landline business, and competition among themselves and with the cable providers and voice over Internet protocol (VOIP) technology.

Software brought up the rear, dropping 10% for the trailing 13 weeks through June 22 and more than 5% for the year to date. Salesforce.com CRM dropped about 25% during the quarter and is down 14% for the year. Analyst Rick Summer likes the company's subscription-based software model, but views the firm as roughly fairly valued at its current price. Additionally, Microsoft MSFT continues to struggle, with the delay of the release of its new Vista program. Morningstar fund analysts have heard conflicting opinions on Microsoft. Some managers are frustrated by the company's delays and its unwillingness to give more cash back to shareholders, while other managers are content to let the heavy cash-generating business continue to invest in other ventures. Equity analyst Toan Tran views the software giant as significantly undervalued at its current price under $23.