First Quarter in Stocks: Equities Still Climbing

Stocks picked up in the first quarter of 2006 where they left off in late 2005, posting solid gains in the face of economic uncertainty and potentially setting the stage for a fourth straight year of equity gains after the brutal bear market from 2000 through 2002.

All Morningstar diversified equity indexes were higher for the trailing 13 weeks through March 22, as small caps led the way in what is now an all-too-familiar pattern. Those anticipating a rotation to large caps will have to wait a little longer, since investors apparently haven't quite lost their affinity for smaller stocks. The Morningstar US Market Index rose 5.6%.

The market weathered additional debt downgrades and intensified solvency questions for embattled automaker General Motors GM, continued weakness in newspaper and traditional media stocks, such as New York Times NYT and TimeWarner TWX, and even weakness in online search-engine Google GOOG, whose meteoric rise had been cited as the proximate cause of traditional media's recent swoon. Additionally, weakness in the newspaper industry encouraged McClatchy MNI to purchase Knight Ridder KRI. Newspaper stocks such as Tribune TRB, New York Times, and Washington Post WPO continue to carry 5 stars, and media spin-off CBS CBS also appears undervalued to us. Analyst Jonathan Schrader thinks traditional media is ripe for a rebound, but Google still looks expensive to us.

Although financier Carl Icahn dropped his bid to restructure TimeWarner, influential investor Bruce Sherman encouraged the McClatchy-Knight Ridder merger. Warren Buffett added private company Business Wire to Berkshire Hathaway BRK.B.

As media stocks continued to suffer, energy stocks continued to surge, finishing with a 7% gain for the trailing 13 weeks through March 22. However, commodity futures prices themselves took a breather. The Dow Jones-AIG Commodity Index dropped nearly 7% for the quarter. Additionally, falling natural-gas prices and revisions by Morningstar's energy analysts to their assumptions placed some businesses in the natural-gas industry, such as Houston Exploration THX, in 5-star territory. Despite commodity price declines, fears of inflation, rising rates, and a slower housing market hindered homebuilders. Beazer Homes BZH, Centex CTX, Hovnanian HOV, and Meritage Homes MTH made appearances on the 5-star list. Nevertheless, REITs remained strong, posting a 13% surge to continue their multiyear run.

New Federal Reserve Chairman Ben Bernanke will have to guide a slowdown in residential housing delicately, taking care not to send prices down precipitously as he manages inflation. The Fed's rate-raising campaign had its effect on bonds, with the Lehman Brothers Aggregate Index adding a measly 0.34% for the quarter through Feb. 28.PAGEBREAK

Surveying the Sectors

The developing world's torrid growth helped industrial-materials stocks lead the way. Cement companies such as Lafarge LAF and steel companies such as Nucor NUE and Mittal MT rose sharply. Mittal made an appearance on the 5-star list in late 2005 and remained until its recent surge. It's one of the few commodity companies that has earned a "narrow moat" designation from our analysts for its competitive advantages. Stock analyst Scott Burns bases Mittal's moat rating on its global presence and its success in purchasing other companies and mills at bargain prices.