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    European stocks are pricing in a real Armageddon, and if that Armageddon doesn't occur, you'll have fairly decent returns, says author Bill Bernstein.

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  4. European Stocks Remain a Better Value Than the U.S.

    The overall growth picture looks quite weak, but valuations of European stocks look compelling, says Morningstar OBSR's Peter Toogood.

Our Take on the Third Quarter

The events of the last three months underscore that the economy's problems will not be fleeting.

Jeremy Glaser, 09/30/2011

Investors hoping for a sleepy summer were deeply disappointed in the third quarter. Sovereign debt woes and concerns about the strength of the economy sent the market on a wild ride that at times resembled the volatility of the financial crisis in 2008. The broad-based Morningstar U.S. Index stumbled 8.54% during the last 13 weeks ended Sept. 27. The index is now down 5.6% year to date but still up 5.4% during the last 12 months.

Sovereign debt and deficits dominated the headlines through much of the quarter. In the United States, a heated battle over raising the debt ceiling led the nation to the brink of default. A last-minute deal averted the immediate crisis as both sides agreed to create a bipartisan congressional committee to consider ways to balance the budget and bring down the deficit. Despite the deal, Standard & Poor's downgraded the United States' sovereign debt rating to AA+ from AAA.

But in many ways the real action was in Europe. Successive plans to stem the sovereign debt crisis and contain it to peripheral eurozone economies failed to soothe investors. Worries that the problems could lead to bank failures, or to the end of the euro altogether, sent shares of French and other European banks plummeting and credit spreads on sovereign debt soaring. Coordinated central bank intervention, continued promises from leaders that they are wiling to act, and another around of Greek austerity measures calmed markets somewhat toward the end of the quarter. But there remain many outstanding questions about whether the eurozone is taking the right steps to solve the crisis and get Europe back on the path to growth.

Economic data during the quarter also gave the market reasons to worry. There weren't signs that the U.S. economy was completely collapsing, but there also weren't any clear signs that the economy was retuning to robust growth. As Morningstar's Bob Johnson puts it, the economy remains stuck in neutral. Job growth is anemic, at best, the housing market remains stuck in the basement, and manufacturing data showed some weakness as well in the quarter. On the other hand, consumer spending remained surprisingly resilient, and inflation stayed largely in check. The story was similar in Europe, where fear about the debt crisis led to very slow growth. Emerging markets remained largely robust, but fear that European woes would spill over remained on investors' minds.

Corporate Strength Still There
Corporations continued to report decent earnings in the quarter. Belt-tightening during the peak of the recession and exposure to emerging markets left firms with lean cost structures and kept profitability high even in the face of relatively weak U.S. demand.

The market volatility kept the IPO market quiet during the third quarter. The largest deal was Dunkin Brands DNKN which debuted in July. The much-anticipated Groupon offering was delayed because of market conditions and also because the SEC questioned some of the firm's accounting practices. The lack of activity has created a backlog of anticipated firms, including Zynga, Norwegian Cruise Line, Manchester United, ILFC Holdings, Carlyle Group, and Frac Tech, that might look to come to market in the fourth quarter.

Stocks lost ground across almost the entire Morningstar Style Box. Small-cap core stocks performed the worst shedding 9.11%, while the small-cap value, mid-cap value, and large-cap value categories followed close behind losing 8.54%, 8.01%, and 7.43%, respectively. Large-cap growth companies constituted the only part of the style box that gained, up by 2.22% on the year.

Returns across stock sectors were fairly widespread. Communications services led the pack, rising 3.89% in the quarter. The second-biggest gain came from the technology sector (up 0.15%) while the consumer defensive sector (down 0.12%) was third. The biggest losses were in financial-services stocks, which dropped 13.00%. The industrials sector was the second-worst with an 8.70% loss, while energy was third with a 6.81% decline.

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