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Our Take on the Third Quarter

Stocks rallied in a remarkably calm third quarter, but watch out for bumps ahead.

Jeremy Glaser, 09/28/2012

After the summer fireworks of the last few years, the third quarter of 2012 was remarkably calm. Global stocks rallied as fears that the world economy was stalling and that the eurozone was headed for a sudden breakup subsided as investors generally cheered policymakers' actions to turn things around. The Morningstar US Market Index jumped 9.1% during the last 13 weeks. The broad-based index is now 15.5% higher on the year and up an annualized 13.7% during the last three years.

Once again, Europe was a primary area of focus during the quarter. But unlike in the past, the continent actually made real progress in fixing the euro crisis during the last three months. European Central Bank president Mario Draghi kicked off the wave of optimism by saying in July that he was willing to do whatever it takes to keep the eurozone together. The ECB followed up on that pledge in September with a new Outright Monetary Transaction program that will allow the bank to buy an unlimited amount of sovereign debt from countries that have accepted a bailout and are in compliance with the bailout's terms. The German high court's approval of the permanent European Stability Mechanism, the return of a pro-euro government in the Netherlands, and some progress in creating a pan-European fiscal union also helped soothe fears. Despite these developments, Europe is hardly clear from danger. Yields on sovereign debt from peripheral countries like Spain remain unsustainably high, data show the eurozone is firmly in a recession, and it will still be years until the necessary institutions are in place to end the crisis once and for all.

All eyes were on the Federal Reserve in the United States. After hinting that it was ready to act to jump-start the recovery again, a series of weak employment reports pushed the Fed to announce its third major round of bond buying. The Fed now plans to buy $40 billion of mortgage-backed securities a month until the employment situation looks much better. The hope is that the purchases will help lower mortgage rates even further and help boost the housing sector. The central bank also extended its commitment to keeping interest rates at very low levels until the middle of 2015.

The IPO market reopened toward the end of the quarter, after glitches with
Facebook's FB offering in the second quarter slowed down new offerings. The major offerings this quarter were from Palo Alto Networks PANW, Manchester United MANU, and Santander Mexico BSMX. There were also a notable S-1 filings in the quarter from WhiteWave Foods, Archstone, and Workday.

Sector-by-Sector Performance
The rising tide lifted all sectors in the third quarter. Energy had the highest return, gaining more than 16% with communication services not far behind with a 15% increase. Basic materials (up 11%) and financial services (up 10%) also had double-digit returns. Utilities (up 2%) turned in the worst performance followed by real estate (up 5%) and consumer defensive (up 6%).

The uptick in prices left stocks looking almost entirely fairly valued at the end of the quarter. The market-cap weighted price/fair value ratio stands at 0.91. Morningstar vice president of global equity and credit research Heather Brilliant says given the full valuations investors should focus "on stock-specific investments, rather than following along with the overall market or macroeconomic picture" and that the best values are in the most cyclical sectors.

Equity precious metals (up 20%) was the best performing domestic-equity open-end fund sector during the last three months. Natural resources (up 14%) and equity energy (up 14%) also posted impressive gains. Real estate (up 4%) and utilities (up 6%) brought up the rear.

International-equity funds had a good quarter. India equity (up 17%), Europe stock (up 13%), and foreign large value (up 12%) were the top performers. China region (up 4%), Japan stock (up 5%), and diversified Pacific/Asia (up 8%) were at the bottom.

Jeremy Glaser is the Markets Editor for Morningstar.com.

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