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Our Take on the Fourth Quarter

Despite ending the final quarter about where they started, stocks turned in solid performance in 2012. 

Jeremy Glaser, 12/31/2012

Politics seemed to dominate the news in the last quarter of the year as the cacophony of November's presidential election quickly turned into worries over the impact of the fiscal cliff. It was quieter outside of the United States as Europe remained mostly calm and emerging markets saw steady growth. Even though there was a fair amount of volatility, the market barely budged during the quarter. The broad-based Morningstar US Market Index was down less than 1% during the last 13 weeks. The index was up nearly 15% on the year and is up almost 11% on an annualized basis during the last three years.

Talk of the fiscal cliff exploded after the election, as the market anxiously waited to see if leaders in Washington would be able to avert the scheduled tax increases and spending cuts expected to begin Jan. 1. Hopes for a deal increased on signs that Republicans were willing to accept higher revenues and that Democrats were willing to put entitlement reforms on the table. However, a quick resolution to the fiscal cliff problem was not in the cards as divisions over how to raise revenues (if at all) and the magnitudes of cuts proved hard to close. The impact of the fiscal cliff could be felt throughout the quarter. The uncertain tax environment caused firms began to make changes even ahead of the new year. A slew of management teams issued special dividends, sped up the payment of regular dividends, and slowed down some investments.

The Federal Reserve also provided a bit of a surprise during the quarter by, for the first time, tying its monetary policy to specific economic indicator instead of to a time period. The central bank said that it would continue its extraordinarily easy monetary policy until the unemployment rate hit 6.5% from the current level of 7.7%. The commitment is not binding; the Fed said it would act if inflation began to become a problem of if the rate fell only because of a reduction in the workforce. Still, the statement was another clear sign that the Fed plans on keeping rates incredibly low of years to come.

Superstorm Sandy wreaked havoc on the East Coast and likely had a major impact on the fourth quarter's economic data. Morningstar director of economic analysis Bob Johnson thinks that after adding in issues with auto-production cycles and other one-time factors, "GDP growth is likely to drop from very close to 3% in the third quarter to a measly 1%-2% in the fourth." Excluding these factors, he sees the true strength of the economy during the quarter at 2%.

After stealing the spotlight for several quarters in a row, Europe receded to the background during the last three months. European Central Bank head Mario Draghi's pronouncement in July that he was willing to do whatever it takes to keep the eurozone together has helped create a lasting lull in the sovereign debt crisis. This quarter a new deal was reached with Greece that allowed another tranche of bailout funds to flow into the country and provided for a private-sector bond buyback allowing the country to stay in the common currency. Despite the recent quiet, there are still multitudes of unsolved problems in the eurozone, and they are more likely than not to re-emerge as serious issues in 2013. 

Sector-by-Sector Performance
Although the market as a whole was down only slightly, there was a much broader range in returns on the sector level. Basic materials led the way, gaining 10.4% during the last three months while financial services was the next best performer with a 9.3% gain. Energy was the worst performer losing 1.7% in the quarter. Utilities (down 1.3%) and communication services (down 1.1%) also lost ground. For 2012, the spread between the best and worst performers were even more dramatic. Consumer cyclical (up 33%), financial services (up 30%), and real estate (up 27%) were on top, while utilities (up 3%), energy (up 5%), and communication services (up 15%) brought up the rear.

Overall, stocks now look to be fully valued; the market price/fair value ratio now stands at 0.98. Morningstar vice president of global equity and credit research Heather Brilliant says that the full valuation makes it increasingly difficult to predict the market's direction, but she thinks that "stock selection is becoming increasingly important" as correlations potentially fall.

Industrials (up 7.7%) was the best-performing sector-stock fund category best-performing domestic-equity open-end fund sector, followed by global real estate (up 6%) and miscellaneous (up 5%). Equity precious metals (down 15%) was the worst category by far, followed by technology (down 3.1%) and equity energy (down 2.8%). During the year, global real estate (up 31%) led the way, while equity precious metals (down 11%) was the worst performer.

For domestic-equity open-end stock funds, mid-cap value (up 2.0%) was the top performer followed closely by mid-cap blend (up 1.9%). Large growth (down 2.0%) and small growth (down 1.9%) were at the bottom. Mid-cap value was also the best performer in 2012, gaining more than 15%. Small growth (up 11%) was the worst performer.

International-stock funds posted another good quarter, with all open-end international categories posting positive performance. China region (up 8.8%) was on top followed by Pacific/Asia ex-Japan Stock (up 6.3%), diversified Pacific/Asia (up 6%), and Europe stock (up 5%). At the bottom were world stock (up 2%) and India equity (up 2.6). For 2012, all categories had gained more than 10%.

Just like last quarter, emerging-markets bonds (up 3.6%) was the best-preforming fixed-income open-end fund category. High-yield bond (up 3%) and multisector bond (up 2%) round out the top three. Intermediate government (down 0.3%) and short government (down 0.1%) were the only categories to lose ground. Over the full year, emerging-market bonds (up 17%) were still at the top of the leaderboard followed by high-yield bond (up 15%) and long-term bond (up 13%). Short government (up 1%) and ultrashort bond (up 2%) were the worst performers this year.

Big 2012 Questions Remain Unanswered
Even though there were some big question marks hanging over investors in 2012, many investors are still going to be smiling when they take a look at their year-end brokerage statements. But a lot of those big question marks haven't been answered. The U.S. fiscal situation will remain challenging, no matter what short-term deal is struck, the crisis Europe could flare up at any moment, and developing-markets growth is far from guaranteed. Combined with our analysts reckoning that stocks are fully valued, the stock market could be in for a bumpy ride in 2013.

Jeremy Glaser is the Markets Editor for Morningstar.com.

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