First Quarter in Stocks: Where Do We Go From Here?

As the first quarter of 2004 drew to a close, the U.S. stock market looked uncertain.

The so-called low-quality rally of 2003, which featured smaller-cap, technology, telecommunications, and Internet companies with dubious balance sheets doubling or tripling in value, seemed to lose momentum toward the end of the first quarter of 2004. However, the long-awaited rotation into the shares of large, high-quality companies with proven records of earnings growth hasn't yet fully materialized.

Optimism fought anxiety during the period. Through March 16, 2004, the Morningstar U.S. Market Index clung to a small gain of 0.6% as investors searched through a fog of conflicting data and news. The economy looked strong, but there remained doubts about the sustainability of its vigor, with anemic job growth a nagging concern. Corporate balance sheets and earnings looked better, but many stocks looked pricey. There were also mixed signals on the geopolitical front. A year after the start of the Iraq War, coalition forces had Saddam Hussein in custody and Iraqi leaders took steps toward forming a democratic government. But violence continued to wrack the occupied country, and commuter-train bombings in Madrid, Spain, exacerbated fears of global terrorism.

Merger news, both good and bad, also influenced the broad market's performance.  Bank One  and  J.P. Morgan Chase , which agreed to combine, were among the leading positive contributors to the Morningstar U.S. Market Index's performance, as was  AT&T Wireless , which sold itself to competitor Cingular for $41 billion. Business-software firm  Oracle  proved to be one of the biggest drags on the broad market in the first quarter. Its stock fell more than 11% as the U.S. Department of Justice filed a lawsuit to block CEO Larry Ellison's bold and controversial bid to buy rival  PeopleSoft .

The picture in the health-care sector was similarly mixed. Large-cap drug stocks languished.  Abbott Laboratories ,  Bristol-Myers Squibb , and  Wyeth  each posted double-digit losses as investors fretted about thin product pipelines, patent expirations, product approvals, and operational issues. Meanwhile, some smaller-cap biotech and specialty pharmaceutical stocks continued to flourish. Enthusiasm for the shares of Sepracor , for example, surged as the FDA gave tentative approval for the firm's insomnia drug.

In the technology sector,  Intel  followed up its triple-digit performance in 2003 by retreating in the first quarter of 2004. With corporate capital spending increasing, the financial performance and prospects of the world's largest semiconductor maker looked as strong as ever, but the stock had gotten expensive in last year's rally. Similarly, networking-gear maker  Cisco Systems , which gave up some of its 2003 gains during the quarter, looked poised for strong growth, but not strong enough to justify its valuation.

Software titan  Microsoft  also struggled as it failed to settle antitrust complaints with European Commission regulators. The company faces fines and orders to change the way it does business, which could affect its operations across the globe. Microsoft has also suffered a drop in its unearned revenue in recent quarters, which could indicate that some large customers are balking at signing big long-term software deals.

Wireless Gear, Services Surge
Wireless equipment was the best performing industry of the quarter, posting an average gain of more than 20% through March 16, 2004.

Strong demand for wireless phones and increased business spending boosted the fortunes of wireless-infrastructure stocks both large and small. Brand-name handset manufacturers, such as  Nokia  and  Motorola , and small speculative players, such as Sierra Wireless , a maker of modems for handheld computers and other devices, benefited.

Nevertheless, the hardware sector, in which most wireless-gear makers reside, was a mixed bag during the quarter. The shares of several big semiconductor, computer, and network equipment companies, such as Intel, Cisco, and  Dell , gave back some of the ground they gained in 2003.

Makers of semiconductor-manufacturing equipment also ceded ground. After posting stellar gains ranging from 50% to more than 100% in 2003, many of that industry's biggest constituents--including  Applied Materials ,  KLA-Tencor ,  ASML Holdings ,  Novellus Systems , and  Lam Research --backslid. Many of these companies' prospects remain strong, but they are notoriously volatile due to their cyclical nature.

Meanwhile, wireless-services providers helped make telecommunications stocks the best performing sector of the quarter with a 4.7% gain through March 16, 2004.  Verizon Communications  gained more than 7% as the firm continued to attract new customers for its wireless services and retain the ones it had. In another boon to telecom-service providers, a Washington, D.C., court struck down some Federal Communications Commission rules governing local-phone competition. The rules gave state regulators authority to tell local phone companies which parts of their networks to open to competitors. The auction of AT&T Wireless, as well as the performance of other wireless-services stocks, such as  Sprint PCS Group , also fueled the sector. Sprint PCS Group's tracking stock is about to recombine with that of corporate sibling  Sprint .

Software was the worst sector by far, shedding more than 7%. Antitrust woes sank Oracle and Microsoft. Other software vendors, such as  SAP ,  Electronic Arts ,  Computer Associates , and  Veritas  took a breather after posting exuberant advances in 2003.

Large Growth
Retreating technology stocks, such as Microsoft, Intel, Cisco, Oracle, and Veritas, swamped advances by AT&T Wireless,  Wal-Mart , and  Qualcomm , making the Morningstar Large Growth Index one of the poorer performing benchmarks of the quarter through March 16.

Also weighing on the large-growth index were media and entertainment stocks such as  Viacom ,  Omnicom Group , and  Clear Channel Communications . Such stocks posted decent gains in 2003 as investors bet an improving economy and the 2004 presidential election would help strengthen the advertising market. After that runup, it wasn't surprising that these issues began the year with a pullback.

Furthermore, Viacom and Clear Channel each weathered firestorms of criticism and a stream of bad publicity over indecent programming. A risqué Super Bowl halftime show embarrassed the media conglomerate Viacom, and Clear Channel fired a controversial radio talk-show host after the FCC fined it for violating decency regulations.

Mid Growth
The Morningstar Mid Growth Index has been treading water so far this year. The index posted a minuscule gain through March 16 as selected health-care and hardware sector stocks such as biotech firm  Biogen Idec  and  Juniper Networks  posted strong gains, but semiconductor equipment makers such as Novellus and software firms such as  Siebel Systems  fell by double digits.

Biogen Idec rose more than 40% as it became clearer that the company's multiple sclerosis drug Antegren had a good chance of reaching the market. Meanwhile, investors excited by a stronger-than-expected rebound in demand for Juniper's products bid up its shares by nearly 40%.

On the other hand, Novellus fell with other chip-equipment stocks that gave back gains after a strong 2003, and Siebel dropped by 20% due to worries about software license sales.

Small Growth
The Morningstar Small Growth Index, the best performing diversified domestic-equity benchmark of 2003, held on to some of its momentum in the first quarter of 2004. The bogy started losing steam in the latter weeks of the period, but still posted a gain of about 1.5% through March 16.

Makers of wireless equipment such as  Andrew Corp.  and Skyworks Solutions  bolstered the index, as did wireless-phone-service provider  Western Wireless . Biotech stocks such as  Protein Design Labs  and Affymetrix  also gained.

Large Core
A lot of pundits predicted investors would shift to so-called high-quality companies this year after gorging themselves on smaller, more speculative names in 2003. One look at the Morningstar Large Core Index, however, shows that the long-awaited rally in "high quality" stocks--those with solid track records of profitability, good prospects for continued growth, and firm balance sheets--didn't really get started in the first quarter.

A few blue chips did rise. Insurer  AIG  gained more than 7% through March 16 due to successful acquisitions and improved growth prospects for its Asian business. Restaurant chain  McDonald's  also advanced about 15% as it shifted its focus from expansion to increasing sales at existing sites.

However, some of the best performing stocks in the index during the quarter, such as  Lucent Technologies  and Motorola, are more turnaround stories than high-quality companies. And lagging pharmaceutical stocks such as Abbott and Wyeth also dragged on the index. Cable-television provider  Comcast , whose shares dropped after its brazen attempt to buy  Walt Disney , also proved detrimental.

Mid Core
Homebuilders fueled a nearly 3% gain in the Morningstar Mid Core Index. Historically low interest rates, strong demand and tight supply for new homes, and consolidation among mom-and-pop developers continued to push stocks such as  D.R. Horton ,  Lennar , and  Pulte Homes  higher. Oil and gas services stocks, such as  B.J. Services  and Smith International , also benefited as high oil and natural gas prices improved the prospects for new exploration and drilling.

Small Core
A mixed bag of stocks helped propel the Morningstar Small Core Index to a more than 3% gain through March 16. Financial-services stocks, such as insurer Fremont General , savings and loans New Century Financial  and Indymac Bancorp , and money manager  Affiliated Managers Group , made prominent contributions. In a sign of the times, InVision Technologies , a maker of an explosive-detection system used in airports, was one of bogy's best performing stocks with a more than 45% gain.

Large Value
The Morningstar Large Value Index put up a respectable 1.5% gain for the quarter. Financial-services giants such as the merging J.P. Morgan Chase and Bank One, as well as  Citigroup  and  Washington Mutual  led the field. Securities firm  Lehman Brothers , which is well-known for its bond business, rose as its efforts to build its equity business bore fruit. Major energy companies, such as  ExxonMobil (XOM) and  ConocoPhillips (COP), benefited from high oil prices.

Mid Value
The Morningstar Mid Value Index was the top-performing benchmark of the quarter with a 3.6% gain through March 16. An eclectic mix of stocks served as the bogy's impetus.

Retailer  J.C. Penney  rose as it made progress in the fourth year of a five-year plan to overhaul its department-store operations. The retailer also said it would sell its Eckerd chain of drugstores.  Simon Property Group (SPG), which controls nearly one third of the best malls in America, rose as low interest rates, tax cuts, and high levels of cash-out refinancing of home mortgages kept shopping centers busy.

 Monsanto  gained as the European Union considered authorizing the sale of the company's genetically modified corn under a strict new labeling and tracing system. Hospital operator Tenet Healthcare (THC), which faces several federal investigations into its billing practices, as well as a potential liquidity squeeze, was the worst performing stock in the index, losing more than a third of its value.

Small Value
The Morningstar Small Value Index also was among the best performing benchmarks. Financial stocks such as health-care REITs Ventas (VTR) and Healthcare Realty Trust (HR) were among the index's top performers, as were mining firms Stillwater Mining  and Coeur d'Alene Mines (CDE). The miners benefited, respectively, from high prices for palladium and gold.

Conclusion
At the end of the first quarter of 2004, the equity market appeared to be at a crossroads.

Stocks had begun to slip in the waning days of the period as concerns about terrorism, jobs, valuations, and company-specific issues swirled. Despite the retreat, though, stocks still looked expensive. Some outstanding investors, including Warren Buffett,  First Eagle Global's (SGENX) Jean-Marie Eveillard, and the team running  Clipper (CFIMX), currently have significant cash holdings because they believe the U.S. market is pricey.

Here at Morningstar, just about 3% of the stocks covered by our stock analysts currently are undervalued enough to have 5 stars (the equity star rating is awarded based on a combination of a stock's business risk and discount to fair value). As the end of the quarter neared, Morningstar's market valuation graph also indicated stocks were overvalued, particularly those with narrow or negligible economic moats (meaning those companies with little or no sustainable competitive advantage).

Given the environment, investors would do well to exercise caution going forward. In the first quarter, no one sector or industry dominated the performance of the Morningstar indexes, and it paid to be selective. Expect more of the same in the future.

It also isn't too late for investors to rebalance their portfolios. With interest rates at historic lows and poised to increase, the decision isn't as simple as trimming stock exposure and adding to bond holdings. Nevertheless, it's probably a good idea to rein in bets on lower-quality small- and mid-cap growth equities, and reallocate money to issues with more attractive valuations further up the market cap and quality spectrum, and even overseas.