Second Quarter in Stocks: Markets in a Holding Pattern

As the second quarter drew to a close, the market seemed more inclined to go out with a whimper than a bang.

After the gut-wrenching highs and lows of the past few years, this year’s market has been in something of a holding pattern. Investors have been holding back ahead of a widely anticipated hike in interest rates at the end of June, and rising commodity prices have prompted new worries about inflation. On the plus side, the economic recovery has proved more robust than originally anticipated, with jobs growth well above previous expectations. But the real test of a sustainable recovery lies with bottom-line profits, and investors have been in wait-and-see mode ahead of second-quarter corporate earnings reports due out in July. Add in the normal uncertainty of an election year, plus continued threats of terrorism and political instability in Iraq and other areas of the world, and you’ve got a wall of worry that’s tough to climb. With most of the positives offset with negatives, Morningstar’s U.S. Market Index had a quarterly gain of just 0.29% through June 15, 2004.

With optimism about the economic recovery weighed down with uncertainty, investors sought refuge in larger-cap stocks--reversing the trend from the previous several quarters, when smaller-cap stocks pulled well ahead of their bigger counterparts. Morningstar’s Large Cap Index gained 1.07% for the quarter to date through June 15, while the Morningstar Small Cap Index chalked up a 2.66% loss. Among investing styles, growth stocks generally fared better than value issues, but size generally had a bigger impact on performance than style. Morningstar’s Large Core Index, which gained 2.08% for the quarter through June 15, was the top performer among the nine style indexes. The Small Growth Index, which tracks the performance of fast-growing small-cap stocks, brought up the rear with a 2.72% loss for the same period.

Among individual stocks, blue-chip names such as Microsoft , ExxonMobil , Johnson & Johnson , and General Electric  were the biggest positive contributors to returns for the U.S. Market Index. While most of these stocks have suffered lackluster returns for the trailing three-year period, recent performance has been stronger as investors have cast favor on big names with relatively predictable earnings. Thanks to the resurgence in online advertising revenue, Yahoo  was another major contributor to index returns. EBay , which has continued to drive revenue growth by expanding into international markets, also contributed gains.

On the negative side, big banks and securities firms--including Citigroup , J.P. Morgan Chase , Morgan Stanley , and Goldman Sachs --suffered from worries about rising interest rates and lackluster returns in the equity markets. With several negative legal developments weighing down tobacco stocks, Altria  was another drag on returns for the U.S. Market Index. The stock doesn’t rank as one of the top 10 holdings in the index, but its 11% loss for the quarter through June 15 still made it one of the biggest negative contributors to performance.

Surveying the Sectors
Performance for Morningstar’s 12 economic sectors was mixed for the quarter through June 15, with roughly half of the sectors posting gains and the other half suffering losses. The spike in oil and gas prices has been bad news for consumers filling up at the pump, but great news for the energy sector, which gained 4.36% for the quarter through June 15. Even though smaller exploration and production and services names surged the most because they’re more leveraged to commodity prices, the big integrated oil companies such as ExxonMobil , BP , Total , and Royal Dutch Petroleum , still enjoyed double-digit stock gains for the quarter.

With corporate technology officers willing to open up their wallets to pay for software upgrades, the software sector was the second-best performer for the quarter, posting a 3.79% gain. Chicago-based Midway Games  surged 106% for the quarter as Sumner Redstone snapped up enough shares to become the company’s biggest shareholder, but stodgier software names like Microsoft , Adobe Systems , and Check Point Software Technologies  also fared well relative to the broader market. Database software maker Oracle , on the other hand, drifted about 2.5% lower for the quarter due to skepticism about its plans to buy PeopleSoft .

The strong economic recovery also boosted the business-services sector, which gained 3.05% for the quarter through June 15. Transportation stocks such as Burlington Northern Santa Fe , Southwest Airlines , and Canadian National Railway  were among the top performers in the sector. More traditional business services companies, including United Parcel Service , First Data , and Accenture , also contributed gains.

The financial services sector brought up the rear, posting a 3.47% loss for the quarter through June 15. Investors have continued to fret about the impact of higher interest rates on bank earnings, and the uncertain state of the market has weighed on share prices of securities firms.

With a 3.38% loss for the same period, the utilities sector was another laggard. Many of the bigger stocks in the industry, such as Exelon , Southern , and Duke Energy , were weighed down by regulatory concerns, and there hasn’t been much of a catalyst to drive stock performance for the rest of the sector.

Industry Performance
Drilling down to the industry level, online retail was at the top of the heap with a 14.92% gain for the quarter through June 15. Online auction leader eBay  has continued to thrive thanks to its successful push into international markets, and Amazon.com  has also benefited from stronger trends in consumer spending. Hotel chains were another beneficiary of strong economic growth, with stocks like Marriott International , Starwood Hotels & Resorts Worldwide , and Hilton Hotels  driving a 12.25% gain for the industry. Global unrest and strong economic growth boosted share prices for stocks in the security services industry, which gained 14.42% over the same period. The biggest players in the industry--Brink’s Company , Kroll , and Corrections Corp of America --all posted double-digit total returns for the period. The aerospace and defense industry was another standout for the quarter, with stocks in the industry delivering an 11.72% average gain for the quarter through June 15.

On the negative side, the gold and silver industry’s 20.76% loss made it by far the worst performer for the quarter, as metal prices fell off their peaks from last year’s big runup. Because gold and silver stocks are inexorably tied to commodity prices, only one stock in the industry (tiny Azco Mining , which has a market cap of just $6 million) made it through the quarter with positive returns. For similar reasons, the nonferrous and nonmetals mining industry was another laggard for the quarter, suffering a 13.45% loss. With higher interest rates looming on the horizon and mortgage rates already increasing, investors gave the cold shoulder to the home-building industry, which dropped 15.11% for the quarter, and the retail furniture industry, which dropped 13.21%. Most of the biggest stocks in these two industries, including Lennar , DR Horton , Centex , Bed Bath & Beyond , and Pier 1 Imports , closed out the quarter with losses.

Style and Cap Indexes
The Happy Medium
With investors in a cautious mood, neither growth stocks nor value issues took a decisive lead, although growth stocks generally fared a bit better. But while investors were willing to bid up speculative growth stocks to nosebleed levels in 2003’s market rally, they’ve generally been more circumspect so far in 2004. With so much uncertainty weighing on the market over the past few months, investors were more likely to take refuge in high-quality stocks with solid track records of profitability, good prospects for steady growth, and clean balance sheets. As a result, Morningstar’s U.S. Core Index, which tracks the performance of stocks that combine both value and growth characteristics, was the best performer of the three style-based indexes, posting a 1.02% total return for the quarter to date through June 15.

Morningstar U.S. Value Index: -0.57%
After taking the lead in the first quarter of 2004, the U.S. Value Index fell behind during the second quarter. Financial services stocks were a significant drag on performance because they make up almost 38% of the index’s sector exposure--a much higher weighting than any other sector. Financial conglomerate Citigroup , which has a hefty 6% weighting in the index, was the biggest negative contributor to returns. Other value favorites, such as Altria Group , Fannie Mae , and BellSouth , also put pressure on returns. Energy stocks such as ExxonMobil , ChevronTexaco , and ConocoPhillips  offset some of the damage, but not enough to pull the index into positive territory for the quarter. Adding insult to injury, the index has almost no exposure to software and business services; as a result, it missed out on these stocks’ gains from the economic recovery.

Morningstar U.S. Core Index: +1.02%
The U.S. Core Index finally benefited from the long-awaited market flight to quality after lagging behind its growth and value counterparts in 2003. Top holding General Electric --which accounts for about 7.42% of the index’s value--finished the quarter with a 4.23% gain. Most of the other major names in the Core Index--including Johnson & Johnson , Procter & Gamble , and Eli Lilly --also delivered decent returns. The index’s 24% stake in lagging financial-services stocks pulled down returns, but positions in health care, consumer goods, and industrial goods offset most of the damage.

Morningstar U.S. Growth Index: +0.43%
The U.S. Growth Index was at the top of the heap in 2003’s bull market, but it hasn’t fared as well so far in 2004. The growth bogy lagged the core and value indexes both in the first quarter and for the second quarter through June 15. Several of the bigger tech holdings in the index, such as Microsoft , Intel , and Dell , posted single-digit gains for the quarter, and a number of smaller holdings, including Yahoo , eBay , Zimmer Holdings , and Stryker , were double-digit gainers. Performance for the growth benchmark’s underlying holdings was volatile under the surface, though, with numerous stocks also posting double-digit losses. Tech issues such as Texas Instruments , EMC , Applied Materials , and International Game Technology  weighed down returns for the quarter, as did media names like Viacom  and Clear Channel Communications . While the health-care sector generally performed well, biotech bellwether Amgen (AMGN) and specialty pharmaceutical Forest Laboratories  fell behind.

Morningstar Large Cap Index: +1.07%
It has been a long time since large-cap stocks have had a day in the sun, but that time finally came in the second quarter. After falling behind their smaller counterparts in both the bear market from 2000 to 2002 and the market rebound in 2003 and 2004, the Large Cap Index pulled ahead by a meaningful margin in 2004’s second quarter. Smaller-cap stocks often fare best in economic recoveries, but there’s been enough uncertainty to drive investors to take refuge in bigger, more reliable names. As a result, the Large Cap Index was the only one of Morningstar’s three size-based indexes to post a positive return for the second quarter through June 15. Most of the biggest holdings in the index were solid performers, and with the exception of Citigroup  and Wal-Mart Stores (WMT), most of the laggards occupied smaller positions in the benchmark.

Morningstar Mid Cap Index: -1.3%
Appropriately enough, the Mid Cap Index has generally turned in middling performance for the past several years, and the second quarter was no exception. Midsize stocks were too risky to excel in an uncertain market, but generally held up better than small-cap names. The biggest positive contributor to mid-cap returns was Texas-based energy holding company TXU Corp , which turned in a 28.7% return thanks to an improved financial outlook and deregulation of the Texas energy market in 2002. ImClone Systems  also made a major contribution to benchmark returns, rocketing up by 55.9% and hitting a new 52-week high during the quarter. But there were plenty of negatives to offset the positives. Top-10 holding Juniper Networks (JNPR) dropped 20% on uncertain demand for telecom equipment, and Simon Property Group (SPG) suffered along with other REITs.

Morningstar Small Cap Index: -2.66%
Bigger was better in the second quarter, and the opposite also held true for small-cap stocks. Because smaller companies are often valued based on expectations for cash flows many years into the future, they’re often more sensitive to interest-rate assumptions used for discount rates, so the expectation of higher rates has been a negative. Investors also haven’t been willing to take on the higher volatility often associated with smaller-cap stocks. Smaller-cap stocks suffered across a range of sectors, including technology, financials, health care, and media issues, pulling the index to a 2.66% loss through June 15.

Fund Categories vs. Benchmarks
Active management is supposed to prove its worth in tougher markets, but that maxim didn’t really hold true in the second quarter of 2004. On average, the returns of the average mutual fund fell behind those of Morningstar’s benchmarks for five of the nine style-based categories. Active managers were able to beat the benchmark for the Mid Core, Large Value, Small Value, and Mid Value indexes. The value of active management was most pronounced in the small-value category, where the average mutual fund posted total returns of negative 1.77% for the quarter, compared with a 3.00% loss for the index. The average small-value fund has about 5.9% of its assets in cash, which helped buffer losses relative to the index. In addition, most small-value managers have underweighted financial services stocks relative to the index, a decision that also helped mitigate some losses.

But the bulk of shareholders’ assets are invested in large-cap categories, where performance of active managers was less impressive. The average large-growth fund lagged Morningstar’s index benchmark by about 1.63 percentage points, and the average large-blend fund fell about 2 percentage points behind. This lackluster showing lends more support to the notion that it’s difficult for active managers to add value in widely followed large-cap stocks.

Conclusion
As 2004’s second quarter drew to a close, mixed economic news continued to keep the market in a holding pattern. Many of the portfolio managers we’ve interviewed have expressed a cautious outlook, and a few have taken refuge in cash. Some outstanding investors, including Fidelity’s Joel Tillinghast, the team at Longleaf Partners, Jim Gipson and his colleagues at Clipper Fund, and FPA’s Bob Rodriguez, currently have significant cash holdings because they haven’t been able to find enough cheaply priced stocks.

Here at Morningstar, we’ve also found the market a bit on the pricey side. Our market valuation graph suggests that the average stock in our coverage universe is trading at about a 7% premium to its estimated fair market value. Only about 4% of the stocks in our coverage universe are currently undervalued enough to earn ratings of 5 stars--down slightly from 5% at the end of the first quarter. Thus, we think investors would do well to exercise caution going forward.