Third Quarter in Stocks: Low Expectations Rule

Welcome to the brave new world of low expectations.

Although the market enjoyed brief periods of optimism during the third quarter, caution has generally been the word of the day. Many investors have been sitting on the sidelines ahead of the November elections, waiting until the votes are counted before putting too much equity money on the line.

The economic outlook has been mixed, as well. On the plus side, inflation seems to be a less imminent threat than it was a few months ago; although oil prices remain historically steep at close to $50 per barrel, prices on other goods have been rising at a relatively temperate pace. Economic news has generally been positive, with jobs growth accelerating in August and most other economic measures holding steady. The Federal Reserve has continued to gradually step up interest rates, implementing widely anticipated hikes of 25 basis points in both August and September. But nagging concern about the sustainability of the recovery has kept the market from surging ahead. High-profile earnings warnings from former consumer stalwarts such as Coca-Cola (KO) and Colgate-Palmolive (CL) have also weighed on investors’ minds. As a result, Morningstar's U.S. Market Index has dipped 0.85% for the quarter to date through Sept. 17, 2004. For the year to date, the benchmark has gained just 3%--a far cry from the double-digit gains enjoyed in 2003’s market rebound.

Continuing the trend of the past few quarters, value stocks have fared better than their growth counterparts, with Morningstar's U.S. Value Index gaining 3.28% for the quarter to date through Sept. 17, versus a 6.09% loss for the U.S. Growth Index. Commodity-driven sectors such as energy and utilities have pulled ahead, but steep losses on tech stocks have kept the growth index in negative territory for both the quarter and the year to date. Style was the biggest influence on returns during the third quarter, but size played a role as well. Morningstar's Large Cap Index lost 0.54% for the quarter to date through Sept. 17, compared with a 2.58% loss for the Small Cap Index. Returns for each of the nine indexes in the Morningstar Style Box followed a consistent pattern, with value stocks consistently outperforming growth and larger-cap stocks edging past small issues. The Large Value Index was the top performer for the quarter, gaining 3.94% through Sept. 17, while the Small Growth Index pulled up the rear with an 8.39% loss.

Among individual stocks, ExxonMobil (XOM), General Electric (GE), and Verizon Communications  (VZ) were among the biggest positive contributors to the U.S. Market Index. Technology bellwethers such as Intel (INTC), Cisco Systems  (CSCO), and Hewlett-Packard (HPQ) were negative contributors, as were beverage giants Coca-Cola and PepsiCo (PEP). Pharmaceutical leader Pfizer (PFE), which ranks as the fourth-largest holding in the index, also suffered a modest loss as investors worried about slowing revenue growth.

Surveying the Sectors
With commodity prices soaring, it's no surprise that the energy sector was the best performer among Morningstar's 12 economic sectors, gaining 7.96% for the quarter to date. Big integrated oil companies such as ExxonMobil, BP  (BP), Total (TOT), and ChevronTexaco (CVX) continued to post higher share prices during the quarter. China-based energy companies such as PetroChina Company  and China Petroleum & Chemical  enjoyed double-digit share-price gains thanks to continued economic growth in China, and oil-services companies such as Varco International  and Transocean (RIG) have also continued to benefit from rising share prices. Failed Russian oil giant Yukos  was one of the few big share-price losers in the energy sector for the quarter.

The telecom sector was a close second with a 7.47% gain for the quarter to date. Wireless communications companies such as Nextel Communications  have continued to suffer as they've grappled with intense price competition and continuously shifting new technologies. However, stocks of most diversified telecom companies and foreign telecom players have performed relatively well.

The utilities sector was another relatively strong performer, gaining 6.07% for the quarter to date. Companies such as Exelon (EXC), Southern (SO), and Duke Energy (DUK) have benefited from a generally favorable regulatory environment, while international utilities such as Korea Electric Power (KEP) and Companhia Energetica de Minas Gerais (CIG) have been buoyed by strong economic growth abroad.

On the negative side, the hardware sector suffered a painful loss of nearly 13% during the third quarter, driven by concerns about slowing IT spending. Shares of Intel, Cisco Systems, and Hewlett-Packard all suffered double-digit losses during the quarter. Conditions in the hardware sector were so poor that almost all of the major stocks in the sector dropped lower for the quarter; handset equipment maker Qualcomm (QCOM) was one of the few exceptions.

The pain wasn't as severe in the software sector, but that sector still qualified as the second-worst performer for the quarter through Sept. 17. The sector's three biggest stocks--Microsoft (MSFT), Oracle (ORCL), and SAP (SAP)--all drifted lower during the quarter.

Industry Performance
At the industry level, real estate stocks continued to surge ahead, with the average stock in the industry gaining about 15% through Sept. 17. Home building stocks such as KB Home (KBH), Pulte Homes (PHM), and Ryland Group  have also been strong performers, generating a 12.32% gain for the quarter to date. Thanks to rising commodity prices, the steel/iron industry also continued to enjoy a strong run in the third quarter.

Chip stocks are notoriously volatile, and the downside of that volatility was painfully evident in the third quarter. The semiconductor, contract manufacturing, and semiconductor equipment industries all suffered deep losses for the quarter, falling well below the prices reached in 2003's market runup. All told, slightly more than half of Morningstar's 129 industry groups finished the quarter with losses.

Style and Cap Indexes
Morningstar U.S. Value Index: +3.28%
The U.S. Value Index was the only style-based index to finish the quarter with positive returns (as of Sept. 17). Because investors have generally shied away from pricier stocks, the Value Index has also been the top performer so far in 2004. Energy stocks--including ExxonMobil, ChevronTexaco, ConocoPhillips (COP), and Occidental Petroleum (OXY)--were among the biggest positive contributors to returns. Financials, such as Bank of America (BAC) and J.P. Morgan Chase & Co.  (JPM), also chipped in decent gains during the quarter. With the exception of Altria Group (MO), DuPont , and Bristol-Myers Squibb (BMY), most of the weaker stocks in the index occupied relatively small positions, thereby minimizing the damage.

Morningstar U.S. Core Index: -0.02%
The U.S. Core Index—which contains stocks that share both value and growth characteristics—dipped slightly into the red for the quarter to date through Sept. 17. Perhaps not surprisingly for a blue-chip bogey, there weren't any dramatic moves among the top holdings stocks in the index, with most finishing the quarter with either modest losses or modest gains. Holdings in financial services and industrial goods generally contributed modest gains for the quarter. On the negative side, the index has virtually no exposure to surging energy stocks. A few technology stocks, such as IBM (IBM) and Hewlett-Packard, also dragged on returns.

Morningstar U.S. Growth Index: -6.09%
The U.S. Growth Index continued to trail the other two style-based indexes by a wide margin during the third quarter. There were plenty of winners reminiscent of last year's bull market run, with stocks such as Qualcomm, Yahoo! , eBay (EBAY), and Biogen IDEC (BIIB) all contributing returns that were well into the double digits. But for the most part, the more heavily weighted stocks in the index saw their share prices sink. Top 10 holdings such as Intel, Cisco Systems, Coca-Cola, and Viacom  all dropped well into the red for the quarter through Sept. 17.

Morningstar Large Cap Index: -0.54%
After taking the lead in the second quarter, the Large Cap Index continued to hold up relatively well during most of the third quarter as investors sought refuge in bigger, more reliable stocks. Because small-cap stocks surged ahead in the earlier stages of the economic recovery, the Large Cap index still lags by a considerable margin over the trailing three-year period. ExxonMobil, General Electric, Verizon Communications, and ChevronTexaco were the most significant positive contributors to index returns. With most investors still relatively cautious, however, a greater number of stocks had negative returns. Health care, consumer stocks, and big tech names such as Intel and Cisco Systems all helped pull the index slightly into negative territory for the quarter to date.

Morningstar Mid Cap Index: -1.33%
Continuing the trend shown in the past few quarters, mid-cap stocks generally finished the quarter with middle-of-the-road returns, lagging a bit behind large-cap names but faring better than the market's smallest stocks. Mall real estate investment trust Rouse  was the biggest contributor to returns for the Mid Cap Index; the stock's price surged more than 40% thanks to a bid from General Growth Properties , which agreed to pay a healthy premium over the previous market price. Perennial turnaround candidate Eastman Kodak  was another positive contributor to returns; the stock gained about 18% during the quarter as it seemed to make some progress on its plan to shift to digital photography. Some of the biggest negative contributors to performance were health-care stocks and beleaguered semiconductor stocks, including National Semiconductor , KLA-Tencor (KLAC), and Micron Technology (MU).

Morningstar Small Cap Index: -2.58%
The Morningstar Small Cap Index remains the top performer of the three size-based indexes for the trailing three-year period, but it slipped behind as investors sought refuge in more stable, large-cap names in the third quarter. Rising interest rates have also been a negative, as smaller companies are often valued based on expectations for cash flows many years into the future. While energy stocks and other commodity-sensitive fare performed well in the small-cap arena, smaller-cap stocks in hardware and telecommunications suffered as companies pulled back on investing in new IT projects.

Fund Categories vs. Benchmarks
Even though active management is supposed to prove its mettle in weaker markets, it proved to be another tough quarter for active managers: The returns of the average mutual fund fell behind those of the relevant style-based benchmark for seven of Morningstar's nine style-based categories. Active managers were able to acquit themselves best in the small growth category, where the average fund posted a loss of 5.66%, compared with an 8.39% loss for the Small Growth Index. The average small growth fund currently holds roughly 4% of its assets in cash, which helped mitigate some losses during the quarter. Many small growth managers also benefited from going light on hardware, software, and health-care stocks relative to the benchmark index, a decision that helped them sidestep some losses during the quarter. Large growth funds, where the average fund lost 3.87% versus a 6.49% loss for the index, told a similar story.

But the picture was less impressive in other categories. In the large value category, for example, the average fund fell more than 3 percentage points behind the benchmark index. One major factor behind that shortfall: The average large value fund has a far lower stake in the financial services sector than the benchmark index, which hamstrung returns as most financial stocks continued to churn out above-average returns. Large blend funds—which currently hold more than $800 million in fund shareholder assets—slipped behind the benchmark index by about 1.8 percentage points, partly because of the impact of expenses. In addition, most funds have more-diversified portfolios compared with the composition of the index, which contains a 10% stake in top holding General Electric.

Conclusion
If there's a bright side to this year's choppy market, it's that equity valuations have declined to somewhat more reasonable levels. Thanks to generally strong earnings growth and lower stock prices, the Morningstar U.S. Market Index currently trades at about 23 times trailing earnings—down from about 27 at the end of 2003. In aggregate, the median stock in our coverage universe now trades at about a 5% premium to our analyst-driven fair value estimate, down from a 7% premium at the end of the second quarter. About 6% of all stocks rated by Morningstar currently earn ratings of 5 stars.

While that suggests that there's still room for continued compression in equity valuations, investors can still find reasonably priced stocks if they're willing to do a bit of digging—and ride out any short-term volatility in the market.