First Quarter in Stocks: Energy Rules the Roost

After an exuberant rise in 2004's fourth quarter, the U.S. stock market was stifled in 2005's first quarter by high energy costs, inflation fears, and higher interest rates. For the year to date through March 28, 2005, Morningstar's U.S. Market Index was down 2.79%.

Investors found little to cheer about during the period. Borrowing costs increased after the Federal Reserve, concerned about inflation, hiked interest rates twice during the period. The U.S. dollar also remained weak.

But one of the biggest drivers of performance was high oil and gas prices. While high energy costs have spelled trouble for parts of the market, record-setting crude oil prices have fueled strong earnings growth at many energy companies and sent their stocks up sharply. The average energy stock posted a double-digit gain for the period, outperforming other sectors by a wide margin.

Big gains among energy stocks also help explain why value stocks outperformed growth during the period. Energy heavyweights such as  ExxonMobil (XOM),  ConocoPhillips (COP), and  ChevronTexaco (CVX)--all prominent members of Morningstar's U.S. Value Index--were among the top contributors to performance in the period. They helped buoy the U.S. Value Index, which declined 1.01% for the year to date through March 28, 2005. The U.S. Growth Index was down 4.95% for the period.

Red-hot energy stocks also helped larger caps outperform smaller caps--a theme that started in late 2004. The Morningstar Large Value Index and Mid Value Index entered the last week of the quarter virtually tied for the best performance among the indexes representing squares in Morningstar's style box. The Large Value bogy was down 0.87% and the Mid Value Index declined 0.40%. Meanwhile, the Morningstar Small Value Index lost 4.29%.

Surveying the Sectors
Of the 12 sectors in Morningstar's database, the energy sector was the first quarter's clear leader. Its 10.66% gain for the year to date through March 28, 2005, far surpassed that of any other sector. Within that peer group, oil and gas products firms, including refinery firm  Valero Energy (VLO), led the way, but drillers and more-diversified exploration-and-production companies also did well.

Utilities, another sector sensitive to high energy prices, came in a distant second with a 1.17% increase. Within that group, the formerly distressed Texas utility  TXU  came up big, as did  Duke Energy (DUK).

The remaining sectors finished the period in the red. Financials stocks struggled, with the average name down 5.11% for the period. Although some of the asset managers and investment banks posted respectable gains, higher interest rates dampened returns for banks. But it was regulatory and Congressional scrutiny that hurt mortgage-buyer  Fannie Mae (FNM), which posted a 22.6% loss and was one of the sector's worst performers for the year to date.

As was the case for much of 2004, technology stocks resumed their downward slide in the first quarter. The software sector brought up the rear, losing 9.37% on average, in large part due to a slump in  Microsoft (MSFT) shares. The hardware sector also struggled as optical equipment companies and contract manufacturers had a particularly tough time.

Industry Returns
Energy-related industries topped the performance lists for the first quarter, with some of the largest gains going to the oil and gas products, oil and gas, and oil and gas services industries. But other commodities-driven industries also performed well in response to a strengthening global economy. Coal companies, for example, gained 9.08% on average, with  Peabody Energy  among the top performers. The steel/iron industry was also a top performer, with firms such as  Nucor (NUE) posting solid results.

Among the worst performing industries was online retail, which dropped 32.04% for the period.  EBay (EBAY), the online auctioneer, was to blame for much of that decline. The company's shares dropped 38.3% on concerns that the firm's growth rate is starting to slow. Automakers also had a tough quarter, losing 8.42% of their value on average.  General Motors (GM) announced during the period that its earnings wouldn't meet Wall Street's expectations, due mainly to light demand for its trucks, and that news weighed heavily on the whole group.

Conclusion
Many of the trends that proved difficult for stocks in the first quarter will likely continue through much of 2005. The Federal Reserve has signaled that it will continue to raise interest rates, and oil and gas prices have remained high due to robust worldwide demand. We've also seen few signs of a significant uptick in corporate technology spending, which would give a shot in the arm to many lagging technology stocks.

Beyond those larger macro trends, it's also worth noting that Morningstar's stock analysts think the market remains largely overvalued. Just 61 stocks of the 1,530 on our coverage list are rated 5 stars as of March 28, 2005, indicating we think they're significantly undervalued. What's more, 383 stocks receive just 1 star, indicating they're trading far above our analysts' estimates of the stocks' fair values. In the energy sector, which has run up considerably in recent months, just two stocks receive a 5-star rating. Thus, those looking for compelling buys have relatively few options, in our view.