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Market Update

First Quarter in Stocks: Equities Still Climbing

Small caps, energy continue their surge.

Stocks picked up in the first quarter of 2006 where they left off in late 2005, posting solid gains in the face of economic uncertainty and potentially setting the stage for a fourth straight year of equity gains following the brutal bear market from 2000 through 2002. All Morningstar diversified equity indexes were higher for the trailing 13 weeks through March 22, as small caps led the way in what is now an all-too-familiar pattern. Those anticipating a rotation to large caps will have to wait a little longer, since investors apparently haven't quite lost their affinity for smaller stocks. The Morningstar US Market Index rose 5.6%.

The market weathered additional debt downgrades and intensified solvency questions for embattled automaker  General Motors (GM), continued weakness in newspaper and traditional media stocks, such as  New York Times (NYT) and  TimeWarner , and even weakness in online search-engine  Google (GOOG), whose meteoric rise had previously been cited as the proximate cause of traditional media's recent swoon. Additionally, weakness in the newspaper industry encouraged  McClatchy  to purchase  Knight Ridder . Newspaper stocks such as  Tribune , New York Times, and  Washington Post (WPO) continue to populate Morningstar's  5-star stock list, and media spin-off  CBS (CBS) also appears undervalued to us. Analyst Jonathan Schrader thinks traditional media is ripe for a rebound, but Google still looks expensive to us.

Although financier Carl Icahn dropped his bid to restructure TimeWarner, influential investor Bruce Sherman encouraged the McClatchy-Knight Ridder merger. Warren Buffett added private company Business Wire to  Berkshire Hathaway (BRK.B).

As media stocks continued to suffer, energy stocks continued to surge, finishing with a 7.0% gain for the trailing 13 weeks through March 22. However, commodity futures prices themselves took a breather. The Dow Jones-AIG Commodity Index dropped nearly 7% for the quarter. Additionally, falling natural-gas prices and revisions by Morningstar's energy analysts to their assumptions placed some businesses in the natural-gas industry, such as  Houston Exploration , in 5-star territory. Despite commodity price declines, fears of inflation, rising rates, and a slower housing market hindered homebuilders.  Beazer Homes (BZH),  Centex ,  Hovnanian (HOV), and  Meritage Homes (MTH) made appearances on the 5-star list. Nevertheless, REITs remained strong, posting a 13% surge to continue their multiyear run.

New Federal Reserve Chairman Ben Bernanke will have to guide a slowdown in residential housing delicately, taking care not to send prices down precipitously as he manages inflation. The Fed's rate-raising campaign had its effect on bonds, with the Lehman Brothers Aggregate Index adding a measly 0.34% for the quarter through Feb. 28.

Surveying the Sectors
The developing world's torrid growth helped industrial-materials stocks lead the way. Cement companies such as Lafarge  and steel companies such as  Nucor (NUE) and  Mittal (MT) rose sharply. Mittal made an appearance on the 5-star list in late 2005 and remained until its recent surge. It's one of the few commodity companies that has earned a "narrow moat" designation from our analysts for its competitive advantages. Stock analyst Scott Burns bases Mittal's moat rating on its global presence and its success in purchasing other companies and mills at bargain prices.

Financials also surged, with Brazilian banks such as  Banco Bradesco SA (BBD) leading the way. London-based  Lloyds TSB PLC (LYG) surged 20% as well, after what analyst Ganesh Rathnam called a "middling" 2005. U.S. investment banks such as  Goldman Sachs (GS) also did well, as mergers, "going privates," and other corporate maneuvers occurred. Analyst Philip Guziec doesn't view the venerable investment bank as particularly cheap now, but he thinks investors should consider the stock if it experiences one of the downturns that are nearly inevitable for a firm whose fortunes are tied to the financial markets.

Industry Performance
Optical equipment makers led all industries with a 34% gain for the quarter through March 22.  Ciena (CIEN), maker of advanced transmission and switching systems for fiber-optic communication networks, surged 65% and  JDS Uniphase (JDSU) powered up 67%. None of these stocks is in 5-star range, but analyst John Slack remarked recently that the demand profile of the industry has improved as telecom service providers seek to expand their networks and range of services. Additionally, recent news of a possible  Lucent - Alcatel (ALA) merger could provide the combined firm a better negotiating stance with its increasingly concentrated customer base, according to Slack.

Online retail suffered, dropping 13%, as  eBay (EBAY),  Expedia (EXPE), and  Amazon (AMZN) showed weakness. The themes here were more varied. For example, eBay's 2006 outlook disappointed Wall Street, additional growth led to compressed margins for Amazon, and Expedia's unanticipated capital expenditures to fend off increasing competition gave investors the jitters. Analyst John Owns recently raised his fair value estimate of eBay, and analyst Sanjay Ayer thinks the market overreacted in sending Expedia down. Both stocks are in 5-star territory.

Radio was the worst performing industry, dropping 14% for the trailing 13 weeks through March 22, just as it did in the last quarter of 2005. Radio content provider  Westwood One  shed 30% after reporting poor fourth-quarter results. Analyst Michael Corty cut his per-share fair value to $15 from $20. He still views Westwood One, currently a 5-star stock, as a leading content provider, but slowing sales growth will be hard to overcome. Moreover, Corty warns investors that an investment here could take a long time to play out.

Style and Market Cap Indexes
Morningstar US Value Index +6.8%
Once again, value beat growth, continuing that multiyear trend. The Morningstar US Value Index added 6.8% for the quarter through March 22, while the Morningstar US Growth Index added 3.3% over the same period. The value index has added nearly 10.5% annually for the trailing five years through March 22, while the growth index has lost 0.2% annually over the same period. Growth certainly looks more stable now, even teasing us at moments into thinking that it has come back into favor, but value's outperformance continues for the time being.

Larger financial components of the index  Citigroup (C) and  Bank of America (BAC) were flat, but oil component  ExxonMobil (XOM) rose 9.3%. ExxonMobil was just added to the Morningstar StockInvestor Bellwether 50, and it is the only energy stock to garner a wide moat rating. As StockInvestor editor Paul Larson puts it, "In an industry where bigger is better, Exxon is the largest, and it can use its massive size to squeeze the most economies of scale from its operations."

Morningstar US Core Index +6.04%
The Morningstar US Core Index nearly matched the value index, surging 6.04% for the quarter through March 22. Top component gains included  Coca-Cola (KO) (+7.0%),  Home Depot (HD) (+7.5%), and  Abbott Labs (ABT) (+12%). Additionally, nearly 24% of the index is in industrial goods firms, many of which tacked on healthy gains. For example,  Rockwell Automation (ROK), maker of industrial process control equipment such as motor starters, relays, and sensors, added 22%. Although we don't consider the stock a buy right now, analyst Eric Landry increased his fair value estimate to $68 per share from $62 in late January. Industrial conglomerate  General Electric (GE), was flat for the quarter, however. This may indicate that the market has been discounting conglomerates and pushing for spin-offs lately. In any case, analyst Tom Goetzinger views GE as fairly valued currently.

Morningstar US Growth Index +3.3%
The Morningstar US Growth Index rose 3.3% for the first quarter of 2006 through March 22. This index is populated with companies growing their earnings at fast clips. Top index component  Microsoft (MSFT) added 4% for the quarter, surging in early March and then falling back on news that the introduction of its Vista software would be delayed. Analyst Toan Tran views the delay as immaterial to his valuation of the business, which is well above the current share price, making Microsoft a 5-star stock. Tran has awarded the software giant a wide moat for its outstanding returns on capital and a Stewardship Grade of A for its adoption of a restricted stock program and its return of excess cash to shareholders.

The second-largest index component,  Johnson & Johnson (JNJ), posted a modest 2% gain for the quarter so far, after halting a swoon dating from mid-2005. The stock is currently trading in 5-star range, and sports a wide-moat rating and a Stewardship Grade of B. Analyst Tom D'Amore views J&J as "a model of consistency and stability" for its steady earnings growth, and director of equities research Pat Dorsey has remarked that J&J has been unjustifiably out of favor due to its refusal to overpay for device-maker  Guidant , making it look like a "loser" in a bidding war with  Boston Scientific (BSX).

John Coumarianos has a position in the following securities mentioned above: HD, MSFT, BRK.B, JNJ, EBAY. Find out about Morningstar’s editorial policies.