Fasten-Seatbelt Sign Lights Up in Second Quarter

Fears of inflation and uncertainty regarding the sustainability of corporate profits led to a market sell-off late in the second quarter. Volatility rudely imposed itself on investors accustomed to calm after the end of the bear market in 2002. All Morningstar diversified equity indexes posted losses for the trailing 13 weeks through June 22, and the Morningstar U.S. Market Index shed 4.3% over the same period, but still managed to eke out a gain of about 1% for the year to date. Once again, smaller-cap and more value-oriented indexes are outperforming for the year, posting gains for 2006 despite second-quarter losses.

Macroeconomic questions gripped the markets, as new Federal Reserve Chairman Ben Bernanke appears poised to raise rates at least one more time as of this writing, precisely as the economy appears to be slowing. Investors fear the Fed tightening too hard, sending the economy into a recession. They also fear a return of "stagflation" from the 1970s, when rising prices (partly due to higher energy costs) and a slowdown visited the economy simultaneously.

There seemed to be no place to hide, with foreign markets also declining, the Lehman Brothers Aggregate Bond Index falling over 1%, and the Dow Jones-AIG Commodity Index dropping from nearly 190 at its peak in May to below 170 on June 22. However, large, slow-growing companies weathered the swoon rather well. The Morningstar large-cap indexes held up the best during the bloodletting of the past month, with the small-cap indexes bringing up the rear.

This didn't catch Morningstar analysts completely by surprise. First, Morningstar's director of stock analysis Pat Dorsey reported on April 21 that a variety of factors pointed toward investor complacency and the inexpensiveness of high-quality stocks. Second, mutual fund analysts have been hearing from their favorite managers that high-quality large-cap stocks haven't looked this cheap in a long time, and fund analyst Gregg Wolper reported that world stock fund managers had noticed topnotch U.S. companies selling at more compelling prices than their foreign counterparts.

The domestic-foreign debate continues, however, with Warren Buffett telling shareholders of his company,  Berkshire Hathaway (BRK.B), not to be surprised if he follows up his recent acquisition of Israeli metal-cutter Iscar with other foreign purchases. Buffett also picked up shares of integrated oil company  ConocoPhillips (COP), industrial conglomerate  General Electric (GE), and package carrier  United Parcel Service (UPS), all of which share the theme of global operations, according to analyst Justin Fuller.

Surveying the Sectors
Media dragged itself up off the mat, posting a 2.4% return for the trailing 13 weeks through June 22. The worst five-year performing sector, media bounced back to the satisfaction of Morningstar analysts, who have viewed newspapers and other media enterprises as cheap for some time.  Tribune , owner of newspapers, radio and television stations, and the Chicago Cubs baseball team, surged 12.8% for the trailing three months through June 22 on pressure from the Chandler Trusts, which are 12% owners, to spin off the television-broadcasting assets. Analyst Jim Walden anticipates increasing pressure for the spin-off, and views Tribune as currently undervalued.

Media conglomerate Liberty Global (LBTYA) powered 12.4% higher for the trailing three months through June 22, while cable companies  Comcast (CMCSA) and  Cablevision  added over 20% each. Analyst Michael Hodel notes that Comcast has been signing up Internet access customers at a fast clip without yet showing signs of pricing pressure from the competition. Some of the cable providers' main rivals, the RBOCs (regional bell operating companies), also dialed up their returns.  Qwest Communications International  tacked on 8% for the trailing three months through June 22 and is up 33% for the year, while  BellSouth  added about 4% during the quarter and is also up 33% for the year. Still, the RBOCs face an uphill battle, according to Morningstar analysts, because of huge capital outlays to deliver video, a declining landline business, and competition among themselves and with the cable providers and voice over Internet protocol (VOIP) technology.

Software brought up the rear, dropping 10% for the trailing 13 weeks through June 22 and more than 5% for the year to date.  Salesforce.com (CRM) dropped about 25% during the quarter and is down 14% for the year. Analyst Rick Summer likes the company's subscription-based software model, but views the firm as roughly fairly valued at its current price. Additionally,  Microsoft (MSFT) continues to struggle, with the delay of the release of its new Vista program. Morningstar fund analysts have heard conflicting opinions on Microsoft. Some managers are frustrated by the company's delays and its unwillingness to give more cash back to shareholders, while other managers are content to let the heavy cash-generating business continue to invest in other ventures. Equity analyst Toan Tran views the software giant as significantly undervalued at its current price under $23.

Industry Performance
Along with cable TV, business/online services, and mining, the hotel industry was among the best performing during the quarter, advancing about 5.5% for the trailing 13 weeks through June 22 and adding to powerful gains for the year. A shortage of hotel rooms and increased travel have driven prices and profits up for companies such as  Four Seasons ,  Starwood , and  Hilton .

While hotels enjoyed surging stocks, homebuilders suffered the hardest share price declines, with the category shedding 27% for the trailing 13 weeks through June 22.  Centex  dropped about 24% over that period and 32% for the year to date.  Hovnanian (HOV),  Pulte (PHM), and  DR Horton (DHI) all experienced similar swoons as investors anticipate lower housing activity given higher interest rates. Morningstar stock analysts Arthur Oduma and Eric Landry, factoring in a slowdown, view these companies as undervalued and solid long-term buys. They all sit on Morningstar's 5-star stock list currently.

Style and Market Cap Indexes
Morningstar US Value Index: -2.0%
Continuing a multiyear trend, value outperformed growth for the quarter. The Morningstar US Value Index dropped 2% for the trailing 13 weeks through June 22, though it maintained a 4.6% gain for the year to date. The energy-heavy index got a boost from integrated oil company  Chevron (CVX), which jumped about 4.5% during the quarter and is up 5.1% for the year. Other energy components ConocoPhillips and  ExxonMobil (XOM) were flat and down 5%, respectively, for the trailing 3 months through June 22, though up about 6% and 4% for the year. ExxonMobil sports a "wide moat" rating from stock analyst Justin Perucki for its high returns on capital and operational efficiencies due to its size. Perucki thinks the stock is worth $75 per share, making it a bargain at its current $58 price.

The Morningstar US Value Index carried a heavy weighting in financials, which rose modestly for the quarter.  Citigroup (C) and  Bank of America (BAC) posted gains of 2% and 3%, respectively, for the trailing three months through June 22, despite the uncertainty of interest rates and inflation. Both stocks are modestly undervalued, trading in 4-star range--below Morningstar analysts' fair value estimates but not quite cheap enough to make them the best candidates for purchase.

Morningstar US Core Index: -4.5%
The Morningstar US Core Index dropped 4.5% for the trailing 13 weeks through June 22, though it maintained a 1.3% gain for the year. Industrial component General Electric continues to flounder, shedding 2% for the trailing three months and nearly 4% for the year to date. As mentioned above, Warren Buffett recently picked up shares of the venerable industrial, and Morningstar analysts have given it a "wide moat" designation and praise the capital-allocation abilities of its executives--an obviously crucial skill set for managers of a conglomerate.

The index's second-largest component  Wal-Mart (WMT) is finishing the quarter flat, maintaining its 4.3% gain for the year through June 22. This seemingly slow-growth stock is actually still growing sales at 10%, according to stock analyst Joseph Beaulieu, and it has found its way into value portfolios, given its historical or relative cheapness. Beaulieu awards the giant retailer a wide moat for its high returns on invested capital and unparalleled distribution system, and he views the stock as undervalued at its current $48 price.

Morningstar US Growth Index: -6.7%
Once again, growth lagged its core and value counterparts, shedding 6.7% for the trailing 13 weeks through June 22 and nearly 4% year to date. Besides Microsoft's extended floundering, the index's second-largest component,  Johnson & Johnson (JNJ), has continued to trade at historically low valuation multiples. The stock gained a modest 1% for the trailing three months and 3% for the year. The growth index is heavy with biotechnology firms, and components  Genentech  and  Amgen (AMGN) suffered 11% losses each for the trailing three months. They are also down 17% and 18% for the year to date, respectively. The decline, however, has put Amgen into 5-star territory. Stock analyst Karen Andersen praises the company's oncology pipeline and its share-repurchase program.

The US Growth Index remains the second-worst for the trailing three- and five-year periods (behind the Morningstar Large Growth Index). Investors will have to wait longer for growth stocks to rebound after their dismal performance during the bear market (2000-02).