Third Quarter in Stocks: Volatility Returns to the Markets

Subprime mortgage worries and a general real estate meltdown led to volatility and a "repricing of risk" in the financial markets during the third quarter of 2007. In other words, investors reconsidered their previous attachment to speculative stocks and low-rated bonds, sending their prices down and effectively demanding greater yields, or returns, from them in relation to safer instruments. Still, the Morningstar US Market Index finished the volatile trailing 13 weeks through Sept. 25 with a modest gain of 1.4%, and it remains up a healthy 8.7% for the year.

Volatility didn't visit all stocks equally. While mortgage companies like  Countrywide  endured breathtaking plunges, despite a capital injection from  Bank of America (BAC), non-financial large-cap stocks generally outperformed their small- and mid-cap brethren for the trailing 13 weeks through Sept. 25. The Morningstar Large Growth, Large Core, and Large Cap indexes finished in the top six diversified slots, posting modest gains. By contrast, the Morningstar Small Value and Mid Value indexes, the darlings of the past few years, brought up the rear, shedding 7.0% and 6.6%, respectively, for the trailing 13 weeks.

The repricing of risk was also apparent in the bond market, as investors piling into high-quality bonds drove the Lehman Brothers US Aggregate Bond Index up 2.8% for the trailing 13 weeks through Sept. 25. The yield on the U.S. 10-year Treasury note settled at around 4.5%, down from about 5.2% in mid-June, as investors sought the safety of lending to the government. (Because bonds offer a fixed coupon, their yield--the coupon rate as a percentage of the price of the bond--shrinks as bond prices rise.) The popularity of Treasuries also caused the Merrill Lynch U.S. High Yield Master Index, an index of low-rated corporate bonds, to post a modest 0.12% loss for the quarter.

The increased difficulty of borrowing money along with a crippled housing market encouraged the Federal Reserve to decrease the discount rate twice during the third quarter and the federal funds rate by a surprising 50 basis points on Sept. 18. Still, Fed Chairman Ben Bernanke remains concerned about inflation, especially as energy prices continue to skyrocket, and investors are far from certain about the Fed's future moves.

Notwithstanding the surprising magnitude of the September cut, the rising cost of borrowed capital has put a damper on the takeover frenzy that characterized the first half of 2007. Additionally, although it's unusual for agreed-upon takeovers to wind up collapsing, the buyouts of  PHH Corp. ,  Genesco (GCO), and  Sallie Mae (SLM) currently remain uncertain as a result of tighter credit.

Still, capital-flush financiers and investors such as Carl Icahn and Warren Buffett remained mostly quiet for the quarter, with Icahn taking a stake in software company  BEA Systems  and encouraging the firm to put itself up for sale. Morningstar analysts like BEA's business model, but think the firm is currently fairly valued. Analyst Justin Fuller, by contrast, thinks Buffett's firm,  Berkshire Hathaway (BRK.B), is currently cheap, and views the conglomerate, with its massive cash hoard and Buffett's legendary track record of capital allocation, as an attractive hedge in a declining stock market.

Surveying the Sectors and Industries
The tightening of credit caused distress in financial stocks. The financial-services sector dropped 0.63% for the trailing three months through Sept. 25, but many banks, brokers, and real estate firms suffered worse. Mortgage lender Countrywide shed a whopping 51% for the trailing three months on concerns that it had engaged in more subprime lending than previously thought. Nevertheless, analyst Erin Swanson thinks the embattled firm is prepared to  weather the storm because of its leadership position in the mortgage origination and servicing businesses, with a considerable scale advantage in servicing.

Many large and super-regional banks also suffered because of mortgage concerns. However, Morningstar financials analysts have judged the stock price declines to be overreactions in many instances. Consequently, Morningstar ETFInvestor editor Sonya Morris thinks financials ETFs  KBW Bank (KBE) and iShares Dow Jones US Regional Banks (IAT) are currently undervalued based on Morningstar fair value estimates for the funds' underlying holdings. KBW Bank contains large multinational banks such as  J.P. Morgan (JPM) and  Citigroup (C), while the iShares ETF contains many super-regional banks such as  US Bancorp (USB),  Washington Mutual (WM), and  BB&T (BBT), all of which currently trade in 4- or 5-star territory.

If financials suffered, the credit crunch left industrial materials and technology stocks virtually unharmed. Industrial materials rose 11% for the trailing three months through Sept. 25, and, showing that it can thrive in uncertain times, the hardware sector also surged ahead 11%. In industrials, mining concern  BHP Billiton  added 29% for the trailing three months. Analyst Mark Taylor has awarded the firm a narrow moat for its wide range of commodities, including many metals and a full suite of energy products, and its proximity (in Australia) to the Asian markets that are driving the commodity boom. The firm currently trades significantly above Taylor's fair value estimate, however.

In technology,  Texas Instruments (TXN) failed to keep pace with its hardware cousins, dropping 2% for the trailing three months, but it's consequently trading far enough below analyst Erik Kobayashi-Solomon's fair value estimate to put it close to 5-star territory. Kobayashi-Solomon thinks that the chipmaker's recent move to diversify its revenue stream and customer base is a good one for long-term investors, and that short-sighted traders are unjustifiably disappointed. He also awards the firm an A for stewardship.

Among the industries, online retail surged 23% for the trailing three months through Sept. 25.  Amazon.com (AMZN) added 36%, though analyst Joseph Beaulieu remains skeptical of the firm's current valuation. Beaulieu has factored in triple-digit returns on invested capital over the long term, but he still can't find the long-term profit support for the stock's current valuation.

Homebuilders again brought up the rear, dropping 33% for the trailing three months through Sept. 25.  Lennar (LEN) shed 40%, as housing inventories continue to build up and sales slow down. Analyst Eric Landry still believes the firm is going to be one of the long-term winners in homebuilding, but he recently put the stock under review as the company's book value continues to deteriorate while losses pile up from continued inventory impairments and option write-offs.

Morningstar Newsletter Portfolios

Morningstar StockInvestor
Telling the same story as the Morningstar indexes, Morningstar StockInvestor's two portfolios showed the surge of growth over value. The Tortoise Portfolio dropped 5.5% for the third quarter through Aug. 31, while the Hare Portfolio shed only 1% for the same time period. Both portfolios have handily outpaced the S&P 500 Index's 35% cumulative return since their inception on June 16, 2001; the Tortoise has returned 91%, while the Hare has returned 61%.

Editor Paul Larson didn't make any major moves in the Tortoise in the third quarter, but he highlighted his position in  American Express (AXP) in a recent issue, touting its "closed-loop" network, which allows Amex to control an entire transaction with one of its cards instead of splitting merchant fees, processing fees, interest fees, and the customer relationship with others. American Express currently trades in 5-star territory as the market worries about a slowdown in consumer spending.

In keeping with the credit card theme, Larson added  Discover Financial (DFS) to the Hare Portfolio. Like American Express, Discover operates a closed-loop network, issuing proprietary cards, extending loans to cardholders, and acquiring transactions from merchants. However, Discover's network is inferior to Amex's. Its cards are less accepted, cardholders use their Discover cards less, and the firm has fewer cards outstanding. These weaknesses amount to the firm having less power to charge merchants higher discount fees on each purchase. Still, the card has a solid brand name and a network that Larson thinks would be difficult to duplicate.

Morningstar DividendInvestor
The Dividend Builder Portfolio rose 1.2% for the third quarter through Sept. 12, while the Dividend Harvest Portfolio shed 5.2% during that period. Although the Builder Portfolio's financial holdings struggled, some of the large-cap consumer products stocks, such as  Diageo (DEO), kept the boat steady. Editor Josh Peters has taken the opportunity to add REITs as they've declined dramatically over the summer. One new addition is  Developers Diversified Realty (DDR), a mall-REIT that Peters thinks can boost its dividend 7% annually.

In the Harvest Portfolio, specialty lenders  CapitalSource  and  Municipal Mortgage & Equity (Muni Mae) (MMA) struggled in the subprime morass. Peters thinks that neither company has subprime exposure, and both are suffering temporarily from a kind of unfair guilt by association. Peters anticipates that CapitalSource will not only survive the current crisis, but will also be in a position to cherry-pick the most credit-worthy borrowers at fat margins. Additionally, he thinks that Muni Mae will benefit from a housing bust, as the affordable housing developments it finances will be more in demand.

Morningstar GrowthInvestor
In the Growth Portfolio, editor Toan Tran didn't pick up  Starbucks (SBUX), as we had speculated last quarter, but he put some of his $30,000 cash hoard to work in two new names, including  Isilon Systems . Isilon is a network storage provider like  EMC , but it stores digital content and large files exceptionally well. Isilon's business model also allows customers a "pay as you grow" platform, so they can add new storage modules as they need them. The likelihood that firms such as MySpace and  Comcast (CMCSA) will require more and more storage capacity for audio and video files is high, according to Tran and analyst Rick Summer. Finally, although technology by itself rarely constitutes a moat, Summer thinks Isilon has successfully differentiated itself from the competition, and storage systems impose onerous switching costs on customers. Once you have a storage system for your Web site, you'd probably rather have a root canal than rip it out.

Tran continues to sit on $24,000, ready to make more moves as opportunities arise.