The Year in Review

Liquidity and credit woes stemming from heavy issuance of subprime mortgages continue to wrack the financial markets as 2007 draws to a close. Financial and retail stocks are among the most battered, as investors worry about firms requiring large amounts of short-term financing or depending on robust consumer spending. Still, despite a seemingly endless parade of bad economic news and pleas from the financial community to the Federal Reserve for lower interest rates, the Morningstar U.S. Market Index has managed to post a 5.7% gain for the year through Dec. 17.

Federal Reserve Chairman Ben Bernanke has been accommodating with three rate cuts, though certain corners of the market have been disappointed, with their denizens expecting more aggressive attempts at relief. Morningstar financials analyst Rachel Barnard, by contrast, has raised questions about the Fed's ability to influence home prices directly and alleviate the credit crunch generally, as the fed-funds rate appears to be less tied to mortgage rates than it had been previously. (See our related video report.) Bernanke continues to weigh the need for liquidity against the possibility of lower rates stoking inflation.

Credit concerns pushed the value indexes--where financials tend to reside--to the bottom of the performance tables, while the Morningstar Mid-Growth and the Morningstar U.S. Growth indexes led the way in the diversified stock categories, posting 18% and 13% year-to-date gains, respectively, through Dec. 17. Similarly, higher-yielding bonds trailed more credit-worthy government bonds, as investors sought the shelter of credit safety. The Merrill Lynch U.S. High Yield Master II Index rose 2.2%, while the Lehman Brothers U.S. Aggregate Bond Index surged 5.7% for the year. The preference for higher-quality government bonds caused the yield on the 10-year U.S. Treasury Note to decline from about 5.3% at its 2007 peak in June to about 4.2%. (Because bonds offer a fixed coupon, their yield--the coupon rate as a percentage of the price of the bond--shrinks as investors bid up their prices.)

Although the difficulty in securing borrowed capital stymied takeover activity in the third quarter, lower rates seemed to provide some limited renewed confidence in the fourth quarter. In mid-December, industrial manufacturer  Ingersoll-Rand (IR) announced that it would purchase air-conditioner maker Trane for $10 billion, while oil drilling equipment maker  National Oilwell Varco (NOV) said that it would acquire pipe manufacturer  Grant Prideco  for $7.4 billion. Still, the market rewarded strong balance sheets, as Warren Buffett's company  Berkshire Hathaway (BRK.B) surged 30% for the year through Dec. 17. Berkshire announced that it had purchased shares of used car retailer  CarMax (KMX), though Buffett still waits to bag an "elephant"--a large firm on which he can spend $10 billion or more of Berkshire's $40 billion cash hoard.

Surveying the Sectors and Industries
Among the sectors, financials stumbled the hardest due to a slowdown in the securitization of mortgages and fears about the credit quality of existing mortgage-backed securities. The Morningstar Financial Services Index lost nearly 19% through Dec. 17. Top holdings  Bank of America (BAC) and  Citigroup (C) shed 18% and 42%, respectively, as both banks took write-downs to account for loan losses. Analyst Ganesh Rathnam sees excellent value in both banks, which are trading at less than 60% of his fair value estimates. Additionally, ETF analyst Sonya Morris favors the KBW Bank ETF (KBE), which has significant stakes in both banks in addition to positions in other regional and super-regional banks.

Real estate investment trusts (REITs), which get classified as financials, also got slammed, putting an end to their torrid multiyear run. Although apartment landlords like  AvalonBay (AVB) and  Post Properties  still look too expensive to Morningstar's REIT team, analysts Akash Dave and Heather Smith like office-retail landlord  Vornado (VNO) and laboratory space provider  Biomed , respectively. Dave notes that Vornado owns properties in land-constrained areas such as New York City and Washington, D.C., and boasts a terrific management team in Steven Roth and Michael Fascitelli. Dave values Vornado at $120 per share, making it attractive at its current price of $85. Smith applauds Biomed for having achieved expertise in a property type whose tenants impose exacting standards on developers and for its properties in medical research hubs such as San Francisco and Boston. Shares are currently trading right around Smith's consider buying price of $23.

In addition to financials, the media sector suffered, dropping 14% through Dec. 19. Advertising continues to migrate to the Internet, with  Google (GOOG) especially capturing a significant share of ad dollars. Nevertheless, analyst Larry Witt thinks  TimeWarner  is doing a better job of selling off noncore businesses and allocating its capital wisely to higher growth areas such as cable, online publishing, and AOL's advertising platform. Witt expects returns on capital to improve, and thinks the stock is a bargain at its current price of around $16 per share.

Energy and utilities led the way among the sectors, with 31% and 17% gains, respectively. Oil and gas firm  Canadian Natural Resources (CNQ) surged 30%. However, analyst Kish Patel still thinks the stock is a bargain at roughly $70 per share, as his revised oil price estimates range from $86 per barrel to $66 per barrel over the next few years. Oil is difficult to extract from the Canadian oil sands, but a high price justifies the expense associated with extraction.

Among the industries, homebuilding and home supply shed 49% and 30%, respectively, for the year through Dec. 19. Builders such as  Lennar (LEN),  Centex , and  Pulte (PHM) are suffering from a high inventory of homes and from tighter credit standards slowing down potential buyers. Analyst Parrish Glover thinks  NVR (NVR) should weather the storm, given its lack of debt and relatively small inventory of land. Home improvement retailer  Home Depot (HD) has also seen its stock cut by over 30% in 2007. However, analyst Brady Lemos likes the firm's efforts to spruce up its stores and hire more full-time employees. Additionally, Lemos likes the fact that the firm has borrowed about $10 billion in order to buy back stock at what he thinks are cheap prices. The short term could be bumpy, but Lemos values the stock at $44 per share and thinks investors who purchase shares below $30, where they are trading now, will be rewarded.

Semiconductor equipment and agrochemicals were the best-performing industries, surging 135% and 97%, respectively, for the year through Dec. 19. Solar equipment makers such as  First Solar (FSLR), which posted a whopping 700% return for the quarter, led the way for semiconductors. Analyst Jordan Zounis likes the firm's proprietary technology and low-cost manufacturing, but thinks the stock is much too rich at $245 per share. In agrochemicals,  Scotts Miracle-Gro (SMG) trades at around $38 per share, just above analyst Ben Johnson's $35 consider buying price. Johnson likes the firm's new focus on investing in its business, but is dismayed that it took the firm so long to realize that it was trying to keep up with Wall Street growth projections at the expense of profitability. Still, Johnson thinks the strength of the franchise will shine through over the longer term.