Markets Draw Toward the End of a Brutal Year

Investors are anxious for the year to close on one of the most brutal markets in history, which has rendered Wall Street's landscape nearly unrecognizable. All of Morningstar's diversified equity indexes declined precipitously during 2008, with the Morningstar U.S. Market Index down 39.3% for the year through Dec. 26.

In general, the growth categories trailed the value categories, but not by much. The mid-growth index posted the worst return, with a breathtaking 48% skid for the year to date. Large-cap categories did somewhat better than their mid-cap and small-cap brethren, with the Morningstar Large Core Index posting the smallest loss (-33.8%). As Morningstar mutual fund analyst David Kathman noted in a recent Morningstar article, it appears as if investors are according the greatest favor to larger, well-capitalized companies that have durable competitive advantages (or "moats") and can sustain themselves with their own free cash flow.

Credit markets remain tight as the government's plan to buy up low-quality mortgage assets from banks has morphed into a strategy to recapitalize them through preferred equity purchases. Additionally, the Bush Administration underwrote a bridge loan ( ) to the embattled Big Three U.S. automakers. Finally, Federal Reserve Chairman Ben Bernanke has lowered interest rates dramatically ( ) in an effort to jump-start the economy. The Fed has targeted 0%-0.25% for the Federal Funds rate, or the rate at which banks lend to each other. The discount rate, the rate at which banks may borrow from the Fed, is now 0.50%. Still, lending remains tepid.

Bonds of all stripes, with the exception of Treasuries, got clobbered as investors demanded to be paid more for assuming higher risk. In recent years, spreads (the difference in yield between a safe Treasury note and that of a riskier bond, such as a high-quality corporate) had been narrow. Investors had bid up the prices of the riskier debt until the fixed coupons were such small percentages of the new higher prices that they barely exceeded the yield of Treasuries. However, 2008's flight to quality punished Morningstar's high-quality corporate indexes, regardless of maturity, sending them down around 4% for the year through Dec. 26. Meanwhile, Morningstar Treasury Indexes added anywhere between 8% and 22%, depending on maturity length. It's difficult to say if Treasuries are in bubble mode, but Morningstar mutual fund analysts have heard many fund managers marvel at what they think are the cheapest corporate bond prices in their careers.

In this environment, investors' preference for businesses that don't require debt has smashed REITs (real estate investment trusts), which carry debt to grow because they must pay out their earnings as dividends. REITs are down around 40% for the year through Dec. 26, roughly in line with the market, but coming off the heels of a 20% decline in 2007. Investors had sought REITs and other firms with "hard assets" fervently after the technology bubble imploded, and they even held up well for most of 2008 as interest rates were cut, but their need for debt finally caused the market to crush them in the early fall and has made them go from post-technology bubble heroes to credit crisis goats in eight years.

Finally, oil and commodity prices tumbled in the last few months of the year as a result of slackening global demand. Oil went from over $140 per barrel to less than $40, while the DJ-AIG Commodity Index, a broad-based index composed of energy, agricultural products, and metals, plummeted from nearly 240 in July to around 113 on Dec. 29.

Brutal markets often spur good investors to activity. Not uncharacteristically, Warren Buffett counseled long-term investors to start buying stocks in an October New York Times OpEd piece, indicating that he had sold all his U.S. Treasury holdings in favor of stocks in his personal accounts. Similarly, Morningstar's 2,000-stock coverage universe appears nearly 30% undervalued, with stocks garnering a wide-moat designation appearing even slightly cheaper than that.

Sectors and Industries
Fearful stock investors fled consumer services and health care less than other sectors, causing them to lead their peers but still post losses of 15.8% and 17.0%, respectively, for the year through Dec. 26. This is a classic recession pattern, as investors assume that consumers have to continue to buy food and medicine regardless of economic conditions. Fast food eateries  Panera Bread  and  McDonald's (MCD) rose 40% and 7% for the year, respectively. They are apparently the beneficiaries of worried consumers trading down from casual and fine dining. Additionally, pharmaceutical firms  Valeant (VRX),  Genentech , and  Celgene  surged 84%, 23%, and 17%, respectively.  Abbott Labs (ABT) shed 4%, but trades close to our consider buying price in 4-star territory.

Industrials and hardware were the worst-performing sectors, plunging even harder than financial services and posting year-to-date losses of about 42% each through Dec. 26. Metals and mining firms such as  Freeport-McMoRan Copper & Gold (FCX) and  United States Steel (X) plunged 77% and 70%, respectively.  Ingersoll-Rand (IR),  Rockwell Automation (ROK), and  General Electric (GE) also struggled with 63%, 54%, and 55% losses for the year to date. All three stocks trade in 5-star territory according to Morningstar equity analysts.

Among hardware,  Texas Instruments (TXN),  Dell , and  Apple (AAPL) each dropped by 56%-57% through Dec. 26, as fear about sluggish orders and growth weighed. All three narrow-moat firms are trading in 5-star territory. Texas Instruments, maker of analog chips and processors found especially in handheld communications devices, has a P/E of below 10 and assets/equity of well over 50%, meaning it would have satisfied legendary investor Ben Graham as an opportunity to buy earnings cheaply along with a strong balance sheet. The stock currently trades in 5-star territory at around $14 per share, well below analyst Dan Su's $27 consider buying price.

No industries posted gains for the year. The best were title insurance, discount stores, and waste management, which posted losses of 0.15%, 0.99%, and 1.52%, respectively, through Dec. 26. Title insurer  Fidelity National Financial (FNF) completed the acquisition of a division of bankrupt competitor LandAmerica. Morningstar equity analyst Jim Ryan thinks Fidelity paid a bargain price and that the move should help it dominate its market in the future. Still, given the stock's 27% run this year, it is currently trading in 3-star territory.

The worst industries were radio, aluminum, and gambling/hotel casinos, which posted losses of 96%, 72%, and 71%, respectively, for the year through Dec. 26. Slot machine maker  International Game Technology  has swooned 75% for the year. However, the firm has earned a wide-moat designation from Morningstar's equity analysts for its economies of scale and the regulatory requirements of the industry, which present barriers to entry. The stock's five-year average P/E is nearly 30, and its current price of around $11 per share means it's trading at around 10 times trailing earnings, making it look tempting. However, analyst Bradley Meeks has a high uncertainty rating on the stock, given how cyclical the casino business is and the uncertainty regarding the length and depth of the current economic downturn. This means there is a large spread between Meeks' $15 fair value estimate and his consider buying price of $6.