Our Take on the Second Quarter

The second quarter began as the first quarter ended--with stocks soaring--but the torrid run appears to have stalled since late May, and the markets have leveled off for the rest of the quarter through June 29. Altogether, the Morningstar U.S. Market Index added 15% for the trailing 13 weeks and is up 5% for the year.

Smaller was distinctively better in the second quarter, as the Morningstar Small Cap Indexes added between 21% and 22% for the trailing 13 weeks through June 29. The mid-cap indexes added between 16% and 20% for the quarter, while the large-cap indexes were the laggards with gains in the 9%-15% range. Value didn't seem to have an edge over growth. The leading components of the small-cap core index that raced higher were a diverse group, including Internet infrastructure firm  Brocade Communications , organic grocer  Whole Foods Market , clothing retailer  Chico's FAS , and personal smart phone maker  Palm .

Still the Morningstar Large Growth Index leads all the other style box indexes for the year, with a gain of 17%, belying the notion that the market's surge has been a "junk rally." In fact, all the growth indexes remain at the top of the heap for the year. While some consumer products stocks, such as  PepsiCo  (PEP), haven't done much, many other components of the growth indexes, such as  Microsoft (MSFT),  Apple (AAPL),  Google (GOOG),  Qualcomm (QCOM), and  Schlumberger (SLB) are up over 20% for the year. Investors have particularly taken a liking to technology stocks, whose balance sheets are generally very solid.

Although the government's Public-Private Investment Program hasn't gotten much traction yet, the markets seem to have taken comfort from it. The markets also took the bankruptcies of General Motors  and Chrysler mostly in stride, and shrugged off congressional hearings starring Ken Lewis, CEO of  Bank of America (BAC), and Federal Reserve Chairman Ben Bernanke and regarding the question of government pressure in the acquisition of Merrill Lynch by Bank of America.

Near the end of the quarter, the Federal Reserve remarked that it will maintain the target range for the federal funds rate of 0% to 0.25% percent, which also provides a measure of confidence. The discount rate, the interest rate charged to commercial banks and other depository institutions on loans they receive from the Fed, remains at 0.5%. However, bond investors sold off Treasuries, elevating interest rates on the 10-year Treasury, perhaps in anticipation of inflation. The 10-year now yields around 3.5%, up from around 3% at the beginning of March. Bonds offer fixed coupons, which represent greater or lesser percentages of what investors are willing to pay for them. Investors are increasingly willing to pay less for the fixed coupons guaranteed by the U.S. government.

Commodities' performance also revealed investor fears of inflation. The Morningstar Long-Only Commodity Index rose 14.8% for the trailing 13 weeks through June 29. The index is up 11% for the year.

 

Sectors and Industries
Although commodity prices surged, the energy sector's 20% rise made it one of the laggards for the trailing three months through June 29. Although  Petro-Canada  rose 38% on news that it would be purchased by  Suncor (SU),  ExxonMobil (XOM) was roughly flat while some natural gas producers declined a bit.  Range Resources (RRC), for example, slid 2% over the trailing three months. Oil and gas "majors" ExxonMobil,  Chevron (CVX), and  ConocoPhillips (COP) are all trading below Morningstar equity analysts' fair value estimates. Chevron is in 4-star territory, while ExxonMobil and Conoco have 5 stars, meaning their discounts to our fair value estimates are bigger and that they represent better bargains, according to our analysts.

Financial services led the way among sectors, with foreign banks and real estate concerns boosting returns.  Barclays PLC (BCS) rose a whopping 86% for the trailing three months through June 29. Meanwhile Shun Tak Holdings , a Hong Kong conglomerate with real estate interests, rose 88%. Embattled credit card firm  American Express (AXP) also rose 63% (and is currently the Dow's biggest gainer for the year to date), but it still trades far below Morningstar analyst Michael Kon's $54 per share fair value estimate at its current price of around $23.

Among industries, some of the most prosaic led the way. Plastics, paper, real estate, auto parts, and rubber products rose 102%, 100%, 65%, 61%, and 52%, respectively. In real estate, Florida land company  St. Joe (JOE) rose nearly 62% for the three months through June 29. At its current price of around $27 per share, it still trades well below Morningstar analyst Anthony Dayrit's $50 fair value estimate. That discount is enough to put the stock in 4-star, but not 5-star territory, because St. Joe is a difficult company to value. It's mostly a real estate development company that owns 600,000 acres of land in the Florida panhandle and concentrates on selling entitlements. (For more on St. Joe, see our recent interview with Bruce Berkowitz of Fairholme Fund, which is a major owner of St. Joe shares.)

Among the worst industries were title insurance, biotechnology, data processing, and agrochemical, which dropped 19%, 17%, 15%, 11%, respectively, for the trailing three months through June 29. Title insurer  First American (FAF) lost 3% for the quarter, and trades in 4-star territory now at around $26 per share. Morningstar analyst Jim Ryan thinks the company is worth $40, though his fair value uncertainty rating is high.

In agrochemicals,  Monsanto  lost over 11% for the quarter. Morningstar analyst Ben Johnson has awarded this leading producer of seeds and herbicides a wide moat rating and thinks the stock is worth $134 per share, or about 80% more than its current $75 share price. Johnson's uncertainty rating is medium, meaning he has a reasonable degree of confidence in his fair value estimate, making this stock worth a look for long-term investors.

Overall, Morningstar's entire coverage universe is about 8% undervalued as of June 29, meaning the market isn't a distinct bargain, according to our Market Valuation Graph. However, within that universe, we think that wide-moat stocks are around 22% undervalued. Fifty-eight stocks currently garner Morningstar's coveted wide-moat rating and trade in 5-star territory, including  3M (MMM),  Abbott Labs (ABT), American Express,  Automatic Data Processing (ADP),  Berkshire Hathaway (BRK.B),  Cintas (CTAS),  Home Depot (HD),  Intel (INTC),  Johnson & Johnson (JNJ), Microsoft,  Procter & Gamble (PG), and  Vulcan Materials (VMC). The market has surged, but investors can still build a diversified portfolio of wide-moat stocks trading at reasonable prices.