Our Take on the Third Quarter

Although the powers that be have yet to officially decree it, the third quarter will likely represent the end of the recession. A year after the collapse of Lehman Brothers sent credit markets into a tailspin, the economy seems to have finally found its bottom and is now trying to dig itself out of a deep hole. Huge challenges remain with respect to employment, debt levels, and deficits, but the worst appears to be over, and the market largely seems to have shrugged off any concerns. The Morningstar U.S. Market Index rose 15.7% over the last three months through Sept. 29, bringing the year-to-date return to 21.6%.

Small-cap stocks once again outperformed the broader market, rising nearly 22% in the quarter compared with 21% for mid-caps and about 14% for large caps. With 30%-plus returns for the year through Sept. 29, small caps and mid-caps are outpacing large caps' 18% return by a decent margin.

Slicing the market by our economic moat rating provides further evidence that smaller and lower-quality firms have been driving the rally this quarter. Over the last three months, wide and narrow moat stocks have returned 11.3% and 16.9% respectively, versus a 23.3% return for no-moat stocks.

The quarter was also marked by an apparent rekindling of greed in the marketplace as evidenced by the rebirth of both the IPO and merger-and-acquisition markets. The volume of IPO offerings exploded in the last three months, with over $5.5 billion raised versus around $2.3 billion in the entire first half of 2009. Notable offerings included health-care revenue and payment cycle solutions provider Emdeon , tech start-up LogMeIn , and the first pharma IPO in roughly 2 years, Cumberland (CPIX). There were also several notable S-1 filings, including Dollar General and Banco Santander Brasil, that we expect to go public in the coming months.

Mergers were also in the news as several firms launched aggressive bids to expand their businesses. Among many other deals,  Kraft (KFT) made an offer to buy  Cadbury  that could end up being valued at $20 billion,  Dell  bought IT services provider  Perot Systems  for $3.9 billion, and  Baker Hughes  bought  BJ Services  for $5.5 billion. Most of these acquisitions were financed with cash on hand or stock, and they generally represented large premiums to the target firms' pre-deal trading prices. Management teams clearly are gaining confidence in the economy and are willing to deploy their capital in ways that would have been unthinkable earlier this year. This is in contrast to the M&A boom at the end of the bull market, which was fueled more by cheap debt than by strategy.

Surprising no one, the Federal Reserve held interest rates steady in the quarter at a target range between 0% and 0.25%. Although the Fed sees stabilization in the economy, it believes a loose monetary policy will be needed for some time and has no plans to raise interest rates anytime soon. The 10-year Treasury rate now stands at around 3.3%, down from 3.5% at the start of the quarter.

Commodity prices slipped in the quarter. The Morningstar long-only index fell 2.23% over the last 13 weeks and is off almost 24% over the last twelve months.

 

Sectors and Industries
Some of the sectors that had been the hardest hit by the downturn saw the best returns this quarter. Media led the way in the quarter posting a 39% return for the trailing three months through Sept. 29. The sector is up a staggering 72% for the year to date. Performance was driven by huge returns from firms such as  McClatchy  (+430% for the trailing three months through Sept. 29),  Gannett (GCI)(+213%), and  Martha Stewart Living Omnimedia  (+111%). The market seems to have decided rumors of "old-media's" demise were greatly exaggerated. Our equity analysts are still unsure and think that many of these names will end up being long-term value traps.

Financial services also had a good quarter, advancing 31% for the trailing three months through Sept. 29. Fear seems to be lifting from the sector as banks are able to raise private capital and wean themselves off government support. A broad spectrum of firms contributed to the rise, including international bank  ING Group (ING) (+68%), credit card firm  Capital One Financial (COF) (+58%), REIT  Vornado (VNO)(+47.3%), and  Citigroup (C) (+56%). Despite these big gains, the financial sector is still in the red over the last year.

Health care finished near the rear this quarter with a 14% return. Much of this underperformance can be traced to uncertainty surrounding health-care legislation that has wound its way through Washington over the last three months. The sector ebbed and flowed as Congress weighed different options for reform. Our analysts have taken an in-depth look at what reform could mean for different types of firms, and they generally believe that the impact of any legislation will be relatively minor for most companies.

Among the best-performing industries this quarter were newspaper publishers, music and video stores, major airlines, and resorts & casinos (up 87%, 57%, 57% and 56%, respectively, for the trailing three months through Sept. 29). One of the common threads here is that these are industries heavily tied to the fate of consumer spending. So far, the consumer has been the weak link in the economic recovery. As other economic metrics begin to improve, consumers seem very reluctant to open their wallets. Some market observers, such as PIMCO's Bill Gross, think that lower consumer spending is a permanent phenomenon and that we need to prepare for a "new normal." However, at the moment, the stock market seems to be validating the thesis that as the rest of the economy improves, consumers will once again splurge on travel and other non-essential items.

The industries with the quarter's worst performance are a more diverse lot including regional investment brokerages (-13%), nonmetallic mineral mining (-8%), auto parts stores (-5%), and savings & loans (-4%). These sectors are at the bottom of the table this quarter for a myriad of reasons, ranging from lower commodity prices to a pullback from strong performance in previous quarters. Of our nearly 100 industry groups, only seven posted negative returns for the trailing three months through Sept. 29.

Overall, our analysts believe that the market is essentially fairly valued. However, there is quite a bit of spread between high- and low-quality firms. Wide moat stocks look to be 12% undervalued while no moat stocks appear to be around 11% overvalued. There are currently  51 stocks bearing our highest rating of 5 stars. This diverse group of firms includes health-care names such as  Abbott Laboratories (ABT),  Becton Dickinson (BDX), and  Covidien ; energy stocks  ExxonMobil (XOM) and Energy Transfer Partners ; and consumer services companies like  Kroger Company (KR) and  Jack In The Box (JACK). Even though the market as a whole does not look as attractively priced as it once was, investors still have plenty of options to buy high-quality firms at a discount.

This article has been corrected since original publication. Click here for details.