Our Take on the Fourth Quarter

With the gloom that overhung the economy at the end of last year, few were predicting that 12 months later the Dow would be flirting with 10,500 and that the economy would be stable and looking to grow again.

Without a doubt, the risk of a double-dip recession, another sharp market pullback, or extended unemployment are very real, but the economy has made impressive progress over the last year and the last quarter. The Morningstar U.S. Market Index rose about 7% over the last 13 weeks bringing the year-to date return to 29%.

For the trailing 13 weeks through Dec. 30, large-growth and mid-cap stocks led the way, advancing 10.7% and 7.5%, respectively, according to Morningstar's stock indexes, reversing a recent trend of small-cap outperformance. For their part, small caps rose 6% over the last 13 weeks. For the full year, small and mid-caps both boasted 40% returns compared to 26% for large-caps.

In the fourth quarter, investors returned to high-quality firms once again, sending wide-moat firms up over 8% while, narrow and no-moat firms were up 6.6% and 5.25%, respectively. This one quarter of outperformance was not enough to change the trend for 2009: No-moat firms handedly outperformed, rising almost 50% compared with a 35% rise for narrow-moat firms and a 20% increase for wide-moat companies.

The IPO market continued to gain traction in the fourth quarter after being awakened last quarter following a long slumber. Notable offerings including  Hyatt Hotels Corporation (H), solar power firm STR Holdings (STRI), RailAmerica , and cardiovascular device player AGA Medical .  Time Warner  also completed its spin-off of  AOL . Many other firms took advantage of the buoyant equity markets to issue secondary offerings to raise capital.

The M&A wave made a big splash in the quarter with several large deals.  ExxonMobil (XOM) agreed to buy  XTO Energy  for $41 billion in an effort to expand into the unconventional natural gas space. Warren Buffett deployed some of his cash hoard as  Berkshire Hathaway (BRK.B) spent $44 billion to buy railroad  Burlington Northern . Drama surrounding  Kraft's (KFT) potential purchase of  Cadbury  continued in the quarter as Kraft took its appeal directly to Cadbury shareholders. Several smaller deals, like  Stanley Works' (SWK) $4.5 billion purchase of  Black & Decker  rounded out the quarter in dealmaking.

The Fed kept interest rates at exceptional low levels in a target range between 0% and 0.25%. The Fed continues to see improvement in many sectors of the economy, but concerns about the sustainability of the uptick have led it to declare that interest rates will remain low for an extended period of time. The 10-year Treasury rate stands at around 3.8%, up from 3.3% at the beginning of the quarter.

Commodity prices rose in the quarter. The Morningstar Long-Only Commodity Index was up about 7% over the last 13 weeks.

Sectors and Industries
Nearly all Morningstar stock sectors clocked in positive returns for the quarter. Software was the leader with a nearly 20% gain. A wide range of software firms led the sector to strong gains in the quarter, including  IMS Health  (+38%),  Wipro (WIT) (+25%), and  Salesforce.com (CRM) (+30). The market is betting that improved corporate spending will boost the IT space as firms invest in technology. Our analysts think that although spending is likely to improve, Mr. Market is being overly optimistic. Currently, both Wipro and Salesforce.com are rated 1-star. (Click here for our tech and telecom sector outlook.)

Media once again had a good quarter, as beaten-down old media stocks continued to bounce off their early 2009 lows. The sector gained 10% in the quarter. Newspaper stocks like  New York Times (NYT) (+55%) and  Gannett (GCI) (+20%) did well, as did book publishers like  Scholastic (SCHL) (+26%). Overall, our analyst staff thinks the sector is around 10% overvalued (check out our market fair value graph for this and other valuation data), and many of the newspaper companies, including New York Times and Gannett, are rated 1-star.

Bringing up the rear is financial services, which was the only sector to see a slight loss for the quarter. Some financial firms--such as  American Express (AXP) (+20%),  Simon Property Group (SPG) (+19%), and  PNC Financial (PNC) (+10%)--did well in the quarter. But many of the big banks did not keep up. Concerns over continued consumer credit losses and commercial real estate exposure dragged down share prices.  Citigroup (C) (-31%),  Bank of America (BAC) (-11%), and  Goldman Sachs (GS) (-9%) all had rough quarters. Our analysts think that much of the underperformance is undeserved and that Citi, BofA, and Goldman (and the sector as a whole) are trading for less than their fair value.

The best performing industries this quarter were a motley crew. They include copper (+75%), semiconductor integrated circuits (+53%), online retail (+38%), and TV broadcasting (+33%). Some of these industries, like copper, were driven by higher commodity prices. Others like online retail were boosted by higher consumer spending levels and a further shifting of consumer dollars online.

On the other side of the coin, resorts & casinos (-57%), wineries & distilleries
(-38%), regional investing brokerages (-36%), money center banks (-31%), communication equipment (-23%), and dairy products (-22%) had less rosy quarters. Many of these industries are directly tied to consumer spending and consumer credit. It is possible that the market decided that these stocks had come back too quickly considering the potential headwinds consumers face in the coming years.

Taking a look at the entire market, our analysts believe stocks are basically fairly valued at the moment. Check out our new market fair value graph to see the price/fair-value ratio for all sectors, industries, moats, and uncertainty ratings.

There are currently  about 30 stocks with our highest, 5-star rating, down from 51 at the start of the quarter. This group includes health-care stocks  Novartis  and  Stryker (SYK), consumer stocks  Lowe's (LOW) and  International Speedway , and utility  Exelon (EXC). The bounty of bargains investors could choose from at the beginning of the year is gone, but there are still some decent choices out there for patient investors.