Our Take on the First Quarter

The stock market rally does not want to quit. It has certainly slowed down, but as we pass the one-year mark of the market's low point, investor sentiment continues to be buoyant even as pundits wring their hands about unemployment, sovereign debt worries, commercial real estate, and runaway cars.

As Morningstar's Bob Johnson points out, some of this optimism is well grounded in the improving fundamentals of the economy. Consumers are out there spending despite the unemployment rate, and the business investment cycle looks set to turn. Although risks to the recovery clearly remain, it appears to be approaching a point where it is self-sustaining.

The Morningstar U.S. Market Index rose 5% over the last 13 weeks ending March 29, and is now up over 49% over the last 12 months. Stocks in all parts of the style box gained in the quarter with small-cap value and small-cap growth leading the way with 11.5% and 9.8% gains, respectively. After a small break in the fourth quarter, small caps are once again outperforming their large brethrens. The small-cap index was up 8.7%, mid-caps gained 7.6%, and large caps brought up the rear with a 1% increase.

Investors preferred lower-quality no-moat stocks in the quarter, keeping up the trend that we've observed throughout the entire rally. No-moat stocks gained 9.9% over the last three months, while narrow- and wide-moat firms were up 5.4% and 2.6%, respectively, over the same time period.

In M&A news, activity remained strong as increasingly confident firms looked to expand or roll up industries.  Kraft (KFT) raised its offer for Cadbury to finally seal the deal for the British confectioner. Oil services firm  Schlumberger (SLB) agreed to acquire rival Smith International for $11 billion. And  Coca-Cola Company (KO) followed in  Pepsico's (PEP) footsteps and decided to bring the North American operations of its largest bottler, Coca-Cola Enterprises, under its roof.

The IPO market remained open in the first quarter. The largest issues were for Sensata Technologies (ST), which raised $550.8 million, and Symetra Financial , which raised $364.8 million. We're keeping an eye on the upcoming IPOs of private equity firm KKR and financial-services firm Envestnet. (Full disclosure: Envestnet is a competitor of Morningstar).

Throughout the quarter, sovereign governments dominated much of the news. Concerns emerged over Greece's ability to meet its obligations, and there was fear that instability in Athens would have a ripple effect throughout the Eurozone. In the United States, debate over health-care reform raged, with a bill finally being signed into law near the end of the quarter.

The Federal Reserve again held core interest rates steady at close to 0% and indicated that it would continue to do so for an extended period. The central bank did note that conditions in the economy were improving and the board of governors raised slightly the discount rate that the Fed charges banks for short-term loans. The 10-year Treasury rate stands at around 3.9%, up slightly from the beginning of the quarter.

Commodity prices fell in the quarter, with the Morningstar long-only commodity index falling 5% over the last 13 weeks.

Sectors and Industries
All but three sectors finished the quarter in positive territory. Financial services led the way with a 10.3% gain. The sector was lifted by an array of firms including the  Royal Bank of Scotland (RBS) (+42%),  SunTrust  (+28%),  BB&T (BBT) (+27%),  Barclays (BCS)(+26%), and  Berkshire Hathaway (BRK.A) (BRK.B) (+24%). The financial sector was the worst performer in the fourth quarter, so some of the outperformance is due to starting the year at a lower point. As most banks continue to pay off government support and start making money again, the memory of the credit crisis is fading and investors may be finding the sector increasingly attractive.

As the market for advertising picks up and consumer spending leaves the basement, media firms, many of which were left for dead, have been gaining steadily. The sector had another quarter near the top of the performance tables with a 9.4% gain. The outperformance was driven by good showings by TiVo  (+67%),  Entercom Communications (ETM) (+63%), and  Liberty Media  (+57%). However, our analyst staff believes the runup has come too far, and that the sector as a whole is around 12% overvalued. (Check out our market fair value graph for this and other valuation data).

Utilities were the worst performer in the quarter, losing 5%. At the rear of the pack were  RRI Energy  (-35%),  Mirant Corporation  (-28%) and  Ormat Technologies (ORA) (-27%). Utility stocks were hurt in the quarter by falling commodity and energy prices, bearish earnings outlooks as firms reported earnings, and a generally negative view of the future of electricity demand.

The top-performing industries of the quarter are a motley crew including resorts & casinos (+136%), toy & hobby stores (+42%), and life insurance (+30%). Other than resorts, major airlines (+22%) and hotel REITs (+22%) also cracked the top 10 industries, showing that investors may be betting that consumers are getting ready to travel again. On the flip side, reinsurance (-58%), trucking (-48%) and music & video stores (-47%) were the worst performers in the quarter.

Stepping back and looking at the entire market, our analysts currently believe that stocks are slightly overvalued at the moment. Check out our market fair value graph to see the breakdown by sector, industries, moats, and uncertainty ratings.

Even though the market as a whole might look more than fully valued, there are still  30 stocks with our highest 5-star rating--the same number of 5-star firms we had at the start of the quarter. The group includes health-care stalwarts like  Abbott Labs (ABT) and  Genzyme , energy companies like  ExxonMobil (XOM), and telecom firms like  Sprint Nextel . There may not be as many buy options as there were a year ago, but long-term investors can still find some values.