Our Take on the Second Quarter

The furious rally from the market's March 2009 lows finally took a breather in the first half of 2010.

Despite some signs that the United States was on track for a self-sustaining economic recovery, concerns about everything from valuation levels to unemployment to the government debt burden kept stock prices in check.

The evidence for the recovery has been building on a few fronts. The first is in the economic data. True, some indicators have been mixed recently: Retail sales have been weaker, employment growth--while still positive--has slowed, and initial unemployment claims remain elevated.

But Morningstar associate director of economic analysis Bob Johnson remains bullish on the economy for a number of reasons, including a manufacturing sector that continues to improve, falling prices in several categories (especially energy), and continuing improvement in the auto sector.

"Industrial production has recovered less than half of what was lost this recession," Johnson wrote. "Inventories, too, are still at record lows in terms of days of sales on hand. It seems to me that there is still a lot of runway in front of us."

Corporate earnings have proved another bright spot. Firms across the spectrum of industries have been blowing analyst expectations out of the water. Some of this upside is from deep cost cuts improving profitability, but first-quarter results in particular also showed resilience in end demand. Consumers and businesses are once again willing to buy and invest, and that is showing up in better-than-expected earnings.

Positive signals are still blinking for industrials, with bellwether  Illinois Tool Works (ITW)--a global firm with 800 businesses in 57 countries--raising its second-quarter forecast in early June. "Things are very, very strong right now through May, and we anticipate them being strong for a while," said Morningstar analyst Eric Landry about the industrials sector. He did caution that growth will have to moderate for industrials at some point, and that some leading indicators were easing, though capital spending still had momentum.

But not all the news is sunny. Although the economy is now creating new jobs, there are still concerns about the stubbornly high unemployment rate and the number of job seekers who have been out of work for months. Job growth could very well be anemic for months or even years, making it that much more difficult to stabilize the housing market and boost consumer spending; people without jobs rarely buy houses or go on shopping sprees.

Sovereign debt concerns also reared their ugly head in the first half of the year. What started off as an isolated worry about Dubai's ability to pay back its loans has blossomed into an international incident. Greece accepted a bailout package, and the European Union enacted a huge fiscal bazooka to keep other members with tenuous fiscal positions, such as Spain and Portugal, off the hot seat. Still, despite these promises, investors remain skeptical of governments' abilities to retire huge amounts of debt without affecting growth rates.

The flash crash shook investors May 6 as the market lost nearly 10% of its value in a matter of minutes only to recover much of the ground late in the trading session. Although the exact cause isn't known, it appears that an errant trade coupled with computerized high-frequency trading let stocks fall even further and faster than anyone expected. Even though human traders stepped in and mitigated some of the losses, the experience was, at best, disconcerting for investors.

Although the market showed resilience through the first quarter, tacking on about 5%, it hit a rough patch in the spring, with the Morningstar US Market Index shedding about 7.17% during the trailing 13 weeks through June 29.

Performance in the first half was uneven across the Morningstar Style Box: Large-cap stocks underperformed their mid- and small-cap brethren. The biggest decliner was large growth, which fell 8.9% during the last 13 weeks through June 29, while mid-growth posted the best return, losing 3.5% during the same period.

Sector returns also varied widely. Hardware and telecom had the best second quarter, falling 1.8% and 2.1%, respectively. Health care and financial services were weak in the quarter, falling 7.6% and 7.2%, respectively.

After the aggregate pause during the last six months, Morningstar stock analysts now think the market is approximately fairly valued. But investors looking for long-term value can still find pockets of opportunities in the marketplace.