Closing Out a Quarter of Troubling News

Tough economic news and continued worries about sovereign debt in the United States and abroad weighed on the market in the second quarter of 2011. The broad-based Morningstar U.S. Index dropped 0.25% during the last 13 weeks ended June 28, 2011. The index is still 4.64% higher on the year and up by more than 24% for the past 12 months.

The phrase "double-dip recession" re-entered the investment lexicon in the quarter after a string of disappointing economic data releases. New figures on employment, housing, manufacturing, consumer spending, and more pointed to a slowdown in growth from not terribly robust first-quarter levels. Although many, including Morningstar's Bob Johnson, see growth picking up in the back half of the year, the data clearly weighed heavily on investor sentiment.

The Greek debt crisis was back in the spotlight during the quarter. Despite severe austerity measures and attempts to raise revenue, it became clear that Greece would not be able to service its debt and that the country would require another round of bailout funds. Major stakeholders from France to Germany to the International Monetary Fund often disagreed on the best course of action to stave off default. They eventually agreed to fund another bailout in return for further austerity measures and other concessions. The plan took the near-term pressure off of Greece but leaves open questions about how to solve the country's long-term insolvency and the potential for the crisis to jump to other countries such as Portugal and Ireland.

Investors showed less concern about the United States breaking through the debt ceiling in May. The Treasury Department is currently shifting funds from other uses and taking other extraordinary measures to keep the federal government from issuing new debt until sometime in August. Congress will have the raise the debt ceiling by then to avoid the potentially disastrous consequences.

IPOs were another big story during the last three months. The high-profile (and high-flying) IPO of social-networking firm  LinkedIn  was the first in an expected line of tech IPOs including Pandora , Groupon, Zynga, and possibly even Facebook by early next year. Other notable IPOs included ZipCar , and McDonald's franchise owner Arcos Dorados (ARCO).

Limited Returns
Stocks lost ground or had anemic returns across the market cap and value-growth axes during the last 13 weeks. Mid-cap stocks fared the best gaining 0.63% while large-cap and small-cap stocks lost 0.5% and 0.18% respectively. Growth equities (up 0.47%) did better than core stocks (down 0.13%) and value stocks (down 1.22%).

Returns among stock sectors were spread widely. Leading the charge was the health care (up 9.64%), consumer defensive (up 6.90%), and consumer cyclical (up 6.03%) sectors. Energy lost the most ground in the quarter falling 5.48% with financial services (down 5.15%) and basic materials (down 1.43) following behind.

Even after the sell-off, our analysts believe that stocks are fairly valued at the moment. Our analysts don't see any "large dislocations between market prices and [their] fair value estimates." Energy appears to be the lone undervalued sector but only slightly so.

After leading the domestic-equity fund category pack in the first quarter, equity energy (down 6.68%) had the worst showing in the second quarter. Natural resources was close behind (down 5.93%) while financials funds lost 5.22%. Health funds did the best in the quarter, rising 9.15%.

The Morningstar Government Bond Index rose 2.70% during the last quarter with the Long-Term Index gaining 4.33% as yields pushed ever lower. The Morningstar Corporate Bond Index rose 2.26% during the last 13 weeks while the Morningstar TIPS Index was up 3.79% for the quarter.

Coming into this quarter, we thought that stocks were more than fully valued. So given the barrage of bad news (an uneven recovery, sovereign debt woes, and so on) it wasn't too surprising to see some weakness in equities during the last three months. Investors will now be watching to see if these issues will be fleeting or if the weakness will continue throughout the rest of the year.

Data as of June 28, 2011.