Our Take on the First Quarter

The ride back in the equity markets from the bottom more than three years ago now has been volatile and nerve-wrecking and looked at times ready to completely stall out. There is still plenty of uncertainty about the path of the recovery and plenty of potential pitfalls in the road ahead, but you wouldn't know by looking at returns in the first quarter. Positive economic data and stabilization in Europe sent stocks almost nowhere but up. Continuing from a strong fourth quarter, the broad-based Morningstar U.S. Index rose 12.5% during the last 13 weeks and is up by more than 9% during the last 12 months and by an annualized 24% during the last three years.

Economic data from the U.S. looked solid in the first three months on the year. As Morningstar's Bob Johnson puts it, the U.S. appears to be on a path of "slow but steady growth." The marquee news came from the employment market. Strong private-sector job growth was seen across the economy, the unemployment rate came down, and more workers are feeling confident enough to quit their jobs voluntarily. Retail sales also looked promising in the quarter. On the downside, news on the all-important housing market remained mixed, and the rising price of gas threatened to slow the economy.

The European sovereign debt crisis stabilized during the last three months. After some tense negotiations, Greece was able to secure another round of bailout financing and avoid a disorderly default by convincing private bondholders to take a big haircut and by passing further austerity measures. The European Central Bank's plan to pump liquidity into the banking system via three-year loans, launched in 2011, also proved a salve to the crisis. Still, many of the underlying issues remain, and the crisis looks poised to rear its head throughout the year.

Corporate earnings reported in the quarter remained fairly robust as firms mostly continued to expand profitability and produce respectable cash flows. Morningstar's vice president of global equity and credit research Heather Brilliant expects continued fundamental corporate growth as a result of pent-up demand for hard goods and sturdy corporate balance sheets. 

The largest IPOs in the quarter came from industrial firm Allison Transmissions  (ALSN) and payment processor Vantiv . However, most of the buzz in the market was centered around the filing of the Facebook S-1. The social-network firm's debut expected in May looks poised to be one of the largest Internet company offerings of all time. 

Sector-by-Sector Performance
Every stock sector posted gains in the first quarter. Technology led the pack with a 23% gain, followed closely by consumer cyclical stocks which were up 20%. Financial services (up 19%), industrials (up 14%), and real estate (up 13%) also were up by double digits. Utilities had the weakest performance (up 5%) with communication services (up 8%) and health care (up 9%) being the next worst performers.

Unsurprisingly when even the worst performing industry is up by more than 5%, valuation levels look much more full now than they did just three months ago. Still, seven of 11 sectors are trading at or below our estimates of their fair value, and our analyst staff is "still finding opportunities, particularly among more economically sensitive sectors."

Technology was the strongest performer among domestic-equity funds with a 21% return. Financial-services (up 18%), consumer cyclical (up 17%), and miscellaneous (up 17%) were the next strongest categories in the quarter. Utilities brought up the rear, gaining only 1.4% in the first quarter.

International-stock funds also had a strong quarter; as a group, they were up nearly 13%. Latin America stocks led the way gaining 16% with foreign small/mid value (up 16%) and foreign small/mid growth (up 15%) trailing right behind. China-region funds had the worst quarter, but they were still up by more than 10%.

Fixed-income funds had posted less eye-popping performance numbers. Taxable bond funds rose 3% in the quarter, while municipal-bond funds were up 2.5%. Emerging-markets bond funds had the best quarter, rising by more than 7%, while long-term government funds (down 3%) were the only fixed-income category to record a loss.

All in all, investors in almost every corner of the market are going to be happy when they rip open their quarterly statements. But is this kind of growth sustainable?  Given current valuation levels, it seems unlikely that there will be too many more quarters where the broad equity market is up more than 10%. And the uncertainty that made 2011 such a wild year very much remains in the marketplace. The developed world is still figuring out how to handle its debt hangover, growth concerns keep popping up in China and elsewhere, and elections across the globe could have a big impact on investors. This year has certainly started with a bang, but investors looking for peace and quiet in the market are unlikely to find it in 2012.