Third Quarter in Stocks: A Hot Summer for Stocks

If you enjoyed the market rebound in the second quarter, you're in for more good news.

The stock market continued to add to its first-half gains despite the seasonally slow summer months. The S&P 500 Index posted a 2.3% quarterly gain through September 26, while the Dow Jones Industrial Average gained 3.6%. Technology stocks, which are typically more volatile than other sectors, continued to outperform the broader market. The Nasdaq Composite climbed 10.4% during the quarter, putting the index up 34.2% for the year to date.

Economic news turned brighter during the quarter. The most recent Bloomberg economic survey now shows that economists expect GDP growth of 4.5% and 4.0% for the third and fourth quarters, respectively. Economists cited increased business spending on equipment and inventories as a key driver, along with the recent tax cuts and high productivity. However, the biggest drag on the economy--unemployment--remained steady at 6.1% after peaking at 6.4% in June, further fueling the debate about whether the recovery is sustainable.

Strong stock market performance was tempered by further allegations of corporate fraud, this time involving the mutual fund industry. New York Attorney General Eliot Spitzer announced an industrywide investigation into trading practices at numerous mutual fund families, including Bank of America's Nations Funds, Bank One, Janus Capital and Strong Funds. Also, the forced resignation of New York Stock Exchange chairman Richard Grasso opened the door for further scrutiny of corporate-governance practices, as well as potential changes in trading practices.

Growth stocks have outpaced value stocks so far this year, but investors have been betting on earnings growth that has yet to materialize. Given the strength of the stock market rally since March, stock prices may have run ahead of expected earnings. Another worrisome trend: The gains have been increasingly fueled by margin buying, pushing the Nasdaq margin debt levels up to 1999 peaks.

Surveying the Sectors
Computer-hardware and software stocks, which led the first quarter, continued to post the highest returns in the third quarter. Despite their rich valuations, investors continued to bid up these stocks in the hopes that the long-awaited return of business technology spending has returned. Consumer services stocks also fared well. Recent tax cuts and the mortgage refinancing boom have put money into consumers' pockets, and same-store sales in August were notably strong across many retail segments. Continued consumer spending, now almost 70% of GDP, benefited discount and specialty retailers.

Utilities and energy stocks were the worst performers as a group, posting flat performance for the quarter. The massive East Coast blackout, which left 50 million customers in the dark, underscored the problems with electric utility companies: falling wholesale prices, high capital expenditures, low returns, and regulatory uncertainty. Energy stocks saw oil prices fall after spiking briefly during the war in Iraq; however, oil prices remain above their long-term averages.

Best and Worst Industries
Contract manufacturers, wireline equipment, and semiconductor-related industries were among the best performers in the technology arena. Both  Intel (INTC) and  Texas Instruments (TXN) raised their earnings forecasts during the quarter, but both stocks are now trading at steep valuations. On the other end of the spectrum, media-related industries such as broadcast TV and radio were among the worst performers, each posting losses of 6%.

Stocks covered by Morningstar analysts posted an average return of 13% for the trailing 3 month return as of September 22, with almost 80% of the companies posting positive returns. Because the market has done so well, our analyst staff is wary of stock valuations. More than 25% of our stock coverage list currently receives a Morningstar Rating of 1 star (indicating a stock price significantly higher than our fair value estimate), while less than 2% receive 5 stars.

The best-performing stock covered by Morningstar was  Solectron , up 97% as of September 22. However, Morningstar analyst Fritz Kaegi notes that the company's overhead costs are high, and the current restructuring efforts will be a challenge for the relatively new management team. Other technology hardware companies such as  Advanced Micro Devices (AMD),  RF Micro Devices , and  Sanmina-SCI (SANM) were all in the top 20 performers, but they also all currently carry a Morningstar Rating of 1 star thanks to their lofty valuations and lack of economic moats.

Of the Morningstar-researched stocks,  Level 3 Communications  posted the worst performance, down 30% for the quarter as of September 22. The stock currently carries a Morningstar Rating of 3 stars, despite the big drop in share price. While Level 3 is shedding costs to overcome the tough telecom environment, the company has no economic moat and a considerable amount of debt to manage.

Conclusion
Upcoming earnings releases and guidance for the fourth quarter (and possibly 2004) will determine if the stock market has overshot its mark. While the economy and the stock market appear to have strong momentum, the risk of overpaying for a good company has grown. Because a good company doesn’t always equate to a good stock investment, we think investors should continue to focus on analyzing the fundamentals and buying stocks with a margin of safety.