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Stock Analyst Update

Stocks Weather Stormy First Quarter

Accounting jitters continued amid signs of economic recovery.

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After a rocky 2001 punctuated by the horrors of the September 11 terrorist attacks and the collapse of energy-powerhouse Enron (ENRNQ), the stock market remained jittery in the first quarter of 2002.

Economic and corporate news often sent conflicting messages to the market. Broadband giant Global Crossing (GBLXQ) and retailer Kmart (KM) declared bankruptcy, yet the economy showed signs of recovery. Still, with the exception of the technology sector, all of Morningstar's 10 stock sectors posted gains for the year to date through March 26, 2002. The Dow Jones Industrial Average rose 4% over the same period, the tech-heavy Nasdaq Composite fell 7%, and the S&P 500 index was flat.

Accounting issues came to the fore this quarter, as more details about the nature of Enron's dubious partnerships came to light. Investors began scrutinizing the financial statements of all public companies with a super-critical eye, and blue-chip conglomerates such as General Electric (GE) and Tyco (TYC) faced tough questions about their complex financial structures. With Big Five accounting firm Arthur Andersen fighting for its life after a federal Enron-related indictment, investors seem more nervous than ever about the financial numbers that are the lifeblood of investing.

But amid all this nervousness, there were also some encouraging macroeconomic signs. A variety of positive indicators seemed to show that the U.S. economy is already coming out of its recession. Some pundits have even suggested that the country was never technically in a recession. Regardless of the label you put on it, the economy does seem to be on the mend, and this trend at least partially offset the market's jitters over the possibility of more Enron-style debacles.

Surveying the Sectors
Among Morningstar's 10 stock sectors, consumer durables was the best-performing group for the first quarter through March 26. Not surprisingly, these stocks tend to benefit first in an economic recovery. Automakers such as General Motors (GM) and Toyota (TOYOF) posted double-digit price gains, and appliance makers Maytag (MYG), Electrolux (ELUX), and Black & Decker (BDK) were up 20% or more for the quarter. With consumer confidence on the rise, people were more willing to open their wallets for major purchases, a trend which also benefited retail and consumer-staples stocks during the quarter.

The worst-performing sector in the first quarter, yet again, was technology. Despite some bright spots here and there, most areas of tech have been in the doldrums since the bubble burst two years ago. Matters were made worse by the market's renewed focus on accounting practices. Many investors grew jittery about the aggressive accounting used by many tech companies during the bull market of the 1990s.

Best and Worst Industries
When we narrow our sights a bit and look at specific industries, there were some surprising winners and losers in the first quarter. Two of the best-performing industries in our database for the year to date through March 26 were gambling and hotel casinos, with such big names as Mandalay Resort Group (MBG) and MGM Mirage (MGG) gaining well over 20% and smaller stocks performing even better. Gambling stocks were hit hard after September 11, but they've come back with surprising vigor, to the extent that most of these stocks look rather expensive now.

Semiconductor equipment also showed signs of coming out of a brutal downturn. Applied Materials (AMAT), KLA-Tencor (KLAC), and Novellus Systems (NVLS) each gained around 30% in the first three months of 2002, amid signals that chipmakers are ready to start spending money on equipment again.

Unfortunately, plenty of industries continued to struggle. The horrendous advertising recession continued to take its toll on the entertainment and online-information industries, two of the worst-performing groups in the first quarter. Giants such as Vivendi (V), AOL Time Warner (AOL), and Metro-Goldwyn-Mayer (MGM) all declined more than 20%, though some others, including Viacom (VIA) and Walt Disney (DIS), bucked the trend to post gains.

Industries connected with telecommunications were also down due to the continued telecom-capacity glut. Global Crossing's high-profile bankruptcy was only the most visible sign of this malaise. Communications equipment was the worst-performing industry in our database for the year to date through March 26, and phone/network equipment, cable/wireless equipment, and wireless communications all posted double-digit losses for the period. Among the well-known telecom stocks that got hammered this quarter were JDS Uniphase (JDSU), Nortel Networks (NT), Juniper Networks (JNPR), Ciena (CIEN), and Tellabs (TLAB), each of which lost more than 30% of their value.

Such losses shouldn't obscure the positive market signs, both in individual industries and the broader economy. But is this recovery the start of a new bull market, or a blip in a further-downward march by stock prices? Only time will tell.

David Kathman does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.