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Market Update

Markets Recover from Second-Quarter Swoon

Third-quarter surge turns red to green for the year to date.

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Markets rebounded strongly in the third quarter, following second-quarter declines. The Morningstar U.S. Market Index added 5.5% for the trailing 13 weeks through Sept. 22. The second-quarter swoon brought the averages back to roughly even, so the third-quarter surges account for nearly all the gains in the indexes for the year.

The markets surged despite macroeconomic uncertainty. Toward the end of the quarter, Federal Reserve Chairman Ben Bernanke received some assistance, in the form of lower commodity prices, in his efforts to control inflation without crashing the economy. Crude oil futures dropped from over $75 per barrel to below $62 as of Sept. 22. Other commodity prices, including natural gas, plummeted too. Higher energy prices present a central banker with unique difficulties because they tend to cause inflation or higher prices of goods and services, prompting the bank to raise rates, while also potentially slowing the economy by hurting consumers, prompting the bank to lower rates.

Bernanke wasn't as lucky with the bond market as he was with commodities, however. Traders continued to buy longer-term bonds, sending the yield down on the 10-year U.S. Treasury Note to around 4.6% as of Sept. 22, defying the Fed's rate-raising efforts through June. The yield curve (the plot of bond yields based on their maturities) is again inverted, indicating that investors are willing to be paid less to lend longer because they anticipate a weaker economy and an eventual lowering of rates.

If the commodity price drops helped the Fed, they caused troubles at hedge funds such as Amaranth Advisors, which has reportedly lost $6 billion primarily on bad natural-gas bets, prompting observers to wonder whether heavy use of derivative instruments by hedge funds will eventually cause an economic crisis. Other prominent investors remained mostly quiet for the quarter, though Warren Buffett's company  Berkshire Hathaway (BRK.B) exercised warrants to purchase stock of sheet-rock maker USG (USG), which emerged from bankruptcy.

Speaking of sheet rock, homebuilders continued to flounder, despite lower long-term interest rates, with many of the industry leaders such as  Centex (CTX),  Pulte (PHM), and  Lennar (LEN) sitting on the 5-star stock list. Morningstar analysts Arthur Oduma and Eric Landry view them as solid long-term buys.

Although homebuilders remained weak, commercial real estate continued its torrid trend. Real estate investment trusts (REITs) enjoyed solid gains, spurred by private acquisitions of public companies. Morningstar analysts are  cautious on REITs at their current prices.

Surveying the Sectors
Software was the strongest sector for the quarter, advancing nearly 14% for the trailing three months through Sept. 22. Morningstar growth favorites  Electronic Arts (ERTS) and  Activision (ATVI) added 38% and 29%, respectively, for the trailing three months. (Activision is a member of the Morningstar GrowthInvestor newsletter portfolio.) Analyst Norman Young awards Electronic Arts a wide-moat designation for its sustainable competitive advantages stemming from its exclusive licenses on popular software. Sector behemoth  Microsoft (MSFT) added 19% on news that it will increase its five-year share buyback program. Analyst Toan Tran favors a special dividend as the best means of returning capital to shareholders and maintains his $34 per share fair value estimate.

The telecommunications sector added 11% for the trailing 13 weeks through Sept. 22, with foreign service providers leading the way. Canadian cell phone service provider  Telus (TU) surged 43% for the quarter on news that it would convert itself into an income trust. Analyst Allan Nichols views this as a good development for shareholders, as they will be able to receive more dividends, and the company will avoid taxes at the corporate level.  Telefonos de Mexico (TMX) also added 23%. Nichols is impressed with the company's "high margins, high returns on capital, acquisition discipline, and management," and awards the firm a narrow economic moat rating. The stock's surge, however, puts it around Nichols' fair value estimate.

Business services and energy sectors brought up the rear, falling 1% each for the trailing three months through Sept. 22. In business services, transportation- and employment-related companies fared poorly in anticipation of a slowing economy. Logistics company and freight broker  Expeditors International (EXPD) dropped nearly 17%, while parcel carrier  United Parcel Service (UPS) lost 11%. However, analyst Peter Smith views the long-term prospects for these companies favorably, awarding them wide moat ratings for their superior profitability and sustainable competitive advantages. They are both currently trading in 5-star territory.

Industry Performance
Entertainment/education media and agrochemicals were the two best-performing industries, adding 29% and 18%, respectively, for the trailing three months through Sept. 22. Many of the software companies mentioned earlier helped entertainment, while  Monsanto's (MON) 22% jump helped it lead agrochemicals. Analyst Ben Johnson has awarded Monsanto a narrow moat designation for its superior technology in the agricultural seed business, though the stock is trading too close to his recently increased fair value estimate to warrant a recommendation.

If investors were excited about agrochemicals and the prospect of ethanol reducing our dependency on crude oil, they were down on the energy companies themselves, as oil and natural-gas prices plummeted. Energy and transportation industries posted among the worst showings for the trailing 13 weeks through Sept. 22. Coal dropped a whopping 27% for the quarter.  James River Coal (JRCC) shed a breathtaking 60%. Analyst Elizabeth Collins thinks the near-term outlook for coal producers is compelling, but figures that the firm will have difficulty earning more than its cost of capital in the long run. Although the stock is trading well below her consider buying price, the company, tied to the price of the commodity, has no moat or sustainable competitive advantage.

Style and Market-Cap Indexes
Morningstar U.S. Value Index +8.3%
Once again, value outperformed its core and growth counterparts, with the Morningstar U.S. Value Index rising 8.3% for the trailing three months through Sept. 22. Top component  ExxonMobil (XOM) rose 12.2%, though that includes a 7% drop over the past month due to declining oil prices. Morningstar analysts recently raised their long-term outlook for oil prices, however, and analyst Justin Perucki thinks that ExxonMobil's massive scale gives it sustainable competitive advantages regardless of energy prices. Perucki thinks the stock currently trades below its fair value estimate, making it a good long-term buy.

Other top components that boosted the index were Microsoft and pharmaceutical behemoth  Pfizer (PFE), which surged 26%. Pfizer pleased investors by shedding its consumer products unit in a deal with rival  Johnson & Johnson (JNJ), but it continues to struggle with restructuring its salesforce and other operations. Analyst Heather Brilliant boosted Pfizer's fair value estimate after the consumer products sale, putting the stock at roughly fair value at its current price.

Morningstar U.S. Core Index +5.3%
The Morningstar U.S. Core Index rose 5.3% for the trailing 13 weeks through Sept. 22. Top component  General Electric (GE) added 5% and consumer products giant  Procter & Gamble (PG) added 12%. Analyst Peter Smith likes GE's collection of businesses and awards the company a wide moat designation. However, he figures the stock isn't a great bargain at its current price of about $34.50. Likewise, analyst Lauren DeSanto thinks P&G is an excellent business, and recently upped her fair value estimate on evidence of stronger sales trends in recent quarters. However, at $62, the stock still doesn't provide investors with quite the margin of safety Morningstar looks for to make a buy recommendation.

The embattled  Hewlett-Packard (HPQ) also rose nearly 8% for the quarter through Sept 22. Despite recent headlines regarding members of the company's board, analyst Mark Lanyon doesn't anticipate changing his Stewardship Grade. However, the stock is trading above his fair value estimate, making it unsuitable for purchase.

Morningstar U.S. Growth Index +2.6%
Again, growth lagged its peers. The Morningstar U.S. Growth Index added 2.6% for the quarter through Sept. 22, half of its core counterpart and less than one third of its value counterpart. Top component  Cisco Systems (CSCO) surged 17%, maintaining its dominant position in the networking equipment market. Analyst John Slack doesn't think the company can achieve the upward trajectory it had in the late 1990s, but he awards the company a wide moat designation and thinks long-term shareholders will be rewarded over the long run if they buy at a discount to his fair value estimate. Unfortunately the stock's surge has put it above that estimate for the time being.

Top components  Google (GOOG) and  Genentech (DNA) didn't fare as well. Google was flat for the quarter through Sept. 22, as investors worry about the amount of advertising spending that will occur in the event of an economic slowdown. Analyst Rick Summer thinks the search engine exhibits some competitive advantages but pegs a fair value for the stock well below its current $400 price. With regard to Genentech, analyst Jill Kiersky is impressed with its novel cancer treatments and research capabilities. Currently, however, the stock is trading near enough to her fair value estimate that it's not much of a bargain.

Investors anticipating a rebound in growth stocks will have to wait a bit longer.

John Coumarianos has a position in the following securities mentioned above: MSFT, BRK.B. Find out about Morningstar’s editorial policies.