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Quarter-End Insights

Our Take on the Second Quarter

Markets plod as oil, credit woes still weigh.

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Financial markets were roiled in the second quarter of 2008, as the economy continued to slog through the worst credit crisis in nearly a generation and tried to acclimate to skyrocketing energy prices without yet showing an official contraction that is the hallmark of recession. After an initial surge and subsequent plunge, the Morningstar U.S. Market Index was registering a 1.7% drop for the trailing 13 weeks through June 27 and was down nearly 11% year-to-date.

Federal Reserve Chairman Ben Bernanke indicated an end to interest rate cuts in his effort to stimulate a slowing economy. For the moment, he appears equally averse to boosting rates in the face of incipient inflation, lest he choke off any potential recovery. The federal funds rate stands at 2%, down from 5.25% last summer, and the Fed announced it was holding steady on rates near the end of the quarter.

Oil prices surged over $140 per barrel, contributing to the economy's woes and to the difficulty of Bernanke's position. Economists define inflation as the condition of more money chasing the same amount of economic output. However, there's little doubt that higher energy costs are rippling through the economy and that consumers have been feeling pinched after filling their gas tanks, leading to worries of a return to 1970s-style "stagflation." During the quarter, Morningstar energy analysts increased their long-term estimates of oil and natural-gas prices putting two of the oil and gas "majors,"  ExxonMobil (XOM) and  ConocoPhillips (COP) in 5-star territory.

Although the Fed kept the short-term interest rates that it controls relatively low, the bond market experienced a sell-off, driving longer-term yields up as it anticipated inflation and future rate increases. This meant that investors couldn't find much safety in bonds. (The market devalues bonds' fixed coupon payments when it anticipates higher rates on bonds issued in the future.) The Morningstar Core Bond Index dropped 0.9% for the trailing 13 weeks through June 27.

Some investors took advantage of distress in the credit markets. Warren Buffett announced in early May that his firm,  Berkshire Hathaway (BRK.B), purchased $4 billion of auction rate securities, which are essentially longer-term municipal obligations whose yields get reset in weekly auctions. (Some corporations also issue auction rate securities.) When auctions began to fail in the early part of the year and prices of these securities plummeted, Buffett pounced. Berkshire Hathaway, one of the most financially secure, wide-moat firms in Morningstar's coverage universe, currently trades in 5-star territory.

Sectors and Industries
Energy led all sectors, with an 18.8% return for the trailing 13 weeks through June 27, as energy and commodity prices surged. North American coal producers such as  Fording Canadian Coal Trust (FDG), which rose 87% for the trailing three months, were among the leaders in the energy group. It's difficult for coal producers to create economic moats or competitive advantages, because they are largely subject to the price of the commodity they're selling. Still, Fording Canadian is sitting on 25 years of proved reserves and doesn't have to spend a lot of money looking for more resources. Unfortunately, it's recent runup has taken it to 1-star territory for now.

 Canadian Natural Resources (CNQ) rose 42% for the trailing three months through June 27, as interest in exploiting Canada's "tar sands" for crude has grown. Despite a slowdown on the West Coast of the U.S., global demand for oil and gas are voracious, meaning that prices will likely stay high enough to make the difficult and expensive extraction of Canadian Natural's assets economically feasible.

The worst sector, of course, was financial services, as investment banks, commercial banks, regional banks, and insurance companies continue to write down anticipated bad debt or insurance swaps related to debt obligations. Domestic and foreign banks such as  Wachovia (WB),  Bank of America (BAC), and  Lloyds TSB (LYG) dropped 39%, 35%, and 31%, respectively, for the trailing 13 weeks through June 27. Behemoth insurer  AIG (AIG) also plummeted 36% over the same period. Bank of America, Lloyd's, and AIG are all in 5-star territory currently.

Among the industries, coal, oil and gas services, mining, and steel/iron led the way, reflecting the dramatically increased global demand for commodities. Oil and gas services giant  Schlumberger (SLB) surged 24% for the quarter through June 27. Analyst Stephen Ellis argues that the firm's narrow moat comes from its leadership in multiple areas such as pressure pumping and seismic surveys, which have made it into an oil-services supermarket and allowed it to lock in customers. Schlumberger's surge has put it slightly above Ellis' fair value estimate currently.

The worst-performing industries were mostly financial- and housing-related, such as title insurance, super-regional banks, and homebuilding, which dropped 27%, 24%, and 21%, respectively. Gambling/hotel casinos also fared badly, dropping more than 26% for the trailing 13 weeks through June 27, as investors worried about the higher travel costs and consumers' willingness and ability to spend on leisure.  MGM Mirage (MGM) and  Boyd Gaming (BYD) shed 43% and 39%, respectively, for the quarter. Analyst Sumit Desai has  elevated his uncertainty ratings on both stocks to "high" and lowered his fair value estimate for Boyd, as casinos have been hit harder than they have in past economic slowdowns. Desai notes that economic pressures related to travel costs and consumer spending mean that weakness could persist, but he's still optimistic about the casino industry's longer-term prospects. Both MGM and Boyd currently trade in 5-star territory.

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