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Quarter-End Insights

Stocks Embark on a Torrid, But Bumpy Run

What's up, what's down, and what's still giving the market fits.

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After plunging nearly 40% in 2008, and opening 2009 with another 25% decline through early March, stocks embarked on a torrid--but bumpy--run near the end of the first quarter. The Morningstar U.S. Market Index pared its losses and was down 10% for the year by March 30.

Reversing the trend of the early part of this decade, the growth indexes outpaced the value indexes, with the Morningstar Large Growth Index down only about 1% for the year through March 30. The Morningstar Small Value Index trailed all other diversified categories with a 21% decline. Investors are according the greatest favor to large businesses with manageable debt levels. Wide-moat stalwart  Coca-Cola (KO) is down just about 2% for the year through March 30, while technology and Internet-related companies such as  Google (GOOG),  Apple (AAPL), and  Qualcomm (QCOM) are up 11%, 22%, and 6%, respectively. The technology firms don't have the steady revenues and earnings of Coke, but they have solid balance sheets. All three have equity/asset ratios of 50% or more, suggesting strong financial health.

Financials, including banks and real estate issues, drove down the value indexes, as credit remains tight, and firms with debt struggle both to refinance and in some cases to make interest payments.

The markets responded poorly to the Obama Administration's initial attempts at managing the credit crisis, plunging precipitously in February after Treasury Secretary Timothy Geithner's economic plan seemed to lack focus and clarity. In March, the markets responded more favorably to the administration's plan for a Public-Private Investment Program ( ) establishing funds to create a market for impaired assets on bank balance sheets. As the secretary put it in his recent Wall Street Journal editorial, "The Public-Private Investment Program will purchase real estate related loans from banks and securities from the broader markets. Banks will have the ability to participate in those funds and take advantage of the financing provided by the government." As the quarter wrapped up, however, the markets hit some turbulence as the government rejected automakers' viability plans and indicated that bankruptcy was an option ( ) for  GM (GM) and Chrysler.

Bonds held up fairly well for the quarter, a reversal of last year's trends when widespread investor fear helped U.S. Treasuries outpace all other issues. The Morningstar Intermediate Core Bond Index rose 1.7% for the quarter through March 30. More specifically, corporate bonds, which tumbled in 2008, stabilized, as the Morningstar Intermediate Corporate Index gained 1.3%. High-yield or "junk" corporate bonds did even better, as the Merrill Lynch High Yield Master II Index increased by 5%. Mortgage bonds and TIPS also did well, with the Morningstar Mortgage Bond Index rising 2.3% and the Morningstar TIPS Index rising over 5%. Government bonds, the darlings of 2008, declined a bit, with the Morningstar Intermediate US Government Bond Index dropping 0.46%.

A big question confronting bond investors now is whether Treasuries are a new bubble, as Warren Buffett suggested in his recently published  Berkshire Hathaway (BRK.B) annual shareholder letter. The government is trying to stem price deflation by printing money and bailing out banks, but there is mounting fear that if it is successful in its efforts, it will create significant inflation. Berkshire, for its part, lost its AAA credit rating from Fitch ( ), which downgraded the firm one notch, while S&P revised its outlook for the firm to negative. Morningstar equity analyst Bill Bergman thinks these developments aren't meaningful for Berkshire shareholders, however.

Traditional inflation hedges such as commodities and real estate were down for the quarter. The Dow Jones-AIG Commodity Index fell around 6% for the quarter through March 30, while the DJ US Real Estate Index was down in the range of a whopping 30%. Real estate firms, including and especially REITs (real estate investment trusts), continue to struggle with their high debt loads and declining businesses, as the recession and credit crunch take their toll.

Sectors and Industries
Media and hardware were the best-performing sectors for the quarter, rising 11% and 5%, respectively, through March 30.  Sirius XM Radio (SIRI) surged 186% for the quarter, but Morningstar equity analyst Tom Corbin thinks the stock is worthless after accounting for the company's limited refinancing options for more than $1 billion in debt coming due in 2009. Overall, radio and newspapers are fundamentally troubled industries, as the Internet has taken away advertising revenue.

In hardware,  Sun Microsystems (JAVA) surged 90%, with  IBM (IBM) in talks to acquire the firm. A host of small- and medium-sized semiconductor makers rose as well, with  Maxim Integrated Products (MXIM), for example, gaining 18% year to date. Maxim, a maker of analog and mixed-signal circuits, has garnered Morningstar's wide-moat designation for its proprietary chips, and it still trades in 5-star territory, despite its recent gains. Analyst Dan Su has estimated the firm's fair value at $22 per share, with a Consider Buying price at $15.40.

Utilities and financial services brought up the rear for the quarter, dropping 11.7% and 15.9%, respectively, through March 30. Dividends at several struggling utilities no longer proved sacred during the quarter. Falling demand and tight credit markets led three utilities-- Constellation Energy (CEG),  Ameren (AEE), and  Great Plains Energy (GXP)--to chop their dividends while many others left investors with no raise. All three were down 20%-30% in the quarter.

In financial services, super-regional banks  Wells Fargo (WFC),  US Bancorp (USB), and  BB&T  (BBT) dropped 54%, 45%, and 40%, respectively, for the quarter through March 30. All three trade under Morningstar analysts' fair value estimates, but only US Bancorp was low enough to hit 5-star territory. Also, credit card firm  American Express (AXP) shed 30% for the quarter. It now trades at a trailing P/E ratio of 5.2 and with a yield of nearly 6%. At around $13.60 per share, it also trades well below Morningstar equity analyst Michael Kon's $54 fair value estimate, putting it deep in 5-star territory. Investing in financials isn't for the faint of heart at this moment, though perhaps one can derive some confidence from the fact that Warren Buffett's Berkshire Hathaway owns shares of Wells, US Bancorp, and American Express.

In industry performance, radio (mentioned above) and securities were among the leaders, with gains of 44% and 39%, respectively, for the quarter through March 30. Meanwhile, Air transport and REITs were among the worst, with 34% and 33% losses, respectively, for the quarter through March 30. The airlines are a perennially embattled group, where rampant competition, tough unions, and high oil prices make it notoriously difficult to find candidates for long-term investment. Our favorite airline,  Southwest (LUV), dropped 28% for the quarter, putting it in 4-star territory.

Among REITs, carnage that began in 2007 has accelerated. Firms associated with nearly every type of property--including mall operator  Macerich (MAC), industrial firm  First Industrial (FR), office firm  Brandywine (BDN), and apartment landlord  Apartment Investment & Management (AIV)--endured drops of 55% or more for the quarter. REITs are suffering from having overloaded on debt when money was cheap in the early part of the decade. Additionally, a slowing economy is keeping rents and occupancy down. Morningstar equity analysts are mostly cautious on the sector, though mutual fund analysts have heard veteran managers argue that the debt of some firms appears attractive. The fund with the longest history of successfully investing in real estate debt is  Third Avenue Real Estate Value (TAREX).

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