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Quarter-End Insights

Our Take on the Fourth Quarter

Underlying corporate strength and an improving U.S. economic picture helped close the year on a high note, but obstacles remain for 2012.

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After a wild third quarter, investors couldn't be blamed for wanting a quieter end of the year. But the market did not want to cooperate. Although the tension was not quite as high as during last quarter's debt-ceiling debate and U.S. sovereign debt downgrade, events in Europe ensured that volatility and uncertainty remained the name of the game. Despite all of the noise in the market, the broad-market Morningstar U.S. Index gained 9.32% during the trailing 13 weeks and was up by 0.85% during the last 12 months.

Europe remained the clear driver of the market throughout the quarter. The sovereign debt crisis remained as intractable as ever as European leaders continued to squabble over bailout details. Stocks were jittery as a seemingly neverending flow of bad news emanated from the continent. From a planned (and then scuttled) Greek referendum on the bailout to soaring credit spreads on Italian debt to an undersubscribed German bond offering, there were plenty of reasons for investors to worry. Markets cheered a plan hatched toward the end of the year to create a stronger fiscal union and for the European Central Bank to provide extensive support to struggling European banks, and the moves bought some time to put more permanent solutions in place.

Although Rome was burning, the U.S. economy was fiddling. Morningstar director of economic analysis Bob Johnson thinks that growth in the fourth quarter was likely north of 3%, much better than the almost-non-existent growth seen at the start of the year. The employment and housing markets began to show real signs of life in the quarter, and consumers continued to open their wallets. Corporations also continued to post strong fundamental growth, but many management teams reiterated that they remain quite cautious about 2012. 
The IPO market woke up somewhat in the fourth quarter with major tech offerings from Groupon (GRPN) and Zynga (ZNGA). However, investor demand abated for these new issues quickly, and performance for all IPOs in 2011 was fairly tepid. As of Dec. 22, only 35% and 27% of companies were trading at higher levels than their offer prices and first-day closes, respectively, according to Morningstar's Jim Krapfel.

Sector-by-Sector Performance
Every stock sector ended the quarter higher. Energy led the pack with an 14.47% return. The consumer defensivereal estate, and industrials sectors were next on the leader board, gaining 9.66%, 9.45%, and 8.54%, respectively, in the fourth quarter. On the flip side, the communication-services sector had the worst quarter, improving by only 2.75%. Utilities (up 3.46%) and basic materials (up 4.11%) were the next worst-performing sectors.

The best-performing industries of the quarter were rubber and plastics (up 32.19%), rental and leasing services (up 30.84%), and gambling (up 30.16%). Solar was by far the worst-performing industry, shedding 34.85%. European regional banks (down 15.77%) and Asian regional banks (down 12.32%) also had weak quarters.

The rise in stock prices made stock valuations less attractive then they had been. However, nine out of 11 sectors remain below fair value, and the other two are fairly valued. Our analyst staff sees "continued undervaluation in economically sensitive sectors such as industrials, basic materials, energy, and financial services."

The small-value category was the best performer among domestic-equity funds with a 14.11% return in the quarter. Real estate and small-blend funds also finished near the top, posting gains of 12.99% and 12.93%, respectively. Technology funds lagged behind, returning only 1.80%.

International stock funds had a less successful quarter. World stock (up 3.85%) and Latin America stock (up 3.30%) were the categories with the best returns. Japan stock had the worst quarter, losing 5.99%.

On the fixed-income side, long government was the best-performing fund category, rising 4.16%. High-yield bond (up 4.09%) and bank loan (up 2.81%) were the next-best performers. World bond was the only fixed-income fund category to lose ground in the quarter, falling 0.16%.

Despite the incredible uncertainty and volatility of 2011, underlying corporate strength and resiliency in the United States and emerging-markets economies helped stocks eke out a gain for the year. At the end of the third quarter, we postulated that the European debt crisis and the United States' fiscal challenges would be two of the biggest open questions facing investors. That remains true today. How successfully the world and individuals are able to deleverage and right their fiscal ships looks poised to be the overriding investment theme for 2012.

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