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Market Update

Second Quarter in Stocks: Let the Good Times Roll

Saying it was a good quarter for stocks would be an understatement.

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Saying it was a good quarter for the stock market would be an understatement. Between April 1 and June 24, 2003, the Dow Jones Industrial Average rose 13.5%, the S&P 500 Index was up 15.7%, and the Nasdaq Composite gained 20.1%. All but one of the Morningstar stock sectors showed double-digit gains, and a majority rose more than 15%.

Certainly one of the reasons for investors' increased exuberance was the end of major fighting in Iraq. During the first quarter as well as most of 2002, the country had to deal with the drumbeat of war and all the uncertainties of a looming conflict. But today, Saddam Hussein is no longer a factor, and the price the country paid for the war (both in lives and money) was far less than it could have been.

The second factor that drove stocks higher was the 45-year low in interest rates, which still had the possibility of going even lower. This not only fueled the mortgage refinancing boom and gave consumers more money in their pockets, but it also made alternative investments--bonds, money market funds, certificates of deposit--relatively unattractive compared with stocks.

Investors also got a boost from Uncle Sam. In May, President Bush signed into law tax reforms that lowered taxes on most dividends to 15%, down from the personal income tax rate of as high as 38.6% before the tax bill. The taxes on long-term capital gains were also cut from 20% to 15%, again adding fuel to the bullish fire and making owning stocks more compelling.

Finally, the market was beaten down after a long period of brutal underperformance. The S&P 500 started the quarter 43% below its highs reached three years before. One might say the markets acted as a coiled spring: The further the market fell, the higher it was going to bounce once sentiment turned more positive. The bounce over the past three months has certainly been impressive.

Surveying the Sectors
Two of the best-performing stock sectors in the second quarter were among those beaten up the worst over the past few years: utilities and telecommunications. While these two sectors have seen their fair share of bankruptcies in the past year--NRG Energy (NRZ) and Worldcom (WCOEQ) were among the largest in each sector--some of the bearishness and anxiety spilled over onto companies that would ultimately survive. Thus, contrarian investors who bought these stocks cheaply after the sector suffered painful losses fared relatively well.

The worst-performing sector of the second quarter was consumer goods. Even though this sector was in positive territory for the past three months, this marks the second straight quarter in which consumer-goods stocks were at the bottom of the performance heap. This may have been because investors preferred more speculative securities instead of the steadier companies that populate the consumer-goods sector, or it could have been because the sector had fewer companies with near-death experiences that have come roaring back.

Best and Worst Industries
At the more specialized industry level, homebuilders were on a tear in the second quarter. With mortgage rates at their lowest levels in most homebuyer's lifetimes, the real estate market remained white hot. Business/online services, which includes many dot-com firms, was another hot industry in the second quarter, up more than 40%. Biotechnology was yet another industry that vastly outperformed, again adding credence to the argument that speculative shares were the most in favor in during the period.

At this writing, only a small handful of the more than 120 industries in Morningstar's database were in the red. Hospitals were the worst-performing industry. With large hospital operator  Tenet Healthcare  (THC) still in turnaround mode and the accounting fraud at  HealthSouth (HLSH) spooking investors from the industry, it is perhaps easy to understand why.

The best-performing stock in the quarter among those that Morningstar rates was speculative and debt-laden  Charter Communications (CHTR), which came roaring back from less than $1 per share and more than tripled. The two worst-performing stocks were biotechnology firm  Cytyc (CYTC) and health-care provider  HCA (HCA). Both fell nearly 20% even though the market roared.

Conclusion
In times like this when the market is flying, keeping expectations in check is key. The returns stocks have given investors since March are simply not sustainable over the long term. Of course, no matter what the market may have done in the recent past, there are always great investment opportunities out there. Check out  the list of stocks that Morningstar's stock analyst team think trade at a sufficient enough discount to their estimated fair values to warrant a 5-star rating.

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