The US stock market had one of its best starts in the first quarter of 2011 buoyed by a very strong performance in the energy sector that was responsible, alone, for almost 40% of the total S&P gains for the entire first quarter. While the &P 500 was up almost 6% for the first quarter, its Energy component was up more than 16% mostly achieved in the first two months of the year. March was very volatile in general with the broad index closing almost unchanged and its Oil subsector being up about 1.5%. The Industrial subsector of the S&P was the only materially consistent performer in the first quarter rising steadily every month and ending the first quarter up by 8.2% making it the only sector other than the Energy sector whose performance was better than the overall S&P 500 index in the first quarter (Energy + 16.29%, Industrials +8.20% versus the S&P 500 +5.92%).

The above illustration is important as it helps explain the strengths of the market so far and it also sheds a light on how concentrated the gains have been so far. If the performance in March is an indication of how the market will perform in April then more volatility and sector rotation might be ahead while industrial stocks might continue their steady advance.

One can argue that the Energy sector’s performance was propped up by all the geopolitical risks in the Middle East and that we witnessed a wave of profit taking in March as traders took profits (in Energy related stocks even though spot oil prices fluctuated but kept going higher) as the specter of oil supply disruptions decreased as the situation in Bahrain cooled down and as the situation in Libya was fully priced in the markets by the end of month. If that is the case then one can expect the Energy sector to underperform the market as soon as geopolitical risks abate. While this is hard to predict, or model for, and while the situation in Yemen may have negative repercussions on Saudi Arabia, we currently know that aside from Libya there aren’t any ongoing military actions taking place in any other significant oil producing country.

While the first quarter started with the general view that the Federal Reserve was there to prop up asset prices (stocks and commodities) with its second round of quantitative easing (there were even some rumors in January and February that QE3 was in the works), April is starting on the heels of relatively strong economic reports the last of which was the March unemployment report that showed a steady increase in job creation and a mild decrease in the unemployment rate. So talk of QE3 are out and the more hawkish members of the FOMC have been all over the wires and airwaves predicting FED tightening sooner (this year)rather than later (next year). This will certainly add to market uncertainty this quarter and, in our opinion, will put downside pressure on commodity prices.

However, countering this uncertainty is the fact that the US economy is certainly improving and that economic reports should reflect that in the months ahead. Given the fact that the S&P 500 is trading near its highs for this year (and for the past 3 years) around the 1340 levels, we believe that much of this anticipated economic recovery is already priced in and hence we advocate a more cautious stance as we enter April and go through earnings season.

Where to Invest in the Second Quarter:

Our two favorite sectors for this quarter are Healthcare, particularly biotech, and Financial Services. The Healthcare sector slightly underperformed the overall market during the first quarter with an advance of 5% versus almost 6% for the market overall. We believe that healthcare stocks will offer a safe haven for investor capital during the second quarter as we see money coming out of commodities and going into more defensive sectors with strong growth potential. Hence, we are more bullish on biotech stocks rather than the big pharmaceutical companies as we see added investor, and M&A, interest in these companies that are working on the next generation of leading edge drugs. One of our favorite stocks in this sector is Seattle Genetics Inc. (SGEN).

One bright spot continues to be the financial services sector. While many bank related stocks sold off after regulators allowed banks to increase their dividends, the announcement itself gives an important insight into the banks’ financial health and, one can argue, into their anticipated first quarter results. Does anyone think regulators would allow a bank to raise its dividend if this bank is going to miss or report bad Q1 earnings?  Add to this, the fact that the Federal Reserve received high levels of interest for the sale of the assets of the Maiden Lane II investment vehicle that contained some of the most toxic assets at the time, residential mortgage-backed securities, that were taken off AIG’s balance sheet at the height of the financial crisis. The high level of interest and the Fed’s decision to sell these assets in the open market is an added insight that a lot of these same assets that are still on many a bank’s books have increased in value and many of these banks should be reporting improved capital positions going forward. We view as the current weakness in many bank stocks as a buying opportunity and some of our favorite stocks in this sector include Fifth Third Bancorp (FITB), New York Community Bancorp Inc. (NYB), E*TRADE Financial Corporation (ETFC), and the preferred shares of Bank of America Corporation (BAC-D).