The Quarter in Review

The new year was instantly positive when January opened, and most major stock benchmarks barely looked back.  First quarter gains were +12.6% for the S&P 500 (with dividends), +18.7% for the Nasdaq Composite, and +12.1% for the Russell 2000.

Traders were apparently glad to have 2011 safely behind them.  The year ended, you may recall, with a rally led by the Energy sector.  The Financials sector was in the middle of the pack as 2011 ended while Technology lagged behind – running only slightly ahead of Utilities.  We have a much different picture now.  Here are the sector SPDR results for the most recent quarter.

Utilities is now joined in the basement by previously-leading Energy.  Technology zoomed higher, led by Apple (AAPL), but the biggest gains were found in Financials.  Of course, the +22% quarterly gain should be viewed in context with a -17% loss in calendar year 2011.  It might be better to speak of Financials “recovery” instead of a “rally.”

Whatever you call it, what happened to make Financials turn around?  Signs of at least a mild economic recovery were certainly helpful, as were the resumption of dividends and stock buybacks that were curtailed during the financial crisis.  The bigger factor, we suspect, was monetary policy.  Federal Reserve action caused the yield curve to “steepen,” which means long-term interest rates rose higher in comparison to short-term rates.  Banks make money by borrowing at short-term rates, lending at long-term rates, and pocketing the difference.  The steeper yield curve was a substantial boost to their profit margins.

Can Financials build on this development?  We are dubious.  The Fed seems happy with current policy.  The steepening benefit is already reflected in stock prices.  Meanwhile the crisis in Europe is flaring up again, led this time by Spain.  We already see long-term Treasury rates declining in April as global cash again seeks haven in the U.S.  The second quarter of 2012 seems unlikely to resemble the first.