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The Financial Services sector is the sixth-best performing sector over the past three months.

In the last quarter of 2007, the Financial services sector lost nearly $10 billion on an operating basis, excluding one-time charges. Earnings for the entire S&P 500 slumped 23% from last year's period. But excluding the financials, earnings were actually up 16%. The financial markets are in the midst of one of the worst crises on record, as subprime troubles continue to permeate all aspects of the financial system.

What took years to build nearly unraveled in a matter of hours. The week of March 17 was one of the most dramatic since the collapse of Long Term Capital. The eleventh-hour Fed-backed rescue of Bear Stearns was one for the record books. The near-failure of an investment bank on Wall Street shook the markets. The Fed's $30 billion backing of JPMorgan's purchase of Bear Stearns will go down as one of the best deals this century. Counter-party risks from the failure of BSC would have wreaked havoc on the world's derivatives markets.

The market weathered this storm with the assistance of a creative and aggressive Federal Reserve. In an unprecedented move, the Fed is now allowing investment banks to borrow at the discount window. As a result of the drastic liquidity action by the Fed, quarterly earnings results from the investment banks and brokers showed that leverage ratios were exhibiting some positive signs and visibility has improved, albeit modestly. The industry's inherent diversity came through in the first quarter as firms benefited from record volume and volatility in currencies, commodities, and rates despite credit market uncertainty. The performance proved the brokers are capable of generating revenues in any type of market environment. 

In addition to liquidity measures, the Federal Reserve is also now accepting non-agency MBS as collateral in exchange for Treasuries. Banks are quickly attempting to deal with mortgage borrowers in order to forestall foreclosures. Recently, federal regulators increased the size of mortgage loans Fannie Mae (FNM) and Freddie Mac (FRE) can buy, which is critical to getting the mortgage market running again. On March 24, Directors of the Federal Housing Finance Board approved a temporary increase for the Federal Home Loan Banks to increase their purchase of mortgage bonds by at least $100 billion as part of an effort to bolster demand for the securities.

The Financials will continue to be a drag on earnings in 2008, but there is a great deal of liquidity being pumped into the financial markets in order to get investment banks back operating normally and commercial banks to start lending again. The Fed's liquidity injections, lower interest rates, and regulatory changes are starting to thaw the credit markets. These measures should start bearing fruit midyear, which underscores our Market Weight rating on the sector, as the risk/reward outlook improves.

Our recommendation is to tread lightly and cover your risk. While we recommend the XLF to minimize headline risk, names we do like for the longer-term investors include Goldman Sachs (GS), Merrill Lynch (MER), Lehman Bros (LEH), US Bancorp (USB), Bank of America (BAC) and JPMorgan (JPM). There remains a great deal of risk out there in the near-term including deteriorating capital positions, default risks, counter-party risk, deleveraging, net charge offs, and asset deflation. We anticipate the headlines will remain filled with casualties of the subprime fallout, but incrementally the picture should start to brighten. The S&P 500 Financial sector trades at a trailing multiple of 17.3x and 1.3x price/book.

The Financial sector comprises ~17.64% of the S&P 500.

The Consumer Staples sector is the third-best performing sector over the past three months.

The Consumer Staples sector continues to offer investors a safe-haven in an increasingly manic environment. The industries within the staples sector are typically less sensitive to economic cycles. That being said, they are exposed to the price inflation that continues to run rampant across virtually all commodities. Raw material costs from wheat to corn and sugar have weighed heavily on manufacturers and distributors of food and beverage producers.

A weak dollar, strong export demand, and an expanding global footprint is helping to atone for cost pressures. Some of our favored names in this category include globally diversified producers with strong brand equity. These include Coca-Cola (KO), Pepsico (PEP), Wal-Mart (WMT), General Mills (GIS), Procter & Gamble (PG), and Avon Products (AVP).  These companies continue to capitalize on enduring growth with the global economy, particularly the emerging markets where companies are experiencing rapid growth rates and market share gains.

The noncyclical nature of the consumer staples sector has enabled it to hold up well. However, weakening economic growth in the U.S. will no doubt have an impact on the domestic-centric names. The risk to the downside is the fiscal and monetary stimulus that will starting flowing through the economy by midyear prompting a sector rotation into more growthy sectors like Technology.

Shareholder value, defensive characteristics, and attractive valuations for now will continue to draw in investment dollars. The sector trades at 22.6x with a ROE of 23% and a dividend yield of 2.25%.

The Consumer Staples sector comprises ~10.23% of the S&P 500.

The Energy sector is the fifth-best performing sector over the past three months.

After fading back to under $90/barrel, oil prices broke out in early February on dollar weakness to new all-time records. The price for a barrel of oil tipped beyond $110 - a seemingly incomprehensible price level only a couple years ago. And while traditionally oil trades on economic growth, the fact the U.S. sits on the verge of a recession has mattered little in terms of price influence. The dollar has dominated this trade and will continue to do so for the near-term.

The dollar's decline has reinvigorated crude prices over the past few weeks. With every tick lower, it takes more dollars to buy every barrel of oil. As the dollar depreciated, oil's investment appeal escalated. Some market participants estimate there is $20 premium priced into every barrel. Recently, however, the dollar reversed on expectations the Fed's creative liquidity efforts will forego excessive rate cuts, which have sparked the dollar's weakness. Before the Easter holiday, crude sold off into the $90s as part of a broader commodity firesale, but regained some ground by the close to $101 per barrel.

The crude markets have remained in backwardation, wherein nearby futures are significantly above deferred futures. When this occurs, it typically tells us that demand remains strong. The markets have been awash in supply concerns after weekly inventory reports have been showing inventory declines. OPEC's recent vote to keep production output unchanged, despite record prices, did little to alleviate supply concerns. 

And while the broader indices have struggled under the weight of the financial market turmoil, commodity prices have skyrocketed. However, record breaking oil prices have culminated in strong returns for the Oil ETF (USO), but they haven't translated into higher returns for the Energy sector. Investors have been choosing to buy the commodity instead of supermajors and the oil services companies. We think this disconnect will change as earnings and valuations become readjusted to reflect higher price band and these stocks will look even more attractive.

While we haven't seen this shift emerge quite yet, we think the oil services group holds the greatest promise in term of earnings growth, valuations, and shareholder returns. Oil services continue to reap the rewards from flush balance sheets and producers spending upcycle, which is less dependent on the macro economy. Our favored stocks include Schlumberger (SLB), Weatherford (WFT), Baker Hughes (BHI), Diamond Offshore (DO) and Transocean (RIG), which has been our primary pick in the group for the past three years. The international drilling market is likely to be capacity constrained into the end of this decade, pushing dayrates even higher and contract terms longer.

The Energy sector comprises ~12.86% of the S&P 500.

The Utilities sector is the third-worst performing sector over the past three months.

The S&P 500 Utilities sector ranks among the worst performers to date. It has underperformed the broader market by over 200 basis points, declining 11% year-to-date. After enjoying a multi-year upcycle -- stretching valuations on a strong fundamental backdrop that included earnings growth, restrengthened balance sheets, a favorable regulatory environment, and build-out cycle -- the utilities have lost their luster as inflation dampens values.

The appeal of utilities centers on the pursuit of yield. But as inflation rises, stocks that have a fixed rate of return become much less attractive as the real yield falls in comparison to the nominal rate. So even though the sector's dividend yields haven't declined nominally, investors are losing on two fronts, lower real rates and falling stock prices. For this reason, we rate the sector Underweight.

The sector suffered extreme pressure in January, and the pressure has continued over the past few weeks. The sell-off in the S&P 500 Utilities index coincides with the January CPI report, in which the core rate came in higher than forecasted. Inflationary concerns will continue to linger over utilities. Furthermore, the 2010 repeal of the dividend tax rate has negative implications not only for the sector, but the broader market as well, since it lessens the value of holding stocks. 

Standard & Poor's forecasts operating earnings growth of 11.9% for FY08. Utilities are currently trading at 14.9x forward earnings.

The Utilities sector comprises ~3.62% of the S&P 500.

The Technology sector is the second-worst performing sector over the past three months.

The Technology sector is down 4.6% compared to the S&P 500. Peaking back in the fall ahead of the critical holiday selling season, technology continued to loose ground on recession worries and consumer health concerns. After trading in a tight range for the last couple weeks, we saw a significant upward move post-Easter with notable gains in Comm/Network Equipment, PC Hardware, and Semis segments. Tech heavyweights, Intel (INTC), Cisco (CSCO), Apple (AAPL), Hewlett-Packard (HPQ) and RIMM (RIMM) seeing strong gains.

Given the fact that the consumer segment accounts for more than 50% of total semiconductor consumption, consumer spending trends, fads, and fancies influence the entire sector from the memory producers to the foundries, assembly and testing, and semi cap equipment. The semiconductor industry is coming off a challenging year in 2007 hurt by a memory chip supply glut, ASP pricing war, chip inventory build ('06/07), and a tightening capital spending environment. The good news is this environment has sparked wide spread restructuring, supply chain management, increased level of outsource manufacturing, M&A activity, and joint ventures aimed to reduce fixed and R&D costs.

And while the situation remain tenuous on macro headwinds, the outlook brightens in the second half helped by fiscal and monetary stimulus. Further, typically consumer electronics enjoy a boost in sales during years with elections and/or Olympic games, which are being held this summer in Beijing. The memory markets meanwhile remain a major overhang as supply outpaces demand. There is a great deal of variance in opinion on Wall Street whether this situation will improve or not this year.

Just take a look at the share price of memory maker Micron (MU) and the situation is clear. Its stock price has fallen precipitously over the last two years, topping out of $18 in September 2006, to below $6 per share. Competitive pressures, once again, weighed heavily on January sales despite modest unit growth. We think the supply/demand picture should improve this year driven by capex control and seasonal demand resulting in greater pricing stability. Memory will remain the wild card for the industry this year. Excluding memory products, semiconductor sales rose 8.1% in January. For the year, the SIA is predicting 12% PC and 12-15% cellular handset unit growth.

More and more, we are finding value across the technology sector. The S&P Tech sector trades at 19.7x trailing and 16.5x forward earnings and 1.8x price to sales. Comparatively, the S&P 500 trades at 20.3x and 14.0x, respectively. Outside SML holdings, CSCO and AAPL, we are becoming more constructive on graphics giant, NVIDIA (NVDA) below $20. The stock is trading at 12.1x forward earnings and a PEG of just 0.6. Notable earnings results in the next couple weeks include Best Buy (BBY) 4/02 ; Micron 4/02; and Research In Motion 4/02.

The Technology sector comprises ~16.73% of the S&P 500.

The basic materials sector has been the second-best performing sector over the past three months.

Recently, we've become increasingly concerned the commodity trade from the metals/miners to energy, coal, and the agricultural sector has become very crowded as market participants seek shelter from a falling dollar. There have been few areas that are working, and working this well, returning double-digit gains. Therefore, there has been an incredible amount of money flowing into these sectors over the past few weeks.

There are rumors hitting Wednesday regarding the possibility that two of the largest fund of funds are going to start redemptions today. If this in fact is the case, it would certainly have an impact on the commodity sector that likely comprises a notable portion of fund holdings.

We are seeing significant selling this morning in crude, silver, wheat, gold, soybean, corn, copper, and heating oil - all registering over two percentage point declines. Major producers are taking a hit with heaving selling in Barrick (ABX -4%), Newmont (NEM -3%), Freeport (FCX -5%), US Steel (X -3%), Golden Star (GSS -6%), Kinross Gold (KGC -6%), BHP Billiton (BHP -3%), Rio Tinto (RTP -4%), and Consol Energy (CNX -2.5%).

While the fundamentals remain solid across all of the commodity sectors, there is a significant amount of momentum money in these markets. This leaves stocks exposed to downside risk if the momentum shifts. In this volatile, and near manic market, it's prudent to cover your risks first and ask questions later. The commodities could be taking a breather for a while, until the market shifts its focus toward the economic recovery which would then revive interest in the early cyclicals. At this point, any selling has been short-lived.

The Basic Materials sector comprises ~3.33% of the S&P 500.

The Industrial sector is the fourth-best performing sector over the past three months.

The Industrials have been a relative outperformer year-to-date. The sector is down just over 3% vs. a near 8% drop in the S&P 500. A lot of ground has been made up, however, over the last month -- to the tune of over 4%. In fact, Industrials is the top performing sector, outpacing Technology. The main driver has been Infrastructure and Rails. The latter of which continues to see buying interest on renewed pricing power and operating leverage resulting in very attractive long-term growth rates and shareholder returns. Intermodal carriers like BurlingtonNorthern (BNI) are benefiting from rising international trade, manufacturing outsourcing to Asia, and coal transportation (carrying larger quantities of low-cost PBR coal longer distances).

Meanwhile the U.S. housing recession continues to weigh heavily on the construction sector. However, global infrastructure and agricultural equipment demand remains robust, assisted by a weaker dollar and soaring commodity prices. The ongoing expansion within the global economy underscores growth opportunities sector wide. The main spending areas include metals, mining, agriculture, and energy. One area of particular strength is power infrastructure. Global growth will likely continue to offset sluggish environments in the U.S. housing and automotive markets over the next year. The defense contractors also remain the benefactors of rising capital spending, along with the long-term upcycle in commercial aviation.

The Consumer Discretionary sector is the best performing sector over the past three months.

The relative outperformance of the consumer discretionary sector (only down 4.4% YTD) is striking in light of the festering concerns regarding the consumer-driven housing market specifically, and the overall economy in general.

The relative strength has been rooted in the expectation that monetary and fiscal policy actions will succeed in turning the tide of negative sentiment, weak spending trends, and declining earnings estimates.

While the deep cyclical auto industry continues to be a notable laggard, the homebuilders comprise not only the best-performing industry group in the sector YTD (+11.6%), but also one of the best-performing groups in the market.

The health care sector is the fourth-worst performing sector over the past three months.

The period from January to March was a particularly rocky one for the stock market, and while a traditionally defensive sector such as health care might have been expected to outperform, its performance was anything but defensive (-10% YTD). Diverse industries such as Biotechs, Managed Care, PBMs, and Pharmaceuticals were all exceptionally weak, although Medical Equipment stocks were a lone bright spot in the sector.

The entire health care sector faces headwinds in 2008. A rash of warnings by the HMOs, citing unexpectedly high costs, have cast a pall over the group. Big Pharma faces a number of high-profile patent expirations in the coming years. PBMs are facing potentially lower margins due to higher volumes resulting from Medicare Part D. Congress has been discussing the feasibility of enacting generic Biotech legislation, which could cripple profit margins. And finally, during a presidential election year a lot of noise will be made about the high cost of health care and what the government needs to "do" about it (which the market typically sees as higher costs and lower margins).

Seen in this light, it's not surprising that the past three months have not been kind to health care stocks.

The Telecom sector is the worst performing sector over the past three months.

The call went out Feb. 19 to sell the carriers as shares in AT&T and Verizon dropped by over 5% and 6%, respectively. The spark was Verizon Wireless' preemptive strike on Sprint (S) by announcing a $99 unlimited fixed rate wireless plan. Its competitors, T-Mobile (DT), and AT&T (T), followed suit only hours later, sparking off fears of a pricing war that would wreak havoc on the industry. Given the fact pricing wars have been going on in the telecom sector since the 1990s, these fears are warranted but we would argue premature.

As wireless industry growth continues to slow, data offers significant growth potential. Carriers are aiming to capitalize on this trend to draw in customers onto a converged platform: voice, data, video, and Internet. News of a fixed rate price plan sparked a panic that once it starts, it wouldn’t end until someone goes out of business. And actually one of the major carriers, Sprint, is in such dire straits.

Sprint has few strategic options left and an unlimited plan had been speculated at the time.  The only question was how low they would go. Verizon just beat them to the punch. The bottom line is that there isn’t a significant portion of subscriber base at the high-end pricing plans ($200-$300/mo), estimated at around only 2%. Therefore it should not have a material impact on the subscriber base and cash flows. Nonetheless, despite its defensive qualities, the negative impression was left sending the telecom sector on a tailspin, losing 14.5% year to date.