US stocks endure wild 1st qtr, financials flounder

NEW YORK (Reuters) - U.S. stocks had a wild ride in the first three months of 2007, although a glance at the negligible net changes of market benchmarks masks the depth of the turmoil.

The Dow Jones industrial average .DJI, Standard & Poor's 500 index .SPX and Nasdaq Composite Index .IXIC each notched moves of less than 1 percent from December 31 through Friday.

For the quarter, the Dow ended down 0.87 percent, while the S&P ended up 0.18 percent and the Nasdaq closed up 0.26 percent.

That was the ordinarily volatile Nasdaq's smallest quarterly percentage move -- up or down -- in at least 27 years.

While investors reviewing their quarterly returns could be forgiven for dismissing the period as the latest in a long stretch of low market volatility, they would be wrong.

The Chicago Board Options Exchange Volatility Index .VIX shot up 27 percent in the first quarter, its biggest rise since the current bull market was born in the fourth quarter of 2002.

The VIX, Wall Street's so-called fear index, was jerked out of its seven-month slumber on February 27, when China's stock market tumbled 9 percent, sparking a worldwide equities sell-off that was compounded by the simultaneous worries.

"The subprime lending problem raised credit concerns and recent tensions in the Middle East have pushed oil prices higher and gasoline back toward the $3-per-gallon level, raising concerns that the consumer will be squeezed," said Scott Fullman, director of Investment Strategy at I.A. Englander & Co., an institutional brokerage in New York.

The quarter also marked Wall Street's worst first quarter in two years.

With so many wild cards in play, investors have sought refuge in safe-haven sectors.

Utilities fared best, gaining 8.44 percent, with their dependable dividend yields luring caution-oriented investors. Materials were a close second with an 8.38 percent gain, helped by consolidation in the steel sector and demand for precious metals.

At the low end of the scale, technology stocks, viewed as the market's riskiest sector, were the second-worst performing group, dropping 1.11 percent. Lastly, financials shed 3.44 percent, making it the worst quarter in eight for the sector.

"You can see there's a lot of uncertainty, and a lot of volatility among higher beta stocks, and the sector performance reflects that," said Ed Peters, chief investment officer at Boston-based PanAgora Asset Management Inc. "The finanicals reflect all the worries about the mortgage area."

If those standings hold up going forward, it may be a bad sign for the broader equity market.

"Utilities and materials are going to have great performance. Their earnings are going to be good. But it's more about price than volume. So it is a false positive in many respects," said Joseph Battipaglia, chief investment officer for Ryan, Beck & Co. in Philadelphia.

"If (utilities) and materials are doing very well, at the expense of the whole economy, that is not enough to provide leadership for the stock market while the financials implode," he added.

For equities to rally, volatility will have to come under control. But for that to happen, analysts say market participants must get on the same page.

"This increase in volatility has occurred because we have so many more polarized expectations. There are some people who think the Fed will cut, some think they will raise. There's also different expectations about the subprime crisis and how far it will spread," said Larry Adam chief investment strategist, Deutsche Bank Alex.Brown in Baltimore.

If market consensus were to form around a likely cut in interest rates by the Federal Reserve, then stocks would turn higher, Adam said. Likewise, a better understanding of the impact of the subprime mortgage meltdown could make investors more likely to dip into financial stocks again.

Until that happens, investors may have to get accustomed to whipsaw sessions, where intraday swings of more than 1 percent on the Dow, S&P and Nasdaq are commonplace.

"This isn't abnormal volatility, This is a return to normality." Peters said. "The second quarter will be much like the first. Everyone's looking at macro data to figure out the direction of the economy. We'll see a lot of reaction to economic news and a lot more volatility."

(Additional reporting by Doris Frankel and Ellis Mnyandu)