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Biggest Investment Themes for Second Quarter

U.S. stocks pared losses and ended the first quarter with a 5.4% gain, on average. But the second quarter presents a new set of risks for investors to navigate.

BOSTON (TheStreet) -- After last year's triumphant rebound, the stock market was wheezing in the first few weeks of 2010. With the labor market sagging and consumer spending on hold, U.S. investors asked themselves "Now what?"

On Feb. 8, every industry in the

S&P 500 Index

had fallen at least 2%. By the end of March, the U.S. benchmark made up that loss and kept rising, finishing the first quarter up 5.4%. Global manufacturing heated up, business spending strengthened, and companies began to hire again, albeit slowly. Investors piled in.

Industrial companies gained an average of 13% in the first quarter, and financial and consumer-discretionary firms increased 11%. Only utilities, considered among the safest investments, fell.

Banks and other financial-services companies have prospered since the government made it clear the most important among them are "too big to fail." They've been given every advantage.

The other top-performing industries show more bullish signs. Gains in the industrial and consumer-discretionary sectors signal that investors are betting on so-called cyclicals as the U.S. pulls out of the deepest recession since the 1930s.

To be sure, the economy likely will continue to sputter for some time, and stronger growth will bring with it other challenges. Investors should expect mean reversion -- the stock market's current pace probably will slow.

On the following pages are three of the largest investing themes for the second quarter and how to play them.

Consumer Price Index

A dreaded side effect of economic-stimulus money is rampant inflation. The fear of rising prices is becoming more real as the consumer price index, or CPI, has climbed. Some take issue with the calculation of the CPI because the methodology has been known to change and the government has incentives to keep the gauge low since entitlement-program spending is linked to the index. As a result, if the CPI is rising, the actual inflation rate may be even higher.

As consumer prices rise, spending tends to slow, especially if unemployment remains high and wages are stagnant. Such a scenario could put a damper on consumer-discretionary stocks such as media company

Walt Disney

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and electronics retailer

Best Buy

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, both of which enjoyed solid gains in the first quarter.

As the real value of income deteriorates, people put off big-ticket purchases. Inflation isn't out of line with long-term averages, but that could change quickly as the slack in the economy is reeled in. Large changes aren't likely to occur soon, though those stocks could be hurt by projections alone.

Gold Prices

The Federal Reserve will need fancy footwork to ward off inflation. If investors get the slightest inkling that the Fed may fumble, consumer-oriented stocks will flag. Investors should consider taking some of their gains in these stocks and plowing the proceeds into inflation-neutral shares.

As the chart above shows, gold prices exploded last year on the same concern about inflation that may eventually sink consumer-discretionary stocks. The same price trend can be seen in aluminum and other commodities priced in dollars. Prices sank around the start of the year but are now rising, which could crimp industrial companies' profits just as orders take off.

General Electric

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United Technologies

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rely heavily on commodities, such as aluminum and steel, to make their goods. As prices rise, profit margins shrink. Due to the length of industrial contracts, however, it's unlikely that sales booked today will immediately erode earnings. Hardcore inflation grabs hold in the later stages of economic cycles. But, by then, everything can come to a crashing halt.

As a result, investors in GE and United Technologies should be concerned with the companies' hedging strategies above all. Contracts generated now ought to be hedged against the risk of rising prices. The downside of not doing so would be too great to ignore it. Gains made in the first quarter stem from a revival from a very low base but, from here on out, sustainable growth will hold the key to their success.

Industrials, which make up 11% of the S&P 500, have launched themselves nicely in the first quarter, but more risks lie ahead. Investors should consider shifting some money from industrials into the materials sector, which includes commodity producers of all sorts, to cash in on inflation in the coming quarters.

Exchange Rates

In the past couple years, countries around the world have been playing a perverse and baffling game whose goal is to allow one's currency to weaken. In a desperate drive to grab growth wherever it's available, a strong currency is a liability, since it tamps down exports. Weak currencies give countries an advantage by having relatively lower costs for exports, boosting the economy through trade.

Adding to America's export pain is the Greek debt fiasco, which has led investors to flee the European Monetary Union, cash in hand, for the safety of U.S. Treasuries. The dollar has strengthened against the euro since December, falling from about $1.50/euro to $1.35/euro. Big companies with lots of foreign-currency sales, such as GE and construction-equipment maker


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, are highly exposed to currency swings. While the companies can "hedge out" currency fluctuations between the contract initiation and the settlement, they still face large amounts of economic risk related to the dollar's power.

Look at it this way: GE and Caterpillar machinery valued at, say, $100 million has increased to $111 million for European customers since December simply because of currency changes. That's a competitive disadvantage because European counterparts like


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may be able to outbid the U.S. companies. Even if GE and Caterpillar accept euros to stay competitive, they'll still need to translate the money into dollars in their financial statements, so the loss will be damaging either way.

Investors should consider diversifying their money to spread currency risks. Siemens is worth considering, but if the thought of prospecting for foreign investments is daunting, there's no shame in holding an international stock-market index fund. The key to any investment strategy is to avoid placing all your eggs in one basket. Those baskets include industries and currencies. The saying is older than Warren Buffett, but it still holds true.

-- Reported by David MacDougall in Boston.

Prior to joining TheStreet Ratings, David MacDougall was an analyst at Cambridge Associates, an investment consulting firm, where he worked with private equity and venture capital funds. He graduated cum laude from Northeastern University with a bachelor's degree in finance and is a Level III CFA candidate.