2 Financial Stocks for the Second Quarter

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

By Ivan Martchev for InvestorPlace

NEW YORK ( InvestorPlace) -- The S&P 500 Index was up 12.59% in the first quarter, with banks coming in as the best-performing sector, up 21.46%. Naturally, the question arises: Should investors chase the Financial Select Sector SPDR ( XLF) for the rest of the year, given that this great start in 2012 might signal this once-glorious group's long-awaited comeback?

My answer: not aggressively.

In a previous outlook on financial stocks reviewing the first quarter and providing outlooks for the second, it was the equivalent of feeding a juicy T-bone to a hungry carnivore. But I prefer taking a top-down perspective because a bottom-up approach to big banks isn't as productive now given the financial system's current situation. Enterprising minds might want to click on the links to the relevant monetary indicators in the text.

As a matter of strategy, I believe long-term investors should avoid most large banks in developed markets. Many of these are good "trading" stocks -- they go up for a few quarters at a time, and then those rallies tend to unwind. So, you can trade them, but you must be careful not to overstay your welcome. That's because the record levels of financial system leverage in the developed world hit a wall in the Great Financial Crisis and have been coming down ever since.

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In the U.S., total debt as a percentage of GDP as measured by the Federal Reserve Flow of Funds Accounts has slid from 385.7% in the first quarter of 2009 to the present 354.7%.

The financial system is deleveraging despite the Fed's pregnant balance sheet balance and Washington's deficit spending. Aggressive monetary and fiscal measures have not produced any sharp inflation as the M1 money multiplier -- a measure of how fractional reserve banking in the U.S. creates system-wide credit -- is plunging, as are the velocities of M1 and M2 money supply measures.

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Think of this in the following way: Because money turns over more slowly and is being hoarded, you have to increase the quantity of excess reserves and seed credit in the system to keep the total amount of credit -- the old M3 measure of money supply that is no longer reported but still can be extrapolated using current Fed data -- from going down and creating deflation.

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