Stocks will take their cues from the oil market this week as unrest rumbles through the Middle East. But so far equity investors are sanguine, believing the economic recovery wins the day.

Sentiment is driving large daily swings as traders vacillate between the fear that oil prices will hit consumers and derail the recovery, and the euphoria that the U.S. labor market is turning a corner.

Reports of escalated fighting in Libya and protests in Bahrain, Yemen and top oil-exporter Saudi Arabia rattled investors on Friday -- oil rose, equities fell.

We are in such a sentiment-driven market right now and everyone is watching the equity market with one eye and oil and commodity markets with the other, said Michael James, a senior trader at Wedbush Morgan in Los Angeles.

SHIFT TO OIL STOCKS

Some hedge funds are trading the inverse correlations between oil and equities that have grown in recent weeks, while other investors are shifting their exposure to oil stocks and paring back in overvalued areas of the market.

Through it all the S&P 500 is down less than 2 percent from a near three-year high hit in late February, which even bears concede is a remarkably robust performance. Last week, stocks ended flat.

So far the trade seems to be a reallocation of risk within equities rather than a move out of stocks altogether.

Zahid Siddique, a portfolio manager at the Gabelli Equity Trust, has used the turmoil as a chance to raise his exposure to energy stocks, which have surged with oil prices.

The S&P energy sector <.GSPE> has risen 10 percent since the middle of January when troubles in the Arab world began. Since then the wider market has crept up by just a fraction of that. Over the same period Brent crude oil rose nearly 18 percent to more than $116 per barrel.

These type of crises make you refresh your portfolio and just take another look, Siddique said. Near-term we may have some volatility in the market ... although the markets could still trend higher within that.

In the energy sector Siddique has added to positions in Suncor Energy , Marathon Oil and Exxon Mobil .

At the same time he has taken the opportunity to pare back positions that he believes are starting to look over-priced. Those include Deere & Co and Caterpillar Inc .

If oil prices spike higher, other areas of the market could start to look more vulnerable.

STRONG ECONOMIC MOMENTUM

Barry Knapp, managing director of equity research at Barclays Capital in New York, recently downgraded the consumer discretionary sector, a move he partly attributes to risks posed by higher oil prices.

If there is one sector that is particularly vulnerable, it would be the consumer discretionary sector, Knapp said.

That sector is the only cyclical sector that Knapp has underweighted as he continues to believe the economy will strengthen.

On balance we do not think that this oil price supply shock is going to be strong enough to offset the economic momentum, he said.

Spending, savings and jobs data during the week continued to inspire confidence in the consumer. Although Friday's payrolls report fell short of the fireworks the market expected, many investors feel the jobs situation has finally turned.

That is feeding into general optimism that the recovery is becoming self sustaining and will continue after the Federal Reserve stops its stimulative asset purchases later this year.

The game changer for this market is and continues to be the consumer, said Douglas Cote, a senior market strategist at ING Investment Management in New York. The consumer, despite 9 percent unemployment, is setting records in not only in their incomes but their spending.

That theory will be tested again this week when consumer confidence and retail sales data are published on Friday.

The Reuters consensus forecast is that confidence will ease slightly in March. Any indication that consumers are less stalwart about rising energy and gasoline prices could be a warning sign.

(Editing by Kenneth Barry)

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