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Sentiment is driving large daily swings as traders vacillate between the fear 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, 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 3-year high hit in late February, which even bears concede is a remarkably robust performance. For the 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 broke out. 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 over $116 per barrel.

"These type of crises make you refresh your portfolio and just take another look," said Siddique. "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 (SU.TO) (SU.N), Marathon Oil (MRO.N), and Exxon Mobil (XOM.N).

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 (DE.N) and Caterpillar Inc (CAT.N).

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

STRONG ECONOMIC MOMENTUM

Friday's gains brought stocks to near levels since the Libyan crisis erupted, indicating markets have been largely resilient to oil's 12 percent surge in the past two weeks.

A reasonably strong correlation between Asian equities and oil shows both track the broad growth story except for periods when markets have grown nervous of a price shock and the resulting spillover impact on inflation.

The region is a big importer of oil.

But the pull-back in oil from 2-1/2 year highs following two days of strong gains that sent a key technical indicator to its most overbought level in more than five years for Brent crude alleviated such concerns.

A strong Wall Street close and hopes that U.S. jobs data due later may show strong gains and reinforce expectations of a steady improvement in the world's biggest economy boosted stocks with Tokyo .N225 and Seoul .KS11 leading gains.

But further gains on Wall Street looked difficult with the S&P 500 Index .SPX set to run into strong resistance around the 1,340-60 zone.

The broader MSCI index of Asia-ex Japan stocks .MIAPJ0000PUS rose more than a percent, extending its weekly gains to nearly three percent.

"Substantial gains are expected in morning trade on hopes for good jobs data in the U.S., but the market may trim gains toward the close because investors remain cautious until they actually see the figures," said Shinichiro Matsushita, a market analyst at Daiwa Securities.

The median estimate is for a gain of 185,000 jobs, according to economists polled by Reuters, but market sentiment was leaning toward a number above 200,000, traders said.

Notwithstanding the Libyan crisis, Asian markets have generally underperformed this year as inflows into emerging market funds have slowed sharply due to concerns of inflation and crowded positioning in some of the region's markets.

But the latest oil driven sell-off has cleaned up some of the technical positioning and enhanced the attractiveness of certain markets such as Korea, according to Barclays Capital strategists.

Foreign investors were net buyers for a second straight day in the stock market, the strongest since January.

EURO RISES

Gains in stocks diminished the safe-haven appeal for gold and U.S. Treasuries with two-year debt yields rising by as much as eight basis points to 0.77 percent.

Nonfarm payrolls increased 185,000, according to a Reuters survey, after a measly 36,000 jobs in January.

The survey was conducted before strong signals this week that the fragile U.S. labor market was recovering more quickly from the worst recession since the Great Depression.

The peak of monthly employment last May was when payrolls were being boosted by government hiring for a census. Still, February's expected gains are unlikely to sway the Federal Reserve from its ultra-easy monetary policies.

The Labor Department will release the closely watched employment report at 8:30 a.m. ET.

"We have moved into the expansion phase of the economic cycle and the economy is self-sustaining," said Brian Levitt, an economist at OppenheimerFunds in New York.

U.S. payrolls in recent months have fallen far short of economists' expectations, despite labor market indicators -- including weekly data on initial claims for jobless benefits and employment measures in surveys by the Institute of Supply Management -- pointing to a faster pace of job creation.

Analysts, however, are increasingly convinced that a foundation is now in place for solid job growth going forward.

"Businesses are actually beginning to realize that they need to hire more aggressively because we do think demand is going to continue strengthening through out the year," said Ryan Sweet, a senior economist at Moody's Analytics in West Chester, Pennsylvania.

Despite the expected bounce in payrolls, the unemployment rate is seen ticking up to 9.1 percent from 9.0 percent in January as once discouraged jobseekers return to the labor force to look for work, a sign of confidence in the economy.

The jobless rate has dropped 0.8 percentage point since November, the biggest two-month decline since 1958. The rate is derived from a survey of households, while the job creation figure comes from a separate survey of employers.

FED WATCHING JOBLESS RATE

The unemployment rate is being closely watched by the Fed and could well determine the timing of the U.S. central bank's first interest rate hike. The Fed, which meets on March 15, has held overnight lending rates near zero since December 2008.

Economists believe the Fed will want to see payroll gains in excess of 200,000 for at least six to nine months and a significant decline in unemployment before starting to withdraw its massive monetary support from the economy.

"If we start to add enough jobs, sufficient to lower the unemployment rate, I think the Fed will feel a little more comfortable in easing off the throttle," said Sweet.

As oil paused from its recent climb, the market's focus shifted to stronger-than-expected economic data a day before the February U.S. employment report.

The median estimate is for a gain of 185,000 jobs, according to economists polled by Reuters, but market sentiment was leaning toward a number above 200,000, traders said.

"There are still concerns about high oil prices but the bottom line is, the U.S. economy is improving. We continue to get confirmations of that, and it's a good sentiment heading into Friday's numbers," said Ryan Detrick, technical analyst at Schaeffer's Investment Research in Cincinnati, Ohio.

The Dow Jones industrial average .DJI was up 191.40 points, or 1.59 percent, at 12,258.20. The Standard & Poor's 500 Index .SPX was up 22.53 points, or 1.72 percent, at 1,330.97. The Nasdaq Composite Index .IXIC was up 50.67 points, or 1.84 percent, at 2,798.74.

The Dow and S&P 500 posted their biggest one-day gains since December 1.

However, volume continued to be below average on days when the market rallies, causing some traders to be skeptical about the durability of the rally. About 7.99 billion shares traded on the New York Stock Exchange, NYSE Amex and Nasdaq, below last year's daily average of 8.47 billion.

The put-to-call ratio in the options market also didn't change much despite the day's rally as traders continued to hedge against a potential drop in the market.

"As much as investors are excited about a pullback so that they can jump in, they are just as concerned about how quickly this market can turn," Detrick said.

Initial jobless claims fell last week to 368,000 -- a 2-1/2 year low -- one day after a robust report on private-sector hiring.

The Institute for Supply Management's non-manufacturing index rose to 59.7 in February, slightly above forecasts and higher than the January result.

Industrial stocks led the market higher, boosted by a weaker dollar and an improving outlook for global demand. The S&P industrial index .GSPI gained 2.4 percent, with Caterpillar Inc (CAT.N) up 3.2 percent to $104.25.

Stocks have shown resilience in the face of economic headwinds. The broad S&P 500 is down only about 1 percent from a peak in late February after falling around 3 percent due to growing violence in oil-producer Libya.

The Arab League said a peace plan for Libya was under consideration. The plan put forth by Venezuelan President Hugo Chavez, if successful, could remove a major headwind for equities.

Oil prices retreated from near 2-1/2 year highs. Brent crude futures fell $1.56 to settle at $114.79 after Venezuela's proposed plan to end Libya's crisis set off profit-taking.

Speaking exclusively to Reuters Insider, Gross said: "Let's cut the deficit, but let's do it gradually," so that real economic growth can take hold.

Lawmakers struck a deal on Wednesday that delays for two weeks a showdown over the current year's spending plan. Republicans are seeking some $61 billion of cuts to help reduce the deficit, estimated to hit $1.65 trillion this year, but Senate Democrats are preparing a measure that would keep funding essentially flat.

The first negotiations on the budget are expected to take place on Thursday, according to congressional aides. Wednesday's deal averted a government shutdown as funding for daily operations had been due to expire on Friday, March 4.

Gross, who oversees $1.2 trillion of assets at the Newport Beach, Calif.-based, investment management firm, said he does not expect a credible deficit reduction plan until after the 2012 elections.

Addressing the risk to markets from the mushrooming budget deficit, Gross said Treasuries are moving toward being "less of a triple-A credit," echoing a concern many bond investors have how long the United States can retain the highest possible rating designated by credit rating agencies.

Gross, who has been avoiding U.S. government debt securities recently, said he suspects the yield on Treasuries will move higher this summer after the Federal Reserve brings an end to its $600 billion Treasury purchasing program.

In a more normal environment, the yield on benchmark U.S. 10-year notes would more closely track the nominal rate of gross domestic product growth, which Gross estimates to be roughly 5 percent.

A yield that high is not likely in this environment, but a 4.0 percent yield for 10-year notes is a "rational expectation" if the Fed "disappears as the buyer of last resort," Gross said. The note currently yields 3.56 percent.

Turning his attention away from the situation, Gross saw European Central Bank President Jean Claude Trichet's comments Thursday on the inflation threat in the euro zone as signaling a near-term rate hike but not the beginning of a trend.

Trichet's use of the term "strong vigilance" following the ECB's monthly policy meeting was "tough talk, there's no doubt about it," Gross said.

The ECB left benchmark rates for the region unchanged at a record low 1.0 percent. Gross said he now expects 25 basis points of increase thanks to high prices for oil and other commodities, which feature more prominently in the ECB's inflation math than in the Fed's.

Still, Gross said sufficient headwinds remain in the euro zone recovery to prevent any near-term rate increase from becoming a trend any time soon. (Reporting by Dan Burns, Jennifer Rogers and Jennifer Ablan)