Why The Rally In Stocks May Come To An End During Q2

| About: SPDR S&P (SPY)

Stocks closed the first quarter on a positive note Friday, with the Dow up 66 points. A few things to note: this was the best quarterly gain for stocks in nearly a decade and a half and stocks have risen for six months in a row. This is despite economic data that has generally underperformed expectations of late and a European debt crisis which actually seems to be getting worse in the wake of Greece's restructuring. Eurozone finance ministers said Friday they will increase the amount earmarked (via the combination of the ESM and the EFSF) for EU member bailouts to 800 billion euros from 500 billion euros, a laughable amount considering a bailout of Italy and Spain would likely cost nearly 3 trillion euros. Belgium's finance minister noted that the 800 billion number was a good middle ground between those who want a 'maximum' firewall and those who want a 'minimum'--again, even though the 'maximum' amount discussed (1 trillion euros) is around a third of what is necessary to bailout Italy and Spain, the latter of which will almost certainly need some sort of assistance in the very near future.

In case you're unfamiliar, the problem in Spain is that the country's banks are groaning beneath a heavy load of souring construction and property debt. Additionally, the nation's banks have recently increased their holdings of Spanish government debt, the price of which is falling as the sovereign debt market continues to lose confidence in Spain's ability to implement painful austerity measures--protests have broken out throughout Spain in a prelude to a Greece-like situation down the road. Spain's financial institutions face the possibility of a war against defaults on two fronts: private debt and government debt.

Spain and Italy of course, are not the only problem areas. Portugal has long been going the way of the Greeks as "GDP is expected to decline between 3% and 6% in 2012 depending on who you ask, and some analysts peg the country's debt-to-GDP ratio at around 140% as opposed to the 111% estimated by the European Commission--for comparison purposes, Greece's debt-to-GDP ratio was around 165% in 2011." These rather dismal statistics are reinforced by the fact that yields on the country's 10-year notes are well above 10% (7% is the level at which countries generally become priced out of the market). Perhaps most disconcerting is the fact that the crisis has now definitively spread to the core of the EU. According to the Wall Street Journal, the Netherlands (traditionally a country with a strong economy) is beginning to show signs of distress. The Dutch recently raised their deficit target for 2012 to 4.6% from 3% and the economy is expected to contract 1% during the year.

Although U.S. stocks managed to decouple from the deteriorating situation in Europe during the first quarter, American investors' selective hearing can only last so long. Europe is essentially betting that the positive effects of LTRO version 2 will continue to drive down borrowing costs for distressed EU countries. The reality of course, is that Spain's rates are on the rise again. It should be noted that one problem with the LTRO funds is that they must be paid back in 3 years. Therefore, the money doesn't exactly encourage investment in risky, long term debt. As Zero Hedge puts it, "LTRO encourages banks to buy 3-year and in paper...[because] there is no funding mismatch at maturity." U.S. markets will find it difficult to ignore the ongoing crisis in Europe should Spain or Italy suddenly lose its ability to borrow. Such an event could precipitate a painful worldwide sell-off.

Importantly, the VIX/VXV term structure indicates that volatility traders are indeed expecting a shake-up in the market three months out. During the middle of March, the VIX/VXV term structure was the steepest it has ever been, which essentially means that the market is far too calm relative to how risky things are over the coming months.

In summary, perhaps the best argument for selling stocks now is the fact that we have already come so far. There is nothing wrong with taking some money off the table when things are good. Personally, I recommend taking some of those profits and placing bets against the S&P 500 (SPY) via put options or, alternatively, betting on a rise in the VIX over the coming months. Remember, nothing lasts forever--not even stock market rallies fueled by excessive central bank stimuli.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.