Bulls, optimists, and everyone else who subscribes to the 'deny financial and economic realities' school of investing that drove the Dow above 13,000 this year, got a dose of reality Friday as stocks sold-off into the close to log their worst weekly performance of the year. The S&P lost 2% on the week and 1% the week before, bringing the index's second quarter performance to -3% thus far.
Spain weighed heavily on investors' minds Friday as the IBEX hit levels last seen in March of 2009 (the very lowest point of the financial crisis). Also of note, the cost to insure Spanish debt hit an all-time high Friday as yields on the country's 10-year note jumped 18 basis points to nearly 6%--the spread between those notes and comparable 10-year German bonds is also near an all-time high. Additionally, the spread between 10-year Spanish bonds and 5-year notes has come-in 40 basis points, a narrowing the likes of which has not been seen since November, all according to Reuters. Consider another disconcerting factoid: the net notional value of Spanish CDS is 5 times that of Greece ($15 billion compared to $3 billion) meaning that in the event of a Spanish default, things might not go-off as smoothly as they did when Greece swapped it's bonds early last month. The turmoil in Spain was reflected in the shares of Spanish bank ADRs this week as Banco Santander (STD) (which I recommended investors bet against last week) fell 10% over the past 5 trading sessions.
No matter what the Fed says about QE3, the fallout from Spain will invariably be felt in U.S. equities as demonstrated by Friday's outsized sell-off. As such, I recommended investors use any precipitous drop in the VIX as an opportunity to bet on increasing volatility. That turned-out to be a decent call as the VIX rose nearly 14% Friday. This should continue to be a good strategy going forward as the VIX term structure continues to show volatility rising above current levels in the intermediate and long term, and as stocks are quite simply becoming more volatile lately: last week, the S&P "moved more than 1% on 4 of 5 days, had the biggest down day of the year, and even the least volatile day way a .7% move."
Investors shouldn't look for relief anytime soon. Next week, Spain will hold 2 and 10-year auctions on Thursday. If recent events are any indication, expect yields on the 10-year to rise above 6%, an event which will almost certainly trigger a sell-off in U.S. equities barring some intervening factor. Spanish banks borrowed a record 316 billion euros from the ECB in March, double February's number, signaling the difficult time Spain's ailing banks are having securing funding from sources other than the central bank--incredibly, "ECB liquidity now accounts for 8.6% of all Spanish banking assets" according to ZeroHedge. This is a problem given that Spanish banks are a major buyer of Spanish government debt.
Investors should read the writing on the wall: The situation in Spain got decisively worse on Friday and next Thursday's Spanish bond auction could spell trouble for U.S. equities. While it undoubtedly seems strange to many novice investors that a bond auction in Spain could derail their investments, that is indeed the reality. Short SPY(NYSEARCA:SPY) or buy puts again this coming week. It worked the last two weeks. Now it's finally the bears' turn to say "the trend is your friend."