The Dow hit a four year high (13,338) intraday on Tuesday after the ISM report showed manufacturing growth was the strongest in nearly a year. I have been saying for some time now that stocks are due for a pull back, and that prediction has come true on several occasions over the past month.
However, each time the market takes a step back it seems to pause before trading significantly lower, as stocks proved remarkably resilient throughout the first month of the second quarter. On Tuesday, the S&P 500, which posted its first monthly decline in 5 months during April, flirted with its recent high of 1422 reached on April 2.
There are a multitude of reasons why the continued strength in U.S. stocks is both curious and troublesome. First, it isn't exactly clear who is doing the buying these days. According to the Investment Company Institute, weekly outflows from domestic equity funds were $1.6 billion last week and $8.7 billion the week before--in fact domestic equity funds haven't seen a monthly inflow in a year. In other words, retail investors are simply not interested in this rally, meaning that the 'sideline' money is not coming into this market anytime soon.
The second reason to fear this market is familiar: Europe. Put simply, the situation is still deteriorating--rapidly. The Spanish banking system is in such bad shape that the country is now considering forming a 'bad bank' to take the assets off the banks' books. In addition to what we already know about Spain (its borrowing costs are flirting with 6% on 10-year notes, its CDS is hovering at 500bps, bank loans account for 170% of GDP, banks are taking out record amounts of loans from the ECB, and bad loans now account for more than 8% of banks' total loan portfolios) a recent report revealed several more disturbing statistics about the Spanish banking system including the fact that
Spanish banks will need another €29 billion in loan loss provisions, 1 out of every 10 euros lent out by Spanish banks will likely not be paid back, Spain's government has limited cash transactions over 2,500 euros to keep capital from flowing out too quickly, and Spanish banks need to roll over 20% of their debt this year.
Note that of all the above-mentioned statistics, it is the last one that might prove to be especially worrisome as this is not exactly an opportune environment to try to renegotiate or pay-off one fifth of your bonds if you're Spain. On top of all of this, S&P recently downgraded 11 Spanish banks including Banco Santander (STD) and BBVA (NYSE:BBVA) with outlook negative, and Spain's banks bought 20 billion euros worth of sovereign debt in March indicating that the relief Spain saw in terms of borrowing costs during that time was solely the result of buying by its own banks.
All in all, if Spain refuses to allow EU rescue funds to be directly injected into the banking system, that system will likely fail, the fallout from which will be widespread. Adding insult to injury, eurozone inflation remained well above the ECB's target range in April at 2.6%, limiting the central bank's ability to fight the debt crisis via rate cuts.
The third reason why this market looks extraordinarily fragile is the state of the U.S. economic recovery. Investors cheered Tuesday's ISM number as though it makes up for all the dismal data we've been getting lately, not the least of which was the first quarter GDP number which, as most investors know, showed growth in Q1 was a disappointing 2.2%, well below estimates and far below the 3% figure reported for the fourth quarter of 2011.
While some cheered the fact that the GDP report showed consumer spending remained strong, ZeroHedge was quick to note that the strength in personal consumption was "expected, as it was precisely the factor most impacted by pulling in demand forward courtesy of 'April in February'". Even the ISM number reported Tuesday may be deceptive - the Wall Street Journal recently reminded investors that all of the regional surveys were weak in April. Data out Wednesday also pointed to economic weakness as orders for factory goods logged their biggest decline in three years during March and the ADP jobs number came in well below expectations at 119,000.
All of this and the Dow is still at its highest levels since before the collapse of Bear Stearns. To those who maintain that this is a good place to get in, I would ask the following question: "What's to like about this market?" Short SPY.