As I predicted on May 10, stocks suffered their worst decline of the year last week with the Dow, S&P, and Nasdaq falling 3.5%, 4.3%, and 5.3% respectively for the week. Several factors contributed to the decline, not the least of which was the rising tide of fear regarding the European debt crisis.
Last week, investors witnessed a modern-day bank run in Greece when reports indicated Greek depositors pulled nearly $1 billion from local banks recently. The panic was triggered when talks to form a coalition government in Greece collapsed and new elections were announced -- the fear is that the new elections will bring the anti-austerity party to power and cause the whole bailout to collapse. The yield on Greek 10-year notes spiked over 200bps on the week bringing the yield on the 'new' bonds to within shouting distance of where it was prior to the debt swap. Things got even worse on Thursday when Fitch downgraded Greece to CCC, citing the risk that the June 17 elections may bring the anti-austerity party to power and trigger a Greek exit from the Eurozone.
As the news out of Greece became increasingly worrisome, borrowing costs for Spain and Italy rose sharply. On Monday, yields on Spanish and Italian 10 year notes soared 22bps and 19bps respectively, while on Thursday Spain saw a 160bps increase in yields on four year notes compared with the last sale of such debt. Also on Thursday, Moody's downgraded 16 Spanish banks, and shares of the partially nationalized Bankia fell as much as 20% at one point after reports surfaced that depositors had pulled more than 1 billion euros out of the bank over the previous five days. Making matters still worse, Spain slipped back into recession according to economic data, and a report on Friday showed bad loans in Spain rose to nearly 8.4% their highest level since 1994.
Financial markets were also roiled last week as new details emerged regarding JPMorgan's (JPM) $3 billion (and climbing) CDS debacle. Shares of JPM have declined 17% as investors are beginning to understand the absurdly complex nature of Bruno Iksil's trade.
All of this likely would have caused U.S. stocks to suffer even worse than they did were it not for the hype surrounding the Facebook (FB) IPO -- much of the bad news out of Europe crossed the wire on Thursday when the U.S. financial media was consumed with Facebook coverage. However, the Facebook IPO disappointed, barely holding the opening price of $38, sending shares of other social media companies into a tailspin Friday, and prompting some to suggest that Morgan Stanley (MS) was forced to buy FB shares to keep it from falling precipitously.
Given all of this, things are looking particularly precarious going into next week. As CNBC notes,
"Europe will keep its chokehold on financial markets in the week ahead...[and] with just a few earnings and economic reports, there will be plenty of opportunity for markets to dwell on Europe and its problems."
German PMI is due on Thursday, a key barometer of the health of the Eurozone's strongest economy, and housing data in the U.S. is also released during the week. If these numbers come in weaker than expected, an already perilous situation could deteriorate further. Additionally, all eyes will be on Facebook to see if the shares can hold the $38 IPO price -- if they fall bellow $38, it could cause collateral damage in shares of LinkedIn (LNKD), Groupon (GRPN), and Zynga (ZNGA).
With all of the wildcards in play next week, investors would do well to hedge their long bets on the broad market with puts on the S&P 500 index (SPY). This is a trade I have recommended for some time now and I think given the landscape, it is very reasonable to expect more pain in the near future. Long VIX, long SPY puts.
Additional disclosure: long LNKD puts