Stocks Face Make Or Break Week As Earnings Season Begins

 |  Includes: QQQ, SPY
by: Colin Lokey

Last week was supposed to be the week investors celebrated the salvation of the eurozone. Instead, stocks ended the holiday week just two points from where they started, as the S&P 500 closed at 1354 on Friday after opening Monday at 1356. In reality though, it could have been quite a bit worse as investors largely ignored a string of decidedly worrisome developments. The bottom finally fell out on Friday however as the abysmal nonfarm payrolls report appeared to be the proverbial straw the broke the camel's back. As bad as it was, the jobs report was not the most disturbing thing to take place in the market.

On Monday, investors learned that Finland and the Netherlands would oppose European Stability Mechanism-funded sovereign debt purchases in the secondary market, a move which effectively cuts the last remaining lifeline for Spanish and Italian bonds. Additionally, Finland balked on the agreed-upon renunciation of the permanent rescue fund's preferred creditor status when it said it would demand collateral for its portion of the Spanish bank bailout. Casting more doubt on the status of the eurozone rescue effort was the announcement that Germany's largest opposition party, the social democrats, would not support direct recapitalization of financial institutions with rescue funds. Just like that, all three of the major breakthroughs from the Summit were scuttled.

The sovereign debt market responded accordingly. By Friday, yields on Spanish 10-year notes were back above 7%, the level at which many believe the country will finally be forced to ask for a full-blown international bailout. Friday marked the first time Spain's debt had entered the 'danger zone' since June 19. Worse still, yields on Spain's 2-year notes rose 32 basis points Friday to 4.93% meaning investors are increasingly worried about a Spanish default or restructuring within the next twenty four months. Italian debt fared little better: yields on Italy's 10-year notes rose above 6% on Friday. Taken together, Spain and Italy's bonds have given back all of their Summit-fueled gains and are now back near their worst levels of the year. In an indication of just how rattled the market it, yields on German 2-year notes turned negative Friday, meaning the country is now borrowing for free.

The CDS market reflected the strain last week as well, with Spain's 5-year CDS (579.65) rising above that of Ireland (543.86) for the first time in 2 years. The euro meanwhile, hit a two year low against the dollar at under 1.23.

Underscoring all of this and adding a bit of fuel to the fire, were Mario Draghi's downbeat comments about the eurozone economy following the ECB's rate cut. Draghi noted that downside risks to the economy had indeed materialized and, in a rather peculiar move, reminded the world that the ECB's bond-buying program was only temporary, as were all of the central bank's 'extraordinary measures.'

A sell-off in distressed sovereign debt wasn't the only thing the ECB triggered Thursday. In addition to the expected 25 basis point rate cut, the ECB also cut its deposit rate to zero in an effort to boost lending. The move prompted JPMorgan, Goldman Sachs, and Blackrock to shut their European money market funds to new investors in order to keep returns above zero. With interest rates so low around the world, money market fund investors are "losing hundreds of billions of dollars in interest income" according to an interview with Crane Data's Peter Crane conducted by Bloomberg.

As Europe began its downward spiral anew, U.S. investors learned that, according to the ISM, the U.S. manufacturing sector is contracting for the first time since the financial crisis. The ISM manufacturing index printed at 49.7 for May while new orders, prices, and exports fell 12%, 10%, and 6% respectively. And then there was Friday's nonfarm payrolls number: 80,000 jobs added versus economists' expectations of 100,000. To put the number in perspective, consider that

"...this means the U.S. economy added just 75k jobs per month during the second quarter, that's 150k less per month than the first quarter and the worst three month period in twenty four months."

Next week, against this rather dismal backdrop, the market enters earnings season. The situation really could not be more precarious. Spain and Italy's fates hang in the balance as time runs short for policymakers to craft a viable plan upon which the region's leaders can agree. Meanwhile, the countries are effectively priced-out of the bond market as investors throw their money at Germany, content with no return whatsoever for their trouble. In the U.S., job creation has ground to a near halt and the manufacturing sector is the weakest its been since July of 2009. This is a tight rope act for stocks and there is quite a strong wind kicking up. Critically, JPMorgan (NYSE:JPM) reports next Friday when the world will finally know exactly what impact the Whale trade had on the firm's quarterly results. Next week is absolutely critical and investors would be acting recklessly not to buy some protection. Long S&P 500 (NYSEARCA:SPY) puts and Nasdaq (NASDAQ:QQQ) puts. At this critical juncture, it's better safe than sorry.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in SPY over the next 72 hours.