Why The Sell-Off In Stocks May Be Just Getting Started

| About: SPDR S&P (SPY)
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Last Saturday, I published an article advising investors to exercise extreme caution in the market during the four day holiday week as a plethora of economic data and a precarious (to say the least) situation in Europe threatened to challenge the market's resolve. I also noted that the 6% sell-off from the beginning of May through Memorial Day was hardly enough to price-in the slumping U.S. economy, a Spain restructuring, and a Greek exit from the EU. That advice turned out to be particularly prescient as stocks sold off markedly throughout the shortened week. The Dow, S&P 500, and the Nasdaq all ended the week down by 3% -- Friday was the single worst day of the year for the market and the Dow is now in the red YTD.

The economic data released during the week was dismal. On Tuesday, consumer confidence missed expectations by a wide margin, printing at 64.9 vs. expectations of 70. The index is 25 points below the level (90) that denotes a healthy economy. Also on Tuesday, the Case-Shiller home prices index missed expectations by half (posting a .1% gain vs. expectations of a .2% increase). The news got materially worse on Thursday as the ADP private sector employment report missed expectations, printing at 133,000 vs. the 148,000 forecasted by economists. Worse still, nearly all the gains were in the service sector-- manufacturing actually lost 2,000 jobs, the second straight monthly decline. The big miss was, of course, Friday's non farm payrolls number which printed at just 69,000 vs. expectations of 150,000. The unemployment rate rose to 8.2%, and April's number was revised down from 115,000 to just 77,000. Adding insult to injury, the ISM number missed on Friday as well.

All of the bad news triggered safe-haven buying of historic proportions as the yield on U.S. Treasury bonds hit fresh lows on almost daily basis (below 1.5%) while yields on 10-year German bunds dropped to an intraday low of close to 1.12% on Friday. The relationship between the two notes (i.e. the spread between 10-year Treasury bonds and 10-year German bunds) serves an illustrative segue into a brief discussion of Europe as the USGER10YR spread compressed late in the week. This likely means that investors are beginning to question how a cascade of bailouts will affect the financial situation in Germany, the eurozone's strongest economy.

In Europe, the situation continued to deteriorate (as expected) as Spain's plan's to rescue the struggling lender Bankia betrayed the severity of the country's financial struggles. Spain proposed injecting sovereign debt into the bank which the firm could pledge as collateral to the ECB to obtain cash. The suggestion was flatly rejected by the central bank as being dangerously close to 'monetary financing' (the funding of governments by central banks), leading Spain to suggest, instead, the sale of more sovereign debt, the proceeds of which could be used to prop-up Bankia. The irony there, of course, is that no one wants Spanish sovereign debt (the yield on the Spanish 10-year blew past 6.5% during the week), meaning that the issuance of such debt would be extraordinarily punitive (in terms of yield) and likely would exacerbate the country's already poor financial position. Meanwhile, the cost of the Bankia bailout has (predictably) ballooned past 25 billion euros as the bank restated last year's earnings which now show a loss of 3 billion euros.

In sum (and here is where the real irony is apparent) the only buyer of any new Spanish debt is likely to be the ECB, the same institution which refused Spain's plan to pledge such debt as collateral for a Bankia cash injection. In other words, the results are the same either way: the ECB ends up with more toxic Spanish sovereign debt in yet another example of the ridiculous and exceedingly dangerous circular relationship between governments, banks, and the ECB. Meanwhile, the anti-bailout party in Greece continued to gain ahead of a June 17 (re)election which many believe will spell the end for Greece in the EU.

All eyes are now on governments both in the U.S. and Europe. If the Fed and the ECB do not come to rescue of their respective economies, this rally (which is no longer a rally) will come to an abrupt end. Next week, Fed Chairman Bernanke gives testimony to the Joint Economic Committee on Thursday in what will be a closely watched speech. The ECB, meanwhile, meets Wednesday and investors will be watching closely to see if it cuts rates.

Mercifully, it will be a light week in terms of economic reports with the only notable data due being weekly claims (which could be bad news) and ISM non manufacturing. The problem for the market now is that it will likely take a more dramatic economic slowdown and a steeper decline for stocks to trigger another round of QE here in the U.S., and the Europeans are notoriously slow to move to stem crises. In the meantime, expect stocks to continue to struggle on uncertainty, rising volatility (the VIX term structure is still rather steep), and the possibility of a European implosion. Short S&P 500 (NYSEARCA:SPY), long VIX.

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