The perception on Spain was more positive last week, or at least less negative, causing a pullback in the downtrend in Spanish stocks. However, this was short lived.

The expectation was some sort of “grand fix” that would rescue the Spanish banks, and thus, the economy. What the market is hoping for, and will not get for the foreseeable future, is an insurance on deposits to defend against a run on the bank, similar to the FDIC guarantee in the United States. However Germany and the Sweden have both signaled that this would be unacceptable. As Germany’s finance minister has said, joint liability would not be acceptable without joint decision making.

Instead, Europe has agreed to lend to Spain $100 billion euros that Spain will then use to purchase equity in its banks.

I think this is actually a good idea. Rather than indebting the banks with more loans, as the United States did with TARP funds, a purchase of bank shares boosts the value of the banks’ equity, which will then allow the banks to directly lend MORE, by reducing the debt-to-equity ratio.

However, the market turned negative after the announcement. The package was not as robust as was hoped, and further, the new loans will have to be paid back before other Spanish bondholders are paid. This does not secure the bondholders place, so yields are rising, and going to continue to rise for the near future.

The worry now is about the Spanish government‘s ability to raise new capital, and to meet its existing payments. Reflexively, these worries are causing them to come to true – as pessimism increases, yields on Spanish bonds increase, and Spain will have to pay higher rates on new debt issued.

These worries are new. Previously the only real concern was the banking system within Spain; the Spanish government itself has a debt to GDP ratio much lower than the other at-risk countries – Portugal, Ireland, Italy, and Greece.

However, it is the original concern about Spanish banks that will have the greatest impact on Spanish stocks. The credit contraction is sharp and will continue – banks cannot lend, because their borrowing costs are high and increasing. Spanish homeowners are saddled with debt, and at least 20% are unemployed.

A reflexive process is also at work, further exacerbating the situation. Ratings agencies are downgrading the debt of the Spanish banking sector, causing borrowing costs to rise, which may trigger further negative perceptions.

The link is clear, and the situation will deteriorate. However, the process is not sustainable, and it will not continue forever. The bailout package, or a future move by the ECB, may have a positive effect in the coming months. But in the short term, I continue to be bearish on the Spanish stock market.

I have a short out via puts on the iShares Spain ETF (EWP). Luckily I was patient enough to wait out the pullback, and I got in late late last week. I am hovering at about cost basis on them, but I believe that perceptions will worsen as we near the Greek elections. The puts are only worth about 1% of my portfolio, so I am not too worried about being wrong – which is likely – because the other 99% of my portfolio is long and will rise if perceptions suddenly turn around. On the other hand, if I have read the market correctly here, I will be able to mitigate the fall in my stocks and maybe end up with greater profit than if I had done nothing.

In the meantime, I am looking to accumulate shares of profitable U.S. stocks, and stocks in Europe that do business outside Europe, like Catering International Services (CTRG) and Petroleum Geo Services (PGS), both of which are linked to commodities. I think we are nearing a bottom on oil, as the Saudis have reached their goal of $100 oil prices (Brent crude) and will probably start to reduce production. So, I might like to accumulate more oil service names, like C&J (CJES) and Halliburton (HAL), but I am hesitant because I am already so overweight on the sector (it represents more than 50% of my portfolio).