| TSG Weekly Market Watch November 30, 2007 |
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| Written by Matt Blackman | ||||||||||||||||||||||||||||||||||||
| Sunday, 02 December 2007 | ||||||||||||||||||||||||||||||||||||
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TSG Stock Market LetterWeek Ending November 30, 2007Topics Discussed This Week:
Tell us what you think of the TSG Weekly Stock Letter!We are conducting a survey so you can tell us how to make this newsletter more useful to you. The survey will take just 5 - 7 minutes. We value your opinion and thanks in advance for your feedback. Click Here to take survey Relief rally fueled by high hopes?After losing 237 points (1.8%) Monday, stocks rallied on the news Tuesday that Citigroup agreed to a $7.5 billion cash infusion from an Abu Dhabi group in the form of a high-yield 11% convertible debenture. Not only is this rate 150 basis-points above average junk bond rates, it is almost double the rate it pays bond holders and as BMO portfolio manager Norman Levine opined on Bloomberg Tuesday, it is more than most of us have to pay on unsecured lines of credit. In Levine’s opinion said, that an institution like Citigroup made this deal is a negative not a positive. It also shows the mounting costs they face to maintain both their dividend and first-tier bank status. Bank regulators require that banks maintain a minimum capital base of 6% of total assets to maintain their first-tier “well-capitalized bank” status and with the cash infusion, Citigoup’s (cash to asset) ratio increased to 7.9% according to Bloomberg. But on November 4, Citigroup estimated that writedowns on mortgage-related securities (including CDOs) could cost the bank as much as $7 billion of profit this quarter according to Bloomberg and given that home price declines are accelerating and that we are nearer to the beginning of the correction than the end, writedowns could be substantially higher. Bloomberg estimates that based on 4.98 billion shares outstanding as of September 30, the 54-cent-a-share dividend costs Citigroup about $2.7 billion a quarter, meaning the capital infusion from Abu Dhabi is enough to pay almost three quarters of dividends. However, Tuesday’s more than 200-point Dow rally on the Citigroup bond news followed by another 331 point jump Wednesday after bearish comments from Fed Vice Chair, Donald Kohn led to hopes of further rate cuts (for the biggest two-day rally in five years) showed how quickly sentiment can turn from negative to positive on Wall Street (see ‘Kohn’ article below). But here’s the concern. Why would the largest U.S. bank by assets with a rating of AA2 (Moody’s ) have to go to Abu Dhabi and pay 150 basis-points higher than prevailing triple B minus junk bond rates? (Continued in Synopsis…) Technically SpeakingLeaders tick higher againThis week, Dan Zanger’s market leaders surged 14% compare to 3% for the Dow Industrials, 2.8% for the S&P500, 2.5% for the Nasdaq and 4.7% for the Dow Transports. His picks this week changed rather dramatically and again included some past favorites Baidu.com (BIDU), Apple (AAPL), Mastercard (MA), Garmin (GRMN) as well as Intuitive Surgical (ISRG), iSharesFTSE/China (FXI) and the MSCI Emerging Market ETF (EEM). While this is the second week his leaders have moved higher with bullish implications, it remains a volatile market suited best for traders with fast reflexes and huge risk tolerances.
Figure 1 – Weekly performance of Zanger’s market leaders compared to the S&P500 (SPX), the Dow Jones Industrial Average (DJX), Dow Transports (DTX) and Nasdaq Composite (IXIC). Data courtesy of The Zanger Report, performance chart courtesy of VectorVest.com. Weekly trading volumes were above average for the S&P500, Dow Industrial Average and Nasdaq Composite as stocks moved higher. However, the Dow Transports also bounced back this week but they are still in a downtrend below the head & shoulders top neckline which is bearish. It is way too early to tell if this was just a serious correction or we are in a more protracted bear market, especially given the reasons that stocks rallied this week (see Synopsis). Volatility settled back a little more this week as the Market Volatility Index (VIX) closed at 22.87 down from 25.61 last week, showing that investors are a still less jumpy. Commodities represented by the NYFE CRB Index fell thanks in part to weaker oil and gold prices closing this week at 451.26 down from 457.39 last week. However, the index remains very close to its upper 2-standard deviation trend channel. Gold fell again this week to $789.10/oz from $822.20/oz up last week but basically back where it was two weeks ago ($787/oz). Meanwhile, the recovery of the U.S. Dollar Index continued as it closed at 76.15, up from 75.07 last week. This is good news short-term but the dollar will likely fall further if investors get their wish and the Fed cuts rates December 11. Oil fell back this week adding further lift to stocks as the NYMEX crude oil (continuous) contract ended the week at $88.71 down from $98.18/bbl last week. The MSCI Emerging Market Index ETF (EEM) reversed direction this week closing at 154.40 up from 147.34 last week and above where the ETF closed two weeks ago (153.80). Perhaps more importantly, support at 142 held and that is bullish. But the Chinese Shanghai Composite Index has dropped 20% from its peak in mid-October and that is bearish… This week, the U.S. prime bank rate held steady at 7.5% while the 3-month London Interbank Offered Rate moved up this again to 5.13% from 5.04% last week and 4.879% three weeks ago. LIBOR is used in computing approximately 90% of mortgage rates and a steady increase over the last month is bad news for mortgagees. Freddie Mac mortgage rates ranged from a high for the 30-year fixed mortgage of 6.1% to a low of 5.43% for the one-year adjustable rate (ARM) very close to where rates were a year ago. EarningsWeakness continues…Another 103 companies reported Q3-07 results this week bringing the total to 4022 companies that have reported so far this earnings season. Earnings improvements held steady at -20% versus Q3-06 (from -19% two weeks ago). This compares to an average earnings improvement of +13% for Q2-07 versus the same quarter the year before. This week the financials group earnings improvements also held steady at -27% with a total of 814 companies reporting (from -25% two weeks ago) which is important given that financials have a habit of leading the broader market. Economic ReportsA number of housing and economic reports were released this week with some revealing stats on housing, the economy and employment as well as interesting comments from the Fed (see ‘Kohn’ article below). While continued housing weakness was predictable, there is growing evidence of a slowdown on the jobs front. Initial jobless claims (the number of Americans filing first time unemployment claims) jumped 23,000 to 352,000 in the week ending November 24, a nine-month high. As well, those continuing to collect jobless benefits rose to 2.665 million, which is the highest number since December 2005 according to Bloomberg. As we have mentioned in the past, Merrill’s chief economist David Rosenberg increased his probability for recession to 65% based on metrics like the rate of change in unemployment commenting that recent rises are above previous recession thresholds. We will be watching non-farm payrolls (next Friday) and Challenger layoffs (next Wednesday) reports closely for further evidence of this trend. Durable goods declined 0.4% in October. It is important to remember that employment and jobs losses are both lagging indicators so that by the time the data confirms a slowdown, it has already begun. Home price declines still accelerating
Chart 1 – Case-Shiller Home Price Index with September data that showed a 4.95% drop (down from a 4.4% drop in August) in the composite of 20-cities across the U.S. over the past year. The 20 city index is now down 5.3% from its July 2006 peak while the national index shows that home prices have dropped 4.5% over the last year. This index began to register home price drops in January and the size of these drops has increased in each of the nine monthly reports. As we see in this next chart, a reversion to the mean given the current index value (September) of 195.62 compared to a 20-year median price of 82.2 suggests prices could fall more than 50%! The index peaked at 206.52 in July 2006.We expect this trend to continue. Existing home sales fall again, median prices drop and inventories near 11 months.
Chart 2 – It was another negative month for existing homes in October as sales dropped another 1.2% to an annual sales rate of 4.97 million homes. It was the lowest rate of home sales since 1999 with sales off nearly 30% from the peak in 2005. As well, the September estimate was revised down dropping the decline from 8 to 8.2% last month. The median price of a new home fell to $207,800 – the median price is now down 9.7% from its peak in July 2006 according to the latest National Association of Realtors data. As we see from chart 1 that is nearly double the 5.3% drop from the peak according to the Case-Shiller home price index, which the NAR have panned as being overly pessimistic and therefore an unrealistic measure. In reality, the more rapid median price drop is the result of the more recent decline in upper end homes that had been skewing median prices higher. That lift now appears to have disappeared but no one knows how much prices are still being distorted by the practice that became widespread of cash bonuses paid by sellers to buyers.
Chart 3 – Meanwhile, the inventory of unsold existing homes continued to climb to a new all-time high of 10.8 months in October, up from a revised estimate of 10.3 months in September and as we see from this chart, there are no signs of leveling off, let alone a decline on the horizon. This does not bode well for a bottoming in price declines any time soon. New home sales figures revised lower
Chart 4 – An interesting new home sales report this month from the Department of Labor. The headline announced an increase in new home sales for October of 1.68% on the sale of 728,000 new homes (annual rate). But the September number was revised more than 7% downward from 770,000 originally reported to 716,000. One big reason for the drop could be cancellations. According to the Wall Street Journal, “more than two of three buyers walked away from [Beazer Home] contracts in the fourth quarter.” While that is one of the highest cancellation rates in the industry, it continues to be a negative factor nationwide. We downloaded the Labor Dep. October new home sales report, went back to revise our chart (above) and found the following: September dropped from +4.8% to -0.14%, August from -7.9% to -9.9%, July from +3.8% to -0.13%, June from -4% to -7.4%... well you get the picture. In every case going back to April, the numbers originally reported have been revised downward and in some cases, drastically. On a year-over-year basis, new home sales are down 23.5% from October 2006. Median new home prices dropped 13% from October 2006 to $217,800. Inventories moderated as the number of new homes on the market fell to 516,000, an 8.5 month supply (from 9 months in September) and down from 553,000 in October 2006. Separately, RealtyTrac reported that home foreclosures nearly doubled in October versus October 2006 with 224,451 filings up 94% from a year earlier (see ‘foreclosure’ article below.) Bank repos increased 35%. One (and only) bright spot in the report is that October foreclosures were 9% below the number in August. Only time will tell if this is the beginning of the end in a trend toward increasing defaults or just a temporary blip. Chart 5 – Preliminary estimates for Q3-07 jumped from 3.8% to 4.9%. However, this number is suspiciously high especially given the cooling economy as John Mauldin points out in his newsletter this week (see http://tradesystemguru.com/content/blogcategory/47/81/#GDP ) It’s important to remember that this does not include much of the weakness resulting from the credit crunch that began in August – we’ll have to wait till next year for the Q4 reports for that impact. However, Fed policy makers have revised their estimates for economic growth in 2008 to the 1.8% to 2.5% range. In another report, the preliminary estimate for Q3-07 corporate profits fell from +5.2% to -1.2%. All eyes will be on the final Q3-07 and Q4-07 GDP reports to see just how much the economy is slowing.
Chart 6 – Chicago PMI rebounded slightly in November but just back to the long-term trendline (red) which as we see, remains strongly negative.
Chart 7 – Construction spending fell 0.8% in October versus a rise of 0.3% in September but again, the trend remains negative. Next WeekHere are the reports we’ll be watching next week.
SynopsisTip of the mortgage iceberg?The Citigroup cash injection from Abu Dhabi shows how desperately management wants to support stock price (and the 7%+ dividend). When it comes to markets, desperation is a dangerous emotion. And this desperation will increase with the news Friday that Moody’s had cut or placed on review $64.9 billion in structured investment vehicle (SIV) debt held by Citigroup. According to Bloomberg Citigroup created the first SIV in 1988 and is the largest SIV manager (see “Moody’s” article below). This story is far from over. There is another interesting crack in the securitization of approximately $6.5 trillion of mortgages (outstanding at the end of 2006) that was exposed following an Ohio federal court ruling on October 31. According to the New York Times, Judge Boyko of Federal District Court in Cleveland dismissed 14 foreclosure cases brought on behalf of brought by Deutsche Bank National Trust Company when the bank was unable to produce mortgage documents on properties it was trying to seize. Why? When a basket of mortgages (sometimes a million or more) are bundled and securitized, mortgage documents are not necessarily given to the end holder. According to the article, a recent study of 1,733 mortgages found that 40% creditors foreclosing did not show proof on ownership as required by law. The obvious question is how many other mortgages bundled into asset backed securities and sold to investors have similar flaws? Because most foreclosures proceed without challenges from borrows, lenders are not normally asked to provide mortgage documents. This case sets a new precedent that will undoubtedly be exploited by defending attorneys but more importantly, creates a whole new level of uncertainty for lenders in the growing number of foreclosure cases going forward. Perhaps most importantly, lenders and investors not already reluctant about buying securitized mortgages (and providing the required liquidity) will certainly be less likely to invest in them now and this will have a further chilling effect on credit markets just as hundreds of billions in new loans will needed as a result of mortgage resets (see “Foreclosures Hit a Snag” and “Financial Tsunami” articles below). This could have a potentially devastating impact on markets especially real estate. This is just one more cockroach appearing from behind the mortgage and credit crisis wall. According to Credit Suisse Group about 1.3 sub-prime mortgages will be in foreclosure by September 2009 but according to Bloomberg news, delinquencies on sub-prime mortgages account for less than 15% of the $11.5 trillion U.S. home mortgage market. According to William Engdahl, author of “The Financial Tsunami” (see below), $690 billion in interest only mortgages come due between December 2007 and July 1, 2008 out of the total of $1.4 trillion in interest only mortgages. Sub-prime mortgages account for another roughly $1.2 trillion. Makes you wonder how secure the other $9 trillion in mortgages are, especially given that house price declines have only just begun… Summing up the stock surge…Normally one of the best months to be in the market, especially during a pre-election year, this November was a clear disappointment with the S&P500 dropping 4.4%, the Dow Industrials down 4% and the Nasdaq Composite losing 6.9%. What is interesting is that the two biggest up days this week were based on what looks to be false premises in my humble opinion. As we saw above, the good news on Citigroup was not really good news at all. But the biggest surge on Wednesday came in the wake of bearish comments from vice Fed chairman Donald Kohn telling us that the Fed had underestimated the credit damage. That should have been bad news but the market focused on the hope that it meant further Fed funds rate cuts. But even that hope seems misplaced in that falling rates mean a weakening economy and is bearish. At least three recessions/depressions in the last 100 years (1929 and 2001 in the U.S. and 1990 in Japan) were accompanied by falling rates and falling equities prices. While the Fed continually cut the funds rate from 2001 and 2002, the S&P fell nearly 50% see http://tradesystemguru.com/content/view/113/61/#Fed . So why all the optimism? First, the correction had been brutal and pushed markets into oversold territory accompanied by extremely bearish sentiment. A relief bounce was due and much of this had to do with changing sentiment. There is also optimism that an economy growing at 4.9% can’t be that badly off. And then there are the bevy of economists and analysts, especially those of the value variety, telling us that buying opportunities abound. Bear in mind, that Q4 growth looks far more muted and consumer spending is slowing. For the short-term, we are cautiously bullish based on market leading stocks but they can turn on a dime, especially given the growing credit crisis and “known unknowns” in the derivatives markets. Certainly not a time for the faint of heart or pocketbook to be making big bets. Stories of interest this week… Paulson, Banks in Talks to Stem Surge in Foreclosures Housing Slump, Third Year to Be Deepest Since WWII Foreclosures Hit a Snag for Lenders Florida Suspends Withdrawals From Investment Pool – Paychecks threatened U.S. Foreclosures Almost Double on Higher Adjustable Mortgages Kohn Sees Risk of Reduced Credit From Market Upheaval Moody's Says Citigroup SIV Debt Ratings Under Threat Citigroup Pays Junk Rate to Keep Dividend After Mortgage Losses Case-Shiller Home Market Index posts record decline Link to updated report – Are we approaching recession? Link to book site – Ahead of the Curve (some very interesting charts!) If you find this newsletter insightful, please feel free to forward this newsletter and share it with a friend (or simply have them opt-in free from our home page http://www.tradesystemguru.com to be added). DisclaimerTradeSystemGuru.com obtains information from sources deemed to be reliable; |
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