| TSG Weekly Market Watch December 7, 2007 |
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| Written by Matt Blackman | ||||||||||||||||||||||||||||||||||||
| Monday, 10 December 2007 | ||||||||||||||||||||||||||||||||||||
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TSG Stock Market LetterWeek Ending December 7, 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 Bush Mortgage Bailout Plan – The Good, the Bad and the UglyOver the last few days the term ‘moral hazard' rose to ubiquity in the media. According to Wikipedia moral hazard is the “prospect that a party insulated from risk may behave differently than it would if it were fully exposed to the risk. Moral hazard arises because an individual or institution does not bear the full consequences of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to bear some responsibility for the consequences of those actions.” Many (mostly conservative republicans and business interests) argue that the Bush mortgage bailout plan euphemistically entitled Hope Now announced December 6 crosses the moral hazard line while those on the other side (mostly democrats, minority interest groups and some civic leaders) who believe that protecting people from themselves is the role of government, argue the plan doesn’t go far enough. The question remains, does the three-pronged Hope Now plan cross the moral hazard line and what impact will it have longer-term? Before we delve into that question, let’s take a look at the goals of the plan as they have been presented so far. The PlanIn announcing the mortgage bailout Thursday, President Bush proclaimed that it was aimed at helping up to 1.2 million subprime borrowers who will be adversely affected by mortgage rates resetting higher in the next 30 months. We shall see if this lofty goal is realistic but here is the backdrop. Mark Zandi of Economy.com estimates that 2.8 million homeowners will face foreclosure and even this pessimistic estimate does not include the possibility that home prices decline more than the current forecast of 13% by 2009 or if we have a recession. His forecast is also based on his assumption that the housing market bottoms in 2008 which is a pipe dream given current inventories and falling sales rates especially if we enter recession. As we discussed in our newsletter last week , Credit Suisse estimated that about 1.3 sub-prime mortgages will be in foreclosure by September 2009. However, delinquencies on subprime mortgages account for less than 15% or roughly $1.2 trillion out of the $11.5 trillion U.S. home mortgage market. Interest only mortgages coming due between December 2007 and July 1, 2008 amount to another $690 billion out of the total of $1.4 trillion in interest only mortgages. But unless interest only mortgages are also subprime they don’t qualify for the Bush plan. Mortgage delinquencies as a percentage of all residential loans are approaching 5.6% (up from 5.1% last quarter), the highest since 1986 according to the Mortgage Bankers Association. Prime rate defaults are now 5% according to Orin Kramer of the New Jersey Investment Council. More than 2.1 million vacant homes are on the market which represents 2.6% of all owner-occupied homes in America. The GoodSo far at least, the plan is voluntary for both distressed homeowners and lenders. And as long as it is voluntary, and does not force lenders by in effect abrogating or changing contracts unilaterally, government will not be overstepping its boundaries. Bush’s plan is not legally binding and was agreed upon by the New Hope Alliance, a group that includes mortgage lenders and service providers plus investors holding mortgage backed securities. In other words, it is a voluntary plan designed to help all concerned. Where there was fraud by either lenders or borrowers, government should act and this plan does not change this. Given that we now have a House and Senate controlled by Democrats and the chances that a Democratic President will rule the roost in 2009 are better than 50%, Republicans had little choice. We are clearly in a real estate bubble and many will suffer. Some sort of action was called for. Here is what the plan proposes. To qualify for help, the mortgage must be an adjustable rate subprime loan. Since subprime loans are designed for those with poor credit histories, the plan helps those who have already demonstrated a lack of responsibility in paying debts. The subprime loan must have been made between January 1, 2005 and July 31, 2007 and the first adjustment must come after January 1, 2008 but before July 31, 2010. You must be in need of help (those who can afford to make payments don’t qualify) but your loan must be current – you cannot have already defaulted or be late on payments, which will eliminate many given that those utilizing subprime loans already have a habit of missing payments. If you can’t handle the current interest rate you are paying you also don’t qualify. (In September, Ohio Attorney General stated that 49% of subprime borrowers in his state failed to make their first payment). You also need to live in the home – it can’t be an investment, second or vacation home which leaves investors and speculators out in the cold. So in a nutshell $10.3 trillion or 90% of the total of $11.5 trillion in outstanding mortgages won’t ever qualify for help under the current plan no matter how bad things get. And the worse things get as the economy slows and home prices drop, the fewer the number of distressed homeowners (as more miss payments) will qualify. The BadRepublicans estimate that as many as 1.2 million homeowners could be helped but detractors say that number is more realistically closer to 145,000. The final tally will depend on what happens to prices and the economy from here and how negotiations between borrower and lender proceed. But here is a useful statistic that comes from an unlikely source – the CEO of company whose stock rallied more than 30% on the forecast that the housing market would rebound in Q4-07.
Table 1 – Estimates provided by Countrywide Financial CEO Angelo Mozilo in keynote presentation at Bank of America’s Annual Investment Conference– September 18, 2007. I say unlikely because Countrywide Financial probably supports the Bush mortgage bailout and would not be expected to provide data to challenge it. But provide such data they did in a September keynote presentation by CEO Angelo Mozilo. As we see from Table 1, the biggest cause of mortgage defaults to July 2007 by a margin of 58% was curtailment of income i.e. loss of work or falling wages. Only 1.4% of foreclosure action taken by Countrywide to July was as a result of an interest rate adjustment. Even if mortgage resets in 2008 triple from 2007, the percentage of borrowers subject to foreclosure that qualify under the plan would rise to just 4.2%. So according to data from the nation’s largest lender, Bush’s bailout will help a tiny percentage of distressed borrowers. More importantly, it is also reason to expect that government intervention with a new Administration will be far more substantial and therefore disruptive to business. It is also realistic to expect that such efforts will not only come at the expense of banks and lenders but on the backs of taxpayers as well. The aftermath of a bubble is never pretty and studies show that in every major bubble in history going back to the South Seas bubble more than 400 years ago, prices reverted to below the previous trendline. In the case of U.S. real estate prices, it implies a drop of at least 40% and possibly more than 50%. No plan can change the fact that when a bubble bursts, pain follows and in the case of property, this pain usually takes years not months to unwind. Add to the equation that we are now in the thralls of the first housing recession in history to occur in lieu of an economic recession. Median existing home prices have fallen 10% in the last four months and the declines have just begun. If we do go into a recession in 2008 or 2009 and we believe we will, job losses will mount and fewer will be able to make mortgage payments no matter what the government does. Inventories of unsold homes are now approaching one year in both new and existing homes and sales continue to fall. This means that even if no new homes are put on the market, the average time to sell a home will steadily increase. The UglyAlthough well intentioned, this mortgage bailout sets or reaffirms some dangerous precedents that could exacerbate an already dire situation. Yes, the plan as presented is voluntary but that could easily change with new party in the White House. Investors, rightly nervous by the message government has sent should be more so given rhetoric coming from the Democratic camps. Hillary Clinton arguably the most business friendly Democratic contender said this on Monday according the Democrat-friendly New York Times. “It seems that President Bush is going to give struggling homeowners far less than they need. With news accounts using terms like ‘whittled down’ and ‘limited’ to describe the scope of the Bush plan, it appears that the president is pushing a freeze for a very narrow group of borrowers.” Clinton has proposed a 90-day moratorium on subprime foreclosures and a rate freeze that would apply to all borrowers current on payments and some who have fallen behind according to the Times. Senator John Edwards proposed a more aggressive plan that includes a seven-year freeze on subprime rates as well as a fund to help distressed borrowers as well as a change in the bankruptcy laws to make that a more viable option. Not to be outdone, Barack Obama’s plan includes a government rescue fund, change in bankruptcy laws and a new tax credit on mortgage interest for those who can’t currently deduct such payments. There is clearly a battle between candidates to milk this issue for the greatest political benefit and that will certainly push moral hazard boundaries. Here is what both parties seem to be saying. ‘Go ahead, make your contracts but if at some time in the future we deem it necessary or desirable, we may change or rescind it.’ While such action would undoubtedly be disputed in court as unconstitutional (to start), it creates a new uncertainty and we all know how markets hate uncertainty. Let’s think about this for a moment. By my calculations, $6.1 trillion out of the total $11.5 trillion currently outstanding in mortgages across our nation were accomplished through structured investment vehicles (SIVs) on Wall Street. That means that more than half of the current mortgages in existence today were made possible by investors providing the cash. With falling property prices and the trend toward increasing government intervention, especially with the potential for a party change at the White House, what incentive does an investor have in buying a mortgage instrument today or tomorrow? And as home prices decline, the incentive for borrowers to continue paying a mortgage worth increasingly more than the home = rising defaults in spite of government bailout programs. Freezes and moratoria simply mean greater investor losses and a growing number of foreclosures as more homeowners take advantage of the uncertainty to live rent and mortgage free. According to Countrywide current estimates times three, rate resets will still be responsible for less than 5% of total mortgage defaults by 2008, a small percentage of the current subprime default rate of 22% according to First American LoanPerformance. Now takeaway those who based on their incomes can technically afford to make the reset payments are late on payments or who are not owner-occupiers. Barclay’s Capital estimated the plan could help about 12% or 240,000 homeowners but that seems generous. But these estimates are meaningless if we go into recession or if home prices continued declining past mid-2008 which will render any government bailout plan short of an out-and-out buyout moot. The TakeawayIn the final analysis, charges that the plan abrogates legal contracts have so far proven unfounded. Under Hope Now, negotiations between parties are voluntary and designed to help them both. But such claims are relevant. While voters believe that something had to be done, the issue has become a political football. And we know the lengths to which governments have gone in the past to get re-elected and this increases the risk of government inserting itself between parties of a legal contract. Once started, where does it stop and perhaps more importantly, what chilling effect does it have on credit markets going forward? Will government then fill the resulting credit vacuum by buying Countrywide Financial and become the nations’ largest mortgage lender? Seems farfetched now but once the moral hazard line has been crossed, where does it end? Such intervention will not stop the decline in home prices that are the result of credit drunkenness and fiscal excess that saw home prices soar more than 50% past any previous inflation-adjusted high. There is a greater chance that it will instead exacerbate an already serious problem that at best delays the inevitable price correction but at worst turn a normal and necessary market correction into a long-standing property depression. It wouldn’t be the first time that this happened. Just take a look at the situation in Japan in 1990 that saw prices decline by up to 80% in urban areas and that continues to plague the Japanese economy17 years later (see “Bad Idea” article below). This latest effort by government should help a small percentage of distressed homeowners but it comes at a heavy price. What government has given with one hand may be taken away in greater proportion by the market by the message such action sends. This and the uncertainty it creates given the current political atmosphere is by far the greatest risk going forward. Now let’s check in on what happened in markets this week.
A matter of interpretation…It was another weekly rally based on an interpretation of the news as opposed to the news itself that has more to do with expectation than reality. It is that time of the year when the Christmas rally can color one’s outlook and for good reason. Over the last 110 years according to Eddy Elfenbein of CrossingWallStreet.com, the 17-day stretch from December 21 through January 7 has been responsible for more than 40% of the yearly Dow gains. Gains over the last two weeks show that investors would rather take their chances in the market than risk missing the Christmas lift. Stocks fell on Monday and Tuesday and were flat on Friday for a net Dow weekly gain of 254 points on a combination of hope and government hype. But the Dow rallies of nearly 200 points Wednesday on weak economic data followed by a 174 point gain Thursday on news of President Bush’s mortgage bailout plan showed how sentiment has changed of late. News both days was in reality negative not positive. As evidence of high expectations, one only has to look at Philadelphia Housing Sector Index (HGX) of 20 home builders that rallied more than 8% and the S&P Homebuilders Index surge of nearly 10% Thursday on the news to see that hope continues to spring eternal on Wall Street. But does the mortgage bailout plan address the credit problems and what does it mean for markets going forward? (Be sure to watch the ‘Shiller’ video below where he expresses his views and outlines his forecast for the housing market.) Technically SpeakingLeaders tick higher againThis week, Dan Zanger’s market leaders surged 4% compared to 1.9% for the Dow Industrials, 1.6% for the S&P500, 1.7% for the Nasdaq and 4.6% for the Dow Transports. His picks this week included past favorites Apple (AAPL), Mastercard (MA), First Solar (FSLR), iSharesFTSE/China (FXI) and the MSCI Emerging Market ETF (EEM) as well as relative newcomers Sigmas Designs (SIGM) and Solarfun Power (SOLF). While this is the third week his leaders have moved higher, momentum has fallen (they were not top performers) and the market remains volatile. 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 back below average for the S&P500, Dow Industrial Average and Nasdaq Composite as stocks moved higher. However, the Dow Transports also continued to move higher breaching the bearish head & shoulders top neckline that if it holds negates the pattern. That stocks rallied on falling volumes however, brings this week’s rally into question. Until we get increasing volumes on rising prices, we remain cautious. Volatility settled back a little more again this week as the Market Volatility Index (VIX) closed at 20.85 down from 22.87 last week and 25.61 two weeks ago. But one jolt of unexpected financial or credit news could easily propel it higher again. As we see from Figure 2, credit spreads which are another measure of investor nervousness, have remained high as Figure 2 shows. Spreads between high-yield corporate bonds and comparable term U.S. Treasuries gave risen to the highest levels since August 2003 and the recent 144% spike is the biggest since 1997.
Figure 2 – Difference in spreads between high-yield corporate bonds and comparable Treasuries, an indication of investor nervousness. Commodities represented by the NYFE CRB Index strengthened again even with weaker oil prices ending the week at 460.16 up from 451.26 last week, very near its upper 2-standard deviation trend channel. Gold fluctuated this week to close right at $800/oz. up from $789.10/oz last week and $822.20/oz two weeks ago. Meanwhile, the recovery of the U.S. Dollar Index ran into resistance this week at its 40-week moving average to close at 76.34 up marginally from 76.15 last week and 75.07 two weeks ago. Are Forex traders anticipating a drop in the Fed funds and possibly discount rate next week? Given Bernanke’s propensity for loosening credit of late, it would seem to be a pretty safe bet. Oil held more or less steady this week as the NYMEX crude oil (continuous) contract ended the week at $88.28 from $88.71 last week but well off its weekly high of $98.18/bbl two weeks ago. The MSCI Emerging Market Index ETF (EEM) enjoyed another positive week closing at 160 this week from 154.40 last week and 147.34 two weeks ago. 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 5.14% from 5.13% last week and 4.88% four weeks ago. LIBOR is used in computing approximately 90% of mortgage rates and the steady increase over the last month despite Fed easing is bad news for mortgagees. Freddie Mac mortgage rates ranged from a high for the 30-year fixed mortgage of 5.96% (6.1% last week) to a low of 5.46% (5.43% last week) for the one-year adjustable rate (ARM). EarningsAn earnings recession in play?Another 87 companies reported Q3-07 results this week bringing the total to 4109 companies that have reported so far this earnings season. Earnings improvements held steady at -20% versus Q3-06 (from -19% three weeks ago). This compares to an average earnings improvement of +13% for Q2-07. This week the financials group earnings improvements dropped to -28% with a total of 850 companies reporting (from -27% last week) which does not bode well for the overall market given that financials have a habit of leading it. Consumer services (497 companies consisting of airlines, hotels, travel & tourism and retailers etc.) saw earnings drop 12% this quarter while technology (583 companies) and telecommunications (47 companies) experienced earnings growth of 20 and 37% respectively, However, one more quarter of negative earnings growth and we will have an official corporate earnings recession. Economic ReportsHere are the reports we were following this week. ISM manufacturing and service indexes weaken
Chart 1 – November ISM manufacturing index came in just above the contraction-expansion threshold of 50 at 50.8 down a hair from 50.9 in October.
Chart 2 – The ISM Service Index was stronger in November with a reading of 54.1 down from 55.8 in October but like its bigger brother, the trend remains negative. Jobs market weakening
Chart 3 – Jobs layoffs jumped 15.9% in November following a drop of 12% in October. Again, the trend tells the longer-term story.
Chart 4 – There were 94,000 new jobs created in November according to the latest report from Labor Department down from a revised 170,000 (up from 166,000) in October. This increases the probability of a rate cut at the next FOMC meeting December 11 but as this chart shows, the trend remains negative. It is also worth noting that the jobs number is a lagging economic indicator. Leading rate of change employment still indicates a better than 50-50 chance of recession ahead. Chart 5 – Although there is little correlation between consumer sentiment and market direction, this chart shows how quickly the consumer has cooled and could warn of lower spending ahead. Certainly the trend is headed lower. In separate consumer news, consumer credit expanded by $4.7 billion in October up from $3.7 billion a month earlier and the trend line is up showing that while the economy has slowed and we are now in earnings and housing recessions, the consumer keeps on borrowing to spend. Next WeekHere are the reports we’ll be watching next week.
SynopsisSumming up the surgeAs we saw last week, November is usually a good month to the markets but that was not the case this year as the S&P500 dropped 4.4%, the Dow Industrials fell 4% and the Nasdaq Composite lost 6.9% for the month. Will December suffer an equally sad fate? As the charts below show, December has been a close second for the best month of the year since 1929. Average gains for the month have averaged 1.4% only bested by January with a 1.5% return. But December has a better up-month average, posting gains 75% of the time.
For the short-term, we are again cautiously bullish based on market leaders and two positive weeks in a row for the major indexes. But credit risks remain and given the fact that millions of investors will be disappointed when they realize that nothing the government can do will stop the drop in real estate prices, we expect disappointments to mount in the coming months. Enjoy the seasonal and monthly rallies as long as they remain but be ready to run for cover on the first hint of trouble. As we said last week, it’s not a market for the faint of heart or pocketbook. Stories of interest this week… White House Plan – Helping Americans Keep Their Homes Homeowner bailout is a lousy idea Video - Shiller Sees Home Prices Falling Despite Bush Mortgage Plan House prices seen falling 30 pct Paulson Mortgage Plan Surfaces Too Late to Stem Housing Slide Mortgage Mess: Is Relief in Sight? New Bailout Plan – Do you qualify? Why Bush's Mortgage Bailout Plan Is a Bad Idea Link to our special report – Are we approaching recession? http://tradesystemguru.com/content/view/113/61/#Recession Link to book site – Ahead of the Curve (some very interesting charts!) http://www.aheadofthecurve-thebook.com/charts.html ------------------------------------------------------------------------------------------------------ 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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