TSG Stock Market Letter

Week Ending July 25, 2008

Topics Discussed This Week:

Stock rally hits resistance

Leaders take another hit

Q2-08 earnings deteriorate further

Existing home market looking up?

But new home sales still challenged

Short interest still rising

Shoveling water - Bubblenomics cure driving legislators crazy at our expense

* EEM Split 3:1 July 24/08

Last Week

Quotes of the week

“Homes purchased in 2004 and beyond are now at risk of turning upside down – negative equity – and there are some 25 million or so of those...A total of $5 trillion of mortgage loans are in risky asset [subprime and Alt-A] categories and that nearly $1 trillion of cumulative losses will finally mark the gravestone of this housing bubble. The problem with writing off $1 trillion from the finance industry’s cumulative balance sheet is that if not matched by capital raising, it necessitates a sale of assets, a reduction in lending or both that in turn begins to affect economic growth, creating what Mohamed El-Erian fears as a “negative feedback loop.””  Bill Gross in PIMCO's August 2008 Investment Outlook.

Rally encounters resistance

It was a week of three days up and two days down for the Dow Industrials with Thursday’s 283 point-loss doing the most damage.  Again mortgage, housing and banking concerns were the problem and as we will see in our Economic Reports, the housing market continued to encounter challenges. So far, this rally is being driven by short covering of the most heavily shorted stocks. If this rally is to last, we need to see strong stocks again start leading but that isn’t happening yet.

Technically Speaking

Leaders struggle again

Dan Zanger’s Sunday list was composed of 11 stocks this week that included Potash (POT), Agrium (AGU), CF Industries (CF), Murphy Oil (MUR), Devon Energy (DVN), Energy Conv (ENER), Apple (AAPL), First Solar (FSLR), Google (GOOG), Goldman Sachs (GS) and US Oil (USO).   

After dropping 7% last week, Dan’s portfolio of stocks again led the market to the downside with a drop of nearly 3%. Second worst performer of the group was the Emerging Markets ETF EEM.  It is interesting to note that the chart pattern shows that the EEM has broken down out of a bearish flag and the stock is closing in on its 2008 lows – a fact made more bearish in that the EEM 3 for 1 stock split July 24 didn’t have the normal positive impact. The most heavily shorted stocks are again leading the market while the stronger stocks are fading and that is also bearish.     

Figure 1 –Five-day performance of Zanger’s market leaders (green) 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 volumes on the NYSE, Dow Industrials and Dow Transports dropped below average again this week which is a mixed signal. But for the Nasdaq Composite that moved up, falling volume is decidedly bearish and shows that buyers aren’t joining the rally.  Stocks can fall of their own weight but need steadily increasing volume to drive them higher.  That volume increases on down days is bearish as it signals that sellers are in control. The same holds true for falling volume on up-days. Most of the reliable technical indicators are saying we should be rallying but the volumes so far show a decided lack of commitment from buyers.

Meanwhile, after spiking to 27.49 two weeks ago, the Market Volatility Index (VIX) settled down for a second week to 22.91 (from 24.04 last week) which is just below the 52-week moving average.  This compares to a VIX north of 31 when the Dow last bottomed during the week of March 14 and shows that fear has so far remained muted.  

But after hitting a high of 611.51 three weeks ago the 19 commodities that make up the NYFE CRB Index took another big hit this week to close at 544.48 from 562.86 last week.  Moving in the opposite direction of stock indexes, the CRB Index had gotten very overbought as the air continues to leak out of the bubble.  

Gold dropped to close the week at $926.90/oz from $957.50/oz last week.  Part of the reason for its strength in the face of falling commodity prices has been the fact that it’s approaching the beginning of a strong seasonal period from the end of July to the end of September.   

Oil dropped again this week as the price of a barrel of NYMEX crude oil contract fell to $123.43/bbl from $129.10 last week and $145.15 two weeks ago.  However, it was the twenty-first consecutive week that oil has remained above $100. Normally, oil hits a seasonal high in mid-October so it will be interesting to see if this correction is just temporary or another indication of the weakening economy.

The U.S. bank prime rate held again this week at 5% and the Fed funds target rate remained at 2%.  The 3-month London Interbank Offered Rate (LIBOR) ticked up to 2.793% (from 2.790% last week and 2.8% five weeks ago).  Freddie Mac mortgage rates surged this week to 6.63% (from 6.26% last week) for the 30-year fixed mortgage while the one-year adjustable rate mortgage (ARM) jumped to 5.49% (from 5.10% last week and 5.09% six weeks ago). LIBOR is the benchmark for $900 billion in subprime mortgage loans which typically adjust to it every six months. Corporations around the world have the interest rates on roughly $9 trillion in debt pegged to LIBOR and rates on more than $380 trillion in derivative interest rate swaps also are based on LIBOR.

As we see below, there has been a disturbing trend toward higher mortgage rates despite the Fed’s determined and significant efforts to flood the market with liquidity over the last nine months.

Earnings

Earnings still deteriorating

This was the third week of Q2-08 reporting season and with a total of 1199 companies having reported (up from 631 companies last week) average earnings have now fallen 33% (from -31% last week and -22% two weeks ago) compared to Q2-07.  This compares to a 30% drop at the end of Q1-08 earnings season with a grand total of 4214 companies having reporting.  This marks the third quarter that earnings have shown a consistent trend to drop as more companies have reported.  Looking at past seasons, there was a drop of 57% for final Q4-07 (3900 companies), a 21% drop (4205 companies) for Q3-07 and a 13% jump for Q2-07.

Economic Reports

This week we focus on the two housing reports released to determine what they may mean for the future.

Existing home market looking up?

It was a rough day on Thursday as more bad news emerged for financials and real estate. Existing home sales dropped more than expected in June with a decline of 2.6%. But as we see from the charts below, it was a mixed bag of sorts. As we have said in the past, existing home prices are an unreliable indicator at best as chart 2 illustrates. We prefer to put our faith in the Case-Shiller Home Price Index which is updated next Tuesday.

But the first two charts show potentially good news. First and most significant, year-over-year existing home sales are declining less rapidly in a trend that shows at least a temporary bottom in February showing that the worst of the declines may be behind us. Median home prices (chart 2) look to have also bottomed in February but this doesn’t necessarily mean the worst is over. Those who bought following the last bottom in prices (January 2007) have paid a higher price than they bargained for. Median price changes are often an indication of a change in market dynamics not a real change in prices – the last fake-out rally was the result of the habit of homes in the upper price ranges to continue to sell after the lower priced market has slowed skewing the median price higher.

Chart 1 – Year-over-year median prices have shown a slow but steady trend toward decreasing declines but median sales were still down 15.6% to 4.86 million sales (annualized) in June versus June 2007 and off 27.25% from their peak in February 2007.

Chart 2 – This chart of National Association of Realtors existing median home prices shows that since their peak in July 2006, prices have fallen just 6.6% and are down 6.15% since last June. This compares to an annual drop of 18% from the July 06 peak for the Case-Shiller home price index and unlike the NAR data, it has shown no sign of turning up.  (We find out what’s really happening with prices when the Case-Shiller index is release Tuesday).

Chart 3 – The inventory of existing homes climbed again in June to an 11.2 month supply and as we see from the chart, there has been no relief in the average time to sell a home. This compares to a 10-month supply in the new home market (see below) where inventories have dropped from a peak of an 11-month supply in March.

But some real housing challenges remain. As we see from chart 3, unsold inventories have remained stubbornly high and are now approaching one-year nationwide. Another challenge is that mortgage rates have been heading higher as banks pull in their horns.

Third, the number of vacant properties in the US hit an all-time high in Q2-08 of 18.6 million according up 6.9% from Q2-07 the Census Bureau reported Thursday. To put this in perspective, there are roughly 120 million homes in the U.S. which means that nearly 10% now remain vacant.  This is due in large part to soaring foreclosures – 740,000 properties received foreclosure filings in Q2, up 14% from Q1, a 121% jump from Q2-07 and bank seizures increased a record 171% in June according to RealtyTrac.   

New home sales still challenged

Chart 4 – New home sales dropped 0.6% in June from May dropping to a seasonally adjusted annual rate of 530,000. But this is still more than 33% below the number of sales in June 2007 and 59% below the peak of 1,283,000 sales hit in 2005.

Chart 5 – But while sales have fallen out of bed, median new home prices remain mysteriously firm with year-over-year prices down less than 2% to $230,900 from June 2007. This discrepancy is due either to the continued use of sizable cash incentives included in the sales price or something else is skewing the data. New home sales have fallen nearly 50% (from the last peak in December 2006) while prices are down just 12% from their peak (March 2007).  It is interesting to note that new home sales peaked in 2005 at 1.283 million when the median price was $240,900, a 4.2% fall since the overall sales peak. In other words, a 60+% decline in sales has resulted in a 12% price fall from the peak. But builder’s share prices have tracked sales not median prices as the Philadelphia Housing Index (HGX) homebuilder’s index has dropped more than more than 60% since peaking in July 2005. Although it’s too bad there isn’t a more reliable price index for new homes (like the Case-Shiller Index), it is interesting to note that share prices peaked 20 months ahead of median prices giving plenty of warning to those following the homebuilder stocks that something was amiss.

Chart 6 – The sound of another shoe dropping… The 30-year fixed rate, the standard against which overall mortgage rates are measured, hit a high not seen since April 2002. As Bespoke said in the title of their article, “this can’t be helping real estate…”

So is the housing market looking up? The worst of the price declines may be over at least for now but as long as foreclosures continue to increase, inventories remain high and the economy remains weak, the market will be hard pressed to find a bottom. And persistently high rates won’t help.

Next Week 

Here are the reports we’ll be watching next week. The ones emboldened are leading, useful or indicators we are tracking, the others have the potential to impact markets short-term.

- Tuesday, May Case Shiller Home Price Index (previous -16.3%), July Conference Board Consumer Confidence (previous 50.4).

- Wednesday, July ADP Employment Report (previous -79,000).

- Thursday, Q2-08 Advance GDP (previous 1.0%), July Chicago PMI (previous 49.6).

- Friday, July Nonfarm Payrolls (previous -62,000), July Unemployment Rate (previous 5.5%), July ISM Manufacturing Business Index (previous 50.2), June Construction Spending (previous -0.4%).

Synopsis

Short interest still rising

Last week we discussed the huge short squeeze that helped propel the market higher and based on figures released from the NYSE, short interest remains high. As of mid-July, short interest hit another new record high. As well, short interest for the S&P500 has increased to an average 6.1% while the S&P1500 saw short interest rise to 11.9% of its float according to Bespoke Investments. Banks were the most heavily shorted sector.  However, since this was before the SEC crackdown on naked shorts, these figures did not reflect changes occurring since then. We will keep you posted on short interest as new information becomes available since the most heavily shorted stocks have been leading this rally so far.

Shoveling water

Legislators remain determined to fix the plethora of popping bubbles no matter what the cost or long-term economic aftermath. We learned on Saturday that Congress has passed another housing bill. It includes a $300 billion program to refinance loans for struggling homeowners, rescue plans for Fannie Mae and Freddie Mac as well as tax breaks for homeowners. More troubling was the fact that they also voted to increase the federal debt limit to $10.6 trillion but unfortunately, they really had no choice.

This follows a myopic bill curbing speculation in oil markets and the SEC rule to banning naked shorts on 19 stocks last week. Going after speculators to bring down the cost of oil is like blaming the water for a sunken ship. Like traders, speculators attempt to take advantage of temporary market inefficiencies but are only a small part of the run-up in prices.

Legislators intent on reversing the breaking of the housing bubble are doling out similar treatment to try to combat the commodity bubble. But as Ben Bernanke said in testimony a couple of weeks ago on Capital Hill, speculators are not to blame. We have seen similar run-ups in materials not traded in commodity markets like iron ore and uranium.  Other markets including corn, wheat, gold and soybeans have also experienced similar bubbles. So is Congress planning on going after those speculators next?

So what is really driving the recent drop in oil prices? Americans are cutting back on driving according to UniCredit in a July 25^th report.

Figure 2 – Graph showing year-over-year changes in miles traveled. Vertical gray bars show recessions.

                  Figure 3 – Global daily oil supply (red horizontal line) versus demand.

But as the U.S. consumes a smaller percentage of total oil output,  consumption in emerging nations like India and China skyrockets. The sad reality is that the world currently produces 85 million barrels a day and even with the drop in U.S. consumption, the world is burning nearly 87 million barrels according to the International Energy Agency. No amount of new U.S. legislation against market participants will change that dynamic. But a global slowdown on the other hand, just might.

However, the concern is this. What damage will well-intentioned legislators do to the market in the meantime in the name of the common good?

Stories of interest this week…

Fannie Mae Unsold $5 Billion Homes Bring Peril to Shareholders

http://www.bloomberg.com/apps/news?pid=20601109&sid=aMz0dl3IdwjU&refer=exclusive

Fannie, Freddie Subordinated Debt May Be Cut by S&P

http://www.bloomberg.com/apps/news?pid=20601087&sid=aDesHvSN6kek&refer=home

Senators Offer Bills Curbing Commodities Speculation

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aq0kPziqFTFo

Congress Pursues $80 Oil With Trading Limits, Disclosure Rules

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aSgx0JCvVOIY

U.S. Economy: Home Resales Decline to 10-Year Low

http://www.bloomberg.com/apps/news?pid=20601087&sid=a55J7k2L8u3A&refer=home

Mortgage Writedowns to Total $1 Trillion, Gross Says

http://www.bloomberg.com/apps/news?pid=20601110&sid=a8i_RD9YLozw

Mooooooo! Bill Gross's Investment Outlook - August 2008

http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2008/Investment+Outlook+Bill+Gross+Mooooooo+August+2008.htm

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