TSG Weekly Market Watch                                                  

Week Ending April 6, 2007

TradeSystemGuru.com

• What homebuilder stocks can tell us about the property market…
• And for what’s in store for builders, look at the Nasdaq post 2000
• Miami market melt
  
• Markets celebrate British military homecoming
• Oil remains high even after Iran wildcard played out

Last week we talked about the seventh anniversary of index peaks and what they mean today. As evidence mounts that housing prices have begun to drop in earnest after peaking in mid-2006, let’s take a look this week at what lies ahead using a good property market leading indicator – home builders.

 
Figure 1 – Incredible run-up in builder’s stocks from 2000 through 2005. The VectorVest Builders (residential/commercial) Index consisting of 26 builders jumped more than 830% over the period. The star performer was Hovnanian Enterprises (HOV) that rocketed up more than 2200% - both classic parabolic blow-off tops.  Perhaps the most famous parabolic blow-off in recent memory occurred in the Nasdaq Composite Index. Between 1995 and 2000 the Index rose 680%, the greatest gains coming in the last six month, before dropping more than 80% by 2002 and back to 1996 levels. Chart by www.VectorVest.com

Between 1995 and 1998, the VectorVest Builders Index of 26 residential and commercial builders rose 200%. By March 2001 it had doubled again in a trend that would see the index rocket up than 1900% by mid-2005. Star performer Hovnanian Enterprises (HOV) gained more than 2200% over the same period.  

 
Figure 2 – The beginning of the fallout from the July 28, 2005 high for builders after which the Builders Index dropped more than 37% to March 30, 2007. And even though Hovnanian is down more than 65% in the 33-months since it peaked, the stock is still up 682% and the Builders Index up more than 500% from 2000.  Chart by www.VectorVest.com

The Builders Index peaked on July 28, 2005 and like the aftermath of most parabolic blow-off peaks, the back-side decline was rapid even as home prices continued to rise. One year later, the Builders Index had been cut nearly in half (48%), and HOV had dropped 63%. Meanwhile home prices nationwide continued to rise and peaked at the same time. It was only by the end of the third quarter of 2006 that were there signs that home prices were falling.

Even now, home prices are only down marginally but the reaction rally that saw builder’s stock prices rise for the second time beginning in July 2006 has again petered out. After peaking again in February 2007, builders resumed their downtrend and the index has dropped another 13.4% in the last eight weeks.  With an approximate one-year delay in building stocks and home prices, what does that mean for property prices? The obvious answer is that there is more downside to come.

 
Figure 3 – The S&P/Shiller-Case Home Price Index – arguably the most accurate national home price index because of the way it is constructed – from 1987 through 2006 showing the doubling of home prices from 1999 to 2006 (two green lines) and the parabolic blow-off that generally portends far lower prices ahead as the trend reverts to the mean. Data – Chicago Mercantile Exchange Housing Futures  

However, a linear comparison ignores one principle difference between stocks and home prices; that of delay. The major factor determining stock price is investor demand. Shares are purchased by those looking for a rate of return and/or capital gains. Real estate serves a number of purposes.

Homes are primarily purchased as a place to live and in a normal market, owner occupied homes represent about 80% of the market. A far smaller market component is investors looking for rental income or capital appreciation. Homeowner occupiers are less inclined to sell when home prices start to fall and for this reason, housing prices are ‘stickier.’

This dynamic can change dramatically when prices begin to rise. Not only do investors and speculators become buyers, owner occupiers join the party in the search for investment property. For example, in Florida the 80/20 owner/investor ratio was set on its head and it was estimated that in 2006, 80% of properties were sold to investors. The ratio of second homes jumped from an historic mean of 16% to 60% by 2006 in Florida.

To give you an idea of how this impacted the market, between 1990 and 2000 about 10,000 apartment units were built in the Miami area. Currently there are 12,000 units under construction and scheduled to be completed in the next 18 months according to Bloomberg. That’s a recipe for disaster in a state where the unsold inventory has already reached a multi-decade high of 18 months.  (See Even a Realtor will tell you: Glut is huge http://tinyurl.com/28cs6s )

 
Figure 4 – No matter which home price chart you look at, they all show the same signature parabolic blow-off. Over the last 100 plus years home prices have appreciated more or less at the average rate of inflation, that is until 2000, highlighting the unusual nature of the recent run-up in prices. By 2005, after adjusting for inflation home prices had soared to more than 50% above any previous bubble high. Chart – R. Shiller

However, when the market reverses and home prices fall, more owners are pushed to the wall. Until owner occupiers are forced to sell, these homes stay off the market and the higher the number of unmotivated sellers, the more stable the market.

Speculators and investors are a different story. Unable to sell for a profit and no-longer able to make mortgage payments, they begin defaulting on loans as the property Ponzi unravels. Foreclosures increase as inventive low-payment mortgages that became so popular, expire and must be renewed at prevailing rates. And like a speeding oil tanker, once started this trend is difficult to stop – the higher the percentage of speculators and new investors, the more unstable the market becomes.

Home prices then become the victim of the foreclosure cycle and it can take up to two years to reach maximum impact. Under normal circumstances, it takes three months from the time a borrower has defaulted until foreclosure proceedings commence. Foreclosure takes another six months. Then banks cannot fire-sale the home, the courts require that they made efforts to get a good price, which often means turning down the first offers. Over time and as the market falls, these offers tend to get lower but at least the bank can show the courts that they were doing their job.  

But as we are seeing now, when the situation begins to look dire pressure builds to delay the process. Lenders are pressured by market conditions and government to give borrowers more time but this only serves to increase the lag and the number of homes eventually hitting the market. As the number of foreclosures rises, downward price pressure grows as unsold inventories rise. Ironically, the more the government meddles the worse the situation gets because this further delays the price correction essential to getting the market moving again.  Homes that might have been on the market as soon as six to eight months after the owner defaulted now may not hit the market for 18 months or longer.

This problem was highlighted with news recently that the Ohio Attorney General pressured a bankrupt New Century Financial to halt foreclosures pending a review. How long this will take is anyone’s guess but it means that failing a miraculous turnaround, prices will be even lower when these properties are finally listed. And as the economy slows, it means that more properties are put up for sale just as the contraction worsens and jobs layoffs are rising. It is impossible to estimate just how large this bulge in the python will be until it hits the market.

So if you want to get a glimpse of where home prices may be headed, take a look at homebuilder’s stocks. If the economy continues to slow (the probability for a recession in 2008 has gone from 20% a few months ago to more than 50% now) and the aftermath of the Nasdaq parabolic blow-off in the late 1990s followed by a more than 80% plunge is any guide, there will most certainly be more stock downside. But the home price decline has just begun and if the fallout is anywhere near the size of the bubble which preceded it, the result should be the biggest price-reversion-to-the-mean in history – but it probably won’t happen until after the pre-election economic lift has run its course.

For an interesting representation of where real estate prices are today, check out the US Home Price Roller Coaster http://tinyurl.com/ytq77e

Now let’s check in on what happened in the stock market this week.

Summary

We are now into the sixth week of manic market mood swings as the index light board switched back to green across the board. The tension in the Gulf last week evaporated as the kidnapped 14 British military personnel were returned home as an “Easter present” from Iran’s maniacal leader.  Oil prices dropped in response if only marginally but this gave stocks an added boost.

Technically Speaking

The classic ‘W’ bottom patterns present in the four major indexes continues to catapult prices higher as the Dow Jones Industrials Average, S&P500, Nasdaq Composite, NYSE Index and Russell 2000 continued to rise above 50-day moving averages.  Meanwhile, even the Dow Transports Average managed to close above its 50-day MA in a bottom pattern that looks like a ‘W’ followed by a ‘V’ which must also be considered bullish.

However, the same cannot be said of the Philadelphia Housing Index (HGX), which is mired below its 200-day MA and is doing its best to hold there. Unfortunately, it is forming a bear flag chart pattern in the process. Like the VectorVest Builders Index discussed in our introduction, this index looks strikingly similar to the Nasdaq Composite post March 2000, immediately after the first (July) of two reaction rally failures in 2000 after which the index began to drop in earnest.   

Commodities continued to trend higher this week as the NYFE CRB Index closed at 409.64 up from 407.45 last week and 399.02 three weeks ago.

Gold also continued to move higher this week as the April contract closed at $674 up from $663.10 last week. What is interesting is that gold moved higher even after the stalemate in Iran ended peacefully and the market rallied. Like the other commodities, rising gold shows increasing inflationary pressure. (This does not bode well for interest rate relief any time soon.)

After peaking intraday above $68 this week, NYMEX crude oil closed Friday at $66.37 versus last weeks close of $65.87 (continuous contract). With summer driving season fast approaching, we don’t expect it to come off much until late summer.

Meanwhile the greenback continued to take it on the chin, as the U.S. Dollar Index closed at 82.45 from 82.66 last week. The buck has dropped 3% in the last seven weeks as investors have assessed the potential impact of growing protectionist and market interventionist trends in the Democratic controlled House and Senate.

Emerging markets rallied strongly this week and the JP Morgan Emerging Market Bond Index (tracking the yield spread between a basket US Treasuries and emerging market bonds) hit another all-time low. The MSCI Emerging Market Index ETF (EEM) closed at 120.30 from 116.50 last week and in the process moved above its Feb 26 high. Both show that international investors and hedge funds have returned to their pre-Feb27 meltdown risk-complacent ways.

Te Market Volatility Index (VIX) continued to settle increasing the probability that we were at a bottom of sorts in mid-March and prices stand a good chance of moving higher at least over the short-term.  

Earnings

With 4021 companies now having reported (up from 3946 companies two-weeks ago)  Q4-06 average earnings improvements over the same period last year dropped slightly to 33% from 34%. Now that this earnings season is effectively over, investors eagerly await Q1-2007 results to see if earnings momentum will be maintained. Any weakness will have a strongly negative impact since it is earnings strength that has kept stocks moving higher over the last few years. 

Economic Reports

It was an average week for economic reports this week. Here’s what the charts had to say.

 
Chart 1 – The Institute of Supply Management reading dropped in March to 50.9 but it was the beginning of the quarter ushering in new money to the market that drove prices higher and the market discounted the bad manufacturing news.

 
Chart 2 – After a more than 4% drop in January and with the market so focused on housing, a better than expected pending home sales report showing a meagre 0.7% increase in February was enough to help drive the Dow up more than 1% of the day and into positive territory for the year .  

 
Chart 3 – This index has been increasingly volatile of late as the 33% rise in January turned into a 42% drop in layoffs in February. But the two-year trend is still for increasing layoffs.   

 
Chart 4 – Non-farm payrolls also pleased to the upside in March with an increase of 180,000 new jobs. The longer-term trend is still negative however and while the market will probably react positively on Monday, it shows that the economy continues to lose momentum.  

Next Week  

It’s a sparse week next week for economic reports. Here are the ones we’ll be watching.

-    Thursday, March import prices (previous 0.2%).
-    Friday, February trade balance (previous -$59.12 billion), March Producer Price Index (previous 1.3%).

Synopsis

One would think that with the growing clouds of a deteriorating housing market and slowing economy, that stocks would be a victim. But even after a global meltdown in late February, stocks have rebounded in a move that looks like it will continue.

Why? There are a number of reasons. First, inflation as evidenced by the price of commodities and especially gold, is very much alive and well. Even the Fed’s extremely downside biased inflation models are flashing warning signals. Finally, the dollar has continued to weaken and this compounds inflationary pressure.

Market complacency has returned with a vengeance (as evidenced by the EEM and EMBI) and liquidity continues to surge around the globe. After taking a brief pause, the carry trade has resumed at full speed. All these things are good for stocks.

Perhaps more importantly, we are in a pre-election year that has historically provided 60% of Dow returns over the last 100 plus years. Is it a coincidence that liquidity is high and the market is doing well as we head into another election? You be the judge but as we have said in the past, it is not a good idea to bet against the government in its efforts to get re-elected no matter how much of a long shot their chances might be and how challenging the economic situation may appear.

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All material presented herein is believed to be reliable but we cannot attest to its accuracy. All material represents the opinions of Matt Blackman. Opinions may change without notice and readers are urged to check with their investment counsellors before making any investment decisions. Matt Blackman may or may not be invested in any investments cited above.