Wednesday, April 11, 2007


Stock market should start down now

The Dow futures are at 12548 as we speak, slightly above the 12525 I originally suggested for shorting the market. My methodology does take the time of a movement into account but it is subordinate to price. Given that, I was surprised the market rallied after 3/28/07 and it has given me pause. The structure of the decline on 3/28 and the potential for the beginning of a major bear market should have meant that the rally off the 3/14 low was not as strong or as long in duration. I think this should push the idea that we are in for a major decline soon into the background; i.e., it is still possible but more likely that we are in a correction which will lead to new highs or that a correction was completed on 3/14.

My new stance requires that I lower the stop order from 12850 to 12670, just above the most recent peak on 4/09.

Recent developments in the interest rate markets have caught my eye. I did not really have much of an opinion on interest rates other than I would expect signs of a weakening economy would mean lower rates over time. Short term, anything could happen and it did when the March non-farm payrolls came in at 180,000 which was 50,000 more than expected. (Remember that employment is a lagging indicator. This should make sense, business' try to cut costs in other areas before they lay off workers especially with a highly skilled work force.) This pushed interest rates higher. Also, Helicopter Ben is speaking today and apparently he said something that spoked the debt markets because they took a dive at 1 p.m. (Chicagotime) when he was scheduled to start speaking. I haven't been able to find anything in the news as of now but I come back to it later.

One thing that the housing market really does not need is higher interest rates. In fact, lower rates are desperately needed to counter the fact that banks are raising lending standards. Bill Gross, head of PIMCO, recent commentary called Grim Reality points out that the real danger is not the defaults on loans which will not be a large percentage of home loans. The danger is the loans that banks won't make that they have been making.

Bulls and bears argue over websites as to the percentage of all lending that subprime and alternative mortgage loans provide but while important, the argument obscures the critical conclusion that tighter lending standards and increased regulation will change the housing outlook for some years to come. As past marginal buyers are forced to sell their home to prevent foreclosures, so too will future marginal buyers be restricted from buying them. No one really knows the amount that homes must fall in order to balance supply and demand nor the time it will take to do so, but if one had to hazard a conclusion, it would have to be based in substantial part on affordability statistics that in turn depend on financing yields and home price levels in a series of different scenarios as outlined in Chart 2. The chart shows the amount that home prices or mortgage rates (or a combination of the two) need to decline in order to revert back to affordability levels in 2003, a year which might have been the last to be described as a "normal" year for home price appreciation. Since then, 10+ annual gains have been the rule whereas average historical estimates provided by Robert Shiller may have suggested something on the order of 4-5%. By that measure alone, homes are likely 15-20% overvalued (3 years x 5%+ annual overpricing). Chart 2, in addition suggests much the same thing. If mortgage rates don't come down, home prices need to decline by 20% in order to reach prior affordability levels. If rates do come down, home prices will drop less.

You'll have to find chart 2 for yourselves. Fair use and all. Gross' point is that a 20% drop in home prices is baked into the cake but if interest rates fall then the marginal buyers and those on the edge of default could be saved by refinancing. He figures that a fall of 120 basis points for mortgages (Approximately 5.00%) would mean prices could stay at current levels. Gross' conclusion is that the Fed will be predisposed to cutting rates for the next several years to shore up housing. I agree, that is, if the market let's the fed cut rates. With the importance of foreign financing of our debt the dollars value has to be taken into account. The euro is flirting with new lows and the pound is around 1.98. Expect a falling dollar to make the news when the pound is over 2.00.

So the Fed is walking a tightrope between the currency and debt markets. The Fed needs the dollar to get strong and interest rates to go down. Two events which work against each other. Actually, what the Fed really needs is for the housing market to stabilize. They are playing a waiting game hoping the housing market does not hurt the economy too much because the Fed is limited in how much they can affect interest rates because of a weak dollar. This is the definition of between a rock and a hard place. The Fed has no one to blame for our precarious position but itself. These are the fruits of an asset bubble- it's almost impossible to prevent the bust once asset prices start to fall.


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