| TSG Weekly Market Watch October 26, 2007 |
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| Written by Matt Blackman | |||||||||||||||||||||||||||||||
| Sunday, 28 October 2007 | |||||||||||||||||||||||||||||||
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TSG Stock Market LetterWeek Ending October 26, 2007Topics Discussed This Week:
Rose colored glasses back on, but do investors have their eyes wide shut?In spite of a new record high in oil, new low in the dollar and for the most part continued bad housing news, investors ignored the torpedoes as hope ruled the week. Optimism drove the Dow and S&P500, up more than 2% and the Nasdaq and Russell 2000 up nearly 3% on the week. A big lift was provided by positive news from Microsoft and Countrywide Financial even as oil sprinted past $90/bbl on Friday. The price of the largest mortgage lender’s stock surged 33% on Friday alone proving that investors bought the company’s positive forecast but we shall see if enthusiastic comments that CFC’s earnings “trough” is behind them are realistic. These earnings expectations reminded me of a sarcastic response to an outrageous claim by one character to another in an Australian movie I saw a few years ago. “I believe you. Millions wouldn’t but I believe you.” It was obvious from the market response, however that millions did believe the Countrywide rhetoric proving that hope on Wall Street that the worst for the housing market is over remains very much alive and well. But to coin another movie phrase, are investors and analysts viewing the situation with their eyes wide shut? Technically SpeakingMarket leaders move higherWhile major indexes rallied 2 – 3%, Zanger’s composite of stocks on Wednesday posted a gain of more than 11%. Fortunately for the bulls, expectations for a brutal Monday failed to materialize. This week, Zanger’s composite consisted of just six stocks – Research in Motion (RIMM), Apple (AAPL), Garmin (GRMN), Dryships (DRYS) and iShares MS Emerging Market ETF (EEM). This is bullish for the market going forward but as we have seen before, it could change with depressing credit news or if investors are disappointed by the Federal Open Market Committee statement on Wednesday.
This week, trading volumes moved above average on a number of exchanges reflecting bullish investor sentiment. But as we have discussed over the last three weeks, the Dow Transports has yet to confirm the positive trend in the Dow Industrials and this is a concern. The last time the Transports began to fall while the Industrials rallied was in the summer of 1999 eight months before the market began to fall apart. Volatility as indicated by the Market Volatility Index (VIX) died down this week after jumping last week. The VIX closed at 19.56 down from to 22.96 last week. Commodities represented by the NYFE CRB Index closed at 450.34 down slightly from 450.56 last week and the index remains near its upper 2-standard deviation (2 sigma) trend channel. Gold again surged higher to close at $787.70 up from $768.6 last week. Still due for a rest, the recent surge is due to continued weakness in the dollar. It was another week of new all-time lows as the U.S. Dollar Index dropped to close at 76.98 from 77.37 last week and 78.16 two weeks ago. The weaker dollar and inventory concerns helped push oil to yet another new all-time high. The NYMEX crude oil (continuous) contract closed at $91.86/bbl up from $86.95 last week.
Figure 2 – Daily chart of the Dow Jones Industrial Average (candles) compared to the Dow Jones Transports (purple) showing the divergence that began in mid-August. Also note that volumes for the DJIA have been lean since then as well. Chart provided by GenesisFT.com Propelled by a weak dollar and strong investor optimism, the MSCI Emerging Market Index ETF (EEM) managed a new high this week closing at 163 up from 152.20 last week as it stayed well above its 2 standard-deviation upper trend channel line. The 3-month London Interbank Offered Rate dropped again this week to 4.983% from 5.15% putting the rate back where it was a year ago. LIBOR is used in computing mortgage rates. Fannie Mae 30-year mortgage (30 day) yields held steady at 6.05%. EarningsLast week we reported that with 760 companies having reported for Q3-07, average earnings dropped 8%. This week with 1395 companies having reported, average earnings were -5%. This is still down from the 9% improvement with 384 companies having reported three weeks ago. Economic ReportsExisting home sales drop more than expected amid inventory jumpThe Dow initially registered a triple digit drop on Wednesday with the release of existing home sales data and the National Association of Realtors have been doing their level best to minimize the damage. But as we see from these charts, the situation with existing homes representing 85% of the housing market is deteriorating at an increasing rate. Although sales surprised this month, the new home market is in worse shape if the NAHB housing market index and housing starts (discussed last week) are any indication.
Chart 1 – Chart showing month-to-month changes in existing home sales published by the National Association of Realtors (NAR). After revising the August number from -4.3% to -4.7%, the September number dropped another 8.03% for the worst monthly decline since sales peaked at 6.68 million in February 2007. Analysts were expecting a 3.6% drop. Sales dropped to 5.04 million in September, a 25% decline in just seven months. It was the seventh consecutive month of sales declines.
Chart 2 – In 2005 when home sales peaked, the inventory of unsold homes was 2.8 million homes – a 4.5 month supply. In September the inventory of existing homes for sale jumped to 4.4 million – a 10.5 month supply according to the NAR. As we see from this chart, while prices have just begun to plummet (see Chart 3), inventories are accelerating which does not bode well for an early recovery. By September the number of vacant homes on the market had soared to 2.2 million according to the latest NAR data but dropped off slightly, prompting some hopeful comments from the organization. Our take is that it was simply a temporary reprieve, especially when you consider that there are now a total of 17.9 million vacant homes as a result of foreclosures (see below). Here is what Yun had to say about the recent report on the NAR website. “It appears raw inventories are stabilizing, but the housing supply is a bit inflated now because the sales pace does not reflect underlying market conditions – sales were dampened by the mortgage cancellations,” Yun explained. “Once the pent-up demand begins to move, we’ll see housing supplies begin to ease and then prices will edge up.” Just how misplaced is optimism that the housing market has turned the corner? According to the latest Census Bureau data, the number of vacant homes hit a record 17.9 million in Q3-2007 up from 16.6 million a year ago as lenders took possession of the growing number of foreclosures. This compares to just 2.09 million vacant homes that according to the report were for sale in Q3. So why is the lion’s share of vacant homes not on the market? Bottlenecks are caused by legal wrangling, growing regulatory red tape and lender restrictions or delays. There is also the temptation for lenders to delay putting homes on the market given current conditions and reluctance to book losses. But at some point, this huge backload of homes will have to be sold. Extended delays will mean a larger backlog of foreclosed homes to be sold in deteriorating condition exposed to the elements and subject to vandalism. Combine that with an acceleration in home price declines and increasing foreclosures increases the probability of a housing market disaster in the future. It is also interesting to note that the Case-Shiller Home Price Index instead uses paired sales prices http://tradesystemguru.com/content/view/91/58/#Case that, shows that existing home prices peaked in July 2006, eleven months before NAR median prices. Median existing home price declines accelerate
Chart 3 – Chart showing rapid increase in median home prices between 2004 and 2006, then a leveling off and recent declines in monthly prices. Again, NAR economist and industry cheerleader Lawrence Yun did his best to put a positive spin on the latest existing home sales report released Wednesday. “The good news is that mortgage availability has markedly improved in recent weeks with interest rates on jumbo loans falling and more people applying for safer conforming FHA mortgage products.” Yun is comparing rates to those in August that spiked higher as a result of the credit crunch. Unfortunately Freddie Mac 30-year and 15-year fixed mortgages were unchanged from a week ago and higher than a year ago, five-year adjustable rate mortgage rates (ARMs) are also unchanged over the last year and one-year ARMs are higher according to the Wall Street Journal. Yun did offer one piece of useful information – there were fewer transactions at the upper end luxury market. While he blamed this weakness for the “downward distortion reflected in lower national median home price,” the truth is that median prices will now more accurately reflect market forces going forward. It has been our contention that a resilient luxury market has had the tendency to skew overall prices higher because it is generally the last segment to roll over in a correction and a weakening upper-end market is more bad news. On a year-over-year basis, median home prices are down 4.2% from September 2006 (first arrow) but as we see from this chart, prices were just leveling off then. Sales lead prices and while year-over-year prices are down 4%, Y-o-Y sales are off 19%. As a case in point, homes sales peaked in the summer of 2005 and have since fallen 30% but prices (Chart 3) continued to appreciate for another two years before peaking June 2007. Thanks to rapidly declining sales, burgeoning inventories, a weakening in the upper end market, and accelerating bankruptcies and foreclosures, we expect median price declines to accelerate. Median prices in September have fallen 7.6% from their June peak of $229, 200. New homes sales surprise to the upside but…
Chart 4 – On Thursday, new home sales numbers were released and to the surprise of many, September sales jumped 4.8% but on a year-over-year basis, sales are down 23.3%. New home inventories also declined to 8.3 months from a peak of 9 months hit in August but the number of unsold home jumped to 770,000 from 735,000 last month. Like each time sales have increased in the past, calls that this was the bottom could be heard but the increase came in the wake of downward revisions in June, July and August sales numbers. Also sobering was the 10.2% decline in new home construction. And like pending sales, new homes sales data do not reflect cancellations – D.R. Horton, the nation’s largest homebuilder reported last week that nearly half its new home orders were cancelled in the last three months, according to the Wall Street Journal. Lastly, did I mention that new homes sales account for less than 15% of all home sales? A real market recovery is from the bottom up; it’s the sales of lower-priced existing homes that recover first since they are the most affordable to the growing number of first-time buyers entering the market. Sub-prime indicator shows situation getting worse
Chart 5 – What is really happening in the mortgage market? Here we the composite of 15 different asset-backed credit default swap indexes from AAA prime to BBB minus sub-prime mortgages monitored by Markit.com. Set at a value of 100 in January, the index had fallen 40% by mid-August before rallying into the second week of September. Since then the composite has declined another 24%. Overall the index is down more than 45% in just 10 months. ABX-HE indexes provide a pulse on the health of the mortgage market as well as insights into the strength of the overall housing market. These recent drops and ongoing build in vacant home inventories bring into serious question Countrywide Financial’s (CFC) optimistic comments that earnings should swing back to positive in Q4-07 and Friday’s 33% rally in the stock price on the news. For a more detailed explanation of the ABX-HE indexes, please see http://tradesystemguru.com/content/view/72/58/#ABX For more on this story, be sure to listen to the interview with Sean Egan of Egan-Jones Ratings and Bloomberg news on Friday. See link in the Synopsis.
Chart 6 – ABX-HE-BBB are the worst performing sub-prime loans the value of which have dropped nearly 80% since January. Since the second week in September, they have been cut in half again. Next WeekIt’s a busier week again for economic reports. Here are the reports we’ll be watching with important ones emboldened. The market awaits the Federal Open Market Committee decision on the Fed funds rate and non-farm payrolls will be heavily anticipated as well.
SynopsisCountrywide Financial reality checkAccording to the latest report from Countrywide Financial, “prospects for the U.S. housing and mortgage markets, as well as for Countrywide, remain very attractive,” President David Sambol said. (I’d love to know what statistics he’s using to come to the conclusion. He would appear to be ignoring the data we are looking at.) Sean Egan Managing Director of Egan-Jones Ratings interviewed by Bloomberg Friday presented a number of good reasons for not buying the positive Countrywide forecast. Here is a bullet list of why he questions the Countrywide forecast for an earnings turnaround in Q4.
Figure 3 – Daily Countrywide Financial chart showing big drop in stock price ahead of the company’s report Friday. It also shows the declining fundamentals in earnings growth rate (GRT) which has dropped from 14% in February to -5% on Friday, earnings per share (EPS) and the growth to PE ratio (GPE). Chart provided by VectorVest.com
It is clear that there was some serious damage control being done by the company. As of Thursday’s close (the day before CFC issued their bullish comments) Countrywide stock had fallen 71% from its peak on February 2, 2007 (see Figure 3). If the company is to continue relying on equity lifelines from Bank of America and investors, the last thing it can afford is further drops in its stock. If a goal of the positive comments was to remedy this situation, it appears to have worked at least for the moment. By the close of Friday the stock had jumped 33%. It is important to point out that the only hopeful technical sign of a stock reversal is the jump in volume on Friday. It could potentially signal capitulation by sellers and short covering. But before a rally can be confirmed, we will need to see a continual volume build accompanied by a series of higher lows and higher highs in stock price that indicate an uptrend. But the greatest challenges facing Countrywide Financial are to be found in both market and corporate fundamentals. The first are outlined above. But market fundamentals are beyond the company’s ability to control. Any improvements in the company’s fortunes will require a reduction in foreclosures, a leveling in home prices, real reductions in mortgage rates and a drastic improvement in the performance of the ABX mortgage indexes. For this to occur, housing demand will have to miraculously turn around. Instead these important fundamentals are deteriorating. Why highlight the Countrywide situation? It is a perfect case study in efforts at damage control in trying to reverse deteriorating investor sentiment. The company knows that if they fail in this effort, the risk of bankruptcy dramatically increases. Industry pundits are playing along because if the largest mortgage lender fails, it will take others with them. This situation also highlights efforts by those in the business who desperately want the good times to return but know to do so they must first win the hearts and minds of home buyers. Amazingly there are indications that the majority of consumers are buying into this argument too. In the most recent University of Michigan consumer sentiment index survey, 64% of consumers believe that now is a good time to buy a home even though an examination of the facts and data should logically lead to the opposite conclusion. It will be fascinating to see if investors continue to buy into the Countrywide argument and in the process push the stock higher. Unfortunately, the technicals and fundamentals in Figure 3 are telling us that Friday’s jump in CFC has all the makings of a sucker’s rally. Broad market rally overviewIn spite of negative signs last week, investors have remained optimistic and that is a good sign. Market leading stocks and emerging markets remain resilient which is also bullish. Thirdly, action this week shows that hope has no bounds and like a snowball hurtling down a mountain, once started is difficult to stop until it has run its course. But this optimism faces serious fundamental gravity. A real estate rebound is fundamentally challenged and until home prices stop falling and housing permits (and starts) level off – probabilities of which must be considered low this point – there will be more pain ahead. A Fed funds rate cut on October 31 may help bolster investor optimism but a falling dollar will further compound problems and reduce the chances of any real reductions in mortgage rates. And then there are the more than $500 billion in mortgage resets in the first half of 2008… All this explains the high volatility in markets since August. It has also made it a tough environment in which to make money and in lieu of a dramatic change in the fundamentals, this situation will likely continue. More on this topic...Countrywide's New Scare - Option ARM Delinquencies Bleed Into Profitable Prime Mortgages (free 7 day access) To watch the Sean Egan Bloomberg interview on Countrywide go to More reasons to believe that the Countrywide forecast is not telling the whole story, read... ------------------------------------------------------------------------------------------------------ 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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