The market amazed us for about 5 or 6 new highs along a progression that we thought would have been almost ideal for a turning point. But it was not to be. Even with the BOJ raising its lending rate to .5% from .25% didn’t have the expected impact on stock prices. The inflation figures came out worse than expected, at least nominally fulfilling Fed-head promises to hike rates if pricing doesn’t slow down and decline. But that was shrugged off as a rounding error! Now we are hearing that our thesis that housing price declines have not yet reached investors ears because of the 90-day delay in reporting home sales. That coupled with commentary from several housing stock mgmt teams points to another down leg in housing very much along the lines predicted in prior notes and comments. 

The problem with housing is that liquidity drives the price appreciation mechanisms, not jobs and wage growth. That means anything that reduces global liquidity will have a negative effect on the housing market. Once an estimated 7 million borrowers who selected adjustable rate loans got hit with a reset from low teaser rates (another issue we have harped on for a year) around 2% to market rates running closer to 7%, a financial squeeze in the middle class began in earnest. We estimate that 70% of refinancing occurred in a period at the start of ’03 into the early fall of that year. Most of the loans issued then were ARMs, putting the number of refi’s that were subject to reset around 7m. Those loans, experts tell us, were almost entirely 3-yr resets with very low teaser rates around 1-2%, but that would reset to sharply higher rates at reset time, especially if interest rates rose during the teaser period as actually occurred. So starting in August ’06 an avalanche of resets begin to hit the most financially strapped borrowers, many who bought their homes with no money down. As these resets dropped financial ‘hand grenades’ into families’ mail boxes, the distressed borrower ranks began to swell in strikingly large numbers. These numbers have now risen to the point that delinquency rates and default rates are now double prior years and climbing at alarmingly high rates. If our estimates are correct, this is just the opening round!

We have talked in prior notes about the surprisingly large increases in inventories of every description across the US economy. Now the housing inventories are swelling even further as the number of potential buyers being turned away by bankers and lenders that have been chastened by the Fed to maintain reasonable credit quality standards soars higher. Once no credit can be had, even qualified buyers go begging when it comes time to buy a home. And if families trying to trade up cannot find buyers with the ability to get Mtg loans then they too are stuck and the demand falls further. We think this pattern will repeat itself over and over again in the economy over the next several weeks as the real estate spring selling season hits full stride only to realize that no buyers can get loans! The housing prices that have been reported are a full 90-days old and reflect demand that is long dead. The current levels of demand will only be reflected in the number of new Mtg loans approved which we suspect will be only a fraction of the former numbers and therefore take the offering prices for homes down hard. Then the vacancy rates will surge, though we have seen evidence that they have already jumped sharply in the last 6 months or so according to gov’t sources. This pattern of events is very likely to follow the same script of the early ‘90s when banks were overextended with bad loans and refused to lend to all but the very most qualified (and very few we might add!) borrowers, the ones who don’t really need the money anyway. That leads to falling prices and another down leg.

Refi’s max out in mid ’03 – when ARMs with 3-yr teasers were the rage – now they reset to near 7% from about 1%

The sub-prime crisis we started working on in early December was the opening tip-off of what was likely to follow. So far our thesis is looking spot-on with Fed warnings about credit standards and banks scrambling to get out of sub-prime lending. The big surge in homes for sale clearly reflects lots of homeowners that need to sell all of a sudden. The Mtg reset theory seems to be panning out as delinquencies and defaults soar higher. Likewise retail sales were weaker during Xmas than expected and profits off those sales looks like they will be even less exciting once the margins are revealed with earnings from a group of retailing stocks due shortly. If the margin squeeze in a variety of industries is reflective of troubled consumers, then there should be plenty of evidence coming out soon. Cell phones have already shown that margins are falling hard now due to extreme price competition; its not that demand is down, just that consumers won't pay up for anything and only take the ‘bait’ (flat screen TVs and smart phones), leaving the ‘switch’ (lower margins and profits) for the vendors to deal with, very much unlike in prior years. If this trend continues, the whole economy may begin to feel the pain of lower growth and weaker profits.

So far only the mid-to-low end products seem to be suffering from margin squeezes. This may change once the momentum of economic strength begins to fade from the low-end up to the high. Rich consumers had a great Xmas, spending ever more on themselves. But the large portions of the middle class that can no longer afford to buy upper range goods and services may soon show up with alarmingly increasing frequency. The best segments for Xmas to us were teens and Yuppies. With inflation chipping away at household spendable income, what is left covers a great deal less than two or three years ago. The public’s perception of inflation seems to be in tune with our suppositions as many business people we asked agreed that the ‘actual’ level of price changes in common goods over the last 6 years has been well beyond anything the CPI can explain. Without the benefit of credit to lubricate the wheels of commerce, the impact of our troubled 7m households could rapidly spread into the upper reaches of Mtg credit traunches. 

Money Supply is coming back to earth – taking global liquidity with it !

The BOJ raised its benchmark lending rate by 25bpts this week. It seems like such a small increase and yet it may well have a rather painful impact on hundreds of billions if not trillions of dollars invested worldwide. The so called ‘yen carry trade’ is a fascinating example of Wall Street genius at work. It came at a time when hedge funds wanted to increase their leverage but banks weren’t willing or able to accommodate them. Instead the financial alchemists of the Street came up with borrowing money in yen at rock bottom rates and then investing across the globe into high yielding marketplaces like the US Treasury Markets. The spread trades made billions in profits and created a fountain of limitless wealth (or at least almost unlimited liquidity which may be as good). The yen carry trade finances ever increasing proportions of global transactions in real estate, stocks, bonds and currencies. This virtuous cycle occurs when one economy has more money than stomach to invest it domestically. They then lend it away to those who do. The trade works until something interrupts the availability of increasing sizes of deals. The new money keeps growing until one day it slows, it doesn’t even have to stop outright, just slow down. The impact of slower cash inflows creates its own dynamics which result in the same crisis as if the carry trade stops, only somewhat more slowly. The impact, however, is the same: the global liquidity cycle peaks and begins to contract. It is that contraction that then shows up in our thesis as defaults in low credit quality borrowers who have the least extra rope to work with. 

Once families are hit with monthly payments that jump from say $1000 to $2k or even $3k per month due to Mtg resets jumping from low teaser rates around 1% to market rates around 7%, then the weakest fold first and the next weakest shortly thereafter. The problem becomes systemic once the numbers reach the size that the natural bid in any marketplace is overwhelmed. This is what has happened in the housing market last fall; owners could no longer make payments and so sold as best they could. Once they could not sell above their breakeven point, walking away from Mtg loans comes next. And it has already begun to happen in alarming numbers for sub-prime and from what we hear, even so called ‘Alto’ traunches of credit, those home buyers putting 20% down on their new home. Once the Alto traunches begin to fail, something we suspect is soon to happen in numbers large enough to wake up lenders and begin to scare investors, the real trouble begins. This is when weak banks and Mtg lenders go bust all of a sudden, sending shock waves like last December in the sub-prime lending market. Then the next layer of lenders gets a rising tide of selling pressure that tests the depth of the natural market bid. Once overwhelmed a crisis unfolds in another part of the market.

Home prices may have hit resistance with another down leg yet to come!

The housing market is signaling that the risks of another down leg are increasing. Housing builders are publicly admitting that they are running into inventory problems as potential buyers walk away. The recent gains in interest rates make current Mtg loans cost more and the flurry of defaults in the sub-prime spaces has sent a chill wind down Mtg lenders backs as the Fed reiterates the need for maintaining credit quality in loans despite competitive issues. Why didn’t the Fed say so sooner, the defaulters might ask? They did! And no one was listening because home prices were still rising. That is the classic end-of-cycle situation: competition drives lenders to accept weaker borrowers and once global liquidity starts to contract, then all at once borrowers can't pay and home prices plunge from too much distressed selling, which in turn sets off the next layer of distressed sellers until the entire marketplace is swamped with losses and defaults. That is when the media will say: ‘they didn’t listen to reason and overextended themselves bringing the roof down on their own heads. Our experience is that everything looks great until the liquidity spigot slows down and then only the very fringes show any signs of trouble until it is

Home prices may have already fallen well below levels currently reported !

too late. Then the obvious crisis emerges once it is too late to do anything about it. That is why Feds of the past have been called the ‘man who takes the punch bowl away from the party just as it starts getting good!’ And it would have been well if they did this time! 

The Fed plays a delicate dance of keeping interest rates low enough to stimulate an economy that was struggling after the Y2k meltdown and over stimulating such that prices begin to spiral higher. The jobs growth that is essential to any sustained recovery didn’t really get started until the Fed started battling deflation around the time of the start to the Iraqi war. The wealth effect made wealthy consumers spend more thanks to portfolio gains and stocks to rally from the P/E effect. But home prices were the key recipient of Fed largess, igniting a bonfire of a rally that has lasted until inflation and jobs once again became a serious threat to the bond market vigilantes. As the Fed faced the prospect of rates running high enough to stall the economy and the housing spiral, it could find no better solution evidently than to make a number of changes under Alan Greenspan that altered the way CPI, a key inflation gauge, calculated price rises. Since CPI no longer calculated how much the proverbial Thanksgiving dinner costs to make but instead figured out how much inflation could not be avoided by household machinations, an entirely different question that is only loosely related to monetary inflation, a rapid rise in the costs of living could be deflected and denied while the US dollar plunged an equivalent amount. Since the victims of Greenspan’s folly were international investors, it must have seemed more palatable to cheat in the name of progress. Still the problem remains: between deficits and home price inflation, price erosion grew enough to make the bond market react, which brings us back to the present. The Fed now can't ease to help the housing market without pushing rates higher. Once the yen carry trade slows due to BOJ hikes, global liquidity will begin to shrink rapidly.

The Fed can't fight inflation without risk of killing the housing market …

So our thesis that rates and inflation, liquidity and credit drive the markets seems to be holding up at least for the moment. Derivatives magnify leverage enormously which is why markets that once were fairly volatile have become much less so once derivatives have been introduced. The ability for a few to manage the movements of an entire marketplace can only be done with leverage and plenty of it. Just read about the wild times when someone tried and failed to corner the market in some commodity. But questions begin to be disquieting when no one, anywhere, knows the answer. Like how many derivatives exist in any given segment of the market. The credit derivative swap market (CDS) is one that recently came into being as a place to hedge away specific credit risks associated with a company’s debt. But today at one of the largest CDS desks in the world, no one can even guess at just how big this actively traded market has become. 

SPX has formed a Terminal formation where wave-1 to w-3 is .618 and wave-3 to w-5 is also .618

As with the Asian Flu of ’97, all it would take is for one broker to go under and then every swap done with them as a counterparty will fall null and void, exposing unsuspecting investors to huge losses. That is how we witnessed a blue chip stock in Thailand go bust in a day as its currency swaps failed under just this scenario costing dozens of billions in losses overnight. It becomes all the more important to understand the risks being taken when entering a trade, something we fear is already gotten out of the bag with the derivatives markets. For now it suffices to watch the dollar, the long bond yield, the level of inflation and the availability of credit. We know from experience what happens when this quorum gets sufficiently out of whack: a recession can all too easily begin, ultimately wiping out millions of jobs and hundreds of billions of investments.

The SPX may have formed a fairly unique pattern in its heretofore extremely effective efforts to completely flummox students of the markets such as ourselves. For the first time in a long time, this is not a wedge! We know that must please some of you who have grown tired with the plethora of wedges; we certainly have had a belly full of them lately! The Terminal is a Fibonacci progression where the deceleration is occurring in a system at an increasing rate. For SPX Terminals may be aptly named because we have only seen them in the final leg of structures rising or falling and usually at the end of a long, developed pattern like the bull from 3/12/03, almost 4 years ago! The SPX is showing signs of deterioration in many small ways. Volumes in stock charts are diminishing as rallies cool. The momentum of moves is beginning to show more clearly and more often in the senior averages. The breadth of the market appears to be narrowing even as new highs are scored. The total picture shows what could very well be a market pattern that has reached saturation or exhaustion after a long, impressive run. The coincident behaviors by markets and sub-segments of the stock market argue that something big is in the works than may not have been present for a long while. The key as always will be in the fast, panicked movement of the major averages like SPX. Wednesday we saw movements down that were rapid, but were quickly reversed thereafter. The action on Thursday seems more powerful yet and clearly to the downside suggesting that something is about to change.

SPX fell hard Weds but recovered only to come down harder yet on Thurs with big divergences building

Wave-1 now just equals wave-5 but RSI is making lower highs even as new price highs are scored!

Hourly Sell signal from 2/8 got price confirmation – a sustained break of SPX 1430 

VAP is vacillating but Momentum is really weak !

S/D has vacillated a lot of late with new Supply lows and almost Trend highs

VAP made a double top but Momentum is not agreeing – suggests that something is changing

Rates have bounced off 50% retracement support targeting 5.5% - 6%+

Weekly S/D has indicated a Sell but needs SPX to drop quickly to confirm it

VAP is slowing and may roll over - Momentum lagged badly and may turn lower soon

Certifications and Disclosures

© 2007 Richard T. Williams, CFA, CMT
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Richard T. Williams, CFA, CMT
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