Back in late February the Fed began to pump up the Money Supply via MZM growth from 5.25% to 17.88% in just 7 weeks. Such a powerful rise in liquidity goes directly into the financial markets from the banking system where it picks up the money multiplier of about 19x (Fed reserve req. is 5%). The effect is enormous and explains how the bull has been able to sustain itself through situations that would in virtually any other scenario have broken down and sold off hard. That the Fed has been supporting the market is not a new idea, but with the GDP Deflator coming in at 4.0% and Prices Paid components in several recent Fed surveys expected it tells us a great deal about inflationary trends. It seems clear to us that the Fed has been caught on the wrong foot with regard to stimulating the economy and the markets while trying to hold off inflation. Evidently the consumer and housing weakness hasn’t been enough to stall out inflationary pressures coming from wage demands. Unit Labor costs are up 3.7% this year while commodities are up between 4%-5%. Jobs growth at 88k last month shows a marked deterioration even from the lackluster levels seen last year. New grads add about 270k/mo to the labor force; and 400k jobs per month are needed to elevate jobs creation back to levels normally seen in strong recoveries like this one. Now that price erosion has taken away a significant portion of purchasing power for households across the US and jobs growth has done little to assuage the problem for the average American, the pressure will likely rise to a boiling point as more and more households fall into financial distress.

LT support for the dollar is now between 80.25 and 81.3
– normally short rates would rise to support the dollar but are at 5.25% now!

Labor has been growing well below normal for post-war recoveries, just covering the new college grads entering the marketplace at about 270k/mo. Over the last 5 years we estimate that the economy has produced between 5-10m fewer jobs than would be expected for an expansion of the duration and magnitude of the present one. If not for an unprecedented revision last October, the jobs numbers would have descended into the red, the recession zone. Jobs reports going forward will have to contend with construction declines and oversupply that has run into 2-3 yrs of normal inventory according to the media. The curious aspect of construction jobs, however, is that housing builders are currently scrambling to raise cash any way that they can to better weather the housing recession already underway. Most builders aggressively built land inventory to capture maximum profits from housing sales. The problem is that undeveloped land cannot be mortgaged to raise cash. The land has to have a house on it to qualify for a mortgage, hence the continuation of the housing overbuild even as supply swamps demand. This too shall pass, making the comeuppance harder yet.

About 90% of Mtgs were ARMs with 3 yr teaser rates – Resets began in ’06 and
now get a 2^nd hike 1 yr later, doubling the sub-prime effect

The housing crisis was born of excessive global liquidity such as the yen carry trade. Enormous pools of money made leverage very attractive and inflated the housing bubble. Mortgage lenders eventually took on lower and lower quality loans as competitive pressures grew. Then liquidity slows and consumers discover that their 1% ARM just turned into a 4% payment and will jump again in a year to 7%, which still below market rates. The sub-prime effect that took housing prices down last fall is not over; quite the opposite is occurring. The numbers of mortgages with resets is about 7m and only 30-40% have hit their reset dates. With refi’s down sharply there is little room for most families to maneuver. They may get a lift from tax refunds, but with credit card debt spiking higher and retail sales dropping hard after Easter, it is clear that consumers are not out of the woods. We estimate that the sub-prime effect is not even half finished. Over the next 6 months the majority of reset ARMs will have passed the 3 yr mark and received at least one reset, but the early resets will have gotten two! That means as spring turns into fall, the sub-prime victims will have a doubling effect as two resets are needed to reach market rates from low teaser rates. That will result in significantly more pressure exerted on troubled consumers in the next few months as the early third of ARMs holders get hit with a 2^nd hike while the middle third get their first one, all in the next 3-4 months.

Another issue with housing is the number of vacant homes hidden among middle class neighborhoods and even into the high-end homes. Brown lawns have become the calling card for empty homes where families handed the keys back to their banker or were evicted for non-payment. What is perhaps most sobering is the number of vacant homes, which is reported to be over 2.5m (or almost 3.25%) homes according to a recent story in Barrons. That number taken with the approximately 7m resetting ARMs holders makes for a formidable pool of selling pressure likely to hit the market at exactly the wrong time. Once a family realizes that it cannot stay in its home, the occupants often engage in a spree of destructive behavior, neglecting the upkeep and even damaging the property out of spite. The costs of maintaining moderate subdivision worth of empty houses for things like taxes, landscaping and repairs falls to the city. Neighbors may even step in and mow the lawn so that their own homes are not taken down in value by the vacancies. Once a neighborhood is tainted by vacancies, the risks multiply that it will experience a downward spiral of the kind not seen since the mid-to-late 70’s. Housing prices will likely take another hit as distressed families are forced to move, driving bids down and depressing comps that in turn exacerbate the vacancy problem in a growing number of cities across the nation.

As borrowers find that they cannot refinance to avoid sharply higher monthly payments as they had done for the last 3-4 yrs based on property value, reset clauses in the large number of ARMs sold to the public since ’03 are raising costs on vulnerable households even to the point of precipitating delinquencies and defaults. That in turn causes another big hit to home prices and sets off another round of defaults and distressed selling. The surprise in all this is that in ’03, the start of the big refinancing boom into ARMs with 3 year teaser rates, record numbers of home owners took out loans that began resetting last spring. The problem then becomes magnified as early resets are now getting another reset from an initial 1% rate to about 4% and then again this year to 7%, still below market rates in many cases. This ‘double down’ effect will cause even financially stable households to live with austerity in order to make payments. The economy could then slow substantially more than it already has due to housing issues because we estimate that only 20% of total refinancing of ARMs since ’03 have reset, but as much as 40-50% may be hit with at least one reset by early fall. Another 20% could be hit with 2^nd resets by November exacerbating the housing crisis by geometrically increasing the number of distressed sellers. Foreigners can see this cascading scenario more easily than we can because they have experienced significant inflation for the past 3 years whereas we have only just begun to feel its effects as oil and other commodities spiral higher.

Banks are in a precarious position with regard to defaults and vacancies. Many bankers would be willing to go easy on payment terms to avoid a large flood of bankruptcies and Sheriff sales. The problem for bankers and the key difference between now and the 70’s housing bust is that the ’05 bankruptcy law changes the rules making it substantially more difficult to walk away from debt. It also forces foreclosures for non-payment which in turn leads to vacancies spiraling higher in many cities around the Country. We checked on about 5 medium sized cities and found that vacancies amounted to between 10%-12% of owner occupied single family housing. Those kinds of numbers suggest that selling pressures have not even begun to hit the bid price of houses for sale. Mortgage lenders further exacerbate the problem by qualifying only a fraction of the willing buyers for lack of income or assets whereas prior to the sub-prime meltdown practically anyone with a heartbeat and a job could get a mortgage. A mortgage official was on TV saying recently that 50% of loans written in the last 2-3 years would not be accepted today. Most noteworthy was that Alt-A and prime loans were equally affected.

With all of the negative issues surrounding the US, many foreign buyers have begun to sell according to Net Inflows data, weakening the currency and buying power in the markets. Once the dollar loses credibility in the global marketplace, several implicit failures will likely have already occurred. The US economy is all about the consumer to those abroad. The Fed is seen as the controller of the economy. For the dollar to fail key support levels, inflation will have to be seen as rising effectively with Fed approval and the consumer will have to be perceived to be in trouble. We have posited in the past that the Fed may be engaged in a tacit policy of disinformation to the public, calling it ‘Conversity’, the act of directing the attention of the nation to exactly the opposite of what is actually happening. Applying Conversity to Fed statements going back to the turn of the Century is a most fascinating and revealing process. When the Fed voiced its concerns about Deflation, Inflation was actually emerging that the problem most needing to be addressed.

LT econ growth is about 3% - the Fed is growing MZM at 16.6% and rapidly rising
– Greenspan-style intervention tends to weaken the dollar

One of the key problems that a loss of credibility causes is that the Fed cannot marshal larger forces to help it accomplish its designs. If the dollar is at risk, a credible Fed will simply jawbone it higher. A less credible Central bank would raise interest rates to increase the relative attractiveness of the greenback compared to other currencies. Once credibility has been lost, the Fed has to carry the entire weight of propping up the dollar and even may have to work against market players betting it will fail, further raising the stakes against it. When Greenspan in ‘03/04 talked about the benefits of using adjustable rate mortgages (ARMs), the best advice would have been to do the reverse and lock in historically favorable LT interest rates. When the Fed told us in ’05 that Inflation was ‘well contained’ the truth turns out to be that it was anything but contained as commodity charts clearly show. The list goes on and on demonstrating that the best advice with regard to protecting and growing individual or institutional wealth is to do the opposite of what the Fed suggests. Imagine that: the nation’s Central Bank giving Americans the worse possible advice. Finally polls show that over 50% of the public no longer believes what the gov’t and more importantly what the Fed says.

Short rates typically turn up and run ahead of a currency problem
– but this time it didn’t seem to help the dollar - Inflation!

It no longer may matter what the US public believes but rather what foreign investors perceive to be the truth about our economy and financial markets. What may be clearer from abroad is that the US consumer is heading into more rather than less trouble relating to housing prices. Since the sub-prime crisis, housing values have fallen sufficiently to impede the refinancing of mortgages on teaser rates based on home equity alone. The subsequent credit tightening where lax lending standards are enforced with perhaps over zealous gusto is turning away any borrower who effectively needs the money as banks consider the risk to their capital and therefore stock prices. The effect is to further reduce home prices by sharply limiting buying power. The next domino to fall is the ‘double down’ effect of mortgage teaser rates resetting higher therefore cutting consumer spending and slowing the rate of economic growth.

International investors are obviously watching this looming consumer crisis build and will react commensurately with perceived opportunities or risks that follow from sharply lower expected spending over a period of perhaps 3+ years since the average debt/equity ratio for US households is about 150% and roughly 33% of income is reasonably ‘discretionary’ in times of austerity. With 70% or more of GDP coming from consumers, the risks to the dollar from potentially enormous capital outflows should foreign investors elect to exit dollar-based assets until after the currency has adjusted to the reality of austerity in place of wild over-consumption so prevalent over this decade are serious and we think proximate, not to mention the impact on US financial markets in a dollar revaluation scenario. The dollar has to fall enough to discount inflation as well as GDP growth relative to major trading partners like the EC, Japan and China. Canada is the biggest of all and has seen its currency rally to parity from a 45% discount only 7-10 yrs ago. If the Fed acts aggressively as we expect it will feel compelled to do, pumping inflationary liquidity into the system to stimulate the economy may only delay the inevitable or exacerbate it. While Enterprise Software stocks benefit from a weaker dollar domestic companies and especially exporters will suffer.

With oil priced in dollars, the US consumer can hide quite effectively from the impact of a lower dollar, but a growing number of foreign central banks and oil exporters have begun a shift away from the dollar and into the euro or yen instead. The average FX holdings in developed countries’ central banks was recently reported to be down from a large majority of dollar holdings to now less than one-third in greenbacks, a negative influence both for exchange rates and for domestic inflation. If critical mass of foreigners denominate oil in currencies other than the dollar, it will begin to show up in oil prices that are adjusted for US inflation whether we like it or not. So far the US consumer as escaped oil price inflation but not for much longer it would seem. With inflation growing at 2.1% even after Greenspan’s 23 changes to CPI, altering its ability to gauge inflation substantially, there is a growing motivation for the world economy to shift away from inflated dollars.

Defaults are spiraling higher – But mtg resets could push them much higher into the fall

The Fed has backed itself into a corner where if it eases liquidity to try and forestall major housing defaults that appear to be already in motion, then the dollar will react negatively forcing a crisis of confidence. If the Fed tightens to fight inflation and restore its lagging credibility then recession comes as the housing market takes its next leg down causing spiraling defaults and vacancies. If the eerie similarities to the 70’s continues, a banking crisis likely follows making the Fed take action or risk a crisis in the financial system which of course gets back quickly to the dollar. Even sitting still doesn’t seem to work with inflation running at increasingly high levels despite economic slowing when it should be simmering down. The vacancy rates in major cities is perhaps the next aspect of the housing crisis to hit the headlines as lawn care costs start to weigh down neighbors and city governments that have to pay them or risk further defaults from falling housing values as vacant homes deteriorate.

Ultimately the Fed will be forced to act. Perhaps prudence would choose to get inflation back under control, washing away unsustainable excesses and quickly setting up a stable basis for the next recovery even if a recession results. But giant debt incurred in the US over the last 5-7 yrs makes it questionable whether any course of action other than hyperinflation is viable – Conversity tells us that means Fed speak that it is being vigilant about inflation first and foremost! Fed-heads regularly say that if inflation doesn’t come down they will need to tighten, yet they never do. Sound familiar?

The SPX as we move beyond 1Q earnings season is hitting new highs yet the growth rates of sales, margins and profits are clearly on a declining trajectory in the software spaces if not the market in general. Fed surveys like Richmond and Philly show sustained growth in Prices Paid as well as slower New Orders. Today’s Durables show us that peaks like the recent one appear to coincide with recessions. The prior peak occurred around June ’00 and the previous one through ’90. Then ’81 and ’79 recorded peaks suggesting that there is a link between peak orders and economic exhaustion. Furniture and transportation predictably were the big losers in the Durables report, but metals were strong as was the ex-defense number. New home sales showed a stark outlook with supply towering over previous highs going back to the 70’s. South and West were still on ugly declines while NE tried to rally off lows. With our ‘double down’ effect and the trends in sales it appears that housing will not hit bottom for some time to come pressuring consumer spending and therefore the dollar.

The dollar has formed a new wedge on top of the throwover of an earlier one. The current pattern is working towards its own throwover stage before a probable reversal back through supports. With so little support below 80 on DXY, the Fed may find itself defending the dollar sooner than it expected, particularly since it has been pumping Money Supply which of course creates more inflation. Yet the usual fix of hiking ST rates doesn’t seem to be an option this time around. Ominously as we show in the second chart in this note on the dollar vs. T-bills, rates are already high relative to previous efforts to save the flagging currency. What the Fed can do this time is not clear; what is, however, may be that the fix will be expensive and potentially ineffectual if inflationary policies like growing deficits and high rates of Money Supply growth are continued.

Foreign markets have largely accompanied US averages in what looks to us like a blow-off top. When fundamentals and technicals (except for momentum) no longer seem relevant then speculation builds to a frothy top. These types of markets, in our experience, never end well. Still the wave count argues for at least a pause in the torrid pace of rally. With interest rates running higher and oil trying to follow, pressures on traditional relationships to the stock market no longer seem to be operative, another sign of a blow-off. Gold is similarly following an inverse relationship to inflation which puzzles to say the least. Some emerging markets have begun to turn lower, some with emphatic force. But to actually turn this momentum juggernaut of a market it will take a surprise of considerable magnitude. Iran could do it as could emerging Junk bond problems. This unpredictability is part of what makes following the market a continual learning experience.

The count for SPX looks like a potential turning point is at hand, but for the Memorial Day holiday which usually supports stocks ahead of the event. Using a 3^rd of the 5^th interpretation SPX is now measuring its 5^th from March lows at 50% of wave-1 in what looks like an extended flat pattern where wave-3 is much bigger than either waves 1 or 5. Usually in this situation the final wave relates or equals the first wave which would put SPX targets at 1538 (.618 of w-1) and 1566 (equal to w-1). Looking at just the progressing wave-5 we see the same structure and measures as with the daily data from 3/14! The w-5 is now 50% of w-1 suggesting ST targets of 1536 and 1545. We find it noteworthy that SPX on an hourly chart is showing marked negative divergences as is true of the daily and weekly periods. While divergences in momentum cannot tell us much about timing, they do tend to be accurate in the health of the trend. In this case it is looking tired. Supply/Demand echoes this situation with sell signals on all timeframes but requiring price confirmation.

With SPX 1552.87 highs from ’3/00 so close it seems likely that the bulls will at least try to match other indices’ new highs. After that its anyone’s game.

RTW

SPX has some upside room still but is at .618 of wave-1 up - RSI suggesting it could turn soon

The Momentum Market continues to run higher – but negative divergences are mounting

Home sales are still falling – our Double Down thesis suggests it will continue for some time to come

Peaks in Durables have signaled each past recession except in ’83 going back to the 60’s

NKY has formed a big wedge and only needs a new high to complete it – but RSI is negative here too!

Prices Paid components are still rising higher!

Hours worked lead jobs cuts – jobs declines signal trouble ahead so this is a key indicator to watch

Empire shows further weakness – jobs falling, inventories rising – but the key may be that prices paid are running higher!

Hourly S/D is in full sell mode – but will prices fail to confirm it?

VAP is falling – RSI didn’t budge on the test of recent highs – a bearish signal!

Housing is clearly hurting consumption – this is the real fear behind the weak dollar

S/D is accelerating a sell signal

VAP has backed off its new high – Momentum is remarkably negative

Rates have confirming RSI on highs – suggests further room to rally yields

Hours worked are deteriorating signaling a slowing economy

Weekly S/D is extended on a buy signal from March

VAP agrees with S/D – But RSI is remarkably weak, suggesting a turn coming

DXY is at mid-range in a wedge with significant negative divergences building – bearish picture

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© 2007 Richard T. Williams, CFA, CMT
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Richard T. Williams, CFA, CMT
Senior Software Analyst
Summit Analytic Partners
Jersey City, NJ
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