The Money Supply has come full circle back to the 5% level after a run to 18% during the sub-prime crisis that peaked in early March. The growth rates of MZM from here will telegraph the Fed’s intentions for the economy and the markets far better than anything that the talking heads might say in our experience. The question is whether the Fed will allow a correction to occur in the market. With liquidity engines falling back to a fast idle, the impetus for higher stock prices may have to come from 2Q earnings which begin with pre-announcement season at the end of June and fill the calendar during the last 2 weeks of July. The outcome of results and perhaps more importantly of guidance forward will play a major role we think in how stocks are priced. The discounting process for risk has been largely absent in the last year or more as liquidity surged higher  taking stocks and real estate higher. The reawakening of risk premia will occur at the same point that investors feel fear rather than the ever present greed that has driven the market and real estate to record levels. 

Money Supply has come full circle back to 5% growth down from 18% weeks ago – MZM is still 3%+ over sustainable growth

The Fed is constrained in its manipulations of the Money Supply, interest rates and Financial system leverage by the value of the dollar. In very large marketplaces like currency markets, even the Fed has to watch its step or risk being swept aside by a tide of global monies that follow profits not promises. The dollar has likely begun its downward slide once again. Trading patterns have formed typical ST topping patterns and now the buck is moving lower with confirming momentum. Should the dollar fall below the crucially important supports between 78 and 80 on the DXY index, the Fed would feel enormous pressures to defend the buck by raising rates to make the currency relatively more attractive to foreign and domestic investors. The problem lies in the fact that the Fed has already raised short rates to levels normally seen at the conclusion of a dollar defense, suggesting that the usual methods of supporting the dollar may not be effective this time around. If so then the Fed may have its hands full in avoiding a serious revaluation of exchange rates lower, a consequence of inflationary policies like persistent deficits and excessive systemic liquidity. The cure is extremely unpalatable: recession and very tight money, last seen in the 1979-81 era. Already credit has become much more difficult to obtain, even for the most creditworthy customers.

ARMs reset after 3 yrs – so the entire sub-prime crisis was caused by about 20% of total resets – this year 50% more will reset !

Sub-prime lending practices became so lax that virtually anyone could get 100% financing regardless of credit history. Once fear was felt by lenders, in the latter months of ’06 after perhaps 10%-20% of ARMs with teaser rates had experienced payment resets, the sub-prime mess resulted in tighter lending standards and therefore far fewer buyers with financing to support home prices. As this year progresses, the same families hit with a payment reset will once again receive a higher reset until they hit the loan’s cap rate or market rates, currently running between 12%-15%, a very long way from 1% teaser rates at the outset! Our ‘Double Down’ theory is that the original 20% of reset ARMs will be hit with a second payment increase at the same time that the class of ’04 is hit with its first reset, transforming the environment substantially as roughly 2.5-times as many mortgage holders will be forced to pay multiples of their prior monthly payments due to resets. 

This doubling effect comes from the class of ’03 numbering about 20% of the total reset ARMs using teaser rates and the class of ’04 amounting to around 30%-50% of the totals. Hence between now and the fall more than twice the number of mortgages will be facing significantly higher payments than was the cause of the sub-prime crisis earlier this year. We expect home prices to come under considerable downward pricing pressure as these distressed households move to sell their homes if possible and to vacate them if not. Either way the number of empty homes for immediate sale will rise sharply higher than is already the case, numbers that up to now already amount to more than twice the 4 million homes sold annually in the U.S. 

One of the key reasons that the dollar hasn’t turned lower already is that China has been recycling its surplus denominated in dollars back to the US in the form of purchasing gov’t bonds. In the last year all the G-8 Central banks have become net sellers of dollar based securities except for China. The latest Net Inflow data from the gov’t shows that China is slowing down its purchases. Further Central banks over the last year or so have been net liquidating dollar holdings and diversifying into other currencies for their reserve holdings. This liquidation of dollars threatens to undo the Bretton-Woods financial system that has greatly benefited the US economy by allowing us to print far more money without spurring inflation than would be the case in any other economy. 

Vacancies have surged higher as sub-prime defaults have risen – many US cities have vacancy rates above 10% today

The next step in the unraveling of the Post-WWII financial order will be to denominate oil in currencies other than the dollar. Up to this point, the American consumer has been largely unaware of the impact of a weaker dollar or for that matter of inflation eroding the purchasing power of their incomes. Increasingly, however, the impact of rising prices is starting to intrude upon the day to day living standards across the country. Anyone buying food can attest to the fact that prices have risen by roughly 5%-7% each year since 2002. But the acid test comes from the rate of return for foreign investors holding dollar-denominated assets over the same period. For bonds the return has been negative while stock returns are only marginally positive despite a 50%+ gain in dollars. Hence the motivation by foreign Central banks to diversify away from dollars in order to protect their own assets.

A simple way to gauge economic activity is to follow copper prices and news paper advertising lineage. With the Olympics coming in a year, Chinese construction efforts will have to complete new buildings and hence stop new construction which argues for a  fairly precipitous drop in the huge volume of copper that has gone to the far East for the last few years. In the past the Olympics has signaled a major economic turning point for most emerging countries over the last few decades, with Greece falling into a sharp decline just as the opening ceremonies kicked off. While China is far more diverse an economy than its smaller peers, the same forces may well be operative signaling a reversal in commodities like steel and copper used in industrial development. Should this scenario come to pass in the next several months, it would shift the demand schedule for the dollar as well with many commodities flowing out of the US and into China and APAC economies. 

Deficits and excess liquidity weaken the dollar – now it is on the last major supports over 40 years – below 78-80 could be real trouble

With the dollar at a significant crossroads just as it sits on key support on the DXY index, anything that could precipitate a decline in the demand for dollars would have a disproportionately large impact on the economy, the Fed and the market. The charts suggest that this pattern could go either way, but not without substantial costs either way. We suspect that the dollar will be a critically important factor in whatever the next steps will be for the market and as such merits close attention.

Defaults are likely to accelerate higher as Mtg resets affect the majority of over 7m ARMs holders

The SPX as we move into 2Q pre-announcement and earnings season is just off new highs yet the growth rates of sales, margins and profits remain 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 stronger New Orders have provided impetus for bullish momentum to build. While the patterns are as of yet too immature to determine whether the upticks are real or just ‘noise’ in the formations, the market may be poised to attempt another try at the highs. Curiously both of our main scenarios argue for at least a modest bounce off the recent lows, but from there the outlooks diverge markedly. The bullish case, the 5^th/5^th/5^th wave count, calls for a final blast off to new highs to complete the bull market structure from ’03 lows. The bearish case is that the bull market has already finished and now a correction that could be of significant magnitude is underway; if so then retracements would be expected to remain in line with typical 50% limits seen in most bear market corrective bounces. The key level at the moment appears to be SPX 1518. Above that level would suggest that the potential wedge throwover stage on the structure that began with the 2/22 highs is poised for a 5^th leg higher off the lows yesterday which significantly hit almost exactly .618, a key level for our DOTF measure. This action points to a 5^th leg higher that will throw over the upper edge of the formation around 1566 today. If so then a rapid run up to SPX 1570-1580, before reversing intra-day to close down on the day signaling an important turning point for the market.

The DOTF or Dilemma of the Fourth Wave is a theory we have put forth that when potential wedges measure the distance between pts 1&2 and pts 3&4. The result in proper wedges tends to be a Fibonacci relationship, often 50% or better yet .618, which forecasts that the pattern will behave as a normal formation would be expected to act rather than surprising with a head fake that ends up being the true pts 3&4. We are currently amassing statistical evidence to support our DOTF thesis.

With our ‘double down’ effect and the recent trends in retail demand, it appears that housing will not hit bottom for some time to come pressuring consumer spending and therefore the dollar. The count for SPX, without getting overly technical, can be argued to support either the bull or bear case, but only for a relatively short time before a clearer resolution becomes visible. SPX targets 1566 when it equals the bull market’s initial rally in the current, and likely final, upward movement before a correction takes hold of stocks. With SPX 1552.87 all-time highs from ’3/00 so close it seems likely that the bulls will take any opportunity to match other indices’ new highs. The alternate count calls for SPX to fail to make any retracements greater than 50%-60% of lost ground, a characteristic of most bear market progressions. The decision point seems to be rapidly approaching. We cannot help but thing that recent weakness in private equity IPOs as well as earnings pre-announcement season will play important roles in this key turning of events. 

The market mind is hard at work coming to a resolution of how far sub-prime problems will spread while also considering the outlook for earnings growth across the economy. If as our Double Down theory supposes sub-prime issues cross over to the mainstream, consumers will be force to cut back on spending in a meaningful way in order to remain solvent. That in turn will lead to more homes for sale and therefore lower housing prices. As interest rates rise and home prices fall, the pressure on troubled consumers grows only more and more intense. Foreclosures are running sharply higher; the schedule for mortgage payment resets suggests that this trend will grow considerably more powerful before it runs its course, driving home prices lower and lower. This is the scenario we foresee based on the available data on mortgages, leading us to expect consumer spending to fall to levels that threaten the viability of the continuing expansion phase of the economy, something that the market should be able to forecast 3-9 months ahead of the fact.

RTW

SPX has come to a potential ST bottom – with RSI positive divergences

A potential wedge throwover could be in the works over the next few days to weeks with a target of SPX 1565-1580

A potential wedge throwover could be in the works over the next few days to weeks with a target of SPX 1565-1580

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!

The uptick is giving bulls hope for a new high – But only represents a 50% retracement

Again this rebound may not be significant  - it could still be pattern ‘noise’

Hourly S/D is on a Buy signal – but prices only confirmed yesterday or today

VAP has made a higher low and higher high – RSI has jumped more robustly than normal !

S/D is getting extended in its sell signal – a bullish bounce could develop from here

VAP may be turning soon – Momentum is now looking decidedly bullish at least in the ST

Rates have broken out after a long consolidation – suggests further room yields to rally

Claims bottom about 1 yr before a recession begins based on historic patterns

Weekly S/D is only part way through a fairly big Sell signal 

VAP is in an established downtrend – RSI is potentially turning down after lagging VAP badly…

DAX is potentially forming a wedge with upside to new highs or beyond – but only if the lows hold

Additional Information Available Upon Request

Certifications and Disclosures

© 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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