(December 12, 2004)
Please note that we switched to a 25% short position from a neutral position in our DJIA Timing System on Friday at 10,543. The combination of declining liquidity, weak breadth, and a still somewhat overbought market is currently concerning this author. We will continue to hold the 25% short position but we reserve the right to change our stance if we see any improvement in any of our technical indicators. Moreover, we will be putting up a section on our website dedicated to our DJIA Timing System sometime this week.
Dear readers - please continue to forward this commentary to anyone who you think may be interested in our services. We still need all the subscribers that we can get. Please also post all your questions about the market and individual stocks in our discussion forum - this will also encourage more discussion and will also help other subscribers and readers in their analyses of the stock market. We have also set up two new discussion boards for our readers - one catering for the bulls and one catering for the bears. Registration is free.
Important news: I will be leaving for Hong Kong on December 19th and will not be back until January 7th, 2005. I will try very hard to update my commentary during that time - but my current publishing schedule is December 18th, December 26th, and December 28th. My partner will be in Los Angeles from December 29th to January 5th so I don't anticipate updating our website after December 28th until I get back from Hong Kong on January 7th. I am also planning to speak to a few investment professionals while I am in Hong Kong and will appreciate it if our readers can act as a reference or recommend people that I can speak to (and which hopefully we can put up as another "interview" on our website) - on topics such as the future economic direction of China, Hong Kong, and her relationship with the United States, etc.
Frequent readers of my commentary know that I have kept an eye on the homebuilder and mortgage financing industry ever since the earnings warning from Pulte Homes in early August due to a weakening in the Las Vegas housing market (which represented approximately 10% of their market). Since then, stocks such as LEN and CFC have endured some periods of significant correction, but during the last couple of weeks, these stocks have regained strength yet again, as evident by the incredible rise of LEND and TOL during that time. Even CFC, a stock which I have outlined in the past as having broken its two-year uptrend now looks technically bullish - as it convincingly broke above its 50-day moving average during Thursday and Friday.
The questions that many people have asked over the last couple of years have been these: Is there a housing bubble in certain parts of the country? And if there is, when will it pop? And if the bubble is due to pop soon, when will it be a good time to short mortgage financing and homebuilder stocks?
Dear readers, these are not easy questions to answer - but I will make my best efforts to answer them (in a general sense - hopefully) in the following paragraphs. The housing sector (and the homebuilding stocks) has been rising at a blistering pace over the last couple of years, as the home has again become the primary investment (in some cases, speculative) for most Americans ever since the technology/telecom bubble burst in early 2000. The bears will say that this rise has defied logic. They will argue that wages and earnings for millions of Americans have not kept pace with housing prices. The bulls will argue otherwise, as the historically low long bond rates have allowed millions of Americans to now afford own and finance a home. The bulls definitely have an argument here, but it now looks like a few chinks are starting to appear in the bull's armor.
I will begin with a chart - a chart which perhaps spells impending trouble for mortgage financing companies (please keep in mind that a significant number of homebuilders also provide mortgage finance loans for their buyers). The following weekly chart shows the differential between the 30-year Treasuries and the Fed Funds rate:
Readers should know that mortgage companies borrow short and lend long - that is, they do the typical carry trade by making money from the spread between the short-term borrowing rates and the long-term borrowing rates. As shown in the above chart, the spread has broken below its October 2002 and June 2003 lows (and is now in a downtrend), suggesting that the profits of mortgage financers (such as CFC and LEND) may be about to be squeezed. Moreover, the last time that the spread was this narrow (relative to the past two years, of course) was November 2001, when CFC was still trading at $10! The anticipated 25 basis point rise in the Fed Funds Rate to 2.25% on December 14th will most probably seal the fate for the mortgage financers.
So why did I overlay the Dow Jones Industrial Average on the above chart? The answer is this: I originally planned to do a historical study between the performance of the DJIA vs. the differential between the long bond and the Fed Funds rate, but I believe that the latest data of the last few weeks is now more applicable to a study of the housing and mortgage financing market. However, it is interesting to note that the stock market has not done well when spreads have tightened (or in the midst of tightening - remember markets always look ahead) in the past. Of course, it is still currently too early to tell, but stock market investors and speculators alike should keep track of this differential going forward.
The fact that mortgage financing stocks have again come alive (or in the case of LEND, making all-time highs as the CEO is planning to dump 10% of his holdings) looks bubbly in the face of narrowing spreads between the long bond and the fed funds rate. Bulls would argue that the reason for these stocks going up is because of an increase in anticipated mortgage origination. Is this the case? No one really knows for sure, but it is interesting to note that even Bank of America (who is still very bullish on homebuilding stocks) is looking for an 8% decline in new home sales in 2005.
I will further argue that the characteristic of the housing markets has now changed. As the Bank Credit Analyst argued in its December 2nd commentary the latest increase in housing prices from the second quarter to the third quarter registered an annualized 18.5% reading - an all-time high. Moreover, both the year-on-year increase in housing prices and the housing price to income ratio hit all-time highs. There also continues to be a huge disparity between housing prices on the coast and on the interior of the United States.
Furthermore, as the latest Flow of Funds data from the Federal Reserve shows, real estate assets held by households and non-profit organizations as a percentage of their total assets are also at an all-time high as of the third quarter of 2004:
As the above chart shows, the latest Flow of Funds data shows a huge rise in real estate assets held by households and non-profit organizations as a percentage of their total assets. This number is now at 29.11%, despite a significant recovery in equity prices during 2003.
The following chart shows the same data along with quarterly percentage changes in the Office of Federal Housing Enterprise Oversight (OFHEO) House Price Index from the second quarter of 1975 to the third quarter of 2004:
Please note that the latest uptick in this percentage corresponded with a quarterly increase of 4.61% in the OFHEO House Price Index - the highest quarterly increase ever and only comparable to the first quarter increase in 1979 - when inflation was running at a rampant rate of 12% (the OFHEO House Price Index is not inflation adjusted). Looking at the above two charts: If history is any guide, then housing prices will most probably underperform during the next few years, especially given that housing prices have skyrocketed with tame inflation and also as a percentage of total assets despite the outstanding performance of equities and corporate bonds in 2003.
Dear readers, it is important to keep in mind that the housing market does not have to crash for the demand of the building of new homes to decrease or to fall off a cliff. I have emphasized this before and will say this again: The homebuilding stocks are very, very cyclical in nature. If there is even a reversion to the mean in housing prices in the next few years, then all of a sudden, demand for the building of new homes can literally be cut into half overnight.
Finally, the fact that homebuilding stocks continue to go up in light of the recent huge increase in housing prices is a cause for concern - are housing prices going to increase even more than during the third quarter of 2003? Most likely not - given historical experience. LEND is projecting a $6.90 EPS number for 2005 (and long-range growth of 15% in its EPS) while TOL has already forecasted that earnings will increase by 20% in 2006 and beyond. Earnings estimates are now projected to be very rosy for the next few years. If there is even a slight hiccup, then the prices for homebuilding and mortgage financing stocks could plummet overnight. For now, we will just take it one day at a time. Readers who are currently trading these stocks should take note that LEN will be reporting earnings on Wednesday morning at 11am ET.
Okay, so much for housing prices. What is the market saying now? Let's take a look at the familiar chart showing the Dow Jones Industrials vs. the Dow Jones Transports:
As the chart shows, both the DJIA and the DJTA have been trading in a narrow band over the last four weeks - suggesting either accumulation or distribution. Readers should know that since our DJIA Timing System is currently 25% short, we are betting on the latter. Of course, we are not 100% sure on this position (no one ever is), but there are clues.
First of all, bullish optimism is still prevalent among advisory services and individual investors. As I mentioned on Wednesday's commentary, the Bulls-Bears% Differential in the Investors Intelligence Survey has grown to 39.1%, a very high reading signaling bullish optimism any way you look at it. However, the corresponding reading in the American Association of Individual Investors Survey is sending out mixed signals, as the Bulls-Bears% Differential declined from a relatively optimistic reading of 32% to last week's 26%:
Taken at face value, the reading on the AAII survey is more of a neutral reading, but the very high reading of 39.1% from the Investors Intelligence Survey still bothers me. Optimism on the part of investors has also been reflected in the put/call ratio readings. While the 10-day moving average of the equity put/call ratio recently bottomed at 0.53 and has since risen to 0.61, the one-day reading of 0.47 last Friday was a very low reading any way you look at it - the surprising (and bearish from a contrarian standpoint) thing being that this low reading came in the face of a flat market on Friday. The following chart is courtesy of decisionpoint.com:
Moreover, the Rydex cash flows ratio is still at levels that has marked ST tops in the stock market. This author does not feel comfortable going long here. The probability calls for at least more consolidation or even a correction, unless the market chooses to "blow off" in a manner similar to late 1999 to early 2000. Again, the following chart is courtesy of decisionpoint.com:
Of course, the market can just take off again here and leave on the bears in the dust. The probability is there, but I do not believe that the chances of this happening (at least in the next ten days) are not very high. Again, readers should be reminded that when it comes to the stock market, it is all about playing the probabilities. Probability is now saying to stay in cash (or in our case, go slightly short the Dow Jones Industrials) - at least according to our calculations anyway.
I have mentioned this to my readers before - we can still rationally go up here if liquidity is ample and if investors should choose to buy with both hands. As I am writing this, the acquisition of PeopleSoft by Oracle has just been announced. The deal is a $10.3 billion all-cash deal which is projected to be done by early to mid-January. All of this cash should mean more liquidity come that time, but for the next ten days, liquidity is still on the bearish side, as 21 IPOs is scheduled to be done this week - representing the busiest week in IPOs since September 2000 (remember that month?). All these supply in shares should have a bearish effect on the stock market - again, at least for the next ten days anyway, as the IPO and secondary offerings calendar should effectively shut down by next Wednesday or Thursday.
All this being said, I am still longer-term bullish on the stock market. If we are to have a correction, then this week will be a "perfect" week to have one. However, if the correction does not happen this week, then bears will have to be careful here - as the IPO and the secondary offerings calendar will effectively shut down by next Wednesday, along with the fact that insider selling will be restricted ahead of earnings and as year-end bonuses start to roll in - all providing ample liquidity to the stock market. The optimal scenario would be for a quick correction this week followed by another bullish swing starting Tuesday or Wednesday of next week and ending in early to mid January. But of course, I am not expecting this to happen since I never get what I wish - at least in the stock market anyway.
Henry K. To, CFA