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Housing Market Decline Not Over Yet

(April 1, 2007)

Dear Subscribers and Readers,

I hope everyone has had a great weekend, not to mention a great April Fool's Day.  On a day like April Fool's, it is important to remember the number one goal of the stock market: That is, to fool the greatest number of investors as possible and to separate as much savings as possible from these investors.  The best thing one can do to avoid being fooled is to adopt a long-term view and to be able think and act independently.  If you must trade, then only do it on a probabilistic basis.  Try to pick good entry points and sell or cut your losses once you do not agree with your original thesis of why you made those trades in the first place.

Before we begin our commentary, let us do an update on the two most recent signals in our DJIA Timing System:

1st signal entered: 50% long position on September 7th at 11,385, giving us a gain of 969.35 points

2nd signal entered: Additional 50% long position on September 25th at 11,505 giving us a gain of 849.35 points

In last weekend's commentary, I stated “... I am still bullish on the U.S. stock market in the longer-term, and after a brief consolidation phase (and hopefully more pessimistic sentiment readings and some kind of washout in margin debt levels), I expect the U.S. stock market to be higher three to six months from now.”  As of Sunday night, April 1st, I still stand by this view – although, obviously, much of what will unfold over the next 3 to 6 months will depend on how the stock market does over the next few weeks.  As I have mentioned before, I am still worried by the surge in margin debt over the last six months.  If there is no significant washout in margin debt during March (we will find out the March statistic in mid April) – and should the market rally over the next several weeks without any further consolidation or correction, then we may be forced to adopt a more bearish view.  For now, however, most of my market breadth (with the exception of the NYSE and NASDAQ McClellan Summation Indexes), volume, sentiment, liquidity, and valuation indicators suggest that the intermediate trend of the stock market remains up.

After our last weekend's commentary was published, one of our longer-term readers kindly pointed out that while looking at the increase of margin debt may be important, it is also good to put the current levels of margin debt into context from a historical standpoint.  More specifically, this reader mentioned to us that it may be more instructive (when gauging just how vulnerable the stock market is to a substantial decline) to instead look at the size of the cash levels in both cash and margin accounts (as tabulated by the NYSE) in relation to the levels of total margin debt outstanding.  I agree – and following is a monthly chart showing the Wilshire 5000 vs. cash levels vs. margin debt from January 1997 to February 2006:

Wilshire 5000 vs. Cash and Margin Debt Ratios (January 1997 to February 2006) - NYSE margin debt outstanding increased over $10 billion in February, and more than $72 billion over the last six months - reflecting the largest six-month increase in margin debt since the month ending April 2000. More importantly, cash levels as a ratio of margin debt is now at a low not seen since April 2006 - although it is definitely encouraging that cash levels as a ratio of the Wilshire 5000 still remains high.

One significant take-away from the above chart is that while the levels of cash in all accounts in relation to outstanding margin debt are still relatively high from a historical standpoint (taking into account the bull market in the late 1990s), it is by no means high when compared to the period since this cyclical bull market began in October 2002.  In fact, the current ratio is now at a level not seen since April 2006 – just 10 days before the start of a brutal six-week correction in both the U.S. stock market and the major international market indices.  However, it is encouraging that cash levels as a ratio of the Wilshire 5000 still remains high, suggesting that much of the speculation continues to be focused on the international and emerging markets.  Again, I will not be totally comfortable with the long side until we see more of a washout in margin debt – but for now, the intermediate trend remains up.

For readers who have not done so, I highly suggest reading the March 12, 2007 Credit Suisse report on mortgage liquidity on Bill Cara's website.  I realize that this link was first posted by John Mauldin a couple of weeks ago, but I would be surprised that much of his readers actually read the report in full (this author did not finish the report until today – talk about being behind the curve!).  I know many of you have busy schedules, but I would definitely suggest taking a couple of hours over the upcoming week to go through this report – perhaps while you are on a plane or on an extended lunch hour.  Trust me, this will not be a waste of your time.

For those that truly do not have the time to go through the report, however, following is a few take-aways straight from the Credit Suisse report.  For the purpose of our readers, I have only summarized those that I believe will have an impact on stock or bond market prices.  That is, I have only summarized those which I believe have not been discounted by the market – whether it is because they are not reflected in any official data (such as anecdotal information) or because much of the situation is still currently in flux (such as the threat of more stringent regulation in the mortgage industry).  Without further ado:

  • The next “shoe to drop” in the mortgage industry will be the “Alt-A” sector.  As the CS report mentioned, while the average credit profit of Alt-A borrowers are higher than those of subprime borrowers (717 average FICO score vs. 646), there is still considerable risk given the “lax underwriting exotic mortgage products utilized in this segment of the market in recent years, both in the form of continued credit deterioration and reduced incremental demand resulting from tightening lending standards.”  For example, the combined loan-to-value ratio was 88% in 2006, with 55% of borrowers taking out simultaneous second mortgages.  The consensus believes that not many Alt-A borrowers take out second mortgages (or what is termed “piggybacks”).  That is simply false.  Moreover, interest-only and option ARM loans made up 62% of all Alt-A originations in 2006.  Given that the biggest Alt-A lenders are IndyMac and Countrywide Financial (with a combined origination volume of nearly 33% of the entire Alt-A market), my guess is that we will see lower lows in the stock prices of these two companies over the next several months.

  • Rising foreclosures as a result of lower liquidity and lower home prices will have a profound effect on “pent-up supply” in the housing market over the next 6 to 12 months – putting additional pressure on home prices, resulting in a “vicious cycle”, if you will.  According to Credit Suisse, rising foreclosures may increase the official inventory numbers (at 3.55 million units) from the NAHB by approximately 20%.  This is not an insignificant number.  Moreover, homebuilders “may also be on the hook for defaults due to early payment default provisions. An early payment default (EPD) for a homebuilder occurs when a loan originated by the builder's mortgage subsidiary defaults within a pre-determined timeframe, and the builder is forced to repurchase the loan from the secondary market investor that it originally sold it to. Based on our survey of private builders, 43% of builders responded that they have EPD provisions attached to their mortgages, with the timeframe that they would be forced to repurchase a defaulted loan ranging anywhere from one month to more than six months. Only 19% of respondents have had to repurchase any loans thus far, although we believe this could become a larger issue if credit conditions continue to deteriorate and builders are forced to take REOs on to the balance sheet.

  • As a response to the rising foreclosures caused by lax underwriting standards during the last few years, it comes as no surprise that many legislators (both at the Federal and the State level) are now calling for tighter lending standards and regulations in the mortgage industry.  What is probably not discounted, however, is the potential for over-regulation – which is usually what happens once the aftermath of a bubble (in this case, the housing bubble) is felt.  This view is also being echoed by a UCLA Anderson forecast that is being published tomorrow – as the report asserts that the subprime market is – for all practical purposes – in the process of shutting down.  In other words, liquidity in the mortgage market is now declining at a rapid pace – and further regulation and legislation will add more fuel to the fire.

  • As for homebuilders' exposure, the Credit Suisse report drew up a very nice table outlining the following risk exposure of each builder: sector, geographic, and price-point risks.  The following table is courtesy of Credit Suisse and was taken from page 58 of their report.  The builders were ranked in order from the highest risk to the lowest risk:

Risk Summary by Builder

Unfortunately, Credit Suisse did not attempt to further quantify the impact of a further deterioration of either the mortgage or the housing market (or both).  The Credit Suisse report did briefly mention potential lower consumer spending in light of a reset in mortgage payments in 2007 – but my guess is that the bulk of the impact will come from the negative wealth effects of rising foreclosures and lower home prices themselves, as opposed to higher interest payments on a mere $500 billion of mortgages (to put this in perspective, a 2% rise in interest rates would translate to a mere $10 billion in interest payments on an annual basis, or the equivalent of a $1.50 rise in crude oil prices).  In the UCLA Anderson forecast, the authors conjectured that they continue to foresee a softening of the economy later this year (1.7% to 2.5% annualized growth in the first nine months of this year and rising back to 3.25% in 2008), as opposed to an outright recession.  The “no recession” view in 2007 is also being echoed by the ECRI Weekly Leading Indicators and the Intrade.com recession futures, for now.

Of course, things can always get worse – and we will continue to update our readers as new information continues to roll in.  For now, we can easily say that the deterioration in the mortgage industry, the homebuilding industry, and housing prices are still not over yet, especially in light of the following chart:

Real Estate held by Households and Nonprofits as a Percentage of Total Assets vs. the Quarter-to-Quarter Change in the OFHEO House Price Index (2Q 1975 to 4Q 2006) - 1) The latest increase in housing prices (1.12%) per the OFHEO HPI - represents the third straight quarter of below average growth in U.S. housing prices. Despite these mediocre increases, however, real estate as a % of household assets is still near a record high at 29.92% - barely below the record high of 30.58% reached during the second quarter of 2006. 2) Previous record quarterly increase - which was surpassed by the increase during the third quarter of 2004!

The above chart is a chronicle of the amount of real estate held by U.S. households and non-profit organizations as a percentage of their total assets from the second quarter of 1975 to the fourth quarter of 2006.  As mentioned on the above chart – despite the mediocre appreciation in housing prices over the last three quarters (note that the OFHEO House Price Index has historically been a huge lagging indicator, however, but this is good enough for our analysis anyway) – real estate as a percentage of household assets is still near a record high at 29.92%, only barely below the record high of 30.58% reached during the second quarter of 2006.  For comparison purposes – ever since records have been kept (1Q 1952), the average for this ratio is 24.90%.  My guess is that this will take at least another couple of years to play out.

No doubt, the continuing deterioration in the mortgage industry, the homebuilding industry, and housing prices will also affect the stock market going forward – but given that our technical, sentiment, liquidity (for now), and valuation indicators are still flashing long-term buy signals, we will continue to remain 100% long in our DJIA Timing System.  That being said, this continuing deterioration is a huge red flag for general market liquidity and sentiment – and will probably eventually play a role in the next stock market correction.  Again, we will continue to keep watch.

Let us now discuss the most recent action in the U.S. stock market via the Dow Theory.  Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown by the following chart from October 1, 2003 to the present:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (October 1, 2003 to March 30, 2007) - Over the last week, both the Dow Industrials and the Dow Transports corrected a significant chunk of their rally in the week prior, with the former declining 126.66 points and the latter declining 162.57 points. For now, the two popular Dow indices still looks like they are stuck in a consolidation phase, but I expect them to start to rally again over the coming weeks. Moreover, the internals of the market and most of the world's stock markets continued to remain healthy. For now, probability suggests that the intermediate term trend remains up, but as always, we will continue to reevaluate our signals in the upcoming days. For now, we will remain 100% long in our DJIA Timing System as we currently believe the latest turbulence represented only a hiccup within the context of an ongoing cyclical bull market.

For the week ending March 30, 2007, the Dow Industrials declined 126.66 points while the Dow Transports declined 162.57 points, as the two popular Dow indices are still mired in a consolidation phase.  More importantly, however, the internals of the stock market remained strong  as the A/D lines of the NYSE Common Stocks only Index, the S&P 500, the S&P 400, and the S&P 600 all made all-time highs less than two weeks ago.  In addition, the Dow Jones Utility Average made a new all-time high last Thursday at the close.  Given that the stock market does not typically top out until four to six months after a peak in the NYSE A/D line (although there are exceptions, such as during June 1946 when the NYSE A/D line and the Dow Industrials topped out at the same time), and the Dow Utilities, we are definitely still not close to the end of this cyclical bull market, just yet. For now, we remain 100% long in our DJIA Timing System – and will continue to do so unless evidence suggests that we should trim down our position.

I will now continue our commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys.  The latest four-week moving average of these sentiment indicators increased from last week's 16.3% to 18.3% for the week ending March 30, 2007.  Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 1997 to the present week:

Average (Four-Week Smoothed) of Market Vane, AAII, and Investors Intelligence Bulls-Bears% Differentials (January 1997 to Present) - For the week ending March 30, 2007, the four-week MA of the combined Bulls-Bears% Differentials increased from 16.3% to 18.3%. While the latest bounce suggests that the trend of increasingly pessimistic readings may have reversed, the fact that this reading did not bounce from a more oversold level suggests that any upcoming rally probably won't be too spectacular. For now, the intermediate term trend remains up.

While the four-week MA of this indicator hit its most pessimistic reading since September 8th of last year on March 23rd, (and now looks to be rebounding), the fact that it isn't bouncing from a more oversold level suggests that any upcoming rally will probably not be too spectacular, although the chances of a new rally high in both the Dow Industrials and the S&P 500 are definitely pretty real.  Given that April tends to be a strong month for the stock market (especially since required quarterly contributions for calendar year-based DB pension plans are due April 15th), my guess is that April will be an up month for the stock market.  Should this rally be accompanied by a spike in readings in the Market Vane, the AAII, and the Investors Intelligence Surveys., however, this author will probably become more cautious and trim down our 100% long position in our DJIA Timing System.

I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index.  For newer subscribers, I want to again provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator going forward.  Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.

When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls.  As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms.  This makes the indicator a perfect contrarian indicator for the stock market, and it has had a great track record so far according to the following Wall Street Journal article.  Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from October 28, 2002 to the present:

ISE Sentiment vs. S&P 500 (October 28, 2002 to Present) - The 20 DMA of the ISE Sentiment bottomed at a reading of 98.5 during the Wednesday before last (representing the lowest reading since the 97.6 reading on October 30, 2002) and has since bounced back to a reading of 102.2 as of last Friday. Meanwhile, the 50 DMA is playing *catch-up* - declining from 118.2 to 115.7 during the latest week. The ISE Sentiment Index is now deeply oversold, and as a result, we should continue to see the stock market sustain its rally over the coming months - unless the ISE Sentiment manages to significantly spike higher over the coming weeks.

As one can see from the above chart, the 20-day moving average of the ISE Sentiment dropped to a reading of 98.5 during the Wednesday before last (representing the most oversold reading since a reading of 97.6 at the close on October 30, 2002) and has since bounced back to a reading of 102.2 last Friday.  In the meantime, the 50 DMA is playing “catch up”, declining from 118.2 to 115.7 – a low not seen since October 24, 2006.  The pessimistic readings coming out of the ISE Sentiment Index suggests pervasive pessimistic sentiment – signaling that the market is definitely a “buy” basis the Dow Industrials or the S&P 500.

Conclusion: While the amount of margin debt outstanding on both the NYSE and NASD still represents a “red flag,” this author believes that the stock market should continue to rise over the longer-term – although the continuing deterioration in the mortgage market, the homebuilding market, and housing prices is also now a red flag that should play a role in the next stock market correction.  Should lending standards become even tighter (which most probably will happen) and should any upcoming regulations of the mortgage industry become tighter than expected, there is a good chance that this “tighter liquidity” will also spill over into the U.S. and most probably the global financial markets as well.  We will continue to keep watch.

Probability also suggests that the intermediate term trend remains up, for now.  Should market internals or valuations deteriorate substantially over the next couple of weeks, we will definitely trim down on our 100% long position in our DJIA Timing System – but as of Sunday evening, we will remain 100% long.  We will continue to reevaluate our position in our DJIA Timing System, and will send out a real-time email alert to our subscribers should we decide to trim our long position in our DJIA Timing System in the upcoming weeks (this will depend on new information such as technicals, liquidity, mutual fund inflows/outflows, sentiment, and so forth).

Signing off,

Henry To, CFA

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