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June 10, 2005

Critical Juncture in the Markets
by Henry To

Dear Subscribers and Readers,

Please note that we switched from a 100% position to a 50% long position in our DJIA Timing System on Tuesday morning at DJIA 10,555. The reason for this pre-emptive move has been partly explained in our commentary over the weekend along with what I wrote last night in our discussion forum. For now, we will continue to hold - but we are definitely getting more wary of the market here. The only reason why we are still holding onto our 50% position in our DJIA Timing System at this point is the fact that the DJIA has now most likely taken upside leadership away from the NASDAQ. Again, don't be surprised if we completely switch to a neutral position sometime in the next few trading days.

Note: We will be conducting another short survey in this weekend's commentary. Please help us out and participate!

Okay, I admit - I erred. I was going to provide an update on the Fed Flow of Funds data during this morning's commentary but then I realized that the latest quarterly data (for the first quarter of 2005) would not be released until later today. As a side note, one of the most significant problems when it comes to writing an economic commentary is the fact that timely data is very difficult to get your hands on - once you do get it, the information is already stale and you can't use it anymore. That being said, one can get a very insightful look at the U.S. economy by studying the Flow of Funds data - along with the fact that the data is good enough for long-term observations.

But I digress. Luckily for me, there is always something interesting going on in the stock market for me to comment on. The day before yesterday, it was rising oil prices, rising bond prices, rising stock prices and rising housing prices - all happening at the same time. Yesterday, it was exactly the reverse. This is another problem with writing a commentary on the stock market. Today you can be a hero and tomorrow the market can turn on you and you can be a "zero" in a matter of 24 hours. For example, as stated in one of my messages in our discussion forum, I shorted Google at a price of $294 and change on Tuesday morning. As I am writing this, I am sitting pretty - but likewise, this position can turn on me on a dime - and the next minute I would be regretting that I have ever posted that message up there for all to see.

We saw what is perhaps a significant reversal in the oil price yesterday - as the WTI crude shot up on a huge drawdown in inventories (as opposed to an increase) but then promptly reversed in price during the late morning and early afternoon - closing at the day's low of $52.54 a barrel despite the huge drawdown. As of yesterday evening, the WTI is down $2.49 for the week. Sure, the White House revised GDP growth lower for the rest of this year from 3.5% to 3.4%, but this wasn't totally unexpected. In fact, I am surprised it hasn't been revised much lower - as all the leading indicators around the world are pretty much heading down. We also saw the Dow Industrials taken upside leadership away from the NASDAQ - along with a severe weakening in the share prices of major internet issues such as Google, Yahoo!, and eBay, even though the NASDAQ was only basically flat in the last two days. The price of the long bond also experienced a classic one-day reversal on Friday in the midst of very bullish sentiment. Even though volume was not very high, I believe it was an authoritative-enough signal to be considered as a "sell signal" - as I discussed in last weekend's commentary.

Okay Henry, the decline of oil prices, stock prices, and bond prices were obvious, but what of housing prices? Aren't they still booming? Yes, they are. In fact, most of the homebuilding stocks that I keep track of are either at or near all-time highs, but as I discussed in our "Update on the Housing Bubble" commentary last Wednesday, I feel the time is now ripe for a top in various regions around the country. Of course, there is no "national housing bubble" just as there were no "stock market bubble" in early 2000 since many value stocks completely tanked during the latter part of 1998 to early 2000, but that is just playing around with words. In fact, as I said in our commentary, such a divergence in housing prices around the country is IN FACT evidence of the existence of a housing bubble. The timing is always difficult, but I am now going to stick my neck out and predict that within the next 9 to 12 months, we will see a general softening in single-family home prices in some of today's hottest states, such as (in order) Nevada (an annualized rise of 31.2% in single-family home prices in the first quarter per the OFHEO), California (25.4%), Hawaii (24.4%), Florida (21.4%), and Maryland (21.0%). Just in case any of our readers have further doubts about such an impending top, perhaps we should take a cue from one of the greatest contrarian indicators of them all:

Historically, the Times Magazine has been a great contrarian indicator. Of course, this is not the fault of the editors - it is just that the reporters of the Time Magazine have usually try to be as mainstream as possible when it comes to writing stories about the United States or the world. However, when an investment/speculation class such as real estate becomes mainstream, then one is definitely nearer the end of the trend rather than the beginning of it. Keep in mind, however, that I am not calling for a crash in the housing bubble. I am merely calling for a softening of prices - most likely in the states that have seen housing prices gone up the most in the last few years. I will come back to this later but let's go ahead and update one of the charts that we saw last week - now that the OFHEO has updated the most recent State House Price Index data up to the first quarter of 2005:

The great divergence among some of the hottest states continues. Please note that the recent rise in housing prices in the markets outlined above are at or above their historical peaks - even during the mid to late 1970s when inflation were running at 10% to 15% each year (notice that these are nominal, not real increases). How long can this go on? No one really knows, but at the risk of "beating a dead horse," I am going to present to you another chart that I constructed using the OFHEO data from all 50 States:

The above chart shows the average annualized appreciation of the top five hottest States (in each quarter) vs. the annualized appreciation of housing prices of the entire United States. The red line shows the difference (what I termed the "divergence"), while the blue line shows the annualized appreciation of housing prices in the United States. Please note that in all three instances (of the last 30 years) when both the divergence and the annualized appreciation of U.S. housing prices were this high, real estate prices in general have subsequently underperformed in the coming years. Again, as I discussed on the above chart, real estate prices will, in general, not crash - but I would not be surprised if some of the most speculative markets will. As an example, the cover story in the Time Magazine starts off with this paragraph:

John Williams, a disc jockey from Long Beach, California, is available for weddings and birthday parties. He also does real estate closings. Williams, 40, recently decided to hitch his fortunes to the Southern California home market, buying houses, fixing them up and - in the parlance of our times - flipping them for a quick profit. "I saw so many friends and colleagues getting rich," he says. "I wanted to get rich too." Williams has made some money - he flipped his first two properties for a combined gain of $27,000 - and quickly discovered he's not alone. "I went to look at some homes in Palmdale-Lancaster [an area of Los Angeles County]," he says, "and the woman showing me and a group of other investors around was a hairdresser who works for Century 21 on the side. We went into Taco Bell for lunch. The girl at the register heard us talking, and she told us she just got her mortgage broker's license."

A host of reasons have been given for the "this time is different" scenario, such as that today's workers are spending more time at home (telecommuting) or that today's kids are moving out and buying homes at a younger age. I do not dispute these reasons. Moreover, while the real median income of Americans have only be inching slightly higher over the last 30 years or so, the incomes of the top percentiles of the population have been rising much faster, and thus are more likely to overpay for high-end homes more than ever. The most recent decline in the yield of the long bond has also convinced many analysts (and many of these same analysts have been calling for higher rates over the last two to three years) that mortgage payments will continue to remain affordable enough to sustain the currently frothy market.

Like I said, I do not dispute these reasons, but do they currently hold water? In our last commentary on the U.S. Housing Bubble, I stated that the analysis of comparing U.S. median home prices with the S&P 500 (in order to show that the former is historically undervalued) is a flawed analysis. This week, I will argue that many of these reasons do not hold water. These arguments would only hold water if many of the recent buyers of homes have the intention to personally live in them. In that case, I don't care how much you pay for a home as long as you can afford the mortgage payments. However, as a recent Fortune article stated, a recent study released by the National Association of Realtors determined that investors now represent 23% of the home-buying public (this number also includes people who are in the market for second homes). The number of pure investors is currently estimated to be about 10% - twice the amount of the historical average in the United States. At the same time, interest-only mortgages only represented 1.6% of all new mortgages as recently as 2001. In 2002, this number jumped to 6%. By the end of 2004, it has jumped to 23%. Various numbers are now being thrown around but interest-only mortgages are now estimated to account for approximately 30% of all mortgages originated in the United States today. The following Bloomberg article (sent to me by a subscriber) is a must-read, IMHO. The percentage of interest-only mortgages has skyrocketed despite the continuing decline of mortgage rates. At the current rate, interest-only mortgages will account for nearly 40% of the entire market by the end of this year. Is this sustainable? Maybe - under an interest-only mortgage, you typically only pay interest for five years - and then the amortization of principal kicks in. In addition to having a higher monthly payment due to the fact you are paying down principal as well as interest, this higher monthly payment will be further exuberated due to a shorter amortization period, typically 25 years in a 30-year mortgage. The rise of interest-only mortgages is an issue of affordability as well as an issue of speculation, but increasingly, it looks like it is the latter. I believe we are now close to "exhaustion" - made the more authoritative given that my "global slowdown" scenario increasingly looks like it is going to come to fruition.

I also want to point out another interesting phenomenon that is happening in the commodity world and which partially relates to what I just discussed about housing prices in the above paragraphs. Following is a weekly chart of the prices of lumber from the end of 2003 to the present:

As discussed on the above chart, the recent lower highs in lumber prices have not been confirming the continuing appreciation in housing prices and new home sales. How much of this weakness is due to the current slowdown in China and how much of it due to the potential loss in momentum in the U.S. real estate market? We will most probably find out in the months ahead.

For now, I will urge all investors in single-family homes in the hottest areas of the United States take a step beck and reevaluate their financial situations. True, there should not be any major crashes, but when you are so leveraged... well, one gets the idea. As for me, please keep in mind that I am only expecting a major softening in demand in various parts of the Untied States - perhaps accompanied by slight declines in home prices over the coming years. This has historically been true and I expect it to be true, once again.

Now, let's move on to the stock market. I will make an exception this time and update the daily chart of the Dow Industrials vs. the Dow Transports for our readers in this mid-week update:

Normally, I don't want to show this chart during the middle of the week since I believe investors can get a clearer picture by focusing on weekly action instead of daily action. However, the huge 75-point decline in the Dow Transports yesterday definitely changed the equation. For the week so far, the Dow Transports is down 92 points. As I said on the above chart, please note that the Dow Transports has been leading the Dow Industrials ever since the last cyclical bottom in October 2002.

Conclusion: The stock, bond, commodity, and housing markets are now at a critical juncture. I do not believe all four markets will fall at once - but the recent weakness all across the board is starting to worry me. In the stock market, it is the recent weakness in Google, Yahoo, and eBay (readers may want to note my somewhat bearish note on both Yahoo and eBay in our discussion forum posted on Monday), along with the fact that the Dow Industrials has taken upside leadership away from both the NASDAQ and the Dow Transports (which has usually meant continuing general weakness in the stock market given the history since October 2002). For more risk-adverse investors, try to look for a good opportunity to trim down on your large cap growth/brand name positions that I have been asking our readers to hold since May 4th. Make no mistake - we are currently still 50% long in our DJIA Timing System solely because the Dow Industrials has been outperforming. If the stock market exhibits further weakness next week, then don't be surprised to see us switch to a totally neutral position in our DJIA Timing System. I will come up with a better conclusion on housing prices this week, including what any potential strategies in taking advantage of the coming weakness (notice I did not say "crash") in housing prices.

Signing off,

Henry K. To, CFA
MarketThoughts.com

Henry To, CFA, is co-founder and partner of the economic advisory firm, MarketThoughts LLC, an advisor to the hedge fund Independence Partners, LP. Marketthoughts.com is a service provided by MarkertThoughts LLC, and provides a twice-a-week commentary designed to educate subscribers about the stock market and the economy beyond the headlines. This commentary usually involves focusing on the fundamentals and technicals of the current stock market, but may also include individual sector and stock analyses - as well as more general investing topics such as the Dow Theory, investing psychology, and financial history.

In January 2000, Henry To, CFA of MarketThoughts LLC alerted his friends and associates about the huge risks created by the historic speculative environment in both the domestic and the international stock markets. Through a series of correspondence and e-mails during January to early April 2000, he discussed his reasons and the implications of this historic mania, and suggested that the best solution was to sell all the technology stocks in ones portfolio. He also alerted his friends and associates about the possible ending of the bear market in gold later in 2000, and suggested that it was the best time to accumulate gold mining stocks with both the Philadelphia Gold and Silver Mining Index and the American Exchange Gold Bugs Index at a value of 40 (today, the value of those indices are at approximately 110 and 240, respectively).Readers who are interested in a 30-day trial of our commentaries can find out more information from our MarketThoughts subscription page.

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