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April 05, 2007

Housing Market Decline Not Over Yet
by Henry To

Dear Subscribers,

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:

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:

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.

More follows for subscribers...

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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