The Risk of ARMs
Economic data released over the past week showed that the economy has continued to expand. The non-manufacturing ISM survey reached a record high in March rising five points to 65.8. Most of the strength came in increases in new orders and prices. New orders increased 2.5 to 65.8, within three points of the high reached in August 2003, and prices shot up 8.4 to 65.7. Prices paid reached the highest level since the record set in March 2000. The list of commodities reported by purchasing managers that experienced price increases continues to grow. The following paragraph is an excerpt from the ISM Non-Manufacturing report:
Significant reports of commodities in short supply or up or down in price in March indicate that steel, steel items, steel pipe, and steel products are in short supply. Price increases are reported for aluminum and aluminum products; asphalt; carbon steel products; chemical products; chemicals; chicken; coffee; computers and peripherals; conduit and fittings; copper; copper products including pipe, cable, tubing and wire; #2 diesel fuel; electronic components and relays; fasteners; food; freight charges; fuel; fuel oil; gasoline; glass tubing and glassware; #2 heating oil; lumber and lumber products; natural gas; nickel alloys; oilfield equipment; paper; paper products; plastic; plastic bags; plywood; polypropylene and polypropylene film; printed materials; PVC; PVC pipe and fittings; roof felt safety equipment; software maintenance and support; stainless steel tube; stainless steel products; steel; steel tube; steel electrical boxes and fittings; steel pipe; steel products; steel scrap; steel surcharges; unleaded gasoline; valves; and waste disposal/removal. Cellular equipment; cellular phone service; and janitorial services are reported down in price.
The manufacturing survey, which was released last week also showed an up tick in the pace of expansion. The March survey increased 1.1 points to 62.5. As has been the case for several months, almost all the sub-indexes showed strong expansion with six out of ten above 60. Prices paid jumped 4.5 points to 86, which was the highest since January 1995 and only 1.1 points away from the highest level reached since the runaway inflationary era of the 1970s. The manufacturing survey also included a list of commodities that were up in price that was similar to the service survey, but I'll save you from reading two lists. Plus I don't need that much filler this week.
Of course the big news last week was the 308,000 jobs added in March. We have felt for a while that the economy has been expanding and it was only a matter of time until jobs were created. The stronger labor market was further confirmed by the Challenger, Gray & Christmas job cuts report. The placement firm reported that announced job cuts dropped by over 9,000 jobs in March to 68,034. This was the lowest level since June 2003 and the second lowest since November 2000. We doubt this expansion is sustainable or healthy since it was created simply by extremely "accommodative" monetary policy combined with a spendthrift government sector.
The surprise increase in payrolls caused bonds to post the worse sell-off since July last year. Additionally, the short end of the curve also jumped. While the yield on the 10-year Treasury increased by 27 basis points to yield 4.15%, the 5-year jumped 30 basis points (yielding 3.14%), the 2-year increased 22 basis points (yielding 1.85%) and even the 1-year yield increased by 12 basis points (yielding 1.32%). The market is clearly anticipating the Federal Reserve to increase interest rates much sooner than just the day prior to the labor report. In fact, fed fund futures are pricing in an 85% chance of an increase at the August 10 FOMC meeting. Looking longer term, economists are forecasting that there will be a 50 basis point increase by the end of the year and an increase to 2.25% by the end of June 2005.
The bond sell off gave investors in homebuilders a reality check as the S&P 500 Homebuilder index lost 6% in the two days that bonds traded down. Perhaps, more important was the increase in short-term rates. More and more homebuyers have gravitated toward adjustable rate mortgages even as rates have held steady. We think this is one indication that homebuyers are overleveraging themselves. According to the Mortgage Bankers Association, more than 20% of mortgage applications have been for ARMs in each of the past 36 weeks. This is the longest stretch since 1999 when the Fed increased rates from 4.75% to 6.5% over a one-year period. With the percent of ARM applications near highs, it will be interesting to see if a larger percent of homebuyers are willing to accept the interest rate risk. Most ARMs have a fixed term of either five or seven year and are being marketed to those that do not expect to live in their house that long. Thus the homebuyer does not perceive that they are incurring any interest rate risk. The situation could develop if interest rates to rise, the pool of potential buyers could be diminished because with higher interest rates, their monthly payments would be significantly higher without accounting for any increase in value of the house. This smaller pool of buyers obviously means less demand which could cause prices to fall. So even if homebuyers anticipate moving within five years, they are shouldering much more risk then they perceive. The labor report gave further evidence that the Fed might be behind the curve. If that is the case, the most recent example to draw from started in 1994 when the Fed increased its target rate from 3% to 6% from February 1994 to February 1995. I have a feeling not many ARM buyers are prepared to have their rates adjust upwards by a few hundred basis points.
In the meantime, the homebuilders continued to rack up record business during the first quarter. M.D.C. Holdings announced that first quarter orders increased 32% year-over-year to a new record. Closings and backlog also reached record levels, up 39% and 34% respectively. Orders were driven by a 20% increase in traffic combined with a 10% increase in the number of subdivisions the builder is active in. The company also experienced a drop in cancellations from 22% to 19% over the past year. M.D.C. also reported that sales in Colorado advanced 25% from a year ago. Colorado had been one the weakest markets for quite a while.
The market will now focus on corporate earnings for the next several weeks. Analysts continued to ratchet up their forecast for first quarter. During March, analysts have increased growth expectations for the S&P 500 from 14.7% to 16.9%. Additionally, estimates increased for the each of the other three quarters this year by 0.7% to 0.9% each. The full year growth estimate has increased to 13.9% from 13.0% over the past month. The sectors that are expected to post the largest earnings growth for the first quarter are technology, materials, and transports. Earnings in these three sectors are expected to increase by 54%, 77%, and 44% respectively. While these would be impressive results, investors have already priced in these earnings and any shortcomings will have adverse affects on stock prices. This week, Alcoa announced earnings increased by over 70% from last year, but failed to meet analysts' estimates causing the stock to sell off about 5%. Additionally, the technology sector received a couple blows from Nokia announcing that handset sales were below forecasts and from Seagate Technology announcing that its earnings will miss guidance due to fewer than anticipated notebook sales.
Retailers will report March sales on Thursday. By most accounts results will be strong due to several reasons. Not only are the comparisons from a year ago rather easy, but consumers have experienced the highest personal income growth in almost three years and have the highest net worth ever recorded, which homeowners continue to monetize at a rapid rate. Consumers are also enjoying an 11% increase in federal tax refunds. The rest of the year will likely pose more challenging for retails as these tailwinds subside. Merrill Lynch agrees with this general idea. Last week, the brokerage firm downgrades several retailers citing five factors. These factors were:
1) Rising interest rates.
2) Removal of apparel quotas.
3) Tough comparisons with strong Christmas season last year.
4) Decelerating corporate profits - retail stocks generally do well as profits rise.
5) Seasonality - retailers generally under perform the second half of the year.
Right now the economy and stock market are at critical junctures. By almost every indication the economy is much stronger than 1% fed fund dictate. The stock market has fully priced in dramatic earnings growth that is on the verge of decelerating. Maybe the Fed knows that the economic growth is solely a function of the amount of stimulus being pumped into the economy and knows it will likely come to a screeching halt once the stimulus fizzle out. The only problem maintaining the current status quo is the housing bubble will inevitable escalate and cause much more economic damage once it pops than the telecom/technology bubble it.