What to do About the Housing Bubble?

By: Henry To | Tue, Jul 19, 2005
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Dear Subscribers and Readers,

We switched from a neutral position to a 25% short position in our DJIA Timing System on the morning of July 14th at DJIA 10,616. Most of the technical indicators that I keep track of are now severely overbought - and coupled with the continued global economic slowdown and the hawkishness of the Federal Reserve, I believe the U.S. equity markets are definitely priced for perfection here. As I have said over the last couple of months, I am still looking for a "blow off" rally to occur later this year, but this can only occur after the market has experienced a significant correction. For now, nimble (retail) traders should stay in cash and use this "down time" to research potential long ideas instead of trying to outwit the very short-term movements of the stock market. Remember: Over the long-run and for the majority of investors, the big money is usually made on the long side.

An update on our latest market poll regarding crude oil: This poll had the biggest turnout so far - nearly 400 of our readers voted, with a plurality (nearly 50% actually) contending that oil prices of over $70 a barrel will be seen in the next 12 to 18 months. As my subscribers should know, I am actually calling for lower to flat oil prices within that timeframe (with much higher prices in three to five years, however), as the global economic slowdown scenario comes into play. For now, we will just wait and see, although as you will find later in this commentary - I am going to revise our ST maximum price for oil from a band of $60.00 to $62.50 a barrel to a wider band of $60.00 to $65.00 a barrel (barring an unforeseen supply disruption).

Two more things and we will get on with our commentary: Don't forget that we will be transitioning to a subscription model later this year - a development that we have previously communicated to our subscribers over the last four to five months. Please give us any final feedback before we articulate our plans for you - most probably in next weekend's commentary. Over the next few weeks, you will be able to see various improvements made to our site - including an expansion of our education section along with an improvement in the organizational of our archives.

Mr. Peter Richardson will be writing a guest commentary for our website in our upcoming Thursday morning's commentary. Peter has been a regular contributor to our discussion forum and I value both his insights and experience in the industry. Peter is currently "semi-retired" but has previously worked in the investment industry for nearly 40 years. You can read more about Peter at his investment blog - appropriately titled "Capital Markets & Economic Analysis."

I want to begin our commentary with a discussion of modern civilization - especially as it pertains to nationalism and war. I am currently going through the first volume of (Sir) Winston Churchill's "World War II" - my knowledge of political science is relatively limited compared to my knowledge of the financial markets but I would like to quote the following passage from this first volume:

It was not until the dawn of the twentieth century of the Christian Era that war began to enter into its kingdom as the potential destroyer of the human race. The organization of mankind into great states and empires, and the rise of nations to full collective consciousness, enabled enterprises of slaughter to be planned and executed upon a scale and with a perseverance never before imagined. All the noblest virtues of individuals were gathered together to strengthen the destructive capacity of the mass. Good finances, the resources of world-wide credit and trade, the accumulation of large capital reserves, made it possible to divert for considerable periods the energies of whole peoples to the task of devastation. Democratic institutions gave expression to the will-power of millions. Education not only brought the course of the conflict within the comprehension of everyone, but rendered each person serviceable in a high degree for the purpose in hand. The press afforded a means of unification and of mutual stimulation. Religion, having discreetly avoided conflict on the fundamental issues, offered its encouragements and consolations, through all its forms, impartially to all the combatants. Lastly, Science unfolded her treasures and her secrets to the desperate demands of men, and placed in their hand agencies and apparatus almost decisive in their character.

Churchill wrote the above passage in the wake of the Great War, or as we call it today, World War I. Throughout the centuries, war usually had been relatively small affairs, but the arousing of the national conscience (proliferated by the mass media and the education of the masses), the availability of "worldwide credit" and finally, the harnessing of science by the military - had completely changed the playing field.

What does this passage have to do with the markets, you ask? Please keep in mind I am not trying to be "chicken little" here - I am actually trying to illustrate a growing trend among Americans that are profoundly worrying. Nationalism is a curious thing. Some will interpret nationalism as patriotism - but in this globalized world, one can also argue otherwise. Witness the recent economic "skirmishes" between China and Japan over the issues that were close to the hearts of Chinese Nationals - even though each is a major trading partner of the other. As for America, protectionism is now spreading throughout the country like a virus - and politicians are taking advantage of this national conscience to advance their own agendas and careers. America has always stood for free trade and the idea of a level playing field. We can complain about the pegged Chinese Renminbi all we want - but at the end of the day, nothing can help the typical steel or textile worker because our wages for those industries are more than 20 times the wages of those workers in China. At that point, a 10% or 20% revaluation of the currency becomes muted. Moreover, both the financial and legal infrastructure of China is not mature enough to handle a floating currency - and doing so right now may ultimately bring on a financial crisis that will dwarf the 1997 Asian Crisis - a crisis that can easily be avoided.

I am worried because the United States is the most powerful and influential country the world has ever seen - and like it or not, most countries in the world still regard the United States as role models. If we engage our trading partners with protectionism, then everything else is "open season." That is, if we adopt protectionism as a policy, then it is almost a guarantee that other countries will respond in kind. Hopefully, the lessons of the 1930s are still entrenched in the minds of the saner politicians. Being the most powerful country in the world has both its upside and drawbacks - and one of the latter (depending on how one view things) is that the U.S. will need to be a responsible global citizen (responsible than most other countries) - whether we as individuals like it or not.

Okay, so much for my worries about protectionism - but it is an important topic that should be on our minds as investors as we try to navigate the rough waters ahead. This could very well be one of the most profound influences in the beginning decade of the 21st century - if we don't play our cards right. Now, let's get on with our commentary...

Readers may be getting tired of our recent talk regarding the "housing bubble" - but I believe what we are about to discuss may be of some interest - especially if one is trying to devise a strategy on how to "play" the homebuilding stocks going forward. For now, most hedge funds and financial advisors are still bullish on homebuilding stocks, but as we have mentioned before, the endgame may be quickly approaching. That being said, it is just - by definition - very difficult to call a top in the stock market. And it is even more difficult to try to make money by doing so. Let's discuss a few examples:

  1. The 1970s gold bull market finally topped out at a closing high of $850 an ounce on January 21, 1980. Let's assume that you know at the end of December 1979 that the great bull market in gold is in the midst of topping - give or take three weeks. You then decide to go short on December 31, 1979. The closing price on that day? $512 an ounce. Obviously, one would have gotten killed when gold further exploded by 66% in three weeks before finally topping.

  2. Let's fast forward nearly ten years and assume you were an investor in Japanese stocks - and specifically, the blue chips in the Nikkei 225. On the first trading day of 1989, you somehow "figured out" that the Nikkei will top out sometime that year, but that you really have no time to watch the markets as you're not a full-time investors/speculator. You decide to go short on that first trading day. The Nikkei closed at 30,244 that day. By the end of the year, the Nikkei would stand at 38,916 - a rise of over 28% in a mere 12 months. Again, going short in a bubble market is usually a thankless task - unless one is able to call the precise top of the bubble - give or take a week.

  3. The rise in the NASDAQ in the late 1990s through to the spring of 2000 should be familiar enough for our readers. This author actually sold all his technology holdings in late January of 2000, and in the space of the next two months, accumulated a very heavy position in long-term put options in the public's favorite stocks, including CSCO, INTC, and ORCL. I somehow got lucky and sold all my put positions on April 14th and April 17th, right at the bottom of that severe late March to mid April 2000 correction in the NASDAQ. I eventually made 150% in a span of six weeks, but not before losing over 25% of my portfolio from late January to mid-March 2000. That period was one of the most gut-wrenching trading periods of my life, even though I "called" the top in the NASDAQ within a timeframe of approximately six weeks. Incidentally, anyone who went short technology stocks in October 1999 most probably got killed, as the NASDAQ Composite rose by more than 80% from the bottom in October 1999 to the top on March 10, 2000 - a mere five months later.

Given the price action of market bubbles - especially in their waning months, how likely can, say, individual investors make money by shorting homebuilding stocks? Quick answer: Not very likely. Remember, the number one rule in investing is to not lose money. Capital preservation is the game.

However, let's play devil's advocate and imagine you are George Soros or Jesse Livermore - just for a quick minute. All you are interested in is to look for a top in the U.S. housing bubble and potentially short the most popular homebuilding stocks. You want to ask the question: "How does the current housing bubble (as exemplified by the most popular homebuilding stocks) compare with the three market bubbles in the most recent past - said bubbles being in gold, the Japanese Nikkei, and the NASDAQ Composite? As shown in the chart below, the appreciation in the stock prices of homebuilders may still not be over yet - as both the length (in terms of time passed) and the price appreciation of homebuilding stocks are still sub-par relative to the three market bubbles in the most recent past:

How Does the Current Housing Bubble Compare with Bubbles of the Past? -  While we definitely have a bubble in housing, history suggests that it can go much further than anyone else thinks.

As an aside, the MarketThoughts HomeBuilders' Index is constructed using an equal weighting of the five biggest homebuilding stocks (by market capitalization) in the United States. We prefer constructing our own homebuilding index given that the S&P 500 Homebuilding Index only consists of three stocks - that being Centex, KB Homes, and Pulte Homes. Given the above chart, would one want to short homebuilding stocks right now? As I have previously argued, however, housing prices are definitely due for a breather here, but who's to say we can't just have a severe and temporary correction here - similar to the severe decline of gold prices from December 1975 to September 1976? Given my global economic slowdown scenario (but not an outright recession), we could very well see a slowdown in homebuilding in the next 12 to 18 months- but a resumption of the uptrend thereafter. This is very much in the cards - as long as the yield of the long bond remains stable at current levels.

I now want to add something to our discussion of crude oil prices in last week's commentary. Again, I would like all our subscribers to at least take a look at Mr. Matt Simmons' new book, entitled "Twilight in the Desert: The Coming Saudi Oil Shock and the World Economy." Disclaimer: we do not know Mr. Simmons nor do we do any business with his company.

In last week's commentary, I discuss the fact that, among other things, the global economy was slowing down and that oil prices have most probably topped at the $60.00 to $62.50 band and should be in a bearish downtrend for the next 12 to 18 months - with a possible bottom at close to $40 a barrel - before a bullish trend will take hold again (which will finally see oil prices in the $80 to $100 a barrel range in the next four to seven years). This is more or less still my current view, although I am now revising the $60.00 to $62.50 "topping out" band slightly - to $60.00 to $65.00 a barrel, given the fact (which was pointed out to me) that the bullish sentiment of crude oil prices is not as high as we thought it was (although our market poll in our discussion forum shows otherwise):

WTI Crude Oil Spot Prices vs. Bullish Sentiment (January 2003 to Present) - 1) The three most recent spikes of oil prices in 2004 were accompanied by bullish sentiment that were even more bullish than the current sentiment - despite current oil prices in the 60s. 2)  Interestingly, the most recent peak of oil prices (at over $61 a barrel), was not accompanied by a higher high in bullish sentiment - suggesting that there is still upside potential for oil prices...

As we outlined in the above chart, the current bullish sentiment in crude oil is still not as extreme as the bullish sentiment during the three most recent peaks from May to October 2004 - suggesting that in the short-run, crude oil prices can still rise further. Moreover, I distinctly remember the mood when crude oil prices touched $55 a barrel in the wake of the Presidential election last year - trust me, everyone was fixated on the oil price at that time. Currently, we are still not seeing such a mood among the citizens of the U.S. - suggesting that there is some likelihood that oil prices may not have topped out in the short-run. Remember, in the short-run, the market can and will do anything to surprise the heck out of everyone. Finally, a further short-term rise in crude oil or energy prices fits in well with my "short-term market top" scenario - as higher oil prices combined with disappointing earnings guidance - could very well be the trigger for lower stock prices ahead.

Note: I am finishing this commentary as of Monday morning and I just have been notified that Citigroup has failed to meet its earnings estimates. Readers shouldn't be surprised - as our relative strength indicator of the Philadelphia Bank Index has precisely been foretelling of such an earnings surprise. As I have outlined many times before in our commentary, the financial sector has been one of the backbones of the post-tech bubble economy (as well as a very reliable historical leading indicator of the stock market) - and any breakdown of the financial indices should be taken very seriously. It will be interesting to see how the markets respond to the Citigroup earnings miss later today.

Let's now get on with our usual discussion of the - starting off with our usual daily chart of the Dow Industrials vs. the Dow Transports:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (July 1, 2003 to July 15, 2005) - 1) The Dow Transports failed to confirm on the downside - which ultimately carried bullish implications for the Dow Industrials! 2) For the week, the Dow Industrials gained 191 points while the Dow Transports gained 56 points.  The huge rally of both the Dow Industrials and the Dow Transports over the few weeks has certainly been very impressive - with the Dow Transports actually surpassing the June 2nd high of 3,649.96 at the close on Thursday.  However, the Transports quickly faded on Friday - declining 15.87 to close at 3,646.03 on Friday.  IMHO, the most recent breakout is just a headfake - and nothing more.  Finally, please note that we switched from a neutral to a 25% short position in our DJIA Timing System last Thursday morning at DJIA 10,616.

As we mentioned in the above chart, the rally in both the Dow Industrials and the Dow Transports were pretty impressive - but as I also outlined in our Thursday morning's commentary, there were many negative divergences along the way - including the lower lows in the McClellan Oscillator (which continues to be the case) and the fact that both the Dow Industrials and the Dow Transports have not been confirming the recent rallies in both the NASDAQ Composite and the S&P 500. For now, the level to watch for the Dow Transports is Thursday's closing high at 3,661.90 - as any continuation of the rally here should depend on whether the Dow Transports can cross and stay above that level. Since we are now 25% short in our DJIA Timing System, I am betting that this is not going to happen.

Let's now turn to our weekly sentiment indicators - starting off with the Bulls-Bears% differential readings in the American Association of Individual Investors (AAII) Survey:

DJIA vs. Bulls-Bears% Differential in the AAII Survey (January 2003 to Present) - The Bulls-Bears% Differential in the AAII survey skyrocketed from 23% to 44% in the latest week - the highest one-week reading since mid-April 2004.  The four-week moving average of this indicator is now at 28% - the most overbought since the first week of January 2005.  The AAII Survey is definitely getting overbought in a realy hurry - and again, probability suggests that we should wait for an oversold situation before actually initiating any positions on the long side.

The Bulls-Bears% Differential in the AAII Survey skyrocketed from 23% to 44% in the latest week - one of the most violent upside moves that we have seen in awhile. The one-week reading of this survey is now at the most overbought since mid-April 2004, with the four-week moving average the most overbought since the first week of January 2005. The fact that this sentiment indicator is at severely overbought levels - combined with the negative divergences I have previously mentioned - suggests that the market is very vulnerable to a significant decline in the coming weeks.

The Bulls-Bears% Differential in the Investors Intelligence Survey is also confirming the severely overbought readings in the AAII Survey:

DJIA vs. Bulls-Bears% Differential in the AAII Survey (January 2003 to Present) - The Bulls-Bears% Differential in the AAII survey skyrocketed from 23% to 44% in the latest week - the highest one-week reading since mid-April 2004.  The four-week moving average of this indicator is now at 28% - the most overbought since the first week of January 2005.  The AAII Survey is definitely getting overbought in a realy hurry - and again, probability suggests that we should wait for an oversold situation before actually initiating any positions on the long side.

Again, the readings coming out of the Investors Intelligence Survey is now very overbought - although not as overbought as they were back in December 2004. That being said, probability does not favor the long side over the next several months. Let's now turn to the "most correct" indicator of all - that of the Market Vane's Bullish Consensus (at least over the last 18 months anyway):

DJIA vs. Bulls-Bears% Differential in the AAII Survey (January 2003 to Present) - The Bulls-Bears% Differential in the AAII survey skyrocketed from 23% to 44% in the latest week - the highest one-week reading since mid-April 2004.  The four-week moving average of this indicator is now at 28% - the most overbought since the first week of January 2005.  The AAII Survey is definitely getting overbought in a realy hurry - and again, probability suggests that we should wait for an oversold situation before actually initiating any positions on the long side.

As I have been saying in our last commentary and over the last several months, the Market Vane's Bullish Consensus is the one sentiment indicator that has been bothering me - in that it never really got that oversold during the various corrections over the last 18 months. In retrospect, this indicator was telling us that the ensuing rallies would be relatively dismal - and it was correct. For the foreseeable future, I believe both our subscribers and us should continue to heed the readings of this indicator. The message remains the same as last week: The Market Vane's Bullish Consensus is telling us to be careful, as the one-week reading rose slightly from 67% to 69% in the latest week - very overbought no matter how you look at it. The ten-week moving average increased yet further from 65.9% to 66.7% - the most overbought since mid-April 2004. Please also note that the Market Vane's Bullish Consensus readings were also high during the Madrid bombings of March 2004 (as a side note, the stock market quickly recovered after the Madrid bombings, but declined quickly afterwards).

Conclusion: It is always difficult to call the top of a market bubble, and the current housing bubble is no exception. As our discussion of the bubble in housing and homebuilding stocks indicates, the housing bubble can go much further than anyone else thinks - although it is definitely due for a breather here. This will also fit in well with our economic slowdown (but not recessionary) scenario. Moreover, trying to make money by shorting the top of a bubble is also pretty much a futile job - one that will arise no sympathy from fellow investors if you fail.

We continue to be ST (next 12 to 18 months) bearish on crude oil prices, although we now believe there is a chance that oil prices may not have topped out yet. Therefore, we have revised our "topping out band" to $60 to $65 a barrel. Going forward, we are still structurally bullish - with a price target of $80 to $100 barrel within the next four to seven years - barring no major supply disruptions within that time frame. In a major supply disruption scenario, this author would not be surprised if we see a WTI oil price close to $200 a barrel.

Finally - the message for the equity markets remains the same from last week: The Summer/Fall correction that I have been looking for is still in play. That is why we are currently 25% short in our DJIA Timing System, although we currently don't have any plans to switch to a 50% short position just yet. My sense is still that the upcoming earnings reports could be the trigger for a more significant correction, but we will see. As for our readers (who are mostly individual investors), I still suggest that the best course of action is to remain neutral - in cash, and wait for a more oversold condition (which may come in a few weeks or a few months) before initiating long positions.

Signing off,


Henry To

Author: Henry To

Henry K. To, CFA

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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