Housing Market Decline Not Over Yet

By: Henry To | Thu, Apr 5, 2007
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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:

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:

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.

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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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