Oh, What a Tangled Web We Weave
By Frank Barbera CMT. February 13, 2007
Back on January 30th, only two weeks ago, we wrote at length with regard to the deteriorating circumstances at the Sub-Prime Mortgage lenders. As it turned out, events last week saw gasoline being poured on the already burning fire, with tremendous damage unfolding within the sector. How important might this be? The answer is very important; so critical, that it could be THE determining factor on where events go from here in all of the capital markets.
We point to the primacy of the housing market as there is a plethora of statistical evidence that suggests that the Housing Real Estate sector has been a major driver for the economy over the course of the most recent recovery cycle. Mind you, it cannot be lost from sight -- even for one moment -- that the current economic cycle has been, by far and away, the weakest recovery cycle seen in the Untied States since the Great Depression. Just look at the chart below which compares the recovery in U.S. employment in this cycle versus the average of recovery cycles from 1958 to 1982, and recovery cycles in the 1990s. This one has clearly lagged in every conceivable manner, creating fewer jobs over a longer period of time. Of course, we have “full employment” with the lagging unemployment rate holding near historical lows, but the low employment rate is a statistical mirage as it remains low, only because participation in the US overall workforce has been contracting. The US has never seen a contracting participation in the labor force during a so-called “recovery.”
What is happening within the broad economy has been erosion, decay and for the middle class, earnings contraction and severe structural changes. High quality jobs are lost or outsourced and replaced with low paying service sector jobs. Sure, maybe the overall number of 'jobs’ is still high, but what about the income creation of those jobs? That has fallen off the proverbial cliff and is very difficult to measure statistically because at the very high end, Wall Street Investment Bankers, Hedge Fund Managers, Real Estate Moguls, and Developers skew the curve. Outsourcing has been damaging, and the real fallout from re-allocated production is well obscured in the statistical data.
In the chart above, we show the annual rate of change for Non-Farm Payrolls which clearly shows a long term pattern of declining peaks. The pattern of successive cycle weakness is clear with the post 1974 recession peak coming in at a 5.46% rate of change in early 1977, followed by a peak of 5.43% in mid 1984 following the 1982 recession, followed by a substantially lower high at +3.48% rate of change in early 1995 following the 1990-1991 Gulf War recession and then there is the current cycle. To date, it appears as though the Non-Farm Payroll Annual Rate of Change peaked this last cycle at a measly rate of +2.14% in early 2006 and is now rolling over from that level. Talk about weak. As of Q4 2006, there were only 5.34% more jobs created than there was at the end of the prior recession, making this recovery the worst performance of the nine recovery cycles seen since World War II. At this point in prior cycles, on average there were nearly 12% more jobs in the economy than existed at the end of the prior recession, implying this recovery has lagged very badly. Another fact: in recent years, the trend in temporary employment has tended to be a good coincidental to leading indicator for “turns” in the broader employment series. In the last few cycles, temporary employment has turned down ahead of the broader series and turned up either in advance, or at the same time. The troublesome fact here, temporary employment peaked in early 2004 and is now very close to moving into recession territory with a near zero annual rate of change.
In a recent report, Barry Ritholtz, Chief Market Analyst at Ritholtz Research and Analytics, makes an excellent and highly compelling case that the recent economic cycle was “backwards” in nature, stating that “in most recoveries, it’s the economy that drives Real Estate, and not Real Estate that drives the economy.” Ritholtz points to a definitive study by Northern Trust which states that “between 2001 to April 2005, 43% of private sector jobs creation was housing related.” Ritholtz concludes that the recovery has been “light on job creation” and overly dependent on Real Estate which has had a huge — disproportionate impact on both consumer spending through positive wealth affects, and job creation. Since 2001, Ritholtz shows that several other studies have highlighted how rising home prices have accounted for a 70% increase in household net worth, with gains in household net worth driving the high end consumer spending that has been the bulwark of GDP growth thus cycle.
In our view, it is this disproportionate dependence on Construction and Real Estate activity that now threatens the broader economy as interest rates have increased dramatically in recent years. Within the Real Estate industry, it is the ultra-sensitive “Option ARMS,” and “Interest Only Loans,” “No Credit Check Loans,” and “Piggy Back” loans that have been a recent product of “Creative Finance,” i.e., The Great Credit Bubble, that are now starting to go sour. These loans, made to clients that in many cases did not have the necessary credit, are known as Sub-Prime Loans, wherein the delinquency rates are now climbing at an alarming pace. Just last week, HSBC Corp, one of the world's largest banks announced that it was raising its provision for bad loans 20% higher than the market was expecting due to “Foreclosures that have shown a higher severity" than expected at the banks Household Finance unit. In a conference call, Chief Executive Michael Geoghegan said, "The major impact was taking into account adjustable mortgage resets," and “The impact of slowing house price growth is being reflected in accelerated delinquency trends across the U.S. sub-prime mortgage market, particularly in the more recent loans." Back in December HSBC noted that the main risk in the near term was in personal lending in the United States, where increases in short-term interest rates are hitting people with adjustable-rate mortgages with the bank also noting that its underlying revenue growth had slowed despite an improvement in third-quarter profit. The slowdown was largely attributable to a weaker performance in HSBC's investment banking arm.
More bad news also came from Irvine (Calif.)-based lender New Century Financial (NEW). New Century, the second-largest subprime mortgage originator in the U.S., announced it would restate results for the first three quarters of 2006 to correct for “accounting errors” related to loan repurchase losses, sending the stock down 30% on Feb. 8. Even more recently, we have seen the following from Reuters just yesterday, suggesting that even non-sub prime delinquencies may be on the rise.
NEW YORK, Feb 12 (Reuters) - Countrywide Financial Corp. <CFC.N> and New Century Financial Corp. <NEW.N> led shares of U.S. mortgage lenders down for a third trading day as a new report suggested that even U.S. homeowners with good credit may be defaulting more often. The report by Moody's Investors Service about "prime" loans came amid mounting concern about "subprime" borrowers, who have weaker credit histories. Investors worry that as home price appreciation slows, people will have more difficulty refinancing adjustable-rate loans as rates reset higher. Shares of Countrywide, the largest U.S. mortgage lender, fell 3.4 percent, while New Century, the No. 2 subprime lender, dropped 5.5 percent. Also declining was Accredited Home Lenders Holding Co. <LEND.O>, a subprime lender whose shares declined 5.1 percent.
Most of the focus has been on subprime loans, and analysts said the risks of holding subprime-related debt are rising. Early this month, Friedman Billings Ramsey & Co. said the default rate on sub-prime loans that were packaged into bonds reached their highest level this decade. Last Wednesday, in a report titled "Inferno," Credit Suisse analysts said the 60-day delinquency rate for second-quarter loans that were six months old had doubled from a year earlier to 5.7 percent.
In my article entitled, “The Great Credit Bubble: What Could Go Wrong?” dated January 30th, I specifically highlighted Accredited Home Lenders, New Century Financial and Fremont General as these three stocks appeared to be in big technical trouble. On the next page, I show the chart of New Century “before” and “after,” with the decline actually unfolding faster than I expected. Ugly! — what more can you say?
Above: the chart seen in the January 30th article, “Great Credit Bubble” and
Below: the reality of the day, one week later, not a pretty picture - down 30% in a day.
Of course, Wall Street has always tended to under-estimate its pockets of excess risk. After all, how else is it possible for stock to be merchandised ‘off portfolio’ into the hands of the general public. “Oh, what a tangled web,” indeed, where the investing public has been conned once again.
Above: Fremont General Corp (FMT) plunges last week to new 52 week lows, and likely headed lower still. Below: Accredited Home Lenders (LEND), again, new 52 week and multi-year lows..
Thus, we see the first ripples of what could be a major, perhaps epic credit contraction now underway, starting at the lowest quality of credit and potentially beginning the path of falling domino’s. What’s next? Could it be Credit Default Swaps? Could it be CMO’s?
Who really knows? All we can know is that Wall Street has gone bonkers in recent years creating all kinds of illiquid, hard to comprehend derivatives, any one of which could be the flash point for a major conflagration in the financial system. In that vein, the investment banks would rank high on our list of “things to watch closely,” as when they roll over the problems that follow will likely be on an order of magnitude perhaps never before seen. On a pure technical level, we would venture an educated guess, that the time of reckoning is drawing near, as my long term Investment Banking-Brokerage Index appears to be completing a secular five wave advance dating back to the last 1970’s. On the chart below, we see a clear-cut, Elliott “Five Wave” advance with Wave Five very likely in its terminal throws. Has it peaked yet? Too soon to be sure. Does it look like it may have? Right now I would say the odds are high it probably has, but to be sure, I would want to see, Goldman Sachs common (GS) close below $209 for at least two to three consecutive sessions.
Employing a little more Elliott Wave, it appears as though Wave (5) of the larger fifth wave was an “extension” and is now finishing an advance from the 2002 lows wherein Wave (5) equals the height of the previous Third Wave. While this does not guarantee a major top, it does highlight what could well turn out to be a formidable resistance zone. In addition, looking back at the very long term chart for the Investment Banks, it is abundantly clear that where long term momentum is concerned, the recent “fifth wave” advance seen over the last few years, has produced sequentially lower levels of upward momentum, a tell tale indication that the advance in the brokers is in its final stages.
Above: seen on a linear scale, the recent fifth wave advance is now equal in amplitude to the preceding third wave, often an important Fibonacci resistance zone. Below: a long term view of the Investment-Banks-Brokers, showing the secular five wave advance against the backdrop of a very long term momentum indicator. Note the long series of lower highs highlighting the fact that every rally has contained less upside “thrust.” Are we in the ninth inning? We should know fairly soon.
Above: the Amex Broker-Dealer Index (XBD) with 50 day average.
In our view, at the present time, the important “248.00” level on the Amex Broker-Dealer Index, the XBD, is the key level to watch. As can be seen in the chart above, the 50 day average is still rising and is now filling in as support in the area of the November 22, 2006 high and the January 29th, 2007 low. Any series of closes below this 248 level on the XBD would be the first major clue that a more important cyclic, and possibly secular high has been seen. Since we are all now living in the age of the Financial Economy, as opposed to the Service Economy or Manufacturing Economy, these stocks more than any other group really speak to the dynamics of our time. On Wall Street, bulls relax amid the thoughts of contemplating a never ending “sea of liquidity.” If a credit contraction of epic degree is in the process of getting underway, the sea of liquidity may be ready for the tide to roll back, in which case the broker dealers are ground zero. For our part, we will be keeping a very close eye on this sector in the weeks ahead.
In addition to the investment banks, change always tends to develop on the outer periphery, in the credit markets, at the lowest quality of debt, the most marginal borrower. Where the “sea of liquidity” is concerned, the Emerging Markets, ripe with high-beta, represent the equity front where nervous capital is most likely to begin an organized retreat. In the current instance, these markets are also of paramount concern, as the chart configurations also herald what could be a very major peak. Of course, no economy has been hotter in recent years than China, And in the final closing moments of 2006, we saw Chinese share prices move almost �straight up.’ Looking back, this kind of near vertical movement over an extended period of months (as was seen in the second half of 2006), strongly suggests a �blow-off’ top, an argument which gained more traction with the nearly 10% decline in the opening sessions of 2007.
Above: the Chinese stock market over the last several years, traced out a potential blow off top amid rampant speculation in the final days of 2006. On the bottom chart, we see that Wave V equaled the net gain of Waves One thru Three, at the peak seen earlier this year.
In addition to the highly volatile and unstable trading pattern seen in China, markets like Brazil and Mexico appear over-extended and toppy. In the case of Brazil’s Bovespa Index, we saw momentum register an important peak back on February 6th of 2006 with the Bovespa at 32,847.61. Since then, prices succumbed to 21.75% decline which bottomed last June, with the second half rally in global equity markets lifting the Bovespa to new all time highs in early December. However, even as the Bovespa attempted to breakout to new highs in December, MACD was making lower highs then had previously been seen at the February 2006 peak. Over the last few weeks, the Bovespa has pushed to new highs once again, this time with a momentum profile that is threatening to go negative. This kind of extreme bearish divergence is often a signal that prices are topping out.
In the case of the Mexican IPC, the market has gained 69.32% SINCE LAST JUNE, annualized; that’s a rate of appreciation north of 138%. In addition, the Mexican Bolsa is also more than 25% above its 200 day average, another “red flag” indicating an overheated market likely to reverse lower. Finally, I also maintain an indicator known as the “Days Up per 50” which in the case of the Mexican Bolsa tells us that the market has now been up 38 of the last 50 days, and it has been holding that level for the better part of two weeks. How much risk does this represent? In my view, it strongly suggests that the capital markets are now living on borrowed time, and that the Emerging Markets are ready to begin rolling over in earnest in the days just ahead. For an over-leveraged financial speculator community including untold hedge funds, this chart should spell ‘trouble ahead’ for anyone who has been in the markets any length of time.
Above: the Mexican IPC Index - sporting a potential fifth wave advance in its terminal stages with prices moving up at a near vertical rate of ascent. Anyone feeling really lucky?
Above: the Percent above the 200 day average for the IPC Bolsa Index. When the indicator is above 25% the market has been seriously over-extended and in relative proximity to major shake outs. Below: we see the IPC Index and the “Days Up Per 50” indicator, telling us that again we have seen a one sided directional market moving straight up. Over the last 50 days, the Mexican Bolsa has been up 38 out of 50 days. Can you say “accident waiting to happen?” Nothing can maintain this rate of ascent indefinitely, leading us to wonder what lies on the other side of this parabolic curve?
For the S&P 500, key support continues in the low 1400 area, and while we may continue to see various markets fray around the edges, for the S&P the low 1400 area looks like it should be strong enough to hold on the first attempt. In the near term, any decline toward 1400 on the S&P should produce a near term trading low, with any subsequent rallies likely to fail in the 1430 to 1435 range. Once prices produce a “lower high,” we will begin to turn more negative on the broad stock market. For now, the risks and danger of the moment lie on the outer rim, on the periphery where serious problems always start and that is where our focus lies.
At the close today, the DJIA ended higher by 102.31 index points to close at 12654.85 with the S&P higher by 10.89 to finish at 1444.26 and the NASDAQ higher by +9.50 ending at 2459.88. In the commodities markets, Gold prices ended higher by +1.20 at $668.50 while Oil prices also gained ground ending at $59.06, up $1.25. The 10-Year Treasury Note ended at 4.81%. That’s all for now.
© 2007 Frank Barbera