Tracking the Perfect Storm
By Frank Barbera CMT. February 27, 2007
There is a blip on the long-range radar, something out there -- out there at extreme range -- yet now steadily closing the distance. Unable to be seen over the expanse of a long horizon, the object draws relentlessly closer bearing down on our position. As it approaches, we begin to feel the lashing winds and violent seas of a still developing ‘perfect storm.’ In advance of its approach, the palpable change is impossible not to notice with the complexion of a sunny day evaporating into a miasma of increasing winds and darkening skies. Like the approaching storm -- a weather system of immense size and power -- today’s violent decline in global financial markets is the signature of steadily darkening storm clouds and a BEAR MARKET in its early stages. Whoa, to the investor that ignores the message of such an unmistakable and powerful force. Bear markets take no prisoners cutting a path through investor portfolios strewn with wreckage and debris.
Over the last few weeks, all of our indicators have pointed to burgeoning trouble spots -- China, Mexico, Brazil, the Investment Banks, Homebuilders, the S&P itself and of course, the Sub-Prime Lenders. They are all actors in ACT I of a still unfolding 7 ACT play. The pain threshold and turbulence is only now just starting to increase, so for those with weak stomachs, now would be a good time to reach for the Dramamine and buckle in. In last week's report, I noted the S&P appeared to be in the final stages of completing a five-wave advancing wedge. In today’s action, that wedge formation broke down violently with prices moving down to test the 1380 to 1390 support zone near the lows of the day.
Above: an update of last weeks hourly S&P chart showing the five wave “Rising Wedge” now breaking down.
For those wondering what a breakdown from a wedge formation implies, it means that prices have left behind what in all likelihood will be THE highs for this cycle. Wedges are ending patterns, and this one has packed the classic wallop. For a “would be” developing bear market, today’s decline is just another straw in the wind, letting us know that the storm is drawing ever closer. Over the next few weeks, the broad market will very likely make a short term low over the next day or two in the 1380 to 1390 zone and then begin a slow, “failing” recovery rally. Odds are high that within two weeks, today’s sell-off will be dismissed by the Wall Street “Buy Side” pundits as nothing but a healthy correction with happier and sunnier days dead ahead. Their bullish prattle will likely be wrong, and likely wrong in a financially costly manner, as was the case in 2000-2002 as it has taken the S&P nearly seven years to recover what was lost in just two. In bear markets, “Down is faster,” a rule many all too quickly forget. No, the clouds are definitely darkening, and this storm has the earmarks of something much deadlier, packing far more firepower than anything seen in a very long time.
At landfall, it will literally unfold all around us with a Housing Crisis — Check!, a Banking Crisis — Check!, and ultimately, a Currency Crisis — Check!. Check, Check, Check! On all three centers of gravity, the vortex will spin faster and faster, becoming ever more self-reinforcing like a maze of tumbling dominos. Only gold, and perhaps oil are likely to withstand, and indeed, thrive within this particular burgeoning onslaught. With today’s decline, the S&P is now down 1.34% for the year, with the NASDAQ down 4 points for the year and the DJIA down 1.98% for the year. So much for the barrage of daily new records repeated and repeated ad nauseam by the squawking parrots on cable TV. We will now undoubtedly be told that the market is “oversold” and sure, the market is becoming oversold on a “short-term” basis. Yet a quick glance at the Medium Term ARMS Index below, shows that even with today’s violent market decline, it is still a long, long way to Tipperary as the ARMS Index ended at a very neutral value of .95.
Historically, the Medium Term ARMS Index would not even begin to signal the presence of an important stock market bottom until readings above 1.30 or higher are seen. The index is plotted on an inverted scale, where “high” readings above 1.30 signal a significant oversold condition, with readings below .85 signaling an overbought condition. As recently as last Wednesday, February 21st, the Medium Term ARMS was heavily overbought at values in the low .70 range with a close of .739 last week. This implies that over the period of let’s say, the next six months, there can be much room for great pain and damage in the stock market indices -- starting with the complete retracement of the market rally of the last six months. From here on, until we see serious oversold values, it will be best to assume that where market rallies are concerned, they should be viewed as opportunities to sell non-gold, and non-oil related stocks.
Of course, the upcoming downturn will likely be global in nature. Two weeks ago, I featured the over-extended charts for Shanghai, Mexico and Brazil, warning of an imminent reversal. Last night, Shanghai registered a nearly 10% decline, one of its largest single day declines in history and a large single day decline even by US historical standards. In Mexico, the IPC Index plunged 4.79% while in Brazil, the Bovespa fell nearly 6.13%. These are not “incidental” declines, nor do they leave a price structure devoid of technical damage. Quite the contrary, within these markets, we have seen the construction of the classic parabolic edifice with these declines puncturing the larger bubble. And yet, the equity bubble was a mere trifle when compared to the much larger credit bubble, the true power plant that will drive the Perfect Storm. Note this morning’s announcement for the venerable Freddie Mac stating that,
Freddie Mac Plans to Stop Buying Some High-Risk Mortgages in Roiled Subprime Market
WASHINGTON (AP) -- Mortgage giant Freddie Mac said Tuesday it will no longer buy high-risk home mortgages that it deems to be highly vulnerable to foreclosure. The surprise move came amid a deteriorating market for subprime loans affected by slumping home prices and rising interest rates. The government-sponsored company, which is the second-biggest financer of home loans in the United States, said it will begin using stricter standards for mortgages that it buys -- including limiting the use of loans requiring less documentation of the borrower's status than conventional mortgages. The goal is "to help ensure that future borrowers have the income necessary to afford their homes," McLean, Va.-based Freddie Mac said.
"The steps we are taking today will provide more protection to consumers and enhance the level of underwriting standards in the market," Richard Syron, the company's chairman and CEO, said in a statement. The changes will take effect Sept. 1, the company said, to avoid disrupting the mortgage market. Roughly half the subprime mortgage-backed securities that Freddie Mac now owns would likely fall short of the new standards, the company estimates. The company's new standards cover certain types of hybrid adjustable-rate mortgages that comprise about three-quarters of the subprime market. An adjustable-rate mortgage is considered a higher-risk loan because it typically draws borrowers in with an initial low, or "teaser" rate, which can rise substantially over time. In a bid to promote a change in the home-loan market, Freddie Mac also said it will "strongly recommend" that banks and other mortgage lenders hold money from borrowers in escrow for paying taxes and insurance.
Like a plate of Rice Krispies, the theme of the day is Snap, Crackle, Pop, as in “Snap” goes China, “Crackle” goes Freddie Mac, and “Pop” goes the Sub-Prime Market. The end result will be a messy brew of another breakfast cereal, this one a soggy bowl of Captain “Credit” Crunch. Within the Credit Markets, we see a contagion well underway. Just look at the destruction on New Century and Novastar Financial. Piloted straight into an asteroid belt, in both cases, we see the proverbial “wrecked” ship with a dead crew. Yet, the ripple affects reverberate up the quality chain, as Wall Street is loathe to mount a brave front in the face of invading hordes.
Above: Moving up the quality chain, we see a long erosive decline underway for months at Novastar Financial, greeted by jeers and laughter from investors in “favorite” IndyMac. Virtually within days of Novastar’s spectacular collapse, IndyMac flirts with 52 week New Highs. The ensuing collapse of Novastar then sends a cold chill through the mortgage industry, with Wall Street quickly reversing gears on even the diversified “darlings” on IndyMac and Countrywide
In the chart abov), we plot the price of New Century Financial against “bluechip” Countrywide. Notice that between September 2004 and October 2005, New Century plunged 52% from $66 to $30 while over the same time, Countrywide corrected by a milder 20%. Thereafter, between October 2005 and April 2006, New Century recovered half its loss, with “high quality” favorite Countrywide moving up to new all time highs at $45. “They are more immune to the pitfalls of a down cycle,” we were told by many and now “are well diversified to stand up to a down-cycle with more “fee” related income.” And so we see still more new highs in Countrywide right up to the very moment of the exploding crisis -- Countrywide hitting still higher highs right into early February 2007, only days before New Century collapsed. Now, in light of the clear and wide-spread admissions from HSBC, Freddie Mac and others that things are not right in Sub-Prime Land, we see the Countrywide stock price starting to sag. Rats just beginning to jump the proverbial ship? Time will tell.
Yet there are many dangers in the current turbulent storm driven seas. The debt bomb is ticking, and like Marisa Tomei’s character in the movie, “My Cousin Vinnie,” is “ticking, ticking, ticking!!!” louder by the day. Case in point, the pending disaster that is Ford Motor (F), often overlooked as a floundering auto-company, Ford is none other that the US chief creator of junk credit market debt. Within the yield curve society of the US Government, US Municipalities, US Agencies, and US Corporation, the big addition in recent years has been Ford Motor, which has so much paper outstanding all by itself, it now owns its own yield curve. Quite an accomplishment in debit proliferation from a company that also mastered the creation of large gas guzzling low mileage trucks. Of course we know they are built Ford Tough, yet one wonders if the same can be said for the Ford Bonds. Here again, the truth will lie ahead in the price action of the months to come.
Unfortunately for Ford, whose current product line does not include much in the way of “economy” oriented transportation, the pattern on the weekly RSI shows a technical failure wherein RSI became fully oversold on the weekly basis with a print of +16.43 on April 15th, 2005 and then fully overbought at a reading of +66.47 the week of September 15th, 2006. What makes the pattern technically weak is the fact that during the entire “oversold” rally from +16 to +66, the stock failed to gain any ground, and in fact, was at $9.49 at the bottom of the fully oversold cycle and ended at $9.48, a penny lower at the peak of the fully overbought cycle. While not quite as dramatic a “failure” as Enron, which started its oversold cycle at $64.50 and peaked its pre-collapse overbought cycle at $37.50, in the process losing a great deal of value, the technical similarities are present with both stocks residing below massive Head and Shoulder distribution patterns, and below long term severely down-trending moving averages.
In addition, both companies showed highly leveraged financial profiles making them extremely vulnerable to the predatory hedge community. Nowhere, if not in the hedge community, does the Theory of Efficient Markets take on a greater conceptual meaning, with Enron’s critical default covenants lining up early in the cross-hairs of the big gun sights for many important funds. We also saw this action in Tyco a few years later, and I marveled at the time how during the assault on conglomerate type companies that followed in the wake of Tyco, even mighty GE was made to flounder. Against this type of deep-pocketed adversary, with cash flow ailing, Ford could be in for a rough ride indeed. Is Ford the next leg in the building Great Credit Crunch of 2007, the next victim of the approaching Perfect Storm? Who knows, but there is an old saying on Wall Street about not trying to catch falling daggers. Today, Ford was down 5.47% leaving a third lower high evident in the $8.50 to $9.00 range.
At the close, the Dow ended down -395.35 index points to close at 12,236.91 for a loss of 3.13%, the S&P 500 down 50.21 at 1399.16 or 3.46%, and the NASDAQ down 93.95 index points at 2410.57, a loss of 3.75%. The Russell 2000 Small Cap Index ended down 30.96 index points or 3.76% at 792.73 with the 10-year bond yield falling 12 basis points from 4.63% to 4.51%. Short term, the market will bounce, but the bigger picture, the storm is gathering strength and today’s market is but one small step forward toward unleashing the bear. That’s all for now.
© 2007 Frank Barbera