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Morning Cup of Jo: Just a Correction?

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These straws have seemingly broken the proverbial camel's back.

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"The world is moving so fast now-a-days that the man who says it can't be done is generally interrupted by someone doing it."
(Elbert Hubbard)



Key Points:

  • Housing, which has been in decline for two years, has the potential to now impact consumer spending and the economy.
  • Will the issues in subprime spill over to other financials and in turn the broader tape?
  • The recent technical damage, along with a pick-up in volatility increases the likelihood the markets test their 200 day moving averages (1350 on SPX).
  • SPX 1320 is critical support – beneath that would call into question a change in LT trend.


Market Commentary:

Last week I discussed a few areas of focus for investors - most notably a potential global liquidity crunch, the Yen carry trade and the problems in the sub-prime housing lender arena. These straws have seemingly broken the proverbial camel's back. This is also why I have been penning words of caution since mid-February and continue to do so. Today I thought it prudent to delve deeper into some or my concerns – all of which happen to be intertwined.

Concerns regarding global liquidity and risk aversion surfaced back on February 12th of this year. That day the Bank of Japan (BOJ) raised interest rates for the second time in six years a quarter point to 0.5%. Looking back this event, in all probability, served as a major catalyst in the unwinding of the Yen carry trade. Last week the European Central Bank (ECB) raised rates for the 17th time since December of 2005 to 3.75% noting further hikes may be necessary to further counter inflationary pressure. Yesterday the words "Hyperinflation" hit the newswire referencing China's release of CPI data (which was up 2.7%). The pressure on The People's Bank of China (PBOC) to raise rates seems high.

For the past two years the housing market has been in the midst of a decline which is no surprise to anyone. However, on Monday, Irvine, California based New Century Financial(NEW) was halted on the NYSE and yesterday was de-listed to the pinks. It joins 36 other sub-prime mortgage lenders that have imploded since late 2006. With concerns growing about the sub-prime market meltdown, many mortgage lenders are tightening standards for loans. This, in turn, could put continuing pressure on the housing market and lead to two separate (but equally negative) situations for the markets.

First, consider that there are $1 trillion dollars in adjustable rate mortgages (ARM's) that will reset by the end of this year. This translates into roughly 3 million households that will have less to spend. If you were to just assume that for every $100,000 in outstanding loans converted to a $75/month increase in payment, that would equate to $750 million dollars less to spend annually in the economy. Considering that the U.S. savings rate is in the red for the last two years this could represent a true house of cards, no pun intended. There was a great article in the New York Times on June 16th of 2005 called "The Trillion-Dollar Bet" for those who wish to take a gander.

Now add the possibility that more restrictive lending standards may also equate to lower demand for new housing. Well you get the point. Over the last several years consumers have spent based on the value of their houses. Homeowners took equity out of their homes in droves in recent years as rates hovered at low levels. Pressure on the housing market obviously depresses prices and therefore works in reverse to crimp spending. That obviously is not a positive for the economy and we'll have to see how this unfolds.

The second critical issue which is yet to be determined is to what extent the sub-prime issues funnel their way through the broader financial sector of the market. The impact this could have is likely extremely underestimated because of both the overall amount of leverage in the financial system as well as the numerous linkages which exist in the form of derivatives.

There are clearly a number of issues out there that provide the bears with some solid ammo to press their bearish bets. That being said, we must consider the major bullish force that has benefited the market in the recent past. Specifically, low interest rates, liquidity, tight corporate spreads, and a relatively benign economic picture have combined to fuel record share repurchases by corporations as well as massive LBO and M&A activity. This has likely prolonged the upward advance, cushioned the downside and provided the fuel for the moves higher off the lows in the end of the year during the last three years.

From a technical standpoint the damage remains significant and I am still of the opinion the markets are not yet done correcting. Because of the prior action this week my firm has trimmed the ST resistance points in the Eye on the Ball section above. The scenario on how this correction should play out is almost picture perfect thus far. We have seen a large volume sell-off, followed by a small declining volume accumulation period and a continuation of the larger volume distribution pressure. We'll have to wait and see what the rest of the week and release of economic data brings.



As for the longer-term picture the question continues to remain, "Is this just a correction or the start of something bigger?" Volatility has picked up recently and that, along with the technical damage, increases the probability that the S&P may test its 200 day moving average (1348). I think a tug of war would likely ensue at that level. Should the market break the 200 dma, the 1320 level on the S&P represents the next major support. This is where the LT upward sloping trend I have discussed numerous times in the past meets the horizontal breakout. A break below this could signal a return of a much longer bearish trend. For now caution and patience are warranted…



Be patient and you shall be rewarded.

Stay tuned & good luck!

No positions in stocks mentioned.

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