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An Inflection Point, Of Sorts

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The Fed's recent benign monetary policy hasn't done much for the broader market. And that much is against historical precedent. But the Fed's slashing of rates has certainly helped to boost shares of thrifts, or savings & loans, up to this point in the cycle.

Before I go on, let's define a thrift, using the nation's largest in Washington Mutual (NYSE:WM) as an example. Washington Mutual, also known as Wamu, provides financial services to consumers and mid-sized businesses. The firm is engaged in the following businesses: consumer and mortgage banking, commercial banking, and financial services. Obviously, the Fed's cutting of rates has benefited Washington Mutual, particularly in its mortgage and lending businesses. Lower rates boost the housing market, thus benefiting the mortgage business. And lower rates also allow for financial firms to borrow on the bid and lend on the offer, so to speak, capturing the spread.

The following weekly chart clearly displays Washington Mutual's positive reception of the Fed's rate cuts. In fact, the stock began rallying well ahead of the Fed's first rate cut, in typical forward-looking fashion, back in March of 2000.

But instead of the stock's, and indeed the savings & loan group's, longer-term trend, I'd like to focus on the last two days' price action. Last Friday, the sector took it on the chin on the heels of bearish analyst comments and a few earnings reductions. On the surface, the premise behind the shift in sentiment is simple: All the good news is discounted. Market participants are beginning to believe that the Fed's benign monetary policy is coming to an end, home buyers may begin shifting to fixed-rate mortgages, and ultimately the good news will come to an end. There's also growing concerns over dropping leasing rates and defaults in the commercial market as the economic slowdown takes its toll and layoffs continue surfacing.

While the premise is simple enough and may prove correct, what was especially interesting last Friday is that the broader market staged a fantastic rally. Indeed, nearly every sector rallied except the savings & loans. The magnitude of price divergence and volume was significant enough last Friday to give this notion a lot of credence. And we're witnessing the same thing again this morning!

Here's where it gets interesting, though. The financial sector, as a whole, is perhaps one of the best indicators for the health of the broader economy - it's the pulse of the economy. And the financial sector, especially the savings & loans, are foretelling something is on the horizon, something big. I think that the move in the S&Ls Friday and again this morning is predicting one of two forthcoming scenarios.

The first, and positive, outcome is that the economy is finally beginning to pick-up. As business cycle-sensitive stocks have stumbled in the wake of the Fed's rate cuts, the S&L stocks have been something of an anomaly for the aforementioned reasons. But now with the Fed perceived to be wrapping up its benign monetary policy, market participants may be betting that the economy is on the mend, thus the follow-through in cycle sensitive names this morning, such as Alcoa, DuPont, Dow Chemical, Caterpillar, and International Paper.

The second, and negative, scenario is that the sell-off in the S&Ls is foretelling of the final bubble to burst: The housing market. There's no denying that up through March of 2000 (Coincidentally THE bottom in the S&Ls) there was a tremendous asset bubble in the U.S.; that bubble has since been popped, except for the housing market. The S&Ls and the housing market track very, very closely for obvious reasons.

The following weekly chart of Beazer Homes (NYSE:BZH), which is one of the larger homebuilders, depicts a very similar price path as the one taken by Washington Mutual since March of 2000.

The housing market has been deemed the savior of the broader economy thanks to the U.S. consumer. Indeed, strong housing economic news has confirmed that much recently, and continues to do so. But the big sell-off in the S&Ls may predict a reversal of trend in housing stocks. If that happens, the U.S. economy may take a turn for the worse and so will the market.

I don't have a bias towards either scenario, but I do think that one will play out in the coming weeks, or perhaps the next few months. Either the thrifts or going to rebound and the market as a whole will advance, or the thrifts will trader lower and take the housing stocks down in a big way.

I think that the upside is limited if the positive scenario takes place. But if the positive scenario does unfold, I think it will be best played with the aforementioned cyclical names.

If the negative scenario takes place, however, I think the magnitude of the downside move in housing stocks will be much larger because it will discount a drop-off in the U.S. consumer, who, up until this point, has kept the U.S. economy afloat.

Eric Utley
Option Investor

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