Tuesday's dip was supposedly an external event caused by a drop in Chinese markets. OK, no harm, no foul. Back to business as usual on Wednesday. Oops! A -200 point drop at the open on positive economic data shocked quite a few traders but the sharp rebound was thought by many to be indicative of a climax bottom. The correction is over now that 12100 has been tested and Thursday should be the beginning of the rebound. Oops! Thursday also started ugly with an even deeper test of 12100 and another sharp rebound. Traders were now convinced the double dip was the end of the selling and were being urged by respected analysts to go shopping for stocks. Oops! Friday failed to produce a rebound and the markets closed at the lows for the day. This is not a positive scenario and the outlook for next week is questionable at best.
Dow Chart - Daily
Friday's economics consisted of the final Consumer Sentiment report for February. It fell from 93.3 to 91.3 but nobody was watching. Those who were watching failed to care. Volatility had captured the attention of everyone still in the market and it was rising to close at the high of the week despite Friday being a relatively calm day. The VIX closed at 18.61 and less than a point below Thursday's intraday high at 19.40. After eight months of negligible volatility it has returned with a roar and if the charts are right there are rocky times ahead.
It won't be economics that captures attention early in the week with the only really important report, Nonfarm Payrolls, not due out until Friday. After last week's heavy calendar this week will be positively boring. Wednesday's Fed Beige Book may attract attention but Bernanke has already blessed the recovery so the report will only be informational not major news. On Friday the February jobs report is expected to show a gain of +100,000 jobs, which would be a slight decline from the +111,000 added in January. I think the more important informational tidbit here is the falling consensus estimates over the last couple of months. Last fall estimates had risen to 133,000 but that number has been in decline for several months despite a constant upward revision in the actual numbers. Analysts are becoming concerned that the jobs situation is growing less positive as the months pass. The slowdown in housing and the continued layoff news at the automakers is reducing expectations. Personally I don't think Friday's number matters unless it drops below 50,000 or suddenly spikes over 150,000. Without a major surprise it is just going to be another economic report worth slightly more than 15 min of airtime.
The crisis for the week is going to continue to be subprime loans. The sector took another hit on Friday when the Federal Reserve and four other Federal agencies called on lenders to exercise caution in making subprime loans and strictly evaluate the borrowers ability to pay. They proposed stiffer guidelines that if formally adopted by the agencies and followed by lenders would result in significantly fewer subprime loan approvals. In 2005-2006 nearly 17% of mortgage volume was subprime loans or nearly half a trillion dollars. Add in Alt-A loans, those just slightly better than subprime, and that number rises to something in the 23% range. Remove that mortgage volume from the market and the housing sector is going to tank even further.
The proposed guidelines were similar to the Freddie Mac announcement earlier in the week. Basically every subprime mortgage product now comes with much stricter requirements that will prevent many subprime borrowers from qualifying. The agencies said they wanted to make sure that borrowers could repay the loans without refinancing and without flipping the property. According to once analyst I heard on Friday the delinquency rate is continuing to rise with 19% of Countrywide Financial's subprime loans are currently delinquent. This rising default rate is expected by many to eventually cause problems farther up the financial ladder. These defaulting loans are like millions of termites eating away at the financial foundation of the banking system and unless the problem is addressed very quickly those foundations could crumble.
Fears of an impending announcement by a major institution in subprime trouble have helped pushed the yields on the ten-year note to 4.5% and better than a two month low. On Friday credit default swaps tied to brokerages traded at their highest level in 19-months as fears of a default rose. Goldman Sachs default swaps are up +30% since the subprime problem began. Merrill Lynch stock is under pressure because two subprime lenders they financed over the last two years have filed for bankruptcy and they bought a subprime lender, First Franklin, for $1.3 billion. All the major brokers package and securitize subprime loans. As part of the deal they keep a portion of those loans for themselves. Reportedly Bear Stearns has loans equal to 13% of their capital, Lehman 11% and others don't disclose the numbers. These firms are not in trouble because of their exposure to subprime defaults but those defaults will impact profits at some point in the future. GM disclosed this week that it had $67 billion in subprime loans in its GMAC subsidiary. We could see hits to GM earnings when they are released sometime in the next couple weeks. 27 subprime lenders have closed their doors in the last year. Quite often when loans default the initiating lender has to buy them back from the investors. This puts severe stress on the cash flow at the initiating lender and this has forced many to close their doors.
New Century Financial (NEW), the second largest subprime lender, announced after the close on Friday they will likely breach a major lending covenant with its financial backers. This poses new questions about the potential for its survival. Their stock price fell another -10% in after hours trading to close at $13.15. NEW said minimum profit requirements to remain in compliance with its loan covenants would not be met for the two quarters ending in December. NEW said it had received waivers from six of the 11 lenders but had not been able to get the waivers from the remaining five. If the waivers are not received the lenders have a right to walk and this could force NEW to shutdown operations. The company's auditor KPMG said without the waivers their ability to continue as a going concern was doubtful.
China may have recovered from its Tuesday meltdown but the US markets failed to attract any real buyers. I could understand the dip on Wednesday and chalk it up to margin selling. Outstanding margin loans rose to a record $285 billion in January. This was higher than the prior record levels of $278.5B we saw back in March 2000 just before the crash. I could easily understand how Wednesday morning's dip was related to margin calls. That does not explain the rest of the week.
There was a major change in sentiment from buying dips to selling the rallies. The bulls tried several times to buy the dips and were successful in the very short term but sellers continued to appear as each bull run began to run out of steam. The resulting decline pushed the markets to their worst weekly performance in the last four years. The Dow ended down -535 points or -4.24% for the week. The Nasdaq lost 147 points or -5.85% with the NDX losing -6.13%. The brokers were the hardest hit with a -7.61% drop followed by the transports at -7.30%. This is only the result of one week of selling. Several of those indexes started declining several days earlier. As of Friday's close the Transports were down -8.2%, Russell -6.6% and Dow 5.4% from their highs. The S&P has been down 7 of the last 8 days. According to Merrill Lynch weakness in the financial sector accounted for 31% of the market drop with tech stocks accounting for another 19%.
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Greenspan's comments about an impending recession in the US last weekend weighed heavily on the markets. So heavy that he was quoted later in the week as saying the prospect was "not likely" as he tried to smooth over the reaction to his original comment. Bernanke also tried to cool the frazzled nerves when he spoke and his positive economic comments had immediate impact with a sharp rebound. That rebound was short lived. In the case of Greenspan you can take back the words you said or try to spin their meaning but it is much harder to make investors forget the initial shock.
About the only entities that benefited from the market decline was companies with a stock buyback program in place and those buyout firms with takeover targets in their crosshairs. Thomson Financial said there were $56 billion in stock buybacks announced in February and that was the 2nd highest month on record. Those contemplating a buyout are said to be lowering target prices after this weeks decline. Thomson also said that 731 deals were announced in February for a total of $161.4 billion. It was the best February on record for M&A and the 12th best month ever. The decline in the markets should accelerate that trend.
For next week the outlook has turned negative. The failure of the market to rebound from Tuesday's China event is a major red flag. Chalk some of it up to margin selling but that is only a temporary pressure factor. The lack of bargain hunters at Friday's close suggests the bulls are in shock. After buying the dip three times last week and seeing their rebound quickly blunted they may have paused to reconsider their trading plan. In point terms Tuesday's drop was the 8th largest one-day point drop in history. However, it was only the 237th worst percentage drop. It may have been a big news item but it was not really a material move. There is an average of 8 one-day -2% drops per year. It had been about 160 trading days according to Ned Davis Research (32 weeks) since we had one of those drops. We were way overdue.
When the market does not rebound from an external event like China's 9% sell off it suggests a dramatic change in sentiment. That is also normal after a long run. Historically a market event that is not quickly dismissed tends to lead to several weeks of higher volatility and large point swings. Basically the drop is a wakeup call for millions of investors. The quick rebounds on the following days are similar to hitting the snooze alarm. Buy the dip and go back to sleep expecting the same rebound we have seen on every dip for the last 8 months. After repeating this process several times with an unsatisfactory result investors finally wake up to the realization that maybe this time is different and quit hitting the buy/snooze button.
With investors now wide awake and staring at some really ugly charts the reality of a sentiment change begins to take hold. Positions they loved for months and where sizeable profit had been accumulated are now giving back those gains on every successive drop. Investors probably added to those positions on the first drop and maybe even the second dip. Now all those positions are underwater or heading there fast and investors have to make a decision. It is no longer a question of capturing remaining profits but of rescuing shrinking capital. This is how a 4% dip becomes a 7% dip or even worse. The farther we fall the more stops get hit and a larger correction becomes a self-fulfilling event.
The charts are clearly indicating more negativity than they did when the smoke cleared on Tuesday. The Nasdaq has broken below strong support at 2400 to close at 2368 and appears to be targeting 2325 for its next support test. The Dow closed right at support at 12100 and looks very weak. We could easily test 12000 on Monday and a break there has trouble written all over it. 11250 will become the next target. The S&P-500 dipped to 1380 on Thursday and rebounded +30 points before tanking once again. Friday's close at 1387 is right on critical support. The 100-day average at 1408 has been broken and is now substantial resistance. The break of the 100-day average typically indicates a secondary correction ahead. All internals are negative and getting worse. 457 S&P stocks declined on Friday compared to only 36 with gains.
Tuesday was the all time record volume across all markets at 8.3 billion shares. Wednesday and Thursday rank 2nd and 3rd with 7.17B and 7.39B shares respectively. A 5% loss for the indexes spanning the top 3 volume days ever is never a good sign. Friday's volume was a paltry 5.66B shares but that would have qualified as heavy only a week ago. It definitely appears there has been a change in sentiment. Whether that sentiment is temporary or lingering is still undetermined. Bank America warned investors on Friday that the time was not right to put fresh money to work saying cheaper valuations were possible.
S&P-500 Chart - Daily
On Tuesday I recommended buying dips to 1385/2400/12000 but cautioned to run for the exits if those levels broke. The Nasdaq closed at 2368 on Friday as the first index to break critical support. With the S&P at 1387 the odds are good it will be the second index to crumble. I still suggest buying the dip over those levels but reversing to a short as those levels are broken. Obviously with the Nasdaq already failing I would be extremely cautious about any dip buys on the other two indexes. At this point I would probably not commit capital to the long side of the market until we see if those levels are going to hold. The key for the markets next week will be Thursday's low on the Dow and S&P. If those lows break it would indicate another leg down and that leg could be steep. Professional traders would like nothing better than a washout early next week. They would like a textbook climatic drop to clear the rest of the margin holders and weak stomachs. Note the Russell-2000 came to a dead stop at very strong support at 775. This is a critical level and a key inflection point for gauging fund manager sentiment. If this level fails then funds are fleeing the market rather than buying the dip. TrimTabs said fund withdrawals on Mon/Tue alone were $3.2 billion. If that snowball is still growing then funds will be forced to sell positions to raise cash for withdrawals.
The economic outlook may have improved slightly in the short term and that is market positive. In light of the subprime problems and the market dip the Fed may be tempted to move to a neutral position when they meet in two weeks and that would be very market friendly. There is the potential for another quarter in Goldilocks mode before the fall 2007 housing worry really begins to take hold.
Dow Transport Chart - Daily
Russell-2000 Chart - Daily
believe this is going to be the straw that eventually breaks the markets back.
Depending on what statistic you read the impact of the new mortgage rules could
take 15-20% of homebuyers out of the market as of Sept-1st. With delinquency
rates rising and foreclosures soaring we could see an additional 20% of homes
purchased over the last three years come back onto the used market through
forced sale or foreclosure. My son lives in an affluent suburb of Denver
starter home prices average about $365,000. There are 109 homes in the
foreclosure process within a 2-mile radius of his house. These will all be on
the existing home market soon and there are probably many more headed for that
process. Multiply this by all the metropolitan areas in the country and that is
a lot of homes coming to market. I believe the spring selling season will be
frantic as subprime borrowers race to buy before the new guidelines shut them
out from purchasing
another home. Once September 1st arrives it will be a true
buyers market and only for those who can pass the tougher rules. Home prices
will fall sharply until supply and demand return to balance. Some estimates I
heard this week suggested declines in the 15% range. Consumer sentiment will
plummet and builders will face another round of cutbacks. Greenspan may have
been right about the potential for a recession in late 2007. I believe it would
only be a mini recession if it occurs
and we should rebound in 2008. I believe
this subprime cancer will continue to eat away at the economy and the market and
this was the real reason for the market drop last week. China may have
accelerated the process but the subprime problem has been quietly eroding the
economic outlook for months. Last week the supports finally began to crumble.