Option Investor
Market Wrap

Houston, We Have a Plan

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Introduction

This morning, the Mortgage Bankers Association (MBAA) released its quarterly delinquency survey. The MBAA reported that the percent of loans already in the foreclosure process and the rate of those entering the foreclosure process were the highest in the history of its survey. A seasonally adjusted 0.78 percent of loans on residential properties of one to four units are entering foreclosure, the MBAA reported.

The Federal Reserve's figures say that homeowners lost $128 billion in real estate equity in the third quarter alone. That's a record. Their equity as a percentage of real estate values declined to a record low, the Fed announced.

In an address to the Committee on Financial Services before the U.S. House of Representatives this morning, Fed Governor Randall S. Kroszner outlined problems contributing to foreclosures as well as the implications of the drastically increasing numbers of consumers defaulting on their loans. "Over 17 percent of subprime adjustable-rate mortgages were in serious delinquency at the end of September," Kroszner said in his statement.

Kroszner outlined the Federal Reserve's response to the subprime problem. That response includes a coordinated enforcement of consumer protection laws and efforts to mitigate losses, including working with lenders and mortgage servicers to encourage them to approach with borrowers in trouble with the goal of keeping them in their homes. He mentioned the Hope Now alliance. The Federal Reserve's efforts also extend to proposing changes in the Truth in Lending Act (TILA) and exercising its rulemaking authority under the Home Ownership and Equity Protection Act (HOEPA).

The subprime problem is not going away as some had hoped it would do by now, and the Federal Reserve notes that comments and study are necessary to effect a reasoned response. However, a plan to staunch the bleeding has been proposed. Yesterday, Treasury Secretary Henry Paulson led negotiations with mortgage industry leaders that resulted in a proposal announced by President Bush today. In addition to making it easier for some whose ARMs are resetting to obtain FHA loans, that proposal freezes the introductory rates offered on subprime loans. Loan rates will not reset for five years under the plan hammered out yesterday.

Only those borrowers whose loans were made from the beginning of 2005 through July 30 of this year and who have not missed any payments will be eligible for the new program. Other rules will apply, too. President Bush stressed that this program is not a bailout and that no government funds will be used. Secretary Paulson, when he spoke after President Bush, called the plan "guidelines" and emphasized that government officials, including Kroszner, were present at the announcement only because of the systematic approach being proposed. It was a private-sector initiative, he insisted.

Whether called a plan, standards or guidelines, the plan's hope is to avoid a tidal wave of foreclosures as mortgages reset. Lately, this tidal wave threatens to sweep the economy into recession. Protests will come from those who feel the plan doesn't go far enough, those who believe it's morally wrong and investors who purchased bundles of mortgage-backed securities, expecting higher interest rates on those bundles as loans reset. Some current presidential contenders want the program to go further: to put a moratorium on foreclosures. Some industry watchers expect lawsuits from the investors who purchased those mortgage-backed securities.

I didn't find specific mention of "the plan" in Kroszner's statement. However, he addressed the importance of investors and mortgage servicers, as well as acknowledging the possible legal concerns that might arise from any systematic action, at least an oblique reference to the plan. These investors and servicers "play a critical role in implementing possible loss mitigation strategies," he said. The problem has reached a point that strategies must be proactive and systematic, he noted. The industry must "go further than it has historically to join together and explore collaborative, creative efforts" to assist large groups of borrowers.

Some industry watchers decry the proposal, saying that it's just postponing the inevitable. What if housing prices have continued to fall for five years, they ask, and five years from now, homeowners face the same difficulties? Others say that, at the least, it will keep more borrowers in their homes and stop the dumping of more homes on a market already weakened by too many homes for sale.

All the worries, concerns, promises and pitfalls will be rehashed for days if not weeks. While the plan provided hope to some that the subprime mess would not swamp the economy, as had been feared, any enthusiasm that might have resulted was initially dampened by disappointing November retail sales among U.S. apparel retailers. Some thought that the extra week in November would help department stores, but many disappointed.

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The divergent actions and concerns of the Bank of England and European Central Bank this morning questioned what our central bank will do next week although Fed speakers certainly have been clear over the last week. That questioning, hesitation ahead of tomorrow's important economic report and next week's FOMC meeting, and technical factors combined to curtail gains until after President Bush and Secretary Paulson spoke in the afternoon. Breakout levels had been previously hit on many indices, but no explosion of prices accompanied the breaks through those levels until their explanation of the plan concluded. Homebuilders, thrifts and mortgages joined with energy-related stocks to send indices higher, and the explosion of prices finally occurred.

Charts

Yesterday's and today's actions met expectations for a potential scenario that I laid out before the market open on Monday morning in the Market Monitor, the live portion of the site. The only problem is that it all unfolded much sooner than I anticipated. I had thought that indices would end up next Monday just where they did yesterday. Furthermore, although it wasnt part of the scenario I laid out for this week, because I didn't think it would happen until next week, I thought that, post FOMC, we might have just the kind of push we had today, and then, after that, we'd see where markets really stood.

So, now I have problem. I think today's plan actually front ran my whole scenario, but what happens next? The day after an FOMC meeting, we often begin to see what the market really believes once we get through all that initial volatility that often attends an FOMC decision. What the market really believes isn't always what it initially believed. Will that happen this time, too?

I don't know. The charts I'll show in the last section will at least give some levels to watch for guidance, but for now let's look at daily charts and get an overview of where we really stand.

Annotated Daily Chart of the SPX:

I was surprised by the ease by which the SPX and some other indices charged right through a 50 percent retracement of the decline off the October high. That's usually powerful resistance, often at least stalling prices a day or two.

If the SPX does stall or even pull back, the 1488-1492 zone might provide support on daily closes, although I wouldn't be surprised to see it breached during intraday moves. In truth, the kind of volatility that we've seen can result in almost anything happening next.

Annotated Daily Chart of the Dow:

Annotated Daily Chart of the Nasdaq:

Annotated Daily Chart of the SOX:

Annotated Daily Chart of the RUT:

The transports were early leaders higher this morning, and those who watch the TRAN for guidance were quickly alerted that if the TRAN were performing its sometimes leading-indicator role, it was leading higher. Morgan Keegan upgraded Ryder (R) to Outperform status this morning.

Annotated Daily Chart of the TRAN:

Today's Developments

Today's slate of economic events was full, but the important release of the week occurs tomorrow. The Non-Farm Payrolls report appears at 8:30. Today's first two releases obliquely related to that release tomorrow.

November's Monster Employment Release appeared before the market open. Previously, Monster pegged the index at 188.0, but this time, it fell five points to 183. This indicates "further moderation in U.S. online recruitment activity," Monster said in its summary. The company deemed the decline a broad one, with only two of 20 industries and two of 23 occupational categories showing increased online job availability.

There wasn't much good news in Monster's report. The index's growth pace declined by 4.6 percent. That was a record drop. Not only did growth slow, but also the deceleration increased, Monster reported. The index pinpointed further deterioration in financial and real estate opportunities, but declines retail/sales and leisure/hospitality opportunities also occurred, highlighting "waning consumer confidence." The most growth was seen in healthcare, and the public sector held its own.

Initial and continuing jobless claims were released at 8:30, as is typical for the weekly release. If the ADP raised hopes that Friday's employment number would be higher than had first been predicted, the weekly jobless claims introduced some concern. Initial claims fell 15,000 to 338,000 but the four-week moving average rose 4,750 to 340,250. The Labor Department pegged that four-week average as the highest it's been since just after Hurricane Katrina. The four-week moving average is considered more reliable than the weekly data. Some economists predict that initial claims will balloon, and that an upward trend is already in evidence.

Continuing claims fell 59,000. The four-week moving average rose 6,000. The insured unemployment rate stayed steady at 2 percent.

Two economic events occurred not in the U.S. but across the pond. The Bank of England lowered interest rates by 25 basis points, while the European Central Bank kept rates steady. Both events were expected. While pundits still debated whether our FOMC would decide on a quarter or half-point rate cut, our treasury rates, at least as demonstrated by the ten-year yield, rose today, whether in response to the actions across the pond or the proposed fix on the subprime mess. Ten-year yields closed above the 10-sma for the first time since October 31. This occurred after these yields retested the 11/26 low earlier in the week. A climb and close above the 11/30 intraday high of 4.04 percent would be a first higher high since October 15.

The Bank of England's cut was the first since August 2005. As late as a couple of weeks ago, the central bank had been expected to hold off on a cut until early next year, but conditions worsened in the U.K. The central bank mentioned a tightening of credit and conditions in the financial markets among other reasons for the cut. As late as late November, the central bank's governor was worrying about inflation risks, risks that may keep the bank from lowering rates again early next year.

Those inflation risks kept the ECB from lowering rates. President Jean-Claude Trichet's statement said that "[an unanticipated rise in inflation to 3 percent] has fully confirmed our assessment that there are upside risks to price stability over the medium term."

Taken together, these two responses pinpoint the dangers our own central bank faces and the tightrope it must walk next week. Deteriorating credit and economic conditions must be balanced against the specter of rising inflation and a potential need to address that inflation.

The Department of Energy released natural gas storage figures at 10:00. Those inventories dropped 88 billion cubic feet. This was far greater than the anticipated decrease of 31 billion cubic feet. Other energy-related news included a report by Bloomberg that unrest in the Niger Delta had led to a halting of about 900,000 barrels a day output from Nigeria. Crude still moved lower for the day.

The impact of the housing slump and subprime mess continued to be demonstrated in other figures released today. A Freddie Mac survey released today said that mortgage rates have dropped to 5.96 percent for the national average interest rate on a 30-year, fixed-rate mortgage. This is the lowest average rate in more than a year. Freddie Mac's president said that mortgage rates followed treasury rates lower after declining consumer spending and personal income gains in October. One has to wonder whether treasury rates will be so accommodative in the future, however, if inflation concerns arise again.

November's chain store sales were released during the day. Some expected dismal results after earlier releases related to retail sales this week. Others pointed to Black Friday promotions, an extra shopping week in November and colder weather as probable boosts to November same-store sales. Although some retailers surprised to the upside, particularly wholesale clubs and discounters, many apparel retailers disappointed. Costco (COST) and Wal-Mart (WMT) beat expectations. Altogether, however, about two thirds of retailers missed November estimates. In addition, Target forecast that December sales would be much lower than its previous estimates, which had already been in the low single-digits.

Companies reporting earnings today included Toll Brothers (TOL). TOL reports a loss of $0.52 a share. Excluding write-downs, it earned $0.72 a share, with Thomson Financial having pegged expectations at $0.77 a share. This was TOL's first quarterly loss as a publicly traded company. After stuttering for a few minutes this morning, TOL gained, consolidated until the press release, and then zoomed higher. It still closed at a descending trendline off the 9/19, 10/11, and 10/29 highs, however, after piercing that trendline during the day.

After hours, National Semiconductor Corp. (NSM) said that it expected to see sales in the fiscal third quarter to slow 1-5 percent from the second quarter's. Second-quarter sales were slightly above expectations as were earnings per share, but the stock was sent lower initially after its report.

Tomorrow's Economic and Earnings Releases

Tomorrow's important report is the November Non-Farm Payrolls number. As of last weekend, economists were predicting an addition of 65,000 jobs, but this week's ADP promised far more new jobs. That complicates the prediction as well as the possible reaction to the actual number. Before the ADP, markets might have reacted with some relief if the number had been the predicted 65,000, but after the ADP, anything near that number may now be a disappointment. Anything below 50,000 would now be a shock.

Neither do market bulls want a too-strong number. A tight labor market might complicate rate-cut hopes.

Yesterday, the quarterly Anderson Forecast by the University of California, Los Angeles, said that in order for the U.S. economy to sink into recession, showing two or more quarters of negative economic growth, the unemployment rate would have to climb to almost 6 percent by the end of next year. The group believes that would require a loss of more than 2 million jobs during that period. Heavy job losses would have to spread outside the construction sector into other sectors for that to occur, and the group doesn't believe that's likely. Monster's Index might argue against that conclusion, but those composing the Anderson Forecast do believe that the economy will be sluggish, with the housing slump, credit problems and a likely slump in consumer spending contributing to that sluggishness.

At 10:00, December's Consumer Sentiment will be released. It's expected to be 76.0, with the prior number at 76.1. The ECRI Weekly Leading Index and October's Consumer Credit follow, at 10:30 and 3:00, respectively.

What about Tomorrow?

Most of the intraday charts I'm going to show you in this section look similar. They're 30-minute Keltner charts, and they show breakouts that occurred in the last few minutes of trading. Breakouts occur when momentum is strong. Keltner channels were originally developed to set up breakout plays because they can be powerful and can lead to big profits.

But . . . you knew there was a "but," didn't you? Trading breakouts can be lucrative only if you're prepared to endure the many whipsawed plays and the frequent draw downs, because that's the character of breakout plays. The signals are often false, and often false many times in a row. I especially don't trust breakouts that occur in the first few or last few minutes of trading. This is when momentum, short covering, amateur-hour antics and all those things can overrun support or resistance. For example, shorts who were trapped after today's developments and looking at the uncertainty attending tomorrow morning's employment number were most certainly forced to cover into the close, if they hadn't done so already.

So, watch those breakout levels on the charts below tomorrow morning. They'll change soon after the open, but you still have the 9-ema's to watch, even if you haven't or can't set up Keltner channels. If indices are coming down to the breakout levels and/or their 30-minute 9-ema's and bouncing from them, as they did today, the short-term uptrend that was put in place Tuesday afternoon is continuing. If instead, indices roll over and those 30-minute 9-ema's begin to be resistance on 30-minute closes, and those closes below them are sustained, the short-term trend is over.

Does that mean a downtrend, short term or otherwise, will ensue? Not necessary. We know from frequent observation that big-range days are often followed by choppy consolidation days. That would fit with a clamping-down-before-FOMC kind of action and could lead to a miserable couple of days of trading Friday and Monday. However, it will all be about positioning ahead of the FOMC meeting, with tomorrow's employment report giving some insight. I think it will also be all about digesting what today's developments meant and what they have to say about the economy, too. The solution that's been proposed may or may not help the economy--it does nothing to address the credit crunch being faced by businesses, for example--but the necessity for the solution points to the dire straits which required them, and that doesn't sound like good news to me.

Watch those 9-ema's for guidance, but anticipate a potentially difficult-to-trade day unless the rally continues unabated or unless a strong downtrend gets set up. Here are the charts.

Annotated 30-Minute Chart of the SPX:

Annotated 30-Minute Chart of the Dow:

Annotated 30-Minute Chart of the Nasdaq:

Annotated 30-Minute Chart of the RUT:

So, don't agonize. Either prices are bouncing handily from those 9-ema's, they're trading back and forth across them without regard to them, or they're bouncing down from them after slipping through. In the first case, action is bullish; in the last, it's bearish. In the middle case, when prices just zigzag across those 9-ema's, 9-ema's that should be flattening in that case, you've got the dreaded choppy consolidation conditions that often follow a big-range day. Stay out if that occurs, because nothing good will happen to your account if you don't.

Whatever happens tomorrow, make a firm decision about whether you want to stay in options over the weekend, ahead of the FOMC meeting and another possible choppy trading day on Monday. What will three days of premium decay do to your position?
 

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