Volumes may be down but summer trading can still be exciting. Last week was a volatile one. Do you remember the fear and panic last Monday? The S&P 500 fell more than 2% thanks to a nearly 6% plunge in the Chinese market and a huge spike in the U.S. dollar. The fear didn't last long as investors pounced on the decline as an opportunity to buy the dip. What looked like a breakdown from its trading range proved to be another bear trap as stocks rallied higher for the next four days. Now stocks have broken out to new highs for 2009.

Friday's rally was fueled by positive comments out of Fed chairman Ben Bernanke at the annual Federal Reserve meeting in Jackson Hole, Wyoming. Some of the media were calling it Ben's victory lap for saving the economy from another great depression. Others saw his speech as a chance for him to save his job and fight off rumors that President Obama would like to replace him. Essentially all he said was that prospects for near-term growth look good and that was enough for the markets. Investors ignore his comments that "difficult challenges still lie ahead."

Just in case Bernanke's comments weren't enough to fuel another round of short covering the National Association of Realtors said July home sales soared 7.2%, the biggest one-month jump in history (or least since records were kept since 1999). The annual sales pace came in at 5.25 million, which was better than the 5.0 million estimate. This was also the fourth monthly gain in a row, a feat not seen in five years. Never mind that about 30% of sales were first-time homebuyers trying to get in before the $8,000 tax credit expires in November. Never mind that more than 30% of sales were foreclosures or short sales. Never mind that home sales valued in the $250-500K range fell more than 6%. The only bull market in housing is for homes under $100K and a lot of those are probably condos. I said last week that the market has selective hearing and they're only hearing the bullish spin for any news these days.

SHORT TERM OUTLOOK

Short-term my outlook is still bullish. We are in a market environment where money managers are chasing performance. I don't want to repeat myself too much but they're scared to miss the rally. The end of October is the fiscal year end for many mutual funds so these managers that have been under invested have just over two months left to catch up. This is probably going to keep a floor under the market with money flooding in to buy the dips.

Technically the breakout over 1,020 in the S&P 500 is also a breakout past the 38.2% Fibonacci retracement of the 2007-2009 sell-off. The next Fib retracement resistance is the 50% mark near the 1100 level. I do see potential resistance in the 1060-1070 zone but odds are the market is now aiming for 1100. The 1,000-980 level should now act as support.

Weekly Chart of the S&P 500:

While seasonally August and September are the worst time of year for stocks I do not believe seasonal trends are going to be a factor this time. The only minefields appear to be a sudden reversal in the currently bullish trend of economic data, which is unlikely, and any abysmally low back-to-school sales data. Fortunately, most of the analysts seem to have already factored in a bad back-to-school season for the retailers.

This coming week we can keep our eyes and ears open for any significant changes in the Q2 GDP number, which is updated this Thursday. Plus, the Treasury Department is selling another $109 billion in 2, 5, and 7-year bonds. Should any of these auctions go poorly it will be bearish for the market but thus far the short-term bond auctions have been pretty strong.

LONGER TERM OUTLOOK

My longer-term outlook is not quite so rosy. I'm mostly bullish for the rest of 2009 but I think 2010 could be a big disappointment. I'm currently in the "W"-shaped economic recovery camp and we can expect the stock market to follow suit with another big swoon. Now I'm not expecting stocks to test their 2009 lows but it's going to be painful. Why? The unemployment-housing-foreclosure-consumer-spending black hole is the reason.

Regular readers have heard this rant before so I'll keep most of it short but I've got some new details on the housing market. First of all we are still near record unemployment and the trend is still up. You've heard the term "jobless recovery". Odds are we're going to see another one. Businesses have slashed costs to the bone and they're going to be reluctant to hire new workers again. As unemployment stays high or ticks higher it will keep a cap on consumer spending. Consumers are nervous about their job security so they're saving more. Baby boomers are retiring soon and they've seen their 401Ks and their home values plummet, so they're saving more. Weak consumer spending is going to fuel to a weak recovery.

The high unemployment and weak spending will continue to power the foreclosure problem. We've had several months of 300,000+ foreclosure filings. Now not all of them turn into foreclosures but enough of them do. This last week the Mortgage Bankers Association said foreclosures hit new all-time highs in the second quarter. More than 9% of homeowners with a mortgage had missed one or more payments (these are delinquent loans) and another 4% of mortgages were in foreclosure. Furthermore the foreclosure plague was spreading from sub-prime to prime fixed-rate loans. You keep hearing analysts remind people that banks still have toxic assets on their balance sheets. Residential mortgages are a major slice of the toxic loans.

A Deutsche Bank analyst provided an interesting forecast this last week. Currently there are about 110 million households in the U.S. Of those about 75.5 million own a home. Close to 68% of homeowners have a mortgage so that's about 51.6 million. Currently 27%, about 14 million homeowners, have a mortgage that is underwater. The DB analyst expects that the number of mortgages that will be underwater by the end of 2010 is going to jump to 48% or almost half of the 51.6 million.

Currently home values are down about 33% from their peak and many analysts are predicting that values will continue to fall another 10-15%. If you're a homeowner and the value of your home is already 30% less than what you owe then you are way more likely to give up and let the bank repossess it. It's going to take years and years before your house ever gets close to breakeven again.

The DB analysts broke down their forecast by mortgage type. Currently 16% of prime loans are underwater. They expect this to jump to 41% by the end of 2010. About 29% of prime-jumbo loans are underwater. This is expected to rise to 47%. Sub-prime loans are already at 50% and expected to reach 68% next year. The option-arm loans I've been warning about for months are already at 77% underwater and forecasted to reach 89% by the end of 2010. Yes, there is a tsunami of foreclosures headed for the U.S. market. What about the big jump in existing home sales on Friday? I believe the tax-credit is pulling a lot of sales forward and July and August are normally the peak of the home-buying season. August could show some strong numbers but it's usually down hill from here. Add to that the tax-credit expiring in November and the drop off in home sales could be very steep.

However, I'm not expecting this to have much of an impact until 2010. The economy is bouncing as businesses gear up for an inventory replenishment phase. We will probably see the GDP turn positive for the third and fourth quarter this year. Where it goes from there is a good guess.

~ James Brown