6/13/08 (The bottom?, Inflation!, Foreclosures)

Traders,

Yesterday looked to be a strong rebound after the consumer spending looked rather strong – but again how much was based on stimulus? Regardless – the rally lost momentum and started to retreat. I was talking to a friend yesterday and asked where I thought the bottom was. It got me thinking about being a child and swimming in a lake in Traverse City, MI (Cedar Lake). The lake is beautiful, surrounded by trees, the water is clear, and if you look at the bottom along the coast it seems nice and sandy. However, after a few steps out you begin to sink into the sand and sometimes deep into soft clay. The perception of a sandy bottom fools many as they take to the water and in some cases sink up past their knees. Is the market that much different? We are continually told the “worst is behind us” and then the bank writes down more money, the company lays off more people, or they lower estimates. Are they lying? Probably not, they really BELIEVE the worst is behind them because traditionally the market moves up and down on perception. However, something is different this time, the expansion of the credit lines way beyond money on deposit is catching up to everyone – which precipitated the Fed to cut rates to stimulate borrowing and keep spending cycle going. However, by doing so they have put serious pressure on the dollar and have spurred inflation – thus sucking out buying power out of the dollar.

The bottom – well I don’t think it is as easy to find, just like Cedar Lake, because of the massive leverage, carry trade borrowing, all of which exceeds capital on deposit. It is the massive leverage and the ability to continue to float positions by borrowing more that keeps a bottom from ever being found.

I talked to a friend about creating a bank that only had HARD ASSETS (Gold, Silver, Dollars, Euros, etc) on deposit – that would not be a part of the Fed Reserve and therefore not borrow money – leverage would not be created – and people could only borrow what was ON deposit (nothing more). You would not really need FDIC insurance would you! And the stability of the bank and its risk would be so transparent that all risk would be fully disclosed. Furthermore – taking it a step further – on the investment bank side – using absolute risk margins (similar but tighter than Haircut Margins) – would give even more strength to managing risk. I am sure smart money would flood to such a secure institution and probably feel more confident that it was not part of the Fed Reserve system. Oh well – dare to dream.

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CPI – Got Inflation?

The CPI rose .6% in May (4.2% year-over-year) actually moving beyond where the Fed feels comfortable as they would prefer to see inflation at 2%, not above 4%. I would argue that it is still very low, since the pre-1990’s method of CPI is showing inflation closer to 8%. Regardless of how you want to do the math – we are seeing inflation – no matter how many new math methods we want to through at it – it can’t fight the rise. What does this mean? It means your dollar is not getting the buying power it once did, but even worst if you are buying treasury bonds you are actually losing money, since what you are getting paid (in interest) is significantly less than the rate of inflation. At the end of the day, you might have $102 (from a 100 investment paying 2%) – but that $102 is now only buying about $98 worth of goods. You just lost buying power. Remember – it’s not how much money you have, it’s how much you can get with that money. Buying Power is the most important factor – not face value.

What does this mean for the Fed? Well he is in a tight spot for sure. After the Lehman news and the continuing problems with the financial sector he is loathed to raise interest rates – since they are all in need of more capital and lending is STILL very tight. If he were to raise rates he will be reopening wounds in the financial sector that needs money. However, he needs to tackle the inflation problem as the economy works based on consumers spending money. If the consumers buying power is diminishing then they buy less (inflation) – so he is no doubt in a pinch. Some economist are predicting some raises at the end of the 3rd quarter and in the 4th quarter between 25 – 50 bps (between 2.25 – 2.50%). However, will that REALLY curb inflation. I am not too sure that would be enough.

The futures pre-market is getting a good solid boost to inflation news (yeah I know if makes no sense – “Cutting rates will boost the market!”, “Raising rates will boost the market!”). There is this guy, Jack (forget his last name – he is a guest on CNBC – a trader), Joe Kernan makes fun of him because he is a perma-bull, he will always argue the markets will go up. Well of course he said cutting rates is good for the market and now he is saying raising rates will be good for the market. Joe pretty much said – which is it? His response – pretty much – it depends. The market is just looking for any news that can be spun into perception as good news. The talk now is that if (when) the Fed raises rates it will strengthen the dollar and thus force commodity prices down. That is good news and so the market will go up. That is the story they are pushing this morning.

The reality on the ground (regardless of market direction) is that inflation is real (whether you believe the CPI or any other model) – that is affecting consumers today. If and when the Fed raises rates is not probably going to happen for months. Therefore – expect MORE volatility going forward.

The Fed has one tool in their tool box – that is raising and lowering short-term interest rates. At the end of the day it trickles through the market slowly and really doesn’t affect prices today.

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Foreclosures rise 48% in May as U.S. bank repos double

The numbers coming out don’t even seem real, 1 in 438 homeowners lost their homes to foreclosure according to the report. That is the highest that RealtyTrac has ever reported. The problem is that banks are not traditionally allowed to hold real estate as an investment and therefore need to sell them as they take possession (REO = Real Estate Own, not REO Speed Wagon). If the banks are tight on money – they will sell them for bigger discounts than the traditional homeowner could – since the homeowner is restrained do to the short-sale issues (home owners were unable to sell the homes below their mortgages without permission from the mortgage company – selling below is called a short sale). If the homeowners continued to pay their mortgages, mortgages companies would refuse to allow short-sales. Thus homes remained unsold and some indicated that the home market had a false bottom prior to the increase of foreclosures, the false bottom is as I pointed out the homeowners couldn’t go any lower in price even if they wanted too.

Lenders took position of 73,794 homes in May, more than double the previous year (28,548 in May of last year). This has caused a second problem, lenders do NOT want to lend. Thus the tightening of money increases down the food chain. Now the question is how long can a lender hold onto the REO before lowering prices to get it off their books.

I have talked with an appraiser and he said usually after 30 days if the bank can’t move the property they start taking down the price and after 90 days they begin to get aggressive in trying to sell. Here is a real world example. Two houses in my hood (both on the water) were purchased only a couple of years ago. Property 1 was purchased for $1.6 million, was foreclosed and a REO for 6 months – it just sold for $775k (52% off), Zilliow had it valued at $1.3 million (40% below their est.). Property 2 was purchased for $2 million, was foreclosed and a REO for about 3 months now, it is still listed $1.1 million – so far no takers. Note these properties are right next to each other. Florida may be different than other areas – but we are getting 40-60% hits in prices down here. By the way, that sale of $775k was the only sale in my neighborhood in a year. REOs might see more pressure and willing to go lower if no one is buying. I think REOs will eventually spell the bottom as they CAN set price, unlike a homeowner.

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Futures Pre-Market

The futures were initially down to flat prior to the CPI report – but they rocketed up when it showed a larger than expected inflation picture, combined with increase in unemployment spells a possible rate increase. The thought is that it would strengthen the dollar, commodities would come down, and consumers could continue to spend. But all this is just speculation. I think we could get a good pop from here – but wouldn’t back that bet with hard deltas. The spread is still wide so expect Arb traders to short futures into the opening and buying the basket as the spread closes. If the futures remain strong going into the opening expect a pop in the market, after that – who knows.

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Support / Resistance

The market was pretty weak yesterday after a good opening rally – we didn’t’ get back up above those short-term supports that we broke down through. The close of today should either give us a clear picture if we are creating (finding) a short-term support or we have room to go down lower.

INDU 12000 / 12500 (We got up over the previous 12200 support/resistance point yesterday and I thought we would remain there – but the market lost its legs and headed back down. A good close above 12200 would lend to a confirmation of a short-term support AGAIN at 12200. Otherwise look at 12000 as the next step down.)

NDX 1900 / 1950 (We saw strength and a attack at the 1950 level – but couldn’t keep the head above water there and slid back down. Some may say 1925 is support – but this index is volatile and I think it warrants larger bands – since it only takes one over weight to drive this index up or down.)

SPX 1325 / 1350 (This too saw strength before giving it up into the close. A close above 1350 would be a good sign of some short-term trading support – we could attack that area again today. Be careful getting short or long at 1350 going into the weekend. I would remain flat at 1350 and take long gamma there.)

RUT 720 / 740 (We are just below KEY support in the broader market – if this sees strength going into the weekend (above 720) even if the above indices are weak – it could be a sign that some short-term strength is returning. I would watch the 720 line very closely to determine if money is REALLY flowing back into the market as a whole.)

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Conclusion

Inflation – I guess we just can’t ignore it any more. I heard an interesting report this morning on Bloomberg as an economist was saying the business cycle recovery is a bigger story than inflation. He said we could see inflation in fuel, food, and energy and a flat Core – as prices of luxury goods fall to spur buying. Which he believes would negate to much inflation. If that is the case (Core vs. Headline differ) he thinks the Fed may hold off raising rates – as it would hurt the financial sector. He said they will be focusing more closely on the Core than ever before. However, he said usually he can put a finger on something in the future that spells recovery for the business cycle – but he can’t and that is what really concerns him more than the recession vs. inflation issue (which pretty much negates each other out). It was an interesting observation and is worth investigating. It is a economy 101 lesson that a recession does starve inflation – however we are in a global market and I think there is more to this puzzle than traditional close market economics would have us believe. I am no economist – so my opinion should not carry very much weight. However, I would hope my observation would lead to those smarter than me to look into it a little more than just applying traditional measures.

This is an interesting time we live in and we do have many variables at play, housing, dollar, oil, elections, credit lines, etc. It is like the whole system is getting rocked pretty good – or tested to see how it can stand up vs. a pretty strong storm. So far we are holding pretty well – surprisingly well – but I don’t think anyone knows where the weak points are. Therefore shoring up risk becomes more a crap shoot than anything else. I can say with certainty that credit ratings, bond insurers, and the investment banks don’t have a clue other than chasing more money to keep things going. The CEOs and CFOs getting fired on a monthly basis from some of the biggest financial companies in the world is not building confidence.