Friday, September 01, 2006

Unobvious obviousness

Watching the market in the past week, the saying kept coming to my mind was, “the market will do the most obvious thing in the most unobvious way”. I have subscribed to the thesis of a housing-led slow down or recession for sometime, and have never been more convinced of its veracity. Yet the market has merrily chugged higher. Does it really know better or is it just doing the “unobvious”?

This blog embraces the “Middle Way” that is a judicious compromise between extremes. While I have always respected market action especially in the short term, a rigid rule like “the market is always right” goes too far in my opinion. After all, the market reflects the perceptions of its participants who are far from infallible. Below, I reflect on two examples of “spin” in the financial media. Things like that convince me the downside risks have not been properly priced in.

Dropping bond yields to save the home owners
This has been the mantra of the bulls when confronted with the prospect of the looming 2 trillion ARM re-set. But a look as the historic fixed rate and ARM rates from HSH Associates reveals that even if home owners were able to refi into another loan, they will still be looking at a large increase in monthly payments. According to, the current average 30-yr FRM is at 5.94%, while the 5/1 ARM is at 5.69%. The current spread betwen 1, 3 and 5-yr ARMs are negligible. Compared with the lows of 3.56% for 1-yr ARM in the spring of 2004 (my guess the 3-yr ARM was about 4% then) or 4.6% in last summer, the increase is still significant. Note that March-June 2004 was the peak of sales in much of California, and last summer was probably the peak in housing overall.

Of course as pointed out by Frugal in this article, someone sitting on a lot of equity can do a cash-out refi to sustain the increased monthly payments. However, in addition to it making absolutely no economic sense (unless they can get an after tax return greater than the mortgage rate), it assumes the home owner hasn’t already tapped the equity in some way. Given the amount of MEW and HELOC loans in the past two years (compare the % cash out and increase in house prices: Freddie Mac), it’s an assumption I’m not willing to make.

National Monthly Averages
Date 15-Year FRM 30-Year FRM 1-Year ARM
Jan-04 5.20% 5.88% 3.83%
Feb-04 5.10% 5.76% 3.72%
Mar-04 4.91% 5.59% 3.56%
Apr-04 5.29% 5.96% 3.77%
May-04 5.77% 6.40% 4.09%
Jun-04 5.81% 6.42% 4.25%
Jul-04 5.61% 6.20% 4.22%
Aug-04 5.41% 6.01% 4.14%
Sep-04 5.28% 5.88% 4.08%
Oct-04 5.25% 5.84% 4.05%
Nov-04 5.26% 5.83% 4.18%
Dec-04 5.27% 5.83% 4.23%
Jan-05 5.27% 5.80% 4.35%
Feb-05 5.26% 5.72% 4.36%
Mar-05 5.54% 6.01% 4.51%
Apr-05 5.58% 6.02% 4.60%
May-05 5.43% 5.87% 4.53%
Jun-05 5.35% 5.77% 4.57%
Jul-05 5.41% 5.84% 4.73%
Aug-05 5.58% 6.00% 4.89%
Sep-05 5.52% 5.94% 4.89%
Oct-05 5.77% 6.21% 5.11%
Nov-05 5.99% 6.44% 5.30%
Dec-05 5.95% 6.39% 5.37%
Jan-06 5.86% 6.28% 5.38%
Feb-06 6.02% 6.40% 5.47%
Mar-06 6.12% 6.47% 5.65%
Apr-06 6.28% 6.63% 5.82%
May-06 6.37% 6.75% 5.92%
Jun-06 6.38% 6.83% 6.03%
Jul-06 6.53% 6.88% 6.16%

Many home owners are in trouble because

  • They overextended themselves and tapped the home ATM to finance their life stle. If they couldn’t afford the fixed rate mortgages last summer or much of 2004 when the rates were about the same or lower than right now, how will they afford them now?
  • Because the short term rates have risen, the ARMs are just as unaffordable as the fixed rate mortgages.
  • This is all assuming the home owner would qualify for the new loan. I haven’t even started on falling comps and tightening lending standards here.

Moreover, current low mortgage rates shouldn’t be taken for granted. As Barry Ritholtz from the Big Picture pointed out, the bond rally is looking tired. In addition, the Yen index has declined from 91.7 in mid May to 85 and change. So part of the rally in the 10-year may be due to the resumption of the yen carry trade on top of the bond traders getting a whiff of a slowing economy. The yen index should have some support just below 85, so a rebound in rates is very likely. Falling oil prices and reconstruction in Lebanon may also translate to less money going into bonds.

Consumer spending
Consumer spending is 70% of the economy and is represented by the Personal Consumption Expenditure index (PCE). July’s 0.8% MoM increase in PCE was much ballyhooed in the main stream financial media. It gives a rather rosy picture of the American consumer, right? How does that jive with the thesis of a housing-led slowdown? Instead of focusing on the Mom change, I looked at the data the same way as in Ahead of the Curve by Joseph Ellis. The YoY %change in the real PCE (inflation adjusted) was used to filter out the seasonal effects. The trailing three-month average was used to smooth out the data series. A different picture emerges: the rate of change including July has clearly been on a downward path. If one examines the spending by category, the slow down in expenditure on durable goods is even more dramatic. In other words, the American consumers may be finally tapping out.

What now
So what do I do if I truly believe the market hasn’t fully priced in the downside risks? My bearish bets have not fared well in the past month although my total portfolio was still up. I’ll respect the current market action by not betting the farm, but I’m stubborn enough to continue placing small bets while waiting for the return of sanity. Labor Day is finally here and I’ll be on the look out for high volume moves in either direction next week. There are some who say this market is manipulated and the powers that be won’t allow it to drop till after the election. Let’s see what the market thinks.

This is not investment advice; please do your own due diligence. Good luck and be safe!