Financial Contagion: From U.S. Housing Bubble to European Debt Crisis

 |  Includes: IYR, SPY, TOL, XHB
by: George Chadwick

Contagion. The 2008 financial crisis emanated from the collapse of Western banks triggered by the bursting of the U.S. housing bubble which is said to have peaked in 2006.

If you want to get real specific, Toll Brothers (TOL), a homebuilding company in the U.S., peaked in July 2005 and began to roll over in August 2005.

In my own view, institutional money (on the long side) began to flow out of the U.S. equities market in November 2007.

Warning Signs. I remember where I was and what I was thinking on both occasions. In August 2005, I was opening up a checking account and I remember telling my wife, "It looks like the housing stocks have finished their run." In November 2007, I remember exactly where I was standing in my house when I told my wife, "It looks absolutely scary the way institutional money is pouring out of the [stock] market."

It turns out, November 2007 wasn't half as scary as January 2008, and then June 2008, and then the granddaddy sell-off in September, October, and November 2008. Then came the final drive-down in March 2009. This was the start of a hefty "cynic's rally." Now that I look at a 10 year monthly chart of the S&P 500, it was a rally-back to the 5/8 (61.8%) resistance level that some call "hidden resistance."

Pumping up the Bubble. Subprime lending took off like crazy in 2004 (see chart below). Investors sought higher yields (interest rates) than what U.S. Treasuries could offer. Junk bonds (such as CDOs) that were based on ever riskier mortgages were created to meet that demand.

If the chart above would not have provided enough of a red flag in 2004, the events enumerated earlier in this article should have. In 2005, housing stocks started to roll over. In November 2007, an outflow of institutional money began which was to become an avalanche in 2008.

Housing Bubble. This can be traced back to super low interest rates during the three years following the year 2000 bursting of the dot-com bubble (to "soften" the blow), creating, in effect, another bubble, the housing bubble. Interest rates were pressured downward even more by the mounting trade deficit (see chart below) and an inflow of foreign capital that pumped the bond (and other assets) bubble even higher.

The events leading up to the stock market crash of 2008 gave plenty of warning (theoretically). The current European Contagion crisis did not seem to give the same kind of "obvious" signals. The so-called signals that were there did not give as much warning. For weeks, we repeatedly heard about the Greek sovereign debt crisis but the stock market continued to move up blithely and complacently until May 4, 2010. Then the panic sell-off of May 6 of close to a 1000 point sell-off in the Dow. That is two days versus 3 or more years of technical and fundamental warning signs that preceded the 2008 market drop. This would lead to a possible conclusion that this is all part of or a continuation the same crisis. The sell off over the past two weeks has been so precipitous that the yearly uptrend is still intact, and that despite a retesting of the panic lows of May 6, 2010.

While originally designed as protection against bond default, Credit Default Swaps (CDS Finstruments) have been increasingly used by speculators to benefit from the collapse of a company or country (see chart above). As with the housing bubble, the European bond bubble was aided by rating agencies and their useless AAA ratings which made the CDSs unrealistically cheap and someone gets left holding the bag due in part due to incorrect pricing of risk. A liquidity squeeze often follows.

So, have we moved from a housing bubble to a "country bubble?" Perhaps even a zone (eurozone) bubble? The thing is, I don't remember any seminal moment of epiphany that I can pinpoint in the same way I could back in 2005 and 2007. I can remember such moments so clearly 5 or more years ago, but no such moments exist even a couple of months ago. This also could lead me to believe (if I knew what to believe) that this current crisis is part of the same issue that became evident over the past 5 years.

I kept telling myself that bear markets aren't made in just two days of trading and price action (May 4 & 6, 2010). Hence, I think it's too early to tell if this will be the start of a bear market or a bull market correction. Continuing that argument, it is probably too early to tell if the one year "cynic's rally" we just had is not part of a massive bear market rally-back (a 61.8% rally back).

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Disclosure: No positions