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The market is performing well in the face of worsening economic data. This downtrend in economic timing is fueled by the continued weakness from the real estate sector. The big worry that this 20% portion of the economy will halt the recovery is being now being expressed by many. Why is everyone all-of-a-sudden so worried about another leg down in real estate? Because in Q2 the construction industry lost 447,000 jobs year over year. The unemployment rate for construction is at 20.7%. Foreclosures rose in 75% of top metropolitan areas in the 1st half of 2010. This weakness is limiting the rest of the economy. Economist Anirban Basu reported “It appears the lack of momentum in the construction industry is a reflection of what appears to be happening now in the U.S. economy.”

The root cause of continued weakness in housing is being caused by a prolonged foreclosure cycle. To ease short term stress on the real estate market, banks held onto foreclosed properties instead of releasing them. The majority of those properties have yet to flood the market. The government decided to offer a tax credit to new homebuyers which was the worst possible move. That incentive should have been given to buyers of foreclosed properties which would have produced a quicker turnaround towards a normalized market. But instead, we languish with the same old inventory problems. Until the foreclosure cycle is over, there can be no sustainable demand for new homes, there will be no construction jobs, and the economy will not be able to take the next leap forward. This industry is too big and too important. For additional analysis on this issue click on the following articles:

- D.R. Horton Tired of Tax Credits

- Negative Equity

- Housing’s Aborted Recovery

- The Foreclosure Crisis That Will Not Go Away

For the first time in over a year, investors are actually expecting the Federal Reserve to announce a plan of quantitative easing at their August 10th meeting. This hope is one of the underlying reasons why the market has been able to remain at the high end of its trading range. In each of the last three months the market has sold off as it approaches the monthly employment report but this time appears to be different. Back on July 8th we suggested that the market’s preeminent variable was now valuation as corporate profits had risen faster than stock prices, resulting in historically low P/E ratios across the board. Although we anticipate the market will eventually shift its focus to the U-shaped economic recovery caused by real estate, so far it has not. The variable of most importance remains the V-shaped profits recovery. As a result, the market is able to shake off every bit of negative economic news. The disconnect between the positive stock market action and the negative economic climate will continue as long as valuation remains the market mover.

We’re not ready to declare that this market has broken out of its 10% up/10% down trading pattern until we see a positive reaction to Friday’s employment report as well as a positive reaction to Tuesday’s Fed decision. These two catalysts present a major opportunity for sellers to regain control of the market. A weak employment report could cause investors to finally focus on the declining manufacturing, housing, consumer spending, and consumer sentiment data of the last two months. Failure of the Fed to introduce a plan of quantitative easing will produce disappointment. The risk of being fully invested for these two catalysts is too great in this kind of environment.

We remain content with current allocations that are strategically positioned for the trading range with 68% of the portfolio in cash. If the market reacts positively to these two catalysts then our allocation of Apple (NASDAQ:AAPL) 2012 LEAPS will take us as high as we're going to go. Additional long exposure is not prudent at this juncture. Until we see a sustainable recovery in housing this market looks destined to repeat the same trading range we have seen since October 2009. Buy at the low end, raise cash at the high end.

Disclosure: Long AAPL

Source: Foreclosure Cycle Creates Profitable Trading Range