Real Estate and Financials: Sell the Rally

I have to admit that I wasn’t expecting the real estate and financial sectors to hold up as well as they have over the past few months. My ultra-short positions (UltraShort Real Estate ProShares (SRS) and UltraShort Financials ProShares (SKF)) have taken a beating, and readers have been emailing and asking what gives. How can these sectors be stabilizing and advancing amidst the flurry of bad news? Here is a quote from an Associated Press article detailing the phenomenon:

Housing stocks rose across the board Thursday, defying a bevy of industry and corporate data that showed the housing market continued to erode in the first part of the year.

Most major builders added at least two percent in midday trading. Lennar Corp. led the gainers with a 6 percent jump to $17.99. D.R. Horton Inc. and KB Homes each added 2 percent. The gains came on a day when the Commerce Department reported that sales of new homes plunged in March to the lowest level in 16 1/2 years — right in time for the start of the spring sales season.

The median price of a home sold in March dropped 13.3 percent compared with March 2007, the biggest year-over-year price decline since a 14.6 percent plunge in July 1970.

Here we witness major home-builders advancing on a day when the statistics show the worst year-on-year price decline in nearly 40 years! And we have witnessed similar trends in the financial sector, where weekly news of massive write-downs, bailouts and bankruptcies are met with sideways training and gains in some cases. Are investors really so optimistic to think that the worst of the crisis is behind us?

In financial news last week, Washington Mutual (WM) reported earnings that were some 35 cents below consensus expectations. The Seattle-based thrift lost $1.40 per share, compared with a profit of $784 million, or 86 cents per share, in the first quarter of 2007. This is a huge miss and a massive decline in earnings for such a large bank. Yet, WaMu stock is up nearly 22% since reporting the news. But this really can’t last and even Morgan Stanley (MS) sees big bank woes just beginning.

NEW YORK (Reuters) - Morgan Stanley analysts on Monday told clients to “sell the rally” in financial stocks, slashing forecasts for big bank earnings and warning that the current credit crunch is only just beginning.

In aggregate, Morgan Stanley reduced its estimates for 2008 large bank earnings by $17 billion, or 26 percent, and reduced 2009 forecasts by $13 billion, or 15 percent. The analysts expect higher loan losses and expenses, offset by higher net interest income, though profits could fall further still if the Federal Reserve stops lowering interest rates.

"More capital hikes and dividend cuts (are) coming as our credit deteriorates and forward earnings decline,” analysts led by Betsy Graseck wrote in a report. “We think we are only in the third inning of the credit cycle and expect this credit cycle will be worse than (the slump in) 1990-91."

I know that markets are swayed by sentiment and can act irrational from time to time. But sanity typically prevails as excess moves in any direction are brought back to some reasonable level of equilibrium. And with that, here is a look at what could be a tremendous trading opportunity unfolding. Both the Real Estate and Financial UltraShort ETFs are way oversold and both of their charts are showing a falling wedge pattern.

Falling wedge patterns are typically very bullish as they are generally resolved to the upside. Volume expansion helps to confirm that the falling wedge is a reversal pattern and the widest portion of the wedge may be added to the breakout level to determine the upside move which follows. If we use the widest portion of the wedge, we could forecast an upward move of about 40% for both of these ETFs. That is some explosive upside potential that could net very hefty profits in a very short time period.

The falling wedge pattern is easily identifiable in the SKF chart below. We also see the 200-day moving average just about to meet the current stock price and provide support for the anticipated move up. Stochastics are oversold and look ready to turn up.

The UltraShort Real Estate ETF is also showing a falling wedge pattern and oversold stochastics. However, the recent crossing of the 50-day moving average down through the 200-day moving average provides mixed signals. If SRS can bounce off 80 with conviction, we could see it quickly move back above 100.

Keep in mind that volume is an essential ingredient to confirm a falling wedge breakout. Without an expansion of volume, the breakout will lack conviction and be vulnerable to failure. Technical analysis should never be used in isolation, but we are now at a point where both the fundamentals and technicals are pointing toward lower prices in the financial and real estate sectors and much higher prices for the UltraShort ETFs discussed within. Traders would be wise to wait for confirmations and set tight stops to avoid any potential head fakes. But if things unfold as expected, the profits will be well worth the wait.

Comments

[fullofhope:]

I cannot see hoe TA can be applied to SKF. Unlike shares in a company, the value of SKF depends on the inverse of a basket of shares in the financial sector. Whether demand for SKF is small or large, their value is determined elsewhere. Not like normal shares, where price moves in response to demand or the lack of it.

2008 Apr 30 08:26 AM

[dcxavier:]

In John Mauldin's most recent newsletter, he points out that new home sales are running at an annual rate of 526K. Meanwhile, housing starts are at 947K/year and permits are at 927K/year. Now, what do you think will happen to home builders?

2008 Apr 30 09:02 AM

[HardHead:]

Don't put your faith in TA alone. If you follow Apple as an example when its 50dma crossed the 200dma... a classic sell at ~$120 and one month later it is ~$175. The financials were beaten into the dirt as Apple due to "PANIC Selling" - In todays market if you trade on TA alone kiss your money GOODBYE!

As SKF drops it would be wise to add a little on 3% drops... Until you see a change in housing :)

HH

2008 Apr 30 09:11 AM

[User 62451:]

I do not have a high opinion about this article. Rather than referring to Morgan Stanley comment and technical analysis, one would expect more profound arguments. Looks to me more like making an excuse for the poor estimate in the first place

2008 Apr 30 09:12 AM

[kfk:]

This approach is a sure path to bankruptcy

2008 Apr 30 10:31 AM

[darcydancer:]

Look at XHB-homebuilders-50 day ma looking to cross 200 day ma with flat rsi and stochastics. This isn't a clear case for being short real estate.

2008 Apr 30 11:07 AM

[sumosama:]

AND SKF does it with 2X leverage to the downside, so TA would not apply...not that I believe in TA in any case.

2008 Apr 30 11:35 AM

[Adam Axler:]

Not a fan of TA, but think the argument is correct. Homebuilders have had a huge run on unfounded optimism, unless you include Bill Miller's call, who has been getting pounded for 2 years now and is trying to cover himself. RealtTrac estimates that 40% of homes on the market will soon be bank owned. How can a homebuilder sell against that environment? I think we'll also continue to see writedowns of impaired land. Look at Centex's recent sale at $.18/dollar of initial purchase and 1/3 the value listed on their books.

2008 Apr 30 12:37 PM

[gianluca:]

I am bearish on the market. I just think the recent strenght is due to over-optimistic expectations about the economy recovering H208. I think the recent actions from the Fed has sedated a little bit the most evindent effects of the recent credit squeeze, but soon we will probably be the ripple effect on the broader economy. I might be wrong, but it just doesn't look right to have a strong equity market in such difficult times... time will tell

2008 Apr 30 01:03 PM

[deefree:]

how about banks like SNV and BBT that have huge exposure to construction financing? how about bank like STI with $15 billion in home equity loans out of $122 billion in total loans, almost all in GA and FL the hardest hit markets outside of CA and NV? all have traded back up? May be another leg down once the earning season has ended and analysts realize that Visa profits and selling other assets are short term solutions in a longer winding recession.

2008 Apr 30 01:09 PM

[Lockstep In...:]

To everyone who is throwing stones at TA...

What gives? TA is applied to the DIA and SPY all the time by the biggest guns, so why should it be any different for SKF? I am sure TA is applied to XLF, so 2x the inverse should demonstrate the same derivative patterns.

In any case, I am SKF just as the author. I just think the market is being irrational in the face of the facts and I am ok with that. That is the game.

2008 Apr 30 03:40 PM

[Joe:]

Jason is surely right in his assessments and expectations. As for the
rather irrational behavior of the market; this has happened before,
in fall for instance and again early this year. At first problematic
stock went up, contrary to sound analysis - only to come down
a while later.
In other words, there might be some absolutely irrational players
in the market, real big losers, the bigger fools. What Jason is
musing about will get clearer only some not so distant future.
Breathtaking, time and again, are those losses run up by the
bigger fools. One explanation might be people in whatever position
addicted to wishful rather than rational analysis.
Some portfolio managers, banks managing portfolios, etc. have
lost big time and obviously continue to lose, behaving like
addicted gamblers. Don't forget opinion makers in the media,
internationally, telling their audience to do this or that, and actually gradually masterminded them into serious losses. Of course, opinion does not have any supra-natural power and is time and again over-
powered by the famous gang of facts.
Suggested case study: the role of the media in the 1929 crash,
as an extreme and easy example. Those who arrange the all too
obvious media frenzy, (time and again).

2008 Apr 30 03:48 PM

[karchad:]

This is the type of article that bottoms are made of. I'm buying homebuilders since 1/2/08, and am gradually accumulating financials. I'm up on both. This guy, when the stuff is up 200%, will tell the public that finally, it's the time to buy.

2008 May 01 02:36 PM

[karchad:]

My definition of technical analysis is this: a mathematical system that has 100% accuracy in determining when to buy and sell ----- 6-12 months after that time has passed.

2008 May 01 02:38 PM

[DJS:]

I generally agree with the author's view. I am long both SRS and SKF after building these positions over the past 2 days. I think these positions will work in the near term. Technical analysis is useful to support the obvious fundamentals.

It is difficult for even an astute investor to "call the bottom" of this market given the complexities of the problems. I happen to think it's way too early to do so. Too many long-only fund managers are anxious to declare the Bear Stearns firesale event as the "bottom" and predict a second half rally. I just don't see it. What has changed? Sure financials have done a bit better with the Fed propping them up, but that cannot last forever. The main profit drivers of investment and commercial banks have dried up. They don't have capital to lend to corporations (or to PE shops to fund M&A), M&A and underwriting fees are down, and the securitization business is dead. So how are the banks going to increase profits in the second half? Moreover, the banks are overleveraged and continuing to take losses on their loan portfolios. They are lending PE shops money to purchase buyout debt at discount rates and raising more capital by selling preferred shares at over 8%? That's junk bond territory! Look at the dilution shareholders in the financials are experiencing!

There is no good news anywhere in the real estate sector, and I do not believe that we will see a true bottom until one or more homebuilders go bankrupt.

As for the recent rally in both financials and real estate? I believe it is a total head fake. Many want to believe that the worst is behind us. If enough investors believe that this is true, then stocks can rally in the short-term, but it's just a self-fulfilling fantasy. The more financials and real estate rise now, the harder they will fall later.

2008 May 02 12:03 PM

[User 187476:]

SKF smashed down through the 200 day moving average yesterday, and continued down this morning before recovering somewhat. If this is all a head fake, it is a very convincing one so far.

2008 May 02 02:56 PM

[steve west:]

ZZZZZZZZZZZZZZZZZZZZZZ...

2008 May 05 05:02 PM

[Bob'29:]

SRS moved forcefully to the upside today May 7 to close at 85.78, a 5.45% gain today. If we look at a longer time frame, we see that it began its climb to highs from 80 or about where it touched today at its low before starting to climbing again. It is very reasonable that it will go to 100 as this is the 50% retracement from its recent high of 120 to its new low of 80. Nice article Jason.

2008 May 08 12:00 AM

[carey_jim:]

Not to say the obvious but human nature is not rational and the markets reflect human nature.
If markets behaved in ways that were completely predictable there would be no need for markets.
Nature is just as irrational. Not only do we have to contend with greed and fear but hurricanes, wars and diseases.
America has grown and prospered since the end of World War II. The perception that America will be prosperous with minor corrections into the foreseeable future is not going to change over night. "Prosperity is just around the corner" was one of the mantras of the 1930's depression. But it wasn't and maybe it isn't.

2008 May 09 12:04 AM