Housing Bottom Should Signal Financials Rally

It is encouraging that major market indexes finished relatively flat in July. This is a vast improvement over the significant declines experienced in recent months. Perhaps investors received some comfort from easing oil prices. Oil prices hit record highs in early July, but in a sign that the bubble may be popping, they closed the month about $13 per barrel lower than in June. This is one reason why we turned bullish on Valero Energy (VLO). As explained in our newsletter (see article on Seeking Alpha tomorrow), the company’s profit margins will expand as long as oil prices fall faster than gasoline prices.

Because energy represents a major expense for consumers, an easing in energy prices is an extremely welcome occurrence. However, housing remains the 800-lb gorilla in the economy. Unfortunately, this gorilla is still struggling, and it will likely keep struggling well into 2009. However, there is finally some hope that there might be light at the end of this very dark tunnel. This hope comes from the most recent figures provided by the S&P/Case-Shiller indexes. According to this data, housing prices fell in May, which was no surprise. Furthermore, the year-over-year declines were the largest ever recorded. That continues to be the bad news. Yet the good news is that in six of the 20 major markets followed, year-over-year declines were actually smaller than they were in April. More importantly, while year-over-year housing prices are still falling at an accelerating rate overall, for the third month in a row, the change in the rate of acceleration declined. As I explained on my blog on July 6, this observation is a necessary requirement before we can have any confidence that price declines are beginning to moderate and eventually come to an end.

Of course, due to the housing crisis, financial stocks have been among the most battered. Almost all finance companies have been affected by the subprime mess. The widely followed financial sector ETF (XLF) is down about 25% year-to-date. Some individual stocks are down much more. Even Warren Buffett’s Berkshire Hathaway, which has significant exposure to the finance and insurance indus-tries, has not escaped the sell-off. That revered company is down about 20% year-to-date. These kinds of stocks will rally strongly only when investors become convinced that the housing crisis is over. Because a bottom in housing is still a long way off, it is still too early to plunge into these stocks. Yet as Forbes columnist David Dreman might put it, perhaps it is time to do some nibbling in this sector.

If energy and housing are two legs of the economic stool, the third is employment. Except for a suspect ADP report that showed an increase in July employment, there is not much good news here either. Initial jobless claims, for example, exceeded 400,000 two weeks in a row. Many economists consider this a critical level.

Downward revisions to GDP growth estimates were perhaps the most ominous sign for the economy. The Commerce Dept. reduced its estimates for overall GDP growth for 2005, 2006, and 2007. For the fourth quarter of 2007, it had previously estimated anemic growth of 0.6%. Now it says the economy actually contracted 0.2% that quar-ter. This suggests it may not be very long before the National Bureau of Economic Research declares an official recession.

Comments

[DaveW:]

If talking about buying financials I hope you bought at/near July 15th & 23rd lows. Look to sell in medium term and go long SKF into 2009. The prime ARMs are the next shoe...

2008 Aug 06 12:04 PM

[Don W:]

3 words. Annual cyclic variation. Summer months are always positive for the housing industry - as well as market indicators. Look at housing sales and market indexes as they fluctuate on a month by month versus previous years, and you will see that May/June/July/August are always climbing. This supposed "slowdown" of the market fall is nothing but a part of that yearly cyclic nature of these markets. The decline this year from 2007 is as big of a gap as 2007 was from 2006. Come October, the cycle will go the other way, and everything will turn down hard - based on both the cyclic nature as well as the slide from 2007 that we are still well entrenched in following through the elections in November.

Is it the nature of analysts and economists to be the first on the bandwagon of "the market is getting better now" - ignoring major trends and data that any decently studied person would bring up to deflate their opinions? How many times are we going to hear someone predict "we are close to the bottom", only to hear the latest hard and reality-based figures that show that the slide continues until the markets have contracted to the levels of sustainability that we had been well over-reaching for 5 years (corrected for nominal growth over 5 years, of course). Look at charts and data that shows nominal averaged growth figures, and they show that we have contracted 18% or so and still have another 9% to contract before we are in the region of where we should have been without the out-of-control financial excesses. Add to those figures that we are paying slightly higher than average per disposable income (dollar adjusted, of course) for energy, and we should be below that nominal growth estimate. Now that China is now slowing down as well, and this winter should prove to be the major world market recession clincher. Once we have caught back up to the re-adjusted indexes - about a year out from here (hopefully) - then we might start saying that we are bottoming out. Until then, don't believe any 'expert' who keeps trying to blow happy smoke.

2008 Aug 07 05:14 PM