Prior to last Thursday's sizable setback, the stock market was engaged in a rather spirited rally off of its July 15 bottom. The S&P 500 had gained 7% in seven trading sessions, and bank stock indexes had soared in excess of 40% from their panic lows. Falling oil prices (crude oil has retreated 15% from its July 11 peak at $147/barrel) contributed to the atmosphere of relief.
Fittingly (since many of our current problems are traceable to the unwinding of the housing bubble), Thursday's gloomy report on June home sales from the National Association of Realtors provided the market a reality check and knocked the major averages back a couple of percent while slamming bank stocks with nearly a 10% loss on the day.
The NAR reported a larger-than-expected drop in sales of existing homes in June to a 10-year low. Combined new and existing home sales volume is down nearly 40% from its July 2005 peak. Meanwhile, an unprecedented total supply of 4.9 million homes (new and existing) sits on the market awaiting buyers. Clearly, all talk of a bottom in housing is premature as long as we continue to see the inventory of unsold homes hitting new record highs. There will be no reversal in home price trends until the inventory of homes gets reduced.
While the inventory overhang is the single greatest cause of house price deflation, tight mortgage credit is adding to the downward pressure on the housing market. Freddie Mac's posted 30-year fixed mortgage rates spiked 37 basis points last week to an 11-month high of 6.63%, reflecting record high yield spreads (i.e. 180 basis points) on government-backed mortgage securities. The "private label" (non-government backed) mortgage-backed securities market is virtually non-existent at present.
Until we see a light at the end of the tunnel for home prices, the risks to the economy and the financial sector remain skewed to the downside. Indeed, partly as a result of the weak housing market, the index of leading economic indicators we track from the Economic Cycle Research Institute [ECRI] had fallen to a five year low, prompting ECRI to comment that "a business cycle recovery is no where in sight." We will know when home prices have dropped enough so that the inventory of unsold homes begins to come down. Clearly, we have not reached that point.
Congress passed its latest emergency housing bill over the weekend in an effort to arrest the current self-feeding cycle of falling house prices, rising foreclosures, and escalating losses on mortgage loans. The most significant provisions of this latest government effort are (1) authorization for the Federal Housing Administration [FHA] to refinance up to $300 billion of troubled mortgages and (2) formal authorization of the previously announced bail-out of Fannie Mae and Freddie Mac. To accommodate this and other forms of deficit spending, Congress raised the government's debt ceiling by $800 billion.
Of course, the government's various relief efforts over the course of this credit and housing crisis have one thing in common - they represent a transfer of credit risks and losses to the U.S. taxpayer, and they ultimately weaken the credit and currency of the U.S. government. It is impossible to measure today the ultimate cost of this latest housing bill, because it will depend on the ultimate scope of mortgage credit losses, but it seems safe to conclude that the tab will reach into the hundreds of billions of dollars.
Turning back to the stock market, the odds seem to favor a continuation of the bear market rally that began mid-month. Sentiment indicators also support a further rebound in prices in the short term. Typically, bear market rallies retrace anywhere from one-third and two-thirds of the prior leg down in prices. In this instance, the prior decline from mid-May to mid-July was 240 points on the S&P 500, which fell from 1440 to 1200. A one-third retracement of this decline would be 80 S&P points, and would project 1280, a target we already reached prior to last week's setback. A two-thirds retracement would be 160 S&P points, which could take the S&P 500 back up to 1360, approximately 100 points above the current price level. We do not suggest that longer-term investors attempt to play this potential rebound. Bear markets have a way of reversing suddenly, and who knows when the next shoes will start dropping to restart the downward momentum. Until much more evidence develops to suggest otherwise, our assumption remains that the bear market is not over and that a lower risk buying opportunity still lies in the future.