Saturday, October 30, 2010

Studying The Herd

A topic that fascinates me as much as any other is the psychology of market participants.  I have read countless books on the subject such as "Irrational Exuberance" and "Manias, Panics, and Crashes" to try and understand what causes people to make the wrong investment decision all at once, all together.  It is known as the herd mentality.

For a sales representative, the herd mentality is your best friend.  Stock brokers selling stocks back in the late 1990's had no trouble convincing new clients to pour their retirement into the stock market.

Real estate agents found that same opportunity in the middle part of this decade.  I remember thinking I was the greatest sales representative in the country at one point because my community was sold out of lots and we would have a lottery every Saturday morning to see who was lucky enough to purchase.

This past week the sales representative for one of my father's IRA accounts called him and told him that he needed more exposure to bonds.  I would imagine that most financial reps are making the same calls all around the country.  Why?  Because investors are currently pouring their life savings into bond funds.  It is the easiest sale out there.

All three scenario's will end the same: disaster.

But why?  How is it possible that investors could get destroyed in stocks, killed in real estate only 5 years later, then get run over by the bond bubble today?

The answer will continue to be a constant focus of mine because I want to understand how to better convince people to not move with the herd, but away from it.  The following NY Times article discusses this theory:

Microscopic Microeconomics

It is interesting to note the author points out that the current bubble is in gold, while the unmentioned real bubble in bonds is staring them directly in the face.  Perhaps the bond bubble can be the focus of their next study.

Friday, October 29, 2010

The Complete Housing Analysis

Every month I provide an update on housing data as it is released to the marketplace.  What I would like to do here is provide a comprehensive outlook for where we are today looking at the total housing picture.  This will provide a benchmark we can build on as data is released in the future.

The following discussion will be broken down as follows:

1.  Basic Supply/Demand Economics
2.  The Current Housing Inventory
3.  The Shadow Housing Inventory
4.  The Total Housing Inventory
5.  Fraudclosure/MERS

The first lesson that we learn in economics is supply vs. demand vs. price.  I was never a fan of the sliding charts that they presented in economics classes (nor was I a fan of just about anything presented in traditional education).  I did better on exams just using common sense, such as:

If you increase the supply of something (the number of homes on your street for sale increases from 3 to 9) and  demand stays the same (the number of qualified buyers in the market looking to purchase a home) then prices will fall.  Simple right?

If the supply stays the same (the number of homes on your street for sale stays at 3) and demand falls (the number of qualified buyers in the market looking for a home decreases) then prices will fall.  Easy.

Alright, now let's look at it how economists and financial analysts do and add in their vocabulary.

The most recent housing sales data (for the month of September which was released on Oct 25th) showed that:

There were 4,040,000 existing homes for sale in September. (Supply)

Total home sales are currently at 377,500 per month. (Demand)

This means there are 10.7 months of inventory on the market.  This is how long it would take for all homes to sell if no additional homes were put on the market.

4,040,000 / 377,500 = 10.7 months

This number is an estimate to show the health of the market.  A strong market has 3 - 6 months of inventory.  A very weak market has above 8 months.

Our discussion so far has left out an important part of the total housing picture.  That is the shadow inventory, which you have probably heard much about on the news.  In order to determine the total months of inventory we need to add the shadow portion.  We will do that now, but before we get there, let's discuss the actual foreclosure process and how homes are labeled at each step along the way.

When a homeowner misses a mortgage payment the home becomes delinquent.  After a certain period of time the home will go into default.  Two things can happen here.  The bank can attempt to sell the home in a short sale meaning they will accept an offer from a buyer for less than the mortgage is worth, allowing them to not have to deal with formal foreclosure proceedings. 

The second option would be to formally foreclose on the property.  The bank will then attempt to sell the house at an auction, and if they do not receive the desired bid the property will become Real Estate Owned. (REO)  That means it sits on the bank's balance sheet as their property.  They will then put the home on the market with a realtor and it will look like any other home on your street for sale.

So we must analyze each portion of this process to determine total shadow inventory:

The easiest number to determine are homes in default, which according to Lender Processing Services, stood at 2,020,000 as of July. (Certainly higher now, but the numbers are released on delay)

Next up are the delinquent homeowners, which is more difficult to determine, but a very important piece of the total puzzle.  When looking at delinquent homeowners you need to estimate how many homeowners that enter delinquency that will end up in foreclosure.  (They will not bring their payments current)

In order to do this we look at the historical cure rate (homeowners paying to become current).  The following graph shows the percentage of homeowners who cure their mortgages when they are 30 days, 60 days, and 90 days late.  The numbers are incredible:

Loans 90 days late are almost certain to enter foreclosure.  This number is at 2,470,000 million.

Loans 60 days late are 95% certain to enter foreclosure.  This number is at 761,000, so 95% of that total would be 723,000.

Loans 30 days late are 70% certain to enter foreclosure.  This number is at 1,800,000, so 70% of that total would be 1.25 million.

(Data based on July number, certainly worse today)

The third category is the final stage of the foreclosure process; the REO's or bank owned properties.  This is most difficult of the three to determine.  These are the true "shadow" homes because they are currently on the bank's books but they are holding them off the market in attempt to stay solvent.  They are praying the housing market comes back.

Estimates from multiple sources that try to track this number range from 500,000 to 2,000,000.  I will take the absolute bottom at 500,000.

This now gives us total shadow inventory:

Deliquent (30, 60, 90 days): 4,443,000
Default: 2,470,000
REO (Held Off Market): 500,000

Total Shadow Inventory: 7,413,000

Total Current Inventory: 4,040,000

Total Inventory: 11,453,000

Current Sales Rate: 377,500 per month

Total Months Of Supply: 30.3 months

This number combines data from September (total current inventory) with data from July (total shadow inventory) so one would would rationally assume that a portion of July shadow has become part of the September current.  This is a correct assumption.

However, understand that the housing market, based on an endless amount of new data, has begun to turn downward since July and the size of the shadow market has most likely grown significantly since the July period.  This would offset the imbalance and perhaps means the situation is worse than what is presented above.

Finally, how does the recent fraudclosure disaster factor into this situation?

More of the homeowners that are diligently paying on their homes that are underwater are going to hear about people that went to the banks and demanded to see the title.  Many of these people will do the same, and many of them will then stop paying their mortgages.  This will add to the shadow inventory above.

The housing market cannot bottom until the inventory is allowed to clear through the market.  Supply must meet demand at free market prices.  The average rate a bank allows a homeowner to live payment free (in delinquency) to formal foreclosure is currently 469 days.  For Bank of America, our country's largest mortgage servicer, this number is over 700 days.

Summary:  The housing market based on fundamental supply and demand projects a picture of pricing collapse, not recovery.  This analysis has only factored in the supply side of the picture.  When looking at demand (unemployment, savings, wages, credit availability) the picture becomes far darker.

h/t Calculated Risk, Keith Jurow

Thursday, October 28, 2010

Angry America

Next weeks cover of The Economist.  We can only imagine what the cover will look like when the real crisis begins.

Wednesday, October 27, 2010

Silver Price Manipulation

Sat down and opened my computer tonight to the headline I've been waiting to see for 6 long years as a silver investor:

"JP Morgan and HSBC Sued For Silver Market Manipulation, Reaping Billions In Illegal Profits."

I've discussed this topic exhaustively over the past 3 years but here is a quick update:

Two large banks control close to 90% of the short interest in the silver market.  Shorting an asset means you sell it into the market with the plan to purchase it back in the future.  (If the price is lower you collect the difference)

The problem is that these two banks have sold short years worth of silver supply into the market without ever owning the asset.  All these "sales" have kept the price suppressed and at times taken down the price significantly. (Summer 2008)

The Commodities Futures Trading Commission has continued to turn a blind eye to the blatant manipulation.  However, yesterday the Financial Times rocked the silver market with this:

Bart Chilton, commissioner at the Commodity Futures Trading Commission, said "members of the public" and "publicly available documents" convinced him the silver markets are tainted by violations of federal commodities law.

"I do believe that there have been repeated attempts to influence prices in the silver markets," Mr Chilton said on Tuesday at a meeting in Washington. "There have been fraudulent efforts to persuade and what I consider deviously control that price."

Now the public is stepping in with lawsuits.  If these big banks are unable to illegally suppress the price downward moving forward, it will ultimately mean seemingly impossible upside price targets for the silver price.

Remember, we are in the early stages of a global currency crisis.  Plus there is the BIG kicker, which the public will discover when it begins to move into the silver market:

Above ground silver inventory is 3 times less than gold.

Huge victory for the often labeled "crazy silver conspiracy theorists" this week.  But the war is far from over, and there will be major price swings ahead.  Tonight though, we can smile and enjoy the silver war cry.

Tuesday, October 26, 2010

Consumer Confidence vs. Stocks

Very nice visual below that tracks consumer confidence (green line) with the stock market (blue line).  Our economy is based 70% on consumption, meaning it is based on Americans borrowing money to purchase goods.

In the summer of 2007 the American consumer died, declared bankruptcy, and threw up the white flag.  They were no longer capable of taking on additional debt to purchase goods.

However, even as the consumer confidence plunged to depression levels (and has stayed there since) the stock market bottomed in March of 2009 and has diverged from the confidence indicator.  You can see the green and blue lines separate below.
What happened?  Two very important things:

1.  The accounting rules were changed in March 2009 allowing banks to mark to myth.  They no longer were forced to take write downs on their toxic assets and mark them to market.

2.  The same month the Federal Reserve announced Quantitative Easing 1, which was the purchase of $1.75 trillion in mortgages and treasury bonds with printed dollars.

Since then, the market has been on a "sugar high" that the Fed hopes to sustain.  My guess is that the blue and green lines below are going to converge closer, and I do not feel it will be due to the consumer confidence (green line) rising.

Marc Faber On Bloomberg

Marc Faber speaks with Bloomberg on his current market outlook, including the importance of the Federal Reserve announcement on Quantitative Easing Part II on November 3rd. 

They will be announcing the amount of money they plan to print to purchase assets.  Faber feels that anything under $1 trillion will disappoint the market, which has already priced in massive printing in just about every asset class across the board.

He feels that it could be a "sell the news" event.  I agree completely.  Full interview below:

Home Prices Turn Back Down

This morning we received the October Case Shiller Home Price index.  The index works on a lag, so it has become a less effective tool to determine home prices.

The data is a 3 month average for June, July, and August.

Back in August I discussed that the price index would not turn down again until October due to the lag time in the report.  That is exactly what we saw this morning.

Prices have turned down month over month by .3%.  This was a major disappointment for the forecasts.

Once again looking forward, the number released in December should be a full on massacre, a merry Christmas present for any Americans still remaining that are paying on their mortgage.

Monday, October 25, 2010

Nassim Taleb: The Economist

Nassim Teleb, author of "The Black Swan," discusses the financial crisis and the dangers of debt. One of the greatest minds of our generation:

60 Minutes: The 99er's

Last night's opening segment on 60 minutes was a look at the unemployment situation in America; specifically the people rapidly approaching the expiration of the 99 weeks of unemployment benefits.

They spoke with residents from a city in California to get a snapshot of the unemployment situation in America as a whole. 

The video does not discuss why we are currently in an economic depression: We are in the early stages of the deleveraging process of a 30 year debt binge that burst in August of 2007. 

In a normal environment the debt is liquidated as the economy restructures itself to become more competitive in the global environment.  (More focused on exports and manufacturing)

Our leaders have taken the exact opposite approach.  They have decided to allow no inefficient companies to fail and have not allowed the toxic debt to be purged from the system.  To cleanse itself.

Instead they have decided to create spending programs with additional borrowed debt, and the Federal Reserve has decided to purchase the toxic debt with printed currency.

This means that our economic depression is not in the latter stages; it has not even begun.  The final outcome will be a hyperinflationary depression and the collapse of our currency.

There will still be no jobs available during this period, only the cost of living will skyrocket.  It will be a period of civil unrest and will most likely take our country to war as our leaders view this as the only economic solution.

History repeats.  Rinses, then repeats.

This final outcome can still be averted but neither a Republican or Democratic win will change things this fall.  Both parties are fully focused on the most destructive outcome possible.

Full 60 minutes clip below:

Sunday, October 24, 2010

Niall Ferguson: Stimulus

Flash Crash In American Dollar

This weekend the legend Art Cashin, director of stock market floor operations for UBS, spoke with Eric King.  Art discussed his memories of the 1987 stock market crash and how it relates to the markets today.  For those that do not remember, in the 1987 crash the stock market dropped over 508 points in a single day, which was a 22% drop at the time.

The equivalent would be for the stock market to drop by 2200 points on Monday.

This was, and still is, the most exciting moment in stock market history.  Here are my top 4:

1. 1987 Crash
2. September 2008 (The week Lehman failed and AIG was saved)
3. October 1929 crash
4. May 6, 2010 flash crash

I've read so much about numbers 1 and 3 that I feel like I was there.  The last two I was fortunate enough to live through as a market participant.

But I digress.  The important part of the discussion was how easily the markets could replicate the 1987 crash today.  Art commented that the markets currently trade in such a uniform manner (dollar down and everything else up, and vice versa) that there is a tremendous danger should there be a event causing a rush toward dollars.

A flash crash, if you will.  Many participants feel that this could never occur in the currency markets because of the sheer size of the market.

That was until this past Friday afternoon after the markets closed.  The DXY, which is the index that tracks the dollar against a basket of currencies, experienced a flash crash.  If this occurred during the actual trading hours when the high frequency trading computers were still turned on, it would have triggered mass chaos in the market.

This is the exact same situation that Art Cashin discussed before this event occurred on Friday evening.  I believe this event is coming again, only it will be in much larger fashion.

This means that investors need to have "dry powder" available at all times to take advantage of a market dislocation.

For example, if the dollar spiked higher due to a currency flash crash, the following assets would sell off in a violent manner:

Gold, Silver, Oil, Agriculture, Canadian dollar, Australian dollar, Asian and Brazilian currencies.

If any of those look attractive to you, (and they should) make sure you have dry powder available.

Here is the snapshot of Friday afternoon's flash crash in the DXY.  It looks horrifying, unless you are prepared for it: