It's Friday, and Chris "Just the Facts" Kimble returns for a cameo Dragnet impersonation, this time with a provocative four-pack of technical clues for solving the mystery of the market.
Joe Friday: Something for people to chew on over the weekend. The Euro up against resistance and a rising wedge has formed. The Dollar rallied today, pressing on the top of a falling channel. The VIX created a huge bullish wick. The Nasdaq 100 created a bearish wick up against resistance.
In the five months since, house prices have resumed their decline.
In his most recent research note, Gary sticks by his "20%" decline prediction. We've included a summary and updated charts from his argument below.
(Gary is offering a special discount on his research service for Business Insider readers. To learn more, please visit Gary's web site or call 1-888-346-7444. Please mention Business Insider.)
Housing: Great Expectations vs. Reality
Last spring, many believed that not only was the housing collapse over but that a robust rebound was underway. Investors were crowding into foreclosed house sales and bidding up prices in California, often the bellwether state for new trends.
The tax credit of up to $8,000 for new homebuyers that expired in April spurred buyers and promised to kick-start housing activity nationwide. TheHomeAffordable Modification Program was trumpeted by the Administration to help 3 million to 4 million homeowners with underwater mortgages by paying lenders to reduce monthly payments to manageable size and then paying homeowners to continue to make those payments.
But then a funny—or not so funny—thing happened on the way to housing recovery...
Also, with almost a quarter of all homeowners with mortgages under water with their mortgage principals exceeding the value of their houses, many can’t sell their existing abodes even if they wanted to buy other houses.
He goes on to observe that 30-day delinquencies are linked to initial claims for unemployment insurance, which fell last year but subsequently leveled off and are now rising (Chart 15). Also, the delinquencies are rising as weak borrowers with modified loans again miss payments. Fitch Rating believes that 65% to 75% of mortgages modified under HAMP will redefault within 12 months.
Existing home sales subsequently fell to a new low, so the tax credits had only “borrowed” sales from future months with no lasting impact.
Notice that, over time, new and existing inventories listed for sale have averaged about 2.5 million. So, we reason, that’s the normal working inventory level and anything over and above 2.5 million is excess.
At the peak of 5 million reached in October 2007, that excess was 2.5 million. It subsequently fell but with the recent jump, the total is 4.0 million, implying excess inventories of 1.5 million.
That’s a lot considering the average annual build of 1.5 million houses. So the inventories over and above normal working levels equals one year's average demand. But wait! There’s more!
As noted earlier, as foreclosures pick up with the ending of the mortgage modification-related moratorium on lender takeovers, “shadow” inventory will become visible as many of those bereaved of their abodes join friends and family.
Furthermore, if we take the Total Housing Inventory numbers published by the Census Bureau at face value—and Tom Lawler, a very careful housing analyst concludes that it takes more than the faith of a mustard seed to do so—there are a lot ofhousing units that are likely to be listed for sale as owners give up trying to wait out the housing bust.
Recently, my wife told me of a friend who finally listed her house for sale right after Labor Day and got nary a nibble in the following three weeks. Then she was further discouraged when two other similar houses in her neighborhood were listed.
But while mortgage modifications were attempted, lenders and servicers were basically forced by the government to suspend foreclosures. Now, as that program unwinds, foreclosures will again jump (Chart 12). Ironically, foreclosure rates have moderated recently because lenders tightened their standards in mid-2008 when housing and mortgages were in free fall. In 2009, two-thirds of all FHA- guaranteed new loans were to borrowers with credit scores over 660, up from 45% in 2008.
Nevertheless, lenders have been loosening in recent months. In January, Fannie initiated a program that allows first-time homebuyers to put down $1,000 or 1% of the purchase price, whichever is greater. In the first half of this year, credit card companies sent out 84.8 million offers to American subprime borrowers, up from 43.7 million a year earlier. In the second quarter of this year, 8% of new car oans were to borrowers with the lowest rank of credit scores, up from 6.2% in the fourth quarter of 2009.
Of that total, 1.1 million were added to the pool of vacant units listed for rent or sale, 2.8 million were occupied by new households and so on down the list. Of the 1.3 million increase in those Held Offthe Market, the 1.1 million rise in the “Other” category is the one of interest. This component has leaped from the earlier norm of about 2.6 million to 3.7 million in the second quarter (Chart 25).
This rapid rise, coinciding with the collapse in housing, suggests strongly that many of these houses are indeed shadow inventory, units withheld in hopes ofhigher prices but highly likely to emerge from the woodwork sooner or later.
If we assume that half the 1.1 million increase since the housing peak in the first quarter o f2006 are shadow inventory, the total excess jumps from 1.5 million to 2 million at present, and is likely to rise further.
But note that those trendless series are extremely volatile, ranging from a peak of almost 2.3 million at annual rates in the current cycle to less than 500,000 recently. Household formation is similarly volatile, not surprising since a household is defined as one or more people living in a separate dwelling unit and not in jail, college, an institution or an army barracks. So household formation is affected by the lust for house appreciation, income growth, employment prospects, family size, mortgage availability and all the other factors that determine the desirability of owning or renting.
No wonder that the homeowner rate, which spurted from its 64% norm to 69%, is now back to 66.9% in the second quarter and probably on its way back to 64% (Chart 18).
The Census Bureau reports that in the last two years, multi-family households jumped 11.6% ( Chart 22) while total households rose a mere 0.6%. Those aged 25-34 living with parents—many of them “boomerang kids” who have returned home—increased by 8.4% to 5.5 million. Not surprising, 43% of those were below the poverty line of $11,161 for an individual.
Who wants to buy an expensive asset with a big mortgage that may be worth much less shortly? And the financial leverage created by a mortgage magnifies the risk tremendously. Someone who buys a house with 5% down sees their equity wiped out if the price falls only 5%. So the fall in house prices and mortgage rates, which have driven up the NAR’s measure of affordability, have been offset by stronger forces.
So, too, will any future increases in the affordability index in all likelihood. The Fed may embark on further purchases of mortgage securities, which could reduce mortgage rates further, but the central bank will probably only act in response to additional economic weakness that will discourage homebuyers. The further declines in house prices we foresee will make them cheaper, but also convinces prospective owners that they are even worse investments.
The rebound in house prices is also suspect and may have peaked out (see chart above). Furthermore, both the previous decline and subsequent reversal probably overstate reality. Earlier, the many sales of foreclosed houses or by distressed homeowners tended to be lower-priced houses and, therefore, depressed average prices. The recent swoon in Los Angeles house prices compared with the early 1990s drop suggests this is true. Conversely, the recent rebound may be overstating reality since, as our good friend and great housing analyst Tom Lawler has noted, the homebuyer tax credit may have induced some to pay up to beat the deadline and to favor higher priced “traditional” house sales over “distressed” homes.
Tom also points out that the Case- Shiller price index for July, which showed increases in 13 of the 20 metro areas (not seasonally adjusted), was based on transactions from April to June and, therefore, included tax credit- related settlements in May and June. Also, seasonally-adjusted data reveals declines in 16 of 20 metro areas and a small 0.1% fall from June to July. Another Home Value Index compiled by Zillow reports that prices nationwide fell in July from June, the 49th consecutive monthly fall. That puts them down 24% from the May-June 2006 peak, similar to the 28% drop in the Case-Shiller index.
This may sound like a lot, but it would return single-family house prices, corrected for general inflation and also for the tendency of houses to increase in size over time, back to the flat trend that has held since 1890 ( Chart 26).
We are strong believers in reversions to the mean, especially when it has held for over a century and through so many huge changes in the economy in those years—two world wars and the 1930s Depression, the leap in government regulation and involvement in the economy, the economic transformation from an agricultural base to manufacturing and then to services, the post- World War II population shift from cities to suburbs, the western and southern transfer of population and economic strength, the movement from renting to homeownership and the accompanying spreading of mortgage financing, etc.
Furthermore, our forecast of another 20% fall in house prices may be conservative. Prices may well end up back on their long- term trendline (Chart 26), but fall below in the meanwhile. Just as they way overshot the trend on the way up, they may do so on the way down, as is often the case in cycles. Furthermore, another big house price decline will spike delinquencies and foreclosures leading to more REO sales by lenders,whichwillfurtherdepress prices. Our analysis indicates that a further 20% drop in prices will push the number of homeowners who are under water from 23% to 40%, resulting in more strategic defaults, more REO, etc.
In California, epicenter ofthe housing boom-bust, construction jobs dropped 43% from June 2006 to June of this year, compared to a 28% decline nationwide, and the unemployment rate in the Golden State jumped to 12.3% in June, far above the 9.5% rate nationally.
Source: Briefing.com
8. ECRI leading indicators composite - possible negative divergence in the weekly leading index but no divergence in the weekly leading index growth rate:
Source both : Shortsideoflong blogspot
9. OECD leading indicators - this data looks out to around July time and there are concerns only for China, India and the PIIGS. Japan, Germany, US and Russia are particularly strong:
Source: OECD
10. Money Supply - growth is positive and strong, whilst the money multiplier which is weak and weakening. This means the banks aren't lending. However, if the ratio was over 1 then the strong money supply growth would likely translate into major inflation. A watch item:
Source: St Louis Fed
11. Stock Market returns - the bull trend remains in place and is therefore forecasting positive
12. Manufacturing data - particularly strong
13. Consumer sentiment/expectations - weak of late
14. Yield curve probability of recession - very low likelihood of imminent recession
15. Ciovacco Bull Market Sustainability Index - positive from 2 months to 1 year out
16. Bloomberg Financial Conditions Index - moved back into positive territory
In summary, leading indicators are overall positive and strong, both in the US and globally, but with the following concerns or watch items: potential ECRI divergence, M1 multiplier, US consumer sentiment/expectations, China and India.
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Let's now turn to Known Issues and Tipping points, and, again, I'll not dwell on the former but focus on the latter:
In relation to point 17, the charts below reveal the threat to stocks that oil over $105 and rising may represent. This is also reflected in research by Bespoke, revealing the negative historical impact on stocks of a period of strongly rising oil prices.
Source: PFS Group
In summary, the oil price represents the biggest current threat to stock market performance and the economy, with watch items of global inflation, the US dollar and Chinese leading indicators.
John Hampson
The silver sector's momentum has taken on a life of its own now, and almost is in a mini-parabolic move higher. A parabolic move is when the rate of change higher begins to accelerate rapidly. It then starts to go higher so much faster that the uptrend becomes unstable and leads to an eventual crash.We don’t believe this is the final move higher for silver, and it is not the end of its bull market; however, you have to tread much more carefully in this kind of market. We really hoped this wouldn’t have happened so fast, but greed and human nature are hard to change. We saw this coming as the March option expiration was arriving, as that is when there is maximum pressure on those who are short silver. We'll have to wait to see what happens with physical silver and the silver miners, but in the meantime there is one stock in the sector that still offers value that we are overweighting at 20% of our silver model portfolio.
The stock that used to be a leader in the sector and was considered a blue chip but suffered recently fundamentally so it has been left behind during the monster rally in the silver mining sector. Pan American Silver (PAAS) is one of the largest primary silver producers, deriving about 66% of revenue from silver and 13% from gold.
It is one of the most diversified silver miners, with mines in Mexico, Peru, Bolivia and Argentina. Pan America has had a history of consistent reserve and production growth for 15 years until this year. About one month ago, it announced its production would fall from 24.3 million ounces in 2010 of silver this year to 23-24 million for 2011, due to reduced percentages derived per ton of ore. That combined with the fact that some new projects have run into some roadblocks and a weak earnings report, and the stock sold off about 5%. It then surged higher along with all silver stocks, but fell back again and is now 11.7% off its 52-week high of $42.33.
We like to use enterprise value divided by revenue as our main valuation criteria. In this case, we estimate PAAS will gross about $840 million in 2011 revenue. With an enterprise value (market cap + net debt - cash) of $3.7 billion, the stock trades at about 4.4 times revenue. We think the stock's fair value right now should be valued at 5.0 times revenue or 13.5% higher at $42.50. With $330 million in cash in excess of its debt, PAAS has the cash necessary to keep investing in its future projects to grow.
The reason for this discount in the stock price is its lack of growth in the next couple of years in annual silver production. However, with the price of silver rising so strongly, we think the revenue and earnings gains alone will be enough to drive the stock higher over the next 12-18 months. We estimate PAAS will earn about $2.30 in 2011, so the stock is trading at 16.3 times this year’s earnings, a slight premium to the market's average 15 price to earnings ratio. We think its earnings will soar to $2.80 in 2012, which means it is trading at 13.4 times 2012 earnings or just an average market multiple -- an average market multiple for a company whose rising price of silver will drive much higher percentage gains in profits.
There is one huge difference, though, with Pan American Silver than the other stocks in the sector: You pay an average enterprise value and price to earnings valuation for a very good large, geographically diverse silver producer. However, you also get a very large potential future project for free. It recently purchased for $585 million the La Navidad project in Argentina. This is a very large new discovery and the economics of it would make it very, very profitable. This project is projected to be able to produce 19.5 million ounces of silver annually versus current production of 24 million ounces, so it could increase its production 81% in the next three to five years.
There is one big problem with the project, though: It is slated to be an open-pit mine; currently, in this province, open-pit mining's not legal. Pan American claims it thinks the government will write a new mining bill allowing it to go forward. We agree that the project will go forward, but that kind of uncertainty is the main reason the potential value of this future growth is not built into the price of the stock.
Over the next three to five years, if this project went forward, it could be enough to drive the stock price 30-50% higher for long-term investors. However, if it was denied, it could knock the price of the stock down temporarily as it would demonstrate PAAS threw away a large chunk of shareholder value pursuing an impossible project. Since you’re not paying that much for the potential of the project already built into the current stock price, we like the potential reward versus risk in this situation.
The bottom line is, in the silver mining sector -- where it has become much more difficult to find value -- Pan American Silver’s valuation trades at about a 14% discount to our estimate of its current operations. Then it has a very large future project that, if it goes as planned, could add about 40% in value to the stock over the next three to five years.
When you combine the current discount and the future potential, Pan American Silver is the last bargain in the silver mining sector. At the end of 2010, it was reported that George Soros had taken a very small position in Pan American Silver. We suspect he added to his position this quarter, and we think investors are attracted by the big future potential at a reasonable price, along with the developing strength of silver prices.
Disclosure: I am long PAAS.
