More On Oil, Foreclosures And Financials

Overseas markets sold off on Friday, and US futures look quite weak in the premarket. Let’s take a look at the SPY (SPY) chart to consider possible near term market action.

Yesterday’s (Thursday) selling was not particularly heavy, and we have considerable support below the current level. If we gap down to anywhere near 83.50, I will be covering shorts and watching for the next move. I think the market would be inclined to bounce from that level. On the other hand, should SPY sink below 82.10, it would be time to re-enter shorts.

Looking at NYMO, we are still overbought in the short term, although a decent gap down could relieve those conditions:

With respect to sentiment, the Bullish Percent Index for S&P 500 (^GSPC) is quite high. The Ticker Sense Poll puts blogger sentiment at 66.67% bullish, also on the high side. I usually take this to be a contrary indicator.

All thing considered, sideways trading appears to be most likely in the near term. I am focused on bullish trades in commodities and emerging markets, and bearish trades in consumer and financial sectors.

If we get a big gap down, my short watchlist will need some adjustment, but here it is for now: HXM, STC, CXW, AKR, EAT, SONC, CEC, CBRL, CPKI, BJRI, DRI, FHN, STT, CTRN, PSS, JNY, SHLD, RSH, BBY, HD, COH, and DFS. I am currently holding puts in the following: IYR, JCG, GE, MET, NLY, PFCB, JPM, AN, RE, KEY, PSS, JOSB, MTH, PNC, XLF, AXP, and DFS. Again, I will take some profits on a gap down this morning, but plan to keep most of them in anticipation of a big drop before the end of January. I think most of these stocks have seen their highs for the foreseeable future.

On the long side, US Oil Fund ETF (USO) is coming off the lows with very high volume, and has broken its downtrend line. While oil gave up some of its early gains toward the end of the day, it remained reasonably strong in the face of a general market selloff. If we see a rally, I would expect oil to lead.

Also note that the US dollar ETF made a very bearish move yesterday:

In related articles, energy economist Philip Verleger says that OPEC will need to reduce production by 7.7 million barrels a day, or reduced demand will continue to drive the price down.

“The implication, then is that OPEC countries need to reduce quotas not by one million or two million barrels per day, but rather by six or seven million barrels,” Verleger says in his report. “Since cuts of such magnitude are out of the question, one should expect prices to come under further downward pressure.”

This type of cut is not going to happen. At the same time, market speculation can drive prices considerably higher in the short term. A large number of people believe oil is oversold, and should see higher prices, regardless of fundamentals. Bespoke Investment Group cites a Bloomberg poll of oil analysts, and makes note of the following:

As shown, the median estimate for the end of this quarter remains at $66, which is more than $20 above the current price of oil. Good luck with that one! For the end of the first quarter, analysts are collectively looking for a price of $64. By the end of Q3 ‘09, analysts expect oil to be at $71.5. Expectations are for $83 by the end of 2010, $100 by the end of 2011, and $95 by the end of 2012. Based on these estimates, analysts aren’t expecting the speculative high of $145 to be reached at any time over the next four years, but they are expecting a considerable rebound.

In summary, I will be looking for a decent bounce in oil prices here, but will not necessarily expect prices to continue higher indefinitely.

Looking at emerging markets charts, the ETFs for China, Russia, and Brazil all look intresting.

- iShares FTSE/Xinhua China 25 Index ETF (FXI) has support in the 28.00 area.

- Market Vectors Russia ETF (RSX): The Russian market will benefit from higher oil prices, and P/E ratios for Russian stocks are relatively low. I will start buying over 15.85.

- iShares MSCI Brazil ETF (EWZ): Brazil will benefit from the rally in commodity stocks, and PBR is a large component of EWZ. The chart looks like it is putting in a low here.

In the bad news department, there is plenty to report. I am generally considering December to be the lull before the next storm, with a resumption of deleveraging and forced redemptions once the new year hits. Plenty of market commentators are saying that the market is reacting well to bad news, which means we have a bottom. I say we are in a brutal bear market, but will get some sizable countertrend moves. The big trend is still down.

- The Big Picture reports that November foreclosures were up 28% as compared to a year ago.

- Mr. Mortgage tells us that people are increasingly walking away from their homes and mortgages.

This story was originally released a couple of weeks ago, but somehow it did not make it to the blog. It goes hand in hand with the Moody’s downgrade of many Bank of America (BAC) Jumbo Prime deals and cites a 13% delinquency rate. A rate this high represents a total meltdown in the sector that nobody is reporting.

Through my proprietary default and foreclosure research, we have been watching this happen in real-time for months… I have warned many times about this and it is amazing it took this long for somebody to say something. Now that the credit raters are reporting such massive default rates, I am going to officially say that the ‘Jumbo Implosion’ is upon us. Sadly, (ex-Countrywide) BofA was one of the better lenders during the bubble years. In my opinion, BofA was much more conservative than Wells Fargo (WFC), Citi (C), Chase (JPM), Wachovia or WaMu.

…The greatest volume of Jumbo Prime was on the 5/1, 7/1 and 10/1 interest only product line, with 5/1 being the most popular. Wells Fargo was the west coast leader for this program, and Chase, Citi, WaMu, Wachovia and Countrywide were also significant players. The 5/1 interest only is fixed for 5-years at a low introductory rate, typically 1.5% or so below a 30-year fixed. Then after 5-years, the rate adjusts higher or lower depending upon the underlying index such as the 1-year T-Bill or LIBOR plus a margin of 2.25-3.25%. Although Pay Options were considered Prime for years, they are not included in this analysis, as they are now in a category of their own.

Jumbo Prime are high-leverage programs that allowed borrowers to buy much more home than they should have. Because Jumbo Prime borrowers had better credit overall, banks were very easy on qualifying. For example, with full-documentation, a 620 credit score could get an 80% $750k first mortgage that allowed a 15% second on top of that, totaling a 95% loan. On top of that, these loans typically qualified at interest only payments. For stated income, the fee was very small, typically .125% in rate, with allowable credit scores around the 660 level. A 50% debt-to-income ratio was typical. THESE ARE NOT PRIME LOANS, and this goes to show how distorted risk management became.

The entire mortgage and housing blow-up is very linear… Subprime to Alt-A to Jumbo Prime and then Prime conventional. HELOCs blow the entire way up the chain. The defaults in Jumbo Prime have to do with a) the way they were structured with longer teasers such as 5, 7, and 10-years b) the high leverage allowing up to 50% debt-to-income ratios on full-doc and unlimited on stated, no ratio and no doc c) the massive negative equity due to median home prices falling in the biggest Jumbo regions by 25 to 70%.

Wells Fargo (WFC) looks like a pretty good short here, as long as it does not gap down too much before the open. Remember that Meredith Whitney, who has been consistently right, tells us that financial companies are still significantly overvalued.

Naked Capitalism reports on the way accounting rules allow banks to cook their books. Eventually, of course, reality comes back to bite them in the ass, along with their shareholders:

Banks are, if nothing else, entirely predictable. If there is a way to game the system, they will avail themselves of it.

Readers may recall that the Financial Standards Accounting Board implemented Statement 157, which required financial firms to identify how they arrived at the “fair value” for their assets. Level 1 are ones where there is a market price. Level 2 are those where there may not be much of a market, but they can nevertheless be priced in reference to similar assets that have a market price.

Then we have Level 3. They are priced using “unobservable inputs.” I have never understood this concept, because the use of sunspots, skirt lengths, the Mayan calendar, or a model using, say, a ratio of bullish versus bearish stories on Bloomberg would be an observable input. And fittingly, Level 3 is colloquially called “mark to make believe.”

And there are indeed signs that indicate that financial firms have playes fast and loose with this rule:

1. In the first quarter of 2007, Wells Fargo created $1.21 billion of Level 3 gains. Without them, it would have posted a loss.

2. Lehman added more assets to the Level 3 category at a time when better trading conditions said it should have been lowering them

And back to Meredith Whitney, she is bearish on financials, and says watch out for consumer credit (interview video available at the link):

In the same interview, she also said the credit-card industry may cut two trillion dollars in credit lines over the next 18 months.

And that, she said Wednesday, is the next major trauma in the credit crisis.

“Just over 70 percent of American households have credit cards, but over 90 percent of those households revolve at least one time a year, so they’re using it as a cash flow management vehicle,” she explained. “The banks now are starting to cut those lines back. That will impact spending.”

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