Dallas, TX
May 17, 2010, 08:00 EST		 Dr. Joe Duarte's Market I.Q.


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Europe Bounced But Wall Street Rolled Over
What's Hot Today:

U.S. stock index futures turned lower in early Monday trading. The Euro fell below 1.24, overnight. Europe had bounced higher but gave back most of its early gains. Asian stocks tumbled.

News For Thought

State tax receipts dip. According to The Wall Street Journal: "April tax collections are falling short of forecasts and even dropping below last year's depressed levels in a number of states, complicating budget troubles and prompting some governors to dip into rainy-day funds. Following several months of modest improvement, the weak April revenue numbers are disappointing for states that hoped for economic recovery soon. Based on reports from more than a dozen states, the figures suggest the recession may have taken a heavier-than-expected toll on employment last year, cutting into income taxes."

Financial "Reform" bill likely to pass, and soon. According to The Washington Post: "Passage of a 1,400-page bill to overhaul the nation's financial regulations would come just two months after Obama signed a landmark health-care overhaul. But in the case of financial regulation, much more so than with health care, the Senate bill largely reflects the administration's initial blueprint, despite the fervent efforts of lobbyists and lawmakers of all stripes to alter it."

To be sure, the excesses of the past few years have led to a huge public backlash of Wall Street. Yet, it's hard to figure out which way this thing will go and what the long lasting effects on the U.S. economy, good or bad, may turn out to be. As The Post points out: "The bill would, among other things, create an independent consumer watchdog aimed at protecting borrowers from lending abuses, establish oversight of the vast derivatives market and enable the government to wind down large, failing firms."

Thailand continues toward the brink. According to The Wall Street Journal: "A rogue Thai army commander that worked with Thailand's Red Shirt movement died after being shot, threatening to crank up tensions as a deadline for protesters to disperse nears."

Europe Bounced But Wall Street Rolled Over
Major Tops Take Time To Form
Friday's market was inconclusive. After all, even if the day was down, buyers and short covering pushed prices off of the bottom at day's end. And although Asia tumbled, Europe rallied. Interestingly, Wall Street's pre-market stock index futures turned lower after a less than stellar report from Lowe's (NYSE: LOW).

That means that this is going to be a nail biting day, if you have positions on either the long or the short side, as things could go either way.



Chart Courtesy of StockCharts.com


A quick look at our recently useful indicators illustrates the market's precarious current position. The Russell 2000 Index (RUT) of small stocks actually closed below its 50-day average on Friday. That's a big decision point for small stock fans. And if the small stocks fall, it would be a sign that the weakness is starting to spread.



Chart Courtesy of StockCharts.com


The S & P 500 (SPX) again failed to rise above its 50-day moving average on Friday. The 20-day moving average (green line) has also turned lower, suggesting that the short term trend has turned down and that selling pressure is increasing. If the 20-day moving average crosses below the 50-day moving average, that will be another negative development. And if the 50-day average rolls over and starts heading lower, even more selling pressure will hit stocks.



Chart Courtesy of StockCharts.com


There are some very weak sectors inside the S & P 500 that are of great concern. One is the Pharmaceuticals Index (DRG), home to the big names like Merck (NYSE: MRK) and Pfizer (NYSE: PFE). But lesser names with more important significance at this time, like Teva (Nasdaq: TEVA) are tracing more negative chart patterns.



Chart Courtesy of StockCharts.com


TEVA, a leading manufacturer of generic drugs is expected to make big money as health plans and rising costs push consumers and health plans toward generic drugs. Yet, even when this company should be in its sweet spot, the shares have fallen some 12% since they topped in March 2010. TEVA has recently made some acquisitions and may be stressed due to that at this point. Yet, it's not very encouraging to see a company that is known for its aggressive management, at a time when the business and regulatory climate is in its favor, take such a drubbing.



Chart Courtesy of StockCharts.com


One more thing. The NYSE advance decline line also rolled over further on Friday. That means that more stocks are falling than rising on a regular basis.

Strategic Default Now Socially Acceptable

As the stock market struggles, we thought it'd be interesting to look for something outside the financial markets to help us get a grip on reality. And, of course, it's mortgage related. And it's disappointing, but not unexpected.

People are starting to walk away from underwater houses on a regular basis. And now, it's "socially acceptable" according to Marketwatch.com. The report notes: "estimates that 12% of mortgage defaults in February were strategic. Other reports estimate an even higher proportion of this type of loan default," and that "Growing social acceptance of this behavior could have ramifications not only for personal credit histories and the health of neighborhoods, but also for the future of mortgage lending, according to those studying the issue."

Marketwatch warns of a "contagion effect" as "more people watch their friends or neighbors choose to default, the more it becomes a viable option for homeowners who may otherwise wait years just to return to a positive equity position in their properties." At some point, it almost becomes a peer pressure type thing, we guess. In other words, the Mrs. Jones bugged out and is doing all right, why should we take one for the team when those fat cats lied to us type thinking takes over, and then it becomes easy to walk away.

What those people don't realize is that lenders will adjust their risk models for default risk, and that home buying in the future will become even more difficult.

Here are two facts to consider. According to Marketwatch.com:
  • "Analysis from Experian and Oliver Wyman estimated that strategic defaulters made up about 18% of all borrowers who went 60 days past due on their mortgage in the fourth quarter of 2008; about 588,000 borrowers strategically defaulted in 2008, up 128% from 2007. Strategic default was also found to be most prevalent in areas that experienced steep price declines, including California and Florida, and among mortgages that originated in or after 2006, because those borrowers didn't experience home price appreciation before prices headed south."

  • "Research from the Chicago Booth/Kellogg School Financial Trust Index found a rising percentage of homeowners are willing to strategically default: The percentage of foreclosures perceived to be strategic was 31% in March, compared with 22% in March 2009. The data is collected through a survey of about 1,000 people."

Conclusion

The stock market has some decisions to make,while many homeowners have already made their most significant decision since buying a home, by walking away from it, if the mortgage is under water.

We think that the two dynamics are connected, perhaps not in a timing sense, yet, but certainly in a trend sense. The trend toward under water mortgages is likely to grow as the resetting of Option ARMS (adjustable rate mortgages) continues throughout the next year or two.

The fact that Fannie Mae and Freddie Mac continue to buy dead loans from mortgage companies and that they are asking for more government money to continue to do so is irrefutable. The fact that the number of houses for sale in some neighborhoods we've driven through is 20-25% of all homes, and that none of them are moving, tells us we're right on this.

And the notion that many investors, outside the real estate sector, have yet to publicly acknowledge this phenomenon, just tells us that they're probably buing credit default swaps or some sort of negative bet on the potential for another major down leg in the mortgage market.

As with the first housing crisis, where it took a while for it to hit critical mass, so may this one take a little longer. But, the ingredients are in place.

We'll be on Twitter some time today before the market closes with some updated comments.

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Market Moves - Stock Of The Day
Home Builders ETF (NYSE: XHB) Could Swoon After Bad News From Lowe's (NYSE: LOW)
Home-improvement's number two, Lowe's Co. (NYSE: LOW) missed analyst's expectations about its future quarter, while Homebuilder ETF (NYSE: XHB) may have a double top.



Chart Courtesy of StockCharts.com


Home improvement and home building are essentially two ends of the same sector. On the way in, you may buy a new home, and somewhere along the way you improve it. When one does well, the other tends to do well also. That's why Lowe's missing analyst expectations about the next quarter could also hit the homebuilders.

Here's the logic. There is a glut of upper end homes on the market now, although the lower end may have stabilized, at least some. There is a huge chunk of Option ARMS (adjustable rate mortgages) that are due to reset over the next year or two. And there are several reports out that conclude that people are starting to walk away from under water mortgages more frequently.

We believe that this is a significant development. And here's why. Most stocks investors rarely pay attention to the currency markets. We think that's a mistake, given the amount of money that is traded in the currency market on a daily basis, and the influence those trades can have on all markets.

In fact, anywhere from 12-18% of new foreclosures are now considered to be due to "strategic defaults" where people just walked away from their mortgages.

Lowe's had a nice bump in their profits for their last quarter, but isn't sure about their next quarter. Could it be because the recent surge in home improvement activity was due to last gasp action from those who know that they're not likely to move from where they are for a long time?

Or was it because they know that taxes are going up and that disposable income is about to fall?

No one really knows. But it makes sense to consider that if Lowe's isn't sure about the next quarter, the homebuilders may want to take notice.

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