Ben's Bushwack

In classic ‘buy the rumor, sell the news’ fashion, the S&P 500 sold off 1.28% today as testimony from Federal Reserve Chairman Ben Bernanke failed to confirm an imminent cut in the 0.25% rate paid on excess bank reserves.  Adding to the disappointment, the chairman echoed, in his own understated manner, two of the primary macroeconomic concerns that have been the focus of the negative sentiment of late:  slow job creation and sliding/stagnant home prices.  While these issues are not new to the market, the fact that the Fed is somewhat distressed by these developments and is willing to say so in a public forum implies that the souring outlook for the U.S. economy is rooted more in fact than in pure speculation.  Volume remained lackluster (4.1 billion S&P 500 shares), but it’s worth noting that the declines of late have routinely seen larger volume readings than those seen during rallies.  The differences are small in absolute terms (larger in percentage terms), but worth noting just the same.  Treasuries, as you would expect, traded higher during the day.  Ten-year yields fell 7.5 basis points to 2.8817%, marking their lowest close since April 2009, while thirty-year yields compressed an impressive 8.9 basis points to 3.8931%.  Energy and precious metal futures were also largely lower on the day as a sizable rally in the dollar coupled with concerns over end demand in a weakening global economy conspired to choke off any positive momentum.

While there is little on the technical front to indicate that today’s dollar rally is anything more than a near term spike, it is worth noting that the correlation between ten-year Treasury bond prices and the dollar has been disconnected since the first week of June.  As both securities have been largely looked upon by investors as safe havens during turbulent market action, the fact that Treasuries have been consistently bid up over the past couple of months while the dollar has lagged is a bit unexpected.  As you can see from the chart below, this disconnect in price movement began in early June and has continued in an unabated fashion.  Also, you can see that deviations in price performance between the two assets are quite normal, but the relationship typically returns to its positive correlation relatively quickly.

The fact that Treasuries had one of their largest rallies in the last month on the same day that the dollar has a significant rally says to me that the positive relationship is likely beginning to return.  This further supports the notion that equities are in for a tough haul in the coming months as a strengthening dollar and rallying Treasury market have often reflected investor's disdain for virtually all risk-oriented asset classes.  As I said at the outset of this paragraph, there is nothing on the charts that implies that a dollar turnaround is imminent.  I merely bring this up as something that's worth watching and could be a harbinger of things to come.


Returning to the Chairman Bernanke's testimony today, it is clear that the future of the housing market is still one of the primary areas of concern for the Federal Reserve.  With more and more homeowners beginning to think in terms of 'strategic default' as a way to get out from under homes with negative equity (you owe more than the house is worth), concern is more than warranted.  A lack of job creation and falling consumer incomes adds even more fuel to this out of control fire.  But these are things that we largely know and have heard about at length in analyst and press reports for the past two years.  What we have not heard much about is how far housing prices could potentially fall from here, especially in light of the declines that have already been seen.  Sure, there are a few commentators out there that have ventured guesses, but very few have offered any empirical evidence of where prices may go.  As such, I decided to take a look at the Case-Shiller composite index of housing prices to see if this data could offer any insight on where things might be headed.  Looking at the data, it seemed reasonable to me to take the housing price growth rate seen during a 'normal' time frame and extend that rate through today to generate an estimate of what the index value should be.  Comparing this to the actual index reading would then generate some sense of how far prices could fall in order to get back to 'normal'.  Before reviewing the findings, let me say that I realize that this is a very simplistic approach to a complex problem.  However, I found the conclusions pretty interesting and hope you will too.  If nothing else, it should at least provide some context on just how far prices have come and, thereby, how far they could fall.

First I divided the data into three distinct time frames:  January 1987 to December 1999, January 2000 to July 2006, and August 2006 to April 2010.  The first time frame I used as the 'normal' period since it is composed of both a boom and bust cycle, which should reflect a fuller range of growth rates.  The second period is the now well known bubble period which, I believe, warranted separation from the rest of the data.  Lastly, the third period captures price changes seen since the bubble burst.  For comparison, the annual housing price growth rate for each of the time periods are as follows:  3.60%, 13.28%, and -9.22%.  As this data shows, the past few years have seen enormous swings in value.  No big surprise.  What's interesting though, is that if you take the 3.60% annual growth rate that was seen in the January 1987 to December 1999 period and apply this rate of growth to the index's initial value, you generate a reading of 143.08.  This is just over 9% lower than the current (April 2010) index reading of 157.37.  So all things being 'normal', housing prices have at least another 9% to go on the downside.  I say 'at least' because this analysis assumes that the economic environment that was seen during the 'normal' time period is somewhat similar to our current situation.  I think it's fair to say that we're not in the midst of a wealth enhancing stock market boom or in situation where the Federal Reserve is inclined to raise rates.  So despite the simplistic nature of this analysis, I think it's instructive as a way to get a sense of where we've been and how things are likely to play out if we just get back to average.  Sadly, many people wish they could get back to 'average' at this point.


As a final point, I think the rumors that surfaced yesterday that helped to push equities higher is a great illustration of why perspective is so key in this market environment.  Without taking the time to think through both the broader technical context of yesterday's rally along with the likely impacts of the rumored Fed action, it would have been very easy to get caught up in the market's mayhem.  Doing so would have likely forced an investor to buy or cover a short position.  Along with this action would have come a decent dose of buyers' remorse as today's sell off would have put some red immediately on their screen.  I'm not trying to say that I saw today's sell off coming because that would be an outright lie.  What I would say, though, is that by doing your homework, you'll end up having more conviction in your positions while maintaining solid risk management practices, which will help avoid 'flush out' days like yesterday.  In all honesty, had the S&P's run above 1,100 today, you can bet that I'd have been on the phone covering my short as the move would have been outside my risk parameters.  Thankfully, though, the market allowed me to hang on to my short for at least another day, which keeps profit potential on the table.  And let's face it, that's what it's all about anyway.  Hopefully, by sharing my perspective, you can find that context needed to weather this market and make some money along the way.  Until tomorrow.....