“The only function of economic forecasting is to make astrology look respectable.”— John Kenneth Galbraith

I’m sitting here this evening on a porch in North Myrtle Beach, South Carolina watching the waves. Earlier, I spent about an hour body surfing those same waves and had a great time with my whole family, including my dad.

There are lots of different types of waves to ride, but I do have my favorite.  The best waves for me are the ones that don’t look like much on the surface but have lots of underwater pull.  They always give the best ride.  For an added benefit, the casual onlooker doesn’t really understand how you went so far, so fast.

In my opinion, that’s the kind of wave that the housing market is about to ride.

The state of the residential housing market is one of the most debated topics in economics right now: has it bottomed and started back up or is the worst yet to come?  If you listen to the media, you probably have the impression that housing has hit bottom and is on its way back up.  Then there’s this complicated but compelling graph that has been cited a lot recently that paints a less rosy picture.  We’ll study both items this week.

Why the Housing Market Matters

[Editor's note: Due to spam filters we can not use the proper spelling of mort-gage in this article, that's why we've used the hyphens.]

Understanding the big economic picture is not just an exercise for institutions and fundamental investors.  Traders of all stripes benefit from understanding the long term economic trend.  These longer term trends are initiated by and sustained by changes in macro influences that affect nearly every household and business in the country.  When these things change, they tend to affect (move) the markets for a long time.  For example, interest rate changes will affect the economy for months and years.

One big driver of the economy is housing.  The housing market is such a huge part of the economy that it has a major effect on investor sentiment and the financial markets.  Housing reports move markets and have done so significantly in the last two years as there have been a lot of changes in that sector recently  (Understatement!).

This was evident again last Friday (8/21) when the National Association of Realtors reported that existing home sales had higher volume figures than expected.  The market popped on the announcement (and this was on top of a very strong up week).

Of course, all the giddy reports of the better volume news failed to mention two other points: the continuing drop in the existing home prices and the rise in the inventory of homes for sale.  Those points were a few more paragraphs down in the press release.  With the current strong near term bullish sentiment, the positive news gets accentuated and the negative news gets ignored.  (Now even my third grade economics students know that if supply goes up and prices go down, demand is not going up.)

Adding Some Longer Term Data to the Outlook

The following Credit Suisse graph has been getting a lot of play recently and for good reason. It shines some much-needed light on the broad mort-gage market story.

GRAPH

For those not familiar with terms here, mort-gage rate resets are the periodic adjustment in interest on home loans that have some type of variable rate.  Naturally, changing the interest rate also changes the mort-gage holder’s monthly payment.  Many homeowners in the last few years bought homes with adjustable rate mort-gages (ARMs) or balloon rate mort-gages that had very low initial or “teaser” rates.  Those low initial rates are then reset higher at some point.

Option ARMs give mort-gage holders alternative payment options.  The lowest cost option is a minimum payment that does not even cover the interest accrued in the last month. This means it’s fairly simple for a homeowner with an option ARM to end up underwater (the homeowner owes more money on the mort-gage than the property is worth).  This can occur even in a market where prices are holding steady.  If real estate prices are dropping though, it is even more likely that a homeowner with an option ARM will end up upside down, which then makes refinancing nearly impossible.

Alt-A is the category of loans made to borrowers with credit scores just above the subprime level.  You have heard, no doubt, about the high foreclosure rates in the subprime area over the last two years and the global financial havoc it wreaked.   Many reputable analysts anticipate Alt-A to be the next big problem.

As you look at the graph, what do you see?  A huge amount of Alt-A and option-ARM resets will happen in 2010-2011, with that peak being even bigger than the subprime peak of last year.  Potentially, a lot could happen to reduce the effect these resets could have on the banking system but this is the 800 pound financial gorilla in the room that you ignore at your own peril!

It is not my intent to paint a negative picture but to paint a fuller picture with a greater depth of data for your own evaluation.  Without some consideration about what is happening in the economy and where it’s going, you lack very important context for trading the market.  Simply taking in the headlines at face value like last Friday’s existing home sales rise can be dangerous.  What does your big picture look like right now?  How do the current market levels fit in with your big picture?

I believe the current market rally is driven by force-fed liquidity (cash injections).  As I have said recently, this artificial stimulus causes us to toss to the sidelines much of our traditional analysis as this market powers upward on excess currency.  In today’s market, you can’t see the underwater pull by just looking at the surface.

If you are riding this wave, be sure you have a firm exit plan or else the wipeout could be nasty…

Great Trading!

D. R.