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The Housing Market Bubble: Impact On Mortgage And Bank Sectors

09/08/06 08:53:26 AM
by Paolo Pezzutti

Although the housing sector presents negative conditions currently, the mortgage and bank sectors should remain in a trading range environment.

Security:   $HGX, $MFX, $BKX
Position:   N/A

Just a few months ago, analysts were predicting a soft landing for the housing sector. Sales of new homes, however, plunged an impressive 21.6% in July from last year, while inventories of unsold homes soared. The housing market is falling much faster than expected. The presumption has been that banks' earnings would be only modestly affected by the softening mortgage business, and further, if there were a recession in the housing market, the banking system would not be able to avoid losses.

In Figure 1, you can see the Philadelphia Housing Sector Index ($HGX) weekly chart. After a breakout to the downside of the trendline that supported the uptrend initiated more than three years ago, the index is now developing a flag. Typically, flags are continuation patterns. Unless something new emerges on the fundamental or technical side, you should expect to see lower prices in this time frame. To support this view, the moving average convergence/divergence (MACD) has printed new lows since 2002. The average directional movement index (ADX), which measures the strength of a trend, has the value of 35, indicating that the ongoing downtrend is well defined and strong.

FIGURE 1: $HGX, WEEKLY. The Philadelphia Housing Sector Index is developing a flag. The ADX above 35 indicates that a trend is ongoing.
Graphic provided by: TradeStation.
In Figure 2, you can see the Philadelphia KBW Mortgage Finance Index ($MFX) daily chart. Prices are just 10% below its May high. Prices should be stable in the intermediate term. Unlike the housing sector index, the mortgage finance index's momentum is low after printing a positive divergence in coincidence with the August low below 92. The ADX has a value of 12, indicating the lack of a formed trend. In the short term, prices could move to the downside again to retest the 92 support.

FIGURE 2: $MFX, DAILY. In the short term, prices could retest recent lows for the Philadelphia KBW Mortgage Finance Index.
Graphic provided by: TradeStation.
So far, banks have seen only modest drops over the past few weeks. The Philadelphia Bank Index ($BKX) (weekly chart in Figure 3) has lost less than 4% from its early August high. Momentum is low and the ADX has the value of 14.43, indicating that this sector for the moment is moving sideways consolidating recent highs. The first support is identified at the level of 106. In this phase, prices should move to the downside and test it. On the fundamental side, analysts observe that most banks are diversified to face a housing downturn. In the present housing boom, however, banks are offering new and exotic types of mortgages to buyers. The level of the banks' exposure to real estate is unprecedented, representing close to 60% of their earnings. Also unprecedented is the size and importance of real estate relative to the entire US economy. Mortgage defaults would force lenders to take charges for unanticipated losses or boost their reserves. Those facing the most immediate risk would be mortgage lenders. Higher interest rates, record-high gasoline, and energy prices are pinching overly indebted consumers. The housing problem should be a top priority for the Federal Reserveas it monitors an evolving situation that could become explosive if not properly managed.

FIGURE 3: $BKX, WEEKLY. The Philadelphia Bank Index is consolidating from recent highs. The low ADX indicates the lack of an ongoing trend.
Graphic provided by: TradeStation.
Markets have not yet perceived the gravity of the housing market's situation and the potential impact on the associated mortgage and bank sectors. The housing sector is displaying a negative situation, and the outlook does not provide indications of a trend reversal. However, the mortgage and bank sectors present a situation in which the continuation of a trading range environment is the most likely outlook in the intermediate term. Markets, though imperfect, are right far more often than they are wrong. A possible evaluation is that a pause of the interest-rate hike process might provide the necessary support to the mortgage sector and the bank sector. The slowdown of the economy, and the possibility of a recession, might favor a soft landing of housing prices without the burst of the bubble (provided that it is such).

The housing, the mortgage, and the bank sectors all present different conditions. As the housing is developing a downtrend in the intermediate term and there are no signs of reversal so far, opening long positions in this phase presents a high risk. The mortgage and bank sectors are moving in a trading range environment. In the short term, they should continue to move to the downside and test the supports recently printed. I'd rather not open positions in this phase to wait and see the indexes' behavior on supports.

Paolo Pezzutti

He is the author of the book "Trading the US Markets - A Comprehensive Guide to US Markets for International Traders and Investors" - Harriman House (July 2008)

Rome, Italy
E-mail address:

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