The collapsing value of mortgage debt and the stock market

The stock market has recently been as 'oversold' as it normally ever gets – in fact, some of the market's internals have produced never before seen records (on one occasion in early October, new lows at the NYSE jumped to almost 2900 issues, which is almost thrice the previous record high; last Thursday the NYSE TICK at one stage in the early day sell-off was recorded at minus 1940, a new record low, to name two examples. It almost doesn't matter which indicators one looks at – they have either produced never before seen extremes, or extremes that were last seen in 1929-1932).

Many of these internals have recently 'eased off', and on Thursday's 'classic retest of the lows' we see numerous divergences (fewer new lows, a lower VIX, lower put/call ratios, a higher RSI reading, a higher MACD reading, etc, etc.) that would normally lead one to expect that some sort of larger relief rally is close at hand.

And yet, there remain a number of flies in the ointment.

Bulls and Bears

The first one is the apparent eagerness of traders wanting to 'buy the bottom'.

The second one is the fact that the bears have apparently capitulated. Yes, you have read correctly – it is the bears, not the bulls, that are doing most of the the capitulating. Consider the updated version of two charts i showed in the 'quo vadis' post a while back, the NYSE short interest ratio deviation and Rydex bear fund cash flows. By the looks of these charts, bears continue to abandon their positions, no doubt chastened by the huge one day wonder rallies that have recently, in illiquid banana republic market fashion , heralded at least two false dawns.


the NYSE short interest ratio deviation– it continues to hover at what is at least a 10 year low, deeply in bearish territory - click on chart for bigger image


the cumulative Rydex bear fund cash flow ratio remains at a multi-year low - click on chart for bigger image


In addition to the above, the net short exposure of CTA's , who are highly flexible traders, is now no larger than in November 2000. This is very little compared to some of the short exposures held by this same group during the bulk of the 2000-2002 bear market.

In this context , consider also the fact that most of the trading volume in stocks continues to occur during those times when stocks go up. Bob Prechter was the first analyst to point this strange phenomenon out – he asks, not unreasonably, how there can have been capitulation (of the bulls/long holders) when most of the trading volume is expended in chasing stocks higher (this was once again in evidence last Thursday in intraday trading. Volume began to expand as soon as the market streaked higher).


Mortgage Debt

The third problem for the market is a group of indicators that used to be widely followed for a time, but have lately not been mentioned much as other financial catastrophes took center stage.

I am referring to the ABX-HE and CMBX index products administered by Markit . The charts below show a cross section of the situation , presenting indexes on variously rated debt, from AAA to BBB. If you want to see regular updates of these charts, they have been taken from here(historical ABX-HE)and here(historical CMBX). These may be useful links to bookmark.

Keep in mind that ABX-HE are indexes that refer to the price of the underlying debt pools of residential mortgage debt(down is bad, up is good), while CMBX refers to the spreads of the underlying commercial mortgage debt (up is bad, down is good).





ABX-HE indexes of various residential mortgage debt pools, from highest to lowest ratings - click on charts for larger images





CMBX spreads for different ratings, again from highest to lowest - click on charts for larger images

As one can clearly see, these instruments show that extraordinary stress continues in the mortgage debt markets. It is no surprise that AIG's bail-out requirements have recently swollen to $150 billion from the originally envisaged $80 billion – many of the credit default swaps written by AIG reportedly were for CDO's backed by mortgage debt. Presumably many of these CDO's were once double and triple A rated – however, as we can see, even triple A rated mortgage debt pools continue plummeting in value at great speed.

This means that many bank assets will be subject to further write-downs. Even if a lot of garbage paper has been swept under the 'Level 3' rug, this further deterioration in prices and spreads will likely force a renewed wave of asset revaluations. ('Level 3' is an accounting term - it is where financial institutions house securities for which there is no market price input, hence they can not be 'marked to market' but are valued according to models, respectively are marked to 'reasonable stab' as the method was once described by a Citigroup spokesman. Some people have dubbed this also 'marked-to-fantasy').

Consider in this context the truly sorry looking chart picture of the BKX index below. Similar to the broader market, we can also detect a number of recent potentially bullish divergences, but it is the price chart itself that gives one pause. It does not inspire much confidence.


the BKX (Philadelphia Exchange Bank Index)- bullish divergences, but bearish price formation - click on chart for larger image

The same ideas regarding the short term outlook as outlined in 'quo vadis' still apply – the market is still within the recent trading range, and the direction in which it will eventually break is not yet certain. It is this latter point i actually want to make – while numerous divergences at the recent third 'retest low' seem to favor a rising market, there are still indications that the underlying stresses in the financial system continue to mount.

The Federal Reserve and other central banks have momentarily stemmed the increase in LIBOR with unlimited dollar swap agreements and revived commercial paper issuance by buying CP directly – but this particular hole in the dike - the plummeting value of mortgage backed securities - continues to grow. Arguably this remains one of the most important things to watch, as the ABX-HE indexes have often reliably led the stock market, and also due to the fact that at the height of the real estate/mortgage credit bubble insanity, a full 63% of all bank assets were tied to real estate financing.

One must therefore continue to keep an open mind regarding near term market direction. It is always possible that the bears who have covered their short bets are 'smart' and will get a better opportunity to re-short, and the oversold ABX-HE indexes may well soon bounce. However, there is considerable uncertainty given these data points, and the market lows of 2002 still beckon.

PS: A few words on the G 20 meeting

The recent G 20 pow-wow can hardly be expected to be a panacea for the ongoing crisis. This is merely a bunch of politicians getting together to 'fix' the economy and markets after all – expectations should be muted accordingly.

From what one hears so far, they are actually busy reinforcing the recent deflationary trend in the credit markets, by proposing – what else – 'more controls and regulations'. As i overheard in a German TV newscast, this control is supposed to encompass credit creation (a.k.a. 'credit dirigisme', as now practiced by Uncle Sam with Fannie and Freddie – the state will decide who is 'worthy' of getting credit and who isn't).
The press meanwhile is dishing out the usual pablum about this meeting representing a confrontation between 'US laissez faire' and 'European regulation' principles. Time Magazine lets loose with gems such as 'To optimists, the mere fact that Sarkozy convinced regulation-wary U.S. President George W. Bush to host and attend such a summit was cause for hope.'
There will be some generalizations about every government feeling free to implement a raft of Keynesian inflationary measures intended to counter the financial and economic contraction (expansion of fiscal deficits and even more interest rate cuts), and of course we are promised - more meetings! This is not surprising, as these get-togethers apparently are marked by lavish banqueting. As a warning sign to all supporters of the free market, 'French top officials have applauded the summit results'.
All that has so far been decided falls roughly under the header of 'how can we make sure of making things worse in the long run' - with the sole exception of a pledge to avoid a return to protectionism. The real reason for the crisis was - as was to be expected – not even mentioned in passing as far as i can tell.

Not a single word about the central banks' money price fixing scheme, or the proliferation of regulations and subsidies that has marked the growth of the post WW2 State everywhere – the colossal failure of the state's economic planning was not deemed worthy of debate. Anyone looking toward a government-mandated crisis solution will eventually find out that the interventionist dogma is at the end of its tether – as i have previously mentioned , the economy's pool of real funding is the limiting factor in all state-led inflationary schemes, and it appears that it is in grave trouble globally.

charts courtesy of marketgauge, stockcharts.com, decisionpoint and markit