Q2 & QE II vs. Long Term Responsibility

Good Evening: U.S. stocks rallied for a sixth straight day on Tuesday, as a positive start to the Q2 earnings season last night was bolstered by a successful sale of short term Greek debt this morning. As a result, the S&P 500, which looked set to probe below 1000 less than two weeks ago, is now perched just below overhead resistance at 1100. Q1 earnings reports were overshadowed this spring by a debt crisis in Greece and the other Club Med countries, one which ultimately led to an almost 20% correction in the major averages. Today’s over-subscribed 26 week bill auction in Greece therefore offered investors a pleasant mirror image to the treacherous market backdrop in late April. That the S&P had a “12 handle” going into the last batch of earnings reports and sports a “10 handle” now will make for an interesting tug of war between bullish and bearish investors as the Q2 season unfolds. Almost forgotten during the rally we’ve seen since last week is the ostensibly worsening state of the U.S. housing market. In the interest of equal time, today we will entertain a bullish — yes, bullish — outlook for home prices.

Stock prices in Asia initially were higher overnight, but a 1.5% decline in Shanghai eventually dragged the region down. Europe, however, was able to shake off the lackluster action in the Far East after Alcoa and CSX were able to report positive earnings surprises. Also giving Europe a tailwind was a successful sale of Greek T-Bills. Oversubscribed by more than 3.5 to 1, the yield at auction for 26 week Greek paper came in at 4.65% — well below the emergency bailout rate of 5% Greece received from its friends in official Europe back in May. U.S stock index futures were impressed enough by the news that they went from essentially unchanged to almost 1% higher. A weaker than expected U.S. trade deficit did little to halt the rally, and stocks were soon up more than 1% when trading commenced in New York.

Stocks rose in sawtooth fashion for most of the rest of the session, with one notable dip occasioned by the release of a negative article about Apple in Consumer Reports. Up 2% or more heading into the final 30 minutes of trading, equity indexes pulled back when the S&P failed to surmount the 1100 level. By day’s end, the major averages finished with gains ranging from 1.4% (Dow) to 3.4% (Russell 2000). No longer sought as a safe haven, Treasurys declined for a fifth day in a row. Yields were 2 to 6 bps higher across the coupon curve after a weakish 10 year note auction. The dollar also fell victim to expanding risk appetites and fell 0.75%. Benefiting from the greenback’s weakness, commodities enjoyed a fairly broad advance. Paced by gains in energy and the precious metals, the CRB index rose 1.4% on Tuesday.

After witnessing the grim parade of negative housing statistics in recent weeks, a friend asked for my opinion on housing. Upon receiving my less than rosy forecast, he asked, “where can I get a second opinion?” A second friend (thank you, Ernie) unwittingly answered the call when he sent me the piece from Credit Suisse you will find attached below. It’s good to question one’s views from time to time, and Credit Suisse does indeed have an interesting take on potentially bullish factors for housing. Unfortunately, while I found their arguments logical, they stem from what might be some faulty assumptions. Readers should at least glance at the piece before considering my counter-arguments, but here they are:

1. An easing of bank lending standards is generally helpful, but will only help housing prices if mortgage lending standards are eased — not just standards for all loans as mentioned in the piece.
2. The historical relationships of home prices to other indicators they mention (including home affordability, retail sales, etc.) are indeed real, but historical relationships tend to break down in the wake of a broken bubble — especially one of the severity we’ve experienced in the last few years..
3. A key distinction about banks holding off on selling foreclosed homeslies in whether the banks want to hold back (i.e. effectively becoming market makers) or have to hold back because they can’t sell their inventories at these prices. I’m guessing banks can value a foreclosed home on their books at almost any number they choose, but I know they have to recognize a specific loss once they actually sell it.

This distinction in #3 is critical to the entire argument Credit Suisse is making, since it is the crucial variable determining whether “shadow inventories” of homes waiting to be sold are either higher or lower than is commonly thought by market participants. I’m guessing inventories (both real and shadow) are higher than is assumed in the piece and that prices (especially at the high end) could fall further. The authors are right in saying a relapse is becoming the consensus call, but, given that their other reasons for being positive about housing are suspect in a post-bubble environment, I don’t find their overall case to be very persuasive.

What would cause me to rethink this cautious stance on housing is a sustained uptick in job creation. A falling unemployment rate obviously will heal a number of other ills as well, but it will likely be a crucial variable for home prices. Time, job creation, and letting the market clear may be the real answers for what ails housing, but our leaders in Washington might not want to wait. Patience is a virtue not often found in our nation’s capitol and November is fast approaching. Even non elected officials like Chairman Bernanke might get a hankering to do something, whether it’s due to his own anti-deflationary philosophies or an anxious phone call or two from the man living on Pennsylvania Avenue who reappointed him. Unable to further cut the funds rate, and worried that a relapse in housing might lead to a deflationary double dip, Mr. Bernanke might well decide that launching QE II is his best option. For a man who has spoken at length about the many ways a central bank can fight deflation, pushing the Easy button is almost always the preferred solution.

Buying another trillion or so of mortgage paper, or pegging interest rates for conventional fixed rate mortgages would indeed keep home affordability aloft at multi-decade highs, but the long term cost for a second short term fix of this nature might just be soaring interest rates in the years ahead. As the recent turmoil in Europe has taught us, global investors don’t look kindly upon shenanigans of the fiscal or monetary variety. If a nation could print its way to prosperity, then Argentina and Zimbabwe would be shining case studies at Harvard Business School instead of dismal poster children at the IMF. So even though our markets are girding for the short term focus inherent with yet another quarterly earnings season, let’s hope our nation starts thinking longer term for a change. Even more than austerity, responsibility is what we need in the months and years ahead.

— Jack McHugh

U.S., European Stocks Jump on Alcoa Earnings
Greek Banks Drive Bill Rates Below EU Loan Rates in Post-Crisis Sale
Ten Year Treasuries Tumble for a Fifth Day After Auction

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