Signal Type	Trade Date	Index	Return since issued
		Nasdaq 100
		Russell 2000
		S&P 500

Market Update

Stocks moved lower again this week as they succumbed to ongoing concerns about the subprime lending market. Since the issue is unlikely to disappear anytime soon, it will continue to weigh on the markets for some time to come. As stocks failed to post a decent rebound to instead drop on heavy volume Tuesday, our Model issued a Sell signal after the market close that day. Stocks were able to move modestly higher on reduced volume Wednesday and Thursday, but the gains proved to be fleeting as the major indexes again dropped heavily Friday to close the week on a sour note. One of the triggers for the sell-off was a disappointing jobs report for July: only 92,000 nonfarm payrolls were created last month, well below the average forecast of 135,000. Also the unemployment rate moved up to 4.6%. The news paints the picture of a weakening economy, which taken together with the fear of a credit crunch, gave investors an excuse to sell aggressively.

For the week, the Nasdaq 100 and S&P 500 respectively lost 1.92% and 1.77%. Once again, the Russell 2000 fared worst, as it shed 2.88%. The Nasdaq 100 has now closed below its 50-day exponential moving average (EMA) but remains above its 200-day EMA. The situation is much worse for the S&P 500 and the Russell 2000 as both indexes are now located below their respective 200-day EMAs. This marks a significant change as the S&P 500 had been able to remain above its 200-day EMA since July 2006. For its part, the Russell 2000 has now undercut its March low and has retraced all its gains since early November.

Our World Index Ranking portfolio only lost 1.03% this week, easily outperforming its US counterparts. The portfolio consists of the 5 top-ranked world indexes as of July 20, which marked the beginning of the current 4-week holding period. Please note that since we now have an active Sell signal, the World Index Ranking approach calls for selling your holdings if you follow the "Long Only" or "Long and Short" strategy. With the former strategy, you would simply remain in cash. If you follow the latter one, you should short the QQQQ instead, which would have given you a weekly gain of 2.51%. Only if you follow the "Buy and Rebalance" strategy should you remain invested in the top 5 indexes, as the strategy calls for staying invested at all times. Please go to our "Strategies" page for all the details.

We now have a Sell signal in effect.

Trend Timing School

Subprime woes and dominos

As housing prices began to drop and interest rates started rising, borrowing costs increased, causing borrower delinquencies and defaults to explode. Economy.com predicts that 2.5 million mortgages will default this year alone and that the trend will not only continue but accelerate until they peak in the summer of 2008. In turn, this has ramifications throughout the credit markets. There is a long and growing list of U.S. mortgage companies who have closed shop or been bailed-out, over 70 since the beginning of 2006, and according to most industry sources we have only seen the tip of the iceberg.

Subprime is just the hot buzzword of the moment because their loans being the most risky makes them the most vulnerable lender segment, and the first to get hit. The problem is much broader than subprime loans; to some degree it spreads to all forms of Adjustable Rate Mortgages (ARMs), whose defining feature is an interest rate that can be adjusted. For those unfamiliar with mortgage jargon there are all sorts of ARMs: Alt-A, Prime, Subprime, Option and Unsecuritized to name but a few. We will not even attempt to explain each category; suffice it to say that they all have one thing in common: the more interest rates rise, the higher the payments for millions of borrowers. The chart below paints a grim picture for the months and years ahead. Each bar in the graph represents how much in ARM loans are scheduled to reset (presumably to a higher rate) in a given month, beginning with January 2007. With nearly $1 trillion dollars of ARMs to reset through the end of next year (month 24 on the chart), including the bulk of the subprime mortgage bubble, and a continuation at similar levels through the end of 2011 (month 60 on the chart), it is clear that we are not out of the woods.

Adjustable Rate Mortgage Reset Schedule


Note: Data as of January 2007.
Source: Credit Suisse Fixed Income U.S. Mortgage Strategy.

At the bottom of an inverted pyramid are millions of home owners who have bought property which in retrospect they really could not afford, and as the artificially low rates and monthly payments get reset higher, many are getting squeezed. We are now seeing 12% delinquency rate for subprime mortgages which means that the losses could be in the hundreds of billions of dollars, if they were confined to the originating lenders. Trouble is that the geniuses who created mortgage derivatives divided them and sub-divided them into "slices" of risk and return, bundled them, leveraged them, and sold them higher in the pyramid through investment bankers and hedge funds at ever increasing levels of leverage. There is an entire industry in mortgage backed securities (MBS) with fancy names and acronyms such as Collateralized Debt Obligation (CDO), Collateralized Mortgage Obligation (CMO) and Collateralized Bond Obligation (CBO). Many in the pyramid have been speculating that interest rates would continue downward forever.

The problems are by no means confined to smaller subprime lenders but in fact appear to be spreading across the mortgage industry as a whole and even to other credit markets. Just today, American Home Mortgage, the tenth largest U.S. home lender specializing in medium risk "Alt-A" mortgages, not subprime, is closing its doors and is expected to seek bankruptcy protection. The collapse, as so many others recently, was attributed to rising defaults which in turn caused American Home's own lenders to cut it off, leading to escalating margin calls. They are not alone. Even Countrywide Financial Corp. the largest U.S. mortgage lender is running into problems and feeling the pain. It recently slashed its earnings forecast for the year citing a rise in late payments by borrowers. Their Chief Executive Officer Angelo Mozilo was quoted as saying "We are experiencing home price depreciation almost like never before, with the exception of the Great Depression". Not a very rosy picture.

Investors in Bear Sterns' subprime hedge funds, also known as leveraged junk credit funds, are learning the dangers of investing in risky bonds with borrowed money. The losses announced are staggering and the lawsuits are flying.

Nor is the subprime problem isolated to the U.S. Just this Wednesday, the German government rescued IKB, Europe's first major subprime casualty. The bailout plan includes a 8 billion Euro ($10.93 billion) fund footed by the state-owned development bank KfW (70%) and by major public and private banks (30%). All these developments point to an upcoming global credit crisis.

If much of the drive behind the nearly 5-year old global bull market in equities is coming from low interest rates and abundant liquidity, as we documented in "Interest rates at a crossroads" and "Global liquidity glut", then it stands to reason that reversals of both of these trends could spell disaster. With the nearly 2 month slide in long-term bond yields, a major bottom continues forming and as many experts suspect we will be seeing substantially higher rates in the months and years ahead. This will exacerbate the woes in the housing and mortgage industries and is bound in time to severely affect the economy and its leading indicator the stock market. As this reality seeps into the collective investor psyche we know the days of the bears are rapidly approaching. Even if the last many market declines turned out to be only disappointing pullbacks, now is not a particularly good time to be second guessing the Model and the Sell signal.

FAQ of the Week

Question: Can you clarify the IRA settlement period issue?

Sadly, this topic is a self inflicted wound we caused with last week's Trend Timing School "Broker update" article in which we erroneously stated that "brokerage IRA accounts incurred a settlement period between the selling of one fund and buying of the next" (note that this error has since been fixed). The issue has to do with the two transactions required for a long and short strategy on any given signal, and our ability to execute both trades on the same day. Most brokers, and we specifically verified this with Fidelity, Interactive brokers, Schwab and Scottrade, will let you place both the sell order (to get out of your long position) and the buy order (to get into the short position with an inverse fund) on the same day, as long as the securities have "compatible settlement periods". Examples to the rescue:

Mutual fund example. You want to sell one mutual fund and buy another; no problem because both have a 1 day settlement period. In fact, if the two funds are in the same fund family this can be done in a single exchange transaction at any broker. What varies between brokers is if, and how much of an early redemption fee they charge

ETF example. You want to sell one ETF and buy another; no problem because both have a 3 day settlement period

Mixed example. You want to sell one ETF and buy a mutual fund: Problem! Most brokers will prevent you from getting into this predicament because, by the time your mutual fund requires the cash to settle your buy order (1 day later), proceeds of your ETF sale would not be available for another 2 days

This is another good reason to stick with one type of equity (and we made no secret of favoring ETFs whenever possible) for both the long and short legs of your trades. We hope this clarifies any confusion we might have created.

Warm wishes and until next week.

The TimingCube Staff