The Weekend Edition # 71

Welcome to another issue of the Weekend Edition. 

Thank you to all who’ve read and subscribed to the newsletter this week!

Here’s what we cover:

• Market Recap - Overbought or not?

• Macro - Mortgage Rates and Homebuilders

• Earnings - Bank Earnings

• Premium Article - December Inflation Numbers

• The Week Ahead - Economic & Earnings Calendar

• Closing Thoughts

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Let’s dive in ⬇️

Market Recap - 03 Jan - 06 Jan, 2023

What a bullish week! The broad market indices all closed higher for the week. The S&P500, DJIA and the Russell 2000 all closed above their respective 200-day moving average. This is certainly quite the bullish sign for traders. But, is it sustainable and has the bear market come to an end?

The simple answer is no, the bear market has not come to an end. The longer-term trend is still down. There are still too many signs that we have further down to go, particularly because we’re just about to enter an earnings recession. And that’s a forgone conclusion.

It’s interesting, however, to see how the technicals play out in a rally and as of now, signs are pointing to bullish momentum. I wouldn’t get too happy about this though because there are also signs of exhaustion and that the market may be overbought, particularly the Russell-2000 small cap index.

Much of the buying started off being driven by call options buying with same day expiries in weak names like Bed, Bath & Beyond and Carvana - both companies looking at possible bankruptcies.

Traders were driving a squeeze in the market, which is when the amount of call buying can squeeze the price up as dealers / market makers have to buy more shares to hedge the calls they’ve sold. When this happens at a rapid pace, it causes a squeeze forcing the market higher. We’ve seen this movie before and it rarely ends well.

Macro of the Week - Mortgage Rates and Homebuilders

When we first got wind of the Fed raising rates our natural instinct was that mortgage rates would go higher and the housing market would start to deteriorate. The obvious consequence was that the homebuilders would collapse. In fact, one of the Fed’s target is probably to pop the housing market bubble.

But recently homebuilders have been surprisingly resilient and even showing strength from their lows in October. What’s going with the homebuilders and where are we going?

Mortgage Rates and the Housing Market

As expected, the mortgage rates soared with the Fed increasing rates, alongside bond yields. We saw the Mortgage Rate hit a peak of 7.08% in late October and then again in early November. It’s no secret that the housing market has taken a hit because of the increase in rates.

However, since then, we’ve seen the mortgage rate decline and with that, we’ve seen the homebuilders gain strength. The homebuilders are rate sensitive and more than any other factor right now they’re being driven by the 30-year mortgage rate.

Why have Mortgage Rates declined? 

A few reasons:

1. Demand: Weekly mortgage applications have declined significantly, i.e., the demand for mortgages have gone down. People are not rushing to refinance their homes or finance new ones. And in simple terms, the rate is the price of money. So with lower demand, we have lower prices. To some extent, banks may adjust their rates lower to attract more demand.

2. Bond Yields: Bond yields certainly play a part in mortgage rates but in more ways than one. Most banks don’t keep their mortgage loans on their books. They sell them as Mortgage-backed Securities (MBS), something we remember all too well from the Great Financial Crisis. These MBS’ are usually keyed off the 10-year treasury rate (usually higher than the rate). This is yet another reason for the mortgage rates declining as the 10-year rate comes down and the yield curve remains inverted.

Does this mean homebuilders are strong? 

Not quite. What we are seeing is a situation where the macro and the fundamentals are quite a bit at odds. A theme that seems to be playing out quite often in the market.

We’ve been tracking the actual performance of the homebuilders. While it’s true that most of the top homebuilders have had solid balance sheets, they are seeing signs of deterioration. Backlog orders and new orders are declining along with average price per home. This is a recipe for lower revenues and lower earnings.

KB Homes reported last week that their net orders had fallen -80% YoY. Ending backlog value decreased 25% to $3.69B. Ending backlog units were down 27% to 7,662. The cancellation rate as a percentage of gross orders was 68%, compared to 13%. None of this is comforting and it’s only a matter of time before the fundamentals start to make a difference.

I’d remain cautious of homebuilders and stay away from buying just yet.

Earnings - Bank Earnings

Bank earnings were out and dominated the headlines. While the stocks fell on the release, they made quite the turnaround during the day to close much higher.

What were some of the takeaways from the bank earnings?

• JP Morgan is certainly pricing in a mild recession. They’ve increased their base case scenario to model for a 5% unemployment rate.

• Net interest income actually came out better than I expected. JPM’s NII was up 72% driven by higher rates. Bank of America’s NII was up 29% YoY. However, much of this came from increases in credit cards and revolving loans, which indicates that the consumer is borrowing more to meet expenses. They also said NII remains unpredictable.

• Expenses increased. JPM saw expenses increase 6.7% to $76B and for 2023 they’re guiding to even higher expenses of $81B. Expenses at Bank of America were up 3% QoQ.

• JPM also saw a decline in deposits and expects further declines. Bank of America saw a -2% decrease in deposits over the quarter. This is a side effect of the decline in the money supply and we are bound to see more of this across all the financials.

• Home equity loans at Bank of America decline to $27B in Q4, 2022, compared to the pre-pandemic level of $41B in Q4, 2019.

• Loan loss provisions increased across the banks. For JPM it was $2.3B of which $887million were charge-offs driven by credit cards. For Bank of America, Q4 provisions were $1.1B, up from $0.9B with net charge-offs of $689 million but this still remains a historically low levels, according to the bank.

• For both JPM and Bank of America returns have still remained strong. JPM posted an ROTCE of 18% and Bank of America posted 15.8% for the fourth quarter.

• Blackrock’s earnings were slightly more challenged. YoY Assets under management declined -14%, revenues declined -8% and operating income declined -13% and net income declined -14%.

Premium Article

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The Week Ahead - US Markets are closed on Jan 16, 2023 for MLK day

Economic Calendar - There’s no rest even if it’s the first week of the year

So many Fed speakers this week that I couldn’t get the calendar in one screenshot!

Closing Thoughts - Market at Odds

For someone like me, who is driven by the macro and fundamentals, it’s not easy to reconcile what’s happening in the markets. When a company such as Bed, Bath & Beyond that is facing bankruptcy is bid up over 30% in a day, you know something isn’t right.

It also isn’t right that the market chooses to ignore the signs that credit conditions are worsening and even if the Fed doesn’t hike aggressively, the cumulative impact of this tightening cycle alongside the balance sheet reduction will begin to show.

But bear market rallies are vicious, and you never know how far they can go. The Dot Com bear market was marked by rallies of over +20% in 2001 and 2002 over the course of a few months. But overall, the SPX fell -49% during that bear market.

I still think caution is warranted here as we have only just seen the start of earnings season. This week was very risk-on, as we saw sector rotations as well with the most defensive sectors at the bottom. For me, that presents a buying opportunity in the defensives - consumer staples, healthcare.

Here’s wishing you safe investing.

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Sincerely yours,

Ayesha Tariq, CFA

There’s always a story behind the numbers

None of the above is Investment Advice. I may or may not have positions in any of the stocks or asset classes mentioned. I have no affiliation with any of the companies other than explicitly mentioned.

Full disclaimer: https://ayeshatariq.substack.com/about

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