Good Expiration Friday To You!

Well we're done with that.

Ok, let's recap where we are.

We have breached the DOW's high and are now in "no upside resistance" level. The S&P500 is within spitting distance of the all-time highs.

But...... (oh, I know....)

We've got a data disconnect here, and somehow we have to either explain it away - or the strength we see in the market is driven by an irrational thesis.

What disconnect? Jobs.

How do you have a 30% decline in housing construction without jobs being lost?

Two possible explanations come to mind:

• There has been significant job loss, but most of it has been in illegal immigrants. These people do not show up in the unemployment statistics, but they sure do in the stores! They are also not likely to "just go home" when jobs get tougher to find.
• There has not yet been significant job loss, but there will be, and it will show up soon. In other words, what's happening so far amounts to "job hoarding" - that is, jobs are indeed a lagging economic indicator as I (and others) have put forward as a thesis in the past.

After all, you can't keep people on the payroll without work for them to do!

This, at the end of the day, is the fundamental question.

So let's look at - gasp - the data!

And who better to look to than Caterpillar. After all, where there is construction, where there is trucking, there is Caterpillar. They are the internationally-known name in that game, from truck engines to construction equipment to machinery. Drive by any construction site, you will see Cat gear.

What does Caterpillar say? Here are some quotes:

"North American machinery sales declined 13% to $3.08 billion in the recent quarter, hurt by the weak U.S. housing market. Caterpillar noted that North American contracts for nonresidential construction fell 3% from a strong year-earlier period, and that commercial and industrial contracting "slowed abruptly." Coal mining also struggled. In addition, Caterpillar said that tighter financial conditions increased uncertainty and prompted users to delay purchases, even in some sectors where activity was good.

North American engine sales fell 9% to $1.17 billion, as sales for on-highway truck usage tumbled 53%. Caterpillar had warned of a large sales decline during the first quarter because of engines that were pre-purchased in 2006. Also, engine shipments declined to accommodate the transition to engines that meet 2007 emissions requirements.

Caterpillar is less upbeat about the U.S. than it was three months ago, lowering its 2007 economic growth forecast to about 2% from 2.5%. It also reduced its U.S. housing starts forecast to 1.5 million units from 1.7 million.

The company noted that weakness has spread from the housing, auto and transportation sectors into capital goods. Caterpillar added that weak economic growth will depress machinery sales this year and pose an additional threat to on-highway truck sales."

WSJ Story

But.... but... but.... the bulls will sputter..... I thought we had a strong construction market outside of housing? And I thought our industrial output was strong? And I thought our economy was roaring?

Wait a second...... Truck engine sales down fifty-three percent? Did I read that right? Machinery sales down thirteen percent? Non-residential construction down three percent (aren't the talking heads telling us that non-residential construction remains strong?)

Hmmmm.....

The background questions are similar, and yet still need to be answered:

• If the "Home Equity ATM" is closed, and we know that it is for a fact, then how does the consumer keep spending? There are only two possibilities, and both have negative repercussions: 1) People can be loading up on credit card debt or 2) Real wages (ex-inflation) can be increasing. (1) of course eventually runs into the brick wall called your credit line, and (2) runs into the brick wall called inflation, forcing a Fed rate increase.
• In order to support a median house price to median income ration of 5:1, 30 year fixed mortgage rates must be at about 2.5%. That has never happened - even in the days following the 2000 tech explosion the lowest the 30/fixed interest rate went was just under 5.5%. We can therefore call the possibility of this valuation as a "stable" part of our economic picture impossible. That, by the way, pegs house values at about twice where they are sustainable - and indeed, that's about where they are. How do we get out of that box without millions of consumers either (1) paying off 50% overvalued houses for the next 30 years, thereby draining consumer spending and liquidity through huge interest payments or (2) home prices dumping by 30-50% nationally, thereby draining consumer's biggest asset and causing them to feel poorer - and cut back spending?
• There are people who say "Home prices aren't that high." Oh yeah? Not according to Goldman Sachs, who issued a warning this afternoon (funny how that happened after the market closed, isn't it?) pointing out (for the first time from one of these "respected" institutions) what I've been banging on for more than a month - home prices in California specifically and in the nation generally were fueled by ARM mortgages offered to borrowers who were already stretching to make the purchase!

Now if these thesis are correct, there should be stresses on the consumer appearing in the data.

Not in "economic surveys" but in the quarterly reports posted by financial firms.

And indeed, there are.

American Express (AXP) just reported earnings. Record earnings! The market loved it and rewarded them with a nice pop in the market. Of course they would. Now how would American Express get record earnings? Card members spend more and retain higher balances on their credit cards. The same story was found at Capital One, which reported a huge earnings miss (due to mortgage problems) but their credit card unit reported record interest earnings. Washington Mutual (WM) reported record card unit interest income, which can only come from balances being carried by consumers.

You don't pay interest on a card if you pay it off every month, do you?

But along with record earnings in each and every one of these firms came sharp increases in delinquency and charge-off rates, and let's not forget that you can't just run out and declare bankruptcy any more! So we'd expect that perhaps delinquency rates would go up, but charge offs would decrease.

That's not what happened!

We need to find an explanation for this - because the only other logical conclusion, if we can't find some other explanation for it, is that the consumer is becoming over-leveraged and starting to buckle under the stress.

This is critical because if the consumer buckles we get a recession. If we get a deep recession, with housing in the tank, it is possible (please note that I am not predicting this!) to get a vicious cycle problem where foreclosures beget more unemployment which beget more housing price pressure which beget more foreclosures - the entire housing problem unwinds violently and we get unemployment in the 10+% range!

What? How's that? Ten percent? You can't be serious! I hear the catcalls already...

I am serious. 30% of our net job growth in this last expansion has been connected to residential housing growth. Now add in all the ancillary growth that new homeowners kick off - lending, banking, investment, etc.

The good news is that such a violent correction wouldn't last long. Home prices would come back to near historical valuation measures within 12 months of the event and the economy would heal itself in the coming year as capacity was absorbed and construction able to restart - however, trillions in wealth would be vaporized. Those people who were over leveraged (e.g. who bought at the top) would be decimated; that drag on the economy would remain for many years.

Next up is balance sheet tricks. Look at WaMu for an example here. Non-cash earnings were half of reported earnings. Yet you can't spend "non-cash" earnings. But wait - they are spending those earnings! How? They're paying out a dividend that exceeds their cash income. How does this work over a long period of time again? Clearly, this is a short-term play with a lot of leverage - if the cash earnings don't pick up and fast you can go broke as you're forced to eat into capital reserves.

This sort of accounting trick is common when you don't want to fess up, and its all over the financial's reports this time around. Capital One, as I noted, appears to not have engaged in such shenanigans. Of course Capital One also got taken to the woodshed today for telling the truth last night in its earnings report. Hmmmm.....

Now let's look at sentiment. Bears? Where? Listen to CNBC lately? Dow Jones 18,000? I really heard that tonight - just now, in fact. Hmmm..... 50% over today's valuation in the next three years eh? And tonight? Zero balance. Have you heard any mention of the balance sheet shenanigans? Paying dividends that are more than net cash income? Organic, US-based negative growth rates for CAT and others?

Anyone remember the book "Dow Jones 30,000" - the recent one? Or "Dow 40,000" of a few years ago? Or "Dow 36,000"? How'd that work out in 2000 for 'ya?

Now we're saying "shift your money out of real estate and into index funds." Hmmm.... got any money left after you unwind all that real estate stuff? Can you unwind that real estate stuff? And how'd that work the last time - you guys told us to stick all our money into the market in 1999, and, well, we just got back where we were. Let's see - eight years, zero return. If you were in the Naz, its eight years and a fifty percent loss!

Should we listen to these butt-clowns?

I don't think so.

I think we should listen to the data.

PERIOD!

Now if the DATA changes, then we change our thesis. Let's see home sales recover. Let's see delinquency rates come down. Let's see net debt carried as a percentage of GDP by consumers go down. Let's see organic growth instead of increased leverage. Let's see inflation actually fall in real terms. Let's see investable capital increase (instead of LBOs via more debt.)

This doesn't mean that you shouldn't be in the market and take advantage of the market when it does irrational things.

DO be in the market. But DO take protection; you don't go out to the bar for a hard night of partying without some rubbers in your wallet, so why would you go long out here without a passel of PUTs against it - long-term PUTs - just in case?

Cost? About 2% for roughly 18 months, assuming you are willing to accept the risk of the first 10% loss yourself.

The higher we fly and the more the bears are driven into hiding, the more nervous I get.