The Next Shoe to Drop?

Subprime pollution from housing is rapidly spreading into so many areas now that inquiring minds may be asking, “What’s the next shoe to drop?” Let’s take a look at a few of the most promising ideas…

First is the rising credit card borrowing trends being seen in the wake of the subprime mortgage collapse. Homeowners, fearful of foreclosures, are continuing to borrow from credit card companies while payment defaults are much higher than last year. According to MSNBC, credit card companies have had to write off payments as uncollectible in the first half of 2007 30% more than last year and delinquencies are expected to rise in the next six to 12 months.

Many think that problems will be avoided as long as employment holds up, so let’s explore the idea that jobs may be the next shoe to drop…

Temporary employment leads and the implications appear unpromising now that the year-over-year change in temporary employment has gone negative. This is bad enough, but one must also consider soaring mass layoffs.

Layoffs began rising dramatically in August, and the financial sector was responsible for nearly half the cuts.  Many mortgage and subprime lenders could not stand up to the pressure of the housing market and were forced into bankruptcy.  This was highlighted by the collapse of Home Mortgage Investment Corp. who fired nearly its entire workforce.

Commercial real estate may be the next shoe to drop and in our opinion, we think it’s going to get crushed. It is overbuilt, over-loved, and due for a collapse. If Ben Bernanke thinks he as a problem now, watch what happens when commercial real estate blows up. Fannie Mae and Freddie Mac might be able to keep people in their houses in lieu of foreclosure by renegotiating terms down and down again (for a while, anyway, but certainly not forever), but bank funding of unneeded strip malls is another thing, indeed.

Other shoes to consider would be a derivatives blowup, a massive unwinding of the carry trade, homebuilder bankruptcies, or a collapse of the U.S. dollar. But so many shoes are in the air and falling that it’s going to be difficult to say precisely which shoe hits the ground first. That’s what happens when it rains shoes…

With all of these shoes starting to drop, it’s time to short short transports. Here’s why…

First, housing has clearly stalled and shows no sign of recovery. With mammoth numbers of adjustable rate mortgages resetting between now and March 2008, things can, and likely will, get much worse. Shipping material for new construction will continue to weaken. Also, shipping needs, to furnish new homes, will continue to weaken as well.

Next, commercial real estate is poised to fall. Deals are collapsing as people who can get out, are getting out. The rate of increase of building new stores, as well as the merchandise required to fill those stores, will fall. That clearly means reduced shipping demand.

And, a weakening job market means less consumer demand. Falling consumer demand means fewer items need to be shipped. Due to this falling demand, truckers can no longer pass on rising fuel costs. One leading shipping company recently cut fuel surcharges 25%, despite crude prices near all-time highs. Don’t be fooled, these price cuts are not done out of the goodness of their hearts. There is a reduced demand for shipping.

Coming out of the 2001 recession, shipments increased until 2005. They began leveling off, and then declined throughout 2006 and so far through 2007. It’s no coincidence that this more or less mirrors the topping of the real estate cycle.

Supply Chain Digest is also reporting that inbound container volume growth has slowed dramatically at U.S. ports over the past year, with May 2007 traffic down 0.2% from a year earlier. This confirms the slowdown we are seeing in truck tonnage, and also suggests the consumer-led economy is slowing.

As the market continues to open its eyes to the effects housing is having on the broader economy, we are seeing important sectors of stocks break down from their bull trend. Now we have seen the transportation stocks follow suit. Over the past year, the Dow transports had rallied themselves into a wedge pattern that usually results in a significant top.

During the market sell-off from the July high, the transports broke down out of their wedge and have consolidated. Breakdowns like this one usually result in a swift move that retraces the entire wedge pattern, which would be more than a 25% decline from here.

Smart investors should recognize this trend and plan accordingly.

Regards,
Mish

October 11, 2007