Small-Cap Sunday - This Sector Is a Victim of the Feds

By Bill Spencer April 5, 2020 Facebook Logo Twitter Logo Email Logo LinkedIn Logo

Hi there...

Thanks for stopping by, and quarantine or no quarantine, I promise you that this weekend conversation will remain open for the duration.

The market has begun making the expected "next leg lower" we've been talking about.

And as we saw with the previous decline, we will see a rally off this next approaching low.

In the meantime, it bears repeating that now is the time to take defensive measures. If you have bullish positions, consider tightening your stops on the ones you're inclined to hold on to.

If you don't have bearish positions -- get some.

Being able to profit when the market falls is one of the most powerful skills you can acquire. It can be the difference between staying in the investing game and having to head for the showers.

And the best way to do that is to look for the weakest sectors and bet against them.

In a moment we're going to look at one particularly weak sector -- Real Estate.

You'll meet a very close contact of mine who has a ringside seat to a particularly nasty disruption unfolding as we speak.

First, let's review the market.

(Click any image to enlarge)

As you can see it was not a pretty week for any of the major indices. And it was particularly ugly for small-caps.

The Russell 2000 (RUT) and the S&P 600 (SML), our small-cap proxies, each fell more than three times the Dow Jones and the S&P 500.

Again, this current selloff is not unexpected. During a selloff (as you've heard me say before) the smaller tickers lead the larger tickers lower.

We're also in a kind of market "no man's land" with this COVID-19 shutdown.

Last week saw 6.65 million jobless claims, the most since records have been kept.

And it's looking like second-quarter earnings for the S&P 500 will shrink more than -13% compared to the same quarter last year, from $335.9 billion down to $291.00 billion.

Above all, we're still waiting for the epidemic to peak. Most of the headlines are cautioning that the coming week or two will be particularly challenging.

Now it's a cliche that "markets hate uncertainty" but it's still a fact.

At their essence, all markets are gigantic living computers. They process information. The less certain the information, the more volatile the market.

One sector that's getting beat up bad right now is Real Estate.

It's ranked #42 out of the 45 sectors we track at True Market Insiders.

Its Bullish Percent Index (BPI) chart just flipped to O's...

When a BPI chart flips from X's to O's, it's telling us that a significant number of stock in the Real Estate sector have gone on point-and-figure "Sell" signals on their respective price charts.

Each box on that chart represents 2% of stocks. So that highlighted column of O's at the right shows where, in April (which is just three trading days old) about 16% of real estate stocks just went on Sell signals.

A stock only goes on a Sell signal when its price falls below a key historical support level. That happens when institutional investors start selling the stock in droves.

A column change on a BPI chart is a sign of short-term strength or weakness. In the case of Real Estate, above, it's a sign of weakness.

What's more, if that highlighted column fills in just two additional boxes, and gets down to where the black arrow is pointing, then the Real Estate sector's BPI chart itself will go on a Sell signal of its own.

That's a sign of longer-term weakness in the sector.

Finally, look at the sector's Relative Strength (RS) chart. This chart (shown, like the BPI  chart, in point-and-figure style) compares the performance of the sector against the equally weighted S&P 500.

The chart just flipped into O's and if it fills just a single box lower (the black arrow) it too will go on a Sell signal.

So Real Estate is underperforming the market.

Now, all of those technical "internal" indicators actually only confirm something a very close contact of mine has been telling me about one segment of the Real Estate sector.

I mean the housing market and the mortgage lending space.

The contact is my sister, Carolyn. We're a very close family, so this is in fact a very "close" contact. In fact, Carolyn would be the perfect sibling if not for her single niggling flaw -- she's ten times smarter than I am.

Carolyn is an integral part of a very successful real estate business in the Virginia-North Carolina Metropolitan Area.

During a recent long talk she opened my eyes to a major disruption going on right now in residential real estate.

Right now the housing market is dealing with an unintended consequence of a recent action by the Federal Reserve bank.

You see, when the Fed cut its prime rate to zero, it created a perfect storm that is hitting residential real estate with particular force.

Carolyn deals closely with the "loan originators" or the people who create the mortgage loans that keep the housing market humming and put millions of people into homes.

Here's what's going on...

Say Bob Jones goes to a Mortgage Originator for a loan. The Originator grants the loan, which is then "serviced" by a third party -- the Servicer. (Some Originators service their own loans.)

The Servicer handles all aspects of the loan -- collecting and forwarding  payments, paying taxes, etc. -- and receives payments for doing so.

"The Servicer typically pays 1% of the loan amount upfront to the loan originator for the privilege of servicing the loan and getting paid," Carolyn says.

The Servicer's payments are around 30 "basis points" (there are 100 basis points in one percent point).

"That means it takes a Servicer about three years to break even on a particular loan they've agreed to service".

Some Servicers finance part of that 1% on margin.

When interest rates drop dramatically, people scramble to refinance. This causes a Servicer's loans to get paid off before their three-year breakeven point. This is called "servicing runoff" and the more loans a Mortgage Lender has in their portfolio, the greater their losses can be.

COVID-19 has put millions out of work. They can't pay their mortgages. The government is granting "forbearance" of mortgage payments for individuals who've lost their jobs.

But... the Servicer is still obliged to hold up their end whether or not they're getting paid from the borrower.

And there's another wrinkle here that is more ominous. A borrower who fails to make the first payment makes that particular loan ineligible to be sold to investors.

Those "investors" are people and institutions who purchased any "mortgage backed securities (MBS)" that the loan has been bundled into.

"If you can't sell those loans, you can't make new ones," Carolyn says.

"One originator did tell me that credit [the mortgage] may be pulled even after closing. That is not something that is actively occurring at the moment, but it's very much out there as a real possibility for the near future".

The Servicer his or herself must hold onto that (now very risky) loan his or herself. With interest rates so low for so long, there's an increasing number of loans that no longer qualify for inclusion in MBS.

There's more to this story, which I'll try to flesh out in a later column.

I'll also be looking for the best ways to play this disruption as it unfolds.

Stay safe and I'll talk with you soon,

Bill Spencer

Editor-in-Chief, True Market Insiders

NYC Marathon Update: Newer readers might not know that I'm a mission to run the New York City Marathon this November. Obviously the COVID-19 debacle is playing havoc with my plans.

Every gym in the New York area, where I live, has closed. Luckily, my old trainer, Freddie, has begun holding live online training sessions via the remarkable "Zoom" application.

I had the first two sessions this week. After lollygagging around on "lockdown" for three weeks, the muscles of my chest and arms are so sore I am forced to type this column with my feet.

No worries. I'll get back into a routine. Right now the expectation is that the Marathon will go off as expected, although the New York Road Runners club has cancelled some of its races.