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By: Bill Spencer — April 19, 2020

Small-Cap Sunday - Let's Get Bearish on Housing

Happy Sunday.

Thanks as always for stopping by...

Today we're going to take up where we left off two weeks ago ("This Sector Is a Victim of the Feds") when we looked at the mortgage home industry.

Specifically, we saw how recent actions by the Federal Reserve have led to some horrific unintended consequences, both for would-be home owners (borrowers) and for Loan Originators (lenders).

In a nutshell, with interest rates near zero, millions of home owners are scrambling to refinance their mortgages.

This is turn is causing so much "run off" that the businesses that service those loans have to remove them from their portfolios before having reached breakeven.

(The servicer pays a fee for the right to service the loan and receives income from so doing. It typically takes three years for a servicer to break even.)

This image, from the Federal National Mortgage Association (Fannie Mae) shows the extent to which applications for new mortgages are plummeting at the same time refinances are soaring.

(Click any image to enlarge)

Fannie Mae also maintains an indicator called the Home Purchase Sentiment Index (HPSI) which basically measures potential home-buyers view of the housing market.

The index  fell 11.7 points (to 80.8) in March, its lowest reading since December 2016.

According to Doug Duncan, Fannie Mae's Senior Vice President and Chief Economist...

"Attitudes about the current home-selling environment deteriorated markedly, falling to their lowest level since January 2017. ... When asked why it’s a bad time to buy or sell a home, approximately 7% of consumers offered COVID-19 as an unprompted response, one of the highest percentages of non-standard answers in the survey’s history.

"We expect these developments to weigh heavily on housing activity during the spring/summer homebuying season."

To make matters worse for Loan Originators or Servicers, the government, in an effort to help home owners, has effectively told borrowers they don't have to pay their mortgages.

But the Servicers have to remit payments to investors (owners of mortgage-backed securities) whether or not the Servicer has received cash from the borrower.

The good news for Servicers is that the Fed has set up a credit facility that Servicers can use to carry them over this hump. But nobody knows for sure when it will be fully up and running.

In a second I'll also show you one way to play this development without having to sell short the mortgage industry.

But first...

The market seems to have settled down a bit since those manic-depressive weeks of late March.

All of the major market averages are showing gains (and losses) we typically see in more typical times.

Here's how the market performed this week.

Last week on the other hand the landscape looked like this...

Pretty manic.

And recall that just weeks before that the shoe was on the other foot.

Pretty depressive.

So the past week's results might foretell a return to normalcy.

As for the economy as a whole, we have 22 million (and counting) out of work...

And with vital economic hubs such as shipping and transportation, oil and energy, retail, restaurants and sports teetering...

We're going to have to wait to finally see (and feel) the full macro-economic effects of this lockdown.

President Trump, after speaking with all 50 state governors, said on Thursday that the White House has a "three-phase" strategy for re-opening the economy beginning on May 1st.

As many as 29 states could be eligible to re-open their economies before then.

But whether or when we turn to anything approaching "normal" is an open question.

The bottom line is, right now the economic picture is fluid and uncertain.

My feeling is that for the next few months at least, the housing and mortgage markets are ripe for shorting.

If you want to channel your inner Michael Burry and gain bearish exposure to this space, consider buying a Put option on a leading mortgage ETF.

The iShares Mortgage Real Estate Capped ETF (REM)  tracks the investment results of the FTSE NAREIT All Mortgage Capped Index.

For its part, the index itself measures the performance of the residential and commercial real estate and mortgage finance sectors of the U.S. stock market. In a nutshell, it's made up of U.S. real estate investment trusts (REITs) that hold U.S. residential and commercial mortgages.

The ETF lost 70% of its value between February 20th and the bottom on April 3rd, falling from $48.35 to $14.45.

Since then its move back up, retracing 46.5%. The price briefly found support at the 23.6% Fibonacci level, near $21 before falling below that level where it could be encountering resistance (The purple rectangle).

The fund currently trades at $21.17.

We're going to play this for a short-term downside move.

While I think REM is going to eventually recover along with the economy, I think in the next few weeks it could fall to $15 (the green line on the price chart) and possibly put in a new low around $12.00 (the blue line).

For one thing, REM is part of the Real Estate sector, which is currently in a column of O's on its BPI chart (highlighted), but also on a point-and-figure (P&F) "Buy" signal.

That means the sector is weak in the short-term only.

The sector is also weak against the market, as seen on this Sector RS chart which shows how Real Estate performs versus the Equal Weighted S&P 500.

The chart is in O's (weak in the short term) and also on a "Sell" signal versus the market (weak in the longer-term).

And look at this snapshot generated by Sector Prophets Pro, our Premium data service).

Not only is the sector weak against the market (first red arrow), REM itself is weak against its sector peers (Sector RS, the first red arrow) and weak against the market as a whole (Market RS, the second red arrow).

The REM October 30 Strike Put Option sells for $10.70 right now (the mid-price between the bid and the ask).

If REM falls to $15 in a few weeks the Put will be worth $15.82 -- a 48% return.

If it falls to $12.00 the Put will be worth $18.77 - a return of 75%.

Stay safe and sane, and I'll see you next week.

Bill Spencer

Editor-in-Chief, True Market Insiders

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