economy

As a trader, in this environment, there’s a credo you really need to live by. Perhaps you’ve heard the expression “I’m not married to my positions?” Well, I’ve expanded that as follows: “I’m not married to my positions-I’m just dating them casually.”

The point here is that when circumstances change, your thought process needs to change and right now, in my opinion, circumstances have changed to the point where I have to close my short dollar and long S&P positions which were taken last Sunday night.

What’s turned me off to that trade is that the coming crisis in commercial real estate came into sharp focus on Wednesday.

First, Fed Chairman Bernanke told the Senate Banking Committee that a potential wave of defaults in commercial real estate may present a “difficult” challenge for the economy, adding that one of the main problems was that the market for securities backed by commercial mortgages (Commercial Mortgage Backed Securities, CMBS) had “completely shut down.”

Second, the profit reports from two of the nation’s largest commercial lenders, Morgan Stanley and Wells Fargo, are likely to bring the market’s severe problems into much sharper focus.  Morgan reported a $700M write-down on its $17B commercial property portfolio this past quarter while its CFO said he doesn’t see “a light at the end of the commercial real estate tunnel yet.” Meanwhile, Wells Fargo saw its non-performing commercial loans rise an eye-popping 69% over the same period. The news here implies that regional banks like PNC and Keycorp are likely to continue facing the same issues since their portfolios are heavily weighted with commercial loans.

I can tell you from firsthand experience that commercial lending is at a virtual standstill right now, because I recently started working at a commercial mortgage bank run by my family. Our firm specializes in the only real form of commercial lending which exists at this time; FHA insured loans for properties like multifamily apartment complexes, senior independent living buildings, and assisted living facilities. For all other types of commercial property (malls, retail strips, office and industrial buildings), unless you have access to private equity (which only the largest players do) you are virtually shut out.

Aside from the problems of commercial property owners being unable to pay their mortgages (a serious enough problem) there exists the problems with performing properties that need to refinance.

Typically, commercial loans are amortized over 20 to 25 years but the terms can be between 5 and 10. At the end of the term, the owner will owe a balloon payment to his or her bank because of the longer amortization period. In normal times, it wasn’t too difficult a problem to just refinance and avoid the balloon but now, in the vast majority of cases, these people cannot find new funding despite the fact that their properties are still performing. And even in the rare circumstance where they can refinance, they’re facing larger down payments (lower loan-to-value ratios), higher interest rates and shorter amortization periods (which naturally makes their monthly payments higher).

The net result of all this stifled lending is going to be a huge amount of defaults and foreclosures. The worst for this market is still in the future.

Now, here’s where the trading lesson is. The situation in commercial property isn’t really new- people like Nouriel Roubini have been warning on this for more than 2 years and prices have already declined about 35%. So the fact that the situation isn’t news might lead you to think that the circumstances regarding commercial property are priced in to the market, meaning that investors have already discounted future value.

What I would say to that is when the Federal Reserve warns members of Congress in public testimony and when banks report on the situation in black and white profit reports, the situation comes more into focus. I would also say to not overestimate the intelligence of investors-they certainly didn’t do such a great job judging how the housing situation would lead to the huge declines in equity markets.

Just to play devil’s advocate here, you might want to argue that despite all the negative news today the market really didn’t decline all that much with the S&P only losing 0.5 points. The answer to that is as a trader, you want to do what good hockey players do-skate to where the puck is going, not to where it’s been. That’s a judgment call obviously but really, isn’t all trading when you come right down to it?

There’s another old expression you should be aware of: housing tends to lead the economy into and out of recessions. Let’s now amend that to read residential and commercial property leads the economy into and out of recessions. If that’s true (and with commercial real estate amounting to about 10% of GDP it likely is) by all accounts it would appear that commercial property isn’t about to lead the economy anywhere but down.

Range Bound Markets

In case you haven’t noticed, things have been kind of range bound over the past month or so for the major currency pairs as well as the S&P 500. Understanding why that’s happening  will lead you into the next trend when conditions change, setting up a good trade.

For many traders, this kind of back and forth movement is much harder to trade than when prices are moving in a trend. I posted a long trade on GBP/JPY and AUD/JPY May 26 on twitter that returned about 1000 pips by June 1 but on June 8 I said “it isn’t a good time to trade currencies due to the lack of a strong fundamental driver.”

This is exactly where trend-following trading systems fail, because there’s no indicator to tell you that markets will go range bound. You have to rely on fundamentals (and your instinct) in order to make a judgment call like that.

While there are a number of arguments that can be made regarding why this is occurring now, for my money it’s the fundamental state of the economy which is dictating the action here at the end of the second quarter. Simply put, it appears that a depression has been avoided and that the recession is slowly coming to an end.  But what also appears to be the case is that the economy will remain sluggish for a period far beyond the end of the recession as the unemployment rate edges inexorably towards 10% (or higher).

This is the view of none other than Nouriel Roubini, who believes that 2010 will “fell like a recession” even if the economy is technically out of one. Meanwhile, San Francisco Federal Reserve Bank President Janet Yellen believes that although the recession is likely to end later in 2009, a “frustratingly slow” recovery marked by continued high unemployment is likely to follow.

“I am not optimistic that the economy will spring back to normal anytime soon,” she said on Tuesday during a scheduled speech. “I’m more concerned that we will be tempted to tighten policy too soon, thereby aborting recovery.”

Unemployment will “remain painfully high for several more years,” she said, which obviously points to more troubled loans for the banks in both residential and commercial mortgages.

She also implied that policy makers will leave the Fed Funds Rate near zero for the next several years, saying that such a policy is “not outside the realm of possibility,” in the press conference which followed her remarks.

Here’s something interesting I found on Bloomberg regarding a Goldman Sachs currency trade:

“Goldman Sachs exited a bet that the Canadian dollar would strengthen versus the Mexican peso,” the article said. “Goldman entered the trade on June 8 and stands to lose about 5% including the cost of carry after being “stopped out” when the peso traded beyond 11.40 per Canadian dollar yesterday.”

This just goes to show that even the best of the best can lose when the fundamentals are too unclear or when they fail to provide a strong impetus.

On To The NFP

The much smaller loss of jobs last month (-345K vs. -504K previous) was accompanied by an increase to 9.4% (from 8.9%) in the unemployment rate. Stocks fell a bit on the news and the dollar gained that day.  Stocks gained for a few days afterwards on the realization that the increase was due in part to greater labor force participation (people who had given up looking for jobs started to look again, a good sign). The rest of the month was basically flat.

Now, if we put the NFP together with what we believe to be the prevailing view of the economy, what we (as traders) want to see is some data that indicates the prevailing view is wrong. So what I would suggest is to come back to this article after the NFP is released; not for an immediate short-term reaction but to see if a reason exists for a trend to be established which will be where the best potential for a good trade will exist.

For example, if by some miracle the unemployment rate were to fall, there would be a good chance to see stocks get a boost over the next few weeks. That would put some pressure on the dollar vs. the euro, pound and A$, and it probably would be positive for those currencies against the yen as well.

A Great Trader

In any discussion of great traders, Marc Faber (the original Dr. Doom) surely comes to mind as being right at the top of the list. He correctly called the commodity rally and dollar bear market early in the decade and more recently said back in March that stocks had probably bottomed.

I always look for his interviews on Bloomberg and CNBC because they’re both entertaining and informative. And I just love the way he concluded his monthly bulletin back in June 2008:

“The federal government is sending each of us a $600 rebate. If we spend that money at Wal-Mart, the money goes to China. If we spend it on gasoline it goes to the Arabs. If we buy a computer/software it will go to India. If we purchase fruit and vegetables it will go to Mexico, Honduras and Guatemala. If we purchase a good car it will go to Germany. If we purchase useless crap it will go to Taiwan and none of it will help the American economy. The only way to keep that money here at home is to spend it on prostitutes and beer, since these are the only products still produced in US. I’ve been doing my part.”

Faber was on Bloomberg the other day saying that the dollar was likely to gain over the next 4 to 6 weeks. If we get a big jump in the unemployment rate he could turn out to be right, especially if riskier assets like stocks and commodities are sold (we did get a jump of 0.5 last month and we didn’t see a strong sell off). But if the data goes the other way (meaning the unemployment rate falls), he’ll likely wind up with egg on his face.