Mutual Funds Research Newsletter
Copyright 2009 Tom Madell, PhD, Publisher
Dec, 2009


-Our Buy, Sell, and Hold Signals Again Prove Accurate
-Will Foreclosesures Derail the Economic Recovery?


Our Buy, Sell, and Hold Signals Again Prove Accurate

In our Aug. 2008 Newsletter, we presented data going back as early as Apr. 1990 on what our research showed was a promising way to make Buy, Sell, and Hold decisions.

That data clearly showed that when we went back and designated fund categories, or the stock market as a whole, as either a Buy, Sell, and Hold based on prior return patterns, we saw marked differences in how the categories performed over the following 5 years.

Specifically, for fund categories we classified as Buys and Holds, the 1, 3, and 5 year annualized returns averaged between 11 and 15%. For fund categories we classified as Sells, the annualized returns averaged between about 2 and 6.5%.

Our classifications were for fund categories through June, 2007, prior to the onset of the Oct. 2007-2009 bear market. For the signals to prove their forward-looking worth since then, it would be highly supportive for such signals to have predicted the very poor returns that lay ahead before they actually occurred, or at least, very early on in the decline. Furthermore, evidence that they were also able to predict the turnaround in stocks that occurred early in 2009 would add greatly to confidence that the signals were indeed a useful decision-aiding tool for mutual fund investors.

I can now provide that evidence, further substantiating the value of our Buy, Hold, or Sell signals using predictions made quarterly starting at the end of Sept. 2007 and continuing through the beginning of 2009.

Data Over the Last Two Years Supports Our Sell Signals

What did our signals show at the end of Sept. '07 at a time when we were still in a bull market? For 7 of the 9 major Morningstar categories, and also the international category, for a total of 10 signals, our signals would have suggested Sell. (Additionally, our signal with regard to the broader market, that is, the S&P 500 Index, also showed Sell.) Only two categories, Large Growth and Large Blend, were classified as Hold. Eventually even these 2 Hold categories registered as Sells before the brunt of the bear market hit.

Since each of these categories have gone down substantially since Sept '07, 8 out of the 10 predictions from Sept '07 turned out to be correct, or an 80% success rate. (Most categories are down in the vicinity of 25% or more, through 11-27-09.)

Data Over the Last Year Supports Our Hold and Small Growth Buy Signals

Our signals continued to predominantly show Sell until the end of Oct. 2008. At that point, while we still deep in the bear market, all previous Sell signals changed to Hold. (In our Nov. '08 as well as Jan.'09 newsletters we strongly argued for holding on to your stock positions.)

So how useful were these new Hold signals? As of one year after (thru the end of Oct. 2009), the table below shows that 9 out of the 10 predictions from the end of Oct '08 turned out to be correct (defined as showing a double digit return), for a 90% success rate.

Category Performance (Total Returns)
Category 1 Yr Return
Large Blend +10.9%
Large Growth +14.7
Large Value +8.6
Mid-Cap Blend +17.5
Mid-Cap Growth +16.7
Mid-Cap Value +18.9
Small-Cap Blend +11.9
Small-Cap Growth +13.3
Small-Cap Value +12.6
International +26.2

In our Feb. 2009 Newsletter, we informed you of our switch from Sells to all Holds, with the exception that Small Growth had now become a Buy. From that date, the category returns thus far thru 11-27-09 have been:

Category Performance (Total Returns)
Category Return
Large Blend +32.4%
Large Growth +35.5
Large Value +31.0
Mid-Cap Blend +37.0
Mid-Cap Growth +36.3
Mid-Cap Value +36.4
Small-Cap Blend +32.2
Small-Cap Growth +32.9
Small-Cap Value +33.1
International +39.3

Note: Returns beginning 1-31-09 (not annualized).

Thus, while the returns shown are for nearly a 10 month period (and might not hold up as well after longer periods), for now at least, it appears they are easily on track for a 100% success rate.

Using Our Signals as a Decision-Making Aid Can Improve Your Returns

As you can see, we now have substantial further evidence that not only our sell signals were on target, but that our recent hold signals (and single Buy signal) were providing useful decision-making aids to investors.

Just a few weeks ago, we emailed subscribers that ALL of the above 10 categories (which would also include the stock market as a whole) became Buys. Obviously, it is far too soon to tell if these predictions of future stock market performance will be correct. However, if as time passes these predictions turn out as well as the above recent predictions, in addition to those already described in our Aug. Newsletter, investors who use our new Buy signals as one element of their decision-making process will likely be happy they did.

Although we have confidence that our signals are likely to continue to suggest when, and in what types of stock funds an investor should be buying, selling, or just holding, we don't advocate using them exclusively as one's source of such information. Rather, we recommend our signals should supplement additional data available on the economy and the prospects for how various investments will perform. After all, our signals are derived from how the universe of funds have performed in the past. So if there were, for example, world events that caused an upcoming, renewed, and prolonged crash in most stock markets, our recent Buy signals might prove much too premature. Thus, there is no guarantee that performance patterns will behave identically in the future, although our data supports the notion that funds do generally give out reliable performance signs indicating relative undervaluation, fair valuation, or overvaluation which form the basis for our empirically developed signals.

If you are interest in reading a more detailed analysis of what our current data show, you may want to visit within the next few days and see our latest article. (Many of our articles can be found on that site's Archives link; our articles are accessible near the bottom of the alphabetical list of authors, under the letter "T" for Tom Madell.)


Will Foreclosesures Derail the Economic Recovery?

by Stephen Shefler

In late November, the Mortgage Bankers Association (MBA) reported that 14.4% of all home mortgages were delinquent or in foreclosure and predicted that percentage would increase before it leveled off. A key question for investors is whether the foreclosure wave will continue to grow and derail the economic recovery. Following are some key excerpts from the MBA report:

  1. The delinquency rate for [home] mortgage loans rose to a seasonally adjusted rate of 9.64 percent as of the end of the third quarter of 2009

  2. This delinquency rate breaks the record set in the second quarter. The records are based on MBA data dating back to 1972.

  3. The combined percentage of loans in foreclosure [4.77 percent] or at least one payment past due [delinquent] was 14.41 percent, the highest ever recorded in the MBA delinquency survey. [Most likely, this is the highest rate of delinquencies and foreclosures since the Great Depression. 5.22 million mortgages were delinquent and 2.35 million were in foreclosure. A very important qualification: approximately 30% of owner-occupied homes have no mortgage: therefore the percentage of all homes delinquent or in foreclosure was significantly lower.]

  4. The outlook is that delinquency rates and foreclosure rates will continue to worsen before they improve.

Looking forward, when will this trend peak out? Will the total number of delinquencies and foreclosures as measured by the MBA reach 16 percent, 17 percent or even more?

Future Delinquincies

Government agencies and financial firms such as Fitch, Moody’s and First American Core Logic have put out numerous reports predicting that mortgage delinquencies will continue to rise. There is, however, substantial disagreement about how much more of an increase will occur and over what time period. Three reasons are generally cited as the basis for predictions that delinquencies will increase:

  1. Recasts of option adjustable rate mortgages, popularly known as pick and pay mortgages: Fitch estimates that approximately 1 million such loans were made during the 2004 to 2007 housing boom. Almost all will recast in the next three years. These loans typically permit buyers three payment options: a fully amortized payment, an interest only payment or a negatively amortized payment. Under the negative amortization option, the borrower pays less than the interest due, thereby increasing their mortgage debt each month. These loans recast five years after the loan was originated or when the loan debt reaches 110 to 125 percent of the original amount due whichever comes sooner. At recast, the loan becomes fully amortized and monthly payments can increase dramatically. According to Fitch, 94 percent of pick and pay borrowers made the lowest possible payments and the average recast will result in a 63 percent higher mortgage payment. As a result, a very large percentage of the borrowers are likely to default.

    46% of pick and pay loans were already delinquent by September this year and that number was rapidly growing. Some lenders holding such loans are aggressively attempting to renegotiate them. Wells Fargo, the bank holding the largest number of these loans, is offering conversions to interest only loans for borrowers able to afford such obligations. These factors will lessen the amount of future pick and pay delinquencies.

  2. Borrower capitulation due to prolonged unemployment: Some borrowers on unemployment or whose wages declined have scraped by and kept their loans current in an effort to save their homes. Some have dipped into limited savings, including 401ks, to avoid delinquencies and foreclosures. The length of unemployment has been unusually long in this recession and more of these borrowers are now becoming delinquent. This trend is likely to continue. The MBA and RealtyTrac cite an increased level of delinquencies among prime borrowers as evidence that there is now a second wave of delinquencies due to unemployment as distinct from the first wave due primarily to resets on subprime loans. If this wave of delinquencies equals the first wave in size, the foreclosure crisis will likely last into 2011.

  3. Future job losses: Most economists believe job losses have not yet peaked and are unlikely to do so until the first or second quarter of 2010. Some project that job losses will end even later. As additional job losses occur more borrowers will become delinquent. The typical lag time between job loss and delinquency is six to nine months.

Notwithstanding the above factors, new delinquencies have recently leveled off. If that trend continues, the MBA’s prediction of increased delinquencies will have been off base.

Future Foreclosures

There is a major debate among housing experts and economists about how many mortgages that are currently delinquent or likely to become delinquent will end up in foreclosure. As noted above the MBA reports that 9.64 percent of mortgages are delinquent and 4.77 percent are in foreclosure – almost twice as many loans are delinquent as are in the foreclosure process.

There are a wide variety of reasons for delays in putting homes into foreclosure: (1) Federal regulatory agencies are applying intense pressure on lenders to modify loans using the government’s Home Affordability Mortgage Program. These agencies are making time consuming modification eligibility determinations a requirement for each delinquent loan. The Congressional threat to modify the bankruptcy laws by allowing judges to reduce loan balances lurks in the background and puts pressure on lenders to consider modifications; (2) Staffing to review the delinquent loans and process them through foreclosures is limited. Foreclosure activity is six times greater than it was four years ago. While lenders/servicers are adding and training staff, satisfying all the legal requirements takes time; (3) Some states are enacting mediation requirements before a foreclosure can be completed.

One big unknown going forward is whether the Home Owner Affordability Program, set up by the government last spring, will reduce the foreclosure rate. The program has two components: modification and refinancing. The Treasury Department hopes to save up to 4 million home owners from foreclosure by loan modification and assist up to 5 million additional home owners by refinancing. Under the modification provision, a home owner is eligible if their house payment (mortgage, taxes and insurance) exceeds 31 percent of their income. They must have suffered a significant increase in mortgage payments due to a resets, recasts or a loss of income since taking out their current mortgage. Lenders must absorb the cost of reducing payments to 38 percent of the borrower’s income. The government then funds a further reduction to 31 percent of income by decreasing the mortgage rate to as low as 2 percent, extending terms for up to 40 years, and/or forgiving up to $5000 of principal. The combination of these factors is intended to lower monthly payments significantly more than ongoing independent lender modification programs and thereby to increase the likelihood that the modifications will succeed. Independent lender modifications have suffered high failure rates.

There is one caveat to the MBA data that has not been widely reported. Many of 650,000 plus homes currently in the HAMP trial modification program were listed as delinquent. This is approximately 12% of delinquent loans. Participation in the program has also been rapidly increasing, so that number will grow. It is simply too early to make any firm assessment of HAMP, i.e., whether it will reduce the foreclosure rate. As a result, it is a major unknown going forward.

In addition to the HAMP, there is he Home Owners Refinance Program (HARP) available to homeowners whose mortgages are financed or guaranteed by Freddie Mac or Fannie Mae and are underwater but by no more than 125 percent of the home’s value. The intent is to save purchasers from foreclosure by lowering their monthly payments. This is done by refinancing, which lengthens the term for repayment and/or reduces the interest rate to the very low levels currently available. Lenders can assist the borrower by forgiving a limited portion of the debt as part of the refinance process.

Lenders (including investors in securitized mortgage pools) are teaming up with distressed borrowers to obtain HAMP and HARP relief in order to profit by increasing the book value of deeply discounted mortgages they currently hold. Their involvement may make the success of the programs more likely.

The HAMP and HARP programs are still in their early stages. Some critics predict that these programs will be major failures. However, the Treasury Department and a number of major lenders seem determined to make the programs succeed, especially given the importance Congressional backers place on these initiatives. The administration’s determination to make the programs succeed should not be lightly dismissed.

One big limitation of HAMP and HARP is that they are not designed to help unemployed workers. They are designed primarily to help with mortgage resets. Foreclosures and delinquencies will grow as long as employees continue to lose jobs and the period of unemployment remains lengthy. The foreclosure crisis is intertwined with the unemployment crisis. In response, a proposal is now being floated in Congress to give unemployed workers temporary extra compensation to avoid foreclosure.

The political process will not stand by idly as millions of homeowners lose their homes to foreclosure, a fact that many economists and housing analysts do not fully take into account.

The Bottom Line

The MBA predicts that foreclosures will not peak until 2011. RealtyTrac, which monitors foreclosure activity, predicts foreclosures will peak in late 2010. Neither predicts how high the foreclosure rate will go before reaching its peak. According to RealtyTrac, there will be 3.2 million foreclosure filings this year, up from 2.3 million last year. Housing experts are all over the board predicting foreclosures in the next couple of years. Estimates range from as low as 3 million to as high as 7 million additional foreclosures. There are so many moving pieces and unknowns, that it is very difficult to make a firm prediction. If, however, foreclosures in the coming year were to continue to increase at the same rate they have over the past couple of years, it would be a cold shower for consumer and market confidence.

Highly esteemed housing analysts Ivy Zelman concludes, “I’ve been pretty bearish on this big ugly pig stuck in the python and this [the MBA report] cements my view that home prices are going back down.” Mark Zandi, Chief Economist at Moody’s, recently said, “I don’t think the housing crisis is over. I think we’re going to see another leg down.” These predictions are supported by the fact that 4 million plus homes are either 90 days plus delinquent or in foreclosure, more than the total number of homes currently on the market. In short, they would double the current inventory.

Investor takeaways: There is a high level of uncertainty about when foreclosures will peak and how many homes will end up in foreclosure. While it does not appear that delinquencies and foreclosures will derail a recovery, they will contribute to keeping the pace of any recovery unusually slow.