Credit & Real Estate Remain Key

After easily topping low Q3 earnings expectations, stocks are finding it difficult to advance from highs reached in October.  Hesitation may be coming from new reports of continued struggles in the housing market where mortgage delinquencies continue to rise and new construction has slowed.

The credit market continues to remains tight and while problems in the commercial real estate market percolate.  Commercial borrowers are finding it difficult to refinance loans and recent regulatory guidelines make it easier for banks to extend terms on many properties, potentially delaying foreclosures.  Banks are also hesitant to foreclose on troubled properties because selling at current prices would require write-downs they don't want to realize.  The key for commercial borrowers is leasing revenue, a function of lease prices and occupancy rates.  As long as borrowers have the cash flow to continue servicing loans the market should remain somewhat stable but defaults have been rising as vacancies increase and rents fall.

As the economic recovery continues to unfold we can see how the performance of banks, commercial real estate, and home builders has transitioned from leading the market to lagging the market, possibly offering a sign of caution as we enter 2010. 

The first chart below shows all three groups leading the S&P 500 from market lows in March up through the middle of October.  Over the last month the tide has shifted.  Commercial REITs have fallen to just match the performance of the S&P 500 and Banks and Builders are lagging by a significant margin.

NOTE: CLICK ON IMAGES FOR FULL VIEW

Given the role real estate and banking played in the market selloff in 2008 we would expect them to play a leading role if markets are going to advance from current levels.

We have also seen a shift in stock leadership.  As the November rally kicked off the Dow Jones Industrial index has outpaced the S&P 500 potentially signaling a shift to larger, more stable companies.  The transportation index has lagged as have small cap stocks, another disappointing development.

The balance of 2009 may see a continued rally in stocks as we enter into the holiday season, often credited with what has been called the "Santa Claus Rally", but the clouds may be forming for what could turn out to be very challenging start for stocks in 2010 unless more fundimental improvement of the economy is reported.