RISK PREMIUM STATISTICS

RISK PREMIUM ANALYSIS:  THE 11^th Rule

For The Week Ended: October 10, 2008

THE 11^th RULE

“Interest means very little when principal is at risk”

One of the questions I am asked most frequently is how I uncovered the Enron house of cards several months in advance.  There is nothing mysterious about it; I used the 10 fundamental rules of security analysis (posted on our website www.wfin.net). I’m amending that list to include an 11^th rule: “Interest means very little when principal is at risk.”

This guideline was given to me by my mentor at Standard & Poor’s (forget the year, it’s not important), Al Copeland, a very wise and hardened analyst.  For Wall Streeters this rule is self-evident, for neophytes it bears elaboration.  It simply means that when investors and lenders perceive that their investments and loans are at serious risk, the rate of return (interest, dividends) should be disregarded.  Certainly this is a variable underlying the current lending seize-up at the interbank and retail levels.

The preservation of capital, regardless of the rate of return offered, has been taken to heart anew by banks. This principle is diametrically opposed to the conventional Wall Street wisdom that “everything has a price” which, to investor dismay, has been seriously challenged if not disproved.   Hence, we are adding this criterion to the “Ten Ways On How To Avoid The Next Enron,” notwithstanding the fact that is does not explicitly pertain to Enron’s circumstances.

ARE WE THERE YET? ...NO

Stocks lost 1,974 points or 18.15% of their value during the week, with the Dow’s Jones Industrial Average’s closing the week at 8,451.19, its lowest level since April 25, 2003.  Since peaking at 14,164.53 the Dow has declined 40.34%.  After a period where stocks have fallen so precipitously, a rally should be expected in short order but we feel that an upward spike would be a classic Bear Market trap and should not be interpreted as the widely hoped for “bottom.”  Our Risk model indicates that that the Dow Industrials could reach 7,500.  At this level stocks should begin to consolidate and form a base from which a sustained rise in stocks is probable.  A dip down into the 7,000 region may not be reached until mid-2009, with intermittent advances along the way. In short, our model does not indicate a steep downward slope.

While there is a long list of reasons to conclude that this bear market has not yet run its course, some of the prominent reasons are:

§  Risk parameters as reflected by P/E multiples have yet to be re-established.  While stocks and bonds may appear “cheap” relative to the figures posted last year, we feel that a systemic alteration in equity valuations is underway. Our Risk Premium Model leads us to conclude that the cost-of-risk curve is shifting higher.  In short, stocks do not appear “cheap” considering historic valuation points, especially 2007 valuation measures.

§  Based on key technical indicators, such as the market breadth, selling sentiment exceeds buying sentiment.

§  As long as house prices are falling, it is difficult to envision the “quality” of the loan portfolio’s of financial institutions increasing.  In addition, as the world economy slips deeper into recession and unemployment increases, there is a “real” chance that despite healthier Balance Sheets, lenders are likely to display less willingness float funds at the “retail” level, thereby impairing an overall economic recovery. This does not bode well for prospects of restoring the profitability of financial institutions (notwithstanding advances made on the Capital side of the Balance Sheet and improved liquidity from the sale of “toxic securities.”

§ Government interventions in markets will require time to demonstrate that they “can be” and “are” effective, extending uncertaintywell into 2009.

§  Banks and other financial intermediaries are still in the process of validating their balance sheets.

§ The money flow freeze is not confined to interbank /wholesale transactions. Lending at the retail level remains extremely inhibited, pointing to a broader problem, namely, the “fear factor.”   Lenders of all types are exhibiting an overwhelming aversion to extend credit to corporate or individual borrowers,

§  Until recently, earnings prospects by many U.S. corporations benefited by a continuous, international demand for goods and services. Once it became apparent that foreign economies were weakening, U.S. stocks lost a critical element of resilience.  As far as timelines go, we place the loss of investor confidence that global economies would pick up the slack at around May of this year.

§  Bear markets typically end with a whisper, not a bang. October 10, 2008 will go down (at least, so far) as being the most volatile trading day in the history of the Dow, with the average swinging 1,019 points during a single trading session.

§  Energy prices should remain volatile, moving in tandem with global economic performance, since we are currently facing a globalslowdown much of the upward pressure on oil & gas prices seems to be alleviated.

RISK PREMIUM MODEL ILLUSTRATES THAT A NEW VALUE EQUILIBRIUM HAS NOT BEEN REACHED

Our Risk Premium model suggests that stocks are not offering investors adequate returns to induce significant buying activity.  The Dow Industrial Risk Premium for the week ended October 10, 2008 advanced to 9.53% from 7.89% the previous week.  The Dow Transportation and Utilities also moved higher, with the Transportation Risk moving to 8.66% from 8.19% and the Dow Utilities 10.64% versus 8.39%.

THE SEARCH FOR NEW VALUE BENCHMARKS...IS 10% A KEY LEVEL?

We feel that 10% could become a pivotal discounting figure.  There have been two financings using preferred stocks having 10% stated dividend rates, plus equity enhancements.  If preferred stocks need to return a nominal 10% this might serve as a glimmer of hope for new discounting rates.  However, since the transactions in question involved financial institutions, this may render the rate an inapplicable guideline to other sectors of the market.

When integrated with our Risk Premium Model, however, common stocks may need to offer prospective rates of return in excess of 10%.  Under various scenarios, the model points toward persistent volatility in the equity markets, with the major trend being lower.  Furthermore, it is likely that mini-rallies may be experienced but, at this point, we feel such moves are more likely to be bear market traps. That being said, a sustainable reversal is apt to occur when least expected. Finally, regardless of who wins the presidential election, the element of “certainty” is likely to benefit the market.

§         The Industrial Risk Premium ended at 9.53% versus 7.89%

§         The Transportation Risk Premium increased to 8.66% from 8.19%

§         The Utility Risk Premium increased to 10.64% from 8.39% n

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