RISK PREMIUM ANALYSIS:

For The Week Ended: October 24, 2008

IT IS DIFFICULT TO BE BULLISH AS CONSUMERS LOOSE BUYING POWER

THE WEEK IN REVIEW

I would like to bring some good news to investors for a change (I’m starting to feel like the Grinch who stole Christmas) but the Risk Premium numbers are what they are and they are not good. All three sectors of the Dow have virtually given back the “coat-hanger” gains made last week. The Dow Industrials closed at 8,378.95, down 473.27 and Transportation fell 214.29 to 3,448.44. Utilities posted a slight 0.9 gain, ending the week at 353.70. By comparison though to the previous week, when the Dow sank though the 8,000 level only to rise above 9,000 during intraday trading, the past week look like a sleepy seaside holiday.

THE SELLING CYCLE

Many funds, for example state pension funds, have found themselves in a difficult position, one which is putting selling pressure on the market. They are finding themselves in the unenviable position of having to sell stock to meet their cash obligations. And the debt markets are throwing off less cash and some investments have actually gone cash- negative as, for example, commercial real estate. This has forced these funds (and many of them are sizeable) to sell stocks to raise large sums quickly. Unfortunately, this is not where the story ends. What have been only paper losses are now real losses and states, for instance, will have to tap various public venues to replenish the shortfalls. Furthermore, some have been hurt by corporate dividend cuts or scaled back expectations. Ironically, when the dust settles the best opportunities to recoup these loses will be in stocks and carefully selected fixed-income securities.

WHERE IS THE BOTTOM?

Fasten your seatbelts. The Dow could trend towards 7,000 but in a somewhat less volatile pattern that we have witnessed over the past year.  Last year’s P/E of 20x could be 2009’s 10x and, depending upon the taxing policies of the new administration, the slump could extend deep into 2010. Unfortunately, the markets will continue to spike on promising but fleeting good news, only to fall back again when reality sets in, deflating expectations. The underlying reason, in short, is that despite the billions thrown at the financial industry (and some will have a beneficial effect) virtually no money appears to be directed at the heart of the problem, namely, hard-pressed mortgage holders. Until this happens, we do not expect to a meaningful reversal in U.S. and global markets.

THE HOUSING EQUATION

As interest rates began to move higher during the first half of 2006, a phenomenon began to surface wherein house prices suddenly started to seem expensive. Around August 2007 it was evident, well before the macro statistics detected trouble brewing, that individuals were feeling financially pinched and behaving accordingly. Homeowners had used their homes as asset collateral by taking out home equity loans based on the accreted value. Some speculated in new home /condo developments that they could not afford while others began to consider their home as a retirement fund. Homes had become multiple sources of capital as consumers used them as a source of leverage.

But, at about the same time house prices began to fall, many of the initial artificially low adjustable-rate mortgages on them were due to be reset. What had been bargain rates suddenly were turning into nightmares for many homeowners who saw their monthly payments jump to unaffordable levels on properties that were suddenly worth less than the mortgages.  Then came the foreclosures and the slump which we seem to be stuck in despite the efforts of central banks to stem the market freefall and provide liquidity to the banking system.

TIME TO HIT THE REWIND BUTTON

If politicians and investors hit the rewind button to the inception of this financial crisis, what they would see is:

·         Abnormally low interest rates. You would have to turn back the clock to the post-Depression years to find rates as low those in experienced in recent times. The giveaway rates -- surprise, surprise-- stimulated heavy consumer spending across the board, especially in housing.

·         Excessively liberal and lax lending policies. These lulled borrowers to take out loans based on unrealistically high appraisals of their homes. Suddenly everybody was speculating, the neophyte and professionals alike, hoping to cash in on the seemingly unending rise in property values.   Flipping properties became the new route to wealth for the easy-money set. But of course it couldn’t and didn’t last.

·         Second mortgages/letters of credit on primary residences. Bankers, spurred on by lucrative bonus payments, could not get homeowners to sign up fast enough for the incredibly low, interest-only loans. (At some point I will delve into the multiplier effect of income/wealth and its role in this bubble)

There is no one cure-all but a good start would be for the banks to do all they can to help work out new affordable mortgages for homeowners in danger of defaulting. This would probably mean forcing banks and the owners of the mortgages to re-appraise the properties realistically and base re-issued mortgages on the inevitably lower valuations.  Of course the banks would have to take a hit on the write-downs.  Perhaps this is where the government could step in with off-setting tax credits among other things.

WHAT WE EXPECT IN THE POST-ELECTION PERIOD

Election choices will undoubtedly affect the availability of cash and credit and thus the duration of this bear market. But until the government begins to deal more directly with the housing issue, it’s difficult to make a solid case for a sustainable bull market. Post election, the market is likely to continue its erratic behavior. Expect a presidential election rally, then an easing when euphoria gives way to reality.  Later, the inauguration should send stocks higher as every new appointment will be characterized as “out with the old and in with the new.” Inevitably there will be the post-inauguration blues, but not to despair: It’s a new beginning and we Americans are an optimistic lot—at least that’s what our leaders will be telling us.

§         The Industrial Risk Premium ended at 9.56% versus 9.09%

§         The Transportation Risk Premium increased to 8.43% from 8.21%

§         The Utility Risk Premium increased to 9.75% from 9.74% n

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