Risk Premiums For The Dow Indices

November 21^st, 2008

HAS THE MARKET BOTTOMED OUT?

The answer is NO! This is not the bottom based on our Risk Premium Model. Is it prudent to purchase stocks with the automakers on the brink of collapse with the market yielding anomalies that may very well force a revamping of how “financial risk” is evaluated?  For instance, the dividend yield on the Dow Jones Industrial Average is currently 3.88% and the Dow Utilities 4.43%, a 55 basis-point differential.

The narrowing gap between industrial and utility dividend averages illustrates investor apprehension, particularly the lack of confidence in earnings and dividend growth prospects.  The historically lofty dividend returns and future growth potential provided by the industrials, especially relative to the long standing bond-surrogate nature of utilities, reflects an earnings-growth inversion this author has never witnessed in more than 30 years as an analyst. 

AN INVESTMENT APPROACH (WITH A HIGH-RISK TOLERANCE)

We have to caution investors to refrain from broad-based equity exposure.  However, for those having the need for an equity presence, the best guidance we are able to give is to select super-high quality companies and expect a long holding period (perhaps, five years).  In addition, investors should consider redeemable preferred stocks and Triple-B corporate bonds maturing in under three years which are selling at discounts and offering yields in excess of 10% - a figure which we think should be moved up today to 11% to 12%.  These securities should be analyzed on a ability to pay at maturity based upon a heavy review of internally generated cash flow, the ability to liquidate short and long term assets and overall financial flexibility.  In effect, a classic bankruptcy probability despite the current investment rating(s).

BE CAREFUL WHAT YOU WISH FOR, YOU MIGHT JUST GET IT

This slight twist on the old adage would appear more appropriate than ever in the wake of the Congressional hearing on the auto industry’s plea for federal aid which fell on mostly deaf ears. That body this week refused to approve a rescue plan for the three U.S. automakers. Instead, they sent them packing, telling their chief executives to craft a self-help proposal rather than count on direct financial relief (at least for now) from the federal government.  In effect, Congress told the auto industry to devise a Plan B, a potentially scary scenario for the economy since that may begin with the bankruptcy word.  While populist-professing politicians are less than comfortable helping bail out well-heeled financial executives and their institutions (their hands were forced by doomsday predictions) legislators’ more ideologically capitalistic colleagues are wary about extending financial aid beyond this sector since it would undoubtedly draw an endless stream of beggars.

THE MORAL HAZARD MYTH MEETS REALITY

It is not reasonable to expect that the government can become the lender of last rest for all corporate America.  Nevertheless, during this difficult and worsening economic crisis, our leaders should be able to judiciously select industries as vital to the economy as our financial institutions for helping.  The U.S. auto industry clearly qualifies with nearly one million jobs dependent on the sector (250,000 directly and some 730,000 in co-dependent businesses).  The ripple effect of a shutdown would be devastating for the U.S. economy. Legislators, labor unions and environmentalists have hounded the auto sector for the past 25 years, saddling it with higher production costs, thereby weakening their competitive position. Unfortunately, few industries can withstand the perennial pounding that the carmakers have. Now the time may have come to “pay the piper” at a price that may very well shock the public.

THE BEST PERFORMING STOCK?

A final note: it is truly unbelievable when Ford makes the daily Best Performing list closing down at pennies over a dollar, a disturbing commentary on the bankrupt status of the economy.

§         The Industrial Risk Premium for the week ended November 21^st advanced to 10.30% versus 9.77% in the prior week

§         Over the same period  the Transportation Risk Premium reached 9.45% from 9.36%

§        Finally, the Utility Risk Premium number remained the same week-over-week, closing at 8.96%

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