UNHAPPY HOLIDAYS

The Dow industrials closed the holiday week down 84.78 points to 13,365.87, on relatively thin trading.  What with disappointing holiday sales data, near-record crude oil prices and falling home prices, the market seems to have incorporated the negative news in a rather orderly fashion.  It should be noted that the risk premium for all three Dow Jones indexes rose for the week ending December 28^th 2007, continuing an upward trend begun in the last quarter. At this point we can observe nearly one complete year of risk premium behavior. Early in the year, a glance at the risk indexes indicated the end of a bull market. The March 9^th spike illustrated that the stock market needed a higher return premium – a trend which remained in place for much of the year despite signs that a reversal may have been underway between March and June. However, as the summer approached, so did the sub-prime crisis and any hope for a mid-year rally went up in flames.  

THE FED: ON THE RIGHT TRACK BUT IT SHOULD TAKE THE EXPRESS TRAIN

The second half of the year has reflected the anxiety underlying demand for stocks – a demand seemingly in lock-step with the actions and anticipated actions of the Fed.  In our judgment, the risk premium has become pegged to the Fed’s movements toward lowering interest rates that began in September. “Officially” the Fed appears to have adopted a wait-and-see attitude before lowering rates (note the criteria it has spelled out for its future actions). The empirical evidence demonstrates that the stock market is being steadied by investor expectations (whether realistic or not) that rates will continue to fall, with some estimates for Fed Funds as low as 1% to 3%.

As long as the Fed remains in a rate-cutting mode (admittedly not a sure thing) stocks should retain their uneasy calm; no serious slide should be expected.  Some think the most recent quarter-point rate cuts may be sufficient to hold the stock market steady in spite of the proliferation of negative economic data, especially on the housing front.  The continuing slump in the housing market though will continue to dampen consumer confidence and, ultimately, spending.  New home sales in November 2007 fell to a 12-year low and are a clear sign that the housing market remains in full retreat – with no light at the end of the tunnel. 

It is obvious that the health of the housing market will more and more dominate investor confidence. This is probably what has led to a consensus among economists that the Fed can be expected to continue to cut rates by quarter-point increments in 2008. However, this is may prove a bold presumption, in our view, especially as this is in contradiction to stated Fed policy.  But, with investors confident that rates will regularly move down, any deviation by the Fed will have a highly negative impact on the markets.  And since the housing market appears to be a long way from bottoming out, the prospect of continuing destabilizing data (witness the troubles at some of the biggest banks and financial houses) indicates to us that the quarter-point strategy may prove to be inadequate. In light of this, we feel that the Fed must take bold and swift action to head off a possible recession (or talk of one). The Fed may be on the right track but it’s taken the local train instead of the express.

THE RISK PREMIUMS

Since the risk premium charts continue their lackluster momentum, we still do not see any impetus for a buying spree, particularly as long as the housing market and consumer confidence remain in a slump.  So in order to halt the nervousness that has seemingly gripped investors the Fed may have to kick it up a notch or two to prevent the market from slipping into bear territory.

§      The Industrial Risk Premium ended at 6.17% versus 6.13%

§      The Transportation Risk Premium increased to 7.02%  from 6.99%

§      The Utility Risk Premiums increased to 5.45 % compared to 5.42%

In our opinion the risk differentials for the week ended December 28^th, 2007 indicate a continuing degree of uncertainty (and the markets do hate uncertainty).  Happy New Year! n 

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For December 21st's Comment Please Click Here

For December 14th's Comment Please Click Here

For December 7th's Comment Please Click Here

For November 30th's Comment Please Click Here

For November 23rd's Comment Please Click Here

For November 16th's Comment Please Click Here.

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