The Second Week of 2008

During a speech this past week Federal Reserve Chairman Ben Bernanke said that “...the Fed should stand ready to take substantive additional actions as needed to support growth and to provide adequate insurance against downside risks.”  Reading between the lines the message from the chairman seems to be that the Fed is determined to do whatever is necessary to head off a recession even though the chairman says the bank “is not currently forecasting a recession.” - To quote from Earl Hadady's book, Contrary Opinion "The facts are unimportant! It's what they are perceived to be that determines the course of events." It has been widely anticipated that the Fed will lower its benchmark interest rate by 50 basis points, effectively doubling its previous 25 basis point reductions, at its next policy meeting, January 29th-30th.  We think so as well.

What makes these comments by Bernanke so different from prior signals is the dramatic change in tone with which he approached the risk of recession. Bernanke has avoided the “R-word” as though it did not exist ever since the credit markets began their melt-down in the spring of 2007. Initially, he approached the collapse in the subprime market as an intra-bank problem rather than a consumer-oriented one.  However, Bernanke noted that recent information has suggested that the “outlook for real activity in 2008 has worsened and the downside risks to growth have become more pronounced.”  Consequently, “additional policy easing may well be necessary,” he said.  It is this latter phrase which has led many Fed watchers to conclude that a more aggressive approach to rate reductions has been “set” by the chairman, despite comments by other Fed members.  The market, however, appears to have “baked in” a 50 basis point cut in rates latter this month and, therefore, no sustained rally should be expected.  Moreover, we feel the Fed’s intervention was simply too late, with an economic slump likely, leaving the stock market to be powered by “earnings.”  Under this scenario, the “E” in P/E will assume the dominate role in the market and company performance – and even a resounding “E” (i.e. earnings per share) may not get the resounding effect it would otherwise.  Inflation concerns and the strength (or weakness of the dollar, depending on your view) of the dollar may have to take a back burner until the Fed has done as much as it can to forestall a recession.

After Bernanke’s remarks the Dow Jones Industrial Average rallied sharply before surrendering some of its gains, closing the day at 12,853.09, up 117.78 points.  But by the end of the week, the market seems to have discounted the Fed’s “new” assertive downward interest-rate stance, ending the week down 193.88 points to close at 12,606.30, a drop of 5% in the first two weeks of 2008. It appears it may take more than 50 basis point increments to avert or reverse the downward trend – depending upon where one views the economy today.  With a soft economy, earnings’ expectations for 2008 may not be realized across several industry sectors, further depressing the market.  In short, it is difficult to have a bullish outlook for the first half of 2008.  Absent some truly surprising action by the Fed, investors may have to endure a recession the magnitude of which is yet to be determined.  We feel that the market will not recover until the housing slump has hit bottom and there is a rebound in employment, consumer confidence and spending.

Bernanke’s assessment of the health of the financial markets was not encouraging, characterizing the financial situation as remaining “fragile.” (...not the kind of words which warm the hearts of investors...or attracts them to buy stocks).  He went on to state that there is “considerable evidence that banks have become more restrictive in their lending to firms and households,” an acknowledgment that economic woes are already manifest at the micro (i.e. consumer) level.  In short, while banks have shored up their balance sheets, consumers have not adjusted to the dislocations caused by the higher rate environment experienced in 2006 and for the first three quarters of 2007.  His observations suggest that lenders may have become gun shy, making credit less available at the retail level, a dangerous prospect for an economy perceived on the verge of a recession.  The inability to obtain credit at the consumer level is certain to have a deleterious effect on the economy.  The Fed can make money available but if lenders are reluctant to lend and borrowers are apprehensive about borrowing, the economy can readily stall – which appears to be the case based on the latest consumer spending data.  Bernanke has previously stated that the Fed would keep a close eye on labor statistics and so noted regarding the December 2007 jobs report, which he commented, was “disappointing” and poses a risk “to consumer spending” should employment continue a downward trend.

In our view one thing is clear: Bernanke is starting to get the message that after shoring up the banking system, consumer psychology cannot be ignored. (...If you wait for tomorrow, tomorrow comes. If you don’t wait for tomorrow, tomorrow comes).  But like the Captain of the Titanic, he may have moved to a rescue mode too late.  We suspect the economy and the markets have been ahead of the conservative-minded Fed Chairman, anticipating that the economy is in a death-spiral.  This new policy of aggressive rate cuts, while beneficial, may prove too little too late to avert a recession.  Perhaps (and this falls in the realm of super hypothetical) the Fed accelerates its policy by lowering Fed Funds rates, for example, a 100 basis points at its next meeting, to 3.25%?  It would still remain within the 1%-3% interest rate parameters it set for 2008.

The Risk Premium evaluation, tends to gage the macro sensitivity of the market, particularly to interest rates, from this point forward earnings will have to do the rest.

The ever-sensitive Risk Premium line shows investor indifference to the prospect of stepped-up Fed actions, ending the week of January 11^th as follows:

§      The Industrial Risk Premium ended at 6.54% versus 6.44%

§      The Transportation Risk Premium increased to 7.75%  from 7.62%

§      The Utility Risk Premiums fell to 5.39 % compared to 5.51% n

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