The Fourth Week of 2008

RISK PREMIUMS: You Can Run, But You Can’t Hide!

The Dow Jones Industrial Average along with other major financial indices began the post-holiday trading week on a roller coaster ride unlike any since the 9/11 terrorist attack.  There was worldwide market turmoil Monday as the U.S. markets were closed in observance of the Martin Luther King Holiday. The futures market indicated steep declines in excess of 400 points were likely when the U.S. markets re-opened on Tuesday. Indeed, that was the case at the opening bell with the Dow quickly dropping 464 points despite the Fed’s bombshell announcement of a ¾ percent drop in the Federal Funds Rate before the market opened. In the ensuing days trading was mixed and best characterized as backing-and filling as investors searched for bargains.  We believe this strategy (i.e. “bottom fishing”) may be a bit premature as a contraction in P/E multiples has not been realistically incorporated into corporate valuations as well as the lower earnings outlook. Our view is that we are in the early stages of a recession and a bear market. 

We cannot be more emphatic that the U.S. stock markets are “treacherous.” Even the bond market is rife with uncertainty as investors attempt to anticipate the Fed’s next move. Its decisions on both the Discount and Fed Funds rates are due to be announced at the Fed’s January 29-30 meeting. Speculation by economists has ranged anywhere from another 50-basis point cut (a 65% probability) to a 25-basis point cut (a 35% chance).  

By the end of a turbulent week following Black Tuesday, stocks regained their initial losses, closing out the week at 12,207.17, up 107.87 points for the week.   The positive upswing in the market led some economists to revise their earlier forecast of the Fed’s next interest-rate move to predications of a 50-basis point cut in interest rates to none at all.  The Fed may still remain determined to front-load its rate cutting activity with at least another 25-basis point reduction to 3.25%. This would not be an unreasonable expectation.  Whether the Board will seek to get rates lower, to the stated goal of between 2.0% and 2.25%, does not seem realistic.  Given the fact that the Fed will not be meeting again until March 1st, they may want to go for a broader reduction (hypothetically even as far as 75-basis points, bringing the Fed Funds rate down to 2.5%) now rather than having to do it in an intra-meeting cut if conditions during February warrant.  We suspect the Fed may want to get ahead of the curve this time as well as market expectations in order to avert another precipitous decline in U.S. and global markets.

WHAT TO EXPECT

The Fed should recognize that all recessions cannot be broadly characterized simply by the “numbers” as each has a distinctive “qualitative” aspect.  As a result of the market fallout from the subprime crisis this particular recession seems to be dominated by consumer reservations over their entire portfolio of assets, of which the greatest component is housing.  Thus, it should come as no surprise that we should not look for a market rebound until consumers are convinced housing prices have stabilized. Moreover, reports of sharply rising credit card delinquencies make it clear that the credit crunch is not limited to housing debt. And there is growing market sentiment that the crisis will spill over into the auto sector.  Concerns over credit problems in these areas of the economy should weigh highly on the Fed’s thinking as there is little doubt they have and will continue to have a bearish influence on domestic stock markets. (...You can run, but you can’t hide).

We continue to believe that the hallmark of this recession is a contraction of P/E multiples and that the Dow Jones Industrial Average will trade in the vicinity of 12x earnings versus the current 14.8x. In addition, we think that such a “value” dislocation could shave 1,000 to 2,000 points off the Dow Industrials before it bottoms out.  Our basis for this belief is that this is a market driven by individual stocks rather than a broad spectrum of stocks.  To illustrate our point, when Apple reported higher fourth-quarter earnings, the stock fell 31.35 points when management noted that second-quarter results would be under not only their earlier estimates but those of the street.  Other companies, despite reporting positive year-end results, have also suffered hits to their share prices when warning of slower times ahead. In short, corporations appear to be envisioning a mild or short recession and accordingly may want to dampen earnings’ expectations.

There Seems To Be No Place To Hide

The Fed’s underestimation of the housing wealth factor is likely to overhang the market.  And retailers will feel the pinch as consumers curtail spending, despite the economic stimulus plan.  While the retailing sector has blunted the initial impact of market pullbacks, it ultimately will suffer as declining wealth - both real and imagined - becomes a factor.  In addition to their subprime-related difficulties financial institutions are now having to deal with problems in the auto and credit card sectors. This is adding to further downward pressures on the market.

Even though technology companies have held their ground up to recently, they now look to be in the initial stages of a bear market. This capital-intensive sector is bound to be impacted as credit lines dry up.  Utilities, long a safe haven, seem to have been the last group to crack. With the Down Jones Utility Average falling nearly 14% from its all-time high, the market has come to realize that this bifurcated industry has ongoing expenses which must either be covered by the markets and/or regulatory relief at the retail level.  Electric utilities are in the formative stages of adjusting to normalized earnings’ multiplies and should be discounted for a slump in industrial kilowatt sales which account for roughly one-third of their business.  Pure distribution utilities may well encounter regulatory reluctance to pass along higher operating costs. Consequently there may be no increase in authorized rates of return, especially as the cost of money falls.  

Until some level of equilibrium can be found, investors might be well advised to seek safety in companies de-coupled from the U.S. economy, with the possible exception of health care (since people get sick with or without a recession).  At this point there are few alternatives to lead this market to a recovery.  We can only point to the Fed as the primary means right now. They need to rewind the interest-rate clock back five years or so in the hope that a bottom can be found. And  then they  can begin a very – and we mean very – gradual rise in interest rates thereby giving consumers and investors time to regain confidence. We think that once there is a restoration of liquidity and a diminution of housing inventories there will be a bottoming out of the market. Remember, it’s more difficult to spot a bottom than a top. While we see light at the end of the tunnel it may be a very long journey (two years would not be an unreasonable time frame).

Our Risk Premium analysis indicates that a bear market is here for investors, resulting in contracting P/E multiplies.  Instead of focusing on broad sectors, investors need to take a defensive posture, concentrating on healthy companies able to withstand a bear market with the least amount of damage to their stock prices.  The old caveat that a falling tide takes down all ships cannot be ignored.  For the week ending January 25^th, the “yellow line” reflects typical bear market financial physics as illustrated in the charts below:

§      The Industrial Risk Premium ended at 6.76% versus 6.82%

§      The Transportation Risk Premium decreased to 7.27%  from 7.73%

§      The Utility Risk Premiums increased to 6.05 % compared to 5.81% n

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