The First Week of 2008: “What Cannot Be Cured Must Be Endured”

Economists and other Wall Street pundits spent the final months of 2007 debating whether or not there would be a recession in 2008.  Every Fed meeting was met with anxious anticipation, hoping for interest rate cuts that would avert a recession in the New Year.  However, despite the Fed’s autumn cuts, there seems to be an overriding consensus that the U.S. economy will experience a mild recession in 2008, even with further decreases in interest rates.  That same consensus holds that the recession period is likely to occur during the first-half of the year. And fresh data released this week revealed a worrisome lack of jobs’ growth, sending stocks and bonds into a freefall, with the Dow Jones Industrials down 565.69 points for the first week of 2008, bringing the Dow to its lowest level since the third week of April 2007 (12,800.18).     

Based on our Risk Premium figures, the stock market is signaling a bear market ahead, firmly breaking its indecisive pattern for the past several weeks and months.  Based on long-term behavior, the “yellow-line” of the Risk Premium hints that the economy is likely to hit an air-pocket sooner rather than later.  And the decline in all asset classes appears likely to extend into late March or to that point in time when the Fed makes it so unattractive to hold cash that investors are compelled to return to the capital markets.  In addition, world markets seem to be anticipating a U.S. consumer-led recession – and it appears as though they will get one.  The S&P 500 consumer discretionary index is now down more than 20% from its peak reached in June 2007, indicating that a bear market has arrived.

Housing Wealth Drop Remains a Drain on Consumer Spending & Confidence

There can be no economic turnaround until housing prices bottom out. The collapse in housing prices is not limited to those financed with subprime loans but the sector as a whole.  In the third quarter of 2007 housing wealth declined by $128 billion.  Based on results through the end of October 2007, S&P’s Case-Shiller housing index fell 6.4%.  The index is a measure (albeit a narrow one since it excludes multi-family and new housing as well as condos) of the value of the U.S. residential real estate market in 20 metropolitan regions. Housing wealth matters because of its impact on consumer confidence and discretionary income. Fewer discretionary dollars can be expected to be circulating in the economy. With fewer spending dollars comes an economic downturn.

THE JANUARY 30^TH FED MEETING-- WHAT TO EXPECT?

Accordingly, the importance of the Fed’s actions and its impact on housing wealth cannot be underestimated.  Many homes that were purchased in the past seven years were financed with floating rate mortgages. With the current level of interest rates those homes have become less affordable or even unaffordable, especially over the past 2 years.   

Predictably, all eyes are on the upcoming Fed’s January 30^th meeting.   Based on a January 4, 2008 survey of economists, a majority now believes the Fed will now cut rates by 50 basis points at this meeting.  We caution that under Fed Chairman Ben Bernanke’s leadership the Fed has made a commitment not to lower rates unless certain conditions are met (see Risk Premium comments December 14^th 2007).  Some hint of what is to come may occur during the Fed Chairman’s Jan 10^th speech to a joint meeting of two banking groups in Washington. We suspect economists are hoping Bernanke will use this opportunity to signal that the Fed might consider a 50-basis point cut.   The employment rate was one of the three critical variables that Bernanke has stressed would be a recurring factor in rate-making decisions.  Last week’s release of weak job statistics sent stocks and bonds lower and increased the prospects of a recession.  

WHAT’S AN INVESTOR TO DO?

We suggest nothing right now. The stock market apparently is building downward momentum and there appears to be nothing on the horizon to stop it. Until the Fed makes money too costly to hold and housing more affordable, in our opinion, this bear market will not experience a reversal.  Commingled with the negative economic news is the absence of strong economic stand-taking by the presidential candidates. The economy appears to be of secondary importance to them given that their highest priority is getting elected. This absence of attention to the economy may prove to be an additional drag on the market.

“What cannot be cured must be endured” and that is our view of this market. Financial institutions and perhaps even housing may be so battered that when the dust does settle these sectors may offer some excellent values.  Right now it appears that companies with sound earnings’ prospects and solid balance sheets are being trashed with the entire market.

§      The Industrial Risk Premium ended at 6.44% versus 6.17%

§      The Transportation Risk Premium increased to 7.62%  from 7.02%

§      The Utility Risk Premiums increased to 5.51 % compared to 5.45%

In our opinion the risk differentials for the week ended January 4th, 2008 all posted significant increases, suggesting a bearish trend is well in place. n 

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