The Fifth Week of 2008

RISK PREMIUMS: Bullish Ending, With Bear Sentiment!

The Dow Jones indices for the week ended February 1, 2008 higher across the board, reacting to a mixed list of economic data.  The Dow Industrials were up 536.02 points (4.39%), ending the week at 12,743.17. The Dow Transportation Average posted the largest percentage gain, up 332.53 points (7.43%) to close the week at 4,807.5. The Dow Utilities rose 23.91 (5.35%) points to 510.05. These gains were overshadowed by the dreadful monthly performance of the overall market, with stocks falling by 7.7 percent for January, one of the worst months on record.  Our Risk Premium Index, however, still points toward a bearish underlying sentiment. This is a market that is trading more on hope than fundamentals. Until this situation corrects itself we will not see a bottom and the beginning of a bullish trend.  Microsoft’s $44.6 billion bid for Yahoo had little real impact on the market.  Yahoo stock has been under pressure as the company struggles to bolster earnings’ prospects by reducing jobs and streamlining its operations – characteristic of a company on the “defensive.”  At the other end of the spectrum Bristol Meyers reported it would be taking a charge-off for Auction Rate Securities (ARS) which consist of subprime mortgage debt, attesting to the pervasive nature of the subprime securities held by a broad spectrum of U.S. corporations.

THE WEEK WAS CHARACTERIZED BY “MIXED” ECONOMIC DATA

Incoming economic data last week did little to clear up the uncertainty on whether the economy is headed for recession or not. Nevertheless, we believe the economy is in the formative stages of a recession and that the recent interest rate reductions and impending (and feeble) economics’ stimulus plan are too late to forestall a slow-down in the economy.

THE FED CUTS RATES BY 50-BASIS POINTS BUT HOUSING DATA REMAINS DEPRESSED

The market anticipated the Fed action on Wednesday which was received with little of the expected enthusiasm. For the most part trading during the week was choppy as the market digested hefty doses of economic data. The most eagerly awaited news clearly came mid-week when the Fed cut both the Fed Funds and Discount rates by 50 basis points each, to 3% and 3.5% respectively.  However, the market had to digest more bad news on the housing front, with an 8.4% price decline in the Case-Shiller Housing Index released at the beginning of the week. The index suffered its biggest drop since Case-Shiller began compiling housing data in 1987.  In addition, there was a 1.1% decline in construction spending in December which signals bad news in both the residential and non-residential sectors.

EMPLOYMENT DATA WEAK

At week’s end statistics on the job market were released.  Payrolls fell by 17,000 last month, the first drop since August 2003. Some economists were expecting an increase. Some commentators took solace from the nominal drop in the unemployment rate which eased to 4.9% from 5%.  It did not rise as had been feared.  Still the poor employment numbers lend credence to the probability that the U.S. economy is slowing down.   

MANUFACTURING DATA STABLE

There was better news on the manufacturing front which showed unexpected strength. This was evidenced by the Institute for Supply Management’s (ISM) manufacturing index, which rose to 50.7 in January from 48.4 the previous month.   At this mid-century plus level the ISM index is consistent with GDP growth of roughly 2%.  In short, the index does not suggest a high probability of a recession. (The ISM index would have to fall to 41.4 in order to “officially” indicate a recession was at hand.)

UNCERTAINTY FACING THE BOND INSURERS: AMBAC AND MBIA

Meanwhile, the credit markets continue to struggle with the fate of the two major bond insurers, Ambac and MBIA.  The New York State Superintendent of Insurance has asked certain banks to devise an industry-wide rescue plan.  This seems like an iffy undertaking considering the round of charge-offs just experienced by many of these same large financial institutions (and the likelihood of further write-offs to come). Moody’s and S&P have placed the Triple-A ratings of Ambac and MBIA under review for possible downgrades unless the bond insurers obtain additional capital. The insurers would be forced to take additional write-downs if the capital is not forthcoming.  This is one of the major uncertainties that overshadows the credit markets.   That is because if the situation is not resolved it could lead to several financial institutions having to take further write-downs.

THE RISK PREMIUM DATA: MOVING IN A BEARISH DIRECTION

Our Risk Premium analysis continues to indicate that a bear market is at hand.  It is one where the “price of risk” is being constantly adjusted, resulting in contracting P/E multiplies. For the week ending February 1, the “yellow line” reflects typical bear market financial dynamics as illustrated in the charts below:

      The Industrial Risk Premium ended at 6.47% versus 6.76%

      The Transportation Risk Premium decreased to 6.90% from 7.27%

      The Utility Risk Premium decreased to 5.88 % compared to 6.05% n

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