The Eighth Week of 2008

Risk Premiums For The Dow Indices

The Slippery Slope

February 22^nd, 2008

Trading in the final minutes Friday was given a positive boost by the Federal Drug Administration’s (FDA) approval of Genentech’s cancer drug, Avastin, for the treatment of advanced breast cancer. It had previously been approved for treatment of lung and colorectal cancers. The late afternoon rallies came after the Dow and NASDAQ had been down for most of the day.  Also contributing to the turn-around was news that major bond insurer Ambac had a rescue plan in the works. Details of the plan were sketchy. The central theme, however, seems to rest on a $2 billion to $3 billion capital infusion through an offering to existing shareholders. These additional funds would be used to shore up the municipal bond guarantee business, in order to free up capital for the structured finance operations.  This gave hope that the Ambac workout could serve as a template for MBIA, the other major bond insurer – highlighting just how important the bond insurers have become to market confidence. Raising fresh capital is far less complex than splitting the business units into two companies and was well received by the markets, although neither path promises to be easy. The positive corporate news enabled the Dow Jones Industrial Average to finish the week up a token 32.8 points or 0.3%.  It closed at 12,381.02 after being in the red for most the week. For the most part, corporate news tended to be bearish this week as many companies revised 2008-outlook profit and revenue figures downward. Corporate health did not benefit from the filing of Chapter 11 earlier in the week by The Sharper Image and Lillian Vernon Corporation, companies which represent both ends of the retail spectrum. Despite the positive finish our Risk Premium analysis indicates that the bear market is still well entrenched and is likely to remain so as long as the problems facing the major bond insurers remain unresolved.

THE FED: Out Of Sight But Not Out Of Mind

The Fed may have been out of sight but not out of mind. Its January meeting minutes released on Wednesday revealed that the Fed has reduced its estimates for economic growth this year to between 1 and 2.2%, down from a projected- range estimate in October of 1.6 to 2.6%. The minutes also saw inflation projected at 2 to 2.8% and a rise in unemployment forecast at between 5 and 5.5%. Furthermore, excerpts from the meeting suggest that interest rates may be headed still lower and remain so for an extended period, notwithstanding the impact on inflation. The Fed reiterated the need to keep borrowing costs at low levels even for healthy companies, suggesting that when its board meets on March 18^th, another lowering in rates of at least 50 to 100-basis points may be in store. Given a projected environment of lower rates, the inevitable question arises of just how low the Fed is prepared to go.  Will it cut rates to near zero even if inflation data remains disappointing?

STAGFLATION: When Economic Stagnation Meets Inflation

Based on rising consumer prices (4.3% for the latest 12-month period) and a downward revision in economic growth, fears have resurfaced that the economy is facing a period of stagflation, a situation not experienced in the U.S. economy since the 1970s. Stagflation is a term used to describe a period of inflation combined with stagnant or declining economic growth as measured by the Gross Domestic Product (GDP). In theory, stagflation is caused by an imbalance in the supply/demand equation for goods and services. Witness the housing market.

The Fed Can Be Expected To Keep Interest Rates Low, Perhaps Extending Into 2009 or 2010.

Lower borrowing costs do not yet appear to be yielding the desired stock market response and housing boost. So it seems likely that the Fed will keep interest rates as low as possible until the current credit crunch and the attendant housing and financial institution problems work themselves out. Housing has a long economic cycle and so the overhanging damper it is putting on the economy may not lift until 2009 or even 2010. In short, there is little basis to argue that a bull market is about to return, especially should the Fed push interest rates closer to zero. Further re-evaluation of risk and therefore stocks will be a continuing necessity as investors face a slippery slope.

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 22^nd, the “yellow line” reflects typical bear market financial dynamics as illustrated in the charts below:

      The Industrial Risk Premium ended at 6.66% versus 6.68%

      The Transportation Risk Premium increased to 7.15% from 6.95%

      The Utility Risk Premium increased to  6.51% compared to 6.42% n

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