RISK PREMIUM ANALYSIS: A Market Trading On Air

Poof Goes The Market – At Least For Financial Firms (J.P. Morgan Chase Excepted) with “Etch A Sketch” Asset Books.

What’s the quickest route to millionaire status?  Be a billionaire and buy into a financial trading firm (Ask Bear Stearns investor Joseph Lewis).  This was once said about the airline business.

Witness the Chernobyl-like meltdown of Bear Stearns.  How else to describe what happened to the legendary Wall Street firm that went from a $20 billion stock market valuation in January 2007 to 3.5 billion Friday to $236 million over the weekend with its Fed orchestrated $2-a-share fire-sale to J.P. Morgan Chase & Co.  Once again it was the Achilles Heel of mortgage-backed securities that brought a firms downfall.  Just like Enron, Bear Stearns crashed as its CEO was assuring the world that all was well.  Now we know better.  Unlike Bear Stearns, though, the Fed did not come to Enron’s aid.

Fed To The Rescue, Finally

With its welcome take-charge leadership over the past few days the Bernanke Fed finally seems to have stepped up to the plate.  This rescue and the Fed’s more generous loan terms may finally begin to start the long process of restoring some confidence in the U.S. banking and financial sectors that have been decimated by the housing crisis and resulting credit crunch.  Don’t hold your breath though.

The Fed Meets March 18: Will It Be A 50-basis point cut, A 75 or 100?

Prior to the Bear Stearns fiasco, it was thought the Fed might continue its more aggressive rate-cutting of late and opt for a 100-basis point rate drop, to 2%.  Now that the Fed has shown that it means to restore stability to the financial system, some observers think that it may make a 50-basis cut.  This, the thinking goes, may help stop the dollar’s free-fall which has resulted in a corresponding jump in the prices of oil and other commodities.  And, anyway, the drop in interest rates hasn’t seemed to benefit consumers or alleviate the housing crisis since lenders seemed to have made it nearly impossible to secure financing.  What is needed is for the Fed to lean on banks to open up their loan windows to credit-worthy borrowers.

Investors Need to Reorient Risk Parameters

The current bear market defies statistical analysis, something that has not been seen for several decades, with interest rate and stock price precedents extending as far back as the 1930’s.  Our model relies on a demand-spread analysis, which currently shows no signs that investors are demanding lower risk premiums. Based on the Risk Premium’s historical behavior, stocks would have to trade below a 12x price multiple before investors can begin to think about the formation of a bear market bottom.  In this regard, the model is heavily biased toward “earnings” improvement.  Given the overall state of the U.S. economy, the vast majority of corporate America is not expected to post higher earnings in the first or second-quarter of 2008.

What Should Investors Do?

We have been inundated with questions from investors on how to navigate this market.  The answer is simple, but not attractive.  One of the most important caveats in finance is that interest means little when principal is at risk.  Stocks afford considerable principal risk right now and therefore we cannot endorse making capital commitments to any sector.  Sitting on the sidelines, investing in U.S. Treasuries and/or precious metals is the best defensive posture investors should adopt at this time.  The market may approach a point where financially solid companies may be supported by their common dividend yield and these companies should offer attractive long-term returns.  In these situations, the dividend return will provide an opportunity to recoup principal losses when normalization is restored to the market.

We feel that as long as the real estate market remains depressed with foreclosure rates on the rise, no sustained rally in stocks is likely.  Investors have grossly underestimated the spill over effect of the real estate crisis, with the financial services sector hardest hit.  Recently, S&P commented that subprime write-downs could reach $285 billion or $20 billion more than the agency previously forecast.  Evidence that financial strain is not limited to the financial and housing sectors was confirmed this week when the commerce department reported that retail sales fell by 0.6% in February. Most economists had been expecting a rise in retail sales.

No Rebound in Stocks without a Rebound in Housings

A signal that the bottom is near will become evident when the housing surplus has started to decline and home prices stabilize.  As long as the biggest component of investor’s portfolios, namely housing, remains under water, there is little chance of breaking the financial grid-lock which pervades all sectors of the market.  While Washington is considering various orthodox and unorthodox measures to achieve this goal, it is uncertain if and what Congress will devise and until the seemingly chronic uncertainty surrounding the real estate market is resolved, it would be premature to be discussing a bull market.  We expect that the housing crisis, with its long recovery cycle, will last through most of 2008 and, perhaps, part of 2009 before there is a turn-around.

The Fed Steps Up it Lending Efforts

The Fed’s intercession reflects its desire to do whatever is necessary to avert a recession and, especially to prevent the collapse of a major financial institution. Concerns over a major recession have been accelerating in recent weeks, driving many experts to predict that the Fed will engage in measures once thought to be extreme or even on the fringe of its purview.  There is a growing awareness that monetary policy actions alone may not be enough to forestall a recession.  Accordingly, the central bank is willing to go so far as to lend financial institutions as much as $436 billion in one-month advances.  In addition, the Fed is encouraging lenders to recapitalize and write down the value of home loans. It is also supporting policy initiatives to finance new home loans through the Federal Housing Administration.

Our Risk Premium analysis remains in bearish territory as the market appears to be “pricing risk” in, resulting in contracting P/E multiples.

For the week ending March 14th the risk premium results are illustrated by the yellow line:

§      The Industrial Risk Premium ended at 6.93% versus 6.90%

§      The Transportation Risk Premium increased to 7.29% from 7.22%

§      The Utility Risk Premium decreased to 6.44% from  6.76% n

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