RISK PREMIUM: Fear Factor

Weekending March 21, 2008

This was a week marked by volatility with the Dow Jones Industrial Average rising and falling as much as 450 and 300 points respectively during the course of a single day.  The Dow managed to end the shortened trading week with a 389-point gain, closing at 12,361 after opening the week at 11,972.25.  Two factors contributed to the positive momentum: the Fed’s 75 basis-point rate cut and J.P. Morgan’s rescue of Bear Stearns from a liquidity-based financial collapse.  The Fed’s reduction in rates seems to have been anticipated by the market and came as no great surprise – in fact, any action to the contrary would have been surprising.

If there was any surprising news during the week it was clearly J.P. Morgan’s eleventh-hour bid for Bear Stearns, offering to pay approximately $2 per share for the ailing brokerage firm (This was latter raised to $10 a share after an outcry and threat of lawsuits by shareholders. Approximately 1/3 of the shares are held by Bear Stearns employees).  The Bear Stearns rescue was orchestrated by the Fed and the U.S. Treasury to forestall an imminent failure by Bear Stearns.  We feel the nature of the Fed’s rare intervention in the private sector gave the market a positive lift.  

FREDDIE AND FANNIE TO THE RESCUE

In addition, the market benefited from news that the government plans to free up billions of dollars at Fannie Mae and Freddie Mac, a move that could help struggling homeowners.  The Office of Federal Housing Enterprise Oversight, which oversees government-backed Fannie and Freddie, said the changes should result in an immediate infusion of up to $200 billion into the market for mortgage-backed securities.  This could result in a greater demand for mortgages and benefit homeowners hoping to refinance at more favorable terms. Created by Congress, the two publicly traded companies buy mortgages from lending institutions and then either hold them in their investment portfolios or resell them as mortgage-backed securities to investors.

Freddie Mac and Fannie Mae play a vital role in providing financing for the housing markets. Since 2004 the companies have been required to hold 30 percent more capital than the minimum previously required, in effect crippling their ability to purchase mortgages when such an action has been most needed by the faltering housing market.  As part of a deal with regulators they will be able to reduce that amount by a third, to 20 percent.  For Fannie Mae, that means holding $3.2 billion less capital, while for Freddie Mac it comes to $2.6 billion less.  At the end of 2007, Fannie Mae had $45 billion in capital and Freddie Mac had $37 billion, for a total of $82 billion between them, providing a $1 trillion cushion supporting the combined debt.

OUR RISK PREMIUM MODEL IS STILL IN BEARISH TERRITORY

Does this mean that stocks have finally reached their long awaited “bottom”?  Not according to Our Risk Premium model, which points toward a continued decline in stock prices.  Keep in mind that we are in the throws of a recession and that the full impact on corporate earnings is yet to be determined.  Inevitably every boom is followed by a bust and that is exactly where the market is right now.  We feel the widely anticipated reversal is not reflected in fundamentals. Rather, we feel the recent rally in stocks is a typical bear-market trap.  Our pricing model continues to point toward a Dow priced in the 10,500 to 11,000 range.  Our model is highly sensitive to Treasury Yields and P/E multiples, of which the latter is showing up-ward resistance.   The heightened level of volatility suggests that investors are facing an uncertain trading market and that long-term value parameters need to normalize before the Dow bottoms out.  We feel the full benefits of the Fed’s actions have about three months remaining before the major impact of its recent aggressive rate cuts are realized. 

CASH IS AVAILABLE AND READY TO BE DEPLOYED

There is liquidity on the sidelines and the lack of new investment opportunities may have played a significant role in the successful initial public offering by Visa, Inc.  The IPO was the largest public offering in U.S. history. Visa sold 406 million shares at $44 each, raising $17.9 billion.  The world's largest credit card processor is not a lender, and, accordingly, investors hope the company can comfortably navigate the faltering U.S. economy and credit climate.  The stock traded up $14.64 (33 percent) closing its first day of trading at $58.64.

INTERESTING HISTORICAL STATISTICS

Looking back at the major boom/bust stock historical corrections, as measured by a broader index such as the S&P 500, we see that serious market pullbacks have averaged 49.25%.

Excluding the highs and lows experienced in the Great Depression (85% decline) and in the downturn of mid-2007 to the present (19%), the average decline for the S&P 500 would be 46.50%.  Using the average 46.50% decline, a bottom would not be reached until the Index fell in the 825-850 range, nearly 475 points below the 1,329 March 20, 2008 close and 715 points from the 1,565 peak reached on October 9, 2007.   Using the 2000-2002 period as a contemporary benchmark, the S&P 500 has another 500 points to fall before reaching a bottom.  We feel that this is a market characterized by fear and great uncertainty.  The recent heightened volatility leads us to characterize this as a “trading market.”

'SPREADS' REFLECT FEAR 

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 6.67% versus 6.90%

§      The Transportation Risk Premium decreased to 6.91% from 7.29%

§      The Utility Risk Premium decreased to 6.23% from  6.44% n 

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