RISK PREMIUM:  GE UNPLUGGED!

For the Week Ended: April 11, 2008

WHAT IS THE QUESTION?

No, stocks have not reached bottom – that seems to be the most pressing question on investor’s minds.  Right now only the Titanic has reached bottom.

RISK PREMIUM STATISTICS

§      The Industrial Risk Premium ended at 6.69% versus 6.54%

§      The Transportation Risk Premium increased to 4.77 from 4.61%

§      The Utility Risk Premium decreased to 5.95% from 5.97%

Do GE’s First Quarter Results Foreshadow A Prolonged Economic Decline?

For the past several weeks we have discussed our belief that the long awaited bear market bottom has not been reached despite an assortment of significant rallies raising hopes that a reversal was at hand.  We are not convinced.  The erratic movement in the Risk Premium model for the Dow Industrial Average, the Dow Transportation Index and the Dow Utility Average does not suggest a bottom.  To the contrary, fundamentals underlying the model pointed to a classic “bear market trap,” dashing expectations of a “V” shaped economic recovery. Investors were advised that the release of first quarter 2008 earning would be very “telling.”  General Electric’s earnings’ performance this week ensnared many investors in the “bear trap,” starting the first quarter earnings’ season off with a bang (the wrong kind).

GE A RECOVERY PROXY FOR THE ECONOMY

Many investors have seen General Electric (GE) shares as a possible “recovery proxy.” However, they were broadsided by GE’s results which underlined the depth of the current economic downturn when the company posted earnings which were 5.8% below expectations and their worst quarter in 5 years.  It appears the corporate giant has taken a hit in its consumer product lines as well as in its health-care related businesses. Its real estate holdings have also been adversely affected by the slump in that market.  GE also reported a $270 million write-down on its stock, loan and securitization assets.  Finally, management cautioned stockholders that earnings for 2008 would increase at most by 5%, down from earlier double-digit estimates. The general market took this negative news in stride but with GE’s shares falling 13%, its biggest loss since the 1987 stock market collapse, while the Dow was off a meager 35.99 points. Given GE’s prominence in corporate America and its consistent winning growth-performance over the years, the market slide was pretty tame. Finally, GE was not the only Dow stock to have a negative first quarter; Alcoa came in with earnings 54% below estimates.

THE RECENT ERRATIC PERFORMANCE OF THE RISK PREMIUM INDEX

The erratic performance in our Risk Premium figures increases our belief that a market upturn is not indicated, particularly with the first-quarter earnings’ season just getting underway.  Without over-simplifying it, the model is still showing a lack of “E” (i.e. earnings) in the equation and results to date are not encouraging.  The causative factor remains the depressed real estate market which continues to drain households of discretionary spending capital. Given that one’s home is the most valuable component in a typical family’s portfolio and is down anywhere from 17% to 22%, if not more, this decline in affluence is having far-reaching and depressing effects on the economy.     

A ‘V’ OR “U” SHAPED REBOUND

The financial community has been projecting a modest drop in overall corporate earnings for the first half of 2008 and a sturdy rebound in the second half.  As the earnings’ season kicks into high gear, optimism seems to be diminishing with more and more economists becoming doubtful about their initial projections for the second half of 2008, moving away from a “V” to a “U” shaped recovery.

Stocks have remained in a narrow trading range on hopes that declines in stock prices would be halted by modest-to-weak earnings reports.  However, the disappointing news from companies like GE and Alcoa has begun to raise serious questions about the earnings’ outlook not only for the first quarter but for the rest of the year as well as.

WHEN CAN A REBOUND BE EXPECTED?

 When will the market hit bottom?  Sorry, we don’t have the answer. We can only look for changes in factors affecting our Risk Premium model. While we hate to be redundant, the answer consistently defaults to a rebound in the real estate market as the catalyst.  The problem with this and most real estate recoveries is “duration” which is influenced by two variables: (1) the inventory of sold homes which needs to be reduced to manageable (i.e. normalized) levels and (2) an increase in prices approaching those reached at the peak of the bubble in order to rebuild “wealth.”  Based on certain cycles we have examined, the inventory glut is obviously the first factor to improve. Pricing upswings follow at a slower pace, thereby prolonging gains in the real estate market.  (This phenomenon is very similar to the behavior of stock prices.) Once the inventory problem is under control, homebuyers will still be bewildered by how much to pay for a new home (the analogy is close to the P/E performance of a stock).  Is the pricing decision based on the market highs or the premise that once prices reach their former highs, will they surpass them?  The empirical evidence supports this finding since pricing valuation tends to extend housing market recoveries well after inventory levels are reduced. This is because price valuations (.i.e. the affordability index) move in an “imperfect” pattern with supply and show a heavy correlation to overall economic vibrancy, especially when factoring in different regional components.  Some post-WWII markets have required a five to seven- year time frame to complete this process.  We are not sure a recovery in real estate will take this long. We offer the number as a broad frame of reference for this particular segment of the economy since there is a distinct possibility that the housing recovery could be shorter or longer.

DON’T DESPAIR

Financial instruments will lead the housing market, having a greater correlation to the general health of the economy and earnings.  The lag in real estate seems to have a closer correlation to the magnitude of the preceding economic decline.  As many economists will acknowledge, each recession has different characteristics and this one is intimately intertwined and causative. Until this particular matrix begins to unravel, hopes for a quick end to the bear market should be placed on hold.  Don’t despair though. What goes down can’t go down forever.  Look on the bright side and think about the upside profit potential with large residual cash building up on the sidelines. n

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