RISK PREMIUM ANALYSIS:  A Neurotic Market

For the Week Ending April 18, 2008

The Dow Jones Industrial Index is entering an anxious phase as corporate America enters the first-quarter earnings-release season.  Based on the historical performance of our Risk Premium Index, stability in the model would be a precursor for an upturn in the market or “the bottom” investors are eagerly hoping for.  Sorry to disappoint the bulls.  When our model performs in a neurotic fashion, the prognosis is usually the continuation of the primary trend, which is bearish.  A trend to watch will be the contraction of hedge funds that haven’t already hit the wall, thereby placing additional selling pressure on the market.

Some Better Than Expected Earnings

Despite some positive earnings’ reports this past week, particularly from a small number of financial institutions and high-profile corporations, the reporting season has yet to begin in earnest.  Last week GE’s failure to meet expectations was attributed to market volatility. Yet the Dow managed to finish the week down merely 30 points, to 12,581.98.  This week, however, respectable financial performances by big businesses such as Coca-Cola, Google and IBM spurred positive expectations, with the Dow ending the trading week at 12,849.36, up over 4% for the week.  The volatile market behavior and, at times, even its resilience (as we had this week), is systematic of an unstable market.  

How Long Can The Dollar Remain Weak? 

Those companies lucky enough to be in the black are deriving a considerable amount of those earnings from outside the United States.  Companies reliant on domestic sales may not prove to be as fortunate.  It is becoming increasing apparent that those companies with businesses outside the U.S., especially emerging markets, are on relatively solid footing.  IBM obtains 65% of its business from outside the U.S. and Google procures 51% of its revenues offshore.  When and if the dollar does reverse its long trip downward we can expect to see a drop in profits from international operations.

April Showers May Not Bring May Flowers

With approximately 165 companies in the S&P 500 yet to report and a number of firms quietly announcing sizeable lay-offs, prospects for a strengthening economy and sustainable positive earnings seem unlikely.  Companies optimistic about their business outlook do not reduce staff or pare back operations. So we encourage investors to be on the alert for such news and carefully examine corporate earnings’ reports and 10-Qs, public companies quarterly financial reports to the SEC. The financial sector remains in a write-off mode and investors seem not only to expect this but are apparently unfazed by their magnitude.  But does this mean good news is on the horizon? Not likely.  The U.S. economic slowdown could continue to yield an ongoing pattern of credit losses as housing and consumer credit problems persist.  These telltale signs of job reduction, contracting operations, the credit freefall and rising oil prices indicate that the economy is operating on a fragile “fundamental” underpinning.  Going into the second half of the year, markets will probably be hamstrung by the uncertainty of the political race right up until Election Day.

Citigroup Posts A Multibillion Dollar Loss

On Friday Citigroup revealed a $5.1 billion loss when it released its first-quarter financial results, prompting Fitch Ratings service to downgrade Citi’s rating by one notch, to AA.  The financial giant noted that it had experienced weakness and losses in its retail, commercial and investment banking businesses and said it plans to reduce costs by some 20% this year, including a fresh round of headcount reductions.  The market seems to have already anticipated and discounted these losses by Citi.  So not surprisingly, the stock closed up 4 ½% on the day, reiterating the adage that you buy on the bad news and sell on the good. 

RISK PREMIUM STATISTICS

For the week ending March 28th, 2008 we noticed a precipitous decline in the Dow Transportation Risk Premium which was heavily influenced by UPS’ drastically lower earnings and the charts below visually depict this impact.  Prospectively, we would not be surprised to find other significant earnings releases to magnify a particular trend in the market.  We believe that these sharp declines may not be anomalies but evolve to new lower levels of return performance. 

§      The Industrial Risk Premium ended at 6.42% versus 6.69%

§      The Transportation Risk Premium decreased to 4.50% from 4.77%

§      The Utility Risk Premium decreased to 5.77% from 5.95% n

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