RISK PREMIUM: SHALLOW OR LONG RECESSION?

For the week ended April 4, 2008

A PROLONGED ECONOMIC DECLINE DIMINISHED HOPED OF A RALLY

For the week ended April 4^th, 2008, the Dow Jones Industrial Index fell 44.94 points (or 0.36%). The release of weak labor statistics followed two days of Congressional interrogation of the Fed chairman.  The Dow managed to close the week at 12,609.42.  Although the economic picture is showing no signs of improving, we feel this market is best characterized as a classic bear trap. We would not be surprised if a rally testing the 13,000 mark might be in store. However, the underpinning fundamentals remain weak and first and second quarter results could result in a serious loss of investor optimism.

BERNANKE ENGAGES CONGRESS TWICE THIS WEEK...AND SURVIVES

In our view Bernanke handled his cross-examination in an admirable fashion. He focused on the core economic issues and argued that the economy needs time to respond to the reductions in interest rates which began last year and that the American public has yet to receive the benefits of the economic stimulus package passed in early 2008.  Stocks made a noble attempt to move higher during the week, looking past the negative economic news. Unfortunately, more bad news came at the end of the week when it was reported that the country suffered its biggest monthly jobs’ loss (80,000) in five years, the third consecutive monthly decline. The poor labor figures are considered by many economists of further evidence that the economy is in a recession.  

WILL THE FED CUT RATES 25 OR 50 BASIS POINTS?

Fears that a recession was at hand were not helped when Bernanke stated that it “is likely that real GDP will not grow much, if at all over the first half of 2008 and could even contract slightly.” He stopped just short of using the dreaded “R” word (i.e. recession), thus increasing speculation that instead of lowering interest rates by 25 basis points when the Fed meets April 29-30th , there is now a growing probability that rates may be slashed 50 basis points.  If not now, a 50 basis- point cut is likely by the June meeting.

THE DOW HOVERS BUT DO NOT PLAN ON “V” SHAPED RECOVERY

The flurry of bad news in recent weeks has not led to a significant decline in stock prices. The blue-chip average is down 4.9% since the beginning of 2008 and 11% off its peak reached in October 2007.  We cannot help but advocate a cautious view when approaching this market since we believe that a bear market is in place and that recent rallies are classic bear traps.  The fractured nature of this bear market is evidenced (see our Risk Premium market comments dated March 28, 2008) by the comments Bernanke made before Congress.  However, we disagree that the recession will be shallow. Higher energy prices, continuing credit woes  and falling real estate values (the greatest source of portfolio wealth for the average consumer) are all factors that will extend this down cycle, dashing hopes that a “V’ shaped recovery is in place.  Also prolonging a recovery is the economic uncertainty with the November elections coming and the unknown economic policies of a new administration.

POLITICAL POSSIBILITIES

We have purposely avoided making any political comments on the presidential candidates.  They have yet to clearly annunciate their individual economic agendas.  Accordingly, we offer the following observations on each of the three major contenders:

Hillary Clinton: She is yet to formulate a detailed economic plan of her own and is apparently waiting until she gets a better handle on the pulse of the American public as the elections approach (Who said she is America’s Eva Peron?) It is difficult to endorse a candidate who is seeking “power for power’s sake.”

John McCain: Since he is clearly the Republican candidate, McCain is attempting to build an economic polity and consensus around his candidacy.  In addition, McCain has previewed a list of running mates, that includes:

                        Tim Pawlenty, Governor of Minnesota

                        Haley Barbour, Governor of Mississippi

                        Charlie Crist, Governor of Florida

                        Mark Sanford, Governor of South Carolina

                        Bobby Jindal, Governor of Louisiana

                        John Thune, Senator from South Dakota

                        Mel Martinez, Senator from Florida

                        Kay Bailey Hutchison, Senator from Texas

                        Joe Lieberman, Senator from Connecticut

                        Condoleezza Rice, U.S. Secretary of State

                        Rob Portman, former Congressman from Ohio

                        Tom Ridge, former Secretary of Homeland Security

                        Mitt Romney, former Governor of Massachusetts

Barrack Obama: In a recent interview with CNBC’s Maria Bartiromo, Senator Obama displayed a penchant for raising taxes. This is simply not the best time to be taking money out of consumer’s hands and his lack of experience is becoming evident.

These candidates do not instill a strong sense of confidence. Their seeming lack of experience at dealing with the economic challenges facing the economy raises questions regarding their abilities to effect an economic rebound.

RISK PREMIUM STATISTICS

            §        The Industrial Risk Premium ended at 6.54% versus 6.75%

            §        The Transportation Risk Premium decreased to 4.61% from 4.83%

            §       The Utility Risk Premium decreased to 5.97% from 6.29%

The Risk Premium index is showing mixed signals but the one signal investors are looking for, namely “a bottom,” is not indicated.  The Transportation index last week showed some strength but has flattened out this week.  The Industrial Index is affected by aberrations in earnings, specifically, when reported earnings are lower, resulting in higher P/E multiples, rather than a reversal in pricing valuation. Finally, the Utility Index has turned towards positive territory, but we feel that a rally is based on investors reaching for the relatively higher dividend yields than that offered by other financial instruments. As such, the sector is vulnerable to the fact that interest rates and yield spreads are firming up.  Contrary to the article in this week’s Barron’s that featured an endorsement of electric utilities (“Power Players for Your Portfolio”), this sector retains its inverse relation to interest rates. Claims that utilities offer secure businesses, reasonable valuations, decent dividends and modest growth can change very quickly as a declining economy results in reduced sales and discretionary cash flows. The latter are not as “discretionary” as they might appear since the industry needs to devote its free cash flow to infrastructure improvements and capacity additions (i.e. capital expenditures). n

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