RISK PREMIUM INDEX: A Week of Bold Predictions for a Tentative Market  

For the Week Ended May 16, 2008

WHY SHOULD INVESTORS BUY STOCKS

The Federal Reserve this week commented that the economy could remain sluggish for some time, dashing hopes that a rebound in the second half of 2008 was likely.  Comments such as this do little to bolster investor confidence.  The lingering and most difficult question is: what will lead to a reversal of this market’s stagnation and spur stocks to rally?  Since stocks plummeted in mid-March, the Dow Jones Industrial Average and even the broader-based S&P 500 have posted modest advances.  Over this past week the Dow rose 240.92 points (1.89%), yet the upward trend since March could hardly be labeled as a bull market since the economic data has often been giving erratic and conflicting signals.

THE ECONOMIC DATA REMAINS MIXED

For example, retail sales for April were firm once auto sales are removed from the equation. But is this adjustment an accurate and reliable signal of economic health?  In April, retail sales were down 0.2% from March. However, the figure would have actually been up 0.5% had there not been a steep fall in auto sales.  A weak auto market has a pervasive effect on the economy and consumer spending (which accounts for two-thirds of that) cannot be expected to be robust given current consumer sentiment, which is decidedly negative according to a recent well-respected survey.  Claims for unemployment, which generally exceed 400,000 per week during recessions, have stayed below that level.  Possibly the current atypical job statistics reflect individuals who have simply given up looking for work or whose benefits have expired.  Finally, many companies are preparing for lower than expected earnings for the rest of the year and it is likely we’ll see them trying to shed certain operations. The most notable example is GE which hopes to raise $5 billion to $8 billion from the sale of its appliance division.

THE FED EXPECTS A “PROLONGED SLOWDOWN”

The Fed has been noticeably reluctant to characterize the economy as being in a recession or even acknowledging that a bear market is in place.  The Fed is in a precarious position.  The official declaration of a recession is the responsibility of the National Bureau of Economic Research (NBER), a non-profit think tank which defines periods of significant economic activity.  The NBER typically requires at least two consecutive quarters of negative GDP before doing so. Its decision to make the declaration also involves a close monitoring of the components of GDP, including income, employment and retail sales.  An April survey of leading Wall Street economists indicated that the probability of a recession had fallen to 60%, well below the 90% consensus in March.  Despite concerns that the economy will remain weak for the rest of the year, the futures markets are indicating a 50-50 chance that the Fed will begin raising interest rates this October – a sobering prospect, especially since the Fed itself acknowledges that the financial markets could remain “sluggish” for some time.

BOLD PREDICTIONS AT A HIGHLY VULNERABLE TIME

The President of the Federal Reserve Bank of San Francisco stated this week that she felt the combined effect of “interest rates set at appropriate levels … coupled with the fiscal stimulus” should stimulate moderate economic growth later this year.  She is clearly overlooking several important points, among these, the probably underwhelming effect of the much-vaunted stimulus dollars. (A half dozen visits to the gas station will swallow those up.)  It would also appear that she and her advisers are not fully factoring in the deleterious effect on the economy of ever-increasing oil prices.  And will the stock market be ready for a return to higher interest rates?  What with American wealth badly depleted by the decline in home values an increase in interest rates would not augur well for the market. Add the possibility of higher taxes into the equation and it is difficult to construct a bullish outlook.

RISK PREMIUM STATISTICS

§         The Industrial Risk Premium ended at 1.15% versus 1.16%

§         The Transportation Risk Premium decreased to 4.27% from 4.41%

§         The Utility Risk Premium decreased to 6.36% from 6.45% n

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