RISK PREMIUM: The Influence Of Political Uncertainty

For the week ended May 2, 2008

Desperately Seeking Returns

The Risk Premium Indexes have returned to a more normalized behavior pattern after the astonishing fall in our Indexes in the previous two weeks. This suggests an underlying bearish sentiment is in place; note the beginning of a reversal in the risk-premium lines heading back into bearish territory. April posted the fourth consecutive month of job cuts (20,000), with the unemployment rate down to 5.0% in April from 5.1% in March, which merely reflects an increase in part-time jobs rather sustainable employment.  It is estimated that that a healthy economy needs to add 100,000 jobs per month, hence the 20,000 rise is a far cry from that necessary to herald an economic rebound.  Moreover, payrolls are shrinking and no relief is expected on this front for the balance of 2008. T he modest decline in jobless rates may be interpreted as a sign that the economy might avoid a deep recession – therein lies the key phrase, “deep recession” but Americans are facing a recession nonetheless. While the jobless rate is good news, the economy could hardly be characterized as healthy and / or in a recovery phase. Home prices are declining at an accelerating pace, credit rating downgrades are outpacing upgrades, oil prices are on the rise (especially going into the higher consumption summer season), it is unclear whether the banking system has fully purged their balance sheets, car sales reached a decade low in April and consumers are confronted with higher food and energy prices.

The Dow continues to hover in a virtual dead-heat from its 52-week high / low, illustrating the lack of investor conviction one way or the other. The negative turn in our Risk Premium Index, after the aggressive Fed intervention this past March further reflects a powerful conviction by investors that the bear market has reached its bottom and investors are staunchly locked in an indecisive pattern. We see not reversal in the factors in the near-term and feel that 2008 is destined to be a wash-out.

The Dow Jones Industrial Average has ranged from a high of 14,165 and a low of 11,740 over the past year. So this week’s 13,058 finish was 7.8% below its 52–week high and 10.1% above its low.  Despite significant interest rate cuts over this period, the market seems to have found a comfort range at the midpoint between the high and low, highlighting the inertia and fragility inherent in the broad market.

It is difficult to feel optimistic about stock prices in the short run.  Contributing to this pessimism is the air of uncertainty surrounding the overall health of the U.S. economy and an end to expectations of further interest rate cuts. (Some economists are even of the opinion that the next rate move, whenever it comes, could see interest rates rising). Further clouding the picture is the depressed housing market and the attendant loss of a sense of wealth by investors.

Then there is the muddled upcoming presidential election. Unfortunately, neither the Democratic or Republican candidates have articulated a coherent economic recovery plan relying instead on political pandering.  Further, their apparent positions on taxing policy could prove to have a serious dampening effect on recovery prospects in 2009. They would appear to be counter-productive and probably result in restraining savings and inhibiting capital investment.  Bear in mind that history has shown that markets bottom out two years after a presidential election. If history repeats itself (which is very likely), weakness in the stock market could extend into 2010.  All these negatives argue against a return to a bull market in 2008.

A “U”- Shaped Recovery Seems the Most Likely Scenario

As noted in the past we expect any recovery to be “U” shaped based on the uncertainties still facing the market.  There is no confidence that corporate earnings in the next three to six quarters will be higher. Companies seem to be struggling to meet Wall Street expectations. Those entities able to pull it off will be heavily dependant on revenue and earnings growth from business outside the United States.

Attempts at a muscular rally show no signs of sustainability even as the Dow Industrials rose above 13,000 this past week.  The Dow ended the week of May 2ndat 13,058.20, up 167.44 points or about 1.3%, extending a pattern of backing and filling underway since the steep decline in mid-March.  The March dip was brought on by unsettling news from the financial sector especially fears that Bear Stearns was on the verge of insolvency. It was only an emergency intervention by both the public (the Fed) and private sectors (J.P. Morgan Chase & Co.) that brought some stability back to the market.  Still, the financial sector is not back on solid footing as evidenced by Citigroup’s move to further shore up its capital base by selling $4.5 billion in common shares and $6 billion in preferred stock.  With Treasuries offering risk-free but feeble rates of return, investors are forced to look to companies with dividend yields that surpass the average 2.41% offered by the Dow Industrials.

Little Optimism On The Housing Front 

The latest report by the S&P’s / Case-Shiller Index showed that home price declines are accelerating nationwide, dashing hopes that a bottom may have been reached in that sector.  The Case-Shiller Index dropped 12.7% year-over-year in February, marking the sharpest decline in the index’s 20-year history.  With an estimated 60% of investors’ wealth linked to real estate, the total property asset portfolio (i.e. measure of total wealth) is down approximately 14.8% off the peak reached in July 2006.  The outlook for home prices shows no near-term signs of improving either, with a number of Wall Street analysts foreseeing an additional 10% decline.

Distorted P/E Multiples

Investors searching for investment opportunities are apparently willing to forego conventional valuation standards.  The best illustration of this is the ever-rising P/E of the Dow Jones Industrial Index which this week hit 70x earnings.  That investors would willingly pay 70 times earnings would typically be indicative of a powerful bull market.  However, we do not believe this to be the case.  Instead, these aberrant figures seem to be the result of money being unable to find adequate returns elsewhere (or returns commensurate with those achieved over the past three or four years) and so investors are willing to tolerate depressed earnings’ results which are driving P/E’s higher.  We fear that the average investor is unknowingly paying 70 times earnings in this current environment.

Reliance On A Growing But Fragile Global Economy

Stock yields and expectations that a fair number of corporations can salvage respectable revenues and earnings’ gains in international markets is making the U.S. more dependent than ever on the global economy, particularly China, to compensate for the depressed domestic market.  If and when the U.S. dollar reverses its long decline, the earnings for U.S. companies could be severely impacted.

 RISK PREMIUM STATISTICS

§      The Industrial Risk Premium ended at 1.42% versus 1.75%

§      The Transportation Risk Premium increased to 4.31% from 4.29%

§      The Utility Risk Premium decreased to 5.91% from 5.92% n

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