RISK PREMIUM: The “W” Factor

For the week ended May 30, 2008

The “W” Factor

The Dow Jones Industrials rose 158.69 points (1.27%) for the week ending May 30, 2008, continuing a backing and filling pattern that has been in place for the past several weeks.  The market is clearly lacking a decisive direction.  The rally this week seems to have been helped by a government report that durable goods’ orders were stronger than expected, shareholder approval of the Bear Stearns buy out by J. P. Morgan Chase, and a dip in oil below $135 per barrel.  In our judgment these developments reflect a market reaching to move higher, but after careful scrutiny, they are not important enough to result in a sustained market advance – in short, we seriously doubt this is the widely hoped for “bottom.”  Investors need to recognize that escalating energy prices are straining the entire value chain, a condition which does not bode well for stocks.   Investors should remain nimble, seeking safety in slightly higher yielding securities, perhaps even “maturing” preferred stocks, and defensive sectors such as health care and companies having global business exposure.

Risk Premium Remains Bearish

Our Risk Premium Index has resumed its bearish trend.  After a cautious examination of the facts, there is no fundamental basis to argue that the economy is on the rebound, many of the recent economic releases torture the data until it confesses.  For example, there is ample basis to worry about the drop in home prices as having a systemic and prolonged effect on an economic recovery.  In addition, the cost of energy, ranging from the price of gasoline at the pump to home heating and electricity, is on a sustainable rise, which will further dampen long-term economic growth.  These factors will significantly effect the profitability of U.S. corporations in the short term (2 to 3 years) which is resulting in mixed economic results.  The decline in wealth and rising energy costs are likely to cause atypical economic conditions in the future and we feel these factors are contributing to the difficulty in declaring that the U.S. economy is currently experiencing a “recession.”

What’s The Fed Up To Next?

The futures market has priced in a 60% probability that the Fed is likely to hike rates this coming October – an abrupt change in opinion from May 8, when investors envisioned no chance of a rate increase.  However, the Fed may feel constrained to act in October – just prior to the Presidential elections, as this may not prove to be politically savvy.  Any signal that the economy is growing, persistent concerns over inflation and weakness/strength of the dollar indicate a bias toward higher rates.   In view of the following, prospects for a rate cut at the next Fed meeting in June seem bleak, dashing any hopes that stocks would get a boost from an interest rate reduction.  Rising oil prices may prompt the Fed to increase interest rates late this year, moving yields above 4% on the 10-year Treasury bond.

The Past Is Not A Prologue to the Future: The “Total Portfolio” Concept

We feel that current assessments of the economy and stock values have not fully taken into account the decline in portfolios from lower real estate values. Historically, the primary measure of wealth has focused on paper assets (primarily stocks, bonds, and savings accounts), with the largest illiquid assets, namely, one’s home, excluded from the valuation of “all” assets held by individuals.  There has been little reason to include one’s “home” as part of a portfolio valuation since for the most part, real estate over time has been an appreciating asset.

Home prices are falling at an accelerating pace. The Standard & Poor's/Case-Shiller index for the first quarter showed prices for existing homes nationwide declined 14.1% from a year earlier, compared with a year-to-year drop of 8.9% in the fourth quarter. An additional S&P index that tracks 20 major metropolitan areas on a monthly basis showed home prices dropped 14.4% in March from a year earlier and 2.2% from February.  Sales of new homes in April rose 3.3% from March yet overall sales remain well below year-earlier levels.  With a glut of unsold homes on the market and little sentiment to buy new homes suggests continued price weakness and a long road to price improvement.

Restoration of Home Equity Has A Long Road Ahead

We feel that the significant correction in home values, the largest segment of an individual’s wealth, may be influencing the valuation investors are now placing on stocks and bonds.  Hence, the valuation of liquid assets today may have a higher correlation to home prices than that experienced since the 1929 depression.   Therefore, we question the reliability of P/E levels investors have become accustomed during the past 10 or 20 years, and extending these levels to stocks in the next 2-3 years.  We feel that this concept of total wealth correlation may effect the discounting rates applied to paper assets. This would go a long way toward explaining the “hovering” behavior of the stock market and the inability of the market sustain an upside break-out.

Energy’s Adverse Impact on Manufacturing & Consumer Spending Sectors

Revenues and profits across the corporate spectrum will be hurt by the recent run up in oil prices – it’s a variable which cannot be dismissed.  Mobility has long been the cornerstone of the U.S. economy and persistently high oil prices could alter consumer spending patterns and behavior.  While the price of oil may display a fair degree of volatility on a day-to-day basis, as there is far degree of emerging market demand and fluctuating political policies create arbitrage prices pressures.  The long term outlook, however, indicates that oil prices will remain high and are likely to go higher over the long-term.   The demand for oil from emerging economies such as China and India is bound to keep pressure on the demand side of the equation. In addition, OPEC may have less control over the supply of oil than in the past.  The “quality” of oil is a subject which has received little attention but we suspect it will become decisive in the years ahead – and have an important bearing on available supplies and, therefore, price.  Constraints on refining, we the U.S. has causally ignored, will also emerge as a key pricing consideration.  The increasing cost of mobility will assume a mounting role in the consumer sector.

Long-Term Factors Cannot Be Overlooked

The past may not prove to be the most dependable guide to the future. The current economic slump may be reflecting factors that heretofore had less of a lasting impact of stock values and we feel that an irregular path to higher stock prices is in store for investors.      

RISK PREMIUM STATISTICS

§         The Industrial Risk Premium ended at 1.17% versus 1.18%

§         The Transportation Risk Premium decreased to 4.20% from 4.46%

§         The Utility Risk Premium decreased to 6.29% from 6.38% n

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