RISK PREMIUM: Financial Gridlock

For the week ended May 9, 2008

Our Bear Market Views Are Still In Place

Our Risk Premium Index has digested first-quarter earnings’ results. The poor performance of many companies, especially those in the Dow Jones Industrial Average, is reflected in the risk profile.  We see lackluster earnings for most of corporate America in 2008. Companies are reacting by taking what some would call the socially and economically undesirable approach of laying off employees and closing operations.  Our judgment is that investors should be extremely nimble and recognize that a “trading” market is in place.  Investors who have a long-term view (five years or more) should find value in well-established companies.  We discourage expectations of making fast money in the months ahead. Our Risk Premium has returned to its bearish mode as the first-quarter earnings’ reporting season comes to a close.

P/E’s Have Posted Peaks Not Observed In Decades

In many instances P/E multiplies have spiked to levels not witnessed for decades when multiples topped 80x and 250x during the 1929 Great Depression.  This week the P/E for the Dow Industrials increased to 85.9x, a 15.6x gain over the previous weekly multiple of 70.3x.  Do these P/E gains indicate that investors are so bullish on stocks that there is a strong willingness to “pay-up” for earnings? We think not.  The big jump in earnings’ multiples reflects significantly lower profits at many companies. This week alone:

§      Estee Lauder reported a 4% profit decline.

§      Lazard’s earnings were down 71%.

§      Cisco’s net dropped 5.4% despite a very optimistic outlook forecast late last year when they argued that its global markets should make up for the                               slowing US economy

§      Legg Mason posted its first loss as a public company.

§      UBS announced that it was in the red by $10.95 billion.

§      FedEx issued a warning that its results would fall below expectations

And the list goes on. However it should be apparent that the surge in P/E’s is not a reflection of an investor buying spree.  Accordingly, subjective judgments are necessary to approximate practical valuation averages.  For the DJIA, on an adjusted basis, we estimate that the most useable P/E is about 14x, down from a historically normalized range of 20-22x.  The earnings’ outlook for the balance of 2008 is showing no signs of improving and we have noticed a handful of economists predicting that the profit slump could extend into 2009, a view which we share.

HOW BAD IS BAD?

In addition to the disturbing spike in P/E, defaults on junk bonds have reached the highest level in five years. For the first four months of 2008, the number of companies carrying a junk bond rating (BB+ or lower) has increased and 28 companies have defaulted and/or filed for bankruptcy, with debt totaling some $18.4 billion. During the same period in 2007, 17 defaults were reported by junk bond companies. Moreover, the overall U.S. corporate default rate grew 2.1% in April, up from 1.8% in March.

The OIL Equation

The Dow fell 312.3 points this week, closing at 12,745.88 on little meaningful news.  According to The Wall Street Journal, stocks dropped due to rising crude oil prices and the continuing credit crunch. Crude oil prices have been on the rise for several months and the upward momentum shows no sign of abating.  Crude oil prices reached another record high this week, moving up to an intraday high of $126.25 per barrel before settling at a record $125.96 for the week on the NYMEX.  At the rate crude is climbing, $150 oil does not seem unrealistic. In fact, if crude continues its current trading behavior one should not be surprised if the price hits the $200 mark in 2009. It would seem that crude’s recent spikes are becoming an everyday fact of life and that the top/bottom range can no longer be assessed with any confidence.  The one variable investors can be confident about is that the continuous step-up in oil prices will squeeze profits on virtually all sectors of corporate America.

And what has been the response of politicians? The usual knee-jerk answer: blame the oil companies and pander to the populace by asking that gasoline taxes be suspended for the summer driving season. Of course it’s an election year. Rather than face up to the problem in a rational and realistic way and show leadership, they tell people what they want to hear. However, we need not be victims of rising oil prices if our leaders were open to new approaches, many of which are viable and some of which have origins dating back to ancient history.

IS THE CREDIT CRUNCH OVER? Depends, Are You A Borrower Or Lender?

When the Fed intervened and bailed out Bear Stearns they hoped to prevent a feared financial meltdown. In addition, it opened the money spigots for financial institutions and continued to lower interest rates. It hoped that this would end the credit crunch by encouraging lenders to re-open their loan windows to credit-worthy consumers and companies, helping kick-start the economy. Anecdotal evidence strongly suggests that this has not happened and that even blue chip borrowers are having a difficult time getting loans or when they do, getting them at reasonable rates. And now it appears that inflationary conditions could put the brakes on further interest-rate cuts and even lead to an increase in rates. Just what a sputtering economy needs.

RISK PREMIUM STATISTICS

§      The Industrial Risk Premium ended at 1.16% versus 1.42%

§      The Transportation Risk Premium increased to 4.41% from 4.31%

§      The Utility Risk Premium increased to 6.45% from 5.91% n

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