RISK PREMIUM: Energy Albatross: Be Afraid, Very Afraid!

For The Week Ending: June 13, 2008

Inflation Fears: Not A Bullish Variable

We cannot endorse a market recovery at this stage as long as energy prices continue to spiral upward thereby increasing the cost of production and delivery of all goods and services.  These higher energy costs will negatively affect profitability – a development which carries long-term implications for stock values.  The stock market has resumed its lateral trading pattern with the Dow Jones Industrial Average closing the week at 12,307.35, up 97.54 points (0.80%).  Our Risk Premium model is still not pointing toward a bull market and when some critical developments are taken into consideration (e.g., the housing downturn, the credit crisis and especially the oil-price run-up) it is even more difficult to have a positive outlook for stocks through the end of 2008.  In our opinion, this market lacks the catalyst for a rally and remains weighed down by the above forces as well as the Fed’s belief that inflationary pressures may force it to increase interest rates (albeit nominally) by year-end.  The combination of a weak economy and a Federal Reserve determined to hike interest rates is not a recipe for a near-term recovery in stocks.

Please, Ben, Shut Up!

While we like Bernanke we sometimes feel the Fed chairman’s academic background can interfere with a pragmatic approach to monetary policy, especially as it relates to overall economic dynamics.  When he warned this week that the Fed was concerned about inflationary pressures, it led the investment community to speculate that a 25-basis point rate hike was in the cards later this year.  Given the turbulence in financial markets and the likelihood that not all the bad news has surfaced yet leads us to fear that Bernanke is playing with fire by pointing toward a rate hike when it is unclear how effective the bank’s rate cuts have been.  The bond market apparently took Bernanke’s comments very seriously with Treasury yields rising across the board and the sensitive two-year note up 65-basis points.  With Presidential elections on the horizon, the Fed will probably feel severely constrained about raising interest rates until next year, when the new administration in place.

Lehman’s Earnings Galvanize Fears That The Credit Crisis Is Alive And Well

This week Lehman Brothers announced that it would be posting a $2.8 billion loss for the first quarter of 2008, illustrating just how vulnerable banks and securities firms are in the current credit crisis. After the Bear Stearns meltdown Lehman assured the financial community that its balance sheet was strong and that the company’s liquidity position was sound.  Its balance sheet and cash flow may have been sound but Lehman neglected to mention that the firm had sizable real estate exposure.  In fact, Lehman’s $2.8 billion loss resulted in large part from two big real estate investments – so there goes the belief that the financial community has worked through its problems.  Home equity loans may surface as the next phase of the credit crunch.  Many regional banks have substantial numbers of these loan commitments on their balance sheets. So as housing values continue to drop these second-tier financial institutions are sure to be severely impacted, exacerbating the existing financial turmoil.

The Housing Sector Is Still Under Pressure And A Return To Normalization Will Not Be Helped By Speculators

The housing market certainly would not welcome higher rates, despite April’s statistics showing a 6.3% gain in pending home sales contracts over the prior month.  Home sales however remain 13.1% below the levels reported in April 2007.  This uptick in pending home sales may prove to be a less reliable indicator of the housing market strength since there was a rash of pending-sale cancellations in the first quarter of the year.  In addition, we think that April’s housing statistics may be skewed by speculators seeking to buy real estate at bargain prices.  We feel that the double-digit decline in home values has attracted speculative investors rather than individuals who plan to live in these homes.  Existing home sales figures for May will be released on June 26th and they may prove more telling.  The real estate market remains seriously depressed and the last thing this sector needs is for investors to create a speculative bubble which would effectively undermine the “true economic equilibrium.” Higher sales led by speculators masks the true housing picture which continues to suffer from the difficulty consumers are having in obtaining financing. The threat of higher interest rates by the Fed will only exacerbate the situation.

The Employment Statistics Are Bleak

On the job front, the news still remains bleak.  The Conference Board, a business research group, released its employment trend index.  The index, which reached 113.7, is at its lowest level since 2004 and has been falling steadily since July 2007.  The board noted that “job losses are expected to continue in the coming months because the labor market has yet to stabilize.”  This worrisome unemployment trend hasn’t seemed to have affected Bernanke’s views on the economy – yet another indication of his academic pedigree.

Do Not Expect Lower Oil Prices: Be Afraid, Very Afraid!

Oil prices eased a bit, ending the week at $134.86, helped by the assumption that the U.S. Dollar has begun to strengthen albeit ever so slightly – an assumption that may prove very short-lived.  But any hope for a meaningful long-term decline in oil prices is delusional since the upward pricing pressure will continue to be boosted by increasing demand from developing economies and OPEC’s stance that it does not plan to materially increase output.  So investors have a right to feel skittish and fearful about the market as long as we have the overhang of high oil prices.

RISK PREMIUM STATISTICS

§         The Industrial Risk Premium ended at 1.20% versus 1.21%

§         The Transportation Risk Premium increased to 4.43% from 4.35%

§         The Utility Risk Premium decreased to 6.27% from 6.42% n

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