Risk Premium: FROM RUMOR TO REALITY

Risk Premium: FROM RUMOR TO REALITY

For The Week Ended: June 27, 2008

THE DOW TRADING BELOW 11,500 IS NO SURPRISE

U.S. stocks tumbled this week, with the Dow Jones Industrial Average ending the week at 11,346.51, down 496.18 points (-4.19%).  The market finally came to the realization that a continuation of interest rate cuts was unlikely.  In the days preceding the Federal Reserve’s mid-week decision to hold the federal funds rate at 2%, the market was rather calm – the proverbial “calm before the storm.”  Despite the sizeable fall in stock prices, it still seems too early to begin discussing any sort of “bottom.”  We are witnessing the semi-comical rush by some market commentators to call a bottom as well as seeing who can mention “market capitulation” first.  On the fundamentals’ front, until housing, oil prices and the dollar/inflation dynamics establish new equilibriums, there is little case to be made for an end to falling equity prices.  Technically, we would like to see a rally accompanied by a bit more momentum (i.e. volume) despite the adage that a bull market ends with a bang and a bear market ends with a whisper.  The first weeks of July will be very telling as companies close out the second quarter and release preliminary earnings’ results.

In our Risk Premium analysis comments dated March 7, 2008, we raised the possibility of the Dow Jones Industrial Average testing the 11,000 level. In that report we stated that: “Our Risk Premium Index points to much lower levels ahead, perhaps testing even the 11,000 threshold.  The Risk Premium Index continues to indicate that the bear market is entrenched and that a downward revaluation of stock prices shows no signs of abating.”

THE FED ENDS THE DEBATE ABOUT ITS NEXT MOVE

The Fed has made it very clear that its aggressive rate-cutting campaign has come to a close, dealing the market a harsh dose of reality. The next move in rates, whenever it comes, is likely to be an increase. The decision marked the first time since the credit crisis erupted last August that the bank voted not to cut the target rate.  Although the Fed gave no indication that an increase was imminent, its rate-setting committee noted that “uncertainty about the inflation outlook remains high."

Continued price increases for energy and other commodities contributed to an “elevated state" of worry for the economy with the Fed indicating that future rate moves would be influenced by inflationary pressures and the continued weakening of the dollar. The combination of a weak dollar and rising oil prices has become a significant constraint on monetary policy.  As such, some economists believe that Ben Bernanke can be bullied into cutting rates one more time by a falling stock market and the need to aid the financial sector. As depreciating dollars chase higher oil prices, based on Bernanke’s strong academic background, we suspect he will resist.

FINANCIAL INSTITUTIONS DRAG DOWN STOCK PRICES

The market sell-off cannot solely be attributed to the Fed’s halt in interest-rate cuts.  The market continued to be hurt by predictions that banks and brokerage firms would face additional write-downs and that a number of prominent financial sector companies would be forced to raise additional capital and reduce dividends – the latter not the best selling point for companies in a capital- raising mode. So hopes for a market rally would seem premature until there is some sense that the financial sector has worked through all its problems and has begun to stabilize.

Insofar as the question of write-downs is concerned, we noted in our Risk Premium review last week that financial intermediaries would continue to struggle as the underlying asset values of their portfolios declines. Consumer confidence fell more than expected in June, hitting a 28-year low as surging prices and mounting job losses contributed to a pessimistic economic outlook.

RISING ENERGY PRICES CONTRIBUTE TO INFLATIONARY FEARS

The cost of energy, whether at the gas pump or the electric meter, just keeps heading north.  Despite some easing in the price early in the week, oil resumed its climb, jumping to above $140 per barrel late in the week, intensifying investor worries that the economic slump would be worse than anticipated. Some commentators are predicting that oil will reach $175 per barrel. And, notwithstanding his self-serving interest, the head of Gazprom, Russia’s leading energy producer, expects oil to reach $250 per barrel next year.  Our own views on oil prices are detailed in the Risk Premium discussion dated June 20, 2008. Not wanting to seem repetitious, it is safe to conclude that a significant step-up in oil prices is underway and that any retrenchment is likely to be temporary in nature.  In fact, we it might not be long before we look back and think $150 oil cheap. Finally, we have long held that this economic cycle would not be “V” shaped. Instead, investors are facing a long and difficult economic adjustment in asset values and the price of risk.

HOUSING: NO RELIEF IN THE NUMBERS

The gloomy news on the economy continues with a report that US house prices in 20 major cities fell at an annual rate of 15.3%. This was according to the latest monthly Standard & Poor's/Case-Shiller real estate index which was released June 24th and covers the 12-month period ending this past April. This was the monthly index's biggest year-on-year decline in 21 years.  The S&P/Case-Shiller index tracks the prices of homes in major metropolitan areas across the US.

RISK PREMIUM STATISTICS

§         The Industrial Risk Premium ended at 1.30% versus 1.25%

§         The Transportation Risk Premium increased to 4.36% from 4.12%

§         The Utility Risk Premium increased to 6.48% from 6.33% n

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