RISK PREMIUM: Just When You Thought It Was Over

For The Week Ending: June 6, 2008

Risk Premium Index: Still Bearish

The recent stagnation in the Dow Jones Industrials and other stock indexes had raised hopes in some quarters that the U.S. economy might be able to avoid a full-blown recession. The National Bureau of Economic Research's (NBER) Business Cycle Dating Committee, which holds the ultimate responsibility for deciding whether the economy has fallen into a recession, may yet decide that the U.S. did so some time during the first half of 2008.  Regardless of the NBER’s official stance, there is a strong consensus that the U.S. is undergoing an economic decline.  As we have noted consistently in our weekly Risk Premium analysis, there is little evidence to support the view that a bull market is in sight.  Our Risk Premium model continues to point toward stocks heading down. The Dow Industrials fell 428.51 points (3.39%) for the week led by weakness in the financial services sector.  Stocks were hurt by worries that the sector was still not out of the woods and that the group may still face additional writes-offs and liquidity problems.  The record-breaking rise in oil prices and a weakening job market also weighed heavily on the market.

The Job Market Offers Little Sign Of Relief

Any glimmer of hope that the U.S. economy might be in recovery mode was dashed by an unusually large jump in unemployment figures showing that payrolls shrank for the fifth consecutive month.  About the only positive conclusion one can draw from the poor employment numbers is that this reduces the probability of the Federal Reserve increasing interest rates in the near future. We further submit that Bernanke’s comments in recent weeks on the status of the dollar and his reservations about stimulating the economy further dash any hope of a continuation of recent rate cuts. The jobless figures reached 5.5% in May. up sharply from the 5% posted in April and the largest one-month rise in two decades. Payroll statistics, released as a separate report, fell by 49,000 jobs, resulting in total job losses so far this year of 324,000.  Some may dispute the severity of this figure, especially when comparisons are made to the Great Depression of 1929 when unemployment reached 23% and John D. Rockefeller was quoted as saying: “Prosperity has always returned and will again.” This, of course, is of little solace to those individuals in the 5.5% unemployment pool.  Indeed, the increasingly poor labor situation attests to the languishing profitability of corporate America.

Energy Price Pressures: It’s Not Just The Price You Pay At The Pump

Two weeks ago, investors were ready to pop open the Champagne when oil drifted down below $130 per barrel.  In our Risk Premium discussion then we cautioned that the slide in oil prices be approached with considerable skepticism because of continuing high global demand and practical limitations on the supply of oil. All this points to an upward bias in energy prices whether it be electric rates, home heating oil or fuel at the pump. As these higher costs filter through the economy it will mean higher prices for goods and services, prompting further cost-cutting measures by businesses as well as cutbacks in consumer spending. So when oil touched $139 per barrel this past week, we did not view it as an anomaly.  In fact, we have previously commented that $150 oil should come as no great surprise.

The rising toll of energy costs was in evidence at the Yale University-sponsored Chief Executive Officer’s symposium we attended last week. Many companies reported that they were trimming costs by reducing operations and cutting back on head counts.  Moreover, many of the CEOs questioned whether these actions would be sufficient to maintain or restore profitability.   Corporate confidence is clearly uneasy and there is a harsh recognition that many aspects of the cost of doing business (as opposed to revenue- enhancing actions) will constrain the profit outlook well into 2009.

Rising Cost of Production Does Not Bode Well For Earnings’ Prospects

There has been a popular belief that this recession (or the more politically palatable downturn) is likely to result in a long and shallow slump in stock prices. But as we have pointed out, a fundamental upward shift in production costs and the need to recoup those costs may force a new risk paradigm.  One in which P/E multiples of 20X or higher is no longer appropriate. Just as the 8X earnings multiple proposed by Graham & Dodd became obsolete for many years, the pendulum may be swinging back.  In short, stocks remain highly unpredictable, largely because many of the underlying economic variables cannot be quantified – a condition which may be unheard of by the current generation of investors.

Some Final Thoughts

Ben Bernanke has commented that the danger of a substantial downturn in the U.S. economy has abated over the last month, yet inflationary pressures are increasing.  We have made a strong effort in recent months to embrace Bernanke’s views. However, every now and again his academic background shines through.  We submit that the problem with this statement is that one month does not make a trend and that other economic indicators have displayed negative trends extending as far back as September 2007.             

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Lehman Brothers’ shares rattled the market midweek over profitability and liquidity concerns. Until now, Lehman appeared it would not get embroiled in the credit crunch decimating the financial sector, especially having infused equity into the firm earlier this year.  However, we remain concerned that Lehman may join the club and report large losses and need an additional equity infusion before year-end in order to restore its capital base. If Lehman falls into this negative pattern it will intensify concerns that the credit crisis is far from over.

RISK PREMIUM STATISTICS

§         The Industrial Risk Premium ended at 1.21% versus 1.17%

§         The Transportation Risk Premium increased to 4.35% from 4.20%

§         The Utility Risk Premium increased to 6.42% from 6.29% n

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