RISK PREMIUM INDEX:  DELEVERAGING CORPORATE AMERICA 

For The Week Ended August 22, 2008

NO CHANGE IN DIRECTION

Our Risk Premium model continues its bearish trend.  On a technical basis the market has made three bold rally attempts since May yet been unable sustain them.  In our judgment the recent rally has the likelihood of being a bear market trap rather than the beginning of a bull market and investors should behave accordingly.  We have encouraged sector rotation, with positions held for relatively short time frames and the use “stop-loss” instructions if a particular company or sector falls out of favor during a given period of days or weeks.  Our model for the week ended August 22, 2008 has yielded a directional “dead-heat.”

THE DOW: AMPLE VOLATILITY BUT NO DIRECTION DISCERNED

The Dow Jones Industrial Average rose 197.85 points Friday, or 1.7%, to 11628.06.  For the week, the Dow fell 0.3%, the second consecutive week of declines after being down four of the last five sessions.  Although the S&P 500 gained 14.48 points, or 1.1%, closing at 1292.20, it was down 0.5% for the week, its first weekly loss in four weeks.  The technology-oriented NASDAQ rose 34.33 points, or 1.4%, to 2414.71.  Stocks continue to be hyper-sensitive to the slightest change in oil prices and rise and fall in tandem with the price of a barrel of oil.  We remain very concerned about the long-term price prospects of oil and do not believe that $200-barrel oil is unrealistic.  Although the weakening world economy has currently dampened the demand for oil, the longer-term outlook (say two years) suggests it will once again resume its meteoric price rise.

THE FED SPEAKS (BUT DOESN’’T SAY MUCH)

Federal Reserve Chairman Ben S. Bernanke on Friday, while attending a Fed Symposium, outlined his views of how the central bank should position itself in order to prevent or ease future financial crises.  Bernanke acknowledged that any such changes are fraught with new risks of their own and will require time to be implemented and offer demonstrable results.  Bernanke wants the Fed to have a more explicit role overseeing the inner workings of the financial system, including computer systems, contractual arrangements and dissemination of information by financial institutions regarding transactions.  The chairman said he hopes that new regulations will focus more on ensuring that the financial system as a whole is in sound shape, not just on the risks facing a particular institution.  Bernanke cautioned that: "An expectation by financial market participants that financial crises will never occur would create its own form of moral hazard…and encourage behavior that would make financial crises more, rather than less, likely."

The Fed chairman used the platform of the meeting to note that inflationary pressures have abated somewhat due chiefly to the recent drop in the price of oil and the slowing of the economy.  He indicated that any decision on an increase in interest rates would depend on what happens with commodity prices and the growth rate of the economy as well as the unemployment picture.  If the economy remains soft and inflation figures in check then there is less likelihood of the Fed raising interest rates in the near term, Bernanke indicated.  Meanwhile credit spreads continue to rise and mortgage rates appear headed upward.

FINANCIAL INSTITUTIONS PUT IN A LONG AND LABORED WEEK

Curiously enough we feel many financial institutions could be nearing the end of their bearish   quagmire.  However, such a turnabout may not be evident until third quarter or year-end results are out.  Financial intermediaries have needed to stabilize both the asset and capital sides of their balance sheets.  As for profit potential, we have discovered a number of banks, credit card companies and the like curtailing existing credit lines – thus, the business segment is not likely to adjust for several months, with less severe consequences from a write-off perspective.

Financial intermediaries are still struggling with declining house prices (not infrequently, below the equity or loan value of the property).  Our expectations are that price stabilization and any rebound in housing prices is unlikely before 2010.  Although the quality of other assets held by banks remains a sore spot, over the next six months asset revaluations should slow or cease.  However, banks may continue to need equity infusions, and not just for financial shoring up but to strengthen investor confidence.

Unfortunately, the lingering effects of charge-offs and securities litigation settlements are the great unknown for the giant financial institutions.  This was made clear again this past week when Merrill Lynch agreed to buy back up to a whopping $7 billion in securities in a comprehensive settlement with the SEC, the NY Attorney General and other state regulators.  Citi and UBS had earlier reached similar multi-billion agreements.  Meanwhile the debate will continue as to whether financial institutions misunderstood or ignored the risks of (negligence) or, in some cases, misrepresented the securities (fraud).  Finally, the continuing headlines on Lehman citing financial stress and asset sales are not helping inspire confidence in the financial sector.

THE FANNY AND FREDDIE CONUNDRUM

Fannie Mae (“Fannie”) and Freddie Mac (“Freddie”) closed out the week again in the single digits; Fannie at $5, down $1.01, and Freddie at $2.81, off $1.58 for the week.  One of the most baffling questions regarding Fannie and Freddie, so-called government sponsored enterprises (GSEs), has been the public notion, implied or otherwise, of a government guarantee to stand behind them.  Over the years these mammoth institutions have successfully accessed the capital markets with this perception that there is a government implied guarantee.

As the Treasury, Congress and the White House have attempted to work out a solution of the Fannie-Freddie mess, it seems that the “implied guarantee” does not extend to common equity.  And there is some speculation that the face value of other junior debt could be compromised (although this seems unlikely to us).  Hence, it is becoming increasingly evident that while these housing giants may have an implied guarantee (“too big to fail”) that guarantee is not absolute. 

·         Common Equity: Holders may ultimately carry the same risks as the shareholders of any corporation, including the possibility of being wiped out through a standard reorganization (only in this case the government will have a seat at the negotiating table). 

·         Preferred Shareholders: Should any salvage plan adopt a parochial view toward preferred shares?  Strictly speaking preferred shares are “equity.”

·         Debt Holders: A breach of the debt covenants would have a chilling effect on the credit markets since, at the very least, it would undermine the efficacy of government guarantees.

In the mean time the government dithers and the patients continue to bleed, with their access to commercial capital all but evaporated.  The Federal Reserve Bank of NY was granted authority to grant these mortgage giants credit.  And the Treasury was granted authority to purchase their shares but its public position has been that it “did not expect to have to use its new powers.”  (And I will soon be celebrating my tenth annual 30^th birthday.)  Meanwhile the markets tread water while awaiting an all-but-certain government bailout.

RISK PREMIUM STATISTICS

§         The Industrial Risk Premium ended at 7.85% versus 7.88%

§         The Transportation Risk Premium increased to 7.83% from 7.78%

§         The Utility Risk Premium decreased to 7.19% from 7.39% n

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