RISK PREMIUM:  DON’T PLACE THIS MARKET ON AUTOPILOT YET

For the week ended:  August 29, 2008

Volume was relatively light this past week when there was only one significant economic data release (2nd quarter GDP) and Wall Street wound down for the Labor Day weekend.  Despite the reduced volume, there was no lack of volatility with the Dow Industrials experiencing 200-point-plus intraday swings for four of the five trading days.  These gyrations are not uncharacteristic of thinly traded markets.  For the week ended August 29, 2008, the Dow lost 84.5 points (0.73%), closing at 11,543.55.  Usually the market reacts to the latest headline or rumor, regardless of merit.  With a dearth of financial news during the week, investors got a respite from the recent barrage of negative banking press.  However, it is not a sector to leave on “autopilot” as the upcoming months will unfortunately see lower corporate earnings and more downbeat economic news.  Among the biggest drags on the market recently has been Lehman which has yet to get its house back in order.

THE FINANCIAL SECTOR

It is still premature to be positive about the financial sector since billions of dollars of refunding are due in the fourth quarter.  This rollover is likely to be costly as the new-issue markets will be very crowded, pushing up yield spreads for all borrowers (including interest-rate sensitive mortgages).  Before the end of 2009, some sources place the just the financial sector’s rollover burden at nearly $800 billion.

ARE WE BECOMING AN EXPORT ECONOMY?

The week was best characterized by the same old, same old.  On Thursday, Dell’s earnings were well below expectations which contributed to the market’s volatility.  U.S. stocks, however, rose Friday with the release of higher second-quarter Gross Domestic Product (GDP) figures, which came in at 2.7%, well above the government’s July preliminary 1.9% estimate.  Revisions to net exports, inventories and personal consumption were the major reasons for the upgraded measure of growth.  Although total GDP gained, consumption, one of its components, eased by 0.4% in real terms, raising questions as to the true extent of the health of the overall economy.  In our judgment the market continues to act erratically, with no clear path to an upside.  As a result we feel investors should take advantage of very well-established and well-financed companies, where the P/Es tends to be below the general market and book value and cash and equivalents are fairly close.  

The revised statistic showed the economy was a long way from recession in the second quarter, leaving some economists to predict that third-quarter GDP would not be as bad as expected.  While strong export numbers were a major reason for the upward revision we feel that the outlook for domestic consumption still remains weak and international consumption is falling.  As the GDP numbers show, the U.S. economy is becoming increasingly dependent on the health of foreign markets – which are questionable at best.

GUSTAV: FADES AWAY

Stocks were affected late in the week by concerns that Hurricane Gustav would disrupt natural gas and oil supplies, leading to a sharp jump in fuel prices.  As it turn out Gustav proved less formidable than expected, sparing the Gulf Coast and its oil facilities.  Earlier warnings about Gustav’s ferocity had sent oil prices upward, approaching $118 per barrel.  But as the storm subsided, oil and natural gas prices declined.  Storms notwithstanding, we caution investors that natural gas and oil will continue to be subject to short-term price gyrations.  Nevertheless, the underlying demand and price trend is higher due to expanding global demand.  Finally, the Department of Energy (DOE) has announced that it would release oil from the Strategic Petroleum Reserve in order to offset supply fluctuations and to help stabilize prices.

FANNIE & FREDDIE

Fannie Mae (FNM) and Freddie Mack (FRE) were largely out of the news this week – which was good since they hold the potential to cause market volatility.  Since the beginning of this year they have lost $100 billion in capital market value, with their shares down 85%.  Investors will be watching closely the $225 billion debt the two agencies will have to refinance by the end of September.  On August 22, 2008, Moody’s kept both entities’ Senior Debt Ratings at Aaa and Subordinated Debt at Aa2 but altered the outlook on Sub-Debt to “negative” from “stable” (Aa2 Negative).  Preferred Shares did not fare as well as Moody’s downgraded those to Baa3 from A1.  Several days earlier S&P affirmed its AAA ratings on Senior Unsecured Debt but reduced their Subordinated Debt to BBB+.  S&P reduced Fannie’s and Freddie’s preferred stock ratings to BBB- from A- and also placed these securities on CreditWatch with “negative” implications.  Yields in the $4.5 trillion market for their mortgage bonds determine rates on new home loans and to the extent that their cost of funds increases so too will the cost of residential mortgages.  As Fannie and Freddie shares fell this year their borrowing costs rose.  The companies had $14.9 billion of losses in the past four quarters as arrears on mortgages rose to the highest on record.  In the most recent $3 billion Freddie five-year note debt refinancing, it was forced to pay 113 basis points more than similarly maturing Treasuries.  Fannie sold $3.5 billion of three-year notes at a record spread of 122.5 basis points versus comparable Treasuries.

RISK PREMIUM STATISTICS

§         The Industrial Risk Premium ended at 7.79% versus 7.83%

§         The Transportation Risk Premium decreased to 7.77% from 7.82%

§         The Utility Risk Premium increased to 7.24% from 7.19% n

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