RISK PREMIUM INDEX:  Get This Party Started!

For the week ended:  August 8, 2008

THE “V” OR THE “W” MARKET OR THE ‘VW” MARKET?

Apparently the market was eager to get the party going, with the Dows Jones gaining 400 points or 3.6%, ending the week at 11,734.32, still way below its 12-month high of 14,164.5.  The Dow Transportation and Utility Index also posted respectable results.  It advanced a healthy 267.3 points (5.4%), reaching 5,216.5.  The all-time high of 5429 was reached in 2007.  Meanwhile the Utilities Index under performed its Industrial and Transportation counterparts, finishing the week up a meager 1.65 points (0.35%), advancing to 471.2, below its 52-week high of 503.92.  In recent weeks the market has posted several spectacular “ups” and “downs.”

THE BULLS HAVE CENTER STAGE

With the help of the 303-point surge in the Dow Industrials on Friday the market had its best weekly performance since April.  The bulls seem to be encouraged by the decline in oil prices as well as the Fed’s freeze on record-low interest rates.  Then there are the investors who see a silver lining in the latest housing statistics.  Hate to dash hopes that a bull market is upon us, but there are several “troublesome” aspects to the bull’s outlook.  First and foremost, the decline in oil prices is merely tracking the global economic downturn.  Once economies start to rebound, so will the demand and price of oil.  Next, while the Fed’s low-interest rate policy has provided generous liquidity to the banking system, the banks, unfortunately, have been stingy with their commercial and consumer clients.  And lastly, the bulls can crunch the housing numbers all they like.  However, the reality is that the housing market has, at best, plateaued, or, at worst, is still in crisis mode with a long way to go before it turns around.  However, in terms of sentiment, the market has hopefully begun an upward trend (one among many over the past 12 months).  But as investors have fewer places to obtain more than nominal returns, some may feel compelled to take their chances with the market, hopefully to awaken in five years to a pleasant surprise.

WE FEEL THAT THE 11,000 THRESHOLD WILL BE APPROACHED AGAIN

In light of the weakness in fundamentals we discussed last week in our Risk Premium analysis, “Hope for the Best, But Plan for the Worst,” we are unconvinced that stocks have reached the bottom in this bear market.  We feel that stocks may be poised to test the 11,000 level again – especially since as they have failed to hold onto recent gains.

THE BULLS REMAIN HOPEFUL (AGAIN)

Despite another week of wild swings in stock prices, in our judgment, investors are reaching for “bottoms.”  A case can be made that since the vast majority of stocks are trading at or near their 52-week lows (as we have commented in the past) they may appear to be oversold if one looks at stocks from the top down.  But if one looks from the bottom up, specifically the price levels posted in August 2006 (arguably a time when the economic outlook was in upswing), stocks appear to offer value.  However, it is difficult to make that same case today since stock values based on absolute numbers and forecasted profitability for the balance of 2008 and even 2009 are merely “passable.”

ARE THE FUNDAMENTALS REALLY BETTER?

With the fall in the price of oil to around $115 per barrel as compared to one month ago when it was in the $145 range, it would appear the slump in the U.S. and global economies has finally curtailed world-wide oil demand, putting downward pressure on prices.  We commented in our Risk Premium report dated June 20^th, that oil prices in the $145-$150 per barrel were not sustainable and noted that: “We expect that the volatility and persistent increase in the price of oil may subside during the next 12 months, perhaps heading down to $100 to $120 barrel.”  Unfortunately, the oil price run-up has already negatively impacted corporate earnings (causing lay-offs) and dampened consumer spending.

Our June observation was based on the slowing U.S. and world economies and, as a consequence, a predictable reduction in the short-term (12-month) demand for oil and its price.  Although this economic downturn may have begun in the U.S., it has now become a global phenomenon.  To the extent that the world economy slows, oil is unlikely to resume its advance.  Nevertheless, when the global economy resumes its expansion, we anticipate that oil prices will approach their 2008 highs and, perhaps, even surpass them.

HAS THE FED DONE ENOUGH?

For the sake of the national economy (and psyche), the Federal Reserve decided to hold interest rates flat at 2%.  Although inflation and the weak dollar are priorities for the Fed, even they were forced to concede that this would be a very bad time to increase interest rates.  The credit crisis is clearly not over as banks continue to hold assets with unreliable values which affects the adequacy of reported equity, liquidity and the price and terms upon which they can raise capital.  This is, indeed an area where the federal government can proactively stabilize the banking system.  It should be apparent though that making funds available to the banking system is only half the solution – banks, in turn, need to extend credit, not pull in the reins on their lending.

ARE LENDING INSTITUTIONS DOING ENOUGH?

Unfortunately, the Fed’s injection of capital is not reaching the ultimate borrowers because lenders have become hyper-risk adverse and have made financing so onerous.  For instance, some banks are now limiting the absolute dollar level of mortgages, effectively limiting the number of loans they will extend.  In other cases, banks are cutting back on credit card limits for individuals and businesses from several thousand dollars to hundreds of dollars.  While efforts by the Fed to pump liquidity into the system are beneficial, it’s unfortunately only half the solution.  The credit crunch will not be solved unless and until banks resume responsible lending.  In short, while banks may have funds to lend, they are not only hesitating to extend credit but are making matters worse by reducing the lines of credit to financially sound customers.  Banks make money by lending money but by virtue of the self-imposed lending limits, financial institution are effectively frustrating their own “earnings” recovery, which, in turn, raises question about the overall economic outlook.

RISK PREMIUM STATISTICS

§         The Industrial Risk Premium ended at 8.14% versus 8.13%

§         The Transportation Risk Premium decreased to 7.87% from 8.06%

§         The Utility Risk Premium increased to 7.33% from 6.73% n

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