RISK PREMIUM INDEX:  When Stress Turns To Distress   

For the weeks ended: September 12, 2008 and September19, 2008

SPECIAL NOTE:  On September 5^th, 2008 our Risk Premium Model yielded results which pointed toward a “very significant” market move.  Based on the weakening fundamental outlook, we concluded that the odds favored a downward fall.  We chose not to publish the data and results for the week ending September 5, 2008 because of the unprecedented magnitude of market change indicated by our model.  Our Risk Premium Analysis originated in the 1982-1984 period and has been reworked and back tested periodically since then.  Over the years, we have had opportunities to challenge the conclusions which the model has produced.  Based on the market close on September 5, 2008 in both the debt and equity markets, the model suggested such a significant “market change” that we began an intense review of the model,  since the spike was the largest ever experienced in nearly 25 years by a dramatic margin.  For the sake of prudence, we opted not to publish our findings.

To our amazement, when we studied market results for the trading week ended September 12^th, the Risk Premium model extended the “movement pattern” even further – causing us to examine yet again the model’s construction, including the simple possibility that there may have been an input error.  No error was discovered and by this time, the model was clearly calling for a market decline rivaling that of the 1987 market crash.

The Dow Industrials: More Bias Towards The Downside

Market developments during the month of September 2008 have proven to be virtually unprecedented by any measure.  We have chosen to publish the model with certain “subjective” alterations, in order to somewhat mute the serious magnitude of stock market change forecasted.  Several months back, when we first broached the notion that the Dow could break through 11,000, many subscribes replied that our conclusion was overly harsh and that our “black box” model was just a little to “black.”

Based on the “daring” and “lonely” prediction I made in August 2001 that Enron was in grave trouble (... being correct can be a very lonely and lethal place), we made the decision to limit the low on the Dow Industrials to 11,000 despite a much lower figure suggested by our Risk Premium model.  As a result we have continually cautioned investors that the long awaited “bottom” to this bear market had not yet been reached and that we would not be surprised to see the Dow break 11,000, which it has done repeatedly in recent months, only to erratically bounce back over and over 11,000.  With considerable trepidation, we are releasing the latest value results from our model, the result is that the Dow Industrials may decline even further, possibly approaching the 10,000 level and at the extreme 9,500 (about 1,500 points lower from its current level).  Much of the recent market behavior appears to be backing and filling in conjunction with investors who are all too eager to jump on the latest headlines before taking the time to really think of the possible ramifications of using a hair trigger response to any information irrespective of the source.

The Market Is Having To Discount Many Significant And Material Events All At The Same Time – “We’re Surrounded!”

Ø  Stocks have yet to fully adjust to the re-pricing of risk and the need for consumer and corporate deleveraging.  In addition, investors will have to consider the transitionary standing of the U.S. in the developing global economy.

Ø  Credit spreads are likely to appear wide relative to those witnessed over the past five years, since under the Alan Greenspan years at the Fed interest rates may have been kept low for an unhealthy period.  Looking forward, as the cost of debt adjusts upward, new commitments to debt and less complex fixed income securities could prove to be the norm and as such may become attractive investments in 2009 and 2010.

Ø  Credit availability. To use an outdated cliché, “you can lead a horse to water, but you can’t make it drink.”  Unfortunately this is the problem borrowers are facing, the Fed is making funds available to the banking system, but lenders have raised the “lending bar” to such a level that funds are not flowing down to the ultimate consumer (i.e. credit stagnation).  Until the financial grid-lock dissipates, there is little chance of a robust economic rebound.   

Ø  The fall in housing prices needs to begin to significantly tapper off as well as to demonstrate clear signs of stabilization.

Ø  Oil prices are likely to remain volatile, with a bias to trending higher over the long term.

The FED, Lender Of Last Resort

The long-term secular outlook must be approached with greater caution as the price of risk (...yes, I know everyone is sick of the phase—but get used to It ...and while expanding your vocabulary, add the term “deleveraging”) is likely to have made a permanent move higher thereby greatly affecting the recovery expectations and price discounting rates for stocks.  The same can be said debt securities, credit risk spreads should expand as new debt comes to market (including that of the Federal Government) and investors will likely demand increasing credit risk premiums, especially relative to the credit spreads offered in recent years.

The Night The Lights Went Out On Wall Street

There is strong political resistance to the Fed acting as the lender of last resort for Broker/Dealer firms.  As a result, the last two remaining “legion” independent brokerage firms Goldman Sachs and Morgan Stanley formed bank Holding Companies, placing both under the scrutiny of the Federal Reserve.  In exchange for restructuring, Goldman and Morgan Stanley will have expanded access to Fed funding; however, the companies will need to boost their capital base.  Effectively, the Fed will assure Goldman Sachs’ and Morgan Stanley’s liquidity and solvency as their security assets are “marked to market” in a very uncertain and depressed market.

Ø  The Fed has encouraged the two remaining independent brokerage to recast themselves to conventional bank holding companies, a move which should mitigate concerns over solvency and liquidity.  (...hence, Sunday September 21^st, 2008 will go down as the night the lights went out on Wall Street).

Ø  The Fed also loosened rules that limit the ability of buyout firms and private investors to take larger stakes in banks.

The Harsh Facts

There is much to be said about the stock market’s behavior on September 17, 2008 and, yet, there is very little to say – the facts speak for themselves and those harsh realities are:

·         On Sunday, September 14, 2008 Lehman (LEH) filed for bankruptcy protection, after an almost soap opera-like effort to secure its viability as an independent entity as its efforts to secure capital or find a “buyer” failed.  Unfortunately, LEH had a fair amount of “lookers” but no “takers.”

·         On Monday, September 15, 2008, Merrill Lynch (MER) unexpectedly announced that it had reached an agreement to be acquired by Bank of America (BAC) while attempting to craft a rescue plan for Lehman.  We suspect MER’s management may have found the offer attractive based on the quality of its asset portfolio (especially in view of MER’s uncertainty regarding the firm’s liability resulting from its sponsorship of Fannie and Freddie). 

·          Also on Monday, on September 15, shares of American International Group Inc. (AIG) tumbled on news accounts that it too was in need of a sizeable capital infusion, perhaps as high as $40 billion, as its future was called into question.  The failure of AIG would have far reaching implications for U.S. households as well as the global economy.  Accordingly, AIG reached out to   the Treasury Department, the Federal Reserve and the New York State Insurance Department.  The parties met at the Federal Reserve Bank of New York with AIG and representatives from other leading financial institutions to discuss possible solutions to the insurer's dilemma, perhaps hoping for a Federal rescue plan not unlike that devised for Bear Stearns.  New York Governor David Paterson intervened by asking Insurance regulators to permit AIG to upstream some $20 billion of capital from its subsidiaries.  The inability of AIG to stabilize its liquidity position and boost capital placed the entire stock market under relentless pressure. 

·         On Monday, September 8, 2008, the Government placed Fannie Mac (FNM) and Freddie Mac (FRE) under “conservatorship” (i.e. effectively an out of Court reorganization), dashing a long held belief that investors in Government Sponsored Enterprises (GSE) could not fail because of “a government guarantee.”

The practical value a GSE’s has long been a source of debate, specifically, the exact nature for debt holders and shareholders a GSE protection.  To the dismay of many, that guarantee appears to be reserved for creditors, not holders of Common Equity and Preferred Stock, arguably a fixed-income (i.e. to some a debt-like) security.

·         Stocks rallied strongly as the government proposed a $700 billion rescue plan, which would remove distressed assets from banks and brokerage books.  The rescue plan faced considerable resistance in Congress, despite urging by the Fed and the Treasury.  Congressional delay will seriously erode confidence in the U.S. financial system and exert downward pressure on stocks.

The convergence of these major structural dislocations caused investors to indiscriminately sell stocks, with the Dow Jones Industrial Average plummeting 504 points (a one day loss of 4.4%), to close at 10,849.51 on September 15^th.  Since then the market has experienced many days of high volatility.

RISK PREMIUM STATISTICS

§         The Industrial Risk Premium ended at 7.78% versus 7.75%

§         The Transportation Risk Premium increased to 7.67% from 7.60%

§         The Utility Risk Premium increased to 7.65% from 7.52% n

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