Risk Premiums For The Dow Indices

BAD NEWS BUFFETT

Week Ended: December 12th, 2008

Despite a continued array of unsettling news, ranging from the $50 billion Madoff scandal to concerns that the Federal Reserve may take the unprecedented move of adjusting its “targeted” interest rate to zero-to-0.25%, the Dow Industrials ended the week down a nominal 5.79 points, to finish the week at 8,629.68.  Our Risk Premium Model for all three Dow Indices remains in a bearish mode.  Based on our model, the market’s inability to substantially hold gains made in September and absolute numbers suggest that the bear market will persist. We are concerned that valuations based on full year 2008 earnings results point toward the Dow Industrials as adequately valued between 6,500-7,000, roughly 1,600 points (18%) lower than current levels. Using a 12 P/E applied and current $478.84 earnings per share would place the Dow in the 5,750 vicinity. Using more generous figures, we have arrived a higher estimate, the point of this exercise is to demonstrate how easily it is to “value” the Dow at lower levels.

THE PROSPECT OF UNPRECEDENTED INTEREST RATES: The zero factor

Insofar as the Federal Reserve’s action to reduce its targeted rate to 0%-to-0.25% we feel it would have positive and negative implications for stock prices. On the plus side, with a near zero interest rate, investors would hopefully be compelled to turn to stocks and corporate bonds as investment vehicles. Within this context, we feel that our approach of seeking out the highest quality companies is the best posture to take since these companies will likely be oversold relative to the broader market.

THE NET EFFECT OF RAISING “THE COST OF CASH”

On the negative side, the Fed’s decision to move rates toward zero, effectively extinguishes this option in the Fed’s tool kit, a concern we expressed earlier this year. However, we believe the net effect of the Fed’s action to be positive for investors since we believe that investors will be forced to realize that the cost of holding cash is far too expensive relative to value, even on a current-dividend income basis to ignore the debt and equity instruments offered by companies with sound business positions and conservative financing practices.

§  The Industrial Risk Premium for the week ended December 12^th increased to 9.61% versus 9.60% in the prior week

§   Over the same period  the Transportation Risk Premium increased to 8.60% from 8.34%

§   Finally, the Utility Risk Premium number declined to 8.98% from 9.08%

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