Final Weeks of 2008: Sweet or Sour?

DO NOT UNDERESTIMATE THE FED’S ZERO-INTEREST TARGET

We find the Federal Reserve’s action to set interest rates at near zero is a non-quantifiable positive for stocks and bonds.  In our judgment, the meager returns offered in the Treasuries market should prompt investors to reassess the risk/reward opportunities offered by stocks and corporate bonds, especially high-grade, despite the specter of further sizeable declines in the broad market.  We anticipate that the last two weeks of 2008 may be relatively calm while investors use the period to digest the impact of the continuing shocks to the market – the Madoff implosion, the automaker meltdown, the retail holiday disaster and the mortgage debacle, to name some of the biggies.

There appears to be no relief in sight according to our latest Risk Premium Model results.  Stocks have somewhat slowed their wild volatility in the past two weeks while the Dow Industrials managed to gain a mere 49.70 points (0.6%), ending the week at 8,628.81. Although the extreme turbulence has subsided, our model remains stubbornly bearish. The black box has served us well over the years and, as a result, we have been reluctant to hit the “override” button. This notwithstanding our fundamental assessment that stocks seem cheap based heavily on dividend yields and a chart pattern which looks to be consolidating and forming a bottom.   The Risk Premium figures for the week ended December 19^th follow:

Risk Premiums For The Dow Indices 

§  The Industrial Risk Premium for the week ended December 19^th increased to 9.66% versus 9.61% in the prior week

§   Over the same period the Transportation Risk Premium decreased to 7.85% from 8.60%

§   Finally, the Utility Risk Premium increased to 9.01% from 8.98%

At this stage, based on technical or fundamental indicators, we see no persuasive argument to make for an immediate reversal in the current negative trend.  Any bullish sentiment we express is based on our subjective view that the Dow Industrials may be consolidating in the 8,500 vicinity.  However, we are concerned that when year-end earnings are released in the first quarter of 2009 the 8,500 plateau may turn out to be a cliff instead which, using our Risk Premium Model, points toward a Dow plunge to the 6,500-7,000 range.

News that S&P had lowered General Electric’s outlook to “negative” and placed its prized AAA credit rating under review for possible downgrade initially had a chilling effect on stocks since GE has long been considered a bellwether for the entire U.S. economy. It goes without saying that S&P’s action does not bode well for the economy.  The number of Moody’s and S&P Triple A- rated corporate issuers in the United States has been in steady decline.

THE BAD NEWS JUST KEEPS ON COMING

TIME TO HIT THE OVERRIDE BUTTON?

Is the market developing immunity to bad news?   With one possible exception (see auto industry loan agreement comment below) the week offered little discernible good news. Stocks opened the week overshadowed by the $50-billion Madoff scandal which seemed to eclipse the lingering auto industry woes. S&P’s change in General Electric’s outlook to negative and Deutsche Bank’s announcement that it intended to exercise its hybrid-debt repayment option (thereby raising doubts concerning it ability to sell new debt) continued the spate of recent bad tidings. Additionally, S&P lowered its credit ratings on 11 banks (seven garnered negative outlooks while the remainder were given stable outlooks). Meanwhile, Moody’s cautioned that it might downgrade nearly $76 billion in U.S. commercial real estate collateralized obligations (CDOs).

Mary Schapiro: Career Regulator

Finally, investors are digesting President-elect Obama’s choices for key administration positions. In naming Mary Schapiro to head the Securities & Exchange Commission (SEC), he chose a long-time securities industry bureaucrat whose selection, a Harper’s Magazine writer said, “doesn’t inspire a lot of confidence.” We’d have to concur. We fear that she may follow the Eliot Spitzer example of pursuing “high profile” financial institutions and cases.  Schapiro is currently CEO of FINRA, the Financial Industry Regulatory Authority.  While she may be extremely well versed on regulations, we cannot help but wonder how effectively she can apply and prioritize those skills since she is lacking “Street” experience.

THE BUSH AUTO PLAN OR THE OBAMA PLAN?

General Motors and Chrysler secured $17.4 billion in a “conditional” loan from the U.S. Treasury.  The two major conditions that need to be satisfied by March 31, 2009 are: (1) the companies must be able to demonstrate that their businesses can provide a positive net present value and (2) obtain concessions from employees (especially the unionized), creditors and shareholders.  This seemingly favorable news appeared to set the tone for a more stable stock performance this week.

While concessions may seem achievable given the three-month window of opportunity, how sizeable they will be may be problematic given the conflicting interests of labor, vendors, creditors and shareholders.  We suspect the UAW will vigorously fight a large reduction in the roughly $9-an-hour wage differential between that of union versus non-union workers.  And shareholders are likely to be trivialized. In fact, we would not rule out a huge reverse common equity split (two or, even. four-to-one is within the realm of possibilities) to help boost the share price and reduce the float, thereby benefiting earnings per share.  On the March 31^st “day of reckoning it will be President Obama and a new Congress evaluating whether or not the terms of the bridge loan have been met.  There is also the possibility that the Obama administration will craft it own plan once in office.

DEUTSCHE BANK’S DEBT BOYCOTT

Deutsche Bank astounded bond and equity investors when it became the first big bank to say it would not repay its $1.42 billion hybrid-capital (debt/equity) bonds as expected in January 2009.  The move raises the question of how many other banks will not repay their own extendable so-called hybrid-capital bonds, an instrument which helped banks expand their balance sheets prior to the credit crisis.  Investors did not take the news well.  In fact, creditors rallied against the giant bank, threatening a “buyers’ strike” against further purchases of Deutsche’s own debt and even debt it tries to sell on behalf of others.  Bondholder boycotts are not very new and have been used mainly in the past as a form of gentle persuasion to induce a company to repay debt.  Should Deutsche Bank not reverse its position, this could set an adverse and costly precedent for future users of “hybrid securities.”<

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