The Third Week of 2008

Risk Premiums For The Dow Indices

Bush Rushes To Rescue Plan: How Effective Can It Be?

January 18^th, 2008

How effective can the president’s proposed stimulus be? Not very if it comes late in the economic cycle.

Federal Reserve Board Chairman Ben Bernanke and President George W. Bush are proposing a $150 billion “fiscal stimulus” package, intended to forestall an economic recession.  The stock market’s continued steep decline illustrates lack of confidence that the federal rescue plan, together with further interest rates cuts, will be effective in halting the slide into a recession. We believe the stock market is correct in discounting the effectiveness of federal aid and larger cuts in interest rates. Although both these measures should prove beneficial over time, we feel the lag in remedial actions will prove to have come too late in the economic cycle to forestall a recession.   

The Dow Jones Industrial average fell this past week 507 points, continuing the bearish behavior experienced in recent months. Since the close of trading in 2007 the Dow has fallen 9.5%. It finished the year at 13,365.87 and has subsequently fallen 1,266 points to date. The industrial index now stands at 12,099.30, well below the 14,164.53 high reached on October 9^th 2007, a fall of 14.5% from the peak.  Other indices such as the S&P 500 and Russell 2000 are also down considerably, with the Russell 2000 off nearly 20%, the threshold number to officially herald a bear market. Foreign markets have recently turned decidedly bearish, suggesting that a U.S. recession will lead a world-wide recession.

President Bush’s stimulus plan and the Fed chairman’s proactive statement’s cannot hurt.  But they may prove ineffective at preventing a recession at this stage of the economic cycle.  A call for action from the White House has done little to alleviate the bearish sentiment across financial markets. The center piece of President Bush’s stimulus plan calls for a one-time tax rebate of $100 billion for individuals and $50 billion for businesses. In theory, investor confidence should be bolstered by the rescue plan. But Congressional action will take time and that is the single most important variable driving our thoughts about the latest thinking on interest rate cuts and the economic aid package.  

Considering that the Fed’s rate cuts will require months to filter through the economy, it is clear now that they should have been steeper at an earlier stage. For example, if a homeowner’s adjustable rate mortgage adjusts in July, that individual will not begin to directly benefit from lower interest rates until this summer. Thus, the Fed’s recent rate cuts will not reach the full market for several months.  There may be light at the end of the tunnel but the economic burden of an ailing housing market will be with us for the foreseeable future. Reduced borrowing costs may not actually begin to entirely manifest themselves until late this year or next.

Complicating a turn-around in real estate is the fact that lenders have raised the bar for extending mortgages, thus making it difficult to mortgage a property in a housing market with surplus inventory and declining home values.  In our view, had the Fed begun lowering rates not only sooner but much more aggressively, the spiraling negative housing loop may not have deteriorated so severely. The real estate death spiral remains a heavy burden on the economy and consumer psychology. Larger rate reductions are more likely to shore up housing confidence.

Can Bernanke’s “aggressive” be translated into a number? Yes, Maybe Now.

 An ever increasing number of economists believe that the Fed may be considering a 75-basis point cut, bringing the Fed Funds rate down to 3.5%.  It did just that in an emergency move prior to the January 22 market openings.  We postulated last week that a 100-basis point reduction this month would offer increased hope for troubled households. The Fed’s next rate official setting meeting is set for January 29-30. Unless there is some news to the contrary and/or the stock market rallies significantly (which we doubt), the Fed may cut rates by another 50 basis points at the month end meeting, to 3.0%.

How helpful will a federal stimulus plan be?

The market did not find the prospects of a fiscal boost reassuring. President Bush has presented a broad program designed to jump-start the economy. As noted above, the economic stimulus approach revolves around tax rebates (i.e. cash which consumers will presumably put back into the economy).  The amount and timing of tax rebates is problematic. Right now, President Bush has only a broad outline of the package on the table. And, while there seems to be bipartisan support for it, Congress is not known for its speed. When it comes to enacting legislation such high profile proposals inevitably find that members of Congress may have different priorities, thereby slowing down passage.  Proposing an economic stimulus plan in an election year raises serious questions in our minds as to the political leverage candidates and parties will seek to claim. Assuming Congress is determined and acts swiftly, the logistics of implementing such an aid package would require time to be implemented.  Qualifying households and retooling the Internal Revenue Service alone could take months. Meanwhile the economy would probably continue to falter.   

Our Risk Premium analysis indicates that a bear market is here for investors, resulting in contracting P/E multiplies.  Instead of focusing on broad sectors, investors need to take a defensive posture, concentrating on healthy companies able to withstand a bear market with the least amount of damage to their stock prices. The old caveat that a falling tide takes down all ships cannot be ignored. For the week ending January 18^th, the “yellow line” reflects typical bear market financial physics as illustrated in the charts below:

§      The Industrial Risk Premium ended at 6.82% versus 6.54%

§      The Transportation Risk Premium decreased to 7.73%  from 7.75%

§      The Utility Risk Premiums increased to 5.81 % compared to 5.39% n

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