The Seventh Week of 2008

Risk Premiums For The Dow Indices

HAPPY VALENTINE’S DAY?: Bernanke’s U.S. Senate Address

February 15^th, 2008

On February 14^th 2008, the Federal Reserve Chairman Ben Bernanke addressed Congress on the status of “the economy and financial markets.” It appears that Bernanke has finally learned how to speak Washington’s language, that is, appearing to say something of import when not really saying anything. The stock market’s Valentine to Bernanke: a 175-point drop followed by a further 28.77 fall the next day. Despite this the market was up 166 for the week thanks to three up days at the beginning of the week.  A Risk Index indicator, however, still reflects negative market sentiment. The recent market stability, on the heels of several weeks of volatility, has not led us to alter our view that a bear market is firmly in place and vulnerable to any adverse news. 

Bernanke Remains “Concerned”

The over-riding conclusion drawn from the chairman’s comments is that he remains concerned about the weaker outlook for the economy. This is primarily based on the sudden risk aversion of investors who are having great difficulty valuing complex and often-times illiquid financial products. This has made them leery about the credit exposure of major financial institutions and their continuing mega write-downs. Insofar as monetary policy is concerned, he said, the Federal Reserve will continue to focus on relieving the pressures in the interbank markets by continuing its recently more aggressive interest-rate fine-tuning.  Bernanke also said the Fed is working “with other central banks to address market strains…”

The chairman also reiterated his concerns about the health of the housing and labor markets: “Although the baseline outlook envisions an improving picture, it is important to recognize that downside risks to growth remain, including the possibilities that the housing market or the labor market may deteriorate to an extent beyond that currently anticipated, or that credit conditions may tighten substantially further.” He promised that the Fed “…will act in a timely manner as needed to support growth and to provide adequate insurance against downside risks.” These comments have been interpreted to indicate the possibility of further interest-rate reductions in the short-run, particularly when the Fed next meets March 18. We feel the market is anticipating another large rate cut, perhaps 100-basis points at this meeting. Rate reductions may be tempered though by the recent inflation-rate surge.  

Multiple-Notch Credit Rating Changes Is Not A Market Positive

In his senate testimony the Fed chairman voiced concerns about the continued deterioration of the bond insurers and the deleterious effect this is having on financial institutions, forcing them into further markdowns. Addressing this problem, the New York insurance regulator and various investment banks have been attempting to craft plans which would allow the major bond insurers, Ambac and MBIA, to recapitalize and possibly retain their Triple-A ratings. One of the more feasible proposals calls for the insurers to split their municipal bond business from their riskier activities. The latter involved guaranteeing “structured” securities, including some backed by subprime mortgages. 

The concept of separating assets is not new and draws from the savings and loan crisis of the late 1980s and early 1990s. There is a list of high profile investors, namely Warren Buffett and Wilbur Ross ready, willing and able to acquire the “good books.” Whether this approach will alleviate the bond insurers’ problems is questionable, however. since significant pressure is being placed on the rating agencies to take some action prior to an “orchestrated” solution. A disorderly resolution of the bond insurers’ problems will benefit no one since their business model depends on having a Triple-A rating.  Already, one of the smaller bond insurers, Financial Guaranty Insurance Company (FGIC) watched Moody’s lower its rating to A3 from a Triple-A rating, an unnerving six-notch drop. Reducing credit ratings by multiple-notches at a time can only be viewed as market negative.

THE RISK PREMIUM DATA: MOVING IN A BEARISH DIRECTION

Our Risk Premium analysis continues to indicate that a bear market is at hand.  It is one where the “price of risk” is being constantly adjusted, resulting in contracting P/E multiplies. For the week ending February 8th, the “yellow line” reflects typical bear market financial dynamics as illustrated in the charts below:

      The Industrial Risk Premium ended at 6.68% versus 6.77%

      The Transportation Risk Premium increased to 6.95% from 6.92%

      The Utility Risk Premium increased to  6.42% compared to 6.50% n

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