RISK PREMIUM: The “W” Factor

For the week ended May 30, 2008

The “W” Factor

The Dow Jones Industrials rose 158.69 points (1.27%) for the week ending May 30, 2008, continuing a seesaw pattern that has been in place for the past several weeks.  The market is lacking a clear direction.  This week’s rally seems to have been helped by a government report that durable goods’ orders were stronger than expected, the shareholder approval of the Bear Stearns buy out by J. P. Morgan Chase and a dip in oil below $135 per barrel.  In our judgment investors’ reaction to these developments reflects a market trying to move higher. However, after careful scrutiny, they are not important enough to result in a sustained market advance. In short, we seriously doubt this is the widely hoped for “bottom.”  Investors need to recognize that escalating energy prices are straining the entire value chain, a condition which does not bode well for stocks.   Investors should remain nimble, seeking safety in slightly higher yielding securities, perhaps even “maturing” preferred stocks and defensive sectors such as health care and companies having global business exposure.

Risk Premium Remains Bearish

Our Risk Premium Index has returned to a bearish direction. After a cautious examination, fundamentals do not point to an economy that is on the rebound, despite a spate of rosy recent press releases that would have you believing it were so.  For example, the drop in home prices is going to continue to have a prolonged effect on economic recovery.  In addition, the escalating cost of energy will further dampen long-term economic growth.  These factors will significantly affect the profitability of U.S. corporations in the short term (two to three years).

What’s The Fed Up To Next?

The futures market has priced in a 60% probability that the Fed is likely to hike rates this October – an abrupt change in opinion from May 8 when investors envisioned little chance of a rate increase.  However, the Fed may be reluctant to do so just days before the presidential elections.  On the other hand, any signal that the economy is growing along with concerns over inflation and dollar weakness would make higher rates seem all but inevitable.  And sooner or later, skyrocketing oil prices will undoubtedly force the Fed to increase interest rates this year, moving yields above 4% on the 10-year Treasury bond.  Meanwhile, in the near term, prospects for a continuation of recent rate cuts at the Fed’s June 24 / 25 meeting seem bleak, dashing any hope that stocks would get a boost from an interest rate reduction.

The Past Is Not A Prologue To The Future: The “Total Portfolio” Concept

We feel that current assessments of the economy and stock values have not fully taken into account the decline in portfolios from lower real estate values. Historically, the primary measure of wealth has focused on paper assets (primarily stocks, bonds and savings accounts), with the largest illiquid assets, namely, one’s home, excluded from the valuation of “all” assets held by individuals.  There has been little reason to include one’s home as part of a portfolio valuation since, for the most part, real estate over time has been an appreciating asset.

Home prices are falling at an accelerating pace. The Standard & Poor's/Case-Shiller index for the first quarter showed prices for existing homes nationwide declined 14.1% from a year earlier, compared with a year-to-year drop of 8.9% in the fourth quarter. An additional S&P index that tracks 20 major metropolitan areas on a monthly basis showed home prices dropped 14.4% in March from a year earlier and 2.2% from February.  Sales of new homes in April rose 3.3% from March yet overall sales remain well below year-earlier levels.  Since there is a glut of unsold homes on the market and little sentiment to buy it would appear that the housing market will continue to experience price weakness.

Restoration Of Home Equity Has A Long Road Ahead

We feel that the significant correction in home values, the largest segment of an individual’s wealth, may be influencing the valuation investors are now placing on stocks and bonds.  Hence, the valuation of liquid assets today may have a higher correlation to home prices than that experienced since the 1929 Great Depression.   Therefore, we question the reliability of taking P/E levels investors have become accustomed to during the past 10 or 20 years and applying these levels to stocks in the next two to three years.  We feel that this concept of total wealth correlation may affect the discounting rates applied to paper assets. This would go a long way toward explaining the “hovering” behavior of the stock market and its inability to mount an upside break-out.

Energy’s Adverse Impact On Manufacturing & Consumer Spending Sectors

Revenues and profits across the corporate spectrum will be hurt by the recent run up in oil prices. Mobility has long been the cornerstone of the U.S. economy and persistently high oil prices could alter consumer spending patterns and behavior.  Unfortunately, the long-term outlook indicates that oil prices will remain high and are likely to go even higher. The demand for oil from emerging economies such as China and India is bound to keep pressure on the demand side of the equation. In addition, OPEC may have less control over the supply of oil than in the past.  Than there is the “quality” of oil, a subject which has received scant attention but, we suspect, will become much more important in the years ahead and have an important bearing on available supplies and, therefore, price.  Constraints on refining, which the U.S. has casually ignored, will also emerge as a key pricing consideration.

Long-Term Factors Cannot Be Overlooked

The past may not prove to be the most dependable guide to the future. The current economic slump may be reflecting factors that heretofore had less of a lasting impact on stock values. Taking this into account, we feel that investors will face a bumpy path to higher stock prices.

RISK PREMIUM STATISTICS

§         The Industrial Risk Premium ended at 1.17% versus 1.18%

§         The Transportation Risk Premium decreased to 4.20% from 4.46%

§         The Utility Risk Premium decreased to 6.29% from 6.38% n

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