A Melman Minute — January 23, 2008

One can only wonder at what Ben Bernanke might be thinking this morning, the day after he threw the proverbial “kitchen sink” at the array of growing economic problems. However, instead of rejoicing with a robust follow-up rally, markets around the world seem to be pausing to take sober second thoughts at the implications of the Fed’s move to lower the Fed Funds rate by three-quarters of a percent.

Among those second thoughts one might find such concerns as the futility of lowering interest rates when few are willing to borrow - or lend - money at any cost and, second, taking such dramatic action is a tacit admission that all the automatic assurances of ongoing and future economic strength which we have heard from the Fed and other government agencies throughout the past many months have turned out to be nothing but hot air. It would also be appropriate to throw in the reality that such dramatic actions point to both further weakening of the U.S. Dollar down the road along with rising inflationary expectations.

There is, in fact, one bright red “warning flag” worth analyzing which points in the direction of demonstrating that there may indeed be deep structural problems embedded within America’s economic structure. We are referring to action in the lesser-watched “Dow Jones Utilities Average.” (DJUA) One look at the chart demonstrates that something dramatic appears to be taking place, as if has recently fallen off the proverbial cliff. After rising smoothly and steadily from 460 in August, 2007 to over 555 by early January, 2008 the Utilities have plunged by over 75 points in just a few trading days, a short term move of virtually unmatched magnitude for the DJUA which normally moves in relatively small increments.

What makes this particular move all the more remarkable is the fact that the Utilities historically react counter to the general movement of interest rates on government debt obligations. The reason this has been true is that utility companies normally pay out a significant portion of their earnings as dividends and are, therefore, an alternative form of interest income for conservative investment portfolios.

If government interest rates are rising, this makes the dividends paid by utilities comparatively less attractive, and the DJU would normally fall. Conversely, if those government debt interest rates were declining, the amount paid by utilities would become more attractive and the average should rise.

For example, if a utility company’s shares were selling at $20 and it was paying $1.00 in dividends, the yield would be 5%. If government interest rates were 5% and steady, one would expect little movement in the stock other than in reaction to their own internal news. However, if government interest rates rose to 6%, then the $1.00 dividend payout of the utility company would be less attractive in comparison, and the price of the shares would likely fall. Conversely, if the government rate fell to four percent, the 5% yield on the utility would become more attractive in comparison and the share price of the utility would be expected to rise.

What makes the present situation so unique is that government interest rates are falling sharply - as illustrated by Bernanke’s recent actions - but the utility average is plunging at one and the same time.

Our interpretation of this anomaly is that the Utility Average is saying all is not well with the economy, that despite the Fed’s action, there is growing weakness, and future power demands - which are the source of the utilities’ revenues - are expected to fall in coming months, thereby reducing earnings and posing a threat to future dividend payments.

This evaluation would seem to be confirmed by action in the base metals this AM which drove the price of those metals lower and two of them fell through recent landmark levels as nickel dropped under the $12.00 per pound mark and zinc descended to just under one Dollar. (All prices US Dollars)

There was one additional important factor the markets had to contend with this AM as Apple Corp. reported results for the last quarter, and, while current earnings grew at about the anticipated rate, the corporation indicated concerns for future results and, based on that information, the price of the shares plunged dramatically, losing sixteen percent of their value in just a few hours. The widely watched NASDAQ Average also continued along its downward trend of late, plunging by over seventy points so far this AM.

One bright spot was action in gold and the other precious metals. After falling overnight in Asia and Europe, gold opened near $876, but within just two hours had risen to the $895 level, just $20 away from the earlier all-time peak. Silver rebounded to about $16.10 and platinum regained some of its recent losses, trading at $1,560, also near its recently-set record high.

Securities markets have been exceedingly volatile, but after two hours, both the TSX and the Dow Industrials are down, the former by over 300 points and the latter by about 200.

DISCLAIMER

The information presented above is based on data which we believe to be from reliable sources, but the accuracy of which cannot be guaranteed. Any opinions or predictions contained herein are those of the editor and are likewise offered also for information purposes only.

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