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May 26, 2005

Housing Bubbles
by Chad Hudson

UNEDITED

Corporate earnings during the first quarter were substantially better than investors anticipated. About 96% of the S&P 500 companies have reported first quarter earnings, which are up 13.6% from last year. At the beginning of the quarter, October 1, 2004, analysts only expected earnings to advance only 7.9%. While companies reported good results for the first quarter, an overwhelming majority said that second quarter earnings would be lower than analysts' current estimates. Of the 138 companies that have undated guidance to analysts, 62% have reduced earnings forecasts, while 22% have said results would be better. This is the highest ratio of negative pre-announcements to positive pre-announcements since the first quarter 2003.

After exhibiting weakness in March, consumer spending has remained solid. Most retailers have reported higher earnings than last year. Of the thirty stocks in the S&P 500 Retail Index, eight companies have reported earnings that were below last year's results. It's a diverse group that does not lead to any conclusions on what areas of consumer spending are lagging. The underperformers were: Dillard's, Gap, Limited Brands, May Department Stores, Office Depot, OfficeMax, RadioShack, TJX Companies. The one common thread that several of these companies have in common is that they have consistently underperformed their competitors over the past couple of years.

Gap Stores reported that first quarter sales fell for the first time in three years. Same store sales dropped 4%. Gap earned $0.31 per shares, which were a penny more than Wall Street expected. "We aren't yet satisfied with woman's products. We aren't expecting significant women's product improvement in the short term." Gross margins shrank by over 200 basis points as the company had to markdown merchandise to help clear inventory. The company missed on the denim fashion trend, but will focus on it for the back-to-school season. Gap may be zigging when is should be zagging. Prudential believes "that a denim glut is brewing for back to school." According to a recent published last week, Abercrombie & Fitch tried to cancel denim orders and the company admitted that it has "looked to have some deliveries pushed off to future periods." Additionally, Abercrombie said that much of their increase in inventory was in denim, which Prudential estimates that their inventory of denim product is more than twice its historical norm.

AnnTaylor was another retailer that reported lower sales and profits. Similar to Gap, the company had to discount its clothing due to higher inventory levels. Its gross margin dropped 700 basis points. Same store sales dropped 3.1%. On a positive note, AnnTaylor said that it saw steady improvement as the quarter progressed.

Durable goods orders increased 1.9% in April from the previous month, slightly higher than the 1.3% expected. Additionally, March's 2.3% drop was revised up to a 1.6% decline. Excluding the volatile transportation sector, orders actually declined 0.2%, which was well below the forecast of a 1.0% gain. On a year-over-year basis, total new orders increase 3.8% following a 1.1% decline last month. Excluding transportation, orders advanced 7.1%. For the third month in a row, inventories increased faster than orders or shipments on a year-over-year basis.

Last week, the Philadelphia Fed survey added to the string of weaker than expected surveys. The survey's diffusion index fell 18 points to 7.3, which was the weakest it has been since June 2003. All but one component (unfilled orders) dropped. Several of the components dropped substantially. Shipments fell 14.5 points to 14.9, price paid dropped 19.6 points to 30.9, and prices received fell 12.3 to 15.7, average employee workweek dropped 23.2 to -2.8. This was the first time it was negative since June 2003. While expectations for the next six months were more optimistic, it dropped 5.2 points to 22.3. This was the least optimistic respondents have been regarding the future since March 2001.

Existing home sales went through the roof, reaching a record 7.18 million unit rate. Economists expected sales to be relatively flat at 6.9 million. Prices also hit a record as well. The median price jumped to 206,000 in April, 15.1% higher than last year. The median condo prices soared 18.4% to 223,600. The 15% increase in the median home price was the steepest increase since November 1980. New home sales were about even with the previous month, but the previous month was revised down substantially.

A recent Fortune cover story discussed the frenzy of housing speculation. The story detailed several "investors" as they raced around the hot markets to purchase homes or even just contracts to purchase homes under construction. Other anecdotal facts that point to increased speculation include "the number of chapters of the National Real Estate Investors Association has jumped from 44 in 2002 to 170 currently." The number of homebuyers in Phoenix that labeled themselves as investors doubled since last year to 2,703 and they purchased 18% of all the home sold in Phoenix last year. Eight-six books on real estate investing were published last year, three times as many as in 1998. According to the article, only 1.6% of mortgages were interest-only in 2001. Three years later in 2004, a whopping 31% were. One investor said he was not worried that he was losing $3,500 per month on his investment houses since he is not renting them all out because he is "in it for the appreciation."

During the latest FOMC meeting, the Fed said that higher energy prices were a factor in damping consumer spending. It also raised the point that it could be simple a focus on "high frequency economic data." This is the exact same point we have been discussing for the past several months. There is so much data that is released, that it is easy to acknowledge what fits a preconceived opinion of the market and simply dismiss anything that is contradictory. There can be no question that the economy has expanded over the past few years. Economists are also focusing too much on the second derivative, or the change in the growth rate. Several economists and investors have sounded alarms because the economy has slowed from over 4% growth to 3% growth. This "slowdown" is often cited as the reason that the Fed should stop raising interest rates sooner rather than later.

With the economy expanding faster than 3% along with inflation running around 3%, short-term interest rates are too low for the current rate of economic growth. The Fed also has to raise rates to restrain the housing boom. Unfortunately, the economic expansion has been due to rapid credit creation which as resulted in an overleveraged economy. Once rates rise enough to quell credit growth, it will be difficult for the economy to maintain its current trajectory. The ensuing recession will likely be much more severe than the past recession.

Chad Hudson
Mid-Week Analysis
PrudentBear.com

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