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June 30, 2005

Will the Fed Remain "Measured"
by Chad Hudson

UNEDITED

First quarter GDP was revised higher by 10 basis points to 3.8% matching the pace from the fourth quarter 2004. Additionally, inflation was more tame than previously forecasted. The GDP deflator was revised down to 2.9% from 3.1%. Most of the upward revision was due to a larger increase in gross private investment, which was fueled by much higher residential construction growth. Previously, the Commerce Department reported that residential construction grew 8.8%. This was revised to 11.5%. Exports were also revised higher along with imports.

Last week, the University of Michigan reported that its Consumer Sentiment Index jumped almost eight points to 94.8. This was the first increase in five months. The present conditions component rose 5.5 points to 110.4, half-a-point from the highest level since the end of 2000. Expectations rose 9.5 points to 84.8, which is the highest since January. The survey conducted by the Conference Board was also stronger in June, adding 2.7 points to 105.8. This was the highest level since June 2002. The current situation increased 2.9 points to 120.7, the highest since September 2001.

Last week, retail sales increased 4.2% from last year according to the International Council of Shopping Centers (ICSC). This was the strongest growth since the first week of April. A few retailers have reported results for the quarter ending May 31. Results have been mixed. Bed Bath & Beyond reported that its earnings rose 21% on a 13% increase in sales with same store sales advancing 4.4%.

Family Dollar reported that its second quarter results were challenging. Same store sales were up only 1.3% and noted that sales were weaker in the cooler geographic regions. Same store sales during May were very weather related. In its colder regions, sales fell double-digits, but sales in Florida increased by double-digits. The company also noted that it is seeing much more of a "pay cycle performance where sales are strong early in the month but taper off towards the end of the month." The company noted that the increase in payrolls has not benefited lower income workers and that the unemployment rate for its customers is almost 8%. This compares to 5.1% for the general population.

The manufacturing sector continued to report mixed signals. This week, the Richmond Fed Manufacturing Survey reported that showed that manufacturing slowed in its district during June. Last week, the Empire State Survey showed activity rebounded in June, while the Philadelphia Fed Survey came in much worse than expected earlier in the month. The Philadelphia Fed Survey dropped 9.5 points to -2.2. This was the first time the survey indicated that manufacturing activity contracted since May 2003.

The domestic automotive manufacturers and their suppliers have been the laggards in the manufacturing sector. This week, Lear joined a long list of auto part suppliers that have announced layoffs and plant closings. The leading manufacturer of automotive interiors announced it will layoff 7,000 workers and close or consolidate up to 20 plants.

International Paper announced that its earnings for the second quarter will not meet analysts' projections. The nation's largest paper maker said the shortfall was due to "weaker-than-expected paper and industrial packaging volumes." Earnings were also pressured by "higher input costs for energy, chemicals and wood."

Hanson, one of the world's largest suppliers of building materials, reported that it expects first-half earnings to increase 20%. It also said that raw materials continued to impact results, but is starting to see some moderation. Higher steel prices cost the company an additional $3.5 million, but said that steel prices were starting to decline. It did say it is seeing renewed strength in plastics pricing. Additionally, Hanson was able to increase its prices enough to realize an additional $3 million in revenue, but was not enough to offset all of the increase it incurred.

This month, several steel producers announced that earnings would be lower due to the drop in steel prices. Nucor said it expects earnings to be on the low end of the $1.95 - $2.15 range it guided to in April. This would still equate to earnings about 25% higher than last year. It still expects end-market demand to pick up during the second half of the year. Commercial Metal also said that earnings would be lower than previously expected. It also said its end markets in North America remain healthy, but Western Europe, especially Germany and Italy, were the company's weakest markets.

Paychex reported earnings for the quarter ending May 31 that were three cents better than analysts estimates. During the conference call the company said that the labor markets have improved this year. During 2004, its clients increased the number of employees by 0.5%. This was the first gain in "several years." During the first quarter the number of workers increased 1.5% from last year. The company also mentioned that it is seeing employee churn increase and that is "an indication that the economy is loosening up a bit." This confirms the data from the household survey that the number of job leavers has increased.

General Mills announced earnings for the quarter ending May 31 that were a penny below consensus estimates. The company also lowered it guidance for the fiscal year 2006 due to the challenging cereal business. Higher commodity prices have been pressuring the food companies. To combat higher commodity costs, General Mills increased prices on its cereals. Unfortunately, competitors didn't. Because of these "uncompetitive merchandising levels" the company suffered a 5% drop in volume during the latest quarter. The company said that over the past three weeks it has seen that its competitors have started to increase their prices. It also expects to increase prices on it soup line, Progresso, this year.

Higher costs will play an important role for second quarter earnings. Several companies guided investors to expect slower earnings growth for the second quarter when they announced first quarter results. These pre-announcements along with those over the past three months have led to the highest negative/positive ratio for the S&P 500 since the first of 2003. More pre-announcements are likely over the next two weeks when earnings season will kick off.

Currently, analysts anticipate earnings for the S&P 500 to increase 6.9%. This is below the estimate of 8.8% at the start of the quarter. This will also be half the pace of earnings growth during the first quarter. Most of the decline in growth estimates since the beginning of the quarter have been due to a decline is growth estimates in the consumer discretionary sector. Earnings growth estimate have dropped from positive 2% to negative 4%. This almost entirely due to the automakers and auto parts manufacturers. Excluding the auto sector, the rest of the consumer discretionary companies are expected to increase earnings by 13%.

While financials have lowered estimate, the majority of the decline from 7% growth on April 1 to 0% currently, is due to the Freddie Mac reporting results for the past year at the beginning of the quarter. Freddie's second quarter earning in 2004 were above estimates by about $1.6 billion. The higher base reduced growth from 7% to 3%. Since then, Morgan Stanley, JPMorgan, and Goldman have had their estimates reduced by 11% to 28%. If the financial sector is excluded, S&P 500 would growth earnings by 9.5%.

While financials and the autos have lowered earnings growth estimates, the energy sector has had its earnings growth increase from 13% to 27%. Without the increase in earnings from the energy sector, S&P 500 earnings would only increase 4.5%.

The markets are focused on the FOMC meeting on Thursday. Everyone will focus on whether the Fed can remain measured. Even if the Fed drops its measured language, companies have been able to pass along price increases at a measured pace.

Chad Hudson
Mid-Week Analysis
PrudentBear.com

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