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April 27, 2006

Earnings Accelerate
by Chad Hudson

While earnings have grabbed investors' attention this week, several economic reports were released indicating that economic growth remains strong.

Consumer confidence rose 2.4 points to 109.6 in April, higher than the 106.2 economists expected and the highest since 2002. Most of the strength came from the current situation sentiment. It was up 2.9 points to 136.2, the highest since August 2001, and was driven by an improving employment outlook. The Conference Board recently started tracing the "Labor Index," which is the jobs plentiful index minus jobs hard to get. This jumped 1.6 points to 9.5%. Constructing this index historically, this was the highest level since August 2001. Given the recent volatility in the housing data, it was interesting to note that the percentage of consumers planning on buying a house dropped to 2.7% from 4.1% last month. This was the lowest since November 2004 and the second lowest since December 1996. Also notable was that consumers' inflation expectations have risen to 5.2%, the highest this year.

This week, the National Association of Realtors reported that exiting home sales slightly rose in March compared to February, but were 0.7% lower than last year. The supply of homes for sale continued to escalate. The number of home for sales increased by 209,000 homes, 7% higher than last month and almost 39% higher than last March. This pushed the months supply to 5.5 months. Median prices rose by 5.0% compared to last year. This was the smallest gain September 2001. Sales in the West dropped 12% compared to last year. All other areas of the country saw an increase in the number existing homes sold, with the Midwest surprisingly the strongest, up 3.8%. New home sales rebounded from the plunge last month and were slightly higher than in January and remained lower than last years pace. The number of new homes available for sale also increased, up 15,000 units or about 2.8%. Only the West region didn't totally recover from the drop in February and remained lower than January sales. Mean and median prices both fell and was the first year-over-year decline in the average price since November 2001. Another indication that housing is weakening was the purchase application data from the Mortgage Bankers Association. Last week, the purchase application index fell to the lowest level since November 2003.

Durable Goods soared 6.1% in March from February and up a staggering 19.7% from last March. Transportation orders contributed significantly to demand, up 14.0% in March and 40.8% from last year. Excluding transportation, orders were up 2.8% from last month and 11.5% from a year ago. The year-over-year increase in durable goods orders was the strongest since June 2000.

There should be little surprise that the latest release for the Federal Reserve's Beige Book said that all twelve districts reported that economic activity expanded in March and early April. Most of the districts reported that consumer spending remained strong, but Richmond and Cleveland "experienced sluggish or disappointing results." The manufacturing sector has remained robust throughout the county, with Atlanta and New York being the least upbeat, all districts reported that manufacturing forecasts are optimistic. The Chicago district reported that production of mining equipment is booked through 2007. Trends in employment and capital spending are also notably positive. Residential real estate cooled or moderated according to most districts. Additionally, price appreciation has slowed. Similar to previous months, commercial real estate remained much more robust with construction following suit. The banking sector also has experienced a shift from consumer and residential real estate demand to commercial and industrial lending. Labor markets were generally described as tight or tightening. Wages are also continued to move up, with New York, Dallas, and Kansas City reporting an acceleration.

When the first quarter started, Wall Street was expecting first quarter earnings to increase 12.6%. As the quarter progressed, analysts trimmed their forecasts and by the end of the quarter, earnings growth was expected to be only 11.2%. Companies are handily beating analysts' earnings forecasts. Over 70% of the 280 S&P 500 that have reported first quarter earnings have exceeded analysts' estimates. Only 11% earned less than Wall Street anticipated. Of those that have reported earnings, first quarter earnings are 19.8% higher than last year (market-cap weighted). This compares with growth of 14.4% in the fourth quarter. This would be the fastest pace of earnings growth since the second quarter of 2004 if this pace is maintained. Not only have earnings been better than analysts' estimates, guidance for second quarter earnings has been upbeat. Of the 64 S&P 500 companies that have updated second quarter guidance, only 45% have been negative. This compares to 52% last year and 50% last quarter.

The railroad companies have benefited from the booming economy and higher energy prices. Burlington Northern reported a 16% increase in revenue. The company said that shipments, rate increases, and fuel surcharges equally accounted for the increase. The company has increased employment by 6% over the past year and it expects to increase employment another 6% during the second quarter. It also plans to spend $2.5 billion on capital improvements this year, mostly by purchasing 52 locomotives. Burlington also that as contracts roll-off this year, it will be adding fuel surcharges to the new contracts. The railroads are also working more with the trucking firms to move trailers part of the way and have the truck pick it up and finish the delivery. The trucking industry has been wrestling with a driver shortage for a long time now and higher fuel costs are not helping either. The trucking companies have embraced the intermodal model to ease their capacity problem. At Norfolk Southern, sales rose 17% driven by a 5% increase in shipments and a 12% increase in it average rate. Coal has been a big driver of the railroad companies' results. Coal revenue rose 20%, due mostly to a 15% rate increase. Intermodal revenue increased 14%, with a 6% rate increase. Norfolk currently has some hedges in place to protect against the rise in diesel, but will let the hedge lapse in a few months. Instead the company will use fuel surcharges as "the perfect hedge."

Stronger global economic growth is pressuring commodities across the board. We have discussed how higher commodity prices would not get passed to end users quickly. Due to long-term supply contracts and hedging practices, manufacturers are protected initially from higher prices. As supply contracts and hedges lapse, manufactures become subject to higher prices and start passing along the higher input costs. The Richmond Fed survey was released on Wednesday. One of the questions on the survey asks about prices received. In April, manufacturers said that the prices they received rose at an annual pace of 2.37%. This was the largest increased since the survey was started in November 1993 and an indication that producers are starting to increases prices.

With the Federal Reserve focusing on the economic data, it is not surprising that the round of strong economic data pushed the probability of the Fed continuing through 5.0% higher. Last week, traders thought there was only about a 50% chance of rates moving past 5.0%. Now the October and November fed funds futures contacts are yielding 5.27%, so traders have started pricing in the chance of 5.5% rates this fall.

Chad Hudson
Mid-Week Analysis
PrudentBear.com

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