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July 06, 2006

Data Dependency
by Chad Hudson

Last week, the Federal Reserve increased the fed funds target rate by 25 basis points to 5.25%. While this was widely expecte, the fed was more dovish than economists expected. The committee removed the phrase, "further policy firming may yet be needed" and said that "The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth." Over the past month the data has been very mixed and Fed's statement will likely cause investors to over-analyze and be hyper-sensitive to data that might provide a catalyst for the Fed to act, or not act.

On Wednesday, traders were spooked by the ADP National Employment Report. According to the nations largest employment payroll processor, payrolls increased by 368,000 in June. This is the largest increase since the survey was started in 2001. The report caused several economists to increase their estimate for the employment report from the Labor Department, which will be released on Friday. This is in stark contrast to the employment component of the ISM index, which fell to the lowest level since October 2003. It should be remembered that the manufacturing sector accounts for only about 13% of the number of business-sector employment. Thursday's service sector survey from the ISM will be more telling than the manufacturing survey. Each month since January, the service sector survey has indicated a stronger job market then the manufacturing survey. The most recent Beige Book also mentioned that labor markets continued to tighten.

Earlier this week, Wal-Mart announced that its same store sales likely rose 1.2% in June. This was on the low end of the forecasted range of 1% to 3%. Last month, Wal-Mart commented that gas prices were crimping the spending of its customers. Gasoline prices have continued to rise and with oil breeching $75 on Wednesday, it's not likely that prices will decline in the near future. Chain store sales are expected to have increased 2.5% to 3.0% in June according to the ICSC. It is likely that the storms in the Northeast adversely affected retail sales.

Last June, GM introduced the employee pricing promotion that led to a surge in sales. This year, GM's sales fell 26% in June compared to last year. The other domestic automakers also experienced declines from last year, Ford's sales were down 6.9% and Chrysler's sales fell 15%. Falling sales caused the market share held by the Big Three to fall to 56.1% from 61.7% last year. It was higher than the 52.9% share held last month. Toyota continued to be the leading auto company. Its sales increased 14.4% and it outsold Chrysler in June and is only lagging the third largest domestic automaker by 2% for the first half of 2006. Honda also increased sales, up 3.4%. Nissan's results were more similar to the domestics, down 19%. The Big Three are starting to boost incentives to clear out inventory prior to the launch on new models. Chrysler is returning to employee discounts on its vehicles in July, and GM rolled out zero-percent financing for 72 months, but only until July 5.

Construction spending dropped 0.4% in May, but is 6.0% higher than a year ago. Residential construction dropped 0.8% over the past month and is higher than a year ago by only 2.5%. The year-over-year gain of 2.5% was the smallest increase in residential spending and the lowest since December 2002. Nonresidential construction was only up 0.2% in May, but was 12.2% higher than last year.

New home sales unexpectedly increased in May, back to levels reminiscent of last year. Purchases of new homes jumped 4.5% to an annualized pace of 1.234 million units in May. April's sales were revised slightly down to 1.18 million from 1.198 million. Homes available for sale fell slightly to 556,000 from 560,000. The median price increased 3.1%, the slowest rate of appreciation since December 2003.

Existing home sales also were stronger in May than economists forecasted. While the pace of sales dropped to 6.67 million on an annualized basis, economists were forecasting a drop to 6.6 million. Sales were weakest in the Northeast and Midwest, dropping 4.2% and 3.8% respectively. The number of homes on the market continues to increase, which will continue to put pressure on home prices. The number of existing homes on the market jumped 5.5% last month to 3.6 million. This was 41% higher than May 2005. The median home price of existing homes increased 6.0%, higher than the 3.7% increase last month but far lower than the double-digit gains last year

Lennar reported second-quarter earnings recently. Orders held up compared to several of the other homebuilders, down only 5%. Gross orders were up significantly since the company disclosed that the cancellation rate was 27% compared to the "teens" last year. Orders were positively impacted by an increased use of incentives. Incentives surged to 7.1% of the sales price from 4.0% last quarter and 2.8% last year. This obviously negatively impacts gross margins. Gross margins fell 120 basis points during the second quarter and the company said that gross margins will be 250-300 basis points lower for the full year. It was also noteworthy that inventory declined sequentially for the first time in at least 10 years.

KB Homes has also reported earnings recently and has taken a different approach than Lennar. KB Home has not boosted the level of incentives as dramatically as Lennar. Sales have suffered from this; gross orders were down 5% with net orders declining 19%. Average price of new homes was up 13% to $295,000. Design options increased from 11.1% of the base price to 11.9%. Cancellation rate rose to 37% from 32% last quarter and 25% last year. Community count was essentially flat, 415 to 419. KB lowered delivery guidance for the year by 5% to 40,000 units, this also resulted in revenue guidance being cut by 5% to $11.4 billion.

Earnings pre-announcements are running below last year and the previous quarter. The low level of pre-announcements has led to estimates for second quarter earnings growth to increase. Earnings are expected to grow 12.3% for the S&P 500, slightly higher than the 11.9% expected at the beginning of the quarter. The energy sector is expected to lead earnings growth, which is expected to increase 26%. Earnings growth is still expected to accelerate in the third quarter to 15.4%. Materials and financial companies are expected to post the highest earnings growth in the third quarter.

Usually investors look forward to the lazy days of summer. This summer will likely provide much more volatility as investors attempt to handicap the economy and the actions of the Federal Reserve. Corporate earnings are also expected to accelerate, but with rates continuing to rise along with commodity prices, its likely that earnings could disappoint later this year.

Chad Hudson
Mid-Week Analysis
PrudentBear.com

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