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March 08, 2007

Economic Growth Appears Vulnerable
by Chad Hudson

Almost all the S&P 500 companies have reported fourth quarter earnings and the tally now shows earnings increased 11.7%. While this was higher than estimates that prevailed at the end of the quarter (10.0%), earnings failed to achieve the 12.8% growth expected at the beginning of the fourth quarter. This was the first time since the fourth quarter of 2005, which was likely a function of the hurricanes that hit the Gulf Coast, and was only the second quarter since the first quarter of 2003 that this has happened. Excluding the fourth quarter of 2005, the last time earnings growth went from beating estimates to missing estimates was the third quarter of 2000 and happened in eight of the next nine quarters. Incidentally, this almost perfectly coincided with the peak and the bottom of the S&P 500. It's likely that first quarter earnings growth will also be lower than estimates at the beginning of the quarter. S&P 500 earnings are now expected to grow 3.9% compared to 8.7% at the beginning of the year. Earnings growth estimates for the rest of the year have also be reduced. Analysts have reduced S&P 500 earnings growth to 6.4% for 2007. This estimate is likely to come down since the quarterly estimates for the first three quarters of the year are 3.9%, 4.4% and 6.0%, for an average of 4.6% for the first three quarters. First Call has not published consensus estimates for the fourth quarter of 2007 yet, but it appears earnings growth would have to accelerate substantially in order for earnings to increase 6.4% for the full year.

Last week, Nordstrom's reported fourth quarter earnings of $0.89 per share and twenty cents better than last year. Results were helped by same store sales jumping 8.3% and 100 basis point increase in EBIT margin. Investors were expecting more margin improvement and earnings fell shy of analysts' estimates by a penny. Additionally, the company guided analysts to expect earnings of $2.78 to $2.84 per share for this year, which was about a dime lower than consensus estimates of $2.91.

Retailers will report February same store sales on Thursday. There is a chance that results will not meet investors' expectations. According to the ICSC, chain stores sales decelerated every week last month. Last week, sales were only 1.5% better than last year. This was the smallest weekly gain since July 8, 2003. Michael Niemira, chief economist for the ICSC, attributed the slowdown to weather. He also slightly reduced his forecasts for February from 3.0% to between 2.5% to 3.0%. This would be lower than the 3.5% gain last month. According to Thompson Financial, Wall Street analysts expect same store sales growth to weaken from January. Wall Street is forecasting same store sales will advance 3.0% and 4.1% excluding Wal-Mart. This compares to 4.9% and 5.0% gains in January.

Last week, the Conference Board reported that consumer confidence reached the highest level since August 2001. The current situation jumped 5.1 points to 139.0. Expectations only increased 0.4 points to 94.8. Complacent might prove a better term rather than confident. There were declines in both jobs plentiful and jobs hard to get. Jobs viewed hard to get dropped to lowest level since August 2001. Interestingly, while jobs were viewed a little more positively, income expectations were muted. Only 17.7% expected income to increase, the lowest May 2006. Plans to purchase an automobile dropped to 5.4%, almost a full percentage point less than last month. But more interesting was the drop in plans to buy a new car. Only 2.2% of consumers anticipate buying a new car, down from 3.0% last month and the lowest response since November 2004. This cannot be good news for Detroit - losing market share in a declining market. Another indication that the consumer is tapped out was that plans to take a vacation dropped 6.1 percentage points to 39.9%. This is the lowest level since the survey was started in 1980. A subset of this is whether travel will be done by air or car. Considering that travel by air only dropped 20 basis points, and by car fell four percentage points could be more evidence that middle income households are coming under pressure. Retail sales continued to decelerate last week. The ICSC reported that chain store sales increased 2.2%.

Housing data was mixed last week. Existing home sales were much better than expected, but new home sales slumped. Existing home sales increased 3% in January. This was the largest jump since January 2005. The median price fell 5.0% from December, which was the largest drop since the data series started in 1999. The year-over-year drop in price was 3.1%. New home sales dropped 16.6% to 937,000 in January and are off 21.3% compared to last January. The West clearly suffered the brunt of the decline, dropping 37.4% in just the past month and has been chopped by 53.8% compared to last January. Total supply dropped by 1,000 to 540,000 homes, but with the drop in sales, the months supply jumped from 5.7 months to 6.8 months. Lastly, pending home sales dropped 4.1%, which was the largest monthly drop since last July.

Hovnanian reported first quarter preliminary results this week. Unit orders dropped 23% as the cancellation rate increased 100 basis points from the previous quarter to 36%. The company noted that excluding its Fort Meyers, FL operations, orders would have only declined 2%. It appears the upper end of the housing market is doing better than the overall market. At a conference hosted by Citigroup, Toll Brothers said that its cancellation rate dropped to 16% over the past five weeks, down from 29.8% at the end of its January quarter. Just a few short hours later, D.R. Horton's CEO, Donald Tomnitz, uttered what turned out to be the quote of the day, "I don't want to be too sophisticated here, but '07 is going to suck. All twelve months of the calendar year."

Over the past two weeks, there have been several indications that the manufacturing sector has weakened. Durable goods orders dropped 7.8% in January. This was the third drop of over 7% over the past year. Excluding transportation, orders dropped 3.1%, matching the weakest month since June 2002. This data series is volatile and part of the weakness was giving back strong gains last month. In December, durable goods orders increased 2.8% and 2.6% excluding transportation. The year-over-year change does smooth the data. Compared to last January, orders were up 2.1%, similar to the three previous months.

Richmond Fed survey indicated that conditions have not improved in February. The overall index increased one point, but still signified a slowing at -10. Only vendor lead times and wages were positive, which indicates expansion. Average workweek and number of employees registered the two biggest drops, down 10 to -20 and down eight to -13 respectively. Not only is activity slowing, but the survey showed that manufacturers are getting squeezed by prices. The average price paid increased 3.52% whereas the change in prices received increased only 1.58%. This discrepancy of almost 200 basis points is the largest since December 2005. The Chicago PMI survey showed similar deterioration. Chicago PMI dropped for the fourth time in five months to a new four-year low. This was the second month of the index being below 50. It is also interesting to note that companies are pushing out capital equipment outlays. The lead time for capital equipment has lengthened from 111.7 days in September to 129.3 days. Similar to the Richmond survey, the Chicago PMI reported that prices paid rose in February. The index tracking prices paid increased 8.3 points to 63.3, the highest since August.

The productivity report from the Department of Labor surprised economists as productivity increased 1.6% during the fourth quarter, almost half the gain that was first reported. More importantly, compensation per hour jumped 8.2%. These two factors combined resulted in unit labor costs jumping 6.6%, the second highest quarterly increase in the past five years. It is also interesting to note that compensation per hour was highest in the business sector and lowest in nondurable manufacturing. This report highlights the problem the Fed faces trying to navigate economic policy. The segments of the economy that are languishing won't necessarily be boosted by looser economic policy. More likely, more credit would flow to areas that are already experiencing a boom and the areas of the economy that are lagging would continue to lag.

There have been several data points indicating that economic activity has moderated, but it has been mostly confined to the manufacturing sector. Plus there is some evidence that this has only been an inventory correction as end demand has remained a stronger area of the economy. Recently, end demand looks to have started to wane. Almost every time this has happened, interest rates have retreated and personal consumption was jump started. The recent turmoil in the subprime mortgage sector could disrupt this cycle, especially if it starts to spread. There were numerous stories discussing the mortgage reset problem facing homeowners. Up until last week, most of these borrowers would have been able to refinance, which would have mitigated a lot of the fears. This is a lot less certain now and could be the tipping point for the seemingly endless consumer spending spree.

Chad Hudson
Mid-Week Analysis
PrudentBear.com

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