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January 17, 2008

Is the Great American Spending Boom Over?
by Chad Hudson

Over the past month, more and more economists have moved over into the recession camp. The latest Wall Street Journal survey of economist found there is a 42% probability of a recession. This was up from 38% last month and 23% six-months ago. While the odds of a recession have increased, only three out of fifty-four economists surveyed actually forecast a recession as their base case scenario. Even if a recession is not forecasted by most economists, the outlook is not rosy. The average expected growth rate for the first half of the year was only 2.0%. Last month, it was 2.5%. Additionally, economists expect the unemployment rate to increase from 5.0% in January to 5.2% at the end of the year. Inflation expectations have also increased. Last month, economists expected year-over-year consumer prices to be up 2.5% in June 2008. Economists now forecast a 2.7% increase. Inflation will continue to be the thorn in the side of the Fed.

Greenspan threw his hat into the recession camp. In an interview with the Wall Street Journal, the former Federal Reserve chairman said that the odds were still close to 50% that the US will slip into a recession, but it's "more likely higher than lower." Of course, he is now working for a hedge fund that made over 500% betting against subprime last year.

The hope among economists rests on the Fed being able to save the day. There has been very little evidence that the Fed has been able to instill confidence in the market or stabilize the economy. Additionally, there is the idea that the housing market will start providing some support simply because it has declined so much it cannot keep going lower and the quarter-to-quarter change has to stabilize. Even Greenspan said that new home sales have likely bottomed because the number of subprime and Alt-A mortgages has fallen to zero. While it's true that the subprime and Alt-A mortgage market has seized up, there is no evidence that prime borrowers are stepping up to the plate.

Well it is now official, holiday sales were weak. The International Council of Shopping Centers reported that the two-month gain was 2.2%, the lowest increase since 2002. December sales were only 0.9%. The retail trade group does not expect this month's sales to be much better, only 1.5% - 2.0% increase is expected.

The government's tally was even worse. The Commerce Department reported that December retail sales dropped 0.4%. Additionally, November's results were revised lower, from 1.4% to 1.0%. The year-over-year gain increased only 3.2%. Inflation is having an impact on retail sales. Two of the strongest categories were gasoline stations and food and beverage stores. This was helped by an 18.1% increase in gasoline sales and a 5.2% gain in food & beverage. The more discretionary retailers showed much weaker results. Furniture sales were down 0.2%, clothing -0.3%, sporting goods 0.8%, restaurants 0.8%. This was the weakest year-over-year increase in restaurants since January 2003, this helps show the strain on consumers. It appears that consumers curtailed spending at restaurants to buy presents, and gift buying was not that great. While there might be a pop in January as the gift cards get spend, we would expect the downtrend in consumer spending to remain on a downward path and likely accelerate.

The number of retailers that have guidance down fourth-quarter guidance is staggering and cuts across all types of segments. Wal-Mart lagged retailers during the first part of 2007, but the slowdown in consumer spending has widened into the middle and higher end customers. The string of retailer's that have warned of lackluster holiday results December marketed only the fifth month in the past five year that Target's same store sales were worse than Wal-Mart's. This was also the largest difference since November 2002. Wal-Mart has much more of its business based on staples type products, whereas Target has much more discretionary purchases. Other retailers that have announced that results would not meet previous expectations were: Sears, Circuit City, Tiffany's, Williams-Sonoma. Just as Target showed, the slowdown in spending has widened to higher income households.

Inventory levels will be the important metric to watch for the retailers. This week, Williams-Sonoma lowered fourth quarter guidance when it reported it holiday sales results. For the nine-week holiday period, same store sales dropped 0.4% and total sales increased 4.4%. Additionally, the company said that for the full quarter sales are likely to increase by 8.6% to 10.4%. These look like very good results, but the company has an extra week this year compared to last year's fourth quarter. On a comparable basis, total sales are expected to increase only 2.7% to 4.2%. For the nine-week holiday period, sales increase might prove lofty as sales for the nine-week holiday period increased only 4.4% with same store sales declining by 0.4%. Adding insult to injury, inventory levels are projected to be 9% to 13% higher then last year. This will pressure gross margins during at least the next quarter and possibly longer.

Earnings estimates for the fourth-quarter have plunged. At the beginning of the fourth quarter S&P 500 earnings were expected to increase by 11%, now S&P 500 earnings are expected to drop by 10%. It should come to any surprise that consumer discretionary and financial earning led the decline. Financial earnings are expected to drop 69.3% compared to a gain of 2.6% expected in October. Consumer discretionary companies are expected to post a 5.5% increase in earnings compared to 18.5% three months ago. First quarter estimates have been halved over the past three months, from 9.3% growth to 4.4% last Friday. Full year 2008 earnings growth, however, has actually increased from 11.3% to 15.2%. This is a function of analysts taking down 2007 earnings estimates, but only slightly reducing 2008 earnings. Investors have already starting pricing in lower earnings for the full year. Several pundits think that 2008 earnings growth expectations have already been lowered to only 3.6%. This is based on using a year-end PE multiple of 15, which is the two-year average. Obviously, there can be multiple contraction, especially under anemic earnings growth. But the counterargument is that ten-year yields are back under 4.0%. Regardless, the S&P 500 has posted its worse start in over 20 years and several economists are forecasting a recession. A significant amount of bad news has been priced into the market and investors will take solace if the bad news stops. Unfortunately, it's much more likely that that bad news is really just starting.

Chad Hudson
Mid-Week Analysis
PrudentBear.com

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