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September 14, 2006

Lower Energy Prices Energize Investors
by Chad Hudson

Corporate earnings have been increasing at a double-digit rate over the past twelve quarters. This has bolstered corporate balance sheets and companies have not been shy spending this cash. This week, Thomson Financial, best know for its First Call product, wrote a research piece detailing the use of cash for S&P 500 companies. It analyzed the year-over-year growth in how companies have been using their cash: dividends paid, mergers & acquisitions, capital expenditures, and share buybacks.

The largest use of cash was for capital expenditures. S&P 500 companies spent $119 billion during the second quarter, up 21% from a year ago. It shouldn't be much of a surprise that the energy sector had the largest increase in capital spending, up 40% to $27.6 billion. In aggregate, dividends paid jumped 13% for the S&P 500 companies. Excluding financial companies, the increase was 15%, led by materials (up 38%) and consumer discretionary (up 32%) companies. Healthcare, financials and telecom were the only sectors to increase spending by single-digits. Companies have also been one of the largest buyers of stock lately. S&P 500 companies spent over $61 billion buying back their own shares, up 86% compared to last year. Additionally, mergers and acquisition activity has surged. During the second quarter, S&P 500 companies spent over $60 billion buying or merging with other companies, over four times as much as last year, and that is just the cash spent, it does not include shares issued. This increase in M&A has skewed the comparisons, but with double-digit increases across the board, it is still apparent that companies are activity spending money. Adding all these categories together, spending surged 54% to $287 billion.

Earnings momentum appears to have continued in the third quarter, but analysts have started lowering earnings growth estimates. Analysts expect third quarter earnings to increase 14.4%, 90 basis points lower than the 15.3% expected just over two months ago. This compares to a 16.3% increase in the second quarter. The consumer discretionary sector has experienced the largest downward revision since July 1, from 20% growth to 13%. It is likely that the homebuilders account for a large portion of this negative revision. There does not appear to be much relief for the housing sector in the near future either. Tom Stevens, president of the National Association of Realtors, told a Senate committee that, "prices will continue to decline." At the same meeting, the National Association of Home Builders Chief Economist said that the decline will bottom out in the middle of next year. At a Credit Swiss sponsored conference, Don Tomnitz, CEO D.R. Horton, said, "But just to be clear, and you alluded to this earlier, as I told the people in our one-on-one today, we anticipate '07 to be tougher than '06, and we believe, and it's somewhat contrary - I don't know your exact numbers; I think I do. But we anticipate some firming stability in the marketplace beginning in 2008. So in the meantime, we are preparing ourselves, obviously, for a slower 2007."

Data released this week by the Mortgage Bankers Association showed that the percent of loans that entered into foreclosure increased to 0.43% at the end of the second quarter. Both prime loans and sub-prime loans saw an increase. The number of prime loans that entered foreclosure increased to 0.27% at the end of the second quarter, up from 0.21 from the prior quarter and the highest since the third quarter of 2002. The percentage of sub-prime ARMs that entered into foreclosure increased to 2.01%, the highest since the fourth quarter of 2003.

The latest employment survey from Manpower reported that companies hiring plans for the fourth quarter slightly decreased. Twenty-eight percent of respondents anticipate adding workers during the fourth quarter while eight percent plan on eliminating employees. The net increase of 20% was lower than the 25% last quarter, and was down slightly from the 21% last year. The seasonally adjusted index was 20, just a point lower than the previous quarter and the same as last year. Construction (24%), manufacturing - durables (23%), and mining (23%) were the industries that expect to increase payrolls the most.

The recent drop in energy prices has emboldened investors. Just last week, the death of the consumer was on everyone's mind. Now, it's assumed that lower energy prices will take the pressure off consumers. While we do not see evidence that consumer spending has slowed dramatically, investors were clearly betting on a weaker consumer. Over the past several years, it has been dangerous to bet against the consumer. Lower energy prices have changed the perception of the health of the consumer and investors pushed up the S&P 500 retail index 6.1% this week. Additionally, the drop in energy prices will likely make the retail sales report on Thursday irrelevant. Since any weakness in spending was due to higher energy prices that have since dissipated. More importantly, Friday's CPI report will be largely ignored because of the now lower energy prices. Economists will be quick to dismiss the report if inflation appeared to accelerate in August since energy prices have declined substantially. Additionally, energy prices surged in August last year, so the year over year change started dropping last month. Just using the end of the month price of oil, the year-over-year change was only 1.9%, compared to increases that have averaged 30.7% for the first seven months this year. It will be important to dig beneath the headlines to discern the extent of the inflationary pressures throughout the economy.

Chad Hudson
Mid-Week Analysis
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