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June 29, 2007

Economic Crosscurrents
by Chad Hudson

After economic growth slowed during the first quarter, almost all economic data released during the first part of the second quarter indicated that growth started to accelerate. Just recently, there have been indications that growth has started to moderate once again. Last week, we mentioned that Best Buy significantly missed earnings expectations. Earlier this week, Target announced that its sales are tracking at the low end of its plan. The manufacturing sector also appears to have hit a rough patch. The Commerce Department reported that durable goods orders fell 2.8% in May. Excluding transportation, orders fell 1.0%. Both these declines were the weakest since January 2007 and weaker than economists were predicting. Compared to last May, orders were up only 0.3% and down 1.1% excluding transportation.

While the durable goods orders suggest that the manufacturing sector weakened in May, recent surveys show that manufacturers have become more optimistic. The Philadelphia Federal Reserve survey jumped 13.8 points to 18.0. This was the highest level since April 2005 and the largest increase since November 2002. New orders jumped 9.7 points to 18.3. The Richmond Fed manufacturing survey also showed strength in June, jumping 14 points to 4. In fact it was the first positive reading since November. New orders jumped from -13 to 6. Order backlog along with capacity utilization increased, but remained negative. Prices paid and prices received both increased. Manufacturers reported that prices paid increased 3.29% compared to last month and prices received increased to 2.09%. These were the largest increases since February and January respectively. The outlook for inflation does not bode well either. Manufacturers expect prices in increase at a 3.81% pace. That is the highest expected price increase since February 2006.

The mood of the consumer soured in June. The Conference Board reported that consumer confidence dropped 4.6 points in June to 103.9. It was the lowest level since August 2006. Most of the weakness was in the present situation component, which fell 8.2 points. The expectations index dropped 2.2 points. Consumers felt that the labor market has weakened. Only 27% of respondents felt there were plentiful employment opportunities, down 2.1 percentage points from May and the lowest since November. Not surprising, there was a similar increase in those that felt jobs were hard to get, which increased to 17% from 14.6% last month. The percentage of consumers that plan on buying a house over the next three months was unchanged at 2.8%, but those planning to buy a new house dropped to 0.6% from 0.8% last month.

Existing home sales dropped 20,000 in May to a 5.99 million annualized rate, which was slightly higher then the 5.97 million units economists were expecting. The median price dropped 2.1% compared to last May. This was the tenth consecutive month of year-over-year price decline; however, prices are still higher than two years ago. Inventory jumped over 200,000 units to 4.431 million, which is almost nine months of supply at current sales rate. Given the amount of inventory and prices have only marginally come down off peaks, home prices are likely to remain under pressure. New home sales also dropped in May. The Commerce Department reported that new home sales dropped by 15,000 units in May from a revised 930,000 units in April. Originally, April sales were reported at 981,000.

On Tuesday, Lennar reported that its second quarter earnings fell short of analyst estimates. The homebuilder lost $1.55 per share, which included impairment charges of $1.33 per share. Homebuilding revenue fell 33% year-over-year, driven by 29% drop in deliveries combined with a 7% drop in the average selling price. Incentives surged to $44,000 on average from $25,000 last year. Management didn't seem optimistic during the company's conference call and actually seemed more reserved than previous conference calls. Below are a few quotes from the conference call:

"Whereas in the beginning of this year, we set an internal goal of maintaining profitability in line with last year, market conditions have eroded so much over the past six months that we are now focused on limiting the loss for the year."

"In addition to the standing inventories of new homes, it is apparent that there is a growing backlog of existing homes that are not selling at yesterday's prices and they will soon be repriced in order to sell. Overall, the supply of homes to sell continues to climb in many markets and we are not yet able to get a good reading on how quickly this inventory will be absorbed."

"But if what you're asking is, is it indicative of the fact that the market has probably hit a new low point? I think the answer would be yes and I think that is what we have tried to come out and say."

"...in terms of new orders. It didn't really vary that much but again, just to highlight that from a standpoint of sales incentives, it did deteriorate throughout the quarter from a sales incentive standpoint; although orders were more consistent, sales incentives did increase throughout the quarter."

Recent economic data has provided enough "evidence" for anyone to make a case that the economy is either slowing or accelerating. Housing remains the only sector that everyone agrees is weak. There has started to be indications that consumer spending is slowing, or it could also be that retailers have simply expanded too fast and there are too many stores for consumers to patronize. As we saw with Best Buy last week, retailers are likely to face difficult times even if overall consumer spending doesn't taper off extensively. And if consumers actually start to retrench and spend less, there will be significant challenges not only for retailers, but for the economy as well.

Chad Hudson
Mid-Week Analysis
PrudentBear.com