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Where Is The Quality?


Last week was filled with economic data. Since I was out last week, I'll just give a quick recap on a few of the data points.

The Conference Board released its consumer confidence survey that showed a 4.9 point decline. The expectations component registered the largest decline, 6.5 points, to 88.4, but the 2.5 point decline, to 59.5, in the present situation component pushed it to the lowest level since November 1993. The most notable aspect of the survey was the results of the purchase to buy questions. I hate reading too much into consumer surveys since consumers have been much more frugal when asked questions in a survey than strolling around in the shopping mall. The percent of respondents planning on purchasing a home dropped 1.1 percentage points to 2.9%, which is the lowest percent since March 1997. There was a similar 1.2 percentage point drop for those planning on purchasing an automobile. Only 5.4% anticipate buying a car in the next six-months, a level not seen since June 1995. There was a 5.9 percentage point drop in those anticipating buying a major appliance. While not multi-year lows, 26.7% plan on purchasing an appliance, which was the lowest since September 2002.

Construction spending gained 0.4% lead by record private residential spending. The 1.4% increase in private residential made up for the 2.6% decline in non-residential spending. Public construction spending increased 0.6%. Fittingly, this week, D.R. Horton announced that fourth-quarter orders rose 21%.

ISM index dropped a point, but remained over 50, showing expansion, for the third consecutive month. New orders increased 0.8 points to 60.4. This was the strongest reading for new orders since December 2002. The service sector of the economy also continued on its roll. Although the non-manufacturing ISM dropped 1.8 points to 63.3, it was better than economists expected and still the second highest level recorded since the index stared in 1997. Interestingly, new orders experienced the largest drop, 7.7 percentage points, while backlogs increased the most, 5.5 percentage points. Prices paid also increased 4.4 to above 60 again.

Lastly, 57,000 jobs were created in September. This not only was above the expectations, but was the first month of job growth since January.

The economy continues to grow due to the flood of liquidity provided by fiscal and monetary policy has ignited the economy. The consensus estimate for third quarter Real GDP growth is 5.2% and assuming a 1% GDP deflator (for simplicity, I'm just using the deflator as second quarter), nominal GDP should increase by 6.2%. With Fed Funds locked at 1%, the discrepancy between GDP growth and Fed Funds rate is historic. Since 1985, there has been only one time that the spread between Fed Funds and nominal GDP has been over 500 basis points. This occurred in the fourth quarter of 1993 when nominal GDP soared 8.7% with Fed Funds at 3.0%. That was the sixth and final quarter of 3% Fed Funds after being lowered from 9.75 starting in 1989. The Fed was clearly caught behind the curve as it increased Fed Funds seven times from February 1994 to February 1995. This tightening resulted in Fed Funds doubling to 6.0% in only one year. Not surprisingly, yields throughout the curve rose dramatically. 10-year Treasury yields increased from about 5.75% in January 1994 to 8% by November 1994.

This type of move in interest rates would severally crimp the economy if this would happen now and the Fed knows it. Thus, the Fed has practically guaranteed that they will not raise interest rates. Clearly the discrepancy between interest rates and 5% plus GDP growth has to be reconciled. Inflation will heat up, and maybe even show up in government numbers. If interest rates are held lower, the next logical outlet for the repercussion from the massive easy monetary policy would be the dollar. Doug Noland addressed the dollar problems better than I ever could in his latest column, so I will defer to him. Here is a link to the latest Credit Bubble Bulletin, Tipping Point?.

The flood of liquidity has also benefited corporate earnings. At the beginning of the quarter I was skeptical that companies would achieve Wall Street earnings estimates. This caution has waned over the quarter as the liquidity spigot continued to pour liquidity into consumer's wallets. Wall Street analysts continued to increase their earnings throughout the third quarter. Earnings growth estimates for S&P 500 companies (excluding Lucent's huge $2.9 billion loss during the third quarter last year) started the quarter at 10.2% and increased to the current estimate of 12.5%.

While earnings season kicks off next week, there have been twelve S&P 500 companies that have reported earning over the past two weeks. Only one, Symbol Technologies, has missed expectations and this is a bad example since the company is just starting to figure out what its revenue has been for the previous five years. For those not keeping track of this story, the following excerpts from its earnings release should give a hint why any financials released by this company are suspect: "Revenue over the 1998 to 2002 period was reduced by $223 million...Gross margin over the 1998 to 2002 period was reduced by $101 million&Shareholders' equity at year-end 2002 was $956 million representing a $225 million reduction from the previously reported $1.211 billion."

Alcoa's earnings always receive quite a bit of press because it's the first Dow component to report earnings. Its earnings were helped by lowered costs and higher alumina prices and offset by "weaker metal shipments." Alcoa cut SG&A expense by 12% from the year ago period, bringing SG&A expense as a percent of sales to 5.7% compared to 6.3% last year. Since actually revenue fell, this decline in SG&A as a percent of sales accounted for more than the entire gain in pre-tax income. Alcoa also benefited from a substantial drop in its income tax rate along with reducing its allowance for doubtful accounts. Achieving earnings growth through cost cutting and lower tax rates cannot last ad infinitum.

Yum! Brands beats earnings estimates by two pennies, however, Prudential noted that earnings quality was poor. In a research note Prudential said, "lower than expected interest expense&added $0.01 per share to the quarter. And a lower then expected tax rate of 29% versus our estimate for 31% added another $0.01 per share. Revenue, particularly in the US business, were light our expectations. But currency (added $6 million to the quarter or $1-$2 million more than expected) and lower franchise license expense helped to offset this line item.

Corporate earnings continue expand, but due in part to cost cutting and other low quality sources. Similarly, the economy is displaying growth right now, but the quality of GDP growth is perhaps worse than corporate earnings growth. Much of the second quarter growth came from the government sector. While we view this low quality growth, it is nevertheless still growth. Also much of the increase in consumer spending has been driven through increased borrowing and other one-time gains (e.g. tax refunds). The economy and corporate America can continue to prop themselves up for only so long. Sooner or later these sources of growth will simply run out. Companies can only reduce costs so much, and consumers can only increase debt loads for so long. The big question is how much longer it can last. It is interesting that Wall Street is staring to pay more attention to the quality of earnings. The decline in the US dollar could be evidence that foreign investors are staring to pay attention to the quality of the US economy.

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