UNEDITED

During the first two week of October the market rallied about 5% coming into earnings season. Investors clearly were anticipating third quarter results to meet forecasts and guidance for fourth quarter would be favorable. By and large results have been ahead of analysts estimates. Almost half of the S&P 500 has reported third quarter results with 64.9% reporting earnings that were higher than projections and only 10.5% missing forecasts. The majority of the companies are also maintaining their guidance for the rest of the year. This is shown by analysts increasing earnings growth estimates for the fourth quarter. On Wednesday, a few companies, namely Amazon and Merck, tainted the plethora of positive news. After the market had been elevated to such lofty heights, this was able to take the wind out of the sail as the market fell 1.5% on Wednesday.

Interestingly, while earnings growth has accelerated from the second quarter, revenue growth in the third quarter appears to be below growth in the second quarter. First Call currently estimates that third quarter revenues for the S&P 500 increased only 6.5% after growing 7.5% in the second quarter. However, the year-over-year comparison is also harder in the third quarter and continues getting more difficult through the first quarter of 2004. Revenue growth in the second quarter last year was only 2.4% and was 4.4% in the third. Fourth quarter last year saw revenues increase by 6.4% with first quarter 2003 jumping 9.9%. In fact, during the past five quarters revenue and earnings growth have been in lock step on a sequential basis. If earnings growth increased sequentially, so did revenue growth. It appears this relationship will end with third quarter results. This is one indication that cost cutting is driving results.

It is also worth repeating that a portion of growth in revenues is being enhanced by currency gains due to the weak dollar. It appears this "benefit" will continue well into the fourth quarter and likely into next year.

Most of the earnings growth is coming from financial, technology and energy sectors. While financial and energy companies are experiencing strong revenue growth, First Call estimates that the technology sector grew revenues by only 4% in the third quarter. The wide disparity between revenue growth and the 24% earnings growth raises questions. One answer questions the appropriateness of the substantial charges the technology sector took over the past several years. Were some future expenses charged off in prior periods?

The use of pro forma financial statements has been questioned since the end of the bull market. Now a lot of companies have abandoned publishing pro forma results. Unfortunately, pro forma results are often very helpful. The best use of pro forma results is after a company has made an acquisition. Usually if the acquisition was material a company would issue a pro-forma income statement depicting results of the combined entity in the prior period. This allows analysis using comparable results. When Danaher announced its third quarter earnings it said that, "Sales for the third quarter grew 14% compared to last year's third quarter, driven primarily by revenues from recent acquisitions." However, the company did not provide a pro forma income statement so it is almost impossible to do any analysis its results. Additionally, companies that once issued pro forma financials to explain away various charges are now filing GAAP results that show a much better picture than results would be if the prior period's pro forma results were used for the year-over-year comparison.

The following are a few excerpts from companies' third quarter earnings announcements.

Consumers continue to spend as much money as someone will lend them. Big ticket items continue to be popular. Artic Cat reported an increase in revenues of 13% with ATV sales increasing 14% and snowmobile sales up 17%. Similarly, West Marine reported that same store sales increased 1.2% in the third quarter this year. The company said it is, "currently running slightly positive comparable store sales month-to-date" and it expects comparable store sales to increase 4.0% next year. However, Mattel said that US revenues down 4%. The rest of the world appears stronger with international revenues up 16%, of which 7% was due to the weaker dollar. Robert A. Eckert, chairman and CEO said that he is, "encouraged as momentum is beginning to build at retail in the U.S. and internationally." Last week we mentioned that several newspaper companies announced that advertising was starting to pick up. During the third quarter, Mattel increased its advertising compared to last year by 5%, which was also a larger percentage of sales as well.

The manufacturing sector is mixed. PPG Industries, reported revenues increased 6.7%. The company benefited from, "stronger pricing in commodity chemicals" and "the strengthening euro" among other items. The company does see, "continuing signs of a slow but likely uneven escalation in the economy." Most of its business units had improved volumes, but selling prices were mixed. Higher pension costs and retiree medical costs were mentioned several times as weighing on third quarter results. The company even used the "i-word" in its press release saying that "inflationary cost increases" dragged down results.

Labor markets are the key focus point right now in the economy. Economists often point to temporary employment to be the leading indicator to signal when employment appears to be getting better. Manpower, the leading staffing company, announced revenues increased 11% in the third quarter, but on a constant currency basis, revenue increased only 1.8%. The company was much more upbeat than previously. "This quarter, more than any other in 2003, we sensed stronger signals for a meaningful recovery. However, clearly we are unable to call an end to the current labor market challenges." This comes as welcome news, however, revenue from U.S. operations fell 2.4%

Third quarter earnings are following closely to second quarter earnings. Both quarters were filled with companies beating estimates and guiding future results higher. The market also performed similarly. During second quarter earnings the market reached an intra-day high on the Monday that kicked off earnings season, June 14. The most recent intra-day high happened last Wednesday, the third day of third quarter earnings season. While it would seem that investors would be getting more nervous with the high stock prices, however, almost every indicator of investor sentiment reveals investors are very complacent. Even after the drop on Wednesday, the VXO index (the old VIX) remains lower than all but three days this year. It is also noteworthy that it appears from talking to various other traders, the majority of the short sellers are on the sidelines. There was not a lot of shorting being done by short selling managers on Wednesday during the decline. I have discussed numerous times how this market has been very unkind to the typical short seller. According to the CSFB/Tremont Hedge Fund Index, dedicated short biased funds were down almost 23% at the end of September. Adding insult to injury, the average short biased hedge fund has erased last year's gains, and is only up about 2% since the beginning of 2000.