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Debt Through Consumption

Second quarter earnings are wrapping up and according to FirstCall the S&P 500 earnings will be 17% lower than the year-ago period. Furthermore, companies are using this earnings period to guide estimates down for the third quarter, and some even for the remaining of the year. Estimates for the third quarter have already come down over 5% in just one month. Estimates currently call for earnings to decline 11.5% in the third quarter and to posts a minor gain of 0.9% in the fourth quarter. However, very few actually expect estimates to maintain these lofty forecasts. FirstCall notes that "The earnings decline in 3Q01 is likely to end up as bad as that of 2Q01, or maybe even worse." Chuck Hill, director of research for First Call, pointed out that "it is now clear that the earliest that earnings will show any meaningful improvement will be the first quarter of 2002." Additionally, FirstCall also noted the remote "potential that a currency crisis in one or more of the developing countries or more severe problems in Japan's banking system could lead to a financial crisis of the type experienced in 3Q98."

Sensing profits will not keep pace with prior guesses, three market strategists lowered their S&P 500 earnings forecasts this week. Doug Cliggott, chief equity strategist at JP Morgan, lowered his forecast the most, from $50 to $44. Tom Galvin, chief strategist at Credit Suisse First Boston, lowered his estimate to $51.50 from $55.25, and Edward Kerschner, chief global market strategist at UBS Warberg, reduced 2001 and 2002 earnings estimates. Kerschner reduced his 2001 estimate to $49 from $53, with 2002 getting trimmed to $59 from $61. Even with his lowered estimates, Kershner is still forecasting earnings will jump 20% in 2002, right along with consensus estimates. With the S&P 500 trading over 1,200, it is priced at over 30 times current earnings. With the extreme amount of uncertainty present in the economy along with companies having "no visibility", investors are not only pricing in a perfect outcome to this current slowdown, but a very quick recovery. The million-dollar question is what is going to happen to 2002 earnings estimates. I'll bet they will not go up. At the beginning of 2001, forecasts called for S&P 500 profits to increase by 10%, now profits are expected to fall 9%.

Last week the Wall Street Journal ran a story stating that Americans have extracted about $33 billion from the equity in their house through refinancing this year. While, we would argue the amount is greater than $33 billion, there is little doubt that this has been a significant factor keeping the consumption binge on track as the rest of the economy falters. The next windfall will be the tax rebate checks that have stated hitting mailboxes. There is a good chance that the tax rebate checks will prolong the binge, and "save the economy from recession." Unfortunately, it is just delays the inevitable. There are structural problems with the U.S. economy developed from years of reckless lending and speculating that a bunch of $300 and $600 checks will not solve. Several economists think that consumers are going to be responsible and either save the money or pay down existing debt. Why do we have any reason to think that the majority of Americans are going to do anything but spend it? Hey, they just got $600, they are going to go out and spend $1000, and then say they saved $600 in doing so.

Consumer confidence fell to 116.5 in July, which was below 118 that economists were expecting. The report seems very contradictory. While both the present situation and the expectations components fell, the number of consumers with plans to purchase big-ticket items increased. The percent planning on buying a home increased to 3.8% from 3.4%, the largest jump since February. Likewise, the percent of consumers planning to buy cars and appliances experienced the largest jump this year. Are consumers already planning to spend their rebate checks? Wait I thought everyone is planing on saving it or reducing debt.

Looking over the GDP report, which was issued last Friday, shows that almost every non-personal line item showed deceleration in the second quarter from the first quarter (state and local government and non-defense federal expenditures the two holdouts). It truly has been the consumer keeping the economy floating. So far this year, personal consumption has increased $81.4 billion, with most of the increases occurring in durable goods purchases and services, each accounting for around $36.5 billion. This compares to a decline of $50 billion in nonresidential investment and a larger $53.3 billion decrease in equipment and software expenditures. It is interesting to note the amount of debt that the consumer has taken on to maintain the binge. There is the $33 billion extracted from home equity, $59 billion increase in consumer credit in the first five months of the year (June data will be released next week), and about $50 billion in home equity loans were originated. This adds up to $142 billion. One caveat on this analysis, GDP is presented in real dollars while the credit and home equity number are nominal. By adjusting the personal expenditure data by the deflator, you end up with consumption increasing around $180 billion. So about three-quarter of the growth in consumption this year was financed.

Commercial real estate in Denver made the papers again. This time a broker tried to put a more favorable spin on the situation. Chris Phenicie, partner of Commercial Colorado, predicts that the northwest corridor will end the year with a 31% vacancy and will recover next year to end 2002 with a vacancy rate of 8%-10%. I hope they are right, but there is currently 1.37 million square feet under construction. If that space were added to the leasing pool, the vacancy rate would soar to 49%. And even to Phenicie's own admission, there is 650,000 square feet of space currently being considered by tenants, of which only 400,000 square feet might be leased. Landlords are facing two major problems. There are simply not as many companies looking for office space, and those that are, are looking for considerable less than just one year ago. Last year, companies would typically lease more space then they currently needed because of their aggressive expansion plans.

It does appear that Silicon Valley real estate is topping out. However, the SF Gate published some "Amazing Statistics" this week that really underscores how inflated it still is.

  • 5,373 homes sold for more than $1 million in the Bay Area, a 74% increase over the prior year. More $1 million homes were sold in the Bay Area than in Southern California, the first time ever. 10 years ago the Bay Area only had about one-fourth the number.
  • Embarcadero Center is San Francisco's most expensive building valued at $1.3 billion, more than double the $582 million it was valued at LAST YEAR.
  • Median price of a home in Marin County (county just north of the Golden Gate Bridge) is $620,000. In 1998 it was only 371,113.

All eyes will be on the employment situation report on Friday. If the anecdotal evidence provides any guide, the outlook is not rosy. A Reuters story reported this week that one San Francisco placement agency stopped interviewing for summer employment since it already has more applicants than positions. Whatever the government data shows, the situation is sure to get worse as the recently announced layoffs start taking affect.

I will probably regret doing this but if you are interested in one more poll, email me at the address below your plans for your $300 or $600 bucks. Me? I'm putting it in the college fund for my new daughter.

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