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Where is the Good News?

The economy continues to show signs of weakness. Industrial production declined for the twelfth consecutive month. This is the longest stretch since the postwar armament slowdown. The 1% drop in September was worse than economists’ estimates of 0.8%. Utilization also declined to 75.5%, which is the lowest since 1983, the end of the last prolonged recession. Mining and oil and gas drilling were the only segments to increase production. The weakness was widespread with auto production getting especially hard hit. The terrorist attacks halted shipment of parts causing plants to shutdown. This along with the poor health of the economy caused auto production to decline 3.6%. Home electronics was down 3%, and is 19% lower than one-year ago. Computer and office equipment declined 2.5%; semiconductor and communication equipment both fell 2.3%

The recent confession from Providian Financial indicates how frail and over-extended the high-risk credit consumers are. Providian reported that its credit loss would be just over 10%. Actually, it’s worse than Providian indicates. Since Providian has aggressively increased its loans and newer loans are seldom the loans that fall behind, a better calculation would involve only loans outstanding six months or a year-ago. It is not only Providian that is experiencing adverse conditions. The American Bankers Association reported that 1% of credit card customers defaulted on their obligations. This was the highest default rate in 21 years.

Today, S&P announced that its credit card delinquency index rose over 20 basis points to 5.07% in August. In a statement S&P said, "The rising unemployment rate and lower income expectations will exacerbate the loss picture."

The slowing economy is starting to effect the budgets of state governments. The terrorist attacks have magnified the squeeze Maryland and Virginia are feeling. Virginia released that the state’s revenue is nearly 10% off the pace needed to maintain a balanced budget. For the quarter ending in September (Virginia’s first fiscal quarter) revenues are 2.4% below last year. Just a couple months ago the Governor was forecasting 7.5% growth this the year. Some estimates are calling for a $1 billion shortfall. In Maryland, August revenues were $83 million below projections and running less than last year.

Earnings season is upon us and FirstCall is forecasting S&P 500 earnings will decline by 22.4%. When combined with poor results in the first two quarters and the likely poor fourth quarter FirstCall expects this year should be the worst year for earnings in a decade. Of course FirstCall uses pro-forma earnings, so reality is much worse. FirstCall reported that 788 companies have issued an earnings warning for the third quarter, near the record pace of 866 issued for the first quarter. However, fourth quarter warnings are running at a faster pace than previous quarters. Earnings for technology and transportation companies will be the hardest hit. Earnings for the S&P 500 technology companies are forecasted to fall 72% and transportation companies are projected to fall 108% this quarter and 148% in the fourth quarter.

Today Greenspan was asked how rate cuts would have any stimulus affect when there is so much over-capacity. Greenspan replied that companies would undertake cost-reduction capital investments instead of increasing production. Good answer, however, there were quite a few technology companies that thought the same thing earlier this year.

The other problem is the lending side. As companies get more vulnerable lenders are less willing to lend to them for two reasons. First the company is more risky, but more importantly, banks will be in a hampered position. As the economy weakens lending portfolios will experience more losses. This makes it difficult for banks to increase risk exposure. This is certainly the case at Bank of America. Just this week Bank of America said that it has reduced its loans to big companies by 20%. This decision was helped by fact that it is writing-down $1.5 billion worth of loans.

Moody’s issued a report discussing leveraged retailers. Moody’s believes the current economic environment will not be favorable to those selling discretionary merchandise. Clothing retailers are most at risk. Clothing retailers have already had a very difficult year, both Gap and Ann Taylor posted double-digit declines in same-stores sales during September. Marie Menendez, Moody’s analyst, believes retailers will get weaker "because consumers’ closets are still full from the shopping spree that ended in mid-2000." Menendez also feels the "lack of a current compelling fashion message will intensified by the negative consumer mood." The retailers have also been expanding at an extremely aggressive rate. This has added a lot of additional expenses and cannibalized their own sales. When retailers finally stop expanding at such an aggressive rate it will be difficult for them to maintain the growth rates that investor have come to expect.

McKinsey Global Institute, the global consulting group, issued a report stating that the increase in IT expenditures had little to do with the increase in productivity. Bill Lewis, director of McKinsey Global Institute, said, "There was a big jump in capital spending on IT and a big jump in productivity in the economy as a whole at the end of the 90s. But the actual correlation between the two is very weak." The report found that the productivity increase was primarily due to just six sectors: retail, wholesale, securities, telecoms, semiconductors, and industrial machinery and equipment. These sectors accounted for only 31% of the non-farm private sector. The other 53 sectors, which make up the other 69% of the economy, contributed only 0.3% productivity growth, but accounted for 62% of the acceleration in IT spending. Several of the sectors actually experienced productivity declines. Retailers were the largest contributors to productivity gains, 25%, with Wal-Mart dominating the gains in the sector with its emphasis on big-box stores and discount pricing.

Another damper on earnings this year and most likely for the foreseeable future, is company pension funds. The bull market of the past several years has allowed companies to fund the expense with investment gains. Since companies did not have to contribute to a pension plan, earnings were higher than would have been. Actually companies were helped even more, because accounting rules require companies to claim excess investment gains as their own. For example, 21% of Raytheon’s pretax income was from excess pension fund income. Now companies not only lose the excess gains but also, will have to start contributing once again.

The New York Times ran the transcripts of a roundtable discussion between some of the most successful and experienced investors of late. Here are a few excerpts along with the link to the article (Round Table: The New Challenges for Wall Street )

STEINHARDT: Can I conceive of this being the start of a more serious bear market? Certainly. Certainly. And my intuition is that the markets acted as if there remains a bullish sentiment. But my sense is that there remains a vast legion of investors who became investors for the first time in the 90's and who are, for the purpose of even a plain old bear market, virginal, much less that which we're experiencing now. And all of that, plus relatively high valuations, plus the negative impacts of globalization in a period when things start contracting, create for a range of uncertainties beyond that of a typical cyclical decline.

KAUFMAN: The problem ahead of us is not so much the consumer, it's the lack of creditworthiness in business today. Balance sheets have deteriorated in the last four or five years. Corporations went out and bought back a huge amount of shares. They borrowed money to do it.

Now you're going to find, in the next half a year, more businesses that are heavily indebted, have debt burdens, have declining earnings. And somehow they've got to be refinanced if we don't want more problems.

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