UNEDITED

With substantially all of the S&P 500 reporting second quarter earnings, earnings growth will be up over 25% for the third consecutive quarter. It is very unlikely that it will be able to extend the streak as third quarter of 2003 saw 21% EPS growth, which makes four consecutive quarter of 20% + EPS growth. Revenue growth is running 12.4% above last year's pace, which was 11.5% itself. As we have discussed before, a large part of the increase has been due to higher energy prices along with the increase in commodity prices such as steel.

While the jump in revenues is indicative of the economy doing better than a year ago, part of the increase is due to surging commodity prices such as oil and steel. But it also has jumped because of the enormous amount of "fluff" in the economy. Earlier this week the CEO of PetSmart was on CNBC discussing the company's moving into the service side of the pet business. The company has started offering grooming and training services and is rolling out its PETsHOTEL concept that provides boarding services and day care service. In our eyes this is a perfect example of the "fluff" that appears in the economy when the money spigot has been left running full blast too long.

Retailing stocks have been stuck in a trading range since late last year after rebounding about 50% off the lows set during the first quarter of 2003. Investors were betting on a recovery in the sector that transpired. However, looking forward retailers are clearly losing momentum with the lack of stimulus that propped up the consumer last year. While calling for the end of the spending binge has been hazardous, there is little doubt that consumer spending will not be able to be sustained at these level indefinitely.

This week, the ICSC's (International Council of Shopping Centers) tally of same store sales growth dropped to 2.9% on a year-over-year basis. This was the slowest rate of growth since the last week of July last year. We have discussed how retailers would face difficult comparisons during the second half of the year and that period has finally come. The ICSC also lowered its forecast for August same store sales growth to 2.5% from its earlier forecast of 3.0% growth. Considering that last year August same store sales increased by 6.0%, a 2.5% increase this year would be impressive. This also compares to 6.0% growth in August 2003. Considering the two previous months experienced growth of 3.1% and 3.0%.

Adding to the weaker same store sales data from the ICSC, Wal-Mart announced its August same store sales would be flat to up 2%, lower than the 2% to 4% increase previously articulated.

Nordstrom reported that same store sales increased 6.8% in the second quarter, which was quite a deceleration from the 13.2% reported in the first quarter this year. The deceleration is expected to continue as management guided third quarter same store sales to 1% to 3%. Furthermore, same store sales are expected to increase between 4% and 6% for the full year. By weighting each quarter's same store sales growth by the amount in sales each quarter has, we calculate that management forecasts fourth quarter same store sales to be flat.

The table below shows the acceleration in same stores sales over the past two years along with the forecasted deceleration.

* Nordstrom management guidance
** Prudent Bear estimate based on full year guidance

Along with the rebound in same stores sales, gross margins have increased to the highest level since at least 1990 as the table below highlights.

Management is forecasting that the gross margin expansion will continue due in part to new inventory management software the company recently implemented. Overlooking the 1999-2000 era, when nothing was at a normal run-rate, the last time gross margins peaked was in fiscal 1995 (year ends January) at about 33%. At that time Wall Street was forecasting that margins would continue to improve due to investment in, you guessed it, inventory management technology. According to a Merrill Lynch reported dated August 23, 1994 (following Nordstrom's fiscal second quarter 1995 earnings), "We expect the combination of this new system and the repositioning to greater value offerings to drive Nordstrom's gross margins consistently higher."

Much of the confidence consumers have is derived from watching the value of their house escalate. For the overwhelming majority of Americans, their house is their largest asset. Calling the top of the housing market has been even more dangerous than trying to forecasts when consumers will retrench. This week, the National Association of Realtors reported that existing home sales dropped to a 6.72 million annualized rate in July from 6.92 million units last month. This was also lower than the 6.81 million units economists forecasted. Then on Wednesday, the Commerce Department announced that new home sales fell to 1.134 million unit pace. Additionally, June's pace of sales was revised sharply downward to 1.211 million from the initial calculation of 1.326 million. It was also well below the 1.3 million economist expected. While both these economic indicators were declined and were below estimates, they remain stronger than any point prior to mid-2003.

Toll Brothers has not experienced a decline in business. The leading luxury homebuilder reported third quarter earnings and revenues jumped 46% during its third quarter. It also reported that the number of contracts signed soared 69% with backlog surging 75%.

Investors have been waiting for the second half of the year to see if economic growth will be self-sustaining. While first indications appear that the consumer sector has at least maintained the elevated levels that were induced by various stimuli that we have discussed on various occasions, growth has definitely decelerated. It is likely that investors will not be satisfied without faster growth than is likely.