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Investors Exhale


With earnings season and the elections over, investors breathed a sigh of relief. The Bush victory is perceived bullish for stocks and third quarter earnings were higher than expected. Over the past few weeks we have concentrated on earnings and discussed companies comments on the current strength of the economy. With earnings season winding down, the strength of the manufacturing sector. Recent economic data has also shown that the economy remains strong.

After trending down throughout most of the third quarter, it appears that third quarter earnings growth will be higher than estimated at the beginning of the quarter. As of last Friday (October 29), 392 companies of the S&P 500 had reported third quarter earnings. The blended earnings growth rate (using actual results for those that have reported and analysts' estimates for those yet to report) was 16.4%, 150 basis points higher than at the beginning of the quarter and 260 basis points higher than at the beginning of October. Several sectors outperformed initial estimates including consumer discretionary (23% now v. 21% at Oct. 1), energy (56% v. 34%), industrials (20% v. 15%), materials (84% v. 70%), and technology (38% v. 34%). While earnings for the third quarter were better than expected, it is not driving fourth quarter estimates up. Earnings estimates for the fourth quarter actually dropped since the beginning of the month. Earnings during the fourth quarter are expected to increase by 15.2% compared to 15.5% at the beginning of the month. Focusing on the top-line estimate for the S&P 500 misses the fact that earnings growth for several sectors has been dramatically reduced. We saw this happen during the third quarter as well. Most notably, earnings growth for consumer discretionary companies has dropped from 15% to 10% during October, health care from 13% to 9%, financial from 13% to 11%. Offsetting these lowered estimates are increases in energy (from 39% to 55%), telecom (-7% to +3), and utilities (3% to 8%).

The latest manufacturing surveys showed a mixed picture. The Chicago purchasing manager survey jumped 7.2 points to 68.5. This not only was almost ten points higher than economists' estimates, but the highest level since 1988. The surge was due to a 20.8 point surge in the production component. This was the highest level since June 1950. New orders also increased significantly, it rose almost ten points to 79.4. This was the highest level of new orders since December 1983. While all the components remained over 50 signaling all the components were expanding, inventory was the biggest drag falling 12.9 points to 51.8.

The Institute for Supply Managers survey didn't show the acceleration that the Chicago survey did. The top-line number actually fell 1.7 points along with six of the ten components. This was the lowest level since September 2003. Three components (inventories, consumers' inventories, and backlog) were below 50, meaning there was contraction in those components. While it might be easy to use the recent weakness in the ISM survey as evidence that the economy is weakening, investors need to remember that the manufacturing sector had a huge surge in activity and there would be a slowdown. This slowdown does not necessarily equate to a weakening manufacturing sector. It shows that expansion has started to level off from the rapid acceleration earlier this year. This is exemplified by this week's release of factory orders for September. According to the report from the Census Bureau factory orders fell 0.4% in September from the prior month. This would be the change that the ISM and other discursion indexes capture. Factory orders compared to last year were up 10.3%. This aligns with the durable goods orders in September that were released last week as well. On a month-over-month basis orders increased 0.2%, but advanced 9.6% from last September. The surge in the price of base metals helped contribute to the increase. Over the past year, orders for primary metals and fabricated metal products increased 34.2% and 11.2% respectively. Either these higher prices will be passed on to end users or companies will experience declining margins.

The service sector expanded in October at a faster rate. The non-manufacturing ISM survey increased 3.1 points to 59.8 reversing a two month decline. The largest increase was in the prices paid component, which jumped seven points to 74.1, just one-half point away from the high set in June 2004. All the components in the non-manufacturing survey remained at 50 or higher.

Chain store sales have held up according to the reports from the International Council of Shopping Centers (ICSC). Over the past two months year-over-year sales growth has been in the range of 2% to 3.7%. These increases are on top of better than 4% growth during the year ago period. On Thursday, retailers will report October same store sales. Analysts are expecting same store sales to increase 3% to 4%.

American consumers are almost insatiable when it comes to spending. Personal income increased only 0.2% in September, but spending jumped 0.6%. On a year-over-year basis, spending jumped 5.9%, while income advanced by only 4.6%. It does not take a math professor, to figure out that the savings rate would have declined. In fact, in September the savings rate dipped to 0.2%, the second lowest on record. It dropped to -0.2% in October 2002. This is one trend that is quickly running out of room to continue. During the recession that marked the 2000 - 2001 period there was never a decline in personal expenditures. It's doubtful that during the next recession that will be the case. At that point, we will find out how overbuilt the retail sector is.

The other economic release this week will be the employment report on Friday. Both ISM surveys have been above 50 for several months and the employment component in the non-manufacturing survey increased 1.2 points to 55.8, which is the fourth highest level it has been since it was conceived in 1997. On the flip side, job cuts remained over 100,000 for the second consecutive month according the Challenger report, the first time since January - February 2003. The placement firm started tracking hiring announcements in May this year and except for a spike in August has generally declined every month. Hiring announcements totaled 11,425 in October, down from 16,166 in September.

Autos sold at a 17.0 million unit rate in October and was again dominated by imports. Sales at GM and Ford dropped by about 5% each, while Toyota sales increased 13%, Nissan up 27% and 10% at Honda. The strong showing from the Asian manufacturers boosted their market share to a record high 35.9%. Part of the decline was caused by the reduction on incentives as the car companies hoped that the appeal of newer models would be enough to drive demand. The average incentive for GM was $5,098, down $70 from September. Ford's average incentive dropped by $66 to $5,113. Conversely, Honda and Nissan increased their incentives last month. Honda's average incentive grew by $128 to $2,311 and Nissan increased theirs by $64 to $2136. GM announced that it will cut production by 10,000 vehicles in the fourth quarter.

Investors bid up stocks following President Bush's reelection. General Motors' September sales reminded investors that problems still exist within the economy. It also shows that the rebound in manufacturing could be in jeopardy if end demand slows. The euphoria of the election may propel the market higher in the short-term, but it does not solve any of the structural problems that we have detailed over the past several years.

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