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Will The Economy Continue to Drive Earnings?

Investors are focused on fourth quarter earnings this week, but the release of the Federal Reserve's Beige Book and CPI report on Wednesday offered brief recesses from the countless conference calls. As of Wednesday night, 85 companies in the S&P 500 Index reported fourth quarter results. Fifty-four (63.5%) have exceeded Wall Street's estimates, with 17 (20.0%) falling short. This is worse than last year at this point. After 90 companies had reported last year, only 11% had missed analysts projections. Investors are realizing that growth is slowing and have become more skeptical. IBM's stock price sold off after beating analysts estimates by a nickel because sales were boosted by a weak dollar that might not contribute to growth if the dollar stabilizes.

Wednesday's release of the Consumer Price Index gave investors reassurance that inflation is not accelerating. On a year-over-year basis, the CPI increased 3.3%, 20 basis points below November's increase. Since most of the decline was due to energy prices retracing some of their increase earlier in the year, the Core CPI remained at the same level as November, 2.2%.

The Federal Reserve published the Beige Book on Wednesday and confirmed the general strength of the economy over the past eight weeks. Eleven of the districts "characterized activity as expanding" while only Cleveland dissented and said economic activity in its district was "mixed." Several districts commented that holiday sales were higher than last year, but started slow, and "picked up appreciably by late December." Tourism was specifically mentioned as an area that showed strength: "Broadway theaters set a box-office record during the last week of the year." "Florida theme parks were filled to capacity." "Ski resorts reported near-record levels of visitors." "Hotels were booked to capacity in coastal areas and that some were turning tourists away during the week after Christmas." Most districts reported that "manufacturing activity firmed" and businesses "planned to increase capital spending in 2005." Commercial real estate continued to improve in most districts and may signal future hiring. Labor markets improved, but "wages pressure generally remained." And of course, "price inflation remained relatively steady in recent weeks."

General Motors earned $1.01 per share in the fourth quarter beating consensus estimates by a dime. However, $0.28 per share was the result of a $160 million one time tax benefit, which caused its North American division to have an effective -32% tax rate. GM also said that it expects first quarter earnings to be "break-even or better" because of a 7% cut in first quarter production volume. The Asian manufacturers have started taking away market share in the high-profit truck and SUV market. There is little chance that GM will be able to recover lost ground early this year, especially in profits, as its only new vehicles launching during the first nine-months of the year are lower-margin products. Investors will have to wait until the fourth quarter and the second quarter of 2006 before new high-margin vehicles are available. John Casesa, auto analyst at Merrill Lynch, lowered his 2005 EPS estimate to $4.00 from $5.50 following GM's earnings conference call. GMAC continued to drive all of GM's profit. It contributed $1.08 of the $1.01 fourth quarter earnings. In order for GM's auto business not to be a detriment to GMAC the company is pursuing changing the structure so it's a wholly owned subsidiary. That way if GM's bond rating is cut to junk status, GMAC's borrowing costs will not diminish.

We have discussed how retailers have conditioned consumers to wait for sales. The Beige Report reiterated that shoppers were more active later in the shopping season when sales were more prevalent. This is an ominous sign for retailers since margins will obviously be compressed if retailers are unable to get full price for their merchandise. It is also appears to be affecting retailers that use the "everyday low price" strategy. Ethan Allen switched to an everyday pricing strategy last June so it does not offer sales anymore. During the conference call, management said that it is having to educate its consumers and is difficult when the competition "is selling their products as a commodity and on sales." The company forecasts that once it gets past the anniversary of the transition, results will be much better for a host of reasons. The company guided analysts to expect 5% same store sales growth and 8% earnings growth. Wall Street is not buying it. Piper Jaffrey lowered its earnings estimate to reflect 5% earnings growth and 3% same store sales growth and said it, "would not be surprised to see guidance revised lower in the coming months if business conditions do not improve materially from current levels".

Ryland Group beat estimates for at least the sixth consecutive quarter. The homebuilder also guided 2005 earnings higher. One chink in the earnings report was a decline in gross margins. It was the first time gross margins declined since the third quarter of 2000. The company cited higher building materials.

Europe is giving mixed signals, Parker Hannifin, one of the largest suppliers to industrial companies, said it is strengthening during its conference call:

"And I think the easiest way to look at Europe is to look at the countries. The UK is still somewhat anemic. That's been our toughest one. Part of that is reduced production, as well as companies actually moving. The other location that has been down or country that has been down is Italy, and I am seeing some signs where Italy is slowly coming back right now. Other than those two, everything else is looking relatively strong. Germany has been inching up. I'm not going to say it is booming, but it has been sequentially getting better. The real encouraging thing in the last two months is our performance in France, which up until now has been flat at best. We're seeing some improvement there. The northern countries in general are very strong, primarily because of construction equipment and forestry. And the place where we are obviously seeing huge growth right now is in some of the eastern countries, large increases in business in Poland, the Czech Republic, and in places such as Turkey. So, I'm pretty optimistic with Europe right now. The numbers are good. I don't see any particular industry that would be going down. So, I'm optimistic there as we go forward."

This is quite a contrast to how 3M described economic conditions in Europe:

"It is hard to take a global view and see tailwind. I think there is decent momentum in the United States, still not great, but there is still air flowing over the wings. I think in Europe you see a group of economies that never got off the ground and show no promise of doing it, really. And I think you see a modest slowdown in Asia. So when you add that all up, it leads to caution at the macroeconomic level."

Stock prices have been zigzagging this year without any direction. The S&P 500 has not experienced two consecutive up or down days in the past two weeks and Wednesday's eleven point drop only erased Tuesday's eleven point gain. As investors determine the prospects for earnings this year, it's likely that the market will breakout of its trading range. It currently appears that earnings growth will be below the estimated growth at the beginning of the quarter. This has not happened since the fourth quarter 2002. The last time earnings growth shifted from beating estimates to coming in below forecasts was in the third quarter of 2000 and that continued for ten consecutive quarters. These periods were also the turning points in the market.

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