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Higher Interest Rates and Slower Earnings Growth


The Federal Reserve increased its target rate by 25 basis points to 2.5%. This was the sixth consecutive increase. The Fed only omitted the word "earlier" in its description of rising oil prices, otherwise the language of the release was exactly the same. With the FOMC meeting being a non-event for most investors, the last week of earnings season was focus of the week. After last week, just over half of the S&P 500 reporting fourth quarter earnings. Growth estimates for the fourth quarter jumped to 18%, from 16.5% the prior week. Unfortunately, estimates for the current quarter dropped again. Earnings growth for the first quarter of 2005 for the S&P 500 is expected to be 6.6%, down from 7.3% last week and 7.6% at the beginning of the year.

The steel companies achieved tremendous operating leverage during 2004 as the price of steel more than doubled. This continued during the fourth quarter. At US Steel, sales jumped 51% in the fourth quarter and EPS was $3.55 compared to at loss of $0.26 per share last year. AK Steel reported that revenue increased 36%. Higher prices drove most of the increases, which were up 31% compared to last year, volume increased 4%. The company expects prices to increase another 8% from the fourth quarter to the first quarter 2005. It also reversed a $0.31 per share loss last year to a $0.68 gain. Steel companies remain optimistic and expect demand and prices to remain at current levels. While it should be expected for the steel companies to be optimistic, most of their customers do not see much relief from the high prices either. Eaton said, "We don't anticipate we're going to see significant metals cost retrenchment during 2005. The strong production requirements in each of our end markets, the continued strong demand, are tending to put a demand floor underneath the demand for metals, and frankly, for oil as well." Caterpillar echoed similar comments, "As we enter 2005, we are not anticipating significant steel price declines until the second half of the year at the earliest. We expect our costs for the first half of 2005 will appear substantially higher than costs in the first half of 2004 because the comparison will contain the relatively low steel cost experienced at that time."

New home sales in December were 1.098 million units, below economists' estimates of 1.2 million. It was the first time there were two consecutive months with sales below 1.1 million annualized units since May 2003. Last week, existing home sales for December also came in below forecasts. In contrast, the homebuilders are reporting earnings that are exceeding analysts' forecasts. Centex earned $1.91, three cents better than analyst. Beazer Homes beat Wall Street's forecast of $4.36 per share by $0.34. DR Horton earned $1.01 per share, more than 8% better than analysts forecasted. Bucking the trend, NVR failed to meet expectations. While earnings increased 35% from last year, the company earned $20.13 per shares, which missed estimates of $20.72. While most homebuilders beat estimates and guided analysts higher, sales in the Midwest was mentioned several times as the one area of weakness. Additionally, homebuilders are not expecting substantial price increases this year.

While the homebuilders are optimistic about sales this year, companies that supply homebuilders are much more cautious. Eaton said, "overall feeling is that US housing starts down about 6%." They admit that they "have been wrong the last three years. We thought it would start to come off and it has not come off." Cooper Industries shared a similar view, "We are pretty convinced that the residential markets have peaked&We think they are going to be probably off a bit in 2005 vs. 2004."

UPS reported that December was slow, especially the period from December 22 until the end of the year. The company attributed part of the weakness to bad weather. The question of bad weather was raised during the Yellow Roadway conference call and it was answered, "It obviously impacted us, but it's an outdoor sport. We try no tot whine too much about the weather."

Rohm & Haas, the worlds largest producer of acrylics used in paint and plastic, reported that fourth quarter sales jumped 13%. Increased volume accounted for 4%, higher prices added 6% and a weaker dollar contributed 3%. Newell Rubbermaid was negatively affected by price increases that the chemical companies are passing through. During its conference call it detailed by each quarter how higher raw materials impacted the company. It said it budgeted $20 million for higher raw materials at the beginning of the year. It experienced $21 million just in the first quarter. The second quarter was $18 million, before accelerating in the third and fourth quarters. The company spent an additional $31 million during the third quarter and $46 million in the fourth. During the fourth quarter, the company was able to more than offset the increase in raw materials due to a $21 million increase in pricing and $37 million in productivity. Newell does not see any relief in 2005. In fact, it expects to spend an additional $170 million on raw materials than it did in 2004, which was up $116 million.

Chicago PMI showed that the manufacturing activity in the Chicago area strengthened slightly in January. The headline number rose half a point to 62.4. Production, new orders and employment all rose while backorders, inventories, supplier delivery and prices paid all declined, but remained over 50. The national ISM survey was weaker and showed that the pace of growth slowed in January. The headline number fell 2.2 points to 56.4. This was the lowest reading since September 2003. Most of the decline was due to a 9.1 point drop in new orders. It was the lowest level since June 2003. The pace of production increased, reversing a four-month decline. But it only increased 0.9 points. The employment component jumped 4.8 points, which was the largest increase since August 2001. Prices dropped 3.0 points, but remain at very high at 69. Even after declining for the past eight months, the headline number represents a growing manufacturing sector. It has been above 55 since August 2003. This is the strongest the survey has been since 1987-1998 when 20 out of 22 months were above 55.

Along with the ISM survey that reported an improved labor market, the latest job-cut report from Challenger, Gray & Christmas said there were 92,350 announced job cuts in January. This was the lowest number of layoffs since August and the lowest number of layoffs announced in January since 2000. Additionally, there were announcements to hire almost 30,000 workers, up from 21,262 in December.

After earnings, the big focus for the week is Friday's nonfarm payroll report. Economists currently expect nonfarm payrolls to increase by 200,000. There has been quite a bit of anecdotal evidence showing the labor market continued to improve in January and it appears that the economy is expanding and an increase in payrolls should not be a surprise. There is also evidence that the labor market is tighter than the current data reveal. This along with the pricing pressure throughout the manufacturing will either pressure margins or lead to higher inflation. It is doubtful that the economy will be able to continue to expand without inflation pressure or margin compression. This will happen at the same time as earnings growth slows and should have a negative impact on earnings multiples.

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