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Cracks in the Foundation?

Last week, retailers reported October same stores sales that were stronger than analysts' estimates. The ICSC's tally of chain store sales increased 4.4%. This was on top of a 4.1% gain last October, which was the strongest month during the second-half of 2005. With retail sales only increasing 1.8% last November, it is likely that retailers will post strong growth in November. November will benefit from Halloween falling on a Monday, since retailers generally close the monthly books on the last Sunday of each month. The ICSC also noted that total sales increased 10.8%, which is the largest increase since June this year. The average monthly gain in total sales has been 10.1% this year. This follows an average gain of 9.7% last year.

Most retailers reported that same store sales were driven mostly by average ticket size and the number of transactions increased less and declined at a few retailers. This was most evident in retailers that sell to lower-income consumers. Dollar General said that it noticed a "payroll cycle," meaning sales were stronger on days on the days workers typically get paid. This is another indication that lower-income households continued to struggle during the month. Conversely, according to the ICSC survey, luxury retailers were one of the best performing categories, along with wholesales clubs and footwear.

Retailers are the last group of companies to report third quarter earnings. On Wednesday, Federated announced third quarter earnings of $0.33 per share, which was much better than the $0.20 analysts were forecasting. The retailer was able to increase its gross margins from 40.4% from 39.8% last year. This is likely to be a trend for the third quarter. Retailers have been able to control inventory levels this year and have not had to markdown merchandise in order to move it. This combined with robust retail sales should result is strong earnings for the retail sector.

This week, Toll Brothers announced that fourth quarter new orders increased only 1%, and were flat excluding acquisitions. This was much lower than analysts' expectations. The main reason the company cited for the shortfall was due to supply constraints. The company said that 25% of its communities had a backlog of 12 months and were not open to new sales. This forced the company to cut 2006 closings from 10,200-10,600 to 9,500-10,200. The company also cited declining consumer confidence and slowing demand. Previous reports of weak orders from the homebuilders have usually been confined to one or two geographic areas. Toll Brothers said that the weakness was widespread and only Las Vegas and Phoenix showed strength. Toll Brothers did say that "it appears we may be entering a period of more modest home price increases, more typical of the past decade than the past two years."

It should be remembered that Toll Brothers is by far has the highest average price, over $700,000, and might not be indicative of the overall housing market. With that said this is one of the first signs that the national housing market is slowing. Both Beazer Homes and Technical Olympia have reported earnings over the past week and didn't see any decline in business. Beazer noted that business has slowed to normal levels in the markets that were red-hot. Beazer issued 2006 EPS guidance at $10.50, which was a little better than Wall Street's estimate of $10.44. It is also 12% higher that 2005 earnings. Technical Olympia raised it guidance for 2006 by a dime to $4.52.

Another indication that residential real estate is starting to slow comes from the rental market. Apartment rentals have started picking up. Apartment Management & Investment, the largest apartment REIT, said that its occupancy increased 2.4% sequentially and 2.7% from last year. Rents are also rising, up 1.1% from the second quarter and up 2.7% from last year. Occupancy continued to increase in October, climbing to 94.7%. Anecdotal evidence from Essex Property Trust hints that the California real estate market is cooling. It said its move-out activity attributable to home purchases dropped to 17.6% from 19.0% last year in Northern California and dropped to 13.0% from 14.6% last year in Southern California.

The non-manufacturing ISM rebounded 6.7 points to 60% after dropping 11.7 points in September. Employment dropped 2 points to 52.9%, which was the lowest level since January. This combined with the lower than expected increase in nonfarm payrolls, indicates that businesses might be getting cautious about the economy. Since the hurricanes hit the Gulf Coast, the employment index of the non-manufacturing ISM index has dropped 6.7 points and gains in nonfarm payrolls have dropped from an average of 200,000 per month this year to a loss of 8,000 jobs in September and a gain of only 56,000 in October. The prices component dropped 3.4 points to 78%, which is the second highest level ever recorded. It is also notable that supplier deliveries jumped 2.5 points to 58.5%. This is the highest level since August 1997 (which is an outlier since the index jumped from 55.5 to 71.5, back to 53.0 in September).

Almost 450 companies in the S&P 500 have reported earnings. Just over 64% of these companies have exceeded earnings estimates and 23.5% missing expectations. In aggregate, S&P 500 earnings are expected to have increased by 16.0% during the third quarter. It should be no surprise that the energy sector had the strongest earnings growth during the third quarter, up 63%. This is the fastest growth since the fourth quarter of 2004. Revenue growth for the third quarter is 13.7%, which is the strongest revenue growth since the first quarter of 2001 when it was 14.0%. This is also substantially higher than it has been the previous two quarter, which were 10.4% and 10.5%. There is little doubt that inflation, especially in the energy sector has boosted revenues. Earnings growth is now expected to slow slightly in the fourth quarter. Earnings growth estimates have fallen from 16.6% to 15.3% over the past five weeks. This slowdown is widespread with only consumer discretionary and financial companies expected to grow earnings faster than in the third quarter.

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