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CEOs Get Gloomy

CEOs across the county have turned into a gloomy bunch. A survey conducted by The Business Roundtable "raises serious concerns for America's workers, companies and overall economy," according to John T. Dillon, chairman of the Business Roundtable and CEO of International Paper. More specifically, 60% of CEOs expect a reduction in their workforce with only 11% planning to add workers. The capital equipment recovery will be pushed back again. Only 19% expect to increase capital expenditures, 57% plan to maintain the level of capital investment with 24% expecting to spend less. Two-thirds of the CEOs are making 2003 plans based on GDP growth of less than 2%, but 71% expect their own revenues to increase in 2003.

Companies are just about finished reporting third quarter earnings. The tally with 50 S&P 500 companies left to report showed earnings up 6.8% from last year, about 2% higher than the final estimates, but substantially below the 16.6% expected at the beginning of the quarter. All eyes are now on fourth quarter earnings and the second half of 2003. First Call expects fourth quarter earnings to increase about 15% from year ago levels. Analysts are currently at 16.8%, which is far below the 27.7% expected in July. Amazingly, analysts expect earnings to grow 16%, but expect revenue to only increase by 5.1%. In the second (revenue +2.4%, earnings + 1.4%) and third quarters (revenue +4.3%, earnings +6.8%), earnings growth was much closer to revenue growth. Companies have been reducing costs; maybe they can grow earnings three times faster than revenue. But all that cost savings will come at the expense of lower revenue for other companies and less toward payrolls. During the first quarter of 2001, earnings fell 11.5% compared to the 21.6% and 21.5% declines in the third and fourth quarters of 2001. However, First Call also notes that first quarter 2003 "estimates now are in free fall." Earnings growth has been reduced to 15% from 28% since October 1.

The latest rate cut might actually hurt banking profits. Usually, rate cuts result in a steeper yield curve that allows banks to lend money at higher rates than it pays for deposits. However, with rates so low now, banks will risk alienating customers if it drops rates on deposits much lower, but with competition fierce in the refinancing arena, banks will not be able to increase the rates and maintain the business.

One companies cost is another companies revenue. Last week, EDS announced it will not meet earnings projections due to cost cutting at General Motors. After having revenue from GM drop by 14% during the first and second quarter this year, revenue fell 22% in the third quarter.

Last week NCO Group, a leading collection agency, held its third quarter conference call that provided an interesting look at the US consumer. Here are a few excerpts from the conference call that details the perilous condition of the consumer:

"As we have seen in prior periods, we are experiencing a reduction in payment patterns."

"In addition, volumes in the traditional bad debt bank business began to uptick at the end of the quarter. This trend was offset by lower than expected collectibility in our business to business or commercial sector."

"During the quarter, our revenue attainment, which is the amount of revenue we derive from a given amount of business declined slightly and remains below our targeted levels. This is the statistic that points to the strength or weakness of the collection environment at a given point in time."

"I would say that business to business was the last one to get hit, but they have all been affected."

A story in the USA Today on Tuesday, Second homes are first investment choice for many, discussed the popularity of second homes. Previously, I had thought that the market for second homes would soften before residential real estate, but with investors losing faith in the stock market and mortgage rates falling to 40-year lows the second home market is as hot as an Internet stock in 1999. Buyers that have extracted equity from their primary residence for the down payment has grown 60% from the pre-2000 level. The fact that housing inflation is being extracted to purchase additional housing using leverage should cause some concern within the industry. But most are content to view housing inflation as wealth creation and the aging population as a reason for a second home to be a good investment.

Merrill Lynch's latest fund manager survey showed managers are getting a little more positive on the prognosis on the economy and stock market. However, looking behind the results paints a different picture. For instance, 63% expect corporate profits to improve, but 75% think it will be the result of cost cutting. Additionally, 58% would rather see companies using cash flow to repay debt compared to 12% wanting more capital spending and 16% wanting higher dividends. Only 9% would most like to see share repurchases. Also interesting, while 78% expect the stock market to be higher in twelve months, the US is viewed as the most overvalued region by 52% of managers. 23% are thinking about overweighting the US, while 30% are thinking about underweighting the US in the next 12 months. The Euro is voted the most favored currency by 48% of managers, compared to 26% that like the dollar, to no surprise the Yen is least favorable by 45%.

Also from Merrill Lynch this week, Richard Bernstein in his U.S. Strategy Update discusses the lack of pricing power companies have. Merrill found that there were 11 industries that experienced an increase in pricing of at least 1.5%, those industries make up about 7% of the market capitalization of the S&P 500. There were 17 industries which suffered pricing declines of at least 1.5%. These industries combine to make up 30% of the S&P 500's market capitalization. Bernstein used this to discuss deflation or disinflation. We disagree that the inflation/deflation debate hinges on the number of industries that are experiencing a lack of pricing power. The bubble economy of the past couple of years distorted the pricing mechanisms throughout the economy. We will agree that the lack of pricing power caused by overcapacity will damper earnings growth in the future. Bernstein also boiled down what we have been discussing at length recently as the most significant risk to the economy:

First, we have written many times that we view the Fed's easing as a negative, and might actually signal mounting unanticipated credit risk. Some investors pooh-pooh this notion, and suggest that the banking system is in the best shape ever for this part of the economic cycle. That might be true (I'm somewhat skeptical), but it seems to us that the non-bank financial sector is not in very good shape at all. The credit card companies, the GSEs, retail credit divisions, and auto credit divisions have all made statements regarding deteriorating credit quality.

Second, my discussions with Dan Castro (Merrill Lynch's Asset Backed Securities Strategist) and his group lead me to believe that some ABS investors might not be fully aware of the credit risk issues surrounding some ABS securities. This is not to say that the ABS market is in danger. That is not my point. However, it seems to be a viable question as to whether the marginal ABS investor fully appreciates the risks of investing in those securities during a deflationary environment. That might be especially true if the employment situation worsens.

As an aside here, I want to remind you that many times these calls we have discussed the problems facing the consumer. In brief, our belief is that the employment situation will be weaker for longer than is current consensus. We think that companies will attempt to restore profitability by streamlining because of the lack alternative routes. Slow nominal growth in the economy combined with the lack of ready access to external capital leaves companies with few alternatives to restore profits.

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