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The Start of Earnings Season

The stock market has been a dangerous environment for short sellers. The liquidity tap has been wide open for several months, which has helped fuel the rally since the fall of Baghdad. Lately, companies have started to remember that inflated stock prices are a form of currency. This week started out with a flurry of merger activity reminiscent of the good old days. The announcement that Yellow Corp. is acquiring Roadway was the biggest surprise, since it involved a 50% premium. Incidentally, the merger announcement coincided with Roadway releasing second quarter earnings. Besides beating Wall Street estimates by a couple pennies, revenue increased 13% and the company expects to maintain double-digit revenue growth during the third quarter before facing tougher comparisons in the fourth quarter. A recent 5.9% general freight rate increase will help drive revenue growth for the rest of the year. Additionally, the company noted that it experienced a shift in mix. Customers reduced use of the higher priced time-critical service and shipments were smaller and were shipped a shorter distance.

There were a few other companies that reported earnings this week, but next week is when earnings season will be in full force. Only eight S&P 500 companies report earnings this week, but next week 124 S&P 500 companies will report earnings followed by 167 the following week. So far most companies have not disappointed investors. That might change Thursday. Wednesday, Yahoo! dropped over $2 in after-hours trading after it reported second quarter earnings of eight cents, inline with Wall Street estimates. While the company raised its revenue guidance for the second half of year, it was below what investors were already forecasting. Yahoo! revised full year revenue guidance to a range of $1.26 billion to $1.31 billion from $1.22 billion to $1.28 billion. Analysts were already expecting full year revenues to be $1.28 billion and investors were hoping the revised mid-point would be higher than current Wall Street estimates.

Alcoa, the first Dow component to report earnings, beat analysts' estimates, but EPS was a penny lighter than last year. The company said aluminum shipments were down 4.9%, buta shift in mix resulted insales increasing 7%. Confirming obvious trends, Alcoa saw automotive sales flat and strength in residential construction.

DR Horton also proved that residential construction is one of the strongest parts of the economy. The company reportedrecord quarterly sales, which were 29% over last year and the homebuilder reported record backlog. But at this point would we expect anything else?

One of the few S&P 500 companies reporting this week, Pepsi Bottling, met analysts' estimates but posted flat earnings compared to last year. Pepsi noted that US volumes declined 2%, but international volumes rose 3%. Offsetting the volume decline, Pepsi Bottling was helped in the US by a 2% increase in pricing. John Cahill, chairman and chief executive, said during the second quarter the group faced "a number of challenging conditions in our US markets".

Consumer debt grew at a faster pace than economists were expecting in May. The consumer credit report published by the Federal Reserve showed that Americans loaded up on another $7.3 billion worth of debt. Revolving credit grew by an annualized rate of 5.0%, or $3.2 billion, while nonrevolving credit increased by a similar 4.9% annualized rate. Along with the consumer credit data, the Fed publishes data on auto loans. Car buyers continue to finance more over a longer term. But, who can blame them with zero-percent financing. The average new car loan carries a 2.4% interest rate with a 60.7 month term. The amount financed has ballooned since March by 11% to almost $28,000. This also represents 97% of the value of the vehicle. These terms cause buyers to beunder water immediately and remain under water for several years. This week, USA Today carried a story discussing upside-down car buyers. The article referenced that JD Powers and Associates found that the average buyer has negative equity of $1,200, double that of 2000. The article also interviewed a Dallas dealer that said 90% of his customers are upside-down. We have discussed this problem in the past, and the announcement by GM and Ford that they will extend incentives until September ensures that it is bound to get worse.

It is almost amazing that consumer debt levels are 3.3% higher than last year given all the cashout refinance activity. Last year homeowners extracted around $100 billion worth of home equity. The Mortgage Bankers Association predicts mortgage originations will increase 32% this year. This should push the amountof extracted equity to a new high as well. But it looks like the refinance wave could be subsiding. The refinance index tumbled 21% last week to the lowest level since the first week in May as interest rates stared ticking back up. While some of the weakness is due to the July 4th holiday, the seasonal adjustment takes out most of that effect. Without any adjustment the refinance index fell 37%. Also signaling weakness in refinancing, purchase applications only fell 5.5% on a seasonally adjusted basis. However, it should be remembered that refinance activity remains higher than all but three weeks of 2001.

The majority of retailers will release June sales results on Thursday. A handful of retailers have already released results that have been better than expected in aggregate. Most notable were the blowout results from Pacific Sunwear and Chico's FAS. Same store sales at Pacific Sunwear increased 13.4%, while Chico's posted 16.5% growth. On the flip side, Deb Shops and Tweeter saw June same store sales drop 11.7% and 10.0% respectively. Analysts expect June same store sales to increase 2.3% year-over-year on top of last year's 5.4% gain. While same store sales may be strong, it will not necessarily translate into profits for retailers. Most retailers had excess inventory at the beginning of the quarter and saidthe summer would be very promotional. This will likely drive the top line, but not the bottom line. Unfortunately, we have to wait until next month to see how profitable the retailers are.

During the next couple months, consumers will reap part of the stimulus from the new tax bill passed last month. Most parents will receive $400 per child, plus most tax payers will see their paychecks get a little bigger as the new withholding rates take affect. This will likely help consumer spending over the next couple months. The one caveat to the fiscal stimulus courtesy of the federal government is that the states are likely to take a large part of it away. Thereare over $17 billion worth of tax increases purposed by state legislatures. However, most of these will not happen until later in the year and next year.

Maintaining guidance should be familiar refrain this quarter as companies report earnings. It is likely companies started seeing signs of an economic boost during the second quarter. Plus all the discussion of a second half recovery will likely cause managers to believe a recovery is underway and will not alter guidance until it is obvious that it is necessary. The question quickly becomes how much is priced in the stock market? Probably a great deal, and when economic weakness becomes evident the market will likely reverse most if not all the recent gains. The economy still suffers from tremendous maladjustments that cannot be solved by fiscal and monetary stimulus. The earnings this week exemplify the current state of the economy. Alcoa experienced a drop in volumes of 4.9%, while DR Horton and Yahoo! saw sales increase 29% and 42% respectively.

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