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Earnings Point to Stronger Growth

Consumer prices dropped 0.5% in September, mostly due to a 7.2% decline in energy prices. While lower energy prices helped tame the headline number, the core rate of inflation rose 0.2% and is up 2.9% over the past year, the largest increase since February 1996. The much discussed, owner's equivalent rent climbed 0.3% and is 4.0% higher than last year. It was the largest year-over-year increase since 2002. Producer prices experienced the same dynamic. Overall producer prices dropped 1.3% in September, however, core prices rose 0.6%. Both were more exaggerated than economists were expecting. Economists were expecting producer prices to drop 0.7% with a rise of 0.2% in the core rate.

While energy costs have declined over the past few months, several other commodity prices have maintained higher prices. Additionally, there is a good chance that managers have changed their thinking regarding inflation and it goes into their business planning much more than it did just two or three years ago. Eaton had comments to this affect during its earnings conference call:

I think we've seen a sea change now personally in the last four years about the industrial economy, once again adjusting to the fact that commodity prices increased. And, if we go back to the 70s, many of us recall that the whole, very important element of anyone's game plan was being able to offset commodity prices and pass them through the supply chain, that went away for 20 years. And really what late 2003 and 2004 and early 2005 was about for many industrial enterprises was learning how to gauge commodity prices and being able to pass them through or work with your supply chain in doing so. I think the economy has learned how to do that, the industrial economy has learned how to do that again. So, I would expect if you saw a big surge, as long as demand is strong, that the economy will pass them on. And our own view, remember, is that the economy, having been throttled by interest rates not just here, but internationally, slows down during the second half of this year that allows us to come back to more term growth in 2007, so I make the comments within that context.

Housing starts unexpectedly rebounded 5.9% in September to a 1.772 million annualized pace. Economists were expecting a slight decline to 1.64 million units. However, building permits fell 6.3% to a 1.619 million rate, the lowest since October 2001. The number of home under construction fell1.2%, but the number of homes completed rose 11.1%. Earlier this week, the National Association of Home Builders reported that its index measuring optimism rebounded by one point to 31 in October. It was the first increase since October 2005, when it was 68. Optimism only increased for the future, which gained 4 points to 41, which offset the 4 point drop in September. Traffic gained a point, while the present situation component was flat.

Ryland Group reported third quarter earnings that were better than Wall Street forecastS and maintained its guidance for the full year as well. Revenue fell 10% due to a 15% drop in closings, which was offset by a 4.7% increase in the average selling price. Ryland's strategy during this downturn was to sacrifice volume in order to maintain price. This led to a huge drop in new orders, down 45.6%. Gross margins fell 320 basis points to 22.5%, this was about half the decline that Lennar had, which has gone the other route and has dropped prices in order to move inventory.

On its conference call, Eaton commented on the residential housing market:

What you have seen this year is as the year has gone on, kind of accelerating weakness on the residential side, a little bit more than we had originally anticipated but not dramatically more. And, I think the way you need to think about residential is, it normally moves in kind of two year buckets. So, that's not likely to be concluded by the end of this year. We would expect that you see a decline again next year in residential. And, so, that's playing out, relatively close. And, I think thinking about residential over a couple of years going down the order of 20 to 25% is not, an out-of-the-box type of dimension.

A couple of trucking companies reported earnings this week that were lower than analysts were forecasting. Werner Enterprises reported that third quarter earnings were $0.31 per share, which was lower than analysts' estimates and only a penny better than last year. Revenue increased 7.3%. The company noted that freight trends in October are weaker than last year and the traditional seasonal pick up has not transpired. Con-way was another trucker that said fourth quarter earnings would be lower than analysts' estimates. It also said that third quarter results were lower than last year. Revenue dropped 0.4%. The company said it tried to be too aggressive on price, which was up 6.4%, which caused tonnage to drop, down 3.9%.

While trucking firms have seen weakness in volume, rails have seen trends improve this year. CSX reported that its trends improved in the third quarter and it expects business to be stronger during the current quarter. Volumes increased 1.8% in the third quarter, which was better than the 1% gain in the second quarter. The company expects volumes to be up 2-3% in the fourth quarter. As has been the case for several quarters, if not years, intermodal volumes were much stronger, up 3.7% in the third quarter and expected to jump 5% to 7% in the fourth quarter. Strong demand for coal and agriculture offset declines in automotive and forest products. The company noted that it benefited from a 5% increase in pricing excluding mix and surcharges.

Manpower noted that its revenue trend softened in June was stable in July and August and then softened again in September to 2% growth. It continued to say that clients are not euphoric about hiring, but they are not seeing any cliffs either. However, the company did comment on the shortage of professional workers:

Now if you were to put that in the context of a talent shortage you'd be seeing a few things. Out of entry-level, mid-level positions in office, clerical and light industrial we are not seeing much wage inflation if at all. When you get into more of the specialty job, the engineering, IT, higher-end office you are seeing some wage inflation and you will - and you're seeing companies want to take those people on because they know that there is a talent shortage and they can't just wait until the last minute.

Recent economic data has shown that the economy has rebounded after a lull this summer, but there remain enough crosscurrents that make it difficult to establish a high confidence factor in estimating the strength of the economy. Third quarter earnings give credence that the soft patch this summer is over as most companies have been exceeding analysts' forecasts. In fact, of the S&P 500 companies that have reported third quarter results, 71% have beat estimates, while only 7.5% failed to achieve Wall Street expectations. While it is early, only 107 of 500 have reported, it does add evidence that the economy has not moderated as much as the Fed was hoping. Plus the two main catalysts for the economy slowing, higher energy prices and higher interest rates, have reversed course. If consumers respond positively to lower energy prices this holiday season, investors will start discounting further rate hikes rather than trying to predict when the Fed will start lowering rates. Another factor to consider is whether companies are starting to get pricing power. The core rates of inflation for both producers and consumers have not moderated with the cost of energy falling, which could be telling.


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