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Earnings Start to Slump

Fourth quarter earnings are not as rosy as they have been over the past several quarters. Just over half of the 500 companies in the S&P 500 have reported fourth quarter earnings. So far, 60% have exceeded estimates. It was over 70% last quarter and has been over 60% since the fourth quarter of 2003. Additionally, estimates for first quarter earnings growth have slowed dramatically. At the beginning of the year, first quarter earnings growth for the S&P 500 was expected to be 8.7%, as of last Friday, it stood at 5.8%. Most of the diminution was due to the drop in estimates in the energy sector. Instead of growing earnings 13% this quarter, analysts now expect earnings to decline 1%. Earnings estimates for technology stocks have also come down, now at 13% growth compared to 17% four weeks ago.

The two weakest sectors of the economy have been automotive production and residential real estate and companies tied to those industries have felt the burden. Johnson Controls, one of the leading manufacturers of vehicle interiors, said that North American auto production was down 8% to the lowest production level in 20 years. The company added that production softened more than it expected throught the quarter. The company's auto sales were also weak in Europe, down 4%. Asian-Pacific volumes were flat as Japan was a slight drag that was offset by the rest of the region. The company also has exposure the residential housing in its HVAC segment. It noted that North American residential sales were down 10%.

Eaton also noted that its automotive business was week during the fourth quarter with sales down 6%. It forecasts that auto production will decline by another 4% this year as well. Eaton has benefited from the surge in heavy truck sales ahead of the change in emissions standard that took effect at the beginning of the year. During the fourth quarter, heavy truck sales increased 13% but are forecasted to drop by 27% in 2007. During its conference call the company noted that the manufacturing sector slowed during the fourth quarter as inventories were burned off. The company expects this weakness will spill over into the first quarter, but thinks manufacturing activity will pick up as the year progresses. Overall the company sees economic growth of between 2.5% to 3.0% in 2007 with the second half being stronger than the first six months. Geographically, the company said that Europe was stronger than anticipated led by Germany and Japan is performing similar to expectations.

The surge in heavy truck sales has caused an oversupply of trucks on the road and has pressured results at most trucking firms. Werner reported fourth quarter earnings of $0.31 per share, 14% lower than a year ago and a penny lower than analysts forecasted. Revenue fell 1.5%. This not only pressures trucking firms, but this has put pressure on some of railroads revenue as well. Union Pacific noted in their conference call that the "ample supply of trucks that led to declines in both the domestic and premium segments." Its revenue increased 9% in the fourth quarter, which was almost entirely due to an 8% increase in revenue per car. The company noted that the weaker economic backdrop led to volume increasing only 1%. Its agriculture and energy segments were the two best performing areas with shipments up 4% and 10% respectively and combined with higher prices, grew revenues by 20%. Automotive, chemical and industrial products all saw lower shipments. Norfolk Southern announced that its fourth quarter earnings rose 6.4%, but reduced its forecasts for the first half of 2007. Norfolk Southern has the largest exposure to vehicles and auto parts. Auto shipments fell 16% in the fourth quarter, which was the fourth consecutive quarterly decline. Additionally, weakness in the housing sector helped cause a 7% drop in shipments of building supplies. Total volume fell 3% in the fourth quarter. That was the first year-over-year drop in over three years.

New home sales increased by an annualized rate of 51,000 to 1.12 million in January, plus December sales were revised higher by 22,000. While, this was the best month since April, it was 11% lower than last year. While everyone continues to believe the bottom in housing will occur this summer, there is very little evidence to support this theory. Even the homebuilders say that the bottom is not in sight, but they still believe that the market will start to rebound later this year.

It also appears that the economy was not as weak during the fourth quarter as economists expected. The Commerce Department reported that fourth quarter GDP grew 3.5% compared to the growth of 3.0% economists were forecasting. Thanks to government accounting, the way auto production is calculated for GDP distorted third quarter and fourth quarter GDP. During the third quarter, GDP was boosted higher by this and was reversed out during the fourth quarter. Adjusting for the anomaly, fourth quarter GDP growth would have been 4.7%. While the GDP report is generally viewed as being stronger than expected, there are a few hints that everything is not as rosy as it appears. David Rosenberg, chief economist at Merrill Lynch, noted that while real personal consumption rose 4.4% in the fourth quarter it was helped by a 0.8% decline in the personal consumption price deflator. This was largely the result of lower energy prices, but it was the first time it was negative since 1961. On a nominal basis, consumer spending slowed to a 3.6% annual rate, which is almost half the 7.0% growth during the first quarter.

Consumer confidence rose slightly in January and stands at the highest level since May 2002. While the present situation increased, expectations fell 1.9 points to 94.5. Last month, expectations jumped 4.4 points last month. Better job prospects were the leading cause for higher confidence. The percent of respondents that felt employment opportunities were plentiful increased 2.3 percentage points to 29.9%, the highest since August 2001. Additionally, those that felt jobs were hard to get dropped to 19.7% from 21.3% last month. Economists will get a look at the labor market on Friday when the Labor Department issues the employment report for January. Economists are expecting that 150,000 jobs were created in January, which would be lower than the previous two months. The ADP Employment survey reported that 152,000 jobs were added in January.

The Federal Reserve kept its target rate at 5.25%. Additionally, there has been a shift in opinion over the past month that the Fed will maintain the current level of interest rates much longer that was previously being forecasted. The July Fed funds futures contract is pricing in a 2% chance of an ease during the first half of the year. Traders are pricing in a 74% probability of a cut this year. On December 1, traders were pricing in an almost 100% probability that there would be three rate cuts in 2007 with two happening during the first half of the year.


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