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Manufacturing Starts to Slow Along with Earnings

Recent economic data along with corporate results have signaled that economic activity was more robust in December than previously reported, but has waned since the beginning of the year. One of the first indications of this dynamic was the January employment report. Earlier this month, the Labor Department reported that 111,000 jobs were created in January. While this was lower than the 150,000 economists were forecasting, the revisions to the previous months totaled 99,000 additional jobs. Of the 111,000 new jobs in January, there were 22,000 added in construction, which was the strongest monthly gain since March 2006. This was likely due to the warmer weather at the beginning of January. There were only 104,000 service sector jobs added last month, which was the smallest gain since April last year.

On Thursday, The Federal Reserve reported that industrial production dropped 0.5% in January, and increased only 2.6% over the past year. This was the largest monthly decline since September 2005 and the weakest year-over-year growth since October 2005. Production of motor vehicles continued to be the largest drag in the manufacturing sector. Auto production was down 6.0% from December and off 7.6% since last year.

Another sign that the manufacturing sector has experienced a slowdown last month was the announcement from Parker Hannifin that its January orders increased 1%. Similar to reports from other companies, international business remained much more robust then domestic activity. International orders increased 8% compared to a 4% drop in North American industrial orders. This followed a 2% drop last month and is the first time since July 2003 that orders were negative. Aerospace remains the one bright spot for domestic manufacturing; aerospace orders increased 4%.

Along with anecdotal reports from companies expressing that business has moderated, the ISM manufacturing survey has cast the manufacturing sector in the same light. After rebounding in December to 51.4, the index measuring activity in the manufacturing sector turned back below the 50 level, to 49.3. There was weakness reported in most of the questions asked. Production declined 2.8 points to 49.6 and new orders dropped 1.6 points to 50.3. Prices paid increased the most, up 5.5 points to 53.0.

Fourth quarter earnings have continued to run ahead of analysts' estimates. Earnings for the S&P 500 are now expected to have increased 10.9% in the fourth quarter. Similar to some of the recent economic data, while the fourth quarter was robust, the first quarter has experienced a drop off. First quarter earnings growth expectations have dropped to 4.6%, almost half of the 8.7% growth forecasted just six weeks ago. The energy sector has experienced the largest drop in expected earnings growth, from 13% to -3%. Earnings for consumer discretionary stocks are expected to contract by 5%. Expectations for technology earnings have also dropped, from 17% growth at the beginning of the year to 12% currently, and that is also the sector that is expected to have the highest earnings growth as well. While estimates for financials first quarter earnings have remained constant (+8%), this is the primary reason earnings growth is expected to slow in the first quarter. Earnings for the financial sector increased 38% in the fourth quarter. Earnings growth for the materials sector has dropped a similar amount, from 38% to 9%. Financials account for 27% of all the earnings in the S&P 500, almost twice as important as the next largest sector, energy at 14%.

There is not expected to be an earnings rebound either. Second quarter earnings are expected to increase at a similar 4.8% clip. A small acceleration is expected in the third quarter, but only to 6.4%. The market has been able to shrug off the drop in earnings growth estimates mainly because the surge in earnings from the energy and materials sectors was discounted by investors as they put a discounted multiple on those peak earnings. As an example, ExxonMobile's PE ratio has dropped from about 15 two years ago to less then 12 now.

KB Homes reported fourth quarter earnings this week. The homebuilder reported land impairments of $343.3 million, which caused a loss of $0.64 per share. Homebuilding revenue increased 9%, which was almost evenly split between an increase in units (+5%) and price (+4%). The Southeast was the strongest region with a 29% increase in revenue. Net orders dropped 38%, due in part to a 48% cancellation rate. While its cancellation rate was higher than most of its competitors, it was down from the 53% reported in the third quarter, but significantly higher than last year's 31%. The drop in orders also caused its backlog to fall by 35% compared to last year. The average price in backlog fell 3%, which will pressure margins during the coming quarters. While homebuilders have gotten the benefit of the doubt on the predictions of the bottom in the housing market, the facts do not necessarily point to that. A few weeks ago the Census Bureau reported that there were 2.1 million vacant homes for sale, or about 2.7% of the housing stock. This is significantly higher than previous reports, which have topped out at 2%.

The bout of cold weather late in January boosted montly same store sales. According to Thompson Financial, same store sales increased 3.9% in January and were up 5.2% excluding Wal-Mart. Estimates were for 3.1% and 4.2% respectively. Moreover, 63% of retailers exceeded analysts' estimates. Department store same store sales had the largest acceleration from December and from last year, up 6.6% compared to 3.6% last month and 2.3% last January. The government data also showed that retail sales held up in January. Compared to last year, retail sales increased 4.3% and increased 5.0% excluding auto sales. That was the quickest pace since August 2006. Clothing stores posted a 6.0% increase in sales. Department stores sales were up 1.9%, matching the strongest year-over-year gain since June 2005. General merchandise sales were also strong, up 6.9%. That was the largest increase since April 2006. It is worth noting that restaurants sales decelerated notably, posting a 5.2% increase, the weakest since February 2005. We have been paying close attention to restaurant sales, since this is the most discretionary purchase consumers can make.


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