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Is The Third Time a Charm?

The past couple of weeks have been dominated by corporate earnings. This week has provided some welcomed economic data to break the monotony. The biggest surprise was that consumer confidence unexpectedly fell 6.9 points to 76.6 in July according to the Conference Board. This was much lower than the 85 reading economists were expecting. The biggest drop was in future expectations, which fell 10 points to 86.4. This was the first drop in three months. The weakness was almost unanimous. More consumers see: jobs as hard to get, business conditions as bad, fewer jobs in six months and income declining. However, consumers continue to voice their support in the "plan to buy" components. Each component increased, with those planning to purchase an automobile jumping to 8.5%, up from just 5.9% last month. This was also the highest percent since October 2001.

The Mortgage Bankers Association index of refinance activity dropped 33% to the lowest level of the year. Purchase applications fell 3.6%, but remain within 10% of the high set in early May. What might prove more alarming was the rise in the percent of purchase applications that are for adjustable rate mortgages (ARM). The percent of mortgages that are for ARMs jumped to 20.6% this week from 16.7% last week. This was the highest percent since the middle of 2000. This provides a little evidence that too many homebuyers are purely speculating in real estate. The increase in the percentage of ARMs when fixed rate mortgages remain near 40-year lows shows that homebuyers are mainly interested in the monthly payment and how large of a house they can afford.

Rounding off the economic news this week will be GDP and Chicago PMI on Thursday and nonfarm payrolls along with the ISM manufacturing survey on Friday. Nonfarm payrolls could mark an important inflection point. Economists expect nonfarm payrolls to increase by 10,000 jobs; this would be the first increase in jobs since January. Economists received some support for these estimates when initial jobless claims fell below 400,000 for the first time since February. Even if the economic data shows the labor market stabilizing, there remains little evidence that employers are anxious to add to their payrolls. Besides most of the earnings growth coming from cost cutting, there are still companies firing workers. On Wednesday, May Department Stores announced it is shutting down 32 Lord & Taylor stores and will layoff 3,700 workers. Additionally, Pillowtex threw in the towel again. For those unaware, Pillowtex makes household textiles under the Cannon and Fieldcrest lines – they make towels. After coming out of Chapter 11 bankruptcy in May 2002, it filed for protection under Chapter 11 again on Wednesday. It has closed 16 plants and will be eliminating over 6,000 workers.

More disappointing news regarding the labor market came for a survey from Mercer Human Resources Consulting. The survey of 1,700 companies found that raises will average just 3.3% in 2003 and 3.5% in 2004. After dropping in 2002 to 3.8%, this would mark three years of sub 4% wage growth. Prior to 2002, consumers were empowered by raises averaging between 4.1% and 4.4% over the previous eight years.

The Federal Reserve Beige Book offered a bit of relief for those forecasting a recovering economy. Most districts reported an increase in economic activity, and only three (Chicago, St. Louis, and San Francisco) reported that economic activity was sluggish. To little surprise residential real estate was strong through all districts, although commercial real estate remains lackluster around most of the country. The big change versus prior reports was the pick up in manufacturing activity. Nine districts had a positive tone discussing manufacturing. Retail activity remained weak in several districts, but about half reported increased retail activity. Companies reported that their costs are increasing, notably healthcare and energy costs.

Corporate earnings have continued to beat analyst's estimate, but have slipped a bit from the earlier pace. Sixty-four percent of the S&P 500 reported earnings that were higher than expectations, while 14% earned less than anticipated. While these earnings have emboldened investors, most of the earnings growth is coming from cost cutting and from the benefit of a weak dollar. Revenue growth in the second quarter was feeble. First Call estimates that revenue growth among the S&P 500 companies was only 3.8%. Furthermore, First Call estimates that the weaker dollar contributed 2% to sales and earnings growth. After reading countless earnings releases from a variety of different companies, this seems low, at least for the larger multi-national firms. I'd ballpark that about 4% to 5% of sales growth came from favorable currency translation. It is difficult to gauge the benefit to earnings since companies hedge their currency exposure by varying amounts. Also, not considered is how a weaker dollar can help U.S. companies' competitiveness in the global economy. A weak dollar allows U.S. companies to lower the prices in local currency and under price domestic competitors. As long as the price reductions are less than the dollar has declined, it will still contribute to sales growth after translation to dollars. Considering companies around the world are trying to cut costs, this has likely helped contribute to sales growth as well.

Investors are further encouraged by companies stating that activity did picked up as the quarter progressed. While most companies have not raised guidance, they are not lowering it either. This has led analysts to raise earnings estimates for the third and fourth quarters. Estimates for third quarter are up to 13.6% and fourth quarter earnings are expected to be an even more impressive 21.6%.

Last week I mentioned that earnings for the third and fourth quarters will be up against tougher year-over-year comparisons. I inadvertently typed in earnings growth from the wrong column. Instead of the 16.6% and 19.9% earnings growth for the third and fourth quarter of 2002, earnings growth was only 6.8% and 9.7%. This remains the highest year-over-year earnings growth since the third quarter of 2000.

With one day left in July, it is likely that highly shorted stocks will outperform the S&P 500 for the fifth consecutive month. While the S&P 500 has added 1.4% thus far in July, highly short stocks added 5.4%. Technology has done a little better shown by the NASDAQ composite gaining 6.1% so far this month.

We will end with the wisdom from our summer intern, Ryan.

Yesterday, Dow component DuPont reported second quarter earnings. DuPont's conference call provided an interesting glimpse into the American manufacturing sector as we attempt to determine when and if the outlook for US industrial production will improve. DuPont and its chemical peers have been in a trading range the past couple of years and at times during this past year have been under pressure due to rising oil and raw material costs. In the past two weeks, however, DuPont, Dow and Eastman Chemical have had a nice run, with DuPont gaining 7% and Dow and Eastman adding 12% each. It would appear that the market thinks the manufacturing sector is poised for a turnaround, with chemicals acting as a leading indicator.

DuPont presently trades at 1.7 times sales and 21 times earnings. For the second quarter, top line growth was nothing to write home about. Sales were $7.4 billion, up 10%, but 5% of that growth was due to currency gains and 4% was due to the net impact of acquired/ divested businesses. DuPont does not offer any insight to when the manufacturing sector will turn the corner. The company stated in its earnings press release that, "Recent month-to-month results for DuPont businesses do not yet signal a clear inflection point in US demand for manufactured goods." Furthermore, in digging into segmented sales for DuPont, we noticed that domestic sales increased 5% over 2Q 2002, yet all of this was due to the net effect of acquisitions, divestitures, or new reporting methods. It does not appear that domestic manufacturers are ordering materials, chemicals among them, in anticipation of this priced-in industrial recovery. Additionally, throughout the conference call, reference was made to low industrial capacity and slowdowns in the automotive and aerospace industries.

Other aspects of DuPont's business are performing admirably in this difficult environment. Agriculture and Nutrition results were strong, as were sales from Asia. The issue is not so much the performance of DuPont as a whole, but what its domestic performance foretells about prospects for the overall economy.

Investors are expecting a second half recovery for the third year in a row. Maybe the third time is a charm, or maybe the clock will strike twelve and the carriage will turn back into a pumpkin. Right now there are several indications that the economy is poised for the long awaited recovery. Several companies have reported that business is picking up. This week's Beige Book also provided evidence that a recovery is likely. Consumers have started receiving the benefits from the tax cuts. However, there are also several companies, like DuPont, that are much more cautious. With interest rates heading back up and taking the wind out of the refinance game, the consumer will face a strong headwind. Economists were hoping consumers would be able to hold up long enough for the manufacturing sector to improve. It appears it might have happened. Unfortunately, the manufacturing sector could start to see end demand falter just as it get out of the starting gate.

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