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Unrealistic Expectations?


Retailers reported August sales last Thursday, which were very strong, but very disjointed. According to a research report published by CSFB, general merchandisers did all the heavy lifting. CSFBs Comparable-Store Sales Index showed a 4.9% increase in August, which was led by a 6.9% jump in general merchandisers' same store sales. Specialty apparel retailers, which are at the mercy of fashion trends, fared much worse. Big declines from Abercrombie & Fitch (-11.0%), American Eagle Outfitters (-10.4%), and Wet Seal (-10.7%) contributed to CSFB's Specialty Apparel & Accessories Index dropping 0.6% in August. This ended the longest streak of positive comparable stores sales in over two years. The index showed positives growth from April to July. Incidentally, the index has shown positive growth in only 8 months since the beginning of 2001 with 5 of those months occurring in 2003. The lackluster results in specialty apparel caused numerous retailers to miss analysts' estimates. A report from Prudential Securities said that only 46% of retailers met consensus forecasts for August same store sales. This compares to over 70% in the each of the previous three months. As expected, most of the weakness was concentrated in the specialty apparel where only 29% of retailers met or exceeded analysts' estimates. This apparent weakness caused retailing stocks to do an about face. After closing at a three year high early last week, the S&P 500 Retailing index has dropped over 6% in the last five trading days. Considering that the 4.9% comparable-store sales growth measured by CSFB is the strongest growth since March 2002, investors obviously had very high expectations. Even the strong 4.9% comparable-store sales growth undermines the strength of the consumer. Retailers have yet to slow expansion plans and several have been able to deliver double-digit total sales growth.

Retailer Total Sales Same Store Sales First Call Estimates
Abercrombie & Fitch +3.0% -11.0% -8.2%
AnnTaylor +18.0% +8.2% +4.9%
Costco +13.0% +9.0% +6.3%
Dillard's -4.0% -4.0% -2.0%
Dollar General +13.2% +4.5% +5.0%
Family Dollar +15.7% +6.1% +4.5%
Federated -0.6% -0.8% -1.3%
Gap +5.0% +4.0% +7.3%
J.C. Penny +3.9% +6.5% +2.1%
Kohl's +15.8% +3.2% +3.8%
Limited -0.4% -2.0% +0.5%
May Department -1.1% -3.2% -1.0%
Neiman Marcus +10.1% +7.6% +4.8%
Nordstrom +11.3% +3.2% +2.1%
Ross Stores +13.0% +2.0% +2.6%
Sears +4.1% +3.9% +0.6%
Sharper Image +11.0% +9.0% +7.0%
Talbots -2.0% -8.7% -4.4%
Target +12.4% +5.7% +3.8%
TJX +8.0% +1.0% +3.3%
Wal-Mart +13.7% +6.9% +4.9%

On Friday, the Census Bureau will release August sales. Economists expect August sales to increase 1.5% and 0.8% excluding auto sales. Considering how strong auto sales were and the strength in overall retail sales, its likely this hurdle will be cleared. It would also mark the third largest increase since September 2000, only behind the auto buying frenzy in October 2001 and the huge March this year which resulted after the Northeast dug out of a few feet of snow.

On Wednesday, Texas Instruments narrowed revenue guidance to a range between $2.39 billion and $2.49 billion. Analysts' were expecting the chip maker to post revenue of $2.4 billion. The company was not as optimistic about the bottom line. The company only shaved a penny off the high and low end of its previous guidance. Again, investors were hoping for something more, its stock fell 7.5% today. No tears need to be shed for the company. The stock is still up almost 30% since August 8 and up 56% year-to-date. On Wednesday, Adobe Systems announced it earned $0.28 per share in the third quarter, beating Wall Street estimates by three pennies. Third quarter earnings were 27% ahead of last year with revenues increasing 12%. Investors bid up Adobe's stock almost 6% in after-hours trading. It appears at this early stage that third quarter earnings season will offer more fireworks, each way, then the second quarter.

Companies have started updating earnings guidance for the third quarter. Usually it is the third quarter has the most negative earnings pre-announcements. This year, however, the ratio of negative to positive pre-announcements is only 1.7, which is considerable less than the 2.1 last year and 2.1 for the second quarter.

At the end of the second quarter, I was skeptical of the double-digit earnings growth that analysts expected in the third quarter. Over the past two month, analysts have increased estimates for earnings growth. Since July 1, estimates for third quarter earnings growth have jumped from 12.7% to 14.7%. Most of that jump has occurred in just the past 30 days. Most of the upward revisions have happened among technology and communication services companies. Tech earnings are now expected to increase 78% versus 54% two months ago. Similarly, communication services earnings growth estimates have jumped from 24% to 33% over the past two months.

The apparent earnings recovery seems to be concentrated in the largest companies. As mentioned above, earnings of S&P 500 companies are expected to increase 14.7% in aggregate. Analysts' are much less optimistic regarding earnings growth for S&P MidCap companies as well as S&P SmallCap companies. The S&P 400 MidCap companies are expected to boost earnings by 12.3%, while the S&P 600 SmallCap companies will grow their bottom line by only 9.3%. Perhaps the more interesting aspect is that earnings growth has been reduced over the past two months for these smaller companies. Since July 1, analysts have lowered their earnings growth forecasts to 12.3% and 9.3% for the MidCap and SmallCap companies respectively, down from 17.4% and 16.6%. Contrary to what would be expected, the S&P 500 has actually underperformed the S&P MidCap and S&P SmallCap indices this year with virtually all the underperformance coming since the end of the second quarter. During the third quarter the S&P 500 has increased 3.7% while the S&P Midcap added 7.2% and the S&P SmallCap index jumped 10.2%. Additionally, the rally in the smaller companies has resulted in valuations eclipsing the S&P 500. While the S&P 500 trades at a lofty 18.7 times 2003 earnings, the S&P MidCap is valued at 19.3 times while the S&P SmallCap is trading for 20.6 times 2003 earnings. It should be mentioned that analysts' are expecting earnings growth to jump to the 20% range for the fourth quarter this year the first quarter next year. However, for the past three quarters growth estimates started out in the 20% range before dropping to low double-digit or even single-digit growth when the score was finally tallied.

The amount of stimulus that has been infused into the economy through both fiscal and monetary means is stunning. There is little doubt that this is propelling the economy forward. According to the latest survey from the Blue Chip Economic Forecasts, economists increased their estimate for third and fourth quarter GDP growth. The consensus estimate for the third quarter jumped 0.8 points to 4.5% growth, while will grow by 3.9%. The fact that the economy is likely to grow at 4.5%, which might end up being low, and the Fed is sitting on the Fed Funds rate at 1.0% is simply historic. We have discussed in detail the imbalances throughout the economy, and I can almost guarantee that this is not the way to try right the ship.

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