Reply #9: It's all about the data

[54anickel]

http://www.prudentbear.com/midweekanalysis.asp

On Tuesday, the Federal Reserve released the minutes from the December 13 FOMC meeting. Last month, the Fed removed the reference to policy being “accommodative,” which signaled that further increases would be limited. The minutes confirmed this assessment. The committee said that “future action would depend on the incoming data” and added “given the information now in hand, the number of additional firming steps required probably would not be large.'

The problem with this assessment of the economy is that the economy is not balanced. While growth in several areas of the economy has moderated recently, it is likely that the drop in interest rates will boost economic activity. This has happened a few times over the past two years, with housing being the driving force. Residential real estate is still the wild card. If mortgage rates drop again, or lenders continue to find creative ways to finance homebuyers, economic growth will likely reaccelerate.

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Earnings estimates have dropped slightly since the beginning of December. Analysts now expect earnings for the S&P 500 to increase 13.0%, down from 13.5% last month. This is substantially lower than hen the fourth quarter started. On October 1, earnings were expected to increase 16.6%. This would be the first time since the second quarter of 2002 that earnings didn’t exceed the estimates at the beginning of the quarter. It is also worth noting that the last time the trend switched from beating initial estimates to missing was the third quarter of 2000.

Margins have improved over the past couple years as companies reduced costs. These lower costs were further leveraged by a strong rebound in economic growth. Most cost cutting measures have already been done so it will be difficult to squeeze anymore margin improvement from cost cutting. Additionally, companies were able to recapitalize their balance sheets at much lower interest rates, which also boosted margins. Without margin improvement, earnings growth will more closely align with revenue growth. During 2004, earnings outpaced revenue by an average of ten percentage points each quarter. During the first three quarters of 2005, this has dropped to only about three percentage points. Earnings expectations are high for 2006 with analysts expected 13% earnings growth. This will likely prove too high if the economy slows and if the economy does not slow, investors will have to face higher interest rates.

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