The markets were down sharply yesterday on negative news from big retailers indicating the housing spillover is getting worse, not better. Yesterday Home Depot lowered its 2007 earnings expectations, announcing earnings per share for the year would drop 15%-18%, greater than the 15% drop previously announced in May.
"We look at the overall market and there's still a correction that lies ahead of us," Chief Executive Frank Blake told analysts. "But we're pretty far ahead in the correction process."
Shedding light on how bad things are for Home Depot, same-store sales are expected to tumble in the mid-single-digit range, marking the second time in Home Depot's history that it has seen negative same-store sales. Total retail sales are expected to slide 1%-2% for the year, greater than the 0%-1% originally estimated.
Also weighing the markets down yesterday was Sears announcement that second-quarter earnings will be in the $1.06 to $1.32 a share range, roughly half Wall Street's call of $2.12 a share. Sears reported that same-store sales fell 4% at U.S. Sears stores, with declines witnessed across most categories and the greatest weakness seen in home appliance sales.
Durable good sales, such as home appliances, have been steadily loosing ground to nondurable goods sales, such as food and beverage, as the economy slows, and the poor home appliance sales at Sears comes as no surprise and does not look to reverse course any time soon.
Figure 1
Source: Moody's Dismal Scientist
Sales at the big retailers are likely to fall even further with their share prices following suit. Railcar shipments are contracting strongly, with the year-over-year (YOY) rate of change falling deeper into negative territory, with retail sales following railcar shipments lower.
Figure 2
Source: Moody's Dismal Scientist
Figure 3
Source: Moody's Dismal Scientist
The weakness in retail sales is coming from the loss of the home ATM, with mortgage equity withdrawl (MEW) falling sharply after peaking in 2005, coinciding with the housing price appreciation peak, with retail sales following a similar pattern.
Figure 4
Source: Moody's Dismal Scientist
Notice that the YOY rate of change in retail sales began to follow the trend in MEW starting in 2000. This coincides with an explosion in the rate of growth in household home mortgage debt outstanding that leaped upwards around the same time and is now decelerating.
Figure 5
Source: Moody's Dismal Scientist
As mortgage debt growth has decelerated, so too have retail sales as a result of higher interest rates. On average, since 1980 the Federal Reserve has lowered the Federal Funds rate ten months after a contraction begins in the YOY rate of change in retail sales. This is shown in the figure below with retail sales lagged by ten months. The Fed should have been lowering interest rates by now as retail sales peaked in May of last year, more than thirteen months ago. So why is the Fed content to stand pat?
Figure 6
Source: Moody's Dismal Scientist
One reason the Fed remains on pause is it continues to see strength in the economy, citing strong job growth as support. However, job growth over the past year is likely weaker than what is reported by the Bureau of Labor Statistics (BLS) due to their birth/death model adjustment (BDA), sending a false message to the Fed.
This is pointed out by Paul Kasriel, Senior V.P. and Director of Economic Research at Northern Trust. His commentary is provided below: Daily Global Commentary (July 09, 2007)
Each month the Bureau of Labor Statistics attempts to estimate how many jobs were created (or eliminated) by smaller businesses not yet included in its survey of employers. This estimate is referred to as the 'birth/death' adjustment. In the 12 months ended June, total-not-seasonally-adjusted nonfarm payrolls increased by 1.982 million. During the same interval, the birth/death adjustment contributed 1.111 million jobs to the total. That is, in the 12 months ended June, the birth/death adjustment accounted for 56.0% of the 12-month increase in total nonfarm payrolls.
What has been happening to the relative contribution of birth/death estimates as the economy has slowed in the past year? The chart below shows that it has been rising. In the 12 months ended March 2006, the birth/death adjustment was contributing only 30.9% of the jobs to the change in nonfarm payrolls. The birth/death relative contribution has been trending higher since then. Notice that as the birth/death contribution to nonfarm payrolls has been trending higher, the percentage of small businesses saying that now is a good time to expand their operations has been trending lower. If existing small business managers do not think now is a good time to expand their operations, does it make sense that there are a lot of new small businesses starting up and hiring?
Figure 7
Source: Moody's Dismal Scientist
When the BLS BDA is removed from total nonfarm payroll employment the weakness in employment becomes apparent. Backing out the BDA, four of the last six months in total nonfarm employment witnessed job losses, not gains, with 195,000 jobs lost in April alone.
Figure 8
Source: Moody's Dismal Scientist
Total nonfarm employment growth in the first half of 2007 with removing the BDA has been anemic, with only 124,000 jobs created. That is 71% less than the 430,000 jobs created in the first half of 2006, and 84% less than the 773,000 jobs created in the second half of 2006.
Employment for construction is also weaker than reported when removing the BLS BDA. Like total nonfarm payroll employment, construction employment with the BDA removed has worsened from 2006. The first half of 2006 saw 61,000 construction jobs created while the second half of 2006 reversed course with 42,000 lost. Construction employment has fallen off a cliff with 104,000 construction jobs lost in the first half of 2007 alone, with February witnessing 88,000 construction jobs lost, more than twice the decline seen in the second half of 2006!
Figure 9
Source: Moody's Dismal Scientist
The economy is indeed weaker than financial pundits on CNBC would like to admit, with retail sales contracting, declining vehicle sales, and weakening employment numbers. The longer the Fed remains on pause the greater the risk to the economy, particularly the housing sector and those exposed to it.
Standard & Poor's put 612 classes of mortgage-backed securities (MBS) on watch for a possible downgrade as a result of increasing losses. The move would affect billion in rated securities, though this only represents 2.1% of the rated residential MBS issued between Q4 2005 and Q4 2006.
At risk from the losses in residential mortgage debt are commercial banks, whose holdings of real estate assets are at record levels. The nation's largest commercial banks hold .75 trillion in residential mortgage debt, which accounts more than a third of total assets.
Figure 10
Source: Moody's Dismal Scientist
Losses are beginning to mount with the erosion in various tranches of asset-backed securities (ABS) backed by home equity. The BBB-tranche ABX index calculated by Markit continues to fall to new lows, down nearly 50% since the middle of January. Erosion is spreading to higher quality tranches with the A-tranche down more than 20% since January, and even the AA-tranche recently slid, falling 5% in the past few weeks.
Figure 11. BBB-Rated Tranche
Source: Markit.com
Figure 12. A-Rated Tranche
Source: Markit.com
Figure 13. AA & AAA-Rated Tranches
Source: Markit.com
Erosion in the MBS market will only worsen as we haven't reached peak adjustable-rate-mortgage (ARM) resets. The resets to higher rates are coming at a time when the financial strain on households is at record levels, which will only exacerbate the housing downturn and put further downward pressure on the economy.
Figure 14
Source: Moody's Dismal Scientist
Figure 15
Source: Moody's Economy.com
Though GDP growth will likely rebound in the second quarter, do not expect strong growth for the rest of the year. Paul Kasriel is forecasting GDP growth around 1.7% in the second half of the year, lower than the Blue ChipEconomic Indicators survey, with comments from his latest economic outlook below: U.S. Economic & Interest Rate Outlook (July, 2007)
We hold the view that the second-quarter slowdown in the growth of consumer spending will persist during the second half this year. As such, we see real GDP growth after the modest second-quarter rebound relapsing into weaker growth in the second half--around 1.7% at an annual rate versus the Blue Chip consensus forecast of 2.7%. This relapse, along with moderation in inflation, especially excluding food and energy prices, could induce the Federal Reserve to take out some anti-recession insurance in the fourth quarter in the form of interest rate cuts.If the Federal Reserve cannot lower the federal funds rate because of higher food and energy prices, so be it. But if the Federal Reserve does not begin lowering the federal funds rate early in the fourth quarter, then our forecast of a 2008 economic rebound will be null and void. Rather, we would view the probabilities of the U.S. economy entering a recession in 2008 as rising significantly.TODAY'S MARKET
The markets recovered some of the lost ground from yesterday on merger and takeover activity with steelmaker Gerdau Ameristeel Corp. announcing late yesterday that it was buying Chaparral Steel Co. for .22 billion with speculation mounting that Colgate-Palmolive Co. was interested in buying all or part of Unilever.
The Dow regained 76.17 points (+0.56%) to close at 13,577.87, while the S&P 500 put in a slightly stronger performance, rising 8.64 points (+0.57%) to close at 1518.76 with the NASDAQ closing at 2651.79, up 12.63 points (+0.48%).
Investors sold Treasuries today with the 10-year note yield rising 4.2 basis points to close at 5.08%. The dollar index was down on the day, falling 0.02 points to close at 80.84. Advancing issues represented 52% and 51% for the NYSE and NASDAQ respectively, with up volume representing 62% and 63% of total volume on the NYSE and NASDAQ, reflecting a mixed rally in the markets.
Energy prices were mostly down on the day after a mixed petroleum inventory release, with brent crude down more than a dollar a barrel (-.08) to close at .32 a barrel, and spot Henry Hub rose 3.33% to close at .66/mmBtu. Precious metals were mostly down with gold falling .20/oz, closing at 1.10/oz (-0.33%), with silver down __spamspan_img_placeholder__.02/oz to close at .90/oz (-0.15%). Base metals were all up with lead putting in the strongest performance (+2.64%), while tin displayed the weakest performance (+0.03%).
Overseas markets were mixed with the Brazil's Bovespa index putting in the strongest performance (+0.85%), while Asian markets displayed the greatest weakness, with the Japan's Nikkei 225 index down 1.11% and Taiwan Taiex index down 1.00%
The rally in the markets was broad based as all ten of the S&P 500 sectors were up on the day, with the materials, telecommunications, and industrial sectors leading the charge, up 1.04%, 0.91%, and 0.90% respectively. The greatest weakness was seen in financial and consumer discretionary sectors, both up 0.41%.
