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Tuesday, September 19, 2006

Earnings, Housing Implications On Consumers, Economic Outlook, Commodities & Small-Cap Stocks

By Yaser Anwar, CSC of Equity Investment Ideas

Analysts continue to rein-in earnings expectations after an impressive three year run of positive revisions. The decrease in earnings expectations will continue until signs emerge that global economic momentum is set improve.

Further weakness is likely as a cooling US economy weighs on global growth. The offset for global stocks is that fund managers are already very bearish on both US economic growth and earnings prospects over the next 12-months, as gauged by the latest Merrill Lynch fund manager survey.

The Chinese government is determined to cool its hot economy and the pace of U.S. growth is already slackening. Thus, economic sensitive industrial commodities are at risk, even though the longer-term backdrop remains supportive. Meanwhile, current high geopolitical tensions mean that the risk premium embedded in oil prices will stay elevated.

From a technical perspective, oil and gas stocks are oversold relative to their metals counterparts and, thus, have some upside. The ratio of oil relative to base metals commodity prices is low. Hence, the backdrop is positive for oil and gas stocks in comparison with industrial metals equities.

Accordingly, a weaker growth environment appears to have already been partially discounted. Hence investors should expect directional uncertainty in equities until yearend based on Q3 earnings results before prospects improve next year.

The Fed's rationale for pausing is that much of the recent pickup reflects gains in the rent component. Outside of rents, core consumer price inflation remains fairly well contained. Moreover, the labor market remains calm and most wage cost measures are benign. Whether the consumer inflation expectations recede as the economy slows and house price inflation turns negative remains to be seen.

Home sales growth continues to contract on an annual basis, while inventories of both new and existing houses have surged in the past year. Housing affordability remains at decade lows, suggesting that housing weakness will persist.

This is a major risk for the consumer sector- housing equity withdrawal had been a massive support to consumer spending in recent years, but with little house price gains in the pipeline, equity withdrawal is drying up. Bottom line: consumers are losing an important source of funds and further weakness in consumption is in the pipeline.

Economic conditions are only partly in place for a Fed pause, based on past cycles. Nonetheless, policymakers are fearful of going too far. Even if the Fed signals a stop this week and bond yields stabilize, the interest burden for US consumers will continue to rise sharply as ARMs and other short-term loans are rolled over at higher interest rates.

The total rise in the interest burden will be much larger than occurred during the 1990s soft landing and could approach levels that preceded the 1990 recession. A recission may not be in the cards now but there will be growing headwind for US consumers.

Small cap stocks have surged into overshoot territory over the past few years, fueled by a steady diet of easy money and rapid economic growth.

In fact, relative performance has reached an extreme, two standard deviations above its 20-year trend. While markets can stay overbought for a prolonged period, the conditions supporting small cap outperformance have begun to fade: liquidity is draining from the financial system at the same time the main engines of growth are slowing, namely the US consumer and Chinese investment growth.

These forces have helped set in motion an upturn in financial market volatility and act as the catalyst to return to large cap leadership.

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