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(Barron's) The Trader: Jobs Report Sends Dow To Six-Year High

Equity investors got everything they were hoping for last week: strong earnings results and an employment report weak enough to keep the Federal Reserve from raising rates after this week's meeting, but strong enough to ensure the economy grows nicely.
The news sent the Dow Jones Industrial Average to a six-year high of 11,577.74
after a 138.88-point gain on Friday that capped a 1.9% rise on the week. The
index notched its third-highest close ever and now stands within 150 points of
its all-time high of 11,722.98, hit in January 2000. Likewise, the S&P 500 added
15.15 points on the week to close at 1325.76, and Nasdaq tacked on 20 points for
a 2342.57 close.
Lots of excitement was created by the Labor Department's report on Friday that
employers added 138,000 jobs to payrolls in April and the unemployment rate
remained at 4.7%. The jobs added were less than the 200,000 economists expected.

"The market loved the employment number because it believes the Fed doesn't
have to be aggressive going forward," says Peter Zuleba, a senior portfolio manager at Glenmede Trust. The Fed is expected to raise the federal-funds rate
one more time this Wednesday to 5%, before pausing. The news helped interest-rate-sensitive sectors, like financials, utilities and home builders, rally on Friday.
The employment news arrived at the end of a week filled with strong earnings
reports. Through Friday, 423 companies in the S&P 500 had reported earnings that
were up 14% on average in the first quarter, according to Thomson Financial.
That result is better than the 12.6% expected on April 1. Of those reporting,
67% beat expectations, 16% matched and 17% missed, which is better than the
long-term averages of 59%, 21% and 20%. For the full year, analysts hope
earnings will grow by 13.3%.
The positive events of the week were more than enough to offset the negatives:
a declining dollar and high oil prices. The dollar fell to a one-year low
against the euro by Friday's close and is down 7% so far this year. Crude oil
managed to pop back over the $70 barrier on Friday. But the market chose not to
care.
While the 8% year-to-date gain in the Dow and the 6.2% return in both the S&P
500 and Nasdaq are certainly impressive, they pale next to certain segments of
the market. The Russell 2000, which hit an all-time high on Friday, has made its
investors 16% richer in just the past four months, and the once stodgy Dow Jones
Transportation Index -- also at an all-time high on Friday -- has gained 18%
year-to-date.
Picking the right stocks has been even more fruitful. Those lucky -- or wise
-- enough to have purchased Caterpillar (ticker: CAT) at the turn of the year
have enjoyed a 38% gain, while Boeing (BA) has returned 26% and Alcoa (AA)
gained 18%. The leaders list in the S&P 500 has a similar industrial feel:
Allegheny Technologies (ATI) has risen 108% since Jan. 1 and Nucor (NUE) is up
75%.
Commodities continue to shine, as well. Gold is up 32%. And silver, which has
jumped 56% this year, would return more than 150% on an annual basis if its
gains continued at the current pace. The sharp moves have many value investors
who loved these names three and four years ago when they were ignored by the
masses saying the market feels much like it did in 1999 before the technology
market bubble popped.
Shares of both Microsoft (MSFT) and Google (GOOG) have underperformed since
the former kicked off the equivalent of an arms war in the world of Internet
search. Last week Microsoft shares fell 35 cents to 23.80, down from 27.25,
where they it stood before the company's earnings report in late April.
Likewise, Google shares, at 394.30, were down 23.64 on the week, or 5.7%, and
have slid 46 points since late April. But they remain above 360, where they
stood when we penned a skeptical piece earlier this year ("In the Drink," Feb.
13, 2006).
Last week, at a meeting with online advertisers, Microsoft said it will double
research and development spending on its MSN network to $1.1 billion in fiscal
2007, up from $500 million in fiscal 2005. The tech giant also plans to increase
capital spending to $500 million in 2007 from $100 million in fiscal 2005.
Microsoft is surely hoping the surge in spending will boost its 13.2% market
share in search, which is well behind Google's 42.7% share.
Both industry titans can finance a battle for quite some time. Microsoft has a
$33.5 billion cash hoard and Google's is $8.4 billion.
"Microsoft is willing to sacrifice short-term profits to turn up the heat on
Google. The big kahuna is coming into the [search] market in a bit way," says
Fred Hickey, editor of the High Tech Strategist newsletter. "Google can't afford
to lose any market share because its stock is priced for perfection." In the
short-term, all this spending could continue hurting both stocks.
Procter & Gamble (PG) handed investors one of their few disappointments last
week. While the company's earnings rose 7% to $2.21 billion, or 63 cents a
share, beating estimates of 61 cents a share, investors instead focused on net
sales that rose to $17.25 billion, missing analysts' target of $17.6 billion.
The personal-care company also gave an earnings range of 52 to 54 cents a share
for its fiscal fourth quarter ending June 30, below the 55 cents expected.
The news ignited fears that Cincinnati-based P&G's acquisition of Gillette
would nick its performance. Gillette's razor and blade sales rose only 1.2% in
the quarter and sales in the Duracell/Braun segments declined 0.7%. By week's
end, P&G shares had fallen to 55.73, down 2.48 on the week and 11% from their
52-week high of 62.50.
Before washing their hands of the company, investors should realize that
inventory reductions at Wal-Mart Stores (WMT) hurt total P&G sales by an
estimated 1.5 percentage points, William Pecoriello of Morgan Stanley says. The
razor category faced tough comparisons in Western Europe, where M3 Power was
introduced last year. Sales also were dragged down by P&G inventory reductions
in the emerging markets.
Meanwhile, investors overlooked some of the good news in the earnings report.
Procter & Gamble has been able to boost prices to offset increases in commodity
costs, and gross profit margin expanded by 1.1 percentage points. Also, the
operating margin grew 1.7 points, thanks to savings from the merger, volume
leverage and some reduced spending on marketing.
The company should enjoy organic top-line growth of 5% to 7%, lower than the
8% it has seen in the past three years but nothing to whine about, either. P&G
has said it plans to achieve $1.2 billion of cost savings from the Gillette
merger, and its internal forecasts are even higher at $1.5 billion, says Bill
Schmitz, an analyst at Deutsche Bank Securities. Meanwhile, the company's market
share is up in two-thirds of the categories in which it competes.
"The stock is the cheapest in the household group, with some of the fastest
top- and bottom-line growth," says Schmitz, who has a Buy recommendation and a
68 price target on the stock. The company's 10-year average multiple is 19.5,
and it currently trades for 17 times expectations of $3.27 a share in earnings
for the 2007 calendar year.
Barron's thought the stock looked interesting last summer ("A Beauty!" Aug.
22, 2005), with the shares trading at 54, and our view hasn't changed.
Friday's underwhelming jobs report, and resulting hopes that the Federal
Reserve would raise interest rates only once more in the current cycle, sent
home builders' shares soaring in the week's final session, after four days of
miserable news for the sector.
Toll Brothers (TOL) shares climbed more than 4% to 30.85 Friday, despite the
company's report that orders declined 32% in the fiscal second quarter, ended
April 30, following a 29% decline in first-quarter orders. The stock was down 4%
on the week, however, and has just about been halved since last summer's high.
Shares of Hovnanian Enterprises (HOV) followed a similar pattern. The stock
climbed 4% Friday to 36.76, but was down 7.6% over the five days and is well off
its high of 73.40 last summer. Early last week the home builder cut guidance for
its second quarter, ended April 30, to $1.40 to $1.50 a share, down from $1.55
to $1.80. Full-year estimates also were reduced to $7.20 to $7.40 a share, from
$8.05 to $8.40. And, like Toll, Hovnanian's orders dropped -- by 20% in the
second quarter.
In another sign of a potential slowdown, privately held ACC Capital Holdings,
which owns subprime-mortgage-lender Ameriquest, said it will cut 3,800 jobs and
close 229 branches. The company said the move was in response to challenging
conditions in the market and the increasing number of people shopping online and
over the phone for mortgages instead of walking into branches.
While the weakness in the housing sector might have been lost on an ebullient
stock market, which instead focused on lagging economic indicators such as
construction spending (up 0.9% in March) and new-home sales (up 13.8% in March),
we'd suggest studying forward-looking indicators. These include mortgage
applications, tracked by the Mortgage Bankers Association, which rose last week
by 11.3%, to 433.3, but remain unsettlingly close to the previous week's level
of 389.4. That's the lowest reading since November 2003.
The pending-home-sales index compiled by the National Association of Realtors
tells a similar tale. Based on home-sales contracts signed, the index eased by
1.2% in March to 116.2, and is 10% below its August peak.

Bulls hope the slowdown in housing mirrors what happened in 1995, when the
increase in prices lessened but prices never declined and a recession didn't
ensue. So, while Bruce Kasman, head of economic research at JPMorgan Chase, is
calling for total home sales to fall 15% this year and 5% next year, he doesn't
expect housing prices on average to fall. Prices in certain over-extended
markets, such as those on the coasts, are likely to see price declines, however.
Housing will drag economic growth down to 3% but not into a recession, he
predicts, because the Fed isn't yet restrictive.
But the housing sector seems a bit like the proverbial canary in the coal mine
and could well be sending a signal the broader market is ignoring. Douglas
Cliggott, chief investment officer at Race Point Asset Management, a hedge fund,
notes that residential investment stands at 6% of gross domestic product, much
higher than the 4.5% level in 1995 and almost double the trough of 3.3% in '91.
Housing's contribution to GDP hasn't been this high since the 1950s, and is well
above the 4.7% average over the past 50 years.
Any continued slowdown is sure to mean job losses, not just among real- estate
brokers but also in the mortgage-finance industry. Then there are the ripple
effects from a real-estate slowdown, whether they be a decrease in advertising
spent to hawk homes, or the reduction of legal or title fees reaped at closings.
Fewer dollars will be spent to fix homes in preparation of a sale or in the wake
of a purchase.

So, while a housing slowdown doesn't guarantee a recession, it certainly
increases the risk, says Cliggott.

 

 

 
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