by Calculated Risk on 10/01/2006 12:40:00 AM

From the NY Times: Is the Corporate Profit Machine About to Sputter? Here are some negative comments:

Thomas M. Doerflinger, equity strategist at UBS [is concerned about the] weakness in housing and a slowdown in consumer spending will eat into profit growth next year, he said. “We are looking for a significant slowdown” in profit growth, to about 4 percent in 2007, he said.

William W. Priest, chief executive of Epoch Investment Partners ... says he believes that some factors that have swelled corporate earnings in the last few years are beginning to turn. Access to cheap labor overseas, along with productivity gains in the United States that have exceeded wage gains, created the best of all worlds for big companies, Mr. Priest said.
...
Mr. Priest also expects to see increasing evidence of retrenchment by consumers. “In the last few years, there’s been an acceleration of consumption relative to income,” he said. “It’s essentially come from the home A.T.M. machine.” But the combination of higher interest rates and declining property values in many areas will make it harder for consumers to draw on the value of their homes.

Over all, Mr. Priest expects profit growth to slow to 3 to 5 percent next year.

Even more pessimistic is Douglas Cliggott, chief investment officer at the hedge fund Race Point Asset Management. Mr. Cliggott expects profits to shrink next year by 10 to 15 percent.

“We’re downshifting from a very favorable environment,” said Mr. Cliggott ...

And the housing bust is the main concern:

Predictions of a worsening housing slump that eventually crimps consumer spending are at the heart of bearish profit forecasts. Already, inventories of unsold homes have been rising, along with mortgage foreclosures, and there is growing evidence of falling prices. Several homebuilders have warned of profits that will not meet forecasts.

And now for some positive views:

But some of the more bullish market watchers do not believe that housing woes will set off a full-blown, profit-smashing recession. “Housing activity is declining faster than we expected, but we don’t expect the spillover effects to produce a general decline in G.D.P.,” said Brian Gendreau, investment strategist at ING Investment Management, a unit of the ING Group. “People still have a large reservoir of housing net worth they can draw on.”.

Steven Wieting, lead economist for domestic equities at Citigroup, is also sanguine about the possible effects of a decline in the housing market. “Industries boom and bust simultaneously,” he said. “Housing could bust and other industries continue to flourish.”

The consumer wealth effect from the long, sustained climb in housing prices should survive any downturn, he said. “If we’re approaching a housing decline, it follows years of wealth accumulation, and that’s not going to be easily reversed.” Still, Mr. Wieting expects a gradual deceleration in profit growth next year, to roughly 7.5 percent.

Do homeowners still have "a large reservoir of housing net worth they can draw on"? Yes and no.

Household equity is at an all time high - because of the rapid increases in prices - but the percentage of equity in household real estate is at a record low of 54.1%. (graph from a previous post)

That may sound like a high percentage of equity, but according to Robert Broeksmit, Chairman of the Residential Board of Governors, Mortgage Bankers Association (from the Senate hearing on Nontraditional Mortgages):

"More than a third of homeowners, approximately 34 percent, own their homes free and clear."

This group is probably risk adverse and it's unlikely they will borrow significantly on their homes to fuel consumption. So the entire debt burden falls on the other 66%. With a record low percentage of household equity, and record homeowner financial obligations ratios, it's hard to see how the housing ATM will continue to support the economy. Especially if home prices start to fall.

And finally some comments from Dirk Van Dijk at Zacks:

AT Zacks, which compiles the analysts’ forecasts that now call for double-digit earnings gains through next year, the research director, Dirk Van Dijk, wonders whether the rosy numbers will come to bloom. “There is some doubt in my mind as to the ’07 numbers,” he allowed. “There are a lot of yellow flags out there in the macro picture.”

I think there are some red flags too.