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What Ad Stocks Say About the Economy

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NEW YORK Last week, the government said consumer prices surged 0.3 percent in October, lifted by the largest jump in gasoline prices in five months. With pump prices expected to reach a new high over Thanksgiving, inflation could be even worse this month. That's just more bad news for retailers, already braced for deep discounting as they enter the crucial holiday season. If merchants are uncertain about what to expect of consumer spending, Wall Street has already decided: Ad stocks are trading near their 52-week lows as forecasters reduce their ad spending estimates for 2008.

The ad industry is seen as a leading indicator of an economic downturn, because ad spending is one of the few large expenses companies can easily cut to boost the bottom line. Observers are making comparisons to the months leading up to the downturn in 2001, but there is a major difference in the current volatility: the outlook for consumer spending. The last time around, consumer discretionary-spending power had not significantly decreased, thanks to then-lower energy costs and interest rates amid a strong housing market. The economy's decline was led by companies because demand was being satisfied by existing inventories and imports.

Retail sales rose just 0.2 percent in October, after a gain of 0.7 percent in September, according to the Commerce Department.

Carl Steidtmann, chief economist with Deloitte Research, said of the current economic signs: "Every business cycle has its own dynamic, and today is very different from 2000-2001, when you had a business investment recession. The consumer skated through that one; this time the consumer is very much at risk. You have a very weak housing market with home prices softening so it's harder to extract equity. The business sector, by contrast, has very strong balance sheets and strong demand from overseas [because of the weak dollar]."

Although the number of consumers cashing in on equity in their property has fallen from its peak, it is still surprisingly strong, equaling 5 percent of real disposable income in the third quarter, according to Deloitte.

Just as the meltdown in tech stocks in 2000 helped precipitate the last economic decline in the business sector, the slump in housing prices is having much the same effect on consumers. Mounting foreclosures are of obvious concern, but the more widespread impact of housing prices in reducing household wealth is eroding consumers' financial confidence. By some estimates, housing prices have more than doubled since 1997, helping to fuel the increase in consumer borrowing against the value of their homes. In September, the price of the median existing home sold was down 4.2 percent.

"It's not just the sub-prime crisis. People have been using their homes as piggy banks, as a way to get cash out of them through refinancing," said Bruce Goerlich, evp, director of strategic resources, Zenith Optimedia.

At the same time, consumers' purchasing power continues to be taxed by the price of oil, which at more than $90 a barrel, is more than 25 percent higher than in August.

Although the jury is still out on what to expect for total industry ad spending in 2007, results for the first half, released in September, revealed sobering signs of caution as it was the first time since 2001 that ad revenue fell for two consecutive quarters. In August, WPP's GroupM projected U.S. spending to climb 2.4 percent this year. GroupM futures director Adam Smith said that percentage would likely be revised downward, to probably a 1 percent gain.

"Housing [is] more serious [than the oil problem] because it's probably more persistent, doing more longer-term damage to consumer demand," Smith said. "The U.S. economy and the U.K. economy particularly depend on consumer demand, much of which has been funded by cheap credit. You turn off those faucets and you're going to suck some out of the economy. It's unavoidable, and that's not good for advertising/marketing."

Some analysts have already come to that conclusion. Joe Arns, with Bank of America, recently reduced his recommendation on Omnicom—the industry's largest player and longtime investor darling—to "sell" from "buy." Arns cited Interpublic Group as a turnaround play, but nonetheless downgraded it to "neutral" from "buy." Arns said he expects ad spending growth to come in at 3.9 percent next year, from an estimated 5.4 percent this year.

According to Alan Gottesman, principal of West End Communications, in a recession "[Marketers] who spend money to purchase [ads] are trying to save money because they see that [sales] revenues aren't what they should be."

At the same time, marketers themselves are feeling the pinch from rising commodity and fuel costs. Procter & Gamble, for instance, is raising prices across the board, increasing the price of Folgers ground coffee by 4 percent and Downey fabric softener by 9 percent last month. Olay and Ivory personal care products, Charmin bath tissue, Bounty towels, Pampers diapers and Gillette blades and razors will all see price hikes in the coming months.

Amid the range of holiday spending forecasts being issued, one thing is consistent: Retail sales are expected to drop as consumers look for more discounted goods and make fewer trips to the mall as gas prices mount. At the higher end, Ernst & Young's consumer products practice expects sales to increase 4.5 percent, down from 4.9 percent in 2006. A more bleak scenario comes from America's Research Group, which expects sales to rise only 2 percent.

Though daily headlines continue to track the macro economic threats of sub-prime lending and soaring oil prices, it's the smaller details that underscore the growing caution of American consumers, who ultimately contribute 70 percent of the country's gross domestic product. ARG's research said 32.4 percent of consumers expect to entertain less at home this holiday season, compared to last year when almost the same number—28.1 percent—said they would entertain more. And last week, when Starbucks released its otherwise robust fiscal fourth-quarter results, the coffee retailer said its U.S. store traffic had slowed for the first time ever.