Diffusion Illusion?...Well, its finally official. The third quarter did indeed see blowout GDP growth results. And as you are probably aware, growth in the third quarter was so strong that one has to travel back to the first quarter of 1984 to find a like or greater one quarter GDP growth rate number. Interestingly, 1984 was an election year. Additionally, the first quarter of 1984 was a post recessionary economic recovery period. Many similarities to conditions of the present. Of course one minor difference between our present experience and that of nineteen years ago was that in the first quarter of 1984, our economy produced 1.2 million new jobs. Our current experience is light years away as we continued to lose jobs in 3Q of this year. The strong GDP results for 3Q should have been no surprise to anyone. A torrent of tax related fiscal stimulus aimed directly at consumer pocketbooks was unleashed upon the economy starting July 1. Moreover, we have been getting increasingly positive readings in many recent economic surveys and statistical releases over the past few months. The recent Kansas City Fed number was one of the highest in years. The still relatively young New York Empire State Manufacturing survey recorded a record high last month. The recent Philly Fed index reading was the largest seen since 1996. Also, the latest Beige Book had a positive tone for just about all components of the report with the exception of labor. In fact the only economic release to suggest continuing deterioration in the last month was the Richmond Fed report. Finally, we know that the ISM numbers have been moving up over the last four to five months. Current economic anecdotes suggest that this will continue near term.

But we need to remember that many of the economic reports being highlighted in the media these days as proof positive that we've arrived in the economic promised land are diffusion indices or surveys. Diffusion indexes simply measure a preponderance of directional responses and say very little about absolute dollar levels of economic activity or magnitude of that activity. As long as a number greater than 50% of the respondents in an ISM survey are positive, we're going to get a number above 50 (connoting expansion). Same deal for the NY Manufacturing report, Chicago PMI, etc. This also applies to each subcomponent of these reports including production, employment, orders, backlog and the like. Additionally, there are a good measure of subjective responses in various Fed district surveys. Don't get us wrong, it's quite encouraging to see these reports and surveys move in a positive direction. Theoretically, these reports should precede an actual dollars and cents expansion, or further expansion. Trying to give the economy the benefit of the doubt, these recent responses will hopefully translate into increased and sustainable real economic activity as we move forward.

But for now, the factual data that characterize production, employment and consumer income don't yet provide confirmation of what many of these surveys are suggesting. For all of the table pounding by Street pundits and media personalities that the economy is well on the way to sustained and broad recovery, the dollars and cents facts of the moment beg to differ. At least for now. Yes, 3Q was great, but it was very heavily influenced by direct government stimulus and a meaningful continuation in system-wide credit expansion. As you know, we have witnessed monetary ease and current short term interest rate levels that have maybe been seen one or two other times in US financial history. Never have we experienced three tax cuts three years in a row. Fiscal stimulus is unprecedented. We are running record trade and budget deficits. We have been the beneficiaries of 30-40 year lows in residential mortgage financing rates. And it just doesn't get any better for consumers than 0%financing, profitless (for the manufacturers) car sales. Just what do we have to show for all of these incredibly anomalistic influences? We do have one blow out GDP quarter. But what about the bedrock economic building blocks of employment, household income and actual physical production? Let's see, shall we?

EMPLOYMENT EXPERIENCE

We'll make this brief. We've talked about labor market weakness extensively over the recent past. Despite improvement in the September payroll report (prior to any revisions, of course), labor conditions in the US remain weak. In no way can anyone claim a recovery in labor has even begun based on one month's data, but that's just what many Street seers have already done. The following is an update of a chart we have shown you many times. It is indexed post recessionary payroll employment experience of the last four recessions. It needs little explanation.

We know employment growth is a lagged indicator. Fair enough. But we're now close to two years past the official grand finale of the last recession. We're just about setting a lagged response record in terms of domestic employment growth. Over the last three years we've lost about 3 million jobs in this country. Actually, many these jobs haven't really been lost or misplaced. You can find them today. You just have to travel to China, India, or other foreign ports of call.

PERSONAL INCOME DATA

Again, we'll make it short in terms of discussing personal income strength. The following chart largely tells the story. We rest near a four decade low in terms of year over year personal income growth. Every economic recovery of the past four decades at least has been accompanied by an expansion in the growth rate of personal income well above what has been realized this far into the current recovery. Although an acceleration in personal income growth may be yet to come, we have not seen it yet.

Of course the major culprit in arresting growth in personal income during this cycle is the very slow recovery in wage and salary growth. This variable being the key component of personal income. In the following table, you are looking at the point to point growth in absolute dollar wages and salaries twenty-two months post the official end of each recession period of the last four decades. As you know, the economic diffusion indices have recently shown indications of labor stabilization. But, again, these reports say nothing about the dollars and cents of critical wage and salary growth. As of September, the year over year change in wages and salaries stood at 1.8%. Less than the already understated CPI rate of inflation last time we checked.

What has been a big boost to disposable household income as of late, and a clearly positive influence on 3Q GDP, has been the cash tax rebates to consumers. But in September, household disposable income dropped 1%. When was the last time something like this happened? A few months after the tax rebate checks in 2001 hit consumer mailboxes, that's when. Certainly the tax rebates found their way directly into consumption during 3Q. But looking ahead, the refi and rebate boom are quietly ending.

As a very quick tangential comment, it is clear that never in modern economic history have global wage arbitrage opportunities for corporations been at a level we now experience. This is truly different in the current cycle. Moreover, the Fed and Administration's attempts to reflate the economy over the past few years have been successful in significantly pushing up the price of US residential real estate. Given that wages and salaries ultimately reflect the cost of supporting ever higher mortgages, have rising real estate values and expanding mortgage credit made US labor that much less competitive in the global marketplace? 1.8% year over year growth in wages and salaries is not going to support significant consumer credit expansion ahead given that interest rates may have seen their long term cyclical lows at this point. On a year over year basis in the first quarter of 1984, wages and salaries were up 10%. Now that's a recovery.

PRODUCTION DATA

For all of the implied positives in recent Fed surveys and economic diffusion index readings concerning manufacturing and production, system wide industrial production activity data reveal something a bit less robust. As of the latest report, the year over year rate of change in total industrial production has actually declined. Is this what we should be seeing in a recovery as apparently vibrant as intimated by the blowout 3Q GDP number? History suggests that the definitive answer to that question is no. In 1Q of 1984, the year over year rate of change in industrial production was in excess of 10%.

During the third quarter, strength in industrial production came from only three sectors. Automotive, energy and high-tech output drove all of the quarter over quarter improvement in industrial production. As you know, automotive and energy are notoriously volatile. High-tech is currently the beneficiary of a relatively modest replacement cycle at this point. High-tech output grew at a 25% annualized rate in 3Q. (There is no question in our minds that a good portion of this is related to the current tax law - $100,000 first year write-offs of capital equipment purchases and accelerated depreciation schedules through December of 2004.) For automotive, output grew 22% and for energy it was 5.5%. Collectively, these three sectors account for only 29% of the total industrial production index. The remaining 70+% of the industrial production complex actually declined (0.4)% in 3Q. Unbalanced is the characterization that comes to mind if you ask us. If we are to experience a true economic recovery reminiscent of past cycles, strength in industrial production needs to broaden. And fast.

Certainly in 3Q corporations again drew down inventories. At some point inventory reductions will themselves become unsustainable. We may be very near that point right now. If consumer demand remains high in the quarters ahead, despite stagnant wage growth, production will move higher. Of course it does remain to be seen just how much of an inventory rebuild might be imported. What we suggest is quite interesting and clearly telling to us is the chart below. The fact is that there has been and continues to be a very strong recovery in industrial production taking place as we speak, with current acceleration rivaling experience seen during the best of economic times. Unfortunately for the domestic US economy, the big recovery and acceleration in industrial production is occurring outside of G7 economies. The following chart is an indexed look at industrial production in both the G7 and non-G7 economic spheres since 1995. The 1995 base year is indexed at 100 and the numbers are quarterly moving average data. Get the picture? Quite simplistically, there has been no production recovery in the G7 economies at all over the last few years. For the US specifically, the latest industrial production reading is where the index stood in 1998.

How can we have a sustained economic recovery if we are producing very little? It can happen as long as we continue to consume a whole lot. After all, that's was 3Q GDP growth was really all about.

NEW ORDERS DATA

Very simplistically, we believe the absolute dollar new order numbers for many important sectors of the economy tell a story similar to employment, income and production in terms of lack of significant acceleration relative to prior post recessionary experience.

Although the cyclical stocks have been very strong this year in anticipation of better times to come, the new orders experience for a large cyclical sector such as machinery has been anything but indicative of the type of acceleration usually associated with a broad based economic expansion. As of September, the year over year rate of change in new machinery orders was 4.6%. But on an absolute dollar basis, orders are where they stood in July of last year. Point to point, no growth at all. Initial economic recovery experience is usually double digit year over year growth for machinery. In absolute dollars, new orders for machinery as of September stood at a level that was seen in 1995, and certainly well below experience of the 1995-2000 period. As you can also see, machinery experienced a straight up recovery post the 1991 recession.

New orders for transportation equipment have been relatively stagnant point to point since late 1996. Another clearly cyclical group, and one whose new orders experience was clearly expanding for a good five years post the 1991 recession, the transports are suggesting to us that we are experiencing something other than a meaningful acceleration in economic activity. Stagnant is more the correct characterization of recent new order experience for transportation.

Despite very big strength in autos on a unit volume basis over the past few years, new orders for consumer durables remain well below the peak experience of the late 1990's on into early 2000. The current year over year growth rate in consumer durable new orders reveals a (3.3)% decline. In absolute dollars, new orders for the broad consumer durable sector as of August stood at a level that was also seen in 1997, and also below monthly experience of literally every month during 2002. Relative to last year, this sector isn't stagnating, it's deteriorating. Once again, post the 1991 recession conclusion, the trajectory was straight up.

As mentioned in comments concerning recent industrial production data, the tech sector experienced a year over year acceleration in 3Q. From the lows of 2002, monthly new order experience as of September for computers and electrical products is up about $3 billion. These days, the value of the SOX index can change that much in about five minutes time. But the acceleration has been narrow. Communications equipment is still experiencing very negative new order numbers. It's largely computer related hardware that is advancing. And, again, it has all the earmarks of a replacement and tax incentive driven cycle as opposed to a new cyclical expansion in broad based tech related corporate capital spending. Notice that the significant absolute dollar expansion in new orders has happened in the last five months. Coinciding perfectly with the tax law change for expensing and depreciating capital equipment purchases. Although something more than a replacement cycle may lie ahead, for now, tech related new orders stand where they were in 1997. Moreover, the year over year rate of change experience, albeit from very depressed levels, is now quite near the historical rate of change peaks of the last decade. Could it be that this replacement cycle is already set for a moderation in new orders growth ahead as characterized by annual rate of change? History suggests that as a very reasonable possibility.

Finally, unlike the very important sectors you see above, there are two sectors of the economy that have displayed positive absolute dollar new order trends over the past few years. Without sounding argumentative, we'd suggest that there are anomalistic reasons as to why these sectors have exhibited positive results in terms of new orders experience. The first sector is the defense capital goods sector. As you'll see in the chart below, new orders for defense capital goods have witnessed an increasing trend over the last two to three years. As you'll see below, August just happened to be one of the best seven monthly experiences for new orders over the entire period shown in the chart. The average monthly year over year growth rate in new orders for defense is 33% in 2003. That's a big number. But as you can also see, post the 1991 recession, there really was no acceleration in defense spending at all. Defense spending does not respond to ordinary economic business cycles, but rather sporadic cycles of global geopolitical tension and conflict. It's no mystery that governmental defense spending was a big support to the GDP number in 2Q. But in terms of trying to assess the prospects for a broad based US economic recovery, this data tells us very little outside of the fact that current government spending is accounting for a meaningful portion of today's GDP growth. It just so happens that government spending was up 1.3% in 3Q. Not a huge increase by any means. But remember, this is already on top of 8.5% government spending growth for 2Q.

Lastly, new orders for non-durable goods are actually quite close to their highs seen early this decade. Again, without trying to turn good news into bad, we believe it's important to realize that we are looking at the very sector here that largely represents domestic consumer spending. And you do not need us to tell you for the umpteenth time that the consumer has been supporting the economy almost single-handedly for close to four years now. But what has been supporting the consumer has been historic anomalies in consumer financing opportunities, especially over the past two to three years. Fifty year lows in interest rates sparked the largest US residential real estate refinancing and equity monetization boom this country has ever experienced in its entire history. A boom and financing extravaganza that appears to be coming to a decided conclusion. Moreover, cash tax rebates as well as personal tax rate reductions putting money into the hands of households three years in a row is unprecedented in modern economic fiscal history. Point blank, fiscal and monetary policy largesse over the last two to three years sure helped drive the new orders experience you see below. Finally, we think it's important to note, much like experience in the computer and electrical equipment sector as of late, the year over year growth rate in new orders for non-durables may have already peaked quite near what has been peak rate of change experience of the last decade. We'll see what happens ahead.

As we step back and look at the factual numbers data regarding employment, income growth, production and new orders experience, it's only in areas that have been directly influenced by government spending where we find pockets of absolute dollar new orders strength and acceleration. And that's it. Moreover, as is concretely clear in virtually all of the charts above, new orders experience in the post 1991 recession period was decidedly upward for a half decade at least. Diffusion indices are wonderful as potential leading indicators. Surveys help give us a sense for business confidence at any point in time. But the real tell tale signs of improvement in any economy show up in employment, income, production and real absolute dollar new orders data. And so far, this real data continues to tell the story of an economy that is struggling from the standpoint of having achieved a broad based acceleration, independent of the influence of government spending. Unless these factual data points improve soon, will investors vision of the facts of this recovery start to improve? Economic electroshock therapy has jolted the patient strongly in 3Q, but is the patient really on the road to an independent recovery?

Cap In Hand...As a final little tribute to the fact that we as an economy cracked the nominal $11 trillion GDP mark for the first time in 3Q, we thought it appropriate for a quick check in on the relationship between current stock market capitalization and GDP. The following is an update of a chart we have shown you in the past. Although the basic infrastructure of the economy today is truly different than 50 or more years ago, we still believe the following relationship is relevant in terms of a longer term valuation perspective. And yes, we have corrected a very significant amount of the market cap to GDP valuation excess of the last few years, but as per the chart, the possibility certainly exists that there is more to go in terms of the correction process. As of now, the relationship stands at a value that is close to double the average level of the last 78 years (inclusive of the mid-to-latter 1990's experience). Just as an anecdote, the conclusion of every major bear market over this period ended at a market cap to GDP level well below that average line. We have the feeling that most folks would currently deem a trip back to the average experience as impossible. A trip well below the average experience as unfathomable. But you know better, nothing is impossible on Wall Street. Or more optimistically, everything is possible. As they say on conference calls these days, "Congratulations, great quarter guys".