UNEDITED

The second quarter of this year was one of the rare times in recent history that gross private investment contributed more to GDP growth than personal consumption. In fact, it was only the fifth quarter since the beginning of 1997 that this has happened. Looking at the recent ISM surveys, it is likely that this happened during the third quarter and might even continue through the fourth quarter. According to the ISM surveys, September was only the eighth month in which the manufacturing survey was higher than the non-manufacturing survey since the non-manufacturing survey started in 1997. Six of those eight months have been in the past eleven months.

Both ISM surveys revealed that business activity moderated in September from the previous unsustainable pace. Last week, the manufacturing survey dropped half-a-point to the lowest level since October last year. New orders dropped 3.1 points to 58.1 and is the first time it has been under 60 since July 2003. Supplier deliveries dropped 3.6 points to 59.6. It was the first time deliveries have been under 60 this year. The prices index fell 5.5 points to 76.0. This was the lowest level since January this year. Bucking the trend, production rebounded 2.1 points in September to 61.6, this was the twelfth month of the previous fourteen that production has been over 60. Employment was the only other component to increase and it reversed a three-month long downturn by rising 2.4 points to 58.1. The White House hopes this translates to a high job growth statistic on Friday. This week the non-manufacturing survey also reported an uptick in employment, it rose 2.1 points to 54.6. Export orders was the only other component to increase. Conversely, import orders posted the largest decline, dropping 7.5 points. All the other declines were nominal; the prices component was the only other one to fall by more than 2 points. It needs to be remembered that while these indexes have fallen recently, they measure the month-to-month changes in activity and have been near record levels over the past few months. Declines are expected and with most components well above 50, it shows that business activity has continued to expand in September, but just at a slower rate.

Every month this year, energy and steel have been on the lists of items that respondents have said are up in price. It's likely that there will not be any relief soon. This week, the world's largest steel producer, Arcelor SA, announced that it may stop shipments to customers that do not accept price increases scheduled for next year. Additionally, the company said it might raise prices for the fifth time this year. Domestic steel producer, AK Steel, reported that it will exceed analysts' forecasts due to strong demand and their ability to increase prices.

We have been chronicling how these higher prices have started to impact corporate earnings. Last week, Caterpillar said that revenues would increase by 25% to 30% compared to last year. This was higher than previously articulated. The company said that, "cost pressures have materialized this year" and did not increase its guidance for earnings growth. The theme of higher costs impacting earnings continues to weigh on companies. La-Z-Boy reduced guidance for the quarter ending October 23, 2004. The company now expects earnings to be between 13 and 15 cents per share, about half of the 29 to 33 cents per share previously forecasted. The primary reason for the short fall is due to, "raw material price increases in lumber and unprecedented increases in steel have risen more significantly than anticipated." Although the company did adjust its pricing, its "backlog during the quarter is not maturing to the new pricing as quickly as we expected and we are absorbing the majority of these prices increases." It's also worth noting that the 75-year old company is transitioning from a domestic manufacturer of recliners to an importer of casegoods. American manufacturing continues to be one of our leading exports.

Consumer spending slowed in September according to the latest ICSC chain store forecast. Last week's tally of chain store sales by the International Council of Shopping Centers (ICSC) dropped to 2.6% on a year-over-year basis from 3.5% last week. Additionally, the ICSC lowered its forecasts for September chain store growth to the low end of the 2% to 3% range it previously predicted.

This past Tuesday was a day that Ruby Tuesday shareholders would probably rather forget. Ruby Tuesday owns and operates approximately 490 restaurants and franchises an additional 240 restaurants. Weak sales for the first quarter and guidance of negative same restaurant sales for the second and third quarters sent the stock reeling 15% on the day.

On top of blended (owned and franchised) negative same restaurant sales of 1% for the first quarter, management said that the second quarter sales started off "very soft" to the tune of a negative 9% comparable number. September's problems were exacerbated by both the hurricanes and a high degree of coupons that the company issued last year. On the conference call, management stated that one of the reasons for their poor sales performance was due to weak consumer spending of "middle America".

You all know this, but it is clear that middle-income Americans have less disposable cash this year than last year. Several factors here are the higher gas prices overlapping tax rebate checks and higher interest rates. All these are resulting in middle income earners having less disposable income."

However, we must give CEO Sandy Beall some credit as he admitted that management missteps have caused "self-inflicted pain" for his company. Included in these was the idea to place all nutritional information on the menus. This didn't go over very well, and eventually the company removed much of this information from the new menus. Ruby Tuesday has decided not to raise prices this year and even reduce prices on some items in an attempt to steal market share from Applebee's and Chili's. Historically restaurants that have lowered menu prices have encountered margin problems.

The homebuilders are among the most hotly debated sectors in the financial markets right now. On Monday evening, Pulte Homes revised its third quarter and full year guidance downward due to signs of tempering home price increases in the Las Vegas region. Apparently in the past few months, new home inventory in the area has nearly tripled. Pulte's Las Vegas cancellation rates have skyrocketed to 75% in September. This compares to an industry average of 25%.

Pulte has been the most aggressive homebuilder in raising prices in Vegas and clearly buyers showed that there is a limit to these price increases. Management said that the cancellation rates were so high because homeowners were having problems selling their existing homes (they bought a new house before they sold the old one), and that customers were better off canceling and buying a cheaper house as prices have declined to that extent.

Pulte management confirmed that they are undertaking what many would consider drastic measures to decrease their cancellation rates in Vegas. For instance, if a home buyer had purchased a home for $200K and their home was in the "backlog" as they say in the homebuilding business, Pulte is calling the customer and offering to lower the price to $180K (an example) so that the customer won't cancel. Because homebuilders have been able to aggressively raise prices of homes in areas like Las Vegas, Southern California, and Washington DC, all these price increases have gone directly to the bottom line. While Pulte is saying that this is a Las Vegas-specific issue, if similar dynamics present themselves in other parts of the country, we could see significant earnings revisions at many of the homebuilders.

This also chips away at one of the main pillars of the bullish story on the homebuilders. Investors have argued that residential real estate is supply constrained and homebuilders are simply creating supply for the excess demand. At the beginning of the year, Pulte said there was about 1,400 homes for sale, new and existing combined. Currently, there is about 14,000. This ten-fold increase was caused by the aggressive price acceleration and one of the basic tenets of economics, higher price produces higher supply.