There is no dearth of information being offered in the mainstream press on the state of the economy. If anything, you'd have to go out of your way to avoid being hit by the current barrage of "everything is just fine" economic reporting and constant repetition of "the economy will continue expanding." But is this necessarily true? If not, how would we discover the true underlying state of the economy?

It's almost universally recognized that mainstream economic analysis is mostly backward-looking. Yet despite this obvious fact institutions dole out millions of dollar each year to pay their legions of economic forecasters to tell them what they see in the rearview mirror. At the same time, business leaders and everyday citizens base their buying and selling decisions on what these academicians see in their extremely limited crystal balls.

The problem with looking at the economic indicators is that for the most part the data only show what has happened in the recent past and cannot be used to predict what is going to happen in the foreseeable future with consistent accuracy. From this is born the classic fallacy of the economist of linear extrapolation, which is to project the current trends forward indefinitely.

Another tendency of the mainstream economist's approach is to be as optimistic as possible, especially when the economic data is mostly positive (as it has been of late). This is probably the biggest pitfall of mainstream economic analysis -- falling victim to the "sunshine and lollipops" syndrome. (This is all the more true when the economist is employed by a major financial establishment as the institutions are always trying to present the rosy picture for their clients and for the general public).

So how can one analyze the economic indicators and at the same time avoid the basic pitfalls described above? First and foremost, by keeping in mind at all times the single most important truth of economics: the Fed controls the U.S. economy through its regulation of the money supply. And it is through the rate of change increase or decrease in money that the economy either rises or falls. All other considerations are germane in comparison to this one.

The 12-mo. rate of change MZM chart (not shown -- above chart is plain MZM courtesy of BullandBearWise.com) shows a somewhat troubling and sharp pullback from the highs of 2001-2003. The Fed of course had been heavily pumping the money supply since 9/11 and that money kept the economy afloat during the 2000-2002 bear market at a time when it was sorely needed. But now that the financial markets have recovered from the 2002 lows and commodities prices have soared beyond the consensus, the Fed has responded by dramatically slowing down money growth. One respected analyst likens this to the doctor taking a patient off the respirator. But there is always the question of how the patient will respond if it is done too soon. We'll soon find out, probably by the fourth quarter, what the outcome will be to the economy. My guess is that we'll see slowdowns in several key areas, including the red-hot homebuilding sector.

Speaking of homebuilding, below is the latest chart of U.S. housing starts, also courtesy of our friends at BullandBearWise.com. You'll note the very pronounced upward spike in new home starts recently, which was in reaction to the improving economic news from earlier this year. This is plainly a blow-off type move as the housing market is reacting too enthusiastically to what is essentially an after-the-fact situation. As we wrote in a commentary last week, many of the new condos and town houses now being built on spec will undoubtedly have a difficult time being sold if by later in the year the economy does show signs of slowing down. As Bert Dohmen has pointed out, buyers can rescind before construction is complete in most states which means many of these "pre-sales" can be cancelled.

The extreme consumer and producer optimism reflected in the housing chart can also be seen in the charts of many key economic indicators, including factory orders. This exuberance is a delayed reaction to the recovery that began in late 2002 as it usually takes 2-3 years for public psychology to respond to shifts in the economy. Will this turn out to be a case of everyone getting too bullish and making major investments at the wrong time? An economic slowdown need not be severe in order to have a negative impact. From a momentum or rate of change standpoint, a slowdown will seem to be exaggerated by comparison of the extreme bullish recovery of the past two years (e.g., a car traveling at 90 mph suddenly forced to slow down to 55 mph -- a normal speed -- will seem very slow in comparison).

Next we turn to the ultimate leading indicator for the economy, the stock market. As Charles Dow used to say, it's the "bloodless verdict of the market" that determines the waxing and waning of America's great financial system and economy. Yet how many mainstream economists take this into account when they perform their intricate analysis of the economy? The stock market is also largely influenced by the Fed through its money supply and securities lending operations and the currents that will eventually ripple through the economy first take their toll on the stock market. As Dow Theory states, the Dow Industrial and Transportation averages are the leading barometers for the business world.

Already the effects of the rate of change slowdown in money supply are being felt in the equities market. You can see the overhead resistance since the 2000 broad market top is starting to weigh against the market once again as the Dow 30 index has failed so far to overcome its yearly high from four years ago. While the Wall Street press keeps hyping the fact that the market recently made a 3 1/2-year high, they conspicuously stop short of mentioning that the 4-year high is far more important from a historical standpoint. The stock market needs to make 4-year rolling highs in order to remain in a strong bull market and so far the Dow and S&P have failed to do this.

While it is too early to predict the magnitude of the coming economic slowdown, it isn't too early to predict its arrival (which should be felt by late 2005/early 2006). Nor is it too early to take precautions and make preparations for it. Some will feel the brunt of it worse than others, particularly those that have over-extended themselves financially. Consumers are way too optimistic over the economic prospects of the next 12-18 months ahead and have shown this optimism by buying second homes, buying extravagant luxury items, and in other ways when they may well come to regret these investment decisions in the months ahead.