The US economic condition
July 9, 2004

I had to write this week’s column in advance since I am in Nicaragua on a site visit and far away from cell phones and notebooks. If anything has happened that warrants a comment I apologize in advance; I’ll have to address current issues in next week’s column -- assuming there is something to address.

To follow up on last week’s column I though it might be useful to look at specifics to see what is really happening in the US economy. For some time now I have been saying that the US economy is fragile and that it will not survive higher interest rates or a decline in foreign investment, both of which are unavoidable.

The market is already much less bullish than it was a year ago. The average P/E ratio of the S&P 500 Index is currently at 22, down from over 32 a year ago, despite the fact that earnings are up by 73%. It shows that the market does not believe the incredible increase in earnings is sustainable. If, in spite of a 73% increase in earnings, stocks were up only 14%, I’d hate to see what happens to those stock prices when earnings decline.

A survey of manufacturing activity in the Midwest, one of the largest industrial areas in the US, offered a somber assessment of conditions: prices are rising and demand is falling. The decline in demand means that manufacturers will not be able to pass the increase in costs on to consumers. Lower revenues (for manufactures) and higher costs are a combination that will be devastating to corporate earnings.

As mentioned last week, higher interest rates and the reversal of the wealth effect will reduce consumer appetite for durable goods. The government has now cut its estimate of durable goods orders for cars and appliances that are meant to last three years or more. Durable goods orders fell 3.7% in the first quarter. Demand for non-defense capital goods -- a key barometer of business spending -- dropped 3.5% in May.

Both Wal-Mart and Target have lowered their sales expectations for June and US automakers reported huge declines in June sales. It’s not just the absolute decline that is worrisome. Consumers seem to be opting for lower priced cars -- reflecting both the pressure of higher gasoline prices and, possibly, the end of the spending binge. It’s the wealth effect in reverse.

Most economists, and consumers believe that higher rates will not adversely affect the economy, but the numbers tell a different story. The Mortgage Bankers Association reported a falloff in mortgage activity and a decline in housing demand. At the same time the percentage of adjustable rate mortgages rose to 30% of all new mortgage applications. This shows that consumers are, indeed, tapped out and can no longer afford the less risky, fixed rate mortgages. In some areas only twenty percent of the population can afford the median-price home. This does not bode well for the real estate market.

Household debt is higher than ever. The debt service ratio, an estimate of debt payments relative to disposable income, is the highest it’s been in more than twenty-four years. As interest rates increase it will become more difficult for consumers to maintain their current debt levels, never mind increase their debt to continue spending. Not surprisingly, personal bankruptcies are soaring: up almost fifty percent since 1993. Last year one in every 73 households filed for bankruptcy, at a rate of 185 per hour.

Clearly, the idea that the US economy is on a recovery path is folly. The expansion cycle that began in 1982 has now, finally, ended. Every expansion phase in the business cycle is followed by a down-cycle: an economic contraction -- better known as a recession, or, depending on its duration, a depression. Before a new expansion phase can commence, the distortions from the previous cycle first have to be corrected.

Interest rates are going higher regardless of what the Fed says or does: financing the Budget Deficit will require issuing bonds and the additional supply of bonds will drive up interest rates. It's as simple as that.

Higher interest rates will reduce consumer spending. Less consumer spending will reduce corporate profits, which will reduce economic activity and bring equities prices and real estate values down, making consumers even less willing to spend.

It remains impossible to predict what will happen to the dollar, the stock market and the gold price in the immediate short term, but the medium to long-term trend is in motion. Position yourself now and be patient. The dollar is going down, interest rates are going up, the stock and bond markets are both going down and the price of gold is going up.

Paul van Eeden

Paul van Eeden works primarily to find investments for his own portfolio and shares his investment ideas with subscribers to his weekly investment publication. For more information please visit his website ( or contact his publisher at (800) 528-0559 or (602) 252-4477.


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