U.S. stocks rallied on Friday despite a disappointing revision to fourth-quarter gross domestic product (GDP).  But then, for now at least, the market doesn’t need even an average rate of GDP growth when below-trend (lower than the long-term average) means the lifespan of QE is extended. 

And speaking of which, Federal Reserve Vice Chair Janet Yellen was out on Friday expressing that policymakers can keep juicing things by communicating that policy will remain accommodative for longer than the market currently expects; STL Fed Bank President James Bullard stated that more QE was not off the table.  It’s really that easy. Of course, stock prices eventually run into the reality that the economy can’t even make it to trend growth even with unprecedentedly easy monetary policy and about the fifth iteration of fiscal stimulus -- this time being the payroll tax rate reduction.  That’s key to understand.

Anyway, back to Friday’s market activity, all 10 of the major indices advanced with financials, basic materials, tech and energy leading the way.  The safe havens of consumer staples, utilities and health-care were the relative losers. 

On the economic front, offsetting the weaker GDP number was the latest reading on consumer confidence that did come in better than expected.  But it’s the stock market driving confidence rather than the other way around…more on that below.

The CRB Index pushed to a fresh post-crisis high.  The energy complex contributed to the move as crude futures bounced back above $98/barrel and gasoline above $2.90/gallon.  But cotton, wheat and corn also played a role as those prices bounced after sliding over the previous few days.

For the week the Dow Industrials fell 2.1%; the S&P 500 slipped 1.7%; and the NASDAQ Composite declined 1.9%.  Mids and smalls lost similar amounts.  The Dow Jones Transportation Average, since we just touched on this index in Thursday’s letter, slid 4.5% for the week.

Market Activity for February 25, 2011

Sector Activity for February 25, 2011

GDP Revision

The first revision to fourth-quarter GDP showed the figure was revised down to 2.8% growth at a real annual rate after initially being reported at 3.2% last month – the consensus estimate was for an upward revision to 3.3%.

Two weeks back we talked about how the revision was going to be pressured by weaker than previously expected retail sales figures, which became abundantly clear when that retail data was released and showed downward revisions for both December and November.  The only thing that would have offset those lower readings was going to be an upward revision to inventories, but that was not the case as the inventory segment of the GDP report came in unchanged from the initial estimate. 

Also weighing on the revision was private investment (as business spending was weaker than previously believed), net exports (as the trade balance didn’t narrow as much as previously believed) and government consumption (as state and local gov’t spending was much weaker – another thing we’ve talked about that will weigh on GDP over the next several quarters as those budgets run into the wall of reality).

Too many economists continue to view this expansion as normal, even remotely normal, which is not the case.  As a result, their models are pointing them in a stronger direction, but it’s wrong.  The fact that we can’t manage 4.5%-5.0% growth (much less the 7.5% that is the average coming out of the three prior-worst recessions of the postwar era), but are muddling at 2.9% now six quarters into this expansion, even with constant short-term stimulus efforts, is a clear sign that things aren’t normal. 

I should also explain that the price indices used to calculate real (inflation-adjusted) GDP crumbled to a very low 0.4% in the fourth quarter, down from 2.0% in the previous two quarters.  This means that nominal GDP is also much weaker than normal – running at 3.8% during this six-quarter expansion when 6.8% is the long-run average and the initial stages of expansion typically run at 10%-plus.  If the inflation gauge used to calculate inflation-adjusted GDP (which doesn’t account for much of the rise in oil prices as most of our oil is imported – the price per barrel of imported oil was 6% higher in Q4 than during Q3) simply matched that of the domestic purchases price index of 2.1% (a gauge that measures the prices paid by U.S. residents) then real GDP would have come in at a pathetically weak 1.7%.   

U of M Confidence

The final revision to the University of Michigan/Reuter’s reading on consumer confidence for February came in at 77.5, up from the 75.1 previously reported two weeks ago and marks the best print since January 2008.

While the measure remains well below average, it has improved very nicely from the low of 55.3 hit in November 2008 and nearly matched that low four months later when the stock market hit its 13-year nadir.  But that’s just it; confidence is being driven by the stock market – it surely isn’t a fabulous job market. 

It’s clear the direction sentiment will take when stocks correct – as occurred during the mid-summer correction when U of M confidence fell back below the 70 mark and consumer activity slumped.  QE can’t augment payroll growth, but it sure can push sentiment higher, at least from deep lows.  As a result, Bernanke will be extremely reluctant to unwind.  But the longer the Fed holds the policy pedal floored and conditions the market and the economy to ultra-low rates, the harsher the reaction when the eventual unwind arrives. 

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Have a great day!

Brent Vondera, Senior Analyst

Phone: 636-449-4900