Why U.S. GDP Contracted for First Time in 3.5 Years

(Make sure to read my important comments today about the stock market in “Where the Market Stands; Where it’s Headed” below.)

The U.S. economy, as measured by gross domestic product (GDP), contracted in the fourth quarter of 2012 for the first time in three and a half years. According to the Bureau of Economic Analysis, U.S. GDP “unexpectedly” declined 0.1% in the fourth quarter of 2012 from the third quarter. (Source: Bureau of Economic Analysis, January 30, 2013.) Economists were estimating growth of one percent in the GDP for the fourth quarter of 2012.

If the first quarter of 2013 proves to be weak for GDP again, the U.S. will have technically entered a recession once more.

What’s behind the contraction in GDP? Defense spending took the biggest cut in 40 years. (Source: Associated Press, January 30, 2013.) But there are other troubles brewing.

Sure, government spending declined. In the fourth quarter of 2012, federal government spending declined 15% in the U.S. economy compared to an increase of 9.5% in the third quarter. Defense spending decreased 22.2% in the fourth quarter, compared to the 12.9% increase in the third quarter of 2012.

Looking deeper into the Bureau’s report, we discover:

• Exports of goods and services adjusted for price change from the U.S. economy fell 5.7% in the fourth quarter. In the third quarter of 2012, exports rose 1.7%.

• In the last quarter of 2012, businesses in the U.S. economy produced less than they did in third quarter of 2012. Inventories increased only by $20.0 billion in the fourth quarter, compared to a $60.3 billion increase in the third quarter and $41.4 billion in the second quarter of 2012.

• The output gap of the U.S. economy—the difference between actual output and what the economy can potentially produce—was $885.4 billion in 2012.

Yes, the stock market is rising (see my “Where the Market Stands; Where it’s Headed” column below), but the U.S. economy is still in deep trouble. We do not have economic growth!

Businesses are nowhere near full production. Consumer confidence has plummeted (see Consumer Confidence Falls to Lowest Level Since November 2011) and thus consumer spending is pulling back.

With consumer confidence falling, and unemployment still high, I don’t expect to see the U.S. economy to get better as the stock market would suggest. Keep in mind that the threats from the global economy to the U.S. are still present. As the eurozone continues to suffer, demand from the global economy is diminishing. Time will certainly tell what’s ahead for the U.S. economy; but my concerns are growing, not diminishing.

Michael’s Personal Notes:

Mark Twain said it best: “Whenever you find yourself on the side of the majority, it is time to pause and reflect.” (Source: Brainy Quote, last accessed January 30, 2013.)

This is exactly what I see happening in the stock market these days—individual investors and stock advisors alike seem to be rushing towards stocks. The optimism is increasing and key stock indices are reaching their all-time highs. But let’s not forget: bull markets crash at the peak of optimism.

As Investors Intelligence’s advisors’ sentiment report suggests, the number of stock advisors bullish towards the key stock indices is progressing towards the danger zone. The number of bulls has increased since mid-November, closing in on an area that suggests markets are near the top. (Source: Investors Intelligence web site, January 30, 2013.)

Similarly, investors are rushing back to the stock markets as the key stock indices are making new highs. Long-term U.S. domestic equity mutual funds saw an inflow of $7.73 billion in the week ending January 9, 2013, and $5.05 billion in the week ending January 16, 2013. (Source: Investment Company Institute web site, January 23, 2013.) Why is this significant? Domestic equity mutual funds have been witnessing continued fund withdrawals since March of 2011.

Unfortunately, as the optimism towards key stock indices rises, and stock advisors turns bullish, the fuel that drives the stock market higher is running out. As I have been saying, corporate earnings—the most important ingredient for a stock market rally—aren’t there. In the third quarter of 2012, the earning growth of companies on key stock indices like the S&P 500 was negative.

We are still waiting on fourth-quarter 2012 earnings growth numbers. But, as of right now, with only 134 out of 500 companies on the S&P 500 having reported their corporate earnings, the earning growth rate sits at 2.3% for the fourth quarter of 2012. (Source: Factset, January 25, 2013.) I won’t be surprised to see this number actually decline, as a significant amount of companies have warned investors about their fourth-quarter earnings.

While corporate earnings pour in for the fourth quarter of 2012, 28 companies on the S&P 500 have already issued negative outlooks about their profitability for the first quarter of 2013.

I am looking at key stock indices rising, investors becoming optimistic, and stock advisors turning bullish as bearish signals It is certainly difficult to predict the exact point of reversal for key stock indices, but it looks to be close by. Be careful, dear reader.

Where the Market Stands; Where it’s Headed:

If you are a long-term reader of Profit Confidential, you are aware of my opinion on the stock market:

In October of 2007, after a 25-year rise in stock prices, we entered a secular bear market. Phase I of that bear market brought the Dow Jones Industrial Average down from 14,164 in October of 2007 to 6,440 on March 9, 2009. At that point, Phase I of the secular bear market was over.

In March of 2009, we started Phase II of the bear market. The purpose of a Phase II bear market is to lure investors back into the stock market with the false sense the economy has recovered and the stock market is a safe place to be again. And guess what? The bear market has done a spectacular job at doing just that!

According to Washington-based Investment Company Institute, stock mutual funds attracted a record $30.0 billion from investors in the first three weeks of January—the best three-week period since 2006! Investors are pouring money into the stock market again, just as the bear wants before he takes the chips away again!

Dear reader; we are getting very, very close to the end of Phase II of the bear market, a period often referred to as the “sucker’s rally.”

What He Said:

“What group of stocks is next to fall in light of the softening U.S. housing market? The stocks of companies that sell retail products to the American consumer, I believe, are next on the hit list. Many retail stocks are already reporting soft sales. In my opinion, they haven’t seen anything yet in respect to weaker sales.” Michael Lombardi in Profit Confidential, August 30, 2006. According to the Dow Jones Retail Index, retail stocks fell 42% from the fall of 2006 through March 2009.