WASHINGTON — The U.S. economy shrank slightly in the final three months of 2012, yet stocks are within striking distance of all-time highs. Is the economy stronger than the statistics say it is, or are financial markets getting ahead of economic fundamentals?
A little of both may be the answer.
The U.S. economy grew at an annualized rate of 2.2 percent for 2011, the Bureau of Economic Analysis reported Wednesday, also noting that the economy's gross domestic product, the broadest measure of sales of goods and services, actually contracted 0.1 percent from October through December.
That's the first time the economy has contracted in more than 31/2 years.
The good news in Wednesday's weak headline number is that the underlying details of the GDP report tell a very different story.
"If you dig deep in the GDP numbers, you saw acceleration in consumer spending, you saw acceleration in housing, and very importantly you saw business fixed spending go from negative to positive," said Nariman Behravesh, chief economist for forecaster IHS Global Insight. "In that sense, there is a lot of underlying good news in that number that is sort of masked by the headline."
A glass-half-empty view is that the economy didn't enter 2013 with a lot of steam. But Behravesh takes the half-full approach, noting the economy grew at an annual rate of 1.5 percent in the second half of 2012.
"We think that we're on track for a first-quarter growth rate of about 2 percent, maybe 2.5 percent, and it will gradually pick up speed," he said. "At the end of the year, barring some craziness from Washington, we could get up to 3 percent."
If he's right, the soaring stock market isn't misfiring. Conventional wisdom is that stocks reflect expectations about the economy three to six months ahead.
"Is sentiment in the stock market optimistic? Maybe, but why shouldn't it be?" said Neil Dutta, head of economic research for Renaissance Macro in New York. "Optimism always picks up early in a recovery. To me, the question is: Do we expect the slow healing process in the economy to continue, to remain in place if not accelerate, if not go forward? I'd argue yes, the economy is going to heal and grow. And is it likely to accelerate? Yes."
Much may depend on what happens with a March deadline for Congress to reach a deal on an alternative package to reduce projected budget deficits or have $109 billion in automatic across-the-board spending cuts this year take effect.
"Markets have been whistling past the graveyard on that. If that would happen, I think it would be a negative event" for the stock market, Dutta said.
Wednesday's GDP numbers are a stark reminder that government spending remains a big part of the U.S. economy. Federal defense spending from October through December fell by an annualized rate of 22.2 percent, dragging down the broader growth rate.
It was the largest quarterly percentage drop in defense spending in 66 years, according to Alan Levenson, chief economist for investment firm T. Rowe Price.
The Federal Reserve continues acting as if subpar economic growth will continue. Its rate-setting Federal Open Market Committee ended a two-day meeting Wednesday with a statement saying it "continues to see downside risks to the economic outlook" and will continue controversial purchases of mortgage bonds and long-term government bonds in order to stimulate the economy.
Those Fed moves are designed in part to help stocks, which have been on a roll and are at five-year highs.
The Dow Jones Industrial Average finished Wednesday off 44 points to 13,910.42. That's just 254.11 points, or less than 2 percent, from the all-time record close of 14,164.53 set in October 2007.
Is this irrational given the sluggish state of the economy? James W. Paulsen, chief investment strategist for Wells Capital Management in Minneapolis, thinks not.
"The broad stock markets are up, yes. But these markets are led by the most cyclical stocks — industrials, emerging markets, financial (sector) stocks, not only in the U.S. but across the world," Paulsen said.