What a Week: Yippee for GDP but Don't Uncork the Bubbly Yet

SAN FRANCISCO -- Rumors of the economy's demise appear to have been greatly exaggerated, judging by this week's economic data. Friday's stronger-than-expected GDP report supported a growing sense that the economy is on the rebound. Such sentiment aided stocks, as investors surmised good economic news is positive for equities -- even if it potentially makes future Federal Reserve rate cuts less aggressive.

The Dow Jones Industrial Average rose 2.2% for the week while the S&P 500 gained 0.8%. After sustaining steep losses Monday and smaller dips Tuesday and Thursday, the Nasdaq Composite finished the week off 4% despite rallying 2% on Friday.

The Commerce Department reported first-quarter Gross Domestic Product rose 2%, well in excess of the 1.1% forecast by economists. Additionally, inventories fell $7.1 billion in the quarter, the first drop since 1991's fourth quarter. The GDP data followed some other positive economic indicators this week, notably Wednesday's stronger-than-expected reports on housing and durable goods.

"The chances of recession in the near term are now dead," Tony Crescenzi, bond market strategist at Miller Tabak, commented at BondTalk.com. "There is now virtually no chance of recession in the near term as second-quarter GDP is likely to be in positive territory, owing largely to an unwinding of the inventory correction and continued modest growth in consumer spending."

Clearly there are reasons to restrain enthusiasm about the economy's outlook, including:

• The GDP report will be revised twice before it becomes final.

• Durable goods actually fell when transportation orders were included.

• Some analysts expect the housing boom to soon peak, because mortgage rates have been rising.

• The Labor Department reported Thursday that unemployment claims rose to their highest level in five years while the Commerce Department said help-wanted advertising fell to its lowest level since April 1993.

• Friday, the University of Michigan said its consumer sentiment survey fell in April.

Furthermore, Friday's GDP report included a 3.3% increase in the GDP deflator vs. 1.9% in the fourth quarter, suggesting inflation pressures may be building after all. Thursday's employment cost index report also contained some potential inflationary implications. The ECI's 1.1% rise was as expected, but up from 0.9% in the fourth quarter as benefit costs climbed 1.3%.

Reflecting growing expectations for economic recovery -- and the potential for inflation's revival -- the long end of the bond market continued to stumble this week. On Friday, the benchmark 10-year Treasury bond fell a full point to 97 18/32, its yield rising to 5.32%.

Inflation fears were the prime reason behind the European Central Bank's decision to leave interest rates unchanged this week. Among others, Treasury Secretary Paul O'Neill and International Monetary Fund managing director Horst Koehler expressed concern at the ECB's recalcitrance to cut rates in order to spur more growth. Clearly, such issues will be discussed at the Group of Seven industrial nations meeting this weekend.

To date, most U.S. investors feel insulated to the ECB's policies. The euro's strength vs. the dollar was halted Friday as the dollar rallied following the strong GDP data. But if euro strength vs. the greenback resumes and intensifies, it could ultimately result in more inflationary pressures here.

Similarly, many Wall Street participants weren't terribly concerned about developments in Argentina, which was forced to cancel a planned $350 million debt sale early in the week. A debt-relief plan calmed Latin American markets by week's end, but the situation is also likely to be prominently discussed at the G-7 meeting.

Accentuate the Positive

Rather than potential problems abroad, U.S. investors this week chose to focus on the fact there is evidence of economic recovery here, but few market players expect it will prevent the Fed from easing further.

"The near-term outlook for further rate cuts ... is not likely to be affected much as the Fed has indicated that they are concerned about the outlook for capital spending," Crescenzi wrote, noting the latter grew just 1.1% in the quarter vs. double-digit growth rates in recent years.

David Orr, chief capital markets economist at First Union in Charlotte, N.C., agreed: The GDP report "does indicate the economy was not in recession in the first quarter" but "more rate cuts are still likely until the [downward] trend of jobs and profits is seen as stabilizing."

Speaking of earnings, this week contained more disappointments and/or warnings from high-tech firms such as Corning (GLW Quote), JDS Uniphase (JDSU Quote) and Qualcomm (QCOM Quote). Yet there was some positive earnings news from Electronic Data Systems (EDS Quote) and PeopleSoft (PSFT Quote), as well as optimistic comments from Intel (INTC Quote).

Outside of tech, positive results were posted by blue-chip firms such as ExxonMobil (XOM Quote), Disney (DIS Quote), PepsiCo (PEP Quote), Pulte Home (PHM Quote), UnitedHealth Group (UNH Quote) and Bristol-Myers Squibb (BMY Quote).

Energy companies' earnings were clearly the week's standout performers, and their investors were summarily rewarded. The Amex Oil & Gas Index rose 4.7% for the week while the Philadelphia Stock Exchange Oil Service Index jumped 8.9%.

For those who put merit in the contrary implications of sentiment indicators, optimists should take heart that Investors' Intelligence reported Wednesday that newsletter writers who are bullish fell to 43.9% for the week ended April 20 vs. 44.7% the prior week. Additionally, pundits continue to make the "bear market rally" case, while many professional investors continue to tread cautiously.

"A lot of people are taking it one day at a time because the next day things could completely change," Bob Basel, director of listed trading at Salomon Smith Barney, said Friday afternoon. "There's some [decent] activity, but nobody is making big bets one way or another."

The past year has shown the perils of making big bets, particularly on the long side. Skeptics cite myriad potential risks and argue the fundamentals do not justify additional gains, particularly for tech stocks. But taking it one day at a time has recently proven more rewarding.