GDP Risk: Too Much Growth

How long can stocks ignore the message of rising bond yields?
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After high-profile earnings and guidance disappointments last week and amid expectations that economic growth will slow, it may seem counterintuitive to say that Friday's fourth-quarter GDP report risks upsetting markets if it is too strong.

But that's pretty much where Wall Street stood on Thursday.

Stronger-than-expected December economic data, together with better earnings, helped the market rebound smartly, with the

Dow Jones Industrial Average

advancing 99.73 points, or 0.93%, to 10,809.47 and returning into positive territory for the year.

Thursday's news that durable-goods orders rose more than expected in December -- 1.3% vs. estimates for a 1% gain, while November was revised up to 5.4% -- brought upside risk to economists' forecasts that growth fell to 2.8% in the fourth quarter, compared with 4.1% in the third quarter. This would mark the first time growth falls below 3% in two and a half years.

A GDP number above expectations, or a stronger-than-expected price deflator -- the GDP's inflation gauge -- may lead bulls to revise their expectations that the

Federal Reserve

, which meets next Tuesday to vote on rates, would stop after one or two rate hikes at most. The GDP deflator is seen rising 2.6%, compared with 3.3% the previous quarter.

"The risk is definitely on the inflation front and its implication for rates," says Owen Fitzpatrick, head of U.S. equity at Deutsche Bank.

The bond market fell for a third consecutive day Thursday after the durable-goods data and the fed fund futures are now fully pricing in a rise to 4.75% by mid-2006. The benchmark 10-year Treasury bond dropped 10/32 while its yield, which moves inversely, rose to 4.51%, its first move above 4.50% since mid-December.

But higher bond yields didn't pressure stocks. Instead, the data also helped the yield curve, which plots the yields of short- vs. long-term bonds, steepen slightly, giving a boost to financial stocks such as

Goldman Sachs

(GS) - Get Report

. Banks make money by borrowing at cheaper short-term rates and lending at higher long-term rates. Financials were also boosted by news that

FirstData

(FDC) - Get Report

plans to spin off Western Union. The S&P financial sector index rose 1.6%, and the broad

S&P 500

index advanced 9.15 points, or 0.72%, to 1273.83.

The

Nasdaq Composite

, meanwhile, rose 22.35 points, or 0.99%, to 2283.

Altera

(ALTR) - Get Report

rose 3% after posting strong earnings Wednesday after the close.

After the closing bell Thursday,

Microsoft

(MSFT) - Get Report

reported record quarterly revenue of $11.84 billion an earnings in-line with expectations.

Microsoft's revenue was a bit shy of Wall Street's expectations and its guidance basically in line with expectations. But Microsoft shares were recently up 1.4% in after-hours trading while

Broadcom

(BRCM)

was recently up more than 20% after reporting blockbuster results. Thursday's after-hours action reflects how the prevailing mood has moved away from the "doom and gloom" scenarios seen last week. This also supports the idea that the market will look at the GDP with the Fed in mind, says Deutsche Bank's Fitzpatrick.

Most economists do expect the economy to slow this year, and that seemed to jibe with the disappointing guidance some high-profile firms issued last week.

But as usual, the devil was in the details. It seems likely that

Apple

(AAPL) - Get Report

,

eBay

(EBAY) - Get Report

and other high-profile companies were more the victims of overly bullish expectations about their prospects rather than a downturn in their industries or a slowing economy.

Two weeks ago, there were also some disappointing earnings from cyclical companies, whose fate is closely tied to the economy, such as

Alcoa

(AA) - Get Report

and

DuPont

(DD) - Get Report

. These firms are among those feeling the pinch of rising energy costs, which they are unable to pass on to customers. In addition, both firms derive a chunk of their revenues from the ailing auto industry; to wit,

General Motors

(GM) - Get Report

reported another staggering loss for the fourth quarter, sending its shares down 3.4%.

Indeed, the key reason that growth is forecast to have dropped last quarter is a slump in auto sales, following a third-quarter surge as automakers used incentives to get rid of inventories. That means consumption is expected to have increased by less than 1% last quarter, making it one of the worst quarters since 1991.

But other cyclical companies, which have had an easier time passing on rising energy costs, said they continued to do well.

Caterpillar

(CAT) - Get Report

cited "unprecedented demand" from the mining and construction sectors for its strong earnings and outlook for 2006.

UPS

(UPS) - Get Report

, likewise, had strong earnings and guidance, even if its quarterly number missed Wall Street expectations by 1 cent.

As the U.S. economy continues its sometimes painful shift away from manufacturing towards toward becoming even more service oriented, it seems that the hits brought by higher energy and higher interest rates remain contained to a few industries.

"Excluding autos, however, the consumption figures look considerably less grim," says Ethan Harris, chief economist at Lehman Brothers, noting that consumption picked up late in the quarter and will likely continue to support growth -- at least early in 2006.

Economists also cheered that the durable-goods orders data pointed to

improved capital spending by firms, which many on Wall Street have been betting on to support economic growth should consumers falter this year.

At this point, what will happen to the economy remains a matter of speculation. But with stronger economic indications, decent earnings, and another one-day rally under its belt, Wall Street will likely feel cautious ahead of the Fed meeting Tuesday.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

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