U.S. Economy Shrinks -- Time to Buy Stocks

NEW YORK ( TheStreet) -- The U.S. economy shrank in the fourth quarter for the first time since 2009, when the country was reeling from the worst financial crisis since the Great Depression.

That startled some investors, who are holding back on pushing the S&P 500 to new multi-year highs today. But the weaker-than-expected headline figure masks true trends in the economy: consumers are spending more freely, companies are generating fatter profits and housing is back in a big way.

The Commerce Department said Wednesday that fourth-quarter gross domestic product fell at an annualized rate of 0.1%, a sharp drop from third-quarter growth in excess of 3%. Most economists were surprised by the contraction.

Still, there are a few surprises in the report that back the bull market in stocks. (Investors put a record $55 billion of cash into stock funds in January as the S&P 500 and Dow Jones Industrial Average touch post-crisis highs.)

Consumer and business spending accelerated in the fourth quarter, even as Hurricane Sandy and the so-called fiscal cliff tempered things. Consumer spending rose 2.2%, compared with 1.6% in the third quarter, while business investment jumped at an annualized rate of 8.4%, reversing a third-quarter decline of 1.8%. Personal income gained sharply ahead of year-end tax increases.

Residential investment spending -- up a whopping 15.3% -- gave support to forecasts of rising home prices and demand.

So what caused the U.S. economy to stall in the fourth quarter?

Federal government spending fell at an annualized rate 15% after a gain of nearly 10% in the third quarter. Notably, defense spending tumbled 22.2%. The White House attributed defense cuts to a looming budget sequester. Meanwhile, inventories and exports turned negative after third-quarter gains.

Diane Swonk, an economist with Mesirow Financial, attributed the drop in defense spending to a pullback from wars in Iraq and Afghanistan and a sharp drop in research, development and weapons testing.

"Frankly, this is the best-looking contraction in GDP you'll ever see," Paul Ashworth, chief U.S. economist at Capital Economics, wrote in a note to clients. "First-quarter GDP growth is going to be pretty weak because of the expiry of the payroll tax cut. But there is nothing in these figures to change our view that U.S. GDP growth will accelerate as this year goes on."

" On balance, this report makes us more bullish," wrote Eric Green, an economist at TD Securities. The report "does nothing to shake our view that GDP will shift into the 2.5% to 3% range over the second half." He added that the headline numbers will likely reinforce the Federal Reserve's accommodative interest-rate policy.

Some investors are thinking the same way. Yields on the 10-year Treasury are now above 2%, a level not seen since April. Meanwhile, stocks are mixed in early trading Wednesday.

The GDP report may not tell the real story of corporate America. After all, earnings per share across the S&P 500 will advance more than 10%, according to analyst estimates compiled by Bloomberg. Revenue will rise in excess of 5%, surpassing even the most bullish forecasts on GDP growth.

So what isn't there to like about Wednesday's GDP figures -- in addition to a report from ADP that showed 192,000 new jobs, beating estimates?

Deceptively fast economic growth could prompt investors to buy riskier assets, posing problems for the Federal Reserve, which is working hard to keep rates low until the job market strengthens.

For instance, Peter Tchir, head of TF Market Advisors highlights a surprising surge in Amazon's ( AMZN) stock after the online retailer missed earnings estimates as an indication of some Fed-fueled investor complacency. " The Fed seems to have created a monster that they can't control. Risk, or at least how investors and companies manage around risk, is being changed. Not necessarily for the better."

Tchir is moderately bearish on stocks because of uncertainty surrounding the Fed's continued support of asset prices such as stocks.

Meanwhile, ratings agency Moody's recently highlighted the prospect of a sharp rise in interest rates as a top risk to the banking system, as lenders get back on track. For the Fed, a jump in interest rates could make it more difficult to wind down a balance sheet that's grown in excess of $3 trillion since the crisis.

Even for banks, rising rates may be a long-term opportunity.

-- Written by Antoine Gara in New York

For where to invest in a recovering economy, see Jim Cramer's 10 stock picks for 2013 and Morningstar's list of 11 top takeout stocks.

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