Economic Archaeology

Story Highlights:

• US stocks rallied Wednesday despite worse-than-expected first quarter GDP data.
• The headline number seemed dour, but investors uncovered reasons for optimism.
• Inventory reduction and personal consumption were notable positives, and some seemingly negative aspects were actually positive.
• Today's market reaction is a small example how markets can quickly move higher in expectation of better economic times ahead.

_______________________________________________________________________________

In the 1981 film Raiders of the Lost Ark, archeology professor and part-time treasure-hunter Indiana Jones saved the world by preventing evil villains from obtaining the Ark of the Covenant, a biblical chest said to offer its holder unlimited power. Despite incredible odds, Jones's tireless conviction prevailed, and after deciphering mysterious hieroglyphics, he uncovered the Ark and saved it from evil use. The film closed with the Ark lowered into a wooden box and slowly wheeled into a massive warehouse piled high with inventory. A key to deciphering today's economic revival might lie in warehouses or other obscure places. Today, investors bid up stock prices after a bit of economic archeology; decoding a seemingly dour GDP report and uncovering reasons for optimism.

Wednesday's preliminary GDP report revealed economic growth in the first quarter well below expectations. GDP decreased at an annualized rate of -6.1% versus an expected -4.7% drop. But underneath the headline number were potential future economic treasures.

The report unveiled a dramatic decrease in inventories. This decreased GDP growth for the quarter, but is a significant positive looking ahead. As we've noted, this recession began with exceptionally lean inventory-to-sales ratios compared to past recessions—important because slim inventories mean new sales cause firms to place new orders. Improved inventory management has allowed firms to keep lower inventory levels in recent years and cut stockpiles faster in response to falling sales. These new systems can lead firms to quickly place new orders as sales improve.

Also on the plus side, personal consumption rose at an annualized rate of 2.2%—higher than expected, signaling consumers may be better off than previously feared. Importantly, personal consumption gains were broad-based across all major consumer categories.

The news wasn't all good. Business investment fell off sharply, and residential construction continues to slide—not unusual for a downturn of this magnitude. But even some negative aspects of the report contained reasons for hope. Government expenditures decreased slightly, lowering GDP growth. Fortunately, upcoming massive fiscal spending should help boost the economy. Inflation was another positive disguised as a negative, rising +2.9% versus an expected +1.8%. Higher-than-expected inflation reduced real GDP, but also eased anxiety about deflation.

We can't know precisely when the economy will turn around, but there are reassuring signs recovery isn't as far off as feared. The market can rise quickly without warning as it begins to discount economic recovery invisible in official statistics for months to come. In the battle between good (meeting your long-term investment objectives) and evil (succumbing to emotionally-charged short-term market volatility) ask yourself, what would Indiana Jones do? We think he would stay focused on his objective and not let hostile natives, gun-toting villains, or volatile seas deter him; we think you should follow his example.