The U. S. economy recently shrank for the first time since 2009. Yet the stock market rallied, evidently believing that means the Fed will keep stimulating the economy. But this path is unsustainable, and investors must be aware of the risks.
When gross domestic product contracted  by 0.1% in the last three months of 2012, that helped the stock market finish its best January performance since 1994, with the Dow Jones Industrial Average up 7% since November. It was the best performance since 1989 for the Standard & Poor’s 500.
News of a shrinking economy sparked a rally because it all but guarantees more quantitative easing  (QE) from the Fed, as well as resistance to federal spending cuts. So in today’s perverse market, bad is good. With QE, the Fed buys Treasury and mortgage bonds, in a bid to keep rates low and pump money into the economy.
The timing of the shrinking economy is fortuitous for those who advocate government stimulus. Unless Congress can negotiate a budget deal, we next month face $984 billion in automatic spending cuts through 2021, with the savings going to pay down federal debt, a process called sequestration . Counting the reduction in interest from debt servicing, the total savings to the government comes to $1.2 trillion.
That amounts to a cut of about $55 billion in defense spending and $55 billion in non-defense spending, or a total of just $110 billion a year from a $3.8 trillion budget. That’s just under 3%. Those who oppose the cuts point out that they can reduce GDP and send the economy back into a recession.
Where’s the Growth?
If quantitative easing and federal spending are supposed to cause economic growth, why is growth so stunted over the past few years when we’ve had record amounts of both?
From 1948 to 2012, the GDP  of the United States grew at an annual average rate of 3.22%. Since coming out of the recession, growth is underwhelming , resulting in an unemployment rate that’s hovered around 8% for years. GDP grew at a rate below 2.4% in 2010, just above 1.8% in 2011 and 2.2% in 2012.
Historically, a deep recession means a quick rate of growth in the recovery. For the four post-recession rebounds between 1960 and 1990, the cumulative growth rate was between 15% and 20%. For the three years following the last recession, GDP grew by just 7.13%, according to The Wall Street Journal .
That should indicate that the combination of QE and high federal spending is not helping the economy.
QE is like steroids for the stock market. It pumps up performance in the short-term, but performance is not grounded in reality. It drives investors to take on more risk in pursuit of elusive returns. And in the long-term, like steroids, it is unhealthy.
Both QE and a high rate of federal spending have undesirable consequences like adding to the federal debt and eventually increasing inflation. Current levels of federal spending are unsustainable and lead to an increasing amount of funding needed just to service the debt.
An economy shrinking by 0.1% doesn’t sound too alarming. But another way to look at it is that the economy is not growing.
The federal government had previously estimated growth of 1.5% in the fourth quarter. Instead, we had a no-growth fourth quarter because businesses reduced inventory, instead of purchasing more, government spending was down at all levels and exports, particularly to Europe, were lower.
Inventory reductions could mean good news ahead, as businesses need to buy more as inventory runs low. Even the housing market is consistently improving.
But there’s plenty to be gloomy about. Americans are still adjusting to the loss of another 2% of their incomes to payroll taxes and to other tax increases. The tax increases resulted in a drop in the Conference Board’s consumer confidence index , which fell 8.1 points to 58.6, its lowest level since November 2011.
Increased government spending might result in higher taxes in the future and another hit to consumer confidence. So is increased government spending really the best way to create economic growth?
Investors also need to be wary. QE pushes down bond yields, pushing big investors into stocks to find growth. This artificially supports company shares and further divorces stock prices from corporate performance.
The result is an overvalued market. High stock prices are supposed to reflect expectations of future profits. This is unlikely if the economy as a whole shrinks.
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Brenda P. Wenning is president of Wenning Investments LLC  in Newton, Mass.
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