While as of the time of writing the markets have not reacted too much to the announcement that the U.S. economy contracted .1% in 4Q 2012, they should. Investors have been banking on a strong recovery in the U.S. through 2013, and ending with the previous year with a contraction in the economy indicates that growth will not be good through the next year.
Businesses cut down on inventories, cutting 1.27% from GDP growth. While that is a one time occurrence, and growth should be stimulated once businesses decide to expand their inventories again, that was not the biggest reason for the contraction. Cuts in government spending (particularly in the defense sector) reduced GDP growth by 1.33%, with worse to come if the sequester on government spending due on March 1st is not avoided. Such a cut in spending could trigger consecutive quarters of GDP contraction, which would be the start of a recession according to some definitions.
We should be looking across the ocean to Great Britain's example, where cuts to government spending have also triggered even greater economic contraction. The U.S. has the ability to fund itself indefinitely (admittedly at the risk of inflation), so it is hard to understand why the deficit has suddenly become so big of an issue when we have millions of people unemployed. Yields on U.S. government 10-year bonds are still around 2%, so the urgency to balance the budget is really unfounded.
What this means in terms of monetary policy is that the Fed will likely continue full-steam ahead in the expansion of their balance sheet in an effort to stimulate the economy further. This is good news for financials such as Bank of America (BAC), who are helped by the boost to the housing market provided by the Federal Reserve. At the same time however, a weak recovery also hurts banks and their ability to lend.
Ultimately it is up to the individual investor how much stock they want to put into the recent GDP report. Personally, I do not see this current rally continuing, and would not want to buy into many companies at current prices.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.