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Economic growth in the second quarter slowed to an anemic 1.6% from 5.0% in the December quarter, and 3.7% in the first quarter.

Hopes have been that things began picking up again in the third quarter and that last year’s recovery from the recession is back on track.

However, with only one more week left in the quarter economists are still surprisingly mixed in their views about the quarter, some forecasting a further drop in GDP growth to perhaps 0.6%, getting close to recession again (negative growth), while others expect growth has picked up this quarter to about 2.0%, and will run at that modest level for the rest of the year before picking up further next year.

We all like to think the Federal Reserve must know better than anyone else, given its huge staff of economists and other experts, and access to any data and inside information it needs.

But the Fed seems to be as uncertain, dare I say as confused, as everyone else.

A couple of months ago Fed chairman Bernanke was talking about signs that the recovery was back on track after stalling in the spring, of the need to begin removing some of last year’s stimulus programs to slow the recovery before it gets too hot and creates inflation.

The Fed has now reversed to expressing disappointment this week that the recovery has continued to stall out, promising it is watching closely and ready to provide more stimulus in the form of ‘quantitative easing’ if the slowing continues.

The economic reports so far for the third quarter seem to indicate considerably slower growth in the quarter. Significant declines from the second quarter in the housing industry, auto sales, manufacturing, factory orders, jobs, and consumer confidence.

For instance, in the very important housing industry, it was reported Thursday that although existing home sales were 7.6% higher in August than in July, August was still the second worst month of existing home sales on record. And with August’s report, the average monthly sales so far in the third quarter are a huge 29.7% lower than in the second quarter.

And on Friday it was reported that new home sales in August were not even able to bounce off their depressed level of July, which was the second lowest level of new home sales since at least 1963.

After the report, economists at Bank of America-Merrill Lynch predicted the depressed spending on building and remodeling homes by itself will subtract 0.7 percentage points from third quarter economic growth.

But every once in awhile there’s a positive report that keeps economists guessing.

For instance, also on Friday morning it was reported that durable goods orders fell 1.3% in August, but with volatile aircraft orders excluded, orders were up 2.0%, somewhat better than forecasts and the best showing in five months.

Nomura Securities said it added 0.2 percentage points to its estimate of third-quarter economic growth as a result of the report.

On Friday the stock market decided to go with the durable goods orders and the 0.2 percentage points it adds to third quarter GDP, and ignore the home sales reports and the 0.7 percentage points they subtract from 3rd quarter growth.

But the continuing rally in the stock market has created its own set of perplexities. The S&P 500 has gained 7.3% in its September rally, but remains 7.6% below its April peak.

Is the market seeing something more positive ahead that economists and the Federal Reserve don’t see? Or is its four-week rally only temporary, the market still in the correction that began in April?

The latter thought has a lot going for it, considering the market’s short-term overbought condition, and that investor sentiment, as measured by the poll of the American Association of Individual Investors, reached an extreme high reading of 50.9% bullish last week.

There have only been three other times since the end of the 2003-2007 bull market that the AAII poll exceeded 50% bullish. It reached 54.6% bullish in October, 2007 just days before the market rolled over into the severe 2007-2009 bear market. It reached 53.3% bullish in May, 2008, just days before the end of a substantial bear market rally, when the market rolled over into the severe 2nd leg down of the 2007-2008 bear market. The S&P 500 was 47% lower by late November. It also reached 50% bullish in August of last year, but at that time bearishness also remained at a high level so the spread between the two was not at the extreme seen on the other occasions and nothing happened.

More recently it reached only 48.5% bullish in April of this year, and that was at the April top, which was followed by the 17% decline to the July low of this year.

So investor sentiment may well be saying the market’s four-week rally isn’t based on anything the market sees in the economy that economists are missing, but is being fueled by excessive investor optimism and bullishness that has reached its danger zone again, and that the economy continues to slow and the market correction from the April top remains intact.

Disclosure: No positions

Source: Has the U.S. Economy Improved in the Third Quarter?