The U.S. economy shrunk for the third consecutive quarter for the first time since 1975 seemingly throwing cold water on recent optimism over a potential recovery. But the market was unfazed by the news, in part, because the Federal Reserve said economic contraction has slowed.

The nation’s real gross domestic product (GDP) – its output of goods and services – decreased at an annual rate of 6.1% in the first quarter of 2009, according to preliminary estimates released by the Bureau of Economic Analysis. The numbers were worse than expected but showed improvement from the fourth quarter of 2008, when the economy contracted at a 6.3% annual rate. Economists had originally forecast a 4.9% decrease in real GDP for the first quarter.

Source: Bureau of Economic Analysis, FactSet

Despite the bad news, stocks continued their strong run in April with the major market indices posting double-digit percentage increases. The Dow Jones Industrial Average closed at 8,185.73 on Wednesday, April 29, 2009, representing a 21% jump from its March 9 close of 6547.05. However, with unemployment at historically high levels and economic fundamentals remaining weak, there is always the possibility of stocks moving lower.

Pacing the contraction in GDP was a 30% decline in real exports, as compared to a 23.6% decrease in the previous quarter, according to the government report. The housing sector also made a significant negative contribution with residential fixed investment falling 38% in the first quarter, down from a 22.8% decline last quarter.

Meanwhile, nonresidential fixed investment decreased 37.9%, compared with a 21.7% decline in the fourth quarter. Equipment and software, private inventory investment and federal government spending also suffered larger setbacks.

Motor vehicle output put a big dent in GDP as well, subtracting 1.36 percentage points from the first-quarter change in real GDP following a 2.01 percentage-point drop in the fourth-quarter change.

But the news wasn’t all bad. Consumer spending, a key component of economic growth, staged a spirited comeback from the previous quarter by rising 2.2% on the heels of a 4.3% drop in the fourth quarter. The recent upswing in spending suggests that the worst part of the recession could be behind us and that a second-half recovery is still within reach.

Further underpinning improved sentiment was a separate report published by The Conference Board, which showed a spike in consumer confidence. The Consumer Confidence Index – a measure of consumer sentiment based on a representative sample of 5,000 U.S. households – rose to a five-month high of 39.2 in April, up from 26.9 in March. The latest reading marks the highest level since November's 44.7 and vastly exceeded economists' expectations for 29.5.

However, a rebound in household spending may not be enough to ward off ongoing job losses, home price depreciation and tight credit, which continue to plague the economic landscape, according to the Federal Reserve. Although the economic outlook has improved modestly, “economic activity is likely to remain weak for a time,” the Fed said following its third Federal Open Market Committee meeting in 2009.

Still, policymakers did provide some soothing words for investors. The Fed acknowledged that while the economy has continued to contract “the pace of contraction appears to be somewhat slower.” And the Fed continues to expect ongoing policy actions to stabilize financial markets and institutions and provide fiscal and monetary stimulus while market forces combine to stimulate sustainable economic growth. Based on the recent performance of the major averages, the market agrees.