In the third quarter of 2011, the US economy expanded at a 2.5 percent annualized pace, the fastest rate of growth in one year and close to double the economy’s 1.3 percent annualized growth in the second quarter. 

At the beginning of the third quarter, most economists expected the US economy would expand by 1.5 percent or less; ironically, several of these naysayers reduced their economic growth expectations just as the economic data began to improve midsummer. Although 2.5 percent is hardly an impressive rate of growth for the US economy by any historical yardstick, it marks a significant improvement from what was expected just a few months ago.

Looking inside this week’s gross domestic product (GDP) release, the picture is even brighter–check out my graph below for a closer look.

Source: Bureau of Economic Analysis(BEA)

This graph illustrates how changes in inventories contributed to US economic growth in every quarter stretching back to 1999. Inventories are simply already-manufactured goods that have not yet found a final buyer. Building inventories add to GDP–building goods adds to economic activity whether or not those goods are ultimately sold on to a customer.

However, when inventories build too quickly, a growth hangover can occur. Goods can’t merely stack up in a warehouse but must be sold through; when demand weakens, companies often slash prices to move their existing inventory or simply produce less and run with leaner stocks of unsold goods. Drawing down of inventories subtracts from GDP. Excess production in one quarter means that companies must cut production in a future quarter to balance supply and demand.

Inventories can also tell us a great deal about business confidence. When companies are worried about future growth prospects or see slowing demand, they’ll often cut their inventories to balance perceived supply and demand.

As you can see from the graph above, inventories were a major contributor to US GDP growth in late 2009 and early 2010 as the economy emerged from recession. This is absolutely normal–companies slashed inventories during the vicious 2007-09 Great Recession and credit freeze-up because they were concerned about demand. When the economy finally did stabilize in early 2009, companies found that they had cut stocks a bit too close to the bone and needed to rebuild their inventories. For at least two quarters, inventory rebuilds added 3 percent to 4 percent to quarterly GDP growth. This is not at all unusual and a turn in the inventory cycle is historically the first push the economy gets as it emerges from recession.

Over the past two quarters, however, inventories have had the opposite effect. Although there’s no way to definitively know the reason for this trend, management comments during quarterly conference calls suggest that concerns about the outlook for economic growth were a major driver of inventory de-stocking. In the third quarter, a decline in inventories subtracted a full 1.08 percent from US GDP.

But just as excess inventory building can create a hangover for GDP in future quarters, an overly lean inventory picture can have the opposite effect; if demand doesn’t decline, businesses will need to rebuild their stocks. I suspect we will see some demand and inventory snap-back in the fourth quarter as concerns about another recession and a credit crunch emanating from Europe recede. This is one reason I believe US fourth-quarter GDP will grow at an annualized pace of close to 3 percent, the fastest growth rate since the second quarter of 2010.

Texas Instruments (NYSE: TXN), a semiconductor firm, recently held an interesting conference call with analysts. Texas Instruments makes chips used in a wide range of industries including third-generation (3G) mobile telephone handsets, wireless infrastructure and base stations, automobiles and industrial/manufacturing equipment. Texas Instruments tends to host both a quarterly conference call and a shorter mid-quarter update, so it’s a good firm to watch for shifts in business conditions.

Back at the company’s second-quarter conference call in July, Texas Instruments reported a slowdown in demand in some of its major end markets and disappointed analysts’ expectations, which sent the stock sharply lower. In early September, at the company’s mid-quarter update call, the news sounded even worse as management reported “broadly lower demand across all segments and customers.” For a company that’s broadly diversified by end market, that’s not a good sign for the broader economy. Management went on to indicate that weakness began in June and seemed to accelerate in July and August.

But Texas Instruments’ third-quarter conference call in October offered more than a ray of hope.  Here’s what the company’s vice president of investor relations Ron Slaymaker had to say:

Let’s move now to the demand environment, which was weak in the third quarter. Revenue was flat sequentially in quarter, when historically it has grown on average about 7 percent. That being said, we were encouraged that revenue landed above the high end of our range of expectations due to a stronger-than-expected month of September. Our book-to-bill ratio was below one for the quarter, and we expect revenue to again decline more than seasonally in the fourth quarter. Even with this outlook, we see conditions that suggest the bottoming process has begun. After a sharp drop in July, the rate of decline in orders slowed considerably in August and September. Lead times are short, and inventories at distributors and OEMs [original equipment manufacturers] are lean.

Texas Instruments Third-Quarter Conference Call Oct. 24, 2011

Texas Instruments indicated that the weakness in semiconductor order trends was acute in July but began to ease by September, a month that was actually stronger than expected. In addition, note that Texas Instruments states that inventories of chips at both distributors and OEMs are lean as these companies were unwilling to stock up when demand appeared to be slowing. This suggests that there’s not much additional room for inventories to decline, unless there is a major further deterioration in demand. It’s likely that a similar scenario is in place across most industry groups–as growth appears to pick up, inventories will need to be replenished.

Another reason for optimism is continued strength in US business spending even amid an uncertain economic environment. Check out my graph below for a closer look.

Source: BEA

This graph shows the contribution to US GDP from business spending on equipment and software products. Generally, business spending since the end of the 2007-09 recession has been the strongest since the late 1990s. In the most recent quarter, spending accelerated once again to add more than 1.2 percent to quarterly GDP growth. The strength was broad-based: Spending on non-residential structures added one-third of a percent to GDP growth, industrial equipment added about the same and software added 0.12 percent to growth. Strong business spending more than offset ongoing weakness in investment in residential housing.

Looking at all of these trends, the economy actually appears to be picking up momentum heading into year-end. My Recession Radar–a proprietary measure that I will unveil in your the next issue of Personal Finance–shows the probability of recession over the next six months at roughly one-in-four, down from over 40 percent just a few weeks ago. Based on recent momentum in economic data, I see the risks of a recession continuing to fade and the summer soft patch giving way to a wintertime pick-up. The overall picture of lumpy, sub-par but positive economic growth hasn’t changed.

Following the massive rally on Oct. 27 in response to Europe’s expanded bailout scheme, there is the potential for some modest near-term profit-taking in stocks. But stocks could have declined over the past week and a half for any number of reasons: The US Budget Super Committee appears to be making no progress on identifying deficit reduction measures, and the EU’s new bailout plan is far from a comprehensive “shock-and-awe” solution to the region’s troubles. Nevertheless, stocks haven’t declined appreciably and investors have seized over any dip in the market as a buying opportunity. When stocks rally on what might be considered “bad” news, that suggests that investors are growing more optimistic. I see this sentiment continuing at least through year-end and my call for a significant year-end run-up remains intact.