In this section, we will explain and dissect the main lagging economic factor: GDP. We will describe it, understand its components, we’ll go over how to read it and identify how it affects the economy and businesses.
Gross Domestic Product
Think of it as the price tag of an economy’s the size of an economy
Gross Domestic Product (GDP) is the measure of a country’s total market value of all finished goods and services produced domestically (within the country) in a certain time period. It is considered to be the most relevant measure of economic health in a country.
This measure is so important because it encompasses almost all components of an economy. It is made up of consumer spending, government spending, business investments, and foreign trade balance:
Consumer spending (consumption expenditure, or consumption) measures the aggregate value of all goods and services purchased by all individuals in a country. It is the largest component in the GDP and, according to economists, it drives the performance of an economy as it accounts for about 70% of the US GDP.
It is the demand for goods by households and individuals; and it is complementary to their personal savings (as people save what they don’t spend), and production (as goods have to be produced to be consumed).
If you think about it, companies exist to provide goods or services to people who want them. Therefore, consumption is naturally essential for business and economic growth.
This component includes all the money spent by the government on the purchase of goods and the provision of services like healthcare, education, social security, etc. Government spending makes up a big portion of the total GDP of a country (about 17% of US GDP) and it is financed through two main sources:
- Taxes: people and businesses pay taxes on pretty much anything they do or consume. That money is used to fund public spending.
- Government borrowing: governments also raise funding by borrowing from investors in the form of government debt, or Treasury securities.
Business investment accounts for purchases made by companies to produce goods and provide services for consumers to enjoy. This measure can be thought of as the cost for businesses to supply goods, and it is significant for the aggregate GDP as it accounts for some 18% of US GDP.
Business investment is split into two sub-components:
- Fixed Investment, which is the purchase of equipment for businesses, such as machines, software, buildings, etc.
- Changes in Inventory Levels, which measures how well companies are selling their products and how much they are planning to sell.
Trade balance includes all imports and exports that take place in an economy. Logically, both elements have opposite effects on GDP.
- Exporting is selling goods and services to other counties, which increases GDP.
- Importing is buying from other countries, which reduces GDP.
Therefore, the trade balance is the net effect of exports and imports in a country.
For example, the US exported about $2.5B in 2019; which, subtracted by the almost $3.5B imports, meant a trade balance (or trade deficit in this case) of negative $1B.This accounted for -5% of the US GDP.
Breakdown of the US 2019 GDP by its components
GDP Growth Rate
The GDP number alone is, as we mentioned earlier, a measure of the size of an economy, which is important because it indicates the economic power an economy may have compared to other countries and it also paints a picture of what makes up that economy.
However, what is arguably more important is the GDP Growth Rate, which measures how fast the economy is growing. This rate is normally an indication of the actual health of an economy, as it reveals whether the economy is growing or shrinking over a certain period of time.
A positive GDP growth rate indicates the economy is expanding, businesses may be making more money, people earn and consume more, etc. However, too much GDP growth can be dangerous as it may not be sustainable. As we saw in our previous section, the historical ideal growth rate is about 2% a year.
If the GDP growth is negative, this indicates the economy is in (or is getting into) a recession.
In future sections, we will see how GDP affects the business cycle in detail.
GDP & The Markets
Even though GDP numbers are a lagging indicator, showing what has happened in the previous quarters, investors still pay special attention to it as it provides a solid long-term perspective of where an economy is headed, which is essential for any investing strategy. A lot of detailed information is provided that breaks down the aggregate GDP number, which offers a great deal of valuable insight into business profits, sector performance, and much more. In addition, comparing the GDP growth trends of different countries can help investors determine which economies pose an opportunity or which ones to stay away from.
GDP also offers a great tool for investors to get a good sense of the total valuation of an equity market. This is achieved by looking at the ratio between the Total Market Capitalization and the GDP. As pointed by Warren Buffett, the percentage of Total Market Cap. (TMC) relative to the US GNP is “probably the best single measure of where valuations stand at any given moment.”
is at about $35 trillion (this is the aggregate market capitalization of all companies in the stock market in the US; in other words, the value of all US companies combined).
which is about 174.9% of the last reported GDP. The US stock market is positioned for an average annualized return of -2.6%, estimated from the historical valuations of the stock market. This includes the returns from the dividends, currently yielding at 1.71%.
As pointed by Warren Buffett, the percentage of total market cap (TMC) relative to the US GNP is “probably the best single measure of where valuations stand at any given moment.”