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A 5 minute introduction to the economy

Lesson in Course: Market movements (beginner, 5min)

What is the economy and what does it mean for me as an investor?

Eureka!

What it's about: We can think about the economy as the sum of all transactions and measure it using GDP.

Why it's important: The health and direction of the economy affect our investment returns.

Key takeaway: The economy and the stock market are not the same.

The economy is something that touches all of our lives. We experience benefits when the economy is healthy; jobs are easier to find, home values increase, and we tend to spend more and save less. In times of hardship, those trends tend to reverse. The economy, and more importantly, the direction of the economy, plays a big part in the movements in the stock markets. 

Wall Street is always hiring economists

The economy, however, is not the same as the stock market, and the two can be seemingly going in different directions at times. 

COVID-19: splitting the economy and the stock market

The stock market's response to COVID-19 shows us how different the markets and the economy can move in two very different directions. Starting at the end of February and through the end of March, the S&P 500 lost approximately 30% of its value; however, sheltering in place and the closing of businesses didn't occur until mid-March for many states. The loss in business and productivity would negatively impact the economy for months to come. Even while 41 million Americans filed for unemployment in May of 2020, the S&P 500 was back to the pre-pandemic levels of Oct 2019.

What is the economy?

The economy is the production and consumption of goods, services, or financial assets.

Hear Ray Dalio, founder of the world's largest hedge fund, break down the economy in this 2-minute clip
https://www.youtube.com/embed/PHe0bXAIuk0?start=33&end=179
 

The economy occurs in cycles where periods of growth, economic expansion, bring prosperity and are followed by periods of loss or economic contraction. The cycles are colloquially known as the boom and bust cycles of business. How do we know when we are booming? Or how do we know a bust is around the corner? We can look at the gross domestic product (aka GDP) to find the answer.

What is Gross domestic product ?

The gross domestic product or GDP is the summary of all the transactions that produce goods and services in a country within a certain time frame. 

The gross domestic product or GDP provides us a current snapshot of our economic health. 

Healthy economies have positive GDP growth

Positive GDP growth shows economic expansion, while negative GDP growth indicates an economic recession. GDP is reported quarterly and summarized yearly by the BEA (Bureau of Economic Analysis) in the US.

Getting a snapshot

In the video above, we saw that every transaction involves transferring of money or credit for goods. Economists can tally up these transactions into either the nominal GDP or the real GDP.

What is Nominal GDP?

A measure of economic health using current market prices for each transaction, nominal GDP is the sum of all the private consumption, government investments, gross investments, imports, and exports.

Here's how they add it all up:

  1. Private consumption within a country sums up all transactions between businesses and consumers.
  2. In addition to private consumption, government investment and spending also contribute to transactions.
  3. Businesses invest in growth, and this gross investment creates additional transactions.
  4. Lastly, countries sell and buy from each other. Exports and imports account for these transactions.

These four categories of measurements combine to arrive at our nominal GDP. Since GDP thus far uses current market prices, couldn't we raise the prices of goods to increase our GDP? Not quite.

GDP growth has to tell us about production and consumption

Let's say a gallon of milk costs $1 more, and everyone still drinks the same amount of milk. Even though this would cause nominal GDP to increase (the value of all milk transactions went up), we aren't actually producing and consuming more stuff, more milk in this case. This is why economists and investors view nominal GDP as an intermediate calculation, leading to the preferred measure of real GDP.

What is Real GDP?

A measure of economic health by adding all the private consumption, government investments, gross investments, imports, and exports AND adjusting for inflation (price changes) 

Adjusting the nominal GDP for inflation to get the real GDP gives us a clearer understanding of production and economic activity. Financial news outlets usually report changes to real GDP.

 

Where it's going

While having real GDP is handy, it doesn't tell us which direction the economy is headed. Instead, we look at the change in GDP or GDP growth rate. 

GDP growth shows the direction of the economy

The GDP growth rate is the annualized percent increase or decrease from the GDP of the prior quarter. 

US BEA
What does 2% annual GDP growth mean?

In Q2 of 2019, the US had 2% more transactions than Q1 on an annualized basis. What does this mean, and how is it calculated? Let's walk through a quick example calculating the GDP growth rate between the years 2016 and 2015.

  1. Find the real GDP numbers reported by the BEA starting with the date of interest and going back 4 quarters. In our example, we'll sum the quarterly real GDP to arrive at the annual GDP.
{\text{2015 GDP}}=\$17,783.60+\$17,998.30+\$18,141.90+\$18,222.80=\$72,146.60
{\text{2016 GDP}}=\$18,281.60+\$18,450.10+\$18,675.30+\$18,860.80=\$74,267.80
Image titled Calculate Annualized GDP Growth Rates Step 3

2. Then, we'll take the difference to arrive at a rate.

Image titled Calculate Annualized GDP Growth Rates Step 4

The annualized GDP growth rate between 2016 and 2016 is 2.9%. According to the quarterly GDP growth chart from the BEA above, we've been in a very long boom cycle.

 

Actionable ideas

GDP growth serves as a general scorecard for the economic cycle and health that you can use in addition to other economic indicators, like the consumer price index for inflation. They can be useful for coming up with expectations about companies' future earning capacity and returns on their investments. 

Don't make the mistake of putting too much emphasis or overly scrutinizing the past. While looking back in history can be helpful to understand the workings of the economy, it isn't always effective at predicting the future. Technology and globalization will continue to change how economies behave and alter the lengths of expansion and contraction cycles. A deeper dive into business cycles helps you better understand investor sentiment looking forward.

Glossary

What is Gross domestic product ?

The gross domestic product or GDP is the summary of all the transactions that produce goods and services in a country within a certain time frame. 

What is Nominal GDP?

A measure of economic health using current market prices for each transaction, nominal GDP is the sum of all the private consumption, government investments, gross investments, imports, and exports.

What is Real GDP?

A measure of economic health by adding all the private consumption, government investments, gross investments, imports, and exports AND adjusting for inflation (price changes)