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.
The economy, however, is not the same as the stock market, and the two can be seemingly going in different directions at times.
What is the economy?
The economy is the production and consumption of goods, services, or financial assets.
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.
The gross domestic product or GDP provides us a current snapshot of our economic health.
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.
Here's how they add it all up:
- Private consumption within a country sums up all transactions between businesses and consumers.
- In addition to private consumption, government investment and spending also contribute to transactions.
- Businesses invest in growth, and this gross investment creates additional transactions.
- 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.
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.
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.
The GDP growth rate is the annualized percent increase or decrease from the GDP of the prior quarter.
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.