The Dow Jones Industrial Average (DJINDICES:^DJI) was up 102 points at 1 p.m. EDT Wednesday, just shy of 20 hours before the Bureau of Economic Analysis is scheduled to release its advanced estimate for first-quarter gross domestic product.
Investors are a forward-looking bunch, but too often they simply react to news, instead of preparing and implementing a long-term strategy. Get ahead of the markets today to understand why this GDP report is going to move the Dow tomorrow.
What is GDP and why should we care?
Gross domestic product is the total dollar value of all items produced in a country in a given time period. The percentage number we'll see tomorrow is the measure of growth from the fourth quarter to the first quarter, shown as an annualized figure.
Sounds simple enough, right? It's just all things produced in total, then shown as a percentage change from last quarter. Straightforward stuff! Well, as with all things macroeconomic, there is some nuance.
Take inflation, for example. Gross domestic product is a measure of total production in dollar terms. So if the dollar inflates, so too will GDP. In a high-inflation environment, it's critical to understand how much of the growth in GDP comes from inflation versus actual increased output. And it's also worth noting that a low-inflation environment (as exists today) is a drag on GDP.
Or consider that GDP measures production, not actual sales. So to really understand who is making money and what is driving the real economy, we must drill down a level and determine who is producing the increased production, how GDP is translating into income, and what that increased income is yielding (more consumption and more output? More investment? More savings?).
Each of these questions can put a different and potentially signficant spin on GDP that belies the headline percentage change.
Applying this framework to today's reality in the U.S., we see that inflation and GDP growth are both below the long-term trend line. The economy has seen massive deleveraging by consumers as a result of the real estate crisis, while corporations have held massive amounts of money in cash in lieu of reinvestment or increased output.
Federal Reserve Chairwoman Janet Yellen told the Economic Club of New York this month that the reality is improving, but only modestly. She pointed to persistently low inflation and the danger of deflation, as well as continuing challenges in the labor market (albeit an improved labor market).
This reality is the "new normal" we've all heard about in the news. Gross domestic product growth has been throttled by the combination of lower consumption by consumers and low inflation.
What to expect tomorrow
The consensus estimate is that GDP will grow 1.1% on an annualized basis from the fourth quarter to the first quarter. This remains well below the long-term U.S. growth rate of 3% per year.
Other economic releases have been mixed recently, priming the Dow for what could be a volatile day if this estimate misses on either the high or low side.
New home sales in March, a key indicator of production and employment in the construction industry, came in well below expectations last week. But reports on the state of the labor market have been steadily improving. Inflation remains subdued.
If GDP comes in higher than expected, I anticipate a strong response by the markets. Optimism for the consumer will outweigh other concerns. However, if the number comes in low, expect the talking heads and markets to focus on the housing markets and paint a doomsday scenario.
Tomorrow's GDP report doesn't matter to you or to me
Remember when I mentioned the nuances of the GDP report lying just beneath the headline number? There's more where that came from.
These quarterly GDP data releases are estimates. That's it. Educated guesses. Nothing more.
It makes sense when you think about it -- how can any body of government, research institute, or other organization accurately assess the exact, total production of an economy as large as the U.S.? It's just impossible.
As such, the BEA revises its GDP estimates after the initial report. The revisions could go up or they could go down -- we can't know.
Taking the long view and boiling down what really matters in the national economy, the real building blocks of GDP can be seen as employment and inflation. Employment drives consumption and inflation accounts for the changing value of the dollar.
With more people working and inflation healthy but in check, growth will return to its long-term 3% trend. If inflation stays low (or dips into deflation), GDP will remain weak. The same is true if more people lose their jobs and can no longer afford to buy goods and services.
If you've read this far, there is something else you should
No matter what the GDP report says tomorrow, you should ignore it.
There, I said it. Ignore it.
If you've been researching a company that is undervalued, and it's the kind of business you'd want to own for the long term, then the GDP report is completely, totally, and utterly meaningless to you.
Macroeconomic reports play far too great a role in many investors' decision making. What matters in a good investment is in the micro, not the macro.
Buying a great company in a poor economy is the same as buying a great company in a strong economy -- except you may be able to buy that company on the cheap. Either way, you're buying a great company at a good price, and that's what matters.
If you're interested in macroeconomics or monetary policy, use it for context to view the investing landscape like you'd view the Earth from the Moon.
When it comes to building your portfolio, what matters is the boots-on-the-ground analysis.