Key takeaways
- GDP is a measure of whether the economy is expanding or contracting.
- While this factor can’t be taken alone, negative GDP is a strong indicator of a future recession.
- Investors should develop an investment plan to take advantage of market declines when GDP falls.
The stock market moves up and down based on demand; the more demand there is for stocks, the higher prices go and vice versa. Gross domestic product is similar in that it grows as consumers, businesses and governments indicate demand by spending more. When spending slows, GDP falls.
Because of this, the stock market and gross domestic product go hand in hand. Understanding GDP is essential if you're tracking the stock market in real time or you want to know where it’s likely to be going.
What is gross domestic product?
Gross domestic product (GDP) measures whether the economy is growing or contracting. There are two ways to measure the gross domestic product: spending or income.
For spending-based GDP, all spending on goods and services is accounted for, which includes individuals, businesses and the government. This number also takes into account our imports and exports.
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For income-based GDP, all income, including wages, profits and return of capital, are taken into account. Adjustments for depreciation and tax sales are often made to arrive at an accurate GDP number.
In both cases, the numbers are adjusted for inflation, and the result is called real GDP. Since prices naturally rise over time, failing to adjust for inflation will skew the calculation, making it very difficult to see whether the economy is growing or shrinking.
GDP is measured annually, and the data is released quarterly and as well as a final year-end report. It is important to know that GDP is a lagging indicator of the economy's health, as the final figure for a given quarter does not come out until one month after the quarter ends. For example, the GDP report for the third quarter of 2022 will be released December 22, 2022 at 8:30am EST.
What is the current measure of GDP?
For the second quarter of 2022 (April-June), real GDP came in at -0.6%. This follows the first quarter 2022 reading of -1.6%. Given the contraction in the economy that this represents, there is considerable debate about whether the U.S. economy is in a recession. Historically, the rule of thumb has been that an economy has entered a recession after two straight negative GDP quarters, which we clearly have here.
If you dig past the headline GDP number, however, you see that exports and retail spending increased during this quarter. Still, declines in federal and state government spending, private inventory investment and residential fixed investment offset these gains. As many experts have said, the consumer's health is good, so we may not be experiencing a true recession. Considering that retail spending continues to grow, there’s some validity to this claim.
Is GDP an indicator of a recession?
The National Bureau of Economic Research (NBER) defines a recession as "a significant decline in economic activity spread across the economy … that lasts more than a few months." But NBER quickly points out that this isn't the rule — just a guide. There have been times when a recession is very short lived. The recession in 2020 only lasted one month. If we average out the past 10 recessions, they normally last around 16 months.
NBER also points out that while GDP is a strong indicator of a recession, it is not the only metric used to make the final determination. Many other indicators play a role. These include the jobs report and wage growth, among others.
As an investor, you can take negative GDP growth as a serious sign of recession. There has never been a period in history that the economy has not entered into a recession after two consecutive quarters of negative GDP growth. The data for this goes back to 1947. So while NBER considers other indicators, GDP is a strong, reliable signal of what is to come.
How to hedge against negative GDP, inflation and volatility
What does all this mean to an investor, and how can you protect yourself when GDP is falling, inflation is rising and the markets are swinging with volatility? You may be tempted to move some investments to cash to avoid the roller coaster. While this is a strategy, understand that trying to time the market is rarely successful. Chances are you will sell too late and enter back in after the majority of the runup on the other end. Missing just the ten best days in a recession can cost you 5% growth. The more days you miss, the lower your return. If you have a large portfolio, that can cost you a lot of money.
A better option is to create a detailed investment plan that considers times of uncertainty and recession since they are natural parts of the economic cycle. Your plan should cover what you are investing in and why, as well as your goals and time horizon. This will help you to better navigate challenging market conditions.
For example, you might invest a portion of your portfolio in bonds to offset some of the stock market risks. You could also consider investing in Q.ai’s Investment Kits. Our artificial intelligence scours the markets for the best investments for all manner of risk tolerances and economic situations.
Finally, when it comes to volatility, you have to take a long-term view of things. A swinging market can be scary. Since 1945, there have been 11 official recessions in the U.S. Some were mild, others more severe. But given enough time, the economy and the stock market marched back upward and prevailed.
If the wild swings of the market scare you, tune it out as best you can, as long as your asset allocation is aligned to fit your investment goals.
On the other hand, if you are opportunistic, consider building up a cash position so that when stock prices decline, you can buy at a discount.
The bottom line
Following the GDP is an easy way to get an idea of where the U.S. economy is going. While experts consider multiple indicators to formally determine whether or not the economy is in a recession, negative GDP growth is a powerful signal. As a result, if you see reports of negative GDP, it might be a good time to pull out your investment plan and review it.
Make sure it is up to date with your investment goals and time horizon. This will allow you to navigate the tricky times ahead.
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