Understanding the GDP

GDP, or gross domestic product, is the monetary value of all finished goods and services made within a country during a specific period.

For example, if you buy a pair of jeans for $15, GDP increases by $15.

GDP figures are used as an indicator to gauge the overall health and potential growth of a country's economy.

If GDP rises, the economy is solid, and the country is moving forward— a sign that people are doing more work and getting a little bit better financially.

On the other hand, the economy might be in trouble if GDP falls. If GDP falls for two quarters in a row, that is known as a recession, which can mean pay freezes and lost jobs.

In the US, the Bureau of Economic Analysis (BEA) publishes an advance release of quarterly GDP four weeks after the quarter ends. Referred to as the first reading, it includes several data points and rough estimates.

These estimated data points get revised each of the next two months as additional information becomes available, and a final release is three months after the quarter ends.

There are two kinds of GDP released—real GDP and nominal GDP. Real GDP takes into account the effects of inflation, while nominal GDP does not. And real GDP is the indicator that says the most about the economy's health.

Since it gives great insight into the actual growth of an economy, GDP is widely followed and discussed by policymakers, economists, investors, and businesses in strategic decision-making.

They use it to establish whether the economy is growing, contracting, or in a recession.

Before every GDP release, analysts make forecasts about the number. It is helpful to compare the number that most of them agree upon, or the market consensus, with the actual GDP number. The greater GDP deviates from their expectations, the more likely you will see a highly volatile reaction from the market.

Investors can look at GDP growth to see if the economy is changing rapidly. This might help them determine if it is appropriate to make adjustments to their asset allocations.

A bad economy has historically meant lower profits for companies, which in turn resulted in lower stock prices for some firms.

One interesting metric that investors can use to get a sense of the valuation of an equity market is the ratio of total market capitalization to GDP.

For example, the US had a market-cap-to-GDP ratio of 142% at the end of 2006, which dropped to 79% by the end of 2008. In retrospect, these represented zones of substantial overvaluation and undervaluation, respectively, for US equities.

But remember, GDP growth doesn't tell the whole story. There are many things the statistics might not consider, including hidden economy, inequality, and so on.