It’s hard to understand the economy in general, because there’s so much data and it’s so often taken out of context. Let’s narrow down only the most important indicators of economic development with this post, and examine real data published by government agencies to get context on these metrics.
I’ve found that this macroeconomic data can be extremely useful in making reasonable projections of future growth for valuation models on companies that trade in the stock market, and it can help you construe when a valuation is really irrational and almost certainly unachievable, or overly optimistic but still within reach.
Whether you’re someone casually interested in economic data or are totally immersed in finance in some capacity, I think you’ll find these explanations and data tables to be clear, organized, and a valuable resource.
It’s also great to know these numbers when confronted with sensational headlines about economic developments in the media and online—to bring clarity on the U.S has actually been doing lately.
GDP, or Gross Domestic Product
If wanting to understand the top economic indicators, it makes sense to start with GDP, or Gross Domestic Product.
You can think of GDP as the income a country generates within its economy. The equation for calculating a country’s GDP is the following:
GDP = C + G + I + NX
C = Consumption
G = Government Spending
I = Investment
NX = Net exports
We will use this base as the focus of the other major indicators of economic development that will be examined in this post. Each category of GDP plays an important role in the overall economy of a country, and which driver is more important can differ between country or even over time within a country.
Many economists and investors will look to GDP as a signal for how much growth to expect in profits (and subsequently, their returns in the stock market).
But, economic indicators like GDP are backwards looking, often months or even more than 1 year until official release. Keep in mind that many stock prices are determined as estimates on the future rather than what’s happened in the past, though analysts will frequently refer to historical data and generally maintain forecasts close to long term historical trends.
Here’s the data with the last 25 years of GDP (1994-2019) for the United States.
Note that the Median and Average are very close, at 4.5% and 4.4% respectively, and that economic growth in the U.S. has appeared to be slowing over the last 10 years despite generally declining interest rates.
This U.S. GDP data represents “nominal GDP”, not to be confused with “real GDP”.
Oftentimes economists and journalists will also quote “real GDP”, which takes the nominal GDP above and adjusts it for inflation.
For the U.S. over the last 25 years, real GDP growth has averaged less than 1%- 2%, which can make the actual growth in profits in the economy sound lower than it really is. Most inflation estimates in the U.S. have averaged around 2%- 3%, and so inflation does play a critical role in adding to overall GDP over time.
Consider that stock market prices quoted online and in the media are generally not adjusted for inflation, and that most fundamental analysis involving profits, revenues, and cash flows are also not adjusted for inflation.
Keep that in mind if using economic data for investment research.
The next logical step would be to examine some of the variables that cause economic development in the form of GDP growth—and it doesn’t have to be complicated.
If we look at the basics of an economy, it makes sense that more people should generally lead to higher economic growth.
More people in a country should mean more entrepreneurs to create jobs and more customers to support businesses and work in those businesses, and that economic cycle continues and reinforces itself repeatedly.
So, let’s provide context on the last 25 years of GDP growth with corresponding growth in the overall population. This chart shows those numbers.
As we can see, both the median and average values over the last 25 years are the same at 0.9%. Like with GDP, population growth has been slowing over the last 10 years and would generally be a negative thing for the economy if that trend continued.
Though birth rates have indeed been slowing in the U.S. and other developed Western countries, that is not the only factor to influence population growth through the years. Today’s population growth can be explained by things like:
- Longer life expectancy
- Birth rates
Positive economic development and growth can lead to increases in all 3 of those categories, which can again be a self-repeating loop for an economy where prosperity feeds on more prosperity.
U.S. Consumer Spending
Next let’s look at Consumer Spending, which has long been a huge driver for the U.S. economy.
It’s pretty well known that the U.S. is a major service economy, especially after having exported manufacturing to countries like China and Mexico. Since the U.S. is a “net importer”, which means that we import more goods and services from other countries than we export, we rely on consumer spending to drive economic growth within the country, and some of that spills over to other countries as well.
Since spending –> business profits –> jobs –> spending, consumer spending can arguably be the most important economic development indicator to monitor—especially in a country like the U.S. where a majority of the GDP equation comes from consumer spending.
Here’s the data for U.S. consumer spending over the last 25 years:
Notice how spending has crossed above $14 trillion, which compared to GDP over $21 trillion is a significant portion.
With consumer spending growth slightly above GDP growth numbers, average of 4.6% and median of 4.7%, consumers could continue driving economic growth forward as long as their incomes grow enough to support those levels of spending growth.
As we’ll see next, that appears to be the case for the United States—implying that the consumer is still very healthy despite much of the negativity in the media ever since the Great Financial Crisis (2008, 2009).
U.S. Disposable Income
Disposable income, or DPI, is defined essentially as after-income. The official formula for DPI is the following:
DPI = Gross Annual Income – (Payable Taxes + Other Deductions)
Disposable income should not be confused with “discretionary income”, which includes essentials such as rent, insurance, food, and even transportation and other essential living expenses.
As you can imagine, there seems to be wide variability and possible interpretations of what constitutes essential expenses and how those average out across regions and income levels. So, I think DPI is a much easier and more reliable indicator to watch and track for an economy’s development.
Some may argue that higher living expenses mean less consumer spending at places like stores and restaurants, but it’s really not less spending—it’s just spending redirected elsewhere.
For example: if rents and/or mortgages become much more expensive relative to other countries (or even its own history), that’s still money that gets spent to landlords and banks (through mortgage interest). That’s still money that flows into the economy through one way or the other.
Alright, enough arguments about income.
Here’s where the U.S. DPI, or disposable income, has been officially recorded over the last 25 years:
Note how close that the average and median values for DPI are compared to U.S. Consumer Spending. With an average of 4.6% growth per year and 5.3% median, these are very close in-line.
Also, I find it interesting that over the last 10 years, DPI has actually grown more in relation to consumer spending—which suggests an average consumer that is becoming more financially resilient rather than less (again, contrary to the loud voices who scream that the U.S. consumer is dead).
With an average of 4.2% growth and median of 4.6% over the last 10 years in U.S. disposable income, consumer spending over the same time period has only grown an average of 4.0% and a median of 3.8%.
Whether these extra savings convert to better economic growth in the future remains to be seen.
Number of U.S. Businesses
Now we will take a turn to the corporate side, which is my favorite part of the indicators of economic development (in big part because I am an investor).
Like we did with the U.S. consumer, I think it’s prudent to start at the absolute base level first. That base level is in the number of businesses. After all, if there are more businesses in general, that should mean more jobs and more chances of capturing profit from consumer spending.
At the very least, knowing the growth (or lack of) in the overall number of businesses can help when making estimates for the future profitability of companies who live in the b2b (business-to-business) space, for example.
The following chart shows the growth in the number of U.S. businesses over the last 25 years:
America has always been well known for their entrepreneurial culture, and yet I’m still shocked that business growth has outpaced population growth over this time period.
Just another reason to be bullish on America…
With an average growth of 1.6% and median of 1.8% for the number of U.S. businesses, these numbers are almost double the growth of the U.S. population over the same time period and run counter to the argument that the U.S. has gotten less competitive (because of big business), or less entrepreneurial.
Again, interpret the data as you want, but this would be my commentary based on what these charts are showing us.
U.S. Corporate Profits After Tax
Next in-line would be corporate profits, which might be the most important indicator of economic development for investors. After all, one of the best investors of all-time Peter Lynch once said:
“I can’t say enough about the fact that earnings are the key to success in investing in stocks. No matter what happens to the market, the earnings will determine the results.”Peter Lynch
So, increases in corporate profits should directly lead to stock market gains over the long run—which can further be compounded for shareholders by other value adding activities such as dividends, share buybacks, and acquisitions.
Notice how corporate profits (after tax) have been much more volatile compared to the other major economic indicators:
The average growth of 8.9% doesn’t accurately explain actual growth for U.S. Corporate Profits After Tax, in my opinion.
You can see that volatility in numbers can skew the averages. Taking the average of a group of values can be mis-representative because it takes just one extreme data point to disproportionately drag the overall average up or down.
In this case, corporate profits dropped from $1.3 trillion in 2007 to $721 billion in 2008, only to rebound back to $1.4 trillion in 2009. The average of those two growth values, -47.3% and 102.8% comes out to 27.8%, but the actual growth (from $1.3 trillion to $1.4 trillion over 2 years) is closer to 7%- 8%.
So, a calculation of the median of growth numbers gives us a better read on the true growth over a longer period of time—in this case, 5.8% for corporate profits over the last 25 years.
Like with the number of businesses/ lives, it seems that corporate profits have been higher than consumer spending and could continue this way in the future, which would be another bullish tailwind for those companies who sell goods and services b2b.
But, the slowdown in corporate profits over the last 10 years seems to be greater relative to its 25 year history than it was for consumer spending. Also, if the corporate tax rate increases again in the future, this could push profits lower for corporations, which would presumably lower their ability to spend on b2b services through things like capital expenditures.
Gross Private Domestic Investment
Businesses can spend just like consumers can, and this can drive economic development in the exact same way.
One way that this transaction is tracked is through an indicator called Gross private domestic investment.
According to this article, Gross private domestic investment includes replacement purchases (maintenance capex) plus net additions to capital assets (growth capex) and investments in inventories (tracked through changes in working capital on the operating section of a cash flow statement).
This spending by businesses flows through the economy just like consumer spending would, and can be a critical part of GDP for a country (like it was for the U.S. right before the Great Depression).
For the United States, Gross private domestic investment over the last 25 years has been recorded as the following:
Again, values on the extreme end of the spectrum have influenced the average, this time on the lower side. The median for private domestic investment was 6.5%, with a slowdown not as pronounced over the last 10 years of 6.2%.
Notice how these growth figures have been much higher than corporate profits themselves, which suggests that business spending in general must have been fueled, at least in part, by debt.
Corporate debt is one of those indicators that the media loves to scream about, and it does have some bearing particularly for the companies with a lot of it. However, note how private (business) investment was only around $2.8 trillion in 2019, compared to consumer spending $14.7 trillion.
A reduction in corporate investment might not be as detrimental to GDP growth as one might assume, though less corporate profitability would presumably lead to less jobs and thus lower consumer spending.
As it is with all indicators of economic development, it pays to simply observe these metrics rather than try to predict them.
You’d be surprised how economic growth can spring from anywhere, since economies are so interconnected and impossible to predict.
U.S. Government Spending
We could go on and on with economic indicators, but the last major indicator I’d like to discuss is U.S. Government Spending.
This metric particularly surprised me because its value was actually much higher than business investment (gross private domestic investment).
Notice how government spending in 2019 amounted to $7.3 trillion, compared to $21.7 trillion in GDP, $14.7 trillion in consumer spending, and $2.8 trillion in Gross domestic private investment.
That’s also a significant component, and was also fueled in part by government debt (albeit at relatively low interest rates).
How government spending can lead to corporate profits can be through revenues to companies involved with infrastructure, or software development, or aerospace, or any goods or service that the government purchases to perform its duties to citizens.
Note that spending like Social Security does not get included in this calculation (it’s counted as a “transfer payment” instead), but does eventually get counted in Consumer Spending if spent on goods and services.
Bottom line for us, it’s interesting to note that government spending has slowed quite a bit over the last 10 years (median of 3.2% growth compared to 3.9% over the last 25). That represents a close to -20% drop and is much higher than the drop in GDP (close to -10% from the last 10 years to the last 25).
Rather than debate where government spending could go, I think it’s important just to note where it’s been.
Examples of Applying Indicators of Economic Development in Stock Analysis
Since this is a website for beginning investors, it’s time to wrap this up by presenting a simplified case of how this macroeconomic data can be useful in evaluating expectations and valuations.
As a critical part of assessing a company’s valuation with a DCF model, an analyst must create an estimate of future growth for those cash flows.
This economic data can be a fantastic baseline level for those projections, to be adjusted further as you get more familiar with a company’s business model, the growth of the industry it’s in, and its competitive advantages (to steal or maintain market share).
Example: construction company
Let’s say we have a construction company that gets 100% of its revenues from U.S. government contracts for infrastructure projects. My growth estimate might be 6%, from these components:
Government spending = 3%
Share Buybacks = 2%
Market share growth = 1%
Using the simple government spending data we uncovered in this article, I can know how much historically the U.S. has grown their spending, and whether I believe it will be closer to the 10 year average, 25 year average, or higher or lower (depending on other analysis).
The share buybacks create growth because they reduce shares outstanding, which is used for a measurement like Free Cash Flow per Share when expressing Intrinsic Value as a Price per Share.
Example: b2b services company
Let’s say now we have a company that strictly caters to businesses. If they provided cloud services for large enterprises, for example, I’d feel more comfortable using Corporate Profits After Tax averages (since the largest companies contribute to the overall growth much more). My growth estimate for FCF/share might be 9%, because of:
Corporate profits after tax = 6%
Share buybacks = 2%
Market share growth = 1%
But say that my b2b services company concentrated on small businesses rather than enterprise companies. In this case, I might not want to use average corporate profits since small businesses likely contribute such a small portion to the overall country average.
I might want a metric such as the number of U.S. Businesses (to determine volume), and then combine that with inflation (to determine price), and make a growth estimate of 6%, like this:
U.S. Businesses = 2%
Inflation = 2%
Share buybacks = 2%
Now, if the industry that my b2b small business services is growing 2x compared to the overall economy (GDP), then I might double the growth from the U.S. businesses portion of my growth estimate to come up with a total growth estimate of 8%.
You have a lot of flexibility with how you interpret this data and intelligently apply it to valuations, but just use common sense.
I like this data a lot because it helps me conceptualize historical growth and if it’s reasonable for a company to achieve or not. Will a company like Tesla grow 10x over the next 10 years? Sure, if they move from a market share of 2% to 20% they will… But if they’re already at a 20-60% market share like a Honda or Toyota, and the auto industry is only growing alongside consumer spending, it’s hard to justify a 10x valuation for an industry leader in a mature industry.
Combine this U.S.-focused data with economic development data from other countries, and you can get a complete picture of both geographically diversified businesses and U.S.-focused businesses too.