Gross domestic product is an economics term that means the size of an economy. If you added up the value of all of the goods sold and services rendered during a given period of time, such as a month, quarter or year, that’s gross domestic product, or GDP.
The importance of GDP is not the relative size of one economy vs. another (though it can be used that way) but its relative change over time. An economy that is growing will have a larger GDP number at the end of a quarter or year than the quarter or year before. The change is expressed as a percent, as in “3% GDP growth.”
The growth of the economy is important because corporate earnings are dependent on spending by individual consumers, other companies and governments. If the economy shrinks, spending tends to draw back. If GDP grows, earnings are likely to grow too.
Rising earnings fuels rising demand for stocks and thus rising stock prices. Any investor interested in putting cash to work in a given economy, large or small, is concerned with how fast the economy can grow in the future.
Faster growth means a quicker rise in corporate earnings, feeding demand for stock. Rising earnings also contributes to steady and rising dividend payments, income from stock investments.
The monetary authority in a country attempts to foster GDP growth by making sure that credit is available and priced responsibly. As money enters the economy it is put to productive use by corporations, building plants and creating jobs, while consumers tend to borrow for homes and cars.
So long as gross domestic product is reasonably steady, that process of lending, receiving interest and reinvestment creates jobs and thus incomes. A virtuous cycle sets in, of which steady GDP growth is a sign.
Small economies, say in the developing world, can grow very quickly but also can exhibit more volatility, growing more or less quickly as consumers and corporations adjust to new opportunities and money.
The largest economies grow more slowly in percentage terms but those percentage point changes represent far larger numbers of sales, services and goods consumed.
When gross domestic product slows or goes into reverse, investors can panic and sell off stocks. Long-term investors, however, often take those momentary sell-offs as an opportunity to increase their position in an investment at lower prices.
It’s very hard to take a single data point on GDP and extrapolate from that a trend or meaningful reason to invest or divest from any given company or country. Like with most indicators, taking a single number in a vacuum can lead to mistakes.
Nevertheless, because changes in growth can affect short-term investor behavior many people pay attention to it just the same.
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