GDP figures misleading

Friday saw the first pass at estimating U.S. GDP for the fourth quarter and the number looks outstanding. GDP grew 5.7% in the fourth quarter.

Analysis: To put that 5.7% figure into perspective you need to know that on average GDP grows around 3% +/- 1.5%. That is, GDP usually ranges between 1.5% to 4.5% growth. So a figure of 5.7% is massive growth. However, that 5.7% growth is utterly bizarre in its composition as most of that growth came from businesses investing massive amounts of money in expanding their inventories. In fact, that contributed 3.4% of that 5.7%, or 59.6% of the GDP figure! Remember that GDP is calculated as: Consumer spending + Investment by businesses (including in inventory) + Government spending + Xports, net…or C + I + G + X = GDP. Normally, the allocation of GDP amongst those four broad categories is as follows:

C = 65-70%
I = 10-15%
G = 20-30%
X = -5%

Obviously the business investment category I, normally is the smallest positive contributor to GDP at between 10-15%. So for I to have contributed 60% is 4x its normal contribution. In other words, this GDP figure is an anomaly. And what we are concerned about as investors is a return to strong, consistent, well-balanced and predictable economic growth. So a GDP figure that clearly defies normalcy deserves some scrutiny. So why did business investment grow so damned much in the fourth quarter?

The recession just ended really negatively affected the U.S. consumer. Typical recessions happen when businesses get overly enthusiastic and start investing their excess profits (i.e. cash) in new investments whose returns are either negative or non-economic. So the direct effects of recession typically affect businesses hardest. That usually results in layoffs as businesses try and adjust their corporate structures for a return to profitability. In the recession just ended the inefficient allocation of excess profits was largely done by the financial services industry (the mortgage underwriters) and home builders. The more important of the two was the financial services industry as they are effectively the heart of the economy and money is the blood. The financial services industry pumps the money throughout the economy. But in this case, the horrible products sold by the mortgage underwriters directly affected consumers because most of the bad products were sold to us. So when real estate prices returned to earth, the finance industry choked off new money flows – especially credit, this freaked out consumers and businesses which both stopped spending money; triggering a cascade of near doom.

When consumers stopped spending money, in the face of tight credit and gigantic layoffs, it caused retailers to build up massive amounts of inventory. In other words, consumers weren’t buying goods that had already been manufactured and that were just sitting on retail shelves. So businesses didn’t want to manufacture new goods until the old ones sold. This led to a big drawdown in excess inventories over the first 3 quarters of 2009. This brings us to the Fourth Quarter.

Businesses, in need of restocking empty shelves and probably gambling that the Holiday season would be robust, boosted inventories. Unfortunately for U.S. businesses, consumer spending did not match the inventory increase. This is also captured in the Fourth Quarter GDP figures. Consumer spending contributed 1.4% of the 5.7% increase. This figure is clearly less than the 3.4% figure contributed by businesses boosting inventories. Which brings us to the most important point…

This Fourth Quarter GDP figure, and especially its composition, is a one-time anomaly that won’t be repeated.

GDP growth from here on out cannot be driven by an inventory rebuild on the part of businesses. The fact is that consumers have to start buying those goods. And what would cause them to do that? You guessed it, if the unemployment situation started improving then consumers would start buying stuff again. In the meantime, economic growth is going to have to rely upon something else. And I don’t know what that ‘else’ is. And that makes me a little nervous.

In conclusion, its my opinion that we are likely to see GDP growth going forward that more closely approximates the 2.2% figure that ‘consumer spending’ contributed in the fourth quarter. In other words, it’s going to be a slow crawl out of the recession.

As investors, this is a time to identify outstanding businesses (note: I didn’t say stocks) that are dominant in their space. These businesses should be managed well as indicated by how they did in the recession relative to their peers. You can figure this out by looking at their operating profit margins relative to their peers. The operating profit margin figure can be found on most financial information websites, like Yahoo finance. If you have identified a great businesses managed by smart people then you want to pay an appropriate price for a share of ownership of that business. Shorthand for an appropriate price is P/E ratios of between 10-20x. The lower the P/E the cheaper the business. An alternative to that is companies whose growth rates exceed their P/E ratios – the so called PEG ratio. If you find just the PEG then it should be less than 1.0. That figure is also available from financial info sites. But refer back to my excellent piece of the dangers of relying on the PEG as there are many, many distortions. But sans selling you a book about how to value a business this is the best I can do in a blog posting.

Importance grade: 10; the GDP figure rates as a 10 because it is indicative of an unhealthy U.S. economic patient that is still in recovery mode from a severe sickness. So today’s GDP figure is very important in the context of: “are we out of this thing?” And the answer is: “not yet.”

I hope that each of you has an excellent, rejuvenating weekend!

Jason