As the consumer goes, so goes the economy." That's the thumping refrain that most economists and financial gurus overwhelm us with every time the economy dives into a funk.
Divining consumer spending for insight into the direction of the economy appears plausible: Personal consumption expenditures doe, after all, account for 70 percent of gross domestic product. No wonder, then, so many professional investors graph the trend in monthly same-store sales at Wal-Mart (NYSE:WMT - News), fret when Home Depot (NYSE:HD - News) misses a quarterly revenue estimate, or wonder if Ford (NYSE:F) is selling fewer F-150s.
But this focus on the consumer and his spending habits is misplaced. The fact is, consumer spending trends consistently higher for the most part, and has been trending consistently higher since the second quarter of 2009.
The above graph raises an obvious question: If consumer spending has recovered why hasn't the economy recovered? The question is legitimate; we've been inculcated on the precept that economic lethargy reflects consumer lethargy, but consumers are obviously not lethargic.
Unbeknownst to many investors, economic activity extends far beyond final consumption. When gross domestic product is calculated, the statisticians at the BEA purposefully focus on final consumption to avoid double-counting. That's not the most accurate measure of economic activity though.
Financier Mark Skousen developed a technique that I find helpful for developing a more inclusive picture of the economy: he adjusts GDP to include business spending. By Skousen's calculations, based on sales receipts and gross business receipts compiled by the IRS, consumption represents only about 30 percent of total spending, while business investment (including intermediate output) accounts for over 50 percent.
GDP growth estimates have been revised downward a few times over the past two years, and I've long suspected weak business investment was the cause. Private business investment, which has only recently begun to show signs of life, remains far off the rate of private investment before the start of the 2008-2009 recession.
In short, the economy continues to struggle not because of a decline in consumer spending nor because of a lack of government spending (which has also increased) but because a very important driver of economic growth - private business investment - remains depressed.
This concept of business investment driving the economy runs counter to much of what we read in media accounts and what we are taught in college. But the fact that business drives consumption and economic growth is a concept French economist Jean-Baptiste Say forwarded 200 years ago.
Say's law is simple and logical - production drives consumption. It can't be any other way. You can't demand what doesn't exist. A hundred years ago, no one demanded a Boeing (NYSE:BA - News) jetliner; 10 years ago, no one demanded an Apple (NASDAQ:AAPL - News) iPhone. Entrepreneurs and businesses create demand and drive the economy forward by developing these products; additional production can be undertaken only by increasing capital investment today, thus increasing consumption and economic growth tomorrow.
Because all consumption is predated by production, I keep a close eye on private investment, new capital expenditures (as opposed to maintenance expenditures, which simply maintain the status quo), and productivity.
The good news is that pockets of strong private fixed investment and growth persist: namely in information technology and in computer and peripheral equipment. I'll be more convinced of the sustainably of a long-term recovery if I see more private investment in sectors where business investment has been weak: manufacturing, transportation equipment, and beleaguered residential real estate.
So, keep a close eye on business investing, because production and investment leads us into and out of recessions, and a farther eye on consumer spending.
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