The Unemployment Rate And The Stock Market
The U.S. Unemployment Rate has moved down to 3.9%, its lowest level since December 2000. If you ask the average person on the street what that means for the stock market, they would likely say it’s a bullish sign. What does it actually mean? Let’s take a look…
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Data Source for all charts/tables herein: FRED, Bloomberg, Robert Shiller
We have data on the Unemployment Rate going back to 1948. Breaking the data up into quintiles, we observe the following:
- An inverse relationship between level of unemployment and forward stock market returns. In the current quintile (2.5% to 4.4% unemployment), the average S&P 500 return over the following year is 5.6% versus and average of 12.7% in all periods. The best returns historically have come after periods of high unemployment.
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- Lower odds of a positive S&P 500 return with lower unemployment rates. In the current quintile (2.5% to 4.4% unemployment), the S&P 500 has been positive 64% of the time over the following year versus 79% in all periods.
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What’s driving this counterintuitive relationship? Valuation. On average, lower unemployment rates tend to be associated with higher valuations and vice versa.
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Why? Because when there’s good news in the economy (low unemployment), people are willing to pay a higher multiple for a given level of earnings than when there’s bad news (high unemployment). That’s important when it comes to stocks because higher valuations tend to be associated with below average forward returns.
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Note: Above table uses CAPE Ratio.
In January, the S&P 500’s valuation hit the 97th percentile, higher than every period in history with the exception of the late 1990s and early 2000s.
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Historically, the combination of higher valuations and lower unemployment has been unfavorable for stocks, with negative returns on average over the following 1-year through 5-year periods.
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Does that mean that the S&P 500 has to go down from here? No, these are just probabilities and tendencies; there are always exceptions.
But it does mean that investors probably shouldn’t view a low Unemployment Rate as a bullish sign for stocks. The evidence seems to suggest that the opposite may be true.
Disclaimer: At Pension Partners, we use Bonds as our defensive position in our absolute return strategies for all of the above reasons. Bonds have provided a more consistent defensive alternative to ...
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