Should Investors be Frightened by Rising Unemployment?
In recent weeks the growing unemployment rate has garnered a great deal of attention from members of the financial press in addition to stock market investors. In an attempt to ease the collective nerves of these individuals I published an article “10% unemployment: A Remarkable Signal for Stocks,” which revealed that over the last 40 years the stock market has performed exceptionally well after unemployment has peaked.
Unfortunately, my article failed to touch on the performance of the stock market prior to the peak in unemployment. With unemployment still on the rise some readers had doubts about the near term prospects of the stock market. So how has the stock market performed prior to the peak in unemployment? Surprisingly stocks are more profitable prior to peaks in unemployment then they are after!
Stock Market Performance Prior to Peaks in Unemployment
Many will be shocked to learn that the stock market has actually performed better right before the peak in unemployment the then it has right after the peak. As illustrated in the table below, the short term time frames before the peak in unemployment all substantially outperform the periods after the peak. Contrary to popular belief, there is actually a lower risk for stocks near unemployment rate peaks (indicated by the green arrows) then there is during unemployment lows (indicated by the orange arrows).
Why does the Stock Market Perform Better Prior to the Unemployment Peak?
On several occasions I have mentioned leading, coincident, and lagging indicators; and their ability to help anticipate changes in financial markets and the economy (see 3 Crucial Economic Indicators). The key reason why stocks yield strong returns prior to the peak in unemployment is because unemployment is a lagging economic indicator and will only start to improve months after the stock market (leading indicator) and economy (coincident indicator) have recovered. In fact, if you analyze all the economic data since WWII unemployment peaks (on average) 9-12 months after the stock market bottoms.
Now let us take a look at how these economic indicators relate to the current financial landscape. In the beginning of the year the Fed dropped their target rate to a historic low of .25%, which remains at that same level today. In March, the U.S. stock market formed a significant bottom and continued to advance with little resistance throughout the year. Recently we received even further confirmation of the economic recovery from the third quarter GDP growth rate, as it expanded at a better then expected rate of 3.5%. The next logical step in the economic sequence is to see improvement in employment numbers and other lagging economic indicators.
What Does this All Mean for Investors?
Only after a confirmation of the peak in unemployment will the Fed decide to raise the federal funds rate and begin to slow down the growth of the economy. As of today, the Fed is still several months away from beginning to raise rates. In keeping with business cycle history, the Fed’s loose monetary policy has led to stock market strength prior to the peak in unemployment.
As you can see the unemployment rate alone is clearly not a valid reason for investors to be sitting on the sidelines during this ongoing cyclical bull market. In contrast, the current unemployment numbers suggest that investors should expect higher stock prices in the months ahead.
Thank you for reading and I look forward to writing more articles in the future! As always, please feel free to contact me should you have any questions or concerns regarding the website.
-Jim
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