Are you concerned about avoiding the next true bear market? Want to preserve your capital before the market turns down again? While it's impossible to tell exactly when the next big bear market will start, there are a few fundamental indicators that can help. One of those indicators is the U.S. unemployment rate.
The Relationship Between the Stock Market and the Unemployment Rate
The stock market and the unemployment rate have an inverse relationship. Historical data shows that as the stock market bottoms, the unemployment rate hits its highest point. Conversely, as the stock market tops, the unemployment rate is hitting its lowest point. This relationship shows that anytime the unemployment rate falls below 5% there is a risk of a bear market occurring.
Figure 1 illustrates this relationship perfectly. Around November 1970, September 1973, April 1982, September 2001, and July 2008 the unemployment rate had reached 5% or less. The stock market was topping at those times, and soon crashed. However, in May 1971, January 1976, June 1983, February 2004, and May 2009 stock market was bottoming and recovering even as the unemployment rate peaked.
Why the Stock Market and Unemployment Rate Have an Inverse Relationship.
Bear markets are caused by several factors. The unemployment rate isn't the sole cause of market downturns, but it is a contributor. Here's why.
Labor is one of the largest costs for any business. As the unemployment rate goes down, the labor supply decreases. Businesses are then forced to pay more in salaries and benefits to attract new employees. Once the unemployment rate is below 5%, there are far fewer candidates with all the skills an employer needs in order to fill open positions. So often companies hire less qualified candidates and pay extra to train them.
These increasing labor costs start taking their toll on the companies' bottom lines. This contributes to declining fundamentals for the businesses. The largest pension and mutual funds notice the declining fundamentals. They switch from buying to selling at that point, and the stock market starts to top.
The reverse is true for market bottoms. Companies lay off workers as the markets tumble in an effort to lower costs. The supply of labor increases, resulting in lower costs for businesses to hire skilled employees. This contributes to the recovery of companies' fundamentals. As fundamentals improve, large investment funds start buying stocks again at bargain prices.
What the Unemployment Rate Means for Us Now.
The unemployment rate is 4.7% as of December 2016. Meanwhile, the stock market continues to make new highs. This means the stock market is starting to have a higher risk of correcting. The further the unemployment rate drops, the higher the risk. That doesn't mean that the stock market is going to drop today, tomorrow, or even this year. History has shown that the unemployment rate can drop well below 4% before a bear market commences. There's also usually a period of high speculation before a big market drop. The topping action tends to move the stock markets sideways for a few weeks to months while unemployment continues to drop. So our current bull market can keep going for a while.
So be on the lookout for extreme speculation entering the market. Watch the charts of the S&P 500, Dow, and Nasdaq for severe angles of ascent (greater than 45 degrees) followed by a short sideways action. Or you can watch the charts of ETFs such as SPY, DIA, and QQQ for the same features. Refer to Sean Emory's excellent article "Anatomy Of Market Tops" for more information about topping actions.
Also carefully consider your long term trades (trades lasting a year or more). Bottoming stocks will provide safer opportunities than stocks hitting all-time highs. Make sure to keep your stop losses in place to protect your capital.
It's best to be a little more cautious in your trading once the speculation sets in. Continue to use trailing stop losses to protect profits and be aware that the market could reverse at any time. Don't get caught up in the hysteria of a bull market in its last stages. Invest wisely, and stay aware of the bigger economic picture.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in DIA over the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.