Is A Low Unemployment Rate 'Great News' For Stocks?

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by: Charlie Bilello

We've come a long way, baby.

In October 2009, the U.S. Unemployment Rate stood at 10%, the highest level since the deep recession in the early 1980's. Since then, it has moved all the way down to 4.7%.

Payrolls have now expanded for 77 consecutive months, by far the longest streak in history.

With economic news improving, the pundits are out in full force declaring "this is great news for the stock market."

Seems intuitive, but is that actually the case? There's only one way to find out: test it.

We have data on the Unemployment Rate going back to 1948. If we break down the rate into quintiles what we find is an interesting relationship with forward stock returns.

As you can see in the tables below, the highest Unemployment Rates have been followed by the strongest returns on average, and the highest probability of a positive return. Conversely, the lowest Unemployment Rates tend to be followed by below average forward returns and a lower probability of a positive return.

What's driving this relationship? Valuation. On average, lower unemployment rates tend to be associated with higher valuations and vice versa.

Why? Because when there's good news (low unemployment), people are willing to pay a higher multiple for a given level of earnings then when there's bad news (high unemployment).

That is important because on average, the higher the valuation, the lower the forward return.

That's not to say that stocks can't do well following low levels of unemployment. They certainly can and have done so in the past. In fact, the all-time low in the Unemployment Rate was in 1953 (at 2.5%), after which stocks had an annualized return of 17.7% over the next 7 years. But stocks were very cheap in 1953 with a CAPE ratio of only 11.6. Today's CAPE ratio of over 29 is not a fair comparison.

If we take all of the data points with an Unemployment Rate of 4.7% below and break them into two groups, one with a CAPE ratio above 20 and the other with a CAPE ratio below 20, we find a clear dichotomy. The group with a CAPE ratio below 20 actually outperforms the average from all periods while the group above 20 underperforms by a wide margin.

So is a 4.7% Unemployment Rate "great news" for the stock market? It would be hard to say that it is because that low Unemployment Rate today is coinciding with high valuations. That doesn't mean it has to be bad news (stocks are still positive on average), it's just not nearly as good for stocks as a high Unemployment Rate.

For the layperson I understand that's not intuitive, because we're often told the stock market is the economy. But as we learn time and again, it is anything but. By the time the Unemployment Rate rises to a level that concerns people again, stocks will likely be much cheaper than they are today. When that happens it will be "great news" for stocks but it won't feel great at all because the news will be bad. Until that time, let's just say the lower Unemployment Rate is great news for anyone who has found a job, and leave the stock market out of it.