If I told you that the unemployment rate was 11.1%, GDP was down -5%, personal income was down -4.2%, what would you think would happen to stocks? Most people would assume stocks would be lower. And most people would be wrong.
In a blog post titled, “The Unemployment-stock Market Correlation in One Chart”. Chris Preston presents a chart that shows the nearly perfect inverse correlation between stock performance and the rate of employment in the U.S. for the last 30 years. While this is not anything new, it is important to study historical data to get an idea to see in which part of the cycle we currently find ourselves in.
Stocks & Unemployment
COVID-19 has made this cycle unique in many ways, but the same in others. I believe the correlation between unemployment and stocks is still relevant, and future returns are tied to future unemployment numbers. Even though many believe stocks are supposed to be lower, and we can debate how much lower they should be, I think the market is focused on the expectation of future employment numbers, even more than the balance sheet of the Federal Reserve.
The reason why stocks have managed to continue to trend higher is not because of Fed manipulation, (although that is definitely a factor), it is mainly tied to unemployment and future expectations of the rate of employment in the country. Preston says, “as 30 years of history on this chart tells us, stocks won’t continue to rise unless the unemployment rate continues to fall sharply, considering how historically high it remains. Only a falling unemployment rate translates to rising share prices.”
So far, the bulls have been right. Economic data has gone their way. The unemployment rate went from 14.7% in April down to 11.1% in June. If you tracked that movement on a chart, stocks dropped more than 34% prior to the peak in unemployment back in March. This coincided with the top in stocks in February, which was also near the bottom in unemployment at 3.5%. Since we all know stocks are forward looking, this makes perfect sense. Therefore, I try to focus on the bigger picture and try not to get caught up in short term volatility and news cycles.
Bottom Line, stocks are neither undervalued, nor over-valued right now. I believe valuation does not matter for the moment. All investors are focused on is resumption of economic activity and how that will look from now on. The unemployment rate continues to be a significant indicator of future stock performance, but it is a lagging indicator, and stocks will often move before the unemployment numbers are published. The best thing we can do is invest in stocks if the unemployment rate continues to trend lower. Once the rate stabilizes, it will be time to get selective. For now, it is best to Buy weakness and sell into strength. That has worked all throughout this crisis. I do not expect that to change anytime soon.