Why Higher Unemployment Is Good for Stocks

The bulls are running! Despite -- or, perhaps, due to (see the explanation below) -- a headline unemployment figure that ticked up to 7.9% in January from 7.8% the previous month, investors sent the S&P 500 (SNPINDEX: ^GSPC  ) and the narrower, price-weighted Dow (DJINDICES: ^DJI  ) up 1% and 1.1%, respectively. Both indexes set new five-year highs. That optimism was reflected in option prices, as the VIX Index (VOLATILITYINDICES: ^VIX  ) dropped 10%, to close below 13. (The VIX, Wall Street's "fear gauge," is calculated from S&P 500 option prices, and reflects investor expectations for stock market volatility over the coming thirty days.)

A lesson from the roaring 90s
To understand what happened in the market today, it's useful to revisit the mid-1990s, back to 1996, the year of the Atlanta Olympics. On July 5, 1996, the Bureau of Labor Statistics released employment data for the previous month that was unexpectedly strong. Nonfarm payrolls rose by 239,000 – nearly double the consensus forecast. That brought the unemployment rate down to 5.3%, from 5.6% the previous month. Average hourly wages increased by $0.09 -- equivalent to an annualized growth rate of 10%. The economy was in rude health.

How did the stock market react? The day the report was released, the S&P 500 declined 2.2%; by July 24th, the fall had extended 7.8%. Why would stocks drop in the face of data that demonstrated economic strength? Because investors anticipated the Federal Reserve would respond by raising interest rates -- a tightening in monetary policy.

Today looks like a mirror image of that mechanism: As the unemployment rate ticked up, investors concluded that potential interest rate increases would be pushed farther out in the future. Logically so, since the Fed explicitly tied interest rates to the unemployment rate in December, saying that it will maintain a zero interest rate policy as long as unemployment remains above 6.5%. Loose monetary policy for a longer period spurs investors to pay higher prices for risk assets, QED.

That's the logic laid bare, but it raises the issue of the dependency of the stock market rally on monetary munificence, and highlights the risk that the Fed will not unwind it as successfully as they deployed it. Bottom line: Stay focused on underlying fundamentals, on valuations, and expect increased price volatility over the short-term.

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  • Report this Comment On February 02, 2013, at 11:13 AM, elHalcon wrote:

    If the stock market follows Fed interest rate policy, what happened in 2008 and 2009 when the Fed was busy expanding the money supply to bring down interest rates and the stock market was busy going down the toilet? The answer is that the stock market responds to interest rate policy among other factors and depending on the other factors, Fed interest rate policy may or may not be associated with market swings. In 2008-09, investors were watching as the American economy disintegrated with job losses of 800,000 per month. At that moment, they didn't care what the Fed did. They wanted out.

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