The Bull Market’s Dangerous Illusion

It's hard to bemoan a bull market, but there's reason to believe that we should. Since the last major correction in the summer of 2011, during which the S&P 500 (SNPINDEX: ^GSPC  ) lost 17% of its value over the course of a month, the broader market is up by 46%. While this is great for anyone who holds stocks, as I and most of our readers do, it's fueled a dangerous illusion of economic prosperity that simply isn't reflected in the underlying economy.

How many times over the last few months have you read about the need for the Federal Reserve to begin tapering its monetary support for the economy? Chances are, a lot. The mainstream financial media can't seem to go a day without postulating if and when the central bank will begin reducing its monthly purchases of long-term treasuries and mortgage-backed securities that are designed to drive down borrowing costs and spur employment.

What's causing this angst? The only reasonable explanation is the media's unhealthy obsession with the daily, weekly, and monthly fluctuations in the stock market. This pressure has built up so much, in fact, that the chairman of the Fed, Ben Bernanke, felt obligated to address the impact of monetary policy on asset prices in a recent speech titled "Monitoring the Financial System."

Of course, the Fed has always paid close attention to financial markets, for both regulatory and monetary policy purposes. However, in recent years, we have both greatly increased the resources we devote to monitoring and taken a more systematic and intensive approach, led by our Office of Financial Stability Policy and Research and drawing on substantial resources from across the Federal Reserve System. This monitoring informs the policy decisions of both the Federal Reserve Board and the Federal Open Market Committee as well as our work with other agencies.

But here's the problem: for legitimate reasons, the stock market has gotten ahead of the underlying economy. The reason is that rising corporate profitability has been fueled, in large part, by expense cuts. Over the last few years, for instance, few companies have failed to announce large-scale labor reductions. Proctor & Gamble announced plans last year to lay off 10% of its workforce. Around the same time, Pepsico did the same, targeting a 3% reduction of its headcount.

With this in mind, nothing demonstrates the decoupling of stock prices from the underlying economy better than the condition of the labor market.

Has unemployment been improving? Absolutely. Since peaking at 10% in October of 2009, the official unemployment rate has come all the way down to 7.5%.

But there are two problems with this. In the first case, even though 7.5% is markedly better than 10%, it's still way too high. To put this in perspective, the average rate of unemployment since the end of World War II is 5.8%. The standard deviation, within which two-thirds of all individual observations lay, is 4.1% to 7.5%. Consequently, not only is the current rate nearly a third higher than the long-run average, it just barely falls within the first standard deviation.

In the second case, there's reason to believe that even the 7.5% figure dramatically understates the actual employment situation. This is because the official rate only takes into consideration people who are both unemployed and currently looking for a job. That is, it excludes people who can only find part-time work, and those who have given up on the job hunt altogether. Once these people are included, the rate skyrockets to 13.9%.

Now, I know what you're saying: it isn't the Fed's responsibility to make sure that people have jobs. Well, actually, yes it is. Under the Federal Reserve Act of 1913, the central bank is legally obliged to "maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates."

The point here is that we're doing ourselves a grave disservice by using the ongoing bull market as a guide for monetary policy. Are stocks too high right now? Yes -- at least in my opinion they are. Is the Fed partly to blame for this? Yes. But the more pressing issue is unemployment and, in the absence of robust fiscal stimulus, the only feasible weapon we have to deploy against this scourge is monetary policy.

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  • Report this Comment On June 01, 2013, at 6:15 PM, brenoboyle wrote:

    Unemployment is at best a lagging indicator for the stock market and the economy, it doesn't tell you when to buy stocks.

    Look at the beginning of the last secular bull market. From Jan-1982 until Jan-1983 the Dow went up 22% and the unemployment rate went up 14%.

    Likewise in the last recession the market hit bottom in Q1 2009 and the unemployment rate only started to drop one year later.

    That's not to say that it isn't too bad that so many people are unemployed. But feeling sorry for them and selling stocks because of it isn't going to make either you or them any richer.

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