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.
Fool contributor Alex Dumortier, CFA has no position in any stocks mentioned; you can follow him @longrunreturns. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.