Despite the robust post-COVID recovery, economic components throughout the U.S. have experienced significant softening this year. Inflation is primarily to blame. Household savings rates have fallen. Corporate earnings have declined. As a result, many investors and economists fear a looming recession.
This is common. You can pick any point in time and find someone predicting the next great crisis. There will always be those that peddle doom and gloom, painting our future democratic nation as one of destruction and ruin. (Not surprisingly, these are the same individuals that are quick to sell you a Gold IRA or a ‘guaranteed’ income annuity. I rank them lower than car salespeople but higher than thieves. Barely.)
However, there IS a looming recession. The data supports it. Leading economic indicators signal a 90% probability that a moderate recession will begin within a few months.
Is it all doom and gloom, as many pundits are predicting? I don’t think so. The severity of a decline in leading indicators usually dictates the severity of a recession.
Yes, these indicators are declining, but they have yet to decline substantially. This recession looks to be a moderate recession (think early 1990s-style recession and not 2008 or 2020).
The Tea Leaves
We are already starting to see the signs. High-growth companies sensitive to tighter economic conditions are beginning to cut nonessential staff. Oil prices have fallen, despite the ongoing Ukrainian invasion. As we talked about a few months ago, housing prices are falling.
Remember, a recession is deflationary. As consumer demand wanes, so does the price of goods and services (think back to your Econ 101 class). We believe that we are starting to see the effects of this throughout many different sectors of the economy (Read why we think inflation is falling here).
Labor: Last Man Standing
The last man standing in the economy is labor. For most of 2022, the labor market has been the lone bright spot in an otherwise bleak economy. We think this will change as the Fed’s war against inflation is finally starting to break the labor market.
If we look at the labor market indicator, a composite index of labor leading indicators, we can see a downward trend. (Data as of Oct 2022)
The Labor Market Indicator is not quite at recession levels, though it is trending that way. The question is whether or not it will continue to drop to recession-warning levels. We do not know, but we will know soon.
Buy Stocks When Unemployment Is High
How will layoffs impact stocks if we assume that layoffs will accelerate soon? I have heard from many individuals that they do not want to invest in stocks until “the storm has passed.” This is a typical response we see from investors, but it is not the right one.
Waiting until the labor market is strong again may make one feel better about putting their capital at risk, but the data is pretty straightforward; deferring your investments until the storm clouds have passed is a pretty lousy strategy.
This may seem counterintuitive, but stock returns are far greater following record-high unemployment than following record-low unemployment.
This is because the unemployment rate is a lagging indicator, whereas the stock market is a forward-looking indicator. Stocks are usually beat-up when the unemployment rate is, signaling better valuations.
Additionally, stocks are very quick to recover, given the slightest positive news. We saw this in March 2009 (Citigroup shows a profit) and March 2020 (Moderna vaccine high efficacy rate), and we will continue to see this behavior during future crises.
Of course, the unemployment rate is nowhere near a record high, though it is starting to rise. The unemployment rate was 3.7% in Nov. vs. 3.5% in Sept. Unemployment claims are also starting to increase, a clear sign that companies are beginning to reduce their headcount as they anticipate (or realize) slower-than-expected revenue growth.
If we were to look at the unemployment rate throughout history, it has peaked above 7% eight times and subsequently bottomed-out below 5% eight times. (Note that I have excluded the 2020 recession as there is not enough data to pull five-years worth of stock returns afterward.)
So, how does the market perform after a bottom in unemployment vs. a peak in unemployment?
|Stocks Avg. Return After Unemployment Bottoms||25.3%|
|Stocks Avg. Return After Unemployment Peaks||72%|
Five years after a bottom in unemployment, the S&P 500 returns a 25.3% average return. Not bad. However, compare that to a 72% average return over the next five years after unemployment peaks.
Always Looking Forward
This makes sense because the stock market is always attempting to price in the future. It is always forward-looking.
If the unemployment rate is high, then the stock market has likely also suffered a significant decline. This also means that the stock market is a lot cheaper, ensuring that future returns are higher. The stock market is sure to rally when the economic outlook doesn’t become quite bleak.
The hard part as an investor is knowing when this will happen. Where the bottom is. Here is a tip: Don’t try to time it. It is a near-impossible task.
Rather, just stay invested. If you have extra cash on the sideline, put that money to work, especially if the unemployment rate is high. Your expected returns are much higher than they would be otherwise.