Friday, January 8, 2016

The December Jobs Report And Stock Market Returns At 5% Unemployment

From the Wall Street Journal/briefly:

The Numbers 
December Jobs Report

  • JOBS

    U.S. employers added a seasonally adjusted 292,000 jobs in December, well above economists’ expectations for a gain of 210,000 jobs. Nonfarm payrolls for the prior two months were revised up by a combined 50,000–employers added 307,000 jobs in October and 252,000 in November. Job creation in 2015 didn’t match that of 2014—the best year for employment growth since 1999. For all of 2015, the economy added an average of 221,000 jobs per month, below the 260,000 averaged in 2014. But last year was the second-best since the turn of the century with solid December hiring. The latest stretch of job gains has run for 63 consecutive months.

    The unemployment rate was unchanged at 5% in December for the third month in a row, and the number of jobless people was “essentially unchanged” at 7.9 million, the Labor Department said. The headline number has fallen sharply from a 10% peak during the recession. Economists surveyed by The Wall Street Journal had expected the jobless rate to fall to 4.9%. The unemployment rate was last below 5% in November 2007.

And something we've had in the link-vault for the last couple weeks. From ZeroHedge, Dec. 25, 2015:

Wall Street's Most Prominent Former Permabull Is Worried About Just One Number
One upon a time, back in early 2012, David Rosenberg was a prominent bear and deflationist, while his nemesis, Wells Capital's Jim Paulsen, was one of Wall Street's biggest equity bulls. The confrontation between the two culminated with a January 2012 article explaining "What (If Anything) The Bulls Are Seeing."
Since then, Rsoenberg infamously flip-flopped to bullish (predicting incorrectly that wages would rise and TSY prices would tumble), while Jim Paulsen, almost exactly a year ago, threw in the permabull towel and warned on January 10 of 2015 that "stocks are massively overvalued."....

.... So now that the 1 year anniversary of Paulsen's cautious - and accurate - forecast is almost upon us, is the Wells strategist back to bullish mode, or is he even more cautious?
The answer, according to this latest letter, depends on just one number: 5%, the so-called "full employment" threshold. Paulsen says that "not only have stock returns proved much less robust once the unemployment rate has reached 5%, but sector leadership has also undergone a fairly radical change."

In the world of fiction, the most famous threshold may be that of 88 miles per hour. In the non-fictional world of economics and finance, however, an even more important threshold is that of 5% unemployment. At that moment everything changes.
Jim Paulsen explains.

During most of the post-war era, the economy was considered to be near full employment once the unemployment rate declined to between 4% to 5%. Reaching full employment marks an important shift in the economic cycle. Once slack in the economy is no longer excessive, further economic growth begins to pressure resource prices and other business costs, inflation risk increases, interest rates typically rise, and policy offi cials begin to lessen or reverse accommodation.

Chart 1 illustrates the U.S. unemployment rate. Since 1948, the unemployment rate has been at or below 5% (i.e., at full employment) only about one-third of the time. Most of the sub-5% labor markets were either prior to the 1970s or since the mid-1990s. Many compare the contemporary era of low inflation and near-zero interest rates with the 1950s and as this Chart illustrates, a sub-5% unemployment rate during the balance of this recovery seems likely to be yet another similarity.
Since the unemployment rate recently neared 5%, wage inflation has shown signs of quickening providing the underpinnings last week for the first Fed funds rate hike in this recovery. The contemporary recovery has seemingly reached full employment and if history is any guide, stock investors should be prepared for some key changes during the rest of this bull market.

Full employment changes the stock market
Exhibit 1 illustrates the performance of the overall U.S. stock market and its individual sectors during the post-war era when the unemployment rate was above 5% compared to when full employment was reached. The data for this comparison and the sector indexes (the defi nitions of the sectors are shown in Exhibit 2) are from the extensive Kenneth R. French data library. It has market capitalization weighted indexes which include all U.S. stocks on the NYSE, AMEX, and NASDAQ since 1948.

The charts in Exhibit 1 are based on average annualized total returns derived from all monthly data since 1948 comparing returns when the unemployment rate was above 5% to returns when the unemployment rate was 5% or less. Chart 1 shows that nearly every stock sector (except energy stocks) posts significantly lower returns once full employment is reached compared to when the unemployment rate is above 5%. Indeed, the annualized return of the overall stock market is 50% lower once full employment is reached and many sectors (e.g., Chems, Shops, Durable, Other, and NoDur) produce returns which are only about one-third of what they are when the unemployment rate is above 5%.

Chart 2 illustrates that full employment brings new challenges for the stock market. Continued economic growth typically produces cost-push pressures eroding profit margins and infl ation and interest rates usually begin to rise. Although full employment does not necessarily end a bull market, as Chart 2 shows, it does tend to signifi cantly lower future stock returns.
Charts 3 and 4 illustrate that full employment also typically brings a leadership change in the stock market. Chart 4 ranks the annualized sector returns in the post-war era when the economy was at less than full employment while Chart 3 shows the ranked sector returns once full employment is reached. Several points are noteworthy. First, before the economy reaches full employment, returns across the stock market are much higher compared to when the economy is at full employment. Overall, the annualized U.S. stock market total return averaged about 15% when the economy was at less than full employment compared to only about 7% once full employment is reached.
Second, the dispersion of sector returns within the stock market widens considerably once the economy reaches full employment. Before full employment, the stock market sector return diff erential is only 4.27% (i.e., from Chart 4 the difference in annualized returns between the best performing sector NoDur and the worst sector Utils is 4.27%). However, the sector return differential widens considerably to 9.31% once the economy operates at full employment. When the unemployment rate is above 5%, the most important investment theme is to be overweight the stock market. Individual sector or stock picking is less important (because sector/individual stock return dispersion is low) compared to the overall asset allocation decision. However, once at full employment, sector or stock picking prowess becomes much more important. Return dispersion tends to widen improving the potential to add signifi cant alpha from sector/individual stock selections.