big red flag for the stock market

This is one of those scenarios where the "good news is the bad news"! Howard R. Gold is a MarketWatch columnist and founder and editor of GoldenEgg Investing, and he wrote a great column on economic implications of low employment rate.

Last week, the Labor Department reported that in March, the official unemployment rate hit 4.5%, the first time that’s happened in 10 years.

That’s good news, of course, because it means the economy is approaching what economists call “full employment.” (I’ll discuss some of the caveats later.)

But ironically, in one of the market’s many good-news-is-bad-news scenarios, it’s also a big red flag for the economy and stocks. Because since 1948, when the Bureau of Labor Statistics started reporting unemployment data, a rock-bottom unemployment rate has been an excellent indicator of upcoming recessions and a very good warning sign of corrections and bear markets ahead.

A market correction is commonly defined as a decline of at least 10% in the S&P 500SPX, -0.28% ; a bear market generally connotes a decline of 20% or more.

The civilian unemployment rate is the percentage of the total labor force that is at least 16 years old and not in school, prison or the military, is jobless, and actively looking for a job.

The table below, which I compiled from BLS stats, the National Bureau of Economic Research (the official scorer of U.S. recessions), and respected Wall Street research firm Yardeni Research, shows the months the unemployment rate hit its low for that cycle, then the dates at which the next recession and bear market began.

Recessions and bear markets follow low unemployment rates
Date of cyclical lowLowestDate of onset of Months toDate of onset of  Months to
unemployment rateratenext recessionrecessionnext bear marketbearmarket
October 20064.4%December 200714October 9, 200712
April 20003.8%March 200111March 24, 20000
March 19895.0%July  199016July 16, 1990*16
May 19795.6%January 19808November 28, 1980**18
October 19734.6%November 19731Bear market ended in October0
September 19683.4%December 196915November 29, 19682
June 19595.0%April 196010January 3, 1962***31
March 19573.7%August 19575July 15, 19574
May 19532.5%July 19532July 15, 195750
January 19483.4%November 194810June 15, 19485
Sources: Bureau of Labor Statistics, National Bureau of Economic Research, Yardeni Research
*The S&P 500 index declined 19.9% from July to October 1990, which Yardeni Research classifies as a correction
**The S&P 500 also corrected 17.1% in February-March 1980.
***The S&P 500 also corrected 13.6% from August 1959 to September 1960.

There were 10 times since 1948 when the unemployment rate hit a cyclical low. The lowest unemployment rate ranged from 2.5% to 5.6%; the average low was 4.1%. Each time, the cyclical low unemployment rate was followed by a recession from one to 16 months later. The average gap between that cycle’s low unemployment rate and the onset of a recession was 9.2 months.

Bear markets also followed low unemployment rates regularly. The nasty bear market of 1973 ended the same month unemployment hit its cyclical low. In March 2000, the bear market began the same month unemployment hit its low of 3.8%. It took more than four years for a full-fledged bear market to follow the cyclical low unemployment rate of 2.5% in May 1953 (though a recession ensued a mere two months later and there were two corrections of nearly 15% in between, according to Yardeni Research). On average, it took nearly 15 months for a bear market to follow a recession, though there was much more variation here.

This means that when unemployment rates get to their low points in any economic cycle, it’s time to start looking for the exits.

There are some obvious issues in using this as an investing strategy, however.

Just as economists find it notoriously difficult to predict recessions (the NBER “calls” recessions only after they’ve begun), so it’s hard to know when the unemployment rate has actually bottomed until after it’s happened.

And the low unemployment rates can continue for a long time. Unemployment fell below 4% in February 1966, but it took more than 2½ years for it to bottom at 3.4%, where it stayed for eight months. In 2006-2007, it hovered in the mid-4% range for more than a year even as a housing bust and financial crisis loomed.

However, a low unemployment rate now may not be what it used to be. Automation and globalization have displaced millions of workers in their prime years. That and an aging population—10,000 baby boomers turn 65 every day—have dropped workforce participation to 63%, way down from a peak of 67.3% in February-March 2000 (around when unemployment bottomed at 3.8%).

Federal Reserve Chairwoman Janet Yellen discussed that in a Q&A at the University of Michigan on Monday. “Some of the decline in labor force participation might reflect a weak economy and be a kind of hidden unemployment,” she said. “We recognize that the unemployment rate itself might be a misleading indicator of the extent of slack in the labor market.”

That could mean the unemployment rate would have to fall further than in the past before we hit what economists call “full employment.” Or that this is the best we can expect.

We won’t know that until later on. But for now, the economy is still growing only around 2%, and frothy post-election sentiment is not yet showing up in the hard data. Meanwhile, the Fed is likely to raise short-term rates at least a couple more times this year, and is even preparing to shrink its $4.5-trillion balance sheet.

So, investors are counting on strong earnings and, especially, “pro-growth” measures from the Trump Administration and Congress to keep the eight-year-old bull market going.

That looks increasingly unlikely as the Trump agenda smashes into the rocks of Washington’s reality. If we’re approaching the rock-bottom low in unemployment this cycle, that’s one more sign we’re much, much closer to the end of this long economic recovery and bull market than to the beginning.

Source: Market Watch