How Unemployment Affects the Stock Market
On the first Friday of every month, the U.S.Bureau of Labor StatisticsreleasesitsNon-Farm Payroll Reportat precisely 8:30 AM Eastern Standard Time, giving American stock markets exactly one hour to digest and interpret the new information before the exchanges open for trading. Contained within this report is the official government estimate of the nation’s unemployment rate, which is the most eagerly anticipated economic figure for Wall Street, Main Street, and the policymakers in Washington D.C. to form judgments regarding the relative health of the U.S. economy.
The monthly ritual mostly becomes an exercise in expectations that are generated, and then repeatedly reset, by a constantly evolving consensus estimate of so-called“blue-chip” economiststhat offer their forecast on the strength of the nation’s labor market.
The unemployment figure is known as a “backward-looking indicator”, meaning the data is a representation of events that have already taken place in the economy, rather than a prospective figure such as the federal budget for the next fiscal year, or a transitory gauge like interest rates that can potentially fluctuate each trading day. This leads to the anachronistic game of economists predicting a result that has already occurred weeks earlier when the U.S.Labor Departmentcollected a sampling of data from private and public organizations across the country regarding changes in the size of their payrolls, the number of state unemployment claims filed, and the number of hours worked each week by employees. Additionally, surveys are conducted to canvas the environment of people who are not currently working to determine if they are able to work and seeking a job. Students, job seekers who are already employed part-time, the disabled, and those who have stopped actively looking for employment are excluded from the unemployment calculations.
Economists end up attempting to quantify a qualitative condition that is filled with subjectivity and inconsistencies, which are powerfully illustrated by the fact that the Bureau of Labor Statistics itself uses an elusive deflator known as the “seasonal adjustment”, and often issues multiple revisions of figures from its own previous monthly Non-Farm Payrolls reports. While neither the estimates nor the results are an exact science, the unemployment rate itself carries enormous importance for the performance of the stock market in several key ways.
The first principal effect of unemployment on the stock market is in the flow of new capital into equity shares and investment funds. When employment is relatively high, the increased number of people working creates greater inflows to retirement accounts, pension funds, and mutual funds through automatic payroll deductions. The larger pool of capital available forinstitutional money managersis what drives stock market performance more than any other single factor, as more investment capital chasing a higher rate of return inevitably impacts risk tolerance and the price of equities.Institutional fundsmust put capital to work for their clients, and the increased inflows each week to these funds as a result of more people receiving paychecks that allocate a certain percentage to their 401k fund, self-directed IRA account, or an organization’s pension fund, means there will be that much more money circulating into the financial markets.
Larger pools of savings and investment generated by more people having steady jobs often have the effect of keeping interest rates low, which in turn attracts more capital to the stock market as the lower risk-free rate of return makes the present value of discounted corporate earnings have much greater appeal. Conversely, when unemployment is high, there is significantly less money flowing into retirement and investment funds, leaving institutional money managers with the task of most effectively distributing their existing portfolio compositions to adjust for the relative scarcity of the dwindling inflows.
The stock market relies heavily on the ability of institutions to bring fresh money into the bidding for equity shares in order to propel the market benchmarks to greater heights. Rather than allocating an abundance of new capital into the stock market, fund managers must cope with the reality of a lack of savings and investment money circulating into institutional accounts when unemployment is high.
One of the most obvious effects of unemployment on the stock market is the impact of less aggregate discretionary income for consumers, and the consequences this condition creates for corporate profits. Clearly, when consumers have less money available to purchase homes, automobiles, luxury goods, and big-screen televisions because of a job loss in a family or related labor market difficulties, eventually the companies in these industries will feel the results in their bottom line earnings. Travel, tourism, entertainment, and the dining industries are all equally vulnerable to the challenges of high unemployment as consumers lack the disposable incomes to take vacations and indulge in extravagant leisure activities.
The bright spot for the stock market under these circumstances is for stocks in companies that produce consumer staples and provide essential services like health care. These defensive sectors of the equity markets tend to outperform the broader market during times of relatively higher unemployment, as investors search for the safety of companies with steady revenues that are less affected by the struggles of ordinary consumers coping with tight household budgets.
Several other impacts of unemployment have a bearing on the value of the stock market. A few indirect correlations between labor and corporate profit performance exist, as well as the effects of the dynamic on both large industrial behemoths and smaller growth companies. For example, during periods of relatively high unemployment, unit labor costs are typically held down or at least remain steady. This helps large corporations by reducing one of their most expensive cost components, which is labor. For multi-national corporations that can retain top-line revenue results, the steadiness or even decrease in costs related to skilled labor, selling, general, and administrative expenses can provide a growth in earnings through savings in these key expenditures. In a far different way, smaller growth companies benefit from high unemployment and lower labor costs by being able to attract and retain higher skilled workers that ordinarily might have been lured away to larger and more established corporations offering them far higher compensation.
High unemployment results in job seekers taking greater risks with smaller organizations, which offers those growth oriented companies a higher level of talent and experience then they would ordinarily have available to them. This can potentially have an enormous transformational impact on certain smaller growth stocks in fields such as technology and communications that are reliant upon recruiting superior talent to expand and develop their business enterprises. Indeed, some of the most successful technology companies in U.S. business history, titans like Microsoft and Apple, were born during times of austerity and high unemployment.
The greatest effect of unemployment on the stock market is the subjective and unquantifiable sense of the direction the economy is heading in. The psychology of investors is all-important for stock market performance, as several instances in recent history have shown. During the late 1990’s when the economy was reportedly nearing full-employment with an unemployment rate around five percent, the stock market was soaring with an effervescent bubble of euphoria. From late 2007 until the financial crisis struck in the autumn of 2008, the unemployment rate was increasing each month as the stock market’s value continued to deteriorate. Both of these conditions were driven by the psychology of market expectations in the minds of investors. The most important effect on the stock market is the perceived rate of change in the labor market, and what direction unemployment is moving in.
