Stock prices, which are normally considered a leading indicator of cyclical change, do much better in anticipating recoveries than recessions. We see the U.S. stock market as fragile and increasingly vulnerable to a downshift in employment.
Lower employment gains and a rise in the unemployment rate could spell an unwelcome catalyst to lower stock prices. We explored the leading relationship between the unemployment rate and stock price in a September 2015 Commentary, U.S. Stock Prices: How Low Can They Go?, in which we signaled the U.S. stock market was a buy.
In that Commentary we concluded that the 2015 pullback in stock prices was temporary because the unemployment rate was still declining. We projected that should the unemployment rate fall to 4.5 percent, the S&P 500 would rise to 2,400, which is about where both indicators are today.
Now, with the unemployment rate near an all-time low and payroll growth slowing, we believe that stock prices are vulnerable to an uptick in the unemployment rate. Since 1990, the unemployment rate has been tightly linked to the level of stock prices as measured by the S&P 500. An increase in the unemployment rate would spell lower stock prices (Chart).
While stock prices lead unemployment in recoveries, an unemployment upturn tends to lead stock price downturns at peaks. Recent trends in recession indicators point to a pending reversal in unemployment, and hence a prospective decline in stock prices. These trends are consistent with the discussion of financial risk and the notion of a U.S. reset/recession.
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