The April unemployment report contained something for everyone. For the optimists, the unemployment rate declined to 6.3 percent; 288,000 jobs were added; and February and March payrolls were revised up again (to 197,000 and 203,000, respectively). For the pessimists, the majority of the fall in the unemployment rate was due to a further decline in the labor force participation rate, as more than 700,000 unemployed dropped out of the labor force entirely. Despite the seemingly good employment numbers, job growth is just keeping pace with population growth.
The S&P 500 greeted this news with a yawn – declining slightly for the day. Notably, the S&P 500 has gained only 2 percent since the start of 2014 after skyrocketing by nearly 30 percent last year – making 2013 the best year for U.S. stocks since 1997. Could it be that the U.S. stock market is aging already in what appears to be an economic cycle that just can’t get started? We think the answer is yes.
In our March 2013 Chart of the Month, we showed that since the mid-1990s, stock market cycles appear to be closely linked to economic cycles as reflected in trends in unemployment. After a long secular rise in U.S. stocks from the 1950s through the early 1990s, stocks began to track the U.S. economic cycle with peaks and troughs in stock prices coinciding with highs and lows in the U.S. unemployment rate. The rise in the unemployment rate in the run-up to the financial crisis actually led the peak and subsequent fall in U.S. stocks by about 5 months.
Can we use the unemployment rate to predict stock prices?
In March 2013, with the unemployment rate still at 7.5 percent, we predicted that stock prices would stay at or above their then-current levels for the foreseeable future as unemployment continued to fall. Today, 6.3 percent unemployment appears much closer to its low point for this expansion – suggesting that market volatility experienced thus far in 2014 is signaling less upside for U.S. stocks going forward, no matter what you assume about future unemployment rates (Chart).
In the above chart, we present three alternative views of the unemployment rate that all lead to a similar conclusion. Only in the most aggressive assumptions about falling labor force participation and continued solid employment growth do U.S. stocks rise meaningfully, with gains that total about 15 percent through the end of 2016. In the two other scenarios, the S&P 500 index remains at roughly the level it is today.
The most likely scenario is slow improvement in the U.S. unemployment rate going forward – reflected in our Baseline projection which uses the International Monetary Fund’s most recent unemployment forecast. However, other scenarios are also plausible.
To be clear, these forecasts are not point-by-point predictors of future stock prices. Rather, this approach uses highly correlated monthly stock prices and unemployment data (as a proxy for the economic cycle) based on the last five years and future unemployment projections to estimate the trend in stock markets over the next few years.
Record-high corporate profits, earnings and supportive monetary policy have driven this bull market for five years, while a truly expansionary economic cycle has still yet to engage. As unemployment edges closer to its trough and Fed support dwindles, this analysis suggests that growth could get better but the stock market could move sideways.
When exactly will it begin to move down? Before the last crisis, a decline in labor demand even in the face of decent growth was an early signal. Will it be so again? Only time will tell.
 Data over longer time periods shows parallel movements at peaks and troughs but is not statistically predictive.
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