The stock market is brutal. How else can you explain that the best returns for stocks have historically occurred when unemployment is at its highest?
Think about that. When the economy has been at its absolute worst, stocks have historically seen their best performance. When the general feeling in the ether is of doom and gloom, all difficult conversations and silence around the dinner table – that’s when the best returns have been had. And we wonder why the investment industry doesn’t enjoy wholehearted love from the public.
I can take a punt at a couple of reasons as to why this has happened, some of which we discussed in the first episode of our new podcast, Taking Stock - After The Bell – which you can watch/listen to if you are so inclined.
First of all, companies seem to regard layoffs as a last resort and therefore it usually takes a while for unemployment to rise in economic slowdowns. By the point that it does, typically a lot of damage has already been done to the economy and in the stock market. In other words, a pretty miserable future has long since been discounted by investors, and future expectations are already low.
When expectations are lowered, so typically are valuations. And while valuation is not always your friend in the short term - paying less for stocks definitely provides a tailwind when investors realise that the economy will not be in the gutter forever, and a brighter future is coming. This realisation usually occurs before unemployment peaks.
Another theory, which is slightly more uncomfortable to sit with, is that layoffs help corporate margins. People are one of the major costs in any business and reducing this has a material impact on the bottom line, which helps earnings and by extension share prices. We can see recent evidence of this in the positive share price reactions to tech companies announcing lay-offs – a theme which I expect to continue. We have moved from a “growth at any cost” environment, to one of capital discipline. Even Facebook seem to have found God.
There is an even more depressing theory, that at times of high unemployment those who remain in a job will “work harder” in order to ensure that they remain employed. Increased productivity leads to increased revenues and earnings for companies. I’m not sure that I fully subscribe to this, not least because I’m unsure there is a catch all method for measuring “hard work” (less time spent on BBC Sport maybe) – but I do think that the recent shift in the balance of power to labour, away from capital, will revert somewhat if we continue to see the economic environment worsen. Just keep an eye on how full the trains into town are.
Market moves in the short term can be totally removed from economic progress - something we have seen regularly in the past - and it can be confusing for many of us to get our heads around in real time. Certainly, intuitively, you would not expect stocks to do best during times of high unemployment – but there we are.
To look at how the performance of the stock market relates more generally to the economy, I asked Billy to dig out similar numbers for the performance of the S&P, this time categorised depending on the rate of US GDP (how quickly the US economy is growing).
We can see that for stocks, the ideal economic environment seems to be the “goldilocks” scenario – not too hot, and not too cold. Stocks tick along just fine unless the economy is overheating, or in recession. It is easy to see why low growth environments or recessions are bad for stocks – there is likely to be less demand for goods and services, and earnings come under pressure. But when the economy is overheating, input costs tend to rise and margins can come under pressure if your customers aren’t prepared to pay up for what you’re selling.
Luckily for us as investors, most of the time, the economy sits in the middle ground. Extreme outcomes in either direction are, by definition, the outlier.
The even better news is that over the long term the progress of the stock market tends to converge with economic progress. Long-term economic progress, like human progress, is forwards. As investors, all we do is make sure our capital is along for the ride.
Have a great week.
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