Unemployment Rate and Stock Market Returns (Backtest And Statistics)

What is the relationship between the unemployment rate and stock market returns?

This is a somewhat confusing and not-so-straightforward relationship. Thus, in this article, we try to investigate the unemployment rate and subsequent stock market returns.

Is the unemployment rate an essential determinant of stock market returns?

Yes, the unemployment rate is an essential indicator of the health of any economy. When the economy is good, profits tend to increase and vice versa.

When the unemployment rate is high, the economy (and society) is not producing enough jobs. Long periods of high unemployment bring down purchasing power and, thus, profits.

Opposite, when the economy thrives, companies hire more people, salaries might increase, and purchasing power might increase.

Unemployment and consumer spending

However, the relationship between unemployment and stock market returns is probably not as straightforward as we like to believe.

There are two reasons for that: the unemployment rate is a lagging indicator, and the stock market always looks into the future. A high unemployment rate today is yesterday’s news! That means a recession might already be discounted when it happens.

Stock market returns are determined by a myriad of factors, and it’s not easy to break down cause and effect. If it were, it would be easy to make money.

Unemployment and consumer spending

As a rule of thumb, high unemployment hurts consumer spending. Thus, companies make less money, and they might hire fewer people. Furthermore, they might look to automate tasks to save money, and productivity might increase.

Eventually, when we hit a cyclical bottom, profits rise because productivity has increased, and rising profits might make management hire more people (again).

As you might imagine, the economy goes in cycles.

Why is the stock market going up when unemployment is high?

This has happened in the past, and this doesn’t look right for many.

But the reason is simple: the financial markets look ahead. If they believe the economy will improve in the coming months, they drive up share prices, even though the current unemployment rate is increasing.

Unemployment rate and stock market correlation

We downloaded monthly unemployment data and compared it to S&P 500. We looked at the monthly unemployment rate and compared that to the closing price of S&P 500 that month. However, the unemployment rate is usually reported on the first Friday of the month, which is at least three weeks before the closing price of that month (in the stock market). Thus, there is a “lag” in our backtest.

Let’s make some backtest to find out what the correlation is like. The chart below looks at correlations between the unemployment rate and S&P 500 for six months, 12 months, 18 months, and 24 months:

The correlation is, on average, low. This is expected because the financial markets look ahead.

For example, the green line is the 24-month correlation, and it’s usually low. Not shown in the chart is that the long-term correlations ( 18 and 24 months) have gradually gone down since 1960.

Unemployment rate and stock market returns

Let’s run some backtests to look at how stocks perform depending on the level of unemployment.

(We looked at the monthly unemployment rate and compared that to the closing price of S&P 500 that month. However, the unemployment rate is usually reported on the first Friday of the month, which is at least three weeks before the closing price of that month (in the stock market), thus, there is a “lag”.)

Let’s start with backtest 1:

Unemployment rate and stock market returns – backtest 1

We make the following trading rules:

• When the unemployment rate crosses ABOVE its 12-month moving average, we go long S&P 500 at the close of the month.
• When the unemployment rate crosses BELOW its 12-month moving average, we sell S&P 500 at the close of the month.

Since 1960 there have been 32 such crosses, and the equity curve looks like this:

The chart above shows that the profits have been mediocre: annual return is only 1.5% (invested around 35% of the time). This means that the reverse strategy has performed much better:

Unemployment rate and stock market returns – backtest 1

We flip the trading rules:

• When the unemployment rate crosses BELOW its 12-month moving average, we go long S&P 500 long at the close of the month.
• When the unemployment rate crosses ABOVE its 12-month moving average, we sell S&P 500 at the close of the month.

As expected, the strategy improves:

The annual return/CAGR is 5.2%. We don’t know what happened in 1985, but clearly, the strategy improved from then on. Part of the result can be explained by the fact that the economy is spending more time in an expanding phase rather than contracting (invested 65% of the time).

Do the results change depending on the length of the moving average? No. The results are pretty good as long as the unemployment rate is falling.

This means that stocks perform the best when unemployment goes down.

What stocks go up when unemployment goes up?

The backtests above show that future stock market returns are better when the unemployment rate is below its moving average.

But is it sectors on the market that show solid returns when unemployment increases?

We looked at many indices and ETFs, and we concluded that very few stocks go up when unemployment increases.

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FAQ:

Why is the unemployment rate considered an essential determinant of stock market returns?

The unemployment rate is a crucial economic indicator. When high, it signifies economic challenges, impacting consumer spending and corporate profits. However, its direct correlation with stock market returns is not straightforward due to factors such as the lag in reporting and the stock market’s forward-looking nature.

How does unemployment affect consumer spending and stock market dynamics?

High unemployment typically hampers consumer spending, leading to reduced corporate profits. However, the impact is nuanced. Companies may respond by cutting costs, improving productivity, and eventually, when the economy improves, hiring more people. The economy operates in cycles, and stock market trends consider these factors.

Why does the stock market sometimes rise when the unemployment rate is high?

The stock market often looks ahead and may rise even during high unemployment if investors believe in future economic improvements. Market trends are influenced by various factors, and the stock market may anticipate positive changes, leading to higher share prices despite the current economic challenges reflected in the unemployment rate.