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Unemployment Rate and Stock Market Returns

June 6, 2018 • Posted in Economic Indicators, Equity Premium

The financial media and expert commentators sometimes cite the U.S. unemployment rate as an indicator of economic and stock market health, generally interpreting a jump (drop) in the unemployment rate as bad (good) for stocks. Conversely, investors may interpret a falling unemployment rate as a trigger for increases in the Federal Reserve target interest rate (and adverse stock market reactions). Is this indicator in fact predictive of U.S. stock market behavior in subsequent months, quarters and years? Using the monthly unemployment rate from the U.S. Bureau of Labor Statistics (BLS) and contemporaneous S&P 500 Index data for the period January 1950 through April 2018 (820 months), we find that:

The following chart compares the behavior of the unemployment rate and the S&P 500 Index (on a logarithmic scale) based on monthly data over the entire sample period. Visual inspection suggests a mostly inverse relationship between the two series, but no obvious lead-lag.

For a closer look, we relate the change in unemployment rate (simple difference) to future stock market returns.

The following scatter plot relates next-month S&P 500 Index return to monthly change in the unemployment rate (released near the beginning of the month) over the entire sample period. The Pearson correlation for the two series is 0.04 and the R-squared statistic 0.002, indicating practically no linear relationship between the two series.

Since 1990, the Pearson correlation is -0.08 and the R-squared statistic 0.006, again indicating practically no linear relationship.

In case there is a material non-linearity, we calculate average future stock market returns by range of changes in the unemployment rate.

The next chart summarizes average next-month S&P 500 Index returns by ranked fifth (quintile) of monthly changes in the unemployment rate over the entire sample period and since 1990. There are 164 (68) observations per quintile for the entire sample period (since 1990). Non-systematic variations across quintiles and inconsistencies across subperiods undermine belief in any useful relationship between changes in the unemployment rate and future stock market returns at a one-month horizon.

Might the relationship between change in the unemployment rate and stock market return be stronger over some longer measurement/forecast interval?

The next chart plots correlations for various lead-lag relationships between quarterly changes in the unemployment rate and quarterly S&P 500 Index returns over the entire sample period and since 1990, ranging from stock market return leads change in the unemployment rate by eight quarters (-8) to change in the unemployment rate leads stock market return by eight quarters (8). Results suggest that:

  • A relatively strong (weak) stock market indicates a decrease (increase) in the unemployment rate over the next year or so.
  • Over the entire sample period, an increase (decrease) in the unemployment rate weakly suggests a stock market advance (decline) over the next year or so. Since 1990, this slight indication disappears.

A possible interpretation is that the stock market tracks/anticipates and the unemployment rate lags general economic activity.

For indications of the strength of the latter contrarian indication, we look at quarterly and annual scatter plots.

The final two scatter plots relate next-quarter (upper chart) and next-year (lower chart) S&P 500 Index returns to quarterly and annual changes in the unemployment rate over the entire sample period.

  • For quarterly intervals, the Pearson correlation for the two series is 0.07 and the R-squared statistic 0.01, indicating a slight positive relationship.
  • For annual intervals, the Pearson correlation for the two series is 0.20 and the R-squared statistic 0.04, indicating a positive relationship with changes in the unemployment rate explaining about 4% of next-year stock market returns.

Results suggest that a big jump (drop) in the unemployment rate is a little good (a little bad) for future stock market return at annual horizons, but the scatter plot exhibits high dispersion.

In summary, evidence from simple tests offers no support for a belief that monthly changes in the U.S. unemployment rate usefully predict next-month U.S. stock market returns. Over longer horizons, there is some support for belief that a strong increase (decrease) in the U.S. unemployment rate is good (bad) for the U.S. stock market over the next year or so.

Cautions regarding findings include:

  • The sample is not very long in terms of number of economic cycles.
  • Analyses are in-sample. An investor operating in real time would not have access to data for the entire sample period and might draw different conclusions.
  • Since unemployment rate releases occur after the end of the month by one to a few days, there is some mismatch between employment growth rates and stock market returns as calculated above. This mismatch could affect the statistics.
  • Unemployment rate data used above is as-revised rather than as-released. BLS consistently revises recent data and sometimes revises longer-term data to reflect changes in methodology. The effect of revisions on statistics could be material.

This analysis does not rule out the possibility that surprises in the unemployment rate, relative to some measurable expectation, usefully forecast stock market returns in accordance with conventional wisdom at a monthly horizon.

See “Employment and Stock Market Returns” for a closely related investigation.

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