I frequently talk to people who look at the rising unemployment rate and conclude that we're still in a recession and that things aren't getting better. I understand why people connect the job market to economic health, but the fact is that rising unemployment doesn't say anything about where the economy is headed tomorrow or when to invest in stocks. This is one of those counter-intuitive thoughts that makes sense once you "get under the hood" and understand the facts. After you read this article you'll be a smarter investor.
"Unemployment" is emotional.
It's easy to understand why people connect the job market to economic health. It's the most visible and emotional manifestation of a recession. People everywhere are stressed about the possibility of getting downsized, right-sized, furloughed, or laid off. When people lose jobs, you feel it. When our co-workers or neighbors lose their jobs we see their stress and we start to worry about our own job security, and how we'll pay our mortgages. The truth is that unemployment and economic health are related - but you have to look at the correct reports to really know how the economy is doing today, and where it's headed tomorrow.
Look what's happening today, not three months ago.
The unemployment figure that gets all the media attention is the monthly Employment Situation, announced generally on the first Friday of every month by the U.S. Department of Labor (today they announced it at 9.8%). Two of the most important statistics in this report are the unemployment rate and the net change in non-farm payrolls.
What people don't know, including most of the journalists who write about it, is that both of these statistics are considered lagging indicators. The unemployment rate rises during the recession and peaks near the end or even after the recession has ended, as shown in the chart below:
The green bars represent time periods during a recession. The red dots show where the unemployment rate was at the beginning of the recession and the blue dots show where unemployment was at the end of the recession. Note that in every recession shown here, unemployment grew worse throughout the recession, and in a number of cases it continued to rise even after the recession was over! Even though we're still seeing new layoffs the recession may actually be over.
The non-farms payroll report suffers from other lag problems. It gets revised 3-4 times before it's finalized. One of the more insightful economists I follow is Bob Dieli at nospinforecast.com. He says this:
"Non-farm payrolls have sharp edges and they should not be touched while they are in motion. As Bob Uecker famously said about catching a knuckleball: 'let it roll to the backstop and pick it up.'"
In other words, don't pay too much attention to the numbers for at least three months - what a lag!
For investors who panicked and sold stocks earlier, this poses a serious dilemma. The stock market typically moves up before the actual recovery - it tends to anticipate the good news, just like it peaks and heads downward prior to the beginning of a recession. So if you wait for the job market to recover before you invest in stocks, you've probably missed out on the biggest profits. According to Ned Davis Research, about half of the profits are gained in the first one-third of the recovery, which means long before the layoffs end.
So if these economic indicators don't tell us what we need to know, which one does? Keep reading to find out.
A better indication of what the job market is doing
My favorite indicator to tell me what the job market is doing today is the initial claims for unemployment, released every Thursday, which tells us how many new people applied for unemployment insurance. The current chart follows:
There are two bits of good news in this chart. First, layoffs have been slowing for several months, and this is the first step before a real turnaround can occur. Second, according to Liz Ann Sonders, Chief Investment Strategist for Charles Schwab & Co., we have never in the past seen new claims drop by this amount while we were still in a recession. If the pattern continues today, this means the recession may have already ended, although we haven't yet heard an official announcement from the National Bureau of Economic Research.
Leading indicators, such as initial unemployment claims, tell us where the economy is today and give us a better clue about where it's headed in the future. The unemployment rate and the non-farm payrolls report are lagging indicators. If you want want a faster and more accurate view of how the job market is fairing, watch for the initial claims report every Thursday morning. You'll be much more confident about how the economy is doing and you'll be a smarter investor.